On February 19, 2019, the SEC voted to propose Rule 163B under the Securities Act of 1933, as amended (the Securities Act), and amendments to Rule 405 (collectively the Proposed Rule) promulgated under the Securities Act to reform the rules regarding “test-the-waters” communications.¹⁴ The Proposed Rule,¹⁵ if adopted, would expand the test-the-waters accommodation, currently available only to emerging growth companies (EGCs), to all issuers, including investment company issuers.

The Proposed Rule would similarly apply to investment company issuers. Test-the-waters communications may help investment companies better assess market demand for a particular investment strategy, as well as appropriate fee structures, prior to incurring the full costs of a registered offering. However, as recognized by the SEC, certain features of investment companies may make their use of the Proposed Rule more limited than other issuers because it is common practice to simultaneously file a registration statement under both the Investment Company Act of 1940, as amended (the 1940 Act), and the Securities Act to take advantage of certain efficiencies. If funds collectively continue to prefer to file a single registration statement under both the 1940 Act and the Securities Act, funds may be less likely to use the Proposed Rule for pre-filing communications than other issuers. However, funds that preliminarily engage in exempt offerings, including certain registered closed-end funds and BDCs, could rely on the Proposed Rule to engage in pre-filing communications if they are considering a subsequent registered offering.

1. Background

   Section 5(c) of the Securities Act generally prohibits any written or oral offers to sell securities prior to the filing of a registration statement. Once a registration statement has been filed, Section 5(b)(1) generally requires issuers to use a prospectus that complies with Section 10 of the Securities Act for any written offers of securities. Any violation of these restrictions is commonly referred to as “gun-jumping.”

   In 2012, Congress passed the Jumpstart Our Business Startups Act, which created Section 5(d) of the Securities Act. Section 5(d) permits EGCs and any person authorized to act on its behalf to engage in oral or written communications with potential investors that are qualified institutional buyers (QIBs) or institutional accredited investors (IAIs) before or after filing a registration statement to gauge such investors’ interest in a contemplated securities offering. In 2017, the SEC expanded another rule, previously available only to EGCs, to allow issuers to submit confidential filings in connection with an initial public offering. Consistent with that prior expansion, the Proposed Rule would provide increased flexibility to issuers in their communications with certain investors in connection with proposed securities offerings.

2. The Proposed Rule

   Below are some important takeaways from the Proposed Rule.

   • Eligibility: All issuers, including non-reporting issuers, EGCs, non-EGCs, well-known seasoned issuers, and investment companies (including registered investment companies and business development companies [BDCs]), would be eligible to rely on the Proposed Rule.
   • Intended Recipients of Test-the-Waters Communications: Under the Proposed Rule, issuers are allowed to engage in test-the-waters communications with QIBs or IAIs either prior to or following the date of filing of a registration statement related to such offering.
   • Reasonable Belief Requirement: The Proposed Rule would require the issuer to have a reasonable belief that a potential investor is a QIB or IAI. Unlike Rule 506(c) of Regulation D, which imposes a burden on issuers to verify investor status, the Proposed Rule only requires the issuer to establish a reasonable belief with respect to the potential investor’s status based on the particular facts and circumstances. The SEC is not proposing to specify the steps that an issuer could or must take to establish a reasonable belief that the intended recipients of test-the-waters communications are QIBs or IAIs. Instead, issuers should continue to rely on the methods they currently use to establish a reasonable belief regarding an investor’s status as a QIB or accredited investor pursuant to Rule 144A and Rule 501(a) of Regulation D, respectively. For example, Rule 144A(d)(1) sets forth non-exclusive means to determine whether a prospective purchaser is a QIB, including allowing issuers to rely on the prospective purchaser’s most recent publicly available financial statements, the most recent publicly available information appearing in documents filed by the prospective purchaser with the SEC or another U.S. federal, state, or local government agency or self-regulatory organization, or with a foreign governmental agency or self-regulatory organization, etc.
   • Test-the-Waters Communications Are “Offers”: According to the SEC, test-the-waters communications, while exempt from the gun-jumping provisions of Section 5, would nonetheless still be considered “offers” as defined in Section 2(a)(3) of the Securities Act and would therefore be subject to Section 12(a)(2) liability, in addition to the anti-fraud provisions of the federal securities laws. Additionally, information provided in a test-the-waters communication under the Proposed Rule must not conflict with material information in the related registration statement. Further, issuers subject to Regulation FD would need to consider whether any information in the test-the-waters communication would trigger any obligations under Regulation FD, or whether an exception to Regulation FD would apply.
   • Legend or Filing Requirement: An issuer contemplating a registered securities offering may solicit interest from QIBs and IAIs without legending or filing test-the-water communications that comply with the Proposed Rule. Although an issuer is not required to file the test-the-waters communications with the SEC, as is currently the practice of the SEC when reviewing offerings conducted by EGCs, the SEC or its staff could request that an issuer furnish the staff any test-the-waters communications used in connection with an offering.
   • Exclusivity: The Proposed Rule would not act as an exclusive election, and an issuer could rely on other Securities Act communication rules or exemptions when determining how, when, and what to communicate with respect to a contemplated securities offering. If the same issuer decides to claim the availability of another exemption or communication rule with respect to those communications, the conditions of the other exemption or rule relied upon must be satisfied.
3. Implications for Investment Companies

The Proposed Rule would similarly apply to investment company issuers. Test-the-waters communications may help investment companies better assess market demand for a particular investment strategy, as well as appropriate fee structures, prior to incurring the full costs of a registered offering. However, as recognized by the SEC, certain features of investment companies may make their use of the Proposed Rule more limited than other issuers because it is common practice to simultaneously file a registration statement under both the Investment Company Act of 1940, as amended (the 1940 Act), and the Securities Act to take advantage of certain efficiencies. If funds collectively continue to prefer to file a single registration statement under both the 1940 Act and the Securities Act, funds may be less likely to use the Proposed Rule for pre-filing communications than other issuers. However, funds that preliminarily engage in exempt offerings, including certain registered closed-end funds and BDCs, could rely on the Proposed Rule to engage in pre-filing communications if they are considering a subsequent registered offering.

14:  See https://www.sec.gov/news/press-release/2019-14
15: Available at https://www.sec.gov/rules/proposed/2019/33-10607.pdf