The JOBS Act enacted in 2012 made the most dramatic changes to the landscape for the marketing and selling of both private and public offerings since the enactment of the Securities Act of 1933. These significant changes include: (i) the creation of Rule 506(c), which came into effect on September 23, 2013, and allows for general solicitation and advertising in private offerings where the purchasers are limited to accredited investors; (ii) the overhaul of Regulation A, creating two tiers of offerings which came into effect on June 19, 2015, and allows for both pre-filing and post-filing marketing of an offering, called “testing the waters”; (iii) the addition of Section 5(d) of the Securities Act, which came into effect in April 2012, permitting emerging growth companies to test the waters by engaging in pre- and post-filing communications with qualified institutional buyers or institutions that are accredited investors; and (iv) Title III crowdfunding, which came into effect May 19, 2016, and allows for the use of Internet-based marketing and sales of securities offerings.
This is the second in a two-part blog on testing the waters. In the first in the series, I discussed test-the-waters marketing of Regulation A/A+ offerings. That blog can be read HERE. In this second part, I am discussing testing the waters in the standard IPO process including under Section 5(d) for public offerings by emerging growth companies.
Test The Waters– Transactions Using S-1
Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. The public offering process is divided into three periods: (1) the pre-filing period, (2) the waiting or pre-effective period, and (3) the post-effective period. Communications made by the company during any of these three periods may, depending on the mode and content, result in violations of Section 5 of the Securities Act of 1933 (the “Securities Act”). Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.”
All forms of communication could create “gun-jumping” issues (e.g., press releases, interviews, and use of social media). “Gun jumping” refers to written or oral offers of securities made before the filing of the registration statement and written offers made after the filing of the registration statement other than by means of a prospectus that meet the requirements of Section 10 of the Securities Act, a free writing prospectus or a communication falling within one of the several safe harbors from the gun-jumping provisions.
“Offers” of securities are very broadly defined. Section 2(a)(3) of the Securities Act define “offer to sell,” “offer for sale,” or “offer” to include “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” The definition specifically excludes discussions and negotiations between a company and an underwriter or underwriters. The Section 2(a)(3) definition of an offer also specifically excludes research reports by broker-dealers, which provision was added by the JOBS Act and is touched on below.
In 2005, in order to modernize the offering process, the SEC adopted the “Securities Offering Reform,” which included adding a number of communication safe harbors from enforcement of Section 5, as discussed in more detail below. The JOBS Act added additional provisions allowing for test-the-waters communications by emerging growth companies during the offering process.
Test-the-waters communications involve solicitations of indications of interest for an offering prior to the effectiveness of a registration statement. Where Regulation A freely allows, and even encourages, test-the-waters communications, the standard IPO process using a Form S-1 still strictly limits pre-effectiveness solicitations of interest and offering communications overall. As with Regulation A, indications of interest as a result of test-the-waters communications are non-binding. Section 5(a) of the Securities Act prohibits the sale of securities before the registration statement is deemed effective.
Test The Waters communications during the pre-filing period
The pre-filing period is that time frame between the decision to proceed with a public offering and the actual filing of a registration statement with the Securities and Exchange Commission. During this period, a potential registrant is in the “quiet period” and is subject to restrictions on public disclosure relating to the offering. The pre-filing period begins when the company, and the underwriters where applicable, agree to proceed with a public offering.
Statements made within 30 days of filing a registration statement that could be considered an attempt to pre-sell the public offering may be considered an illegal prospectus, resulting in a Section 5 “gun-jumping” violation, if no exception or safe harbor applies. This might result in liability for violating securities laws, the SEC’s delaying of the public offering, and/or requiring prospectus disclosures of these potential securities law violations. Press interviews, participation in investment banker-sponsored conferences, and new advertising campaigns are generally discouraged during this period.
Section 5(c) of the Securities Act generally prohibits oral and written offers of a security before a registration statement is filed, which encompasses the quiet and pre-filing period. There are, however, many exceptions and safe harbor rules to this general prohibition.
Section 105(c) of the JOBS Act – “Test The Waters” by an Emerging Growth Company:
In April 2012, the Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted, which, in part, established a new process and disclosures for public offerings by a new class of companies referred to as “emerging growth companies” or “EGCs.” An EGC is defined as a company with total annual gross revenues of less than $1 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011.
Section 105(c) of the JOBS Act provides an EGC with the flexibility to “test the waters” by engaging in oral or written communications with qualified institutional buyers (“QIBs”) and institutional accredited investors (“IAIs”) in order to gauge their interest in a proposed offering, whether prior to (irrespective of the 30-day safe harbor) or following the first filing of any registration statement, subject to the requirement that no security may be sold unless accompanied or preceded by a Section 10(a) prospectus. Generally, in order to be considered a QIB, you must own and invest $100 million of securities, and in order to be considered an IAI, you must have a minimum of $5 million in assets.
As an EGC would not have filed any documents or requests with the SEC at this stage, it will be up to the EGC to determine whether it qualifies as an EGC prior to commencing test-the-waters communications. Under the rules, “well-known seasoned issuers,” or WKSIs, can engage in similar test-the-waters communications, but smaller reporting companies that do not otherwise qualify as an EGC cannot.
An EGC may utilize the testing-the-waters provision with respect to any registered offerings that it conducts while qualifying for EGC status. Test-the-waters communications can be oral or written. An EGC may also engage in test-the-waters communications with QIBs and institutional accredited investors in connection with exchange offers and mergers. When doing so, an EGC would still be required to make filings under Sections 13 and 14 of the Exchange Act for pre-commencement tender offer communications and proxy soliciting materials in connection with a business combination transaction.
There are no form or content restrictions on these communications, and there is no requirement to file written communications with the SEC. During the first year or two following enactment of the JOBS Act, the SEC staff regularly asked to see any written test-the-waters materials during the course of the registration statement review process, but eventually these requests ceased. The SEC staff maintains the right to ask to review test-the-waters, or any, communications made by a company during the S-1 review process. For more information on the SEC review process and responding the SEC comments in general, see my blog HERE.
In practice the marketing of an IPO offering generally begins during the waiting period after the filing of the S-1 with the SEC and generally not until the two to three weeks prior to the effectiveness of the registration and launching of the offering itself. However, an EGC can make test-the-waters communications even before filing the registration statement. It is important to note that anti-fraud provisions, such as Section 12(a)(2) and 10(b), still apply to such communications.
Exception for Research Reports
Section 105(a) of the JOBS Act amended Section 2(a)(3) of the Securities Act to eliminate restrictions on publishing analyst research and communications while IPOs are under way. Under prior law, research reports by analysts, especially those participating in an underwriting of securities of the subject company, could be deemed to be “offers” of those securities under the Securities Act and, as result, could not be issued prior to completion of an offering. Section 2(a)(3) of the Securities Act as amended by Section 105(a) of the JOBS Act provides that publication or distribution by a broker or dealer of a research report about an EGC that is the subject of a proposed public offering of its securities does not constitute an offer of securities, even if the broker or dealer that publishes the research is participating or will participate as an underwriter in the offering. Moreover, the term “research” is defined broadly as any information, opinion or recommendation about a company and includes oral as well as written and electronic communications. This research need not be accompanied by a full prospectus and need not provide information “reasonably sufficient upon which to base an investment decision.” The research need not even be consistent with the prospectus, if there is one. In other words, research providers are free to say just about anything they wish about an IPO candidate, limited only by the general anti-fraud rules.
Section 105(b) of the JOBS Act eliminates existing restrictions on publishing research following an IPO or around the time the IPO lockup period expires or is released. Currently, under SEC and Financial Industry Regulatory Authority (“FINRA”) rules, underwriters of an IPO cannot publish research for 25 days after the offering (40 days if they served as a manager or co-manager), and managers or co-managers cannot publish research within 15 days prior to or after the release or expiration of the IPO lockup agreements (so-called “booster shot” reports). The Act requires FINRA and the SEC to eliminate these restrictions with respect to EGCs. As a result, any research analyst will be able to publish at any time after an EGC IPO, including immediately after the offering. On October 11, 2012, FINRA amended its rules to conform with the requirements under Section 105(b) of the JOBS Act. In particular, it amended NASD Rule 2711 to eliminate all quiet periods.
Rule 135 Safe Harbor
Rule 135 allows for the publication of a limited announcement of a proposed public offering before the filing of the registration statement. The Rule 135 notice is often referred to as a “tombstone” ad. Such tombstone notice is limited to: (i) the name of the company; (ii) the title, amount, and basic terms of the securities; (iii) the amount to be offered by any selling shareholders; (iv) the anticipated timing of the offering; (v) a brief statement of the manner and purpose of offering, without naming the underwriters; (vi) whether the offering is directed to a particular class of purchaser (such as accredited only); and (vii) state and federal legends as required by law (including that it is not an “offer”). If the “tombstone” notice complies with the above Rule 135 requirements, the notice will not be treated as an “offer.”
A Rule 135 communication must contain a disclaimer/legend “to the effect that it does not constitute an offer of any securities for sale.” Sample legends include:
This announcement is being made pursuant to and in accordance with Rule 135 under the Securities Act of 1933. As required by Rule 135, this press release does not constitute an offer to sell or the solicitation of an offer to buy securities, and shall not constitute an offer, solicitation or sale in any jurisdiction in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of that jurisdiction.
Rule 135 can be effective as a test-the-waters tool. Responses to a publication, or lack thereof, can provide valuable information regarding the public interest in a particular planned public offering. A Rule 135 announcement can only be made before a registration statement is filed. Following the filing, the appropriate announcement would be under Rule 134 as discussed below.
Test The Waters Communications during the Post-filing, Pre-effectiveness Period
The waiting or pre-effective period is that time frame between the filing date and the effective date of the registration statement. During this period, the company may generally make oral offers, but may not enter into binding agreements to sell the offered security.
The pre-effective period is the period during which, among other things, the company begins marketing the offering, through real-time oral offers, including calls to potential investors. Section 5(b)(1) of the Securities Act prohibits written offers other than by means of a prospectus that meets the requirements of Section 10 of the Securities Act. An S-1 meets such requirements. Such bans are designed to prohibit inappropriate marketing, conditioning or “hyping” of the security before all investors have access to publicly available information about the company so that they can make informed investment decisions.
Oral communications are allowed following the filing of a registration statement, subject to the anti-fraud provisions.
Other than a free writing prospectus for qualified companies and test-the-waters communications by an EGC satisfying the requirements of Section 5(d) of the Securities Act (i.e., Rule 105(c) of the JOBS Act), the only written sales material that may be distributed by the company during this period is the preliminary prospectus, which must satisfy specified SEC requirements. While binding commitments cannot be made during this period, the underwriters will receive indications of interest from potential purchasers, indicating the price they would be willing to pay and the number of shares they would purchase.
During this period, key management personnel generally will make a series of presentations covering the company’s business and industry, market opportunities and financial matters to the investment community. The underwriters will use these presentations as an opportunity to ask questions and establish their due diligence. This presentation period is commonly referred to as the “road show” and generally is conducted in the two-to-three-week period immediately prior to the effectiveness of the registration statement and ability to complete sales of the securities.
As with other offering periods, many exemptions and safe harbors exist to allow for communications during the pre-effective waiting period.
Section 105(c) of the JOBS Act – “Test The Waters” by an EGC:
Section 105 of the JOBS Act is also available during the post-filing, pre-effective waiting period.
Rule 134 Written Solicitation of Interest:
Rule 134 permits the company to communicate limited factual information about the offering after the Section 10 prospectus is filed (i.e., an S-1). Rule 134 communications are not deemed to be either prospectuses or free writing prospectuses. Rule 134 communications may only be made after a registration statement has been filed with the SEC. The allowable content of a Rule 134 communication is similar to that of a Rule 135 communication; however, a Rule 135 communication is just a notice of a proposed registered offering, whereas a Rule 134 communication relates to a filed registration statement for a particular offering.
A Rule 134 communication may include one or more of the following information: (i) factual information about the legal identity and business location of the company including name, address, phone number, web address, e-mail address, principal office location, investor relations contact information, country or state of location or organization and similar information; (ii) the title and amount of securities offered, which can include a designation such as “preferred,” “convertible” or “secured”; (iii) a brief statement of the general type of business of the company; (iv) the price of the security, if known; (v) a brief description of the intended use of proceeds; (vi) the type of underwriting (self, firm commitment or best efforts); (vii) names of underwriters and other offering participants; (viii) schedule and timing of the offering, including road show dates, times and locations; (ix) legal opinions as to specified tax treatment; (x) the names of selling security holders; (xi) names of exchanges or other markets where the security currently trades, and (x) the ticker symbol.
The communications must contain the prescribed legend, be preceded or accompanied by a Section 10 prospectus, and state where the statutory prospectus can be obtained. The required legend is as follows:
A registration statement relating to these securities has been filed with the Securities and Exchange Commission but has not yet become effective. These securities may not be sold nor may offers to buy be accepted prior to the time the registration statement becomes effective.
Subject to limited exceptions, the following should also be included:
No offer to buy the securities can be accepted and no part of the purchase price can be received until the registration statement has become effective, and any such offer may be withdrawn or revoked, without obligation or commitment of any kind, at any time prior to notice of its acceptance given after the effective date.
Free Writing Prospectus
A free writing prospectus would include any written communication that could constitute an offer to sell or a solicitation of an offer to buy securities subject to a registration statement that is used after the filing of a registration statement and before its effectiveness. A free writing prospectus is a supplemental writing that is not part of the filed registration statement. If the writing is simply a repetition of information contained in the filed registration statement, it may be used without regard to the separate free writing prospectus rule.
For purposes of rules related to free writing prospectuses, all communications that can be reduced to writing are considered a written communication. Accordingly, radio and TV interviews, other than those published or given to unaffiliated and uncompensated media, would be considered a free writing prospectus and subject to the SEC use and filing rules.
All free writing prospectuses must contain a specific notice legend as set forth in Rule 433 of the Securities Act. A free writing prospectus must be filed with the SEC, using Form 8-K, no later than the date of first use. An after-hours filing will satisfy this requirement as long as it is the same calendar day. Moreover, all free writing prospectuses must be filed with the SEC, whether distributed by the registrant or another offering participant and whether such distribution was intentional or unintentional.
A free writing prospectus may not be used by any issuer that is “ineligible” for such use. The following entities are ineligible to use a free writing prospectus: (i) companies that are or were in the past three years a blank check company; (ii) companies that are or were in the past three years a shell company; (iii) penny stock issuers; (iv) companies that conducted a penny stock offering within the past three years; (v) business development companies; (vi) companies that are delinquent in their Exchange Act reporting requirements; (vii) limited partnerships that are engaged in an offering that is not a firm commitment offering; and (viii) companies that have filed or have been forced into bankruptcy in the last three years.
Small- and micro-cap issuers will rarely be eligible to use a free writing prospectus.
Live Road Shows
A road show is regulated under Rule 433 of the Securities Act and the free writing prospectus rules. Written road show materials may be considered free writing prospectus and must be filed with the SEC, and may only be used by companies eligible to use a free writing prospectus. As mentioned, if the writing is simply a repetition of the information contained in the filed registration statement, it is not considered a free writing prospectus and may be used by all companies that have filed a registration statement with the SEC. Accordingly, written materials used in a road show by any company that is not eligible to use a free writing prospectus (such as most small- and micro-cap companies) are strictly limited to the contents of the registration statement itself.
Oral communications in a live road show are exempt from the free writing prospectus requirements under Rule 433 and accordingly may be used by all companies with a filed registration statement (not before).
“Live road shows” include: (i) a live, in-person presentation to a live, in-person audience; (ii) a live, real-time presentation to a live audience transmitted electronically; (iii) a concurrent live and presentation and real-time electronic transmittal of such presentation; (iv) a webcast or video conference that originates live and is transmitted in real time; and (v) the slide deck or other presentation materials used during the road show as unless investors are allowed to print or take copies of the information.
Smaller Reporting Company Dilemma
The opportunities for a smaller reporting company to engage in marketing, test-the-waters, and other pre-effective communications related to a public offering are limited. A “smaller reporting company” is defined as one that, among other things, has a public float of less than $75 million in common equity, or if unable to calculate the public float, has less than $50 million in annual revenues. As described above, an “emerging growth company” is one with total annual gross revenues of less than $1 billion during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. At times a company will qualify as both a smaller reporting company and an emerging growth company, but not always.
A smaller “reporting” company is, by definition, a company subject to the “reporting” requirements of the Securities Exchange Act of 1934 (“Exchange Act”). Companies that are subject to the Exchange Act do not qualify to use Regulation A. Accordingly, a smaller reporting company cannot avail itself of the broad allowable pre-offering test-the-waters communications allowed in a Regulation A public offering. I do note that some smaller reporting companies are voluntary filers. That is, they voluntarily file reports with the SEC and are not actually subject to the Exchange Act reporting requirements. These companies can complete a Regulation A public offering.
Where a smaller reporting company is not also an EGC, it cannot engage in Section 105(c) test-the-waters communications made available under the JOBS Act. This is clearly a legislative miss. The JOBS Act is intended to create capital raising opportunities for small companies. Although I understand that the thought was to assist EGC’s in the IPO process, the fact is that many smaller reporting companies engage in a series of follow-on public offerings before reaching a size and level of maturity where they no longer need the assistance of rules and laws designed to encourage capital in smaller companies. Ironically, by that point, these companies will be able to engage in additional communications only available to eligible larger issues, such as free writing prospectus and Rule 163 communications. Rule 163 communications are only available to well-known, seasoned issuers (big companies) and have not been addressed in this blog.
Many of these smaller reporting companies trade on the OTC Markets, which, despite continued and ongoing best efforts, face liquidity issues and need extra legislative support in conducting offerings just as the legislature clearly realizes an EGC’s needs. For a good refresher on liquidity issues for small companies, see my blog HERE.
That leaves a copy of the actual filed registration statement, Rules 134 and 135 for written communications and live road shows for smaller reporting companies engaging in initial and follow-on public offerings.
Smaller reporting companies are usually better off engaging in a Rule 506(c) advertised private offering than a registered public offering from a marketing perspective. This likely unintended consequence seems a dichotomy to the SEC objective of preferring registration and its accompanying complete disclosure in the issuance of securities.
Laura Anthony, Esq.
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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