How Securities Come to Market

A company or a government needs money, so it sells new securities to investors. This lesson follows that sale, from the issuer's decision to the document your customer receives.

Who does what

The issuer is the company or government that sells the new securities and keeps the money raised.

• The investment banker is the firm that advises the issuer and distributes the deal. It helps set the size, the structure, and the price. Once that firm takes on the securities, you call it the underwriter.
• The underwriting syndicate is a group of broker-dealers formed for one offering. They split the shares, the risk, and the fee. One member runs the group as the lead underwriter.
• The selling group is a set of firms that help sell the shares but buy none, so they carry no risk.
• The municipal advisor is a firm that advises a state or local government on issuing municipal securities.

The exam likes this contrast. The underwriter deals with the issuer at arm's length, as a buyer. The municipal advisor owes its municipal client a fiduciary duty, so the client's interest comes first.

Public, private, and the three offering names

A public offering sells securities to the general investing public. A private offering, also called a private placement, sells to a small group of chosen investors. Public offerings register with the SEC. Private offerings rely on an exemption.

Three names for offerings come up constantly:

• An initial public offering (IPO) is a company's first sale of stock to the public. The private company becomes public.
• A follow-on offering is a later sale of newly created shares by a company that is already public. The issuer gets the money.
• A secondary offering is a sale of shares that already exist, by large holders such as founders or early investors. Those sellers get the money, not the issuer.

The exam swaps the last two. Ask two questions: are the shares new, and who gets paid? New shares plus money to the company means follow-on. Existing shares plus money to the seller means secondary. A secondary offering is not the secondary market, where investors trade with each other.

How the underwriter takes on the deal

Two methods of distribution cover most exam questions:

• Firm commitment: the underwriter buys the whole issue from the issuer and resells it. The underwriter acts as a principal and keeps any shares it cannot sell.
• Best efforts: the underwriter agrees only to try. It acts as an agent, returns unsold shares to the issuer, and risks nothing.

Numbers make this stick. An issuer sells 2 million shares to the public at $18. Under a firm commitment the underwriter pays the issuer $17.10 a share and keeps the $0.90 difference, which is the underwriting spread. If buyers take only 1.6 million shares, the underwriter owns the other 400,000. Under best efforts that shortfall costs the underwriter nothing, and the issuer raises less.

Two best-efforts variations show up. All-or-none cancels the deal unless every share sells. Mini-max sets a floor and a ceiling on the amount sold.

Shelf registration

A shelf registration lets an issuer register a block of securities once, then sell it in pieces over the following years. The securities sit on the shelf until the issuer wants the cash. The purpose is timing. When the market looks good, the issuer sells without filing a fresh registration. A shelf generally stays usable for up to three years.

The offering documents

Every buyer in a new offering receives a disclosure document. Which document depends on the product:

• A prospectus describes a registered offering of corporate stock, corporate bonds, or fund shares. It forms part of the registration statement filed with the SEC.
• An official statement describes a new municipal securities offering. Municipal issuers are exempt from SEC registration, so they publish this instead. The MSRB posts them on its EMMA website.
• A program disclosure document describes a municipal fund security, most often a 529 college savings plan. It covers the investment options, the fees, and the tax rules.

The waiting time between the SEC filing and the effective date is the cooling-off period, which runs a minimum of 20 days. During that wait the underwriter may use a preliminary prospectus, nicknamed the red herring. It carries no final price. Before you accept any order, wait for the effective date. Until then the underwriter may only take indications of interest, which bind nobody.

Filing and exemptions

The Securities Act of 1933 is the registration law. The issuer files a registration statement covering the business, the security, the management, and financial statements certified by independent accountants. Registration means the issuer disclosed what the law requires. It never means the SEC approved the investment.

Some offerings skip SEC registration:

• Government securities, including US Treasury issues and municipal issues.
• Intrastate offerings, where the issuer and every buyer sit in one state. Rule 147 sets those conditions.
• Offerings under a small size limit.
• Private placements under Regulation D, sold mainly to accredited investors. An accredited investor is an institution or a person who meets an income or net worth test.

Securities bought in a private placement are restricted securities, and you cannot resell them freely. Rule 144 sets the conditions: a holding period first, and for insiders a volume cap in any three-month period. Rule 144A is the institutional shortcut. It lets holders resell restricted securities to qualified institutional buyers, the largest institutional investors.

State law still applies. Blue-sky laws are the securities laws of the individual states. An offering may need to register in each state where the firm sells it. A federal filing does not erase the state one.

How this gets tested

The exam asks four things over and over:

• Who gets the money.
• Who carries the risk.
• Which document goes with which product.
• Registered or exempt.

A question about leftover shares is a firm commitment question. A 529 plan points to the program disclosure document. A city's new bond points to the official statement.