Pomerantz LLP

SEC Issues Expanded "Test-the-Waters" Communication Rules


On February 19, 2019, the U.S. Securities and Exchange Commission (the “SEC”) proposed a rule under the Securities Act of 1933, Rule 163B, that would relax regulatory burdens for all issuers, including investment company issuers. Specifically, the new rule would permit all issuers to solicit investor views about potential offerings and to consider these views at an earlier stage than currently is permissible. Such a rule would expand the “test-thewaters” accommodation that is currently available to emerging growth companies (“ECGs”). If adopted, this rule would result in earlier communications with potential investors to assist in evaluating the market and developing relationships with them.

The notion of test-the-waters was originally introduced when Congress passed the Jumpstart Our Business Startups Act (the “JOBS Act”) in 2012. Under the JOBS Act, ECGs are allowed to assess the interest of qualified institutional buyers and institutional accredited investors in connection with proposed securities offerings.

The proposed Rule 163B would allow issuers to engage in oral or written communications with potential investors that are, or that the issuer reasonably believes to be, qualified institutional buyers or institutional accredited investors. A qualified institutional buyer is a specified institution that owns and invests on a discretionary basis at least $100 million in securities of unaffiliated issuers. Institutional investors, including organizations not formed for the purpose of acquiring the securities offered and with assets in excess of $5 million, are considered accredited investors and must meet the criteria of SEC Rule 501(a)(1), (a)(2), (a)(3), (a)(7), or (a)(8), The SEC thus believes that these types of entities do not need the protection of the Securities Act’s registration process as they are more financially sophisticated than an average investor.

An issuer or person authorized to act on the issuer’s behalf would be required only to reasonably believe that a potential investor is a qualified institutional buyer or institutional accredited investor. The SEC failed to provide specific steps that an issuer could or must take to establish a reasonable belief that the intended recipient of the communications is qualified. Instead, the SEC is apparently assuming that issuers can and should continue to rely on current and previous methods used to assess an investor’s status.

SEC chairman Jay Clayton issued a press release announcing the proposed rule with the goal that “[e]xtending the test-the-waters reform to a broader range of issuers is designed to enhance [the issuer’s] ability to conduct successful public securities offerings and lower their cost of capital, and ultimately to provide investors with more opportunities to invest in public companies.”

Proponents of this new rule argue that in allowing more issuers to engage with a set of financially sophisticated institutional investors while the company is in the process of preparing for a securities offering could help issuers assess the demand for and value of their securities. Further, issuers would be able to discern which terms and structural components of the offering would be important to investors before the company incurs costs associated with the launch of an offering.

Ultimately, it appears that the SEC’s goal is to increase registered offerings in the United States. In doing so, the SEC believes that it can “have long-term benefits for investors and [the U.S.] markets, including issuer disclosures, increased transparency in the marketplace, better informed investors, and a broader pool of issuers in which any investor may invest.” According to the Wall Street Journal, the number of public companies has declined by about 50% since the mid-1990s. The JOBS Act failed to substantially increase the number of initial public offerings (“IPOs”) that occurred in the past few years. Close to 40% of eligible ECGs that conducted IPOs took advantage of the JOBS Act test-the-waters provision in 2015, but that percentage fell to less than 25% in 2016. It is difficult to ascertain at this time whether Rule 163B will increase IPOs. If that is the case, one can only hope that the SEC’s goal of providing issuers and investors flexibility and transparency alike does not lead to increased litigation regarding fraudulent claims as we have previously seen in IPOs filed and a company’s related subsequent stock drop.

Taking the potential benefits of Rule 163B into consideration, the next logical question that follows would be how these expanded rules play into the protection that investors would be afforded. Although the new rule would exempt test-the-waters communications and would need not be filed with the SEC, that is not to say that investors are left without any type of protection. The proposed rule provides that such communications would still be considered “offers” as defined under the Securities Act, thereby allowing liability and anti-fraud provisions to continue to be applicable. Further, the information disclosed during communications must not conflict with material information in the related registration statement and, as is the practice of the SEC when reviewing offerings conducted by EGCs, the SEC or its staff can “request that an issuer furnish the staff any test-the-waters communication used in connection with an offering.” Lastly, the SEC cautioned public companies that certain test-the-water communications could trigger disclosure under Regulation FD, which requires public companies to make public disclosure of any material non-public information that has been selectively disclosed to certain securities market professionals or shareholders. To avoid the application of Regulation FD, the SEC recommended having the recipient of the communication enter into a non-disclosure agreement to mitigate the need for public disclosure.

Flexibility and efficiency continue to be touted as reasons why this proposed rule is beneficial. The SEC argues that it will increase access to public capital markets by providing flexibility to issuers regarding their communications and determining which investors qualify under Rule 163B as intended recipients of such communications. As such, companies are in a better position to evaluate market interest and have discussions regarding the transaction terms required to address the most important concerns institutional investors may have, thereby providing a more efficient and effective capital-raising process. By the same token, the goal for investors will be transparency and obtaining information that may allow for more sound, confident financial decisions. Ultimately, investor protection must be at the forefront of any regulation created or amended by the SEC, without which interest in capital markets would greatly decrease.

Proposed Rule 163B was subject to a 60-day public comment period following its publication in the Federal Register. That period ended on April 29, 2019.