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May 08, 2019

Better Markets frets SEC’s offering plan amid positive reviews

Test-the-water proposal raises information asymmetry concerns, group says

Business groups and corporate attorneys have welcomed plans that would allow companies to check out interest in their potential IPOs without having to take formal steps – but concerns have also been raised by Better Markets.

The SEC has proposed expanding the scope of the so-called test-the-water regulatory tool that allows prospective issuers to gauge market interest in a possible IPO or other registered securities through discussions with certain investors before deciding whether to file a registration statement. This accommodation is currently available only to emerging growth companies (EGCs), but the SEC is proposing making it available to all issuers, including investment companies.

These test-the-water communications would be exempt from restrictions imposed by Section 5 of the Securities Act on written and oral offers before or after filing a registration statement and would be limited to qualified institutional buyers (QIBs) and institutional accredited investors (IAIs).

The measure was introduced under the Jumpstart Our Business Startups (Jobs) Act to help boost capital formation in the public markets. Following on from that, the agency’s division of corporation finance in 2017 extended another EGC reform to all issuers: the ability to initially submit certain filings in draft, non-public form as they begin the process of becoming a public company.

The proposal is intended to give increased flexibility to issuers regarding their communications with institutional investors about potential registered securities offerings, as well as a cost-effective means to evaluate market interest before incurring the costs associated with such an offering.

The popularity of the proposal among many commenters is not entirely surprising. Extending the test-the-waters provision featured on a wish-list of reforms presented by a coalition of business groups last year aimed at smoothing the path for more companies to go public in the US.

Items requested in that 36-page report also address research coverage, corporate governance, financial reporting burdens and equity market structure for small public companies. It was authored by the Securities Industry and Financial Markets Association (Sifma), the US Chamber of Commerce, the American Securities Association, the Biotechnology Innovation Organization, the Equity Dealers of America, TechNet, Nasdaq and the National Venture Capital Association.

The Chamber of Commerce writes in its comment letter on the new SEC proposal: ‘Allowing all issuers to test the waters with potential qualified investors would allow issuers to take advantage of one of the more popular provisions of the Jobs Act… [E]ven seasoned issuers can also benefit from testing the waters in secondary and follow-on offerings… We do not believe that adopting [proposed] Rule 163B in the manner proposed would compromise investor protection.’

Similarly, Sifma writes in its comment letter: ‘We appreciate the efforts of the commission and its staff to encourage greater participation in our public markets in a manner consistent with investor protection interests.’

Attorneys at Cleary Gottlieb Steen & Hamilton write separately: ‘We strongly support the proposed rule. Experience with EGC issuers has proven the Section 5(d) accommodation to be a valuable tool in securities offerings, particularly in the IPO context, and that experience does not suggest any reason to hesitate in extending the same accommodation to other issuers.’

But Better Markets, which was founded following the financial crisis with an eye on reforming Wall Street, raises concerns about the SEC’s plan.

For one thing, the group argues that the SEC proposal creates ‘a dangerous loophole’ by not requiring issuers, and those authorized to act on their behalf such as underwriters, to validate the status of the investor – to make sure the investor is truly a QIB or an IAI – before a solicitation is made.

‘This loophole would permit solicitations to retail and other investors that either lack financial sophistication or cannot bear the financial risks associated with investing in highly risky investments such as those offered by, for example, penny stock issuers, leveraged business development companies or asset-backed security issuers,’ writes Better Market president and CEO Dennis Kelleher.

‘Rule 163B would, in effect, permit anyone to check a box at the bottom of a lengthy fine-print disclaimer that would self-certify that the investor meets the eligibility criteria,’ he states. ‘This self-certification would in turn permit the issuer or anyone acting on its behalf to claim that the issuer has attained reasonable belief that the solicitation is directed at QIBs and IAIs. This dangerous, anti-investor protection loophole must be closed before the proposal is finalized.’

Better Markets also calls for the SEC to require issuers that engage in testing the water and then file a registration statement for a securities offering to file their testing-the-water communications with the agency. These communications are already prepared and disseminated, so making companies file them would not impose compliance burdens but it would give the SEC information it can use to monitor and police the market, according to Better Markets. It would also allow investors to compare the communications with the issuer’s prospectus and the performance of the securities, the group states.

‘[P]ermitting issuers (and persons authorized to act on their behalf, including underwriters) to communicate with QIBs and IAIs of their choosing increases the problem of information asymmetry between a selected subset of investors that are in the know and all other similarly qualified investors that learn about the existence and characteristics of a securities offering only once it is made public through the ordinary filing of a registration statement,’ Kelleher writes.

‘This creates an unlevel playing field and gives further advantage to selected sophisticated investors, which are able to afford underwriters and other intermediaries more connected to existing or prospective issuers, over other similarly qualified investors, such as smaller pension funds or asset managers that do not have similar connections.’

Ben Maiden

Ben Maiden is the editor-at-large of Governance Intelligence, an IR Media publication, having joined the company in December 2016. He is based in New York. Ben was previously managing editor of Compliance Reporter, covering regulatory and compliance...