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Textbook
1. Introduction
2. Common stock
3. Preferred stock
4. Bond fundamentals
5. Corporate debt
6. Municipal debt
7. US government debt
8. Investment companies
9. Alternative pooled investments
10. Options
11. Taxes
12. The primary market
12.1 Review
12.2 The IPO process
12.3 Exemptions
12.4 Rule 144
12.5 Other rules
13. The secondary market
14. Brokerage accounts
15. Retirement & education plans
16. Rules & ethics
17. Suitability
18. Wrapping up
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12.5 Other rules
Achievable Series 7
12. The primary market

Other rules

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Several rules and regulations exist that don’t apply to every primary market offering. We’ll discuss these various topics in this section.

Shelf offerings (Rule 415)

Throughout this unit, we’ve discussed the typical securities registration process, which involves the 20-day cooling off period. But what if an issuer wanted to register a security in the future but wanted to take advantage of market conditions quickly? For example, an issuer wants to raise capital through a bond issuance, but wants to wait until interest rates decline. When interest rates fall below a certain threshold, the issuer intends to offer security quickly to take advantage of the new lower cost of borrowing.

Issuers can bypass the normal rules and obtain quick security registration through the shelf registration rule, formally known as SEC Rule 415. Continuing with our example above, the issuer would file registration paperwork for the debt security with the Securities and Exchange Commission (SEC) (technically SEC Form S-3). Some of the form is left blank, including the security’s coupon (interest rate) and maturity, among other characteristics. As we stated above, the issuer is waiting until interest rates decline to offer the security, so some of the security’s features are yet to be determined. Regardless, the issuer still must make significant disclosures that will eventually be provided to investors by prospectus.

The SEC reviews the registration form for completeness, except for the blank sections not required to be filled out yet. If all the necessary disclosures are provided, the regulator grants the security effective registration. The issuer will now wait to offer the security to investors as the registration form is placed on a metaphorical “shelf” at the SEC. At any point in the next three years, the issuer can take the registration form off the “shelf,” fill out the missing parts, and offer the security quickly to investors.

Let’s assume interest rates decline far enough a year later. The issuer will now provide the SEC with the information left blank on the initial form (e.g., coupon, maturity, etc.). The security can then be offered to investors 48 hours (two days) after the new SEC filing. Registering a security this way allows the issuer to avoid the 20 day cooling off period, saving 18 days of waiting time.

Rule 145

In some circumstances, changes to stock or corporate structures require registration with the SEC. Rule 145 establishes what events or changes require registration. These are the three instances:

Reclassifications

  • Substituting one security for another
  • Example: switching a common stock share for another common stock share with less voting power

Mergers or consolidations

  • Two or more companies becoming one
  • Example: Exxon and Mobil merge together and continue operations as Exxon Mobil

Transfers of assets

  • Transferring assets from one company to another
  • Example: bankrupt business reforms as another business and transfers business assets to new business

Not only do these events require registration with the SEC, but they also require shareholder approval. There are other scenarios where new shares of stock are created but don’t require registration with the SEC. Stock splits (forward and reverse) and stock dividends result in new shares being created, but do not require registration. As a reminder, stock splits require shareholder approval, but stock dividends do not.

Rule 433

Rule 433 provides the legal basis and conditions for using free writing prospectuses (FWPs). FWPs are written communications used in conjunction with a shelf offering and can be any written material regarding a new issue. They are flexible and can be materials such as emails, term sheets, websites, or PowerPoints that provide additional information to potential investors. Rule 433 enables WKSIs (Well-Known Seasoned Issuer) to use FWPs.

Generally, the FWP must be filed with the SEC by the date of first use. There are exceptions for immaterial or unintentional failures to file, as long as reasonable efforts are made to comply. Additionally, the FWP can contain information not included in the registration statement, but it cannot conflict with the registration statement or any incorporated SEC reports.

Regulation S

Issuers from the United States sell securities outside of the country on occasion. Regulation S establishes when these issuers avoid registering securities sold outside the United States. In most cases, there are no registration requirements if the offering meets these conditions:

  • Offering takes place outside of the US
  • Investors cannot be US residents
  • No marketing materials distributed in the US

Non-US residents purchasing Regulation S securities can sell the security at any time outside of the US. However, these investors are barred from selling the securities in the US for these time periods (after the offering closes):

  • Debt securities: 40 days
  • Equity securities: 1 year

Green shoe clause

Judging the demand for a new issue is a difficult task. There are many resources underwriters use to forecast demand for a new issue. For example, indications of interest and internet search queries are utilized to measure investor interest. Even with these tools, finding the perfect price for a new issue is near impossible. Regardless, the underwriter can utilize certain tools if they misjudge demand.

If there’s more demand than the underwriter expected, they can initiate the green shoe clause, which was named after the Green Shoe Manufacturing Company (now known as Stride Rite Corporation). The rule allows the underwriter to request up to 15% more shares from the issuer, which helps meet the extra demand for shares. The Green Shoe Manufacturing Company was the first company to institute this rule in its underwriting agreement.

During Facebook’s IPO in 2012, Morgan Stanley (the lead underwriter) considered instituting the green shoe clause. 421 million Facebook shares were initially set to be sold, but Morgan Stanley increased the offering to 484 million shares (15% more) after they saw signs of increased demand. This is where things get interesting. Morgan Stanley sold short the additional 63 million shares, which left them with two choices.

Option 1: to cover the short position, they could institute the green shoe clause and buy the additional 63 million shares from Facebook. They would pursue this action if the IPO was successful, which is measured by Facebook’s trading price in the secondary market. Facebook’s POP (public offering price) was $38. If the stock began trading in the secondary market above $38, Morgan Stanley would institute the clause and purchase the shares (to close the short position) directly from Facebook at $38 (minus fees).

Option 2: they could institute a stabilizing bid.

Stabilizing bids

Stabilizing bids are utilized by underwriters when they have a “sticky” issue, which occurs when the stock begins trading in the secondary market below its POP. This is what happened to Facebook during its IPO (continuing the story from above). The shares were sold at $38 in the IPO, but they fell well below $38 once they began trading in the secondary market. To help influence the price of the stock back upwards, Morgan Stanley bought back shares at $38 through a stabilizing bid.

Stabilizing bids are the only legal form of market manipulation. Essentially, the lead underwriter floods the secondary market with requests to purchase the stock, driving demand and the stock price upward. From Morgan Stanley’s perspective, they could’ve bought the shares from Facebook at $38 (to close its 63 million share short position), but they chose to go to the market instead. By doing so, they closed the short position and “stabilized” Facebook’s stock price.

The SEC allows stabilizing bids to occur as long as certain requirements are met. First, the bid must be at or below the POP. It can never be above; in the Facebook example, Morgan Stanley stabilized exactly at the POP ($38). Second, there can only be one bid placed at a time, meaning other syndicate members cannot stabilize at different prices separate from the lead underwriter. Last, the possibility of stabilization must be disclosed in the prospectus.

On some occasions, customers that purchased shares from the syndicate during the IPO will sell their shares back to the syndicate during stabilization. Essentially, the investor bought IPO shares only to resell them immediately back to the syndicate. If this occurs, the syndicate member that sold those shares is assessed a penalty bid. A penalty bid results in the syndicate member relinquishing the selling concession they earned when selling the shares. This should make sense - why should the syndicate member be compensated for a sale when the shares were sold back immediately to the syndicate? To avoid this from happening, many syndicate members emphasize the importance of long-term ownership to their customers.

Regulation crowdfunding

Regulation crowdfunding (Reg CF) allows companies to raise up to $5 million in a 12-month period, but this must be done through a FINRA approved crowdfunding platform. Both accredited and non-accredited investors can participate in Reg CF offerings.

Non-accredited investors are limited to how much they can buy based on their net worth or annual income:

  • An income or net worth less than $124,000 has an investment limit of $2,500 or 5% of the greater of the non-accredited investor’s annual income or net worth
  • An income or net worth of more than $124,000 has an investment limit of 10% of the greater of their annual income or net worth.
  • During any 12-month period, the amount may not exceed $124,000, regardless of the non-accredited investor’s annual income or net worth.

Certain companies are not eligible to use the Regulation Crowdfunding exemption. These include:

  • non-U.S. companies
  • Exchange Act reporting companies
  • certain investment companies
  • Companies that are disqualified under Regulation Crowdfunding’s disqualification rules
  • Companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement; and
  • Companies with no specific business plan or have indicated their business plan are to engage in a merger or acquisition with an unidentified company or companies.

While some exceptions apply, securities purchased through Reg CF cannot be resold for a period of one year.

Key points

Shelf registration rule

  • Allows issuers to quickly offer securities
  • Issuer files “blank” registration form
    • Reviewed by the SEC
    • Granted as effective if all required disclosures provided
  • The security may be sold quickly within the next 3 years
  • When the security is ready to be sold:
    • Issuer contacts SEC, provides information left “blank”
    • The security can then be sold 48 hours later
    • Allows avoidance of the 20-day cooling-off period

Rule 145

  • Require registration and shareholder approval:
    • Reclassifications
    • Mergers or consolidations
    • Transfer of assets
  • Do not require registration:
    • Stock splits
    • Stock dividends

Rule 433

  • FWP must be filed with the SEC by the date of first use
  • FWP cannot conflict with the registration statement or any incorporated SEC reports

Regulation S

  • Registration is not required for securities sold outside of the US

Green shoe clause

  • The underwriter can request 15% more shares from the issuer
  • Instituted if demand is high

Stabilizing bids

  • Underwriter buys IPO securities back from the market
  • Bids must be at or below POP

Regulation crowdfunding

  • Allows companies to raise up to $5 million in a 12-month period
  • Non-accredited investors are limited to how much they can buy based on their net worth or annual income

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