Unit 1 Learning Objectives:

When you have completed this unit, you will be able to accomplish the following.

• LO 1.a  Recall the purpose and participants in the primary markets.

• LO 1.b  Order the process for selling new issues in the primary market.

• LO 1.c  Recognize the types of exempt issues, exempt issuers, and exempt transactions.

• LO 1.d  Define the major market centers of the secondary markets.

• LO 1.e  Recall the participants in the secondary markets.

• LO 1.f  Identify the components of a quote.

• LO 1.g  Differentiate the major types of orders.

• LO 1.h  Differentiate principal and agency capacity in trading.

• LO 1.i  Relate the requirements for settlement of different trades.

Your exam will include approximately 9 questions from the topics covered in Unit 1.

For a person to become an investor, they need to own a security. They may invest in one of two ways. Either they can purchase a security from the issuer (corporations or governments) in the primary market, or they can purchase a security from another investor who is ready to sell it in the secondary market. In this unit you will learn about these markets, collectively referred to as the capital markets.

In this lesson, you will learn how securities are sold and why those who issue securities choose to do so. The primary markets are a vitally important part of the economy, allowing issuers to raise capital and investors to participate in their success.

LO 1.a
Recall the purpose and participants in the primary markets.

The primary market is where securities are sold by the issuer—a corporation or a government—to the investing public in what are known as issuer transactions. The issuer of the securities receives the proceeds generated by the sale of the securities in the primary market. By contrast, the secondary markets are where securities trade between investors. Another term for these markets is capital markets.

When you see the terms primary offer or primary market, you know that we are talking about an issuer that is selling a security to raise capital. The sale of securities to the public allows corporations to raise capital relatively quickly to take advantage of changes in the economy. This activity is a key piece of a modern economy, allowing corporations to raise the money needed to build factories, buy equipment, and expand the demand for labor, creating jobs. At the same time, it allows investors, from the wealthiest billionaire to the regular person saving in a 401(k), to grow their assets alongside the economy as a whole. The person who owns a mutual fund share that holds a partial share of a corporation earns the same return (on a per share basis) as the largest stockholder of that company. A corporation may issue up to the number of shares that are authorized in the corporation's bylaws.

Governments use the primary markets to raise money for infrastructure projects (such as bridges, roads, dam, ports, etc.) as well as to fund other programs for the public good. Take a look at a bridge over a river that ties two cities together and benefits both. Who built that bridge? Well, construction workers built it, engineers designed it, and it was paid for by investors who believed the project was worth supporting and hoped for a return on their investment.

Offerings of securities to the public in the primary market generally come in two types: the initial public offering (IPO) or an additional public offering (APO). An APO may be called a follow-on offering or a subsequent public offering.

Initial Public Offering (IPO)

The first time an issuer distributes securities to the public, it is called an initial public offering (IPO). Any subsequent offerings are known as APOs.

Additional Public Offerings (APOs, Follow-On Offerings)

As mentioned earlier, a corporation may offer additional shares of stock to the public as a primary market transaction. These follow-on offerings go by several names: additional public offerings (APOs), subsequent public offerings, or follow-on offerings. Sometimes, the word primary is used instead of public: additional primary offering or subsequent primary offering. There may be multiple APOs over time. The two defining characteristics are that these are primary offerings (the proceeds go to the issuer) and they come after the IPO (this class of shares is already available to the public).

In the next section, we will discuss the participants in the primary market and their respective roles.

Issuers

Issuers of securities can be corporations, municipalities, and the federal government or its agencies.

Corporations

corporations may issue both equities (stocks) and debt issues (bonds). Larger corporations' stocks that, after being issued, trade on a national exchange (listed) or the Nasdaq system are called National Market System (NMS) securities. Stocks that will not be listed are non-NMS securities. More detail on these parts of the secondary market are covered later in this unit.

Municipalities

Municipal governments issue municipal bonds and other types of debt. As a reminder, municipalities are governments at the state or lower level, such as counties and cities. This debt is sometimes called munis.

The Federal Government and Agencies

The largest issuer of debt in the United States is the Treasury Department. Debt issued by the government is sometimes called govies. A small number of agencies of the federal government also issue debt. Agency debt is covered in the Debt Securities unit.

Underwriters (Broker-Dealers, Investment Bankers)

An underwriter is a type of broker-dealer (BD) (also called an investment banker) that works with an issuer to bring its securities to the market and sell them to the investing public. Investment bankers help the issuer to structure new issues and, at times, form syndicates with other underwriters to facilitate this capital-raising process. (Syndicates are explained in more detail later in this section.)

Underwriting Commitments

Different types of underwriting agreements require different levels of commitment from the underwriters. This results in different levels of risk for the underwriters and the issuer.

Best Efforts Underwriting (Investment Banker Acting as Agent)

A best efforts underwriting calls for the underwriters (or the syndicate) to sell securities from the issuer to the investor acting simply as an agent. This means that the underwriters are not committed to purchasing the shares themselves and are therefore not at risk. Best efforts deals are closed by collecting client funds into an escrow account, so no underwriter capital is at risk in this type of offering. The underwriter is acting as an agent contingent on the underwriter's ability to sell shares in either a public offering or a private placement. The underwriter is not at risk for the shares, but the issuer is. If enough of the shares cannot be sold, the issuer will not raise the needed capital.

There are two types of best efforts underwritings to be familiar with:

• All-or-none (AON). In an AON underwriting, the issuing corporation has determined that it wants an agreement outlining that the underwriter must either sell all the shares or cancel the underwriting. Because of the uncertainty of the outcome of an AON offering, any funds collected from investors during the offering period must be held in escrow pending final disposition of the underwriting.

• Mini-max. A mini-max underwriting sets a minimum amount the issuer needs to raise to move forward with the underwriting, as well as a maximum amount of securities the issuer is willing to sell. The underwriter must locate enough interested buyers to support the minimum (floor) issuance requirement. Once the minimum is met, the underwriter can expand the offering up to the maximum (ceiling) amount of shares the issuer specified.

Firm commitment underwriting (Investment Banker Acting as Principal)

Firm commitment underwriting is a widely used type of underwriting contract. Under its terms, the underwriters contract with the issuer to buy the securities. The underwriters buy shares from the issuer, resell the securities to the public at a higher price—the public offering price (POP)—and earn this price differential (spread) for their efforts. Here, the underwriters are acting as principals rather than agents. They are committing to purchasing any unsold shares for the syndicate account. In this type of underwriting, it is the underwriters, not the issuer, who are at risk for any shares they cannot sell to the public. If the shares cannot be sold, the underwriters must place the securities into their inventory and run the risk of losing money if the position falls in value. The issuer knows that all the capital needed will be raised because the underwriters purchase the entire issue. Please note that a firm may never guarantee to a customer that it will repurchase the shares at the POP if the deal subsequently trades lower.

Syndicates

In large firm commitment underwritings, it is common for a group of BDs to form a syndicate. A syndicate is a type of joint venture where the BDs share both the risk and the profits from the offering. One of the members of the syndicate will act as the managing underwriter, taking on a lead role and providing significant resources to the venture.

Often syndicates will bring in other BDs to assist the syndicate in the sale of the securities. This is the selling group. The members of the selling group do not commit capital, nor do they hold the securities in inventory the way a syndicate member does. Selling group members take on no liability for unsold shares.

Investors

Investors in the primary markets are those who are purchasing the new issue and intending to hold the security for a period of time. They may be divided into three groups: institutional, retail, and accredited.

Institutional Investors

An institutional investor is an entity that pools money to purchase securities and other investment assets. Institutional investors can include banks, insurance companies, employee benefit plans like pensions, hedge funds, investment advisers, and mutual funds.

Some institutional investors are called qualified institutional buyers (QIBs). This generally means that the QIB owns and invests a minimum of $100 million in securities on a discretionary basis.

Retail Investors

The typical retail investor is investing their own assets. Any investor that does not qualify as an institution should be treated as a retail investor. Though these investors may be quite large, most are smaller investors. As they tend to be less knowledgeable than institutional investors, sales to retail investors have higher communication and disclosure expectations.

Accredited Investors

Accredited investors are a subset of investors made up of all institutional investors and certain retail investors.

The following are retail investors who qualify as accredited investors:

• Insiders of the security's issuer (officers, board members, major stockholders)

• Those who meet certain financial criteria

  • An income of at least $200,000 or more the past two years and are expected to meet that criteria in the current year (if the purchase is in a joint account, this number is increased to $300,000)

  • Or have a net worth of $1,000,000 or more (not including equity in the primary residence)

• 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

Note that the investor must meet at least one of the listed criteria to be an accredited investor. They may meet more than one but do not have to.

The assumption is that the accredited investor will have a higher sophistication level than the average retail investor and will not need the same level of protection. These qualifications appear in Rule 501 of Regulation D of the Securities Act of 1933.

Take Note

Retail and institutional investors are active participants in the secondary markets, but the designation of accredited investor is used exclusively in primary market transactions.

Municipal Advisors

Municipal advisors are a type of investment banker that advise municipalities on the issuing of municipal debt and other types of municipal securities. Municipal advisors work under a contract with the municipality to provide advice on issues such as debt structure, bond features, and other issues involved with raising capital.

Municipal advisors may assist in some of the underwriting functions, such as preparing the official notice, but they may not be compensated as part of the underwriting (sale) of any issue they provide advice on. In other words, they may not switch roles from advisor to underwriter.

LO 1.b
Order the process for selling new issues in the primary market.

Issuing a New Security by IPO

The main purpose of the Securities Act of 1933 (also called the Paper Act) is to ensure that the investing public is fully informed about a security and its issuing company when the security is first sold in the primary market. The Securities Act of 1933 protects investors who buy new issues by:

• requiring registration of new issues (unless exempt under the act);

• requiring an issuer to provide full and fair disclosure about itself and the offering;

• requiring an issuer to make available all material information necessary for an investor to judge the issue's merit;

• regulating the underwriting and distribution of primary issues; and

• providing criminal penalties for fraud in the issuance of new securities.

The Securities Act of 1933 requires that several steps be taken before a new issue is brought to market, including the distribution of a registration statement, a cooling-off period, and the filing of a final prospectus.

The Registration Statement

When an issuer desires to sell a security that does not meet one of the exemptions to registration under the Act of 1933 (detailed later in this unit), the issue must first be registered with the SEC. The first step in this process is for the issuer to file a registration statement (called an S-1) with the SEC.

The statement discloses material information about the issue. Part of the registration statement is a disclosure document called a prospectus, which must be provided to all purchasers of the new issue.

The registration statement must contain:

• a description of the issuer's business;

• the names and addresses of company officers and directors, their salaries, and a five-year business history of each;

• the amount of corporate securities company officers and directors own and identification of investors who own 10% or more of the company;

• the company's capitalization, including its equity and debt;

• a description of how the proceeds will be used; and

• whether the company is involved in any legal proceedings.

Underwriters (BDs, investment bankers) may assist the issuer in preparing and filing the registration statement and prospectus. However, the accuracy and adequacy of these documents is the responsibility of the issuer.

The Cooling-Off Period

After filing the registration statement, the cooling-off period begins. The cooling-off period lasts for a minimum of 20 calendar days, though the period is often longer. If the SEC finds that the registration statement needs revision or expansion, the SEC may suspend the review and issue a deficiency letter to the issuer of the securities. The 20-day cooling-off period resumes when the issuer submits a corrected registration statement. Note that it resumes where it left off and does not begin anew.

During the cooling-off period, no one can solicit sales of the securities. However, there are several activities that are allowed during the cooling-off period.

The issuer may place a tombstone advertisement.

Certain types of advertisements relating to a new issue are allowed to run before the effective date. These are known as tombstone ads because of the bare-bones, minimum information provided. Tombstone ads are an announcement and description of the securities to be offered.

Tombstone ads are the only form of advertising that is permitted during the cooling-off period. Remember that the cooling-off period is the time between the registration filing with the SEC and the effective date (when the SEC allows the security to be sold). While tombstone ads may run to announce a new issue during the cooling-off period, they are not required, and the ad does not need to be filed with the SEC.

Tombstone ads may be placed by the issuer directly or with the assistance of the underwriters. They are limited to the following information:

• Name of the issuer

• Type of security being offered

• Number of shares to be sold

• POP, or a range if the POP is not yet set

• Names of the underwriting members (when placed by the underwriters instead of the issuer)

All tombstone ads must contain the following 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."

A preliminary prospectus (red herring) may be delivered.

The preliminary prospectus, or red herring, can be used as a prospecting tool, allowing issuers and underwriters to gauge investor interest and gather indications of interest. The final price (POP) is not required for the preliminary prospectus, though a range is often included. The preliminary prospectus must be made available to any customer who expresses interest in the securities during the cooling-off period.

Indications of interest may be gathered.

An indication of interest is an investor's declaration of potential interest in purchasing some of the issue from the underwriter after the security is released for sale. An investor's indication of interest is not a commitment to buy because sales are prohibited until after the registration becomes effective on the effective date. An indication of interest from an investor is neither a commitment from the investor to buy nor a promise by the underwriter to sell; it is nonbinding to either party. Also, no money changes hands. It is, in essence, an investor saying, "I might be interested; let me know when it becomes available."

Due diligence takes place.

Underwriters and selling group members examine the issue to determine for which customers the issue is suitable. Often, the managing underwriter and the issuer will have due diligence meetings to make a formal presentation to those representatives that may offer the security to their customers.

State registration requirements (blue-sky filings) are addressed.

In addition to the federal government, the individual states have securities laws. The process of coordinating the federal and the state registrations is called blue sky. 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.

The release (or effective) date is reached.

Sometime on or after (usually after) 20 days of cooling off, the SEC will allow the security to be offered to investors. It is important to note that the SEC does not "approve" the issue. The SEC avoids language that sounds like an endorsement, preferring to say it "allows" the issue to be "released." Starting on the release date, investors may purchase the issue. Generally it will begin trading in the secondary markets shortly after the IPO.

Final Prospectus

The cooling-off period ends with the delivery of a final prospectus, which is made available at release. The final prospectus will be delivered to all who purchase the new security at the IPO. It will contain the same information as the preliminary prospectus plus two additional items: the release date and the POP.

A copy of the final prospectus must precede or accompany all sales confirmations. The prospectus must include the following:

• Description of the offering

• Offering price

• Selling discounts

• Release (effective) date

• Use of the proceeds

• Description of the underwriting, but not the actual contract

• History of the business

• Risks to the purchasers

• Description of management

• Material financial information

• Legal opinion concerning the formation of the corporation

• SEC disclaimer

The process for preparing a new issue for the primary market is pictured here.

The Three Phases of a Underwriting

You will note in the graphic that on the effective date, it says "offering period may begin." We tend to think of IPOs in terms of the hot offering, where all the securities are sold almost instantly. This is not true for most offers. It may take days, or even weeks, to sell the entire offer. Note that anyone who buys from the offering pays the POP and receives the final prospectus.

Issuing a New Security by Shelf Offering

Through a shelf offering registration, an issuer who is already a publicly traded company can register new securities without selling any of the shares until later. They may choose to sell some of the shares initially and wait to sell the remaining shares later. Once filed, the registration is good for two years and allows the issuer to sell portions of a registered shelf offering over the two-year period without having to reregister the security. While the base rule for shelf offerings is two years, the vast majority of such offerings qualify for three years. This provision under the Securities Act of 1933 allows issuers to quickly raise capital when needed or when market conditions are favorable.

From the Primary Market to the Secondary Market: Prospectus Delivery Rules

As discussed, any offering of a corporate security in a primary market transaction requires the delivery of a prospectus to the investors that purchase the security. In addition to those investors that buy shares at the IPO (or APO), investors that purchase these shares in the secondary market are also entitled to the final prospectus if the purchase is made within a certain number of days of the release date. These rules about post-effective-date prospectus delivery are specific to corporate offerings.

An investor that buys a new security in the secondary market will be entitled to the final prospectus if the purchase occurs within the following timelines:

• For IPOs of NMS securities—25 days

• For APOs of NMS securities—0 days (no requirement)

• For IPOs of non-NMS securities—90 days

• For APOs of non-NMS securities—40 days

Access to a prospectus on the SEC website is sufficient to meet delivery requirements.

NMS securities are defined in the Take Note earlier in this section.

LO 1.c
Recognize the types of exempt issues, exempt issuers, and exempt transactions.

When securities are required to be registered in order to be sold to the public, they are known as nonexempt securities (not exempt from registration and must be registered). However, there are exemptions from the registration requirements, which we will discuss now.

Exempt Issuers

Certain securities are exempt from the registration and prospectus requirements of the Securities Act of 1933 because the issuer is the federal government, an agency of the federal government, or a municipal government or because another government regulatory agency has jurisdiction over the issuer.

These exempt issuers include:

• the U.S. government;

• municipalities;

• national and state banks (but not bank holding companies);

• building and loans and savings and loans (S&Ls);

• charitable, religious, educational, and nonprofit associations; and

• common carriers (e.g., railroad equipment trust certificates).

Exempt Issues

Certain issues (securities) are exempt from the registration statement and prospectus requirements of the Securities Act of 1933. There are several such exemptions. The two exemptions that appear on the exam are:

• commercial paper, bankers' acceptances, and other securities that have maturities of 270 days or less; and

• insurance policies and fixed annuity contracts (but not variable annuities).

Exempt Transactions

Some securities are exempt from registration requirements due to the nature of the transaction. Often these are smaller offerings or have restrictions on who may invest.

Regulation A: Small- and Medium-Sized Offerings

With the passage of the JOBS Act, a rule was put into place that would ease the requirements for small- and medium-sized companies to raise capital. Regulation A provides two offering tiers for small- and medium-sized companies that allow the companies to raise capital in amounts substantially more than the $5 million previously allowed under this rule:

• Tier 1. Securities offerings up to $20 million in a 12-month period will be allowed in Tier 1. Of the $20 million, no more than $6 million can be sold on behalf of existing selling shareholders (similar to a combination offering covered earlier). The offering would be subject to a coordinated review by individual states and the SEC.

• Tier 2. Securities offerings up to $75 million in a 12-month period will be allowed in Tier 2. Of the $75 million, no more than $22.5 million can be sold on behalf of existing selling shareholders. These offerings are subject to SEC review only and none at the state level. Tier 2 offerings are still subject to rigorous disclosure requirements to the SEC, including audited financial statements and annual, semiannual, and current reports.

Offerings under both tiers are open to the public, and general solicitation (advertising) is permitted for both tiers. However, Tier 2 investors must be qualified investors, and there are two ways to qualify.

• Be an accredited investor as defined in Rule 501 of Regulation D.

• Limit the investment to a maximum of the greater of 10% of the investor's net worth or 10% of the investor's net income per offering. Note that self-certification for Tier 2 as to net worth and income is all that is required with no burdensome filings.

Tier 1 has no investment limits.

Finally, remembering that Regulation A is intended for small- and medium-sized companies, the regulation specifically excludes investment companies (i.e., private equity funds, venture capital funds, and hedge funds).

Rule 147: The Intrastate Offering Rule

Under Rule 147, offerings that take place entirely in one state are exempt from registration when the issuer has its principal office (headquarters) in the state and all purchasers are residents of the state.

In addition, the company must meet one of the following criteria.

• It receives at least 80% of its income in the state.

• At least 80% of the issuer's assets are located within the state.

• At least 80% of the offering proceeds are used within the state.

• The majority of the company's employees work in the state.

Also, if there is a BD acting as underwriter, the BD must be based in the state.

Securities sold under Rule 147 may not be resold to nonresidents of the state for six months after the initial purchase.

Regulation D: Exempt Transactions (Private Placements) Under Rule 506(b)

The SEC does not require registration of an offering under Regulation D as long as there are no more than 35 nonaccredited investors. There is no limit to the number of accredited investors that may invest in the private placement.

Purchasers in private placements must have access to the same type of information they would receive if the securities were being sold under prospectus in a registered offering. The amount of capital that can be raised is unlimited.

A private placement investor must sign a letter stating that they intend to hold the stock for investment purposes only. Private placement stock is called lettered stock due to this investment letter. The certificate may bear a legend indicating that it cannot be transferred without registration or exemption; therefore, private placement stock is also called legend stock.

The SEC requires that all companies raising capital in a nonpublic offering that qualify under the Regulation D exemption file the information on Form D online. The SEC also specifies the instances when an amended Form D must be filed, such as to correct a mistake of fact or an error or to reflect a change in information.

General Solicitations and Advertising Private Placements Under Rule 506(c)

In order to solicit or advertise exempt securities offerings (private placements), a business will need to meet certain requirements regarding the intended investors. First, meeting the requirements assumes that the securities are in fact being offered under the Regulation D registration exemption. Beyond that assumption, the requirements are as follows.

• All purchasers of the advertised securities must be accredited investors, or the business must reasonably believe that the investors are accredited investors at the time of the sale. In other words, while businesses may sell to up to 35 nonaccredited investors, in order to solicit or advertise, all purchasers must be accredited.

• The business must take reasonable steps to verify that all purchasers are accredited, considering background, relevant facts (such as reported income), and particular circumstances of each purchaser.