Red Herring (Preliminary Prospectus)

A red herring is the preliminary prospectus circulated during the cooling-off period, named for the red-ink warning printed down its left margin stating that the registration is not yet effective.

The red herring solves a timing problem created by the Securities Act of 1933. An issuer files a registration statement, then waits out a cooling-off period, conventionally 20 days, while the SEC reviews it. Underwriters need to know during that wait whether demand exists and at what price, but may not sell yet. The red herring is what they may circulate meanwhile.

What the document is, and is not

It is incomplete on purpose. Two things are missing because they are not yet known: the final public offering price, along with figures that depend on it such as the underwriting spread, and the effective date. A price range may appear, but a range is an estimate.

During the cooling-off period the firm may distribute the red herring and record non-binding indications of interest. A tombstone ad limited to basic facts about the offering may also run, because the law does not treat it as a prospectus. No sales, no orders, no money in any form. An indication binds nobody: the customer may walk away at pricing, and the firm need not fill the whole indication if the deal is oversubscribed.

Example: a customer reads a red herring for an IPO expected to price between $14 and $16, then mails a signed order for 500 shares and a $7,500 check. The representative returns the check and records a non-binding indication of interest for 500 shares. Nothing more happens until the registration is effective and the final prospectus, carrying the actual price, is available.

The exam trap

The exam tests this term through scenarios in which a representative tries to be helpful. Three variants recur, and all three are wrong.

Escrow the check until the effective date. This borrows the escrow mechanic of all-or-none and mini-max contingency offerings, where it belongs. During the cooling-off period customer funds may not be accepted at all, escrowed or not.

Hold the check uncashed and enter the order on the effective date. Holding a signed order and a customer’s money is accepting both before effectiveness.

Accept the order because the customer already has the red herring. Delivering the preliminary prospectus permits gauging interest. It never authorizes an order or a payment.

A fourth version catches candidates who have the money rules cold. The red herring must go out exactly as filed. Highlighting the attractive sections, attaching a research note, or adding a line reading “expected to price near $18, strong buy” are all prohibited. The unaltered document is the only offering material permitted.

Related distinctions

Keep the two documents apart: the red herring carries no price, and the final prospectus carries the offering price and is what a buyer must receive. The governing idea is disclosure, not merit. Effectiveness means the SEC cleared the filing, never that it approved the security.

Check yourself

1. During the cooling-off period a customer mails a representative a signed order for 300 shares "at whatever the final price turns out to be," with a $15,000 check. What should the representative do?

   1. Deposit the check in escrow until the registration is effective
   2. Hold the check uncashed and enter the order on the effective date
   3. Return the check and record only a non-binding indication of interest
   4. Accept the order, because the customer already has the red herring

   Show answer and explanation

   Answer: C. Return the check and record only a non-binding indication of interest.

   All three wrong answers are ways of saying yes politely. A misapplies the escrow feature of contingency offerings; B assumes delayed execution cures it, when holding a signed order and a check is already accepting both; D treats delivery of the red herring as authorization to sell. Before the effective date: no orders, no funds.

2. While an IPO is in its cooling-off period, a representative wants to email clients the preliminary prospectus with the strongest growth figures highlighted, plus a bullish research note. What may he send?

   1. The research note only, since it is the firm's own opinion
   2. The preliminary prospectus exactly as filed, unmarked and unaccompanied
   3. Both, if a principal approves them first
   4. The highlighted prospectus, since highlighting adds nothing new

   Show answer and explanation

   Answer: B. The preliminary prospectus exactly as filed, unmarked and unaccompanied.

   The trap is assuming anything drawn from the document itself must be acceptable. During the registration period the unaltered red herring is the only offering material that may circulate. Highlights, summaries, price predictions, and attached sales literature are prohibited, and principal approval does not cure it.

Practice it: offerings practice questions