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Published : August 11, 2010 | Author : modhura.roy
Category : Company Law | Total Views : 21799 | Rating :

Modhura Roy, IInd Year, Rajiv Gandhi School of Intellectual Property Law, Indian Institute of Technology, Kharagpur

Underwriting contract at the time of issue of securities

Financial services are an important component of the financial system. They fulfill the needs of financial institutions, financial markets and financial instruments. The smooth functioning of a financial system will depend upon the range of financial services extended by the providers. The services contribute a lot to the efforts of speeding up the process of economic growth and development.

Financial services in India have witnessed remarkable changes in the recent past after the implementation of “Liberalization, privatization and globalization”. Policies of the Government, the rapid development in information and communication technology in the financial services sector created radical changes in respect of firms, generation of innovative financial products, and financial markets. The credit cult is developing very fast in the country. The use of sophisticated and advanced technology could be reckoned as another specific feature of the global financial services industry. It has now come out with a new instrument known as “stored value card”. The activity of the financial services sector can be charted out through the study of the following:

·Merchant Banking
·Mutual Funds
·Venture Capital
·Credit Rating
·Lease Financing
·Securities and Exchange Board of India (SEBI)
·Depository System

To carry on with the project at hand elucidation on some of the above mentioned topics will be done as and when required with special emphasis on “Underwriting” contract at the time of issue of securities.

Merchant Banking
Funds are tapped from the capital market to finance various mega industrial projects. In attracting public savings, merchant bankers play a vital role as specialized agencies. The function of raising resources happens to be one of their primary businesses. The primary market holds the key to rapid capital formation, growth in industrial production and exports. There has to be accountability to the end use of funds raised from the market. The functions of merchant banks can be summarized as:

·Issue capital
·Foreign loan business
·Finance foreign trade
·Manage individual funds and undertake
·Foreign security business

Today, the merchant bankers play the role of brokers and promoters in issue of securities. They are actively involved in launching and organizing industrial units, mergers and acquisition, transformation of private companies into public owned companies.

The Securities and Exchange Board of India (Merchant Bankers) Rules of 1992 defined a merchant banker[1], “as any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager, consultant, adviser or rendering corporate advisory service in relation to such issue management”. The meaning of the merchant bank refers to an organization that underwrites securities and advises such clients on issues like corporate managers in the ownership of commercial ventures.

Merchant bankers are fully involved in finding investors for “Initial Public Offering (IPO)” of securities sold in the New Issue market. They bring the buyers and sellers together and create market by making arrangements for the public issue. In modern times, importance of merchant banker is very much, because it the key intermediary between the company and issue of capital. Activities of the merchant bankers are –determining the composition of the capital structure, drafting of prospectus and application forms, compliance with procedural

formalities, appointment of registrars to deal with the share application and transfer, listing of securities, arrangement of underwriting / sub-underwriting, placing of issues, selection of brokers, bankers to the issue, publicity and advertising agents, printers and so on. Due to overwhelming importance of merchant banker, it is now mandatory that merchant banker(s) functioning as lead manager(s) should manage all public issues.

In India, merchant banking activities are regulated by:
·Guidelines of the SEBI
·Guidelines of the Ministry of Finance
·Companies Act, 1956
·Securities Contracts (Regulations) Act, 1956
·Listed guidelines of the stock exchanges

Underwriting is the nature of an insurance against the adverse situation in the timing of the public issue. It can be defined as “bearing the risk of not being able to sell a security at the established price by virtue of purchasing the security for resale to the public; also known as firm commitment underwriting”.[2] The person who assures is called as “Underwriter”; and the consideration for the assurance is known as “Underwriting Commission”. The Underwriters give guarantee for the public subscription and in turn they receive the commission. In public issues, after the merchant bankers, the next position goes to the Underwriters, where they play a very major role. The SEBI has defined the Underwriting as “an agreement with or without conditions tot subscribe to the securities of a body corporate where the existing shareholders of such body corporate or the public do not subscribe to securities offered to them”.[3] The Underwriter has been defined as “a person who engages in the business of Underwriting of an issue of securities of a body corporate”.[4] The Underwriting is mandatory for the public issue. The stock exchange regulations clearly specify that no stock broker is allowed to underwrite more than 5 per cent of the public issue and the concerned stock exchange should approve the appointment of broker underwriters. Usually the bankers can underwrite upto 10 per cent of the public issue. The Underwriting Commission cannot be paid on the amounts contributed by promoters, directors, employees and business associates. It is an important element of the primary market. It is appointed by the issuing company in consultation with the merchant bankers. The name of the Underwriter and his obligations should be disclosed in the prospectus. There are a number of financial institutions, commercial banks, insurance companies as well as a number of private companies which provide underwriting. An Underwriter issue is the safe way of marketing securities and the investors are influenced by the prestige of the underwriters. The issuing companies may appoint one or more of the following parties: (A) Financial Institutions, (B) Brokers, (C) Bankers, (D) Investment Companies, and (E) Trusts.

Objectives Of The Underwriting
The objectives of the Underwriting are presented below:

·It guarantees the sale of securities at a given price.

·It facilitates the provision of money during the financial crisis of the company.

·The Underwriter helps the new company in its reorganization.

The following are the salient features of an underwriting agreement:

·The Underwriter may not be able to sell the issues in some situations. The unsold securities are distributed among the underwriters in the agreed proportion.

·The offering price must be maintained for the successful distribution of the securities.

·The company makes a delivery of the securities to the manager and receives the payment on the closing date

·At the termination of the underwriting, the manager must make the final accounting for each underwriter. He should also remit the commissions and accounts for the expenditure incurred.

Underwriting is insurance for the new securities of the public. It is one of the methods of marketing securities. The other methods are:

·Prospectus method, where the capital is raised by this method is very prevalent in India. The distribution expenses may be substantially saved.

·Offer for sale, where the sales are sold largely to the brokers/issue houses. The issue house/brokers again sell the shares to the public at a fixed price. This method saves the company the cost and the trouble of selling the shares to the public. Here a Third party takes over the responsibility.

·Private placement, where the funds are raised in the primary market by selling the security issue to one investor or a small group of investors without resorting to underwriting. The cost of the issue is minimal. It is the most effective way of procuring the long term funds. There is no need to follow the statutory formalities. The offer is made to select a group of known persons.

Kinds Of Underwriting
The following are the various kinds of underwriting agreements:

·The Purchase Contract

·Agreement between Underwriters and Representatives

·The selling agreement

The Purchase Contract: Here the sale of shares is made to the underwriters at an accepted level of proportion. There will be an agreement among several underwriters to purchase the securities from the company.

Agreement between Underwriters and Representatives: This is an agreement between the Underwriters and the Representatives or Managers. The agreement includes all the aspects of the issue of securities:

§ To fix the time of offering;

§ To reserve a proportion of securities for the selected dealers and institutions;

§ Place, date and delivery of securities;

§ Provisions regarding the termination and settlement of the underwriters’ account;

§ Underwriters’ responsibility.

The selling agreement: In this method, the issuer company will make an agreement with the dealers to subscribe the new securities. The agreement includes the offering price, selling concession and provisions for delivery and payment.

An Underwriter is a financial intermediary in the primary market. The Underwriter has been defined as “a person who engages in the business of Underwriting of an issue of securities of a body corporate”[5]. The Underwriters give guarantee for the public subscription and in turn they receive the commission.

Classification Of Underwriters
Underwriters in India may be classified into:
·Institutional Underwriters
·Non-Institutional Underwriters

Institutional Underwriters:
The following are the Institutional Underwriters:

§ Development Banks
§ Commercial Banks
§ Insurance Companies
§ State Finance Corporations
§ Unit Trust of India

The Development Banks are also known as Industrial Banks. They have got long term deposits and are in a position to enter into long term investments. The Industrial banks help the industries by underwriting their shares and debentures. When an Industrial Unit approaches for underwriting the shares and for direct financial aid, the industrial banks investigate the prospects of the industry, the soundness of the financial requirements, the feasibilities and the utilities of the schemes. If the shares and debentures are not fully subscribed or the minimum subscription is not taken up by the public within a specified period, the Development Banks come to the rescue and take up the residual amount of shares and debentures. The Underwriting facilitates the direct financial aids to the new industrial set up. Some of the Development banks are Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI) among others.

The Commercial Banks, also known as Public banks, perform the routine banking. Lending and underwriting are their main objectives. A few of them have been rendering services as syndicators of loans and managers to the issue. The Commercial Banks normally act as passive agents by supplying the forms only on request rather than on their own initiative and earn brokerage.

The Insurance Companies are basically investment institution and not development institutions. Life Insurance Corporation (LIC) and General Insurance Corporation (GIC) are the premier institutions in the country which are involved in the insurance sector. These two conventional investment institutions supply funds mainly to provide the liquidity to the investments for developing the corporate sector. The objectives of these corporations are direct lending to industry, subscription to shares and bonds to special industrial financial institution, and purchase of securities of the Joint stock companies from the capital market. The Government corporations also are involved in underwriting business.

The State Financial Corporations are also involved in underwriting business for stimulating the capital market.

The Unit Trust of India is the other conventional investment institution which enjoys superiority as an organizational device because of some activities. It is involved in continuous sale of units, redemption of units at Net Asset Value (NAV), convenience to the small investors of small amount.

Non-Institutional Underwriters
There are two types of non-institutional underwriters in India:

§ Stock brokers

§ Individuals

The Stock brokers act as intermediaries in the purchase and sale of securities in the primary and secondary markets. These persons have a network of brokers, working under them, who spread throughout the length and breadth of the country. They are known as sub-brokers. These people spread message and give publicity about various issues in the offering. They rapidly supply application forms or even go to the extent of collecting money from the investors. They play a very crucial role in the area of underwriting. The brokers can influence their clients by persuasion.

The Individuals/Investment Companies obtain funds from a large number of investors by selling the shares. The pooled funds are placed before the experts to deploy the purchase of financial assets. The benefits derived from the capital market will surpass that of the shareholders. There are two types of investment companies namely: (a) Fixed Investment Trusts, and (b) Management Investment Trusts.

Underwriters are appointed by the issuing companies after consulting the merchant bankers. To act as an Underwriter, a certificate of registration must be obtained from the SEBI. The SEBI has the full authority to grant the certificate of registration. No person should act as an underwriter unless he holds a certificate granted by the SEBI. The stock broker or the merchant banker should hold a valid certificate or registration u/s 12 of the Act.

According to SEBI (UNDERWRITERS) RULES AND REGULATIONS, 1993, section 30, the prospecting person should apply for the grant of the certificate in a particular format (FORM A as per regulation). The board takes into account all the matters that are relevant to underwriting and particularly regarding the below facilities before granting the certificate:

·The applicant has the necessary infrastructure.

·The applicant should have the experience otherwise he should appoint two experienced members.

·The underwriter should satisfy the capital adequacy requirement of net worth of Rs 20.00 Lakhs

·The purpose of net worth means, the applicant might be a proprietary concern or a firm or an association of persons or any body of individuals, the value of capital plus free reserves of business.

·In the case of a body corporate, the value of the paid up capital plus free reserves should be disclosed in the looks of account of the applicant.

If the SEBI believes that the applicant is eligible, then it sends intimation to the applicant that he/she is eligible for the grant of certificate; and thus it grants the certificate in FORM B after the payment of the prescribed fee.

Underwriters had to pay Rs. 5 lakhs as registration fee and Rs. 2 lakhs as renewal fee every three years from the fourth year from the date of initial registration. Failure to pay renewal fee leads to cancellation of certificate of registration.

General Obligations And Responsibilities
Code of Conduct:
Every underwriter has at all times to abide by the code of conduct; he has to maintain a high standard of integrity, dignity and fairness in all his dealings. He must not make any written or oral statement to misrepresent (a) the services that he is capable of performing for the issuer or has rendered to other issues or (b) his underwriting commitment.

Agreements 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 force, the amount of underwriting obligations, the period within which the underwriter has to subscribe to the issue after being intimated by/on behalf of the issuer, the amount of commission/brokerage, and details of arrangements, if any, made by the underwriter for fulfilling the underwriting obligations.

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 underwriting agreements of an underwriter cannot exceed twenty times his net worth. Underwriters have to subscribe for securities under the agreement within 45 days of the receipt of intimation from the issuers.

Every Underwriter should maintain the following accounts, namely:
·If the Underwriter belongs to a body corporate-

§ A copy of the balance sheet, profit and loss account as specified in the Sections 211 and 212 of the Companies Act, 1956;

§ A copy of the auditor’s report referred in Section 227 of the Companies Act, 1956.

·If the Underwriter belongs to a body corporate-

§ The records in respect of all the sums of money received and expended by them; and the matters in respect of the receipt and expenditure

§ Their assets and liabilities

Commission Of Underwriters
The underwriting commission is paid only in accordance with the Section 76 of the Companies Act, 1956. The statutory regulations and other obligations regarding the commission are:

·The underwriting commission should be paid only with the acceptance of the article of association of the company

·The underwriting commission should be paid in accordance with the rules and regulations as prescribed by the Government.

·In case of shares, the amount or rate of commission which is not offered to the public should be disclosed in the statement in lieu of prospectus.

·The number of underwriters and their proposition should be indicated in the statement.

·An underwriting agreement copy should be submitted to the Registrar of Companies at the time of delivery of the prospectus.

The Central Government has prescribed the following rates of underwriting commission:

P/S On Amounts in developing on the underwriter On amounts subscribed by the Public
(a) Equality shares

2.5% 2.5%
b)   Preference shares/convertible and non-convertible debentures    
For amounts upto Rs. 5 lakhs


For amount in excess of Rs.5 lakhs



Agreement Of Underwriting
Depending on the type of commitment required by the issuing company, several kinds of underwriting agreements are formed, each with its own level of risk:

·Firm Commitment:
Firm commitment is the most commonly used type of underwriting contract. The underwriter agrees to buy securities from the issuing corporation and pay the proceeds to the company. Any losses that occur due to unsold shares are prorated amongst the participating underwriting firms according to their proportional participation.

·Best Efforts:
Best efforts underwriting allows the firm (or underwriting syndicate) to act as agent for the issuing corporation and limits the responsibility of that firm to the shares it is able to sell. All unsold shares are absorbed by the issuer.

·All or None:
All or none underwriting allows the issuing corporation to contract for the sale of all shares. If any shares remain at the end of the underwriting process, the underwriting is cancelled. Underwriters cannot deceive investors by stating that all of the securities in the underwriting have been sold if it is not true.

Stand by underwriting allows an underwriting firm (or syndicate) to wait in the wings in an additional offering for any unused pre-emptive rights that are not executed by the company’s current shareholders. The underwriter will purchase the unused rights, exercise them and sell the shares.

Sebi Guidelines
According to the SEBI guidelines the following factors are to be fulfilled:

·The minimum requirement of 90% subscription is mandatory for each issue of capital to the public. This clause is applicable for both public and rights issue.

·If the company is not able to receive the issued amount from the public subscription and accepted development from the underwriters, then the company refunds the amount.

·The underwriting agreement should be filed with the stock exchanges.

·The registration number of the underwriter is to be quoted in all correspondence with the SEBI, government authorities and clients.

·The SEBI may issue warning letters or penalty advances by which the underwriters would be forewarned in respect of their omissions

·In order to standardize the legal relationship between the issuing company and the underwriters, the SEBI has formulated the model underwriting agreement.

·The total underwriting obligations under all the agreements should not exceed twenty times the network of the underwriter.

Embedded Difficulties Of The Underwriting System
The Underwriting is an agreement between the issuer and the financial intermediary. The Underwriting Institutions in India are suffering from some weaknesses. The Underwriting system is not developed in India. Here, we do not have any special institution to carry out underwriting business. The activities are dominated by the development banks which are the primary leading institutions. They are burdened with other responsibilities like guaranteeing deferred payments, making direct subscription to the corporate securities and doing entrepreneurial work. The small enterprises are unable to utilize the services of the Underwriters. There is a strong need to develop this sector to build confidence among the small organizations. The establishment of large number of small enterprises creates more employment opportunities. This also enhances the per capita income. The Indian primary market does not have the organized machinery to facilitate these services. There is no arrangement to pursue the investors towards small savings.

Measures To Improve The Underwriting System
·A lot of efforts should be made to develop the present structure of underwriting organizations, and also to enlarge the underwriting facilities.

·There is a strong need to create the financial syndication in the activities of the underwriters. The consortium creates the confidence among the corporate clients.

·The project evaluation is the most important one in the industrial finance process. A detailed investigation should be done by the technical and financial experts about the viability of the project. For the purpose, a permanent body should be made with eminent personalities who are drawn from all the fields, i.e., marketing, technical, finance etc.,

·The project evaluation board creates the confidence among the small concerns.

·To encourage the small concerns, underwriting by the stock brokers should be invited with adequate financial and other incentives.

·The services of the project evaluation board could be made available to the stock brokers with a nominal fee.

·The underwriting syndicate should create a large network of retailers and dealers.

·The underwriting should become a profession as in the case of the Merchant Banking.

·The encouragement to stock brokers and commercial banks lead to the development of the underwriting profession. A separate body should be constituted by the Chartered Accountants; and a special curriculum should be introduced at a post-graduate level for this specialized skilful operations.

·The Government should think about the scale of underwriting commission and brokerage.
[1] A. Sudhakar, Merchant Banking- Capital Markets, Financial Services, Delta Publishing House, (Delhi, 1997), p. 45
[2] James C. Van. Horne & John M. Wachowicz, Fundamentals of Financial Management, Princeton Hall India, (11th ed., 2001), p. 527
[3] Nabhi, Manual of SEBI, p. 512
[4] Ibid.
[5] Nabhi, Manual of SEBI, p. 512

Authors contact info - articles The  author can be reached at: modhuraroy@legalserviceindia.com

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