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.
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
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