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17.1
Explain what is meant by “information asymmetries” and how these affect the raising of capital.
17.2
Explain the purpose of securities law and regulations in the financial markets.
17.3
Explain what a prospectus is, what it contains, and why it is critical for initial public offerings (IPOs).
17.4
Outline the basic steps in taking a firm public through an initial public offering (IPO) of securities.
17.5
Explain why continuous disclosure requirements are important for investors and how they affect secondary offerings.

17.1 CONFLICTS BETWEEN ISSUERS AND
INVESTORS
• Issuers of Securities
– Corporations must issue securities to raise capital in order to invest in plant, equipment, working capital, research and development in order to produce products and services that meet needs in a competitive market environment
– Corporations must design securities that meet the needs of investors
• Investors in Securities
– Investors have surplus cash at the moment, but hope to invest the cash and increase its value
– Some investors have long investment horizons and the capacity to accept risk (e.g., large pension funds)
– Other investors have shorter investment horizons, require liquid investments and can only accept minimal risk
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17.1 CONFLICTS BETWEEN ISSUERS AND
INVESTORS
• In addition to issuers and investors, other participants in the financial markets include:
– Financial intermediaries (e.g., brokers) that bring buyers and sellers together
– Underwriters that help bring new security issues to market
– Speculators
– Arbitrageurs
• Given the diversity of parties, interests, goals, skills and access to information, the financial marketplace is an attractive target for scam artists who seek to take advantage of others.
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17.1 CONFLICTS BETWEEN ISSUERS AND
INVESTORS
• Asymmetric Information
– Information asymmetries occur when one party in a deal has more information than another party
– The party with superior information can use that information for their own benefit at the expense of another party
• Implications of Fraud for Financial Markets
– If investors are not convinced that markets are reasonably fair and that participants obey the law, they will not invest.
– Healthy capital markets are necessary for businesses to have access to capital so they can invest and create economic growth, thereby raising peoples’ standards of living.
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17.1 CONFLICTS BETWEEN ISSUERS AND
INVESTORS
Examples of Fraudulent Activities
– William Lyons attempting to sell US$220 million of fraudulently issued zero-coupon bonds to Bear Sterns, Merrill Lynch, Goldman
Sachs, and Chase Manhattan
– The use of bearer bonds in Europe
– Ponzi schemes
– Madoff scandal
– Securities dealers dealing in penny stocks through “bucket shops”
• Highly speculative mining and real estate companies issue shares
• “Wash sales” and high pressure sales tactics are used
– The case of Norbourg Asset Management Inc., where its founder was accused of stealing $84 million of investors money from the firm he controlled
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17.2 A PRIMER ON SECURITIES
LEGISLATION IN CANADA
Securities Legislation—Basic Responsibilities
– Under the Canadian Constitution provinces are responsible for securities regulation
– Many argue that a national securities regulator would improve the efficiency of Canadian financial markets by harmonizing laws and their enforcement
– Provincial regulators, like the Ontario Securities Commission, meet regularly to coordinate efforts through the Canadian
Securities Administrator (CSA)
– The CSA issues national policy statements that provide recommendations for provincial regulators, and maintains the
System for Electronic Data Access and Retrieval (SEDAR), a website that publishes information on all publicly-traded companies in Canada
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17.2 A PRIMER ON SECURITIES
LEGISLATION IN CANADA
– A security includes “any document, investment or writing commonly known as a security.”
– The factors considered to determine if a security exists are:
• Whether the promoter raises money and leads the investor to expect a profit
• Whether the investor has any control on how the money is spent
• Whether there is risk involved
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17.2 A PRIMER ON SECURITIES
LEGISLATION IN CANADA
Securities Legislation—Basic Responsibilities
• Ontario Securities Commission (OSC) Oversight
– Since the largest Canadian stock market, the Toronto Stock
Exchange, is in Ontario, the OSC has considerable responsibility and influence over securities regulation in
Canada
– The OSC is involved in five major areas where securities are either transferred or traded:
• Primary market offerings
• Secondary market trading
• Activities of investment professionals
• Insider trading
• Takeover bids
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17.2 A PRIMER ON SECURITIES
LEGISLATION IN CANADA
– Initial Public Offerings (IPOs) are primary offerings of securities to the public in a first-time distribution by the issuer which must be accompanied by a prospectus
– A prospectus is a document in support of a public offering of securities that must provide “full, true and plain disclosure of all material information pertaining to the security being issued.”
– A long-form prospectus contains information about the corporate issuer, directors, financial performance, operations, etc.
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17.2 A PRIMER ON SECURITIES
LEGISLATION IN CANADA
– A short-form prospectus contains information about the particular securities being offered including the price, type of security, intended use of proceeds, etc.
– An offering memorandum is a disclosure document in support of an offering of securities in the exempt market , and has the same objectives of disclosure as a prospectus but offers significantly less information because of the nature of exempt (i.e., sophisticated) investors.
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17.3 IPOs AND INVESTMENT BANKING
The Motivation for IPOs
• Going public requires a firm to incur significant changes and costs, including:
– Costs of meeting market listing requirements such as information disclosure requirements
– Underwriting and distribution costs, e.g., prospectus costs, underwriter’s spread and any underpricing of the IPO
– Listing fees
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17.3 IPOs AND INVESTMENT BANKING
The Motivation for IPOs
• The motivations for going public include:
– Access to capital
– Greater public visibility, which could increase the market demand for the firm’s products and services
– Providing venture capital firms and entrepreneurs the opportunity to harvest their investment
– Rewarding managers through options that have a market value
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17.3 IPOs AND INVESTMENT BANKING
• Stage 1: Initial discussion with an investment dealer, which then triggers the formal IPO process
• Stage 2: Drafting an initial prospectus and deciding on the broad type and terms of the public offering (choosing from four types: best efforts offerings , firm commitment offerings , bought deals , or standby/rights offerings )
• Stage 3: Finalizing the prospectus and waiting for clearance from the securities commission (commonly called the
“ waiting period ”)
• Stage 4: Pricing and distributing the issue and providing aftermarket stabilization (commonly called the “ distribution period ”)
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17.3 IPOs AND INVESTMENT BANKING
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17.3 IPOs AND INVESTMENT BANKING
IPO Underpricing
• IPO underpricing occurs when the initial offering price of an IPO is less than its market value on the first day of trading
• Systematic underpricing in occurs in some OECD countries because of:
– Competition for underwriting business
– Litigiousness of investors
– Spinning , where the underwriter allocates IPOs to favoured clients knowing they will make a large profit on the first day of trading
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17.4 POST-IPO REGULATION AND
SEASONED OFFERINGS
The Post-IPO Market
– Following the IPO a quiet period is required before the investment dealer’s research analysts can initiate coverage on the company, since the prospectus is assumed to provide sufficient information during the distribution phase.
– Misleading research reports were identified in the U.S. during the Internet bubble of the 1990s and analysts from major U.S. underwriters were charged for providing these reports.
– Some of the guilty underwriting firms encouraged and rewarded the practice of providing misleading information because of
“self-dealing.” The underwriter had a financial interest in the success of the security offering and so encouraged its analysts to write overly positive reports on the security’s prospects.
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17.4 POST-IPO REGULATION AND
SEASONED OFFERINGS
Continuous Disclosure Requirements
• After an IPO, investors do not receive a prospectus when they invest in the securities
• Public companies are expected to become reporting issuers and provide continuous disclosure , including:
– Quarterly and annual financial statements
– Annual information forms (AIFs)
– Proxy and information circulars
– Press releases on any material information
• All required information for public issuers in Canada is available at www.sedar.com
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17.4 POST-IPO REGULATION AND
SEASONED OFFERINGS
Seasoned Offerings and Short-Form Prospectuses
• Reporting issuers in Canada can take advantage of the annual information form and short-form prospectus (a system known as the Prompt Offering Prospectus, POP, system) in order to speed their access to capital markets.
• The short-form prospectus system has given rise to the use of the “bought deal” in Canada, where the underwriting contract is signed even before the drafting of the preliminary prospectus.
• The underwriting market in Canada has become extremely competitive as information requirements have been decreased through the POP system.
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17.4 POST-IPO REGULATION AND
SEASONED OFFERINGS
The Size of the Investment Banking Market
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 Textbook Companion Website (resources for students and instructors): www.wiley.com/go/boothcanada
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