What Is a Market Out Clause?

A market out clause is a stipulation in an underwriting agreement that allows the underwriter to cancel the agreement without penalty. A market out clause can be activated for specific reasons such as souring market conditions or simply because the underwriter is having difficulty in selling the company's stock. However, though the reasons can be varied, they must be noted in the market out clause.

Key Takeaways

  • With a market out clause, an underwriter that has agreed to market and sell a company's stocks can cancel that agreement without having to pay a penalty.
  • Such agreements are typically put in place in a firm commitment underwriting, in which an agreement has been made for the underwriter to assume all inventory risk and buy all securities for an IPO to be sold to the public.
  • The market out clause can kick into gear for reasons that include a change or decline in market conditions or to relieve an underwriter of the financial burden of holding stock that will not sell.
  • The market out clause has to state specifically what conditions must occur for the underwriter to be allowed to enact the clause.

Understanding a Market Out Clause

A market out clause is all about reducing an underwriter's risks in a firm commitment underwriting. The underwriter for an IPO contracts with the issuing company to market and sell the company's stock to investors in the primary market. With a firm commitment underwriting, the underwriter agrees to assume all inventory risk and buy all securities for an initial public offering (IPO) straight from the issuer to sell to the public.

Of course, this entails a fair amount of risk resulting from overhype and other factors. Underwriters can suffer a major financial loss by being forced to underwrite an offering that it later discovers may have little interest to investors – either because of circumstances within the issuing company or because of declining market conditions. Hence, a market out clause is generally invoked when the market has hit a rough patch or other IPOs have underperformed.

A market out clause can also allow the underwriting syndicate to opt-out of the underwriting agreement prior to the initial public offering (IPO) if, for example, trading in the company's securities is suspended, a material change adversely affects the issuer or other such occurrences make it impractical for the securities to be sold at the agreed-upon price. 

Counsel for an issuing company that is preparing an IPO underwriting agreement must carefully review the conditions in the agreement that will allow the market out clause to be activated. An overly broad market out clause will effectively negate the concept of a firm commitment underwriting. Such an overreaching clause will permit an underwriter to cancel the underwriting agreement for virtually any reason, effectively placing all the risk on the issuing company.

Sample Market Out Clause Language

Here's a section from an underwriting agreement between Rackable Systems and its underwriters to sell 2.6 million shares of the company's common stock.

(l) Subsequent to the execution and delivery of this Agreement there shall not have occurred any of the following: (i) trading in securities generally on the New York Stock Exchange or the American Stock Exchange or in the over-the-counter market, or trading in any securities of the Company on any exchange or in the over-the-counter market, shall have been suspended or the settlement of such trading generally shall have been materially disrupted or minimum prices shall have been established on any such exchange or such market by the Commission, by such exchange or by any other regulatory body or governmental authority having jurisdiction, (ii) a banking moratorium shall have been declared by Federal or state authorities, (iii) the United States shall have become engaged in hostilities, there shall have been an escalation in hostilities involving the United States or there shall have been a declaration of a national emergency or war by the United States or (iv) there shall have occurred such a material adverse change in general economic, political or financial conditions, including without limitation as a result of terrorist activities after the date hereof, (or the effect of international conditions on the financial markets in the United States shall be such) as to make it, in the judgment of the Representatives, impracticable or inadvisable to proceed with the public offering or delivery of the Stock being delivered on such Delivery Date on the terms and in the manner contemplated in the Prospectus.