UNDERWRITING
We have already mentioned that development banks and
financial institutions underwrite the issue of shares and debentures of public
limited companies. Besides, investment trusts, stock-brokers, issue houses and
other similar organisations also underwrite the public issue of shares and
debentures. Those who underwrite security issues are known as Underwriters. Let
us study in detail about underwriting.
What is underwriting?
Before issuing the prospectus inviting public subscription
for shares and debentures, the promoters of a company generally make
arrangements whereby public response to the issue may be encouraging.
Otherwise, the promoters cannot be sure the shares or debentures would be fully
or substantially subscribed by the public finance would he available.
Similarly, when any existing company to raise additional finance by issuing
shares or debentures, it has to be reasonably sure that there is adequate
response to the issue.
Underwriting refers to an agreement between the promoters or
directors of a company on the one hand and an individual, firm or institution
(known as underwriter) the other, whereby the latter agrees to take up the
whole or part of the shares or debentures issued which may not be subscribed by
the public. In consideration undertaking given by the underwriter, the company
agrees to pay a commission which is known as 'underwriting commission'. The
commission agreed upon is generally a percentage of the issue price of the
shares or debentures underwritten.
Terms and
Conditions of Underwriting
There is a written agreement between the company and the
underwriter known as the ‘Underwriting Agreement' (or Contract). Usually, the
following aspects are specified in this agreement.
i)
The number of shares or debentures which are
agreed to be underwritten.
ii)
An undertaking by the underwriters to take up
such of the shares or debentures as are not subscribed by the public.
iii)
An undertaking by the company that the terms of
issue given in the prospect, will not be changed without the consent of
underwriters.
iv)
Authority of the underwriters to the company to
allot them the balance of shares or debentures not taken up by the public.
v)
The rate of commission to he paid to the
underwriters and the mode of payment.
The commission is payable as a
percentage of the issue price of all the shares or debentures even if the issue
is fully subscribed by the public.
Sometimes the underwriters want to
subscribe to a block of shares or debentures even if the total issue is fully
subscribed by the public. This is known as 'firm offer’ A clause to that
effect is then included in the underwriting agreement. 'Thereby the
underwriters are assured of allotment of the block of shares or debentures
specified for which they have made a firm offer.
Legal
Regulations
Regarding payment of underwriting commission, certain legal
requirements, as prescribed under the Companies Act, must be fulfilled by the
company. First, the payment of the commission must have been authorised by the
Articles of Association of the company. Secondly, the commission agreed to be
paid must not exceed 5% of the issue price of shares, and in the case of
debentures it must not exceed 2.5% of the issue price. The amount or rate of
commission agreed to be psi must be disclosed in the prospectus or statement in
lieu of prospectus. The commission may be paid out of capital or out of
profits.
Advantages
and Limitations of Underwriting
To the promoters of a company the most important advantage
of underwriting is that the funds required for the enterprise become available
whether or not there is adequate public response to the issue of shares and
debentures. The underwriters ensure the availability of finance. A new company
has to invariably enter into various contracts with different parties for
purchase of fixed assets and other arrangements, before the commencement of
business. The promoters can confidently proceed with the preliminary steps
after the underwriting agreement. They now have to wait for the public response
and actual subscription to the issue of slurp debentures. Thus, precious time
may be saved and business activities started on a sound basis as a result of
underwriting.
Another advantage of underwriting is that the company gets
the benefit of expert advice from the underwriters. Every underwriter, before
entering into an agreement, carefully examines the scheme of financing the
business ventures prepared by the company. The underwriter signs the contract
only when the scheme is sound, while examining the scheme, the underwriter may
suggest improvements in the scheme and thus enable the company to avoid future
setbacks. If a reputed firm has underwritten the issue of shares or debentures,
it creates confidence in the public and helps the company to raise the
necessary amount of finance from the public.
Underwriters usually have working arrangement with brokers
and agents who secure public subscription on behalf of the company and earn
commission for their services. Thus, public response to the issue of shares and
debentures is not restricted to any particular area but secured from different
areas. Members of the public who intend to invest their savings are also
benefited as a result of underwriting of shares and debentures offered by a
company. It is expected that the underwriters must have fully satisfied
themselves about the soundness of the issue before underwriting the same.
Hence, an investor runs much less risk when he subscribes to the issue which
has been underwritten than otherwise.
The only disadvantage of underwriting is that it adds to the
cost of raising finance. Thus, the rate of return on investment proposed to be
made with the funds raised must be sufficiently high so as to absorb the
additional cost of floating shares and debentures. But the significance of
underwriting arrangement is such that even well-established profitable
companies cannot avoid it while issuing additional shares or debentures to the
public. Smaller companies often find the cost involved quite heavy.
Underwriting
Agencies and Institutions
We have stated before that any individual,
partnership firm, company or financial institution may become an underwriter.
They may be regarded as underwriting agencies or institutions. In India, the
development banks, commercial banks, investment companies, investment trusts
and stock brokers (share brokers) engage underwriting business. Some of the
well-known underwriting agencies in India are given below.
1-
Development banks-- IFCI, IDBI, ICICI, SFCs
2-
Investment Institutions-- LIC, GIC, UTI and Investment Companies
3-
Commercial Banks-- State Bank of India, Central Bank.
Bank of India, Bank of Baroda, etc.
4-
Others--
Stock brokers and financiers like the Firm of Place, Siddens and Gough,
etc.
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