The SEC has adopted final rules allowing all issuers to test the waters prior to the effectiveness of a registration statement in a public offering. The rule change is designed to encourage more companies to go public. Although it will help in this regard, a much larger expansion of testing the waters, allowing unlimited testing the waters (subject to anti-fraud of course) for all registered offerings under $50 million, would go far to improve the floundering small cap IPO market.
Prior to the rule change, only emerging growth companies (“EGCs”) (or companies engaging in a Regulation A offering) could test the waters in advance of a public offering of securities. The proposal implements a new Securities Act Rule 163B.
Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. The public offering process is divided into three periods: (1) the pre-filing period, (2) the waiting or pre-effective period, and (3) the post-effective period. Communications made by the company during any of these three periods may, depending on the mode and content, result in violations of Section 5 of the Securities Act of 1933 (the “Securities Act”). Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.”
All forms of communication could create “gun-jumping” issues (e.g., press releases, interviews, and use of social media). “Gun jumping” refers to written or oral offers of securities made before the filing of the registration statement and written offers made after the filing of the registration statement other than by means of a prospectus that meet the requirements of Section 10 of the Securities Act, a free writing prospectus or a communication falling within one of the several safe harbors from the gun-jumping provisions.
In April 2012, the JOBS Act established a new process and disclosures for public offerings by a new class of companies – i.e., emerging growth companies (“EGCs.”) An EGC is defined as a company with total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. In particular, Section 5(d) of the Securities Act of 1933 (“Securities Act”) allows EGCs to test the waters by engaging in communications with certain qualified investors. The SEC has now created new Securities Act Rule 163B allowing all companies intending to file, or who have filed, a registration statement.
Permitting companies to test the waters is intended to provide increased flexibility to such issuers with respect to their communications about contemplated registered securities offerings, as well as a cost-effective means for evaluating market interest before incurring the costs associated with such an offering. Since the enactment of the JOBS Act, 87% of all IPOs have been by EGCs, leaving non-EGC companies at a disadvantage where specific rules favor EGC status.
The current rule change is consistent with other SEC actions to extend benefits afforded to EGCs to other issuers.
Section 5(d) of the Securities Act – Testing the Waters; New Rule 163B
Section 5(d) of the Securities Act provides an EGC with the flexibility to “test the waters” by engaging in oral or written communications with qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”) in order to gauge their interest in a proposed offering, whether prior to or following the first filing of any registration statement, subject to the requirement that no security may be sold unless accompanied or preceded by a Section 10(a) prospectus. Generally, in order to be considered a QIB, you must own and invest $100 million of securities, and in order to be considered an IAI, you must have a minimum of $5 million in assets.
Prior to the new rule, “well-known seasoned issuers,” or WKSIs, could engage in similar test-the-waters communications, but smaller reporting companies that do not otherwise qualify as an EGC could not.
An EGC may utilize the test-the-waters provision with respect to any registered offerings that it conducts while qualifying for EGC status. Test-the-waters communications can be oral or written. An EGC may also engage in test-the-waters communications with QIBs and institutional accredited investors in connection with exchange offers and mergers. When doing so, an EGC would still be required to make filings under Sections 13 and 14 of the Exchange Act for pre-commencement tender offer communications and proxy soliciting materials in connection with a business combination transaction.
There are no form or content restrictions on these communications, and there is no requirement to file written communications with the SEC. During the first year or two following enactment of the JOBS Act, the SEC staff regularly asked to see any written test-the-waters materials during the course of the registration statement review process, but eventually these requests ceased. The SEC staff maintains the right to ask to review test-the-waters, or any, communications made by a company during the S-1 review process.
The new rules expand the test-the-waters provisions currently available to EGCs, to all companies. In particular, Securities Act Rule 163B permits any issuer, including investment companies, or any person authorized to act on its behalf, to engage in oral or written communications with potential investors that are, or are reasonably believed to be, QIBs or IAIs, either prior to or following the filing of a registration statement, to determine whether such investors might have an interest in a contemplated registered securities offering. The rule is a non-exclusive, and an issuer can rely on other Securities Act communications rules or exemptions when determining how, when, and what to communicate related to a contemplated securities offering.
The rule does not require a filing with the SEC or any particular legend on the communications. Like other communications during a registration process, the test-the-waters communications must be consistent with, and cannot conflict with, the information in a related registration statement. The communications are considered “offers” and accordingly anti-fraud provisions, such as Section 12(a)(2) and 10(b), still apply to such communications.
Companies that are subject to Regulation FD will need to be cognizant of whether any information in a test-the-waters communication would trigger a disclosure obligation under Regulation FD and make the required disclosure accordingly. As a reminder, Regulation FD requires that companies take steps to ensure that material information is disclosed to the general public in a fair and fully accessible manner such that the public as a whole has simultaneous access to the information. Regulation FD requires the filing of a Form 8-K immediately prior to or simultaneously with the issuance of the information. Where information is accidentally released, the filing must be made immediately after the release and on the same calendar day.
Thoughts on the Rule
The SEC believes that by allowing more test-the-waters communications, companies will be encouraged to participate in public markets which, in turn, promotes more investment opportunities for more investors and improves transparency and resiliency in the marketplace. Furthermore, added communication can enhance the ability of issuers to conduct successful offerings and lower the cost of capital. I agree, but it is not enough. Although the rule change is certainly welcome, I would advocate for a rule amendment that not only expands test-the-waters communications for all issuers but that broadens the category of potential investor that could be the subject of such communications, to include all accredited investors, and for offerings under $50 million, to include all investors analogous to Regulation A.
In its proposal release, the SEC noted that the 2015 modernization of Regulation A, which allows companies to test the waters with all potential investors, without restriction as to the type of investors, has helped modernize the Securities Act communication rules. I have trouble understanding why the SEC is comfortable with the unfettered Regulation A test-the-waters communications, but is limiting offerings registered under the Securities Act to qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”). Certainly the potential total investor loss is limited in a Regulation A offering (with the high end maxing out at $50 million for a Tier 2 offering) and Regulation A communications require specified disclaimers and filing with the SEC, but I still find it to be a disconnect.
In the final rule release, on several occasions, the SEC points out that QIBs and IAIs are sophisticated and do not need the protections of the Securities Act. I believe that the current change is in line with a conservative “incremental change” approach. A next-step middle ground could be to require any test-the-waters communications that are made available to potential investors that are not QIBs or IAIs to contain a specified legend and be filed with the SEC. That way, a company embarking on an offering could decide if it wants to take on the filing liability under Section 11 of the Securities Act or limit its test-the-waters communications to QIBs and IAIs.
Ultimately, I would like to see unlimited test the waters for any offering that is $50 Million or under, or whatever the Regulation A upper limit is at that time, if increased. An S-1 or other registered offering under the Securities Act has more robust disclosures than a Form 1-A and requires additional follow on disclosure obligations under the Exchange Act. The small cap IPO market, once active, is practically non-existent in today’s world and without it, our economy and Main Street investors will suffer. As a result of multiple factors including the devastating blow of large cap IPO failures like WeWork, Pelaton and Uber together with our shifting capital markets and the regulatory burdens for trading in lower priced securities small cap investment banking houses have no outlet for small cap IPO’s.
I firmly believe that if unlimited test the waters communications were allowed in a regular S-1 IPO, it would encourage bankers to work with small cap companies and help invigorate the market place. Although Regulation A is great, and a I am big advocate and fan, a Regulation A offering does not operate the same as a registered offering on the back-end such as closing through a clearing firm (T+2) or utilizing greenshoe overallotment options with market support. By limiting open test the waters for offerings up to $50 million, a small cap company could have the same benefits of a Regulation A offering with the additional investor protections associated with a standard registered IPO.