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January 19, 2020


Last updated: June 29, 2024

FINRA Exam Prep Issuing Securities

By: Securities Institute Staff

In this article we are going to take a look at how corporate securities are offered to investors for sale for the very first time. When we take a look at offering corporate securities we have to start a review with the Securities Act of 1933. The Securities Act of 1933 regulates the primary market. And the primary market consists exclusively of issuer to investor transactions, one where the issuing entity receives the proceeds of the sale.

The Securities Act of 1933 was the first piece of major securities industry regulation that came about largely due to the stock market crash in 1929. Anything on a test which indicates a year prior to 1933 is a wrong answer, because prior to 1933 there were no major industry regulations out there. Seeing as it is the first piece of major industry regulation, it seems appropriate that it does regulate the primary, or the first market. And again, that consists exclusively of issuer to investor transactions.

This is known as the Truth in Securities Act. It’s also called the Paper Act, or the Prospectus Act. What it really, really focuses on is full and fair disclosure of all material facts relating to the new issue. It wants to make sure that potential investors are well-informed prior to making any investment decision when a company is issuing securities to the investing public.

Every prospectus or offering document provided to investors has to have the SEC no approval clause on the cover. It states that the SEC neither approves nor disapproves of the securities offered herein. Nor do they make any representations on the accuracy or the adequacy of their information contained in the prospectus or offering document. They basically say, we looked at it, we have no opinion. Remember, this is all focusing on full and fair disclosure, The SEC wants to ensure that investors and potential investors have all the facts before buying a security.

Now, let’s take a look at how the process starts. Securities have to be registered with the SEC. And the issuer is going to file a registration statement, formally known as an S-1, with the SEC. 

The registration statement will be on review with the SEC for a minimum of 20 days. And that 20 days is known as the cooling off period. During these 20 days, while the information is being reviewed by the SEC, broker-dealers and their registered representatives are fairly limited as to what they can do as it relates to these securities that are in registration while the registration is still pending.

So the first thing you need to know is, no sales can take place during this period of time. They cannot guarantee an investor will get a certain number of shares. They cannot accept checks or anything of that nature. The only thing they can do during the cooling off period is accept indications of interest.

A registered rep could call up one of their customers and say “Hey, Bob, XYZ might be coming public in the next few weeks. Would you be interested in buying some shares?” And Bob “responds, sure, I think that sounds like a nice opportunity. I would like to learn more about that.”

So what would happen here is the registered representative would send him a preliminary prospectus, or a red herring, so that he can review the information on an initial basis. So during the cooling off period, you can accept indications of interest from potential investors who may be interested in the offering of the securities. You can also conduct roadshows, or due diligence meetings. A road show, or due diligence meeting, is used to drum up interest in the potential offering and to discuss it with potential investors.

Another thing you can do during the cooling off period is run a tombstone ad. A tombstone ad is an announcement regarding the securities and registration, saying xyz may be coming public in the next few weeks. Expected price range is $15 to $20, 500 million shares, Information about where you can obtain a preliminary prospectus, the names of the underwriters will also be contained in the tombstone ad. And it must contain information that the securities have not yet become registered, and therefore may not be sold.

Now in a perfect world, after this 20 days has elapsed, the SEC will issue an effective date. The issue is said to become effective. The SEC does not approve it, they don’t pass on it, they issue the securities an effective date. And on that day broker dealers  may then go ahead and sell the securities to the investors who had expressed indications of interest.

Now this is in a perfect world, but we don’t really live in a perfect world. So oftentimes, the cooling off period extends beyond the 20 days because the SEC has some questions regarding the issue and the information that has been provided to them. So if during the span of this 20 days the SEC has questions relating to the registration statement, they will issue what is known as a “deficiency letter”.

So If the SEC has questions or wants clarification of anything in that registration statement they’re going to issue a deficiency letter. They won’t call the issuer, they won’t call the underwriters, they are going to send a letter known as a deficiency letter. 

And while that deficiency letter is outstanding, the cooling off period is increasing. So a deficiency letter will indeed extend the cooling off period beyond that 20 days. But at the very least, for test purposes, if they ask you how long the cooling off period is, it is indeed 20 days. And remember, during the cooling off period, your activities are limited to indications of interest, a roadshow, a due diligence meeting, and a tombstone ad. No sales of a kind can take place until the SEC has offered or issued an effective date.

Now let’s take a look at several different types of prospectus that you are going to be required to know for your upcoming exam. A preliminary prospectus, also known as a red herring, as we said in our previous discussion, is used to solicit or to obtain indications of interest. It’s known as a red herring because on the cover of the preliminary prospectus, in red ink, it has a disclosure or a disclaimer stating that the securities registration has not yet become effective, and therefore, the securities may not be sold. So that’s where the term red herring comes from.

A few points you want to be aware of regarding the preliminary prospectus. First and foremost, everything is subject to change in that preliminary prospectus. With that in mind, the preliminary prospectus will largely have most of the information that’s going to be contained in the final prospectus with a few exceptions.

The preliminary prospectus will not have the final offering price because it has not yet been determined. So therefore, the preliminary prospectus will usually have a range.  For example, XYZ being offered to the public. $15 to $20 is the estimated price range.

Now because the price where the securities will be offered is not known, the issuer does not know the proceeds to the company. They don’t know the proceeds to the company because they don’t know how much they’re going to sell the securities for. The other item that is not going to  be in the preliminary prospectus, the underwriters discount. That still remains unknown. And it all goes back to the fact that the price is not yet known.

Now a preliminary prospectus has to be given to investors in hard copy, meaning it can’t be delivered electronically. The regulators want to make sure that the preliminary prospectus is seen in its hard copy form so that if they do go ahead and purchase, they are sure that they saw that piece of information before making that final purchase. The final prospectus is also known as a statutory prospectus.

And the final prospectus must be given to all purchasers at the time the order is completed, or the purchase is completed. The final prospectus, however, may be delivered electronically through a link. The access equals delivery rule states that if the prospectus is available on the SEC’s website, that prospectus has been deemed to have been delivered. So for the final prospectus, it’s access equals delivery.

Now let’s take a look at this last one here. And it’s known as a free writing prospectus, a free writing prospectus. And definitionally, of free writing prospectus is any communication about the issue in registration which does not meet the definition of a statutory prospectus. It’s a little confusing, so we’ll go through it again.

A free writing prospectus is anything that does not meet the definition of a statutory prospectus and its communication about the company, the issuer, or the securities in registration. Most likely, a free writing prospectus could be a term sheet, it could be a graph, it could be an email. It could even be something the president of the company says in an interview.

All of these things contain information about the issuer, or the securities in registration. And that would meet the conditions of a free writing prospectus, So graphs, emails, slide decks, pitch decks, and things said during an interview are all free writing prospectuses.

A hot issue is one that when it comes out, it trades at an immediate premium in a secondary market. This speaks specifically to IPOs, Initial Public Offerings. Companies are coming public for the first time, there’s a lot of investor enthusiasm. Very, very difficult for individual investors to purchase shares in what they call a hot IPO.

Usually, it’s all gobbled up by the large institutions before retail investors get their share. But by rule and definition, the broker-dealers are required to make a full and complete offering of all shares, and may not withhold any for their own account. We’re going to kind of go through some of the subtleties here on that.

Let’s say XYZ is coming public at $25 per share. And the demand is very high for the stock. Everybody wants it.

And as soon as that stock starts trading on the New York Stock Exchange, it’s trading at $40. It’s an immediate premium. Nobody’s been able to buy this stock before because it wasn’t public. It’s an Initial Public Offering, or an IPO.

Now this would be a really easy way for registered representatives and broker-dealers to make money if they could keep this for their own accounts, or for their account of their family members. But FINRA rules, and specifically here FINRA Rule 5130, says that registered representatives may not withhold these shares for themselves, they’re financially-supported family members. Nor can a broker-dealer withhold it for their own trading account. So this is what they call a hot issue. And that may not be withheld from the investing public.

Now there are some contingently-approved people, who may be able to buy shares of a hot issue. A non-supported relative, perhaps a father or father-in-law may be able to get a few shares if they have a history of buying new issues. Meaning, they have bought new issues before and the amount that they purchase is insubstantial.

They might be able to get 100 or 200 shares. They’re not going to get 4,000 or 5,000 shares because that would be more significant. So a contingently-approved family member, the primary criteria is that they are not supported by the registered rep, and they are people who have history of buying new issues before. And to be perfectly technically correct by rule, they should buy these shares through another broker-dealer. 

 this has been a great review of some of the information that you will need to know to pass your finra securities exams.  All of our finra exam prep products that come with our greenlight exam come with our greenlight money back pass guarantee

Good Luck on your exam !

The Securities Institute