Many thanks to Gary Brown of Nelson Mullins, who leads our SEC Reporting and Practice Skills for Lawyers and many other PLI programs, for his thoughts in this post!

In the “What We Do” section of the SEC’s web page, the very first thing the SEC states is its mission:

The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

 In the public company reporting world we frequently focus on the investor protection part of this mission. These words are often heard when the staff speaks and even arise occasionally in the comment process.

Facilitation of capital formation can be at odds with protection of investors.  The 1933 Act requires that all securities offers and sales be registered unless there is an exemption.  When one hears a comment about the “protection of the ’33 Act,” what that means is the information that one would find in a registration statement – that, in conjunction with potential liability for sellers of securities, is what protects investors.  The basis for many of the exemptions from registration is that there is an alternative scheme of regulation (e.g. bank stocks) that provides the information or that sales are limited to accredited and other sophisticated investors who can, in the words of the Supreme Court, “fend for themselves” and do not need the protection of the 1933 Act.

Which brings us to the SEC’s recent proposed rule to allow “testing-the-waters” communications by all issuers.  To understand the importance of this rule and why it is necessary requires one to understand the SEC’s “gun-jumping” rules.  The heart of these rules is Section 5 of the 1933 Act, which, in part:

• prohibits “offers” (verbal or written) before a registration statement is filed; and
• limits the use of certain “prospectuses” (which essentially is a written “offer”) after the filing of the registration statement but before it is declared effective.

A violation of section 5 is a serious matter – at a minimum, investors in essence have a “put” back to the issuer in the form of a rescission right under Section 12(a)(1). There doesn’t have to be fraud – it’s a simple matter of making an unlawful “offer” or using an unlawful “prospectus.”

The problem begins with the broad definition of “offer” in the 1933 Act.  As many know, it includes “conditioning the market” for a securities offering.

Dealing with business and communication realities in the face of the definition of “offer” began with the drafters of the 1933 Act.  Preliminary negotiations with and among underwriters were carved out of the statutory definition of “offer”.  That’s the first acknowledgement that some communications are essential to the offering process (capital formation) and pose no real danger to investors (investor protection).

Over the years, we have seen the SEC, through guidance or rulemaking, as well as Congress, through amendments to the Securities Act, add to the list of items that would not run afoul of the “gun jumping” rules.  These include:

• Statutory carve out in Section 2(a)(10) definition of “prospectus” of certain notices containing information specified by the SEC (think “tombstone” ads). This forms the basis for Rule 135 (Notice of Proposed Registered Offerings), which allows communications that otherwise would be unlawful “offers.”

• Securities Act Rel. 33-5180, which allows ordinary business communications to continue after a company is “in registration.”

• Rule 163, which conditionally exempts “well-known seasoned issuers” from the rules relative to pre-filing communications.

• Rule 163A, which conditionally exempts communications made more than 30 days before filing a registration statement.

• Rule 164, which conditionally allows “free writing” prospectuses by deeming them “section 10(b) prospectuses”.

• Rule 165, which conditionally exempts communications in business combination transactions from both the pre-filing prohibitions of section 5(c) and the “prospectus” requirements of section 5(b).

• Rules 168 and 169, which expand on Securities Act Rel. 33-5180, and conditionally allow ordinary business communications to continue while “in registration” by deeming such communications not to be “offers” for purposes of section 5.

• Research reports on emerging growth companies are not deemed “offers” (amendment to definition of “offer” in Section 2(a)(3))

• “Testing the waters” allowed for “emerging growth companies” with respect to “qualified institutional buyers” (“QIBs”) and institutional accredited investors (“IAIs”) (Amendment to Securities Act section 5) – the theory being that this facilitates capital formation and restricting the communications to QIBs and IAIs is consistent with investor protection because they do not need the “protection of the Act”.

• “Testing the waters” allowed in Regulation A offerings with respect to QIBs and IAIs (Rule 255) – again, the theory being that this facilitates capital formation and restricting the communications to QIBs and IAIs is consistent with investor protection because they do not need the “protection of the Act”.

This situation addressed by these statutory provisions and rules is a great example of how the three parts of the SEC’s mission are frequently in conflict with each other.  A reduction in the amount of information required to be provided to investors, which would likely make raising capital easier, may well leave investors less well informed as they make investment decisions.  That’s why in many of these cases, either the scope or the recipients (e.g., limited to QIBs and IAIs) is restricted – that addresses the investor protection mission.

The balancing act between what information investors really need and the cost of this information and its impact on the capital formation process is complex.  It is not a simple or cut-and-dried decision-making process. Dealing with the conflict in these parts of the SEC’s mission requires judgment.

This capital formation part of the SEC’s mission has received more attention in recent years.  Perhaps the clearest example is the bi-partisan passage of the JOB’s Act in 2012 to create the “IPO On-Ramp” for Emerging Growth Companies or EGCs.  Simplifications such as allowing Emerging Growth Companies to provide two years of financial statements clearly reduces information available to investors, and just as clearly reduces the cost of capital formation.  Time, and hopefully a retrospective analysis of the effect of this change, will tell whether it was good for investors and issuers.

The current administration at the SEC has clearly put more emphasis on the capital formation part of the SEC’s mission, which brings us to recent development in this area.  On February 19, 2019,  the SEC issued  proposed Rule 163B, which would extend the “testing the water” provisions (prefiling communications to QIBs and IAIs) provided to EGCs (as well as WKSIs and companies doing Reg A offerings) to all offerings.

Taken as a whole, proposed Rule 163B , coupled with several of the other exemptions referenced above, should substantially reduce the risks of mistimed communications about proposed offerings (“gun jumping” violations), which can result in significant costs and delays. Summarizing its rationale for proposing Rule 163B, the SEC states in the adopting release:

We believe that, by allowing more issuers to engage with certain sophisticated institutional investors while in the process of preparing for a contemplated registered securities offering, the proposed rule could help issuers to better assess the demand for and valuation of their securities and to discern which terms and structural components of the offering may be most important to investors. This in turn could enhance the ability of issuers to conduct successful offerings and lower their cost of capital.

As you can read in the SEC’s Fact Sheet the proposal would enable all issuers to engage in test-the-waters communications with QIBs and IAIs.  All issuers would be able to test-the-waters with QIBs and IAIs about contemplated registered securities offerings to determine whether such investors might have an interest in such an offering.  These communications could occur prior to or following the filing of a registration statement.

Importantly, these communications would be exempt from the “prospectus” restrictions imposed by Section 5(b)(1) of the Securities Act and the restrictions on “offers” imposed by Section 5(c) o the Securities Act. These communications, however, are nevertheless deemed to be “offers,” which means that they are subject to antifraud liabilities.  In other words – they are “offers,” just not prohibited“offers.”

From the Fact Sheet:

The proposed rule would be non-exclusive and an issuer could rely on other Securities Act communications rules or exemptions when determining how, when, and what to communicate related to a contemplated securities offering.

Under the proposed rule:

• there would be no filing or legending requirements;
• test-the-waters communications may not conflict with material information in the related registration statement; and
• issuers subject to Regulation FD would 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.

Some of the actions here (just as those exempted under other provisions described above) would have been unlawful “gun jumping” without these changes.  They represent a big change from a long-standing part of the offering process. While the proposals would only apply communications to QIBs and IAIs, investors who are assumed to be knowledgeable and experienced enough to protect themselves, this kind of change is always uncertain.  What will the ultimate impact be as the SEC works to balance the contradictory parts of its mission?  In the proposal’s words:

“The expanded test-the-waters provision, as proposed, would provide all issuers with appropriate flexibility in determining when to proceed with a registered public offering while maintaining investor protections.”

This nicely describes the balancing act!

The proposal will have a 60-day public comment period.

As always, your thoughts and comments are welcome.