Expanding the “Test The Waters” Rule: Weighing Opportunities and Risks

Welcome to the February 2019 edition of our newsletter!  In this issue, we’ll examine the potential impact of the SEC expanding its “test the waters” rules to smaller companies.

If Small Companies Test IPO Waters, Will Investors Get Bitten?

As part of the 2012 JOBS Act, companies with revenue under $1 billion were able to solicit feedback from investors – typically larger money managers – before considering an initial public offering, a process that came to be known as “testing the waters.”  A recent statement by the SEC has proposed lifting the revenue limit altogether, allowing “all issuers, including investment company issuers” to participate, not just “emerging growth companies” which meet the criteria laid out in the 2012 law.

In announcing the move, SEC Chairman Jay Clayton said expanding access would lower the cost of raising capital in public markets.  But the move also carries risks, even if those risks are diluted when large institutional investors are involved (thus limiting damage that could be done to, say, individual retirement accounts invested in those funds.)  The SEC acknowledged the risk posed to investors who relied on the earlier information, rather than later formal offering documents, to make an investment decision, and asserted with some measure of confidence that “We expect such potential adverse effects on investors to be mitigated by several factors, including the general applicability of anti-fraud provisions of the federal securities laws.”

Private Companies Seeking Public Capital – Equal to Trouble?

Creating further grey areas that could allow earlier stage growth companies to access public market capital without simply going public would seem to carry risks, which may or may not be mitigated as the commission asserts.  We have seen some companies raise millions via private placements, raising their public profile in the process, only to become embroiled in various scandals which, if they were publicly traded at the time, would have had an adverse effect on a broader range of investors.  In a way, such scandals have been a proxy for the pitfalls of the SEC’s push to expand access to capital.  While investors, when confronted when violent markets wings caused by actions of an “immature” company or its management, typically can only find recourse via litigation, will broadening access create other layers of liability?  Although the rule as proposed restricts access to “qualified institutional buyers” and “institutional accredited investors” – stating in part that “the Commission’s rules have long recognized that QIBs and accredited investors have a level of financial sophistication and ability to sustain investment losses that render the protections of the Securities Act’s registration process unnecessary” – it does not state what penalties, if any, would be imposed upon new issuers if they did include misleading information in “test the waters” communication.   This leaves the burden to perform due diligence on the investor, and presumably once again leaves litigation as the main recourse if fraud is suspected or other adverse events occur.  While growing companies developing innovative technologies or needed products that have yet to come to market are inherently appealing, investors seem obligated to rely on their own information to vet new issuer offerings, given that the rules differ from traditional public market communications.