During an initial public offering (IPO), the issuer and underwriter must follow strict guidelines and rules. These regulations come from the Securities Act of 1933, which oversees the primary market.
The financial markets were full of fraud, deceit, and manipulation in the early 1900s, some of which contributed to the Great Depression. 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. The rules in this law are extensive and require attention to detail. To ensure compliance with the law, issuers hire lawyers, accountants, and even obtain help from their underwriter.
As we discussed previously, issuers hire underwriters to sell their securities to investors. The issuer and underwriter sign a contract that details the fees to be paid by the issuer, the liabilities (commitments), and generally how the sale will unfold.
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. 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 details in the registration form include the following:
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.
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 until the lacking information is submitted. It will take time to properly finish the registration form and re-file it with the SEC.
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.
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.
A FINRA rule requires underwriters to avoid IPO sales of common stock to industry insiders. This rule exists to ensure the public will gain access to the IPO. Otherwise, it’s possible the underwriting syndicate sells the issue to industry insiders and/or keeps the new issue for themselves, especially for stock in high demand.
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 are defined as parents, siblings, and children, plus anyone that is financially dependent on the industry insider. Some refer to the “rule of 1” when remembering what family members the rule applies to. It applies to “1 up” (parents), “1 down” (children), and “1 over” (siblings and spouses). In-laws are also included in the definition, so a father-in-law, sister-in-law, or any other in-law of a registered representative would be prevented from participating in common stock IPOs. This rule only applies to common stock IPOs and does not apply to IPOs of preferred stock, debt offerings, or any other security.
Professionals connected to the offering are also barred from purchasing common stock IPOs. This includes consultants of the underwriter (sometimes referred to as 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. Portfolio managers can purchase the IPO for the funds they manage, just not for themselves personally. Last, passive owners of broker-dealers are also barred. A passive owner is someone not involved in day-to-day operations, so they’re not registered representatives. Regardless, they are considered insiders for purposes of this rule.
New issues are sold at the public offering price (POP). You probably remember this term from the Investment Companies 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.
Prospectus delivery not only applies to the syndicate selling the new issue, but also to any financial firm selling the new shares in the secondary market for a short amount of time after the IPO is finished. 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
Listed securities are eligible to be traded on exchanges (e.g. the NYSE, while unlisted securities only trade in the OTC markets. APOs (additional public offerings), also known as follow-on offerings, occur when an issuer already has shares outstanding and plans to sell more shares.
The SEC maintains an “access equals delivery” rule, which allows a prospectus to be delivered electronically to investors. Issuers comply with this rule by posting prospectuses to the SEC’s Electronic Data Gathering, Analysis, and Retrieval system, better known as EDGAR. Investors can simply visit EDGAR to retrieve any prospectus. For example, here’s a link to Instacart’s prospectus for the company’s 2023 IPO.
After security is sold in the primary market, investors trade it in the secondary market. Some IPO customers will be long-term investors, while others may make a quick profit by selling their shares swiftly. We’ll learn more about the secondary market in the next chapter.
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