Securities Law Blog

“Testing the waters,” as this term is used by the Securities and Exchange Commission, means oral and written communications between an issuer and potential investors for the purpose of assessing investor interest before having to commit the time and expense necessary to carry out a contemplated securities offering.

On February 19, 2019, the SEC proposed new Rule 163B under the Securities Act of 1933 to allow all issuers of securities in a registered public offering to engage in test-the-waters communications with potential investors that are, or the issuer reasonably believes to be, qualified institutional buyers or institutional accredited investors, either prior to or following the date of filing a registration statement related to such offering. Release No. 33-10607, File No. S7-01-19.  This accommodation to the “gun-jumping” provisions of Section 5 of the Securities Act is currently available only to emerging growth companies conducting IPOs, which was part of the reforms enacted under the JOBS Act in 2012.

In light of the SEC’s experience with test-the-waters communications for emerging growth companies (i.e., an issuer that had annual revenues of less than $1.07 billion during its last fiscal year) and given the sophisticated nature of the institutional investors to which communications under the proposed rule could be directed, the SEC believes it is appropriate to eliminate any distinction between emerging growth companies and other issuers including non-reporting issuers, non-EGCs with more than $1.07 billion in annual revenues, well-known seasoned issuers, registered investment companies, business development companies, blank check issuers and penny stock issuers.

According to the SEC’s proposing release, 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. For example, through such communications, a smaller issuer may be better able to determine an offering size and price range that is appropriate, and whether a common stock only offering versus a unit offering consisting of warrants or other securities is realistic, and this could all theoretically be accomplished in advance without a needless series of time-consuming and costly registration statement amendments to calibrate demand in the public markets.

The SEC believes the ability of issuers in conducting successful offerings and lowering their cost of capital would be enhanced by earlier communications with potential investors, and would encourage additional registered offerings in the United States.

While the proposed rule would extend the JOBS Act’s testing the waters provision to all issuers, regardless of size, and to all types of securities offerings, it is important to note the following:

• An issuer’s test-the-waters communications would be restricted to certain institutional investors, and would not include retail investors or other potential types of investors.
• The test-the-waters communications with permissible investors could be made by not only the issuer, but also by persons authorized to act on behalf of the issuer such as an underwriter.
• The test-the-waters communications (in written form or a written description of the oral communications) would not need to be filed with the SEC and would not need to include any specific legends or disclaimers, as is the case under Regulation A which requires the filing of the communication as an exhibit to the offering statement.
• When reviewing an offering, the SEC staff could request that an issuer furnish the staff any test-the-waters communications used in connection with an offering, presumably on a supplemental basis. To the extent any information provided in the test-the-waters communications conflicts with material information in the related registration statement, the issuer would need to provide corrected disclosure in the filing.
• A written communication used in reliance of the proposed rule would not be considered a “free writing prospectus” under Securities Act Rule 405.
• Existing public companies utilizing the proposed rule would need to consider whether any information disclosed to certain securities markets professionals or shareholders, such as qualified institutional buyers and institutional accredited investors, in the test-the-waters communications constitutes material nonpublic information triggering an obligation under Regulation FD to make public disclosure of that information, absent an exemption from Regulation FD (such as obtaining confidentiality agreements from potential investors). On this point, the SEC has requested comment from the public as to whether there should be a specific exception to Regulation FD for some or all communications made in compliance with the proposed rule.
• Issuers and those acting on behalf of issuers would not be required to verify an institutional investor’s status (à la Rule 506(c)(2)(ii)), provided issuers and such advisors “reasonably believe” the potential investor meets the requirements of the proposed rule.

The testing the waters proposal has a 60-day public comment period following publication in the Federal Register.

The SEC’s proposal exemplifies – just two years after allowing all issuers to confidentially file draft registration statements – the SEC’s willingness to revisit regulations with limited utility for issuers, investors and the public markets, and to propose thoughtful, balanced modifications to encourage more registered public offerings in the United States.