Only for Creative_Writer Finance 5

One purpose of financial markets is to facilitate the transfer of funds from individuals (and firms and governments) with funds to invest to those individuals (and firms and governments) that need funds. One method is an indirect transfer through a financial intermediary such as a commercial bank. The other method is the direct investment in the firm by the general public. This transfer occurs when you start your own business and invest your savings in the operation. But the direct transfer is not limited to investing in your own business. Firms (and governments) also raise funds by selling securities directly to the general public.

While companies could sell securities directly to you (and some do sell modest amounts of securities through programs such as the dividend reinvestment plans described in Chapter 10), the majority of these sales are executed through investment bankers. In effect, an investment banker serves as a middleman to channel money from investors to firms and governments that need the funds. If this sale is the first sale of common stock, it is referred to as an initial public offering (IPO). Exhibit 3.1 is the title page for the initial public offering of Yahoo! common stock and is used to illustrate the process of an initial public offering.

Firms sell securities when internally generated funds are insufficient to finance the desired level of spending and when the management believes it is advantageous to obtain outside funding from the general public. Such public funding may increase interest in the firm and avoid some of the restrictive covenants required by financial institutions.

Most sales of new securities are made with the assistance of investment bankers. Unfortunately, the term investment banker may be confusing, since investment bankers are often not bankers and generally do not invest. Instead they are usually a division of a brokerage firm such as Goldman, Sachs & Co., Donaldson, Lufkin & Jenerette Securities Corporation, or Montgomery Securities. (See Exhibit 3.1.) Although these firms may own securities, they do not necessarily buy and hold newly issued securities in their own accounts for investment purposes. Instead they are the middlemen that bring together individuals with funds to invest and the firms that need financing.

The firm in need of funds approaches the investment bankers to discuss an underwriting. If the investment bankers guarantee the sale, they make a “firm commitment” to raise a specified amount of money. In effect, the underwriters buy the securities with the intention to sell them to the general public. By agreeing to buy the securities, the underwriters guarantee the sale and bear the risk associated with the sale. If the investment bankers are unable to sell the securities to the general public, they must still pay the agreed-on sum to the issuing firm. Failure to sell the securities imposes losses on the underwriters, who must remit funds for securities that have not been sold to the general public.

Source: Reproduced with permission of Yahoo! Inc. © 2000 by Yahoo! Inc. YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc.

Because an underwriting starts with a particular brokerage firm, which manages the underwriting, that firm is called the originating house. The originating house may not be a single firm if the negotiation involves several investment bankers. In that case, several firms join together to manage the underwriting. The originating house usually does not sell all the securities but forms a syndicate. The syndicate is a group of brokerage houses that joins together to underwrite and market a specific sale of securities. The firms that manage the sale are often referred to as the lead underwriters. In the Yahoo! illustration, 17 additional firms joined the three lead underwriters to sell the securities.

The use of a syndicate has several advantages. The syndicate has access to more potential buyers, and using a syndicate reduces the number of securities that each firm must sell, which also increases the probability that the entire issue will be sold. Thus, syndication makes possible both the sale of a large offering and a reduction in the risk borne by each member of the selling group.

If the investment bankers do not want to bear the risk of the sale, they can agree to sell the securities through a best efforts agreement. The investment bankers do not underwrite the sale and do not guarantee that a specified amount of money will be raised. Instead, the investment bankers agree to make their best efforts to sell the securities, but the risk of the sale is borne by the issuing firm. If the securities do not sell, the firm does not receive the funds. While most sales of new securities are by underwriting, small issues of risky securities are often best efforts sales.

Because most sales of new securities are underwritings, the pricing of securities is crucial. If the initial offer price is too high, the syndicate will be unable to sell the securities. When this occurs, the investment bankers have two choices: (1) to maintain the offer price and to hold the securities in inventory until they are sold, or (2) to let the market find a lower price level that will induce investors to purchase the securities. Neither choice benefits the investment bankers.

If the underwriters purchase the securities and hold them in inventory, they either must tie up their own funds, which could be earning a return elsewhere, or must borrow funds to pay for the securities. The investment bankers must pay interest on these borrowed funds. Thus, the decision to support the offer price of the securities prevents the investment bankers from investing their own capital elsewhere or (more likely) requires that they borrow the funds. In either case, the profit margin on the underwriting is decreased, and the investment bankers may even experience a loss on the underwriting.

Instead of supporting the price, the underwriters may choose to let the price of the securities fall. The inventory of unsold securities can then be sold at the lower price. The underwriters will not tie up capital or have to borrow money from their sources of credit. If the underwriters make this choice, they force losses on themselves when they sell the securities at less than cost. But they also cause the customers who bought the securities at the initial offer price to lose. The underwriters certainly do not want to inflict losses on these customers, because the underwriters’ market for future new security issues will vanish. Therefore, the investment bankers try not to overprice a new issue of securities, for overpricing will ultimately result in their suffering losses.

There is also an incentive to avoid underpricing new securities. If the issue is underpriced, all the securities will readily be sold, and their price will rise because demand will have exceeded supply. The buyers of the securities will be satisfied, for the price of the securities will have increased as a result of the underpricing. The initial purchasers of the securities reap windfall profits, but these profits are really at the expense of the company whose securities were underpriced. If the underwriters had assigned a higher price to the securities, the company would have raised more capital.

Although there are reasons for the underwriters to avoid either underpricing or overpricing, there appears to be a greater incentive to underprice the securities. Studies have found that initial purchases earned higher returns as the buyers were given a price incentive to buy the new offering.1 Subsequent buyers, however, did not fare as well, and any initial underpricing appears to disappear soon after the original offering. In addition, many initial public offerings subsequently underperform the market during the first years after the original sale.

1See Seth Anderson, Initial Public Offerings (Boston: Kluwer Academic Publishers, 1995).

Once the terms of the sale have been agreed upon, the managing house may issue a preliminary prospectus. The preliminary prospectus is often referred to as a red herring, a term that connotes the document should be read with caution as it is not final and complete. (The phrase “red herring” is derived from British fugitives’ rubbing herring across their trails to confuse pursuing bloodhounds.) The preliminary prospectus informs potential buyers that the securities are being registered with the Securities and Exchange Commission (SEC) and may subsequently be offered for sale. Registration refers to the disclosure of information concerning the firm, the securities being offered for sale, and the use of the proceeds from the sale.2

The new issue market (especially for initial public offerings of common stock, or IPOs) can be extremely volatile. Periods have occurred when the investing public seemed willing to purchase virtually any security that was being sold (e.g., the dot-com period during the late 1990s). There have also been periods during which new companies were simply unable to raise money, and large companies did so only under onerous terms.

The new issue market is volatile not only regarding the number of securities that are offered but also regarding the price changes of the new issues. When the new issue market is “hot,” it is not unusual for the prices to rise dramatically. Yahoo!’s stock was initially offered at $13 and closed at $33 after reaching a high of $43 during the first day of trading.

Few new issues perform as well as Yahoo!, and many that initially do well subsequently fall on hard times. Boston Chicken (parent of Boston Market) went public at $20 a share and rose to $48½ by the end of the first day of trading. The company’s rapid expansion overextended the firm’s ability to sustain profitable operations. Boston Chicken filed for bankruptcy, and the stock traded for a few pennies a share. (One of the questions facing the holders of any IPO whose stock price rises dramatically is whether the initial performance can be continued, or at least sufficiently maintained so that the price does not fall.)

All firms, of course, were small at one time, and each one had to go public to have a market for its shares. Someone bought the shares of IBM, Microsoft, and Johnson & Johnson when these firms initially sold shares to the general public. The new issue market offers the opportunity to invest in emerging firms, some of which may achieve substantial returns for those investors or speculators who are willing to accept the risk. It is the possibility of large rewards that makes the new issue market so exciting. However, if the past is an indicator of the future, many firms that go public will fail and will inflict losses on those investors who have accepted this risk by purchasing securities issued by the small, emerging firms.

The previous discussion was cast in terms of firms initially selling their stock to the general public (that is, the “initial public offering” or “going public”). Firms that have previously issued securities and are currently public also raise funds by selling new securities. If the sales are to the general public, the same basic procedure applies. The new securities must be registered with and approved by the SEC before they may be sold to the public, and the firm often uses the services of an investment banker to facilitate the sale.

There are, however, differences between an initial public offering and the sale of additional securities by a publicly held firm. The first major difference concerns the price of the securities. Because a market already exists for the firm’s stock, the problem of an appropriate price for the additional shares is virtually eliminated. This price will approximate the going market price on the date of issue. Second, because the firm must periodically publish information (for instance, the annual report) and file documents with the SEC, there is less need for a detailed prospectus. Many publicly held firms construct a prospectus describing a proposed issue of new securities and file it with the SEC. This document is called a “shelf registration.” After the shelf registration has been accepted, the firm may sell the securities whenever the need for funds arises. For example, Dominion Resources filed a shelf registration that covered debt securities, preferred stock, common stock, and rights to purchase stock. Such a shelf registration gives Dominion Resources considerable flexibility. Not all the various types of securities have to be issued, and specific securities can be sold quickly if the firm deems that conditions are optimal for the sale.

In addition to public sales of securities, firms may raise funds through private placements, which are nonpublic sales of securities. Such sales are made to venture capital firms or mutual funds that specialize in emerging firms. Small firms are often unable to raise capital through traditional sources. The size of the issue may be too small or the firm perceived as too risky for an underwriting through an investment banker. Venture capitalists thus fill a void by acquiring securities issued by small firms with exceptional growth potential.

Of course, not all small firms with exceptional growth potential realize that potential. Venture capitalists often sustain large losses on these investments, but their successes can generate large returns. If a venture capitalist invests $1,000,000 in five firms and four fail but one grows into a successful business, the one large gain can more than offset the investments in the four losers.

The venture capitalist’s success depends on the ability to identify quality management and new products with market potential. While venture capitalists must negotiate terms that will reward their risk taking, they must not stifle the entrepreneurial spirit necessary to successfully manage an emerging business.

Once the firm does grow and achieve success, the securities purchased by the venture capitalist may be sold to the general public as part of the initial public offering. Many public offerings of securities combine a sale of new securities to raise funds for the firm and a sale of securities by existing stockholders. These holdings are often composed of shares originally purchased by the venture capitalists who are using the initial public sale as a means to realize their profits on their investments in the successful firm.

The securities industry is subject to a large amount of regulation. Since the majority of securities cross state borders, the primary regulation is at the federal level. The purpose of this regulation is to protect the investing public by providing investors with information to help prevent fraud and the manipulation of securities prices. The regulation in no way assures you that you will make profits on your investments. It is not the purpose of the regulation to protect you from your own mistakes.

Federal regulation developed as a direct result of the debacle in the securities markets during the early 1930s. The first major pieces of legislation were the Securities Act of 1933 and the Securities Exchange Act of 1934. These are concerned with issuing and trading securities. The 1933 act covers new issues of securities, and the 1934 act is devoted to trading in existing securities. To administer these acts, the Securities and Exchange Commission (commonly called the SEC) was established.3

The large increase in stock prices experienced during 1998 and into 2000, and the subsequent decline in prices, may partially be attributed to fraudulent (or at least questionable) accounting practices and securities analysts’ touting of stocks. These scandals led to the creation of the Sarbanes-Oxley Act, which was intended to restore public confidence in the securities markets. While it is too early to determine the ramifications of Sarbanes-Oxley, its range and coverage are extensive. The main provisions encompass:

· The independence of auditors and the creation of the Public Company Accounting Oversight Board

· Corporate responsibility and financial disclosure

· Conflicts of interest and corporate fraud and accountability

Sarbanes-Oxley created the Public Company Accounting Oversight Board, whose purpose is to oversee the auditing of the financial statements of publicly held companies. The board has the power to establish audit reporting rules and standards and to enforce compliance by public accounting firms. Firms and individuals who conduct audits are prohibited from performing nonaudit services for clients that they audit.

Corporate responsibility and financial disclosure require a publicly held firm’s chief executive officer (CEO) and chief financial officer (CFO) to certify that the financial statements do not contain untrue statements or material omissions. These officers are also responsible for internal controls to ensure that they receive accurate information upon which to base their certifications of the financial statements. Corporate personnel cannot exert improper influence on auditors to accept misleading financial statements. Directors and executive officers are also banned from trading in the firm’s securities during blackout periods when the firm’s pensions are not permitted to trade the securities. Personal loans to executives and directors are prohibited, and senior management must disclose purchases and sales of the firm’s securities within two business days.

Conflicts of interest revolve around the roles played by securities analysts and by investment bankers. Investment bankers facilitate a firm’s raising of funds. Analysts determine if securities are under- or overvalued. Both are employed by financial firms such as Merrill Lynch. If a securities analyst determines that a stock is overvalued, this will damage the relationship between the investment bankers and the firm wishing to sell the securities. Hence, there is an obvious conflict of interest between the securities analysts and the investment bankers working for the same financial firm.

These two divisions need to be independent of each other. While the financial firms asserted that a “firewall” did exist between the investment bankers and the securities analysts, the actions of the securities analysts often implied the opposite. Sarbanes-Oxley strengthens the firewall. Investment bankers’ ability to preapprove a securities analyst’s research reports is restricted. Individuals concerned with investment banking activities cannot supervise securities analysts. Retaliation against securities analysts for negative reports is prohibited. An analyst must disclose whether he or she owns securities or received compensation from the companies covered by the analyst. Penalties for violating Sarbanes-Oxley and existing corporate fraud laws that prohibit the destruction of documents and impeding or obstructing investigations were increased, with penalties including fines and imprisonment of up to 20 years.

All firms must have a source of funds to acquire assets and retire outstanding debt. One possible source for these funds includes savers who are not currently using all of their income to buy goods and services. The transfer of these funds may occur indirectly through a financial intermediary or directly through the purchase of securities issued by firms.

When a firm (or government) issues new securities, it usually employs the services of investment bankers to facilitate the sale. The investment bankers act as a middleman between the firm and investors. In many cases, the investment bankers underwrite the securities and guarantee the issuing firm a specified amount of money. The investment bankers buy the securities with the intention of reselling them to the investing public.

New issues of corporate stocks and bonds that are sold to the general public must be registered with the Securities and Exchange Commission (SEC). The registration provides individuals with information so they may make informed investment decisions. The SEC also enforces the federal securities laws that govern the trading of corporate stocks and bonds in the secondary markets.

Investors’ accounts with brokerage firms are insured by the Securities Investor Protection Corporation (SIPC). This insurance covers up to $500,000 an individual’s securities held by a broker, but many brokerage firms carry more insurance. The intent of SIPC is to increase public confidence in the securities industry by reducing the risk of loss from a failure by a brokerage firm. The most recent securities legislation was the Sarbanes-Oxley Act of 2002. Fraudulent corporation activities, misleading accounting practices, and the resulting severe stock market price declines reduced investor confidence. By increasing corporate responsibility and financial disclosure requirements, creating stronger firewalls between investment bankers and securities analysts, and increasing the punishment for violations, Sarbanes-Oxley is designed to help restore investor confidence in the securities markets.

Now that you have completed this chapter, you should be able to

1. Explain the role of investment bankers (pp. 37–43).

2. Describe the components of a public sale of securities (pp. 38–41).

3. Differentiate a best-effort agreement from a firm commitment (pp. 39–40).

4. Explain the purpose of a shelf registration and a private placement (pp. 42–43).

5. Identify the regulatory body that enforces the federal securities laws (p. 43).

6. State the primary purpose of the federal securities laws (pp. 43–46).