SEC proposes to Expand Test-the-Waters Communications to all Issuers

By Steve Quinlivan, Bryan Pitko, and Jaclyn Schroeder

The SEC has proposed new rules that would permit all issuers to solicit investor views about potential offerings at an earlier stage in the offering process than is the case today. The new rule and related amendments would expand the "test-the-waters" accommodation—currently only available to emerging growth companies (EGCs)—to all issuers, including investment company issuers. The ability for EGCs to engage in test-the-waters communications was provided for under the JOBS Act.

The proposed rule would ease regulatory burdens for issuers who do not qualify as EGCs. Section 5(c) of the Securities Act prohibits any written or oral offers prior to the filing of a formal registration statement with the SEC. Once an issuer has filed a registration statement, Section 5(b)(1) limits written offers to a formal prospectus that conforms to the requirements of the Securities Act. As such, without the proposed rule change, most communications by issuers seeking to gauge investor interest would violate the Securities Act and constitute what is popularly referred to as "gun jumping." According to the SEC, the ability of EGCs to engage in test-the-waters communications under the JOBS Act has not impaired investor protection.

The proposed rule will allow all issuers to engage in test-the-waters communications with potential investors that are, or that the issuer reasonably believes to be, qualified institutional buyers (QIBs) or institutional accredited investors (IAIs), either prior to or following the date of filing of a registration statement related to such offering. Generally a QIB is a specified institution that, acting for its own account or the accounts of other QIBs, in the aggregate, owns and invests on a discretionary basis at least $100 million in securities of unaffiliated issuers. IAIs are institutional investors that are also accredited investors, that meet the criteria of SEC Rule 501(a)(1), (a)(2), (a)(3), (a)(7) or (a)(8), and include organizations with assets in excess of $5 million not formed for the purpose of acquiring the securities offered. The SEC believes these types of entities do not need the protections of the Securities Act’s registration process.

The SEC noted its belief that allowing more issuers to engage with certain sophisticated institutional investors while in the process of preparing for a contemplated registered securities offering could help issuers better assess the demand for and valuation of their securities. Additionally, issuers could gain insight to help discern which terms and structural components of the offering may be most important to investors before incurring costs associated with launching an offering. This, in turn, could enhance the ability of issuers to conduct successful offerings and lower their cost of capital.

Test-the-waters communications that comply with the proposed rule would not need to be filed with the SEC, nor would they be required to include any specified legends. The SEC does not believe it is necessary to impose such requirements, because communications under the proposed rule would be limited to investors which are, or are reasonably believed to be, QIBs and IAIs. These types of investors are generally considered to have the ability to assess investment opportunities, thereby reducing the need for the additional safeguards provided by a filing or legending requirement.

Information provided in test-the-waters communications under the proposed rule must not conflict with material information in a related registration statement. As is currently the practice of the SEC staff when reviewing offerings conducted by EGCs, the SEC or its staff could request that an issuer furnish the staff any test-the-waters communication used in connection with an offering.

The SEC cautioned public companies to consider whether any information in test-the-waters communications would trigger any obligations under Regulation FD. Regulation FD requires public companies to make public disclosure of any material nonpublic information that has been selectively disclosed to certain securities market professionals or shareholders. To avoid the application of Regulation FD, a public company could consider obtaining a confidentiality agreement from any potential investor prior to providing the test-the-waters communications.

In addition, the SEC noted that although the new rule would exempt test-the-waters communications from the gun-jumping provisions of Section 5, such communications would still be considered “offers” as defined under the Securities Act such that Section 12(a)(2) liability and the anti-fraud provisions of the federal securities laws would continue to apply.

Under the proposed rule, any potential investor solicited must meet, or issuers must reasonably believe that the potential investor meets, the requirements of the rule. The SEC believes this standard would avoid imposing an undue burden on issuers compared to requiring issuers to verify investor status. For example, under the proposed rule, an issuer could reasonably believe that a potential investor is a QIB or IAI even though the investor provided false information or documentation to the issuer. The SEC does not believe that an issuer should be subject to a violation of Section 5 in such circumstances, so long as the issuer established a reasonable belief with respect to the potential investor’s status based on the particular facts and circumstances.

The SEC did not propose specific steps that an issuer could or must take to establish reasonable belief that intended recipients of test-the-waters communications are QIBs or IAIs. Identifying specific steps or providing additional guidance that could be used by an issuer to establish such reasonable belief could result in such steps or guidance becoming a de facto minimum standard. The SEC believes issuers should continue to rely on the methods they currently use to establish reasonable belief regarding an investor’s status in analogous circumstances. By not specifying the steps an issuer could or must take to establish reasonable belief as to investor status, this approach is intended to provide issuers with the flexibility to use methods that are cost-effective but appropriate in light of the facts and circumstances of each contemplated offering and each potential investor.

For more information on the test-the-waters accommodation, please contact Steve Quinlivan, Bryan Pitko, Jaclyn Schroeder or the Stinson LLP contact with whom you regularly work.

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