Chapter 17 - § 17.2 • NEW OBLIGATIONS ON COMPLETION OF INITIAL PUBLIC OFFERING

• Jurisdiction: Colorado

§ 17.2 • NEW OBLIGATIONS ON COMPLETION OF INITIAL PUBLIC OFFERING

Completion of the first public securities offering imposes many new obligations upon the corporation, its officers, directors, and principal shareholders. Management and shareholders of most private companies have been accustomed to informal methods of operation, leaving legal considerations for the most part to counsel. The public offering, however, brings with it a number of legal duties, the violation of which — even if unintentional — may expose management and the principal shareholders, as well as the company, to both the Securities and Exchange Commission and state administrative sanctions, potential criminal liabilities, and potential civil liabilities to third parties.

§ 17.2.1—Duty To Disclose Material Information

One of the principal purposes of the federal securities laws is to protect the investing public by securing full disclosure of corporate information. Any corporation that has just gone public has already undergone one of the major exercises in disclosure — registration under the 1933 Act. In § 409 of the Sarbanes-Oxley Act of 2002, Congress added § 13(1) to the 1934 Act to require issuers to make rapid and current disclosure of material information as follows:

(1) Real time issuer disclosures. Each issuer reporting under section 13(a) or 15(d) shall disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English, which may include trend and qualitative information and graphic presentations, as the Commission determines, by rule, is necessary or useful for the protection of investors and in the public interest.

In Rule 13a-20,¹⁶ the SEC requires that disclosure be in "plain English," and then proceeds to define plain English similarly to 1933 Act Rule 421. Although the requirement under the 1934 Act only specifically applies to certain items, the SEC staff has routinely objected to any 1934 Act disclosure not considered to be sufficiently clear.

The case of In re Merck & Co., Inc. Securities Litigation¹⁷ shows the benefits of making disclosure. Merck made disclosure of certain accounting practices in a registration statement two months prior to a precipitous decline in its stock price. The decline was apparently caused by a newspaper article analyzing the magnitude of the effect of the accounting practice on Merck's reported earnings. Although the court found that the disclosure in the registration statement was "minimal" and "opaque in revealing the effect of the accounting practice," it was sufficient to protect Merck from liability — because (in part) the disclosure stood for two months without impacting the market and was, therefore, immaterial. Had the time period between the disclosure and market reaction been shorter, the court might have reached a different conclusion.

§ 17.2.2—Amending The Prospectus

The 1933 Act requires securities dealers to deliver a prospectus to purchasers of securities in the initial issuance or in secondary transactions during a defined period following the effective date. The underwriting agreement generally requires the registrant to amend or supplement the prospectus to reflect any material changes in the information contained therein that occur during the offering period.

A company should generally try to avoid actions during the offering period that would result in a change in any information contained in the prospectus (except actions contemplated by the prospectus) unless it is prepared to pay the expense of preparing, clearing, printing, filing, and distributing a supplement to the prospectus.

That is, of course, easier to say than for a company engaged in business operations to accomplish. Thus, companies need to be prepared to amend the prospectus when events require. As discussed in Chapter 3, when the issuer has used a registration statement on Form S-3, each 1934 Act report filed acts to update the prospectus, since they are incorporated into the prospectus by reference.

§ 17.2.3—Continuing Obligations

The duty of disclosure does not stop with the prospectus. As a publicly held company, the company now has an important obligation to make timely disclosure of material developments. It is a continuing obligation that the company must be very careful to fulfill. The obligation of public disclosure may stem from listing on a stock exchange if the company's securities should become listed on an exchange (such as NASDAQ), or simply good corporate practice. For example, NASDAQ IM-5250-1¹⁸ provides, in part:

Rule 5250(b)(1) requires that, except in unusual circumstances, Nasdaq Companies disclose promptly to the public through any Regulation FD compliant method (or combination of methods) of disclosure any material information that would reasonably be expected to affect the value of their securities or influence investors' decisions.

Rule 401(a) of the American Stock Exchange Company Guide is similar. In all cases, company news releases must not contain material misrepresentations or omissions. The company must strive for accuracy, completeness, and balance; news releases by the company should not be treated as commercial advertising.

§ 17.2.4—What Is Material?

Of course, the disclosure obligation does not extend to every detail of the company's business. It does, however, extend to all information that is "material" from the viewpoint of the investing public. Deciding what is material is sometimes a difficult matter of judgment, and "may be characterized as a mixed question of law and fact. . . . The determination requires delicate assessments of the inferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those inferences to him, and these assessments are peculiarly ones for the trier of fact."¹⁹

In Staff Accounting Bulletin 99 (Aug. 12, 1999), the staff advised that "registrants and their auditors should not rely exclusively on quantitative benchmarks to determine whether an item is material to the financial statements." Qualitative, subjective issues are relevant to any determination of materiality. See § 14.11, "The Concept of Materiality," for a more detailed discussion of "materiality."

Although it is not possible to prepare a definitive list, the following kinds of information may be considered material: mergers; stock split or dividend; unusual earnings or dividends; acquisition or loss of a significant contract; a significant new product or discovery; change in control or significant change in management; purchase or sale of a significant asset; a significant labor dispute; establishment of a share repurchase program; a tender offer; or any 1934 Act reportable event.

In addition to the pre-existing requirements for disclosure, the Sarbanes-Oxley Act (SOA) added several requirements that impact corporate disclosure:

• 15 U.S.C. § 7266(a) (added by SOA) requires the SEC to conduct a regular and systematic review of disclosures made by certain classes of corporations.
• In response to the requirements of 15 U.S.C. § 7241(a) (added by SOA), the SEC adopted Item 307 to Regulation S-K. This requires that the principal executive officer and the principal financial officer review the company's disclosure controls and reach conclusions regarding their effectiveness to ensure that material information is brought to the attention of the appropriate officers within a time frame necessary to make appropriate disclosure. Clearly, this includes disclosure of environmental issues. SEC Rule 13a-14(a) requires that the principal executive officer and the principal financial officer certify as to the effectiveness of these disclosure controls on each annual report (Form 10-K) and quarterly report (Form 10-Q) filed with the SEC. See Exhibit 31, Item 601, of Regulation S-K.
• Finally, 18 U.S.C. § 1350 (implemented by SEC Rule 13a-14(b)) requires a second certification by the chief executive and financial officers. This certification, which carries criminal penalties if wrong, requires the chief executive officer and the chief financial officer to certify that the financial statements contained in a periodic report filed with the SEC "fairly presents, in all material respects, the financial condition and results of operations of the issuer." See Exhibit 32, Item 601, of Regulations S-K and S-B.

§ 17.2.5—When Should Disclosure Be Made?

As a general rule, material information should be disclosed as promptly as is practicable. As discussed above, pursuant to § 13(1) of the 1934 Act (added by § 409 of Sarbanes-Oxley), issuers must disclosure material information to the public "on a rapid and continuous basis." This does not mean the company must maintain a continuous output of raw data, or must disclose speculative or unripe...