New issues are offered in the primary market and sold to the public for the first time as initial public offerings, or IPOs. New issues are usually handled for a corporation by an underwriting syndicate comprised of investment banks and selling groups. An underwriter will advise the issuing corporation on the best price at which to offer shares of the new security to the public. Factors considered in arriving at a price include prevailing market conditions, indications of interest from the underwriter's book of business, prices of similar companies and the company's general financial health.

If the topic of IPOs is new to you, or if you are curious how individuals became rich off of them during the dot-com boom, refer to the following tutorial: IPO Basics

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 canceled. Underwriters cannot deceive investors by stating that all of the securities in the underwriting have been sold if it is not true.
     
  • Standby: Standby underwriting allows an underwriting firm (or syndicate) to wait in the wings during an additional offering of shares under a rights offering. The standby underwriter will purchase any shares  that are not purchased by the company's current shareholders. The underwriter will purchase the unused rights, exercise them and sell the shares.
Exam Tips and Tricks
The exam will probably ask you to distinguish between the various types of underwriting agreements.

 

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