On February 28, the Securities and Exchange Commission proposed a new rule under the Securities Act of 1933. The new rule 163B would expand the availability to follow-on and other registered offerings and to all issuers of “test the waters” communications with qualified institutional buyers (QIBs) and institutional accredited investors (IAIs) in order to gauge market interest prior to filing a registration statement. If adopted, the proposed rule would allow test-the-waters communications for any type of registration statement. Eligible issuers would be expanded to include registered investment companies. Currently, test-the-waters communications prior to a registered public offering can only be conducted by emerging growth companies (EGCs).1 Comments to the proposed rule must be received by April 29, 2019.
The Current Legal Framework: Testing the Waters or Jumping the Gun
Traditionally, an issuer had to file a registration statement before it could communicate with investors about a securities offering. In 2012, Congress passed legislation that permits a certain type of issuer — an EGC — to communicate with two types of investors even before filing a registration statement. These communications allow an EGC to test the waters for its offering by gauging the interest of QIBs and IAIs.
EGCs are not entirely alone in their ability to test the waters. Under certain circumstances, both well-known seasoned issuers (WKSIs) — which are “the most widely followed issuers representing the most significant amount of capital raised and traded in the U.S.”2 — or issuers conducting a Regulation A “conditional small issues exemption” offering are allowed to communicate with investors prior to filing.
Outside of these three limited groups, however, written and oral offers by an issuer prior to filing a registration statement are generally prohibited. Registration is aimed at enabling investors to make informed judgments about whether to purchase a company’s securities through the disclosure of financial information. An issuer could attempt to arouse investor interest, and thereby enhance the prospective market value of its offered securities, by “conditioning the market” before a registration statement covering the offering has been filed. Absent an exemption, an issuer soliciting such investor interest prior to filing a registration statement therefore risks “gun-jumping,” which could result in the delay of the effectiveness of the registration statement.
The Proposed Rule: Test-the-Waters Communications Expanded
The Commission’s proposed rule would permit all issuers to engage in oral or written communications, either prior to or following the filing of a registration statement, with potential investors that are, or are reasonably believed to be, QIBs or IAIs to determine whether these investors might have an interest in a contemplated registered securities offering.
Expanding the availability of these pre-filing communications would allow any issuer to evaluate market interest before incurring costs for registration. Moreover, the proposed rule also would allow those acting on behalf of issuers to engage in the same pre-filing solicitations of interest — meaning underwriters could also contact certain investors to gauge interest. Under current rules, WKSIs may not engage in test-the-waters communications through underwriters.
With the ability to test the waters with certain types of investors, an issuer should be able to gain information to better structure an offering and assess demand and valuation. Broadening test-the-waters communications is therefore aimed at promoting more investment opportunities in the pool of public markets.
To prevent abuse, the Commission makes clear that the expanded opportunity provided by the proposed rule would not be available for any communication that is part of a plan or scheme to evade the filing requirements. Similarly, any pre-filing communications under the proposed rule by an issuer or its representative would remain an offer — meaning the communication would still be subject to antifraud provisions.
Why Don’t QIBs and IAIs Need Protection From Gun-Jumping?
The proposed rule only expands communications by an issuer with two types of investors:
A QIB is an institution that owns and invests on a discretionary basis at least $100 million in securities of unaffiliated issuers. Banks, other financial institutions and registered broker-dealers also can qualify as a QIB in some cases under different tests.
An IAI is any institutional investor that is also an accredited investor under the criteria established at Rule 501 (a)(1), (a)(2), (a)(3), (a)(7) or (a)(8) under Regulation D. The criteria applies to, among other things, banks, savings and loan associations, brokers or dealers, insurance companies, investment companies, business development companies, certain employee benefit plans, an organization with total assets in excess of $5 million, certain trusts with total assets in excess of $5 million, or an entity in which all equity owners are accredited investors. Notably, individual accredited investors — such as directors, executive officers or general partners of the issuer or any natural person whose individual or joint net worth with his or her spouse exceeds $1 million — are excluded from the IAI criteria.
The policy rationale behind the proposed rule is consistent with the existing rule allowing pre-filing solicitation of QIBs and IAIs by EGCs. The Commission notes that EGC pre-filing solicitation of these types of investors has “not been a significant cause for concern with respect to investor protection.” As noted by the SEC at footnote 6 of the proposed rule, QIBs and IAIs are presumed to have a level of financial sophistication that allows them to assess investment opportunities, reducing the need for the traditional safeguards provided by communication timing requirements.
Traps for an Unwary Issuer: Look Before You Leap
Although the proposed rule would expand an issuer’s ability to test the waters with QIBs and IAIs, there remain traps for an unwary issuer. Only communications that are limited to gauging interest would come within the scope of the new rule; any other communication could trigger certain timing, legending and filing requirements. Moreover, a test-the-waters communication under the proposed rule must not conflict with material information under the related registration statement, and issuers subject to Regulation FD — generally SEC reporting companies — may face public disclosure obligations for any material nonpublic information without appropriate confidentiality protections in place. Finally, the Commission could request that an issuer furnish the staff with the test-the-waters communications, so recordkeeping under the new rule would be critical.
Commission Seeks Comments on Proposed Expansion
Do test-the-waters communications aid issuers in assessing demand for their offerings? Do they aid issuers in structuring their offerings? Does this information potentially lead to a lower cost of capital? Would the additional flexibility provided by the proposed rule result in a greater number of issuers pursuing a registered public offering?
Does the proposed expansion of permissible test-the-waters communications raise investor protection concerns? Does the proposed expansion of permissible test-the-waters communications raise concerns of inappropriate marketing, conditioning or hyping?
Should the proposed rule be available to all issuers as proposed?
Should issuers be required to establish a reasonable belief that the potential investors involved in proposed test-the-waters communications are QIBs and IAIs, as proposed?
Should the proposed rule limit test-the-waters communications to QIBs and IAIs, as proposed? If not, what different types of investors should issuers be permitted to communicate with? Alternatively, should there be no restrictions on the types of investors that issuers could communicate with under this proposed rule? If there are no restrictions on the types of investors that issuers could communicate with, should the rules impose any filing or legending requirements for the communications?
Those interested may comment on the proposed rule before April 29, 2019. Comments may be submitted electronically via the SEC’s comment form at http://www.sec.gov/rules/proposed.shtml or by email to firstname.lastname@example.org. Paper comments may be sent in triplicate to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090, to be received before the April 29 deadline. Regardless of the form of submission, the comment should reference File Number S7-01-19.
1 An issuer qualifies as an EGC when it had total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and, as of December 8, 2011, had not sold common equity securities under a registration statement. That issuer continues to be an EGC for the first five fiscal years after the date of the first sale of its common equity securities pursuant to an effective registration statement, unless it surpasses certain thresholds for annual gross revenue or issuance of nonconvertible debt or becomes a large accelerated filer as defined under the Exchange Act of 1934.
2 U.S. Securities and Exchange Commission Division of Corporate Finance, Revised Statement on Well-Known Seasoned Issuer Waivers (Apr. 24, 2014). For the definition of a WSKI, see 17 C.F.R. § 230.405.
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