In an effort to encourage companies to access public markets, the Securities and Exchange Commission adopted a new rule that allows all organizations interested in potentially ging public to assess market interest in an initial public offering or other registered securities by having discussions, or “testing the waters,” with certain institutional investors.
The “Solicitations of Interest Prior to a Registered Public Offering” rule, published in the Federal Register on Oct. 4, becomes effective Dec. 3.
“Investors and companies alike will benefit from test-the-waters communications, including increasing the likelihood of successful public securities offerings,” SEC Chairman Jay Clayton said in a statement issued when the Commission voted to adopt the new rule.
The rule could prove to be a money saver for companies thinking of going public. “The final rule generally will allow issuers to consult effectively with investors as they evaluate market interest in a contemplated registered securities offering before incurring the costs associated with such an offering, while maintaining adequate investor protections,” the SEC wrote in its preamble.
“Investors and companies alike will benefit from test-the-waters communications, including increasing the likelihood of successful public securities offerings.”
Jay Clayton, Chairman, SEC
Indeed, the regulated community generally seems supportive of the SEC’s initiative. The SEC notes in its preamble to the final rule that commenters “broadly supported the proposal.”
“This is another example of the SEC taking action to encourage public capital formation,” explains Andrew Brady, of counsel at the law firm Skadden, Arps, Slate, Meagher & Flom. “But it is more in the form of an evolution, not a revolution.”
A boost for investors from Main Street to Wall Street
Issuers’ expanded ability to conduct “test-the-waters” discussions is limited to “qualified institutional buyers,” or QIBs in SEC parlance, and to institutional accredited investors, explains Andrew Fabens, a co-chair of the capital markets practice group at the law firm Gibson, Dunn & Crutcher. Even so, the new rule “helps Main Street investors indirectly,” he says.
The final rule as adopted by the SEC “marginally simplifies the process of going public or, if already public, of raising additional capital,” Fabens explains. “That should make it a little bit more attractive to be a public company, which ultimately means more investment opportunities accessible to Main Street investors.”
In 2012, Congress passed the Jumpstart Our Business Startups Act (the “JOBS Act”), which created Section 5(d) of the Securities Act. Section 5(d) permits an emerging growth company (“EGC”) and any person acting on its behalf to engage in oral or written communications with potential investors that are QIBs and IAIs before or after filing a registration statement to gauge such investors’ interest in a contemplated securities offering. The new rule extends this “test-the-waters” accommodation to non-EGCs, thereby encouraging more issuers to consider entering our public equity markets.
Securities Act Rule 163B will permit any issuer, 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 non-exclusive and an issuer may rely on other Securities Act communications rules or exemptions when determining how, when, and what to communicate about a contemplated securities offering.
Under the rule: there are no filing or legending requirements; the communications are deemed “offers”; and issuers subject to Regulation FD will need to consider whether any information in a test-the-waters communication would trigger disclosure obligations under Regulation FD or whether an exemption under Regulation FD would apply.
Source: Securities and Exchange Commission
The American Securities Association expressed a similar view in its comments submitted when the rule was proposed. Expanded “test-the-waters” capabilities “will ultimately help more companies complete a successful” initial public offering, the Association wrote. “When fewer companies go public, long-term economic growth is inhibited and Main Street investors have fewer opportunities to invest their hard-earned money in growing businesses.” Other commenters, including the Center for Capital Markets Competitiveness, also supported the notion the expanded rule would inspire more companies to consider public offerings.
A naysayer could possibly criticize the rule because it only OKs “test-the-waters” communications with certain investors—the rich and powerful. Still, “it’s an attractive tool for issuers and underwriters because it levels the playing field and permits all issuers to assess market demand for a registered offering on a confidential basis,” Brady says. And, ultimately, if an offering moves forward, any investor can buy shares once a company goes public.
A word of caution for chief compliance officers
The good news that issuers can indeed assess interest in public offerings should be tempered by the reality that these communications are still subject to some restraints. “The rule change could be misinterpreted as allowing no-holds-barred investor outreach,” Fabens cautions. “That is certainly not the case,” he continues.
“CCOs at companies that can take advantage of these new rules need to maintain communications policies that limit offering-related communications made prior to a registration statement filing to QIBs or institutional accredited investors,” Fabens says.
In addition, CCOs “must also maintain the normal anti-fraud guardrails,” suggests Fabens, noting that SEC Rule 10b-5, which prohibits the use of fraudulent or untrue statements in connection with securities sales, still applies. In addition, “test-the-waters” communications “are considered ‘offers’” under the Securities Act of 1933, Fabens says, and thus are subject to its liability provisions concerning material misstatements or omissions.
Issuers subject to disclosure requirements under Regulation FD (Reg FD) that are planning to test the waters may need to ask the investors with whom such discussions will be conducted to sign confidentiality agreements. Otherwise, Reg FD would generally require issuers that selectively disclose material nonpublic information while testing the waters to disclose that information publicly.
Fortunately, an exception to Reg FD may apply. “Some issuers are not subject to Regulation FD and those that are may avail themselves of one of the exceptions” under that regulation, the SEC wrote in its preamble to the final “test-the-waters” rule. The Commission specifically identified the exception involving confidentiality agreements.
Lori Tripoli is a writer based in the greater New York City area who focuses on legal and regulatory issues.
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