What Is an 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 purpose of the underwriting agreement is to ensure that all of the players understand their responsibility in the process, thus minimizing potential conflict. The underwriting agreement is also called an underwriting contract.

Understanding Underwriting Agreements

The underwriting agreement may be considered the contract between a corporation issuing a new securities issue, and the underwriting group that agrees to purchase and resell the issue for a profit.

As mentioned above, the contract is generally between the corporation issuing the new security and investment bankers who form a syndicate. A syndicate is a temporary group of financial professionals formed to handle a large financial transaction that would be difficult to handle individually.

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, the initial resale price, and the settlement date.

There are several different kinds of underwriting agreements: the firm commitment agreement, the best efforts agreement, the mini-maxi agreement, the all or none agreement, and the standby agreement.

Types of Underwriting Agreements

In a firm commitment underwriting, the underwriter guarantees to purchase all the securities offered for sale by the issuer regardless of whether they can sell them to investors. It is the most desirable agreement because it guarantees all of the issuer's money right away. The more in demand the offering is, the more likely it will be done on a firm commitment basis. In a firm commitment, the underwriter puts its own money at risk if it can’t sell the securities to investors.

Underwriting a securities offering on a firm commitment basis exposes the underwriter to substantial risk. As such, underwriters often insist on including a market out clause in the underwriting agreement. This clause frees the underwriter from its obligation to purchase all of the securities in case there is a development that impairs the quality of the securities. Poor market conditions, though, are not a qualifying condition. One example of when a market out clause could be invoked is if the issuer was a biotech company and the FDA just denied approval of the company's new drug. 

In a best-efforts underwriting agreement, underwriters do their best to sell all the securities offered by the issuer, but the underwriter isn't obligated to purchase the securities for its own account. The lower the demand for an issue, the greater the likelihood 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.

[Important: A best-efforts underwriting agreement is mainly used in the sales of high-risk securities.]

A mini-maxi agreement is a type of best efforts underwriting that does not become effective until a minimum amount of securities is sold. Once the minimum is 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 are held in escrow until the underwriting is completed. If the minimum amount of securities specified by the offering cannot be reached, the offering is canceled and the investors’ funds are returned to them.

With an all or none underwriting, the issuer determines 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 are released to the issuer. If all of the securities are not sold, the issue is canceled and the investors’ funds are 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.

Key Takeaways

  • An underwriting agreement takes place between a syndicate of investment bankers who form an underwriting group and the issuing corporation of a new securities issue.
  • The agreement ensures everyone involved understands their responsibility in the process.
  • The contract outlines the underwriting group's commitment to purchase the new securities issue, the agreed-upon price, the initial resale price, and the settlement date.