Selling New Securities - Final Prospectus

The prospectus is a short form of the SEC registration, containing only those facts necessary for an investor to make an intelligent decision regarding the issue. It can only be distributed after the effective date of SEC registration. 

The final prospectus must be published and sent to each investor no later than the confirmation date of the purchase. The final prospectus will have the price of the new securities, the underwriters' discount, and any requirements specified by the SEC in approving the registration. The final prospectus will also contain the latest financial information about the company. 

The price of the new securities is decided when the registration is approved, but if market conditions or lack of interest lower the marketable price sufficiently, the underwriting may be postponed or even canceled. The SEC requires that any prospectus that is more than 9 months old must not have any financial information that is more than 16 months old. If there is any event during the distribution of the prospectus that could have a material impact on the company, then the prospectus must be amended to reflect the new developments. In the past, this has been done by stickering, actually pasting a new page on top of the obsolete material. Nowadays, however, with prospectuses in electronic format, the new material can be added, and the obsolete material can be amended or deleted directly.

When the new issue of securities is a first-time sale of stock by a company, it is called an initial public offering (IPO), or going public. This allows the founders and venture capitalists who invested in the company to profit from their investment.

90-Day Rule for IPOs:

Before a company goes public, most of its financial information is confidential and has not been published. Therefore, the SEC requires that a prospectus be available for at least 90 days after the effective date to provide financial information. After 90 days, the company will have posted its 1st required financial statements with the SEC, which any investor can examined for the latest financial information about the company.

40-Day Rule for New Issues:

A new issue is any offering of new issues of stock that is not an IPO. In this case, the company will have already filed periodic financial statements with the SEC, so the SEC requires that a prospectus for the new offering has to be available for at least 40 days after the effective date of the new issue.

25-Day Rule for Exchange traded Issues:

If the new issue is going to be traded on a public stock exchange, then a prospectus must be available for at least 25 days after the effective date.

Public Distribution of New Issues:

All members of the underwriting syndicate must make a bona fide public distribution of the new issue at the public offering price.
 

Overallotments:

Usually, the underwriting syndicate members will accept a small percentage of orders over their allotment, because they know that some clients will cancel their order before delivery. Therefore, the underwriting manager will distribute more new issues to each syndicate member than they are required to sell—an overallotment. If fewer clients cancel than expected, then either the issuer will issue more shares to cover the additional sales—and get more money—or the underwriting syndicate will have to go short to cover the additional sales, which is a risk to the underwriting members, and will have to buy it back, probably at a higher price, in the secondary market to cover their shorts.

Stabilization:

When a new issue doesn't sell as well as expected, then initial investors may sell their shares in the secondary market for less than the public offering price while the syndicate members still have shares to sell. However, the underwriting syndicate cannot sell the shares for less than the public offering price, so, in this situation, they would not be able to sell their remaining shares.

To prevent a drop in price before all shares have been distributed to the public, the underwriting manager stands ready to buy any issues offered in the secondary market at or slightly below—but never above—the public offering price as a way to stabilize (aka peg, fix) the price of the new offering until it has been fully distributed to the public. Price-fixing is generally illegal, but is allowable in the distribution of new issues by Rule 104 of the Securities Exchange Act of 1934, but only until all shares have been publicly distributed—pegging the price afterward is against the law.

Stabilization may not work. The underwriting syndicate may be unable to sell all of the shares at the public offering price, in which case, they will have to take the loss. 

Syndicate Penalty Bid:

To stabilize the new issue, the underwriting manager buys the stock back at or near the public offering price. If the manager buys the stock back from a client of a syndicate member, then the manager has already paid or credited the syndicate member its underwriter's allowance. The syndicate penalty bid takes this money back from the syndicate member during the stabilization period, because the underwriting manager will have to re-sell those shares.

Selling a IPO by a Dutch Auction

In a hot IPO, when many investors are clamoring to get shares, many of those who do get the newly issued shares will flip it—immediately sell it in the open market for instant profits. The investment bank must, by law, sell the new shares at the offering price regardless of demand. Because of the demand for the new issues, they have to be allocated, and usually it's the biggest clients of the investment bankers who get the issue—small investors almost never get to participate. Furthermore, neither the investment bankers nor the issuer can profit from flipping. However, flipping is an indication that the offering price was set too low, but, on the other hand, the bankers don't want to set the price too high so that they can be sure to sell the entire issue quickly.

With a hot IPO, it is difficult to ascertain what price would be best, so some companies use a Dutch auction to determine the price. Google used this method for its IPO, for instance. In a Dutch auction, the public is invited to submit closed bids, indicating how many shares they want and at what price they are willing to pay. Then the company sets the offering price that will sell out the whole issue. Everyone who bid at or above the offering price will get shares at the offering price, even if they bid higher. 

Those who bid below the price will get no shares. In most cases, the successful bidders will not get all of the shares that they requested, because there will not be enough, so the shares will be allocated proportionally to the amount that they requested to the total amount requested. So, if the successful bidders requested 10,000,000 shares, but there are only 2,000,000 shares available, then each bidder will get 20% of whatever they requested.

Standby Commitment for a Rights Offering — Lay Off

When the investment bank also has a standby commitment with its client, then the investment bank agrees to purchase any subsequent new issues of stock shares at the subscription price that are not purchased by current stockholders in a rights offering, which it will then sell to the general public as a dealer in the stock.

The investment bank takes a risk, however, in that the price of the stock could decline during the 2 to 4 weeks of a rights offering. To minimize this risk, the investment bank may do a lay off:

buying up any rights that are sold by the current stockholders, then exercising the right and selling the stock; and by selling enough stock short, up to 1/2% of a new issue, to cover an expected proportion of unexercised rights, then using the rights to cover the short.

Best Efforts Underwriting

Most agreements for the sale of new securities are an underwriting, but sometimes the investment bank will agree to a best efforts approach because the company is perceived as a risky investment for a new issue. The investment bank will do its best to sell all of the new securities, but it does not guarantee it. The company bears the risk that the investment bank may fail to sell all of the new issue, thereby lessening the amount of money that the company receives.

There are 2 variations of the best-efforts underwriting: all-or-none or mini-max. An all-or-none underwriting requires that the entire issue be sold within a specified time, or else the program is terminated. A mini-max (aka part-or-none) underwriting is similar, except that only a specified minimum must be sold. In either case, SEC Rule 15c2-4 requires that all money collected from any sales be deposited in a separate escrow account at an independent bank for the benefit of the investors. If the sale is canceled, then the money must be returned to the investors, and no more orders will be taken; if the underwriting is successful, then most of the money goes to the issuer minus the fees paid to the underwriters.