11.1 The Primary Market
Key Takeaways
- The Securities Act of 1933 governs new issues, mandating full disclosure through a registration statement and prospectus.
- Registration moves through three periods: pre-filing (no offers), cooling-off (oral offers and red herring only), and post-effective (sales).
- Firm commitment makes underwriters principals bearing risk; best efforts makes them agents with risk staying on the issuer.
- The spread breaks into manager's fee, underwriting fee, and selling concession, with reallowance going to non-syndicate dealers.
- Government, municipal, and bank securities are exempt; Regulation D and Rule 147 are exempt transactions.
The Securities Act of 1933
The primary market is where securities are created and sold to investors for the first time, generating proceeds for the issuer. The Securities Act of 1933 (the "Paper Act" or "Truth in Securities Act") governs it. Its core demand is full and fair disclosure: an issuer must register most new securities with the SEC and deliver a prospectus so investors can make an informed decision.
The Series 7 loves the trap that the SEC does not approve, endorse, or guarantee the accuracy of an offering. The SEC only confirms that required disclosures were made. Any claim or implication that the SEC "approved" a security is a federal violation.
The Three Time Periods
Registration unfolds in three distinct windows, and the exam tests precisely what is allowed in each.
| Period | Trigger | Permitted | Prohibited |
|---|---|---|---|
| Pre-filing | Before registration is filed | Nothing public | No offers, no sales, no advertising |
| Cooling-off | Filing to effective date (min. 20 days) | Oral offers, indications of interest, red herring, tombstone ads | Written offers (except red herring), sales, accepting payment |
| Post-effective | SEC declares effective | Sales, final prospectus delivery | Selling without prospectus delivery |
During the cooling-off period a representative may take indications of interest, which are non-binding and may not be confirmed into an order until the effective date. The preliminary prospectus (red herring) carries a red-ink legend stating registration is not yet effective; it omits the public offering price (POP) and effective date but otherwise mirrors the final prospectus.
Prospectus Types
| Type | Use |
|---|---|
| Preliminary (red herring) | Cooling-off; no POP, no effective date |
| Final | Delivered with or before the trade confirmation |
| Summary | Condensed form, common for mutual funds |
The prospectus delivery requirement persists after the effective date: for an IPO of an exchange-listed or NASDAQ security, dealers must deliver a prospectus for 90 days; for an additional (follow-on) issue, 40 days. Non-NASDAQ/non-listed IPOs require 90 days.
Underwriting Commitments
Underwriting is how investment banks distribute the issue. The commitment type determines who carries the risk of unsold shares.
| Type | Mechanics | Risk bearer | Capacity |
|---|---|---|---|
| Firm commitment | Underwriter buys the entire issue, resells to the public | Underwriter | Principal |
| Best efforts | Underwriter sells what it can; unsold returns to issuer | Issuer | Agent |
| All-or-none (AON) | Deal cancelled unless 100% sells | Issuer (deal voids) | Agent |
| Mini-max | Deal voids unless a floor sells; sales capped at a maximum | Issuer | Agent |
Under firm commitment the syndicate acts as principal and takes on inventory risk; in best efforts arrangements the firm is an agent. AON and mini-max require investor funds to sit in escrow until the contingency is met.
The Spread
The spread is the difference between the POP and what the issuer nets. It is divided among the participants.
| Component | Recipient |
|---|---|
| Manager's fee | Lead/managing underwriter |
| Underwriting fee | Syndicate members (for assuming risk) |
| Selling concession | Whoever actually sells the shares |
| Reallowance | Non-syndicate dealers who sell |
Worked example: POP = $20, issuer receives $18, so the total spread = $2. If the manager's fee is $0.25 and the underwriting fee is $0.50, the selling concession is $1.25. The selling concession is always the largest slice because distribution is where the work happens.
Stabilization and Exemptions
Stabilizing bids are the only legal price manipulation: the manager may bid at or below the POP (never above) to support a new issue, and it must be disclosed in the prospectus.
Exempt securities (never need registration): U.S. government securities, municipal bonds, bank-issued securities, commercial paper maturing in 270 days or less, and securities of nonprofit/religious issuers. Exempt transactions include Regulation D private placements, Regulation A (Tier 1 up to $20M, Tier 2 up to $75M in 12 months), Rule 147 intrastate offerings, and Rule 144 resales.
Under Regulation D, an accredited investor is an individual with $1 million net worth excluding primary residence, or $200,000 annual income ($300,000 jointly) over the past two years. Rule 506(b) permits up to 35 non-accredited purchasers; Rule 506(c) allows general solicitation but only to verified accredited investors.
Shelf Registration and SEC Review
Large, seasoned issuers may use Rule 415 shelf registration to register securities once and sell them in tranches over time (generally up to three years), "taking them off the shelf" as market conditions allow. This avoids re-registering for each follow-on sale and is common for well-known seasoned issuers (WKSIs).
During the cooling-off period, the registered representative's conduct is sharply limited. A rep may discuss the issue orally, send a red herring, and run a tombstone advertisement, which is the only written communication besides the preliminary prospectus permitted before the effective date. A tombstone is not an offer to sell; it merely identifies the issuer, the type of security, the underwriters, and where to obtain a prospectus.
Common Exam Traps
- The SEC does not pass on the merits of a security; "the SEC approved this IPO" is always a wrong/illegal statement.
- An indication of interest is not a sale and may be withdrawn by the customer at any time before the effective date.
- In firm commitment the underwriter is the principal at risk; do not confuse this with best efforts, where the issuer keeps the risk.
- Municipal and U.S. government securities are exempt from registration but are not exempt from the antifraud provisions of the Acts.
- The selling concession is the largest piece of the spread because distribution is the value-added activity; the manager's fee is typically the smallest.
- Commercial paper qualifies as exempt only if it matures in 270 days or less and is used for current operations.
During the cooling-off period of a registration, which activity is permitted?
An issue has a public offering price of $20 and the issuer receives $18. The manager's fee is $0.25 and the underwriting fee is $0.50. What is the selling concession?
In a best efforts underwriting, the underwriter acts in what capacity and who bears the risk of unsold shares?