The Primary Market
The primary market is where securities are created and sold for the first time. Understanding the Securities Act of 1933, the registration process, and underwriting is essential for Series 7 representatives.
Securities Act of 1933
The Securities Act of 1933 governs the primary market and the issuance of new securities. Often called the "Paper Act" or "Truth in Securities Act," it was enacted in response to the market abuses that contributed to the Great Depression.
Key Provisions
| Provision | Description |
|---|---|
| Full Disclosure | Issuers must disclose all material information |
| Registration | Most new securities must be registered with SEC |
| Prospectus | Investors must receive a prospectus before purchase |
| Anti-Fraud | Prohibits fraud in the offer or sale of securities |
What the 1933 Act Does NOT Do
Important: The SEC does not approve or disapprove securities or guarantee accuracy of disclosures. It only ensures that required information is provided.
The Registration Process
Registration Statement
Before selling securities to the public, issuers must file a registration statement with the SEC containing:
- Description of the business
- Management information and compensation
- Financial statements (audited)
- Use of proceeds from the offering
- Risk factors
- Legal matters
The Three Periods
| Period | What Happens | What's Allowed |
|---|---|---|
| Pre-Filing (Pre-Registration) | Before registration filed | No offers, no sales |
| Cooling-Off Period | SEC reviews registration (min. 20 days) | Oral offers, indications of interest, red herring |
| Post-Effective | SEC declares registration effective | Sales and delivery of final prospectus |
Cooling-Off Period Activities
During the 20-day (minimum) cooling-off period:
Permitted:
- Oral offers (no written materials)
- Indications of interest (non-binding)
- Distribution of preliminary prospectus (red herring)
- Taking "indications of interest" but NOT orders
Prohibited:
- Written offers (except red herring)
- Sales or binding commitments
- Accepting payment
The Prospectus
| Type | Description |
|---|---|
| Preliminary (Red Herring) | Used during cooling-off; lacks price, effective date |
| Final Prospectus | Complete document; must be delivered with or before confirmation |
| Summary Prospectus | Shortened version for mutual funds |
Red Herring: Called this because of the red legend stating the registration is not yet effective. It contains substantially the same information as the final prospectus except the public offering price (POP) and effective date.
Underwriting
Underwriting is the process by which investment banks help issuers sell new securities to the public.
Participants in an Underwriting
| Participant | Role |
|---|---|
| Issuer | Company selling the securities |
| Managing Underwriter (Lead) | Heads the syndicate, manages the offering |
| Syndicate Members | Underwriters who share risk and distribution |
| Selling Group | Dealers who sell but don't underwrite |
Types of Underwriting Commitments
| Type | Description | Risk Bearer |
|---|---|---|
| Firm Commitment | Underwriter buys all securities, resells to public | Underwriter |
| Best Efforts | Underwriter sells what it can; unsold returns to issuer | Issuer |
| All-or-None | Must sell all or deal is cancelled | Neither (deal cancelled) |
| Mini-Max | Minimum must sell or deal cancelled; maximum is cap | Depends on sales |
Key Point: In firm commitment, underwriters act as principals (dealers), purchasing the securities and taking on the risk. In best efforts, they act as agents (brokers).
The Underwriter's Spread
The spread is the difference between what the underwriter pays the issuer and what the public pays.
| Component | Recipient |
|---|---|
| Manager's Fee | Managing underwriter |
| Underwriting Fee | Syndicate members |
| Selling Concession | Whoever sells the security |
| Reallowance | Non-syndicate dealers |
Example: Public Offering Price = $20, Issuer receives $18
- Total Spread = $2
- Manager's Fee = $0.25
- Underwriting Fee = $0.50
- Selling Concession = $1.25
Stabilization
Stabilization is the only legal form of market manipulation. The managing underwriter may place bids to support the price of a new issue in the secondary market.
Rules for Stabilization:
- Cannot exceed the public offering price
- Must be disclosed in the prospectus
- Used to prevent price decline during distribution
Exempt Securities and Transactions
Securities Exempt from Registration
| Exempt Security | Reason |
|---|---|
| U.S. Government securities | Backed by full faith and credit |
| Municipal bonds | Government issuers |
| Bank securities | Regulated by banking authorities |
| Commercial paper (< 270 days) | Short-term, high quality |
| Non-profit securities | Religious, charitable organizations |
Exempt Transactions
| Exemption | Description |
|---|---|
| Regulation D (Private Placement) | Limited offerings to accredited investors |
| Regulation A (Tier 1 & 2) | Simplified registration for smaller offerings |
| Rule 147 (Intrastate) | Offerings within a single state |
| Rule 144 | Resale of restricted/control securities |
Regulation D (Private Placement)
Regulation D allows issuers to raise capital without full SEC registration:
- Rule 504: Up to $10 million in 12 months
- Rule 506(b): Unlimited amount, up to 35 non-accredited investors
- Rule 506(c): Unlimited amount, accredited investors only, general solicitation allowed
Accredited Investors include:
- Individuals with $1 million net worth (excluding primary residence)
- Individuals with $200,000 income ($300,000 with spouse) for past 2 years
- Institutions with $5 million in assets
On the Exam
The Series 7 exam frequently tests:
- The three time periods (pre-filing, cooling-off, post-effective)
- What can and cannot be done during cooling-off period
- Differences between firm commitment and best efforts
- Exempt securities and transactions
- Components of the underwriter's spread
During the cooling-off period, which of the following is permitted?
In a firm commitment underwriting, who bears the risk of unsold securities?
Which of the following securities is exempt from registration under the Securities Act of 1933?
The portion of the underwriter's spread that is paid to the dealer who actually sells the securities to investors is called the:
11.2 The Secondary Market
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