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Securities Registration: The SEC Cracks Down on Directed Share Programs

Directed share programs have come under increased scrutiny by the SEC, and the improper administration of these programs has resulted in ugly prospectus disclosure related to possible securities law violations. Early advice and oversight can help to avoid problems that are hard to solve later.

In recent months the SEC has been closely scrutinizing the administration of directed share programs in public offerings. A directed share program permits an issuer to direct a portion of the shares sold in an underwritten public offering to persons of its choosing rather than those identified by the underwriters. SEC examiners have been making routine verbal and written requests to issuers during the review of registration statements seeking information about how the issuer's directed share program was conducted. The answers to seemingly innocuous requests can lead to severe consequences: issuers are conceding that the administration of their directed share programs may have violated federal securities laws, ugly risk factor disclosures are appearing in prospectuses about potential liabilities, underwriters have agreed to indemnify issuers and the other underwriters against potential liability and several directed share programs have been abandoned altogether. These consequences have resulted from the SEC's view that the administration of many directed share programs violates Section 5 of the Securities Act of 1933 (Securities Act) because issuers and underwriters are making unlawful written communications to solicit interest in the securities. This article draws attention to these Securities Act issues and offers some guidance as to what issuers, underwriters and their respective counsel should be thinking about when administering a directed share program.

Directed Share Programs

Directed share programs have become a fairly common feature of public offerings, particularly IPOs where no prior public market for the shares has existed. The lead underwriter usually agrees to administer a directed share program as a service to the issuer. It is typical for the underwriter to reserve up to five percent of an offering and to permit the issuer to designate as many as 500 or more individuals to receive the opportunity to purchase shares. The program is a valuable tool for issuers, who use it to involve directors, officers, employees, suppliers and other business partners in the public offering process in the hope of giving them a stake in the issuer's future success. A list of recipients of directed shares is drawn up by the issuer's senior executives and provided to the underwriter administering the process. Generally, the directed shares are freely tradable securities, and they are not subject to the underwriter's lock-up agreement. Directed shares are not gifts of the issuer's shares. They are purchased by the persons named on the list at the time of the offering at the same price per share that is offered to the public. The sales are underwritten, and the same spread is paid to the underwriters on directed shares as on the other shares sold in the offering.

Traditionally a directed share program has been almost de minimis in its impact on the distribution of an issuer's securities. The numbers of shares are small, and if they are "flipped" (i.e., resold immediately into the trading market), the directed shares wind up in the hands of traditional purchasers. However, some issuers are beginning to use directed share programs to take a stronger hand in deciding who their initial public shareholders will be. For example, the underwriters of the IPO of Internet Capital Group, Inc. ("ICG") agreed to reserve almost 30 percent of the shares being offered so that ICG could directly offer its shares to business associates. As a directed share program becomes a larger portion of an offering, the SEC may request additional disclosure of program on the cover page of the prospectus notwithstanding the plain english rules which limit extensive cover page disclosure. This would be in addition to the customary disclosure in the "Underwriting" section.

The Securities Act Pitfall

The legal basis for the SEC's recent crackdown on directed share programs arises from potential violations of Section 5 of the Securities Act. Section 5 makes it unlawful during the "waiting period" (the time after a registration statement is filed and before it becomes effective) for a person, directly or indirectly, to communicate in writing an offer to sell a security other than by way of a prospectus meeting the requirements of Section 10(a). Section 2 of the Act contains a broad definition of a prospectus, extending to "any notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security". Section 10(a) requires the prospectus to contain almost all of the information contained in the registration statement. The prospectus delivery requirements of Section 5 are strict in that during the waiting period any written communication that does not meet the disclosure standard established by Section 10(a) - even if accompanied by material that meets Section 10(a) - is prohibited.

The principal exception to the Section 5 prohibition on writings other than a statutory prospectus is found in Rule 134. Rule 134(a) excludes from the definition of a prospectus written communications that do no more than state the name of the issuer, the type of security, a brief description of the business, the price of the security, the name and address of the sender of the communication, the names of the managing underwriters, the expected date of the offering and other more technical statements. Rule 134(b) requires that the communication be accompanied by a specified legend. Rule 134(b) also requires that the written communication must state whether the security is being offered in connection with a distribution by the issuer or by a security holder, or both, and whether the issue represents new financing or refunding or both, and the name and address of a person or person from whom a prospectus may be obtained. However, Rule 134(c) provides that the Rule 134(b) information need not be included if the communication is accompanied or preceded by a prospectus, or does no more than identify the security, state the price, state from whom a prospectus can be obtained and state by whom orders will be executed. The Rule 134(a) exception is relied on by issuers in almost every public offering because it provides the legal basis for the issuance of a press release announcing the filing of a registration statement.

Potential participants in a directed share program could lawfully be provided with a copy of the Rule 134(a) press release for an offering, but a complying press release would lack necessary practical and logistical details. The fact that the individual is being invited to participate, the permitted level of participation and the mechanics of how to accept the invitation all fall outside what is permitted in a Rule 134(a) communication. These details could lawfully be communicated orally, but that might be cumbersome, particularly if hundreds of people are being invited to participate. Fortunately, Rule 134 has an answer to the problem of written solicitation presented by a large directed share program. The solution requires different steps than those used in a press release, however. Pursuant to Rule 134(d), the written solicitation is permissible, but only if it is accompanied or preceded by a prospectus and contains a specific but different legend.

While complying with Rule 134 in the administration of a directed share program might seem easy enough, mistakes are apparently occurring with some frequency, which is presumably the reason for the SEC's crackdown. Moreover, difficult questions lurk below the surface simplicity of the rule. For example, is it permissible to open an account for a potential directed shares participant before the registration statement is effective? Is it a sale if the potential investor deposits funds in the account?

The SEC Cracks Down

Over the last several months, the SEC has paid close attention to the administration of directed share programs to determine compliance with Section 5 and Rule 134. SEC examiners have posed the following kinds of questions to issuers:

  • Supplementally describe the mechanics of how and when these shares are offered and sold to investors in the directed share program for this offering.
  • What communications were provided to prospective participants?
  • When the prospective directed shares purchasers established accounts, did they provide funds to open the accounts?
    How do participants become committed to purchase shares?

The central issue is the timing and manner in making a solicitation of interest in an issuer's directed share program. In some cases, the SEC has requested detailed information right down to the names of the individuals who were solicited and copies of the communications. As noted above, Rule 134(d) requires that a prospectus be delivered when soliciting written offers and that the appropriate legend be included. Without full compliance with Rule 134(d) when soliciting offers, a violation of Section 5 of the Securities Act is triggered. The SEC also wants to determine whether or not a sale of any directed shares has occurred prior to effectiveness, since that too would be a violation of Section 5.

Ugly Consequences

As most practitioners are aware, a violation of Section 5 triggers a right of the purchaser to rescind the purchase of securities for up to one year. Thus, potential violations of Section 5 and Rule 134 have led to rather undesirable consequences for issuers and underwriters during the offering process. For example, as a result of potential Section 5 violations, issuers have been including additional disclosure in the prospectus to warn investors of potential liabilities arising from the manner in which offers to purchase shares under a directed share program were solicited. A risk factor in the prospectus of Engage Technologies Inc. illustrates a particularly unpleasant result:

Prior to the effectiveness of the registration statement covering the shares of our common stock being sold in this offering, Hambrecht & Quist, an underwriter of this offering, provided written materials to approximately 80 employees of Engage that we had designated as potential purchasers of up to 300,000 shares of common stock in this offering through a directed share program. These materials may constitute a prospectus that does not meet the requirements of the Securities Act of 1933. No employee who received these written materials should rely upon them in any manner in making a decision whether to purchase shares of common stock in this offering.

If the distribution of these materials by Hambrecht & Quist did constitute a violation of the Securities Act of 1933, the recipients of these materials who purchased common stock in this offering would have the right, for a period of one year from the date of their purchase of common stock, to obtain recovery of the consideration paid in connection with their purchase of common stock or, if they had already sold the stock, sue us for damages resulting from their purchase of common stock. These damages could total up to approximately $4.5 million plus interest, based on the initial public offering price of $15.00 per share, if these investors seek recovery or damages after an entire loss of their investment. If this occurs, our business, results of operations and financial condition would be harmed.

Engage's prospectus is not the only one to contain such disclosure. Other examples include the prospectuses of JFAX.COM, NetIQ Corporation and Active Software, Inc. In some cases, the issuer and underwriters have agreed to abandon the directed share program altogether, though in theory this would not wholly cure the problem. In other cases, underwriters not involved in the administration of the directed share program obtained the agreement of the underwriter managing the program and the issuer to indemnify them against potential liability. Even issuers have obtained indemnities when they were not the party distributing communications in possible violation of securities laws. It is clear that both issuers and underwriters have been responsible for directed share violations.

Administration of Directed Share Programs

There are several factors that explain why issuers and underwriters are tripping up in complying with the Securities Act provisions in the administration of directed share programs. First, it has become almost universal for issuers to wait for at least one set of comments from the SEC prior to printing preliminary prospectuses in volume. Second, in the hot IPO markets experienced recently, the interest that is generated in a directed share program means that a fair amount of organization is required to incorporate the program into an offering. Where prior common practice for soliciting offers to buy directed shares involved a mailing to the prospective recipients that included a copy of the preliminary prospectus, it seems that many issuers and underwriters are now soliciting orders prior to the preliminary prospectus being available.

Finally, solicitations of interest in directed shares have been reduced to writing far more often than before as a result of the use of electronic media, notably e-mail, electronic bulletin boards and firm wide intranets. Several directed share programs in the last few months have been closely scrutinized by the SEC because they involved e-mails sent by the underwriter or the issuer. The SEC made the following supplementary comment to one issuer after learning about its procedures for the directed share program:

We note that you used e-mail to correspond with employees in response to inquiries about the directed share program. We also note that some of your executive officers used e-mail to contact their nominees to see whether they would be interested in participating in the directed share program. Tell us what information was contained in the e-mails. If possible, provide copies of the e-mails. Provide your analysis of whether these e-mails were permissible communications during the filing period of the registration statement.

The liability provisions of the federal securities laws probably apply equally to electronic and paper-based media, and thus an e-mail communication should be considered to be covered by the broad definition of a prospectus in Section 2 of the Securities Act. Unless an e-mail soliciting interest in the directed share program complies with all of the requirements of Section 10(a) (and does not include additional information) or fits within the Rule 134 exception, it is an unlawful prospectus and violates Section 5.

One advantage of using electronic media rather than the telephone to organize a directed share program is that a far greater number of people can be reached in a shorter period of time. For the issuer, electronic media may be used for almost all other aspects of corporate operations, so it is not surprising that executives turn to e-mail and the corporate intranet to solicit interest in directed shares. Underwriters, who in the past would have relied on a more formal mailing process for soliciting offers from persons named by the issuer, are resorting to electronic media as a more efficient means of administering the directed share program.

A more troublesome form of communication for issuers who are soliciting interest in directed shares is the website. For example, some issuers have posted on their websites a description of the opportunity for existing and potential business partners to receive directed shares in the issuer's IPO. Indeed, issuers have fought hard to make electronic distribution a legal means to offer securities, and many underwriters have appeared on the scene to make it their business. While these underwriters are ensuring that they comply with the Securities Act with respect to the offer and sale of securities to the general public using electronic means, ensuring that directed share programs also comply appears to have received little attention.

In addition to Section 5 and Rule 134, underwriters and issuers must keep in mind the SEC guidelines for the use of electronic media. Two releases have been published by the SEC , in addition to a groundbreaking letter and a report to Congress. Just as with the offer and sale of securities to the general public, these concerns affect the administration of a directed share program when electronic media is used. One problem, as has been noted on several occasions by the SEC and other commentators, is the hyperlink function which enables information to be viewed directly as if it were in the same envelope. Instantaneous access to information via the internet, including the inclusion of hyperlinks in e-mails and on web pages, creates the risk of including an unlawful prospectus. If potential purchasers of directed shares are directed to an issuer's website, for example, it would be difficult to avoid including an unlawful prospectus in the offer.

One underwriter delivered e-mails to prospective purchasers of directed shares and "attached" documents which fully complied with the requirements of Rule 134. However, the body of the e-mail did not include the Rule 134(d) legend and the SEC scolded the issuer and underwriter as a result. The example shows that the SEC may be taking the position that each piece of a communication must comply with Rule 134, which could be problematic in the context of electronic media, but is not necessarily inconsistent with a strict reading of Rule 134 or its interpretation when paper communications were the norm.

Another potential pitfall with directed share programs, particularly for the underwriters, is the possibility of creating contracts of sale prior to the effectiveness of the registration statement. In some instances, the SEC has expressed its concern that the proposed arrangements of several underwriters may actually be obligating the potential participants to buy based on their pre-effective expressions of interest. Certainly, many underwriters will open accounts for directed share participants prior to effectiveness. Logistically, it would be hard to get the deal closed in three business days if accounts were not opened ahead of time, and there is no reason to conclude that merely opening an account is a premature sale. Receiving a deposit of funds into an account is a harder question, and many underwriters do not request funds until after the registration statement is effective. Conceptually, requesting a potential recipient of directed shares to place funds into a new account should not be treated differently than the situation where the funds already happen to sit in an existing account. However, it would be important for underwriters to ensure that there is no mechanism binding the person to purchase the directed shares, and that the money could be used by the participant for other purposes or withdrawn. Otherwise, a pre-effective sale could be deemed to have occurred and liability could attach.

Roadmap To Conducting A Directed Share Program

In order to stay prudently within the rules, issuers and underwriters should consider the following guidelines in conducting a directed share program:

  • Issuers should try to avoid contacting potential participants in writing or by e-mail. For employees, the best approach would be to hold meetings run by senior executives where the directed share program is discussed and questions are answered. No written materials should be handed out at these meetings. Employees should then contact a designated individual by telephone to register their interest in participating in the program. Discussions with business partners and other potential participants outside the company should also be conducted orally. Practically, it is best if one person at the company is tasked with acting as a point person for taking "orders".
  • Issuers should be very clear with potential participants that there is no agreement on the number of shares that will be allocated, since participants are often allocated fewer shares than they requested. Issuers must be careful not to allocate more shares to an individual than he has expressly stated that he would purchase. If the issuer does not end up allocating all the shares that have been set aside under the directed share program, the underwriters will take up the excess and reallocate those shares to their customers.
  • Underwriters administering the program should not begin implementation of a directed share program until a preliminary prospectus is available.
  • Once the preliminary prospectuses are available, underwriters administering the program should send out no more information to participants than is absolutely necessary. The information should be limited to a brief letter explaining the program, the preliminary prospectus, new account information and a "Free-Riding and Withholding" questionnaire as required by the National Association of Securities Dealers. Under no circumstances should any information about the issuer be disseminated, other than the preliminary prospectus.
  • If the underwriter chooses to disseminate this information electronically, it must ensure that the potential participant cannot register interest in participation (i.e. filling out new account information or other form of indications of interest) without first having to view a preliminary prospectus. The preliminary prospectus must be included in the communication.
  • Every single separate communication sent out by the underwriter administering the program (or anyone else) must contain the appropriate Rule 134(d) language. This includes e-mails.
  • It must be made clear to participants that there will be no obligation to purchase any shares until the registration statement has been declared effective, and that participants have the right to decline to purchase prior to that date. However, once the registration statement is effective and the deal has been priced, those who agree to purchase are obligated to buy the shares.
  • Issuers and underwriters should not require potential participants to send funds in advance of the registration statement being declared effective.
  • The issuer's website should not be used to invite participation in the directed share program. Electronic communications about the directed share program should not contain links to any websites, including the issuer's. Do not rely on electronic delivery of the preliminary prospectus unless the recipient has consented.
  • Those subject to short-swing trading liability with respect to the issuer should consider the potential for damages that could result from participation in a directed shares program. "Flipping" the shares acquired in the offering back into the market would be an obvious short swing trade.


Proper administration of a directed share program has been taken for granted by issuers' or underwriters' counsel. The standard practice has been to rely on the compliance function within the underwriting houses to ensure proper administration. Recent problems in the area and the rather severe consequences that have followed demonstrate that practitioners must be alert to the issue and be prepared to give advice at the start of the IPO process.


1Copies of each of the prospectuses referred to can be obtained from the EDGAR database maintained by the SEC at
2See Sec. Act Release No. 33-7233 (October 6, 1995) and Sec. Act Release No. 7606A (November 13, 1998).
3Sec. Act Release No 33-7233 (October 6, 1995) and Sec. Act Release No. 33-7288 (May 9, 1996).
4Brown & Wood (February 17, 1995). For a recent discussion, see Wit Capital Corporation, SEC Staff No-Action Letter (July 14, 1999).
5The Impact of Recent Technological Advances on the Securities Markets (September, 1997).
6 Merely taking funds from the prospective purchaser falls outside the scope of the definition of "sale" found at Section 2(a)(3) of the Securities Act which states: "The term 'sale' or 'sell' shall include every contract of sale or disposition of a security or interest in security, for value." However, by using the non-exhaustive words "shall include", the Securities Act does not totally preclude the argument.

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