Underwriting agreement

What Is Underwriting Agreement?

An underwriting agreement is a legally binding contract between a company (the issuer) issuing new securities and the lead underwriter(s) who agree to purchase or sell those securities to the public. This agreement formalizes the terms and conditions of a new public offering within the broader capital markets landscape. It meticulously details the obligations of both parties, the type of underwriting commitment, the offering price, the underwriting spread, and any indemnities. The underwriting agreement is a crucial document in the process of raising capital through the issuance of stocks or bonds.

History and Origin

The concept of underwriting, particularly in the context of securities, has roots in the syndication practices of early financial markets. However, the modern form of the underwriting agreement, as a structured legal document for public offerings, largely evolved with the growth of regulated securities markets. A pivotal moment in its formalization was the enactment of the Securities Act of 1933 in the United States. This legislation, designed to ensure full and fair disclosure in the sale of securities, significantly shaped the responsibilities and liabilities of underwriters and issuers, thereby necessitating comprehensive underwriting agreements.²¹, ²², ²³, ²⁴

Key Takeaways

An underwriting agreement is a contract between an issuer and an underwriter for a securities offering.
It specifies the type of commitment (e.g., firm commitment or best efforts), pricing, and responsibilities.
The agreement includes clauses for indemnification and representations and warranties by the issuer.
It is fundamental to the process of an initial public offering (IPO) or other new issues.
The agreement aims to protect both the issuer and the underwriter by clearly defining roles and risks.

Formula and Calculation

An underwriting agreement itself does not involve a specific formula or calculation in the traditional sense, as it is a legal contract. However, it does outline the financial terms crucial to the offering's success, primarily the underwriting spread.

The underwriting spread is the difference between the price at which the underwriter purchases the securities from the issuer and the public offering price at which they are sold to investors. It represents the gross profit margin for the underwriting syndicate.

Underwriting Spread (per share) = Public Offering Price (POP) - Price Paid to Issuer

For example, if an underwriter buys shares from the issuer at $19.00 and sells them to the public at $20.00, the underwriting spread is $1.00 per share. This spread covers the underwriter's expenses, fees, and profit.

Interpreting the Underwriting Agreement

Interpreting an underwriting agreement involves understanding the allocation of risk management and responsibilities between the issuer and the underwriter. Key sections to scrutinize include:

Type of Commitment: This defines the underwriter's obligation. In a firm commitment underwriting, the underwriter agrees to purchase all the securities from the issuer, thus assuming the full risk of unsold shares. In a best efforts agreement, the underwriter only commits to selling as many securities as possible without assuming inventory risk.
Representations and Warranties: These are assurances from the issuer regarding the accuracy of information in the prospectus and the legal standing of the company. Breaches can lead to legal action.
Indemnification Clauses: These specify how liabilities (e.g., from misstatements in the prospectus) are shared or assumed by one party, often protecting the underwriter from issuer-related legal claims.
Conditions to Closing: These outline preconditions that must be met before the sale of securities is finalized, such as regulatory approvals or the absence of adverse market changes.

Understanding these elements helps parties assess their exposure and obligations throughout the offering process.

Hypothetical Example

Imagine "GreenTech Innovations Inc." wants to raise capital by issuing 10 million new shares to fund a solar panel manufacturing expansion. They engage "Global Capital Markets," an investment bank, as their lead underwriter.

Drafting the Agreement: GreenTech and Global Capital Markets draft an underwriting agreement. This agreement specifies a firm commitment underwriting, meaning Global Capital Markets will buy all 10 million shares.
Pricing: After extensive due diligence, they agree on a price of $24.00 per share that Global Capital Markets will pay to GreenTech. The public offering price is set at $25.00 per share.
Syndicate Formation: Global Capital Markets forms an underwriting syndicate with other investment banks to help distribute the shares.
Sales and Settlement: Once regulatory approvals are secured and the offering commences, Global Capital Markets and the syndicate sell the shares to investors at $25.00 each. They then remit $24.00 per share to GreenTech. The $1.00 difference per share is the underwriting spread, totaling $10 million for the 10 million shares.
Contingencies: The agreement also includes clauses stating that if, for example, a major natural disaster significantly impacts GreenTech's manufacturing facilities before the closing date, Global Capital Markets has the right to terminate the agreement, protecting them from unforeseen risks.

This hypothetical scenario demonstrates how the underwriting agreement underpins the entire process, outlining the financial terms, responsibilities, and protective measures for both the issuer and the underwriter.

Practical Applications

Underwriting agreements are indispensable in primary market transactions, particularly in the realm of initial public offerings and subsequent seasoned equity offerings, as well as debt issuances. They are the legal backbone for how new securities are brought to market and subsequently traded on a stock exchange. Regulators, such as FINRA, oversee the terms and arrangements outlined in these agreements to ensure fairness and transparency. For instance, FINRA Rule 5110 (Corporate Financing Rule) sets forth requirements for the filing and review of underwriting terms and compensation arrangements in public offerings, aiming to prevent unfair practices.¹⁶, ¹⁷, ¹⁸, ¹⁹, ²⁰ This regulatory oversight underscores the importance of a meticulously drafted underwriting agreement in maintaining market integrity and investor protection.¹³, ¹⁴, ¹⁵

Limitations and Criticisms

While underwriting agreements are critical for capital formation, they are not without limitations or criticisms. One common critique, particularly in the context of IPOs, is the phenomenon of "IPO underpricing." This occurs when the initial public offering price is set below the price at which the shares trade in the secondary market shortly after the offering. Critics argue that significant underpricing results in "money left on the table" for the issuing company, effectively transferring wealth from the issuer to the initial investors and the underwriters. Research, such as studies published by the National Bureau of Economic Research (NBER), has extensively documented and analyzed the reasons for and implications of IPO underpricing, including potential conflicts of interest for underwriters who might benefit from a lower offering price to ensure successful distribution. Additionally, the extensive due diligence required of underwriters, while crucial for investor protection, can be resource-intensive and may not always uncover every potential issue with an issuer.

Underwriting Agreement vs. Placement Agent Agreement

The distinction between an underwriting agreement and a placement agent agreement lies primarily in the level of commitment and risk assumed by the financial intermediary.

An underwriting agreement typically involves an underwriter (or a syndicate of underwriters) providing a commitment to an issuer. In a "firm commitment" underwriting, the underwriter guarantees the purchase of all the securities being offered, effectively assuming the inventory risk if they cannot resell them to investors. This arrangement is common in large public offerings, such as IPOs.

In contrast, a placement agent agreement involves a "best efforts" arrangement. The placement agent agrees to use their best efforts to sell the securities on behalf of the issuer but does not guarantee the sale of all, or any, of the securities. The issuer retains the risk of unsold securities. This type of agreement is more common in private placements or for smaller, less established offerings where the risk for the intermediary is too high for a firm commitment.

FAQs

What is the primary purpose of an underwriting agreement?

The primary purpose of an underwriting agreement is to formalize the terms and conditions under which an underwriter helps an issuer sell new securities to the public, defining responsibilities, pricing, and risk allocation.

Are all underwriting agreements the same?

No, underwriting agreements vary significantly based on the type of offering (e.g., stock vs. bonds), the nature of the underwriter's commitment (e.g., firm commitment vs. best efforts), and the specific terms negotiated between the issuer and the underwriter.

What is an underwriting syndicate?

An underwriting syndicate is a group of investment banks that collectively agree to underwrite and distribute a large securities offering. The lead underwriter manages the syndicate and the overall process.

Does an underwriting agreement protect investors?

Indirectly, yes. The stringent due diligence requirements on underwriters, formalized within the underwriting agreement, help ensure the accuracy and completeness of information presented to investors in the prospectus. This contributes to investor protection by promoting transparency.

What happens if an underwriter cannot sell all the securities?

If an underwriter has a firm commitment underwriting agreement, they are obligated to purchase the unsold securities, incurring a loss if they cannot resell them. In a best efforts agreement, the issuer bears the risk of unsold securities.¹, ², ³ ⁴, ⁵, ⁶, ⁷, ⁸ ⁹, ¹⁰, ¹¹, ¹²