Underwriting arrangementsTypes of arrangement
What types of underwriting arrangements are commonly used?
Public securities offerings in the United States are generally made through a syndicate of underwriters led by one or more managing underwriters. The underwriting agreement defines the relationship between the underwriters and the issuer and is the document pursuant to which the underwriters commit to purchase the securities that are the subject of the offering. The underwriters typically agree to purchase the securities two business days after the pricing date. In contrast with the practices in many other countries, the underwriters’ commitments to purchase securities pursuant to the underwriting agreement are always several rather than joint-and-several. This practice reflects the limitation of liability of an underwriter under section 11 of the Securities Act to the total offering price of the securities that it underwrites.Typical provisions
What does the underwriting agreement typically provide with respect to indemnity, force majeure clauses, success fees and overallotment options?
The issuer will covenant in the underwriting agreement to indemnify the underwriters (and their officers, directors, agents and controlling persons) against all liabilities and expenses arising out of alleged misstatements or omissions in the registration statement, the prospectus as well as any free writing prospectuses and roadshow materials, excluding certain minor portions for which the underwriters assume responsibility. Because of existing legal uncertainty as to the enforceability of such indemnity provisions, underwriting agreements also usually provide that if indemnification is held by a court to be unavailable, the issuer and the underwriters will share aggregate losses in such proportion as is appropriate to reflect the relative fault for the misstatement or omission giving rise to the loss, the relative benefits received by the issuer and the underwriters from the offering of the securities (with the liability of each underwriter being capped by the underwriting discount or commission received by such underwriter in respect of the sale of such securities), or both the losses and benefits.
Underwriting agreements in US offerings also routinely contain force majeure and termination clauses permitting the underwriters to terminate their obligations under the underwriting agreement if, in their judgement, there has been a sharp downturn in market conditions or deterioration of the financial condition or business of the issuer between the signing of the underwriting agreement and the scheduled closing of the offering such that consummating the offering would be impracticable. Typical force majeure clauses also extend to the occurrence of natural disasters or calamities, such as an outbreak of hostilities or suspension of trading in the United States or, in certain cases, non-US securities markets. Underwriters tend to view the unilateral right to declare a force majeure event and to terminate as a fundamental protection provided to them in the underwriting agreement. Nonetheless, force majeure clauses in US offerings are rarely exercised by the underwriters, principally because of the limited period of time between the signing of the underwriting agreement and the closing of the offering (typically two business days) and the potential reputational harm associated with an underwriter’s exercise of such clauses.
Because it is customary in US offerings to authorise the managing underwriters to over-allot (ie, to offer and sell more securities than the underwriters have contracted to purchase from the issuer), it is also customary in the underwriting agreement to provide the underwriters with an ‘overallotment option’ allowing them to purchase from the issuer at the public offering price (less commission) up to an additional 15 per cent of the securities being offered to cover such overallotments. The overallotment option is more commonly found in equity offerings (and equity-linked offerings such as convertible debt) than in debt offerings.
These are rare in US offerings because of the unique liability provisions of the Securities Act. Section 11(e) of the Securities Act limits the liability of an underwriter to the total price at which the securities underwritten by it and distributed to the public were offered. However, if any underwriter receives from the issuer some benefit, direct or indirect, for its services that is not shared proportionately with the other underwriters, then such an underwriter forfeits this limitation on liability. As a result, success fees are generally avoided by underwriters.Other regulations
What additional regulations apply to underwriting arrangements?
Several rules and regulations of the Financial Industry Regulatory Authority (FINRA) apply to underwriting arrangements in registered securities offerings. Subject to a number of exemptions depending on the class of security and the particular offering, FINRA will review the underwriting agreement and certain other offering documentation governing the underwriting arrangements prior to an offering to ensure that the terms of such agreements and arrangements are fair and reasonable. FINRA also requires that any overallotment option be limited to 15 per cent or less of the securities being offered. FINRA places limits on the amount of total compensation that any underwriter can receive in connection with an offering, as well as on participation by any underwriter with certain conflicts of interest in respect of the offering (eg, if the issuer will use offering proceeds to repay a loan to an affiliate of an underwriter). FINRA also imposes several limitations on the allocation of securities and other distribution practices, particularly in ‘hot issues’ in which demand for the securities is high, the market price of the offered securities rises after pricing and potential abuses are considered more likely to occur.