[co-author: Jake DuCharme]
Overview
On September 26, 2019, the Securities and Exchange Commission (SEC) announced that it has expanded the “testing-the-waters” exemption to all issuers. The new rule and related amendments under the Securities Act of 1933, as amended (the Securities Act), extend the accommodation currently available to emerging growth companies1 (EGCs) under Securities Act Section 5(d) to all issuers, including funds. All issuers are now permitted to communicate with qualified institutional buyers2 (QIBs) and institutional accredited investors3 (IAIs) regarding contemplated registered securities offerings, before or after such issuers file registration statements. The SEC adopted the rule, which it initially proposed in February 2019,4 without significant amendments.
Background on Testing-the-Waters
In 2012, Congress passed the Jumpstart Our Business Startups Act (JOBS Act) which, among other things, created a new Section 5(d) of the Securities Act and eased the restrictions on so-called “gun- jumping” communications by introducing the “testing-the-waters” exemption. Section 5(d) permits an EGC, or any person authorized to act on behalf of an EGC, to engage in oral or written communications with potential investors that are QIBs or IAIs to determine whether such investors may be interested in a contemplated securities offering. These communications may occur either before or after the EGC files a registration statement with respect to such securities and are limited to QIBs and IAIs because these investors generally are considered to be financially sophisticated and have the ability to sustain investment losses.
The rationale behind the “testing-the-waters” exemption is to provide: (1) increased flexibility to issuers regarding their communications about contemplated registered securities offerings, and (2) a cost-effective means for evaluating market interest before incurring the costs associated with such an offering.
Since Congress enacted the JOBS Act, EGCs have dominated the IPO market. EGCs account for an estimated 88% of priced exchange-listed IPOs and a significant portion of these EGC issuers used the testing-the-waters exemption.
As SEC Chairman Jay Clayton stated, “[e]xtending the test-the-waters reform to a broader range of issuers is designed to enhance their 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.” This is consistent with other remarks Chairman Clayton has made endorsing the SEC’s efforts to promote capital formation.5
Securities Act Rule 163B
The expanded “testing-the-waters” exemption is codified in the new Securities Act Rule 163B (the Rule), which provides a non-exclusive safe harbor that permits any issuer, or any person authorized to act on its behalf, to communicate with potential investors that are, or are reasonably believed to be, QIBs or IAIs before or after filing a registration statement.
The scope of the Rule is similar to the current testing-the-waters exemption for EGCs, except that the Rule provides more flexibility in specifically allowing communications with investors that an issuer reasonably believes to be QIBs and IAIs. The SEC adopted the reasonable belief standard as proposed, and the Rule does not establish a specific method by which an issuer must determine that a potential investor is a QIB or an IAI. The SEC specifically chose this standard 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.” Accordingly, issuers may continue to rely on the methods that they currently use to establish a reasonable belief regarding an investor’s status under current Securities Act rules.
Similar to the Section 5(d) exemption for EGCs, the SEC will not require issuers to file or include specific legends on testing-the-waters communications made under the Rule, and the SEC specifically clarified that 163B communications are not free writing prospectuses.6 However, the SEC Staff may request any such communications for review to ensure that the testing-the-waters communications do not conflict with any material information included in the registration statement. Additionally, testing-the-waters communications under the Rule would continue to be considered “offers” under the Securities Act. Thus, such communications would be subject to potential liability under the Securities Act and other anti-fraud provisions of the federal securities laws.7
Application to Business Development Companies and Registered Investment Companies
Although registered investment companies and business development companies (together, Funds) would be eligible to make pre- and post-filing communications under the Rule, the SEC noted that the benefits associated with using testing-the-waters communications could be more limited under the current disclosure framework applicable to certain Funds.
Specifically, the SEC noted that testing-the-waters communications generally would be considered advertisements or “sales literature,” which are subject to certain filing, disclosure and legend requirements under the Securities Act and the Investment Company Act of 1940, as amended (Investment Company Act). To allow Funds to benefit from the Rule to the same extent as other filers, the Rule exempts Funds’ testing-the-waters communications from complying with the filing, disclosure and legend requirements that would otherwise apply to such communications.
The SEC also noted that Funds may be less likely to use testing-the-waters communications during the pre-filing period because Funds contemplating registered offerings often file registration statements under both the Securities Act and the Investment Company Act immediately upon organizing. While the SEC declined to provide a new exemption under the Investment Company Act to allow Funds otherwise required to register under Section 8 of the Investment Company Act to avoid the registration requirement while they engage in communications under the Rule, the SEC specifically noted that BDCs, which are not required to register under the Investment Company Act, are allowed to engage in pre-filing communications under the Rule when contemplating a registered offering close in time to the fund’s inception. Additionally, the SEC noted that Funds would be able to rely on the Rule if it considers a subsequent registered offering after initially conducting an exempt offering.
The Rule will become effective 60 days after publication in the Federal Register.
SEC Press Release: SEC Adopts New Rule to Allow All Issuers to “Test-the-Waters”
Proposed Rule: Solicitations of Interest Prior to a Registered Public Offering
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1 An emerging growth company refers to an issuer that 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 emerging growth company 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 one of the following occurs: its total annual gross revenues are $1.07 billion or more; it has issued more than $1 billion in non-convertible debt in the past three years; or it becomes a “large accelerated filer.” See Rule 405 and Rule 12b-2 (defining “emerging growth company”).
2 As defined in paragraph (a) of 17 CFR 230.144A (Rule 144A).
3 Any institutional investor that is also an accredited investor, as defined in 17 CFR 230.501 (Rule 501) of Regulation D.
4 SEC Press Release: SEC Proposes to Expand “Test-the-Waters” Modernization Reform to All Issuers. More information on the proposal is available at, Legal Alert: SEC proposes to expand “testing-the-waters” provisions to all issuers
5 See, e.g., Speech by Chairman Jay Clayton, U.S. Securities and Exchange Comm’n., Remarks on Capital Formation at the Nashville 36|86 Entrepreneurship Festival (Aug. 29, 2018), https://www.sec.gov/news/speech/speech-clayton-082918.
6 In response to comments on the proposed rule, the SEC revised the definition of “free writing prospectus” in Rule 405 to clarify that Section 5(d) and 163B communications would not be treated as free writing prospectuses, consistent with current SEC practice.
7 Rule 163B(a)(2) was removed. In the proposal, Section (a)(2) stated the rule would be “unavailable for any communication that, while in technical compliance with the rule, is part of a plan or scheme to evade the requirements of Section 5 of the Act.” Because the covered communications are deemed offers, and offers are already subject to the anti-fraud and other applicable provisions of the federal securities laws, the SEC eliminated the anti-evasion language to avoid any confusion or chilling effect the language could cause without introducing significant risk to investors.
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