HOW IS AN S-1 LIKE AN INSURANCE POLICY?

There are two types of regulatory standards in the United States for the sale of securities.– The Merit system and the Disclosure system.

The Merit system is in place for most of the 50 states (yes, yourhttp://www.gopublic.com IPO does need to be cleared in every state in which you sell!). The merit system seeks the answer to the question: Is this a safe deal for investors of our state, and if not safe, how can it be modified to protect them?  In the State of California, for example, offerings which are not deemed to be of high value will have offering restrictions imposed, such as limiting the offering to person with high income or net worth requirements.

Federally, the SEC adheres to a disclosure standard. The Prospectus (the part of the S-1 which is given to investors) has to be truthful. It must disclose all “material” facts, and not omit facts which a reasonable investor would consider “material.” If your Prospectus omits a material fact, any purchaser can ask for his money back, and the company and its officers and directors could be subject to personal liability and even criminal penalties.

On the other hand, if a company sets forth, fully and honestly, the potential for problems to occur, and one of those problems does come to pass, the company and its directors and officers will not be liable. The Prospectus becomes their insurance policy.

If a company follows the disclosure guidelines in the S-1 rules, it will disclose most, but not necessarily all, of the material facts. Part of assuring “full and fair disclosure” in going public is having an outsider’s expert eye to look for material issues that investors should be aware of.

A very important part of the Prospectus is the Risk Factor section. This section contains a series of paragraphs that explain what could go wrong with the particular company. These are key to outlining the material risks.

A company which is developing a new drug, for example, must set forth in the Prospectus the procedures it must follow in order to obtain approval from the FDA, how long it might take, the specific special obstacles relevant to that drug and what would happen if the FDA did not approve. For example, imagine a company which is in Phase III (human) trials for a lung cancer drug. Just before effectiveness of the S-1, one of the doctors in the Phase II trials tells the Company’s chief scientific officer that some of her lung cancer patients taking the drug suffer strokes. The doctor believes that those patients did not have medical conditions that would make them at risk for having strokes. The chief scientific officer tells the Board of Directors of this issue, but the S-1 does not include this problem. The IPO goes ahead with this error.

Nine months after the S-1 is effective, Phase III trials are halted because so many patients are having strokes. The company and its directors and officer are liable.