Business Glossary

Insurance: to assume risk in exchange for a premium.

Investments: to assume the risk of buying a new issue of securities from the issuing corporation or government entity and reselling them to the public, either directly or through dealers. The underwriter makes a profit on the difference between the price paid to the issuer and the public offering price, called the underwriting spread.

Underwriting is the business of investment bankers, who usually form an underwriting group (also called a purchase group or syndicate) to pool the risk and assure successful distribution of the issue. The syndicate operates under an agreement among underwriters, also termed a syndicate contract or purchase group contract.

The underwriting group appoints a managing underwriter, also known as lead underwriter, syndicate manager, or simply manager, that is usually the originating investment banker-the firm that began working with the issuer months before to plan details of the issue and prepare the registration materials to be filed with the Securities and Exchange Commission. The manager, acting as agent for the group, signs the underwriting agreement (or purchase contract) with the issuer. This agreement sets forth the terms and conditions of the arrangement and the responsibilities of both issuer and underwriter. During the offering period, it is the manager's responsibility to stabilize the market price of the issuer's shares by bidding in the open market, a process called pegging. The manager may also appoint a selling group, comprised of dealers and the underwriters themselves, to assist in distribution of the issue.

Strictly speaking, underwrite is properly used only in a firm commitment underwriting, also known as a bought deal, where the securities are purchased outright from the issuer.

Other investment banking arrangements to which the term is sometimes loosely applied are best effort, All Or None, and standby commitments; in each of these, the risk is shared between the issuer and the investment banker.

The term is also sometimes used in connection with a registered secondary offering, which involves essentially the same process as a new issue, except that the proceeds go to the selling investor, not to the issuer. For these arrangements, the term secondary offering or secondary distribution is preferable to underwriting, which is usually reserved for new, or primary, distributions.

There are two basic methods by which underwriters are chosen by issuers and underwriting spreads are determined: negotiated underwritings and competitive bid underwritings. Generally, the negotiated method is used in corporate equity (stock) issues and most corporate debt (bond) issues, whereas the competitive bidding method is used by municipalities and public utilities.

"off the board" offering of a previously issued security from an investment institution, acting as underwriter or as selling investor, to other members of the exchange on which the security is listed. Sales of this nature are usually block sales. Allowing such a sale to take place on the exchange floor might severely lower the price of the stock. Certain block dispositions require SEC sanction.

cost of issuing new stocks or bonds. It varies with the amount of underwriting risk and the job of physical distribution. It comprises two elements: (1) the compensation earned by the investment bankers (the underwriters) in the form of the spread between the price paid to the issuer (the corporation or government agency) and the offering price to the public, and (2) the expenses of the issuer (legal, accounting, printing, and other out-of-pocket expenses). Securities and Exchange Commission studies reveal that flotation costs are higher for stocks than for bonds, reflecting the generally wider distribution and greater volatility of common stock as opposed to bonds, which are usually sold in large blocks to relatively few investors. The SEC also found that flotation costs as a percentage of gross proceeds are greater for smaller issues than for larger ones. This occurs because the issuer's legal and other expenses tend to be relatively large and fixed; also, smaller issues tend to originate with less established issuers, requiring more information development and marketing expense. An issue involving a rights offering can involve negligible underwriting risk and selling effort and therefore minimal flotation cost, especially if the underpricing is substantial.

The underwriting spread is the key variable in flotation cost, historically ranging from 23.7% of the size of a small issue of common stock to as low as 1.25% of the par value of high-grade bonds. Spreads are determined by both negotiation and competitive bidding.

arrangement whereby investment bankers, acting as agents, agree to do their best to sell an issue to the public. Instead of buying the securities outright, these agents have an option to buy and an authority to sell the securities. Depending on the contract, the agents exercise their option and buy enough shares to cover their sales to clients, or they cancel the incompletely sold issue altogether and forgo the fee. Best efforts deals, which were common prior to 1900, entailed risks and delays from the issuer's standpoint. What is more, the broadening of the securities markets has made marketing new issues easier, and the practice of outright purchase by investment bankers, called firm commitment underwriting, has become commonplace. For the most part, the best efforts deals we occasionally see today are handled by firms specializing in the more speculative securities of new and unseasoned companies.

Lending: term used by lenders to refer to an agreement to make a loan to a specific borrower within a specific period of time and, if applicable, on a specific property.See also commitment fee.
Securities underwriting: arrangement whereby investment bankers make outright purchases from the issuer of securities to be offered to the public; also called firm commitment underwriting. The underwriters, as the investment bankers are called in such an arrangement, make their profit on the difference between the purchase price- determined through either competitive bidding or negotiation-and the public offering price. Firm commitment underwriting is to be distinguished from conditional arrangements for distributing new securities, such as standby commitments and best efforts commitments. The word underwriting is frequently misused with respect to such conditional arrangements. It is used correctly only with respect to firm commitment underwritings or, as they are sometimes called, bought deal. See also best effort; standby commitment.