Effective registration

During the cooling off period, the SEC checks the issuer’s registration form for completeness. They don’t check the accuracy of the form, nor do they approve (or disapprove) of the issue. The SEC’s only concern is whether the form was filled out completely. If the issuer lied or misled in any way, the SEC will pursue penalties when it’s discovered.

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.

FINRA rule 5130 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. Industry insiders are defined as:

FINRA member firms (financial firms registered with FINRA), 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 this as the “rule of 1,” or that it applies to family members “1 up” (parents), “1 down” (children), and “1 over” (siblings and spouses). This restriction applies to in-laws as well (e.g. son-in-law, mother-in-law, etc.). These limitations do not apply to other family members not meeting the “rule of 1” (e.g. aunts, uncles, grandparents, nieces, nephews, cousins, etc.) unless they are financially dependent on the industry insider.

This FINRA rule only applies to common stock IPOs and does not prevent restricted persons from purchasing IPOs of preferred stock, debt offerings, or any other security. Additionally, FINRA allows exceptions for certain accounts in which a restricted person does not exceed a 10% ownership level. This is common to apply to investment clubs. For example, assume a registered representative owns 10% (or less) of an investment club. The investment club could legally purchase a common stock IPO although a restricted person was part owner.

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 underwriter 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.

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 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 make a quick profit by selling their shares swiftly. We’ll learn more about the secondary market in the next chapter.