A Primer for Physician Investors and Medical Professionals

By: Dr. David Edward Marcinko; MBA, CMP™

[Editor-in-Chief] http://www.CertifiedMedicalPlanner.org

[PART 3 OF 8]

NOTE: This is an eight part ME-P series based on a weekend lecture I gave more than a decade ago to an interested group of graduate, business and medical school students. The material is a bit dated and some facts and specifics may have changed since then. But, the overall thought-leadership information of the essay remains interesting and informative. We trust you will enjoy it.

Introduction

Some securities issues move very well, like traditional blue chips stocks (ie., Wallgreen). Some are dogs, like smaller dot.com companies (iixl.com). Then, there are issues that are former darling, but are now ice cold; like PPMCs (i.e., Phycor) and internet stocks (i.e., Dr. Koop).  How far can an underwriting manager go in nudging along an issue that’s not selling well? SEC rules do permit a certain amount of help by the manager, even if this takes on the appearance of price-fixing. This help is called stabilizing the issue.

Simply put, if shortly after a new offering begins, supply exceeds demand, there will be downward pressure on the price. But, the law requires that all purchasers of the new issue pay the official offering price on the prospectus. If public holders of the stock become willing to bail out and accept a low selling price, the investor looking to buy will find he is able to buy stock of the issuer cheaper in the open market than buying it new from the syndicate members.

To prevent such a decline in the price of a security during a public offering, SEC rules permit the manager to offer to buy shares in \ the open market at a bid price at, or just below, the official offering price of the new issue. This is referred to as stabilizing and his bid price is called the stabilizing bid. There is always the risk, in a firm commitment underwriting, that the underwriters will have difficulty selling the new issue. What they can’t sell, they’re “stuck” with. That’s where the term “sticky issue” comes from.

As a physician executive, or potential investor in a new issue, be aware that the best way to get an issue to sell is to increase the compensation to the sales force (i.e., stock broker or Registered Rep).

Another choice is through stabilization. Stabilizing is a permitted form of market manipulation which tends to protect underwriters against loss. It allows the underwriting syndicate (usually through the efforts of the syndicate manager) to stabilize (peg or fix) the secondary market trading price in a new issue at the published public offering price. It works something like this.

When a new issue is selling slowly, some of the investors who initially purchased, may be dissatisfied with the performance of the stock (if it is selling slowly and the underwriters have plenty to sell at the public offering price, this is anything but a hot issue and the security price will not have risen).

This dissatisfaction with performance leads to these investors desiring to sell the securities they have just purchased. If the underwriters are unable to sell at the public offering price, certainly an individual investor will have to take less when bailing out. As market makers begin to trade the stock in the secondary market, they would only be able to compete with the underwriters by offering the stock at a lower price than the public offering  price. This would make it difficult (if not impossible) for the underwriters to distribute the remaining new shares.

In order to prevent this from happening, the managing underwriter (who is usually the one to assume the role of stabilizing underwriter), agrees to purchase back any of the new shares at or just slightly below the public offering price. That is a higher price than any market maker could, in all practicality, bid for the shares. When the shares are repurchased by the stabilizing underwriter, it is as if the initial trade were annulled and never took place so that these new shares are now placed back into the distribution and are sold as new shares at the public offering price. SEC rules do, however, require disclosure of this practice.

Therefore, no syndicate manager may engage in stabilizing unless the following phrase appears in bold print on the inside front cover page of the prospectus:

IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS MAY OVER ALLOT OR EFFECT TRANSACTIONS WHICH STABILIZE OR MAINTAIN THE MARKET PRICE OF (XYZ COMPANY) AT A LEVEL ABOVE THAT WHICH MIGHT OTHERWISE PREVAIL IN THE OPEN MARKET. SUCH TRANSACTIONS MAY BE EFFECTED ON (NYSE) STABILIZING, IF COMMENCED, MAY BE DISCONTINUED AT ANY TIME.

Of course, it would be manipulation and, therefore, a violation of law, if this “price-pegging” activity continued after the entire new issue was sold out. This activity costs the syndicate manager money which is recouped by levying a syndicate penalty bid against those members of the syndicate whose clients turn shares in on a stabilizing bid.

One way to avoid stabilization is to over allot  to each of the syndicate members. This is the same concept as “over booking” that’s done by the airlines. Most airlines typically sell 5% to 10% more seats than the airplane has knowing that there will be last minute cancellations and no shows. This tends to ensure that the plan will fly full. In the same manner, managing under-writers frequently over allot an additional 10% to each of their syndicate members so that last minute cancellations should still leave the syndicate with sell orders for 100% of the issue. If there are no “drop outs”, one of two things may happen.

1. The issuer will issue the additional shares (which results in it raising more money).
2. The issuer will not issue the additional shares and the syndicate will have to go short. Any losses suffered by the syndicate through taking of this short position are shared proportionately by the syndicate members.

Now, what if market conditions and the fervor surrounding a new issue like e-commerce company Ariba,  in 1999, remain so that the issue doesn’t cool down during the cooling off period? Such hot issues are a mixed blessing to be sure.

On the one hand, the issue is a sure sell-out. On the other hand, just how many healthcare investors are going to be told by brokers that additional shares can not be obtained.

Furthermore, the SEC and the NASD/FINRA are vigorous [or should be] in their scrutiny of  proper distribution channels for hot issues. Just what is a “proper” distribution?  It can be summed up in one sentence. Member firms have an obligation to make a “bona fide” public distribution of all the shares at the public offering price. The key to this rule lies within the definition of bona fide public distribution.

While the underwriting procedures for corporate bonds are almost identical to corporate stock, there are significant differences in the underwriting of municipal securities. Municipal securities are exempt from the registration filing requirements or the Securities Act of 1933. A state or local government, in the issuance of municipal securities, is not required to register the offering with the SEC, so there is no filing of a registration statement and there is no prospectus which would otherwise have to be given to investors.

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Municipal Underwriting

There are two main methods of financing when it comes to municipal securities. One method is known as negotiated. In the case of a negotiated sale, the municipality looking to borrow money would approach an investment bank and negotiate the terms of the offering directly with the firm. This is really not very different from the above equity discussions.

The other type of municipal underwriting is known as competitive bidding. Under the terms of competitive bidding, an issuer announces that it wishes to borrow money and is looking for syndicates to submit competitive bids. The issue will then be sold to the syndicate which submits the best bid, resulting in the municipality having the lowest net interest cost (lowest expense to the issuer).

If the issue is to be done by a competitive bid, the municipality will use a Notice of Sale to announce that fact. The notice of sale will generally include most or all of the following information.

• Date, time, and place. This does not mean when the bonds will be sold to the public, but when the issue will be awarded (sold) to the syndicate issuing the bid.
• Description of the issue and the manner in which the bid is to be made (sealed bid or oral). Type of bond (general obligation, revenue, etc.)
• Semi-annual interest payment dates and the denominations in which the bonds will be printed.
• Amount of good faith deposit required, if any.
• Name of the law firm providing the legal opinion and where to acquire a bid form.
• The basis upon which the bid will  e awarded, generally the lowest net interest cost.

Since municipal securities are not registered with the SEC, the municipality must hire a law firm in order to make sure that they are issuing the securities in compliance with all state, local and federal laws. This is known as the bond attorney, or independent bond counsel. Some functions are included below:

• 1. Establishes the exemption from federal income tax by verifying  requirements for the exemption.
  2. Determines proper authority for the bond issuance.
  3. Identifies and monitors proper issuance procedures.
  4. Examines the physical bond  ertificates to make sure that they are proper
  5. Issues the debt and a legal opinion, since municipal bonds are the only securities that require an opinion.
  6. Does not prepare the official statement.

When medical investors purchase new issue municipal securities from syndicate or selling group members, there is no prospectus to be delivered to investors, but there is a document which is provided to purchasers very similar in nature to a prospectus. It is known as an Official Statement. The Official Statement contains all of the information an investor needs to make a prudent decision regarding a proposed municipal bond purchase.

The formation of a municipal underwriting syndicate is very similar to that for a corporate  issue. When there is a negotiated underwriting, an Agreement Among Underwriters (AAU) is used. When the issue is competitive bid, the agreement is known as a Syndicate Letter. In the syndicate letter, the managing underwriter details all of the underwriting agreements among members of the syndicate. Eastern (undivided) and Western (divided) accounts are also used, but there are  several different types of orders in a municipal underwriting. The traditional types of orders, in priority order, are:

Pre-Sale Order: Made before the syndicate actually offers the bonds. They have first priority over any other order turned in.

Syndicate (group net) Order: Made once the offering is under way at the public offering price. The purchase is credited to each syndicate member in proportion to its allotment. An institutional buyer will frequently purchase” group net”, since many of the firms in the syndicate may consider this buyer to be their client and he wishes to please all of them.

Designated Order: Sales to medical investors (usually healthcare institutions) at the public offering price where the investor designates which member or members of the syndicate are to be given credit.

Member Orders: Purchased  by members of  the syndicate at the take-down price (spread). The syndicate member keeps the full take-down if the bonds are sold to investors, or earns the take-down less the concession if the sale is made to a member of the selling group. Should the offering be over-subscribed, and the demand for the new bonds exceeds the supply, the first orders to be filled are the pre-sale orders. Those are followed by the syndicate (sometimes called group net) orders, the designated orders, and the last orders filled are the member’s.

Finally, be aware that the term bond scale, is a listing of coupon rates, maturity dates, and yield or price at which the syndicate is re-offering the bonds to the public. The scale is usually found in the center of a tombstone ad and on the front cover of the official statement.

One of the reasons why the word “scale” is used is, that like the scale on a piano, it normally goes up. A regular or positive scale is one in which the yield to maturity is lowest on the near term maturities and highest on the long term maturities. This is also known as a positive yield curve, since the longer the maturity, the higher the yield. In times of very tight money, such as in 1980-81, one might find a bond offering with a negative scale.

A negative (sometimes called inverted) scale is just the opposite of a positive one, with, yields on the short term maturities are higher than those on the long term maturities.

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