MBA 588

PART I
S E C U R I T I E S R E G U L AT I O N
OVERVIEW

PART II
FINANCING
13.10.2021
 PART I
S E C U R I T I E S R E G U L AT I O N
OVERVIEW
 SECURITIES ACT OF 1933
• Two main objectives:
– to require that investors receive financial and other significant
information concerning securities being offered for public sale;
– and to prohibit deceit, misrepresentations and other fraud in the sale
of securities
• In general, securities sold in the U.S. must be registered with the
Securities and Exchange Commission (SEC) (unless qualified for
certain exemptions) and must provide a minimum required
amount of information regarding the security
• After a registration statement is filed with the SEC, an
investment prospectus must be provided to investors
GLASS-STEAGALL ACT
(1933)
• This Act separated commercial and investment banks and
limited the underwriting capabilities of commercial banks
• Officials of firms associated with security investments were
restricted from serving as directors or officers of
commercial banks
• The Federal Deposit Insurance Corporation (FDIC) was
founded by this Act to insure bank deposits
SECURITIES EXCHANGE ACT
OF 1934
• This Act deals primarily with the supervision of new security offerings,
ongoing reporting requirements for these offerings and the conduct
of exchanges
• Companies with >$10 million in assets and >500 owners must file
annual and other periodic reports
• Proxy solicitations and the acquisition of >5% ownership stakes in
registered companies are subject to filing requirements
• This Act created the SEC
• Insider trading is prohibited by this Act
INVESTMENT COMPANY ACT
OF 1940
• The Act's purpose is "to mitigate and... eliminate the
conditions... which adversely affect the national public interest
and the interest of investors"
• Specifically, the Act regulates conflicts of interest in investment
companies and securities exchanges
• It protects the public primarily by requiring disclosure of
material details about the investment company and also places
some restrictions on mutual fund activities such as short selling
shares
• However, the Act does not include provisions for the SEC to
make specific judgments about or even supervise an investment
company's actual investment decisions
• The Act requires investment companies to publicly disclose
information about their own financial health
GRAMM-LEACH-BLILEY ACT
(1999)
• This Act overturned the mandatory separation of
commercial and investment banks, as originally required by
the Glass-Steagall Act
• Following passage of this Act, large commercial banks
significantly expanded their investment banking business
• JP Morgan, Citigroup and Bank of America created the
largest investment banking franchises among US
commercial banks
GLOBAL RESEARCH
SETTLEMENT (2003)
• Investment banks were required to comply with significant
restrictions relating to interaction between the Investment
Banking Division and the equity research department (part
of the Trading Division)
– No influence on research opinions or coverage
– No payment of compensation or influence on promotion
– Restriction on communications
• The practice of “spinning” hot IPOs is restricted
DODD-FRANK WALL STREET
REFORM AND CONSUMER
PROTECTION ACT (2010)
16 titles, with regulators to interpret meaning over time, including:
• Title 1-Financial Stability:
– creates the Financial Stability Oversight Council and the Office of Financial
Research (both attached to the Treasury Department) to identify threats to
financial stability, promote market discipline and respond to financial risk
• Title 2-Orderly Liquidation Authority granted to FDIC, Fed and SEC:
– provides authority to liquidate banks, depositary institutions and securities firms
• Title 3-Transer of Powers to Comptroller, FDIC and Fed:
– streamlines banking regulation and reduces competition and overlap between
regulators
• Title 4-Regulation of Advisors to Hedge Funds and similar private fund
investment advisers:
– increases reporting requirements and limits ability to exclude information
reporting
DODD-FRANK ACT (CONT.)
• Title 6-Improvements to Regulation of Proprietary Trading:
– incorporates the “Volker Rule” which limits bank proprietary trading activity
(except with clients) and ownership of or investment in a hedge fund or
private equity fund
• Title 7-Wall Street Transparency and Accountability:
– regulates over the counter swaps, including credit default swaps, and
encourages derivatives characterized as swaps to be traded through
exchanges or clearinghouses
• Title 9-Investor Protections and Improvements to the Regulation of
Securities:
– revises the powers and structure of the SEC, credit rating organizations and
the relationships between customers and broker-dealers
• Title 10-Bureau of Consumer Financial Protection:
– creates the Bureau of Consumer Financial Protection
• Title 11-Fed System Provisions:
– allows the Fed to establish standards for risk-based capital requirements,
leverage, liquidity, credit exposure and concentration limits and to determine
overall risk management requirements
FINANCIAL CRISIS
REGULATORY REFORM
Following the financial crisis of 2007-2008, a number of global
reforms were initiated that impact investment banks, including
the role of central banks, the supervision of banks, bank capital
guidelines, consumer protection, global accounting standards
and the “harmonization” of OTC derivatives regulation
GLOBAL FINANCIAL REFORM
• Enhancing Risk Assessment and Measurement
– Regulators are correcting faulty risk-
measurement methods, including analysis of
stressed asset valuations
– Default and migration risk of counterparties in
trading businesses will be better recognized
– Derivative positions require longer margin
periods and higher risk weights if not cleared
with central counterparties
GLOBAL FINANCIAL REFORM

• Strengthening the Capital Base

– Regulators scrutinizing core equity to make sure it is fully available to
creditors in case of default
– More narrowly defining Tier 1 to be principally common shares and
retained earnings
– Hybrid capital instruments will no longer be eligible for Tier 1 status
unless satisfy strict criteria
– Tier 1 capital will be reduced by unrealized gains and losses, net deferred
taxes, defined benefit deficits, minority interests and goodwill
GLOBAL FINANCIAL REFORM
• Imposing a Maximum Leverage Ratio
– The leverage ratio will relate Tier 1 capital to
the gross balance sheet, including off-balance-
sheet items
– This will result in larger leverage ratios shown
by investment banks
– Leverage ratios will be reduced to maximum
allowed levels through reduction in assets,
including loans
GLOBAL FİNANCİAL REFORM
• Setting a Global Standard for Minimum Liquidity
– Banks will be forced to hold sufficient liquidity
to survive a short-term period (30 days) of
stressed market conditions
– Regulators will require a long-term net stable
funding ratio that classifies and compares both
assets and liabilities according to their
expected terms and liquidity: short-term and
non-stable funding will require large deductions
when calculating the ratio
GLOBAL FINANCIAL REFORM
• Accounting for Systemic Risks
– Regulators will try to make sure the financial
system is sound by focusing on risks posed by
the largest institutions during market
downturns
– Dividends may be restricted in downturns,
capital will be required to increase in positive
markets and credit growth will be monitored
– Accounting standards will apply forward-
looking expected-loss approach to provisioning
GLOBAL FINANCIAL REFORM
In addition to the general initiatives that are
common to most countries, certain regulatory
regimes are also focusing on the following:
– Realignment of bank business models,
restricting size and activities of individual banks
– Separation of deposit taking banks and
investment banks
– Forced divestitures of hedge fund and private
equity investment businesses
– Prohibition of proprietary trading activity
 PART II
FINANCING
CAPITAL MARKETS
FINANCING
• A capital markets financing is a long-term funding obtained through the issuance of
a security in a regulated market or through a private placement
• The security can be debt (bonds, debentures, or notes), equity (common stock) or
a hybrid (both debt-like and equity-like characteristics, such as preferred shares or
convertibles)
• A capital markets financing is underwritten by investment banks (the banks take
on risk when purchasing securities from an issuer and then reselling those
securities to investors) or distributed by banks as a private placement on an
agency or principal basis
• In the US, a securities offering must either be registered with the Securities and
Exchange Commission (SEC) through a registration statement ( a portion of
which is called a “prospectus”) or sold as a private placement pursuant to an
exemption from this registration requirement
PRIVATE PLACEMENTS

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olan sandıklar, kamuya yararlı dernekler ile nitelikleri itibariyle bu kurumlara benzer olduğu Kurulca belirlenecek diğer
yatırımcılar ve halka arz tarihi itibariyle en az 1 milyon Türk Lirası tutarında Türk ve/veya yabancı para ve sermaye piyasası
aracına sahip olan gerçek ve tüzel kişileri ifade etmektedir.
UNDERWRITING AND
LEAGUE TABLES
• A group, or “syndicate” of investment banks underwrites a securities
offering
• The issuer must decide which banks in the syndicate will act as the “lead
bookrunners” of the transaction
• These banks determine the marketing method and pricing for the
transaction and, therefore, receive the highest underwriting allocation and
a proportionately higher percentage of the gross spread
• The investment banking industry keeps track of underwriting
participations by all banks and this becomes a basis for comparing banks’
underwriting capabilities
• This underwriting record is called a “league table”: every different type of
security (and geographic region) has its own league table
FINANCING
CONSIDERATIONS
• Bankers focus on liquidity (cash balances, marketable securities, and
available lines of credit), cash flow multiples, debt/earnings multiples,
cost of capital and rating agency considerations before recommending
whether a client should raise financing and, if so, whether it should be
in the form of debt, equity or a hybrid security like convertibles
• Bankers analyze liquidity as a percentage of market capitalization, total
debt, annual interest payment obligations and other balance sheet and
income statement metrics
• These metrics are then compared with results from other companies
in the same industry to determine whether the client has relatively
more or less liquidity than its competitors
CORPORATE FOCUS ON
CASH BALANCES
DETERMINING THE TYPE OF
FINANCING: EQUITY, DEBT OR
CONVERTIBLES
• An equity offering generally has a higher cost of capital than a debt financing and will likely cause
a drop in earnings per share (EPS) for the issuer, which may negatively impact the company’s
share price
• However, equity will strengthen the company’s balance sheet and may lead to a higher credit
rating, resulting in lower future debt financing costs and potentially higher long-term value
• A debt offering usually has a lower cost of capital, but may weaken the company’s balance sheet
and reduce financial flexibility
• Before issuing new debt, one must consider both the impact of debt on cash flow multiples (to
determine if additional interest charges can be adequately covered by cash flow) and the likely
impact on credit ratings
• Risk-adjusted cost of capital, credit ratings, peer comparisons, equity and debt analyst views, and
management comfort with the resultant balance sheet are all important considerations when
determining whether to raise financing from debt, equity or convertible markets

Risk-adjusted return on capital (RAROC) is a modified return on investment

(ROI) figure that takes elements of risk into account. In financial analysis,
projects and investments with greater risk levels must be evaluated
differently; RAROC thus accounts for changes in an investment’s profile
by discounting risky cash flows against less-risky cash flows.
FINANCING ALTERNATVES
CAPITAL MARKETS GROUP
 CAPITAL MARKETS GROUP

• The capital markets group is responsible for originating and executing capital markets
transactions
• They coordinate with client coverage bankers to target likely issuers and, with the
syndicate desk and sales professionals from the Trading Division, determine
appropriate potential pricing
• Most capital markets financings shift price risk during the sales process to the issuer
under a “best efforts” or “fully marketed” offering
• Competitive pressures sometimes compel investment banks to undertake
considerable risks, such as agreeing to a “bought deal” (also called “block trade”),
where the banks take complete price risk in reselling the purchased security
• Another risk that investment banks sometimes assume involves providing a large loan
to a client as a “bridge” financing (to support an M&A transaction) prior to a
subsequent “take-out” financing underwritten by the bank in the capital markets
 TYPES OF EQUITY
UNDERWRITINGS
A red herring
is a preliminary
prospectus
filed by a
company with
the Securities
and Exchange
Commission
(SEC), usually
in connection
with the
company's
initial public
offering (IPO).
TYPES OF BOND
UNDERWRİTİNGS
 SEC REGISTRATION
PROCESS
• When a company files a registration statement with the SEC, this starts a “quiet
period”, which ends when the SEC declares the registration “effective”, meaning
that all required information is provided (which could take several days to several
months, depending on the company)
• The securities are priced and sold immediately following effectiveness
• During the quiet period, the lead bank may conduct a roadshow for the company
to discuss the prospective offering with investors and an internal presentation to
sales professionals to get them ready to sell the offering
• The company and bank are only allowed to discuss information provided in the
prospectus with prospective investors in order to avoid the discussion being
deemed an “offer to sell” securities, which is a “gun jumping” violation
• For Well-Known Seasoned Issuers (WKIS filers), a registration statement may
become immediately effective and usable for offerings, without SEC review,
allowing the issuer, through the bank, to immediately make offers to sell after filing,
which avoids the potential gun jumping problem
 SEC REGISTRATION PROCESS-
WKSI
• An issuer that meets all of the following requirements at some point during a
60-day period preceding the date the issuer satisfies its obligation to update its
shelf registration statement (generally the date of filing its Form 10-K or Form
20-F):
• It must be eligible to register a primary offering of its securities on Form S-3 or
Form F-3.
• As of some date within 60 days of its eligibility determination date, it must have
had an outstanding minimum $700 million in worldwide market value of voting
and non-voting equity held by non-affiliates or have issued in the last three years
at least $1 billion aggregate amount of non-convertible securities other than
common equity, in primary offerings for cash, not exchange.
• It must not be an ineligible issuer.
• Issuers of asset-backed-securities, registered investment companies, and
business development companies as defined in the Investment Company Act of
1940, as amended cannot qualify as well-known seasoned issuers.
EQUITY OFFERINGS

• When a company sells stock to the public for the first time in an SEC-
registered offering, this is an Initial Public Offering (IPO)
• Subsequent sales of stock to the public by the company are called
“follow-on” offerings
• Selling shareholders can sell shares using the company’s registration
statement, which is called a “selling shareholders” or “secondary” offering,
with proceeds received by the shareholder and not the company
• The difference between the purchase and sale price of a securities
offering is called the “gross spread” and represents compensation for
the bank for undertaking a distribution effort and certain legal risks
PROSPECTIVE EQUITY
ISSUERS
 GREEN SHOE OPTION (OVERALLOTMENT
OPTION)

• Allows an investment bank to sell short securities that are equal to 15% of the
securities sold in a public offering
• For example, bank sells 100 shares for a company @ $100/share = $10,000
• Bank simultaneously sells short 15 company shares @ $100/share = $1,500
• If company’s share price increases after the offering, the bank buys 15 shares
from the company @ $100/share and delivers these shares to the short buyers
• The company therefore sells 115 shares and receives proceeds of $11,500
• If company’s share price decreases after the offering, the bank buys 15 shares
from the market at, say, $99/share and delivers these share to the short buyers
• These market purchases mitigate further downside price movement in the
stock
• If share price increases, the bank earns $11,500 x 2% gross spread = $230
• If share price decreases, the bank earns $10,000 x 2% gross spread = $200 plus
trading profits of $100-$99 = $1 for each share sold short, so earnings of $215
BENEFITS AND DISADVANTAGES OF AN
IPO
• Benefits include:
– access to public market funding,
– enhanced profile and marketing benefits,
– creation of an acquisition currency and compensation
vehicle and
– liquidity for shareholders
• Disadvantages include:
– SEC reporting requirements,
– costs associated with on-going reporting (including
Sarbanes-Oxley),
– disclosure of sensitive information and short term
focus by management to meet investor expectations
in quarterly reports
IPO PRICING
• An investment bank determines the expected
value of the company based on comparisons with
publicly traded comparable companies or values
derived through other methods (including DCF
analyses)
• This is an imperfect process that requires analysis
of both historical operating earnings and revenues
and forecasts of future earnings and revenues
• In order to encourage investor interest in an IPO
company that does not have a track record as a
public company, typically, bankers will set an IPO
price at a discount to the determined value
IPO TİMETABLE
 CONVERTIBLES
• A convertible security is a type of equity offering, even though
most convertibles are originally issued in the form of a bond or
preferred shares
• Most convertible bonds or convertible preferred shares are
convertible anytime (after a three month period following
issuance), at the option of the investor, into a predetermined
number of common shares of the issuer
• This is called an “optionally converting convertible”
• The other type of a convertible is a “mandatorily converting
convertible”, where the investor must receive a variable number
of common shares (based on a floating conversion price) at
maturity (a mandatory receipt rather than an option to receive)
 CONVERTIBLES (CONT.)
• The issuer’s preference regarding equity content of the
convertible determines whether the convertible will be issued as
an optionally converting convertible or a mandatorily converting
convertible
• From the perspective of a credit rating agency, an optionally
converting bond is considered to have bond-type characteristics
since there is no assurance that the bond will convert into
common shares and there is a fixed coupon payment obligation
• As a result, when originally issued, an optionally converting bond
weakens a company’s balance sheet in almost the same way that a
straight bond of the same size and maturity would (although the
company’s balance sheet will subsequently be strengthened if the
convertible bond eventually converts into common shares)
CONVERTİBLES (CONT.)

• By contrast, mandatorily converting convertibles (mandatory

convertible), from a credit rating agency perspective, are
considered to have equity-type characteristics
• This is because there is certainty regarding conversion into
common stock (and therefore no cash repayment obligation at
maturity in the event of non-conversion)
• Therefore, mandatory convertibles strengthen a company’s
balance sheet in almost the same way that a common share
offering of the same size would
RATIONAL FOR ISSUING A
CONVERTIBLE
• If a company wants to issue debt, they might consider a
convertible bond rather than a straight bond in order to
reduce the coupon associated with debt issuance
• For example, if a company could issue a $100 million bond
with a seven-year maturity and a coupon of 6%, that same
company might be able to issue a convertible bond for the
same amount and maturity, but with a coupon of 3%
• The reason convertible bond investors might accept a
coupon that is 3% lower than a straight bond coupon is
because the convertible bond gives them the option to
receive a predetermined number of common shares of the
issuer’s stock in lieu of receiving cash repayment
RATIONALE (CONT.)

• If the value of the common shares that convertible bond

investors have the right to receive does not exceed $100
million during the life of the convertible, they will generally
not elect to convert the bond into shares and will therefore
receive $100 million in cash at maturity in seven years
• If the value of the shares exceeds $100 million on or anytime
before maturity, investors may elect to convert the bond and
receive shares
 CONVERTIBLE BOND
EXAMPLE
• A company issues a $100 million convertible with a seven-year maturity and a
3% annual coupon. Investors are given the right to receive either $100 million
repayment at maturity or, at their option, give up receipt of this cash amount
in exchange for receiving a predetermined number of shares of the issuer’s
common stock
• On the date of convertible issuance, the company’s stock price is trading at
$25, and the company agrees to a “conversion price” for the convertible of
$31.25, which is 25% above $25. This percentage is called the “conversion
premium,” because the conversion price is set at a premium (in this case, a
25% premium) to the company’s share price on the date of convertible
issuance
• The conversion price determines the number of shares that the investor has
the right to convert into. This determination is made by dividing the total
proceeds of the offering by the conversion price
• The result, in this example, is $100 million / $31.25 = 3.2 million shares
CONVERTIBLE EXAMPLE
(CONT.)
 Convertible investors, therefore, have a choice to make:
either take $100 million in cash at maturity or give up the
cash right in exchange for receiving 3.2 million shares
anytime at or before maturity
 If, for example, the issuer’s share price increases to $45 at
maturity in seven years, convertible investors might elect to
give up the right to receive $100 million in cash in exchange
for 3.2 million shares because the value of these shares
would be 3.2 million x $45 = $144 million
 In practice, most investors wait until maturity to make the
conversion decision due to the value of the options
embedded in the convertible, but they have the right to
convert earlier.
BONDS VS LOANS

• A bond is debt in the form of a security, issued as

a long-term obligation of a borrower with a
specific maturity and coupon
INVESTMENT GRADE AND BELOW
INVESTMENT GRADE (HİGH YİELD OR JUNK)
BONDS