ABA Section of Business Law
ABA Section of Business Law
Business Law Today
November/December 1999
Beyond the millennium I
A savvy group talks about how securities laws should evolve
By JAMES D. COX and EDWARD F. GREENE
Cox is a professor of law at Duke University in Durham, N.C., and Greene is a partner in the London office of Cleary, Gottlieb, Steen & Hamilton
A year ago this November, the Securities and Exchange Commission proposed the most extensive changes to its regulation of public offerings of securities in more than 20 years. The sweeping proposals are set forth in a document commonly referred to as the "Aircraft Carrier Release," an expression that captures the breadth of the proposed reforms. They have become highly controversial and have evoked heated debate among those interested in the market. Among the changes proposed are the following:
• Allows sales materials that are not part of the filed registration statement to be used in the promotion of the security prior to the registration statement becoming effective; currently such "free writing" can occur only after the registration statement has become effective.
• Introduces a bright-line safe harbor for communications that can have the effect of piquing investors’ interest in the security being registered; for seasoned issuers, the SEC proposes a safe harbor for any communication more than 15 days prior to its first offer and for unseasoned issuers, it proposes a safe harbor for communications that are more than 30 days prior to filing the registration statement.
• Liberalizes the restrictions on publication of research reports by broker-dealers.
• Requires that a preliminary prospectus be delivered to the purchaser of a security of an unseasoned issuer seven days (three days for seasoned issuers) prior to its price being set.
• Shortens the time periods in which issuers will be required to file their annual and quarterly reports.
• Withdraws a long-held position that allowed nonequity securities to be privately placed with institutional purchasers without registration after an undertaking by the issuer that it would soon register a class of security into which the unregistered security could be exchanged.
The comment period on the Aircraft Carrier Release has closed and the SEC is presently assessing its proposals in light of the reactions it has received.
On April 8-9, 1999, more than 60 prominent securities lawyers, regulators and academics took part in a roundtable discussion in Washington on what the future content of the U.S. securities laws should be. As the conference’s co-conveners, our purpose was to see if a consensus could be forged regarding the direction the reform of the U.S. securities laws might take. Coincidentally, the SEC had extended the original comment period for its Aircraft Carrier Release to June 30, 1999. With the extended comment period, we were able to discuss many aspects of the reform proposals embodied in the release.
We offer here a summary of what we believe to be the central beliefs, conclusions and approaches expressed at the meeting. What follows is our synthesis of a highly stimulating and thoughtful day-and-a-half debate on the future content of U.S. securities laws.
A threshold issue we considered is the scope of the SEC’s power to implement reform according to its exemptive authority under Section 28 of the Securities Act of 1933. On the one hand, there was a consensus that the SEC could not use this authority to swallow up the act, such as by exempting all offerings of an issuer if the effect were to eliminate the responsibilities of the issuer or its directors under Section 11. On the other hand, the group recognized that the SEC now enjoys broad authority to reduce the regulatory reach of Section 5, such as by narrowing the current definition of an offer to sell, by modifying the content requirements of the registration statement, by delineating what constitutes delivery of a prospectus, and by expanding the contours of the private-placement exemption to deregulate the offering process and to permit more liquidity with respect to restricted securities.
There was no sentiment for scrapping the current statutory framework of U.S. securities laws. There was also a consensus that legislative action is both unnecessary and undesirable; any necessary reform can and should occur within the present statutory framework using the broad rule making and exemptive authority the commission currently possesses. The analogy invoked in our discussion was a need to locate and repair "potholes" in the road, rather than constructing a new freeway that will pass through unfamiliar terrain. The strongest sentiment for maintaining the status quo was expressed for initial public offerings for which registration and review by the SEC’s staff was not questioned. However, for all types of registrants, the conference participants believed that there is a need to rethink the current prospectus delivery requirements.
A registration statement should continue to be the regulatory cornerstone for public offerings by any issuer. However, the disclosure requirements for any statement should not be thought of as containing all the information an investor should have to reach an informed decision to purchase the security; mandatory disclosure should focus on those items of information uniquely known to the issuer. The view was expressed that information in the registration statement should be available during the investors’ decision-making period. Nevertheless, questions abounded as to whether availability from issuers and distribution participants should be the same for all registrants and more particularly whether any prospectus-delivery requirements were needed for seasoned companies.
Because seasoned issuers are followed closely by analysts and their size and effect on their industry or the national economy generally assures that they are truly in the public eye, investment decisions respecting their securities occur within an extremely rich information environment. For such companies, to require that any information regarding the issuer be further distributed to possible investors or purchasers, or to require that restrictions be imposed during the offering process on the types of information registrants or distribution participants may release or the timing of delivery, are each ill-advised. Such restrictions reflect only an historical reference to a more primitive investment environment.
For seasoned issuers, the policy should be one that seeks to encourage, not discourage, the dissemination of analysts’ reports and other information about the issuer from a variety of sources. Any linkage between such reports and the issuer or its underwriter should be handled through appropriate disclosures and not through the traditional "gun-jumping" framework or a requirement that these reports be filed as part of the registration statement.
Even more important in considering the regulation of public offers by seasoned issuers is the dominant role of financial institutions that traditionally enjoy access to a richer information base than that provided by the registration statement. Indeed, some expressed the view that, in a world composed only of reporting companies and in which Exchange Act reports were subject to a due-diligence standard, there would be no need for a Securities Act.
A strong consensus was expressed that seasoned issuers should enjoy quick, even instant, access to capital markets. Many proposals in the Aircraft Carrier Release were seen as imposing on seasoned issuers and their investors needless uncertainty as to timing and therefore additional costs. The sentiment was repeatedly expressed that the Aircraft Carrier proposals fail to differentiate between the capital-raising process for seasoned issuers and initial public offerings so that the proposals, if adopted, would introduce significant market risks on seasoned issuers and their investors with no countervailing benefits.
These harmful effects would especially occur under the Aircraft Carrier Release’s proposal that investors purchasing from seasoned issuers receive at least a written term sheet before pricing, in other words before their investment decision is made. Today, under "shelf registration," terms are communicated orally and the prospectus or supplement is delivered after setting the price and with the confirmation. The sentiment of the group was that this system was functioning well, was responsive to the needs for rapid access to the U.S. capital markets and was being emulated in other markets.
Many felt that the Aircraft Carrier proposals for seasoned issuers were a step backward from the current shelf-registration practice, which relies heavily on advance preparation of documentation and oral communication. There was general support for advance delivery for IPOs, but an absolute seven-day rule was believed to be too rigid, especially if a transaction were increased in size — one would have to wait seven days from the date the last investor was contacted.
Needless market risks will also be introduced by the Aircraft Carrier’s proposal to rescind the Exxon Capital no-action letter in connection with offerings of certain senior securities. That letter permits investment-grade preferred stock and debt securities to be sold privately, under Rule 144A or Regulation D, followed by a registered exchange offer of identical securities. The consequence is that the holders have unrestricted securities. In its place, the release proposes that all SEC-reporting issuers may conduct equity and debt offerings on Form B provided that the offering is only to qualified institutional buyers (QIBs). Form B would not be reviewed by the staff and would be effective at a date specified by the issuer.
This proposal was seen as terminating a near instant capital-raising procedure that now occurs routinely with no demonstrated harm to investors. In its place, the release would substitute a new system in which issuers and their underwriters will face delay as they await the effectiveness of the registration statement (if Form B is not available), heightened liability because of the application of Section 11 and uncertainty regarding the status of QIBs that resell the securities acquired in the offering. The overall sentiment was that the SEC would be well advised to preserve Exxon Capital.
If Exxon Capital were to be repealed, then all issuers — whether or not SEC-reporting companies — would be permitted to offer their debt securities on Form B. This proposal prompted some to urge that all offerings to a specified percentage of QIBs be allowed on Form B, whether or not an IPO, the result of which is the instant access currently supplied by the Exxon Capital letter. This suggestion raised among the participants two important regulatory issues.
First, if Form B is available to all issuers so long as a specified percentage of sales are only to QIBs, the concern was expressed that without significant resale restrictions, offerings on Form A would rarely occur since most issuers would be guided to the more user-friendly Form B. Second, the proposal could lead to offerings in which QIBs purchase directly from the issuers and quickly resell into the market a major portion of the securities purchased. Even though the presumptive underwriter doctrine has long been rejected by the SEC, doubts arose among the participants whether such reselling QIBs would be deemed effective underwriters, particularly if they enjoyed gains because of the resales.
The Aircraft Carrier Release extends instant access only to reporting companies selling to QIBs. It does not help private companies that seek to issue debt followed by a registered exchange offer. Such private companies would have to register their debt securities on Form A and incur the attendant uncertainty and expense of doing so. Many participants accepted the illogic of Exxon Capital on the pragmatic basis that the offerings serve the interests of both investors and issuers. There was some support for repealing the letter, provided debt offerings would be permitted to be made on Form B — whether the issuers were private or seasoned — when purchased only by QIBs or if a high percentage of the offering were purchased by QIBs.
In the area of private placements, a consensus was expressed that the SEC adopt a position similar to that taken in Rule 1001 where issuers may engage in advertisements and solicitations of any kind, in any medium, provided sales occur only to those who satisfy the criteria of a specific exemption. The authorization for communications in connection with exempt offerings that are permitted today would, of course, coexist with resale restrictions on the securities purchasers so as to assure that the offering comes to rest only in the hands of those who meet the exemption’s criteria.
Some urged the SEC to permit more active trading of the securities among eligible investors during the restricted period. Others noted that in some countries, sales are permitted to professional investors, distinguished from intermediaries, with very limited restrictions on resales.
The roundtable participants supported the proposed 30-day cooling off period for unseasoned issuers (the "gun-jumping" reforms) during which traditional restrictions would apply to communications that had the effect of conditioning the market. The participants believed that no cooling-off period is necessary for seasoned issuers. To impose restrictions on information flows of companies that are already in the public eye was seen as counterproductive to the protection of investors, and unrealistic since a decision to do an offering by shelf-issuers could be taken well within the cooling-off period.
A separate program session was devoted to the viability of the SEC continuing to require foreign issuers to reconcile their financial statements to U.S. Generally Accepted Accounting Principles (GAAP) as a condition to registering or listing their securities in the United States. There was consensus that it was not likely that harmonization of reporting standards or accounting principles would occur or that reciprocity among jurisdictions would expand beyond the Multi-Jurisdictional Disclosure System (MJDS) that currently exists only with Canada.
Conference participants were optimistic that over time there would continue to be convergence of financial and general disclosure standards, and supported the idea that the goal is not rigid comparability but sufficient transparency among alternative reporting systems so that issuers may be fairly assessed.
However, strong sentiment was expressed that as foreign capital markets continue to gain liquidity (in part because of increasing trading volume from U.S.-based investors) foreign markets will very soon challenge the preeminence of U.S. capital markets.
To date, the U.S. market for primary distributions has not felt the full challenge posed by the SEC’s requirement that foreign issuers must reconcile their financial statements to the U.S. GAAP. Conference participants believed that this challenge is coming and is coming very soon. The consensus was that the forthcoming International Accounting Standards Committee (IASC) proposed core-principles project represents an unparalleled opportunity for the SEC to embrace International Accounting Standards (IAS) without fear of undercutting its continuing support for the Financial Accounting Standards Board (FASB) at least with respect to the European Union.
Whatever the outcome, it was also agreed that unlike the MJDS, the SEC must stay engaged in reviewing applications of existing standards and developing new standards under both U.S. GAAP and IAS, since international standard setting and enforcement might not be sufficiently rigorous.
The final area of this report’s focus on the public offering of securities concerns the appropriate liability standards that should apply to the public offering of securities. Among the concerns here was how to improve the overall quality of the information in the registration statement. This concern was voiced both for registrants engaged in an initial public offering as well as seasoned issuers involved in a shelf registration.
The issue we addressed simply was what liability mechanism — and more important, the duty that would be enforced through that liability standard — is likely to improve the quality of reported information. A consensus was reached that issuers should continue to have absolute liability to their purchasers should the registration statement contain an omission or misstatement of a material fact if capital were being raised from the public.
There was consensus as well that underwriters should continue to have legal responsibilities in connection with the contents of the registration statement. However, these responsibilities should be assessed in the context of a truly meaningful safe harbor, especially for distributions by seasoned issuers. Such a safe harbor would best be developed by an appropriate self-regulatory organization and would set forth best-practice criteria for underwriters.
There was a consensus that the best practices that would reflect, among other factors, the type of security being underwritten and that best practices for investment-grade debt securities would be quite different from those set forth for high-yield debt or equity securities.
Moreover, we envisioned that because best practices evolve over time, the safe harbor would itself be evolutionary in nature. The constantly evolving nature of such best practices and their incorporation into a safe harbor especially commend the safe harbor’s contents to the continuing efforts of a self-regulatory organization rather than the SEC, where the efforts might be more episodic.
Though the sentiment was expressed that outside directors who are not on the audit committee are not in a position to engage in serious monitoring responsibilities, the consensus was that outside directors should have well-defined duties with respect to steps they should take to assure themselves that the registration statement is not misleading.
The strong preference of the group was that there be a system whereby the obligations of directors, as well as underwriters, not be set on an ad hoc basis and after the fact, as occurs under the current liability-based regime. The consensus was that liability should arise as a means to enforce standards that the directors are able to fulfill.
The participants were skeptical of the present requirement that directors sign the registration statement and Form 10-K, and of the proposed requirement in the Aircraft Carrier Release that management make statements about the accuracy of ’34 Act filings. Their skepticism was based on there being no definitive guidance of what directors and other signatories are attesting to when they sign the registration statement. There was a clear consensus that the SEC should provide definitive standards of what directors realistically are expected to do. Such an articulation by the SEC would then be the basis for directors, and perhaps others, to then attest that they have taken the steps called for by the SEC to satisfy the due-diligence requirements of Section 11.
The final session of the conference was devoted to regulatory issues pertaining to exchanges and alternative trading systems (ATSs). The conference participants believed the foremost distinguishing feature of the New York Stock Exchange is the liquidity it provides investors. Our discussions focused heavily on whether the emergence of ATSs and electronic communications networks (ECNs) — Instinent, Island, Bloomberg L.P. and Optimark — will produce harmful effects by fragmenting the market for securities that otherwise would be traded in a single market, such as the NYSE. One obvious concern with fragmentation is that it may lead to wider trading spreads for trades executed on behalf of retail investors. Institutional investors could experience a loss of liquidity.
One group of commentators strongly believed that a single market will always provide greater liquidity in terms of depth and continuity than if there were several simultaneously available trading venues for a security. If there are to be multiple markets for a single security, some believed the regulatory focus should be on the interconnectedness of those markets in which protocols would provide for time-priced priority among orders that would be exposed through a single electronic switch to all markets.
The opposing view took the position that regulation designed to connect markets may impose serious obstacles to innovation; the operators of ATSs or ECNs, instead of complying with what they perceive as burdensome regulatory demands, may locate their activities outside the United States with the concomitant effect that the SEC or U.S.-based SROs will have no regulatory powers over their internal affairs. A further fear of restricting the development of ATSs or ECNs is that each regulatory curtailment increases the monopoly-like position of the primary exchange for the traded security.
The final issue addressed at the conference was whether the regula-tory functions presently carried out by the NYSE and the NASD should be combined into a new, super self-regulatory organization. Among the perceived benefits of such a combination would be reduced compliance costs since a single, rather than duplicate, regulation would then exist. Though this development may have some cost savings, several concerns must first be addressed.
First, there is a wide range of regulatory issues that are best addressed by a body with first-hand experience operating a market. The current regulatory structure in which the SROs are both regulators and operate markets assures that the regulatory function is informed by the vast reservoir of experience the SRO derives from the markets it operates.
Second, the cost savings by combining the organizations may not be great. The new regulatory body would require an administrative structure and support staff that currently is shared with their host SRO. Funding for the operations of a single regulatory body would continue to be provided by the NYSE and NASD, so that there may well not be a significant decline in their overall operating costs.
Third, over time, a single private-sector regulator, because it lacks an operating connection with the market whose participants it is charged with regulating, may be seen as superfluous to the SEC.
The overall sentiment of the conference participants is that the present regulatory framework of the U.S. securities laws works reasonably well. There is no need for Congress to supplant the present laws with a new and untried framework.
Change in the areas described above is desirable; the changes called for here can occur under rule-making and exemptive powers that the SEC already possesses.
