- The SEC plans to develop a proactive and agile regulatory framework through which it can anticipate issues and address them proactively, even as the capital markets continue to undergo rapid change.
- Though Rule 506(c) of Regulation D allowing for the use of general solicitation in connection with private placements was passed back in 2013, issuers are continuing to rely primarily on the old Rule 506(b) in connection with Rule 506 offerings.
- Issuers appear to be wary of the enhanced investor verification standards imposed by new Rule 506(c) in connection with the use of general solicitation.
- The SEC has established working groups to monitor recently passed rules (and intends to continue to do so in the future).
- The SEC’s disclosure rules are an area where the SEC’s new proactive approach can work to provide great value to issuers and investors alike.
- In addition to its current review of certain provisions of Regulation S-X, the SEC plans to review Regulation S-K and other Industry Guides.
- The SEC’s planned proactive approach will enable the SEC to stay abreast of developments in the capital markets even in the absence of major legislative initiatives.
In a recent Keynote Address at the 47th Annual Securities Regulation Institute, Mary Jo White, Chairwoman of the U.S. Securities and Exchange Commission (SEC), discussed how the SEC is working to understand the impact of recent regulatory changes so as to build an effective regulatory structure for the rapidly changing capital markets.1
Chair White’s speech touched on a broad range of topics including the significant reforms to the securities offering process brought about by the JOBS Act2 and the related rules passed by the SEC in response. In addition, Chair White articulated a vision in which the SEC develops a proactive and agile regulatory framework through which it can anticipate issues and respond to them quickly, whether through modified regulations, staff guidance, enforcement, or other available tools.
This Dechert OnPoint discusses a few of the key takeaways from Chair White’s speech concerning securities offering regulations and the role of the SEC in the process.
The JOBS Act
Among other things, the JOBS Act:
- allowed emerging growth companies (EGCs) to take advantage of the initial public offering (IPO) “on-ramp” and submit confidentially draft registration statements for IPOs;3
- directed the SEC to amend Rules for offerings exempt from registration pursuant to Rule 506 of Regulation D4 and Regulation A;5 and
- required the SEC to adopt rules creating a new exemption from the registration requirements of the Securities Act of 1933, as amended (the Securities Act), to implement crowdfunding.
Chair White noted that the SEC has already passed many of the rules required under the JOBS Act, including final rules related to both Rule 5066 and Regulation A7, while she noted she expected the SEC to consider a registration exemption for crowdfunding in the near future, which the SEC in fact did two days later.8
In 2013 the SEC amended the Rule 506 safe harbor for private placements under a registration exemption afforded by Section 4(a)(2) of the Securities Act. New Rule 506(c), which now permits general solicitations in connection with private placements under certain limited circumstances, effectively deregulated offers, but not sales, of securities in such private placements. In order to fall within the Rule 506(c) safe harbor, issuers must take reasonable steps to verify that all investors in such offerings are “accredited investors.” Chair White explained that, while Rule 506(c) is still relatively new, it appears that, since its adoption, a majority of companies undertaking Rule 506 offerings have elected not to take advantage of Rule 506(c) to engage in general solicitations.
It is unclear why issuers of securities would not take advantage of the opportunity to engage in unregulated offers in connection with private placements. One would think that they would be eager to do so in a world where communications technology offers fast and efficient means to reach potential investors (email blasts and social media, to name a few). Perhaps the reason for this reluctance on the part of issuers lies in the high standard that the SEC has imposed for issuers to verify the “accredited investor” status of prospective investors. Historically (and continuing for offerings conducted under Rule 506(b)), investors were only required to self-certify their accredited investor status by checking a few boxes and/or making certain basic representations, and an issuer’s obligation was limited to confirming that such representations were made. In contrast, Rule 506(c) requires an issuer to take “reasonable steps” to verify the status of investors.9 The SEC published guidance indicating that relying on investors’ self-certification alone will not be deemed to constitute “reasonable steps” on the part of the issuer when general solicitations are used to market an offering.10 In taking such “reasonable steps” the issuer often must intrusively inquire of investors as to the basis of their representations that they meet accredited investor thresholds. These steps, in turn, raise potential privacy issues in handling investors’ personal financial information and may be met with resistance by prospective investors. Issuers, then, must weigh the potential benefit of general solicitations against the intrusiveness of such steps, the potential for deterring investors and possible liability for incorrectly policing investor status. While the SEC has provided certain non-exclusive safe harbors under which an issuer can be certain (barring direct knowledge to the contrary) that met the standards for such “reasonable steps”11 it appears that most issuers prefer to conduct private placements under the established course of Rule 506(b), despite its blanket prohibition on general solicitations.
Chair White noted that the SEC has some investigations open into companies who have taken advantage of the new general solicitation provisions under Rule 506(c). She further stated that, despite initial fears when Rule 506(c) was passed, these investigations have not indicated that there has been widespread fraud in offerings under such rule.
In her remarks, Chair White did not look beyond the concrete actions of the SEC in implementing the JOBS Act. She did not, for example, discuss any positive impact that the statute’s relaxed regulation of emerging growth companies may have had on the number and size of initial public offerings (IPOs) by U.S. companies or the apparent resurgence of interest in U.S. listings by non-U.S. companies in the wake of the JOBS Act. She also did not address the benefits or costs, and the effect on capital formation in the United States, of other provisions in the JOBS Act, such as the ability of issuers to “test the waters” with institutional investors prior to commencing an initial public offering; the salutatory effect of confidential filing on contemplated exit financings by private equity firms; and the flexibility of private companies to defer SEC registration pursuant to the higher threshold for the number of stockholders permitted before such registration is required. Her remarks conveyed satisfaction with the manner in which the SEC and its staff have implemented the JOBS Act and avoided the pitfalls anticipated by commentators when it was passed. She did not, however, explore ways in which its liberalizing provisions could be usefully expanded through other regulatory initiatives.
Proactive Review and Assessment
Another interesting takeaway from Chair White’s speech is her view on the SEC’s mission going forward. Chair White explained that she is currently driving assessment of how the SEC’s recent rulemaking governing securities offerings is functioning. Chair White outlined a regulatory framework to identify nascent problems and to address them proactively, with a view to protecting investors even as the capital markets continue to undergo rapid change. She noted that the SEC has established working groups to monitor recently passed rules (and how it intends to do so in the future for any new rules). These working groups are designed to develop experience both with the specific rule and the markets to which such rule relates. Such working groups complement other SEC-wide initiatives to “identify new practices in the market that could impact investors, potential inefficiencies in various offering methods, and relationships with other channels for building capital, such as bank loans and private equity.”12
Based on these remarks, it appears that issuers and investors alike can expect more proactive monitoring (and rulemaking) by the SEC, including regulation to address anticipated market issues. Chair White noted that the SEC also plans to employ discrete regulatory adjustments and, where necessary, targeted enforcement actions to effect its proactive posture. She asserted that this combined regulatory approach should enable the SEC to address issues more precisely and quickly, with fewer delays or setbacks. The challenge implicit in this policy will be in drafting regulations and bringing enforcement actions with the necessary nuances to address emerging risks while avoiding indirect adverse consequences of such actions, and doing all of this at a reasonable cost to investors and issuers. Even Chair White recognized that this is a daunting task, acknowledging that it remains to be seen whether the SEC can anticipate the effects of its future rulemaking given the many variables at play.
Chair White singled out the SEC’s disclosure rules as an area where the SEC can provide great value to issuers and investors alike by acting proactively. She asserted that a focused approach to enhanced disclosure, utilizing interpretive releases, FAQs and other staff guidance, can have a meaningful and rapid impact on the markets.13 Already in progress, Chair White noted, is the Disclosure Effectiveness Review, where the SEC’s Division of Corporation Finance is considering ways to improve public company disclosure for the benefit of both investors and issuers.14
Chair White pointed to the recently published SEC request for public comment regarding the financial disclosure requirements in Regulation S-X15 for certain entities other than the issuer as an example of this approach.16 The discrete subset of the Regulation S-X disclosure requirements being evaluated for possible amendment include:
- Rule 3-05, which requires issuers to provide pre-acquisition and pro forma financial statements if an acquisition is deemed significant;
- Rule 3-09, which requires issuers to provide financial statements of entities that they own 50% or less of, if those entities are significant;
- Rule 3-10, which permits issuers to provide more limited disclosure under certain conditions, such as when the subsidiary issuer and guarantor is “100% owned” by the parent company and the guarantees are “full and unconditional”; and
- Rule 3-16, which requires issuers to provide separate financial statements for each affiliate whose securities constitute a substantial portion of the collateral for any class of securities, as if the affiliate were a separate registrant.17
It is noteworthy that, prior to this release, the SEC had not solicited comments regarding these regulations for many years. These disclosure requirements affect a large number of companies and are not limited to any particular industry or field. Changes to these rules could provide investors better insight into the actual financial situation of an entity following a sale or acquisition. For example, the pro forma information required under Regulation S-X lacks comparative prior periods, is not audited, and does not reflect some significant changes implemented by registrants, such as workforce reductions and factory closings, for want of certainty at the time they are prepared. Further, pro forma information is currently not required to be filed until 75 days following a reportable event (in the absence of a registration statement), which is often long after investors need such information to make informed investment decisions. With respect to the other rules identified, there may be opportunities to add bright-line tests with regard to determining “significance” which, in turn, drives the inclusion of certain financial disclosure and streamline the treatment of financial statements prepared by different entities under different reporting standards, which render reconciliation with an issuer’s financial statements difficult. Both issuers and the investing public now have the opportunity to provide the SEC with insight into how these disclosure requirements affect them and where improvements could be made.
Chair White indicated that the SEC’s next step will be to similarly review Regulation S-K and certain Industry Guides. She did not address other initiatives that are underway to make disclosure less cumbersome and repetitious, such as an initiative regarding small business reporting, nor did she address in any detail areas where existing disclosure mandates could be eliminated without creating harm to investors. Rather, Chair White articulated an approach that will enable the SEC to stay abreast of developments in the capital markets even in the absence of major legislative initiatives. As she put it in her speech, “what is effective today may not be effective tomorrow.”
As the capital markets grow and the regulatory landscape continues to change, it will be interesting to see how the approach the SEC is taking deals with evolving regulatory issues. Chair White’s proactive and interdivisional approach to monitor the impact of new rules and to develop new ones could avoid the need for massive reactive regulation in response to future crises. It would be useful if this proactive posture could be coupled with efforts to streamline disclosure requirements and focus enforcement actions so as to eliminate bars to capital formation as well as reducing risk, which was another aim of the JOBS Act. It bears monitoring to see how Chair White’s proposed approach, and the specific initiatives undertaken by the SEC as a result, will affect issuers and the investing public.