Series 6 Study Guide
Post 2 of 13
- 1.1 Reaching out to current and potential customers
- 1.2 Describing to potential and current customers
- 2.1 Provides information about the different account types
- 2.2 Secures customer information/documentation and looks out for suspicious activity
- 2.3 Tries to secure investment profile information regarding the customer
- 2.4 Opening accounts and the supervisory approval
- 3.1 Give customers details regarding strategies for investment
- 3.2 Studies and scrutinizes the investment profiles of customers
- 3.3 Highlights various disclosures to customers about investment products
- 3.4 Keeps customer records
- 4.1 Gives current quotes
- 4.2 Confirmation for customer transactions in line with all regulatory requirements
- 4.3 Tell relevant superior and help with the solution to any customer complaints
Post 2 of 13 in the Series 6 Study Guide
Much of the new business a registered representative will look to generate will come from new securities on the primary market, so let’s start there.
THE PRIMARY MARKET AND NEW SECURITIES
We start with this section and in particular, we need to look at how new issues are brought to market.
There’s much of this process that is covered on the SIE exam but for Series 6, it’s expanded further.
How new issues are brought to the primary market
When they are wanting to grow their business and need capital to do so, a corporation will issue equity and debt securities.
The income generated by the sale of these securities could be used in numerous ways, from buying out a competitor to building new infrastructure like a new factory, for example.
When these securities are made available on the primary market, they are known as new issues.
They can be issued by any number of organizations.
We’ve already mentioned corporations but new issues can originate from municipalities and the federal government, for example.
There’s the secondary market where securities are traded as well.
These are never new issues, however, and generally, the trade here is between various investors.
For now, we will focus on the process of bringing new issues to the market.
The Securities Act (1933)
This act plays a crucial role when it comes to securities.
Because of excessive speculation with regards to newly issued stock and as a result of the stock market crash of 1929, a way to protect investors was needed.
That’s why in 1933, Congress instituted the Securities Act.
The idea behind this was to issue that any new securities that were issued had to have registration statements filed with the Securities and Exchange Commission (SEC).
By doing so, investors could obtain information that was accurate regarding particular security which would help them make the right investments.
To get this information, a disclosure document for each registered security had to be filed by the issuer and usually takes the form of a prospectus.
The delivery of this prospectus must take place before or at the time of confirmation.
The requirements set out by the act are placed on new securities which are commonly called nonexempt issues.
While there are exempt issues that don’t have to follow the regulations as set out in the act, they have their own set of specific requirements that pertain to them.
Who are the participants in corporate new issues?
When we speak of new issues, there are two main parties that are involved in getting them to the market: the issuer and the underwriter.
Usually, in the case of the underwriter, it’s the broker-dealer that acts in this capacity.
Let’s start with the issuer.
In general, this is a company or municipal government that is going to issue new securities as a way to raise capital
To do this, together with the underwriter, a specific form must be filed with the SEC (unless an exemption exists).
This form is known as an S-1 registration statement.
Then we have the underwriter.
Generally, a broker-dealer will act in the position of the underwriter and will have specialized staff to handle the various tasks that need to be completed.
The functions an underwriter will perform include:
- When it comes to raising long-term capital, helping corporations find the best ways to do so
- Selling of new securities and in doing so help issuers to raise capital
- Purchasing securities from companies issuing them and then selling them back to the public
- Issuing blocks of stock to both institutions and the public
- Ensuring that issuers act in accordance with various securities laws and regulations
At no time will investment bankers loan money.
They are only involved with issuers in helping to sell their securities.
If a firm is to act as an underwriter for a specific security, they have to be a FINRA member before it can carry out any underwriting tasks.
Various underwriting agreements will be drawn up between the issuer and the underwriter.
These all have various commitment levels that are expected of the underwriter, depending on the agreement reached.
Depending on the underwriting agreement signed between the two parties, different levels of risk exist for both as well.
Types of underwriting agreements
In this section, we look specifically at two types of underwriting: best efforts and firm commitment.
Let’s start with best efforts underwriting.
The first important thing to understand with this type of underwriting is that the investment banker will act as an agent.
Customers are assisted in buying securities from the issuer by the underwriters, usually acting as a syndicate.
The underwriters do not act as a principal at all, only as an agent.
In doing so, they are not subjected to any risk whatsoever.
That’s because they are not buying any of the shares themselves, they are simply facilitating the sale.
When it comes to closing deals for best effort underwriting, an escrow account is used to collect the funds from those clients that are buying the issued shares.
Again, this means less risk, in this case, specifically when it comes to underwriter capital.
In terms of overall risk for the shares, well that risk is for the issuer alone, not the underwriter.
In other words, should they not be able to sell the minimum number of shares needed, then the capital outlay they wanted to raise for the project they wanted to be funded simply won’t be raised.
Best efforts underwriting can be split into two types:
- All or none (AON) underwriting: With this type of underwriting, an agreement is reached between the corporation issuing the shares and the underwriter where all the shares must be sold or the underwriting is canceled. During the process, as shares are sold, they are kept in an escrow account until the final outcome of the underwriting effort is known.
- Mini-max underwriting: With this type of underwriting, a minimum or floor amount is set. This signifies the lowest amount that the issuer wants to raise for the underwriting to move forward. A ceiling is set too. This relates to the highest dollar amount the issuer is wanting to sell. For the underwriting to proceed, several interested buyers needed to cover the floor amount must be found by the underwriter to allow for those securities to be issued. Once that’s done, the offering can be expanded but never higher than the ceiling as specified by the issuer.
Then you also have firm commitment underwriting which is often used when it comes to selling securities.
This is a little different in the fact that the underwriters will buy securities from the issuer.
They then resell the securities at a higher price to the general public.
This price is known as the public offering price or POP.
For their efforts, underwriters will earn the difference between the price they paid for the securities and the price that they then sold them to the public for.
This is commonly known as the spread.
In this scenario, the underwriter is not acting as an agent but instead as a principal.
A commitment is made by the underwriter that should there be any unsold securities, they will be purchased by them for the underwriting syndicate account.
The issuer has no risk for securities that are not sold to the public in this form of underwriting, that risk falls on the underwriter themselves and it can become an issue should the price of the securities fall.
That scenario can play itself out when the securities cannot be sold.
If that happens, they are put into the inventory of the underwriter until they are sold, but as we’ve already mentioned, if their positions fall on the market, the underwriter runs the risk of losing money.
For the issuer, because the underwriter will purchase all the shares that they issue, they know that they will be able to raise the necessary capital that they need.
Registration of securities
When a company issues new securities, they must always be registered with the SEC as per the Securities Act of 1933.
This is easily done through a registration statement that will be filed by the issuer with the regulatory body.
In most cases, the prospectus for the securities will come from that registration statement.
Let’s focus on the registration process a little more.
A cooling-off period will begin once the securities are registered by the issuer with the regulatory body.
This is necessary to allow the SEC to check on the registration statement that represents the relevant securities.
Should they find fault with it, for example, not all the required information has been provided, they can then issue a stop order on those securities.
The registration statement is commonly called an S-1.
It contains information about:
- The security
- The company issuing them
- The officers representing that company
While a registration statement is important for the SEC to review, it also provides relevant information to investors.
Ultimately, this can help them make a decision as to whether they will add a security to their portfolios.
The cooling-off period in which the SEC reviews the registration statement takes a minimum of 20 days and during this time, the security is “in registration”.
Once approved, the information contained in the registration document is used as the foundation of the prospectus which is the full disclosure document about the security.
The onus on ensuring that everything the prospectus discloses to the public about the security it represents is accurate falls on both the issuer as well as the underwriter.
For the Series 6 exam, it’s worth remembering that during the cooling-off period, the following activities may and may not take place.
- The distribution of red herrings
- The publication of tombstone advertising
- Locating indications of interest
- The securities cannot be offered for sale
- The final prospectus cannot be distributed
- Advertising and sales material cannot be sent out
- Orders cannot be taken
- Postdated checks cannot be accepted
Let’s move on to the various disclosure documents related to securities.
Also known as a red herring, this generally will include the registration statement for a new security issue.
This document is commonly called a prospecting tool.
Investor interest can be gauged by both issuers and underwriters throughout it.
It cannot gauge orders, however as an investor can only show their interest in the security.
A preliminary prospectus won’t include a final price for the security either but to give potential investors an idea of what it might cost, it is allowed to have an estimated price range for the security.
Should any investor show an interest in the security during the cooling-off period, they should be sent the preliminary prospectus.
The preliminary prospectus can be amended as soon as the registration statement becomes effective.
These amendments include the final offering price that appears in the final prospectus as well as other information which we will cover below.
Once the final prospectus is ready, orders can now be taken for the securities on offer.
Here’s the information that a final prospectus must include
- The offering’s description
- The price of the offering
- Selling discounts
- What the proceeds generated will be used for
- Underwriting description (the contract isn’t necessary, however)
- A statement regarding the issue price and that there is a possibility it may be stabilized
- The business history of the company issuing the offering
- The overall risk to purchasers
- Company management description
- Material financial information
- Legal opinion covering the company’s formation
- Disclaimer from the SEC
For the Series 6 exam, it’s important to understand that all the SEC does is release an offering so that it may go up for sale.
It will never endorse or approve any offerings that come before it.
As we mentioned above, the SEC disclaimer that confirms that they do not approve or disapprove of the security must appear in the final prospectus.
Mutual funds disclosure documents
When it comes to mutual funds, there are several disclosure requirements that we will cover later in the course, specifically when we look into investment companies.
Disclosure documents for other investment types
Let’s look at other types of investments and the disclosure documents that relate specifically to them, starting with municipal securities.
An official statement is the primary disclosure document when it comes to these securities.
It serves exactly the same function as a prospectus would for new issues and contains much of the same type of information.
Then we have private placements, Regulation A, and other types of exempt securities.
For any other type of exempt securities, the disclosure document is commonly known as an offering circular.
But it also can have another name from time to time and that’s a notice of sale.
While it will have some of the same information that you will find in a prospectus, the difference here is that the disclosures in an offering circular are not nearly as detailed.
Exempt issuers as described by the 1933 Securities Act
When the public is able to buy securities that need to be registered first before the sale can take place, these securities are called nonexempt securities.
The “nonexempt” part ties in with the fact that when it comes to registration, that’s a given, they are not exempt from it.
But when it comes to these registration requirements, there are some exceptions and that’s what we are going to look at in a little more detail now.
So which of these issuers are exempt from registering their securities?
Well, it’s actually quite simple.
When the issuer is the federal government, an agency thereof, or a municipal government, they are exempt issuers and for that reason, the securities they issue don’t have to be registered with the SEC.
Here’s a full list of exempt issuers/securities that you should know:
- U.S. government
- National and state bank securities
- Building and loan securities
- Saving and loan securities
- Securities issued by religious, educational, charitable, and other nonprofit organizations
- Interests in common carries (for example, certificates for railroad equipment)
It’s important to note that securities of bank-holding companies are not exempt, only those of banks.
In some cases, because of the nature of the transaction, certain securities are exempt when it comes to the registration requirements as set out by the SEC.
There may be other restrictions as to who can invest, however, and generally, these offerings are smaller.
Regulation A offerings: Small and mid-sized
There are two offering tiers for Regulation A offerings.
These, which fall under the JOBs Act, are allowed for small and mid-sized companies.
It provides a way for them to raise capital and the amount that can be generated from these offering tiers is far more than what was allowed before under previous laws (Regulation A).
In fact, that only allowed up to $5 million but now, these small and mid-sized companies can generate even more.
Let’s look at both tiers in a little more detail:
- Tier 1: Over a 12-month period, $20 million in security offerings are permitted. When it comes to existing shareholders, only a portion of up to $6 million may be sold on their behalf. A coordinated review by the SEC and individual states will be carried out on the offering.
- Tier 2: Over a 12-month period, $75 million in security offerings are permitted. When it comes to existing shareholders, only a portion of up to $22.5 million can be sold on their behalf. A review of this offering will be carried out by the SEC but not by the state.
Note that several SEC disclosure requirements are necessary when it comes to Tier 2 offerings.
- Current, semi-annual, and annual reports
- Financial statements (fully audited)
For both of these tiers, advertising of the securities is allowed and the general public may purchase them.
That said, should they want to buy securities that are from Tier 2, they must be seen as qualified investors.
This can be done in two ways:
- As defined by Rule 501 of Regulation D, they could already be an accredited investor and that will qualify them
- They can limit their investment. It must be limited to the greater of these two options: 10% of the overall net worth of the investor OR 10% of the net income per offering of the investor
There are no investment limits for those investors who would prefer to buy Tier 1 securities.
Regulation A does not include any types of investment companies including hedge funds, venture capital funds, or private equity funds.
Investors will never receive a full prospectus with a Regulation A offering.
Instead, they will get a notice of sale/offering circular that the issuer has to file with their regional SEC office.
Intrastate offering rule (Rule 147)
Should the issuer have headquarters based in a certain state and all the purchasers of the securities on offer come from the same state, under Rule 147, those securities are exempt from registration.
In this situation, there is also one of the following benchmarks that must be met:
- 80% of the income received must come from the that state
- 80% of the assets of the issuer must be located in that state
- 80% of the proceeds offerings must be used in that state
- Most of the workers of the issuer must come from the state in which the securities are issued
What of the broker-dealer?
Do they need to be based in the state as well?
Well, the answer to that is yes.
Following a period of six months from the point that they were initially purchased, those securities that are sold by an issuer under this rule cannot be sold to non-state residents.
Once that period of six months has passed, however, they can be sold to anyone in any location in the United States.
As for advertising, well that can go out to both residents of the state and non-residents too.
Just as long as the purchase of shares is only for residents for those six months initially.
Private placements exempt transactions (Regulation D)
Those security offerings that fall under Regulation D are exempt from registration as well.
But what does Regulation D stipulate for these securities to remain exempt?
Well, it’s all linked to the investor numbers.
For the securities to remain exempt, there can be no more than 35 non accredited investors.
Note, however, that when it comes to accredited investors, no limit is placed by Regulation D and any amount may invest in a private placement.
With this type of exempt transaction, there is no limit to the amount of capital an issuer could raise while investors have to be provided with information similar to a registered offering that is sold under a prospectus.
There are a few requirements that an investor in a private placement must carry out.
For example, they have to indicate that the stocks purchased are for investment purposes only and that they will hold them.
Regulation D requirements state that a letter stating this intention must be signed by private placement investors.
It’s also because of this letter of commitment to holding the stock that you will find private placement stock called lettered stock.
But it’s also called legend stock.
That’s because a legend sometimes can be found on the stock certificates which states that without registration or exemption, it may not be transferred.
When a company wants to use a nonpublic offering to raise capital under the Regulation D exemption as outlined above, it will need to submit a Form D to the SEC.
This can be done electronically.
We’ve spoken a little about an accredited investor above, but what are they exactly?
This investor type is usually made up of two classes:
- Institutional investors
- Certain types of retail investors
Those retail investors that are accredited include:
- Insiders linked to the issuer of the security (this includes major stockholders, officers, and board members)
- Those that meet specific financial criteria (they must have generated an income of $200,000 and over for the last two years and expect to do the same in the current year. If the purchase is made in a joint name, the figure becomes $300,000).
- Their overall net worth is $1 million or higher (this figure does not include primary residence equity)
- People with specific credentials, designations, and/or certifications recognized professionally, for example, Series 82, 65, or 7. Not these must be natural persons.
Only one of these requirements is necessary for a retail investor to be able to be seen as an accredited investor.
Accredited investors are seen as more sophisticated when it comes to the world of securities than a regular retail investor.
For that reason, they will not need the same protection as they understand the potential risks involved.
Advertising private placements
There are a number of requirements that a business that wants to advertise private placements (or private securities offerings) to intended investors will need to meet to do so.
These requirements already assume that the securities come with a registration exemption under Regulation D.
The requirements are:
- The advertised securities must be purchased by accredited investors. 35 nonaccredited investors can purchase the securities, but the rest must be accredited.
- It’s the responsibility of the issuer to attempt to verify that purchasers are indeed accredited. There are various steps that they can take to do this including checking their reported income (or other relevant facts) as well as their overall circumstances.
Let’s just briefly touch on state-security laws.
Also known as blue-sky laws, these expect that securities, broker-dealers, and registered representatives are registered.
Securities issued can be blue-skyed by the issuer or investment banker in the following ways:
- Qualification: Independent of registration with federal authorities, the issuer will file with the state. This means that all state requirements will need to be met.
- Coordination: Here the issuer registers the securities with the SEC and the state at the same time which means that on the same date, the registrations are effective.
- Notice filing: This deals with federal covered securities (those listed on Nasdaq, major stock exchanges, and registered by investment companies under the 1940 Investment Company Act). In most states, registration is not required. Most will request that a notice is filed, however. This notice explains the intention of the issuer to sell securities in the state and that a filing fee can therefore be asked for from the state.