ABA Section of Business Law

ABA Section of Business Law
Business Law Today
July/August 1999

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Clear the decks

The SEC’s ‘aircraft carrier’ proposes sweeping reforms

• Highlights of the aircraft carrier

By KEITH M. MOSKOWITZ

Moskowitz is a senior associate in the New York City office of Graham & James LLP. Special thanks to Eric Ruder, at the same firm, for his assistance and dedication in the preparation of this article

It was a bold move by the SEC. In November 1998, it launched the "aircraft carrier" — a series of proposals aimed at streamlining the regulation of securities offerings.

The release follows an in-depth evaluation over the last several years of the federal securities laws and their impact on capital raising. If adopted, the proposals would effectively repeal a number of bedrock practices and principles that have become part of the fabric of the existing regulatory scheme.

The existing scheme reflects certain basic decisions made by Congress when it enacted the Securities Act in 1933. First, it chose a system that is based on full and fair disclosure as opposed to merit review. Second, Congress chose to regulate the offer as well as the sale of securities. Third, the statutory prospectus was chosen as the exclusive means of communicating written information during an offering. Fourth, Congress chose to require SEC review, or at least the potential for SEC review, of all public offerings. Fifth, the legislators chose to require delivery of a final prospectus in connection with all registered offerings.

These decisions have remained largely unaffected and intact for the past 60 plus years. Relying on its general exemptive authority — which Congress recently granted to the SEC as part of the National Securities Markets Improvement Act of 1996 — the aircraft carrier would modify all but the first of these longstanding congressional decisions.

Comments to the release were due June 30, 1999. As might have been expected, it has spawned much debate. Comments have ranged from suggesting minor revisions to advocating major overhaul. This article summarizes key aspects of the release and highlights some of the concerns raised by the securities bar and investment community. Important aspects of the release not covered in this article are its impact on foreign issuers (including Canadian issuers under the multijurisdictional disclosure system) and the use of Form C, which is proposed to replace existing Form S-4 for business combinations.

Under the proposed system, most of the existing Securities Act registration statement forms would be eliminated. New Forms A, B and C would be added in their place. Both domestic and foreign issuers would use these forms, which would retain existing accommodations afforded foreign issuers. Small-business issuers could continue to use the SB forms.

Form A would be available for smaller or unseasoned issuers, as well as for initial public offerings. Whether an issuer is "seasoned" depends primarily on the length of its reporting history. Form B would be available for offerings by larger, seasoned issuers and offerings by smaller seasoned issuers to certain sophisticated or well-informed investors. Form C would be used for business combinations.

In contrast to existing practice, under the proposed system, the type of form used by an issuer would not only dictate the level of required disclosure, but also the speed with which the offering can be accomplished. Form B issuers, which are generally the largest issuers, would have the greatest flexibility.

Form A would replace Form S-1 as the standard registration form. Like Form S-1, it would be used when no other form is available. Form A would require disclosure comparable to that required by Form S-1. Unlike S-1, Form A would allow seasoned issuers to incorporate their Exchange Act reports by reference.

"Seasoned" issuers, for purposes of Form A, would be companies that have at least a 24-month Exchange Act reporting history and have a public float of at least $75 million, or companies that have been reporting for at least 24 months and have filed at lease two annual reports. A seasoned issuer with public float of at least $75 million or whose annual report incorporated by reference in the Form A has been recently reviewed by the SEC, may designate the effective date of its Form A registration statement, which would not be subject to prior SEC review. To accelerate the review process for issuers with less than $75 million in public float, these issuers could request SEC review of their Exchange Act reports even before filing Form A.

Form B would be available to large seasoned issuers for offerings to any investor. Unlike Form A, which determines whether an issuer is "seasoned" by reference to a two-year period, "seasoned" for Form B purposes requires reporting for at least one year and the filing of at least one annual report. To be considered large, an issuer must have either a public float of at least $250 million, or a public float of at least $75 million and an average daily trading volume of at least $1 million.

Seasoned issuers that are not considered "large" could still use Form B for specific types of offerings. For example, Form B would be available for offerings made solely to Rule 144A qualified institutional buyers and certain offerings to existing security holders (whom the SEC would presume to be informed about the issuer as a result of their existing investment). Form B would also be available for offerings of nonconvertible investment grade securities and offerings involving market-making transactions by brokers and dealers who are affiliates of the issuer.

Like Form S-3, Form B would include "bad boy" provisions that would disqualify its use by certain issuers. The disqualifications are broader in scope than current Form S-3 disqualifications and include issuers that have significant liquidity concerns, issuers that have abused the registration system or federal securities laws (or whose management or underwriters have done the same) and issuers who have not complied with outstanding SEC comments to their Exchange Act reports. Some commentators have suggested that the latter disqualification would give the SEC too much leverage where an issuer legitimately objects to certain Exchange Act disclosure.

Form B would not be subject to SEC staff review and could, if requested by the issuer, become effective immediately on filing. As such, unlike today where a registration statement must be filed prior to making offers, under the proposed scheme, Form B wouldn’t have to be filed until immediately prior to the first sale. By removing the potential for a lengthy SEC review, Form B issuers would have significantly greater control over the timing of their offerings.

In a related proposal, the SEC would repeal a line of no-action letters covering transactions known as Exxon Capital exchanges. These transactions involve the sale of debt securities in a private offering (such as to institutional investors) quickly followed by an exchange of those securities for substantially identical newly registered securities. The SEC estimated that Exxon Capital transactions accounted for more than one-third of all IPOs conducted between July and November 1998.

As the SEC noted, issuers use this procedure, in part, because it allows them access to capital without delays associated with registration. Since delays currently associated with registration would no longer exist for Form B issuers (and for medium size Form A issuers), the SEC has proposed repealing this line of no-action letters. The commission has also questioned the underlying justification for Exxon Capital transactions and seeks comment as to whether these letters should be repealed regardless of whether any reform to the registration system is adopted. Needless to say, this proposal has been the subject of intense criticism, especially from investment bankers and the securities bar involved in these transactions.

Recognizing that acceleration of the registration process for many offerings could push underwriters to abbreviate their due-diligence investigations, the SEC has proposed specific due-diligence practices that it believes would enhance an underwriter’s due-diligence investigation in connection with expedited offerings. The proposed practices relate only to Form B offerings, and only to those offerings that are marketed and sold in less than five days. The underwriter’s due-diligence investigation is important because, if properly conducted, it can serve as a defense to Securities Act liability.

Similar to Form S-3, the Form B prospectus would include the issuer’s Exchange Act reports through an incorporation by reference. The prospectus would also include offering or transactional information. The SEC seeks comment on two alternative levels of disclosure for such information. One would require all itemized transactional information currently required by Form S-3. The other, which should give issuers greater flexibility in crafting appropriate disclosure, would limit the itemized disclosure while requiring all material transactional information. Form B issuers would also be permitted to use and distribute a securities term sheet, which would also be part of the prospectus.

Small-business issuers would continue to use the SB forms — which require somewhat less burdensome disclosure. In a change from current practice, seasoned small-business issuers would be permitted to incorporate by reference, similar to Form A issuers. The proposals would also redefine small-business issuers to increase the revenue test from $25 million to $50 million and eliminate the public-float test.

The Securities Act restricts communications that an issuer may make during a registered public offering. In the pre-filing period, no offers may be made. During the waiting period, oral offers are permitted and written offers may only be made by a preliminary prospectus. The proposed rules would lift these restrictions for many offerings.

For Form B offerings, there would be no restrictions on communications. Issuers would be permitted to make offers, orally or in writing, at any time. Any communications during the offering period would have to be filed with the SEC and would be subject to differing liability standards, depending on whether the communication is considered offering information or merely "free writing" material.

For Form A issuers, the proposals would continue the prohibition on offers during the pre-filing period, but would permit free writing during the waiting period. Like Form B issuers, Form A issuers would need to file copies of the free writing material with the SEC. The commission would also clarify that the pre-filing period during which communications are restricted is limited to the 30-day period prior to filing the registration statement. During that period, disclosure of business information and, for reporting companies, regularly released forward-looking information, would be permitted.

The proposals would also expand existing safe harbors for research reports issued by certain brokers and dealers. For Form B offerings, the proposals would allow analysts to publish research reports without any interruption due to the public offering.

Today, all issuers must deliver a final prospectus to purchasers. There is no requirement to deliver a preliminary prospectus except in connection with IPOs. The proposals de-emphasize final prospectus delivery in favor of preliminary prospectus delivery.

For Form B offerings, the proposed rules would not require delivery of a typical prospectus. Rather, key transaction information, such as would be included in a securities term sheet, would need to be delivered. For other offerings, a preliminary prospectus would be required to be delivered either seven days or three days before pricing, depending on whether the issuer is seasoned. Some commentators have suggested that this may cause practical difficulties and could prevent some investors who first arrive on the scene during that period from participating in the offering.

Under the proposals, there would be no final prospectus delivery requirements for most offerings (assuming preliminary prospectus information has previously been delivered). But a final prospectus would still need to be filed with the SEC. The proposed rules would also expand the after-market prospectus delivery obligations imposed on dealers. The obligation would apply to all offerings, not just IPOs as is currently the case, and would continue for a 25-day period. Rather than requiring physical delivery, the obligation would be deemed satisfied if a final prospectus is on file with the SEC and investors are notified, on or before confirmation of sale, where they can obtain the final prospectus.

The proposals would also eliminate uncertainties that deter issuers from switching between public and private offerings. Companies that have begun an offering either as a private placement or as a registered public offering are limited by current rules in their ability to quickly convert the offering to the other type. Since filing a registration statement is deemed to be a general solicitation, issuers may face difficulties in quickly switching from a public offering to a private placement. Likewise, since the Securities Act prohibits offers during the pre-filing period, issuers could face difficulty converting a private offering to a public offering. By allowing greater flexibility in switching between registered and nonregistered offerings, the proposals would permit issuers to test market demand for a particular type of offering, while eliminating uncertainties that could result in securities-laws violations.

Switching from a private offering to public offering would not be a problem for Form B issuers since these issuers are not prohibited from making pre-filing offers. For other issuers, the proposed rules would permit filing a registration statement immediately following abandonment of a private placement, unless the issuer offered securities to persons who would not have been eligible to purchase under the §4(2) private-placement exemption. In that case, the issuer would have to wait a 30-day cooling-off period before filing the registration statement.

For offerings initially begun as public, the SEC noted that these issuers are currently subject to a six-month cooling-off period to be certain that they can then begin a private placement. Under the proposed safe harbor, the issuer could withdraw the public offering registration statement and either wait 30 days to sell privately or sell privately sooner and accept a higher standard of liability (under §11 of the Securities Act) for written disclosure provided to purchasers.

The proposed rules place increased emphasis on Exchange Act reporting. The changes reflect a desire for more prompt and expanded disclosure. A number of the changes are designed to increase management participation in, and accountability for, the reporting process. These changes, a number of which have begun to meet opposition, include expansion of the required signatures on quarterly reports to include principal executive officers and a majority of the board of directors; a requirement that all persons signing Exchange Act reports (as well as Securities Act registration statements) certify that, to their knowledge, the filing contains no material misstatements or omissions; and a requirement that all current reports (Form 8-K) certify that a copy has been delivered to the registrant’s board of directors. Comment is solicited as to whether 10-Ks should include as an exhibit a management report identifying the procedures established to ensure the integrity of the registrant’s Exchange Act reports.

The proposals would also require more prompt disclosure of annual and quarterly financial results as well as accelerated due dates for 8-K filings and annual reports for foreign issuers. Triggering events for 8-Ks would be expanded to include items such as modifications to rights of security holders, departures of executives and material defaults on senior securities.

Though many companies typically include risk factors in their quarterly and annual reports, the proposals would require disclosure of certain risk factors in plain English — a recent hot topic at the SEC. In that regard, the SEC also seeks comment as to what extent Exchange Act reports should be in plain English.

While it is still far too early to predict with any degree of accuracy the timing, extent and nature of the changes that will ultimately be adopted, one thing seems certain — change is on the horizon. For the initiated reader, the full text of the aircraft carrier release, as well as comments received electronically, are available at the SEC’s Web site at http://www.sec.gov.