Underwriting is an act of guarantee by an organization for the sale of certain minimum amount of shares and debentures issued by a Public Limited company.
According to the Companies Act, when a person agrees to take up shares specified in the underwriting agreement when the public or others failed to subscribe for them, it is called underwriting agreement. For this purpose, the underwriter who guarantees for the sale of shares, is given a commission.
When the public to whom the shares of issue fails to subscribe, it is the underwriter who has to subscribe up to the limit he has agreed. Later on, when the market improves he may off load the shares by selling them to the public. Thus, the underwriter makes a promise to get the underwritten issue subscribed either by him or by others.
According to Indian Companies Act every public limited company must raise minimum capital and if it fails to raise within 60 days from the date of issue of prospectus, the directors should return the money to the public. If the return is delayed by more than 78 days, the company has to pay interest on the refund amount.
Importance of Underwriting
The persons responsible for issuing shares in the company, known as issuers, have the option of deciding for the underwriting of shares. If the issue is not underwritten, there is a possibility of the issue eiting under subscribed and even if 90% of minimum subscription is not received, the money has to be refunded in full. Hence, there is an urgent need on the part of the issuer, to seek the assistance of underwriters for a successful completion of issue of shares.
SEBI’s Guidelines for Underwriting
According to SEBI, the number of underwriters should be decided well in advance by the issuer and he must obtain prior permission from SEBI. Permission will be granted by SEBI only after finding out the net worth of the underwriters and their outstanding commitments.
The Stock Exchange, where the security is going to be listed must also be informed about the arrangements made with the underwriters.
25% of each class of securities must be offered to the public and in the remaining 75%, the following method of firm allotment could be adopted.
SEBI has instructed companies to allot to three major categories of allotees, namely,
HNI refers to high net worth individuals, investing more than Rs. 1 lakh in a single company security.
Retailers are individuals who are investing less than Rs. one lakh.
Types of Underwriters
There are two types of underwriters. They are
Institutional underwriters – IDBI, IFCI, UTI, SBI Capital Market
Non-Institutional underwriters – Any NBFC.
Institutional underwriting in India helps companies to raise capital in their early stages. In fact, many companies which may not come to the notice of the public were promoted due to the support given by institutional underwriters.
Many institutional underwriters were responsible for the promotion of infrastructure companies in the area of steel, chemicals, fertilizer, etc.
Responsibilities of Underwriters
1. An underwriter, not only has to underwrite the securities but has to subscribe within 45 days that part of shares which remain unsubscribed by the public.
2. His underwriting obligations should not exceed, at any time, 20 times of his net worth.
3. The underwriter cannot derive any other benefit except the underwriting commission which is 5% for shares and 2½% for debentures.
Merits of Underwriting
1. Underwriting ensures success of the proposed issue of shares since it provides an insurance against the risk.
2. Underwriting enables a company to get the required minimum subscription. Even if the public fail to subscribe, the underwriters will fulfill their commitments.
3. The reputation of the underwriter acts as a confidence to investors. The underwriters who are called the lead managers provide financial recognition to the company, whose shares are issued to the public. Thus, the reputation of the issuing company also improves because of the reputation of underwriters.
What is Syndicate underwriting
Whenever an investment house in charge of the particular company’s issue, is unable to handle the issue of shares, it may enter into an agreement with other underwriting concerns or investment house. Such a kind of underwriting is known as Syndicate underwriting. By Syndicate underwriting, the risk involved in underwriting the shares is reduced and the collective reputation of underwriters is also capitalized.
Benefits due to professional underwriters
1. Large issues could be undertaken successfully.
2. Companies with a long gestation period cannot raise capital without support of professional underwriters.
3. Technocrats could promote companies with their poor financial knowledge.
4. New projects in the market could be taken boldly.
5. Companies could be promoted in backward areas.
6. Certain projects which are not financially viable in the initial stages, especially in priority sector (agriculture, small scale industry, export oriented units) could be promoted with the support of institutional underwriters.