This practice note examines some of the issues most commonly raised in initial Securities and Exchange Commission (SEC) comment letters on registration statement filed for initial public offering (IPOs). It is intended to guide you, as counsel to an IPO company, in assisting your client in efficiently navigating the SEC comment and review process.
This practice note discusses comments that apply to IPO prospectuses generally, including comments on plain English principles and expert consent requirements, and comments on specific sections of a prospectus, including the risk factors, management's discussion and analysis of financial condition and results of operations, and others. It provides excerpts from, and links to, representative SEC comment letters, and offers drafting and other tips to help issuers avoid receiving these types of comments or, failing that, to respond effectively to the SEC's concerns.
This practice note does not provide a comprehensive list of the types of comments that the staff of the SEC's Division of Corporation Finance (SEC staff or staff) can issue, and does not address SEC staff comments on executive compensation disclosure, which has become less important since the Jumpstart Our Business Startups Act of 2012 (JOBS Act) enabled emerging growth company (EGCs) to provide less detailed executive compensation disclosures in their registration statements, which most EGCs undertaking IPOs have done. It also does not discuss financial statement and related accounting issues, which are typically addressed by the issuer's chief financial officer and its outside auditor. SEC staff comments can vary widely from offering to offering and depend on the issuer's industry sector, the stage of the issuer's business, and the issuer's financial condition. Accordingly, each issuer must draft its IPO prospectus disclosures to accurately reflect its own unique facts and circumstances.
For information about preparing the registration statement and prospectus for an IPO, see Registration Statement and Preliminary Prospectus Preparations for an IPO, Top 10 Practice Tips: Drafting a Registration Statement, and Form S-1 Registration Statements. For information about the IPO process, see Initial Public Offering Process. For information generally on responding to SEC comment letters and the SEC staff review process, see SEC Comment Letter Responses and Understanding the SEC Review Process.
SEC Review Process
After a company files a registration statement on Form S-1 (or Form F-1 for foreign private issuer), the SEC staff will perform a cover-to-cover review of the document to ensure compliance with the applicable disclosure and accounting requirements under the Securities Act of 1933, as amended (Securities Act). The SEC staff does not evaluate the merits of an investment in an IPO but rather focuses on whether the disclosures provided in the registration statement provide investors with enough information to make an informed investment decision.
The SEC Staff's Comment Letter
Virtually all IPO registration statements receive comments. The SEC staff will generally issue a comment letter within 30 days from the date the registration statement is filed (whether submitted confidentially or publicly on EDGAR). According to the SEC's Fiscal Year 2016 Annual Performance Report, available at https://www.sec.gov/ files/secfy18congbudgjust.pdf, in 2016 the SEC staff issued initial comments within an average of 25.5 days.
The SEC staff's comments will include a description of any deficiencies identified in their review and may also include requests for supplemental information from the company if the staff believes the disclosures do not comply with SEC disclosure requirements or omit information that may be material to investors. Each comment letter is unique to the filing and may include comments that require substantial revisions to the registration statement. The number of comments in the SEC staff's initial comment letter can range from just a few to 70 or more. There may be several rounds of letters from the SEC staff and responses from the company until the issues identified in the staff's review are resolved.
Responding to SEC Staff Comment Letters
You should work with your client, underwriters' counsel, the company's auditor, and the other members of the IPO working group to carefully address each SEC staff comment in the company's response letter and in any amended registration statement filed with it.
When responding to the SEC, it is important to be mindful of your responses as they will eventually be made publicly available. If you do not fully understand a specific comment, you should contact the SEC staff reviewer for clarification so you can provide an appropriate response. Thoughtful, well-written response letters are crucial to resolve SEC staff comments efficiently. Responses should focus on the SEC staff's specific questions and cite the SEC's rules, guidance, and other authoritative sources (especially for accounting comments) wherever possible. Although it is helpful to review other registrants' response letters, a company's response letter should address its unique facts and circumstances. If an amendment to the registration statement is being filed with the response letter, the responses should indicate specifically where the revisions have been made to address the SEC staff's comments.
You should not assume that receiving a comment means that the SEC staff reviewer disagrees with the company's approach or disclosure. Often comments seek additional information and clarification to better understand the company's position. You should not, however, respond to a comment by adding disclosures to the registration statement that you believe to be immaterial. If you believe that a comment concerns an immaterial matter, you should communicate that to the SEC staff reviewer (legal or accounting) responsible for the comment as early as possible in the review process to avoid causing any delays in resolving the comment. The response letter should thoroughly explain the judgments the company applied in drafting such disclosure to assist the SEC staff in understanding why additional disclosure is not material to investors or necessary to comply with the disclosure requirements.
Generally, SEC comment letters request responses within 10 business days. However, if you believe more time is needed to respond to the comments, you should discuss this with the appropriate SEC staff reviewer.
Once all the SEC staff's comments on its registration statement have been resolved, the company can request that the SEC declare the registration statement effective, which allows it to proceed with the IPO. The SEC staff will upload its comment letters and the company's responses to EDGAR within 20 days of declaring the registration statement effective.
For additional information about the SEC review process, see Understanding the SEC Review Process.
To minimize the number of SEC staff comments on your client's registration statement, you should review staff comment letters and company response letters from recently completed IPOs in the same industry to identify industry-specific issues that the SEC staff may have, as well as IPOs for companies that have adopted similar accounting principles to identify any accounting-specific issues that the SEC staff is focused on. Foreign private issuers should also review SEC comment letters and company response letters from recently completed IPOs for issuers with the same country of domicile. However, many comments tend to fall under the recurring themes discussed below.
Common SEC Comments on IPO Prospect uses
The following types of comments apply to prospectuses generally.
Rule 421 under the Securities Act (17 CFR 230.421) requires companies to use plain English writing principles in their prospectuses. Here are some examples of comments received by issuers that failed to do so:
"Throughout the prospectus numerous statements in your disclosure are unclear because they are not written in plain English or the concept is not fully described. Please review your entire prospectus to ensure that your disclosure throughout is written in plain English and the concepts that you describe are fully explained. See Rule 421(b) of Regulation C." (SEC Comment Letter to Achison Inc. (Sept. 20, 2016), Comment #1).
"Please note that the summary is subject to the plain English principles under Securities Act Rule 421(d). Revise to eliminate unnecessary redundancy. For example, the fourth paragraph in this section appears to repeat much of the information in the first paragraph." (SEC Comment Letter to UPAY, Inc. (Aug. 4, 2016), Comment #1).
"Throughout your registration statement you utilize industry jargon. For example purposes only, we note your reference to "commercial real estate CDOs" on page 6. Please concisely explain these terms where you first use them." (SEC Comment Letter to TPG RE Finance Trust, Inc. (May 24, 2017), Comment #3).
"Please revise to explain industry jargon to an investor not in your business, such as "technology white space," and eliminate marketing language." (SEC Comment Letter to Ameri Holdings, Inc. (Mar. 6, 2017), Comment #9).
To avoid this type of comment, you should write in short declarative sentences, use definite and concrete everyday language, use active voice, present complex information in tabular format, and avoid legal and industry jargon and double negatives. Descriptive headings and bullet lists are also recommended. If highly technical or legal jargon cannot be avoided, then you should include a glossary in the prospectus to facilitate the reader's understanding of the prospectus disclosure.
The SEC staff may comment if there is too much redundant information in the prospectus. The problem of repetitive disclosure most commonly arises in the summary section of the prospectus. Here is an example of this type of comment:
"Please identify those aspects of the offering and your company that are most significant, and highlight these points in plain, clear language. The summary should not, and is not required to repeat the detailed information in the prospectus. The detailed description of your business, competitive strengths, and strategy is unnecessary since you repeat them verbatim in the business section of the prospectus." (SEC Comment Letter to Valvoline Inc. (Jun. 27, 2016), Comment #2).
In preparing the summary section, you should avoid repeating too much information from the business section. The summary should highlight the most significant aspects of the company's business, with a lengthier description reserved for the business section. Item 503(a) of Regulation S-K (17 CFR 229.503) provides that the prospectus summary should be brief and provide an overview of the key aspects of the offering, and the SEC staff will object if it is too long. When drafting the summary, you and your client should consider and identify those aspects of the offering that are most significant and determine how to best highlight those points in clear, plain language.
Clarifying the Basis for the Issuer's Statements
Although the prospectus is, in part, a marketing tool, companies should avoid hyperbolic statements and marketing language. Statements of belief should be clearly labeled as such and be accompanied by an explanation of the basis for each belief. Companies should also be cognizant of potential liability under the federal securities laws for misstatements or omissions in the registration statement. Here are some examples of this type of comment:
"We note your statement that you believe Top Kontrol is "the most advanced anti-theft and personal safety automobile device of its kind currently available." Please expand here and in all applicable places in the document to disclose the nature of the Top Kontrol device, such as how it is installed and how it works. Please also better explain the basis for your belief that it is the "most advanced" of its kind currently available. In this regard, we note that on page 25 you compare Top Kontrol to Viper and LoJack. As each of Viper and LoJack offer multiple products with multiple features, please clarify to which of their products you are referring in making the comparison to Top Kontrol." (SEC Comment Letter to SecureTech Innovations, Inc. (Mar. 15, 2018), Comment #2).
"Disclose the basis for your assertion that nervonic acid "is known to be beneficial to memory related brain health, anti-aging, blood lipid regulation, and anti-fatigue symptoms." Disclose whether this information is based upon management's belief, industry data, reports/articles or any other source. In this regard, you state on page 14 that the benefits are claimed by studies. Elaborate upon the nature of these studies and whether you or a third party commissioned such studies." (SEC Comment Letter to CAT9 Group Inc. (Jan. 23, 2018), Comment #6).
To avoid comments on statements about a company's relative position in the industry, such as being a leader in a field, the company should disclose the relevant metric used for making the assertion, such as industrywide sales figures or, if possible, a third-party source. It should also be clear when a statement is made based on management's belief (i.e., "We believe that . . ."). Although phrasing a statement as a belief may weaken its impact, it can help companies avoid liability under federal securities laws for misstatements or omissions of material facts. If a company has a good faith basis for its belief or opinion, and does not omit any material facts necessary to make the statements not misleading, statements of belief and opinion should be insulated from liability under Section 11 of the Securities Act (15 U.S.C. § 77k). Additionally, a good faith belief can support a defense against claims asserted under Section 10(b) (15 U.S.C. § 78j) of the Securities Exchange Act of 1934, as amended (Exchange Act), and Rule 10b-5 thereunder (17 CFR 240.10b-5), which require proof of an intent to deceive, manipulate, or defraud to impose liability.
For more information about the liability under the federal securities laws of participants in IPOs, see Liability under the Federal Securities Laws for Securities Offerings and Liability for Securities Offerings Checklist.
The SEC staff may, nonetheless, ask for the company's basis for a statement of belief. When responding to such comments, the company should carefully review how the statement of belief is phrased and provide support where possible, as in this example:
"Please tell us the basis for your belief that your company is 'the only service available which is a patented methodology to effectively safeguard an individual's personal rights.'" (SEC Comment Letter to Right of Reply Ltd (Nov. 27, 2017), Comment #2).
"We have amended our disclosure to state that the Company is "one of the only..." in lieu of "the only...". We have also attached as Exhibits A and B to this letter opinions of counsel for the Company which we believe supports the statement highlighted in your comment." (Response to SEC Comment Letter to Right of Reply Ltd. (Jan. 3, 2018), Response #2).
The SEC staff will also typically ask the company to provide copies of all sources cited in the prospectus:
"Please supplementally provide the report by the National Institute of Health Research in the United Kingdom referred to in this section." (SEC Comment Letter to OncoGenex Pharmaceuticals, Inc. (May 17, 2017), Comment #7).
"Please provide us with supplemental support for the factual assertions made throughout your prospectus. To the extent you do not have independent support for a statement, please revise the language to clarify the basis for the statement. In addition, to the extent that some of these statements are intended to be qualified to your belief, please revise your disclosure to state the basis, to the extent material, for your belief." (SEC Comment Letter to FTS International, Inc. (Jan. 31, 2017), Comment #7).
To facilitate a timely response, you should prepare copies of all relevant third-party reports in advance and clearly highlight the relevant portions of the reports that support the statements included in the prospectus. Third-party reports and other supplemental information submitted in response to SEC staff comments are generally not filed on EDGAR and thus will not be made publicly available.
Rule 436 under the Securities Act (17 CFR 230.436) requires that the written consent of any expert (e.g., the issuer's independent auditor) or counsel whose report is quoted or summarized in the prospectus be filed as an exhibit to the registration statement. Here are some examples of this type of comment:
"We note your response to comment 5 and your revised disclosure on page 12. It appears that this disclosure is being attributed to Savills PLC. Please provide an analysis as to why this third-party attributed disclosure is not expertized disclosure requiring a consent. Refer to Rule 436 of the Securities Act and Securities Act Compliance and Disclosure Interpretation Question 233.02." (SEC Comment Letter to Majulah Investment, Inc. (Oct. 23, 2017), Comment #2).
"We note your disclosure throughout that Egan-Jones has rated the CM Loan at "A+" and that you have rated the loan an "A." Please file the consent for the Egan-Jones Ratings Company, as required by Securities Act Rule 436. Alternatively, please remove the references to the credit rating. For further guidance, please consider our Securities Act Rules Compliance and Disclosure Interpretations Questions 233.04 and 233.05." (SEC Comment Letter to Korth Direct Mortgage, LLC (Sep. 8, 2017), Comment #13).
"We note references throughout your prospectus to third-party sources, such as Notch Consulting and ACT Research, for statistical, qualitative and comparative statements contained in your prospectus. Please provide us with copies of any materials that support third-party statements, appropriately marked to highlight the sections relied upon. Please also tell us if any reports were commissioned by you for use in connection with this registration statement and, if so, please file the consent as an exhibit. See Rule 436 of Regulation C of the Securities Act of 1933." (SEC Comment Letter to PQ Group Holdings Inc. (Jul. 7, 2017), Comment #4).
The SEC staff will not require a consent when the prospectus cites a publicly available report, but will require a consent when the report or other information was prepared by a third party at the company's request. Third parties may be reluctant to be deemed to be "experts" because experts are subject to liability under Section 11 of the Securities Act for any material misrepresentations in or omissions from their reports or other information included in the prospectus. Therefore, before filing your client's initial registration statement, you should determine whether any third-party information included in the prospectus will require a consent and whether the third party(ies) would be willing to deliver a consent.
If the company believes that an expert's consent is not required, it should explain its position in its response to the SEC:
"We note your reference to a study commissioned by you and conducted by Millward Brown regarding your brand awareness among women in the United States. Please file the consent of the named researchers as an exhibit to your registration statement or provide us with your analysis as to why you do not believe you are required to do so. Refer to Rule 436 under the Securities Act." (SEC Comment Letter to Stitch Fix, Inc. (Nov. 1, 2017), Comment #2).
"The Company respectfully submits that Millward Brown is not an "expert" under Rule 436. Rule 436 requires that a consent be filed if any portion of a report or opinion of an expert is quoted or summarized as such in a registration statement. Section 7 of the Securities Act of 1933, as amended, provides that an expert is "any accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him." The Company respectfully submits that Millward Brown, the third party provider of this study, is not among the class of persons subject to Section 7 and Rule 436 as "experts" unless the Company expressly identifies such provider as an expert or the statements are purported to be made on the authority of such provider as an "expert." Accordingly, the Company believes that Millward Brown should not be considered an "expert" within the meaning of Rule 436 and the federal securities laws.
In addition, the Company notes that the consent requirements of Section 7 and Rule 436 are generally directed at circumstances in which an issuer has engaged a third party expert or counsel to prepare a valuation, opinion or other report specifically for use in connection with a registration statement. The information from this study included in the Amended Registration Statement was not prepared in connection with the Registration Statement or the Amended Registration Statement. In fact, the study was commissioned in November 2016, at which time the methodology, study details, key deliverables and price were set. As a result of the foregoing, the Company respectfully submits that the third party provider of this study is not an expert of the kind whose consent is required to be filed pursuant to Rule 436." (Response to SEC Comment Letter to Stitch Fix, Inc. (Nov. 6, 2017), Response #2).
In the example above, the company, through its outside counsel, responded to the SEC staff's comment citing the applicable rules to explain why an expert's consent was not needed.To view the full article click here
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