Lesson 1.1: Primary and Secondary Markets

Primary Markets and Secondary Markets

Primary Markets

  • The primary market is where issuers (corporations or governments) sell securities to the investing public through issuer transactions.

  • Issuers receive proceeds from the sale of securities in the primary market.

  • Secondary markets are where securities trade between investors, also known as capital markets.

  • Primary Offer/Market: An issuer sells securities to raise capital, enabling corporations to fund expansions, equipment, and job creation.

  • Allows investors to grow assets alongside the economy.

  • A corporation may issue up to the number of shares authorized in its bylaws.

  • Governments use primary markets for infrastructure projects and public programs.

  • Securities Act of 1933: Requires full and fair disclosure in the sale of securities to the public.

    • New issues must be registered with the SEC unless exempt.

    • Investors receive a detailed disclosure document (prospectus) before purchase.

  • Offerings:

    • Initial Public Offering (IPO): The first time an issuer distributes shares to the public.

    • Additional Public Offering (APO): Subsequent offerings (also called follow-on or subsequent public offerings).

IPO Example

  • ABC Shoe Co. issued shares to the public for the first time (IPO) and received the proceeds.

  • Four years later, ABC Shoe raised additional capital through a follow-on offering (APO) and also received all the proceeds.

  • Both IPO and follow-on offerings are primary because the issuer receives the proceeds and must go through SEC registration.

Additional Public Offerings (APOs)

  • Corporations can offer additional stock to the public as a primary market transaction.

  • Names for APOs: additional public offerings, subsequent public offerings, or follow-on offerings.

  • Can also be called additional primary offering or subsequent primary offering.

  • Multiple APOs can occur over time.

  • Characteristics: Primary offerings (proceeds to issuer), occur after the IPO (shares already public).

Participants in the Primary Market

Issuers

  • Person: A natural person (human being) or a legal entity (corporation or government).

  • Issuers can be corporations, municipalities, and the federal government/agencies.

Corporations

  • Issue equities (stocks) and debt (bonds).

  • National Market System (NMS) Securities: Stocks of larger corporations traded on a national exchange or Nasdaq.

  • Stocks not listed are non-NMS securities.

Municipalities

  • Issue municipal bonds (munis).

  • Municipalities are state or lower-level governments (counties, cities).

Federal Government and Agencies

  • Treasury Department: The largest debt issuer (govies).

  • Federal agencies also issue debt (covered in the Debt Securities unit).

Underwriters

  • Underwriter: A broker-dealer (BD) or investment banker that helps issuers bring securities to market.

  • Investment bankers help structure new issues, sometimes forming syndicates with other underwriters.

  • Syndicates: Groups of BDs working together (explained later).

Underwriting Commitments

Different agreement result in different levels of risk for underwriters.

Best Efforts Underwriting

  • The underwriter sells securities as an agent of the issuer, not committing to purchase shares.

  • Underwriters are not at risk, and funds are collected into an escrow account.

  • The underwriter's ability to sell determines success; the issuer bears the risk.

  • If enough shares cannot be sold, the issuer does not raise capital.

Types of Best Efforts Underwritings:

  • All-or-None (AON): The underwriter must sell all shares or cancel the underwriting.

    • Funds collected are held in escrow pending final disposition.

  • Mini-Max: Sets a minimum (floor) and maximum (ceiling) amount of securities to be sold.

    • The underwriter must find enough buyers to meet the minimum requirement and can expand up to the maximum.

Firm Commitment Underwriting

  • The underwriter contracts with the issuer to buy the securities, acting as a principal.

  • The underwriter buys shares and resells them to the public at a higher price (Public Offering Price - POP).

  • The difference between the purchase price and POP equals the spread earned.

  • Underwriters commit to purchasing any unsold shares.

  • The underwriter, not the issuer, is at risk for unsold shares.

  • If shares cannot be sold, the underwriter holds them in inventory and risks potential losses.

  • The issuer receives all needed capital because the underwriters purchase the entire issue.

  • Firms can never guarantee to a customer that it will repurchase the shares at the POP if the deal subsequently trades lower.

Syndicates

  • Syndicate: A joint venture where BDs share the risk and profits of large firm commitment underwritings.

  • Managing Underwriter: A lead member providing significant resources.

  • Selling Group: BDs assisting the syndicate in the sale but not committing capital or holding inventory.

  • Selling group members have no liability for unsold shares.

Investors

  • Investors in primary markets purchase new issues intending to hold them.

  • Three groups: institutional, retail, and accredited. (The primary markets investors are those who are purchasing the new issue and intending to hold the security for a period of time.)

Institutional Investors

  • Entities that pool money to purchase securities (banks, insurance companies, pension plans, hedge funds, investment advisers, mutual funds).

  • Qualified Institutional Buyers (QIBs): Own and invest a minimum of 100100 million in securities on a discretionary basis.

Retail Investors

  • Investors using their own assets.

  • Smaller and less knowledgeable investors have higher communication and disclosure expectations.

Accredited Investors

  • Subset of investors, including all institutional investors and certain retail investors.

  • Retail investors who qualify:

    • Insiders: officers, board members, major stockholders.

    • Financial Criteria:

      • Income: At least 200,000200,000 (or 300,000300,000 for joint accounts) for the past two years and expected to continue.

      • Net Worth: 1,000,0001,000,000 or more (excluding primary residence equity).

    • Natural persons qualified based on certain professional certifications, designations, or credentials or other credentials issued by an accredited educational institution

    • Holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons the Securities and Exchange Commission (SEC) has the flexibility to reevaluate or add certifications, designations, or credentials in the future

  • Must meet at least one criterion to be accredited.

  • Accredited investors are assumed to be more sophisticated and need less protection.

  • Qualifications are in Rule 501 of Regulation D of the Securities Act of 1933.

Summary

  • Retail and institutional investors participate in secondary markets.

  • Accredited investor designation is exclusive to primary market transactions.

Municipal Advisors

  • Investment bankers advise municipalities on issuing municipal debt.

  • Work under contract, advising on debt structure and bond features.

  • May assist in underwriting functions but cannot be compensated for selling issues they advise on.

  • They may not switch roles from advisor to underwriter.

Issuing a New Security by IPO

Securities Act of 1933 (Paper Act)

  • Ensures the investing public is fully informed about a security and its issuing company.

  • Protects investors by:

    • Requiring registration of new issues (unless exempt).

    • Requiring full and fair disclosure about the issuer and offering.

    • Providing all material information for investors to judge the issue's merit.

    • Regulating underwriting and distribution of primary issues.

    • Providing criminal penalties for fraud in new securities issuance.

The SEC

  • The primary federal regulator in the securities industry.

  • The Securities Act of 1933 requires several steps:

    • Distribution of a registration statement.

    • Cooling-off period.

    • Filing of a final prospectus.

Registration Statement

  • Required for non-exempt securities.

  • Filed with the SEC (S-1 form).

  • Discloses material information about the issue.

  • Includes a prospectus (disclosure document for purchasers).

  • Must contain:

    • Description of the issuer's business.

    • Names, addresses, salaries, and five-year business history of officers and directors.

    • Amount of corporate securities owned by officers and directors and identification of investors owning 10%10\% or more of the company.

    • Company's capitalization, including equity and debt.

    • Description of how proceeds will be used.

    • Whether the company is involved in legal proceedings.

  • Underwriters may assist, but the issuer is responsible for accuracy and adequacy.

Cooling-Off Period

  • Begins after filing the registration statement.

  • Minimum of 20 calendar days (often longer).

  • The SEC can suspend review and issue a deficiency letter if revisions are needed.

  • The 20-day period resumes when a corrected registration statement is submitted, and picks up where it left off.

  • No one can solicit sales during the cooling-off period.

Permitted Activities During Cooling-Off Period

  • Tombstone Advertisement: Announces and describes the securities to be offered.

    • The only allowed advertising during the cooling-off period (the time between registration filing and the effective date).

    • Not required and does not need to be filed with the SEC.

    • May be placed by the issuer or underwriters, limited to:

      • Name of the issuer.

      • Type of security.

      • Number of shares to be sold.

      • POP (or range if not yet set).

      • Names of underwriting members (if placed by underwriters).

    • Must contain the advisory statement: “This announcement is neither an offer to sell nor a solicitation of an offer for any of these securities. This offer is made only by prospectus.”

  • Preliminary Prospectus (Red Herring): Used to gauge investor interest.

    • The final price (POP) is not required but is often included as a range.

    • Must be given to interested customers.

  • Indications of Interest: Investor's declaration of potential interest.

    • Not a commitment to buy, as sales are prohibited until the effective date.

    • Nonbinding to either party, and no money changes hands.

  • Due Diligence: Underwriters examine the issue to determine suitability for customers.

    • Formal presentations are given to representatives.
      State Registration Requirements (Blue-Sky Filings): Coordinating federal and state registrations.
      When the proper forms have been filed, the security is registered in the states at the same time it is released for sale by the SEC.

Release (or Effective) Date

  • The SEC allows the security to be offered to investors (usually after 20 days of cooling off).

  • The SEC does not "approve" but “allows” the issue to be