SEC Issues Final Rules Extending “Test-the-Waters” Provisions to All Companies

Starting in December, large companies will be able to gauge investor interest in their potential initial public offering (“IPO”) in the same way smaller companies already do. (Ramonas, Bloomberg Law). The U.S. Securities and Exchange Commission (“SEC”) recently voted 5-0 to adopt new regulations under Rule 163B of the Securities Act of 1933 (“Securities Act”), which extend the rule’s “test-the-waters” provisions from emerging growth companies to all companies considering an IPO. (Id.) The ability to gauge institutional investor interest in a potential IPO will help companies better tailor the size and terms of their offerings to the demand of the market and allow companies to avoid the costs of pursuing an IPO if the interest is simply not there. 

The so-called “gun-jumping” provisions in Section 5 of the Securities Act generally prohibit oral and written communications with investors prior to the filing of a registration statement. (Juergens et al., Law360). In 2012, Congress passed the Jumpstart Our Business Startups Act (“JOBS Act”), which created an exception to the gun-jumping provisions for emerging growth companies (“EGCs”) and led to the promulgation of the current Rule 163B. (Id.) Under the rule, EGCs— companies with less than $1.07 billion in annual revenue—are permitted to “test-the-waters” by engaging in oral and written communications with potential investors who are qualified institutional buyers or institutional accredited investors (“Institutional Investors”) prior to or after the filing of a registration statement. (Id.) 

The new regulations update Rule 163B to apply to all companies and also exclude “test-the-waters” communications from the free writing prospectus requirements which typically apply to any written offers or solicitations of offers to buy SEC-registered securities under the Securities Act . (Id.) These updates bring U.S. regulations more in line with European practice where test-the-waters-type communications are common. (Id.) The changes also have strong support in Congress; the House of Representatives voted overwhelmingly in support of expanding test-the-waters provisions when it passed the JOBS Act 3.0 in July 2018, though the bill was not taken up by the Senate before the SEC proposed the new Rule 163B in February 2019. (Advisory, Alston & Bird).

To prepare the final rules, the SEC considered approximately 20 comment letters, the majority of which supported the expansion of the test-the-waters provisions. (SEC Release). In its release, the SEC clarified that while Rule 163B exempts companies from the gun-jumping provisions, the communications would still be considered “offers” of securities which would make them subject to both the liability provisions for offers under Section 12(a)(2) of the Securities Act and the general anti-fraud provisions of other securities laws. (Id.) Further, the SEC noted that communications under new Rule 163B must not conflict with material information in the related registration statement. (Juergens et al., Law360). 

These expanded rules apply only to Institutional Investors and maintain a large degree of protections for non-sophisticated investors. First, under the rules, companies can only communicate with Institutional Investors, who are sophisticated investors, and do not require the same level of protection under securities laws as smaller retail investors. (Nasdaq Letter, SEC). Second, investors are still protected by multiple anti-fraud provisions in the federal securities laws. (Id.) And third, if a company pursues an IPO after “testing-the-waters,” it will need to make all relevant disclosures in its registration statement, and ensure that all investors have access to it. (Id.) In short, the changes contained in the new rule do not significantly reduce investor protections.

The expansion of the “test-the-waters” rule could help prevent some lackluster offerings from coming to the market. (Setty, CNBC). Of the 120 companies to go public so far in 2019, 57 are trading below their offer price. (Id.) Companies that have dropped in value since their IPO include, Peloton, which finished 11% down on its debut last week; Slack, which is 15% down from its June debut; Uber, which is 33% down from its debut price; and SmileDirectClub, which is 36% down. (Id.) As another sign that investors see many IPO companies as overpriced, Endeavor–a global entertainment, sports and content company, and Hollywood’s biggest talent agency holder– cancelled its IPO hours before it was set to price shares due to low investor demand at the price the company sought to make the offering. (Bhattacharjee, CNBC). While many factors impact the value of the companies and performance of their stocks, including market and corporate governance issues, the new “test-the-waters” provisions could help larger companies get better positioned in the market to avoid disappointment with a lackluster IPO.