Underwriting in Financial Services

Launching a public issue of shares or debentures involves substantial financial and reputational risk. If an issuing company fails to receive enough public applications, the entire issue fails, money must be refunded to applicants, and heavy issue expenses go down the drain. Underwriting provides an insurance-like financial safety net that guarantees the success of capital raising.

1. What is Underwriting?

Underwriting is a contractual agreement between an issuing company and one or more financial institutions or merchant bankers (called the Underwriters), whereby the underwriters guarantee to subscribe to the unsold or unsubscribed portion of shares or debentures in return for an agreed financial fee called Underwriting Commission.

The 90% Minimum Subscription Mandate

Under SEBI (Issue of Capital and Disclosure Requirements) Regulations:

An issuing company must receive a minimum public subscription of 90 percent of the net offer to the public.
If the company fails to receive 90 percent subscription within the specified bidding period, the issue is considered a failure. The company is legally required to refund all subscription money immediately.
Why Underwriting Matters: Underwriters step in and purchase the deficit shares, ensuring the 90 percent threshold is crossed and the issue succeeds.

2. Types of Underwriting Agreements

┌────────────────────────────────────────────────────────────────────────┐
│                      TYPES OF UNDERWRITING                             │
├─────────────────┬──────────────────┬─────────────────┬─────────────────┤
│ 1. Pure /       │ 2. Firm          │ 3. Complete     │ 4. Partial      │
│    Conditional  │    Underwriting  │    Underwriting │    Underwriting │
│ (Contingent on  │ (Agrees to buy a │ (100% of issue  │ (Only a fixed   │
│  shortfall)     │  set quota       │  is guaranteed) │  percentage is  │
│                 │  regardless)     │                 │  guaranteed)    │
└─────────────────┴──────────────────┴─────────────────┴─────────────────┘

1. Pure (Conditional) Underwriting

The underwriter promises to subscribe to shares only if the public does not subscribe in full. If the public subscribes to 100 percent of the issue, the underwriter has zero liability and simply pockets their underwriting commission.

2. Firm Underwriting

The underwriter agrees to subscribe to a definite, fixed number of shares upfront, regardless of whether the public issue is over-subscribed or under-subscribed, in addition to their contingent commitment for any public shortfall.

3. Complete vs Partial Underwriting

Complete Underwriting: The entire public issue (100 percent) is underwritten by one or a consortium of underwriters.
Partial Underwriting: Only a portion of the issue (e.g., 60 percent or 75 percent) is underwritten; the balance risk is borne by the company itself.

4. Sub-Underwriting & Syndicated Underwriting

Syndicated Underwriting: Two or more large merchant banks form a syndicate to jointly share the underwriting risk of a multi-thousand-crore mega IPO.
Sub-Underwriting: A lead underwriter contracts a portion of their risk to smaller brokers or sub-underwriters in exchange for a portion of their commission.

3. Key Terms in Calculating Underwriter Liability

When calculating how many shares each underwriter must buy, three standard terms are used:

Gross Liability: The total number of shares an underwriter agrees to guarantee as stated in the underwriting contract.
Marked Applications: Public application forms bearing the official rubber stamp or identification code of a specific underwriter. The underwriter receives full credit for these applications against their gross liability.
Unmarked Applications: Direct applications submitted by the public that do not carry any underwriter’s stamp. These are credited among all underwriters in the ratio of their gross liabilities.

Standard Step-by-Step Liability Formula

Step 1: Gross Liability of Underwriter
Minus:  Marked Applications received for that underwriter
Equals: Balance Liability
Minus:  Share of Unmarked Applications (Distributed in Gross Liability Ratio)
Equals: Net Underwriting Liability (Actual shares the underwriter must purchase)

(If Firm Underwriting exists, the firm underwriting commitment is added to this net figure).

4. Underwriting Commission Rules in India

Under the Companies Act, 2013 (Section 40) and SEBI guidelines:

Authorisation: Underwriting commission must be expressly authorized by the company’s Articles of Association (AOA).
Statutory Ceiling Rates:
- Equity Shares: Maximum commission cannot exceed 5 percent of the issue price of the shares (or the rate authorized in the AOA, whichever is lower). In market practice, SEBI guidelines cap it at 2.5 percent.
- Debentures / Bonds: Maximum commission cannot exceed 2.5 percent of the issue price of the debentures.
Disclosure: Details of commission paid, names of underwriters, and their net liabilities must be disclosed in the prospectus.

5. Economic Benefits of Underwriting

┌────────────────────────────────────────────────────────────────────────┐
│                         BENEFITS OF UNDERWRITING                       │
├──────────────────────────┬─────────────────────────────────────────────┤
│ To the Issuing Company   │ • Assured capital raising without fear of   │
│                          │   issue cancellation or 90% refund crisis.  │
│                          │ • Protects market reputation and goodwill.  │
├──────────────────────────┼─────────────────────────────────────────────┤
│ To Public Investors      │ • Acts as a stamp of credibility. Top-tier  │
│                          │   underwriters perform due diligence before │
│                          │   committing their balance sheets.          │
├──────────────────────────┼─────────────────────────────────────────────┤
│ To the Capital Market    │ • Smooths capital formation and enables bold│
│                          │   industrial projects to get funded.        │
└──────────────────────────┴─────────────────────────────────────────────┘

6. Summary for BBA Exams

Underwriting is an insurance against public under-subscription in capital issues.
Triggers if public subscription falls below the 90 percent SEBI minimum threshold.
Types: Pure / Conditional (only covers shortfall) vs Firm (mandatory purchase of a fixed block).
Terminology: Gross Liability, Marked Applications (stamped), Unmarked Applications (credited per gross ratio), and Net Liability.
Commission ceiling under Companies Act: Max 5% on shares and 2.5% on debentures.

Underwriting in Financial Services | BBA DAVV Notes