Before any security can be sold to the public, it must go through a structured process governed by the Securities Act of 1933. Understanding the sequence of steps (and who is responsible at each stage) is essential for the exam.
Due Diligence
- The underwriter investigates the issuer's business, financials, management, and legal standing before agreeing to underwrite the offering
- This process protects both the underwriter and future investors by ensuring the issuer's claims are accurate
- Due diligence drives everything that follows: the registration statement, the prospectus, and the pricing of the issue
Exam Tip: Gotchas
Due diligence is the underwriter's responsibility, not the issuer's. If the underwriter fails to verify material facts, it shares liability for misstatements in the registration statement under the Securities Act of 1933.
Registration Statement
- Filed with the Securities and Exchange Commission (SEC) under the Securities Act of 1933
- Two parts:
- Part I (Prospectus): Distributed to investors; contains business description, financial statements, use of proceeds, risk factors, management information, and underwriting arrangements
- Part II (Supplemental Information): Available on request; contains additional exhibits and data not required in the prospectus
Exam Tip: Gotchas
Only Part I (the prospectus) is delivered to investors. Part II is filed with the SEC and available on request, but investors do not routinely receive it.
Key Documents in the Process
| Document | When Used | Key Features |
|---|---|---|
| Preliminary prospectus (red herring) | During the cooling-off period | Same as final prospectus but omits the final offering price and effective date; printed with a red ink legend on the cover |
| Final prospectus | After SEC declares registration effective | Complete document with final price, effective date, and underwriting spread; must be delivered to all purchasers |
| Underwriting agreement | Between issuer and lead underwriter | Specifies firm commitment vs. best efforts, spread, and number of shares |
| Selling group agreement | Between syndicate and non-syndicate dealers | Selling group members earn a concession but do NOT assume underwriting risk |
Exam Tip: Gotchas
The red herring is identified by the red legend on its cover. It omits the final price and effective date because those have not yet been set. A final prospectus with those fields filled in supersedes it once the registration becomes effective.
Types of Underwriting Commitments
The type of commitment determines who bears the risk if the offering doesn't sell out.
| Type | Risk to Underwriter | What Happens to Unsold Shares |
|---|---|---|
| Firm commitment | Underwriter purchases the entire issue; bears full financial risk | Underwriter keeps them and absorbs the loss |
| Best efforts | Underwriter acts as agent; no obligation to buy unsold shares | Returned to the issuer |
| All-or-none | A type of best efforts; entire issue must sell or the deal is cancelled | All shares returned; investors refunded |
| Mini-max | A type of best efforts; a minimum must sell for the deal to close | Shares below minimum trigger cancellation |
Exam Tip: Gotchas
In a firm commitment, the underwriter buys the ENTIRE issue from the issuer. If the underwriter cannot sell all shares to the public, the underwriter (not the issuer) absorbs the loss. In best efforts, unsold shares go back to the issuer. The exam loves to test who bears the risk in each type.
Roles in a Capital Raise
Beyond the underwriter relationship, the Series 7 tests role-identification scenarios where a company is raising funds, and the answer choices list broker, agent, dealer, issuer. Knowing which party handles which responsibility prevents these from becoming guesses.
| Role | Responsibility |
|---|---|
| Issuer | The company itself. Creates and sells the new securities; files all regulatory documents (Form S-1, state registration, exemption filings); receives the proceeds |
| Broker-dealer (underwriter) | The firm hired to distribute the securities to the public. Acts as principal/dealer in a firm commitment, agent/broker in best efforts |
| Agent | An individual (natural person) representing the BD or issuer in effecting transactions; never an entity |
| Dealer | A BD acting in a principal capacity, buying and selling for its own account |
| Rating agency | A separate third party (Moody's, S&P, Fitch); assigns credit ratings to debt issues. Not listed alongside broker/agent/dealer/issuer in role-identification questions |
Exam Tip: Gotchas
When the question lists broker, agent, dealer, and issuer as answer choices, match the responsibility to the role:
- Issuance and regulatory filings → issuer
- Distributing securities to the public → broker-dealer
- Effecting transactions as an individual → agent
- Trading for own account → dealer
- Rating the securities → none of those four; the answer is the rating agency
Blue-Sky Laws
- State securities registration requirements that exist in addition to federal SEC registration
- Issuers must register or qualify offerings in each state where securities will be sold
- Named "blue-sky laws" because they were designed to protect investors from speculative schemes that had "no more substance than so many feet of blue sky"
- Some exemptions (like Regulation A Tier 2 and federally covered private-placement offerings) preempt state registration requirements
Exam Tip: Gotchas
Blue-sky laws apply on top of federal SEC registration, not in place of it. A security must be registered or qualified in each state where it is sold, unless a federal preemption or state-level exemption applies.