With the SEC's Securities Offering Reforms in December 2005 came a new tool for offering securities: the free writing prospectus. No longer would an issuer be required to satisfy all of the form requirements of Regulation C under the Securities Act of 1933 (the "Securities Act"), as required when using a prospectus supplement or preliminary pricing supplement. The free writing prospectus ("FWP") was designed to allow more flexibility for issuers and underwriters.
When first introduced, it was generally accepted that the point of the FWP was to address the need for disclosures that didn't neatly fit into, or require, a full prospectus meeting all of the SEC's form requirements. Prior to December 2005, these types of disclosures were known as "free writings," and permissible uses were extremely limited.
The new FWP allowed for free writings, within the provisions of Rule 433 under the Securities Act. For example, a brief FWP might be filed to add some small piece of new material information that had come up after the initial filing of the preliminary pricing supplement, or to correct an error. In the context of a medium-term note program using a shelf registration statement, a one-page FWP could be used without filing if it contained only the preliminary terms of an offering, and another one-page FWP could be filed with the final terms of the offering. These FWPs would be delivered with the underlying base prospectus and any prospectus supplement and preliminary pricing supplement. In each case, the FWP would not have to satisfy the requirements of Regulation S-K Items 501-509, but instead meet the requirements of Rule 433. Provided that the FWP contained the required legend under Rule 433(c)(2)(i), the form and content of the FWP were essentially wide open, as compared to a preliminary pricing supplement. In practice, FWPs used in offerings of structured notes tend to look suspiciously like preliminary pricing supplements, generally meeting the Regulation S-K requirements to the letter.
FWPs are very important for offerings of structured notes. In addition to the underlying base prospectus, prospectus or product supplement (if any) and preliminary pricing supplement, distribution participants will also use fact cards for a particular offering, or even materials not related to any particular security. For example, if an affiliate of an issuer or underwriter is the administrator of a proprietary index underlying the issuer's structured note, there may be explanatory materials about the index (which may include backtesting) that the underwriter or dealer may use in conjunction with the securities-related offering materials. Depending on how these materials are used, a regulator could deem these to be FWPs.
Issuers and underwriters, particularly affiliated underwriters, may also produce generic materials describing particular structures, or even "educational" materials, designed to be provided to investors and used as part of a structured notes offering program, even though the materials do not relate to any particular security. Again, depending on how these materials are used, they could, in hindsight, be viewed as FWPs.
But pity the poor underwriter that wants to use a FWP. With the flexible disclosure option came liability. Underwriters using a FWP are subject to liability under Section 12(a)(2) of the Securities Act. Under Rule 159A(b)(1) under the Securities Act, it is difficult for an underwriter using a FWP to escape liability under Section 12(a)(2) of the Securities Act if the FWP contains a misstatement or omission.
That section reads:
Definition of by Means of for Purposes of Section 12(a)(2) of the Act. (1) For purposes of section 12(a)(2) of the Act only, an offering participant other than the issuer shall not be considered to offer or sell securities that are the subject of a registration statement by means of a free writing prospectus as to a purchaser unless one or more of the following circumstances shall exist:
- The offering participant used or referred to the free writing prospectus in offering or selling the securities to the purchaser;
- The offering participant offered or sold securities to the purchaser and participated in planning for the use of the free writing prospectus by one or more other offering participants and such free writing prospectus was used or referred to in offering or selling securities to the purchaser by one or more of such other offering participants; or
- The offering participant was required to file the free writing prospectus pursuant to the conditions to use in Rule 433. [Emphasis added.]
In short, under the Rule 159A liability scheme, an underwriter that "uses or refers to" a FWP or "participates in the planning for the use of the FWP" in an offering with other offering participants will be liable under Section 12(a)(2) of the Securities Act if the FWP contains a material misstatement or omission.
For issuers, Rule 159A fastens liability by stating that any free writing prospectus "prepared by or on behalf of the issuer or used or referred to by the issuer" causes the issuer to be a "seller" for purposes of liability under Section 12(a)(2) of the Securities Act in an initial distribution of the securities. The note to Rule 159A(a) states that "information is provided or a communication is made by or on behalf of an issuer if an issuer or an agent or representative of the issuer authorizes or approves the information or communication before its provision or use."
These provisions raised many questions:
- For an issuer, where does "authorize or approve" begin and end?
- For underwriters, what does "used or referred to" mean?
- For underwriters, what constitutes "participated in planning for the use of the FWP"?
Issuers and underwriters regularly review each other's communications to investors, generally for the purpose of correcting errors and improving clarity. During this process, there are multiple communications between issuers and underwriters, with multiple drafts of the communication being improved along the way.
Rather than engage in hair-splitting about whether any activities fall into the Rule 159A liability traps, issuers and underwriters developed several practical responses to these questions, all for the purpose of establishing ownership of the FWP.
In underwriting and distribution agreements, issuers and underwriters generally agree that only the issuer will create an issuer free writing prospectus, to be approved by the lead underwriter. In the case of distribution agreements used in structured notes offerings, the issuer creates the issuer free writing prospectus and its affiliated broker-dealer approves the form before use. In dealer agreements between an underwriter and a downstream selected dealer, generally the downstream dealer will be prohibited from creating FWPs. If a downstream dealer has the ability to create FWPs, it will indemnify the underwriter for claims arising from those FWPs.
Liability is also somewhat limited by the practice of conforming structured notes FWPs to the form requirements of Regulation S-K.
ISSUER FWP OR UNDERWRITER FWP?
These provisions prevent the creation of a FWP whose paternity may be disputed. However, these provisions do not clarify who is liable for the agreed-upon FWP when one or both parties have reviewed, commented on, approved and used the FWP.
The solution to this problem is to have the issuer take ownership by filing the FWP as an "issuer free writing prospectus" in almost every situation.1 This is the case even though there may be a clear exemption from filing for some FWPs or the FWP may have been originated by the broker-dealer affiliate of the issuer. This also comports with the general theme of allocation of liability in underwriting agreements – the issuer is getting the most benefit from the offering, and therefore should bear a proportionately larger part of the potential liability.
Even though Rule 433(d)(5)(i) provides an exemption from filing for FWPs that do not contain the final terms of an offering, market practice is that a structured notes issuer using a FWP within this exemption from filing instead of a preliminary pricing supplement will file the FWP as an issuer free writing prospectus. An agreement by an issuer to file a FWP will be built into the terms of a distribution agreement for structured products. Why would an issuer do so when there is a clear filing exemption available?
When Rule 433 was adopted, there were some open questions for which practitioners didn't have easy answers. For example, if an underwriter or two had their names on the bottom of a FWP for an issuer's offering, would that make that FWP an "underwriter free writing prospectus," for which the underwriters would take liability, instead of the issuer? The filing requirement in Rule 433(d)(1)(ii) states that "any offering participant, other than the issuer, shall file any free writing prospectus that is used or referred to by such offering participant and distributed by or on behalf of such person in a manner reasonably designed to lead to its broad unrestricted dissemination." A FWP used in any offering of securities would have a broad unrestricted dissemination. Most underwriters are not, and do not want to be, SEC filers.
Another question was whether a FWP created by an underwriter affiliated with an issuer for an offering of the issuer's securities would be viewed as an underwriter free writing prospectus or an issuer free writing prospectus.
By filing FWPs as issuer free writing prospectuses, any named underwriter escapes the Rule 433(d)(1)(ii) filing requirement and also the related FINRA Rule 2210(c)(7)(f) filing requirement. Representatives of FINRA have also stated in public forums that FINRA would not view an issuer free writing prospectus as "belonging" to an affiliated underwriter, and thus being a underwriter free writing prospectus, even though the FWP originated on the affiliated underwriter's desk. That is helpful because even though issuer free writing prospectuses filed with the SEC are carved out of FINRA's filing requirements for retail communications under Rule 2210(c)(7)(F), FWPs that are exempt from SEC filing (such as under Rule 433(d)(5)(i)), and underwriter free writing prospectuses are subject to FINRA's filing requirements. Any FWP that contains backtested data and is filed as an issuer free writing prospectus would also not be subject to FINRA's prohibitions of the use of such data in retail communications.
Originally published in REVERSEInquiries Volume 2, Issue 5.
1. See Rule 433(h)(1); issuer FWPs are required to be filed under Rule 433(d)(1)(i).
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