Underwriting is an agreement, entered into by a company with a financial agency, in order to ensure that the public will subscribe for the entire issue of shares or debentures made by the company. The financial agency is known as the underwriter and it agrees to buy that part of the company issues which are not subscribed to by the public in consideration of a specified underwriting commission. The underwriting agreement, among others, must provide for the period during which the agreement is in force, the amount of underwriting obligations, the period within which the underwriter has to subscribe to the issue after being intimated by the issuer, the amount of commission and details of arrangements, if any, made by the underwriter for fulfilling the underwriting obligations. The underwriting commission may not exceed 5 percent on shares and 2.5 percent in case of debentures.
Underwriting has become very important in recent years with the growth of the corporate sector. It provides several BENEFITS to a company:-
- It relieves the company of the risk and uncertainty of marketing the securities.
- Underwriters have an intimate and specialized knowledge of the capital market. They offer valuable advice to the issuing company in the preparation of the prospectus, time of floatation and the price of securities, etc. They also provide publicity service to the companies which have entered into underwriting agreements with them.
- It helps in financing of new enterprises and in the expansion of the existing projects.
- It builds up investors’ confidence in the issue of securities.
- The issuing company is assured of the availability of funds. Important projects are not delayed for want of funds.
- It facilitates the geographical dispersal of securities because generally, the underwriters maintain contacts with investors throughout the country.
Types of Underwriting
- Syndicate Underwriting: – is one in which, two or more agencies or underwriters jointly underwrite an issue of securities. Such an arrangement is entered into when the total issue is beyond the resources of one underwriter or when he does not want to block up large amount of funds in one issue.
- Sub-Underwriting:- is one in which an underwriter gets a part of the issue further underwritten by another agency. This is done to diffuse the risk involved in underwriting.
- Firm Underwriting: – is one in which the underwriters apply for a block of securities. Under it, the underwriters agree to take up and pay for this block of securities as ordinary subscribers in addition to their commitment as underwriters.
Underwriters
Another important intermediary in the new issue/primary market is the underwriters to the issues of capital who agree to take u securities which are not fully, subscribed. They make a commitment to get the issue subscribed either by other or by them. Through underwriting is not mandatory after April 1995, its organization is an important element of the primary market. Are appointed by the issuing companies in consultation with the lead manager/ merchant banker to the issues. A statement to the effect that in the opinion of the lead manager, the underwriters asset are adequate to meet their obligation should be incorporated in the prospectus certificate.
Registration
To act as underwriter, a certificate of registration must be obtained from the SEBI in granting the registration, the SEBI considers all matters relevant relating to the underwriting and in particular,
- The necessary infrastructural like adequate office space, equipment and manpower to effectively discharged the activity:
- Past experience in underwriting/ employment of at least two persons with experience in underwriting:
- Any person directly/ indirectly connect with the applicant is not registered with the SEBI as underwriter or previous application of any such person has been rejected or any disciplinary action has been taken against such person under the SEBI act/rules/regulation.
- Capital adequacy requirement of not less than the net worth ( CAPITAL + free reserve) of Rs. 20 lakh: and
- The applicant/ director/ principle officer/ partner has been convicted of offence involving moral turpitude or found guilty of any economic offence. Fee underwriters, had to, for grant or renewal of registration, pay a fee to the SEBI from the date of initial grant of certificate, Rs 2 lakh for the first and second year and Rs 1 lakh for the third year. A fee of Rs 20,000 was payable every year to keep the certificate in force or for its renewal. Since 1999 the registration fee has been raised to Rs 5 lakh. To keep the registration in force, renewal fee of Rs 1 lakh. Every three years from the forth year the date of initial registration is payable. Failure to pay the fee would result in the suspension of the certificate of registration.
General obligations and responsibilities of Underwriters:
a) Code of conduct :
Every underwriter has at all time to abide by a code of conduct; he has to maintain high standard of integrity, dignity and fairness in all his dealings with his clients and, other underwriters in the conduct of his business. He has to ensure that he and his personal act in an ethical manner in all dealing with the issuers of capital. An underwriter has to rendered high standard of service exercise due diligence, ensure proper care and exercise independent professional judgment. He must disclose to the issuer his possible source/ potential areas of conflict of duties and interest of other underwriters to place them in a disadvantageous position in relation to him while competing for/carrying out any assignment. He must not make any written or oral statement to misrepresent.
- The service that he to be capable of performing for the issuer/ or has rendered to other issuer or
- He underwriting commitment
He should not divulge to other issuer/ any party any confidence information about his issuer, which forms the come to his knowledge and deal in securities of any issuer without disclosing to the SEBI or to the board of directors of the issuer. An underwriter should not willfully make untrue statement/suppress material fact in any document, reports, papers or information furnished to the SEBI.
b) Agreement with clients:
Every underwriter has to enter into an agreement with the issuing company. The agreement, among others, provides for the period during which the agreement is in for amount of underwriting obligations, the period within which the underwriter has to subscribe to the after being intimated by/on behalf of the issue, the amount of commission/ brokerage, and detail of arrangement, If any , made by the underwriter for fulfilling the underwriting obligations.
c) General responsibilities :
An underwriter cannot derive any direct or indirect benefit from underwriting the issue other than by the underwriting commission. The maximum obligation under all writing agreements of an underwriter cannot exceed 20 times his net worth, underwriters have to subscribe for securities under the agreement within 45 days of the receipt of intimation from he issuer.
d) Inspection and disciplinary proceedings:
The framework of the SEBI right to undertake the inspection of the book of account, other record documents of the underwriters, the procedure for inspection and obligation of the underwriters is on the same pattern as applicable to the lead manager
e) Action in case of default :
The liability for action in case of default arising out of
- Non-compliance with any conditions subject to which registration was granted,
- Contravention of any provision of the SEBI act/rules/ regulation underwriter involves the suspension/cancellation of registration: the effect of suspension/ cancellation on the lines followed by the SEBI in case of lead manager.
Role and Selection of Underwriters
- The primary role of the underwriter is to purchase securities from the issuer and resell them to investors.
- Underwriters act as intermediaries between issuers and investors, providing for an efficient of capital.
- The underwriters take the risk that it will be able to resell the securities at a profit.
- Perhaps the most visible and familiar element of the initial public offering process is the underwriter. The underwriter is the organization that is actually responsible for pricing, selling, and organizing the issue, and it may or may not provide additional services. With direct public offerings, there is no need for an underwriter.
Selection of a good underwriter is of the utmost importance, but it’s important to understand that many underwriters are equally selective of their clients. Because an underwriter’s reputation depends on successful issues, few firms will be willing to stake their reputation on questionable companies.
- When selecting an underwriter, it’s important to seek out an established company with a good reputation and quality research coverage in your field. The decision may also depend on the kind of agreement the underwriter is willing to make regarding the sale of shares. For profitable and established private companies, it shouldn’t be difficult to locate an underwriter willing to make a firm commitment arrangement. Under such an agreement, the underwriter agrees to buy all issues shares, regardless of ability to sell them at a particular price.
- For riskier or less established companies, an underwriter may offer best efforts arrangement for the initial public offering. A best efforts contract requires the underwriter to buy only enough shares to fill investor demand. Under this arrangement, the underwriter accepts no responsibility for unsold shares.
- Aside from fees and sales arrangements, most underwriters are fairly similar in their roles. An underwriter will assist in the preparation and submission of all appropriate SEC filings, helping potential investors make informed decisions about your offering. All underwriters are required to exercise due diligence in verifying the information they submit, so a certain amount of investigation should be expected from any responsible underwriter.
In addition to SEC registration filings, the underwriter will create a preliminary prospectus that will become a major part of the issue’s marketing campaign. This document is also referred to as the red herring, after a small red passage in the document that states that the company is not attempting to sell shares prior to SEC approval.
Once SEC approval is obtained, the underwriter and the corporation will embark on a road show to gauge and attract interest from investors. While the road show does not involve getting binding commitments from investors, it helps the underwriter determine the best strategies for pricing and issuance.
After the initial public offering, the underwriter continues to provide services for the newly public corporation. For months or even years after the offering, the underwriter may continue to make a market for the stock, ensuring liquidity for investors and making the shares more desirable. Twenty-five days after the issue, the underwriter is also permitted to make statements or projections regarding the company and its prospects.