No one wants to jump into a shower that is too cold. The same holds true for emerging growth companies (EGCs) and other issuers interested in offering their securities in the public markets.
Since 2012, federal law has allowed EGCs to “test the waters,” communicating with institutional investors ahead of a public offering—indeed, ahead of a registration filing—to determine if there is sufficient investor interest in their securities. In 2019, the law was expanded to allow all issuers to engage in “testing-the-waters” communications.
Testing-the-waters communications help companies avoid devoting resources—including substantial time and money—to the registration process for an offering that is likely to fall flat with investors. As the Securities and Exchange Commission (SEC) notes, testing-the-waters rules are “intended to provide issuers a cost-effective means for evaluating market interest in a potential registered offering before incurring the costs associated with such an offering.”
Rules allowing testing-the-waters communications for are of relatively recent vintage. For decades, Section 5 of the Securities Act of 1933 has generally prohibited issuers from making written or oral offers to investors prior to a registration statement. In 2012, however, the Jumpstart Our Business Startups Act of 2012 (JOBS Act) added Section 5(d) to the Securities Act, which created an exemption allowing EGCs to engage in testing-the-waters communications. Under the 2012 law, any issuer, or person authorized to act on behalf of the issuer, including an underwriter, may engage in exempt oral or written communications with potential investors. These testing-the-waters communications may occur either prior to or following the date of filing of a registration statement for an or other public offerings. Initially limited to emerging growth companies, the testing-the-waters exemption was broadened in 2019 by the adoption of Rule 163B, which expanded the exemption to all issuers, not just EGCs.
However, there are limits on the types of investors issuers may approach with testing-the-waters communications. To maintain investor protections, the SEC allows only investors that are qualified institutional buyers (QIBs) and institutional accredited investors (IAIs) to receive testing-the-waters communications.
EGCs may rely on either Section 5(d) or Rule 163B for their testing-the-waters strategies. The rules are similar with a few key differences. Some may see advantages in using Rule 163B, for example, because it provides a less onerous requirement for determining if institutional investors meet the definitions of QIBs and IAIs under SEC rules. The 163B standard allows issuers to proceed with testing the waters if they have “a reasonable belief” that investors meet the institutional investor criteria. On the other hand, Section 5(d) may give issuers room to maneuver to avoid liability for a material misstatement or omission in their communications with investors. Rule 163B explicitly classifies all statements made during the testing-the-waters process as offers. Section 5(d) does not. An issuer may be able to use this to their advantage if accused of making an error—arguing that their statements during testing-the-waters communications were not offers.
EGCs can use either Rule 163B or Section 5(d) to conduct testing-the-waters communications, but issuers that are not EGCs can use only Rule 163B. A company qualifies as an EGC if it has total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and, as of December 8, 2011, had not sold common equity securities under a registration statement. EGC status provides the company with relief from some of the registration and reporting requirements of public companies.
MEETINGS AND MATERIALS
In practical terms, testing-the-waters communications usually occur in the form of meetings with investors. The meetings give companies a chance to gauge and generate investor interest in a public offering. Testing-the-waters meetings can occur at any time, though they are routinely held after the submission of confidential registration documents to the SEC but prior to any public filings.
Meetings are not required to be kept confidential, though participants are generally asked to agree to keep them so. Written materials may be provided to participants for review, but they are generally collected at the end of the meeting.
While there are no restrictions on the content and no requirement to file written materials with the SEC, the SEC staff may ask to see copies of materials. Companies should take care to ensure that written materials reflect their registrations and that they avoid material misstatements or omissions. This is particularly critical if the meetings involve an offer of securities.
WORKING WITH COUNSEL
Issuers considering a public offering should work closely with their counsel to determine whether a testing-the-waters strategy is right for them and to ensure compliance with regulatory requirements. While testing-the-waters provisions allow issuers to communicate with investors, key limitations remain, and other prohibitions on communications with the public—such as during the pre-IPO quiet period—also remain in effect. Experienced counsel can help ensure the issuer avoids communications pitfalls in the testing-the-waters process.
- Emerging Growth Companies or other issuers and people acting on the issuer’s behalf can engage in testing-the-waters communications.
- Testing-the-waters communication can occur any time prior to registration and after a registration statement has been filed with the SEC.
- Only qualified institutional buyers and institutional accredited investors are eligible for testing-the-waters communications.
To learn more about how Kaplan Voekler Cunningham & Frank, PLC assists EGCs and other issuers through the public offering process, contact us for a consultation.