Note: Mark Astarita was the legal columnist for Research Magazine from 1995 to 2000. This column was the first in of 5 years of monthly articles.
By now, you’re probably aware of Spring Street Brewing’s successful initial public offering completed last year. The company conducted a self-underwriting almost entirely on the Internet and then commenced trading of its securities on its Internet World Wide Web site.
In March of this year, the Securities and Exchange Commission (SEC) asked Spring Street to cease the trading activity, but then permitted Spring Street to resume trading with certain stipulations including the provision that a registered broker/dealer handle actual transactions. The text of the Commission’s letter to Spring Street that set forth the conditions is available on the Internet at https://www.seclaw.com/docs/secwit.htm.
Spring Street’s so-called “Internet Offering” piqued the interest of investors and entrepreneurs, many of whom believed they found the holy grail of small stock offerings. Spring Street’s trading mechanism swelled the hopes of many investors looking for liquidity in small, lesser-known issuers.
The entire episode has also raised concerns in the brokerage community. Aspects of the Spring Street event point to a potential for decreased revenue on the underwriting side of the business as well on the retail side, with talk of a future without underwriters and without commissioned salesmen and exchange fees eating into investor profits.
Is that the lesson of Spring Street? Probably not. Underwriters play an extremely important role in the offering process, and the Internet will assist underwriters in conducting offerings by providing an extremely economical and effective means of disseminating news to the investment community. The importance of an underwriter will be revealed as other companies attempt to follow Spring Street’s lead. They will find that the skills that make a successful entrepreneur do not necessarily make a successful underwriter.
That lesson is already being learned by a group of entrepreneurs who are in the process of attempting an “Internet Offering.” Internet Offerings have not, thus far, been the success that the small business owner had hoped. While investment bankers might find other reasons for the lack of success of an Internet Offering by a startup company (or of any offering for a startup, for that matter), finding investors in these companies is going to be as difficult as it was without the Internet or perhaps even more so. While the Internet and the World Wide Web offer a tremendous audience of potential investors, far more than any “traditional” issuer effort, entrepreneurs are finding that the added exposure only provides a higher number of investor rejections.
The reason should be obvious, but is apparently being lost in the hype. Companies that need the benefits of the varied exemptions from registration that form the basis for “Internet Offerings” (such as Regulation A and the SCOR offering) are going to have the most problems raising capital. Aside from not being able to afford the underwriter’s fees associated with an offering, these companies cannot attract an underwriter in the first instance. The majority of investors and underwriters are looking for companies with a proven track record of sales, and hopefully, profits. If the prospective public company had a track record of sales and profits, it would not need the exemption and would proceed with a traditional underwriting. But the same reasons that these companies cannot attract underwriters is the reason that they have trouble with the SCOR or Internet offering they simply do not have the fundamentals that will attract investors.
Moreover, these exemptions require the company to sell their own securities themselves. This creates a double whammy an offering commenced by inexperienced “brokers” in a company with no fundamentals.
Therefore, the Internet Offering is only going to be of marginal value to the issuer community. It may be useful for the successful company that needs to raise less than $5 million and is willing to take on the additional burdens of placing the offering. However, an issuer fitting that description is going to be rare.
Will the approval of Wit-Trade, Spring Street’s bulletin board-based stock-trading mechanism have an effect on the industry? Although the concept initially appears to be an intriguing method of eliminating brokers, commissions and exchanges, a deeper look proves otherwise.
Unlike Internet Offerings, Internet-based trading mechanisms may provide new services to the investment community and new opportunities to the brokerage community. The Internet already has proven to be an excellent medium for the dissemination of information to the investment community. Internet-based trading may enhance this by improving liquidity and providing timely market information to investors of the smaller-cap companies.
Systems such as Wit-Trade certainly offer investors the potential for greater liquidity in the securities of small issuers. Even so, the process is fraught with potential danger for investors and issuers. The potential for manipulation of the market in a issuer-based bulletin board system cannot be overlooked. These securities are extremely illiquid, with a small float, and easily controlled by a small group of people. Information available on these securities, such as trading history, time and sales information, is scarce, and there is no specialist or market maker acting to stabilize the market. This creates, in turn, a huge potential for fraud and investor losses.
There is also a potential problem for the users themselves. Users of such a system quickly will realize that they can simultaneously post bids and offers on such a system, thereby capturing the “spread” for themselves. Mini-market makers? Potentially, but the federal securities laws would undoubtedly require such a user to become registered as a “Dealer” (defined in Sec.3(a) of the Exchange Act as “any person engaged in the business of buying or selling securities for his own account…”). Rather than offer liquidity, such systems may well offer the opportunity to be named in an SEC action.
And although it appears from the Commission’s letter that Wit-Trade initially intended to handle customer funds itself, this certainly would violate the broker/dealer registration requirements of the Exchange Act, as noted by the Commission. Therefore, the Commission suggested that Wit-Trade be modified, eliminating the company’s control over investor funds. Instead, independent agents will handle the financial aspects of the system.
An additional issue arises as to whether these trading systems will be deemed an “exchange” for purposes of the Exchange Act. Although the SEC did not address the issue in the Spring Street letter, registration as an exchange may be required in certain scenarios. The Exchange Act defines an “exchange” as “any organization, association or group of persons… which constitutes, maintains or provides a marketplace or facilities for bringing together purchasers and sellers of securities…”.
All these potential problems may provide opportunities for the broker/dealer who takes advantage of the new technology. Broker-dealers may be able to economically handle the financial aspects of a issuer-based trading system and thereby increase its own exposure to the Internet investment community. Creation of a new Internet-based exchange may provide previously unknown potential for small-cap companies as well as the broker/dealers who assist them in their financing efforts.
Both aspects of the Spring Street scenario the offering and the trading provide a glimpse of the future and demonstrate the wide application of the Internet to the most traditional financial transactions, such as underwritings and brokerage services. Whether the financial community makes good use of this potential remains to be seen.
Mark J. Astarita, Esq., is a partner in the New York City law firm of Sallah Astarita & Cox, LLC. He represents financial professionals in a wide variety of matters, including customer arbitrations. He can be reached at or by e-mail. This article originally appeared in the June 1996 edition of Research Magazine.
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