Definition
A red herring is a preliminary prospectus filed by a company with the SEC or state securities commission that provides details about an upcoming securities offering, such as an initial public offering (IPO). It is called a “red herring” because the document has a red disclaimer statement on its front page, indicating that the registration statement has been filed but has not yet become effective. Therefore, the information contained in it is subject to amendments.
Key Characteristics
- Preliminary: Not the final version; subject to changes before the final prospectus.
- Disclaimer: Contains a red-lettered legend stating that the registration statement has been filed but not approved by the SEC.
- Information: Provides details about the company, including its financial status, management, and planned use of proceeds from the securities offering.
Examples
- Tech Start-up IPO: A growing tech start-up decides to go public to raise capital for expansion. It files a red herring with the SEC that includes financial statements, a business summary, and projections.
- Pharmaceutical Company: A pharmaceutical company planning an IPO includes information in its red herring about its new drug development pipeline, financial health, potential market, and risks.
Frequently Asked Questions (FAQs)
1. What information is included in a red herring?
A red herring typically includes the company’s important financial data, business model, management team, market strategies, and risks. It also outlines the potential number of shares to be offered and the intended use of the proceeds.
2. Why is it called a red herring?
The term “red herring” comes from the red disclaimer on the preliminary prospectus which indicates that the registration statement is not yet effective and is subject to changes.
3. Can securities be sold based on the information in a red herring?
No, securities cannot be sold based on a red herring prospectus. The document is only intended to provide potential investors with preliminary information.
4. Who files a red herring prospectus?
Companies planning to issue securities, such as during an IPO, file a red herring with the Securities and Exchange Commission as part of their registration process.
5. How does a red herring differ from a final prospectus?
A red herring is preliminary and subject to change, while a final prospectus is the official and approved version that includes settled details about the offering and can be used to sell the securities.
Related Terms with Definitions
- Initial Public Offering (IPO): The first sale of shares by a company to the public.
- Prospectus: A formal document describing the details of a securities offering, which must be provided to potential investors.
- Securities and Exchange Commission (SEC): A U.S. government agency responsible for regulating the securities markets and protecting investors.
- Registration Statement: Official documentation filed with the SEC that a company must use to register its securities before making a public offering.
Online Resources
- SEC’s Guide on Registration Statements
- Investopedia: Red Herring Definition
- SEC Edgar Database for searching company filings including red herrings
References
- Securities and Exchange Commission. “Investor Publications,” SEC.gov.
- “Prospectuses”, Investopedia.
Suggested Books for Further Studies
- “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions” by Joshua Rosenbaum and Joshua Pearl
- “The Intelligent Investor: The Definitive Book on Value Investing” by Benjamin Graham and Jason Zweig
- “One Up On Wall Street” by Peter Lynch and John Rothchild
Real Estate Basics: Red Herring Fundamentals Quiz
### What does a "red herring" refer to in the context of securities?
- [ ] A misleading financial document.
- [ ] An effective registration statement.
- [x] A preliminary prospectus filed with the SEC.
- [ ] A finalized prospectus approved by the SEC.
> **Explanation:** A red herring is a preliminary prospectus filed with the SEC, subject to change, and not yet approved for selling securities.
### Where would you find the "red herring" statement?
- [ ] In the final prospectus.
- [x] On the front page of the preliminary prospectus.
- [ ] In the investment summary.
- [ ] In the financial statements section.
> **Explanation:** The red herring statement appears prominently on the front page of the preliminary prospectus, alerting that the information is not yet finalized.
### Can securities be sold using the information in a red herring?
- [ ] Yes, immediately after it is filed.
- [ ] No, only after the final prospectus is approved.
- [x] No, because the red herring is not yet an approved document.
- [ ] Yes, as soon as the SEC reviews it.
> **Explanation:** Securities cannot be sold based on a red herring because it is a preliminary document that has not been approved by the SEC.
### What key disclaimer does a red herring include?
- [ ] "Approved for public use."
- [ ] "Final statement of registration."
- [x] "Filed with the SEC but not yet effective."
- [ ] "Guaranteed financial projections."
> **Explanation:** The red herring includes a disclaimer stating that it has been filed with the SEC but is not yet effective and may be subject to changes.
### Who primarily reviews a red herring document?
- [ ] Stock exchanges
- [ ] Potential investors
- [x] The Securities and Exchange Commission (SEC)
- [ ] Financial analysts
> **Explanation:** The primary review of a red herring prospectus is conducted by the Securities and Exchange Commission (SEC) to ensure the information meets regulatory requirements before approval.
### Why is a red herring important for an IPO?
- [x] It provides initial key information about the offering.
- [ ] It marks the end of the IPO process.
- [ ] It allows immediate fundraising.
- [ ] It is a final regulatory requirement.
> **Explanation:** A red herring is important because it gives potential investors preliminary information about the company and the offering before the final approval.
### What are the companies providing in a red herring?
- [x] Financial data, business model, management info, market strategies, and risks.
- [ ] Finalized financial plans.
- [ ] Binding commitments.
- [ ] Shareholder returns.
> **Explanation:** Companies include comprehensive preliminary information such as financial data, business strategies, management details, risks, etc., in a red herring.
### In terms of investment documents, what does a red herring not equate to?
- [x] A finalized investment offer.
- [ ] A company financial statement.
- [ ] An SEC filing summary.
- [ ] Managerial report.
> **Explanation:** A red herring is preliminary and no securities can be sold based on it, unlike a finalized investment offer published in the final prospectus.
### If an investor reads a red herring, what should they do next?
- [x] Wait for the release of the final prospectus.
- [ ] Buy shares immediately.
- [ ] Invest based on the preliminary data.
- [ ] Ignore subsequent information.
> **Explanation:** Investors should wait for the final prospectus before making any investment decisions since the red herring is not yet an approved document.
### How does a red herring prospectus contribute to market transparency?
- [x] By providing potential investors with detailed preparatory information about an upcoming offering.
- [ ] By avoiding the disclosure of financial risks.
- [ ] By selling shares pre-approval.
- [ ] By creating less scrutiny for new stocks.
> **Explanation:** A red herring enhances market transparency by sharing detailed preliminary information with potential investors prior to any securities sales.
