Underwriting of a Company

Meaning of Underwriting:

Underwriting in the context of a company means undertaking a responsibility or giving a guarantee that the shares or debentures offered to the public will be subscribed for.

There are firms which undertake this sort of work and are very useful to companies which want to raise funds by the issue of shares or debentures. If the shares or debentures are not taken up by the public wholly, the underwriters will have to take them up and pay for them.

For this service, they charge a commission which is generally calculated at a specified rate on the issue price of the whole of the shares or debentures underwritten.

Even if the public takes up all the shares or debentures offered and the underwriters are not called upon to take up any share, commission will be payable on the whole of the shares or debentures underwritten. A company cannot pay any commission on issue of shares unless it is permitted by its Articles.

Commission cannot be paid to any person on shares or debentures which are not offered to the public for subscription [section 76 (4A)]. The amount or rate per cent of the commission paid or payable as also the number of shares (or debentures) which a person has agreed to subscribe for commission has to be disclosed in the prospectus or the statement in lieu of prospectus, as the case may be.

The directors must also state in the prospectus that, in their view, the underwriters are capable of meeting their obligations under the underwriting contract.

The law limits the commission in case of issue of shares to 5% (or a lower rate if the Articles so state) of the issue price of shares and in case of issue of debentures to 2½% or such lower rate as is provided in the Articles.

However, pursuant to Guidelines issued by the Stock Exchange division of the Department of Economic Affairs, Ministry of Finance vide their reference No. F14/1/SE/85, dated 7th May, 1985, the following rates for payment of underwriting commission are in force-

(i) The rates of underwriting commission mentioned above are maximum ceiling rates, within which any company will be free to negotiate the same with the underwriters.

(ii) Underwriting commission will not be payable on amounts taken up by the promoters group, employees, directors, their friends and business associates.

Sub-underwriters:

In addition to the underwriter, there may be several underwriters working under him. These will be called sub-underwriters. They are responsible only to the underwriter and generally have no privacy of contract with the company.

For subscriptions procured by the sub- underwriters, the underwriter receives a small commission payable, called overall commission. The limits for commission cover commission to the sub-underwriters and the overall commission.

Brokerage:

Brokerage, as against underwriting, is merely the act of procuring subscriptions for shares or debentures without any responsibility. A broker receives commission on the shares subscribed through him but is under no obligation to take up any shares that may remain unsold. Brokerage can be paid in addition to the underwriting commission, if any.

The Ministry of Finance (Department of Economic Affairs) vide its letter dated 7th May, 1987 has laid down the following rules regarding brokerage:

(i) Brokerage applicable to all types of public issues of industrial securities is fixed at 1.5 per cent whether the issue is underwritten or not.

(ii) The mailing cost and other out-of-pocket expenses for canvassing of public issues, etc. will be borne by the stock brokers and no payment on that account will be made by the companies. A clause to this effect must be included in the agreement to be entered into between the broker and the company.

(iii) The listed companies are allowed to pay brokerage on private placement of capital at the maximum rate of 0.5 per cent.

(iv) Brokerage will not be allowed in respect of promoters quota, including the amounts taken up by the directors, their friends and the employees; and in respect of the right issues taken up or renounced by the existing shareholders.

(v) Brokerage will not be paid when the applications are made by the institutions/banks against their underwriting commitments or on the amounts devolving on them as underwriters consequent to under-subscription of the issues.

Marked Applications:

Underwriters or brokers issue application forms for shares or debentures to members of the public. Such application forms are stamped with the name of the underwriters or brokers. The company can then find out how many shares have been applied for through a particular broker or underwriter. Such applications are known as Marked Applications.

Those applications which do not bear the stamp of the underwriter or the broker are known as Unmarked Applications. If there is a sole underwriter who has underwritten the whole of issue, it does not matter whether applications are marked or not as he will be given credit for all applications whether sent through him or directly.

But as will be seen later, it does matter if there are two or more underwriters or if the issue has been only partially underwritten.

Underwriting Commission:

The entry for underwriting commission or brokerage is:

Underwriting Commission (or Brokerage) on Issue of Shares (or Debentures).. Dr.

  To Underwriter (or Broker).

Calculation of Liability of Underwriter—Partial Underwriting:

If an underwriter underwrites the whole of the issue, the shares or debentures left unsubscribed by the public will have to be taken up by the underwriter. But if the underwriter undertakes responsibility for only part of the issue, the company will have to set against the underwriter’s undertaking, applications received through him (marked applications).

Suppose, out of an issue of 10,000 shares, only 6,000 shares are underwritten.

Then, if the marked applications amount to 5,400 shares, the underwriter’s liability will be 600 shares (6,000 – 5,400). But, if all the shares are subscribed (even though the marked applications are less than the number underwritten) the underwriter has no liability.

Suppose, A and B, two underwriters, underwrite 4,000 and 6,000 shares. Total applications are for 8,000 shares out of which marked applications are for A 3,500 and for B 4,000. Then the liabilities of A and B for the 2,000 unsubscribed shares (10,000—8,000) will be determined as follows:

Solved Problems:

Illustration 1:

A joint stock company issues 20,000 shares. The issue is underwritten by X, Y, Z in the ratio of 5:3:2 respectively.

Unmarked applications total 1,000 whereas marked applications are as follows:

Illustration 2:

A company issues 1 lakh equity shares of Rs 10 each at par and 500 debentures of Rs 1 000 each @ Rs 950. The whole of the issue has been underwritten by M/s. P. Bhalla & Co. for a commission of 2 per cent on shares and 1 per cent on debentures (nominal value).

The whole of the shares were applied for but only 400 debentures were applied for. All applications were accepted. Give journal entries and show the entries in the balance sheet assuming all amounts have been received.

Illustration 3:

A company issues 1,000 14% Debentures of Rs 1,000 each at a premium of 20%. Sixty per cent of the issue was underwritten by M/s. Bulls & Bears for a commission @ 1.5% of the issue price of debentures underwritten. Applications were received for 800 debentures which were accepted and payment of these was received in full. Give journal entries.

Solution:

Since M/s. Bulls & Bears underwrite 60% of the issue, the company must itself be treated as an underwriter of the remaining 40%. In the absence of any information, the applications for 800 debentures must be deemed to have been marked 60% in favour of the underwriters, viz., 480 debentures. The underwriters are, therefore, liable to take up 120 debentures (600 – 480).

The journal entries are as follows:

Firm Underwriting:

When an underwriter agrees to buy or subscribe a certain number of shares or debentures irrespective of the result of the issue of the prospectus, it is a case of firm underwriting. Strictly speaking, an underwriter is not allowed to set off his firm underwriting against his liability otherwise determined.

This means that he will have to subscribe both for shares underwritten firm and for shares which, ignoring firm underwriting, he has to take under the underwriting contract.

Suppose, A underwrites 6,000 shares and also 500 shares firm, the total issue being 10,000 shares. The marked applications are 5,400. He will have to take 1,100 shares in all-500 underwritten firm and 600 under the underwriting agreement. This, of course, is subject to the terms of the contract. If the contract so provides, the net liability of the underwriter will be calculated after taking the firm underwriting into account.

Illustration 4:

The following underwriting takes place:

A 6,000 shares; B 2,500 shares and C 1,500 shares.

In addition there is firm underwriting:

A, 800 shares; B, 300 shares and C, 1,000 shares.

The share issue is 10,000. Total subscription including firm underwriting was 7,100 shares and the forms included the following marked forms:

A, 1,000 shares; B, 2,000 shares; and C, 500 shares.

Show the allocation of liability of the underwriters. (C.A. Final)

Illustration 5:

Sam Ltd. invited applications from public for 1,00,000 equity shares of Rs 10 each at a premium of Rs 5 per share. The entire issue was underwritten by the underwritten A, B, C and D to the extent of 30%, 30%, 20% and 20% respectively with the provision of firm underwriting of 3,000, 2,000, 1,000 and 1,000 shares respectively. The underwriters were entitled to the maximum commission permitted by law.

The company received applications for 70,000 shares from public out of which applications for 19,000, 10,000, 21,000 and 8,000 shares were marked in favour of A, B, C and D respectively.

Calculate the liability of each one of the underwriters. Also ascertain the underwriting commission payable to the different underwriters. [C S. (Inter) June, 1997]