In our last issue,1 we discussed the potential impact of the Department of Labor’s new rules on sales of structured products. In that article, we discussed some of the reasons why future sales of structured notes to retirement accounts may be preferable to effect on an agency basis, as opposed to on an underwritten basis.
However, due to the predominance of underwritten offerings in the structured products space, we find that not all market participants are familiar with the agented format. Accordingly, in this article, we describe some of the aspects of these types of offerings, and how they vary from current practices.
Most of today’s structured notes are offered on an underwritten basis. Under the underwriter’s agreement with the issuer,2 the underwriter is contractually obligated to purchase the relevant notes from the issuer, for its own account, for resale to investors. The underwriter, in turn, agrees with each investor at the time of purchase to sell the notes from its own account to the investor. Accordingly, the underwritten offering essentially consists of two different purchases and sales: (1) the underwriter purchasing the securities from the issuer and (2) the investor purchasing the securities from the underwriter.3
In an underwritten offering, the aggregate principal amount of the transaction (set forth on the cover page of the final prospectus) is usually determined based upon the amount of offers received. Subject to the satisfaction of the relevant conditions in the offering documents, the underwriter must purchase all of the notes covered by the applicable prospectus. If an investor fails to settle the purchase, or cancels its order between the pricing date and the settlement date, the underwriter will still be obligated to purchase the full amount of the notes. Traditionally, because of this risk borne by the underwriter, the underwriting commission may be higher than it would be for an offering in which the underwriter does not have this type of a commitment.
In an agented offering, the “underwriter” is acting contractually solely as the agent of the issuer. This type of broker-dealer does not have any obligation to purchase the relevant notes for its own account. The ultimate investors are effectively agreeing with the broker-dealer, acting as agent of the issuer, to purchase the notes from the issuer.
Because the offering is agented, and the broker-dealer does not have an obligation to purchase any securities, the relevant “underwriter” doesn’t need to use its regulatory capital for purposes of the offering. However, in terms of its potential liabilities, it is typically viewed as a “statutory underwriter,” with potential liability for misstatements or omissions in the prospectus. (Conversely, it would also potentially have a due diligence defense if the accuracy of the prospectus disclosure was challenged.)
Some agented offerings of different types of securities require an escrow agent for the offering proceeds, due to the provisions of Rule 15c2-4 under the Exchange Act. This requirement is not applicable to most agented offerings under MTN programs, which are conducted on a so-called “any or all” basis.
Versatility of Program Agreements
Today, structured notes are typically issued in the U.S. under so-called medium-term programs. Not too many years ago, MTN programs were structured principally as agented offerings; accordingly, many of these arrangements refer to the relevant broker-dealers as “agents” or “selling agents,” as opposed to “underwriters.” However, over the years, most of these agreements, when used by frequent issuers, have been broadened to contemplate underwritten offerings as well. And, in practice, as noted above, most of the offering activity in fact takes place in underwritten offerings.
As noted above, in many distributions of structured products, the underwriter may be distributing the notes through third-party broker-dealers. These dealers will each typically be party to an “MSDA” (master selected dealer agreement) or similar agreement with the underwriter. (Such dealers may also be “wholesalers,” selling to other dealers, lengthening this distribution chain.)
In many cases, it will be one or more of these “dealers,” and not the “underwriter,” that has the relationship with the relevant ERISA account. In this situation, this dealer would need to make the sale on an agency basis. Depending on the distribution arrangements, the dealer could, for example, act as agent for the underwriter. These arrangements would need to be carefully documented to ensure that the role and responsibilities of each of the parties is properly reflected.
Transitioning from Underwritten Offerings to Agented Offerings
In order to convert offerings from the underwritten format to the agented format, a variety of steps should be taken, for example:
- the issuer and the underwriter should review their program agreement or similar agreement (including the relevant “administrative procedures memorandum,” if applicable) to make sure that it provides for such an arrangement;
- the provisions of any relevant MSDAs may need to be revised to ensure that, where appropriate, the dealers are effecting sales on an agency basis;
- the plan of distribution and related disclosures in offering documents may need to be updated to reflect these arrangements; and
- confirmations furnished to investors would need to be revised to remove any references to the broker-dealer acting as principal.
Any practice of underwriters holding the offering securities “in inventory” for potential sale to retirement accounts would likely cease, as those sales could not take place on a principal basis.