The SEC has voted to propose a new rule, Rule 163B, that would expand the JOBS Act’s “test-the-waters” reform beyond emerging growth companies to apply to all issuers. If expanded as proposed, the new rule would allow a company (and its authorized representatives, including underwriters) to engage in oral or written communications, either prior to or following the filing of a registration statement, with potential investors that are, or are reasonably believed to be, qualified institutional buyers (QIBs) or institutional accredited investors (IAIs) to determine whether they might be interested in the contemplated registered offering. The proposed new rule is designed to allow the company to gauge market interest in the deal before committing to the time-consuming prospectus drafting and SEC review process or incurring many of the costs associated with an offering. According to the press release, SEC Chair Jay Clayton views the extension of this reform as a way to enhance the ability of companies “to conduct successful public securities offerings and lower their cost of capital, and ultimately to provide investors with more opportunities to invest in public companies…. [Clayton has] seen first-hand how the modernization reforms of the JOBS Act have helped companies and investors. The proposed rules would allow companies to more effectively consult with investors and better identify information that is important to them in advance of a public offering.”
The proposal is so uncontroversial that the SEC did not even hold an open meeting to vote on it. I’d don’t think I’d be going out on too much of a limb if I predicted that, although there may be tweaks to it, the proposed new rule is just about a done deal. The proposal will have a 60-day public comment period following its publication in the Federal Register.
Corp Fin took a similar step in 2017 when it extended to all IPOs (and most follow-on offerings made in the first year post-IPO) the JOBS Act reform that allowed the confidential submission of draft registration statements. That accommodation has generally been well-received. (See this PubCo post.) Currently, the JOBS Act permits only EGCs to test the waters (although “well known seasoned issuers” can engage in similar communications under a different rule). The proposed new rule could help to “level the playing field with respect to permissible investor solicitations for EGCs and other issuers.” With regard to EGCs’ use of test the waters so far, the SEC said that pre-filing solicitations “have not been a significant cause for concern with respect to investor protection.” The SEC expects that allowing more companies to test the waters
“could help issuers to better assess the demand for and valuation of their securities and to discern which terms and structural components of the offering may be most important to investors. This in turn could enhance the ability of issuers to conduct successful offerings and lower their cost of capital. To the extent this is the case, the proposed rule could encourage additional registered offerings in the U.S. [The SEC believes] that increasing the number of registered offerings can have long-term benefits for investors and our markets, including improved issuer disclosure, increased transparency in the marketplace, better informed investors, and a broader pool of issuers in which any investor may invest.”
According to the WSJ, the number of public companies has declined by about 50% since the mid-1990s. The article reports that close to 40% of eligible EGCs conducting IPOs took advantage of testing the waters in 2015, but the percentage fell to less than 25% in 2016. Although, according to the article, the SEC does not “view testing the waters as a panacea for the diminished appeal of going public,” some regulators do seem to believe it will encourage companies to go public: at the San Diego Securities Conference in January 2018, the article reports, Corp Fin Director William Hinman argued that “[i]f we can be successful in reducing the burdens associated with joining the public capital markets, we think we will get companies to join us at an earlier stage.”
In this report, Expanding the On-Ramp: Recommendations to Help More Companies Go and Stay Public, eight organizations—the American Securities Association, Biotechnology Innovation Organization, Equity Dealers of America, Nasdaq, National Venture Capital Association, Securities Industry and Financial Markets Association, TechNet and the U.S. Chamber of Commerce—joined forces to make recommendations about how to revitalize the IPO market and make public company status more appealing. One of the recommendations was to permit all issuers to “test the waters” with QIBs and IAIs to determine interest in a securities offering. (See this PubCo post.) Similarly, a 2017 report from the Treasury Department, A Financial System That Creates Economic Opportunities—Capital Markets, called for an expansion of the test-the-waters provision of the JOBS Act to allow all companies, not just EGCs, to “test the waters.” (See this PubCo post.)
However, many commentators view the issue of the decline in IPOs as more complex than just the volume of red tape. Among the factors commonly cited for the decline are the availability of capital in the private markets, the greater maturity expected of IPO candidates, more opportunities for liquidity for investors and employees through secondary trading in the private markets, changes to the Exchange Act registration threshold that permit companies to stay private longer and concerns regarding hedge-fund activists with control intent and short-term views, among other reasons. (See this PubCo post and this PubCo post.)
Generally, there are a number of restrictions on issuer communications during the offering process. In the absence of this reform or other exemption, written and oral offers prior to filing of a registration statement are prohibited under Section 5, a violation referred to as “gun-jumping.” Section 5(c) prohibits any written or oral offers prior to the filing of a registration statement, and after filing, Section 5(b)(1) limits written offers to a “statutory prospectus” that conforms to Section 10. Proposed new Rule 163B would provide an exemption from Section 5(b)(1) and Section 5(c) of the Securities Act for test-the-waters communications by all issuers —including non-reporting issuers, EGCs, non-EGCs, WKSIs, and, not discussed in this post, investment companies—whether before or after filing of the registration statement, to potential investors that the issuer (or person authorized to act on its behalf) has a reasonable belief is a QIB or IAI. Of course, if the communication is in technical compliance with the rule, but is part of a plan or scheme to evade the requirements of Section 5, the new rule would not be available.
Test-the-waters communications that comply with the proposed rule would not need to be filed with the SEC, and no specific legends would be required. The SEC believes that type of requirement to be unnecessary because communications under the new rule would be limited to financially sophisticated potential investors. In addition, the SEC is also proposing to amend Rule 405 to exclude from the definition of “free writing prospectus” any written communication used in reliance on the proposed rule and limited to gauging interest in a contemplated registered offering. Also, communications made under the proposed rule would not be required to be filed under Rule 424(a).
That’s not to say that investor protections have exactly been eviscerated under the proposed rule. Notably, these communications would still be considered “offers” under the Securities Act, and both oral and written communications before and after filing would be subject to Section 12(a)(2) liability. The anti-fraud provisions of the federal securities laws would also be applicable. In addition, information in these communications must not conflict with material information in the related registration statement; as “is currently the practice of Commission staff when reviewing offerings conducted by EGCs, the Commission or its staff could request that an issuer furnish the staff any test-the-waters communication used in connection with an offering.” And companies subject to Reg FD would need to consider whether any information in the communication would trigger obligations for public disclosure under Reg FD or be otherwise excluded, for example, if confidentiality agreements were obtained from potential investors. (And if the company determined not to go forward with the offering and the filing of a registration statement at that time, the company could choose to disclose publicly information regarding the communications to release the potential investors from the terms of such confidentiality agreement.)
Under the proposed rule, an issuer or a person authorized to act on its behalf would be required to reasonably believe a potential investor is a QIB or IAI, both types of investors that are “financially sophisticated and therefore do not require the same level of protections of the Securities Act’s registration process as other types of investors.” As summarized in the proposing release, a QIB is
“a specified institution that, acting for its own account or the accounts of other QIBs, in the aggregate, owns and invests on a discretionary basis at least $100 million in securities of unaffiliated issuers. Banks and other specified financial institutions must also have a net worth of at least $25 million. A registered broker-dealer qualifies as a QIB if, in the aggregate, it owns and invests on a discretionary basis at least $10 million in securities of issuers that are not affiliated with the broker-dealer. IAIs are any institutional investor that is also an accredited investor, as defined in paragraph (a) of Rule 501 of Regulation D. Specifically, for the purposes of the proposed rule, an IAI would be an institution that meets the criteria of Rule 501(a)(1), (a)(2), (a)(3), (a)(7), or (a)(8).”
The SEC believes that the “reasonable belief” standard should not be unduly burdensome compared to the Reg D requirement to verify investor status. So long as the company “established a reasonable belief with respect to the potential investor’s status based on the particular facts and circumstances,” the company should not be subject to a Section 5 violation, even if the potential investor may have provided false information or documentation. However, the SEC is not providing specific guidance regarding how to establish “reasonable belief” out of concern that the guidance “would become a de facto minimum standard. Instead, [the SEC believes] issuers should continue to rely on the methods they currently use to establish a reasonable belief regarding an investor’s status as a QIB or accredited investor pursuant to Securities Act Rules 144A and 501(a), respectively.” But companies will have more “flexibility to use methods that are cost-effective but appropriate in light of the facts and circumstances of each contemplated offering and each potential investor.”
As summarized in the proposing release, Rule 144A(d)(1) sets forth non-exclusive means to determine whether a prospective purchaser is a QIB, identifying “the following non-exclusive methods of establishing the prospective purchaser’s ownership and discretionary investment of securities: (i) the prospective purchaser’s most recent publicly available financial statements; (ii) the most recent publicly available information appearing in documents filed by the prospective purchaser with the Commission or another U.S. federal, state, or local government agency or self-regulatory organization, or with a foreign governmental agency or self-regulatory organization; (iii) the most recent publicly available information appearing in a recognized securities manual; or (iv) a certification by the chief financial officer, a person fulfilling an equivalent function, or other executive officer of the purchaser, specifying the amount of securities owned and invested on a discretionary basis by the purchaser as of a specific date on or since the close of the purchaser’s most recent fiscal year.”
The proposed rule would be non-exclusive, allowing companies to rely on other communications rules and exemptions, such as Section 5(d) or Rules 163, 164 or 255, when available. For example, EGCs would be able to rely on the proposed rule and on the statutory accommodation in Section 5(d). The release includes a very convenient table that summarizes these other provisions and helps to identify some of the finer distinctions. For example, Rule 163, which allows WKSIs to test the waters, does not restrict communications to any particular group of investors, but is not available for use by underwriter offering participants and requires legending and filing. As a result, if a WKSI begins with QIBs only under Rule 163B, but later expands beyond the types of investors permitted under that rule, to claim exemption under Rule 163, the WKSI “must have complied with Rule 163’s legending requirements from the start of any communications with non-QIBs or non-IAIs, and would have to file the legended materials if a registration statement is filed.”