During an initial public offering (IPO), the issuer and underwriter must follow strict rules. Most of these rules come from the Securities Act of 1933, which governs the primary market.
In the early 1900s, financial markets were full of fraud, deceit, and manipulation - problems that helped set the stage for the Great Depression. To protect investors, Congress passed the Securities Act of 1933. The law requires issuers to fully disclose key information about any securities they plan to sell to the public.
Because the rules are detailed, issuers typically hire lawyers and accountants and rely heavily on their underwriter to help ensure compliance.
As we discussed previously, issuers hire underwriters to sell their securities to investors. The issuer and underwriter sign a contract that lays out:
After the contract is signed, the underwriter guides the issuer through the due diligence phase. The Securities Act of 1933 requires the issuer to disclose a significant amount of information to the public. To do that, the issuer completes and files the SEC’s registration form. This form requests information such as the company’s business history, details about officers and directors, and its current financial condition.
Specific items detailed in the registration form include:
Filing the registration form starts the 20-day “cooling off” period. During this time, the SEC reviews the filing to confirm it is complete. That review takes time, which is why the period lasts 20 days.
The SEC’s goal is to make sure the public has access to the required disclosures before any selling begins. As a result, during the cooling-off period the underwriter (and any other firm involved in the IPO) cannot:
In other words, sales activity is off-limits during this 20-day period.
Some activities are allowed during the cooling-off period. The information in the SEC registration form is compiled into a document called the prospectus. Investors use the prospectus to learn about the issuer and the security.
During the 20-day cooling-off period, the registration form is used to create a preliminary prospectus, which may be provided to potential investors on a solicited or unsolicited basis.
The preliminary prospectus is sometimes called a “red herring.” It remains preliminary until the SEC officially registers the security. The term ‘red herring’ comes from a message printed in red on the preliminary prospectus:
A Registration Statement relating to these securities has been filed with the Securities and Exchange Commission but has not yet become effective. Information contained herein is subject to completion or amendment. These securities may not be sold nor may offers to buy be accepted prior to the time the Registration Statement becomes effective.
In plain English: the preliminary prospectus may change because the SEC review is not finished.
It’s also important to understand what the SEC does not do. The SEC reviews the registration form for completeness, not accuracy, and it does not guarantee anything about the new issue. If an issuer lies or misleads investors in the registration form, the issuer (and any individuals involved) may face significant fines and sanctions. Jail time is also possible.
The SEC’s job is to determine whether the registration form is complete. If something is missing, the SEC sends a deficiency letter to the issuer identifying what must be added or corrected. This pauses the registration process until the missing information is submitted. The issuer must update the filing and re-file it with the SEC, which extends the timeline.
Part of the underwriter’s job is to price the new security. This is especially challenging with common stock, because its market value depends heavily on demand.
To estimate demand for the IPO, the underwriter may solicit or receive indications of interest from potential investors during the 20-day cooling-off period.
Indications are just indications - they are not binding on either party:
In order to notify the public of the new issue, a tombstone may be published. The term “tombstone” refers to the ad’s appearance (it resembles a tombstone).
Tombstones are typically published in newspapers and online outlets. They are the only form of advertising the SEC allows during the cooling-off period.
A tombstone contains factual information only. It cannot “pump up” the issue or recommend it.
Typical tombstone information
To summarize, here’s what can and cannot be done during the 20-day cooling-off period.
Legal during the 20-day cooling off period
Illegal during the 20-day cooling off period
After the SEC reviews a completed registration form, the SEC will register the security. At some point during the cooling-off period, an effective date is announced. The effective date is the first day the security may be legally sold to the public.
Once the registration becomes effective, the underwriter contacts customers who submitted indications of interest. If demand is high, the underwriter must decide which investors receive shares. There are few formal guidelines here, so underwriters often allocate shares to their most profitable customers.
A FINRA rule requires underwriters to avoid selling common stock IPOs to industry insiders. The purpose is to ensure the public has access to IPO shares. Without this rule, the underwriting syndicate could sell the issue to insiders and/or keep shares for themselves - especially when demand is high.
FINRA member firms (financial firms), their employees, and their immediate family members are considered restricted persons and are prohibited from purchasing common stock IPOs.
Immediate family members include parents, siblings, and children, plus anyone financially dependent on the industry insider. Some people use the “rule of 1” to remember this:
In-laws are also included. For example, a father-in-law or sister-in-law of a registered representative would be restricted from participating in common stock IPOs.
This restriction applies only to common stock IPOs. It does not apply to IPOs of preferred stock, debt offerings, or other types of securities.
Professionals connected to the offering are also barred from purchasing common stock IPOs. This includes consultants of the underwriter (sometimes called finders) and professionals working for the issuer (accountants, lawyers, and other fiduciaries).
Additionally, portfolio managers (e.g. mutual fund managers) are barred from purchasing the IPO for their personal accounts. They may purchase the IPO for the funds they manage, but not for themselves.
Last, passive owners of broker-dealers are also barred. A passive owner is not involved in day-to-day operations (so they aren’t registered representatives), but they are still treated as insiders for this rule.
New issues are sold at the public offering price (POP). You probably remember this term from the investment companies chapter. Similar to buying a mutual fund, IPO shares are purchased at the POP.
The Securities Act of 1933 requires the underwriting syndicate to deliver a prospectus to each investor buying the IPO. The following pieces of information are found in an issuer’s prospectus:
*In every prospectus, you’ll find language like this:
Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.
There’s one key point here: registration is not the same as SEC approval. Regulators avoid implying approval or disapproval because securities are not suitable for every investor. Instead, the SEC declares a registration effective once the required disclosures have been made.
Here’s a real-world example of Airbnb’s prospectus offered to investors during their late 2020 IPO. Don’t worry about the specifics - it’s a 350-page document. The main takeaway is what a prospectus is and the major topics it covers.
The prospectus must be delivered to investors in its original, unaltered form. Firms cannot highlight, summarize, or modify a prospectus in any way.
Prospectus delivery applies not only to the syndicate selling the new issue, but also to any financial firm selling the shares in the secondary market for a short period after the IPO is completed. A prospectus must be delivered by financial firms (like securities dealers and broker-dealers) for these time frames after the IPO is closed:
| Type of offering | Prospectus timeframe |
|---|---|
| Listed IPO | 25 days |
| Unlisted APO | 40 days |
| Unlisted IPO | 90 days |
| Listed APO | No requirement |
Listed securities are eligible to be traded on exchanges (e.g. the NYSE, while unlisted securities only trade in the OTC markets. We’ll learn more about listed and unlisted securities in the following unit.
After the issue is sold in the primary market, investors trade it in the secondary market. Some IPO customers will be long-term investors, while others may try to make a quick profit by selling their shares soon after the IPO. The following unit provides more detail on the structure and rules of the secondary market.
Sign up for free to take 12 quiz questions on this topic