July 2012

We’ve been thinking about whether the changes to Rule 506 offerings are likely to have any effect on the PIPE market.  Our preliminary conclusion is that the ability to use general solicitation is unlikely to have much effect on PIPE transactions.  An already public company generally turns to a PIPE transaction for financing because the company wants to ensure that it will be able to obtain definitive commitments from PIPE purchasers before announcing the financing.  In order to address Regulation FD concerns and avoid a premature disclosure regarding the potential private financing, the company and its financial intermediary will obtain confidentiality undertakings from potential purchasers.  It would be inconsistent with this approach to rely on general solicitation.  Moreover, there often are special circumstances, such as an acquisition, that compel the company to rely on a PIPE transaction instead of a shelf takedown.  To the extent that a company shares material non-public information with potential PIPE purchasers (which information will later be made public through a cleansing release), using general solicitation in connection with the PIPE transaction also would not be possible.  However, the practices relating to PIPE press releases may change going forward.  Now, the press release announcing the entry into definitive PIPE purchase agreements does not name the PIPE placement agent since that would not comport with the strict requirements of Rule 135c.  Given the additional flexibility relating to general solicitation, counsel may be more comfortable with naming the financial intermediary in a Rule 135c release.

 

On July 20, 2012, the SEC delivered to Congress the report required by Section 106 of the JOBS Act, which directed the SEC to examine the impact of decimalization on IPOs and the impact of this decade-old change on liquidity for small- and mid-cap securities. Section 106 goes on to say that if the SEC determines that securities of emerging growth companies should be quoted or traded using a minimum increment higher than $0.01, then the SEC may, by rule, not later than 180 days following enactment of the JOBS Act, designate a higher minimum increment between $0.01 and $0.10.  It doesn’t look like any such change is coming down the pike based on the Staff’s conclusions and recommendations in the study.

The study notes the observations of the IPO Task Force regarding the changing market structure and economics arising from the shift to decimal stock quotes, which point toward a negative impact on the economic sustainability of sell-side research and the greater emphasis placed on liquid, very large capitalization stocks at the expense of smaller capitalization stocks.  The SEC’s study takes a three-pronged approach to examining the issues: (i) reviewing empirical studies regarding tick size and decimalization; (ii) participation in, and review of materials prepare in connection with, discussions concerning the impact of market structure on small and middle capitalization companies and on IPOs as part of the SEC Advisory Committee on Small and Emerging Companies; and (iii) a survey of tick-size conventions in foreign markets.

Not surprisingly, the Staff concluded that decimalization may have been one of a number of factors that have influenced the IPO market, and that the existing literature did not isolate the effect of decimalization from the many other factors. The Staff also noted that markets have evolved significantly since decimalization was implemented over a decade ago, and that other countries have utilized multiple tick sizes rather than the “one size fits all” approach implemented in theUnited States.  Based on the observations reported in the study, the Staff recommends that the Commission should not proceed with specific rulemaking to increase tick sizes, but should rather consider additional steps that may be needed to determine whether rulemaking should be undertaken, which might include soliciting the views of investors, companies, market professionals, academics and others on the broad topic of decimalization and the impact on IPOs and the markets.  In particular, the study notes the possibility of a roundtable where these issues can be addressed.

While the study does a nice job framing the debate regarding decimalization and its impact on the markets, it doesn’t move the ball forward appreciably in terms of potential for rule changes responding to the debate. We’ll have to wait to see how this all unfolds.

Many smaller banks in the United States recently received a bit of surprising news.  The banking agencies published their notices of proposed rulemaking relating to the bank capital requirements.  The Basel III NPR made clear that only the smallest banks in the United States would be exempt from compliance with the heightened regulatory capital requirements of Basel III.  Over time, smaller banks will need to raise capital in order to meet the new requirements that will be phased in over the next few years.  Historically, smaller banks have found it difficult and expensive to raise capital.  Many smaller banks were not able to raise capital on their own, and turned to issuances of trust preferred securities, which then got pooled with trust preferred securities issued by other small banks, and sold (on a packaged basis) to investors.  Trust preferred securities will no longer be eligible for favorable regulatory capital treatment.  Smaller banks must offer common stock, or non-cumulative perpetual preferred stock, or REIT preferred stock.  Memories are probably too fresh to accept a new pool instrument, even if it were a simpler pooled non-cumulative preferred.  A few JOBS Act changes may provide some new alternatives for smaller banks.  First, small banks might want to consider issuing securities at the bank level and rely on the exemption from registration offered by Section 3(a)(2).  A national bank generally relies on Part 16 of the Office of the Comptroller of the Currency’s (the “OCC”) regulations in connection with offerings pursuant to Section 3(a)(2).  The Part 16 regulations generally require that a national bank offer and sell its securities pursuant to a registration statement filed with the OCC, unless there is an available exemption.  An exemption from the registration requirement is available if the national bank offers and sells its securities in transactions that comply with the Regulation D safe harbor or in Rule 144A qualifying transactions.  Generally, banks have structured their offerings of securities to comply with the Regulation D safe harbor in order to avoid the OCC registration statement requirement.  Once the SEC promulgates rules to permit general solicitation and general advertising in connection with Rule 506 offerings and resales under Rule 144A, banks should have an easier time raising capital.  Banks will be able to offer securities at the bank level in 3(a)(2) offerings, using general solicitation, provided that actual investors are verified to be accredited investors.  If the institution were to issue securities at the bank holding company level instead (for which the 3(a)(2) exemption is not available), this new flexibility in relation to private offerings is still quite useful.

One of the thorniest issues for securities lawyers always has been addressing potential integration questions.  We have been trained to recognize that there are heightened concerns associated with offerings occurring in close proximity to one another, or changes in offering format (from private to public or public to private offering).  Over time, the SEC has provided increased certainty regarding integration issues by formulating and adopting various integration safe harbors.  However, the capital markets evolve continually, and as we’ve noted in other posts, there is considerable “blurring” of the lines between the types of offering formats that are characterized as private placements and those that are characterized as public offerings.  These hybrid offerings, like PIPE transactions, registered direct offerings, and confidentially marketed public offerings (or wall-crossed offerings), test the limits, and highlights the infirmities, of many integration principles.  Now, we have the JOBS Act, which seems to stress further many of the basic integration ground rules.  As a young securities lawyer, I was regularly reminded that an offering that starts as a private offering must be completed as a private offering, and, of course, the corollary, that an offering started as a public offering must be completed as a public offering.  Will that continue to hold true?  An emerging growth company may now engage in test-the-waters communications prior to pursuing an initial public offering.  An EGC also can continue to test the waters once it has submitted confidentially to the SEC a registration statement, or even once it has publicly filed with the SEC its registration statement.  Before the public filing, one could say that these discussions would not constitute a “general solicitation” given that the EGC may only approach QIBs and institutional accredited investors.  One could also say that the “offering” has not commenced as a private offering, given that the conversations are not considered an “offer.”  However, once the registration statement has been publicly filed, it is hard to see why the filing would not constitute a “general solicitation” and why permitting the test-the-waters discussions to continue would not challenge the conventional integration wisdom.  A number of similar questions are prompted by the JOBS Act, which makes one wonder whether the notion of integration will fall by the wayside.

In considering the relaxation of the prohibition against general solicitation and general advertising that was incorporated into the JOBS Act, Congressional attention seemed to focus on some quid pro quo arrangement that demands verification of accredited investor status.  This leads us to wonder why it takes a “trade” of this sort to justify removing the ban on general solicitation, which was deemed anachronistic long before the JOBS Act was contemplated.  For at least the last decade, practitioners have been urging the SEC to consider whether the prohibition against general solicitation made sense given advances in communications.  In fact, the deregulation of “offers” had been proposed as far back as the late 80s.  Throughout this period, there have been few studies regarding any fraud or evidence that investors misrepresent their status as accredited investors in order to gain access to certain investment opportunities, or that this type of conduct might be so prevalent that traditional means of certifying investor status should be set aside in favor of a more burdensome process.  In the pre-comment period, we note that a variety of views have been submitted to the SEC Staff regarding investor accreditation.  Some suggested approaches advance the notion of a bifurcated path—that is, if you want to use general advertising, you must may the price and engage in a more rigorous verification process.  Why?  Again, we understand the idea of rough justice.  If you will not benefit from the more relaxed communications rules, then you shouldn’t pay the added toll of verifying.  But, neither experience nor logic suggests that investors are not that likely to embellish their status if there is no general solicitation but more prone to do so if they are alerted to an opportunity through the use of general advertising.  Other commenters have suggested that if a broker-dealer or financial intermediary is involved in facilitating the private placement, the broker-dealer should be the “gatekeeper,” and should take additional steps (beyond the traditional certification process) to verify status.  Don’t the know-your-customer and suitability rules already require a baseline level of inquiry?  All in all, the intense focus on verification of accreditation seems overdone.

Section 201(a)(1) of the JOBS Act directs the SEC to repeal the ban on general solicitation and general advertising in securities offerings under Rule 506 of Regulation D and Rule 144A.  Can advertisements for hedge funds in Cigar Aficionado and The Wine Spectator be far behind?

Not so fast.  The SEC has missed its July 4 deadline to adopt regulations to implement Section 201(a)(1).  It recently scheduled an open meeting for August 22, 2012 to consider rules to eliminate the general solicitation and advertising prohibitions in private placement offerings.

But the devil is in the details.  We have no indication whether the SEC will take an expansive or narrow approach to general solicitation and general advertising rules for private funds, or whether it will tackle the thorny issue of performance advertising by private funds at all in this round of rulemaking.

This appears to be yet another contentious issue for the SEC to address.  Many believe that private funds should be able to advertise performance as part of a general solicitation, because, at the end of the day, only sophisticated investors may invest in those funds, thus mitigating the likelihood that the advertisements will mislead the average investor.  Others, like the Investment Company Institute, have argued that the SEC should prohibit performance advertising by private funds until it adopts standards similar to those that apply to mutual funds.  In particular, the ICI has urged the SEC to apply the performance advertising standards of Rule 482 under the Securities Act of 1933 to private funds.

The SEC Division of Investment Management’s dance card is already full, as it considers controversial regulations covering money market funds, use of derivatives and leverage by investment companies, and distribution fees.  In light of the pending regulatory drama and the staff’s ballooning workload, we may not see new rules governing private fund performance advertising any time soon.

Performance advertising is not the only challenge relating to private funds that the SEC faces. The SEC’s rules must “require the issuer to take reasonable steps to verify” that investors are “accredited investors.”  Private fund sponsors generally believe that the current rules do just that.  A comment letter from a well-known hedge fund sponsor argued that Congress mandated the SEC only to establish a reasonable safe harbor for issuers to verify whether an issuer is accredited, and that an investor’s certification is a reasonable verification.  Others, like William Galvin, the Massachusetts Secretary of the Commonwealth, disagree, calling for rules that require issuers to determine whether investors are accredited based on documentary evidence.

The SEC has an opportunity to address other issues of concern to private fund issuers.  For example, although Section 201(b) clearly states that offerings that comply with Rule 506 shall not be deemed public offerings under federal securities laws, there is no comparable reference to a Rule 144A offering.  The Committee on Federal Regulation of Securities of the American Bar Association’s Business law section suggested that the SEC should confirm that a general solicitation or general advertising by a private fund will not be a “public offering” for purposes of Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.

Whatever the SEC does at its open meeting on August 22, 2012 regarding private fund offerings, the proposals are likely to generate passionate debate that may not be resolved any time soon.

 

 

Have you noticed that most of the terms relating to contacting potential investors to gauge their interest in possible securities offerings take their inspiration from terms related to the sea?  We wonder why.  Probably not an homage to Jacques Cousteau or Wes Anderson.  In Europe and Asia, for some time, bankers have had greater flexibility to discuss potential offerings with investors in order to gauge their interest.  This process often is referred to as pilot fishing.  Wikipedia tells us that pilot fish are carnivorous fish that congregate around sharks and lead sharks to food, but rarely get eaten by sharks due to the erratic behavior of pilot fish when caught.  This doesn’t exactly make it obvious why bankers refer to the process as “pilot fishing.”  Perhaps a better explanation comes from the etymological origins of the name—which is the belief by early mariners that pilot fish would direct, or pilot, their ships to land.  For quite a long time, given the prohibitions on communications prior to a securities offering, it was difficult for bankers in the United States to engage in these types of conversations with potential investors, without fear of having these activities considered impermissible gun-jumping.  Of course, the JOBS Act significantly updates the regulatory framework governing offering related communications for emerging growth companies.  Making it all the more important to understand the types of pre-offering communications that have been part of the bookbuilding process in Europe.  Conducting preliminary investor inquiries, or “pre-soundings” (the reference to “soundings” is intuitively obvious), in Europe and Asia has yielded important information about valuation and has helped during volatile market conditions.  Usually, following pilot fishing, book runners then identify anchor investors (again, what’s with the nautical references).  Even under our updated JOBS Act framework, it would be impermissible to obtain orders from key investors in advance of having a preliminary prospectus with a price range.  However, we often do see financial sponsor types (QIBs) step up and participate in a private placement completed contemporaneously with the proposed IPO.  It is interesting that just as the process for interacting with investors in the United States is becoming more fluid, the pre-sounding process in Europe and Asia (at least in relation to follow-ons) is becoming somewhat more constrained.  Maybe the practices will coalesce at sea.

The JOBS Act directed the GAO to undertake a study concerning the factors impeding greater use of currently Regulation A.  The GAO study examines trends in Regulation A offerings, noting that the number of offerings increased from 1992 through 1997.  This increase followed the SEC’s changes to the offering ceiling for Regulation A offerings from $1.5 million to $5 million.  Since 1997, however, the number of Regulation A offerings has declined.  The study notes that issuers have tended to favor Regulation D offerings.  The report cites a number of factors that likely have contributed to the lack of interest in using Regulation A for capital-raising.   For example, the report cites the delays associated with the SEC review of Regulation A offering statements (whereas an issuer faces no disclosure requirements in connection with a Regulation 506 offering made to accredited investors) and, of course, the time-consuming and expensive process for complying with state securities laws.  The report details a number of significant advantages associated with Regulation D offerings.

The report does lead one to consider the relative attractiveness of various offering alternatives.

For example, if an issuer (not a reporting company) is prepared to make its offering available only to (verified) accredited investors, the issuer soon will be able to solicit and will not have specific disclosure requirements.  Of course, the securities sold in the Rule 506 Regulation D offering will be restricted.  No limit on dollars that can be raised.

If the issuer completes one or many such offerings, provided it stays below the new 12g threshold, it will not be required to furnish periodic information to the SEC.

An issuer that is not a reporting company might undertake crowdfunding offerings, through a funding portal or a broker-dealer, to investors meeting certain standards, but then the issuer must comply with certain disclosure requirements in connection with the offering, and also be subject to ongoing albeit limited information requirements.  The securities sold in the crowdfunding offering will be restricted.  The dollar amounts are small.

Under the JOBS Act, in conjunction with the new Regulation A+ or 3(b)(2), the SEC has discretion to require that the offering document contain audited financials, and that the issuer subsequently make periodic disclosures.  Will new 3(b)(2) be appealing?  What are the trade-offs for an issuer?  If the issuer wants to avoid the costs associated with state blue sky review, then the issuer will either contemporaneously list its securities on a national exchange, or sell to “qualified purchasers.”  We don’t yet know who would be classified as a qualified purchaser.  The issuer could generally solicit.  The issuer will have to comply with specific disclosure requirements in connection with the offering, and, in addition, it will have ongoing disclosure requirements.  Of course, the securities sold will not be restricted securities.  Is it worth it?  Well, the answer to this question will depend largely on the approach taken by the SEC in its rulemaking on 3(b)(2).  Will some consideration being given to the fact that there was widespread support for amending Regulation A, even before the JOBS Act had materialized?  Will the SEC conduct some cost/benefit analysis and appreciate that if new 3(b)(2) is made sufficiently burdensome it will not provide the useful capital raising alternative that Congress and others had envisioned for emerging companies.  Let’s assume the SEC will exercise its discretion to require some additional disclosures.  At least, it would make sense to put a premium on clear, concise disclosure, which would be meaningful to investors.

As the SEC turns to rulemaking related to the JOBS Act, it would be well advised to cast a skeptical eye on the quiet period that follows the pricing of an IPO.  The JOBS Act permits analysts to provide coverage on emerging growth companies prior to pricing.  It is reasonably logical to anticipate that, in due course, this approach may be extended to IPOs of all companies, not just emerging growth companies.  Whether or not this turns out to be the case, what’s the logic that supports the practice of permitting analysts to share research views with select audiences, or to share research views for EGCs, but prohibiting the sharing of this information for other companies, and permitting companies to comment on the very developments that analysts will be discussing with institutional investors?  Whatever it is, it is far from compelling.  The efficacy of the JOBS Act will be influenced by how well the SEC does in creating rules that promote a level playing field for institutional and retail investors.  Permitting analysts to communicate freely before and after IPOs (for all companies) and providing companies with the ability to communicate free of quiet period restrictions, will be important steps in improving the somewhat dented IPO process.

Today, FINRA published Notice 12-34 requesting public comment on the scope of FINRA regulation that would be appropriate for member firms active in crowdfunding offerings. This is a welcome request, as it confirms FINRA’s role as the SRO with oversight over funding portals (which are not broker-dealers), and also seems to recognize that regulation of funding portals should be “right-sized” and that the entire regulatory framework applicable to broker-dealers needn’t be applied to funding portals. Comments requested by August 31, 2012.