Registering securities with the SEC

Unless the securities are exempt from registration (see “Exempt Securities” later in this chapter), when a company wants to go public (sell stock to public investors), it has to file a registration statement and a prospectus with the SEC. (See “Getting the skinny on the issue and issuer: The prospectus” later in this chapter.)

The registration statement includes

• The issuer’s name, address, and description of its business
• The company’s articles of incorporation (unless previously supplied)
• The names and addresses of the underwriter(s) and all commissions or discounts they will receive either directly or indirectly from the sale
• The price at which the security shall be offered to the public
• The names and addresses of all the company’s control persons, such as officers, directors, and anyone owning more than 10 percent of the corporation’s securities and how much they hold of the corporation's securities
• The estimated net proceeds of the sale from the security to be issued and what the proceeds will be used for, including property (if any), or good will (if any), other businesses to be purchased (if any)
• The company’s capitalization (authorized and outstanding stock, par value of its stock if any, voting rights, exchange rights, and so on)
• Complete financial statements (including balance sheets and income statements)
• Any legal proceedings against the corporation that may have an impact on it
• Any net proceeds derived from any security sold by the issuer in the previous 2 years along with the underwriter's particulars
• The names and addresses of the counsel who have passed on the legality of the issue and a copy of their opinion or opinions with regard to legality of the issue
• Any agreements or indentures which might affect the securities being offered

The information above regarding the Registration Statement is known as Schedule A, and it typically applies to corporations issuing new securities. There is also a Schedule B, which applies to local government issues (typically municipal bonds). The information required when a local government issues securities is as you can imagine geared toward what a local government would have to supply in its registration statement. Most of the information required is very similar; in fact, you can substitute the word “municipality” for “company” for most of the items required. You need to know the name of the borrowing government or subdivision, what it is raising the money for, the amount of funded debt and the amount of floating debt there will be after the new security is issued, whether the issuer has defaulted on debt in the last 20 years, the names of all people involved (such as counsel, underwriter(s), and so on), commission to be paid to the underwriters, a copy of the agreement(s) made with the underwriter(s), a legal opinion made by the counsel with regard to the legality, and possible tax-free nature of the issue, and so on.

Shelving the issue: Shelf registration

Since the registration process to sell securities is a somewhat daunting and costly process for issuers, they may register more securities than they may need to sell now. Shelf registration (SEC Rule 415) allows the issuer or selling shareholders (insiders) to sell securities on a delayed or continuous basis that were previously registered with the SEC without needing additional permission. Shelf registration allows issuers up to 2 to 3 years (depending on their status) to sell previously registered shares.

Cooling-off period

After the issuer files a registration statement (the filing date) with the SEC, a 20-day cooling-off period begins. During the 20-day (and often longer) cooling-off period, the good old SEC reviews the registration statement. At the end of the cooling-off period, the issue will (hopefully) be cleared for sale to the public (the effective date of registration). In the event that the SEC sees that the registration statement needs to be amended or it needs additional information, it will issue a deficiency letter and halt the registration process until it receives the information required. If the SEC (the Commission) finds that the registration statement is misleading because the issuer included untrue statements of material fact or omits a material fact, it issues a stop order, which suspends the effectiveness of the registration statement. At this point, the issuer will be required to amend the registration statement and answer any questions posed by the Commission in order to continue the registration process.

Neither the SEC nor any self-regulatory organization approves an issue. The SEC just clears the issue for sale. The SEC also is not responsible for making sure that the information included on the registration statement is true and accurate. As a matter of fact, it is unlawful to in any way represent that the SEC approved of an issue or issuer.

During the cooling-off period, the underwriter (or underwriters) can obtain indications of interest from investors who may want to purchase the issue. Agents scramble to get indications of interest from prospective purchasers of the securities. Although the underwriters may keep records of indications of interest, they may not accept any money in advance of the public offering.

Indications of interest aren’t binding on customers or underwriters. A customer always has the prerogative to change his mind, and underwriters may not have enough shares available to meet everyone’s needs.

A tombstone ad — a newspaper ad that’s shaped like a, well, tombstone (it’s rectangular with black borders) — is simply an announcement (but not an offer) of a new security for sale. It’s the only advertisement allowed during the cooling-off period. These ads contain just a simple statement of facts about the new issue (for example, the issuer, type of security, amount of shares or bonds available, underwriter’s name, and so on). In addition, tombstone ads often provide investors with information about how to obtain a prospectus. Tombstone ads are optional.

Underwriters and selling group members use the preliminary prospectus to obtain indications of interest from prospective customers. The preliminary prospectus must be made available to all customers who are interested in the new issue during the cooling-off period. I talk more about what that prospectus has to include in the section “Getting the skinny on the issue and issuer: The prospectus” a little later in this chapter.

Due diligence meeting

Toward the end of the cooling-off period, the underwriter holds a due diligence meeting. During this meeting, the underwriter provides information about the issue and what the issuer will use the proceeds of the sale for. This meeting is designed to provide such information to syndicate members, selling groups, brokers, analysts, institutions, and so on.

The last time syndicate members can back out of an underwriting agreement is toward the end of the cooling-off period (around the time of the due diligence meeting). You can assume that if syndicate members are backing out, it’s most likely due to negative market conditions.

Blue skies: Registering with the states

All blue sky laws, or state laws that apply to security offerings and sales, say that in order to sell a security to a customer, the broker-dealer (brokerage firm), the registered representative, and the security must be registered in the customer’s home state. The issuer is responsible for registering the security not only with the U.S. Securities and Exchange Commission (the SEC) but also with the state administrator in each state in which the securities are to be sold. State securities laws are covered under the Uniform Securities Act (USA).

Here are the methods of state security registration:

• Notification (registration by filing): Notification is the simplest form of registration for established companies. Companies who have previously sold securities in a state can renew their previous application.
• Coordination: This method involves registering with the SEC and states at the same time. The SEC helps companies meet the blue sky laws by notifying all states in which the securities are to be sold.
• Qualification: Companies use this registration method for securities that are exempt from registration with the SEC but require registration with the state.

Effective date

The effective date is at the end of the cooling-off period. This is the first day that the security can actually be sold to the public. Just prior to the security going public, the offering price will be determined. At this point, you can call all your customers who expressed indications of interest and ask, “How much do you want?” Remember, all purchasers and potential purchasers must be provided with a copy of the final prospectus, which includes the public offering price. A copy of the final prospectus must be delivered no later than the time the sale is confirmed (see Chapter 16). The final prospectus may be provided either electronically (that is, via email) or through the mail.

Firm commitment

In a firm commitment underwriting, the lead underwriter and syndicate members (other underwriters who may be helping in the sale of the securities) agree to purchase all the securities that remain unsold after the offering. In this case, the underwriters assume all the financial risk.

Another type of firm commitment offering is a stand-by. A stand-by underwriter signs an agreement with the issuer to purchase any stock not purchased by the public if or when an issuer has a rights offering (see Chapter 10).

Best efforts

In a best efforts underwriting, the underwriters are agreeing to make their best efforts to sell all the securities to the public. (Hey, that's how they make money.) If, however, they cannot sell all the securities to the public, the issuer has the right to either cancel the offering or take back some of the unsold securities depending on whether it is an All or None offering or a Mini-Max offering:

• All or None (AON): If the offering is set up as an AON agreement, all the securities must be sold by the deadline or the deal is cancelled.
• Mini-Max: A mini-max offering is one in which a specified minimum number of securities must be sold in order for the deal not to be cancelled. If that minimum threshold is reached, the issuer will take back any securities that remain unsold.

You should be aware that if securities are sold on a best efforts basis, purchasers and potential purchasers must be made aware that the offering could be cancelled. Purchasers’ money is held in an escrow account until the terms are met or the deal is cancelled. Once the specified number of securities are sold, the underwriters release the securities to the purchasers. If, however, the underwriters do not sell enough of the securities by the deadline, the purchasers receive their money back.

Nogo Auto Corp., which specializes in fuel-efficient cars, is in the process of selling new shares of its company to the public. Nogo contacts Thor Broker-Dealer Corp. to underwrite the securities. Thor realizes that the issue is too big to underwrite by itself, so it forms a syndicate. Nogo will receive $15.00 per share for each share issued and the public offering price will be $16.20. If the manager’s fee is $0.25 per share and the concession is $0.40 per share, what is the additional takedown?

(A) $0.55

(B) $0.80

(C) $0.95

(D) $1.20

The correct answer is Choice (A). This question is a little tricky because you have to determine the takedown (the profit syndicate members make) before you can figure out the additional takedown. The additional takedown is the profit syndicate members make on shares sold by the selling group. The spread of $1.20 ($16.20 selling price – $15.00 to Nogo) is made up of the manager’s fee of $0.25 and the takedown of $0.95 ($1.20 spread – $0.25 manager’s fee). If the syndicate members had sold the shares by themselves, they would have received the takedown of $0.95 per share. However, the selling group sold the shares, receiving a concession of $0.40 per share. The concession is paid out of the takedown; thus, the additional takedown is $0.55 per share ($0.95 – $0.40).

A syndicate is underwriting $5,000,000 worth of municipal general obligation bonds. There are 10 syndicate members, each with an equal participation. Firm A, which is part of the syndicate, sells its entire allotment. However, $1,000,000 worth of bonds remain unsold by other members of the syndicate. If the syndicate agreement was set up on an Eastern account basis, what is Firm A’s responsibility regarding the unsold bonds?

(A) No responsibility

(B) $100,000 worth of bonds

(C) $200,000 worth of bonds

(D) $1,000,000 worth of bonds

The right answer is Choice (B). Your key to this question is that the underwriting was done on an Eastern account basis. On an Eastern account basis, the underwriters (because they’re so nice) have to help the slackers sell any shares of unsold bonds. Firm A sold all its bonds, so it has to help sell the remaining bonds that the other syndicate members didn’t sell. Firm A’s responsibility is in proportion to its original responsibility. Because it was responsible for 10 percent of the original issue (10 syndicate members with equal participation), it’s responsible for selling 10 percent of the unsold bonds:

If the underwriting had been on a Western account basis, the correct answer would have been Choice (A).

DEF Corp. is offering 2,000,000 shares of its common stock to the public; 1,500,000 shares are authorized but previously unissued, and insiders of the company are selling the other 500,000 shares. Which of the following are TRUE about this offering?

1. The EPS of DEF will increase.
2. The EPS of DEF will decrease.
3. The number of outstanding shares will increase by 500,000.
4. The number of outstanding shares will increase by 1,500,000.

(A) I and III

(B) I and IV

(C) II and III

(D) II and IV

The answer you’re looking for is Choice (D). This offering is a combined, or split, offering. The 1,500,000 shares that were previously unissued are a primary offering, and the 500,000 shares held by insiders are a secondary offering. Answering this question correctly requires a little bit of deduction on your part. You first have to note that unissued shares aren’t considered part of the outstanding shares (because for stockholders, owning the shares before they’re even offered would be a pretty impressive feat!). Because 1,500,000 shares were previously unissued (kept by the company for future use), the number of outstanding shares will increase by that amount. When considering whether the earnings per share (EPS) will increase or decrease, you can assume that the company earns the same amount of money. Now that same amount of money has to be divided among 1,500,000 more shares. Therefore, you deduce that the EPS will decrease, not increase.

Intrastate offerings (Section 3[a][11] and Rule 147)

An intrastate offering is, naturally, an offering of securities within one state. For such an offering to be exempt from SEC registration, the company must be incorporated in the state in which it’s selling securities, 80 percent of its business has to be within the state, 80 percent of the proceeds raised by the offering are used within the state, and it may sell securities only to residents of the state. The securities still require registration at the state level.

Don’t confuse intrastate offerings (securities sold in one state) with interstate offerings (securities sold in many states). Interstate offerings do need SEC registration. To help you remember, think of an interstate roadway, which continues from one state to the next.

Regulation A+ (Reg A+) offerings

An offering of securities worth $20 million (Tier 1) or $50 million (Tier 2) or less within a 12-month period is Regulation A+. Although these companies may seem large to you, they're relatively small in market terms. Regulation A+ offerings are exempt from the full registration requirements but the issuer still has to file a simplified registration or abbreviated registration statement. In addition, the issuer also has to file an offering circular and provide it to potential investors. An offering circular is similar to a prospectus but not quite as extensive.

• Tier 1: Besides the $20 million in 12 months' cap, of the $20 million, no more than $6 million can be sold on behalf of existing stockholders.
• Tier 2: Besides the $50 million in 12 months' cap, of the $50 million, not more than $15 million can be sold on behalf of existing stockholders. In addition, Tier 2 investors must be accredited (see the definition of accredited under Regulation D offerings) or limited to a maximum of 10 percent of the investor's net income or 10 percent of the investor's net worth, whichever is higher.

Regulation S (Reg S) offerings

An offering of securities by U.S. issuers made outside of the U.S. Regulation S offerings is not subject to registration requirements of securities sold in the U.S. because the sale of these securities takes place in another country.

Regulation D (Reg D) offerings

Also known as a private placement (private securities offering), a Regulation D offering is an offering to no more than 35 unaccredited investors per year. Companies who issue securities through private placement are allowed to raise an unlimited amount of money but are limited in terms of the number of unaccredited investors but not limited in the amount of accredited investors (see below). Sales of Reg D securities are subject to the sales limitations set forth under Rule 144 (see “Rule 144” later).

Investors of private placements must sign a letter (agreement) that they will hold the stock for investment purposes only. Stock purchased through private placement is sometimes called lettered or legend stock because purchasers must sign the investment letter.

Under SEC Rule 501, an accredited or sophisticated investor is an insider of the issuer; a Qualified Institution Buyer (see below); or one with a net worth of $1 million or more or an investor who has had a yearly income of at least $200,000 (for an individual investor) or $300,000 (for joint income with spouse) for the previous two years and is expected to earn at least that much in the current year.

For the purposes of private placements, Qualified Institutional Buyers (QIB) are allowed to purchases private placements in the same way that accredited investors are. QIBs can be a bank, insurance company, employee benefit plan, a trust fund, a business development company, and so on that owns and invests on a discretionary basis at least $100 million in securities of issuers not affiliated with the entity. Broker-dealers may also be considered QIBs if they own and invest on a discretionary bases at least $10 million in securities of issuers not affiliated with the broker-dealer.

Private placements aren't for everyone, so there are restrictions placed on firms soliciting or advertising for private placements under SEC Rule 506. Either the company refrains from advertising and solicitation and limits the number of accredited investors to 35 or if the company solicits or advertises, it sells only to accredited investors.

Rule 144

This rule covers the sale of restricted, unregistered, and control securities (stock owned by directors, officers, or persons [including holdings of immediate family members] owning 10% or more of the issuer's voting stock). According to Rule 144, sellers of these securities must wait anywhere from 6 months to a year, depending on whether the corporation that issued the securities is subject to the reporting requirements of the Securities Exchange Act of 1934 prior to selling the securities to the public. Additionally, the most an investor can sell at one time is 1 percent of the outstanding shares or the average weekly trading volume for the previous four weeks, whichever is greater.

Rule 144A

This rule allows unregistered domestic and foreign securities to be sold to Qualified Institutional Buyers in the U.S. without a holding period.

The following example tests your ability to answer restricted-stock questions.

John Bullini is a control person who purchased shares of restricted stock and wants to sell under Rule 144. John has fully paid for the shares and has held them for over one year. There are 1,500,000 shares outstanding. Form 144 is filed on Monday, May 28, and the weekly trading volume for the restricted stock is as follows:

Week Ending	Trading Volume
May 25	16,000 shares
May 18	15,000 shares
May 11	17,000 shares
May 4	15,000 shares
April 27	18,000 shares

What is the maximum number of shares John can sell with this filing?

(A) 15,000

(B) 15,750

(C) 16,200

(D) 16,250

The right answer is Choice (B). The test writers often try to trick you on the Series 7 exam by giving you at least one week more than you need to answer the question. Because John has held his restricted stock for over a year, he can sell 1 percent of the outstanding shares or the averaged weekly trading volume for the previous four weeks, whichever is greater:

In this case, the previous four weeks are the top four in the list, but be careful; the examiners are just as likely to use the bottom four to give the table a different look.

Figure out 1 percent of the outstanding shares by multiplying the outstanding shares by 1 percent (easy, right?). In this case, you come up with an answer of 15,000 shares. That’s one possible answer. The other possible answer is the average weekly trading volume for the previous four weeks. Add the trading volume for the previous four weeks (the top four in the chart) and divide by 4 to get an answer of 15,750 shares. Because you’re looking for the greater number, the answer is Choice (B).

Even securities exempt from registration are subject to antifraud rules. All securities are subject to antifraud provisions of the Securities Act of 1933, which requires issuers to provide accurate information regarding any securities offered to the public.