presentation materials: calling an audible: financing ...apr 21, 2016 · consumer financial...

Calling an Audible:

Financing Alternatives in Rapidly Changing Markets

Thursday, April 21, 2016

9:00 AM – 10:00 AM EDT

Seminar

Presenters:

Geoffrey R. Peck, Partner, Morrison & Foerster LLP Anna T. Pinedo, Partner, Morrison & Foerster LLP James R. Tanenbaum, Partner, Morrison & Foerster LLP

1. Presentation

2. Morrison & Foerster Infographic

“PIPE Transactions 2015”

3. Morrison & Foerster Infographic “U.S. Late Stage Financings”

4. Morrison & Foerster Summary Chart:

“Investor Criteria for U.S. Private Placements and Other Offerings”

5. Morrison & Foerster Client Alert: “A Lofty Concept: Disclosure Effectiveness”

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April 2016

Calling an Audible

2

Agenda • During today’s session, we will address:

• The current IPO market

• The late-stage private placement market

• Financings in close proximity to or concurrent with an IPO

• Considerations for equity private placements

• Venture debt and considerations related to debt financings

• Other alternatives

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3

The IPO Market

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4

The IPO market

IPOs Filed

[units]

18

44

3

0

5

10

15

20

25

30

35

40

45

50

IPO Backlog

[units]

38

91

30

0

10

20

30

40

50

60

70

80

90

100

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5

The IPO market (cont’d)

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IPOs Priced – Yearly(1)

($ billions)

635

525

349

524

424

84 73 73

198

183 181

192

26 54

137

95 105

173

243

136

9

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

0

100

200

300

400

500

600

700

IPOs Priced - Monthly

[units]

12

31

1

0

5

10

15

20

25

30

35

40

45

50

Source: Dealogic as of April 9, 2016. Excludes IPOs for BDCs, CLEFs, MLPs, REITs and SPACs. (1) Total dollar value excludes offerings greater than $10 billion.

6


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IPO Detail – Last 15

($ millions) Pricing Deal Market % of % Initial File/Offer % Change Offer/ Primary

Date Issuer Value Value Company Sold Primary % ∆ Price vs. Range Share Count 1 Day Current Sector

4/6/16 Aeglea Biotherapeutics Inc $50.0 $129.3 38.7% 100.0% (41.2%) Below Upsized (2.3%) 19.9% Healthcare

3/22/16 Corvus Pharmaceuticals Inc $70.5 $306.1 23.0% 100.0% (6.3%) In Range As Filed (5.0%) (1.7%) Healthcare

3/17/16 Senseonics Holdings Inc $45.0 $315.9 14.3% 100.0% (13.6%) Below Downsized 0.0% 6.3% Healthcare

3/16/16 Hutchison China Meditech Ltd $101.3 $1,968.8 5.1% 100.0% (9.0%) Below Upsized (0.7%) (1.5%) Healthcare

3/2/16 Syndax Pharmaceuticals Inc $57.7 $213.4 27.0% 100.0% (20.0%) Below As Filed 0.1% 26.1% Healthcare

2/10/16 Proteostasis Therapeutics Inc $50.0 $152.9 32.7% 100.0% (38.5%) Below Upsized (17.0%) 25.0% Healthcare

2/10/16 AveXis Inc $105.6 $458.6 23.0% 100.0% 0.0% In Range Upsized (9.8%) 24.9% Healthcare

2/2/16 Editas Medicine Inc $108.6 $585.4 18.5% 100.0% (5.9%) In Range As Filed 13.8% 152.8% Healthcare

2/2/16 BeiGene Ltd $182.2 $780.2 23.3% 100.0% 4.3% In Range Upsized 18.0% 30.2% Healthcare

12/17/15 Yirendai Ltd $75.0 $585.0 12.8% 100.0% 0.0% In Range As Filed (9.0%) 10.0% Technology

12/9/15 Atlassian Corp plc $531.3 $4,382.2 12.1% 100.0% 20.0% Above Upsized 32.3% 10.7% Technology

11/19/15 Duluth Holdings Inc $92.0 $387.5 23.7% 100.0% (20.0%) Below As Filed 13.8% 81.1% Consumer

11/19/15 Axsome Therapeutics Inc $51.0 $172.2 29.6% 100.0% (25.0%) Below Upsized (2.9%) 12.9% Healthcare

11/18/15 Match Group Inc $460.0 $2,940.6 15.6% 100.0% (7.7%) In Range As Filed 22.8% (13.0%) Technology

11/18/15 Square Inc $279.5 $2,988.0 9.4% 95.0% (25.0%) Below As Filed 45.2% 68.1% Technology

In/Above As Filed/

Mean $150.6 $1,091.1 20.6% 99.7% (12.5%) Range Upsized 6.6% 30.1%

Median $92.0 $458.6 23.0% 100.0% (9.0%) 47% 93% 0.0% 19.9%

7


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33% 21%

13% 25%

71% 83%

42%

25%

75%

100% 40%

50%

40%

50%

17%

58%

50%

75%

25% 27% 29%

47%

25% 29%

50%

15 28 15 8 7 12 12 2 4 4 1

0%

20%

40%

60%

80%

100%

Offer Price vs. Filing Range

Below In Range Above

7%

13% 25% 25%

8%

25%

47% 54%

33%

63%

29%

58%

58%

50%

25%

50%

47% 46% 53%

13%

71%

17%

33%

50%

75%

25%

100%

15 28 15 8 7 12 12 2 4 4 1

0%

20%

40%

60%

80%

100%

Shares offers vs. Shares Filed

Downsized As Filed Upsized

8


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IPOs by Sector

[units]

% of Market Cap Sold

Median: 23%

10%

8%

46%

11%

4%

21%

Priced LTM

Consumer

Financial

Healthcare

Industrial

Services

Technology

13%

13%

42%

10%

6%

16%

Current Backlog

0% - 20%

20% - 40%

40% - 100% 34%

59%

7%

Priced LTM

9


• The downturn in the IPO market had become evident in 2015 – a

total of 170 IPOs were completed in the United States in 2015, which

represented a 53% decline from 2014

• The decline in VC-backed and PE-backed IPOs was significant, as well as the

absence of any “mega” deals

• The downturn continued through first quarter 2016, making it the

slowest quarter for IPOs in the United States since 2009

• No PE-backed IPOs

• All six IPOs were biotech and all six included participation from insiders and

existing investors

• Although there is a robust pipeline of IPOs, it is clear that timelines

for IPOs will be elongated and it will be important for IPO candidates

to have formulated financing alternatives

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10

Late-Stage Private Placements

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Rationale • There may be a variety of different motivations for a late stage or pre-

IPO private placement

• Company may want to defer IPO and need to raise additional capital prior to

the IPO

• Company may want to take out early friends and family and angel investors and

“clean up” balance sheet or provide partial liquidity for longstanding holders

• Company may want to bring in strategic investors

• Company may be advised that it should prepare itself for the IPO by gaining

support and validation from key sector investors that are opinion leaders

• Company and bankers may want to “de-risk” IPO by bringing in cross-over

investors that will also invest in the IPO

• Company may be advised that an up round will make higher IPO pricing easier for

IPO investors to accept

• May be quite sector dependent

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Market Trends U.S. LATE STAGE ACTIVITY BY QUARTER

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Market Trends (cont’d)

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Market Trends (cont’d)

• In recent months, we have observed various trends:

• A decline in the number of financings completed

• A decline in the valuations at which financings were completed

• Longer trajectories

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Late stage (or pre-IPO) private placements

• Terms for the late-stage round

• Liquidation preference: are investors asking for a liquidation preference over

common stock? over other classes of outstanding preferred stock?

• Anti-dilution protections: most include weighted average anti-dilution adjustments

(as opposed to full ratchets)

• Voting rights: class votes or “super voting” rights

• IPO protections

• Investors now commonly ask for and expect to receive IPO protection

• Blocking rights: IPO price must be as high as the last private round or at a

specified premium to the last private round price

• IPO ratchet: late stage investor receives additional shares (as in Square) if

the IPO price is less than the last private round (or other specified price)

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Late stage (or pre-IPO) private placements (cont’d)

• Investments with strategic partners raise additional concerns, such as

a need to consider standstill provisions, special transfer restrictions,

restrictions on investments in competitors

• Valuation concerns

• Announced SEC enforcement area of interest

• Down-round considerations

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Blurred Lines

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Financings in close proximity • We will discuss a few common scenarios

• Scenario 1: Issuer engaged in discussions with investment banks about a

potential IPO. Investment banks recommended that the issuer commence

working on the potential IPO while also pursuing an institutional private placement.

In the course of the issuer’s discussions, the issuer has received interest from

potential strategic investors.

• Issues to consider in advising the issuer and its financial

intermediaries:

• Valuation of institutional private placement: will institutional investors seek to

invest at a lower valuation? if so, what adjustments are triggered in prior rounds?

how will a down-round be explained in the context of an anticipated IPO? will there

be a milestone or valuation-creation event between completion of the institutional

private placement and the IPO?

• What forecasts or projections have been shared with the institutional investors?

are these the same as those shared with research analysts? have research

analysts had an opportunity to conduct their own diligence?

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Financings in close proximity (cont’d)

• What will be the financial statement impact of the financing?

• Are the institutional investors negotiating rights for themselves that will affect the

IPO? an acquisition?

• What other information has been shared with the institutional investors

• Securities law issues: are all of the investors “institutional accredited investors” or

“QIBs” so that if conversations were received as testing-the-waters discussions

there would not be a Section 5 issue?

• What kind of contractual commitment (if any) can be obtained from institutional

investors regarding their participation in the IPO?

• Indication of interest: is this something that can be disclosed in the

IPO prospectus?

• Contractual commitment to participate in another private placement

contemporaneous with the IPO

• Rules for “anchor” or “cornerstone” investors in the United States differ from

those in Europe and Asia

• No “confirmed” order in the U.S. without the pricing terms – cannot begin an

offering as a private placement and continue it as a public offering

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Financings in close proximity (cont’d)

• Scenario 2: Issuer has submitted its IPO registration statement to the

SEC; issuer was already in discussions about a late-stage private

placement but the placement had not come to fruition at the time the

IPO registration statement was submitted; IPO process has been

elongated as a result of market volatility. Issuer needs additional

funds. IPO underwriters also want to test the waters.

• Do you need to focus on integration of the various potential offerings? or in

potential gun-jumping issues? Does analysis change if the IPO is on file?

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Financings in close proximity - integration

• Prevents circumvention of registration requirements by separating

single non-exempt offering into several exempt offerings

• Six-month safe harbor ─ Rule 502(a)

• SEC’s integration doctrine may apply to an offering that otherwise

qualifies for an exemption under Regulation D

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Financings in close proximity –

integration – five factor test

Under SEC’s integration doctrine, the following factors (“five

factors”) are considered in determining whether one sale of

securities by an issuer will be integrated with (i.e., treated as part of

the same offering as) a prior or subsequent offer or sale of

securities by the issuer:

Part of a single financing plan;

Issuances of the same class of securities;

Sales occur at or about the same time;

Same type of consideration is received; and

Proceeds will be used for same general purpose.


Financings in close proximity –

integration ─ SEC interpretive guidance

C&DI 139.25, which addresses a side-by-side private offering (under

Section 4(a)(2) or Rule 506) with a registered public offering without

having to limit the private offering to QIBs and a small number of

large institutional accredited investors

The focus is on how the investors in the private offering are solicited

Investors were not identified or contacted in connection with the public offering

Investors did not contact the issuer as a result of the general solicitation by

means of the registration statement


Financings in close proximity

Keeping track of the various offering processes

Which categories of potential investors will be contacted? by whom? to participate

in which offering?

What materials are used?

Who has received what information?

Will all of the information be included in the IPO prospectus?

Who has received material non-public information? SEC has made clear that it is

focused on “MNPI” or informational asymmetries

If an investor participated in an institutional private placement and received

information that will not be in the IPO prospectus, is there a basis on which it

can participate in the IPO?


Debt private placements

Many pre-IPO companies traditionally have focused on equity

offerings; however, business development companies, venture debt

lenders and other sources of capital should be considered

Structure of venture and BDC debt investments

Principal negotiating issues

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Other Approaches

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27

Merging with and into an already public

company

• Using the life sciences sector as an example, there are a number of

public companies that were successful in raising capital to fund their

clinical development, but which have failed trials.

• Instead of liquidating and distributing their capital to stockholders,

these companies may be interested in considering

merger opportunities

• An issuer that has already commenced its IPO preparations but has

found that its IPO has been delayed may consider a reverse merger

into the already public company

• Unlike the “reverse mergers” into shell companies, which raise a

number of concerns, a reverse merger into an operating company

can be a worthwhile alternative

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28

Regulation A+ Tier 2 offering, with a

listing

• An issuer that already commenced its IPO preparations and has found that

its IPO may be delayed may consider a Tier 2 Regulation A offering with a

contemporaneous stock exchange listing

• The disclosures prepared for a Form S-1 can easily be repurposed and used

to prepare a Form 1-A for a Regulation A offering

• Bankers may not have identified investor interest in an amount sufficient

(from the bankers’ perspective) for a traditional IPO; however, an issuer can

only raise up to $50 million in a Tier 2 Regulation A offering. The

expectations are that a Tier 2 Regulation A offering will not be as big as a

traditional IPO, so this offering format may provide a lower threshold for the

offering size

• By listing concurrently with the completion of the Regulation A offering, the

issuer will have a class of stock that it can use for stock-based compensation

awards, partnering transactions, or other purposes

• Furthermore, securities sold in a Tier 2 Regulation A offering are not

considered “restricted securities,” so funds that have limits on the

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29

Regulation A+ Tier 2 offering, with a

listing (cont’d)

• Percentage of their portfolio that they can invest in private placements will be

able to invest in the offering

• Moreover, by establishing a public market for its securities, the issuer will

have many more options going forward, whether to provide liquidity for

existing VC and PE sponsors or to raise additional capital for its own

corporate purposes

• Following completion of the Tier 2 offering with listing, the issuer will be

considered an “EGC”

• It may be the case that investment banks that are disinclined to undertake

what they consider to be small IPOs may be more receptive to assisting with

what might be viewed as a large Regulation A Tier 2 offering

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30

Exchange Act listing, without a capital

raise

• An issuer that already has undertaken the work required in

connection with an IPO may find it worthwhile to repurpose its Form

S-1 into a Registration Statement on Form 10, which is an Exchange

Act registration statement, and list its securities on an exchange

• The Form 10 enables an issuer to enter the SEC reporting regime

• After a Form 10 is cleared through the SEC, the issuer will be a

reporting company, responsible for periodic SEC filings, as well as

subject to Sarbanes-Oxley requirements

• A Form 10 registration statement cannot be used to raise capital

• If the issuer wants to raise capital, it would have to conduct an

exempt offering prior to, or alongside, the Form 10

registration process

• The issuer might consider a Reg D/Rule 506 offering to accredited

investors, or a Rule 144A offering to QIBs, or a combination of these

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31

Exchange Act listing, without a capital

raise (cont’d)

• Assuming that the issuer had its Form 10 declared effective, and also

listed its securities on an exchange, it may subsequently raise capital

through exempt offerings (a private placement, a PIPE transaction, a

144A offering) or through a registered follow-on offering

• For a registered follow on offering, the issuer will still need to use a

Form S-1 to register the offered securities

• If the issuer did not list its securities on an exchange (just on OTC

BB), and the issuer wants to do a follow-on offering, it should

consider trying to move up to Nasdaq or NYSE MKT in conjunction

with the follow-on in order to address blue sky concerns

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This is MoFo. 32

The RE-IPO

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This is MoFo. 33

Foreign exchanges • Foreign securities exchanges, such as the AIM, the TASE, the

Frankfurt exchange, and various of the Nordic exchanges, have been

successful in attracting strong, technology-based companies across a

range of sectors

• Founders, sponsors, or others may have advocated to have these

companies list their securities on these exchanges in order to create

a liquidity opportunity, as well as to provide a “currency” for potential

acquisitions or stock-based awards

• However, many of these exchanges have failed to develop any real

liquidity for their listed companies and the stocks have languished as

a result of market structure issues (i.e., “small currencies,” lack of

market makers, exchange rules), rather than as a result of company-

specific concerns

This is MoFo. 34

Recapitalization The company could then be recapitalized as follows:

• An institutional private placement in the United States completed “at market” by

reference to the home country securities exchange (which, by definition, will be

lower than the valuation that would be ascribed for a similarly situated company

listed on a U.S. securities exchange)

• In its home country, the company will undertake to register the resale of the

securities purchased in the private placement

• The institutional private placement is followed by a rights offering in the company’s

home country to existing stockholders, allowing existing stockholders to participate

at the same price as the new institutional holders

• Contemporaneously with the institutional private placement and the rights offering,

the company will proceed to undertake an IPO in the United States as an EGC

relying on the confidential submission process; the IPO could include a resale

component, or subsequent to the IPO, the company could file a resale for the

institutional investors

PIPE TRANSACTIONS 2015 What are “PIPEs”? A PIPE (Private Investment in Public Equity) refers to any private placement of securities of an already-public company that is made to selected accredited investors (usually to selected institutional accredited investors). In a typical PIPE transaction, investors enter into a purchase agreement that commits them to purchase securities and usually requires the issuer to file a resale registration statement covering the resale from time to time of the privately purchased securities.

Instruments Issued in PIPE Transactions in 2015

61.80%

11.12%

0.09% 14.77%

2.46% 0.18%

2.55%

6.93%

0.09%

Top Five Most Active Sectors

Biotech

14.9% Pharmaceuticals

& Related

11.5%

Energy: Oil & Gas

7.4%

Metals, Minerals & Stones

6.1%

Healthcare: Medical Equipment

5.6%

Common stock…61.80% Convertible debt…14.77% Convertible preferred stock…11.12% Equity line…6.93% Prepaid warrant…2.55% Non-convertible debt…2.46% Other: convertible…0.18% Non-convertible preferred stock…0.09% Unknown…0.09%

Number of PIPE Transactions

1116 1099

1177

1097

2012 2013 2014 2015

The information provided herein does not constitute legal advice, and should not be acted upon; always obtain specific legal advice based on particular situations. The views expressed herein shall not be attributed to Morrison & Foerster, its attorneys or clients. Data Source: PrivateRaise © 2016 Morrison & Foerster LLP | mofo.com

For more information on PIPE transactions, see our FAQs on PIPEs: http://media.mofo.com/files/

Uploads/Images/FAQsPIPEs.pdf

2015

2014

2013

2012 $36.1 billion

Dollars Raised in PIPE Transactions

Less than $50M 156

$50M-$99M 31

$100M-$249M 44

$250M-$499M 32

$500M-999M 15

$1B-4.9B 21

Greater than $5B 8

$34.6 billion

$23.8 billion

No. of PIPE Transactions By Market Capitalization

$57.0 billion

As privately held companies choose to remain private longer and defer their initial public offerings orother liquidity opportunities, these companies are focused on raising capital in private placementsmade principally to institutional investors, cross-over funds and strategic investors. Late stageprivate placements have almost become a prerequisite to an IPO, or perhaps they are the new IPOs.

U.S. LATE STAGE FINANCINGS

In the technology sector, there were712 late stage deals completed,which raised $27.6 billion.

$44.9 billion 1,548 Deals

$40.4 billion 1,862 Deals

2015

2014CAPITAL RAISED - - - - NO. OF DEALS COMPLETED

$28.9 million [avg. deal size]

$21.7 million [avg. deal size]

Software36%

Healthcare11%

CommercialServices

10%

Pharma/Biotech

6%

Consumer4%

IT Hardware3%

Media4%

Energy2%

VOLUME BY SECTOR IN 2015

UNICORNS"Unicorns" are private companies

valued at $1 billion and above.

As of April 2016 there were a total of93 Unicorns in the United States

valued at over $326 billion.

Other sectors: 23%

For more information about late stage financings, visit:http://www.mofo.com/practices/services/ business--finance/capital-markets/late-stage-investments

(C) 2016 Morrison & Foerster LLP | mofo.com"Late Stage" references Series B through Series Z+ rounds.

Sources: Pitchbook, CB Insights

In the biotech sector, there were106 late stage deals completed,which raised $3.3 billion.

Investor Criteria for U.S. Private Placements and Other Offerings

Summary Tables and Comparisons

| 1

Regulation D: Accredited Investors

• Banks and savings and loan associations. • Registered brokers or dealers. • Insurance companies. • Registered investment companies, business development

companies, small business investment companies. • Employee benefit plans established by a state or its

subdivision with assets exceeding $5 million. • ERISA plans where the investment decision is made by a

plan fiduciary, or if the plan has assets exceeding $5 million. (Or if a self-directed plan, investment decisions are made by accredited investors.)

• Private business development company under the Investment Advisers Act.

• Corporations and other entities with assets in excess of $5 million.

Source: Rule 501 of Regulation D.

• Director, executive officer or general partner of the issuer of the securities being offered (or any director, executive officer, or general partner of a general partner of that issuer).

• Natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1 million.

• Natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years (and has a reasonable expectation of reaching the same income level in the current year).

• Any trust, with total assets in excess of $5 million, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person”.

• Any entity in which all of the equity owners are accredited investors.

Institutional Accredited Investor: Regulation D

This category is not a defined term in Regulation D. Instead, an offering document or agreement may limit sales of the applicable securities solely to the Regulation D accredited investor categories that are institutional in nature (i.e., to those described in Rule 501(a)(1), (a)(2), (a)(3) or (a)(7)). This limitation is imposed in Regulation D offerings when the offering participants do not want individuals to purchase securities in the offering.

Rule 144A: Qualified Institutional Buyers

• Any of the following, which owns and invests at least $100 million in securities of unaffiliated entities:

o Insurance companies.

o Registered investment companies (subject to special aggregation rules relating to fund families) or any business development company.

o Licensed small business investment company.

o Employee plan established by a state or a subdivision.

o ERISA employee benefit plans.

o Certain trust funds where the trustee is a bank or trust company, and where the participants are certain institutions.

o Business development companies.

o Corporations and other entities.

o Registered investment advisers.

• Registered broker-dealers, acting for their own accounts or the accounts of other QIBs, that owns and invests at least $10 million in securities of unaffiliated issuers.

• Any entity, all the equity owners of which are QIBs, acting for its own account or the accounts of other QIBs.

• Any bank, savings and loan or non-U.S. bank or savings and loan that owns at least $100 million in securities of unaffiliated issuers that are not affiliated with it and that has an audited net worth of at least $25 million.

Source: Rule 144A(a).

Major U.S. Institutional Investor: Securities Exchange Act

• A U.S. institutional investor that has, or has under management, total assets in excess of $100 million (for purposes of determining the total assets of an investment company under this rule, the investment company may include the assets of the family of investment companies of which it is a part).

• A registered investment adviser that has total assets under management in excess of $100 million. • Must be:

o A registered investment company; or o A bank, savings and loan association, insurance company, business development company, small business investment

company, or certain employee benefit plans; a private business development company (as defined in Rule 501(a)(2)); a 501(c)(3) entity; or a trust.

Source: Rule 15a-6 under the Securities Exchange Act.

Investor Criteria for U.S. Private Placements and Other Offerings

Summary Tables and Comparisons

| 2

Qualified Purchaser: Investment Company Act

• Any natural person who owns at least $5 million in investments.

• Any company that owns at least $5 million in investments and that is owned by or for 2 or more natural persons that are related (or foundations or trusts established for their benefit).

• Certain trusts established for the investors in the two prior bullets.

• Any person, acting for its own account or the account of other qualified purchasers, who owns and investment at least $25 million in investments.

Source: Section 2(a)(51) of the Investment Company Act.

Knowledgeable Employee: Investment Advisers Act

• An executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the investment company or an affiliated management person.

• An employee of the investment company or an affiliated management person who participates in the investment activities of the investment company or its affiliates, provided that the individuals has performed these duties for at least one year.

Source: Rule 3c-5 under the Investment Advisers Act.

Qualified Client: Investment Advisers Act

• A natural person or a company that has at least $1 million under the management of the investment adviser.

• A person or a company that investment reasonably believes either:

o Has a net worth (together with a spouse) of more than $2.1 million (as of August 15, 2016); or

o Is a “qualified purchaser” under the Investment Company Act.

• A natural person who is:

o Part of the investment adviser’s management; or

o An employee of the investment adviser who participates in the investment activities of such investment adviser, and has had such duties for at least one year.

Source: Rule 205-3 under the Investment Advisers Act.

Eligible Contract Participant: Commodity Exchange Act

• Entities with more than $10 million in assets (or an entity guaranteed by such an entity).

• Individuals with at least $10 million invested (or $5 million if the individual is hedging).

• An entity with a net worth of at least $1 million that are hedging commercial risk.

• Financial institutions.

• Insurance companies.

• Registered investment companies and similar non-U.S. entities.

• Commodity pools with at least $5 million in assets under management.

• ERISA plans with assets of at least $5 million (or that have investment decisions made by a registered commodity pool adviser, commodity trading adviser or a financial institution or insurance company).

• U.S. federal, state and non-U.S. government entities.

• U.S. registered broker-dealers and similar non-U.S. entities.

• Futures commission merchants and similar non-U.S. entities.

Source: Section 1a(18) of the Commodity Exchange Act.

1 Attorney Advertisement

Client Alert April 18, 2016

A Lofty Concept:

Disclosure Effectiveness

Even before the JOBS Act had been proposed, policymakers focused on the downturn in the number of initial

public offerings (IPOs) speculated that the burdensome disclosure requirements applicable to public companies

were deterring private companies from undertaking public offerings. A number of market participants, including

even a few then-Commissioners of the Securities and Exchange Commission (the “Commission”), noted that the

disclosures contained in IPO prospectuses, as well as those contained in Securities Exchange Act (“Exchange Act”)

filings, had consistently become longer in recent years. Then-Commissioner Paredes noted that disclosure

overload brought with it the possibility that investors might no longer be able to identify the information that was

material to an investment decision amidst pages of generic or repetitive text. In an effort to jumpstart the IPO

market and reduce the regulatory burdens for IPO candidates, Title I of the JOBS Act (the “IPO on ramp”

provisions) required that the Commission produce a report to Congress examining the requirements of

Regulation S-K with a view to modernizing and simplifying the registration process for emerging growth

companies (EGCs). The SEC Staff’s 2013 report identified a number of guiding principles that should inform a

review of the effectiveness of disclosure requirements. Paramount among these is the notion of promoting

investor confidence in the reliability of public filings through enhanced transparency, while encouraging capital

formation. These and other objectives have been at the center of the Commission’s “Disclosure Effectiveness”

initiative, which has been underway since 2013. Last week, the Commission took another step toward furthering

its review of Regulation S-K requirements by voting to issue a Concept Release requesting comment on the

business and financial disclosures that public companies provide in their Exchange Act filings.1 The release

specifically does not comment on the other disclosure requirements of Regulation S-K, such as corporate

governance or compensation-related items, or the required disclosures for foreign private issuers, business

development companies or other types of registrants.

Overview

Given the public availability of information, investors are assumed to have access to disclosures made by reporting

issuers—whether that disclosure is contained in filings made pursuant to the Securities Act of 1933 or the

Exchange Act. Disclosures required pursuant to the Securities Act and the Exchange Act are coordinated through

an integrated disclosure system. For U.S. domestic issuers, the required non-financial disclosure items are set

forth in Regulation S-K, and the required financial disclosure items are set forth in Regulation S-X. In 1977, the

1 Concept Release, Business and Financial Disclosure Required by Regulation S-K, Release No. 33-10064; 34-77599, available at: https://www.sec.gov/rules/concept/2016/33-10064.pdf.


Commission took its first step toward establishing an integrated disclosure system when it adopted

Regulation S-K. Regulation S-K provides a single set of instructions to be used by registrants under the

Securities Act forms, as well as the Exchange Act forms. Despite its significance, Regulation S-K has only been

updated a few times since its adoption.

In the Concept Release, the Commission seeks comment on, among other things, whether the current

requirements appropriately balance the costs of disclosure with the benefits, how disclosure requirements could

be improved in order to enhance the information made available to investors, whether there are tools or

approaches that can modernize the methods of presenting disclosures such that these are adaptable to changes in

market conditions and advancements in technology.

In addition to requesting comment on various specific line items of Regulation S-K, as we note below, the

Concept Release poses some fundamental questions regarding disclosure matters.

Principles-Based Disclosures or Prescriptive Disclosures: The Concept Release raises

the age-old “principles-based” versus “prescriptive” disclosure question. Currently, much of the

information called for under Regulation S-K is principles-based and relies on the issuer’s

assessment regarding materiality of the information in the context of the issuer’s business and

financial condition. In considering “materiality,” the Commission has accepted the Supreme

Court’s view that information is material if there is a substantial likelihood that a reasonable

investor would consider the information important in deciding how to vote or how to make an

investment decision. Information is material if there is substantial likelihood that the disclosure

of the omitted fact would have been viewed by the reasonable investor as having significantly

altered the “total mix” of information available. Of course, materiality determinations inevitably

involve judgment and, as a result, may be difficult to apply, and application may lead to

disclosures that are inconsistent from issuer to issuer. The release notes that there are other

requirements under Regulation S-K that incorporate objective, quantitative thresholds or require

that issuers disclose information in all cases. The use of prescriptive disclosure requirements is

characterized as resulting in greater consistency and comparability among filings, which may be

useful to investors, and in the case of some matters, even enables software to track and report

these differences. The release solicits input on the most effective approach as between

principles-based and prescriptive disclosure requirements and offers up a third concept,

“objectives-based” disclosure requirements, for consideration.

Investor Sophistication: The Concept Release asks an important question that often is the

very first question we ask when we are writing a memorandum or an alert: in crafting disclosures,

what level of sophistication should be presumed of the reader? As the release notes, the answer to

this question affects not only the level of detail that is required to be disclosed and the type of

information that is shared, but it also affects where (in which documents) the disclosure should

be contained, the manner in which the disclosure should be required to be furnished (such as

through cross-references, hyperlink or incorporation by reference) and the presentation of the

information. Given technological advancements and the rapid accessibility of information, there

is good reason to provide more flexibility for issuers in terms of how and where information is

presented. In recent years, there have been a number of studies published by government

agencies (some were required by the Dodd-Frank Act) regarding financial literacy and the way in


which investors review and react to disclosures.2 These studies appear to suggest that investors

prefer disclosures that are clear and concise, incorporating bullet points, tables, charts and other

graphic presentations. Investors also appear to have a preference for “layered disclosure,” in

which different formats (and amounts of text) co-exist for the benefit of different types

of investors.

Core Company Business Information: Item 101(a) of Regulation S-K requires a description

of the general development of the business of the registrant during the past five years or such

shorter period as the registrant may have been engaged in business. The release requests

comment on whether this information is available elsewhere, whether the requirement is still

useful for registrants with a reporting history, whether a more detailed discussion should be

required every few years and whether the disclosure should contain a discussion of the

registrant’s strategy or focus on changes that have occurred in the business. The release also asks

whether, with respect to Item 101(c), any additional specific disclosures should be required.

Scaled Disclosures: Scaled disclosures are available to smaller reporting companies (SRCs),

and the JOBS Act made certain disclosure accommodations available to EGCs. Since enactment

of the JOBS Act, market participants have urged the Commission Staff to review the scaled

disclosures for SRCs in light of the EGC accommodations. Also, proposed legislation has been

introduced that would redefine the filer categories (i.e., accelerated filers, non-accelerated filers,

etc.) for various purposes, including in order to provide some relief from disclosure requirements

that are perceived as potentially burdensome. The FAST Act also directs the Commission to

revise Regulation S-K to further scale or eliminate disclosure requirements in order to reduce the

burden on SRCs, EGCs and accelerated filers, while still providing all material information to

investors. The release requests input on various issues related to scaled disclosures.

Frequency of Disclosures: The release addresses the current debate regarding

“short-termism” by acknowledging the possibility that quarterly disclosure requirements may

lead the management of public companies to focus on near-term results rather than long-term

investment. The release requests comment regarding the benefits or disadvantages associated

with quarterly reporting, whether the reporting requirements should be different for different

types of companies (i.e., for SRCs, EGCs, etc.), whether there would be significant savings or

benefits associated with semi-annual reporting and some quantification of these costs.

Cross-References, Hyperlinks, Layered Disclosures and Other Presentation Issues:

The release solicits comments on the presentation of information and the extent to which tools or

approaches can be used that would make information more accessible and reduce repetition and

disclosure of immaterial information. The release discusses the use of cross-references, reliance

on incorporation by reference, use of hyperlinks (including links to information that may be

provided on company websites), use of standardized formatting (including standardized charts,

tables, Q&As, etc., in order to promote comparability) and layered disclosures.

2 See, for example, Study Regarding Financial Literacy Among Investors, as required by Section 917 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, delivered by the Staff of the Commission, available at: https://www.sec.gov/news/studies/2012/917-financial-literacy-study-part1.pdf.


Specific Areas of Focus

In addition to addressing and seeking comment on some overarching disclosure principles, the Concept Release

also addresses a number of specific disclosure requirements, reviews the underpinnings of the current

requirements and solicits input on potential areas of improvement that would provide more meaningful

information for investors while not burdening issuers. We highlight below a few of the more important areas

covered by the release:

Financial Information and the MD&A: The release discusses the Item 301 selected

financial data requirement, and asks whether this information is repetitive of information that is

otherwise available to investors or whether there is utility to the data as it may highlight trends.

Item 302 requires disclosure of certain quarterly data as to which the release solicits comments.

The release also discusses the Commission’s guidance over the years on the objectives of the

MD&A section, the use of an executive-level overview and the types of trend data that the

Commission has sought. In this regard, the release requests comment on various matters,

including whether the sources of Commission guidance on MD&A should be consolidated,

whether a different format or presentation should be required and whether auditor involvement

should be required. The release also solicits comment regarding the current “two-step” guidance

for determining whether forward-looking information is required in MD&A. As to results of

operations, the release asks whether period-to-period comparisons should be retained, eliminated

or modified; how the results of operations disclosures can be improved; and whether the

three-year comparison provides material information that would not be reflected in prior period

filings. The release also requests comment on the liquidity and capital resources disclosures

(Items 303(a)(1) and (2)), off-balance sheet arrangements (Item 303(a)(4)), contractual

obligations (Item 303(a)(5)) and critical accounting estimates (Item 303).

Risks and Risk Management: The release asks whether all risk-related disclosures required

to be included in a report should be consolidated and whether this would improve the quality of

the information. This is an interesting approach and, in fact, in grouping in its Concept Release

all of the “risk-related” items under a single heading and considering them together, the release

seems to take a view. The release more specifically requests comment on whether and how

registrants could be discouraged from including generic or boilerplate risk factors or risks

common to an industry and instead focus on risks specific to the registrant and its business.

Along these lines, the release asks for comment relating to additional requirements for specificity

in the risk factors, more detailed discussion of context and the possibility of discussing the

probability of occurrence of the factors identified in the section.

Line Item Requirements: The Concept Release also seeks comment regarding specific items

of Regulation S-K, including disclosure requirements relating to intellectual property rights

(Item 101(c)(1)(iv)), government contracts and regulation (Items 101(c)(1)(ix) and (xii)),

employees (Item 101(c)(1)(xiii)), properties (Item 102), number of equity holders (Item 201(b)),

description of capital stock (Item 202), recent sales of unregistered securities (Items 701(a)-(e)),

use of proceeds from registered securities (Item 701(f)) and purchases of equity securities by the

issuer and affiliated purchasers (Item 703).


Industry Guides: Consistent with the JOBS Act Regulation S-K study, the release solicits

comments on the various industry guides and whether these guides require industry-specific

information that is otherwise not disclosed and which remains useful to investors.

Exhibits: The release also seeks input on Item 601 of Regulation S-K related to exhibit

requirements. In particular, the release focuses on whether schedules and attachments from filed

exhibits should be omitted and under what circumstances, whether registrants should continue to

be required to file amendments or modifications to previously filed exhibits, whether it is clear

which contracts are entered into in the ordinary course and whether it would be helpful for the

Commission to provide additional guidance to help registrants determine which contracts should

be filed to the extent that the registrants are “substantially dependent” on these.

What to Expect

For many years, the SEC and issuers have struggled with how to best provide material disclosure to investors. In

recent years, many issuers have undertaken initiatives to make their public disclosures more effective through the

use of charts, tables, and other graphics. This trend is most evident in proxy statements, with many issuers having

concluded that more effective disclosure of executive compensation and governance information provided a better

platform for engaging directly with stockholders. Further, at the urging of the SEC Staff, numerous issuers have

also sought to make the disclosure in their periodic reports and registration statements more effective, although

the changes in these filings have been much more modest. One of the often-cited concerns in “voluntarily” paring

back disclosures that may be immaterial, minimizing repetition, and deleting “generic” risk factors is that

significant disclosure changes may open the door to potential securities litigation. The Concept Release now

suggests a willingness on the part of the Commission to consider many of the basic underpinnings of

Regulation S-K that could bring about meaningful changes to the ways in which public reporting companies share

information with their stakeholders, and therefore represents one of the best opportunities in a generation to

make some real progress in the way that public companies communicate with their investors.

Authors

Lloyd Harmetz New York (212) 468-8061 [email protected]

David Lynn Washington D.C. (202) 887-1563 [email protected]

Anna Pinedo New York (212) 468-8179 [email protected]

About Morrison & Foerster

We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial

institutions, investment banks, Fortune 100, technology and life sciences companies. We’ve been included on The American

Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are

committed to achieving innovative and business-minded results for our clients while preserving the differences that make us

stronger. This is MoFo. Visit us at www.mofo.com. © 2016 Morrison & Foerster LLP. All rights reserved. For more updates, follow

Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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