Underwriting Contract at the time of Issue of Securities

Swetha Dhinesh

20 Mar, 2023

In the realm of business, it is frequently required to attract a pool of investors willing to stake money in a company and its projected enterprise. Typically, investors put money into businesses by buying bonds and other securities in the hope of making big profits. Corporations and even governments widely use underwriters to obtain funds through the issuing of stocks, bonds, or other security instruments.
The underwriting process is used to assess the risk that each applicant bears and brings to the table when it comes to loans and insurance. You must undergo the underwriting procedure every time you apply for a loan or purchase insurance. Let us discuss the concept of underwriting, its objectives, the guidelines of SEBI and the process of underwriting at the time of the issue of securities.

Concept of underwriting

Underwriting is the process through which an investment bank secures funding from institutional investors in the form of debt or equity on behalf of a client. The firm is hired by clients who need capital raising, typically a corporate, to handle the process and effectively negotiate the terms.

The process by which a company, person, or institution accepts a financial risk in exchange for payment or at a predetermined cost is referred to as underwriting. Usually, when taking out loans, insurance, or investments, this risk is assumed. According to the definition of underwriting, an underwriter is a person or organisation who signs their name next to the total amount of risk they are ready to accept in exchange for a certain sum of money or premium.

What is the work of underwriters?

A risk assessment is done by an underwriter, who also creates a fair and stable market for financial transactions. To ensure the financial institution is profitable, they decide which contracts are worth the risk as well as the rate to assign those situations. Although their duties can change according to their employer, underwriters commonly do the following tasks:

• Examining insurance, loan, mortgage, and initial public offering applications (IPOs^[1]). 
• Using software to assess risk
• Examining prospective borrowers’ backgrounds, possessions, earnings, and other characteristics
• Doing research and assessing potential documents
• Deciding whether to accept or reject applications based on analyses and studies

The key components of an underwriting agreement are as follows:

• In some circumstances, the underwriter might not be able to sell the issues. The underwriters receive an equal distribution of the unsold securities according to the predetermined ratio.
• The offering price must be maintained for the issue of securities to be distributed successfully.
• The manager receives the securities from the corporation, which also receives money on the closing date.
• The manager is required to provide a final accounting for each underwriter at the conclusion of the underwriting. He must also account for the expenses incurred and remit the commissions.
• Underwriting serves as insurance for newly issued public securities. It is a technique used to market the issue of securities. 

Underwriting Types

Let’s examine the three main types of underwriting: loans, insurance, and securities-

• The underwriting process for loans comprises examining the applicant’s credit history, financial standing, and the worth of the collateral put up as security for the loan. The amount and type of loan requested will determine which aspects are examined, and the entire appraisal process could take a few minutes to many weeks. Mortgage loans are among the loan types that undergo the most underwriting.
• The potential policyholder, who is the person obtaining health or life insurance, is the main focus of insurance underwriting. The policyholder’s age, health, lifestyle, medical history, occupation, family, and other criteria that the underwriter determines may be evaluated throughout the insurance underwriting process.
• The issue of securities in underwriting is done on behalf of the prospective investor or frequently a financial institution to determine the level of risk and acceptable pricing for a particular asset. It occurs more frequently with initial public offerings or IPOs. This procedure guarantees that the company’s initial public offering (IPO) will collect the required funding and pay the underwriters.

Process of underwriting at the time of issue of securities

The underwriting or capital raising process has three primary phases: issue structure, timing, and timing assessment. 

• Identification of investor themes, comprehension of investment justification, and estimation of anticipated investor demand or interest are all part of the planning step.
• In order to establish the appropriate timing and demand for an offering, the underwriter must assess the current market circumstances, investor appetite, investor experience, precedents, benchmark offerings, and current news flow. 
• The issue structure must also be determined by the underwriter based on whether institutional or retail investors are the primary target market and if a domestic or foreign issue is required.

The underwriters assess loans, more specifically mortgages, to establish the chance that the borrower will repay the loan as promised and to make sure that enough collateral has been provided in the event of a default. When it comes to insurance, the underwriters evaluate the health of the policyholder and other characteristics to distribute the potential risk across as many people as possible.

The most common method of underwriting  the issue of securities is through initial public offerings, or IPOs, which can be used to assess a company’s true worth in relation to the risk involved in financing an IPO. A financial underwriter’s main responsibility is establishing a fair and stable market for financial transactions. 

Every loan, insurance policy, or initial public offering (IPO) entails a certain risk in that the borrower could default on the loan, which could result in a potential loss for the lender or the insurer. The underwriting process aims to prevent this. 

The underwriter’s primary responsibility is to consider all the risk variables involved before choosing whether or not to approve the borrower for a loan or insurance coverage. The underwriters decide on a case-by-case basis what risk is really worth in the market. This process will be handled based on the transactions they are willing to cover and the profit margins required. 

The underwriting process is also highly beneficial in revealing high-risk applicants, such as unemployed persons asking for a sizable loan, sick people seeking life insurance, or businesses that are still trying to go public but are relatively new to the market. The underwriter may refuse to provide coverage to such candidates.

The overall risk of expensive claims and defaults is decreased via underwriting. It gives loan lenders, insurance agents, and investment banks a feeling of security and enables them to provide competitive rates to individuals with a lower-risk profile.

Underwriting procedures in IPO 

The underwriting procedure is utilised when a company files for an IPO to make sure it will obtain the required funding and give the underwriters the predetermined premium or profit in exchange for their services. Investors gain from underwriting by getting assistance in making wise investment choices.

• The public issue must have underwriting. No stock broker is permitted to underwrite more than 5% of the public issue, according to the stock exchange regulations, and the concerned stock exchange must approve the appointment of broker underwriters. 
• Typically, bankers can support up to 10% of the public offering. Promoter, director, employee, and business associate contributions cannot be used to pay the Underwriting Commission. It plays a significant role in the main market. In agreement with merchant bankers, it is chosen by the issuing corporation.
• ​​The prospectus needs to provide information on the Underwriter’s obligations and name. Several financial institutions, commercial banks, insurance firms, and private businesses offer underwriting services. 
• The safest method of marketing and issue of securities is through an underwriter issue, and the reputation of the underwriters sways investors. The issuing companies may choose the following parties: Trusts, Brokers, Bankers, Investment Companies and Financial Institutions.

Guidelines of SEBI

The following conditions must be fulfilled in accordance with SEBI guidelines:

• A minimum subscription of 90% is required for every public capital offering. Both public and rights issues are under the purview of this section.
• If the company is unable to collect the issued sum from the public subscription and the underwriters’ accepted development, the sum will be refunded.
• The underwriting agreement should be filed with the stock exchanges.
• In all correspondence with the SEBI, governmental bodies, and clients, the underwriter must use its registration number.
• The SEBI may send underwriters warning letters or penalty advances in order to make them aware of their omissions.
• The SEBI has developed the model underwriting agreement in order to simplify the legal relationship between the issuing business and the underwriters.
• The overall underwriting commitments made under all of the agreements should be at most twenty times the underwriter’s network.

Conclusion

When releasing new securities into the market, underwriting is now crucial. Being insured is preferable to playing it safe, which could lead to a huge financial burden. Choosing an underwriting agreement based on the issuer’s needs is advantageous.

Also Read: Regulatory framework of issue of securities to foreigners