Testing the Waters Communications and Anchor Investors in IPOs

Practical Law Article 0-572-8590 (Approx. 7 pages)

Testing the Waters Communications and Anchor Investors in IPOs

by Richard D. Truesdell, Jr., , with Practical Law Corporate & Securities

Pre-JOBS Act Law and Practice

Before the JOBS Act was enacted, there were two main legal impediments to companies and their investment bankers communicating with prospective investors in the period before the company filed a registration statement for a proposed IPO:

Securities Act Section 5. Section 5 of the Securities Act of 1933 (Securities Act) prohibited any written or oral communications relating to a potential IPO until a registration statement had been filed with the Securities and Exchange Commission (SEC).
Exchange Act Rule 15c2-8. Rule 15c2-8 under the Securities Exchange Act of 1934 (Exchange Act) was generally understood to restrict the solicitation of offers or even indications of interest in an IPO (even after the registration statement had been filed) until a preliminary prospectus including a bona fide estimated offering price range had been filed with the SEC. The preliminary prospectus including a price range is typically not filed until shortly before the road show for the offering, well into the IPO process.

Because of Section 5, a company and its investment bankers could not test the waters before the company’s initial filing of its IPO registration statement. After the initial registration statement filing, but before the filing of a preliminary prospectus including a price range, the prevailing interpretation of Rule 15c2-8 placed continuing limits on investment bankers' ability to gauge interest in the offering. While investment bankers occasionally conducted "investor education" discussions with large institutional investors, these were limited to a general discussion about the company and its industry, with a strict prohibition on soliciting indications of interest or valuation feedback.

This inability to gauge investor interest was a significant issue for companies considering an IPO. Typically, most of the expenses associated with an IPO are front-end loaded. For example, to file a registration statement, a company must, among other things:

Hire auditors and complete an audit of its financial statements for the last three fiscal years.
Hire attorneys.
Conduct management, legal and accounting due diligence.
Draft a registration statement.

For more on factors that companies should consider when preparing for an IPO, see Practice Note, Preparing a Company for an Initial Public Offering.

A company cannot minimize the expense of these undertakings by filing a registration statement "shell" (a registration statement in outline form excluding most of the required substantive information). This is because the SEC does not accept partially completed registration statements that are missing the required financial statements or any other significant sections.

Understandably, many issuers were reluctant to incur the bulk of the expenses of an IPO before they could solicit any feedback from the market as to the attractiveness and viability of the proposed offering. As a consequence of this dynamic, many issuers that were uncertain about market receptivity were discouraged from pursuing an IPO.

JOBS Act Permits Testing the Waters

As a result of the JOBS Act, emerging growth companies (EGCs) and persons authorized to act on their behalf are now able to test the waters before filing a registration statement and incurring the related expenses (Section 5(d), Securities Act). Generally, a company with annual gross revenues of less than $1 billion during its most recently completed fiscal year that has not completed a US IPO before December 8, 2011 qualifies as an EGC (Section 2(a)(19), Securities Act; Section 101(d), JOBS Act). Over 80% of the companies that publicly filed for IPOs in 2013 qualified as EGCs.

From a legal perspective, the only requirements for testing the waters communications by EGCs are that they:

Are made by the issuer or a person authorized to act on its behalf.
Are limited to qualified institutional buyers (as defined in Rule 144A under the Securities Act) and institutional accredited investors (as defined in Rule 501(a) under the Securities Act).
Do not rise to soliciting a binding customer order (as opposed to an indication of interest).
Are free of material misstatements or omissions.

While it retains EGC status, a company may engage in testing the waters communications before and after it files a registration statement for its IPO or another public offering.

For more on accommodations available to EGCs under the JOBS Act, see Practice Note, JOBS Act: On-ramp to the Capital Markets for Emerging Growth Companies Summary.

SEC Guidance Clarifies Rule 15c2-8

As discussed above, before the JOBS Act, Rule 15c2-8 under the Exchange Act was generally understood to restrict the solicitation of offers or even indications of interest in an IPO until a preliminary prospectus that included a bona fide estimate of the offering price range had been filed with the SEC. The JOBS Act did not amend Rule 15c2-8. However, JOBS Act-related SEC staff guidance issued in August 2012 stated that:

Generally, if an underwriter is requesting from a customer a non-binding indication of interest that includes the amount of shares the customer might purchase in the potential offering at particular price levels – but does not ask the customer to commit to purchase the relevant securities – the underwriter, absent other factors, would likely not be soliciting a customer order for purposes of Rule 15c2-8(e).

(Question 1, Jumpstart Our Business Startups Act Frequently Asked Questions About Research Analysts and Underwriters (August 22, 2012).)

This guidance effectively clarifies that, in the SEC staff's view, pre-JOBS Act market practice was too conservative, and seeking indications of interest is not tantamount to soliciting customers' orders (which would require a preliminary prospectus including a price range to have previously been filed). Therefore, seeking indications of interest is not prohibited by Rule 15c2-8, even before the preliminary prospectus including the price range is on file. This guidance has opened the door to investment bankers building a soft book of anchor orders at an early stage of the IPO process.

Testing the Waters Practice Varies by Industry

The frequency of companies and their investment bankers taking advantage of their ability to test the waters varies significantly by industry.

In certain industries, such as biotech, testing the waters communications are used in practically every offering. In these industries, it is common for companies and their investment bankers to test the waters at multiple stages of the process. Testing the waters communications often occur:

Before the registration statement is filed to gauge investor interest in the concept.
Later in the offering process to test the investment banks' valuation of the company.
Shortly before the road show to solicit soft anchor orders.

In many other industries, testing the waters communications are rarely used. In these industries, a company's and its investment bankers' decision to test the waters might even be viewed as indicating a lack of confidence in the offering. However, the use of testing the waters communications has been increasing in all industries. While some have speculated that multiple meetings for a single offering would result in investor fatigue, the phenomenon continues to gain momentum. Increasingly, issuers are conducting testing the waters meetings by themselves before they even hire attorneys or investment bankers.

Investment Bank Guidelines for Testing the Waters Communications

Most investment banks have adopted internal guidelines for testing the waters communications in offerings that they are participating in. These guidelines, which go above and beyond the legal requirements discussed above, are driven predominately by liability concerns. While these guidelines vary from bank to bank, they often include:

Requiring the issuer to execute a "procedures" letter before testing the waters communications begin.
Requiring testing the waters communications to be limited to information that is included or will be included in the registration statement.
Limiting the use of any written materials.
Limiting the number of institutions met or spoken with as part of testing the waters communications.

Procedures Letter

To fall under the Securities Act Section 5(d) exemption, any testing the waters communications by a party other than the EGC must be authorized by the EGC. In addition, most investment banks have internal policies setting requirements for testing the waters communications taking place in offerings they participate in. Therefore, before testing the waters communications begin, many investment banks ask an issuer to execute a procedures letter which:

Authorizes the investment banks to engage in testing the waters activity on the issuer's behalf.
Includes the stipulation of the issuer to abide by certain limits on testing the waters activity set by the investment banks' internal policies, including limits on:
- the scope of information;
- the use of written materials; and
- the number of institutions that may be approached as part of testing the waters communications.

Limiting the Scope of Information

Many investment banks require that testing the waters discussions and presentations be limited to information that is included or will be included in the registration statement for the offering.

Under the JOBS Act, testing the waters communications meeting the requirements of Section 5(d) do not violate Section 5 of the Securities Act. However, these communications remain subject to potential liability for misleading statements and omissions under the anti-fraud provisions of the securities laws, including (arguably) Section 12 of the Securities Act and Rule 10b-5 under the Exchange Act.

Unlike the registration statement, testing the waters communications are not covered by documents designed to ensure accuracy and to establish a due diligence defense, such as counsel's disclosure (or 10b-5) letter and the auditor's comfort letter. Accordingly, investment banks are concerned about potential liability for testing the waters communications. To address this, most investment banks require that any testing the waters presentations be limited to information that is included or will be included in the registration statement.

This approach is generally workable for testing the waters meetings held after the first confidential submission of the registration statement to the SEC. It can be challenging, however, in meetings held earlier in the process. Before the first confidential submission, the issuer and investment banks have not completed their due diligence or determined exactly what information ultimately will be included in the registration statement. As a result, early stage testing the waters meetings tend to be higher level and focus on the company’s overall story as opposed to the details of the proposed IPO.

Limiting Written Materials

Before the JOBS Act, the only written materials that could be used to market a registered offering, subject to limited exceptions, were:

The prospectus.
Free writing prospectuses (FWPs). FWPs are written materials that generally may be used only after a preliminary prospectus including a bona fide estimated offering price range has been filed with the SEC. FWPs generally must be filed with the SEC.

Therefore, generally speaking, before the JOBS Act, SEC rules effectively banned the use of written materials to market a registered offering before a preliminary prospectus including a price range had been filed. Now, however, EGCs may use written testing the waters materials both before and after a registration statement for the offering is filed. Written testing the waters materials are not required to be:

Accompanied or preceded by a preliminary prospectus that includes a price range.
Filed with the SEC as FWPs.

However, investment banks' policies vary on whether, and what type of, written testing the waters materials may be used in offerings that they participate in.

Most investment banks start from a general presumption that no written materials may be used other than a slide presentation or "flip book" which is based on the draft road show presentation. Some banks do not allow even the confidentially submitted draft registration statement to be used as part of testing the waters meetings. These limitations are driven by:

Concerns about liability.
The SEC staff's policy, as a standard part of its review of EGC IPO registration statements, of requiring issuers to supplementally furnish all written testing the waters materials for SEC staff review.

SEC staff comment letters typically request that an EGC supplementally furnish all testing the waters materials that are "written" within the meaning of Rule 405 under the Securities Act. Under Rule 405, live presentation aids that investors are not allowed to retain are not considered written. Despite this, the typical SEC staff comment letter requests written testing the waters materials "whether or not investors are allowed to retain them."

Limiting Offerees

Some investment banks place numerical limits on the number of testing the waters meetings that can be held for any one issuer. This is driven by two concerns.

The JOBS Act allows EGCs to confidentially submit a registration statement to the SEC for confidential review, provided that the initial confidential submission and all related amendments are publicly filed at least 21 days before the beginning of the road show for the offering. If extensive testing the waters meetings occur during the 21-day period between the first public filing of the registration statement and the beginning of the road show, there is a concern that it may be difficult to distinguish between the road show and the testing the waters activity. Accordingly, there is a risk that the SEC could argue that the public filing was not made 21 days before the beginning of the road show as required.

SEC staff guidance has clarified that Rule 15c2-8 under the Exchange Act does not, as previously believed, prohibit soliciting non-binding orders before a preliminary prospectus including a bona fide estimated offering price range is on file (see SEC Guidance Clarifies Rule 15c2-8). Despite this, if the entire book is built before the price range is established, there is a concern that it could appear to the SEC that binding orders were solicited before the preliminary prospectus including the range was filed.

Role of Anchor Investors

Testing the waters meetings can, and do, occur at different and even multiple times during the IPO process. Companies and their investment bankers may solicit anchor indications of interest before the launch of the road show.

As a result, an increasing number of offerings have included disclosure at the commencement of the road show indicating that a number of investors have already expressed interest in purchasing a substantial portion of the offering. The ability to solicit and disclose these anchor indications of interest is considered beneficial from a marketing perspective. Disclosing anchor orders is thought to:

Create a scarcity of supply with a substantial portion of the deal already accounted for.
Provide a validation of the offering and valuation by these sophisticated investors.

Testing the Waters Communications by Non-EGCs

Most of the focus on testing the waters communications has been on EGCs. However, testing the waters activity has also increased among non-EGCs.

While the JOBS Act amendment of Securities Act Section 5 to allow testing the waters communications before a registration statement is filed is limited to EGCs, the SEC's interpretive guidance regarding Rule 15c2-8 under the Exchange Act is not. Accordingly, while non-EGCs (other than well known seasoned issuers, or WKSIs) still may not test the waters for an offering before publicly filing a registration statement, these companies may test the waters after filing the registration statement but before the filing of a preliminary prospectus containing a price range.

Looking Ahead

Unfortunately, most of the flexibility provided by the JOBS Act is limited to EGCs. Hopefully, the obvious benefits to capital formation and the absence of any examples of abuse will embolden Congress to extend these benefits to non-EGCs. While there are nine related bills that have passed the House and there is talk of combining some elements of them in a "JOBS Act 2.0," it looks increasingly unlikely that any legislation will be passed during this session.

Testing the Waters Communications and Anchor Investors in IPOs | Practical Law