What is Underwriting Agreement
An underwriting agreement is a contract between a group of investment bankers who form an underwriting group or syndicate, and the issuing corporation of a new securities issue. The underwriting agreement contains the details of the transaction, including the underwriting group's commitment to purchase the new securities issue, the agreed-upon price and the initial resale price.
BREAKING DOWN Underwriting Agreement
The underwriting agreement can be considered the contract between a corporation issuing a new securities issue and the underwriting group that has agreed to purchase and then resell the issue for a profit. The purpose of the underwriting agreement is to ensure that all of the players understand their responsibility in the process, thus minimizing potential conflict.
Types of Underwriting Agreements
Firm Commitment Agreement
In a firm commitment underwriting, the underwriter guarantees to purchase all of the securities being offered for sale by the issuer regardless of whether they can sell them to investors. A firm commitment underwriting agreement is the most desirable for the issuer because it guarantees them all of their money right away. The more in demand the offering is, the more likely it is that it will be done on a firm commitment basis. In a firm commitment, the underwriter puts their own money at risk if they can’t sell the securities to investors.
Underwriting a securities offering on a firm commitment basis exposes the underwriter to substantial amount of risk. As such, underwriters often insist on including a market out clause in the underwriting agreement. A market out clause frees the underwriter from their obligation to purchase all of the securities in case of a development that impairs the quality of the securities or that adversely affects the issuer. However, poor market conditions is not a qualifying condition. One example of when a market out clause could be invoked is if the issuer was a bio tech company and the FDA just denied approval of the company's new drug.
Best Efforts Agreement
In a best efforts underwriting agreement, underwriters do their best to sell all of the securities offered by the issuer, but the underwriter isn't obligated to purchase the securities for their own account. The lower the demand for an issue, the greater likelihood that it will be done on a best efforts basis. Any shares or bonds in a best efforts underwriting that have not been sold will be returned to the issuer.
A mini-maxi agreement is a type of best efforts underwriting that does not become effective until a minimum amount of the securities have been sold. Once the minimum has been met, the underwriter may then sell the securities up to the maximum amount specified under the terms of the offering. All funds collected from investors will be held in escrow until the underwriting is completed. If the minimum amount of securities specified by the offering cannot be reached, the offering will be canceled and the investors’ funds that were collected will be returned to them.
All or None Agreement
With an all or none underwriting, the issuer has determined that it must receive the proceeds from the sale of all of the securities. Investors’ funds are held in escrow until all of the securities are sold. If all of the securities are sold, the proceeds will be released to the issuer. If all of the securities are not sold, the issue is canceled and the investors’ funds will be returned to them.
A standby underwriting agreement is used in conjunction with a preemptive rights offering. All standby underwritings are done on a firm commitment basis. The standby underwriter agrees to purchase any shares that current shareholders do not purchase. The standby underwriter will then resell the securities to the public.