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A prospectus is a complex legal document that must accompany the sale or solicitation of the initial offering of a security that is registered with the United States Securities and Exchange Commission (SEC). Common securities that require a prospectus are stocks, exchange-traded funds (ETFs), mutual funds, and retirement planning products such as variable annuities.

Developing a Prospectus

When a company wishes to engage in a public offering of a security, it must register that security with the SEC with the submission of a registration statement. The registration statement is a set of documents, including a draft prospectus, containing information about the security and the issuer. The SEC will review the registration, notify the issuer of any comments or objections, and then the issuer will work to resolve any issues and submit as many versions of the document as needed until it satisfies the requirements of the SEC.

It is important to note that the SEC does not approve a prospectus. If the prospectus meets all requirements, the SEC will declare the prospectus effective, but they go out of their way to ensure that this is not to be interpreted as an approval or endorsement of the security.

Before the prospectus is declared effective, the draft prospectus may be distributed to potential investors to incite interest in purchasing the security once it is for sale. This preliminary prospectus is referred to as a “red herring” prospectus. The name comes from the language printed in red on the cover of the prospectus disclosing that the prospectus is not effective and distribution of the prospectus is not a sales solicitation.

What’s in a Prospectus?

We have established that the prospectus is an important document, but you may be wondering what information is contained in a prospectus.

A prospectus includes information about the purpose of the issue, the price of the security, and detailed information about the issuer. This usually includes biographies of the issuer’s directors, and outstanding legal issues that the issuer may be dealing with, and information on the financial health of the issuer.

Public offerings of securities must be done through a firm known as a principal underwriter. The principal underwriter is usually an investment bank, although insurance companies usually own their principal underwriter as an affiliate. The prospectus will disclosure who is underwriting the issue.

For mutual funds and ETFs, the prospectus will discuss in detail the investment objective of the fund, as well as any sales charges and ongoing management fees associated with owning shares of the fund.

When is a Prospectus Not Required?

Because a prospectus is only required with the initial public offering of a security, a prospectus is not required for the sale of a security on the secondary market. This primarily refers to stocks and ETFs. If the original owner of the shares sells them to someone else, then a prospectus is not required to accompany the sale. The same is true for any subsequent sales.

Prospectus requirements only apply to registered securities. There are many financial products that resemble securities but are not registered with the SEC and thus are not required to be sold with a prospectus. Some examples of these products are certificates of deposit (CDs) and retirement planning products such as fixed and indexed annuities.

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