Series 7 Study Guide 1.2 - Describing investment products to potential and current customers

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With the intent of soliciting business, describing investment products to both potential and current customers

As you know, there are numerous types of securities available in the marketplace including those issued by governments (federal, state, and local) as well as corporations.

For the most part, these securities are purchased as new issues by investors.

Following that first purchase, securities are then traded between investors on the secondary market.

In this section, we are going to specifically look at new issues of securities and how they are brought to the market as well as the legal requirements that accompany that process.

The process of bringing new issues to market

Primary market

Let’s quickly recap on what the primary market is before we get into new issues.

This is where securities are sold to investors, plain and simple.

That process is known as issuer transactions.

In other words, those who issue securities will receive the proceeds of their sales.

For the most part, these haven’t been made available to the investing public before.

Shares like that are called IPOs which stand for the initial public (or primary) offering.

Issuers can have more than one primary offering too, as is the case with mutual funds.

If extra capital needs to be raised by the issuer after the initial IPO, as we know, that’s achieved through an additional primary offering (APO).

Note that when treasury stock is involved, the issuer will receive the proceeds although this isn’t an IPO.

This could be a possible test question on the Series 7 exam.

The secondary market mostly involves nonissue transactions.

Here the proceeds go to the shareholder and not the issuer.

While this is all basic knowledge, it is critical when it comes to markets.

New issue participants

When a new issue is brought to the primary market, there are two critical participants:

The issuer
Broker-dealer acting as the underwriter (investment banker)

Issuer

A registration statement must be filed with the SEC by the company selling the securities to raise money before they are brought to the market.

Registration statements include information on the security offered, the company offering it, and the company officers.

It’s necessary so an investor weighing up whether they should buy the security or not has enough information to help them make an informed choice.

The document is reviewed by the SEC and it ensures that there is sufficient information about the potential investment for investors but it doesn’t necessarily look at the accuracy thereof and therefore does not guarantee that prospectus is sufficient.

The SEC review process is known as the 20-day cooling-off period.

Following that, the process of due diligence comes to the fore.

Due diligence is the collective name for processes that take place during underwriting.

This includes preliminary studies, all investigations, research, meetings, and compiling of information regarding the corporation and the new issue.

The formal due diligence meeting held following the cooling-off period delivers information about:

The issue
The financial background of the company offering the issue
The use of the proceeds generated by the sale of the issue

These meetings are attended by representatives of the issuing company and the underwriter.

In it, they will be asked questions from a range of industry players such as institutions, other broker-dealers, and analysts.

Note that should municipal bonds be underwritten, a feasibility study needs to be carried out first and will look at project costs, estimated reviews, and an assessment of competitors.

The due diligence process will see investment bankers:

Look into what the proceeds of the sale will be used for
Look into how stable the issuing company is
Determine if reasonable risk is associated with the offering
Carry out analysis of finances and overall feasibility

Underwriter

Any business that is going to issue securities to sell on the primary market has to work with an underwriter to do so.

Underwriters have numerous functions including:

Making sure securities laws are upheld by the issuer
Stock distribution to not only the public but institutions too
Buying securities
Reselling securities to the investing public
Distributing new securities and raising capital for issuers
Guiding corporations in the best practices for securing long-term capital

An underwriter does not loan money to any parties.

When negotiating with an issuer, the person (investment banker) doing so is commonly called the underwriting manager.

Sometimes they are also known as the syndicate manager and there can be more than one person that fulfills this position.

The whole underwriting process is overseen and managed by them.

This includes:

Signing the underwriting agreement
Holding and controlling the due diligence meeting
The process of distribution for the issues

Formation of a syndicate

A syndicate occurs when a group of underwriters teams up to help a company bring the securities they want to sell to the public.

Often, this is also called a selling syndicate and occurs so the risk of underwriting the issues for sale are shared.

Syndicates also help improve distribution channels and in raising capital.

The members of the syndicate help to bring the securities to the investing public and make a financial commitment to do so.

For firm commitment offerings, syndicate members pledge to purchase securities from the company that issues them.

They then will distribute them at the agreed-upon price.

Those in the syndicate will all agree to a syndicate agreement.

That outlines the responsibilities of the participants and how syndicate profits are distributed, should there be any.

For negotiated underwriting, the number of securities offered, their price, and the fee charged by the underwriter are negotiated between them and the issuer.

This is often the standard underwriting practice when it comes to corporate securities.

Required by state law in most cases, competitive bid underwriting is used when it comes to municipal securities.

Here, a municipal government or even a state has a new issue of bonds and will ask investment bankers to bid on them.

The underwriters who win the bid are those who have the lowest net interest cost.

A reminder that net interest cost (NIC) helps to compare bids and is a calculation used when awarding bond issues.

It’s a combination of the number of proceeds the issuer will receive against the total coupon interest they will have to pay.

There’s true interest cost (TIC) that you should know about as well.

This also provides an equivalent comparison of costs but modified for the time value of money.

If this is the basis used, the lowest NIC (which is a straight mathematical interest rate calculation) will be the winner.

Formation of a selling group

While an underwriting syndicate is tasked with underwriting an offering from a company, they might enlist the help of other firms when it comes to the actual distribution of the securities.

Those other firms then become members of what is known as a selling group.

Those extra firms who form part of the selling group are not committed in any way to buying the securities on sale.

Instead, they just help to sell them.

As to whether a selling group is necessary or not, well that’s the decision of the managing underwriter.

If they decide that one is necessary, they will also then determine which firms should be included.

When securities are an attractive option, there won’t be a problem finding other companies that want to participate.

Those firms that join the selling group will sign a selling group agreement.

This contains the following:

A declaration that states that the managing underwriter acts for all others
The allotment of securities for each selling group member
An estimated public offering price (POP) for the securities (which is firmed up by the offering date)
The concession (or portion of the underwriting spread) on sales made by members of the selling group
Terms as to when and how to share payments to the managing underwriter will be made
Legal provisions pertaining to members of the selling groups liability related to the underwriting

Remember, all the financial liability falls on the syndicate members acting as the principal.

Those in the selling group have no liability whatsoever.

That’s because there is no commitment to buy the securities from the buyer, they just help find others who want to purchase them.

Underwriting agreements

Underwriting agreements document the commitment and liability of each underwriter.

Of critical importance here is what will happen at the termination of the syndicate and with any shares that have not been sold.

Underwriting agreements also empower the syndicate manager to act for those firms who are members of the syndicate.

It also gives the manager the power to:

Decide on the offer price with the issuer
Establish the timing of the offering
Handle advertising and all filing required by regulations

Firm commitment underwriting

This is the most popular type of contract for underwriting.

In it, the underwriter pledges to buy the issuer’s securities and resell them to public investors.

Potential losses or the financial risk of not selling all the shares to the public are taken on by the underwriter.

This underwriting contract can take on two forms:

Competitive bid arrangement
Negotiated underwriting contract

Most corporate issues will make use of a negotiated underwriting contract whereas a competitive bid arrangement is used in the municipal securities market for new issues.

The effective date of the offering in either of these is when sales can begin.

Another type of firm commitment underwriting is known as standby and it’s used with corporate rights offerings.

In it, underwriters are ready to buy shares that remain unsold when current stockholders of the company don’t use their preemptive rights to buy up additional stock that has been made available.

Best effort underwriting

With this agreement, the issuing corporation sees the underwriter acting as an agent who sells shares to the public.

The idea is that they try to sell as much as possible but there is no financial liability placed on the underwriter – who is acting in an agency capacity – should shares remain unsold.

Best effort agreements are split into two types: all-or-none (AON) and mini-max.

AON agreements see the underwriter tasked with selling all of the shares made available and if they don’t, the underwriting is canceled.

Mini-max agreements set both a minimum to move forward and a maximum when it comes to shares sold.

First up, the underwriters are tasked with finding the number of buyers to reach the minimum number of shares sold.

Once they’ve done that, they can expand the offering to meet the maximum amount of shares sold.

With both AON or mini-max agreements, any funds collected for sales must be kept in an escrow account until the agreement goals have been reached or the underwriting is terminated.

Municipal securities underwriting

While much the same as corporate securities, there are some differences when underwriting municipal securities.

Should there be successive offerings at a municipality, it’s often the same syndicate that will handle them.

They will decide to add more syndicate members if:

Demand for the municipal security is high
There are presale orders
The extent of liability has been determined
The scale and spread has been considered
It considers the capacity to sell the issue

A syndicate agreement or letter will be signed between all participants in a competitive bid.

In a negotiated underwriting, a syndicate contract or agreement among underwriters is signed.

Syndicate letters contain details of:

The level of commitment from each firm
Order allocation priority
Syndicate account duration
Selection of the account’s manager who will act as the principal agent
A breakdown of the spread
Fee charged by the managing underwriter
Good faith deposits
Liability for any unsold bonds
Member expenses

Syndicate account types

The syndicate account type chosen helps to establish the type of financial liability that underwriters will be exposed to.

There are two kinds of arrangements in this regard:

Western account: This is a divided account. Here, an underwriting allocation is assigned to each underwriter and that’s what they are responsible for.
Eastern account: This is an undivided account. At the start, a portion of the issue is allocated to each underwriter. Following substantial distribution thereof, additional bonds are allocated. These constitute their applicable share portion of any unsold bonds. What this means is that their financial liability might not be over after their initial allocation has been distributed.

One of the most critical things to remember here is which account is divided and which is undivided.

Syndicate bids

The right to represent the new issue on the primary market is placed in a bid by the syndicate to the issuer.

The syndicate that has the winning bid sells the bonds as an IPO to the public.

That we know, but let’s talk a little about the process of syndicate bids.

To start, it needs to be established.

The competitive bid is not something that’s plucked out of the air.

Instead, the syndicate holds meetings to help determine it.

Here, member dealers will discuss a range of criteria including the proposed offering scale as well as the underwriting spread.

Ultimately, they want to make a profit but still come up with the best price to offer the issuer so that they can win the bid.

During the first meeting, members agree tentatively on the yields (prices) of the maturities in the issue, the gross profit, and the underwriting spread.

A few days before the final bid is due, members will agree on the final price for the bond they are bidding on.

Should not all members agree on the final price, a majority vote is necessary to finalize it.

There’s a name for the process in which the price for each maturity is established.

In the underwriting business, this is called writing the scale.

The scale referred to is the different maturities of the bond issues in listed form.

Each of these will be assigned a yield (price) if the coupon rate has been determined.

Once the scale has been written and finalized, the final bid is prepared.

This must take into account any distinct qualifications as set out by the issuer.

When a competitive bid is submitted, it’s done as a firm commitment.

Of course, there are fees involved in all of this, so let’s briefly focus on that.

These fees will need to be disclosed to the members as part of the syndicate letter and are paid to clearing agencies.

Manager fees or the number of groups spread paid to the manager will also be established.

The bid is awarded to the syndicate that will underwrite the bonds at the lowest true interest cost.

The syndicate that has been successful in its bid will now purchase the bonds and then reoffer them to the public.

This is done at the offering price agreed upon as part of their bid.

The good faith deposit of all other bidders is returned to them by the issuer but not that of the syndicate winning the bid.

That’s kept to see that they carry out their selling commitment.

As for the good faith deposits, there are around 1% to 2% of the offering’s total par value.

Once the issue has been awarded to the syndicate making the lowest bid, a syndicate account, managed by the syndicate manager, is created.

All expenses will be paid from this account while all proceeds generated from sales will be placed here too.

Settlement accounts are to be settled 30 calendar days from the time the securities are delivered to the syndicate by the issuer.

In other words, syndicates last for a maximum period of 30 calendar days from the delivery of the securities.

Spread breakdown

Syndicates decide on the price at which bonds will be sold to the public.

This is called the reoffering price (yield).

The spread, however, is the compensation the syndicate receives for new issue underwriting.

In other words, it’s the difference between the reoffering price and the price paid by the syndicate.

Depending on their role in the underwriting process, each member of the syndicate will receive a portion of the spread.

Remember that the offering price that the investing public will pay for a share already includes the spread.

It’s not added to the existing price of the share.

Take note of the term production, too.

This covers the total earned (in dollars) as a result of the sale of municipal issues.

If you take the amount bid for the issues from this, you have the spread.

Syndicate management fee

This is a fee paid per bond that’s paid to the syndicate managers for taking the issues to the market.

When subtracting the management fee from the spread that remains, you now have the total takedown.

The takedown describes the price at which bonds are bought from the syndicate manager by members.

Bonds purchased by a syndicate member at the takedown can be sold in two ways.

Firstly, at the offering price to customers or secondly below the offering price to a dealer in the selling group.

For those firms that help the syndicate sell bonds, there is no financial risk.

They do receive compensation, however, and this is known as the selling concession.

Order allocation

Priorities set by the syndicate in advance will determine how municipal bond orders are allocated and must be sent to members in writing.

Syndicates must come up with priority allocation provisions for orders as required by the MSRB.

The syndicate agreement will also contain both allocation priorities and confirmation procedures.

A sequence in which orders will be accepted must also be established.

This cannot just be left to the discretion of the syndicate manager.

Finally, the order of all allocation priorities is accepted by syndicate members but that must be done in writing.

Should this order change for any reason, the syndicate manager is tasked with informing members in writing of these changes.

Order period

This order period runs the day following the awarding of the bid for about an hour.

The order period is a municipal underwriting timeline as established by the MSRB.

Set by the syndicate manager, syndicates solicit customers for the specific issue.

Orders are then allocated.

The sequence in which they were received doesn’t play a role.

Allocation priorities

When a bond issue is oversubscribed, the allocation priority is critical.

Here’s the normal priority order:

Presale order: These are entered even before the bid is won by the syndicate. In other words, customers will place an order even if they don’t know what the final price is or even if the syndicate is going to win the bid or not. In terms of priority, this comes out on top over any other order. Note that all syndicate members will split the takedown according to their participation.
Groupnet order: After the bid is awarded, this type of order can be placed. Should a customer order be expected to receive priority, it is entered as a groupnet order by a syndicate member. Upon completion of the underwriting, the takedown on this order, which was initially deposited in the syndicate account, is split amongst all syndicate members.
Designated order: Designated orders assign the takedown to certain syndicate members. Institutions usually make use of designated orders.
Member and member-related orders: These are the lowest priority orders available. An order like this is for the inventory or related accounts of a member firm, for example, dealer-sponsored UITs.

When it comes to order priority, remember that top priority is always given to the order where members will receive the most benefit.

Should an order be placed for a related account by a syndicate member, the syndicate manager must be informed.

These are then given the lowest priority of all the orders.

Syndicate managers are tasked with providing a written account order allocation.

This must be a written account and sent to all syndicate members within two business days of the date of sale.

Registration requirements

There are many rules and regulations that govern securities.

The SEC needs registration statements that are filed when new securities are issued.

This helps provide a clear and accurate picture when it comes to these securities and it is all about protecting the investor.

That clear, accurate information about the securities on offer can be found in the prospectus.

It’s an important document, that’s for sure.

Some issuers are exempt from these federal registrations.

These include:

The government of the United States
Municipalities and territories in the United States
Charitable, non-profit, educational, and religious organizations
Savings and loan organizations
Banks
Public utilities
Common carriers

There are securities as well that are exempt including:

Commercial papers (they mature in less than 270 days)
Bankers’ acceptances ((they mature in less than 270 days)
As per Regulation D – securities in private placements

State registration

But what about state registration?

Well, the laws that govern securities in states, often called blue-sky laws require the registration of registered representatives, broker-dealers, and securities.

Issues can be blue-skyed in a state by an issuer or investment banking in the following ways:

Qualification: Here registration by the issuer is with the state only and specific requirements come from there only. Because issues are only sold intrastate, there is no federal registration necessary.
Coordination: Here registration takes place with the SEC and the state and are effective on the same date.
Notice filing: Here investment companies registered under the Investment Company Act (1940) and securities listed on major stock exchanges are called federal covered securities. While state registration is not required, most will ask that a notice be filed saying that the securities will be offered in the state for sale by the issuer. In some cases, a filing fee must also be paid.

Registration process

New issues are the first thing you would think of when it comes to the registration process.

Time registration, however, is required with secondary distribution.

This involves securities owned by major stockholders, for example, the founders of a corporation or the principal owners, and distributed with a prospectus.

In this case, the proceeds from a sale don’t go to the issuer but to the seller of the stock.

In some cases, there could even be a split or combined offering.

Here, a securities public offering has both a primary and secondary offering combined.

Part of the issue will be considered to be the primary offering and the issuing corporation will receive the proceeds of the sales from it.

The secondary offering is the remaining part of the issue and when this is sold, the proceeds go to stockholders.

Once a registration statement is filed with the SEC by the issuer, a 20-day cooling-off period begins.

This gives the SEC the chance to look through the registration statement and if they find something amiss or not all the information they need is forthcoming, they can issue a stop order.

If everything is found to be acceptable during the cooling-off period, the offering period can begin on what is known as the effective date.

While 20 days for a cooling-off period seems a long time in which nothing can be sold the issuer can still gauge interest through the use of a red herring.

A preliminary prospectus, it’s used to gather an idea of interest in the corporate securities on offer as well as to gauge overall investor reactions.

The prospectus can be discussed by a registered representative during the cooling-off period and investors wanting preliminary information can obtain it easily enough.

It’s essential that they know that the SEC has received the registration statement but that it has not yet approved it.

This is usually done by including the information in the red herring itself.

One thing you won’t find in it, however, is the underwriting spread or the final offering price.

So let’s recap on what may and what may not be done during the cooling-off period.

Red herrings can be distributed
Tombstone advertisements can be published
Indications of interest can be sought out
Securities can not be offered for sale
The final prospectus cannot be distributed
Advertising material or sales literature cannot be disseminated
No orders may be taken

Only with a final prospectus available can the sale of public offerings occur as stipulated by SEC regulations.

We’ve mentioned tombstone advertising, so let’s just recap what that is.

These can be published during the cooling-off period.

They offer information to investors and are usually published after the offering has been given clearance for sale but are more informational than anything else, usually appearing before the effective sale date.

In other words, the securities are not offered for sale in tombstone advertising.

This isn’t a necessity either.

No issuers are regulated to use tombstone advertising if they do not want to.

If they are used, tombstone advertising will include the following information:

Issuer name
Security type
Underwriter
Price
Effective date of sale

Publicly traded securities new issue pricing

The issuing corporation is advised by the underwriter of the best price to offer the securities to the public during the cooling-off period.

There are numerous variables that are taken into consideration with new issue pricing:

The interest shown in the securities
The current conditions on the market (for example, the price of securities that are similar to the new issue)
What syndicate members will accept as a pricing option
Similar companies’ price-to-earning (P/E) ratio. This is so the new issues P/E ratio can be similar to other stocks
The overall financial health of the company and its dividend payment ratio record, if applicable
The debt ratio of the company

FINRA also has a say on the size of the spread.

They determine if the compensation that the underwriter earns is fair and reasonable.

To do this, they undertake a review of the underwriting.

But there are other factors involved too.

These below can affect the issues in terms of how the spread varies:

Type of commitment: A large spread will be available through a firm commitment when compared to a best efforts agreement. That’s because the underwriter takes much of the risk.
Security marketability: AAA rated bonds will have a smaller spread when compared to a speculative stock, for example.
Issuer business: When comparing a volatile stock against a more stable one, it’s the latter that will have a smaller spread
Offering size: In a large offering, the per share cost can be lower if the underwriter spreads cost over a larger number of shares

Final prospectus

The preliminary prospectus is amended as soon as the registration for the corporate securities comes into effect.

Information is added and this includes the final offering price as well as the underwriting spread.

Once that’s done, orders from customers who initially showed interest during the cooling-off period can be taken.

All purchase confirmation, however, must be accompanied or preceded by a final prospectus copy.

A final prospectus includes the following:

The offering description
What it is priced at
If there are any selling
The offering date
How the proceeds will be used
Underwriting description (this does not include the contract)
Business history
If there are any risks for purchasers
Management description
Other financial information
Disclaimer from the SEC

Just a word on the SEC disclaimer.

This does not guarantee the overall accuracy of the prospectus and what’s found in it.

It just says that it’s been checked so that it contains the material facts that are necessary to allow the sale of the security that it covers.

The disclaimer is not an approval either.

All it means is that the security covered by the prospectus is now cleared to be sold and doesn’t break any federal laws in doing so.

Should the SEC believe that something is amiss with the registration statement or it is changed in any way, a stop order may be issued.

This will stop the process and in some cases, it could be halted for good.

Note that in this disclaimer, the SEC doesn’t approve or disapprove the issue of securities.

Instead, it just clears them so that they are allowed to go on sale.

Summary prospectus

Covered under SEC Rule 498, a summary prospectus can be used for the physical delivery requirements for open-end investment companies.

So investors can receive one for a mutual fund, especially if it allows investors to apply to purchase shares from the fund.

Inside a summary prospectus, you will find the critical information that forms part of a full prospectus.

With it, investors can use the application to purchase shares, or request a full prospectus should they require further information.

If they do request the full one, it must be sent in three working days.

These are the disclosures that must appear in a summary prospectus:

Performance, risks, investments, and fee table as part of a risk/return summary
Disclosure of portfolio holdings, investment objectives, investment strategies to be used, risks related to investment
Structure of capital, the organization, and the management team
Information on shareholders
Distribution arrangements
Information regarding financial highlights

SAI – Statement of additional information

From time to time, investors may request even more information not covered in the prospectus.

While this information isn’t critical in making investment decisions, some investors prefer to have it before buying shares.

This information can be covered in a statement of additional information (SAI) and it must be made available for free should it be requested.

Investors can ask for an SAI from the SEC, the investment company, or a broker selling the shares.

Information continued in this document includes the consolidated financial statements of the fund, various policies as well as the history thereof.

1939 Trust Indenture Act

Passed to provide protection for bondholders, the Trust Indenture Act (1939) applies to corporate bonds.

They must have the following characteristics:

Be offered at an interstate level
Have a maturity of nine months or higher
$50 million issues within a period of 12 months

Documentation for municipal bonds

In this section, we cover the various forms of documentation for municipal bonds specifically.

Official statement

What is an official statement (OS)?

Well, the MSRB gives it an official description, which you can read here.

But let’s break it down.

An official statement document deals with the primary offering offered by the issuer of municipal securities and contains information on those securities.

This information includes:

The purpose of the issue
How securities will be repaid
Financial and economic characteristics of the issuer, conduit borrower, or any other obligated persons
The creditworthiness of the issue

This information can be used by intermediaries and investors in numerous ways.

This includes seeing the credit quality the securities offer as well as any potential risks that should be noted.

In other words, this is similar to a prospectus from a registered issuer but obviously relates to municipal bonds.

Note that a fair disclosure of material facts is required, even though municipal bonds are held to the filing requirements set out in the Securities Act (1933).

That’s because they are subject to the Securities Exchange Act’s (1934) anti-fraud arrangements.

In a nutshell, the OS is a full and fair disclosure document for municipal securities.

There is a preliminary version too that helps underwriters to determine dealer and investment interest in the municipal securities they’d like to offer.

An OS will typically have the following information:

A summary statement
The terms of the offering
The purpose of the issue
Basic legal documents description (including Indenture, authorizing resolution, and trust agreement)
Security backing the bonds on sale
Bond description
Issuer description (including organization, management, and financial summary)
The program of construction
Statement regarding project feasibility
Specific provisions related to indenture/resolution, fund, and accounts, investment of funds, more bonds, default events, and insurance
Tax status
Credit enhancements
Legal proceedings (if any)

Official notice of sale

With new issues, an official notice of sale is another important document.

That’s because it tells potential underwriters that there is a new issue that’s going to be up for sale at some point.

It’s needed as it helps solicit bids for the bonds that are up for sale.

Usually, this is hosted in local newspapers or specialized publications, like Bond Buyer, for example.

An official notice of sale will include the following information:

Place, time, and date of the sale
Name of the issuer
Description of the issuer
Bond type on sale
If there are any bidding restrictions (a sealed bid for example)
The dates on which interest will be paid
Interest accrual (dated) date
First coupon payment date
Maturity structure of the bond
Call provisions (if there are any)
Registration provisions
Issuer expenses
Purchaser expenses
Good faith deposit amounts
Who are the trustees or paying agents
Bound carousel (which firm will provide legal opinion)
Delivery details
The issuer’s right to reject all bids
Criteria that govern how the issue will be awarded

A notice of sale won’t include an underwriter’s name as this is something that would not have been determined at the time it is put out.

The same can be said of the bond rating.

Once investment bankers receive the notice of sale, they will prepare their bids for the municipal securities based on the information within.

They also, however, will look at market conditions at the time, supply and demand, and other factors before placing their bids.

A reminder that the winner will either have the lower NIC or TIC to the issuers.

New issue worksheet

The final document to talk about in this section is a new issue worksheet.

Rules and regulations for new issues

There are numerous rules and regulations, both from FINRA and the SEC when it comes to new issues.

Let’s start first with securities that are exempt.

Transactions that are exempt

Under one of these exclusionary provisions below, some securities may be exempt from both prospectus requirements and a registration statement as set out in the Securities Act (1933).

Small/medium corporate offerings – Regulation A+
Private placements – Regulation D
Intrastate securities (both offered and sold) – Rule 147
Exempt transactions under Rule 144, 144a and 145

Small/medium corporate offerings – Regulation A+

Let’s start with looking at small/medium corporate offerings under Regulation A+

This allows companies the opportunity to raise capital amounts of more than $5 million which was allowed under Regulation A.

It does this by offering two option tiers.

These are for small and medium-sized companies and exclude private equity funds, hedge funds, private capital funds, and other types of investment companies.

Tier1: Here securities offerings over a 12-month period of up to $20 million are permitted. However, when it comes to securities sold for existing shareholders, the total may not be over $6 million. Individual states as well as the SEC will hold reviews of this type of security offering.
Tier 2: Here, securities offerings over a 12-month period of up to $50 million are permitted. However, when it comes to securities sold for existing shareholders, the total may not be over $15 million. There is no state level review for the tier but the SEC still demands thorough disclosure requirements. This includes current, annual, and semi-annual reports as well as audited financial statements.

General solicitation is available for both these tiers and available to the general public as well.

There is an added exemption in place when it comes to Tier 2 offerings, however.

Those who buy into them can only be qualified investors.

To qualify to buy Tier 2 issues:

They must fill the role of an accredited investor. This is defined in Regulation D Rule 501
They can only make a limited investment. This is 10% of their net income per offering or 10% of their net worth.

There are no such restrictions or investment limits when it comes to Tier 1 issues.

The issuer in a Regulation A+ offering must provide their regional SEC office with the following documents for these issues if they want to make them available.

Condensed notice of sale
Or an offering circular

This is provided to investors that show an interest in the offering.

Finally, there is a 20-day cooling-off period between the final date for the issues and the effective date.

A final offering circular must be sent to those buying this type of offering 48 hours before the confirmation of the sale.

Private placements – Regulation D

The SEC adopted Regulation D to help facilitate small businesses’ capital formation needs.

Essentially, it allows for private placements exempt from transactions, and securities offered in compliance with it don’t have to be registered with the SEC either or at the state level.

In this section, we specifically focus on SEC Rule 506 where there is a no dollar limit on the number of private placements sold.

In 2012, there were numerous changes made to Rule 506 of Regulation D with the passing of the JOBS Act.

There are two sections, in particular, 506(b) and 506(c) to focus on.

Under 506(b), offerings used by a company wanting to raise capital with a private placement can be sold to any number of accredited investors as well as up to 35 non-accredited investors.

No advertising is allowed for the offering, however.

That’s not the case with 506(c) however as with this regulation, the offering can be advertised but only if these requirements are met.

First, only accredited investors can purchase the offerings.

Second, steps are put in place that allows the issuer to determine if they are accredited investors, for example, reviewing various documentation (tax returns, W-2s, brokerage statements, credit reports, and more).

There are exceptions to some issuers using Rule 506 and they may be disqualified from doing so.

The JOBS Act covers this under the “bad actor rule” which covers the issuer and others associated with them including underwriters, officers, directors, or shareholders.

Should any of these parties at some point be convicted of any securities violation, including securities fraud, then the offering cannot take place under Rule 506.

We’ve talked about accredited investors above, but let’s get into that a little more.

Rule 501 from the SEC gives several categories of accredited investors in relation to Regulation D.

As we’ve mentioned already, the issuer or those acting on their behalf must carry out inquiries to make sure they are accredited and that they can be placed in one of these categories from Regulation D.

A registered investment company, insurance company, or a bank
An employer benefit plan where investment decisions are made by either a registered investment adviser or insurance company or it has $5 million or more in total assets.
A corporation, charity, or partnership with $5 million or more in total assets.
GPs, executive officers, or directors from the issuing company
A natural person that has a net worth, or joint net worth with their spouse of over $1 million. This value must be at the time of purchase and excludes the net equity on their primary residence.
A natural person that has $200,000 or more individual income over a two-year period or $300,000 joint income with their spouse and who should reach the same amount in the current year.
Other entities that already include accredited investors

Note, it’s with private placements only where you will see the term, accredited investor.

All investors who buy private placements will sign a letter on doing so.

This states that it’s for investment purposes only that they have bought the stock.

Because of this letter, private placement stock is often referred to as lettered stock in the industry.

At times, it is also known as legend stock.

Finally, let’s touch on one last requirement from the SEC when securities in the offering in reliance on Regulation D are sold.

That says that a Form D must be filed electronically within 15 days of the first sale.

This form reports to the SEC that the offerings are now being sold.

Intrastate offerings: Rule 147

Under this rule, if offerings are only available in one state, they can be exempt from registration if:

80% of the income the issuer receives comes from the state and its principal office is located there
80% or more of the issuer assets are located in the state
80% of the proceeds from the offering will be used in the state
The state is where a large percentage of the issuers’ employees work
Those who purchase the issue reside in the state

Note, however, that only one of the three 80% rules we’ve covered above needs to be met, however, all those who purchase the offering must live in the state.

Also, those who have purchased the stock have to wait a period of six months before they can sell it to someone living in another state.

Regulation S

The Securities Act (1933) does not allow registration provisions for both offers and sales made from outside the United States.

This is for both U.S. and foreign issues.

Securities distributed offshore don’t need to be registered with the SEC but are restricted on the basis of Rule 144.

Regulation S registration can be avoided if:

An offshore transaction handles the offer and sale
No directed selling efforts can be connected to the offering in the United States

No offers or sales can be made to an entity or person within the United States for it to be considered an offshore transaction.

However, a citizen of the United States who currently lives outside of its borders is allowed to purchase securities.

Ultimately, Regulation S deals with issuers based in the United States selling unregistered securities to non-U.S. residents.

These Regulation S securities have a holding period of six months or one year

That’s dependent on the issuer’s reporting status.

No foreign issuers are subject to the terms and conditions as laid out in Regulation S.

To qualify as a foreign issuer only 50% or less of voting securities and 20% of debt securities can be owned by someone with an address in the United States

Rule 415 – Shelf Registrations

According to the Securities Act (1933) Regulation C Rule 415, should market conditions be favorable and if they need to, issuers can quickly raise money on capital markets.

This is often called delayed or continuous offering and sale of securities.

As an example, a company may file a shelf registration statement with the SEC.

They can then hold the securities linked to it and wait for the right time to sell them, for example, if they need to raise capital for an emergency project.

This can all be carried out without a review from the SEC.

Rule 144

This rule deals with control and restricted securities.

It helps to regulate the sale thereof and does so in several ways.

This includes the use of filing proceedings, how they are sold, quality limitations, and stipulating a holding period, for example.

Rule 144 defines control securities as those owned by officers or directors of the company selling them as well as any persons who own 10% or more of the voting stock of the company.

These are often referred to as company insiders.

When someone buys securities in a manner other than a registered public offering, these are known as restricted securities.

For example, those purchased in a private placement would qualify as a restricted security.

These need to be held for six months at least before they can be sold.

Rule 144 states that if an affiliate wants to sell shares after the six-month period has passed, they will need to submit a Form 144 to do so.

There are also volume restrictions in place.

Investors can sell the greater of:

At the time of sale, only 1% of the same class of total outstanding shares or;
The Nasdaq reported or average weekly trading volume of the stock on all exchanges over the past four weeks

Should 5,000 or fewer shares be sold and the dollar amount comes to $50,000 or less, a Form 144 does not need to be filed.

This is known as a de minimis exemption and it applies to any sales that take place in any 90-day period.

Following the six-month holding period, volume restrictions are still applied to affiliated persons.

This is kept in place as long as they remain affiliated.

Following the passing of the six-month holding period, stock can be sold without restrictions for unaffiliated persons.

Shares are effectively registered if sold under Rule 144.

That means that buyers are not subject to any restrictions when they choose to resell the shares.

When dealing with Rule 144, it’s always critical that you identify the type of stock first, either restricted or control.

Then see who is selling it.

That makes it so much easier in working things out.

There are a few other terms you should know too.

Short swing profit: This is when control stock is sold by an affiliate without it being held for at least six months.
Disgorged: When a short swing profit happens, it must be disgorged. This means the profit returns to the issuer. This is not linked to Rule 144 but is an SEC rule governing unrestricted stock sold by control persons.

Rule 144A

Rule 144a covers nonregistered foreign and domestic securities.

Through it, they can be sold without holding period requirements to certain institutional investors based in the United States.

Only qualified institutional buyers (QIB) qualify for this exemption.

They cannot be affiliated with the company selling the securities and must have a minimum of $100 million invested on a discretionary basis.

FINRA Rule 5130 – Protecting the public and restricted persons prohibitions

This FINRA rule protects the public offering process and its integrity.

It does this by:

Ensuring that a bona fide public offering of securities at the public offering price (POP) is made by members.
Ensuring that securities in a public offering are not withheld by members to benefit themselves or others that can direct business in the future to the member.
Ensure that no advantage is taken by industry insiders such as associated persons or members in gaining access to new issues to the detriment of public customers.

Any IPO of equity securities, or a new issue, is covered by this rule.

There are no additional offerings, debt securities, convertible securities, preferred stock, REITS, investment company securities, or other similar issues that fall under FINRA Rule 5130.

Member firms cannot sell new issues to restricted persons or accounts where they are the beneficial owners.

The rule defines restricted persons as:

Member firms and their employees.
Attorneys, accountants, financial consultants, and other finders and fiduciaries that act on behalf of the issue underwriters
Those who have the authority to buy or sell securities for other institutions like portfolio managers, or people belonging to saving and loan associations, banks, investment, and insurance companies
Those who own 10% or more in the member firm

The immediate family members of those mentioned in points two, three, and four above will fall under the restriction as well.

FINRA considers immediate family members as spouses, siblings, children, parents, and even in-laws.

Also, it should be noted that there is an exception.

When specifically directed by an issuer, securities are not placed under the same prohibitions that the sale and purchase of new issues have.

For example, employees are allowed to purchase stock when a company goes public.

Normally, they would not be able to purchase new issues at all.

Restricted persons may never be given access to stock in this manner, however.

A de minimis exception is in play here too.

An account can purchase new security issues if a restricted person’s beneficial interests are not more than 10% of it.

Finally in this section, let’s talk about spinning.

This sees IPOS shares being allocated to certain individuals.

These individuals are well placed and able to pass on business to the company allocating the shares to them.

Of course, this is not allowed and it’s why the restricted person description applies to portfolio managers.

That’s why a representative selling an IPO to an account must get written representation from the owner first.

This will state new common stock at the public offering price can be bought by that account.

This representation is kept for three years but must be obtained in a 12-month period before the new issue is sold.

Series 7 Study Guide 1.2 – Describing investment products to potential and current customers