Each year, investors large and small invest trillions of dollars in securities like stocks, bonds, mutual funds and hedge funds that hold these securities.
Securities do not appear out of thin air. Long chains of events precede their existence and investors’ access to them. The company started from an idea, chugged along for a while, and, to grow, needs more capital from a broader set of investors. The company reaches these investors by “offering” to sell its securities to them. There are two broad categories of offerings: “public” and “exempt.”
In this module, we will explore the processes through which securities reach investors. First, we will look at “public” offerings, which must be registered with the Securities and Exchange Commission and “exempt” offerings which do not need to be registered. Second, we will more closely examine the process of publicly offering securities and the registration requirements. Third, we will survey the major types of “exempt” offerings, including private offerings, intrastate offerings and governmental securities offerings.
Lawmakers designed The Securities Act of 1933 to balance investor and private company needs.[1] First, the law seeks to ensure that an investor receives critical and essential information regarding companies before investing and, second, to make certain that investment dollars go to companies that have favorable, or at least fully disclosed, prospects.
A public offering is an investment process used by an existing company to raise capital from the public.[2] By the time a company goes public, it usually has had some success, but needs to raise money to expand in scale or venture into new areas.
A company may want to go public for several reasons. First, it generates immediate capital by allowing the sale of stock to the public. Second, it positions itself for future capital through future stock offerings. Third, it gives its employees the opportunity to receive compensation through stock or stock options. Finally, a company that goes public can use the stock it holds on to as a form of currency with which to acquire other companies.
There are, however, also drawbacks. First, the company loses management control, as shareholders will have the ultimate say in company management and who sits on the board of directors. Second, there are enhanced reporting requirements, as public corporations must publish extensive disclosures about its financial condition, compensation of directors and officers and business operations. Finally, going public increases the potential liability of the company and its officers and directors for mismanagement.
For example, poor management decisions may bring shareholder derivative lawsuits in addition to loss of value. In addition, federal law requires disclosure of information about how the company operates. Investors can sue the company and its management for self-dealing, making material misrepresentations to shareholders or omitting information that the federal securities laws require to be disclosed.
The Initial Public Offering Process
A public offering involves three phases. Each phase has its own set of rules. The first, the pre-filing period, begins when the company reaches an understanding with a managing underwriter regarding the public offering. It ends when the company files a registration statement with the SEC.
The Pre-Filing Period
During the pre-filing period, the company works with “underwriters.” Typically, a large investment bank, an underwriter is an intermediary between the company and the investors it hopes to reach.[3] It will consult the company on the likelihood of reaching a target share price in the public offering process and provide some type of assurance that the company will receive that price for each share it sells to the public. A company will engage multiple underwriters, who are referred to as a “syndicate.”[4]
There are three basic types of underwriting: firm commitment underwriting, standby underwriting, and best efforts underwriting.[5]
In a firm commitment underwriting, the underwriter agrees to purchase the shares from the company for a set price and sell them to the investing public. It earns its fee from the difference between the price at which it buys the shares from the company and that at which they are sold to the public, sometimes referred to as the “spread” or “mark-up.”
In a standby commitment underwriting, the company and underwriter agree that the company will offer a specified number of shares to existing shareholders, and the underwriter will buy any unsold shares at a lower price. The underwriter charges a fee that factors in the risk of it having to buy unsold shares.
In a best efforts underwriting, the company and underwriter agree that the underwriter will undertake its “best efforts” to help the company sell a specified number of shares at a set price to the investing public. For this service, the underwriter will charge a fee. It does not obligate itself to buy any of the shares. Its compensation comes solely from the fee it charges the company.[6]
During this period, the company is prohibited from selling the securities, offering to sell them, touting the value of the securities, or disclosing the underwriters’ identities.[7] All of these prohibited activities are known as “gun-jumping.” If a company engages in gun-jumping, the SEC may order a delay in the IPO to allow a “cooling-off period.”[8] The SEC may also impose sanctions or fines, and investors who purchased shares can require the company to buy them back for the full purchase price plus interest.
“Offer to sell” includes any conduct that can be perceived as either letting someone know the company is interested in selling the securities or attempting to entice an investor into offering to buy the securities.
The Waiting Period
The second phase, the waiting period, begins when the company files its registration statement, which is filed with the SEC with a “prospectus” before the securities can be sold to the public at large.[9] The prospectus and registration statement provide the essential facts regarding the company, including:
(1) a description of the company’s property, assets and business;
(2) a description of the security to be offered for sale;
(3) information about the management of the company; and
(4) financial statements certified by independent accountants.[10]
Each category of information is critical to an informed investment decision. Investors must know what a company does and plans on doing in the future and what assets it presently owns. Investors must also know what types of securities are being offered. These can, for example, include stocks and bonds. If it is a stock, does it pay dividends? If so, how often? If it is a bond, what rate of interest does it pay, and when will the principal be returned? Do the board and senior management have sufficient experience to run this type of company? Etc.
Investors should also know the current financial condition of the company, and that it has been audited by an independent accounting firm. This information is critical to understanding the near-term financial prospects of the company and any debts or major liabilities that might impact the company after the IPO. Having an independent accountant certify a financial statement lends expertise and objectivity to the revenue, expense, debt and profit numbers that the company reports.
During the waiting period, the company cannot sell securities.[11] However, it can offer the securities for sale orally or in writing with a preliminary prospectus that contains the required information. For example, it can solicit indications of interest from investors, including the price at which they might be interested.
During the waiting period, the company may also conduct a “roadshow” with underwriters to market the upcoming IPO to investors. This typically consists of presentations by the senior executives of the company to institutional investors to generate enthusiasm for the upcoming offering.[12]
The SEC reviews the registration statement during the waiting period. It may require the company to add or clarify information or correct potentially confusing statements. This second phase ends when the SEC declares the registration statement effective.
The Post-Effective Period
The post-effective period begins when the SEC declares the registration statement to be effective and ends 25 days later. During this phase, the company and underwriters determine the offering price based on the feedback that they received from prospective investors during the waiting period. Sales are permitted, though offers to sell must be accompanied by the final prospectus.[13]
During this period, the company and underwriter enter into a formal agreement regarding the price at which the securities will be sold, the form of the underwriting and the fee to be paid to the underwriters.
The Securities Act requires that the company and underwriter either physically deliver a copy of the final prospectus to each investor who purchased during the initial public offering or file a registered prospectus with the SEC which is published on the SEC’s website and is available to any investor.[14]
Non-Public Offerings
Companies frequently sell stock to early investors in private offerings. Private placement provides funding through direct negotiation with private financial institutions. The private financial institution may provide loans or purchase shares in the company. The Securities Act exempts “private offerings” from the requirement that an issuer register securities with the SEC.[15] The term “private offering” is not defined in the Securities Act. Courts and regulators consider several factors to determine whether an offering is “private” versus “public.”[16]
The first is the manner in which the company offers the securities. How were the purchasers found and what is their relationship to the issuer? If there was a general solicitation or advertising to the public at large, or a large number of prospective investors, no exemption applies. The second factor is the nature of the investors whom the issuer targets. Are they sophisticated and familiar with investing and the business at hand, and can they bear the risk of loss? If the investors aren’t experienced with purchasing securities, it’s likely a public offering. Third is the quality of information the company provides to prospective investors. The information for a private offering doesn’t need to be as extensive as a registration statement and prospectus for public offerings, but it must be close. The less information provided, the more likely it is to be considered a private offering. Finally, courts and regulators will look at whether the company is selling the securities to an investor who will resell them. The greater the probability that the buyers will re-sell the securities, the more likely it is to be considered a public offering.
The SEC has established regulations that provide an issuer with a “safe harbor” when conducting a private offering.[17] It provides categories of exemptions based upon the dollar amount of the securities being sold or the wealth or sophistication of the investors to whom they are sold. Although the rules do not require a registration statement and prospectus to be filed with the SEC, they do require that the issuer file with the SEC a Form D, which provides basic information about the company, its officers and the size and date of the private offering as well as a notice of sale.[18]
Publicly Reselling Securities Acquired in Private Transactions
An investor who has purchased a security in a private transaction and has held it for a sufficient period of time- typically at least six months- may resell the security in a private sale without registering it.[19] Issuers and underwriters, though, are not eligible for this relief from the registration requirement.[20] Moreover, an investor cannot buy the security and immediately turn around and resell it; otherwise he may be deemed an underwriter because he’s bought the security with a view towards reselling it.[21]
The investor can also resell a security publicly assuming two criteria are met. First, the investor must hold the securities for a period of at least six months (if the company files reports under the Exchange Act of 1934) or twelve months if the company is private. Second, information about the company of the type that is required in registration statements must be publicly available. Large shareholders, senior officers and directors must abide by additional volume limitations set forth by SEC Rule 144.[22]
Third, the investor can resell the security in a direct listing. This is similar to an IPO. The difference is that an IPO involves new securities that the company issues and sells to new investors, whereas a direct listing involves existing securities that the existing owners sell to new investors.
If the company grows and becomes well-known to the public, its early investors may want to sell their shares to the public rather than relying on the less liquid private markets. Or, the company itself may want its securities publicly tradable so it can use the shares as a form of currency to acquire other companies. The company can make these existing securities publicly tradable through a direct listing. The company registers the securities and the current holders can then sell them to new investors on a public exchange.[23] The exchanges typically limit direct listings to companies that are sufficiently large and established.[24]
Exempt Offerings
The law allows for some additional exemptions to the registration requirements. These exemptions are interpreted narrowly because the goal of the Securities Act is to protect the investors, not the companies that are issuing securities. We’ll examine three registration exemptions.
Governmental Securities
Under the governmental securities exemption, securities issued by governmental entities like federal, state or county governments or government-run utilities do not need to be registered. For example, treasury, state and local bonds are covered by this exemption. The reason for this exemption is that the investing public has access to information concerning the entity issuing the securities by virtue of its being a public, governmental entity. Moreover, the public entity has the ability to make good on its obligations through the power to tax its residents, if necessary, to repay the bond obligations.[25]
Intrastate Offerings
If a company issues securities only to residents of the state in which it is incorporated, it need not register the securities.[26] The idea behind this exemption is that the offering is more of an in-state matter, and thus the state regulators can ensure compliance.
There are three requirements for intrastate offering exemption.[27] First, the company must be incorporated in the state and it must do business predominantly in that state. It can have offices in other states, but the majority of its business must be in the state in which it is offering the securities. Second, the company must use the proceeds from the sale of securities in the state, meaning it cannot acquire investor dollars in one state, and then use the investment for operations in another state. Finally, the securities must be offered only to investors in the state, and the company must take care to ensure that these investors are not buying the securities with a view to reselling them outside the state. The intention is that the securities will “come to rest” within the state.
Crowdfunding
As technological advances have allowed for increased flow of information through the Internet, the SEC has authorized other means of offering securities without requiring registration. One such innovation is reflected in “Regulation Crowdfunding.”[28] This regulation permits small companies to raise up to $1,070,000 in any twelve-month period in an unregistered offering. The idea is that the company will receive only small investments from each member of the “crowd.”
Regulation Crowdfunding imposes considerable requirements on an issuer for the exemption to apply. For example, the issuer must file a “Form C” which provides critical information regarding the company such as its accounts receivable, short-term debt, long-term debt, revenues and taxes paid.[29] Moreover, the issuer may offer the securities only through broker-dealers or funding portals that are registered with the SEC and FINRA.[30] Additionally, an investor may only acquire a certain dollar amount in crowdfunded securities in any given year, with the amounts depending on the investor’s income and net worth. The issuer must conduct due diligence to make sure its investors are abiding by these limits.[31]
In our next module, we’ll consider securities fraud and important concepts related to antifraud laws.
[1] “The Laws That Govern the Securities Industry,” U.S. Securities and Exchange Commission, https://www.sec.gov/answers/about-lawsshtml.html#secact1933 (last visited Oct. 7, 2018).
[2] “Public Offering,” Investopedia, https://www.investopedia.com/terms/p/publicoffering.asp (last visited Oct. 7, 2018).
[3] Richard M. Carson, “United States: Fundamentals of Initial Public Offerings,” Mondaq, (Sept. 25, 2013), http://www.mondaq.com/unitedstates/x/265126/Securities/Fundamentals+Of+Initial+Public+Offerings.
[4] “Underwriting Syndicate,” Nasdaq, https://www.nasdaq.com/investing/glossary/u/underwriting-syndicate (last visited Oct. 7, 2018).
[5] Securities Institute of America, Inc., “Types of Underwriting Commitments,” Investopedia, https://www.investopedia.com/study-guide/series-62/issuing-corporate-securities/types-underwriting-commitments/ (last visited Oct. 7, 2018).
[6] Id.
[7] See 15 U.S.C. § 77e(c); see also Richard M. Carson, “United States: Fundamentals of Initial Public Offerings,” Mondaq, (Sept. 25, 2013), http://www.mondaq.com/unitedstates/x/265126/Securities/Fundamentals+Of+Initial+Public+Offerings.
[8] “Quiet Period,” U.S. Securities and Exchange Commission, https://www.sec.gov/fast-answers/answersquiethtm.html (last visited Oct. 7, 2018).
[9] Richard M. Carson, “United States: Fundamentals of Initial Public Offerings,” Mondaq, (Sept. 25, 2013), http://www.mondaq.com/unitedstates/x/265126/Securities/Fundamentals+Of+Initial+Public+Offerings.
[10] See “What We Do,” U.S. Securities and Exchange Commission, https://www.sec.gov/Article/whatwedo.html#laws (last visited Oct. 7, 2018).
[11] See 15U.S.C. § 77e(a).
[12] Richard M. Carson, “United States: Fundamentals of Initial Public Offerings,” Mondaq, (Sept. 25, 2013), http://www.mondaq.com/unitedstates/x/265126/Securities/Fundamentals+Of+Initial+Public+Offerings.
[13] Id.
[14] Brenda Hamilton, “What are the Prospectus Delivery Requirements? Going Public,” SecuritiesLawyer101, https://www.securitieslawyer101.com/2014/prospectus-delivery-requirements/ (last visited Oct. 7, 2018); “Final Prospectus,” Investopedia, https://www.investopedia.com/terms/f/finalprospectus.asp (last visited Oct. 7, 2018).
[15] See 15U.S.C. § 77d(a)(2).
[16] See SEC v. Ralston Purina Corp., 346 U.S. 119, 126-27 (1953).
[17] See 17C.F.R. §§ 230.501 – 230.506.
[18] See “Form D,” U.S. Securities and Exchange Commission, https://www.sec.gov/files/formd.pdf (last visited Oct. 7, 2018).
[19] See 15 U.S.C. § 77d(a)(1).
[20] See id.
[21] See 15U.S.C. § 77b(a)(11).
[22] 17 C.F.R. § 230.144.
[23] See Andre Brady, Phyllis Korff and Michael Zeidel, “New NYSE Rules for Non-IPO Listings,” Harvard Law School Forum on Corporate Governance and Financial Regulation (Feb. 24, 2018), https://corpgov.law.harvard.edu/2018/02/24/new-nyse-rules-for-non-ipo-listings/.
[24] See Erin Griffith, “How Will Spotify’s Direct Listing Work?,” Fortune (July 31, 2017), http://fortune.com/2017/07/31/spotify-ipo-direct-listing-2/.
[25] “Securities Exempt from Registration under the Securities Act of 1933,” ThisMatter.com, https://thismatter.com/money/stocks/exempt-securities.htm (last visited Oct. 7, 2018).
[26] See 15U.S.C. § 77c(a)(11).
[27] See Busch v. Carpenter, 827 F.2d 653, 657 (10th Cir. 1987); see also “Intrastate Offering Exemptions: A Small Entity Compliance Guide for Issuers,” U.S. Securities and Exchange Commission, https://www.sec.gov/info/smallbus/secg/intrastate-offering-exemptions-compliance-guide-041917.htm (last visited Oct. 7, 2018).
[28] See 17C.F.R. § 227.100, et seq.
[29] “Form C,” U.S. Securities and Exchange Commission, https://www.sec.gov/files/formc.pdf, (last visited Oct. 7, 2018).
[30] “Updated: Crowdfunding and the JOBS Act: What Investors Should Know,” FINRA, http://www.finra.org/investors/alerts/crowdfunding-and-jobs-act-what-investors-should-know (last updated Oct. 7, 2018).
[31] See “Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers,” U.S. Securities and Exchange Commission, (May 13, 2016), https://www.sec.gov/info/smallbus/secg/rccomplianceguide-051316.htm.