Investment Banking and Securities Law

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Chapter 17 – Investment Banking and Chapter 17 – Investment Banking and Securities LawSecurities Law

CHAPTER 17CHAPTER 17 Investment Banking and Investment Banking and

Securities LawsSecurities Laws

CHAPTER 17 – Investment Banking and Securities Law 17 - 3

Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Conflicts between Issuers and InvestorsConflicts between Issuers and Investors• Securities Legislation in CanadaSecurities Legislation in Canada• IPOs and Investment BankingIPOs and Investment Banking• Post-IPO Regulation and Seasoned OfferingsPost-IPO Regulation and Seasoned Offerings• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions


Learning ObjectivesLearning Objectives

You should understand the following:You should understand the following:

• That the core problem in raising capital is information That the core problem in raising capital is information asymmetry, which, in extreme cases, can to lead to asymmetry, which, in extreme cases, can to lead to fraudulent activitiesfraudulent activities

• The importance of securities laws and regulations in The importance of securities laws and regulations in financial marketsfinancial markets

• The basic steps included in the initial public offering The basic steps included in the initial public offering (IPO) process(IPO) process

• What is included in a prospectus and why it is critical What is included in a prospectus and why it is critical for IPOsfor IPOs

• Why continuous disclosure requirements are important Why continuous disclosure requirements are important for investors, and how they affect secondary offerings.for investors, and how they affect secondary offerings.


Important Chapter TermsImportant Chapter Terms

• Agency theoryAgency theory• Asymmetric informationAsymmetric information• Banking (or dealer) Banking (or dealer)

syndicatesyndicate• Bearer bondsBearer bonds• Best efforts offeringBest efforts offering• Bought dealBought deal• Continuous disclosureContinuous disclosure• Distribution periodDistribution period• Due diligenceDue diligence• Exempt marketExempt market• Fair disclosureFair disclosure• Firm commitment offeringFirm commitment offering

• GreenshoeGreenshoe• Initial public offering (IPO) Initial public offering (IPO)

Investment Dealers Investment Dealers AssociationAssociation

• Lead investment dealerLead investment dealer• Limit ordersLimit orders• Lock-up periodLock-up period• Long-form prospectusLong-form prospectus• Market or disaster “out” Market or disaster “out”

clauseclause• Market ordersMarket orders• Offering memorandumOffering memorandum• OverallotmentOverallotment


Important Chapter Terms…Important Chapter Terms…

• Ponzi schemePonzi scheme• Preliminary Preliminary

prospectusprospectus• Private equity Private equity • ProspectusProspectus• Reporting issuersReporting issuers• Securities and Securities and

Exchange Commission Exchange Commission (SEC)(SEC)

• Selling groupSelling group• Short-form prospectusShort-form prospectus• SpinningSpinning• SpreadSpread

• Standby or rights Standby or rights offeringoffering

• UnderpricingUnderpricing• UnderwriteUnderwrite• Venture capitalVenture capital• Waiting periodWaiting period

Participants in Securities MarketsParticipants in Securities Markets

Investment Banking and Securities Investment Banking and Securities LawLaw


Issuers and Investors in SecuritiesIssuers and Investors in Securities

Issuers of SecuritiesIssuers of Securities• Corporations must issue Corporations must issue

securities to raise capital in securities to raise capital in order to invest in order to invest in plant/equipment, working plant/equipment, working capital, research and capital, research and development in order to development in order to produce products and produce products and services that meet needs services that meet needs in a competitive market in a competitive market environment.environment.

• Corporations must design Corporations must design securities that meet the securities that meet the investing needs of investing needs of investors.investors.

Investors in SecuritiesInvestors in Securities• Investors has surplus cash Investors has surplus cash

at the moment, but hope at the moment, but hope to transform that cash into to transform that cash into larger sums in the future larger sums in the future by investing in appropriate by investing in appropriate securitiessecurities

• Some investors have long Some investors have long investment time horizons investment time horizons and have the capacity to and have the capacity to accept risk (for example a accept risk (for example a large pension fund)large pension fund)

• Other investors have short Other investors have short investment time horizons, investment time horizons, require a liquid investment require a liquid investment and do not have the and do not have the capacity to accept riskcapacity to accept risk


Other Participants in the Markets for Other Participants in the Markets for SecuritiesSecurities

In addition to issuers and investors there are other In addition to issuers and investors there are other participants in the financial markets including:participants in the financial markets including:

• Financial intermediaries that bring buyers and sellers of securities Financial intermediaries that bring buyers and sellers of securities together (brokers)together (brokers)

• Underwriters (that help issuers bring new security issues to market)Underwriters (that help issuers bring new security issues to market)

• SpeculatorsSpeculators

• Arbitrageurs Arbitrageurs

Given the diversity of parties, interests, goals, skills Given the diversity of parties, interests, goals, skills and access to information, the financial marketplace is and access to information, the financial marketplace is an attractive target for scam artists who seek to try to an attractive target for scam artists who seek to try to take advantage of others.take advantage of others.

Information AsymmetryInformation Asymmetry



Conflicts Between Issuers and InvestorsConflicts Between Issuers and InvestorsThe Basic Problem of Asymmetric InformationThe Basic Problem of Asymmetric Information

• Information asymmetry occurs when one Information asymmetry occurs when one party to a transaction has information that party to a transaction has information that the other party doesn’t.the other party doesn’t.

• Superior information creates a situation Superior information creates a situation where one party can use that information for where one party can use that information for their own benefit at the expense of the other.their own benefit at the expense of the other.


Conflicts Between Issuers and InvestorsConflicts Between Issuers and InvestorsReal-World Examples of Fraudulent ActivitiesReal-World Examples of Fraudulent Activities

• William E. Lyons attempting to sell US $220 William E. Lyons attempting to sell US $220 million in fraudulently issued zero coupon million in fraudulently issued zero coupon bonds to Bear Stearns, Merrill Lynch, bonds to Bear Stearns, Merrill Lynch, Goldman Sachs Group and Chase ManhattanGoldman Sachs Group and Chase Manhattan

• Common use of bearer bonds in EuropeCommon use of bearer bonds in Europe• Ponzi schemesPonzi schemes


Conflicts Between Issuers and InvestorsConflicts Between Issuers and InvestorsSome Canadian Examples of Fraudulent ActivitiesSome Canadian Examples of Fraudulent Activities

• Broker-dealers (securities dealers) dealing in Broker-dealers (securities dealers) dealing in penny stocks known as “bucket shops”penny stocks known as “bucket shops”– Issuing shares in highly speculative mining and real Issuing shares in highly speculative mining and real

estate companiesestate companies– Use of ‘ wash sales’ and high pressure sales tacticsUse of ‘ wash sales’ and high pressure sales tactics

• The case of Norbourg Asset Management Inc. The case of Norbourg Asset Management Inc. where founder Lacroix was accused of where founder Lacroix was accused of stealing $84 million of investors money from stealing $84 million of investors money from the firm he controlled.the firm he controlled.


Implications of Financial Fraud for Implications of Financial Fraud for Financial MarketsFinancial Markets

• If investors are not convinced that the markets are If investors are not convinced that the markets are reasonably fair, they will not invest.reasonably fair, they will not invest.

– Societies where individuals do not respect the rule of law, or Societies where individuals do not respect the rule of law, or where law breakers are not found and punished, find that where law breakers are not found and punished, find that financial markets cannot developfinancial markets cannot develop

– In these cases, legitimate businesses operating those countries In these cases, legitimate businesses operating those countries lack access to capital, cannot invest, cannot create jobs and lack access to capital, cannot invest, cannot create jobs and cannot compete in international markets for their products and cannot compete in international markets for their products and services.services.

– In the end, the standard of living in countries with no respect for In the end, the standard of living in countries with no respect for the rule of law is extremely low, and they are often plunged into the rule of law is extremely low, and they are often plunged into political turmoil.political turmoil.

– In such places, people bury their funds or hide them under their In such places, people bury their funds or hide them under their pillow cases…and everyone loses! pillow cases…and everyone loses!

Primer on Securities Laws in CanadaPrimer on Securities Laws in Canada



Primer on Securities Legislation in CanadaPrimer on Securities Legislation in CanadaBasic ResponsibilitiesBasic Responsibilities

• Provinces are responsible under the Canadian Provinces are responsible under the Canadian Constitution for securities regulation.Constitution for securities regulation.

• Many argue that a national regulator would improve Many argue that a national regulator would improve the efficiency of Canadian financial markets by the efficiency of Canadian financial markets by harmonizing laws and their enforcement.harmonizing laws and their enforcement.

• Provincial regulators (like the Ontario Securities Provincial regulators (like the Ontario Securities Commission) meet regularly to coordinate efforts Commission) meet regularly to coordinate efforts through the CSA (Canadian Securities Administrators)through the CSA (Canadian Securities Administrators)

• The CSA among other things:The CSA among other things:– Issues National Policy statements that provide recommendations Issues National Policy statements that provide recommendations

for Provincial regulators to followfor Provincial regulators to follow– Maintain SEDAR.com (System for Electronic Data Access and Maintain SEDAR.com (System for Electronic Data Access and

Retrieval) which is a website that maintains all information for Retrieval) which is a website that maintains all information for publicly-traded companies in Canada.publicly-traded companies in Canada.


Primer on Securities Legislation in CanadaPrimer on Securities Legislation in CanadaWhat is a Security?What is a Security?

A security includes “ any document, A security includes “ any document, investment or writing commonly known as a investment or writing commonly known as a security”security”

• In determining whether a security exists, the In determining whether a security exists, the following are factors that are considered:following are factors that are considered:– Whether the promoter raises money and leads the Whether the promoter raises money and leads the

investor to expect a profitinvestor to expect a profit– Whether the investor has any control on how the Whether the investor has any control on how the

money is spentmoney is spent– Whether there is risk involved.Whether there is risk involved.


Primer on Securities Legislation in CanadaPrimer on Securities Legislation in CanadaOntario Securities Commission (OSC)OversightOntario Securities Commission (OSC)Oversight

• Given that the markets for stocks are concentrated in Given that the markets for stocks are concentrated in Ontario (TSX, TSX Venture Exchange) the OSC has Ontario (TSX, TSX Venture Exchange) the OSC has considerable responsibility and influence over considerable responsibility and influence over securities regulation in Canada.securities regulation in Canada.

• The OSC is involved in five major areas in which The OSC is involved in five major areas in which securities are transferred or traded:securities are transferred or traded:– Primary market offeringsPrimary market offerings– Secondary market tradingSecondary market trading– Activities of investment professionalsActivities of investment professionals– Insider tradingInsider trading– Takeover bidsTakeover bids

Securities OfferingsSecurities Offerings



Security OfferingsSecurity OfferingsThe Prospectus Versus Offering MemorandumThe Prospectus Versus Offering Memorandum

ProspectusProspectus• A disclosure document in support of public offering of securitiesA disclosure document in support of public offering of securities• Must provide “full, true and plain disclosure of all material Must provide “full, true and plain disclosure of all material

information pertaining to the security being issued”information pertaining to the security being issued”• Consists of two parts:Consists of two parts:

– Long-form prospectus – contains information about the corporate Long-form prospectus – contains information about the corporate issuer, directors, financial performance, operations, etc.issuer, directors, financial performance, operations, etc.

– Short-term prospectus – contains information pertaining to the Short-term prospectus – contains information pertaining to the particular securities that are being offered including price, type of particular securities that are being offered including price, type of security, intended use of the proceeds, etc.security, intended use of the proceeds, etc.

Offering MemorandumOffering Memorandum• A disclosure document in support of an offering of securities in the A disclosure document in support of an offering of securities in the

exempt marketexempt market• Has the same objectives of disclosure as a prospectus, however, Has the same objectives of disclosure as a prospectus, however,

offers significantly less information because of the nature of offers significantly less information because of the nature of exempt /sophisticated investorsexempt /sophisticated investors

Public Offerings of Securities Public Offerings of Securities IPOs and Seasoned OfferingsIPOs and Seasoned Offerings



IPOs and Investment BankingIPOs and Investment Banking

• IPO – Initial Public OfferingIPO – Initial Public Offering– Primary offering of securities to the public ( a first-time Primary offering of securities to the public ( a first-time

distribution by the issuer)distribution by the issuer)– Difficult to ‘value’ or price because there is no prior Difficult to ‘value’ or price because there is no prior

history of trading in the securities by unrelated parties history of trading in the securities by unrelated parties in arms length tradingin arms length trading

– Must be accompanied by a prospectus.Must be accompanied by a prospectus.


IPOs and Investment BankingIPOs and Investment BankingMotivation for IPOsMotivation for IPOs

• Going public requires the firm to incur significant Going public requires the firm to incur significant changes and costs including:changes and costs including:– Costs of meeting market listing requirements including the costs Costs of meeting market listing requirements including the costs

associated with information disclosure requirements expected of public associated with information disclosure requirements expected of public companiescompanies

– Underwriting and distribution costs associated with the public offering Underwriting and distribution costs associated with the public offering including prospectus and underwriters spread and potentially including prospectus and underwriters spread and potentially underpricing costs associated with the IPOunderpricing costs associated with the IPO

– Listing feesListing fees• The motivation for going public include:The motivation for going public include:

– Access to capitalAccess to capital– Greater public visibility (perhaps increasing the market demand for the Greater public visibility (perhaps increasing the market demand for the

firm’s products and services)firm’s products and services)– Ability for venture capital firm and/or entrepreneur to ‘harvest’ their Ability for venture capital firm and/or entrepreneur to ‘harvest’ their

investmentinvestment– Ability to reward managers through options that will now have a market Ability to reward managers through options that will now have a market

valuevalue


IPOs and Investment BankingIPOs and Investment BankingThe Stages of the IPO ProcessThe Stages of the IPO Process

17 - 1 FIGURE

Discussion triggers IPO

Preliminary prospectus: three to five months

Waiting period and road shows: one to two months

Pricing, distribution, and after-market stabilization: one-month

Initial filing: red herring

Final clearance


IPOs and Investment BankingIPOs and Investment Banking Types of Public OfferingsTypes of Public Offerings

1.1. Best efforts offeringBest efforts offering

2.2. Firm commitment offeringFirm commitment offering

3.3. Bought dealBought deal

4.4. Standby or rights offeringStandby or rights offering


IPOs and Investment BankingIPOs and Investment Banking IPO Underpricing IPO Underpricing

• Underpricing of an IPO occurs when the price of the IPO Underpricing of an IPO occurs when the price of the IPO is less than its market valueis less than its market value– Measured as the difference between the initial offering price and Measured as the difference between the initial offering price and

the price on the first day of trading.the price on the first day of trading.

• There is evidence of systemic underpricing in most There is evidence of systemic underpricing in most OECD countries (see Table 17 -1 on the following slide)OECD countries (see Table 17 -1 on the following slide)

• Reasons for underpricing and the various degrees of Reasons for underpricing and the various degrees of underpricing in different capital markets include:underpricing in different capital markets include:– Degree of competition for underwriting businessDegree of competition for underwriting business– Litigiousness of the investors in the countryLitigiousness of the investors in the country– ‘‘Spinning’ where the underwriter allocates IPOs to favoured clients Spinning’ where the underwriter allocates IPOs to favoured clients

knowing that they will make a large profit on the first day of trading.knowing that they will make a large profit on the first day of trading.


IPO Underpricing EvidenceIPO Underpricing Evidence

Country Sample Period Return

Canada 500 1971-1999 6.3

United Kingdom 3,122 1959-2001 17.4

United States 14,840 1960-2001 18.4

Australia 381 1976-1995 12.1

New Zealand 201 1981-1999 19.1

Table 17-1 IPO Underpricing Evidence

Source: Jay Ritter, "Dif ferences betw een European and American IPO Markets." European

Financial Management 9, no. 4 (2002), pp. 421-434.


Post-IPOs Regulation and Seasoned OfferingsPost-IPOs Regulation and Seasoned Offerings The Post-IPO Market The Post-IPO Market

• Following the IPO a quiet period is required before the Following the IPO a quiet period is required before the investment dealer’s research analysts can initiate investment dealer’s research analysts can initiate coverage on the company.coverage on the company.– The prospectus is assumed to provide sufficient information The prospectus is assumed to provide sufficient information

during the distribution phase.during the distribution phase.

• Misleading research reports were identified in the U.S. Misleading research reports were identified in the U.S. during the internet bubble and analysts from major during the internet bubble and analysts from major U.S. underwriters were charged for providing such U.S. underwriters were charged for providing such reports.reports.– These practices were found to be encouraged and rewarded by These practices were found to be encouraged and rewarded by

the underwriting firms as a form of ‘self-dealing’ where the the underwriting firms as a form of ‘self-dealing’ where the underwriter had a financial interest in the success of the security underwriter had a financial interest in the success of the security offering, and therefore, had it’s analysts write overly positive offering, and therefore, had it’s analysts write overly positive reports on the security.reports on the security.


Post-IPOs Regulation and Seasoned OfferingsPost-IPOs Regulation and Seasoned Offerings Continuous Disclosure Requirements Continuous Disclosure Requirements

• Following the IPO investors do not receive the Following the IPO investors do not receive the prospectus when investing in securitiesprospectus when investing in securities

• Public companies are expected to become reporting Public companies are expected to become reporting issuers and provide continuous disclosure including:issuers and provide continuous disclosure including:– Quarterly and annual financial statementsQuarterly and annual financial statements

– Annual information forms (AIF)Annual information forms (AIF)

– Proxy and information circularsProxy and information circulars

– Press releases on any material informationPress releases on any material information

• All required information for public issuers in Canada All required information for public issuers in Canada is available at SEDAR.comis available at SEDAR.com


Post-IPOs Regulation and Seasoned OfferingsPost-IPOs Regulation and Seasoned Offerings Seasoned Offerings and Short-Form Prospectuses Seasoned Offerings and Short-Form Prospectuses

• Reporting issuers in Canada can take advantage of the Reporting issuers in Canada can take advantage of the annual information form and short-form prospectus (a annual information form and short-form prospectus (a system known as the Prompt Offering Prospectus (POP) system known as the Prompt Offering Prospectus (POP) system) in order to speed their access to capital markets.system) in order to speed their access to capital markets.

• The short-form prospectus system has given rise to the The short-form prospectus system has given rise to the use of the ‘bought deal’ in Canada.use of the ‘bought deal’ in Canada.– In a bought deal, the underwriting contract is signed even before the In a bought deal, the underwriting contract is signed even before the

drafting of the preliminary prospectusdrafting of the preliminary prospectus• The underwriting market in Canada has become extremely The underwriting market in Canada has become extremely

competitive as information requirements have been competitive as information requirements have been decreased through the POP system. decreased through the POP system.

(See Table 17 -2 on the following slide for recent Canadian underwriting trends.)(See Table 17 -2 on the following slide for recent Canadian underwriting trends.)


Canadian FinancingsCanadian Financings

Book Runner Proceeds

US$ (million)

Proceeds

Rank

Share

(%)

Number

of Deals

CIBC World Markets 2,468.5 1 20.1 25

RBCDS 1,972.9 2 16.1 23TD Securities 1,309.5 3 10.7 21

Canaccord Capital 951.3 4 7.8 15

GMP Capital Trust 949.7 5 7.7 19

BMO Nesbitt Burns 693.1 6 5.7 15

Merrill Lynch 583.9 7 4.8 4

Scotia Capital 448.4 8 3.7 7

National Bank Financial 393.7 9 3.2 9

Sprott Securities 309.9 10 2.5 10

Top Ten 10,080.9 82.3 148

Industry 12,276.1 100.0 157

Source: Data from Thomson Financial Inc., Globe and Mail , July 12, 2006.

Table 17-2 Canadian Financings (January to June 2006)


Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:

– The basics of securities lawThe basics of securities law– About information asymmetry and the impacts of this About information asymmetry and the impacts of this

on financial markets, market participants and the on financial markets, market participants and the occurrence of financial fraudoccurrence of financial fraud

– The role of securities regulators and securities The role of securities regulators and securities regulation and the costs associated with regulation, regulation and the costs associated with regulation, monitoring and enforcement.monitoring and enforcement.

Concept Review QuestionsConcept Review Questions



Concept Review Question 1Concept Review Question 1Asymmetric InformationAsymmetric Information

How does the existence of asymmetric How does the existence of asymmetric information lead to market inefficiencies?information lead to market inefficiencies?


CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.

Investment Banking and Securities Law

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