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US Securities and Exchange Commission

SEC: Test the waters before diving in

Tobi J. Carter Richards  

Tobi J. Carter Richards  

What does “test the waters” mean? As part of its ongoing efforts to stimulate U.S. capital markets and boost capital formation, the SEC has adopted a new rule that allows all registrants the opportunity to gauge market interest in possible securities offerings by “testing the waters.”

Test the waters

Effective December 3, 2019, the SEC adopted Rule 163B under the Securities Act (available on Thomson Reuters Checkpoint), allowing all registrants and their agents to participate in oral or written communications with certain potential investors both before and after the filing of a registration statement as a means of evaluating market interest in possible securities offerings (“test-the-waters” communications).  Previously, only emerging growth companies (EGCs) could engage in these types of communications, and before that, the accommodation was virtually nonexistent.  With this greater leeway in determining whether to move forward with a registered public offering, all registrants are now better positioned to take advantage of the expanded access to the public capital markets.

To sink or swim

Traditionally, Section 5 of the Securities Act made it difficult for registrants to test the waters or gauge the interest of prospective investors in a potential securities offering before a registration statement was filed with the SEC and declared effective.  The Jumpstart Our Business Startups (JOBS) Act, signed into law in 2012, eased capital raising for smaller companies by creating a new category of public company called EGCs and adding Section 5(d) to allow them the freedom to test the waters both before and after filing registration statements.  The JOBS Act also allowed EGCs to confidentially submit draft registration statements when conducting IPOs and certain subsequent offerings—an option that goes together with the test-the-waters communications in which EGCs often engage after receiving comments from the SEC on a confidential draft registration statement.

In 2017, the SEC expanded this confidential submission process to apply to all issuers. Unlike EGCs, however, non-EGCs didn’t have the authority to communicate with potential investors during the key time between submitting confidential draft registration statements and publicly filing registration statements, thus limiting the usefulness of the confidential draft registration process. Rule 163B has closed this gap. It evens the playing field for all registrants who want to test the waters before diving in and represents a huge step towards encouraging entry into the public markets.

Let’s tread water … carefully

Non-EGCs, as you exercise your newfound ability to test the waters, keep top of mind the following key features of Rule 163B and the related implications:

1) Restrictions on type of investor.  Communications must be limited to qualified institutional buyers (QIBs), institutional accredited investors (IAIs) and investors reasonably believed to be a QIB or an IAI.

  • Note that the Rule neither provides steps that must be, or even should be, taken for you to establish a reasonable belief that an investor is a QIB or an IAI, nor requires you to verify an investor’s status, allowing you the flexibility to use any method appropriate for your circumstances.
  • Also note that in response to concerns about QIBs and IAIs sharing test-the-waters information in violation of confidentiality or other obligations, the SEC clarified that so long as you’ve taken reasonable steps to prevent that information from being shared with nonqualified parties, the sharing of the information alone will not give rise to Section 5 liability for offering or selling a security in violation of the Securities Act’s registration requirements.

2) No filing or legends required.  Test-the-waters communications aren’t required to be filed with the SEC or to include legends.

  • The SEC’s expectation is that Division of Corporation Finance Staff will still ask registrants to furnish test the waters communications if it reviews registration statements, given that it’s routinely done in the case of EGCs testing the waters under Section 5(d).

3) Liability.  Test-the-waters communications under the Rule are subject to potential liability under Securities Act Section 12(a)(2) and the anti-fraud provisions of the federal securities laws for misstatements and omissions of material facts.

  • Given this potential liability, the SEC urges you to approach test-the-waters communications with the same care and diligence that you would apply to Securities Act filings and other offering-related disclosures.

4) Non-ExclusiveThe Rule is non-exclusive, meaning that you can rely on it while relying on other Securities Act communications exemptions and rules.

  • If, for example, you choose to rely on Rule 163B and another communications rule, then you must comply with the conditions for both rules, even if the other rule requires something that Rule 163B does not and vice versa.
  • Another important implication relates to private placements. You can legitimately participate in test the waters communications under Rule 163B and in communications related to a private offering at the same time. However, the SEC warns that if you decide to pursue a private placement immediately after ditching efforts to carry out a registered public offering, it’s imperative that you consider whether any test the waters communications qualify as a general solicitation because that could rule out any private placement exemption.

5) Regulation FD.  Rule 163B doesn’t exempt test the waters communications from Regulation FD, which requires public disclosure of material non-public information that is intentionally disclosed to certain securities market professionals and shareholders.  While the types of communications that registrants rely on Rule 163B for don’t generally fall within the public offering disclosures that are exempt from Regulation FD, the Regulation does specifically exclude from its scope communications made to any person that expressly agrees to keep confidential the disclosed information.

  • Given this confidentiality-agreement exclusion, it is good practice for you to have confidentiality agreements in place with the QIBs and IAIs that you plan to engage.

Takeaway

Whereas previously you might have avoided the public-offering route because of uncertainty around investor demand for your potential securities offering, Rule 163B removes a lot of that risk. As you consider the more friendly waters of the recently improved public-offering route, be mindful of the benefits and implications discussed above, then enjoy the freedom to dive right in after having tested the waters.

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