|To recap, the following steps are usually taken in laying the
groundwork for bringing an issue public: |
File registration statement with Securities and Exchange Commission
Blue Sky the Issue
Issue Preliminary Prospectus
Due Diligence Meeting
Issue Final Prospectus.
Earlier we discussed in detail the steps leading up to the issuance of the final prospectus so we felt that it would be apropos to address the most difficult aspect of the process independently. This can be very painful for all of the people involved because no one is quite sure what the rules really are. We have been told that the SEC gives all of its examiners a secret book that details exactly what the final prospectus should contain but we have never met anybody that has actually seen it. Supposedly, each of the SEC representatives carries this book about him wherever he goes.
Some have said it is biblical in nature and the agent is to read it at all hours that he is not on the job. This book is a roadmap advising the agent on how to best make the issuer totally miserable. When exciting new methods of torturing companies new to the process are discovered, a new edition of the book is immediately published containing this important information so that it can be shared by the field staff. Some embittered issuers have stated that the SEC must be rewarding examiners who create new impediments with substantial bonuses.
The final prospectus must be promptly distributed to prospective buyers of the issue after the effective issue's date. Once the purchaser of the shares in the offering has had time to peruse the final document, he has the right to rescind his purchase literally for any reason whatsoever. In practice this occurs only when there are substantial differences between statements made by the broker and the facts that appear in the prospectus. Even if every client purchasing stock in the IPO, if it were a firm deal, were to rescind it would not effect the company in that they received good funds from the underwriter at the time the deal became effective.
Many people can't tell whether they have been told the truth or not by reading the prospectus because it is written in a language which at best is must be considered most unusual. Knowledgeable people have said that it is a cross between Sanskrit and Esperanto which we are told, the SEC believes is the language of the future. Having qualified interpreters available to determine what was meant in these languages has not been too successful in court. The next hurdle the is the most difficult,
These are securities that are not subject to the registration requirements of the 1933 Securities Act. Exempt securities also include securities that do not have to follow certain provisions of the Securities Exchange Act of 1934 in terms of margin, registration of deals, certain reporting requirements, and the identity of market makers.
U.S. Government and U.S. Government. Agency Securities
Securities issued by non-profit organizations
They may be exempt, but we are not sure what that means. It may have something to do with registration the fact that they can be freely offered without a regulatory authority passing on them. In the particular case of Government securities, we think that the term exempt means that the government is not going to lie in an offering memorandum regarding the placement of their securities and a buyer shouldn't worry too much. In other words, if you can't trust Uncle Sam, who can you trust?
At the same time, salesmen recommending government securities have several problems. First, there is not much profit in these instruments for the broker. Second, it is hard to get a customer once invested in governments to switch into a penny stock on which the broker makes a lot of money. Therefore, when all is said and done, the U. S. Government has taken the position that you can call its securities whatever you want, but don't call them late for dinner.
For some period of time firms that dealt exclusively in the U. S. government arena didn't even have to be registered as a broker. Some people, such as the more prestigious brokers and banks, abused their privileges and did bad things in the government market, treating it more as their territory than the Government's. The Government became upset at losing turf and was forced to punish some of them severely. They made the government look bad. These are institutions you do business with everyday.
The government said, even though our securities are exempt, you cannot go around breaking securities laws whenever you want. After all, the public is still protected by the anti-fraud provisions in the act aren't they? Well the bad guys said, awe come-on, when you needed your merchandise moved you didn't mind our rigging the market now and then, now that you don't need help any more you're becoming sassy. What the bad guys said is mostly true.
Now municipal bonds are something else. They are almost universal free from Federal Taxation. Because of all the rights granted the states in the constitution, states and their subdivisions could independently do their own financing and not have to worry about paying assessments to the federal government. Because of this quirk, the states, cities, municipalities and taxing districts were able to pass along this benefit to the buyers of their bonds. Municipal bonds of an equivalent rating with that of the U. S. Government would sell at a price equal to the current federal income tax rate deducted from the equivalent government bond. In other words you have to compare apples with apples and not with oranges. A 20-year Virginia general obligation compared with a 20-year Treasury bond.
In any event, the non-federal taxing authorities found a good idea. They would raise a lot of money by telling people that they were going to do something or other and then they wouldn't do it. (After all the bonds were exempt, weren't they?). Instead, they would buy U. S. Government paper with the proceeds, thus making a profit on the difference between their interest cost on debt and the rate they received from Uncle Sam. This caused taxpayers in states that weren't smart enough to do illegal things to ship money into states that were engaged in these activities. Luckily, I always lived in a state that knew how to do this. They fact that they lied as to what they were going to do with the money seemed to be OK because they were the government. I guess that seems all right, but I'm really not sure.
Another thing that the non-federal tax accessing bodies can do that seems strange is that they can sell bonds that represent financing for private industrial concerns. These strange bonds are called industrial revenues. States and other taxing authorities interesting in attracting industry can give companies showing interest in their location various benefits. These could include tax abatements, free land, plant and machinery, a cash bounty for each employee they hire along with a never ending list of additional goodies if the facility will ultimately hire enough residents, produce enough taxes and become a good enough citizen. The package given to various Japanese auto companies by various states to set up manufacturing literally went on for pages and pages. I have often wondered why no American company ever qualified for something like that but Doctor Bob said it has something to do with the CIA and it is best not to pry.
To most company's, the most singly beneficial part of the offering package is the ability to get Industrial Revenue Status. This allows the company to issue a tax-free bond and rates under those of the competition that is only paid back from the particular revenue of the project being financed. Often startup or companies with poor credit can raise money through this method that would be unavailable under any other scenario.
Primarily, because of these strange characteristics, many people have lost their savings in these investments. Vietnam veterans and old people have been particular targets of inventive financiers who create companies as fast as nefarious brokerage houses can move the paper that they generate. To some degree a damper has been put on this activity after everyone's money was lost so I guess I shouldn't even have brought it up but I still feel sorry for some of those people.
Charities that qualify for tax exempt status, are able to raise money with reasonable latitude. Recently one organization offered investors the opportunity of donating to a fund that would match whatever they put up dollar for dollar. Thus, the potential patrons were told they would receive a double deduction from the internal revenue service. With taxes (including federal income taxes) approaching 50% in some states, money could be given to charity and when the tax benefits were added in, there literally would be no cost to the donor and he would be held in great esteem in his community. Many important people donated to this cause because they wanted to be held in greater esteem then they already were. When the whole thing turned out to be a fraud, they became liable for unpaid taxes, and lost whatever esteem they had previously garnered and probably a little more for being such idiots to believe in being able to get something for nothing. They guy is that ran the charity is going to be in jail for a long time but that won't help everybody who got screwed.
Most of the money we donate to charity is never used for the purpose the donor intended. By far the largest percentage as a rule goes for general and administrative expenses, so that the people running the charity can have nice homes, big cars and send their kids to college so that they can become legitimate when they graduate. I guess that's why charities are exempt. If we knew that none of the money was going where we intended, we probably wouldn't be so generous and these kids couldn't go to college. We think that continued exemptions for charities is probably a good idea, Uncle Louie runs a not-for-profit and maybe someday I'll need a good job.
Bank Securities are also exempt. This may be because most of the crash of 1929 was blamed on the banks and when the securities laws were written in 1933 and 1934 it was thought best to stay totally clear of anything remotely connected with banking because it would give the brokerage industry a bad name. Brokers have gotten a bad name on their own and many of the exemptions in the 1933 and 1934 acts are no longer required.
It was also felt that banks needed more latitude in telling their stories so that they could raise money. If banks had to disclose everything, the SEC felt that no one would ever put money into that kind of security. They felt it best to allow the banks to make up whatever story they wanted for the good of making the industry health again. The banks became very adept at making up stories and raised substantial sums of money.
The Securities and Exchange Regulation D exempts registration for private placements of Securities and Exchange Commission if:
Issuer believes buyer is a sophisticated investor- I think this is one of the more important definitions that we will deal with. Notice that the discretion as to the buyers sophistication is left to the Issuer. This seems a little like having the fox guard the chicken coupe. I can just picture the president of Blodget Widgets, a company that is down to its last $20 in the bank, saying to an investor holding a check for $ 1 million, "I don't believe that you are sophisticated enough to invest in may company". It is possible that this has occurred in the distant past, but it was not the action of a company officer that caused the event; it was more likely the corporate counsel that was afraid to lose his license to practice. You can make book on the fact that the attorney never did any work for Blodgett again.
Another confusing aspect of this regulation is the fact that the going definition of an accredited person is one who earned $200,000 during the previous two years and has a net worth of $1 million. I'm not sure that this is a good definition of a sophisticated investor. Doctor Bob is probably worth a whole lot more than that and he certainly earns more than $200 thousand a year, but I have never seen anybody worse with money.
I mean this guy puts his money into every hair-brained investment that comes down the pike. You may remember that he was the guy that said buy comic books; comic books are going through the roof. That was just before they collapsed. Next he started buying something called commemorative plates that were also going to make him a lot of money. The plate market fell apart when the moving people were moving them into the warehouse, the guy dropped them on the pavement. Then he invested in a company that looked for sunken treasure, and they actual found the stuff, but the state impounded it. Doctor Bob still visits his treasure in the state nautical museum though and thinks of what might have been.
Ultimately, things got so bad that they had to appoint a conservator for Doctor Bob so he wouldn't keep messing up. Well, in spite of the fact that the court won't let him sign his own name to a check for anything but groceries, Doctor Bob can still fill out private placement memorandums and qualify as a sophisticated investor in the eyes of the securities laws of the U. S. Government. Things keep going from bad to worse for him. Yesterday the fella in the white jacket said that Doctor Bob couldn't write with anything that had a sharp point anymore. How is he going to write complicated prescriptions?
Buyer must have financial information in memorandum form. This too is extremely important. It makes a lot of sense that they get all of this information, except for one thing, the financials are not necessarily done by an accountant. As a matter of fact for the most part, they are created by highly imaginative people that could have found more successful careers writing science fiction. They weave stories that would make the characters in Alice in Wonderland stand up and take notice.
Almost all private placement memoranda show a series of projections that have no basis in fact in the real world; they predict that the issuing company will have a profit somewhat in excess of the combined gross national products of the European Community by the year 2004. Many people with great intellect (among them Doctor Bob) place a lot of faith in these projections. It was once estimated that if you added all of the projected after-tax income to be generated by companies doing private placements in 1996, they would show earnings of more than the estimated gross domestic product of China, The United States and Japan in 2050. These kind of statistics make a person less than sanguine when approaching financials that appear in many of the private placement memoranda.
Issuer is assured buyer does not intend to make a quick sale of the securities. This one is a real corker. The private placement memorandum contains a statement that the buyer is not going to turn around and sell the offering immediately. We don't understand why that is of any consequence, other than as a subliminal message by the government saying, "your odds of ever seeing a nickel on this investment are next to zilch. Don't get any ideas that you're going to be able to turn this thing around for a quick profit." We would ask the government a more germane question. To whom would I sell this thing if I could sell it at all? Maybe the government knows people that are buying up all of these gems and they are subversive or something. Doctor Bob would certainly like to meet them.
Things tend to get so bad in these deals that for the most part we won't do them at all unless there is an exit strategy. What this means is that I have no interest in becoming a permanent minority stockholder in a company run by a bunch of people I know nothing about. If it is successful I don't want management filtering all of the profits out of the company in large salaries and expenses accounts. I am not interested in helping put their children through school by having the corporation pay interest on classes of stock I don't own and I am not interested in having to go through extensive litigation to get what I was promised in the first place. What we insist upon is management's agreement to a definitive exit program, in writing, before we even think of making the investment.
There are many ways that it can be done such as guaranteeing to do a public offering in which your shares are freed up as part of the registration process. For legal purposes, these intentions should be spelled out, chapter and verse within the private placement itself. This will not help a lot, because if the deal is a bummer anyway, nothing is going to save you from losing your money. One major American brokerage firm admittedly sold its customers over a billion dollars worth of questionable securities and is now after getting caught is trying to figure out how much they have to give back. An exit strategy only protects you from losing all of your money if the deal is a success and even then your odds are poor.
Securities may not be sold to more than 35 non-accredited investors. Sometimes this statement is true and sometimes it isn't. In the deals that you are likely to run across it is probably true. In actuality, this is not what the SEC means and it is somewhat strange that it has become so convoluted over time. While it is true that most transactions cannot be sold to more than 35 non-accredited investors, it is also the fact that it cannot be shown to more than 35 non-accredited investors. Doctor Bob was telling me about a Temperance League meeting he went at which they were pushing a Monaco gold mining investment.
Doctor Bob was saying that this guy got up at the League meeting and started talking about all the gold laying all over the place and that everyone could be rich and we could spread the word on alcoholism to the far corners of the earth with all the money we would make. Doctor Bob got a warm and fuzzy feeling from the excitement and indicated that he had a large tax loss carry-forward and would be using his gains to offset his substantial losses of past years.
The rest of the audience was mostly elderly women who were living on social security pensions. Usually there are over a hundred at any given meeting and with an opportunity like this you can bet that at least that many were present. Many of them saw the last of their cash go down the drain on Monaco Gold and yet, the transaction was totally illegal relative to the Securities Act. It would also have been illegal under the "Blue Sky" laws of the state in which the offering was made. Once a general solicitation was made to over thirty-five people they had closed the books on taking any money at all from unaccredited investors. We are fairly certain that the intent of this regulation is bent out of shape on a regular basis.
Rule 147- Intrastate-offering exemption for securities sold within borders of one state.
Small Issue exemption -- Regulation A- a new issue of $5 million or less during a 12 month period and is exempt under the Act (Rule 147). Issuer must file an offering statement with the Securities and Exchange Commission.
Rule 144 -- exempts persons from the definition of underwriter. Actually, Rule 144 frees up the stock that you got in that private placement issue. As you remember, we signed essentially a lock-up agreement when we purchased the private placement by agreeing to hold the securities. Even if we had not agreed to that, companies have to file registration statements governing their securities' ability to be bought and sold in the marketplace. Historically these rules allowed sales after the securities were held for a period of two years if the company was a filing company. If the company was not a filing company, the securities had to be held for three years or longer.
In spite of the fact that you may well, own a security that you bought in a private placement 20 years ago you can negotiate away the shares' fungability. For example, management negotiates an IPO with an underwriter who as a precondition for the deal has management agree to "lock up" all of the potentially free trading securities in the company. The lock up is a contractual agreement stating that although you have the right under securities laws to sell your stock whenever you want to, you are waiving that right and for the purpose of interesting us in doing your IPO and you must agree to hold it for another 18 months.
Often your alternative to not signing the lockup is either sitting around for another twenty years waiting for the next offer, which if you are lucky will be pretty much under the same terms and conditions as what you are not agreeing to now. That probably won't be something to worry about, without the public offering the company will not have enough money to survive and go out of business. This happened regularly to Doctor Bob.
The underwriters position is that I am not going to do two underwritings, the first of which is the sale of the shares of your company to my clients and then after that is finished, also find a home for all of the selling shareholders of your company in the open market. If you don't like this approach and your shareholders are unwilling to hold their stock just a little longer to insure the company's success, why the hell should I.
There are certain people that can hold on to their stock forever and yet without a registration statement will be restricted to some degree as long as they own the shares and are affiliated with the company. These are shares owned by officers, directors and affiliated persons of the company, as well as holders of 10% or more of the corporation's shares. These folks are insiders. For the most part they may not sell more than 1% of the outstanding shares in the company every quarter.
This may not seem like a lot, but to guys like Bill Gates, who files to sell every quarter, you are not talking about chum change. Gates' quarterly sales amount to hundreds of millions of dollars, the number of hundreds of millions depends on what price the stock is selling at when his quarterly prerogative comes due. For the foreseeable future we believe that Bill Gates will be able to sell over $1 billion per year of Microsoft shares per year and not materially effect the price of the stock or his percentage ownership in the company.
Object of investment banking is to raise capital. Sometimes, proceeds represent new funds, which others are refinancing their capital structure. Investment Bankers is at term of art yet nobody had aptly defined to our satisfaction. Because it sounds respectable, some brokers call themselves Investment Bankers, but that term is usually left to those people on the street that have a little money to invest for themselves and know where a lot more is buried. We think of it as a term of endearment for the many years most of us toiled as executives and floor brokers for broker dealers. Investment Bankers are for the most part, people with some money searching potentially rewarding transactions for themselves and their associates. This field if it were located in England would probably be known more as Merchant Banking.
Underwriter, i.e. a banker, assumes risk by buying the new issue from the corporation and reselling it to the public. There are two basic types of underwriting, one is called a "best efforts" and other is called a "firm commitment". Neither is a guaranteed contract that anything is going to happen and when one friend of our attempted to borrow on his brokers firm commitment contract his banker called the police. These contracts have so many holes in them that they make limburger cheese seem solid. These are agreements that are as good as the people that are involved in them, thus, some firms on the street, anything they give is not worth the paper it is written on while with others nothing in writing is really critical.
A best effort type of financing usually consists of the underwriter taking the client out to dinner, asking for a $50,000 retainer and having him agree that he will try really hard to get the deal done. To some underwriters, "really hard" consists of discussing the deal's merits with their mistresses, in others it may be just a case of waiting for a sign.
Usually the client has to pay for a road show, accountant and legal, all of which can amount to a substantial amount of money if the deal never happens. This occurs more often than the "street" would care to admit and usually the reasons are earth shattering, the most common heard on the street is the fact that the stars were not lined up in proper sequence and concluding the fund raising under those circumstances would have probably resulted an a global catastrophe. "It is best for us all to forget that we have ever heard of this deal", is the common pronouncement of horoscope driven underwriters. It is best to ask if you are in sink with the underwriter before giving him the money.
Another all too often heard response to an underwriter's failure is the fact that the market is not acting well. It can be going up or down to conform to this anomaly. We have learned that if the market is going down, it may make sense to use this as an excuse for pocketing $50,000 and not doing anything for it but when it is going up it become a more serious situation. An underwriter cornered by someone asking these types of questions will answer on of the following depending upon what business the Subject Company is in:
Only the cyclicals are performing well.
Only the non-cyclicals are performing well .
Only the blue chips are seeing any buying interest and it looks better than it is.
Only the non-blue chips are seeing any buying and your company is considered a blue chip.
The high-techs are hot and the cyclicals aren't going anywhere.
Your company is terrific but it just doesn't have enough sex appeal in this market.
Your company has a lot of sex appeal but the guys in your industry did so many deals in the last couple of months that the market became saturated.
Interest rates are so high; people are buying bonds not equities.
Interest rates are so low; people are buying proven companies with dividends and not speculating.
People are waiting to see if the new capital gains tax reduction takes place.
When I took your money, I didn't tell you that it was going to done in this decade.
Therefore, the deal didn't get done and the money is down the drain. However, the underwriter didn't really promise you anything either. All he said was that he would use his best efforts; I am sure he did. The guy you picked has been using his best efforts for the last 20 years and it hasn't been good enough to get a deal done yet.
Then we have the sure thing, the "firm commitment" underwriting that is issued by only the most blue nose, high quality brokerage firms in the country. I mean their firm commitment means they are on that day putting their capital at risk by buying the entire underwriting for their own account and redistributing to their clients and other broker dealers. You say that in retrospect when Goldman Sachs offered to give you a firm commitment you took the Best Effort of Ajax Concrete and Broker Dealer Services instead? You thought that best efforts meant that they would try harder. While Goldman probably would have completed the deal even at a loss in a bad market, many of the "better firms" on the street would look to their "out" clauses instead. Can't you see in the fine print's fine print where it says we will only do the deal if the principal of the client's firm is caught in a tornado in a telephone booth on the day the deal is effective or at our discretion? Another "out" clause that is common besides the old tornado in the telephone booth excuse is old the "subject to market conditions" ploy. Every IPO has that clause in the body of the agreement and as we have seen, for the guy wanting to wiggle out of deal, it is the perfect excuse.
"You mean to tell me that a high grade firm doing a firm commitment deal would use the same flimsy excuse as the firm that was only doing a 'best efforts' deal?"
"You bet your bonnet he would bunkie! You think the guys on this street were born yesterday? "Every Rube thinks he can come to town and take the street for a ride, but tell you what we're going to do. You sit here and start calling every friend and relative and customer you have. Get them to buy seventy-five percent of the deal and we'll still do the rest of because we have a lot of confidence in your deal. Bunkie, you can even use my desk, but don't take long, now."
Several takeoffs on the "best efforts" form of deal are the "mini - maxi" and the "all or none". These apocryphal sounding visions are Wall Street works of art. The "mini - maxi" means, "I can't raise less than this or more than that." In many cases the accounting, legal, printing, and underwriting fees are included in the "less than this". Thus, all of the shareholders participating in the transactions have made many friends in the legal and accounting professions with their charity but they have not been left with much of a company. It would be wise not to invest in too many "mini-maxi's" or you could wind up keeping Doctor Bob company at the funny farm.
The "all or none" is a much kinder type of underwriting to shareholders, but it usually acts as a depth charge hitting a submarine amidships as far as the target company is concerned. It has been estimated by the SEC that accounting, legal, and other costs run over $300,000 in the average offering. Obviously the company wouldn't trying to go public if it didn't need the financing, so the principals begged, borrowed and stole the necessary $50,000 non-refundable deposit for the underwriter. The underwriter had them hire a Big Six accounting firm that his son was apprenticing at, mind you not because his son is there but because it would look good on the title page. The law firm that the underwriter said was necessary to get the deal done asked for $100,000 retainer and assigned the job to a $400 an hour partner. "We need a firm that is reliable and can get the work out on time,"
Usually, about the same time that the principal at the brokerage firm announces that he can't do the whole deal and that you have to bring in the customers, he will have available in his handy, dandy pocket legal reference guide the names of attorneys that specialize in bankruptcy reorganizations, plans for victims of failed IPO's. I really believe that some firms on the street are paid for as many deals that they don't do as they complete.
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