For any new offering of securities, a corporation must file a registration statement with the SEC that contains the following information:
- A description of the corporation.
- A concise biography of the officers and directors of the corporation.
- Financial stakes of all insiders, the directors and officers (control persons) in the corporation, and a list of anyone holding more than 10% of the corporation’s securities.
- Complete financial statements.
- What securities are being offered for sale, and how will the money be used.
- Any legal proceedings that may have a material impact on the company.
The SEC will review the registration to be sure that everything is in compliance with the law, and that there is full disclosure. If it is, then the SEC will approve the registration, and allow the company to sell its securities on a specified date—the effective date. However, SEC approval is not an endorsement of the issue, but only that there has been proper disclosure.
If there is any problem with the registration, then the SEC will send a deficiency letter to remedy the problem. Generally, the underwriting manager handles the deficiency letters quickly, because deficiency letters delay the effective date. No securities can be sold or even offered for sale before the effective date.
The time between filing and the effective date is known as the cooling-off period. During this time, no reports, recommendations, or sales literature may be sent to anyone. The underwriters may, however, send a preliminary prospectus—often called a red herring, because of the red lettering on the title page—that provides potential investors with all the necessary information that an investor would need to make an intelligent decision, which includes a description of the company and its business, income statement and balance sheets, any pending events that could have an impact on the business, such as mergers or acquisitions, its competition, and the agencies that regulate it. What it does not contain, however, is the public offering price of the new securities and the effective date for the sale, since the effective date would not yet be known.
A preliminary prospectus is published to generate and gauge interest among investors in the new securities, but it cannot offer them for sale until the registration has been approved by the SEC. The indication of interest will be used by the investment bank to price the new securities.
SEC Rule 134 does permit 1 other type of publication during the cooling-off period—the tombstone ad. The tombstone ad must be clear that it is an announcement only, and not an offer to sell nor a solicitation to buy.
Blue Sky Registration
The new securities must also be registered in each state in which they will be offered for sale. There are 3 types of state registration: notification, coordination, and qualification.
- Notification (aka filing) registration is the filing of an offering document with certain disclosures. This is available in most states. However, this filing type is available only to those issuers who have been in continuous operation over the past 3 years with a specified amount of earnings. If there are no problems, then the state registration becomes effective on the effective date of the SEC registration.
- Coordination registration is the automatic registration in some states on the effective date of the SEC registration.
- Qualification registration, available in all states, has greater requirements for state registration, and the registration for that state does not become effective until the State Administrator approves it. This method is used only when the other methods are not available, especially when the issuer does not qualify for a notification registration.
Due Diligence Meeting
Before the effective date of registration, the investment bankers meet with the corporate officers. The purpose of this due diligence meeting is to discuss:
- whether all materials facts that have been sent to the SEC are true and remain true since the filing of the registration;
- has there been any other developments since the filing of the registration that would have a material impact upon the corporation;
- any changes to be made in the final prospectus. However, the public offering price is not set—that will occur on the effective date.
The importance of this meeting is underscored by the liability that both corporate officers and investment bankers will be exposed to if there have been any material omissions or errors in the SEC registration, for they will have to sign the final registration before it can become effective.
The prospectus is a short form of the SEC registration, containing only those facts necessary for an investor to make an intelligent decision regarding the issue. It can only be distributed after the effective date of SEC registration.
The final prospectus must be published and sent to each investor no later than the confirmation date of the purchase. The final prospectus will have the price of the new securities, the underwriters’ discount, and any requirements specified by the SEC in approving the registration. The final prospectus will also contain the latest financial information about the company.
The price of the new securities is decided when the registration is approved, but if market conditions or lack of interest lower the marketable price sufficiently, the underwriting may be postponed or even canceled. The SEC requires that any prospectus that is more than 9 months old must not have any financial information that is more than 16 months old. If there is any event during the distribution of the prospectus that could have a material impact on the company, then the prospectus must be amended to reflect the new developments. In the past, this has been done by stickering, actually pasting a new page on top of the obsolete material. Nowadays, however, with prospectuses in electronic format, the new material can be added, and the obsolete material can be amended or deleted directly.
When the new issue of securities is a first-time sale of stock by a company, it is called an initial public offering (IPO), or going public. This allows the founders and venture capitalists who invested in the company to profit from their investment.
90-Day Rule for IPOs
Before a company goes public, most of its financial information is confidential and has not been published. Therefore, the SEC requires that a prospectus be available for at least 90 days after the effective date to provide financial information. After 90 days, the company will have posted its 1st required financial statements with the SEC, which any investor can examined for the latest financial information about the company.
40-Day Rule for New Issues
A new issue is any offering of new issues of stock that is not an IPO. In this case, the company will have already filed periodic financial statements with the SEC, so the SEC requires that a prospectus for the new offering has to be available for at least 40 days after the effective date of the new issue.
25-Day Rule for Exchange traded Issues
If the new issue is going to be traded on a public stock exchange, then a prospectus must be available for at least 25 days after the effective date.
Public Distribution of New Issues
All members of the underwriting syndicate must make a bona fide public distribution of the new issue at the public offering price.
Usually, the underwriting syndicate members will accept a small percentage of orders over their allotment, because they know that some clients will cancel their order before delivery. Therefore, the underwriting manager will distribute more new issues to each syndicate member than they are required to sell—an overallotment. If fewer clients cancel than expected, then either the issuer will issue more shares to cover the additional sales—and get more money—or the underwriting syndicate will have to go short to cover the additional sales, which is a risk to the underwriting members, and will have to buy it back, probably at a higher price, in the secondary market to cover their shorts.
When a new issue doesn’t sell as well as expected, then initial investors may sell their shares in the secondary market for less than the public offering price while the syndicate members still have shares to sell. However, the underwriting syndicate cannot sell the shares for less than the public offering price, so, in this situation, they would not be able to sell their remaining shares.
To prevent a drop in price before all shares have been distributed to the public, the underwriting manager stands ready to buy any issues offered in the secondary market at or slightly below—but never above—the public offering price as a way to stabilize (aka peg, fix) the price of the new offering until it has been fully distributed to the public. Price-fixing is generally illegal, but is allowable in the distribution of new issues by Rule 104 of the Securities Exchange Act of 1934, but only until all shares have been publicly distributed—pegging the price afterward is against the law.
Stabilization may not work. The underwriting syndicate may be unable to sell all of the shares at the public offering price, in which case, they will have to take the loss.
Syndicate Penalty Bid
To stabilize the new issue, the underwriting manager buys the stock back at or near the public offering price. If the manager buys the stock back from a client of a syndicate member, then the manager has already paid or credited the syndicate member its underwriter’s allowance. The syndicate penalty bid takes this money back from the syndicate member during the stabilization period, because the underwriting manager will have to re-sell those shares.
Shelf Registration — SEC Rule 415
If, after the IPO, a company wants to issue and sell more new securities, it would have to go through the same basic procedure as the IPO, but with some differences. First, the price of the new securities would be determined by the current market price of the securities that are already being bought and sold in the secondary market. Secondly, the new prospectus would not have to be as detailed, because the public company must publish financial reports continually, and file those reports with the SEC.
In the 1980’s, the SEC adopted Rule 415, which allowed public companies to register new securities, but then shelve the public offering for up to 2 years. Thus, the company can make a public offering when the company needs the money, or market conditions are favorable, with a minimum of expense and effort.
SEC Rule 144 — Private Placement Market
Companies that are too small or risky for an IPO can get financing through private placements, which is also cheaper and faster than a public offering. SEC Rule 144 governs private placement transactions.
A private placement is the selling of unregistered securities, either stocks or bonds, to qualified institutional investors—investment companies, pension funds, and insurance companies, especially life insurance companies. The cost of a private placement is much less than a public offering, because the securities do not have to be registered with the SEC, the issuer does not have to comply with U.S. generally accepted accounting principles, and because there are usually only a few institutional investors involved, marketing costs are much less.
The SEC enacted Regulation D in 1982 which defines a qualified institutional investor as one who can understand, or can employ those who understand, the return and the risk of securities, and can bear the risks.
However, the purchaser of a private placement must sign a letter of intent, called an investment letter, which states that the securities are being bought for investment and not for resale. Thus, these securities are often called letter securities, or in the case of bonds,letter bonds. If the letter securities are stocks, then they may be called letter stocks, or 144 stocks.
Although the issuer does not have to give a prospectus to buyers in a private placement, it still must furnish information that the SEC deems material in the form of a private placement memorandum to potential investors. Unlike a prospectus, though, the SEC does not review the memorandum. Because there are usually few investors in any given private placement, the investors can negotiate the characteristics of the issue, giving them more flexibility than they would have in a public offering.
Letter securities cannot be resold for 2 years (1 year if more onerous conditions are met), and when they are, it must be a regular brokerage transaction.
Most private placement bonds are not investment grade, and because they were privately placed, they can’t be resold to the public unless they are first registered with the SEC. Thus, they generally pay a higher interest rate compared to other securities of comparable terms.
An investment banker can tailor private placements for their institutional customers.
SEC Rule 144A — Increasing Liquidity and Foreign Investment, and Domestic Issuance of Foreign Securities
Previously, investors who bought private-placement securities could not resell them for 2 years. This cost issuers more because they had to pay a higher yield to compensate investors for the illiquidity of their purchase. In April, 1990, the SEC enacted Rule 144A, which allowed institutional investors to trade the investments among themselves at any time, and without having to register the securities. This not only lowered the cost of raising funds by the issuer, but it also increased foreign investment, which increased the supply of money, and thereby reduced its cost even more. Rule 144A offerings are underwritten by investment bankers.
Rule 144A also enhanced the domestic issuance of securities for foreign issuers, primarily because it eliminated the need to register the securities, thereby saving time and expense.
Rule 415 — Delayed or Continuous Offering and Sale of Securities — the actual legal text of Rule 415 — Delayed or Continuous Offering and Sale of Securities.