Issuing Securities

PROCEDURE FOR COMPANIES SELLING SECURITIES TO THE

PUBLIC The Basic Procedure for a New Issue The exact procedure to be followed by a company making a public floatation of securities will depend on the precise terms of the issue. However, the following is a summary of the principal steps that are to be borne in mind: 1. Management’s first step in any issue of securities to the public is to obtain approval from the board of directors. 2. Next, the firm must prepare and file a registration statement with the SECP. This statement contains a great deal of financial information, including financial history, details of the existing business, proposed financing, and plans for the future. It can easily run to 50 or more pages. 3. The SECP studies the registration statement during a waiting period. During this time, the firm may distribute copies of a preliminary prospectus. A prospectus contains much of the information put into registration statement, and is given to potential investors by the firm. The company cannot sell the securities during the waiting period. However, oral offers can be made. 4. The registration statement does not initially contain the price of the new issue. On the effective date of the registration statement, a price is determined and a full-fledged selling efforts gets under way. A final prospectus must accompany the delivery of securities or confirmation of sale, whichever comes first. Where a company allots any shares or debentures with a view to offering those shares or debentures for sale to the public, any document by which the offer for the sale to the public shall be made, for all purposes, be deemed to be a prospectus. 5. Prospectus, when issued, is an invitation to the public to make offers for the company’s securities. The prospectus embodies the terms of the invitation for offer, the application made by intending purchasers of securities to go in for the securities are in the application made by

intending purchasers of securities to go in for the securities are in the nature of offers made to the company which the company might accept or reject. 6. The company then makes the subscription lists of those whose application for securities are accepted. 7. Process of allotment of securities begins to those who are in the subscription list. 8. Letters of allotment are send to whom the securities are allotted. Auction market is a system by which securities are bought and sold at the best possible price through competitive bidding. Prices are established by brokers acting as agents of buyers and sellers, as well as principal dealers acting for their own accounts. In the securities market, the best example is the Karachi Stock Exchange, where buyers and sellers make competitive bids for exchange listed securities by submitting order tickets to the exchange. The commodity futures market where interest rate fixtures are traded, is in contrast, an open outcry market, where market prices are set by direct interaction of exchange members, standing in a pit on the trading floor.

Alternative Issue Methods When a company decides to issue a new security, then it can sell it as a public issue or a private issue. If it is a public issue, the firm is required to register with the SECP. Is the issue is sold to fewer than 35 investors, then it can be treated as a private issue. A registration statement is not required in this case. There are two kinds of public issues: the general cash offer and the rights offer. Cash offers are sold to all interest investors, and rights offers are sold to existing shareholders. Equity is sold by both cash offer and the rights offer, though almost all debt is sold by cash offer. The first public equity issue that is made by a company is referred to as an initial public offering or an unseasoned new issue. All initial public offerings are cash offers because, if the firm’s existing shareholders wanted to buy the shares, the firm would not need to sell them publicly. A seasoned new issue refers to a new issue where the company’s securities have been previously issued. A seasoned new issue of common stock may be made by using a cash offer or a rights offer.

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Public Issue Cash Offer Stock is sold to all interest investors in a cash offer. If the cash offer is a public one, investment banks are usually involved. Investment banks are financial intermediaries who perform a wide variety of services. In addition to aiding in the sale of securities, they may facilitate mergers and other corporate reorganizations, act as brokers to both individual and institutional clients and trade for their own accounts. There are two basic methods of issuing securities for cash: 1. Firm Commitment: Under this method, the investment bank (or a

group of investment banks) buys the securities for less than the offering price and accepts the risk of not being able to sell them. Investment banker underwrites the securities in a firm commitment. The difference between the underwriters’s buying price and offering price is called the spread or discount. It is the compensation received by the underwriter. Firm-commitment underwriting is just a purchase-sale agreement and the syndicate’s fee is the spread. The issuer receives the full amount of the proceeds less the spread, and all risk is transferred to the underwriter. If the applications for buying the securities exceed the number of securities offered, then they are scaled down in proportion. If the underwriter cannot sell all of the issue at the agreed-upon offering price, it may need to lower the price on the unsold shares. However, because the offering price usually is not set until the underwriters have investigated how receptive market is to the issue, this risk is usually minimal. So, any unsold shares are usually left with the underwriters. 2. Best Efforts: The underwriter bears risk with a firm commitment

because it buys the entire issue. Conversely, the syndicate avoids this risk under a best-efforts offering because it does not purchase the shares. Instead, it merely acts as an agent, receiving a commission for each share sold. The syndicate is legally bound to use its best efforts to sell the securities at the agreed-upon offering price. If the share cannot be sold at the offering price, it is usually withdrawn. This form is more common for IPOs than for seasoned issues.

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For either firm-commitment or best-efforts issues, the principal underwriter is permitted to buy shares if the market price falls below the offering price. The purpose is to support the market and stabilize the price from temporary downward pressure. If the issue remains unsold after a time, members may leave the group and sell their shares at whatever price the market will allow.

Role of Investment Bankers

Investment Banker

Issuer buying price

Investor offer price or issue price

Investment bankers are at the heart of new security issues. They provide advice, market the securities (after investigating the market’s receptiveness to the issue), and underwriter the proceeds. They accept the risk that the market price may fall between the date the offering price is set and the time the issue is sold. In addition, investment banks have the responsibility of pricing fairly. When a firm goes public, particularly for the first time, the buyers know relatively little about the firm’s operations. So, the buyers have to rely on the judgment of the investment bank, who has presumably examined the firm in detail. Determining the correct offering price is the most difficult the lead investment bank must do for an initial public offering. The issuing firm faces a potential cost if the offering price is set too high or too low. If the issue is priced too high, it may be unsuccessful and be withdrawn. If the issue is priced below the true market price, the issuer’s existing shareholders will experience an opportunity loss.

The Cost of New Issues Issuing securities to the public is not free, and the costs of different issuing methods are important determinants of which will be used. The costs fall into following categories:

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1. Spread or underwriting discount: The spread is the difference

between the price the issue receives and the price offered to the public. 2. Other direct expenses: These costs incurred by the issuer that are

not part of the compensation to underwriters. They include filing fees, legal fees, and taxes-all reported in the prospectus. 3. Indirect expenses: These costs are not reported in the prospectus

and include management time on the new issue. 4. Abnormal returns: In a seasoned issue of stock, the price drops

by 3 percent to 4 percent upon the announcement of the issue. The drop protects new shareholders against the firm’s selling overpriced stock to new shareholders. 5. Underpricing: For initial public offerings, the stock typically rises

substantially after the issue date. This is a cost to the firm because the stock is sold for less than its efficient price in the aftermarket. 6. Green Shoe Option: The Green Shoe option gives the

underwriters the right to buy additional shares at the offer price to cover overallotments. This is a cost to the firm because the underwriter will only buy additional shares when the offer price is below the price in the aftermarket.

Rights When new shares of common stock are offered to the general public, the proportionate ownership of existing shareholders is likely to be reduced. However, if a preemptive right is contained in the firm’s articles of incorporation, the firm must first offer any new issue of common stock to existing shareholders. This assures each owner his or her proportionate owner’s share. An issue of common stock to existing stockholders is called a rights offering. Here, each shareholder is issued an option to buy a specified number of new shares from the firm at a specified price within a specified time, after which the rights expire. For example, a firm whose stock is selling at Rs.30 may let current stockholders buy a fixed number of shares at Rs.10 per share within two months. The terms of the option are evidenced by

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certificates known as warrants or rights. Such rights are often traded on securities exchange or over the counter. The process of issuing rights differs from the process of issuing shares of stock for cash. Existing shareholders are notified that they have been given one right for each share of stock they own. Exercise occurs when a shareholder sends payment to the firm’s subscription agent (usually a bank) and turns in the required number of rights. Shareholders have the choice to exercise their rights or sell them. In rights offering, the subscription price is the price that existing shareholders are allowed to pay for a share of stock. A rational shareholder will only subscribe to the rights offering if the subscription price is below the market price of the stock on the offer’s expiration date. For example, if the stock price is Rs.13 and the subscription price is Rs.15, no rational shareholder will subscribe. As long as the market price does not fall by half before expiration, the rights offering will succeed. Undersubscription can occur if investors throw away rights or if bad news causes the market price of the stock to fall below the subscription price. To ensure against these possibilities, rights offerings are typically arranged by standby underwriting. Here, the underwriter makes a firm commitment to purchase the unsubscribed portion of the issue at the subscription price less a take-up fee. The underwriter usually receives a standby fee as compensation for his risk-bearing function. In practice, the subscription price is usually set well below the current market price, making the probability of a rights failure quite small.

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