On February 19, 2019, the Securities and Exchange Commission (SEC) voted to propose a new rule under the Securities Act of 1933 (the Securities Act), and amendments to Rule 405 (together, the Proposed Rule), to expand the permissible use of testing-the-waters communications. The Proposed Rule, if adopted, would allow any issuer, or persons authorized to act on their behalf, to make oral and written offers to qualified institutional buys (QIBs), and institutional accredited investors (IAIs) before or after the filing of a registration statement to gauge investor interest in a registered offering.
For years, there have been calls for the SEC to expand the accommodation to issuers beyond emerging growth companies (EGCs) and certain exempt offerings. This proposal appears to seek to level the playing field with respect to investor solicitations among all issuers, and indicative of the SEC’s willingness to listen to market participants. Some advocates of expanding pre-filing communications may use the comment period as an opportunity to try to move the needle further so these communications may apply to all investors rather than only certain investors. This view is often based on promoting capital formation, helping companies ascertain whether capital markets are the best place to raise money for a particular company, as well as promoting fair and efficient markets in which all investors have access to the same information. Opponents of expanding pre-filing communications to allow for offers may use the comment period to discuss investor protection and whether investment decisions are ultimately made at the offer stage, which would render their content particularly important from a disclosure standpoint.
Notably, the SEC already permits testing-the-waters communications to all investors in Regulation A offerings. Regulation A testing-the-waters materials must include a legend, among other things, identifying them as such and indicating that (1) no money is being solicited or accepted, (2) no sales will be made or commitments to purchase accepted until the offering statement is qualified, and (3) a prospective purchaser’s indication of interest is non-binding. The Regulation A testing-the-waters materials must also be submitted to the SEC under Part III of Form 1-A, which is reviewed for consistency with the Offering Circular prior to qualification.
In 2012, Congress passed the Jumpstart Our Business Startups Act (JOBS Act), which created Section 5(d) of the Securities Act, known as the “testing-the-waters” rule. Section 5(d) permits ECGs ease regulatory burdens on smaller companies and facilitate public and private capital formation. The rule was intended to allow EGCs to test-the-waters to ease long-standing restrictions on “gun-jumping” under Section 5 of the Securities Act by allowing EGCs or persons acting on their behalf to enjoy increased flexibility to make testing-the-waters communications before or after the filing of a registration statement to gauge investors’ interest in a registered securities offering. Doing so allows EGCs to enjoy cost-effective benefits in evaluating market interest before incurring any costs associated with the offering.
Three years later, on June 19, 2015, the SEC finalized new rules for Regulation A/A+. Regulation A was divided into tiers: “Tier 1,” Regulation A, allows for offerings of up to $20 million in any 12 month period, and “Tier 2,” which allows for offerings of up to $50 million in any 12 month period. Regulation A allows for testing-the-waters both before and after the initial filing of a Form 1-A registration statement. The solicitation material used before qualification of the Form 1-A must contain the legend discussed above. And unlike testing-the-waters for EGCs, which are limited to QIBs and accredited investors, a Regulation A company can reach out to retail and non-accredited investors. Issuers of Tier 1 offerings need be careful however, because these offerings do not preempt state law and therefore issuers intending to test-the-waters for these offerings must comply with the individual state law(s) in which they intend to qualify the offering.
Generally, testing-the-waters has been seen as helpful when building investor interest and excitement for an offering. Indeed, since adoption of the JOBS Act, EGCs have used testing-the-waters communications in a majority of their initial public offerings (IPOs). In its proposed release, the SEC noted that based on comment letter responses, 35% of EGC IPOs between 2012-2017 used the test-the-waters provision.
The Proposed Rule
Proposed Rule 163B would allow any issuer or person authorized to act on its behalf to engage in testing-the-waters communications with potential investors who are, or reasonably believed to be, QIBs or IAIs, either prior to or following the date of filing a registration statement related to a registered offering. The purpose of testing-the-waters is to assess interest in an offering before undergoing the expensive and time-consuming proposition of Section 5 registration. Under the Proposed Rule, all issuers, including EGCs, non-EGCs, non-reporting issuers, well-known seasoned issuers, and investment companies would be eligible to engage in these communications—but only with certain institutional investors.
In proposing this rule, the SEC is allowing issuers to assess the demand for their securities in a way that would likely improve issuers’ ability to conduct successful offerings at a lower cost. By allowing companies to ascertain demand, the SEC may also be attempting to encourage increased market participation. In its summary of the basis for the Proposed Rule, the SEC noted that the increasing number of registered offerings could have long-term benefits for investors, improve issuer disclosure, increase transparency in the marketplace, create better informed investors, and broaden the pool of issuers in which an investor may invest. Expanding upon these sentiments, SEC Chairman Jay Clayton believes that in doing so, companies would be better equipped to consult with investors and identify information important to them in advance of a public offering.
- The Proposed Rule is non-exclusive, meaning that a company may rely on other Securities Act rules or exemptions, although Rule 163B may eliminate the need to rely on existing rules when engaging in pre-offering communications. Of course an issuer cannot rely on the rule if it is intending to use it for a communication that, while in compliance with the rule, is part of a scheme to evade the requirements of Section 5 of the Securities Act.
- There are no SEC-mandated filing requirements or legend requirements. Communications are excluded from the definition of a free writing prospectus.
- Issuers are not required to verify investor status as long as the issuer reasonably believes the investor meets the requirement of the rule. There are no specific actions an issuer must take to establish this reasonable belief.
- The communications cannot conflict with material information in the related registration statement. Consistent with its practice, SEC staff could request that an issuer provide copies of any testing-the-waters communications used in connection with an offering.
- Testing-the-waters communications are exempt from restrictions imposed by Section 5 of the Securities Act but are nevertheless considered “offers” as defined by Section 2(a)(3) of the Securities Act, and therefore subject to Section 12(a)(2) liability in addition to anti-fraud provisions.
- Issuers subject to Regulation FD (Reg FD) need to assess whether information in the testing-the-waters communication would trigger disclosure obligations under Reg FD. To avoid application of Reg FD, the issuer could obtain a confidential agreement from a potential investor found using Rule 163B because Reg FD generally does not apply if disclosure is made to an individual owing a duty of trust or confidence to the issuer who agrees to maintain the disclosed information in confidence.
The SEC is currently soliciting comments on the proposal until 60 days after its publication in the Federal Register, April 29, 2019. For more information and guidance on this topic, including submission of comments on this rule proposal, please contact Teresa M. Goody, Michelle N. Tanney, or another member of BakerHostetler’s Securities and Governance Litigation team.