Primary market securities offered to the public are typically subject to registration requirements. As we discussed in a previous chapter, issuer transactions take place in the primary market. An issuer transaction occurs when the sales proceeds from a securities transaction are collected by the issuer. Interstate* (more than one state) issuer transactions are subject to the Securities Act of 1933, which is the federal law covering primary market offerings.
*Intrastate (within one state) issuer transactions are subject to Uniform Securities Act (USA). We will learn more about the specifics later in this unit.
If you follow the real-world securities markets, you may already be aware of the list below. All were interstate initial public offerings (IPOs) subject to the rules embedded in the Securities Act of 1933. An IPO is the first public primary market offering an issuer is involved in.
In each of the IPOs listed above, the issuers (Doordash, AirBnB, and Robinhood) were required to follow specific protocols enforced by the Securities and Exchange Commission (SEC). We’ll learn about those protocols in this chapter, but let’s first jump into a time machine to better understand why primary market laws exist.
The financial markets were full of fraud, deceit, and manipulation in the early 1900s, some of which contributed to the Great Depression. Let’s assume you’re offered stock by a slick salesman in the 1920s. How would you know whether it was worth your purchase? Or if the salesman was lying to you? Or if the issuer even existed. This was a time without the internet or television, which significantly limited access to the necessary information to make informed investment decisions.
Signed into law to protect the investing public, the Securities Act of 1933 requires issuers to fully divulge the characteristics of the securities they intend to sell. To ensure all potential investors have access to this information, issuers and their underwriters are required to follow a number of protocols prior to and during the offering.
Underwriters are hired by issuers to help navigate the sale and marketing of securities to the public. Investment banking, also known as underwriting, can be a huge business. For example, Facebook’s underwriters made over $100 million during their IPO in 2012. Underwriters have many roles, ranging from general advice to actually selling the security. Real-world examples of underwriters include:
Issuers typically go through an extensive search to find the right underwriter. After the right fit is found and a 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. They fill out and file the SEC’s registration form, which requests items such as business history, information on officers and directors, and current financial status. Specific items details in the registration form include:
The filing of the registration form kicks off the 20-day “cooling off” period. During this time, the SEC reviews and confirms the completeness of the form. This takes some time, which is why the period lasts 20 days.
The SEC must ensure the public has access to all of the issuer’s required disclosures before any sales activity occurs. Therefore, the underwriter or any other financial firm connected to the IPO cannot advertise or recommend the new issue to any customer. Additionally, they cannot sell the new issue or take deposits for future sales. Anything sales related is off-limits during this 20-day period.
Some activities may occur during the cooling off period. The information filled out in the SEC’s registration form is compiled into a document called the prospectus. Investors learn about the issuer and the security by reading the prospectus. During the 20-day cooling off period, the SEC registration form is transformed into a “preliminary” prospectus, which can be given to potential investors on a solicited or unsolicited basis.
Sometimes referred to as the “red herring,” this form is considered preliminary until the SEC officially registers the security. The term ‘red herring’ comes from a message written 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.
Here’s a link to Robinhood’s preliminary prospectus for their IPO in 2021. You’ll find similar language shaded in red if you scroll down below the ‘Calculation of Registration Fee’ section.
In plain English, the information in the preliminary prospectus hasn’t been properly reviewed for completeness and may change. However, the SEC does not check the registration form for accuracy, nor do they guarantee anything about the new issue. If the issuer misleads or lies on the registration form, they’ll be subject to significant fines and sanctions. Jail time is also possible for anyone who lied while filling out the form.
The SEC’s job is to determine if the registration form is complete. If something is missing, they’ll send a deficiency letter to the issuer and notify them of the missing pieces. Unfortunately for the issuer and underwriter, this pauses the registration process. It will take time to properly finish the registration form and re-file it with the SEC.
If you’re really curious, you can look into a real-world version of a deficiency letter related to the We Company (the company that owns WeWork), by clicking here. The company’s attempt to register its securities with the SEC in 2019 for public sale is now notorious for many missteps. If you want to learn more, read this article or watch this documentary.
Part of the underwriter’s job is to price the new security. This is especially tough with stock, given its market value is based 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, and are not binding on any party. If a customer indicates they’re interested in buying the issue, they have no obligation to do so. If the underwriter takes an indication of interest from a potential investor, they have no obligation to sell them the issue.
In order to notify the public of the new issue, a tombstone may be published. The term ‘tombstone’ refers to what they look like (kind of like a tombstone).
Tombstones typically are published in newspapers and online outlets. They are the only form of legal advertising the SEC allows during the cooling off period. The tombstone contains factual pieces of information that don’t “pump up” or recommend the issue in any way.
Typical tombstone information
To summarize, here’s what can and cannot be done during the 20-day cooling-off period.
Legal during 20-day cooling off period
Distribute the preliminary prospectus
Take indications of interest
Publish a tombstone
Illegal during 20-day cooling off period
Recommend the new issue
Advertise the new issue
Sell the new issue
Take a deposit for the new issue
After a completed registration form is reviewed by the SEC, they will effectively 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. Similar to the rules covering registered persons, issuers and/or underwriters may not claim their registration has been approved.
When a new issue’s registration is effective, the underwriter reaches out to customers who submitted indications of interest. If demand is high for the issue, they must be selective when determining which customers get shares. There aren’t many guidelines here, so underwriters typically sell shares to their most profitable customers.
New issues are sold at the public offering price (POP). You probably remember this term from the Mutual funds chapter. Similar to an investor buying a mutual fund, IPOs are purchased at the POP.
The Securities Act of 1933 requires the underwriting syndicate to deliver a prospectus to each customer buying the IPO. The prospectus contains all the information on the issuer and new issue that was filed in the registration statement, plus the POP. The prospectus must be delivered to customers in its original, unaltered form. Firms cannot highlight, summarize, or modify a prospectus in any way.
After the issue is sold in the primary market, investors trade it in the secondary market.
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