Primary and Secondary Markets

CHAPTER 7

Primary and Secondary Markets

Learning Objectives

After reading this chapter you will understand:

• How the SEC regulates the distribution of newly issued securities
• What a registration statement is
• What a traditional private placement offering is
• What a bought deal underwriting for a bond issue is and why it is used
• What a competitive bidding underwriting is and the different methods for determing the price of winning bidders
• What a preemptive rights offering is and why a standby underwriting arrangement may be needed
• The definition of a secondary market
• The need for secondary markets for financial assets
• The different types of architectural structures for secondary markets: order-driven and qoute-driven markets
• Trading mechanisms: the types of orders, margin buying and short selling
• What securities finance is: securities lending and repurchase agreements
• The role of a dealer as a market maker and the costs associated with market making
• What is meant by the operational efficiency of a market
• What is meant by the pricing efficiency of a market and the different forms of pricing efficiency
• The implications of pricing efficiency for market participants
• Transaction costs, which include commissions, fees, executions costs, and opportunity costs

PRIMARY MARKETS

REGULATION OF THE ISSUANCE OF SECURITIES

Underwriting activities are regulated by the Securities and Exchange Commission. The Securities Act governs issuance of securities. The act requires that the registration statement be filed with the SEC by the issuer of the security.

The type of information contained in the registration statement is the nature of the business of the issuer, key provisions or features about the security, the nature of the investment risks associated with the security, and the background of management. Financial statements must be included in the registration statement and they must be certified by an independent public accountant.

TWO PART OF REGISTRATION

Part I is the prospectus. This part is typically distributed to the public as an offering of the securities.

Part II contains supplemental information, which is not distributed to the public s part of the offering but is available from the SEC upon request.

IMPORTANT DUTIES OF AN UNDERWRITER

The important duties of an underwriter is to perform due diligence. The following qoute is taken from a court decision that explains the obligation of an underwriter to perform due diligence:

An underwriter by participating  in an offering constructively represents that statements made in the registration materials are complete and accurate. The investing public properly relies upon the underwriter to check the accuracy of the statements and the soundness of the offer; when the underwriter does not speak pot, the investor reasonably assumes that there are no undisclosed material deficiencies. The representation in the registration statement are those of the underwriter as much as they are those of the issuer.

The filing of a registration statement with the SEC does not mean that the security can be offered to the public. The registration statement must be reviewed and approved by the SEC’s Division of Corporate Finance before the security can be offered to the public.

The time interval between the initial filing of the registration statement and the time the registration statement becomes effective is referred to as the waiting period. During the waiting period, the SEC does allow the underwriters to distribute a preliminary prospectus. Because the prospectus is not effective, the cover page of the prospectus states this status in red ink and as a result, the preliminary prospectus is commonly referred to as red herring. During the waiting period, the underwriter cannot sell the security nor may it accept written offers from investors to buy the security.

SHELF REGISTRATION RULE

         The rule permits certain issuers to file a single registration document indicating that it intends to sell a certain amount of a certain class of securities at one or more times within the next 2 years. The securities can be viewed as sitting on a “shelf” and can be taken off that shelf and sold to the public without obtaining additional SEC approval.

The filing of a single registration document allows the issuer to come to market quickly because the sale of the security has been preapproved by the SEC. For example, if a corporation felt that interest rates were attractive and wanted to issue a bond, it had to file a registration statement and could not issue the bond until the registration statement become effective. The corporation then takes the chance that during the waiting period interest rates will rise, making the bond offering more costly.

Continued Reporting

Any company that publicly offers a security becomes a becomes a reporting company and, as such, is subject to the Securities Exchange Act. This act specifies that a reporting company file with the SEC annual and periodic financial reports. The Financial reports must be prepared according to generally accepted accounting principles (GAAP).

PRIVATE PLACEMENT OF SECURITIES

Private offerings of securities differ in terms of the regulatory requirements. The securities acts allow three exemptions from federal registration. First, intrastate offerings - that is, securities sold only within a state - are exempt. Second, a small-offering exemption (Regulation A) specifically applies if the offerings is for 1 million or less, then the securities need not be registered. Finally, Act exempts from registration “transactions by an issuer not involving any public offering.” However, the Act does not provide specific guidelines to identify what is private offering or placement.