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The SEC’s New “Testing the Waters” Proposal


March 14, 2019
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The SEC Recently Proposed a New Rule for Testing the Waters Prior to Conducting an IPO…

The Securities and Exchange Commission (SEC) recently proposed a new rule that would allow all issuers to “test the waters’ prior to conducting an initial public offering (IPO). According to the SEC, the expanded test-the-waters provision would provide all issuers with appropriate flexibility in determining when to proceed with a registered public offering while also preserving investor protections. 

As the SEC highlights in its rule proposal, “testing the waters” is often a cost-effective means for startups and other businesses to gauge market interest before incurring the costs associated with an IPO. “Extending 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,” said SEC Chairman Jay Clayton. “I have seen first-hand how the modernization reforms of the JOBS Act have helped companies and investors. The proposed rules would allow companies to more effectively consult with investors and better identify information that is important to them in advance of a public offering.”

Testing the Waters Under the JOBS Act

The Securities Act generally restricts communications by issuers contemplating a registered securities offering during various phases of the offering process. Under Section 5 of the Securities Act of 1933 and related Securities Act rules, the communication restrictions depend primarily on the timing of the communication.

Section 5(c) prohibits any written or oral offers prior to the filing of a registration statement. Once an issuer has filed a registration statement, Section 5(b)(1) limits written offers to a “statutory prospectus” that conforms to the information requirements of Securities Act Section 10. Any violation of these restrictions is commonly referred to as “gun-jumping.”

Over the past several years, the SEC has relaxed the above requirements in certain situations. In 2012, the Jumpstart Our Business Startups Act (JOBS Act) created Section 5(d) of the Securities Act, which allows an emerging growth company (EGC) and any person acting on its behalf to engage in oral or written communications with potential investors that are qualified institutional buyers (QIBs) and institutional accredited investors (IAIs) before or after filing a registration statement to gauge such investors’ interest in a contemplated securities offering. 

When it amended Regulation A in 2015, the SEC also authorized eligible issuers conducting an offering under Regulation A to engage in test-the-waters communications with potential investors, without restriction as to the type of investors, subject to compliance with certain disclaimers and filing requirements.

SEC’s Proposed Securities Act Rule 163B 

The SEC’s Proposed Securities Act Rule 163B would extend the “test-the-waters” provision to non-EGCs. Specifically, the proposed exemption would permit any issuer or person authorized to act on behalf of an issuer, including an underwriter, either prior to or following the filing of a registration statement, to engage in oral or written communications with potential investors that are, or that the issuer reasonably believes are, QIBs or IAIs, to determine whether such investors might have an interest in the contemplated offering.

Test-the-waters communications that comply with the proposed rule would not need to be filed with the SEC. They would also not be required to include any specified legends. In addition, the SEC plans to amend Securities Act Rule 405 to specify that testing-the-waters communications would not be considered a free writing prospectus.

The proposed rule would not be available 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 Securities Act. As the SEC highlights, “testing the waters” communications would also 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. Further, information provided in a test-the-waters communication under the proposed rule must not conflict with material information in the related registration statement.

Issuers subject to Regulation FD would need to consider whether any nonpublic information in the test-the-waters communication would trigger any obligations under Regulation FD, or whether an exception to Regulation FD would apply. Regulation FD generally does not apply if the selective disclosure was made to a person who owes a duty of trust or confidence to the issuer or to a person who expressly agrees to maintain the disclosed information in confidence. Accordingly, as the SEC notes in its proposal, to avoid the application of Regulation FD, an issuer could consider obtaining confidentiality agreements from any potential investor engaged under the proposed rule.

What’s Next?

The SEC’s latest proposal will be subject to a 60-day public comment period following its publication in the Federal Register. We will continue to monitor its progress and post updates. In the meantime, if you have questions about how “testing the waters” may benefit your business, we encourage you to contact a member of the Scarinci Hollenbeck Business Law Group.

If you have any questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work, at 201-806-3364.