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In short, the opening quotations and the opening “market” were based on trading of but a fraction of the outstanding shares, and on information that could not be said to reflect accurately the potential supply at the premium or any other price.
Supply of the stock of many “first” offerings also was restricted by the practice of “free-riding and withholding" Despite NASD and Commission prohibitions against the practice, participants in distributions would place portions of new issues in the accounts of insiders of the firm and their families. In some offerings, substantial amounts of stock were thus “shelved," while demand was being stimulated by trading activities, publicity, and solicitation of customers. Withheld shares were then sold to customers at premium prices in what amounted to a redistribution of the shares offered.
Buying interest, unlike selling interest, was likely to be reflected in the trading markets at the very outset. Buying interest was frequently communicated to the trading markets prior to the effective date, by both distributors and nondistributors of the security. Trading firms based their opening quotations on orders placed with them prior to effectiveness. Moreover, solicitation of after-market purchases was common and might be actively engaged in by one or more of the major distributors. While it was often difficult to determine whether solicitation of purchases in the after-market occurred prior to or immediately following the effective date, the study indicates that significant public buying on the first day of trading was usually by customers of one or two or several participants, thus suggesting the presence of active solicitation or recommendation by such participants at least as early as the notice of effectiveness. To add to the after-market excitement, some managing underwriters arranged for solicitation of customers at premium prices through nonparticipating firms. Demand for new issues was further stimulated in some cases by market letters, advisory recommendations, articles in the financial
press, and other planned publicity, usually optimistic in tone. The disclosure provisions of the Securities Act assume a particular importance to the purchaser of a new issue in the after-market, especially in periods of intense demand. The study of new issues indicates that many persons who received original allotments of new issues were sophisticated investors aware of and able to assume the risks of investing in a speculative issue. On the other hand, persons who bought in the after-market often were less sophisticated and more susceptible to the allure of publicity and rumor about "hot issues." These persons, who frequently purchased at premium prices, probably needed the benefits of the information contained in the prospectus more than the original distributees. Yet in many cases they never received a prospectus as required during the first 40 days of the offering
In extreme cases it appears that the original distributees, whether "insiders" or favored customers of the underwriters and selling group members, and the trading firms which made markets in the stock served merely as conduits through which the shares were funneled to the "real" distributees of the new issues—the customers who purchased at premium prices, often pursuant to direct solicitation and influenced by favorable publicity and market letters, rather than the prospectus.
A separate inquiry undertaken by the Special Study showed a high degree of failure among small companies which went public during
the past decade. Under the philosophy of the Securities Act it is not the role of the Federal Government, of course, to pass on the merits of securities or decide which companies should receive the investor's dollar. The role of the Government is to insure disclosure of information and fairness of the markets in which securities are distributed and traded. Certain specific improvements in disclosures and market practices, with particular regard to new issues, are suggested by the study's data.
Determination of the suitability of issues for public financing has traditionally been part of the role of the underwriter, a role demanding particular skill, experience and sense of responsibility. Many of the broker-dealers who undertook the role of underwriter under the stimulus of the new-issue boom not only were lacking in these qualities but were substantially judgment-proof with respect to their statutory liability under the Securities Act to those purchasing issues underwritten by them. These underwriters usually sold stock on a "best efforts” basis and in some cases were organized to merchandise only one or two issues. The recommendation in chapter II of this report, that all underwriters have a minimum capital commitment, should help to eliminate the paradox that underwriters who fail to make even the most rudimentary investigations of an issuer can be immune from the basic sanctions contemplated by the Congress in enacting the civil liability provisions of the Securities Act.
During the years 1959–61, the "truth in securities” philosophy of the Federal securities laws became irrevelant for many investors. An accurate prospectus is of little value to a purchaser who does not care about a company's asset value, operating history or prospects but who buys only in the expectation of an immediate premium for its stock. Neither the disclosure philosophy nor the registration requirements of the Securities Act and the procedural machinery which has grown up around them is in any way invalidated by the results of this study. What these findings do demonstrate, however, is that particular problems exist in the distribution and trading of new issues, and that certain requirements, not applicable to distributions of securities by seasoned issuers but designed to reach some of the specific excesses revealed in the new-issue phenomenon of 1959–61, should be instituted and enforced.
The Special Study concludes and recommends:
1. The Commission's administration of the registration provisions and related exemption provisions of the Securities Act has been one of its most outstanding achievements, and the statute itself has proved generally adequate and workable. Nevertheless, there are limited respects in which provisions of that statute and the administration thereof or of related provisions of the Exchange Act should be modified in order to adapt them more closely to experienced needs. The troublesome and sometimes dangerous phenomenon of “hot” issues is primarily associated with "first” issues, i.e., first public offerings of securities of a particular issuer. Accordingly, such "first” issues, whether fully registered or exempt under regulation A, should receive particular attention, with a view to preventing certain practices that appear to have contributed unnecessarily to "hotness," while not interfering with normal and legitimate practices in connection with underwriting of "first” or any other issues or the flow of venture capital into new business.
2. Appropriate rules should be adopted by the NASD and/or the Commission, applicable to “first” issues of common stock generally, designed to eliminate or temper certain factors which, either independently or in interaction with each other, appear to have produced artificially high but ephemeral premiums in many instances. Among the types of rules that would appear appropriate for consideration and adoption would be rules (a) requiring that, with respect to allotments resulting from solicitations or indications of interest prior to the effective date, notices of allotment (in the form of confirmations or otherwise) be given to purchasers as promptly as reasonably possible, any delay of more than (say) 24 hours after the effective date to be deemed prima facie unreasonable; (b) requiring that, again with respect to allotments resulting from solicitations or indications of interest prior to the effective date, certificates of stock be delivered or made available for delivery to purchasers as promptly as reasonably possible, any delay of more than (say) 2 weeks after the effective date or more than (say) 1 week after the underwriting closing to be deemed prima facie unreasonable; (c) prohibiting all broker-dealers from initiating a trading market for a limited period of (say) 72 hours after the effective date, except for stabilizing activities in conformance with rule 10b_7 and such other exceptions as may be provided by rule or in specific circumstances; (d) clarifying or defining restrictions on soliciting, holding, or transmitting, prior to the effective date, indications of interest or orders to purchase in the open market after the effective date; and (e) prohibiting all participants in the public offering, until the distribution is completed or for a period of (say) 40 days after the effective date, whichever is later, from soliciting or recommending purchases of the stock (including placing stock in discretionary accounts) at a price in excess of (say) 120 percent of the public offering price.
3. Acceleration by the Commission of the effective date of a registration statement or permitting clearance of a regulation A filing, with respect to any "first” issue of common stock, should normally be conditioned on delivery of a prospectus or offering circular in substantially final form to each person to whom any participant in the distribution expects to make original allotments at least (say) 48 hours before any sales are made.
4. The 40-day period during which all dealers are required to deliver prospectuses should be extended to 90 days in the case of "first” issues of common stock, except as may be otherwise permitted by rule or in specific circumstances. The same provisions should apply to offering circulars under regulation A exemptions. (It is recommended below that the 40-day requirement be eliminated in connection with offerings of securities of issuers subject to the continuous reporting requirements of sections 13, 14, and 16 of the Exchange Act.)
5. The NASD should strengthen its enforcement of the prohibitions against "free-riding and withholding" by requiring, in the case of any “first” issue of common stock for which a price in excess of (say) 120 percent of the public offering price is reached
within (say) 40 days after the effective date, a report of the managing underwriter showing all stock allotted to any participant in the distribution (other than stock resold at or below the public offering price) or its principals or members of their immediate families or to any broker-dealer other than a participant, and the disposition thereof, if any. In general, since those violating the "free-riding and withholding” prohibitions may be in a position to realize profits greatly surpassing the fines customarily imposed by the NASD, substantially severer penalties should be imposed in flagrant cases so as to provide an adequate deterrent.
6. The NASD has a taken a forward step in providing for the review of underwriting arrangements in connection with offerings of unseasoned companies. To provide guidance to its membership, the NASD should periodically publish summaries of specific rulings relating to the amounts of compensation and types of compensation arrangements that have been considered unacceptable in given circumstances.
7. Underwriters receiving options, warrants, or “cheap stock" in connection with any public offering should be required to report to the Commission and the NASD: (a) upon exercise of options or warrants, the date and price; (b) upon transfer of options or warrants, the date, consideration, and identity of transferee; and (c) upon disposition of underlying securities without a posteffective amendment, the date, consideration, identity of distributee, or class of distributees, and the exemption relied on. The general subject of transfer of such options, warrants, or “cheap stock” to registered representatives, traders, or others not directly involved in the underwriting of an offering should receive greater attention of the NASD, with a view to adoption of rules or a statement of policy defining circumstances in which such transfer is deemed consistent or inconsistent with high standards of commercial honor and just and equitable principles of trade.
8. In light of widespread misunderstandings or uncertainties among broker-dealers, as discussed in this and other portions of the report, the Commission should take appropriate steps to clarify the application of rule 10b-6 (a) during a period when stock is being held "for investment” by a broker-dealer, (b) in connection with various forms of "shelf” registration, (c) in connection with a planned reduction of inventory or "workout," and (d) in connection with unregistered distributions generally.
PART C. UNREGISTERED DISTRIBUTIONS
Unregistered distributions can be quite sizable individually, and in the aggregate they are a very significant phenomenon in the securities markets. They are of growing importance because of the increasing participation of institutional investors in the markets. From the point of view of public customers, they are often indistinguishable from registered distributions in respect of disclosure needs. Yet they occur, for the most part, without even the minimum disclosure protections that would seem practical and with a speed that does not permit careful consideration of the merits of the security being distributed.
If a distribution emanates from the issuer or a controlling stockholder, it is the theory of the Securities Act that the issuer, selling stockholder (if any) and underwriter can and should supply comprehensive data about the issuer and the distribution itself. But if the distribution is from any other source, even though the factual distinctions may be narrow ones and the needs of investors may be no different, no disclosures are usually required even as to the distribution itself (except in the case of certain but not all exchangeapproved distributions). Granting that the basic distinctions in kinds and amounts of disclosure must be maintained for practical reasons, there is no reason why certain basic data with respect to the distribution itself cannot be provided just as readily in the case of an unregistered distribution as in the case of a registered one. The needs for protection of investors are no less great in the former case than in the latter.
The disclosure requirements applicable to exchange distribution and special offering plans under rules of the New York Stock Exchange and other exchanges, as described above in section 2, provide a useful pattern in considering the minimum disclosures that are needed and practical to obtain. These requirements should be extended to all unregistered distributions in defined categories so that, in addition to notifying the Commission, there will be disclosed to prospective purchasers prior to completion of the transaction the total amount involved in the distribution, whether it is for the brokerdealer's account or on behalf of other persons (with or without identifying the persons); the underwriting arrangements and/or discounts and commissions involved; and whether stabilizing transactions may be effected. Some of this information should also be supplied to the prospective purchaser at the time of solicitation in view of the importance of disclosure at this point in the making of an investment decision. Consideration should be given, also, to the feasibility of requiring a minimum interval between announcement and actual commencement of an unregistered distribution.
In view of the importance of rule 10b-6, the basic antimanipulative rule in respect of distributions and the uncertainty concerning its application to unregistered distributions, it would appear that appropriate measures should be taken by the Commission to clarify its applicability.
The Special Study concludes and recommends:
1. Any broker-dealer managing an unregistered distribution should be required to file with the Commission a brief notification as to the total amount of securities involved in the distribution; whether the distribution represents inventory or investment stock of the broker-dealer and/or is on behalf of one or more other persons (with or without identification of such other persons); the offering price and underwriting arrangements and/or discounts or commissions involved; and whether stabilizing transactions may be effected. Consideration should be given, also, to the feasibility of requiring, with respect to all or specified categories of unregistered distributions, an interval of time, say 48 hours, between the filing of the notification and the commencement of the distribution (in which case only the method of determining price and spread rather than actual amounts would be set forth).