Introduction to Securities Industry Professor Goodfellow: Ok, now that you've seen how this course will run,

let's meet some of the players that make this process possible and comprise the Investment World. We'll start with those who issue securities, take a look at the people who want to get money from their investments, and then look at those who manage these investment transactions. Then we'll introduce you to the products that people invest in and how these products are issued or traded. We'll wrap up your introduction to the Investment World with the basic terms and concepts that we'll encounter throughout this course on the Fundamentals of the Securities Industry.

The Investment World

The People

Issuers Investors Financial Industry Professionals

The Major Products

Traditional Secondary

Terms/Concepts The Basic Processes

Raising Capital Choosing the Investment Banker The Syndicate Full Disclosure The Cooling-Off Period Distributing the Security

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Learning Objectives: After completing this module, you'll be able to:

Gain a basic understanding of the investment world and the Securities Industry Understand the role of Primary and Secondary Markets Understand the process of a Public Offering

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The Issuer:

Harry Allen: Alright, now here's where I'd like to come in. I'm Harry Allen, I'll be telling you about the way things work in the real world. You got your IBMs, you got your mom-'n-pop shops. But all corporations need capital to replace plants and equipment, launch new business ventures, and bridge gaps in their cash flow. Governments also need capital for replacing buildings and equipment, for building roads and bridges, and for sustaining government operations until expected revenues materialize.

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People: The Investors

Individual investors are interested in the securities industry for a variety of reasons: the author whose earnings vary from year to year, and who needs a steady flow of investment income; the couple who want to establish a fund for their children's college education; the professional who is doing well now and is willing to put some earnings in highrisk, highgain investments; and the couple who just sold a car and need to "park" their money temporarily until they find another car to buy.

Individual Investors want to:

ensure a steady income establish a fund for future use invest extra cash for high gains use securities as a money-management tool

In recent years, institutions of various sorts have come to play an enormously influential role in the investment world. Institutions invest in securities for a variety of reasons: one organization might need to invest for their employee pension funds to provide pension payments in the future; another organization might need to invest a short-term cash surplus. Institutional Investors might need to:

invest pension funds for future pension payments temporarily invest a short-term cash surplus

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People: Financial Industry Professionals

So that transactions among the participating parties can proceed efficiently, the securities industry needs people and places that bring them together: the markets and the market makers. In addition, investors, corporations, and governments need representatives to act on their behalf in transacting business: the brokers, traders, and investment bankers. Finally, regulators monitor the industry as a whole. They are responsible for setting the ground rules and protecting all the parties, including the general public. Examples of regulatory authorities.

Together these professionals represent the bulk of what people tend to lump together with the shorthand term, "Wall Street".

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Market Maker Synonymous with an OTC dealer, a market maker is an NASD member firm that disseminates bid and ask prices at wchich it stands ready to buy stock into, and sell stock from, its inventory at its own risk in the over-the-counter market. On the stock exchanges, the Specialist performs the function of market maker as well as handling the book of public orders. On the CBOE, the market maker maintains bid and ask prices in options contracts.

Investment banker: Firm acting as underwriter or agent that serves as intermediary between as issuer of securities and the investing public. See also underwriting agreement. Late in 2008 all of the largest Investment Banks in America received Commercial Bank charters. At this time it appears that they will continue to perform all of the tasks traditionally performed by Investment Banks as well as some functions traditionally performed by Commercial Banks.

Investment Products: Professor Goodfellow: Now that you have a sense of the investment world's major players, we'll examine the investment instruments they use. While the growing number and variety of instruments have led to greater complexity, investors can more easily tailor an investment program to their individual needs and risk tolerance. Let's have a look at the many types of securities.

Types of Investment Products

Preferred Stocks Rights and Warrants U.S. Treasury Bills, Notes and Bonds Commercial Paper Certificates of Deposit (CDs) Options Swaps Common Stock Corporate Bonds and Notes Municipal Bonds and Notes Asset-Backed Securities Banker's Acceptances Mutual Funds Futures Currency

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Investment Products
Traditional Products

Equity securities (stocks) Debt securities (bonds)

Second-generation Instruments

Derivatives: warrants, options, rights, futures Pass Thrus, CMO's and Asset Backed Securities

Stocks and bonds are also called capital market securities. Buying equity securities, that is shares of stock, makes investors part-owners of a business. By buying debt securitiesbondsinvestors lend money to a business or government. Mostbut not allsecond-generation instruments "build on" the traditional ones. Products like warrants, options, and rights are derived from or represent variations on the basic themes of stocks and bonds. That's why many of these instruments are called derivatives. Products related to the futures market are a bit different. Futures trading is essentially a variation on the buyer-seller relationship... displaced in time.

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Warrant: Type of security, usually issued together with a Bond or Preferred Stock, that entitles the holder to buy a proportionate amount of common stock at a specified price, usually higher than the market price at the time of issuance, for a period of years or to perpetuity. Also known as a subscription warrant. Option: The right to buy or sell a security (or a more complicated version of these). Right: The privilege granted to existing shareholders of a corporation to subscribe to shares of a new issue of common stock before it is offered to the public. Also known as a subscription right.

The Basic Processes

The Markets

Primary Secondary Methods of Investing Completing a Transaction (or "The Deal") Regulation

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Harry Allen: The professor gave you some solid basics on the players and products in the investment world. Lets have a look at the fundamental processes that these products go through from seller to buyer. Youll get an overview of the different markets where securities are sold, the ways in which buyers can invest, the process of completing a transaction and the mechanisms in place to ensure a level playing field for all investors.

The Basic Processes

The Primary Market

The Secondary Market People

Brokers Investors Process Trading on the secondary market involves brokers and investorsbut usually not the issuing organization. Once the "initial issues" have been sold on the primary market, they can be traded on the secondary market: On the various stock exchanges, where prices are determined by auction Over the counter, where prices are determined by negotiation

Both traditional and second-generation investment instruments are traded on the secondary market. Products

Warrants Bonds Stocks Rights

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The Basic Processes

Methods of Investing

Just as with any other type of purchase, there are several ways to invest in securities.

Cash On Margin Selling Short

Obviously, there are different strategies and risks involved in each of these processes. Completing a Transaction Once an actual purchase is maderegardless of methodthe most visible aspect of a transaction is over. At this point, the buyer and seller (and their representatives) must follow through and complete, or settle, the transaction by: 1. Recording the transaction. 2. Exchanging payment (on the one side) for the security (on the other side). Regulation Government and industry agencies regulate all aspects of issuing, trading, and settlement to ensure a "level playing field" on which the various parties can conduct business with confidence.

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Cash In a cash account, all securities are paid for completely with either cash or highly liquid, risk-free securities which are converted to cash to settle the trade.

On Margin You can buy on credit-that is, on margin. Buying on margin, you can try to take advantage of an expected increase in the item's price even if you can't, or choose not to, put out the total amount of cash required.

Selling Short When you sell a security short, you sell what you do not own. To do this, you must borrow the stock today and buy it back at a future date. It is your hope that you will sell it today at a higher price and buy it back in the future at a lower price. You would keep the difference. Selling short is where you hope the price of the security will fall. Sell high; buy low.

Basic Terms and concepts: Professor Goodfellow: Alright then, now we've got a feel for the players, the products and the processes in the Investment World. Now, we'll run by you some of the basic terms and concepts that you will encounter again and again in the Fundamentals of the Securities Industry. Some of these terms have multiple meanings. For example, yield is not something you do to let other drivers pass you by, it's the return on an investment. Let's now turn to our final overview of the investment world before we turn to the process by which a security is brought to the market.

Module Assignment Answers to the following questions:

Who are the issuers of securities?

What are derivatives?

Distinguish between the primary and the secondary market. Assignment Answers Who are the issuers of securities? Issuers of securities include commercial companies, governments, government agencies, local authorities and international and supranational organizations (such as the World Bank) and in the case of many ABS Special Purpose Vehicles.

What are derivatives? A derivative is a financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.

Distinguish between the primary and the secondary market. The primary market is the financial market for the initial issue and placement of securities. Unlike in the secondary market, no organized stock exchanges are necessary. An organization that needs funds contacts their investment banker who typically assembles a syndicate of securities dealers that will sell the new stock issue. Securities dealers see this as the wholesale part of their business. This process of selling the new stock issues to prospective investors in the primary market is called underwriting. The securites that they sell are called initial public offerings (IPOs). This is contrasted with the retail part of the business, which is acting as an intermediary between buyers and sellers of securities in the secondary market where trading of securities that have already been issued in its initial private or public offering happens. Stock exchanges are examples of secondary markets. Close

Raising Capital
The Primary Market

Let's examine how companies raise capital. We want to know what types of securities are issued and how they are issued. When do they come to the market and who brings them to the market? But first let's take a look at a new company looking to raise capital.

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Professor Goodfellow: Ok, now let's get to the reason we're all here. We want to know how companies and governments raise capital: they do it by trading on the Primary Market. Here's where an Initial Public Offering (IPO) is born. Narrator: A hot new company, Quality Copies, is striving to be a biotechnology leader. Remember Dolly the sheep? DNA cloning? Well, Quality Copies is developing the technology to copy the whole human genome, not just pieces of DNA. They see this as the wave of the future, the next biotechnology revolution. This is gonna be HOT. But their product still requires a lot of expensive research and development the final product will take a long time to get to market. But it falls to the CEO to hit the street and raise the necessary capital.

How can Quality Copies come up with the R&D money it needs now? Should Quality Copies: 1. Borrow money by issuing a bond? 2. Sell stocks in the company by issuing shares of stock? 3. Look into a merger or other form of business combination? 4. Borrow money directly from a bank or other lending institution? A bank loan may not be a viable option for QC.

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Why Bank Loans May Not Be Viable Options Unfortunately, bank loans often prove to be inadequate for four main reasons: 1. Banks are often unable to provide the terms that a borrower wants. A company might want to borrow money at a fixed rate for 20 years, whereas most banks will not make fixed-rate commercial loans with terms longer than seven years. 2. Banks are often unable to lend to companies or government bodies with low credit ratings.

New companies often don't have enough collateral to secure bank financing. Because banks have a duty to their depositors not to take excessive risks with their deposits, there is some truth to the adage that "the only way to get a bank loan is to have so much money that you don't need one." On the other hand, individual investors are often willing to invest in risky situations if they feel the potential reward justifies the risk.
3. Banks often charge borrowers higher interest rates than credit-worthy companies and governments have to pay if they raise capital directly from investors. 4. Banks are often unable to lend potential borrowers the amount of money that they need to borrow.

For example, the United States' government has borrowed over $14 trillion. Not even a consortium of the largest banks could make a loan of this size.

Raising Capital: The Process

When a corporation first offers its stock for sale to the public, it is said to be going public. This is also known as an IPOinitial public offering. The process by which the stock is offered, or issued, is called an underwriting. There are two basic types of underwritings: firm and best efforts. They differ primarily in the investment firm's level of commitment to the underwriting.

The process of "going public" involves many steps:

Choosing the Investment Banker Registration Statement Full Disclosure The Cooling-Off Period Distributing the Security

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Initial Public Offering (IPO): The corporation is offering a new issue [class] of securities to the public for the first time. Investment banker: Firm acting as underwriter or agent that serves as intermediary between as issuer of securities and the investing public. See also underwriting agreement. Cooling-off period: A period during which the SEC examines the proposed registration documents for errors.

The Investment Banker

Companies and governments often turn to an investment banker for help in raising capital. An investment banker is usually a brokerage firm that serves as an intermediary between potential investors, and the companies and governments seeking to raise capital. Because such firms, through their brokers, are in contact with thousands of investors, they help the company or organization to: 1. Identify opportunities to raise capital 2. Structure the Securities Offering 3. Raise money In other words, the investment banker can match securities issuers with investors for whom the securities are appropriate. For example, if a small, growth company wants to continue its promising research and development program, it needs to sell stock to raise the money. The investment bank matches the company with investors who are seeking high-risk/high-reward investments. On the other hand, if the issuer is the U.S. government, the investment banking firm matches it with investors who do not want any credit risk. The term underwriter is used to describe the investment banker's role in this procedure.

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Types of Underwritings
Firm Underwritings This represents a very high commitment on the part of the investment banking firm. The syndicate actually buys the securities from the issuing company using the firm's own capital and then resells the securities (usually on the same day) to investors that the syndicate has lined up. The investment banking firm charges investors a slightly higher price than they paid the issuer in order to make a profit on the overall transaction. This difference between the price the underwriter pays for the security and the price at which the underwriter sells it is called the Underwriter's Spread. If the investment bank can't resell the securities, then they own them. The issuing company still gets its money from the sale. Negotiated versus Competitive Since Quality Copies is a pretty great idea, with attractive growth potential, lots of investment firms will want to underwrite the offering. So Quality Copies gets to choose the underwriter that's willing to pay the most for its securities. This is Competitive Underwriting. But what if it wasn't such a great company with such a great idea? What if only one investment bank was interested in underwriting? Then the firm would negotiate the price with that investment bank. And that's called Negotiated Underwriting.

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Syndicate: A short term partnership formed for the purpose of underwriting and selling a new issue of securities.

The Process of a Public Offering

The investment bank Acker Kern & Acker has agreed to be the lead manager of the syndicate underwriting the IPO for Quality Copies. They have listed a fair market price of $12.00 per share in the prospectus. But it's thought that Quality Copies' stock is going to shoot straight up on the first day of issuance and become what's called a "hot issue".

HOT ISSUES A hot issue is a new security offering that is very actively sought after by investors. If a new IPO is really super hot, the market price of the newly issued securities quickly rises in the secondary market, ensuring an immediate profit for the initial investors. To prevent investment firms from keeping these profits to themselves, neither the firms themselves, nor their employees, nor relatives of employees are allowed to buy any shares of a hot issue during the offering.

...nobody were interested in risking their capital on the little company with the risky idea?

Then a company resorts to a "best efforts" underwriting, where the investment bank does not buy the securities from the issuing firm, but acts only as a sales agent. The investment bank makes no guarantees as to how many shares it can sell or what price they will be sold for.

Now, normally an issue of a small company's shares would be done on a "best-efforts" basis, where the investment bank simply makes its best effort to sell the shares. But Quality Copies got Acker Kern & Acker to issue the shares on a "firm basis". This means that the underwriter has actually bought all the stock from Quality Copies at one price, and now they want to sell it on the market at a higher price.

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Professor Goodfellow: Quality Copies has decided to raise the capital that it needs through the primary market, by asking an investment banker to serve as an intermediary between potential investors and Quality Copies. Best Effort: An arrangement whereby investment bankers, acting as agents, agree to do their best to sell an issue to the public. Instead of buying the securities outright, these agents have an option to buy and an authority to sell the securities.

The Process of a Public Offering

Full Disclosure

Amid the aftershocks of the 1929 stock market "crash," Congress passed the Securities Act of 1933. To enforce the requirements of the 1933 Act, The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC). With respect to underwriting, the SEC supervises the registration of new securities and makes sure that the important information about an investment is disclosed to the public.

Various other federal and state laws also protect the investing public from being given false, inaccurate, or misleading information, or being otherwise defrauded. Offenders are subject to stiff fines and imprisonment.

When a corporate issuer sets out to offer its securities to the public, it must first file a registration statement with the Securities and Exchange Commission, which reviews the statement to determine if full disclosure has been made. The SEC examines the statement, and, if they deem no changes are necessary, it becomes accepted, and thus effective, after twenty days. (This 20-day period is often called the cooling-off period.)

In its review, the SEC neither approves nor disapproves of the securities, nor does it pass judgment on the investment merit of the proposed offering. The SEC merely "accepts" or "rejects" the registration statement on the basis of whether it includes all of the information that the SEC feels potential investors require when considering the purchase of the securities. By accepting a registration, the SEC is saying only that all the legally required information is adequately disclosed and that the necessary supporting documents have been included. Nevertheless, acceptance is crucial to an underwriting, because the securities can't be sold to the public until the SEC accepts the registration statement, which is then said to be effective.

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Narrator: At that point, Quality Copies, under the guidance of the investment banker and a full team of lawyers issues the full disclosure statement. Information included in the registration statement 1. The name of the issuer. 2. The name of the state or sovereign power under which the issuer is organized. 3. The location of the issuer's principal office. 4. The names and addresses of the directors and other senior officials. 5. The names and addresses of the underwriters (if any). 6. The names and addresses of persons owning 10% or more of any class of the issuer's stock.

7. The quantities of securities owned by the directors, senior officials, underwriters, and 10% or greater holders. 8. The general character of the issuer's business. 9. A statement of the issuer's capitalization. 10. A statement of securities reserved for options outstanding, with names and addresses of persons allotted 10% or more of these options. 11. The amount of capital stock of each class included in this offer. 12. The issuer's funded debt. 13. The purposes to which the proceeds of this offering will be applied. 14. Remuneration payable to the issuers directly, naming them specifically when annual payments exceed $25,000. 15. The estimated net proceeds to be derived from the offering. 16. The price range at which the public offering will be attempted. 17. Commissions, fees, and so on, to be paid to the underwriters. 18. An itemized detail of expenses incurred by the issuer in connection with this offering. 19. The net proceeds derived from any securities sold by the issuer in the preceding two years and pertinent details of those sales. 20. Any consideration paid to a promoter in the preceding two years. 21. The names and addresses of any vendors of property or goodwill to be acquired with the proceeds of this offering. 22. Full particulars of any dealings between the issuer and its officers, directors, and holders of 10% or more of its stock that transpired in the preceding two years. 23. The names and addresses of counsel passing upon the legality of the issue. 24. The dates and details of material contracts created outside the issuer's ordinary course of business within the preceding two years. 25. Certified financial statements of any issuer or business to be acquired with proceeds of this offering. 26. A copy of the underwriting contract or agreement. 27. A copy of the law firm's written opinion attesting to the legality of the issue. 28. A copy of all material contracts referred to in item 24. 29. A copy of the issuer's charter, bylaws, trust agreement, partnership agreement, and so forth, as the case may be. 30. A copy of the underlying agreement or indenture affecting any security offered or to be offered by the issuer.

Understanding How an IPO Happens

While the SEC reviews the registration statement, the corporation's officers and the investment bankers scurry to finalize the arrangements for implementing the public offering. Let's see what they're up to.

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Understanding How an IPO Happens

Red Herring During the cooling off period, AKA's sales team and bankers are working furiously to circle the stock and form a syndicate. The investment bankers ask their clients if they might be interested in purchasing Quality Copies' IPO, and if so, for how much. If investors want to "read something" about Quality Copies' proposed offering, AKA can send them the "red herring." This document summarizes the information contained in the main part of the registration statement filed with the SEC. However, the red herring is missing various types of information. Missing from the original prospectus (red herring):

offering price the coupon or interest rate of the debt instrument (sometimes) list of the underwriters participating in the offering

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Understanding How an IPO Happens

The Syndicate

While the firm's brokers busily line up potential investors, the firm's investment banking group builds a syndicate. Most firms don't attempt to sell an entire new offering by themselves (unless the offering is a small one). Instead, they solicit help from other firms. All of the firms involved in selling a new offering, acting as a group, are referred to as a syndicate. The firm that puts the deal together is called the syndicate's lead manager.

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Understanding How an IPO Happens

Blue Skying the Issue Narrator: At the same time, the firm's legal department submits the registration statement and other supporting documents to the state securities regulators in every state in which the securities will be offered. Obtaining state approval for a securities offering is called blue skying the issue.

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Understanding How an IPO Happens

The Distribution

Assuming there are no problems with the registration statement, sometime after the cooling-off period, the SEC informs the investment banking firm that the offering has become effective.

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Understanding How an IPO Happens

Due Diligence Meeting The lead manager holds a due diligence meeting with all the interested parties. There are several purposes for holding this meeting:

to give all the interested parties an opportunity to hear the corporation's top management and their advisors discuss the issuing company, and the offering's terms and conditions to give people an opportunity to ask any question concerning the distribution to prepare a final prospectus (a condensed version of the registration statement)

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Understanding How an IPO Happens

IPO Launch After the offering is completely distributed (remember, not all offerings sell out on their first day), the syndicate is disbanded, and the deal is said to have "broken syndicate." The stock may now be bought and sold freely on the secondary market.

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Professor Goodfellow: Finally, a price is set, final prospectuses are printed and an effective date, the date on which the stock may be sold, is set. Then an advertisement, often called a tombstone, is placed in the financial press for the day of issue. For Quality Copies, that day is today and it's being listed on Nasdaq, an American Over-the-Counter exchange.

Understanding How an IPO Happens

Quality Copies will now have the capital that it sought and investors will be able to follow Quality Copies' stock quotations in the papers and on the news under the ticker symbol QC.

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2011 New York Institute of Finance

Module Wrap Up

Harry and I have tried to give you some good solid basics. Next, you may want to check out the module on Equity Securities. But first, you must take your review quiz. Good luck.

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