Free writing prospectuses (FWPs) were first permitted under the SEC rules in December 2005. No industry has benefitted from them as much as the structured products. From red herrings, to term sheets, to product brochures, issuers, underwriters and downstream broker-dealers prepare a variety of materials designed to help investors understand how the products work, and their potential risks and benefits.
Of course, FWPs were new in 2005. Lawyers and others immediately asked the question, “who will be liable for the contents of the FWP?” The question remains important in the structured products industry, as different parties may have different degrees of involvement in their preparation. The issuer and the underwriter may work together on creating an FWP that operates as a red herring for the offering. But the issuer and underwriter don’t always know in all cases what marketing materials may be in use by downstream distributors.
The article describes the relevant SEC rules, identifies the remaining areas of uncertainty, and describes a number of contractual provisions and other practices that have been used by market participants to address these issues.
Liability and FWPs
The SEC attempted to address questions about FWP liability by adopting Rule 159A. This rule addresses what are sometimes referred to as “cross-liability issues.” The rule provides that an offering participant other than the issuer will not be deemed to offer or sell securities to a person “by means of” an FWP unless:
- the offering participant used or referred to the FWP in offering or selling the securities;
- the offering participant offered or sold the securities and participated in planning for the use of that FWP by other offering participants, and the FWP was used or referred to in offering or selling securities by one or more of such other offering participants; or
- the offering participant is required to file the FWP with the SEC under Rule 433.
Rule 159A also provides that a person will not be considered to have offered or sold securities by means of an FWP solely because another person has used or referred to the FWP or filed it with the SEC.
As to issuers, Rule 159A provides that an FWP is deemed to be made by or on behalf of an issuer if the issuer or an agent or representative of the issuer authorizes or approves the information or communication before its provision or use.
Within this framework, a variety of uncertainties remain, including as to the provisions of Rule 159A. For example, what sort of involvement in the drafting of a document constitutes “participating in the planning for the use of an FWP”? Discussing the contents and format? Being included in an e-mail distribution of drafts of the document? Commenting on the document, or indicating that one has no comments on the document?
In practice, market participants respond to this regulatory structure with a variety of contractual provisions and practices.
Issuers and Underwriters. Issuers and underwriters will be parties to an underwriting agreement or program agreement. As a starting point, in order to protect both parties, the agreement will typically include restrictions that bar each side from preparing FWPs without the other party’s approval. This type of provision is designed to ensure that both the issuer and the underwriter can review any relevant FWP, and understand how it will be used. However, there are a variety of circumstances under which it may not be practical or desirable for an underwriter to be required to submit an FWP to an issuer for approval. For example, in the case of an active note program, with frequent investor inquiries and negotiations, it may not make sense for an issuer or its counsel to review all preliminary term sheets that are proposed or negotiated. That is, requiring review by the issuer or its counsel may not help at all to facilitate, and could even impede, the execution of reverse inquiry and similar transactions on a timely basis. Such provisions may also result in relatively significant time and expense in connection with preliminary term sheets for various proposals that don’t result in actual transactions.
Similarly, an underwriter with a multi-issuer structured notes platform may have a variety of FWPs that are generic marketing materials that relate to its platform, and which do not contain any material information about any particular issuer. These materials will also not be furnished to any investor without the robust red herring for the actual live transaction, so they tend to be of less interest to any specific issuer.
For these categories of FWPs, and where the underwriter is deemed to have sufficient expertise in the area, an issuer may be willing to provide advance permission to create and distribute these types of materials.
Selling Group Members. The situation with respect to distributors that are not in privity of contract with the issuer can be more fluid. The practices of these entities may vary. For example, some of these entities may sell the securities directly to end-investors; some may sell them to other dealers for further distribution, while others may sell the securities to a combination of the two. Some distributors may be perfectly happy to use only the offering materials prepared by the issuer and the lead underwriter; however, others may seek to prepare materials of their own. In addition, some brokers may have a more established track record than others in working on these types of offerings, and greater familiarity with the laws and practices that apply to FWPs. Accordingly, a greater variety of practices may exist as to the circumstances under which these entities may be permitted to create their own FWPs.
As a starting point, most underwriters will have provisions in their “selected dealer agreements” or similar documents that prohibit the selling group members from creating the members’ own marketing materials. Those dealers who don’t prepare their own marketing materials, will often be content to simply execute the document on that basis. However, what happens in the case of a dealer that does in fact plan to create its own marketing materials about the relevant offering?
- The lead underwriter and the dealer may agree that the lead underwriter will have the right to review and approve of those materials. Due to the potential liabilities discussed above, that underwriter may do so only reluctantly, with a view to potentially limiting its own exposure in the event that any aspect of that document is incorrect.
- The lead underwriter may grant the dealer limited permission to create its own FWPs, such as term sheets that are limited to the economic terms of the offering, and that include only content that is in the red herring provided by the issuer and underwriter.
- The lead underwriter may request indemnification (both for itself, any other underwriters and perhaps the issuer) with respect to any misstatements in that document.
Impact of FINRA Filing Rules. In the past few years, FINRA’s revisions of its communications rules encouraged many underwriters to attempt to have issuers take ownership of certain types of FWPs, and file them with the SEC. Specifically, FINRA’s revised filing rules relating to communications, which went into effect in 2013, required a variety of types of structured note FWPs used by broker-dealers to be filed with FINRA’s advertising department. One type of document exempted from the filing requirements was an FWP filed by an issuer under Rule 433. Accordingly, several underwriters adopted a practice of having preliminary offering materials, such as detailed term sheets, filed by the issuer on the EDGAR system.
At the start of each new distribution relationship, and sometimes, at the start of each offering, the parties will need to understand what types of documents are planned, and who is creating them. By doing so, uncertainty as to who must review them, who must file them, and who is ultimately responsible for them, can be best avoided.