By Anchal Dhir and Monal Mukherjee
Underwriting in a capital markets transaction typically means an obligation to subscribe to, or procure subscription for, the offered securities of a company. While the term “underwriter” is loosely used to refer to merchant bankers or lead managers or sponsors, an underwriter essentially is the entity that undertakes ‘underwriting’ in a transaction, thereby ensuring allocation of execution risk of a transaction amongst parties.
In the United States, underwriting is typically through a syndicate of investment banking firms that engage in marketing and book building, and make a firm commitment to purchase the securities at a discount to the public offer price and resell them to investors. Underwriters in such transactions are referred to as ‘initial purchasers’. The net difference between the proceeds from public sale of offered securities and the amount the issuer receives is called the ‘spread’, being the compensation underwriters receive for bearing the execution risk of the entire offering. However, there are offerings made on a “best efforts” basis as well, involving an agency agreement instead of a purchase or underwriting agreement. Such best efforts agency agreements do not involve a commitment to subscribe, and the investment banker is paid a commission based on subscriptions procured by it from third-party purchasers.
The underwriting process in India differs from that in the United States, primarily in that the issuer offers securities directly to potential investors and underwriters commit to purchase securities that remain unsubscribed, typically, only for certain limited instances. This has led to use of the term ‘soft underwriting’ to describe underwriting in Indian public issuances. This is different from placements on a ‘best efforts’ basis, because ‘soft underwriting’ does include a commitment to subscribe, even though with respect to limited instances. The concept of ‘hard underwriting’ has also been explored in the Indian markets in a few issuances, where firm commitment for subscription was sought from underwriters to enable issuers to receive minimum subscription in order to make the transactions successful. While this may seem similar to underwriting arrangements in the United States, these transactions were peculiar to falling markets, where firm commitment for subscription was sought much in advance of entering into underwriting agreements. Additionally, while ‘firm commitment’ underwriting agreements are essentially purchase agreements, the same cannot be said of ‘hard underwriting’ agreements, as any subscription under these is conditional.
Indian regulatory regime
Equity issuances in India by listed companies or companies seeking listing are required to be undertaken in terms of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (“ICDR Regulations”). While an issuer may choose to ask for underwriting in a fixed price issue, a book-built public offer is required to be underwritten. Whether such underwriting shall be up to 50% of the issue size or up to the minimum subscription requirement of 90% would depend upon the issue structure, which varies based on compliance with eligibility conditions under the ICDR Regulations. Further, merchant bankers in book-built public issuances are required to act as underwriters. In 2010, SEBI introduced provisions for public issuances by ‘small and medium enterprises’, which require such issuances to be underwritten entirely, with mandatory subscription obligation of 15% of the issue size on the merchant bankers to the issue.
In terms of the SEBI (Underwriters) Regulations, 1993 (“UW Regulations”), underwriting activities can only be undertaken by an entity registered with SEBI, as an underwriter under these regulations, or as a merchant banker or stock broker in terms of applicable SEBI regulations. The UW Regulations provide a “fit and proper person” test for an entity to act as an underwriter, which includes minimum net worth of at least Rs. 20 lakhs. The underwriting obligation undertaken by an underwriter cannot exceed twenty times its net worth.
Section 76 of the Companies Act, 1956, provides that the underwriting commission payable to an underwriter cannot exceed five per cent of the price at which underwritten shares are issued, or the amount or rate authorised by the articles of association of the issuer, whichever is less.
Underwriting process and market practices
Per market practice prevalent in India, in a public issue, only such under-subscription is underwritten which is pursuant to default in payment by a bidder or pursuant to withdrawal of a bid prior to allotment. Underwriting in such instances is required as bidders other than qualified institutional buyers may withdraw or their cheques may bounce. Further, the obligation of each underwriter is several (not joint) and only with respect to bids procured by it. Consequently, any bid made through ‘self certified syndicate banks’ under the ‘application supported by blocked amount’ route (“ASBA”) is not underwritten. This also implies that if there are portions of any or all categories in a public issue that do not receive bids, such unsubscribed portions are not underwritten. As underwriting obligations in a public issue are limited, this is generally termed as “soft underwriting”. Further, pursuant to introduction of ASBA, instances of default in payments by bidders have reduced, however, withdrawals remain a risk to the issue.
Additionally, underwriting obligations with respect to under-subscription only devolve once the option of setting it off against excess subscription in the same or any other category of investors is exhausted. The underwriting agreement in a public issue is executed after closure of the issue and prior to filing the prospectus, which contains disclosures of the underwriting obligations. Although the underwriting arrangements subsumes risks and commitment of capital, the risk is tempered by the timing of the final commitment, which, being post closing of the issue, assumes knowledge of acceptance of the transaction by investors as well as market reactions. If subscription in an issue does not reach 90%, the underwriting agreement would not be executed and the issue would be withdrawn. Thus, the risk undertaken by underwriters in Indian public issuances is clearly identified.
Underwriting for other modes of capital issuances under the ICDR Regulations, being rights issues and qualified institutional placements (“QIP”), is not mandatory. In a rights issue, the ICDR Regulations require that the intention of promoters and promoter group be disclosed with respect to subscription of their rights entitlement and of subscription beyond their entitlement. Usually, promoters undertake to subscribe to the entire under-subscription, subject to compliance with minimum public float requirements. Where subscription to the entire under-subscription may result in breach of regulatory requirements or where promoters are unwilling to subscribe, an issuer may consider appointing underwriters. The underwriting agreement in such instances is executed prior to filing the ‘letter of offer’ with the stock exchanges, which includes disclosures of underwriting obligations. Unlike in a public issue, the underwriting agreement in a rights issue is executed prior to opening of the issue and thus exposes underwriters to substantial market risks. Given this peculiarity, underwriting agreements in rights issues are a rarity.
In a QIP undertaken under the ICDR Regulations, a placement agreement is executed between the issuer and lead managers, where, typically, the lead managers undertake to arrange subscribers on a ‘best efforts’ basis. In contrast to an underwriting arrangement, where the issuer can cause the underwriter to subscribe to its obligation, the issuer cannot do so under a placement agreement. However, the placement agreement may be negotiated such that the lead managers commit to procure subscription.
Provisions of an Underwriting Agreement
Under the UW Regulations, an underwriting agreement is required to provide: a) term of the agreement; b) allocation of responsibilities between underwriter and issuer; c) amount of underwriting obligation; d) period within which underwriter has to subscribe to the devolvement after being intimated of it; e) commission payable; and f) arrangements made by the underwriter to fulfil its obligations.
In addition to the above and the basic subscription commitment, an underwriting agreement contains other terms governing the relationship between the issuer and/or selling shareholders and underwriters.
The underwriting agreement contains representations and warranties from the issuer to the underwriters, which, although customary, may be subject to negotiation. The basic ‘all embracing’ representation is that the offering documents comply with applicable disclosure requirements in all material respects and do not contain any untrue statement of a material fact or omit to state any material fact necessary to make statements therein, in the light of circumstances under which they were made, not misleading. The representation traditionally carves out misstatements or omissions made in reliance on information furnished to the issuer by the underwriters. Other representations are of legal and financial nature and the underwriters may also seek issuer’s business specific representations.
Covenants and undertakings included in the underwriting agreement usually pertain to obligations and confirmations of the issuer in relation to issue procedure and activities undertaken prior to and after closing of the issue, in order to enable underwriters to fulfill their obligations under the agreement and applicable SEBI regulations. The underwriting agreement also provides conditions precedent to an underwriter’s continued participation, such as any materially adverse changes not having occurred in the business of the issuer or the regulatory environment or market conditions, that make the issue impossible or impracticable, and the receipt of opinions from legal counsels, comfort letters from auditors and officer’s certificate confirming the representations made and no material adverse changes, at the prescribed times.
The issuer agrees to indemnify each underwriter and each of its controlling persons against liabilities and expenses arising from alleged misstatements or omissions in the offering documents. Underwriters indemnify the issuer with respect to information provided by such underwriters. The indemnity clause provides the procedure if a claim is made against the indemnified party, terms of appointment of counsel and payment of fee of such counsel by the indemnifying party, and obligations of the indemnifying party if the indemnified party enters settlement proceedings. To cover instances where indemnification provided is insufficient or unavailable, the indemnity provision also covers a ‘contribution’ clause, which requires each party to contribute, severally, a percentage of the relative benefit received by it pursuant to the issue towards the claim raised against the indemnified party, which, in usual course, would have been brought against all parties. The contribution required from underwriters is usually limited to the fee received by them in terms of the agreement.
In terms of the UW Regulations, the underwriting obligations of an underwriter only trigger when existing shareholders or the public do not subscribe to securities offered by the issuer. Thus, Indian securities law and market practices that have developed over the years contemplate the role of an underwriter as someone bridging the gap to ensure a successful transaction.
This is in contrast to the role played by underwriters in the United States, where underwriters, being initial purchasers, are actively involved in market creation for the offered securities, as they are the primary risk bearers if there is less demand. Being the primary go between for investors and the company, underwriters in such transactions are responsible for adequate disclosures being made by the issuer. Given added risks and liability concerns, there are higher rewards in store for underwriters.
As Indian regulations do not allow underwriters to act as initial purchasers, there are limited risks and rewards enjoyed by Indian underwriters. While underwriters do have the flexibility to explore “hard underwritten” transactions for higher commissions, such transactions typically would involve lesser market outs for the underwriters, including lesser control on timing and pricing, thereby increasing the risk profile. Such underwriting arrangements may be more of an exception than the rule and, thus, not a sustainable model.
Anchal Dhir and Monal Mukherjee are Senior Associates with Amarchand Mangaldas.