Underwriting is an act of guarantee by an organisation for the sale of a certain minimum number of shares and debentures issued by a public limited company.
According to the Companies Act, when a person agrees to take up shares specified in the underwriting agreement when the public or others fail to subscribe for them, it is called an underwriting agreement. For this purpose, the underwriter, who guarantees the sale of shares, is given a commission.
When the public to whom the shares are issued fails to subscribe, it is the underwriter who has to subscribe up to the limit he has agreed. Later on, when the market improves, he may offload the shares by selling them to the public. Thus, the underwriter makes a promise to get the underwritten issue subscribed either by him or by others.
According to the Indian Companies Act, every public limited company must raise minimum capital, and if it fails to raise within 60 days from the date of issue of the prospectus, the directors should return the money to the public. If the return is delayed by more than 78 days, the company has to pay interest on the refund amount.
What is an underwriter?
An underwriter is a member of a financial organization. They work for mortgage, insurance, loan, or investment companies. They assess, evaluate, and assume the risk of another party for a fee.
Often, you’ll see this fee in the form of a commission, premium, spread, or interest. At any rate, if you’re working with an underwriter, you’re most likely seeking approval for a large purchase or insurance coverage.
Each industry has its own underwriters, and these individuals must understand the intricacies of their specific field. They use their knowledge and expertise to best asses the risk of an applicant. Underwriters determine if giving a loan or issuing an insurance policy will work in the favour of their company. However, if the contract turns out to be too risky, the underwriter is accountable for the loss.
Most underwriters have a bachelor’s degree and have completed a training program. Typically, they have an academic major within their industry of specialization. Common majors include finance, business, and economics.
The History of Underwriters:
The term "underwriter" first emerged in the early days of marine insurance.
Ship owners sought insurance for a ship and its cargo to protect themselves if the boat and its contents were lost. Ship owners would prepare a document that described their ship, its contents, crew, and destination.
An agreed-upon rate and terms were set out in the paper. Business people who wished to assume some obligation or risk would sign their name at the bottom and indicate how much exposure they were willing to accept. These businessmen became known as underwriters.
What Do Underwriters Do?
An underwriter is a professional who assesses risk and establishes a stable and fair market for financial transactions. An underwriter does this by approving calculated risk when making decisions on a case-by-case basis.
They determine which contracts are worth the risk and the rate they will assign to these cases to ensure they or their employer make a profit.
The following are the top duties of an underwriter:
Examining applications for insurance, loans, mortgages, or IPOs
Potential borrowers are vetted based on their backgrounds, assets, incomes, and other factors.
Using software to evaluate risk
Conducting research and evaluating applicant documents
Approving or declining applications based on research and evaluations
The importance of underwriters
The underwriters are in charge of issuing shares in the company, which are known as issuers, and they have the option of deciding on share underwriting.
If the issue is not underwritten, there is a possibility of the issue being under subscribed, and even if 90% of the minimum subscription is not received, the money has to be refunded in full. Hence, there is an urgent need on the part of the issuer to seek the assistance of underwriters for the successful completion of the issue of shares. Investors need underwriters to determine if a business risk is worth investing in. In addition, underwriters also contribute to the success of sales-type activities.
Using the knowledge they have in their field, underwriters decide if a contract is worth the risk. For example, underwriters who work with health insurance companies evaluate the health risk of applicants.
The underwriter will review the applicant’s information, including age, current health condition, and past medical and family history. Using this information and other factors, an underwriter will enter the data into underwriting software. The software will determine the premium amount and terms that should apply to the policy. Also, this assessment determines if the policy is too risky to move forward.
The information provided to various underwriters is subject to the specific case. For example, an underwriter for a health insurance company will review medical details, while a loan underwriter will assess factors like credit history. An underwriter’s job is complex. They have to determine an acceptable level of risk and what’s eligible for approval based on their risk assessment. When assessing complicated situations, underwriters may need to conduct research and acquire a large number of details.
SEBI RULES AND REGULATIONS 1993:
1. No person can act as an underwriter unless he holds a certificate of registration granted by SEBI. However, any stock broker or merchant banker who holds a valid SEBI certificate of registration may act as an underwriter without obtaining a separate certificate for underwriting activities.
2. An underwriter shall make all efforts to protect the interests of its clients.
3. An underwriter shall maintain high standards of integrity, dignity, and fairness in the conduct of its business.
4. An underwriter shall put in place a mechanism to resolve any conflict of interest situation that may arise in the conduct of its business or where any conflict of interest arises, shall take reasonable steps to resolve the same in an equitable manner.
5. An underwriter shall make appropriate disclosure to the client of its possible source or potential areas of conflict of duties and interest while acting as an underwriter, which would impair its ability to render fair, objective, and unbiased services.
6. An underwriter shall ensure that the board is promptly informed about any action, legal proceedings, etc., initiated against it in respect of any material breach or non-compliance by it of any law, rules, and regulations, directions of the board or of any other regulatory body.
7. An underwriter cannot derive any direct or indirect benefit from underwriting the issue other than the commission or brokerage payable under the agreement.
8. Every underwriter, in the event of being called upon to subscribe for securities of a body corporate pursuant to an underwriting agreement, has to subscribe for such securities within 45 days of the receipt of such intimation from such body corporate.
9. An underwriter shall have internal control procedures and financial and operational capabilities that can be reasonably expected to protect its operations, its clients, and other registered entities from financial loss arising from theft, fraud, and other dishonest acts, professional misconduct, or omissions.
One very significant aspect of the many tasks an underwriter performs is that he plays the role of a market-maker. This accounts for a large portion of the volume of trading within the first few days after the stocks start trading. Therefore, it is the underwriters who have liquidity for the newly traded public offering. Therefore, they play a critical role in creating a suitable business environment by mitigating the risks for the issuing companies.
This article is written by Vishal Rangwani of KC Law college.