The Primary Market

Question 1

Which law regulates the new issue of securities?

Answer 1

The Securities Act of 1933.

Question 2

Which securites law was first to require a prospectus and register with the SEC before securities could be sold to the public?

Answer 2

Securities Act of 1933

Question 3

What things does the Securities act of 1933 require in order to protect customers?

Answer 3

• Any security is going to be distributed in more than one state, will be regulated under the 1933 act and requires securities registration and a prospectus
• The wording in the law is that comanies must provide full disclosure to investors
• created the regulatory body for securities in the primary and secondary markets
• For the first time, defined criminal penalties in the event of securities fraud.

Question 4

The Act of 1933 requires a registration statment to be made to the SEC. What must this registration statement contain?

Answer 4

• Anyone who owns 10% or more of the company must be identified.
• How the capital the firm is raising will be used
• Any outstanding legal cases pending agains the company
• The names and addresses of company officers and directors
• Compensation and a 5 year business history of officers and directors. Usually this is just a list of prior employers.
• The amount and structure of the companies current capitalizaton.

Question 5

What are “blue sky” laws?

Answer 5

Since securities offered only in one state are exempt from the full registration under the securities act of 1933, the blue sky laws are state security laws. They are called blue sky since they are exempt from the full scrutiny of the Act of 1933, securities registered only in one state made inflated claims about their business prospects.

Question 6

What are the three phases of taking a company public as described in the Securities Act of 1933?

Answer 6

1. Registration phase
2. Cooling off phase
3. Due Diligence phase

Question 7

Does the SEC approve the registration document filed during the registration phase?

Answer 7

Actually No.

In fact, the law specifically mentions that the SEC will neither approve or disapprove of the filing but only review for appropriate disclosures such that an investor could make an informed decision on the company.

Question 8

What is a “tombstone”?

Answer 8

The Act of ‘33 prohibits solicitation for sales during the cooling off period after the initial registration.

However, a so called “tombstone” ad listing all the broker dealers involved in the transaction could be placed in newspapers indicating the security is coming to market

It is called a tombstone because the way the names line up of the broker dealers in the ad, it has the appearance of names on a tombstone.

Question 9

What is the cooling off phase?

Answer 9

After the initial registration under the Act of ‘33, there is a minimum period of 20 days where no solicitations can be made other than tombstone ads but could extend to longer periods if the SEC requires changes to the original filing.

Question 10

In which phase can a “red herring” be issued?

Answer 10

During the underwriting process, after the initial filing and during the cooling off period, the issuer can create a so-called red herring.

The red herring is another name for preliminary prospectus and is another and is another way for broker dealers to guage interest in the issue.

When someone responds to the tombstone ad, the red herring is what the broker dealer will provide with them. So: First tombston ad, investor replies, preliminary prospectus is sent.

There is one important thing missing from a red herring: It won’t contain the IPO price.

Question 11

What is permitted and prohibited during the cooling off period?

Answer 11

• Prohibited
  
  • No solicitations for orders
  • Cannot send out advertising material other than the red herring.
• Permitted
  
  • Respond to indications of interest
  • Publish tombstone ads

Question 12

What is permitted during the due diligence phase?

Answer 12

The cooling off period is sometimes called the road show because bankers can hold meetings about the upcoming issue.

During this time, alot more detail can be discussed including how the issuer is going to use the money, any new legal matters, but more importantly this is the first discussion of pricing.

Question 13

What are the requirements of each investment bank involved in the issue during the cooling off period?

Answer 13

• The bankers must make a judgement on the company as a whole and verify the feasability of the claims made by the issuer
• They are providing feedback to the issuer about pricing and demand for the issue.

Question 14

What is the final prospectus called and what does it contain?

Answer 14

This is the statutory prospectus and will contain the final offering price as well as the spread the banks are earning for underwriting the issue.

It will also include:

• History of the business and a statment about the perceived riskiness of the issue
• The offering price
• Offering Date
• A legal opinion declaring the corporation is, in fact, registered as a corporate entity and has the authority to issue securities.
• It will also include ways the underwriters can halt the fall in price on the day of the IPO. Mostly this means using bank capital to support the price of the IPO

Question 15

What is the intent of the SEC’s no approval clause printed on the first page of a prospectus?

Answer 15

Basically this absolves the SEC from any liability. It is very clear the SEC is not guaranteeing the accuracy of anything and is not recommending or approving the security in any way.

Question 16

What is the role of the investment banker during the underwritting proces

Answer 16

First and foremost the banks actually buy the stock from the issuing corporation so if you buy an IPO, you are buying it from the banks and not the issuer themselves.

Banks also perform an important advisory role in determing captial mix between debt and equity issuance because of their secondary marke knowledge

Banks also distribute large blocks of stock to institutions

Lastly there is the issue of complying with all the securities laws. The underwritter will make sure this happens and the company complies with all laws.

Question 17

What is the issuers role in the underwriting process?

Answer 17

• File registration statement - Required by Act of 1933
• File state level registrations - Blue Sky
• Negotiate the price of the shares sold to the investment banking underwriting group

Question 18

Define the “Chinese Wall” in Investment Banking

Answer 18

Typically an investment bank will a merchant/investment bank but also trading operations where those same securities issued by the bank will be also traded in the secondary market

The Chinese Wall is the prohibition against any contact between the investment banking side and the Broker-Dealer side of the firm as a way to prevent conflicts of interest.

Question 19

What three players comprise the selling syndicate?

Answer 19

1. Investment Bank
2. Selling Group
3. Underwriters

Question 20

What aspect of a new issue would increase the size of the selling group?

Answer 20

Very large deals that require large amounts of capital to bring to the market will typically have large selling groups to spread the risk around.

Question 21

How is the Selling Group distinct from the Selling syndicate?

Answer 21

Members of the selling syndicate put up bank capital to purchase the shares of the new issuer. Members of the selling group may assist in the distribution of shares by selling them to clients but they have no capital at risk.

Question 22

What is the total spread?

Answer 22

This is the difference between the public IPO price and the amount of that price the issuer will actually get.

The spread is divided among members of the syndicate as compensation for the risk they took and each member of the group gets a different amount.

Question 23

What is the management fee?

Answer 23

This goes to the banker on the deal and is paid on every share sold.

Question 24

What is the selling concession?

Answer 24

This goes to the member of the broker-dealer who sold the shares that was a member of the syndicate

If a syndicate member broker dealer needs to use non members broker dealers to sell the shares then that fee, called the reallowance, will be paid to the non member.

Question 25

What are the two types of security offerings?

Answer 25

Private placements and Public Offerings

Question 26

What are the key distinctions with private placements?

Answer 26

• Are generally exempt from all aspects of registration under the Act of 1933
• Tend to go directly to large asset managers or wealthy individuals as a large, bulk transaction
• There can be no advertisement of the transaction.

Question 27

What offering type is made up of new securities that are already publicly traded?

Answer 27

This is called an additional issue offering.

Question 28

What type of offering gives its proceeds directly to the issuer?

Answer 28

This is called a primary offering and is where the primary market gets its name. Think IPO where the cash raised goes to the company.

Question 29

In what type of offering do the proceeds go to existing shareholders?

Answer 29

This is called a secondary offering and occurs when a large holder of stock from the primary offering sells it to a second party.

Question 30

What is Rule 415?

Answer 30

This is called a Shelf Offering and allows an issuer to register a new security prior to selling out of the current issue, effectively keeping the offering on a shelf.

The shelf is open for two years without re-registration but does require a supplemental prospectus with each new sale.

Question 31

What are the two types of underwriting agreements?

Answer 31

• Firm Commitment
• Best Efforts

Question 32

What is the defining element of a firm commitment?

Answer 32

In this case the underwriter is guaranteeing a set proceeds to the issuer by commiting their own capital to buy the shares if they don’t sell during the underwriting process. This exposes the bank to the most risk.

Question 33

What type of underwriting is available during a rights offering?

Answer 33

If existing shareholders don’t purchase the new shares available during the rights offering, a Standby Underwriting commitment is made to buy the unsold new stock.

Since the issuer knows all the new stock will be sold, a standby commitment is a type of a firm commitment.

Question 34

Does a best efforts offering have more or less risk for the underwriter?

Answer 34

Best efforts carries less risk for the underwriter because they are commiting no capital or making no commitments on the amount of the sale.

Question 35

What are the Two Types of Best Efforts Underwriting?

Answer 35

• All or None
• Minimum Amount

All or none means the banker must secure the sale of the entire offering or the deal is called off. A best efforts minimum offering means there is some minimum threshold that must be sold for the offering to proceed.

Question 36

What are the 4 criteria for fairness when determining underwriting spreads?

Answer 36

There are no set rules that define how much bankers can earn in spread on a deal. The NASD has said these factors should be considered:

• The volatility of the business of the underwriter
• The Offering Size
• How safe or speculative the security is
• The type of commitment: Firm or Best Efforts

Question 37

What is the specific allocation of buy orders during the IPO?

Answer 37

• Pre - Sale
• Syndicate Members
• Designated Selling Members
• Other member orders

The order is important because a deal could be over-subsribed or over sold meaning some orders dont get filled and have to go to the secondary market - potentially paying a higher price.

Question 38

What are the two types of syndicate agreements can be set up?

Answer 38

• Eastern - This means syndicate members are responsible for unsold shares. Even if they sell all of their allocation. This exposes the syndicate members to additional risk
• Western - This is lower risk because each syndicate member is responsible for their own allocation.

Question 39

What securities are exempt from registration under the Act of 1933?

Answer 39

1. Any charitable or non-profit issue
2. Insurance policies
3. Short term issues less than 9 months or commercial paper
4. All Municipal securities are exempt
5. All U.S. Government securities are exempt from registraton.

Question 40

What criteria must be met before an issue is available for an Intrastate Offering?

Answer 40

• Intrastate offerings are exempt from the Act of 1933 because they are only offered in the issuers home state.
• Not only must a company sell only in the home state but also must get 80% of its income from the state.
• Can be sold outside the state after a 9 month restriction period.

Question 41

What criteria must be met before a company can offer a Regulation D offering?

Answer 41

• Also known as a private placement, this is offered to no more that 35 small investors
• Can have any number of accredited investors
• Selling regulation D stock is governed by Rule 144 - no sales in the first year, partial sales in the second year and no restrictions in the third year.

Note: There is a exemption from Rule 144 where shares can be sold to institutional buyers during the first year.

Question 42

Who are corporate insiders?

Answer 42

• Any single person owning more than 10% of a company or their spouses.
• Any officer or director of the company

Question 43

What rule governs the sale of Regulation D shares?

Answer 43

Rule 144 and the exceptions to the rule are called 144A

Question 44

After filing, how long is Form 144 effective for?

Answer 44

90 Days

Question 45

What stock is subject to Rule 144?

Answer 45

All resale of restricted stock falls under rule 144 in addition to control stock held by corporate outsiders. Restricted securities are limited to a two year holding period but control stock is not restricted to a two year holding period but does still fall under Rule 144

Question 46

What is the rule for how much restricted stock can be sold at any given time under Rule 144

Answer 46

The greater of these two can be sold:

1. The average weekly trading volume for the previous four weeks.
2. 1% of the oustanding shares

Note: it is important to remember this formula applies to Regulation D securities only in the second year after the holding period but control stock, while subject to the same volume of sales, has no holding period.