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The SEC recently released Frequently Asked Questions relating to provisions of the JOBS Act concerning coverage by research analysts of equity offerings by Emerging Growth Companies, or EGCs. An EGC is a company that was not a public company on December 8, 2011, and that had less than $1 billion (adjusted for inflation) in gross revenues in its most recently completed fiscal year.  A company ceases to be an EGC upon the earliest to occur of the following milestones: (1) it reaches $1 billion in gross annual revenue; (2) it has been a public company for 5 years; (3) it issues, or has issued in the prior 3 years, at least $1 billion in non-convertible debt; or (4) it becomes a “large accelerated filer” pursuant to SEC Rules.

This post provides some highlights from the FAQs and some further explanation.  For additional context on the complicated regulatory regime that is the backdrop for the JOBS Act, scroll to the bottom first.  One of the take-aways from the FAQs is that the SEC is interpreting the JOBS Act in the way that disrupts the fewest existing regulations.  Sometimes that means taking a narrow view of the JOBS Act (as with respect to Section 105(b)), and sometimes that means filling in the blanks inadvertently left by Congress (as with respect to Section 105(d)).

For further background on the JOBS Act, you can find a good summary and power point presentation here.

Testing the Waters and Rule 15c2-8(e)

Rule 15c2-8(e) under the Exchange Act relates to the solicitation of customer orders for the purchase of securities prior to the effective date of their registration.  Rule 15c2-8(e) requires a broker-dealer to take reasonable steps to ensure that, prior to the time an associated person solicits customer orders for securities that are not yet registered, a preliminary prospectus is delivered to the associated person.

Section 105(c) of the JOBS Act permits EGCs and their authorized representatives to engage in oral or written communications with certain classes of qualified potential investors prior to the filing of a registration statement – known as “testing the waters.”  The question is whether testing the waters by contacting potential investors prior to the filing of a registration statement conflicts with Rule 15c2-8(e).  In other words, how does a broker-dealer ensure delivery of a preliminary prospectus prior to the solicitation customer orders by an associated person if the associated person is testing the waters before a preliminary prospectus exists?

The SEC believes that “testing the waters” does not always rise to the level of solicitation of customers for purposes of Rule 15c2-8(e), and therefore the JOBS Act is compatible with the rule.  The SEC notes that testing the waters by informally asking potential investors whether they would invest in an offering, how much they would invest, at what prices, etc., is not a solicitation under Rule 15c2-8 if the potential customer is not asked to make a commitment to purchase the securities.

The SEC also notes that submitting a confidential draft registration statement for confidential review by the SEC pursuant to Section 106(a) of the JOBS Act does not constitute a “filing” of a registration statement for purposes of Rule 15c2-8, thus ensuring that issuers cannot pre-file draft registration statements early to allow associated persons of a broker-dealer to solicit customer orders outside the reach of Rule 15c2-8.

Communications Between Analysts and Investors

NASD Rule 2711(c)(6) prohibits investment bankers from directing research analysts to engage in sales, marketing efforts, or communications with a current or prospective customer regarding an investment banking transaction.

Section 105(b) of the JOBS Act, in turn, prohibits FINRA and the SEC from adopting or maintaining any rules that (1) restrict which associated persons of a broker, dealer, or FINRA member can arrange communications between a potential customer and an analyst, and (2) restrict an analyst from participating in communications with the management of an EGC if the communication is also attended by another associated person of the broker, dealer, or FINRA member who is not an analyst.

The SEC was posed with the question of whether the arranging activities that are prohibited-from-being-prohibited by the JOBS Act conflict with NASD Rule 2711(c)(6) by providing an indirect means for investment bankers to direct research analysts to engage in sales or marketing efforts.  The SEC does not believe there is a conflict because it characterizes the conduct described by the JOBS Act as consisting of little more than sharing client lists and scheduling phone calls.  The SEC also notes that other rules relating to customer communications, such as those that require such communications to be fair, balanced, and not misleading, would still apply to communications that fall within the scope of Section 105(b) of the JOBS Act.

Analyst Participation in Meetings with EGC Management

Prior to the enactment of the JOBS Act, analysts were prohibited from participating in meetings with a company’s management if investment bankers were also participating in the meetings.  The purpose of the rule was to create a firewall between the sales force behind an IPO and the analysts who would be writing about the IPO.  With respect to EGCs, section 105(b) of the JOBS Act now prohibits rules prohibiting meetings among the EGC management, investment bankers, and research analysts.

The goal of this provision of the JOBS Act was to avoid duplicative meetings (one with the investment bankers, a separate one with the research analysts) during a time when an EGC’s executives are already under significant time pressures.  Research analysts can now attend management meetings of an EGC along with investment bankers.

However, the SEC is interpreting Section 105(b) of the JOBS Act narrowly, such that it does not affect a variety of other rules relating to the conduct of research analysts.  As a result, research analysts are still prohibited by NASD Rule 2711 from participating in road shows or engaging in communications with customers about an investment banking transaction in the presence of investment bankers.  Research analysts are also unable to participate in “test the waters” communications.

Publication of Analyst Reports During Quiet Periods

NASD Rule 2711 contains prohibitions on the publication of research reports and public appearances (“quiet periods”) during certain specified time periods (1) after an IPO, (2) after the expiration of a lock-up agreement, (3) before the termination or waiver of a lock-up agreement, and (4) after a secondary offering.

With respect to EGCs, Section 105(d) of the JOBS Act prohibits rules that impose quiet periods following the IPO of an EGC or prior to the expiration of any lock-up agreement.  Technically, Section 105(d) of the JOBS Act only addressed quiet periods in the first of the four categories listed above.  However, the SEC believes that Congress intended to fully address all quiet periods, and so it interprets Section 105(d) as prohibiting each of the four types of quiet periods listed above with respect to EGCs.  The SEC also notes that FINRA is considering changes to NASD Rule 2711(f) to specifically eliminate these quiet periods for EGCs.

Regulation AC is Unaffected by the JOBS Act

Regulation AC requires research analysts to include with their reports certifications that the report accurately reflects the analyst’s personal views and a statement as to whether any of the analyst’s compensation is directly related to the views or recommendations contained in the report.  If any of the analyst’s compensation is related to the report, then additional disclosure is required.  Regulation AC also requires investment banking firms to keep certain records relating to the public appearances of research analysts.

Section 105(a) of the JOBS Act broadens the definition of “research reports” in Section 2(a)(3) of the Securities Act with respect to EGCs.  As a result, there was some concern that this broader definition would also require the Regulation AC certifications on a wider range of documents.  However, the SEC has clarified that the JOBS Act does not affect Regulation AC.  Whether a report qualifies as a “research report” for purposes of Regulation AC is an independent consideration of whether a document is a “research report” for purposes of the amended Section 2(a)(3) of the Securities Act.

A Note About the Regulatory Regime

The regulatory framework that forms the backdrop for this post can be confusing  and may be worth some additional explanation.  The first layer of regulation consists of the governing statutes themselves, the Securities Act of 1933 and the Securities Exchange Act of 1934. The second layer consists of the Securities Act Rules and the Exchange Act Rules, each promulgated by the SEC to implement the respective statutes.

The third layer consists of a host of secondary rules, such as the rules adopted by the New York Stock Exchange, which apply to all issuers listed on the NYSE, the rules adopted by the National Association of Securities Dealers, or NASD, and the rules adopted by the Financial Industry Regulatory Authority, or FINRA.  Before FINRA existed, NASD adopted a host of rules that apply to broker-dealers in the U.S.  In some cases, the NASD rules and the NYSE rules addressed substantially the same topics, but in slightly different ways. In 2007 the enforcement arm of the NYSE combined with NASD to form FINRA.  In an effort to resolve duplication of rules, new FINRA rules are being adopted over time to replace the dual NASD and NYSE rules.  As a result, there are currently effective FINRA rules side by side NASD and NYSE rules that are also still effective.

The fourth layer of regulation for our purposes consists of the JOBS Act, which is really just a set of amendments to our first layer of regulation.  For our purposes, though, it is conceptually useful to think of the JOBS Act as a separate layer.  The JOBS Act works not by affirmatively authorizing certain conduct, but by prohibiting the SEC and FINRA from adopting or maintaining rules that prohibit certain conduct.  The JOBS Act prohibits the SEC and FINRA from prohibiting certain conduct.

The conduct that is the subject of this post is governed in part by NASD Rule 2711 and NYSE Rule 472, which have not yet been consolidated into a new FINRA rule. In this post, I refer only to NASD Rule 2711 as a matter of convenience, but the two rules are conceptually indistinct for our purposes.

Check frequently for updated information on the JOBS Act, the Dodd-Frank Act and other important securities law matters.