Primary and Secondary Markets

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The guidelines require that, in general, the securities cannot be offered through any form of general advertising or general solicitation that would prevail for public offerings. Most importantly, the guidelines restrict the sale of securities to “sophisticated” investors. Such “accredited” investors are defined as those (1) with the capability to evaluate (or who can afford to employ an advisor to evaluate) the risk and return characteristics of the securities, and (2) with the resources to bear the economic risks.

VARIATIONS IN THE UNDERWRITING OF SECURITIES

Not all deals are underwritten using traditional syndicate process. Variations include the “bought deal” for the underwriting of bonds, the auction process for both stocks and bonds, and a rights offering for common stock.

BOUGHT DEAL

The mechanics of a bought deal - used solely for debt securities - are as follows. The lead manager, or a group of managers, offers a potential issuer of debt securities a firm bid to purchase a specified amount of the securities with a certain interest (coupon) rate and maturity. The issuer is given a day or so (it might even be a few hours) to accept or reject the bid. If the bid is accepted, the underwriting firm has “bought of the deal.” it can, in turn, sell the securities to other investment banking firms for distribution to their clients and/or distribute securities to its own clients. Typically, the underwriting firm that buys the deal will have presold most of the issue to its institutional clients.

The bought deal appears to have found its way into the United States in mid-1985 when Merrill Lynch did a bond deal in which it was the only underwriter. The gross spread on the bond, a $50 million issue of Northwest Financial, was 0.268%. This is far less than 0.7% gross spread that was typical of deals at that time. Merrill Lynch offered a portion of the securities to investors and the balance to other investment banking firms.

Some underwriting firms find the bought deal attractive for two reasons. First, a lengthy period was required before a security could be sold to the public. It gave certain issuers timing flexibility to take advantage of windows of opportunity in the global marketplace, it required that investment banking firms be prepared to respond on short notice to commit funds to a deal. This requirement meant underwriting firm had little time to line up a syndicate, favoring the bought deal. However, as a consequence, underwriting firms needed to expand their capital in order to commit greater amounts of funds to such deals.

Second, the risk of capital loss in a bought deal may not be as great as it may first appear. Some deals are so straightforward that a large underwriting firm may have enough institutional investor interest to minimize the risks of distributing the issue at the reoffering price. Moreover, in the case of bonds, hedging strategies using the interest rate risk control tools, reduce the risk of realizing a loss of selling the bonds at a price below reoffering price.

AUCTION PROCESS

In this method, the issuer announces the terms of the issue and the interested parties submit bids for the entire issue. The auction form is mandated for certain securities of regulated public utilities and many municipal debt obligations. It is commonly referred to as a competitive biding underwriting. For example, suppose that a public utility wishes to issue $200 million of bonds. Various underwriters will form syndicates and bid on the issue. The syndicate that bids the lowest yield (i.e., the lowest cost to the issuer) wins the entire $200 million bond issue and then reoffers it to the public.

In a variant of the process, the bidders indicate the price they are willing to pay and the amount they are willing to buy. The security is then allocated to bidders on the basis of the highest bid price (lowest yield in the case of a bond) to lower bid prices (higher yield bids in the case of a bond) until the entire issue is allocated. For example, suppose that an issuer is offering $500 million of a bond issue, and nine bidders submitted the following yield bids:

Bidder

Amount ($ millions)

Bid

A

$150

5.1%

B

110

5.2

C

90

5.2

D

100

5.3

E

75

5.4

F

25

5.4

G

80

5.5

H

70

5.6

I

85

5.7

Bidders A, B, C and D will be allocated the amount of the issue for which they bid because they submitted the lowest yield bid. In total, they will receive $450 million of the $500 million to be issued. That leaves $50 million to be allocated to the next lowest bidders. Both E and F submitted the next lowest yield bid, 5.4%. In total, they bid for $100 million. Because the total they bid exceeds the $50 million remaining to be allocated, they will receive an amount proportionate to the amount for which they bid. Specifically, E will be allocated three quarters ($75 million divided by $100 million) of the $50 million, or $37.5 million; and F will be allocated one quarter ($25 million divided by $100 million) of the $50 million, or $12.5 million.

PREEMPTIVE RIGHTS OFFERING

A corporation can issue new common stock directly to existing shareholders via a preemptive rights offering. A preemptive right grants existing shareholders the right to buy some proportion of the new shares issued at a price below market value. The price at which new shares can