Effective registration

During the cooling off period, the SEC reviews the issuer’s registration statement to make sure it’s complete. The SEC does not verify the accuracy of the information, and it does not approve (or disapprove) of the offering. Its focus is whether the required disclosures were provided. If the issuer makes false or misleading statements, the SEC can pursue penalties once the problem is discovered.

After the SEC reviews the registration statement and finds it complete, the security becomes effective. During the cooling off period, the SEC announces an effective date. The effective date is the first day the security may be legally sold to the public.

When a new issue becomes effective, the underwriter contacts customers who submitted indications of interest. If demand is high, the underwriter has to decide which customers receive shares. Because there are limited guidelines for allocation, underwriters often prioritize their most profitable customers.

FINRA rule 5130 requires underwriters to avoid selling common stock IPOs to industry insiders. The goal is to keep IPO access available to the public. Without this rule, an underwriting syndicate could allocate a high-demand IPO to insiders and/or keep shares for itself. 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,” meaning 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 applies only to common stock IPOs. It does not prevent restricted persons from purchasing IPOs of preferred stock, debt offerings, or any other security. FINRA also allows exceptions for certain accounts in which restricted persons do not exceed a 10% ownership level. This exception commonly applies 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 even though a restricted person is a part owner.

New issues are sold at the public offering price (POP). You may remember this term from the Investment Companies chapter. Similar to buying a mutual fund, IPO investors purchase shares at the POP.

The Securities Act of 1933 requires the underwriter to deliver a prospectus to each customer buying the IPO. The prospectus includes the information about the issuer and the new issue that was filed in the registration statement, along with the POP. The prospectus must be delivered in its original, unaltered form. Firms can’t 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. Issuers comply by posting prospectuses to the SEC’s Electronic Data Gathering, Analysis, and Retrieval system, better known as EDGAR. Investors can visit EDGAR to retrieve a prospectus. For example, here’s 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 hold shares long term, while others sell quickly to try to lock in a profit. We’ll cover the secondary market in the next chapter.