Monthly Archives: October 2020
One year after proposing amendments to the financial statements and other disclosure requirements related to the acquisitions and dispositions of businesses, in May 2020 the SEC adopted final amendments (see here for my blog on the proposed amendments HERE). The amendments involved a long process; years earlier, in September 2015, the SEC issued a request for public comment related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates which was the first step culminating in the final rules (see HERE).
The amendments make changes to Rules 3-05 and 3-14, 8-04, 8-05, and 8-06 of Regulation S-x, as well as Article 11. The SEC also amended the significance tests in the “significant subsidiary” definition in Rule 1-02(w), Securities Act Rule 405, and Exchange Act Rule 12b-2. Like all recent disclosure changes, the proposed rules are designed to improve the information for investors while reducing complexity and compliance costs for reporting companies. The amendments also make several related conforming rule and form changes. The new amendments go into effect on January 1, 2021 but voluntary compliance is permitted immediately.
When a company acquires a significant business, other than a real estate operation, Rule 3-05 of Regulation S-X generally requires the company to provide separate audited annual and unaudited interim pre-acquisition financial statements of that business. Similarly, Rule 3-14 requires a company to file financial statements with respect to a significant real estate acquisition. The number of years of financial information that must be provided depends on the relative significance of the acquisition to the company.
Article 11 requires a company to file unaudited pro forma financial information, including a balance sheet and income statements, relating to the acquisition or disposition of businesses. Pro forma financial information is intended to show how the acquisition or disposition might have affected those financial statements.
Form 8-K generally requires that the audited financial statements and pro forma financial information be filed in an amendment to the original transaction closing form 8-K within 71 days of that closing 8-K (i.e., 75 days from the closing). Where an acquisition or disposition is not significant, no separate audits or pro forma’s are required.
The final amendments will:
- update the significance tests under these rules by revising the investment test to compare the company’s investments in and advances to the acquired or disposed of business to the company’s worldwide market value;
- update the significance tests under these rules by revising the income test by adding a revenue component;
- expanding the use of pro forma financial information in measuring significance;
- conforming the significance threshold and tests for a disposed business;
- modify and enhance the required disclosure for the aggregate effects of acquisitions for which financial statements are not required by increasing the pro forma information related to the aggregated businesses and eliminating historical financial information for insignificant businesses;
- reduce the period of the financial statements of the acquired business from three years to the two most recent fiscal years;
- permit disclosure of financial statements that omit certain expenses for certain acquisitions of a component of an entity;
- permit the use in certain circumstances of, or reconciliation to, International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB);
- no longer require separate acquired business financial statements once the business has been included in the company’s post-acquisition financial statements for nine months or a complete fiscal year, depending on significance;
- align Rule 3-14 with Rule 3-05 where no unique industry considerations exist;
- clarify the application of Rule 3-14 regarding the determination of significance, the need for interim income statements, special provisions for blind pool offerings, and the scope of the rule’s requirements;
- amend the pro forma financial information requirements to include disclosure of “Transaction Accounting Adjustments,” reflecting the accounting for the transaction; “Autonomous Entity Adjustments,” reflecting the operations and financial position of a company as autonomous where it was previously part of another entity; and “Management’s Adjustments,” reflecting reasonably estimable synergies and transaction effects;
- make corresponding changes to the smaller reporting company and Regulation A requirements in Article 8 of Regulation S-X;
- add a definition of significant subsidiary that is tailored for investment companies; and
- add a new Rule 6-11 and amend Form N-14 to cover financial reporting for fund acquisitions by investment companies and business development companies.
The rules related to disclosures for the acquisitions and dispositions of businesses are complex and involve a significant accounting analysis. I like to leave the accounting to the accountants, but legal advisors need to be able to understand the requirements and assist client companies in making fully informed business decisions regarding the acquisition or disposition of a business. This blog will focus on explaining the rules without diving into the overly labyrinthine accounting technicalities.
Rules 3-05 and 8-04 of Regulation S-X – Financial Statements of Businesses Acquired or to Be Acquired
Summary of Current Rule
Rule 3-05 of Regulation S-X requires a reporting company to provide separate audited annual and reviewed stub period financial statements for any business that is being acquired if that business is significant to the company. A “business” can be acquired whether the transaction is fashioned as an asset or stock purchase. The question of whether it is an acquired “business” revolves around whether the revenue-producing activity of the target will remain generally the same after the acquisition. Accordingly, the purchase of revenue-producing assets will likely be treated as the purchase of a business.
In determining whether an acquired business is significant, a company must consider the investment, asset and income tests set out in Rule 1-02 of Regulation S-X. The “investment test” considers the value of investments in and advances to the acquired business relative to the value of the total assets of the company prior to the purchase. The “asset test” considers the total value of the assets of the company pre- and post-acquisition. The “income test” considers the change in income of the company as a result of the acquisition.
Rule 3-05 requires increased disclosure as the size of the acquisition, relative to the size of the reporting acquiring company, increases based on the investment, asset and income test results. If none of the test results exceed 20%, there is no separate financial statement reporting requirement as to the target company. If one of the tests exceeds 20% but none exceed 40%, Rule 3-05 requires separate target financial statements for the most recent fiscal year and any interim stub periods. If any Rule 3-05 text exceeds 40% but none exceed 50%, Rule 3-05 requires separate target financial statements for the most recent two fiscal years and any interim stub periods. When at least one Rule 3-05 test exceeds 50%, a third fiscal year of financial statements are required, except that smaller reporting and emerging growth companies are never required to add that third year.
Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the registrant is a smaller reporting company.
Both Rule 3-05 and 8-04 require pro forma financial statements. Pro forma financial statements are the most recent balance sheet and most recent annual and interim income statements, adjusted to show what such financial statements would look like if the acquisition had occurred at that earlier time.
An 8-K must be filed within 4 days of a business acquisition, disclosing the transaction. The Rule 3-05 or 8-04 financial statements must be filed within 75 days of the closing of the transaction via an amendment to the initial closing 8-K. Where the acquiring public reporting company is a shell company, the required Rule 8-04 financial statements must be included in that first initial 8-K filed within 4 days of the transaction closing (commonly referred to as a Super 8-K). By definition, a shell company would always be either an emerging growth or smaller reporting company and accordingly, the more extensive Rule 3-05 financial reporting requirements would not apply in that case.
The Rule 3-05 or Rule 8-04 financial statements are also required in a pre-closing registration statement filed to register the transaction shares or certain other pre-closing registration statements where the investment, asset or income tests exceed 50%. Likewise, the Rule 3-05 or Rule 8-04 financial statements are required to be included in pre-closing proxy or information statements filed under Section 14 of the Exchange Act seeking either shareholder approval of the transaction itself or corporate actions in advance of a transaction (such as a reverse split or name change). See my short blog HERE discussing pre-merger Schedule 14C financial statement requirements.
In what could be a difficult and expensive process for companies engaged in an acquisition growth model, if the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses.
Final Rule Change
The SEC has substantively revised the investment and income tests for non-investment companies and made non-substantive changes to the asset test. All three significance tests have been revised for investment companies. The final amendments also provide that, for acquisitions, intercompany transactions with the acquired business must be eliminated from the company’s and its subsidiaries’ consolidated total assets when computing the Asset Test.
The investment test compares the company’s and its other subsidiaries’ investments in (i.e., the purchase consideration paid) and advances to the tested subsidiary to the total assets of the company and its subsidiaries consolidated reflected at the end of the most recently completed fiscal year, or in the case of an acquired business, in the company’s most recent annual financial statements required to be filed at or prior to the acquisition date.
The SEC has amended the investment test such that the company’s investments in and advances to the acquired business will be compared to the aggregate worldwide market value of the company’s voting and non-voting common equity when available. If the company does not have a worldwide market value, the existing test would still be used. The SEC believes that market value is a better parameter for determining the economic significance of an acquisition. I agree. Assets generally remain on the books at purchase price valuation, or are reduced for depreciation or amortization. For non-investment companies, assets are never marked up to fair value and, as such, can quickly become a stale indication of a company’s current value.
The amendments specifically address when aggregate market value should be determined, provide instructions for determining investments and advances, including contingent consideration, and clarify the use of the test for related party transactions.
The income test compares the company’s equity in the tested subsidiary’s income from continuing operations before income taxes, including only income amounts contributed to the company’s particular equity in the subsidiary (such as when the subsidiary is not wholly owned) to such income of the company for the most recently completed fiscal year.
The SEC has revised the income test by adding a revenue component and by using income or loss from continuing operations after income taxes (as opposed to before income taxes). This change will help account for factors that could distort income in a given year such as non-recurring expense items. In addition, the change will reduce the anomalous result of making an otherwise insignificant acquisition seem significant, where a company has marginal or break-even net income or loss in a year.
Under the amendment, where a company and the target have recurring revenue, both revenue and income should be tested. By revising the income test to require that the company exceed both the revenue and net income components when the revenue component applies, the SEC believes the test will more accurately determine whether a tested subsidiary is significant. If the company or the target does not have recurring revenue, only the net income test would be used.
In addition, the SEC has eliminated the requirement that three years of financial statements be provided for certain significant acquisitions and instead has capped the period at two years. The SEC has also revised Rule 3-05 for acquisitions where a significance test exceeds 20%, but none exceeds 40%, to require financial statements for the “most recent” interim period specified in Rule 3-01 and 3-02 rather than “any” interim period.
The final amendments also clarify that where a Form 10-K is filed after an acquisition closes but prior to the filing of the target financial statements, significance can be determined using either the last Form 10-K filed prior to the acquisition closing, or the newest Form 10-K filed after the closing. The final amendments also make various definition and word changes thought to more clearly and accurately reflect the implementation of the rules.
Where assets are purchased that constitute a business, but are not all of the assets or products of the seller, it can be difficult to create historical financial statements that only cover the sold assets. Accordingly, the SEC has amended the rules to permit companies to provide abbreviated audited financial statements including a balance sheet consisting of assets acquired and liabilities assumed, and statements of revenues and expenses (exclusive of corporate overhead, interest and income tax expenses) if: (i) the business constitutes less than 20% all of the assets and revenues of the seller, after eliminating intercompany transactions, as of the most recent fiscal year-end; (ii) the acquired business was not a separate entity, subsidiary, segment, or division during the periods for which the acquired business financial statements would be required; (iii) separate financial statements for the business have not previously been prepared; (iv) the seller has not maintained the distinct and separate accounts necessary to present financial statements that include the omitted expenses and it is impracticable to prepare such financial statements; (iv) interest expense may only be excluded if the corresponding debt will not be assumed; (v) the financial statements do not omit selling, distribution, marketing, general and administrative, research and development, or other expenses other than corporate overhead, interest in some cases, and income taxes, incurred by or on behalf of the acquired business during the periods to be presented; and (vi) the notes to financial statements include certain additional disclosures.
Foreign Business Acquisition
The SEC is modified Rule 3-05 to permit financial statements to be prepared in accordance with IFRS-IASB without reconciliation to U.S. GAAP if the acquired business would qualify to use IFRS-IASB if it were a registrant, and to permit foreign private issuers that prepare their financial statements using IFRS-IASB to provide Rule 3-05 financial statements prepared using home country GAAP to be reconciled to IFRS-IASB rather than U.S. GAAP.
Smaller Reporting Companies and Regulation A Issuers
As mentioned above, Rule 8-04 is the sister rule to 3-05 for smaller reporting companies. Rule 8-04 is substantially similar to Rule 3-05 with the same investment, asset and income tests and same 20%, 40% and 50% thresholds. However, Rule 8-04 has some pared-down requirements, including, for example, that a third year of audited financial statements is never required where the company is a smaller reporting company. Regulation A issuers are permitted to follow Rule 8-04.
The SEC has revised Rule 8-04 such that smaller reporting companies would be directed to Rule 3-05 for the requirement relating to the financial statements of businesses acquired or to be acquired, other than for form and content requirements for such financial statements, which would continue to be prepared in accordance with Article 8.
Additionally, under the amendments, a smaller reporting company is eligible to exclude acquired business financial statements from a registration statement if the business acquisition was consummated no more than 74 days prior to the date of the relevant final prospectus or prospectus supplement, rather than 74 days prior to the effective date of the registration statement as under the current rules.
Financial Statements in Registration Statements and Proxy Statements
Prior to the amendments, the rules could result in separate historical financial statements of the acquired business required to be included in registration statements and/or proxy statements after the closing of the acquisition and after SEC reports have been filed including the consolidated financial statements of the then combined entities. The amendment rule no longer requires Rule 3-05 financial statements in registration statements and proxy statements once the acquired business is reflected in filed post-acquisition company consolidated financial statements in certain circumstances.
Specifically, where an acquisition exceeds 20% but is less than 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least nine months, separate financial statements will no longer need to be included in proxy or registration statements. Where an acquisition exceeds 40% significance once financial statements are included in the company’s audited post-acquisition consolidated financial statements for a period of at least a complete fiscal year, separate financial statements will no longer need to be included in proxy or registration statements.
Individually Insignificant Acquisitions
If the aggregate impact of individually insignificant business acquisitions exceeds 50% of the investment, asset or income tests, Rule 3-05 or Rule 8-04 financial statements and pro forma financial statements must be included for at least the substantial majority of the individual acquired businesses. The rule amendments require disclosure if the aggregate impact of businesses acquired or to be acquired since the date of the most recent audited balance sheet filed for the company, exceeds 50%. Pro forma financial information is only required for those businesses whose individual significance exceeds 20% but are not yet required to file financial statements.
Use of Pro Forma Financial Information to Measure Significance
A company is generally permitted to use pro forma, rather than historical, financial information to test significance of a subsequently acquired business if the company made a significant acquisition after the latest fiscal year-end and filed its Rule 3-05 Financial Statements and pro forma financial information on Form 8-K as required. The amended rules continue to permit a company to use these pro forma financial statements and expands that ability to include pro forma financial information that only depicts significant business acquisitions and dispositions consummated after the latest fiscal year-end as long as such pro forma information has been filed in an 8-K or amended 8-K.
Rule 3-14 of Regulation S-X – Financial Statements of Real Estate Acquired or to Be Acquired
The SEC has historically believed that the real estate industry has distinct considerations. For example, audited financial statements for a real estate operation are rarely available from the seller without additional effort and expense because most real estate managers do not maintain their books on a U.S. GAAP basis or obtain audits. However, in reality the SEC had found that the differences between the financial statement materiality throughout the industries is much less significant than thought. As such, the SEC has amended the rules to more closely align the financial statement requirement of Rule 3-14 with Rule 3-05.
Article 11 – Pro Forma Financial Information
Article 11 of Regulation S-X details the pro forma financial statement requirements that must accompany both Rule 3-05 and 3-14 financial statements. Typically, pro forma financial information includes the most recent balance sheet and most recent annual and interim period income statements. Pro forma financial information for an acquired business is required at the 20% and 10% significance thresholds under Rule 3-05 and Rule 3-14, respectively. The rules also require pro forma financial information for a significant disposed business at a 10% significance threshold for all companies.
The SEC has revised the accounting adjustments made in preparation of the pro forma financial statements with the intent of simplifying the requirements and better reflecting the synergies of the transaction. The SEC amended Article 11, by replacing the existing pro forma adjustment criteria with simplified requirements to depict the accounting for the transaction and to provide the option to depict synergies and dis-synergies of the acquisitions and dispositions for which pro forma effect is being given.
The SEC also raised the pro forma financial statement requirement for a disposition from 10% to 20% based on significance testing. Rule 8-05 for smaller reporting companies and Regulation A issuers have been amended to align with the pro forma financial statement requirements in Article 11.
Now that the market can review and dissect two quarters of Covid-related disclosures and reporting companies are gearing up for third-quarter reporting, Covid disclosures are no longer pure speculation. Following the two official guidelines released by the SEC (Disclosure Guidance Topic No. 9A which supplemented the previously issued Topic No. 9), a new CD&I issued on Covid-19 executive employment benefits, and numerous unofficial statements and speeches on the topic, the investment community and reporting companies are navigating the areas that require the most attention and thoughtful disclosure. Not surprisingly, the areas requiring the greatest consideration are management, discussion and analysis (including human capital disclosures and forecasting), risk factors, and internal controls over financial reporting.
Covid-19 “Benefits” – SEC Issues New C&DI
On September 21, 2020, the SEC issued a new compliance and disclosure interpretation (C&DI) related to the reporting of compensation perks or benefits. In particular, the SEC stated that:
In reporting compensation for periods affected by Covid-19, questions may arise as to whether benefits provided to executive officers because of the Covid-19 pandemic constitute perquisites or personal benefits for purposes of the disclosure required by Item 402(c)(2)(ix)(A) and determining which executive officers are “named executive officers” under Item 402(a)(3)(iii) and (iv). The two-step analysis articulated by the Commission in Release 33-8732A continues to apply when determining whether an item provided because of the Covid-19 pandemic constitutes a perquisite or personal benefit.
- An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties.
- Otherwise, an item that confers a direct or indirect benefit and that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, is a perquisite or personal benefit unless it is generally available on a non-discriminatory basis to all employees.
Whether an item is “integrally and directly related to the performance of the executive’s duties” depends on the particular facts. In some cases, an item considered a perquisite or personal benefit when provided in the past may not be considered as such when provided as a result of Covid-19. For example, enhanced technology needed to make the CEO’s home his or her primary workplace upon imposition of local stay-at-home orders would generally not be a perquisite or personal benefit because of the integral and direct relationship to the performance of the executive’s duties. On the other hand, items such as new health-related or personal transportation benefits provided to address new risks arising because of Covid-19, if they are not integrally and directly related to the performance of the executive’s duties, may be perquisites or personal benefits even if the company would not have provided the benefit but for the Covid-19 pandemic, unless they are generally available to all employees.
Although not tied into Covid, a week after issuing the new C&DI, the SEC filed settled enforcement charges against Hilton Worldwide Holdings for failing to fully disclose perquisites and personal benefits provided to executive officers. This is clearly a topic the SEC is paying attention to.
Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A)
Item 303 of Regulation S-K (MD&A) requires discussions on liquidity, capital resources, results of operations, off-balance-sheet arrangements, and contractual obligations including any material changes. For example, Item 303 requires disclosure of “known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.” It also requires disclosure of unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations as well as known trends or uncertainties that have had or that the the company reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations.
In January 2020, the SEC issued interpretative guidance on MD&A (see Here) reminding companies to include information not specifically referenced in the item that the company believes is necessary to an understanding of its financial condition, changes in financial condition and results of operations. Covid-19 has made MD&A a source of heartburn for most companies.
A part of MD&A necessarily involves a level of forecasting, especially related to liquidity and cash flows and uses (in addition to the obvious forecasting included in earnings releases and published guidance – see Here). The Covid pandemic has affected different companies and sectors of the economy dramatically differently, with some struggling to get back to pre-outbreak operations (airlines) and others benefiting (Amazon). Either way, management has to use all of its available resources to provide meaningful MD&A disclosure on the results of operations for current periods and potential future impacts and changes. Moreover, it is likely that the world will not simply return to pre-Covid growth and operations, but rather, there could be a permanent shift in business models as a result of the pandemic.
Some steps management can take to assist in forecasting include (i) focusing on factors that the management can control and that are known; (ii) automating operational data to the greatest extent possible to maintain real-time updated information; and (iii) modeling different scenarios and weighing which ones seem most likely in light of current information.
In addition to operational changes, whether positive or negative, management has been carefully considering and disclosing the impact Covid has had on various expenses such as work-from-home changes or the restructuring of severance, impairments or stock incentive plans. Some expenses and write-downs have evolved into ordinary as opposed to unusual or non-recurring. On the flip side, a company must disclose the receipt of government assistance and the impact that is having on liquidity and the likely impact when such assistance is used up and no longer available.
Although there is an outstanding proposed rule amendment which would alter this structure, the substantive information that must be disclosed by management, including related to Covid-19 and its impact on a business, would remain unchanged.
Covid-19 risk factors are now included in close to 100% of periodic reports that require risk factor disclosures and likewise in close to 100% of Securities Act and Exchange Act registration statements. As a reminder, smaller reporting companies are not required to include risk factors in their Exchange Act reports though they are required in all registration statements and Regulation A offering circulars.
Almost all companies, whether truly directly impacted or not, now include general risk factors related to uncertainty regarding the duration of the Covid-19 pandemic, the impact of the economic downturn, and changes in consumer behaviors both during and after the pandemic. In addition, almost all companies in which such disclosures could be applicable, include general risk factors regarding travel and energy, work-from-home practices and governmental stay-at-home orders.
Internal Controls over Financial Reporting (ICFR)
One of the most difficult aspects of managing the Covid-19 crisis has been the impact on internal controls over financial reporting (ICFR). In particular, managing remote workforces, the sometimes drastic impacts on income and expenses, government-mandated shutdowns, cluster breakouts in some businesses, and controlling the expenditures of government PPP loans have all had a direct impact on ICFR.
In addition to the high level necessity of ensuring that ICFR procedures make certain that transactions are executed in accordance with management’s general or specific authorization and recorded as necessary to permit preparation of financial statements in conformity with US GAAP or International Financial Reporting Standards (IFRS), ICFR procedures include ensuring that access to assets, including cash and inventory, is only had in accordance with management’s instructions or authorization. Recorded accountability for assets must be compared with the existing assets at reasonable intervals and appropriate action be taken with respect to any differences. Covid-19 necessarily has an impact on these responsibilities.
It is vitally important that a company carefully review its ICFR, including with the advice of professionals, and make adjustments to be sure that proper controls are and remain in place. Potential and actual disruptions to a company’s supply chain, customer base, operations, processes and workforce should be weighed when evaluating the operating effectiveness of legacy controls. In situations in which the responsibilities for controls have been reassigned because of changes in personnel, companies should specifically evaluate whether appropriate segregation of duties continues to exist. Technology and cyber-security must also be reviewed to be sure that remote workers can continue to perform effectively.
Some companies are adapting quickly implementing video technology for inventory and asset review and improved technology, including blockchain, for real-time assessments.
It is also important that management’s assessment over internal controls in the body of Forms 10-Q and 10-K be carefully reviewed to ensure that any deficiencies created by Covid-19 are disclosed together with remedial measures.
Non-GAAP – EBITDAC Reporting
Since Covid began, some companies have created a new metric of for reporting financial results – earnings before interest, taxes, depreciation, amortization, and Covid – or EBITDAC. The form of EBITDAC varies with some companies adjusting EBITDA for Covid-19-related expenses or presenting gross margin without Covid-19 impacts.
Despite the natural inclination to want to disclose to the marketplace that, but for Covid, results of operations would be better than they actually are, the SEC is scrutinizing any such creative financial metric. Also, Topic 9 specified that the SEC does not think it is appropriate to present non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company. Any metric must include an explanation as to why management finds the measure useful and how it helps investors assess the impact of Covid on the company’s financial position and results of operations.
Also, it is important that companies remember that whenever presenting a figure or metric that is non-GAAP, it must comply with Regulation G or Item 10 of Regulation S-K, including providing a reconciliation to GAAP numbers, the reasons for presenting the non-GAAP numbers and particulars on the presentation and formatting of the information – see Here.
In the 4th quarter of 2018, the SEC finalized amendments to the disclosure requirements for mining companies under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). See HERE. In addition to providing better information to investors about a company’s mining properties, the amendments were intended to more closely align the SEC rules with industry and global regulatory practices and standards as set out in by the Committee for Reserves International Reporting Standards (CRIRSCO). The amendments rescinded Industry Guide 7 and consolidated the disclosure requirements for registrants with material mining operations in a new subpart of Regulation S-K.
The final amendments require companies with mining operations to disclose information concerning their mineral resources and mineral reserves. Disclosures on mineral resource estimates were previously only allowed in limited circumstances. The rule amendments provided for a two-year transition period with compliance beginning in the first fiscal year on or after January 1, 2021.
In April 2020 the SEC issued three new compliance and disclosure interpretations (C&DI) providing guidance on the new rules.
The C&DI focus on when a company must comply with the new rules. The SEC clarifies that a company engaged in mining operations must comply with Subpart 1300’s disclosure rules beginning with its Exchange Act annual report for the first fiscal year beginning on or after January 1, 2021. Until then, staff will not object if the company relies on the guidance provided in Guide 7 and by the Division of Corporation Finance staff for the purpose of filing an Exchange Act annual report. To be clear, a company with a fiscal year end of December 31st would not have to comply with the new rules until its annual report for the year ended December 31, 2021.
The second C&DI clarifies requirements for Securities Act registration statements for mining companies. In particular, where a company qualifies to utilize incorporation by reference (see HERE), it may do so when filing a Securities Act registration statement, even if the Exchange Act report being incorporated does not satisfy the requirements of the new Subpart 1300 disclosure requirements.
Until annual financial statements for the first fiscal year beginning on or after January 1, 2021 are required to be included in the registration statement, the SEC will not object if a Securities Act registration statement incorporates by reference disclosure prepared in accordance with Guide 7 from an Exchange Act annual report for the appropriate period filed by a company engaged in mining operations if otherwise permitted to do so. The SEC also reminds companies to consider all SEC rules related to incorporation by reference when doing so, including that information must not be incorporated by reference in any case where such incorporation would render the disclosure incomplete, unclear, or confusing.
Likewise, the third C&DI drills down on the “when” for compliance with the new Subpart 1300 rules. An Exchange Act or Securities Act registration statement that does not incorporate by reference mining property disclosure from an Exchange Act annual report filed by a registrant engaged in mining operations must comply with the new mining property disclosure rules set forth in Subpart 1300 of Regulation S-K on or after the first day of the first fiscal year beginning on or after January 1, 2021.
For example, a calendar year-end company would be required to comply with the new mining property disclosure rules when filing an Exchange Act registration statement or a Securities Act registration statement that does not incorporate by reference from its Exchange Act annual report on or after January 1, 2021, while a company with a June 30th fiscal year-end would be required to comply with the new mining property disclosure rules when filing an Exchange Act or Securities Act registration statement that does not incorporate by reference disclosure from its Exchange Act annual report on or after July 1, 2021.
Refresher on Subpart 1300
In amending the disclosure rules for mining companies, the SEC considered that many companies are already subject to one or more of the rules and that by aligning the SEC reporting requirements to these rules, the compliance burden and costs for these companies could be reduced while still providing the necessary investor protections.
Under the final rules, a company with material mining operations must disclose specific information related to its mineral resources and mineral reserves on one or more of its properties. The rules define “mineral reserve” to include diluting materials and allowances for losses that may occur when the material is mined or extracted. The rules also amend the definition of “mineral resource” to exclude geothermal energy. Consistent with CRIRSCO standards, a company must disclose exploration results, mineral resources, or mineral reserves in SEC filings based on information and supporting documentation prepared by a mining expert referred to as a “qualified person.”
A company must obtain a dated and signed technical report summary from the qualified person related to mineral resources and reserves determined to be on each material property. The report must be signed either directly by the qualified person or the firm that employs them. Moreover, multiple qualified persons may take part in preparing the final technical report summary. The qualified person may conduct either a pre-feasibility or final feasibility study to support a determination of mineral reserves even in high-risk situations. The report must be filed as an exhibit to the company’s SEC report when first disclosed and subsequent changes or amendments to the report must also be filed as exhibits. A technical report on exploration results may also be voluntarily filed as an exhibit.
The final rules require the qualified person to use a price for each commodity that provides a reasonable basis for establishing estimates of mineral resources or reserves. The price may be either historical or forward-looking, but the report must disclose and explain the reasons for using the selected price, including any material underlying assumptions. Similarly, instead of requiring a specific point of reference, the qualified person may choose any point of reference subject to disclosure and explanations. The technical report summary may disclose mineral resources as mineral reserves as long as it also discloses mineral resources excluding mineral reserves.
A qualified person is not subject to expert liability under Section 11 of the Securities Act of 1933 (“Securities Act”) for information and factors that are outside that person’s expertise, even if discussed in the technical report.
Although the proposed rule amendment provided for quantitative presumptions as to when mineral resources or reserves will be deemed material, the final rule did not include this provision, instead allowing management to rely on a principles-based approach in determining materiality. Likewise, management can determine when a change in previously reported estimates of mineral resources or reserves is material. Also, the proposed rule would have required a table with certain information on a company’s top 20 properties, but the final rule instead also uses a principles-based approach, again leaving it to the company to determine material disclosures of its properties and mining operations.
Materiality relating to mineral resources and reserves has been modified to consistently rely on a principles-based approach. A principles-based approach requires the company to “rely on a registrant’s management to evaluate the significance of information in the context of the registrant’s overall business and financial circumstances” and to “exercise judgment” in determining whether disclosure is required. The SEC has shown a trend towards this principles-based approach for determining materiality for purposes of disclosure in its recent reviews and amendments to Regulation S-K and Regulation S-X (see, for example, HERE and HERE). Practitioners, including the American Bar Association (“ABA”), have advocated for principles-based disclosure over quantitative or bright line tests (see HERE) believing that a quantitative guideline results in lengthy, and often immaterial, information.
The number of summaries and tables that are currently required has been reduced from seven to two and the company may now choose to make its disclosures using either tables or a narrative format. A company is permitted to voluntarily disclose exploration targets in its SEC reports as long as they are accompanied by certain specified cautionary and explanatory statements. Disclosure of exploration activity and results is mandatory once the company determines the information is material to investors. Also, the qualified person may include inferred resources in their economic analysis as long as certain conditions are met.
A company may now use historical estimates of mineral resources or reserves in SEC filings pertaining to mergers, acquisitions, or business combinations if they are unable to update the estimate prior to the completion of the relevant transaction, provided that the company discloses the source and date of the estimate, and does not treat the estimate as a current estimate.
Finally, the amended rules allow a company holding a royalty or similar interest to omit any information required under the summary and individual property disclosure provisions to which it lacks access and which it cannot obtain without incurring an unreasonable burden or expense.
As is usual, there are times where I find there are fewer current events to write about in the world of capital markets and I go back to the basics of this regulatory regime I find so fascinating, and others where I have 30 current topics in my writing queue and then a global pandemic occurs adding daily new topics to my list and poof! – six months goes by. Although they were bumped down the list, many of the proposed and completed regulatory changes, and other events, that were on the list remain worthy of attention.
In December 2019, the SEC proposed amendments to codify and modernize certain aspects of the auditor independence framework. The current audit independence rules were created in 2000 and amended in 2003 in response to the financial crisis facilitated by the downfall of Enron, WorldCom and auditing giant Arthur Andersen, and despite evolving circumstances have remained unchanged since that time. The new rules are meant to ease restrictions such that relationships and services that would not pose threats to an auditor’s objectivity and impartiality do not trigger non-substantive rule breaches or potentially time consuming audit committee review of non-substantive matters.
The underlying theory to Rule 2-01, the auditor independence rule, is that if an auditor is not independent, investors will have less confidence in their report and the financial statements of a company. The more confidence an investor and the capital markets participants have in audited financial statements, the more a company will enjoy better access to liquidity and capital finance in the public markets. Rule 2-01 requires that an auditor be independent of their audit clients in “fact and appearance.”
In 2000, the SEC adopted a comprehensive framework of rules governing auditor independence, laying out governing principles and describing certain specific financial, employment, business, and non-audit service relationships that would cause an auditor not to be independent. Like most SEC rules, the auditor independence rules require an examination of all relevant facts and circumstances. Under Rule 2-01(b), an auditor is not independent if that auditor, in light of all facts and circumstances, could not reasonably be capable of exercising objective and impartial judgment on all issues encompassed within the audit duties. Rule 2-01(c) provides a non-exclusive list of circumstances in which the SEC would consider inconsistent with independence.
However, over the years, based on company and SEC staff review and feedback, it has become apparent that the current rules should be updated to address changing market conditions and eliminate unnecessary burdens and expenses associated with the client-auditor relationship.
Definition of Audit Client
The SEC is proposing to amend the definition of an “audit client” with a focus of decreasing the number of sister or affiliated entities that could come within the current definition but that may be immaterial or far removed from the entity actually being audited. Currently an audit client includes not only the entity being audited but also affiliates of the audit client. Affiliates is broadly defined and includes entities under common control of the audit client, such as sister entities. Moreover, the current definition of investment company complex (“ICC”) includes not just the investment companies that share an investment adviser or sponsor with an investment company audit client, but also includes any investment company advised by a sister investment adviser or has a sister sponsor.
The SEC recognizes challenges in identifying and applying the common control element of independence, especially where the sister entity is immaterial and/or part of a complex group of investment funds and their portfolio companies. In the private equity and investment company context, where there potentially is a significant volume of acquisitions and dispositions of unrelated portfolio companies, the definition of affiliate of the audit client may result in an expansive and constantly changing list of entities that are considered to be affiliates of the audit client.
Monitoring the relationships results in increased compliance costs, even where there is not a likely threat to the auditor’s objectivity and impartiality. In addition, the pool of available auditors for sister or private equity portfolio companies can be negatively impacted where audit firms provide services to sister or related entities that currently technically would violate the independence rules.
The SEC is proposing to amend the definition of affiliate and ICC as relates to an “audit client” to include materiality qualifiers in the common control provisions and to provide distinctions for when an auditor is auditing a portfolio company, an investment company, or an investment advisor or sponsor. The amendment to the definition would not alter the general requirement that an auditor review all facts and circumstances to confirm independence. The changes are expected to make it easier to identify conflicts and to increase choices and competition for audit services.
Audit and Professional Engagement Period
Currently the definition of audit engagement period is different for foreign private issuers (FPIs) and domestic companies. For a domestic company, the audit engagement period begins when the auditor is first engaged to audit or review financial statements that will be filed with the SEC. For an FPI, the audit engagement period begins on the first day of the last fiscal year before the FPI first filed, or was required to file, a registration statement or report with the SEC. That is, if a domestic company conducts an IPO requiring two years of financial statements, the auditor must be independent for both of those years; however, if an FPI conducts an IPO, the auditor only has to be independent during the most recently completed fiscal year.
The SEC believes this disparity puts domestic issuers at a disadvantage in entering the US capital markets when compared to an FPI. The SEC, and commenters, believe shortening the look-back period may encourage capital formation for domestic companies contemplating an IPO.
The SEC is proposing to amend the rules such that an audit engagement period for domestic issuers will match that for FPIs aligning both with a one-year look-back for first-time filers.
Loans and Debtor-Creditor Relationships
Currently an auditor is not independent if the firm, any covered person in the firm, or any of their immediate family members has any loans (including a margin loan) to or from an audit client or certain entities related to the audit client. The Rule contains specific exceptions where the following loans are given from a financial institution under normal procedures: (i) automobile loans and leases; (ii) insurance policy loans; (iii) loans fully collateralized by cash deposits at the same financial institution; (iv) primary residence mortgage loans that were not obtained while the covered person was a covered person; (v) credit card balances that are reduced to $10,000 or less on a current basis.
The SEC is now proposing to add student loans that are not obtained while the covered person was a covered person, to the list of exceptions. In addition, the SEC is proposing to add language to the mortgage loan exception so that it is clear that all loans on a primary residence, including second mortgages and equity lines of credit, are included in the exception.
The SEC is also proposing to revise the credit card rule to refer to “consumer loans” to encompass any consumer loan balance owed to a lender that is an audit client that is not reduced to $10,000 or less on a current basis taking into consideration the payment due date and available grace period.
Business Relationship Rule
The current rules prohibit the audit firm, or any covered person, from having any direct or material indirect business relationship with the audit client or affiliate, including the audit client’s officers, directors or substantial stockholders. The SEC is proposing to replace the term “substantial stockholders” in the business relationships rule with the phrase “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.”
As additional guidance, the SEC clarifies that the business relationships analysis should be on persons with decision-making authority over the audit client and not affiliates of the audit client.
Inadvertent Violations for Mergers and Acquisitions
An independence violation can arise as a result of a corporate event, such as a merger or acquisition, where the services or relationships that are the basis for the violation were not prohibited by applicable independence standards before the consummation of transaction. The SEC is proposing a transition framework for mergers and acquisitions to address inadvertent violations related to such transactions so the auditor and its audit client can transition out of prohibited services and relationships in an orderly manner. Under the proposed rule, an auditor will need to correct the independence violations as promptly as possible considering all relevant facts and circumstances. Audit firms will also need to effectuate quality control standards that anticipate and provide for procedures in the event of a merger or acquisition.
Although many aspects of an IPO are unaffected by a pandemic, assuming the capital markets continue to have an appetite for public offerings, the grueling road show has gone virtual, and it may be here to stay. An old-fashioned road show involved an intense travel schedule and expensive setup. The new virtual road show can be completed in half the time and a fraction of the price, and interestingly, the IPO’s that have been completed since March 2020, have all priced their deals at the midpoint or higher of their ranges. The lack of face-to-face presentations is not hurting the deals.
I tend to believe the world has changed forever. However, fluidity of memory and a capacity to adapt are fundamental human traits and we have and will adapt our business style to adjust to a world where germs are a real enemy and getting sick doesn’t just mean a day or two out of the office. There has been a perfect storm of advanced technology that allows us to see and hear each other in real time, coupled with a need to avoid crowds and close person-to-person contact with people you don’t live with. We are all comfortable with Zoom, and very quickly 3D holographic images, avatars and other AR/VR technologies could become business commonplace.
In addition to the dramatic change of the road show, IPO’s in the Covid world require a more complex carefully crafted registration statement and prospectus. As I’ve discussed in a series of blogs on Covid-related disclosures (see here for the most recent which contains links to prior blogs on the topic HERE), regulators and the marketplace expect in-depth discussions on the current and anticipated effects of the virus on businesses, with updates as those effects and projections evolve. Risk factors are generally much more robust with drill-downs on an array of potential issues from debt management to human resource uncertainties.
The good news is that the markets are booming. Tech and pharma IPO’s continue unabated and even increased compared to other mid-summer years, especially election years. The country is mired in the worst pandemic in a century and suffered its steepest-ever quarterly plunge in economic activity in the second quarter. Yet the equity markets are rallying, and tech and pharma stocks are trading at historical premiums. Some are predicting there will be at least 15 venture-backed tech IPO’s before the end of the year. Also, although analysts and venture firms focus on the big-board IPO’s, the small and lower middle market deals are busier than ever with IPO’s, a record-setting number of SPAC deals, and a non-stop string of follow on offerings.
We are resilient and the success of the virtual road show is just an example of that resilience. In addition, to the decreased time and expense, as explained below, a virtual road show will almost never involve a written offering or free writing prospectus, allowing for widespread use by all levels of companies.
The Road Show
We often hear the words “road show” associated with a securities offering. A road show is simply a series of presentations made by company management to key members of buy-side market participants such as broker-dealers that may participate in the syndication of an offering, and institutional investor groups and money managers that may invest into an offering. A road show is designed to provide these market participants with more information about the issuer and the offering and a chance to meet and assess management, including their presentation skills and competence in a Q&A setting. Investors often place a high level of importance on road show presentations and as such, a well-run road show can make the difference as to the level of success of an offering. In a virtual road show it is extremely important that the best technology be utilized so the audience can clearly see and hear the presenter to be able to make the same type of assessment as they would in person.
A road show historically involved an intensive period of multiple meetings and presentations in a number of different cities over a one-to-two-week period. Although road shows were generally live, even before Covid they were sometimes by teleconference, or electronic using prepared written presentation materials. Road shows are often recorded from a live presentation and made available publicly for a period of time. The meetings and presentations can vary in length and depth depending on the size and importance of the particular audience. During the road show, the underwriters are building a book of interest which will help determine the pricing for the offering.
A company can also conduct a “non-deal road show” for the purpose of driving interest in the company and its stock, where no particular offering is planned.
Unless it is a non-deal road show, the road show involves an offer of securities. “Offers” of securities are very broadly defined. Section 2(a)(3) of the Securities Act defines “offer to sell,” “offer for sale,” or “offer” to include “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.”
The timing and manner of all offers of securities are regulated, and especially so in registered offerings. All issuers that have filed a registration statement are permitted to make oral offers of their securities, but only certain types of written offers are allowed. Written offers must comply with Section 10 of the Securities Act, including a requirement that a prospectus meeting the information requirements in Section 10(a) be delivered at the time of or prior to the offer. Delivery can be accomplished through the filing of a preliminary prospectus with the SEC, which is publicly available on the EDGAR system.
In addition, certain eligible issuers may provide supplemental written information and graphic communications not otherwise included in the prospectus that is filed with the SEC (i.e., a free writing prospectus) as part of an offer of securities. All of these oral and written communication rules are implicated in the road show process and must be considered when planning and completing the road show whether it is live or virtual.
A road show is generally timed to be completed in the last few weeks before a registration statement goes effective or a Regulation A offering circular becomes qualified. In a registered offering, Section 5(c) prohibits offers prior to the filing of the registration statement and as such, the road show would never commence pre-filing. Regulation A is not a registered offering for purposes of Section 5(c), but for practical purposes, a Regulation A road show also commences right before SEC qualification.
Securities Act Rule 163 provides an exception to the pre-filing offer rules only available to well-known seasoned issuers. A well-known seasoned issuer is generally one with a non-affiliate public float of more than $700 million or has issued at least $1 billion in non-convertible securities in primary offerings for cash in the last 3 years, is S-3 eligible (see HERE), is not an ineligible issuer (described below), is not an asset-backed issuer and is not an investment company.
For a private offering, the road show occurs once the offering documents are completed. A company that has filed its registration statement on a confidential basis must make the initial filing and all confidentially submitted amendments public a minimum of 15 days prior to starting the road show. For more information on confidential filings, and when a company is eligible to do so, see HERE.
A road show is subject to the test-the-waters and pre-effective communication rules. For a review of testing the waters in a registered offering, see HERE and HERE and for Regulation A offerings, see HERE.
A road show is specifically regulated under Rule 433 of the Securities Act and the free writing prospectus rules. Securities Act Rule 433(h)(4) defines a road show as an offer, other than a statutory prospectus, that “contains a presentation regarding an offering by one or more of the members of the issuer’s management ….. and includes discussion of one or more of the issuer, such management, and the securities being offered.”
The SEC definition of road show includes the language “other than a statutory prospectus.” The statutory prospectus is one that meets the requirements of Section 10(a) of the Securities Act and is generally the filed prospectus that contains the disclosures outlined in the particular offering form being used (for example, Form S-1 or 1-A) and including disclosures delineated in Regulations S-K and S-X. To meet the requirements of Section 10(a), the prospectus must include a price range and estimate of volume of shares to be registered.
In general, if the information being presented in a road show is nothing more than what is already included in the prospectus filed with the SEC, there are no particular SEC filing requirements. On the other hand, if the information is written and goes beyond the statutory prospectus, it may be considered a “free writing prospectus” and be subject to specific eligibility requirements for use, form and content and SEC filing requirements all as set forth in Rule 433 and discussed herein.
Securities Act Rule 405 of the Securities Act defines a free writing prospectus (“FWP”) as “any written communication as defined in this section that constitutes an offer to sell or a solicitation of an offer to buy the securities relating to a registered offering that is used after the registration statement in respect of the offering is filed… and is made by means other than (i) a prospectus satisfying the requirements of Section 10(a) of the Act…; (2) a written communication used in reliance on Rule 167 and Rule 426 (note that both rules relate to offerings by asset backed issuers); or (3) a written communication that constitutes an offer to sell or solicitation of an offer to buy such securities that falls within the exception from the definition of prospectus in clause (a) of Section 2(a)(10) of the Act.” Section 2(a)(10)(a), in turn, exempts written communications that are provided after a registration statement goes effective with the SEC as long as the effective registration statement is provided to the recipient prior to or at the same time.
Types of Road Shows; Oral/Live vs. Written; Free Writing Prospectus (FWP) Requirements
The rules distinguish between a “live” vs. a “written” road show communication, with one being an “oral offer” and more freely allowed and the other being a “written offer” and more strictly regulated. In addition, the rules differentiate requirements based on whether a road show is for a registered or private offering and, if a registered offering, whether such offering is an initial public offering (IPO) involving common or convertible equity.
Where a road show communication is purely oral, even if virtual, it is not an FWP and thus there are no specific SEC filing requirements (though see the discussion on Regulation FD below). Where an oral communication implicates Regulation FD, a Form 8-K would need to be filed regardless of whether the communication is during a road show or in any other forum.
Although road shows are generally live and specifically designed to constitute oral offers, they can also be electronic using prepared written presentation materials. Both live and electronic road shows may be made available for replay electronically over the Internet. The live virtual road show has made the recording and replay process even easier.
Live road shows include: (i) a live, in-person presentation to a live, in-person audience; (ii) a live, real-time presentation to a live audience or simultaneous multiple audiences transmitted electronically; (iii) a concurrent live presentation and real-time electronic transmittal of such presentation; (iv) a webcast or video conference that originates live and is transmitted in real time; (v) a live telephone conversation, even if it is recorded; and (vi) the slide deck or other presentation materials used during the road show unless investors are allowed to print or take copies of the information.
The explanatory note to Rule 433(d)(8) states: “A communication that is provided or transmitted simultaneously with a road show and is provided or transmitted in a manner designed to make the communication available only as part of the road show and not separately is deemed to be part of the road show. Therefore, if the road show is not a written communication, such a simultaneous communication (even if it would otherwise be a graphic communication or other written communication) is also deemed not to be written.”
Accordingly, road show slides and video clips are not considered to be written offers as long as copies are not left behind. Even handouts are not written offers so long as they are collected at the end of the presentation. If they are left behind, however, they become a free writing prospectus (FWP) and are subject to Securities Act Rules 164 and 433, including a requirement that the materials be filed with the SEC. Accordingly, if a company is not FWP eligible, it is important to make sure that there are no downloadable materials when completing a virtual road show.
A video recording of the road show meeting will not need to be filed as an FWP so long as it is available on the Internet to everyone and covers the same ground as the live road show. Such video road shows are considered a “bona fide electronic road show.” Rule 433(h)(5) defines a “bona fide electronic road show” as a road show “that is a written communication transmitted by graphic means that contains a presentation by one or more officers of an issuer or other persons in an issuer’s management….” It is permissible to have multiple versions of a bona fide electronic road show as long as all versions are available to an unrestricted audience. For example, different members of management may record different presentations and, although access must be unrestricted, management may record versions that are more retail investor facing or institutional investor facing.
On the other hand, a FWP would include any written communication that could constitute an offer to sell or a solicitation of an offer to buy securities subject to a registration statement that is used after the filing of a registration statement and before its effectiveness. A FWP is a supplemental writing that is not part of the filed registration statement. If the writing is simply a repetition of information contained in the filed registration statement, it may be used without regard to the separate FWP rule.
Rule 405 of the Securities Act defines a written communication as any communication that is “written, printed, a radio or television broadcast or a graphic communication.” A graphic communication includes “all forms of electronic media, including but not limited to, audiotapes, videotapes, facsimiles, CD Rom, electronic mail, internet websites, substantially similar messages widely distributed (rather than individually distributed) on telephone answering or voice mail systems, computers, computer networks and other forms of computer data compilation.” Basically, for purposes of rules related to FWP’s, all communications that can be reduced to writing are considered a written communication. Accordingly, radio and TV interviews, other than those published by unaffiliated and uncompensated media, would be considered a FWP and subject to the SEC use and filing rules.
Electronic road shows that do not originate live and in real time are considered written communications and FWP’s. Once it is determined that a road show includes a FWP, unless an exemption applies, an SEC filing is required. As mentioned, bona fide electronic road shows are not required to be filed with the SEC. In addition, Rule 433 only requires the filing of a FWP for an IPO of common or convertible equity.
A non-exempted FWP must be filed with the SEC, using Form 8-K, no later than the date of first use. An after-hours filing will satisfy this requirement as long as it is on the same calendar day. Moreover, all FWP’s must be filed with the SEC, whether distributed by the registrant or another offering participant and whether such distribution was intentional or unintentional.
The use of a FWP has specific eligibility requirements. A FWP may not be used by any issuer that is “ineligible” for such use. The following entities are ineligible to use a free writing prospectus: (i) companies that are or were in the past three years a blank-check company; (ii) companies that are or were in the past three years a shell company; (iii) penny-stock issuers; (iv) companies that conducted a penny-stock offering within the past three years; (v) business development companies; (vi) companies that are delinquent in their Exchange Act reporting requirements; (vii) limited partnerships that are engaged in an offering that is not a firm commitment offering; and (viii) companies that have filed or have been forced into bankruptcy in the last three years.
Small- and micro-cap issuers will rarely be eligible to use a free writing prospectus. Accordingly, small and micro-cap companies generally are limited to live road shows involving oral offers not constituting a FWP.
Moreover, underwriters generally require specific representations and warranties and indemnification related to FWP’s regardless of whether they are required to be filed with the SEC.
The road show presentation usually covers key aspects of the offering itself, including the reasons for the offering and use of proceeds. In addition, management will also cover important aspects of their business and growth plans, industry trends, competition and the market for their products or services. An important aspect of the road show is the question-and-answer period or Q&A, though obviously this is only included in live or virtual real-time interactive road shows. It is common for materials to include drilled-down information that is provided on a higher level in the prospectus as well as theory and thoughts behind business plans and management goals.
The preparation of the road show content is usually a collaborative effort between the company, underwriters and legal counsel. Although the road show begins much later in the process, since its content is derived from the registration statement, ideally the planning begins at the same time as the registration statement drafting. Also, slides, PowerPoint presentations and other presentation materials should be carefully prepared to get the most out of their effectiveness.
The lawyer generally reviews all materials for compliance with the rules related to offering communications as well as potential liability for the representations themselves. Part of the compliance review is ensuring that no statements conflict with or provide a material change to the information in the filed offering prospectus that could be deemed materially misleading by content or omission, and compliance with Regulation FD if applicable.
Also from a technical legal perspective, all road show materials should contain a disclaimer for forward-looking statements, and that disclaimer should be read in live, virtual or prerecorded road show presentations. Where the road show content includes a FWP, it is required to contain a legend indicating that a prospectus has been filed, where it can be read (a hyperlink can satisfy this requirement), and advising prospectus investors to read the prospectus.
Pursuant to Rule 433(b)(2), the FWP for a non-reporting or unseasoned company must be accompanied with or preceded by the prospectus filed with the SEC. The delivery requirement can be satisfied by providing a hyperlink to the filed prospectus on the EDGAR database.
Road show materials, even those that are also a FWP, generally are not subject to liability under Section 11 of the Securities Act. Section 11 provides a private cause of action in favor of purchasers of securities, against those involved in filing a false or misleading public offering registration statement. Road-show materials, including FWPs, are not a part of the registration statement, but rather are supplemental materials. Section 12 liability, however, does apply to road-show materials. Section 12 provides liability against the seller of securities for material misstatements or omissions in connection with that sale, whether oral or in writing.
Follow-on Offerings and Regulation FD
Regulation FD requires that companies subject to the SEC reporting requirements 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. Consequently, Regulation FD would be implicated in connection with communications in a road show for a follow-on offering by a company already subject to the Exchange Act reporting requirements. Regulation FD excludes communications (i) to a person who owes the issuer a duty of trust or confidence, such as legal counsel and financial advisors; (ii) communications to any person who expressly agrees to maintain the information in confidence; and (iii) communications in connection with certain offerings of securities registered under the Securities Act of 1933 (this exemption does not include registered shelf offerings).
Where a road show is being conducted by a company subject to the Exchange Act reporting requirements, counsel should ensure that that the presentation either does not include material non-public information or that the information is simultaneously disclosed to the public in a Form 8-K. As a backstop where Regulation FD applies, the company should also consider having all road-show attendees sign a confidentiality agreement.