Underwriting Mechanics

The commitment types

In a firm commitment underwriting, the underwriters buy the entire issue from the issuer and resell it. The issuer's proceeds are certain; the underwriters bear the risk of unsold securities. This is the standard structure for a large corporate offering, and it is why the underwriters' due diligence is more than a formality — they are about to own the securities.

In a best efforts underwriting, the underwriter acts as agent and undertakes to use its best efforts to sell, with unsold securities returned to the issuer. The issuer bears the risk. Two variants add conditions.

All-or-none: unless the entire issue is sold, the offering is cancelled and all funds are returned to investors. Money raised in the interim is held in escrow.

Mini-max: a minimum must be sold for the offering to proceed, and up to a stated maximum may be sold. Below the minimum, funds are returned.

A standby underwriting is used with a rights offering. The underwriter agrees to purchase, at a stated price, any shares that existing shareholders do not subscribe for, ensuring the issuer raises the full amount. It is a firm commitment on the residual.

When an all-or-none or mini-max offering escrows investor funds, SEC Rule 15c2-4 requires the money be promptly transmitted to an escrow agent — because the risk being managed is the underwriter using investors' money before the contingency is satisfied.

The syndicate and the selling group

Large issues are distributed by a syndicate — a temporary association of underwriters formed for one offering.

The managing underwriter, also called the lead or book-running manager, negotiates with the issuer, forms the syndicate, runs the due diligence process, allocates the issue and stabilizes the aftermarket. It signs the underwriting agreement with the issuer on behalf of the syndicate and the agreement among underwriters with the syndicate members.

Syndicate members commit to take a stated portion of the issue and bear the corresponding risk. Their liability may be divided — each responsible only for its own allotment, the Western account — or undivided, where each remains liable for its proportionate share of anything unsold, the Eastern account. Eastern is the more onerous, and it is the standard exam contrast, exactly as in the municipal syndicate covered in lesson 4.5.

A selling group is brought in to help distribute, but takes no underwriting commitment and bears no risk of unsold securities. Selling group members buy at a concession from the public offering price and have no liability for what they do not sell. The difference between a syndicate member and a selling group member is exactly the presence of risk.

The spread

The underwriting spread is the difference between what the issuer receives and the public offering price, and it divides in a fixed hierarchy.

The manager's fee, the smallest component, goes to the managing underwriter for organizing the deal.

The underwriting fee compensates syndicate members for bearing the risk of the commitment.

The selling concession is the largest component and is earned by whoever actually places the security with an investor.

The total takedown is the underwriting fee plus the concession — what a syndicate member earns on securities it sells itself. A selling group member earns only the concession. A dealer outside both groups may be granted a reallowance, which is smaller still.

Worked example. A stock is offered at $20 with a spread of $1.20, divided as a $0.20 manager's fee, a $0.30 underwriting fee and a $0.70 concession. The issuer receives $18.80. A syndicate member selling a share earns the total takedown of $1.00. A selling group member earns $0.70.

The hierarchy is worth memorizing in that order — manager's fee, underwriting fee, concession — because questions give you two of the three and ask for the missing one.

Limits on compensation and conflicts

FINRA Rule 5110, the Corporate Financing Rule, requires that documents and information relating to a public offering be filed with FINRA for review, and prohibits underwriting terms and arrangements that are unfair or unreasonable. The review looks at total compensation — including the spread, expense reimbursements, securities received, and rights of first refusal — measured against the size and type of the offering.

FINRA Rule 5121 governs public offerings of securities with a conflict of interest — where the member underwriting the offering has an interest in the issuer, or where the issuer is the member itself or an affiliate. In defined cases the offering requires participation by a qualified independent underwriter, and prominent disclosure of the conflict in the prospectus. The conflict is that a firm distributing its own or an affiliate's securities has an incentive that is not the customer's.

Rule 5141 governs sales in a fixed price offering: a member selling at a price other than the stated public offering price, before the offering terminates, undermines the fixed price and is generally prohibited. Rule 5160 requires disclosure of price and concessions in selling agreements, and Rule 5190 requires notification to FINRA at defined points in an offering.

Stabilization and the over-allotment

Regulation M governs the activities of distribution participants during an offering, and its general position is that people distributing a security must not simultaneously be bidding for it — that is manipulation of the market they are selling into.

One narrow exception is permitted: stabilization. The managing underwriter may enter a stabilizing bid to support the price during the distribution, subject to strict conditions. A stabilizing bid may not be above the public offering price, must be identified as a stabilizing bid, and must be disclosed in the prospectus. It is the only price manipulation the securities laws expressly permit, and it exists to prevent an orderly distribution collapsing into a disorderly one.

A syndicate covering transaction is a purchase to cover a short position the syndicate created by over-allotting the issue. A penalty bid allows the manager to reclaim the concession from a syndicate member whose customers immediately flip their allocation into the stabilizing bid.

The over-allotment option, commonly called the green shoe after the company whose offering first used it, permits the underwriters to purchase additional shares from the issuer — conventionally up to 15 percent of the offering — to cover over-allotments. If the deal trades well the option is exercised and the issuer sells more; if it trades badly the underwriters cover their short in the market, which supports the price. It is a mechanism that provides aftermarket support without additional risk to the syndicate.

For a representative, the operational point is narrow: stabilization is legitimate, it is disclosed, and describing the resulting price support to a customer as evidence of natural demand would be a misrepresentation.