After reading this article you will learn about the Underwriting of Capital Issues:- 1. Meaning and Nature of Underwriting 2. Forms of Underwriting 3. Need and Significance 4. SEBI’S Guidelines.
Meaning and Nature of Underwriting:
Underwriting in the context of a company means undertaking a responsibility or giving a guarantee that the securities (shares and debentures) offered to the public will be subscribed for. The firms which undertake the guarantee are called ‘underwriters’. Underwriting is similar to insurance in the sense that it provides protection to the issuing company against the failure of an issue of capital to the public.
It ensures success of new issues of capital and if the shares or debentures are not subscribed by the public. Wholly, the underwriters will have to take them up and pay for them. Underwriting is, therefore, an act of undertaking the guarantee by an underwriter of buying the shares or debentures placed before the public in the event of non- subscription.
According to SEBI Rules 1993, underwriting means an agreement with or without conditions to subscribe to the securities of a body corporate when the existing shareholders of such body corporate or the public do not subscribe to the securities offered to them. ‘Underwriter’ means a person who engages in the business of underwriting of an issue of securities of a body corporate.
The underwriters, for providing this service to the issuing companies charge a commission generally calculated at an agreed specified rate on the issue price of whole of the shares or debentures under written. Such a commission is called underwriting commission which is payable on the whole of shares or debentures underwritten even if the public takes up all the shares or debentures offered.
The issuing company has, thus, to enter into an agreement with one or more underwriter/s who may be either an individual, a firm, bank or some financial institution.
In an English case, the learned Judge defined underwriting as “an agreement entered into before the shares are brought before the public that in the event of the public not taking up the whole of them or the number mentioned in the agreement, the underwriter will, for an agreed commission take an allotment of such part of the shares as the public has not applied for”.
In India, the Companies Act, 1956 limits the underwriting commission on issue of shares at 5% of the issue price of shares and in case of debentures at 2½% of the issue price of debentures.
Forms of Underwriting:
The nature and form of underwriting transactions depend mainly upon the nature of the project, the state of the capital market, the general response of the investors to the new issues, the reputation of the promoters and capacity of the underwriters. It may be undertaken on a commission basis.
An issuing company may get underwriting from a single underwriter but where the size of the issue is so large that it is unmanageable by a single underwriter and the risk involved is also high, the company may approach a number of underwriters.
Thus, an underwriting agreement may take any of the following forms:
1. Full Underwriting:
It is an agreement under which the underwriter undertakes the guarantee of buying the whole of shares or debentures placed before the public in the event of non-subscription. The liability of the underwriter is to buy and pay for the entire unsubscribed portion of the issue.
2. Partial Underwriting:
Under this type of agreement, the underwriter undertakes the guarantee for only part of the issue offered to the public and his liability is limited to the extent of unsubscribed portion of the issue underwritten by him.
3. Joint Underwriting:
In case of a large issue which is unmanageable by a single underwriter and where the risk involved is too high, the issuing company may enter into underwriting agreement with more than one underwriter. Each underwriter undertakes the guarantee for the issue of a certain portion of the whole issue offered to the public.
Thus, underwriters share the risk involved in the ratio of the number of shares or debentures underwritten by them. Sometimes the promoters of issuing company prefer joint underwriting from underwriters operating in different regions of the country so as to diffuse the issue over a number of investors scattered all over the country and retain control over management of the company.
4. Syndicate Underwriting:
Under this type of underwriting, a number of underwriting firms enter into an agreement among themselves to undertake the guarantee of buying shares or debentures of a large issue offered to the public involving huge funds and risk.
Syndicate underwriting is essentially different from joint underwriting so far as the agreement among the underwriters is concerned. Thus, in syndicate underwriting two types of separate agreements take place, one between the issuing company and the syndicate of underwriters, and the other among the underwriters who are members of the syndicate.
5. Firm Underwriting:
When an underwriter undertakes to buy or subscribe a certain number of shares or debentures irrespective of the subscription from the public, it is called firm underwriting.
The liability of underwriters in case of firm underwriting is both for shares underwritten as well as such part of the shares as the public has not applied for. Firm underwriting generates confidence among investors and increases the chances of success of the issue.
6. Sub-Underwriting:
Sometimes, the underwriter enters into agreement with some other underwriters to undertake guarantee for the issue of whole or part of the issue underwritten by him. Such an agreement between the underwriter and the other underwriters (called sub-underwriters) is known as sub-underwriting.
The sub-underwriters have no agreement with the issuing company and work under the main underwriter who pays them some commission out of his underwriting commission.
7. Outright Purchases of Issues:
In all the six forms of underwriting agreements discussed above, the underwriters provide the services on commission basis.
However, in some cases the underwriters, instead of undertaking guarantee to buy shares or debentures not subscribed by the public, may enter into an agreement to out-rightly purchase the issue (shares or debentures) at an agreed price and arrange to sell the same latter through their own arrangements.
Need and Significance of Underwriting:
Whenever new issues of capital are made, there is always certain risk of non-subscription or under- subscription of securities by the public. The plans of the promoters of the companies remain unimplemented and their reputation adversely affected if the issues are not successful.
Underwriting is a safer way of marketing securities for new issues of capital. It is an insurance in the sense that it provides protection against such risks.
Thus, it is a very useful method of raising finance through issue of securities (shares and debentures). It is not only the issues of equity share capital that need be underwritten. The analysis of underwriting of issues indicates that almost 100 percent of the issues of preference share capital and debentures are underwritten in India.
Although, the need for underwriting of initial issues is more, especially in case of new un-experienced promoters; the further issues of capital are also underwritten. The extent of underwriting required depends upon the nature of the project, the state of the capital market, the general response of the investors and the reputation of the promoters.
Thus, underwriting plays a very significant role in corporate financing.
The importance of underwriting can further be highlighted from the following functions performed by the underwriters:
1. Assurance of Adequate Finance:
Underwriting is an act of undertaking guarantee by an underwriter to buy and pay for the shares or debentures placed before the public in the event of their non-subscription. Thus, through underwriting, an issuing company is assured of procuring the required funds from the issue of shares or debentures.
In the event of non-subscription by the public, underwriters purchase the unsubscribed part of the issue and provide finance to the company.
2. Supplying Valuable Information to Companies:
In addition to the protection of risk of the issuing companies with regard to the success of the issue, the underwriters supply valuable information in regard to capital market conditions, general response of the investors, etc. to the issuing companies. These companies are, usually, benefited from the expert-advice of the underwriters.
3. Distribution of Securities:
After purchasing securities, underwriters distribute the same to the real investors. The underwriters, through agents and others diffuse the issue over a large number of investors scattered in different part of the country. Thus, underwriting helps promoters to retain control over the management of the company.
4. Increase in Goodwill of the Issuing Company:
The underwriting of capital issues by prestigious institutions generates confidence among investors and improves their response to the issues. Investors in advanced countries are influenced more by the prestige of the underwriting agencies than by the prestige of the issuing company. Underwriting, thus, ultimately increases the goodwill of the issuing company.
5. Service to Prospective Investors:
Underwriters provide essential information about the issuing companies to the prospective investors and also advise them about various issues. They encourage people to save more and direct their savings in corporate securities. Thus, investors are also benefited through underwriting.
6. Service to the Society:
The pace of industrialisation of a country depends to a great extent upon the successful flotation of capital issues. By mobilising resources and providing adequate finance, underwriters play a very important role in setting up of new projects, increasing employment, production and per capita income. Thus, it is not only the corporate enterprises but also the society at large which is benefited by underwriting.
SEBI’S Guidelines on Underwriting:
(a) As per the original Guidelines issued by SEBI on 11.6.1992, underwriting was mandatory for full issue and minimum requirement of 90% subscription was also mandatory for each issue of capital to public. However, as per the Revised Guidelines issued by SEBI on 10.10.94, underwriting is not mandatory now and the issuers have the option of deciding whether the issue is to be underwritten or not.
Number of underwriters would also be decided by the issuers.
(b) If the issue is not underwritten and if the minimum subscription of 90% of the offer to the public is not received, the entire amount received as subscription would have to be returned in full.
(c) If the issue is underwritten and if the company does not receive 90% of the issued amount from public subscription plus accepted development from underwriters, within 60 days of the opening of the issue, the company should refund the amount of subscription. In case of disputed devolvement, the company should refund the subscription if the above conditions are not met.
(d) The lead manager(s) must satisfy themselves about the net worth of the underwriters and the outstanding commitment and disclose the same to SEBI. A statement to this effect should be incorporated in the prospectus.
(e) The underwriting agreement may be filed to SEBI.