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Chapter 14

Primary Markets and the Underwriting of Securities

Primary market

Investment banker


Investment bankers perform the following 3 functions:

1. Advising the issuer on the terms and timing of the offering
2. Buying the securities from the issuer
3. Distributing the issue to the public

Investment bankers may design new types of securities, if warranted. For example, during a
high interest rate environment, an investment banker may advise issuing convertible bonds or
preferreds, high-yield or junk bonds, etc.

Best efforts
Firm commitment

Gross spread = underwriter discount

Initial Public Offering (IPO)

Lead underwriter (running the books for the deal)
Underwriting syndicate

Selling group

Key Points

1. There are 3 functions performed by investment bankers in the offering of new
2. Depending on the type of underwriting agreement, the underwriting function my
expose the investment banking firm to the risk of selling the securities to the public at a
price less than the price paid to the issuer.
3. The gross spread earned by the underwriter depends numerous factors.
4. Because of the risks associated with the underwriting of securities, an underwriting
syndicate and selling group are typically formed.


Prior to repeal of Glass-Steagall Act in 1999, commercial banks in the US could not underwrite

Since the repeal of Glass-Steagall, commercial banks and even insurance companies my
underwrite securities.
Japanese securities regulations place even greater restrictions on commercial banks in the
matter of underwriting/securities issuance than Glass-Steagall.

On the contrary, in Germany there is no separation between commercial and investment
banking. German banks are referred to as Universal banks.

Key Points

1. The two groups that underwrite securities are investment banking firms and commercial
banks. The limitations on commercial bank underwriting activities have been
significantly reduced by the legislation in 1999 that repealed Glass-Steagall.
2. There are 4 major firms that dominate investment banking in Japan.


Registration Statement contains a prospectus in part 1 and supplemental information in part 2.

Propectus is required to be released to the public prior to the public issue.

Underwriters are required to perform due diligence with respect to information provided to the
public in a prospectus.

The registration statement must be reviewed and approved by the SEC, which typically requires
a response to a deficiency letter sent by SEC to the issuer, before a registration statement is
approved. A public offering may only be made after SECs approval of the registration

Waiting period is the period between submission of a registration statement and its final
approval. During the waiting period the preliminary prospectus is called a red herring and
underwriters may not sell the security or accept offers from investors to buy the security.

Shelf registration rule authorizes SEC to permit certain issuers to file a single registration
document for the sale of a certain amount of a certain class of securities one or more times
within the next 2 years.

Key Points

1. The SEC regulates underwriting activities
2. An issuer must file a registration statement, part 1 of which is the prospectus
3. The underwriter must exercise due diligence to assure that there are no mis-statements
or omissions of fact in the registration statement of the prospectus.
4. SEC rule 415 (the shelf registration rule) gives greater flexibility to certain issuers by
permitting them to file a single registration document for the offering of certain


Bought Deal

Auction Process (or competitive bidding process)
single-price auction (Dutch auction), or
multiple-price auction

Preemptive Rights Offering
Underwriting not normally required; however
A standby underwriting arrangement may be used; for which
A standby fee may be paid

In a preemptive rights offering, the rights offered may be sold in open market at around the
following price:

(anticipated price per share after rights issued subscription price of new
share)/number of rights required to subscribe for one share.

Key Points

1. There are variations in the traditional underwriting process
2. In a bought deal, a lead manager or a group of managers offers a potential issuer of
debt securities a firm bid to purchase a specified amount of the security
3. An offering of a new security may be made by means of an auction process
4. A corporation can offer existing shareholders new shares in a preemptive rights offering,
and using a standby underwriting arrangement, the corporation can have an investment
banking firm agree to distribute any shares not subscribed to.


Private placement of securities is an alternative to an underwritten public issue.

One major advantage of a private placement is that SEC regulations that govern private
placements are significantly less onerous than those that govern public offerings. Consequently,
the costs of raising funds through private placements are also significantly lower than the
costs of raising funds through public offerings.

Private placements do not typically require underwriting but investing banking firms provide
several services in private placements as well: (1) in designing the issue; and (2) in lining up

Rule 144A

One restriction placed on buyers of privately placed securities is that they may not resell such
securities for 2 years after acquisition.

However, under Rule 144A, the two-year holding period is eliminated by permitting large
institutions to trade securities acquired in private placements among themselves, without
having to register such securities with SEC.

Accredited or sophisticated investors are those investors who are deemed to have (1) the
capacity to evaluate the risk and return characteristics of given securities; and (2) the financial
resources to bear the economic risks of investing in given securities. Some of the regulations
that relate to public offerings do not apply to offerings to accredited or sophisticated

Key Points

1. A private placement is the distribution of shares to a limited number of institutional
investors rather than through a public offering.
2. The SEC specifies the conditions that must be satisfied to qualify for a private
3. Investment bankers will typically work with issuers in the design of a security for private
placement and in lining up potential investors.
4. SEC Rule 144A improves the liquidity of securities acquired by certain institutional
investors in private placements.


The primary market involves the distribution to investors of newly issued securities.

Investment bankers perform one or more of the following functions:
1. Advising issuers on the terms and timing of the offering.
2. Buying the securities from the issuer. This activity is referred to as underwriting.
3. Distributing the issue to investors.

Investment banking activities are performed by commercial banks and securities houses.

The SEC is responsible for regulating the issuance of new securities. The issuer must file a
registration statement (including a prospectus) for approval by SEC. The shelf registration rule
(Rule 415), permits certain issuers to file a single registration document indicating that they
intend to sell a certain amount and class of securities at one or more times within the following
2 years.

Variations in the underwriting process include the bought deal for underwriting of bonds, the
auction process for both stocks and bonds, and a rights offering coupled with a standby
underwriting arrangement for common stock.

A private placement is different from the public offering of securities in terms of the regulatory
requirements that must be satisfied by the issuer. If an issue qualifies as a private placement, it
is exempt from the more complex registration requirements imposed on public offerings. Rule
144A has contributed to the growth of the private placement market by improving the liquidity
of securities issued in this market.