DATA GATHERING

Sources of information:o Industry analysiso Government publications

NAICS Census PPI CPI

o Surveyso Industry studieso Trade press/trade associationso Business and financial press

WSJ Barron’s Financial Times Etc.

o Business information services Capital IQ SNL Financial

Reports, forms and scheduleso 10-K and 10-Qo 8-K – reports made to the SEC if an event that would materially affect the issuer’s financial

condition or share price, including: Business and operations Financial information Securities and trading markets Accountants and financial statements Corporate governance and management Asset-Backed Securities Regulation FD Financial statements and exhibits Other events

o Schedule 13D – requires anyone who acquires 5% or more of an issuer’s equity securities to notify the issuer, the exchange where the securities are traded, and the SEC within 10 days

o Schedule 13G – an alternative to Schedule 13D filed usually by institutional investors that have no intention to influence or control the issuer

o Schedule 13F – requires quarterly filings when institutional investment managers exercise investment discretion over at least $100 million in equity securities

o Proxy Statements on Form 14A – contains information that will be voted on during the annual shareholder meeting

o Beneficial Ownership Reports – Form 3,4,5 required of insiders that own stock Registration Statements

o S-1 – used for IPOso S-3 – short form registration available for WKSIs with at least $75 million in public floato S-4 – if securities are to be issued in connection with a mergero Proxy Statements – required in merger combinations, contains:

Press release Definitive agreement Fairness opinion Capital structure of transaction

Going Private Transactions:o Schedule 13E-3

Tender Offerso Schedule 14D-9 or Schedule TO

Communications with research department:o IB department is restricted from exercising any control whatsoever over its research departmento Prohibit communications between a member’s research and investment banking departments

other than to verify information or check conflictso Have to route written communication through compliance departmento Can’t threaten to retaliate for adverse, negative, or unfavorable research reports that may be

detrimental to the member’s current or prospective investment banking business

ECONOMICS

Gross National Product – measures the total value of all goods and services produced by a national economy (includes goods produced in and out of the U.S. by U.S.-based companies)

Gross Domestic Product – measures the output of goods and services produced by labor and property located in the U.S., without regard to the origin of the producer

o Real GDP – adjusted for inflation using constant dollars CPI – measure of inflation that measures the prices of a fixed basket of goods bought by a typical

consumer Inflation:

o Nominal rate less inflation rate = real rate Ex: bond earns 10% (nominal rate) and inflation is 3%, real rate = 7%

Disinflation – reduction in the rate of inflation Stagflation – prolonged period of a high rate of inflation at the same time as a high rate of

unemployment Leading Economic Indicators – precede the upward and downward movements of the business cycle

o Average workweek for production workers in manufacturingo Average weekly initial claims for state unemployment insuranceo New orders for consumer goods and materialso Vendor performance (companies receiving slower deliveries from suppliers)o Contracts and orders for plant and equipmento New building permits for private housing unitso S&P 500o Money Supply (M2)o Change in credit outstanding for business and consumer borrowingo Interest rate spreads, 10-year Treasury bonds less federal fundso Index of consumer expectations

Coincident Economic Indicators – mirror the movements of the business cycleo Employees on nonagricultural payrollso Personal income less transfer paymentso Index of industrial productiono Manufacturing and trade sales

Lagging Economic Indicators – change after the economy has moved through a given stage of the business cycle

o Average duration of unemploymento Relationship of inventories to sales, manufacturing, and tradeo Labor cost per unit of output for manufactured goodso Average prime rate charged by bankso Commercial and industrial loans outstanding

o Relationship of consumer installment credit to personal incomeo CPI for services

Market Capitalizationo Large-cap = more than $10 billiono Mid-cap = $2 billion to $10 billiono Small-cap = $300 million to $2 billiono Micro-cap = $50 million to $300 milliono Nano-cap = below $50 million

Economic Theoryo Keynesian:

States that government intervention in the economy is necessary for sustained economic growth and stability

Further states that government should use fiscal policy to combat the effects of inflation and deflation

Fiscal policy – government’s use of taxation and expenditure programs to maintain a stable growing economy

o Supply-Side Economics: Places an emphasis on reducing taxes and the size of government to stimulate the

economyo Monetary Policy:

Attempts to control the supply of money and credit in the economy. This in turn will affect interest rates causing an increase or decrease in economic activity

Money supply M1 = currency in circulation + demand deposits + other checkable deposits M2 = M1 + money market deposit accounts + savings and relatively small time

deposits + balances at money funds + overnight repurchase agreements at banks M3 = M2 + large time deposits + term repurchase agreements at banks and S&Ls

(no longer published by the FRB) Tools of the Federal Reserve Board (FRB)

o Setting reserve requirements Lowering reserve requirements banks extend more credit money supply increases

(opposite for raising reserve requirements) Multiplier effect – rate at which banks can create new money by relending deposits and,

in turn, creating new depositso Setting the discount rate

Decreasing the discount rate encourages borrowing, which expands the money supply Only rate directly set by the FRB

o Implementing open market operations Federal Open Market Committee (FOMC) oversees the FRB’s buying and selling of U.S.

government securities in the secondary market Most effective and frequently used tool of monetary control If the Fed buys securities, it pays for them with funds that are ultimately deposited in

commercial banks. This causes deposits at banks to increase and thus adds to the funds available for loans. The result is an increase in reserves

If the Fed sells securities to banks and dealers, this will tighten the money supply Repurchase agreement (repo) – contract entered into by the Federal Reserve to purchase

U.S. government securities from dealers, at a fixed price. This practice increases bank reserves as it is lending money

Reverse repo (matched sale) – occurs when the FRB sells securities to dealers with the intention of buying the securities back at a future date. This has the short-term effect of absorbing funds from the money supply

o Setting margin requirements By increasing margin requirements the FRB reduces the amount of brokers and banks

that may lend, causing the money supply to tighten Least effective method that the FRB uses to control credit because it only affects

securities market transactionso Utilizing moral suasion (jawboning)

Fed exerts its influence through the public media in effort to control the money supply

ActivityEffect on Money Supply & Credit (Loan) Availability

Impact on General Interest Rate Levels

Raise bank reserve requirements Decrease RaiseRaise the discount rate Decrease RaiseRaise the margin requirement Decrease RaiseSell securities in the open market Decrease RaiseLower bank reserve requirements Increase LowerLower the discount rate Increase LowerLower margin requirements Increase LowerBuy securities in the open market Increase Lower

Intermediation – the ability of financial intermediaries (such as banks) to attract deposits and, in turn, extend credit

Disintermediation – the process by which investors withdraw funds from banks and seek high-yielding investments elsewhere

Investment Objectiveso Growth strategy – investing in companies or industries that are expected to grow faster than

those of its peers Above-average earnings or revenue growth Pay little to no dividends Higher risk (high P/E ratios) Higher potential for capital appreciation

o Value investing – investing in companies that are underpriced from a fundamental or financial point of view

Low price-to-book Low P/E High dividend yield

o Growth at a Reasonable Price (GARP) – combines value and growth. The investor is seeking companies with good growth potential that seem to be undervalued

Low P/E Low PEG Low price-to-book

Investment risko Capital risk – risk that investors will not fully recover their entire investmento Credit risk – risk that an issuer may be unable to pay interest and/or principal when due on fixed

income securitieso Liquidity risk – the investor’s ability to sell a security quickly at a reasonable price compared to

recent transactionso Inflationary (purchasing power) risk – risk that, due to inflation, the value of a dollar will

decline over time, causing a decline in purchasing power

o Interest-rate risk – risk that if interest rates rise, the price of an investor’s bond holdings will decline

o Exchange-rate risk – risk that the income received from foreign investments will be worth less due to currency fluctuations

o Market (systematic) risk – risk that a security’s value may decline, not because of a change in the specific company, but due to a decline in the market as a whole (measured as Beta)

Investment strategies:o Momentum trading – describes a situation where prices are moving in a certain direction and

there is a high level of trading volumeo Short sales – involve the sale of a security that is not owned by the sellero Market neutral – used to describe an attempt to profit by buying securities while, at the same

time, selling short other securities within the same (or similar) sectoro Arbitrage investing – objective is to profit by identifying two related but mispriced securitieso Index investing – passive investing designed to minimize transaction costs and taxable eventso Distressed investing – involves investors searching for companies and/or securities that are in

default, bankruptcy, or moving in that direction

FINANCE

Balance Sheet Income Statement Cash Flow Statement Special Issues in Accounting:

o Depreciation Straight Line: typically used for book purposes MACRS: required by IRS – under this system the assets are fully depreciated and have

no salvage value Double-Declining Balance: only accelerated depreciation method allowed by the IRS

o Accounting for investments in stock: Cost method: up to 20% of company ownership Equity method: 20-50% of company ownership Purchase method: over 50% of company ownership

Mandatory for use in a cash deal Viewed as an acquisition of new assets Book value is “marked to market” Goodwill is created if purchase price exceeds fair value of assets acquired Minority interest

Balance sheet = liability Income statement = other expense to reduce net income by the amount of

company earnings not owned by the parento Goodwill Impairment

Step One: identify potential impairments by comparing fair value to book value Step Two: If carrying amount of goodwill exceeds its implied fair value, an impairment

loss is recognized equal to the excess and presented on a separate line item on the income statement

o Stock dividends vs. stock splits

Stock Split Stock DividendPaid in capital No change Increase

Retained earnings No change DecreasePar value No change IncreasePar value per share Decrease No change

o Inventory Cost of goods available for sale Cost of goods sold Periodic inventory system (physical counts) Specific identification method First In, First Out (FIFO) Last In, Last Out (LIFO) Weighted Average

o Restructuring charges – shown on the income statement in the operating section as well as in the footnotes of a company’s financial statements

Financial Statement Analysis:o Turnover Ratios

Asset Turnover = Sales/Average Assets Receivable Turnover = Sales/Average Receivables Payables Turnover = COGS/Average Payables Inventory Turnover = COGS/Average Inventory

o Liquidity Analysis Ratios Current Ratio = Current Assets/Current Liabilities Quick Ratio (Acid Test) = (Cash and Equivalents + Receivables)/Current Liabilities

o Probability Analysis Ratios EPS Fully diluted EPS EBITDA margins Profit margins Return on assets = Net Income/Average Assets Return on equity = Net Income/Average Equity Return on invested capital = (EBIT * (1-T))/Invested Capital

Invested capital has many different calculations, including Fixed Assets + Current Assets – Current Liabilities – Cash Fixed Assets + Noncash Working Capital Total Assets – Noninterest Bearing Current Liabilities + Excess Cash

Days sales outstanding (DSO) = Accounts Receivable / (Net Sales/365)o Capital Structure and Capital Markets Analysis

Debt-to-total capital = Debt / (Debt + Equity) Debt-to-equity = Debt / Equity Debt-to-EBITDA = Debt / EBITDA Dividend payout = Dividends / Net Income Interest coverage = EBIT / Interest

GENERAL SECURITIES

Activities allowed by nonregistered persons:o Extend invitations to firm-sponsored eventso Inquire whether a prospective customer wishes to discuss investments with a registered repo Inquire whether a prospective customer wishes to receive investment literature from the firm

Manipulationo Fraudulent to withhold material information from a client

o Wash sale = purchasing and sale of securities without any beneficial change of ownership (buying stock from one broker and selling from another at the same price) – also called “painting the tape”

o Use of pro forma financials is considered fraudulent unless the assumptions are clearly laid out SEC Rule 10b-18

o Controls how an issuer or affiliate may buy its own stock in the secondary market (does not apply to public tender offers)

o 10b-18 Safe Harbor Use of one broker dealer to make purchases on any trading session Avoid making purchases at certain times of day

Can’t be the first transaction of the day Can’t be during the last half-hour of normal trading day (unless actively traded,

then can’t be within last 10 minutes) Limit the bid or purchase price

Can’t be higher than the highest independent bid or the last independent transaction price

Limit the amount of stock purchased on any single day Total volume purchased may not exceed 25% of the ADTV for that security Once a week you can effect one block purchase in excess of 25% if no other 10b-

18 purchases are made that day NYSE Rule 77

o Prohibits dealings and activities for members on the Floor from: Buying or selling securities “on stop” above or below the market Buying or selling securities “at the close” Buying or selling dividends Betting on the course of the market Buying or selling privileges to receive or deliver securities

Insider Tradingo Unlawful, in connection with the purchase or sale of any security, to:

Employ any device, scheme, or artifice to defraud Make any untrue statement of a material fact or omit to state a material fact necessary in

order to make the statements made not misleading Engage in any act, practice, or course of business that operates or would operate as a

fraud or deceit upon any persono Tippers and tippeeso Insider trading legislation as a result of 1980s scandals:

Insider Trading Sanctions Act of 1984 (ITSA) Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA)

o Establishment of procedures: System for monitoring employees’ personal trading and trading in firm proprietary

accounts Restriction or monitoring of trading in securities where the firm has access to inside

information Procedures to restrict access to files containing confidential information, including the

establishment of information barriers Education of employees regarding insider trading issues

o Information barrier procedures Preventing the transmission of confidential information from one department to another

within a broker-dealer (Chinese walls) SEC has not mandated any particular system

o Restricted and Watch Lists:

Lists apply to both employees and to solicited transactions with customers Restricted list is distributed to all employees Watch list is only known by senior management

o Consequences Civil: up to 3 times the amount of gain, or loss avoided Criminal:

Individuals: up to $5 million fine and up to 20 years in prison for each violation Corporations: up to $25 million fine for each violation

Bounties: the Act allows payment of bounties, but limits to no more than 10% of the penalty

Office of Supervisory Jurisdiction (OSJ)o Any location at which one or more of the following activities takes place:

Market-making and/or order execution Structuring of public offerings or private placements Maintaining custody of customers’ funds and/or securities Final acceptance of new accounts Review and endorsement of customer orders Final approval of advertising or sales literature Responsibility for supervising other branch offices

Branch officeso Where one or more of the firm’s associated personnel regularly conduct the business of effecting

transactions in, or inducing or attempting to induce the purchase or sale of any securityo Do not include:

Nonsales office (back-office and operations offices) Locations of convenience Floor of an exchange Temporary offices Location primarily used for nonsecurities business and from which less than 25 securities

transactions are effected annually Record keeping

o Includes emailo Required to maintain records for 3 years

Anti-Money Laundering (AML)o All member broker-dealers are required to have an annual AML test for employeeso Penalties: up to 20 years in prison and $500,000 or twice the amount of money involved,

whichever is more Customer Identification Program (CIP)

o U.S. Citizens: client name, date of birth, address, and taxpayer IDo Non-U.S. Citizens: all of the above and at least one of the following:

Taxpayer ID Passport number and country of issuance Government issued document with a picture that provides proof of nationality

Accounts for employees of other member firms:o Notify the employer member in writing of the intention to open the accounto Send duplicate confirmations and statements to the employer member, if requestedo Notify the person opening the account that these procedures will be followed

Private securities transactionso Selling away – transactions outside the regular scope of a person’s employment

If compensated for the transaction, the member must specifically approve the transaction in writing

If no compensation, the member may require the person to adhere to specific conditions

Guarantees – never guarantee against losses in any way Sharing in accounts is acceptable, provided:

o Employee has made a financial contributiono Sharing of profits and losses is in direct relationship to the employee’s financial contributiono Employee has obtained written permission from the member firm carrying the account

Borrowing and lending with customers, unless one of the following is meto Customer and registered person are immediate family memberso Customer is a financial institution regularly involved in the business of extending credito Both parties are registered with the same firmo Loan is based on a personal relationship between the customer and registered persono Loan is based on a business relationship independent of the customer-broker relationshipo If the last 3 prevail, the firm must approve prior to lending activity

Gifts:o No gift greater than $100 per recipient per year to people employed by other member firmso Excludes occasional meals, tickets, reminder advertising, and expenses related to legitimate

business travel Members are required to maintain a separate file of all written complaints in each office of supervisory

jurisdiction Quarterly reports:

o Required to provide statistical and summary information about customer complaints on a quarterly basis, unless no complaints were received during the quarter

Resolving Problems:o Code of Procedure: describes FINRA’s disciplinary process

Sanctions: a Hearing Panel may impose the following Censure a member firm or associated person Fine a member firm or associated person (no limit) Suspend the membership of a firm or suspend the registration of a person Expel a member firm or cancel its membership; revoke or cancel the registration

of an associated person Suspend or bar an associated person from association with any member firm Impose any other fitting sanction

Cannot sentence anyone to prison Appeals: respondent has 25 days to file an appeal

Hearing Panel National Adjudicatory Council (NAC) SEC Federal Courtso Code of Arbitration: requires that disputes between members and other members be settled by

arbitration

Mediation Arbitration

A negotiation processA hearing process at which the two parties present their cases

Mediator attempts to facilitate a resolution – does not impose a settlement

Arbitrator imposes a binding settlement

Either party can withdraw Parties cannot unilaterally withdrawInformal discussion process More formal process – testimony under oath

Settlement must be mutually agreeableArbitrator decides the outcome – it is more of a “win or lose” decision

Parties must be willing to see strengths in other side’s position

Useful where the position of one or both parties is inflexible

Can be less costly and quicker than arbitration Often more expensive and time-consuming than mediation, but usually cheaper and quicker than

litigationProcess is private, settlement is confidential Hearings are private, decision is public

MERGERS & ACQUISITIONS (M&A)

Merger – two companies join together and reorganize as a new entity. Shareholders from both companies surrender their stakes and are given ownership in a newly created entity

Acquisition – the buyer acquires the target company for either cash and/or stock. The target company ceases to exist in a legal sense.

Deal Participantso Sellerso Buyers

Strategic Financial

Which buyer will pay more? In normal markets Strategic buyers will pay moreo Synergieso Access to low cost of capital (credit or stock)

Valuationo Comparable companies analysiso Precedent transaction comparableso DCFo Pro formao LBO

Deal structureo Asset Deal – Buyer wants assets because of tax advantages and step up in basis, ability to leave

behind liabilitieso Stock Deal – Seller wants stock deal because of tax advantages and ability to leave behind all

liabilities Transaction currency

o Cash buyout – simplest type of deal Provides certainty for the seller Creates an immediate taxable event for the seller

o Acquisition with stock – target’s shares are tendered for shares of the acquiring company Does not create an immediate tax liability for the sellers (assign cost basis of their old

position to the new shares) Constant (fixed) share exchange agreement – buyer offers a fixed ratio of its shares

regardless of any price fluctuations that may occur in either stock between signing and closing

If the acquirer’s shares rise in value preclosing, the target is effectively paid more and, if the price declines, the seller receives less

Fixed value agreement – the deal’s total dollar valuation is guaranteed by altering the number of shares issued to the target

Collars – negotiated parameters which set a lower range (the floor) and an upper range (the cap) on the acquirer’s stock price, to give both parties high and low end valuations for the transaction

Material adverse change (MAC) clauses Floating collar – buyer and seller agree to a fixed exchange ratio provided the acquirer’s

share price remains within the collar range

Fixed value (payment) arrangement – the buyer guarantees to the target firms’ shareholders that they will be paid a fixed dollar value in stock, provided the buyer’s shares remain within the collar

Transaction Typeso Consolidation merger – Brand new company is formed for the purpose of buying both companies

and combining them under the new entityo Spinoffs – When a company is seeking to divest a division

Each shareholder of the parent retains her original shares, but is also given shares in the newly created entity

No immediate tax consequenceso Splitoffs – Corporation is split into pieces

One group of shareholders will ultimately own shares solely in the original parent, while the other group will own shares solely in the split-off entity

Used to split corporate assets between groups of feuding shareholders No tax liability is created

o Reverse Merger – Private company buys a public shell company with the acquirer’s shareholders swapping their shares for a majority stake in the publicly traded corporation

Doesn’t have to be a shell corporationo Triangular mergers – Involves three entities (buyer, target, subsidiary owned by buyer)

Forward triangular – subsidiary merges with the seller. The legal structure that was the selling entity is liquidated while the subsidiary survives

Reverse triangular – subsidiary merges into the seller with the target company as the surviving entity

Used when selling entity has significant contracts in place that would not survive the acquisition

Merger Typeso Vertical merger – transaction between two firms at different levels of the production chaino Horizontal merger – combining two companies that are in direct competition with one anothero Product extension merger – transaction involving two companies that sell different, but

somewhat related productso Market extension merger – combination of two companies that sell the same products or

services into different marketso Conglomerate merger – when buyer and seller companies sell products in completely different

markets Hostile Deals: Takeover Defenses

o Shareholders rights plan – target company issues rights to existing shareholders to acquire a large number of new securities

o Staggered boards – staggering board election to prevent hostile takeoverso Supermajority approvals – requiring the vast majority of BOD members to agree on significant

issues such as mergers or the sale of a firmo Golden parachutes – severance payment made to a senior officer in the event of a takeover or

change of control Seller Initiated Transactions

o Controlled Auctiono Full Public Auction

Auction Processo Sign the engagement lettero Develop contact/prospect listo Create the teasero Confidentiality agreement

o Confidential information memorandumo Distribution of initial bid procedure lettero Creation of the data roomo Conducting management presentationso Collection of initial bidso Evaluation of initial bidso Term sheet creationo Final bid procedure lettero Final bid placemento Selecting the winnero Signing definitive agreementso Creation of fairness opinion(s)o Signing and closing the deal

Distressed Sellerso Chapter 11 Bankruptcy (reorganization)o Chapter 7 Bankruptcy (liquidation)

Tender Offerso Buyer goes directly to the shareholders when seeking to acquire shares in a companyo Often part of a takeover strategy or an attempt to get sufficient votes to gain Board representationo Must specify the period the offer is extended for, the price, and quantity of shares the buyer

wants to purchaseo Can be initiated by the company itself to acquire its own securitieso SEC rules require tender offers be conducted in a fair manner, including the following rules:

Shareholders must be notified no later than 10 business days after the tender is made Management must advise shareholders of a recommendation Must generally be held open for at least 20 business days from the time they are

announced to security holders If the offer is amended, the revised offer must remain open for at least 10 more business

days In order to extend the expiration, public announcement must be made on the earlier of (i)

9am EST on the day after expiration or (ii) opening of the exchange on the next business day

Fraudulent to not pay the tender or to fail to return the securities tenderedo Rule 14e-5 – no open market purchases during the tender period

Buyers engaged in a tender can’t buy additional shares in the open market once the tender has commenced

Exceptions Purchases by the dealer-manager or its affiliates on an agency basis Purchases on a principal basis, provided the dealer-manager and its affiliates are

not market makers Purchases by an affiliate of the dealer-manager, if the affiliate maintains and

enforces written policies and procedures that are designed to prevent the flow of information, and the purchases are not made to facilitate the tender offer

Securities can be tendered only if the investor is long the stock, or long an equivalent security

o Rule 14e-1 – extension of time period May not extend unless done in a press release or other public announcement

o Rule 14d-9 – notification of tender Company must notify shareholders within 10 business days Schedule TO must contain the following (used as the basis for the proxy statement):

Summary term sheet Subject company information Identity and background of filing person Terms of transaction Past contacts, transactions, negotiations, and agreements Purpose of the transaction and plans or proposals Source and amount of funds or other consideration Interest in securities of the subject company Persons/assets retained, employed, compensated, or used Financial statements

o Prohibited practices Trading with material nonpublic information regarding a tender offer Rule 14d-10 – no preferential pricing

o Issuer Share Buybacks Often use a modified Dutch auction

o SEC Review of Issuer Distributed Materials Going private – SEC Rule 13e-3 Federal filings required in M&A

Schedule 13D – must file Schedule TO as soon as practical on the commencement date

File Form 13D within 10 days of the transaction Mini-Tenders – no need to file if the tender is less than 5% Schedule 8-K – initial regulatory document filed in a friendly M&A transaction Rule 145 – applies to situations where securities are offered as a result of business

combinations due to mergers, acquisitions, etc.o Securities are required to be registered, likely with Form S-4

SEC Rule 165 – written communications are permitted once there is a public announcement of a business combination

Form S-4 – if securities will be offered in connection with a merger or acquisition, etc.

Rule 135 – an issuer is permitted to publish a notice that contains only limited information

o Nameso Business descriptiono Date and timeo Brief transaction description

Regulation M-A – facilitate communications and disclosures made by companies engaged in cash and stock tender offers, or mergers and acquisitions

o Requires a summary term sheet be provided to investors as part of the disclosures made in a tender offer or merger

Hart Scott-Rodino Acto Federal antitrust law

Thresholds: Acquiring party will hold aggregate stock and assets valued at more than $65.2

million Total transaction is valued at more than $260.7 million

OFFERING TYPES

Types of issuer organizationso C-Corporations

Pay corporate taxes on income Shareholders must pay personal taxes on profits received (double taxation) No limit on number of shareholders

o S-Corporations Taxed like a partnership (pass through to shareholders) Limit of 100 shareholders All shareholders must be U.S. citizens or resident aliens Shareholders must be individuals, estates, or certain types of trusts Must be domestic Cannot be part of an affiliated group of corporations Only one class of voting stock

o Limited Liability Company Pass through for taxes Limited liability for owners Does not continue to new owners oftentimes

o Partnerships Pass through for taxes General partnerships have unlimited liability for each owner May be dissolved at any time by any partner

o Real Estate Investment Trust (REIT) 95% of gross income must be derived from real estate-related activities Must be a trust Must distribute a minimum of 90% of its income to shareholders Must be at least 100 separate shareholders and 5 or fewer individuals may not own more

than 50% of its common stock during the last half of its taxable year Types of Investors

o Institutional investors Bank Savings and loan association Insurance company Investment adviser Any other entity with total assets of at least $50 million 403(b) employee benefit plan Member or an associated person of the member, or a person acting on behalf of an

institutional investor Qualified Institutional Investor

Insurance companies, registered investment companies, pension plans, corporations, and registered investment advisers

Buyer must be purchasing for its own account or the account of other QIBs Buyer must own and invest at least $100 million of securities of issuers not

affiliated with the buyer Hedge Funds Private Equity Firms

Types of Financing Transactionso Public Offeringo Private Placemento Private Investment in Public Equity (PIPE)

Stock price often declines when announced for 2 reasons: Increase in shares that will become outstanding Perception that the company is in need of capital and has limited means of raising

it

SEC Registration Formso S-1: basic form that issuers may use, generally used by IPO candidateso S-3: used for shelf registrations (short form). Only available for issuers with $75 million in

public float and not available for issuers that have failed to pay dividends on preferred stock, interest on a bond, or are delinquent on SEC filings

o S-4: used for issues that are a result of M&A, consolidations, reclassifications of securities, or transfers of corporate assets

o S-8: registering securities that are made available through employee benefit plans Registration Process:

o Requirements for filing: 5 copies of preliminary prospectus, which must include

Character of issuer’s business Balance sheet no older than 90 days prior to the filing Income statements for the latest year and 2 preceding years Amount of capitalization and use of proceeds Monies paid to affiliated persons or businesses of the issuer Shareholdings of senior officers, directors, and underwriters

o Preregistration process Preparing registration statement Underwriters may not discuss the new issue with customers during this period Underwriters perform due diligence

o Waiting Period SEC reviews the registration to determine that it is complete Underwriters are permitted to:

Discuss the issue Provide the red-herring (preliminary prospectus) Record names of potential purchasers

Underwriters are not permitted to: Sell the new issue Accept payment for the new issue

Blue sky laws Effective date – 20 days after the last amendment filed in response to a deficiency letter

o Posteffective Period Marketing process Price of the offering is set on the morning of the effective date Final prospectus sent to potential purchasers Stop Order:

If new, material information becomes available after the effective date, the SEC can require the prospectus to be amended and all sales orders be ceased until that prospectus is effective

o Prospectus Delivery Requirement Prospectuses must be delivered for 40 days after the effective date in the case of issuers

with publicly traded securities already outstanding and 90 days for IPOs Two exceptions

If an issuer was subject to the reporting requirements of the SEA of 1934 prior to the filing, there is no prospectus delivery requirement

If the issuer was not a reporting company prior to filing, but will be listed on an exchange or on NASDAQ as of the effective date, the requirement applies for 25 days

Reporting Status at Exchange or Nasdaq Listing After the Offering, Dealers Must

Time of Filing Status Provide a Prospectus forNonreporting Will be listed 25 Days

NonreportingWill NOT be listed and is not an IPO

40 Days

Nonreporting Will NOT be listed and is an IPO 90 Days

NonreportingAftermarket prospectus requirements do not apply

o Categories of Issuers: SEC Rule 405 defines the different categories of issuers Well-Known Seasoned Issuer (WKSI) – required to file reports under Section 13(a) or

Section 15(d) of the SEA of 1934 and meet the following: Eligible to register on Form S-3 (short form of registration) or Form F-3

(registration statement for certain foreign private issuers) Within 60 days of eligibility, must have:

Market cap greater than $700 million Issued at least $1 billion total nonconvertible securities, other than

common equity, in primary offerings for cash in the past 3 years May not be an ineligible issuer Shelf registrations are immediately effective with no SEC review

Majority-Owned Subsidiary of WKSI – qualifies as WKSI if: Securities are nonconvertible, other than common equity, and parent guarantees

the securities fully and unconditionally Securities are investment-grade Securities are guarantees of nonconvertible securities

Seasoned Issuer Eligible to use Form S-3 or F-3 to register a primary offering of securities

Unseasoned Issuer Required to file reports under Section 13 or Section 15(d) but does not meet the

requirements for Form S-3 or Form F-3 Nonreporting Issuer

Not required to file reports, even if the issuer files reports voluntarily Ineligible Issuer

Issuers required to file reports that have failed to do so Blank-check company Shell company Penny stock issuer LP offering its membership units through methods other than a firm commitment

underwriting Issuer that has filed for bankruptcy or a filing was made against the issuer for

insolvency in the past 3 years Issuer convicted of a felony or misdemeanor that involves securities in the past 3

years Issuer that has been the subject of a refusal or stop order

o Shelf Registration: Governed by Rule 415; allows securities to be sold on a delayed or continuous basis

For securities sold in connection with a business combination, registration is allowed only for an amount that may reasonably be expected to be sold within 2 years after the initial date

Standard shelf registrations are valid for 3 years after initial effective date if:

An offering that will begin immediately and last for a period greater than 30 days from the effective date

An offering that is for S-3 or F-3 registered, offered and sold on an immediate, continuous, or delayed basis

o At-the-Market Offerings (ATM) Securities are sold at the prevailing market price directly into the secondary market

through a designated broker-dealer on a continuous basis Only S-3 or F-3 eligible can use ATMs

o Types of Offering Communications: Written Oral (includes recordings) Research Reports Advertising Internal Syndicate Memoranda

o Gun-Jumping Provisions: restrict the type of communications that may be made during a registered public offering

Rule 134: Communications not deemed a prospectus Tombstone ads shown in the newspaper may include:

Name of the issuer Full title of security Amount of offering Business description Price of security Date of sale Underwriters Statement of effectiveness Contact information Offering schedule Exchanges Selling security holders (if disclosed in prospectus)

Rule 135: Generic advertising Advertisements describing, in general, how investment companies work

Gun-jumping safe harbors Rule 168 allows the issuer to continue publishing or disseminating regularly

released factual business and forward-looking information at any timeo Electronic road shows:

Live real-time road shows are not written communications Live road shows are oral communications Recorded road shows are written communications Road shows for follow-on offerings and nonconvertible debt offerings do not need to be

filed with the SECo Regulation S-K

Establishes guidelines for the format used for projectionso Regulation S-X

Establishes format and content for financial statements Pro forma Schedules Interim statements Accountant reports Consolidated and combined statements ESOPs, etc.

Research Reports:

o Rule 137: Persons not participating in an offering Broker dealers that are not involved in an offering can publish research reports for

securities that are in the registration process Broker dealer may distribute research reports for securities in registration when it does so

on a regular basiso Rule 138: Nonequivalent securities

If a registration statement has been filed for a nonconvertible debt security or a nonconvertible preferred stock, a broker dealer may publish or distribute in the normal course of business reports regarding common stock and convertible securities of the issuer (EVEN IF BROKER DEALER IS IN THE DEAL)

o Rule 139: Research Reports Can publish reports on WKSIs whenever Industry reports must contain substantial information regarding certain companies

Communication-Related Liabilityo False Registration Statement: the parties that may be sued for untrue statements and material

omissions: Everyone who signed the registration statement Every director or partner of issuer at time of filing Every accountant, engineer, or appraiser named as having prepared or certified any part

of the registration statement Every underwriter

o Salespersons – liable for the investment amount, reasonable amount of interest, and amount of income received from the investment if they did not exercise reasonable care regarding the untrue statements

Regulation FD – Fair Disclosureo Bars issuers from selectively disclosing nonpublic, material information to securities

professionals or to shareholders if it is “reasonably foreseeable” that they will trade on the information

o If the disclosure was intentional, then the company must simultaneously disclose the information to the public

o If the disclosure was unintentional, the company has 24 hours to publicly disclose the information

Sarbanes-Oxley Acto Annual reportso Financial disclosureo CEO and CFO certifications of annual and quarterly reportso Loans to officers and directorso Disclosure of insider transactionso Code of ethicso Section 404 – stress test on internal controls

Exempt securitieso Certain securities are exempt from the registration process, including:

U.S. government and government agency securities Municipal securities Nonprofit organizations Short-term corporate debt (less than 270 days) Domestic bank and trust companies (not bank holding companies) Small business investment companies (SBIC)

o Regulation A: Exemption for small issues of securities

Company must be U.S. or Canada-based with 2 years of financial statements

Maximum amount is $5 million within a 12 month period and no more than $1.5 million can be sold by current shareholders

Issuers may not make a written or oral offer unless a Form 1-A has been filed with the SEC

Preliminary or final offering circular must be distributed to prospective buyers at least 48 hours prior to mailing confirmation of the sale

Issuers are allowed to “test the waters” regarding investment interest prior to filing an offering statement with the SEC

o Exempt Transactions Private Placements

Placement Agent Placement Agent Agreement Engagement Letter Teaser Term Sheet Confidentiality Agreement Subscription Agreement Section 4(2) exemptions: exempts from registration transactions by an issuer that

does not involve a public offering Section 4(6) exemptions: exempt if:

Total amount is less than $5 million No advertising or public solicitation may be used Only sold to accredited investors (includes institutional investors)

Regulation D Also allows 35 nonaccredited investors to participate Form D must be filed with the SEC no later than 15 days after the first sale

of securities Rule 504: covers offerings less than $1 million within a 12 month period

Unlimited number of investors without regard to experience or sophistication

Three types of issuers are not eligible: SEC Reporting companies Investment companies Development stage companies with no business plan

Rule 505: covers offerings less than $5 million within a 12 month period Unlimited number of accredited investors

Financial institutions Director, executive officer, or GP of the issuer Individuals that have net worth > $1 million or gross

income for each of last 2 years of at least $200k ($300k with spouse)

Rule 506: covers offerings of unlimited amounts Nonaccredited investors must be restricted to those who, either

alone or with their purchaser representative, have the knowledge and experience in financial and business matters to be able to evaluate the merits and risks of the investment

Restricted securities: Securities under Regulation D are cannot be sold until they become

registered, or they are sold under a registration exemption 144A: permits the sale of restricted stock to “qualified institutional buyers”

without the conditions imposed by Rule 144 Ineligible securities

Securities that are the same class as those listed on an exchange or quoted on Nasdaq

Securities issued by registered investment companies Qualified Institutional Buyers (QIB)

Insurance companies Registered investment companies Small BDCs Private and public pension plans Certain bank trust funds Corporation, partnerships, business trusts, and certain nonprofits Registered investment advisers *Must be purchasing for its own account or the account of

other QIBs *Must own and invest at least $100 million or securities of issuers

not affiliated with the buyer Rule 144

Holding period With restricted stock, the purchaser must hold the stock for six

months before selling it (begins when the securities were bought by the original purchaser and must have been fully paid for at time of purchase)

Six month period applies to: Individuals purchasing stock Individuals given the stock Securities acquired by a trust from a beneficiary who was

the original purchaser Securities acquired by a pledge from a pledgor who was the

original purchaser No holding period for estates of a deceased person No holding period for control stock Holding period applies for restricted stock

Exception = person who has not been an affiliate of the company for at least three months prior to the sale and has owned the stock for at least one year prior to the sale

TYPES OF SECURITIES

Preferred vs. common stock – preference over common:o Regarding payment of dividendso In the event the company has to liquidate its assets

Stockholders have the right to:o Freely transfer shareso Inspect certain books and records of the company

Dividends:o Declaration Date = date that the dividend is authorizedo Record Date = date on which the shareholder must officially own the stock to be entitled to

receive the dividendo Ex-Dividend Date = Time between record date and date that the dividend is paid when the stock

trades “without the dividend” Voting

o Only common stockholders have voting rights

o Statutory voting = shareholders vote each of their shares once for each director slot being contested

o Cumulative voting = shareholders may multiply the number of shares they own by the number of directors being elected and cast all the votes in any way they want

Preferred Stocko Always carries a specified dividend

o Only represents the maximum amount, if the company is not performing they may choose not to pay out preferred dividends

o Cumulative vs. Non-cumulative: With cumulative preferred, if the dividend is suspended for a period of time, the preferred

shareholders must receive payment for the dividends deferred in years past before the common shareholders get anything

Ex: If over the last 3 years preferred shareholders specified dividend amount is $5 per year but they only received $2 per year, they must receive $11 before the common shareholders receive anything ($6 for years past and $5 for current year)

In non-cumulative preferred, dividends in arrears are not paid to stockholderso Participating Preferred: in addition to the specified dividend rate, if common dividends reach a

specified level, the preferred owners get additional dividendso Callable Preferred: the company has the right to repurchase (call) the stock at a specified price

some time in the future. Usually the call price is higher than par value.o Convertible Preferred: Ability to exchange shares for common stock at a specified price at the

shareholders’ discretion Determine the conversion ratio by dividing the par value by the conversion price

Ex. Par value = $100, conversion price = $25 Conversion ratio = 4-to-1 and the preferred shareholder would receive four

shares of common stock for each share of preferred Appeals to investors who want higher, more secure income than common stocks, but also

want the higher potential for capital appreciation

Characteristic Common Preferred

Ownership in the company P PMore likely to receive regular dividends PHigher priority if the company goes bankrupt PGreater potential for capital appreciation PVoting rights PIssued with a specific dividend rate P

oDividend Yield = Annualized dividend / current stock price Rights and Warrants:

o Preemptive right – if the corporation issues new stock, current shareholders have the right to buy before the shares are offered to the public

o Rights Offering – Process of offering preemptive rights to common shareholderso Subscription Price – Purchase price for a rights offering, which is well below the current market

value of the stocko Warrants

Similar to stock options, but unlike options, warrants do not expire for a number of years after issuance (some are perpetual).

Subscription price is usually higher than the current market price of the stock when it is first issued.

Can usually be detached and sold separately from the underlying securityo Stock Appreciation Rights – Issued by a company and provide employees (not investors) with

the right to receive the difference between the current market value and a fixed price American Depositary Receipts or Shares

o Used to facilitate trading of foreign stocks in the United Stateso ADR represents a claim to foreign securities, with the shares themselves being held by U.S.

banks abroado Sponsored ADR – Company pays a depositary bank to issue shares in the U.S. Issue will be on

NYSE or Nasdaq.o Unsponsored ADR – Company does not pay for the cost associated with trading in the U.S. Issue

will be in the OTC market. Fixed Income Securities (Bonds)

o Par Value – Principal or face valueo Prices - $1,000 face value = 100% = 100

Each 1% increment is known as a pointo Maturity Date – Day on which the issuer mush pay the principal of the bond to the investoro Coupon Rate – Stated amount of interest that the issuer agrees to pay. Typically bonds pay

interest semiannually.o Zero-Coupon Bonds

Do not pay interest at regular intervals Typically bought at a deep discount Yields are usually slightly higher but prices tend to be more volatile

o Calculating returns: There are 4 ways to calculate returns on fixed income securities: Nominal yield – stated, fixed coupon Current yield – Annual interest payment divided by current market price Yield to maturity – Most widely used. Includes yearly interest as well as the difference

between what the investor paid for the bond and the amount received at maturity. Yield to call – Takes into account a bond’s cash flow through its first call date. It is

calculated the same way as yield to maturity, except that it reflects the bond’s interest payments until it is called, rather than when it matures

o Call Provisions Refunding – When the issuer has the option to retire a more expensive bond and

refinance with a lower interest rate bond Call Risk – Risk that bondholders take that the issuer will call the bond in a falling

interest rate environment Call Protection – Restriction on how soon the call feature can be exercised, typically 5-10

years from the date of issue Call Premium – Issuer will usually need to pay investors more than the par value of the

bonds in order to compensate them for the call risko Sinking Funds – Funds that issuers set up to accumulate money to redeem their bondso Put Provisions – Gives the bondholder the right to redeem the bond on a specified date or dates

prior to maturity, usually receiving par value.o Yields on callable bonds would be higher than the same bonds that are not callable, to give

investors an incentive to purchase callable debto Yields on bonds with put features are typically lower, given the ability of bondholders to redeem

their bonds and reinvest the principal should interest rates rise.o Prices and Yields: An Inverse Relationship: As interest rates rise, the value of existing bonds

will decline since the demand for existing bonds that now offer lower interest rates will decline, driving down their prices. If interest rates decline, the value of existing bonds will increase since

they are worth more than a new bond with a lower coupon. Therefore, yield and price movements have an inverse relationship.

o Relationship of prices and various yield measurements Discount bond: Nominal yield < Current yield < Yield to maturity Premium bond: Nominal yield > Current yield > Yield to maturity Prices of long-term bonds tend to fluctuate more than those with shorter maturities Bonds selling at a discount fluctuate more than bonds selling at a premium Short-term bonds’ yields fluctuate more than those for long-term bonds.

o Duration or Modified Duration: Duration is a measure, expressed in years, of a fixed-income security’s price sensitivity to

increases or declines in interest rates. Duration measures the % change in the market value of a bond, given a small change in

interest rates Duration allows the comparison of interest-rate risk among securities with different

coupons, maturities, and credit qualityo Convexity

The relationship between yield and price is not linear Positive convexity describes the condition where, as yields decline, prices increase at a

faster rate for long-term bonds as compared to intermediate or short-term bonds. In other words, durations lengthen when rates fall and durations shorten as rates rise

Negative convexity occurs in mortgage-backed securities where duration shortens when rates fall and lengthens when rates rise

o Trust Indenture Act of 1939 – A corporation issuing more than $10 million of debt must provide an indenture between the issuer and a trustee who will act on behalf of the bondholders.

o Types of Bonds: Secured Bonds

Mortgage – collateral = real estate Equipment trust – collateral = equipment Collateral trust – collateral = stocks or bonds

o Liquidation Rights: 1st = Bondholders

Secured Unsecured Subordinate 2nd = Preferred stockholders 3rd = Common stockholders

o Convertible Bonds: Conversion price is set at the time the bond is issued Number of shares to be received is calculated with conversion ratio

Par Value of Bond ($1,000) divided by Conversion Price Conversion price and ratio are adjusted for stock splits and stock dividends Advantages:

Allow corporations to borrow at a lower rate because convertible feature is attractive to investors

Give investors a greater degree of safety than preferred or common stock but give them the potential for capital appreciation if the underlying stock appreciates in value

Investor has downside protection Disadvantages

Significantly dilutes current shareholders if all the bonds are converted into stock

Forced conversion: when the investor is essentially forced to convert if the bonds are called by the issuer at a disadvantageous point in time

o Other types of bonds Income bonds – Issuer promises to pay principal at maturity, but only promises to pay

interest if it has sufficient interest Eurodollar Bond – Dollar-denominated deposit outside the U.S. Pay principal and interest

in U.S. dollars and are issued outside the U.S. Yankee Bond – Allow foreign entities to borrow money in the U.S. marketplace Eurobond – Sold in one country and denominated in the currency of another

Treasury Securitieso Savings bonds = non-negotiable because they can’t be sold in the secondary market (only

redeemable by the U.S. government)o Marketable (negotiable) securities:

Treasury bonds Treasury notes Treasury bills STRIPS TIPS CMBs

o Prices – quoted in 1/32nds of par, while prices of most other bonds are quoted in increments of 1/8th

o Treasury Inflation-Protected Securities (TIPS) – Based on the CPI; rate of interest is fixed, however the principal amount on which the interest is paid may vary

o T-Bills – Short-term securities that mature in one year or lesso Cash Management Bills (CMB) – Unscheduled short-term debt offerings used to even out

Treasury cash flows. Duration can be as short as one day.o Treasury STRIPS – Dealers may purchase T-notes and T-bonds and separately resell the coupon

and principal payments as zero-coupons after requesting this treatment through a federal reserve bank.

Sold at a discounto Agency Securities

Federal Home Loan Banks (FHLB) Federal Home Loan Mortgage Corporation (FHLMC Freddie Mac) Federal National Mortgage Association (FNMA or Fannie Mae) Government National Mortgage Association (GNMA or Ginnie Mae)

Derivativeso Examples:

Forward contracts Futures contracts Options Structured products Collateralized mortgage obligations (CMOs)

o Options: Put vs. call Listed vs. OTC

Listed are traded on CBOE, AMEX, PHLX, or PSE Listed options are cleared through the Options Clearing Corporation (OCC) OTC are not cleared and have the risk that the counterparty may default on its

obligation Components:

Underlying security

Expiration month Exercise price

American vs. European American – option contract may be exercised anytime up to the

day before expiration European – option can be exercised only during a specific period,

though it is usually the day before expiration Premium – market price of an option at a particular time (amount paid by the

buyer to the seller for the rights conveyed by the contract) Buying calls:

Allows investors to employ leverage – to get control of the stock for a smaller amount of money than if they bought the stock outright

Potential profit is theoretically unlimited Risk is limited to the premium plus commission costs

Selling calls: Writing covered calls:

Allows investors to increase the return on their portfolios and to partially insulate their stocks against falling prices

Ex: an investor owns 100 shares of XYZ, for which they paid $100 per share, or a total of $10,000. The investor writes a call against this stock with a strike price of $110 and a premium of $5.

If the price of the stock remains the same, the investor has earned an additional $500 on this position ($5 x 100)

If the stock declines, the premium from the covered call reduces the investor’s losses. Assume XYZ drops to $90 and the call is not exercised. The stock is now worth $1,000 less than the investor paid for it, but the $500 premium reduces total losses from $1,000 down to $500

If the stock rises and the call is exercised, the investor still retains the premium plus whatever they make from selling the stock at its strike price

Writing uncovered calls: Among the riskiest of option strategies If the call is exercised, the writer will have to buy the stock in the open

market in order to deliver it to the call owner Since there is no upward limit on how high the stock may rise, the

investor’s potential loss is unlimited Unsuitable for most investors

Buying puts: For an investor who is bearish on a particular stock

Selling puts If the stock rises, the investor gets to keep the premium If the stock falls, the investor will need to buy the stock for more than it’s worth Maximum potential loss is the exercise price of the contract minus whatever

premium received for selling the puto Futures

Obligates the buyer to purchase the underlying commodity and the seller to sell it, unless the contract is offset before settlement date

Forwards were the precursors of futures Now used for currency transactions Non-transferable

Futures can be readily bought and sold on the exchange on which they trade

Must have 2 characteristics – (1) supply and demand for the underlying commodity or financial instrument must be large, (2) different units of the underlying item must be fungible (easily interchanged)

o Structured Products Prepackaged securities that often combine securities, such as a bond with a derivative May be linked to any of the following underlying assets:

Stock index Foreign currency Interest rate and inflation linked product Commodity Basket of securities Change in spread between asset classes Single security

UNDERWRITING

Underwriting Commitmentso Sale of a public offering is typically conducted through a group of broker-dealers, known as the

underwriting syndicateo Firm Commitment: if the syndicate agrees to purchase the entire issue and absorb any securities

that are not soldo Best Efforts: If the underwriters agree to place as much of the new offering as they can,

returning the unsold securities to the issuero All-or-None: Corporation might require a specific minimum of capital

Escrow Account: deal may be canceled if not enough is sold, so funds are held in an escrow account until the offering is complete

o Standby Agreement: Used in rights offerings. Syndicate agrees (in return for a fee) to purchase any unsubscribed shares from the rights offering

Distribution of Securitieso Syndicate: lead by one of the underwriters (managing underwriter)

Other broker dealers will be invited to participate in the distributions Syndicate members sign an underwriters agreement that specifies rights and obligations

o Selling group: Sometimes the syndicate will recruit other broker-dealers to assist in the sale of the

offering (known as the selling group) Do not assume any financial liability in the offering, acting instead as placement agents

o Syndicate process: Underwriters assess demand and determine public offering price May not sell at a lower price Underwriting spread:

Syndicate’s gross profit Underwriters give selling group members a portion of the spread (not in addition) See page 8-5 for additional details

o Green Shoe: allows the underwriters to purchase up to 15% more shares than were originally slated for the offering

o Market-Out Clause: allows the syndicate to cancel its commitment, if certain events occur that make marketing the issue difficult, or impossible

Industry Regulations Concerning Marketing Restrictions:o ATM Offeringso State or Blue Sky Lawso FINRA Suitability Rules

Retail clients Institutional clients

o Research-related rules Solicitation of investment banking business – research analysts are prohibited from

participating in the solicitation of investment banking services Road shows – research analysts are prohibited from participating in a road show if their

firm is connected with an investment banking service transaction Communication with customers – research analysts are allowed to discuss the issue with

clients once their firm has the mandate for the transaction and it has been publicly announced

Investment banking department Investment bankers are prohibited from directing a research analyst to participate

in the sales and marketing efforts for an investment banking service transaction Promise of favorable research – a research analyst may not accept compensation from an

issuer to prepare a favorable research report Restrictions on issuing reports

For IPOs, analysts can’t issue reports for 40 calendar days following the offering For Secondaries, analysts can’t issue reports for 10 calendar days following the

offering Does not apply for securities that are actively traded as defined under

Regulation M (average daily trading volume of at least $1 million and public float of $150 million)

Restrictions on public appearances: Research analysts are not permitted to make a public appearance regarding the

issuer during the quiet period Conference call Seminar Media interview Articles Exception = significant news

Termination of research coverage Firm must publish a final report if it decides to terminate coverage

FINRA Rules on Securities Distributiono Corporate Financing Rules

Filing requirements: If securities are registered, broker dealers must file documentation no later than 1

business day after filing the issuer’s registration statement. If securities are unregistered, disclosures must be filed at least 15 days prior to the

anticipated offering Documents to be filed

Copies of registration statement, offering memo, offering circular Copies of any underwriting agreements, letters of intent, escrow agreement Copies of pre-and-post amendments to the registration statement Copies of the final registration declared effective

Information to be filed: Estimate of maximum offering price Estimate of maximum underwriting discount, or commission, underwriters’

counsel fees, maximum finders’ fees, and statement of any other type of compensation

Statement concerning the affiliation with any member firm of an officer or director of the issuer, or a beneficial owner of 5% or more of the issuer’s securities

Detailed statement explaining any other arrangement entered into during the 180 day period prior to the filing date

Statement demonstrating compliance with any exception from the definition of underwriting compensation

Regulation M: restricts distribution participants and issuers from bidding for or purchasing in the secondary market stock that is being offered in a distribution for a certain period revolving around the effective date

o Rule 101 – Activities of Distribution Participants Prevent those interested in a distribution from manipulating secondary market trading for

their own benefit These parties are not permitted to buy or bid for the subject security within a critical time

frame called the restricted period Restricted Period

ADTV < $100k and Public Float < $25 million = 5 days ADTV > $100k and Public Float > $25 million = 1 day

Also applies to reference securities (ex: underlying common stock in a convertible bond deal)

Exceptions: Government and muni bonds ADTV > $1 million and Public Float > $150 million Odd-lot transactions Exercising options Unsolicited brokerage transactions and purchases Selling to QIBs Transactions in the subject security that are part of a basket strategy (can’t be

more than 5% of the basket)o Rule 102 – Activities of Issuers

Prohibits issuers and selling security holders (insiders) from supporting or raising the prices of a security being distributed

May not purchase or bid for a covered security, or induce others to do so Exceptions:

Unsolicited purchases 144A Exercise of convertible securities Odd-lot Exempted securities

101 Exemptions not available: Actively traded securities of the issuer or affiliate Basket transactions Inadvertent transactions

o Rule 102 – Passive Market Making Permits distribution participants to continue making markets in a Nasdaq stock on a

passive basis The market maker may not enter a bid or effect a purchase at a price that exceeds the

highest independent bid on Nasdaq Limit on quantity purchased = greater of 30% of ADTV, or 200 shares Falling market

In a falling market, when the last independent bid drops below that of a passive market maker, the passive market maker may maintain its bid until its purchases have reached or exceeded the lesser of two times the minimum quote size, or the passive market maker’s remaining daily limit

o Rule 104 – Stabilization

Placing a bid, or effecting a purchase, for the purpose of pegging, fixing, or otherwise maintaining the price of a security

This is permitted by an underwritero Rule 105 – Short Sales in Connection with an Offering

It is a violation for any person to sell short the security that is the subject of an offering then purchase the offered security from an underwriter

If the short was executed during the 5 bus. days prior to pricing Exception:

If the person was not aware of the offering and changed their mind, closing out the short at least one business day prior to the pricing

Record Keepingo Syndicates must maintain the following information

Percentage participation or commitment for each member Names and addresses of the member of the syndicate Dates when the penalty bid was in effect Name and class of any security stabilized or any security in which a syndicate short

covering transaction was effected Price, date, and time at which each stabilizing purchase or syndicate short was effected

o General records: All records must be kept for the first two years in an easily accessible place Requires broker dealers obtain the following information from associated persons:

Name, address, SSN, starting date DOB Business background for 10 years Disciplinary action for securities Felony indictments Aliases

Listing Requirementso NYSE

400 U.S. shareholders 1,100,000 shares outstanding Market cap of $140 million Stock price of $4 at time of listing At least one of several alternative financial tests

o Nasdaq Different requirements for Global Select, Global Market, and Capital Market Only 3 must be satisfied under all three standards:

$4 minimum bid price 3 or 4 market makers Subject to corporate governance

Other requirements: Pretax earnings Cash flow Market cap Revenue

Global Select = Most stringent

Capital Market = Least stringent

VALUATION

Relative Valuationo Price to Earnings (P/E) – indication of how the market capitalizes a company’s earnings or what

the market is willing to pay for each dollar of earningso Earnings Yield = EPS / Price per Share (reciprocal of P/E ratio)

Use this when earnings are negativeo P/E to Growth Ratio

P/E/Growth rate (not percentage, so 10% growth would use 10, not 0.10) PEG ratio greater than 1.0 could indicate an overvalued stock and vice versa for PEG

ratios less than 1.0 Use forward looking or trailing information Not relevant for companies with negative earnings

o Be prepared to calculate all three ratios using various input datao Compound Annual Growth Rate = CAGR

(Ending Value/Beginning Value) ^ (1/n) – 1 Won’t have the capabilities to do this so will have to just simply average growth rates to

approximate CAGRo Price to Free Cash Flowo Price to Sales

Used for start-up industries that do not have significant earnings yeto Price to Booko Enterprise Value

Equity Value = Market Price x Shares Outstanding Plus Long-Term Debt Less Cash and Equivalents

Discounted Cash Flowo Values a company on the present value of the expected cash flowso Need to have

Estimated discount rate (WACC) Estimate of cash flows for given period Estimate of terminal value

Multiple method Perpetuity Growth method

= CF(n+1) / (WACC – g)o Dividend Growth Model

Cost of equity created by retained earnings K = (Dt/P0) + G

K = Required Rate of Return Dt = Dividend to be paid at the end of the year P0 = Current market price G = Growth rate per year

o Free Cash Flow to the Firm EBIT x (1 – t) + Depreciation and Amortization - Capex +/- Change in Working Capital

o Free Cash Flow to Equity Net Income + Depreciation and Amortization - Capex +/- Changes in Working Capital

o Dividend Discount Model

Assumes investors buy stock solely for dividends and desire a current return P0 = (d1/(1+k))+ (d2/(1+k)2) + (dn/(1+k)n) Constant Growth Case = k = (d+g)/P0

P0 = D1/(k-g) Known as Gordon Growth Model

Economic Profit – differs from accounting profit as it takes into consideration the cost of capital (profit above the expected returns on capex)

o Looking at unit costs for manufacturing businesseso Return on equityo Marginal revenue vs. marginal cost analysis

Sum of the Parts Analysiso If the company were sold today, would the individual business segments sell for more than the

total corporate entity? Valuation Multiples

o Multiples of Earnings P / E EV / EBITDA or EV / EBIT Cash earnings multiples

o Multiples of Book Value P / BV or P / TBV EV / BV

o Multiples of Revenue P / Sales EV / Sales

Sector Multiple Used RationaleCyclical Relative P/E Use when normalized earningsHigh Tech, High Growth

PEG When there are big differences across firms

High Tech, No Earnings

Price/Sales or EV/Sales

Assume future margins will be good

Heavy Infrastructure EV/EBITDAFirms in sector have losses in early years and reported earnings can vary depending on depreciation method

REITsPrice/Cash Flow or FFO

Generally no capex; investments come from equity earnings

Financial ServicesPrice/BV, EV/BV, P/TBV

Book value often marked to market

Retailing Price / Sales If leverage is the same across firmsRetailing EV / Sales If leverage is different across firms

Other methodologies to be familiar witho Comparable Transactionso Comparable Companieso Leveraged Buyout

Effects of exchange rate risk:o Strong U.S. dollar: make foreign companies more attractive takeover targets for U.S. based

buyers; U.S. companies will be less attractive for foreign buyerso Weak U.S. dollar: Opposite