On October 29, 1929, the stock market lost 12% of its value in a single day. Within three years, it would fall 89% from its peak. Fortunes evaporated. Banks failed. The Great Depression began. And Congress decided it was time to do something about the Wild West of securities sales.
The result was the Securities Act of 1933, the first federal law requiring companies to tell investors the truth before taking their money. This chapter covers how companies bring new securities to market, the rules that govern the process, and the people who make it happen.
Section 1: The Securities Act of 1933
Before 1933, companies could sell securities to the public with virtually no disclosure requirements. A promoter could spin tales of gold mines and oil wells, collect investors' money, and disappear into the sunset. The crash of 1929 finally convinced Congress that investors deserved better.
- Full disclosure: Require companies to publicly disclose all relevant financial information before offering securities for sale
- Antifraud: Prohibit fraud and deceit in the sale of securities
Primary vs. Secondary Market
The primary market is where companies and governments raise money by selling new securities to investors. The proceeds go to the issuer. Think of it as buying directly from the source.
The secondary market is where investors trade securities among themselves. When you buy Apple stock on the NYSE, Apple doesn't receive any of your money. It goes to whoever sold you the shares.
The capital market, because this is where issuers raise longer-term funding. The '33 Act governs this market specifically.
The Registration Statement
Nonexempt securities must be registered with the SEC before being offered for sale to the public. The first step is filing a registration statement that contains:
- Details about the company's business operations
- Information about management
- Description of the security being offered
- Plans for how the money raised will be used
- Financial statements certified by independent accountants
The Prospectus
Part of the registration statement becomes a prospectus: the disclosure document given to investors. It provides all the information potential investors need to make an informed decision.
Test Tip: The SEC does NOT "approve" securities. It simply registers them and allows them to be sold. The SEC doesn't judge whether a security is a good or bad investment; it only ensures disclosure requirements are met.
The Effective Date
Once the SEC determines that registration requirements have been met, the securities receive an effective date. Only after this date can securities be sold to the public at the public offering price (POP).
A copy of the prospectus must be sent to a customer at or before an offer or sale of any registered primary offering.
Section 2: Exempt Securities and Transactions
Not every security needs to go through the full SEC registration process. Some issuers and some transactions are exempt, either because they're already regulated elsewhere or because requiring full registration would be impractical.
Exempt Issuers
| Security Type | Registration Status |
|---|---|
| U.S. Government securities | Exempt from federal AND state registration |
| Municipal bonds | Exempt from federal registration (still subject to antifraud provisions) |
| Bank securities | Exempt (already regulated by banking agencies) |
| Nonprofit/charitable issues | Exempt (no profit motive) |
| Commercial paper (9 months or less) | Exempt |
Exempt Transactions
Rule 147: Intrastate Exemption
Securities sold only to residents within a single state may be exempt from federal registration. The logic: if everything stays in one state, let that state regulate it.
- Issuer must be incorporated and doing business in the state
- "Doing business" = 80% revenue, 80% assets, 80% proceeds used in state
- All purchasers must be state residents
- Cannot resell to out-of-state buyers for 6 months
Regulation A (Small Offerings)
Regulation A provides a simplified registration process for smaller offerings. Instead of a full prospectus, issuers file an offering circular.
| Regulation A Tier | Maximum Offering | Key Features |
|---|---|---|
| Tier 1 | Up to $20 million in 12 months | Subject to state registration ("blue sky") |
| Tier 2 | Up to $75 million in 12 months | Exempt from state registration; ongoing reporting required |
Regulation D: Private Placements
To avoid the cost and time of full registration, issuers can sell to a private group of investors rather than the general public. This is a private placement.
| Reg D Rule | Maximum Size | Investors Allowed | General Solicitation? |
|---|---|---|---|
| Rule 504 | $10 million | Accredited + up to 35 non-accredited | No |
| Rule 506(b) | Unlimited | Unlimited accredited + up to 35 sophisticated non-accredited | No |
| Rule 506(c) | Unlimited | Only accredited investors | Yes (must verify accredited status) |
An individual qualifies as an accredited investor if they have:
- Net worth (excluding primary residence) exceeding $1 million, OR
- Income over $200,000 ($300,000 with spouse) for each of the last 2 years with expectation of the same
Institutions with assets over $5 million and directors/officers of the issuer also qualify.
Rule 144: Resale of Restricted and Control Stock
Restricted securities (from private placements or employee compensation) and control stock (owned by affiliates like directors, officers, or 10%+ shareholders) have special resale rules.
- Holding period: 6 months (SEC-reporting company) or 12 months (non-reporting)
- Volume limitation: Greater of 1% of outstanding shares OR average weekly trading volume (4 weeks)
- Filing: Form 144 required if sale exceeds 5,000 shares or $50,000
Rule 144A: Sales to Qualified Institutional Buyers
Rule 144A allows restricted securities to be resold to Qualified Institutional Buyers (QIBs): institutions that own and invest at least $100 million in securities. No holding period required for these sales.
Section 3: The Underwriting Process
When a company decides to go public, it typically doesn't sell shares directly to the public. Instead, it hires an investment banker (or underwriter) to manage the offering, navigate the regulatory process, and distribute the securities.
Types of Public Offerings
| Offering Type | Description | Who Receives Proceeds? |
|---|---|---|
| IPO | First time a company sells stock to the public | Issuer |
| Follow-on (Additional Issue) | Company that already has public stock issues more shares | Issuer |
| Secondary Offering | Large shareholder sells their existing shares | Selling shareholder |
| Split/Combined Offering | Combination of new shares from issuer and existing shares from shareholders | Both issuer and shareholders |
Shelf Registration
A shelf registration allows an issuer to file one registration statement for a large number of securities, then sell them over time as market conditions allow. It's like keeping securities "on a shelf" until you need them.
Shelf registrations are valid for up to 3 years. Securities can be sold in portions over that time without filing a new registration statement.
Selecting the Underwriter
| Method | How It Works | Most Common For |
|---|---|---|
| Negotiated | Issuer chooses underwriter and negotiates terms | Corporate securities |
| Competitive Bid | Multiple firms submit bids; lowest cost wins | Municipal GO bonds |
Test Tip: Assume that a general obligation bond will use a competitive bid process unless told otherwise.
Underwriting Commitments
Firm Commitment
In a firm commitment, the underwriter purchases ALL the securities from the issuer at a discount, then resells them to the public. The underwriter takes on the risk of any unsold shares. This is the most common type for corporate offerings.
Best Efforts
In a best-efforts commitment, the underwriter agrees to use its best efforts to sell the issuer's securities but does NOT guarantee all shares will be sold. The underwriter acts as an agent, not a principal, and is not liable for unsold shares.
| Firm Commitment | Best Efforts | |
|---|---|---|
| Underwriter's role | Principal (buys securities) | Agent (sells securities) |
| Risk of unsold shares | Underwriter bears risk | Issuer bears risk |
| Common for | Established companies | Smaller/newer companies, private placements |
| Escrow required? | No | Yes (investor protection) |
Best-Efforts Variations
- All-or-None (AON): If the underwriter can't sell all securities, the entire offering is canceled
- Mini-Max: A minimum amount must be sold; underwriter continues trying to sell the remainder on a best-efforts basis
Standby Underwriting
Standby underwriting is used with rights offerings. If existing shareholders don't purchase all the shares, the underwriter "stands by" to buy the remainder on a firm commitment basis.
The Syndicate
For large offerings, the lead underwriter forms a syndicate: a group of investment banks that share the risk and distribution responsibilities.
| Account Type | Liability for Unsold Shares |
|---|---|
| Western (Divided) | Each member responsible only for their allotted shares |
| Eastern (Undivided) | All members jointly responsible for all unsold shares |
The Underwriting Spread
The underwriting spread is the difference between what the underwriter pays the issuer and the public offering price. It compensates everyone involved in bringing the securities to market.
| Component | Who Receives It |
|---|---|
| Manager's fee | Lead underwriter (for organizing the deal) |
| Underwriting fee | Syndicate members (for taking risk) |
| Selling concession | Whoever sells the shares (largest portion) |
A company offers 10 million shares at $10 (POP). The underwriting spread is $0.70/share:
- Managing fee: $0.10/share = $1 million
- Underwriting fee: $0.10/share = $1 million
- Selling concession: $0.50/share = $5 million
Issuer receives: $100 million - $7 million = $93 million
Section 4: The Underwriting Timeline
The journey from deciding to go public to actually selling shares follows a carefully regulated timeline with three distinct periods, each with its own rules about what can and cannot be communicated.
| Period | What's Happening | Offers Allowed? | Sales Allowed? |
|---|---|---|---|
| Pre-Filing | Preparing registration statement | No | No |
| Cooling-Off | SEC reviewing (minimum 20 days) | Yes (limited) | No |
| Post-Effective | SEC has cleared registration | Yes | Yes |
Pre-Filing Period
Before the registration statement is filed, the issuer and underwriter can prepare materials and conduct due diligence, but they cannot offer or sell securities. No written materials about the offering can be distributed.
Cooling-Off Period
The cooling-off period (also called the waiting period) begins when the registration statement is filed and lasts at least 20 days while the SEC reviews it. During this time, limited communications are permitted.
What's Allowed During Cooling-Off
- Oral offers: Representatives can discuss the offering with potential investors
- Preliminary prospectus (red herring): Contains most information but NOT the final price or proceeds
- Tombstone advertisement: Very limited announcement with issuer name, security type, and how to get more information
- Indications of interest: Investors can express interest (not binding commitments)
The preliminary prospectus is called a "red herring" because of the red ink legend on its cover warning that the information is not final and subject to change. It does NOT contain the final public offering price.
Test Tip: The preliminary prospectus does NOT contain the public offering price. That information only appears in the final prospectus after the effective date.
Post-Effective Period
Once the SEC clears the registration statement (the "effective date"), the securities can be sold. The final prospectus must now be used, which includes:
- Final public offering price
- Underwriting spread
- Net proceeds to issuer
Prospectus Delivery Requirements
| Offering Type | Delivery Period After Effective Date |
|---|---|
| IPO | 90 days |
| Additional offering (follow-on) | 40 days |
| Exchange-listed securities | 25 days |
Section 5: Rules and Regulations
FINRA Corporate Financing Rule (Rule 5110)
FINRA limits underwriting compensation to prevent excessive spreads. If total compensation exceeds $500,000, a filing with FINRA is required.
Total underwriting compensation cannot exceed 8% of gross proceeds.
FINRA Rule 5130: Restricted Persons
Certain people are prohibited from purchasing IPO shares to ensure fair distribution of "hot" IPOs to the public.
- FINRA member firms and their employees
- Immediate family members of the above (spouse, parents, children, siblings, in-laws)
- Finders or fiduciaries to the issuer
- Portfolio managers who purchase IPOs for client accounts
Prohibited Practices
Spinning
Spinning is allocating IPO shares to executives of a company in exchange for (or hope of) investment banking business. This is strictly prohibited.
(Giving hot IPO shares to a CEO you're hoping will hire you to underwrite their next offering is the kind of quid pro quo that makes regulators very unhappy.)
Flipping
Flipping is quickly selling newly purchased IPO shares for a profit. While not illegal, underwriters discourage it and may penalize customers who flip by withholding future IPO allocations.
Free-Riding and Withholding
Free-riding is withholding shares of a new offering to sell later at a higher price. Broker-dealers must make a bona fide public distribution; they cannot hoard shares for their own benefit.
FINRA Rule 5121: Conflicts of Interest
When a member firm has a conflict of interest in an underwriting, additional protections are required.
- 10% or more of net proceeds go to a FINRA member
- FINRA member will use proceeds to pay debt to another member
- Firm is issuing its own securities
When conflicts exist, a Qualified Independent Underwriter (QIU) must perform due diligence and price the offering independently.
Regulation M: Market Manipulation
SEC Regulation M prohibits underwriters and issuers from manipulating the market during an offering. They cannot bid for or purchase securities in the secondary market during the distribution.
Exception: Stabilization
Stabilization is a limited exception allowing the managing underwriter to place a bid to support the price and prevent rapid decline during distribution.
- Stabilizing bid must be at or BELOW the public offering price
- Must be disclosed in the prospectus
- Only the managing underwriter may place stabilizing bids
Penalty Bids
If syndicate members' or customers' flip shares, the managing underwriter can impose a penalty bid: reclaiming the selling concession from the broker whose customer flipped. This must be disclosed in the prospectus.
Chapter 14 Key Terms Glossary
| Term | Definition |
|---|---|
| Primary market | Where issuers sell new securities; proceeds go to issuer |
| Secondary market | Where investors trade existing securities among themselves |
| Registration statement | SEC filing required before offering nonexempt securities |
| Prospectus | Disclosure document for investors; part of registration statement |
| Effective date | When SEC clears registration; sales may begin |
| IPO | Initial public offering; first sale of stock to public |
| Follow-on offering | Additional shares issued after IPO; also a primary offering |
| Secondary offering | Large shareholder sells existing shares; proceeds to shareholder |
| Shelf registration | Register securities now, sell over 3 years |
| Firm commitment | Underwriter buys all shares; bears risk of unsold |
| Best efforts | Underwriter tries to sell; no guarantee; escrow required |
| All-or-none | Best-efforts type; if can't sell all, offering canceled |
| Mini-max | Best-efforts type; must sell minimum; continue with remainder |
| Syndicate | Group of investment banks sharing risk and distribution |
| Western (Divided) account | Each syndicate member liable only for their allotment |
| Eastern (Undivided) account | Syndicate members jointly liable for all unsold shares |
| Underwriting spread | Difference between price paid to issuer and POP |
| Cooling-off period | 20+ days while SEC reviews; limited offers allowed; no sales |
| Red herring | Preliminary prospectus; no final price |
| Tombstone ad | Limited announcement; not an offer to sell |
| Regulation A | Simplified registration; Tier 1 up to $20M, Tier 2 up to $75M |
| Regulation D | Private placement exemption; Rules 504, 506(b), 506(c) |
| Accredited investor | $1M net worth (ex-home) or $200K/$300K income |
| Rule 144 | Governs resale of restricted and control stock |
| Rule 144A | Resale to QIBs ($100M+); no holding period |
| Rule 147 | Intrastate exemption; 80% test; 6-month resale restriction |
| Stabilization | Bid at/below POP to support price during distribution |
| Spinning | Prohibited; giving IPO shares for banking business |
| Flipping | Quick resale of IPO shares; discouraged but not illegal |
Chapter 14 covers the birth of securities: how companies bring new securities to market, the regulations designed to protect investors, and the process that turns a private company into a public one. Next up: the Securities Exchange Act of 1934, which governs what happens after securities start trading.