Quick Answer
An underwriter buys securities from an issuer with a view to distribution, sells for an issuer in a distribution, or otherwise participates in that distribution. The three underwriting arrangements (firm commitment, best efforts, and all-or-none) determine whether the underwriter or the issuer bears the risk of unsold shares.
Now that you understand what a broker-dealer is, let's look at one of the most important roles broker-dealers play: bringing new securities to the public through underwriting.
What Is an Underwriter?
Under the Securities Act of 1933 (SA), an underwriter is any person who:
- Purchases securities from an issuer with a view to distribution (buying to resell to the public)
- Offers or sells securities for an issuer in connection with a distribution
- Participates in the direct or indirect underwriting of any such undertaking
- Excludes a person whose interest is limited to a usual and customary seller's commission
The key concept is distribution: an underwriter's role is to facilitate the sale of newly issued securities from the issuer to the investing public. This is distinct from regular secondary market trading.
Exam Tip: Gotchas
- An underwriter is defined by its role in distribution, not by its title. Anyone who purchases from an issuer with a view to distribution qualifies as an underwriter under the Securities Act of 1933 (SA).
What Are the Types of Underwriting Commitments?
When a broker-dealer underwrites a new issue, the arrangement between the underwriter and the issuer determines who bears the risk of unsold shares:
| Type | Risk Bearer | How It Works |
|---|---|---|
| Firm commitment | Underwriter | Commits to buy the entire issue from the issuer, then resells to investors. The underwriter bears full risk of unsold shares. |
| Best efforts | Issuer | Agrees to sell as many shares as possible but does not guarantee the entire issue will sell. Because the underwriter never purchased the shares, unsold shares simply remain unissued with the issuer. |
| All-or-none | Issuer | A variation of best efforts: the entire offering must sell or the deal is canceled and investor funds are returned. |
- In a firm commitment, the underwriter has committed to purchase the entire issue and bears the risk of unsold inventory; this commitment does not itself mean the purchase has already closed the moment the registration statement becomes effective
- In best efforts, the underwriter acts more like an agent, bringing buyers and sellers together rather than buying from its own inventory
- All-or-none protects the issuer from a partial raise that may not be enough to fund its business objectives
Exam Tip: Gotchas
- Firm commitment = underwriter bears risk. The underwriter buys the entire issue outright, so any unsold shares are the underwriter's problem.
- Best efforts = issuer bears risk. The underwriter has no obligation to buy unsold shares; the risk stays with the issuer.
- All-or-none is a type of best efforts, not a type of firm commitment. The entire offering must sell or the deal is canceled.
What Is an Underwriting Syndicate?
For large offerings, a single underwriter may not have the capital or distribution network to handle the entire issue alone. The solution:
- The managing (lead) underwriter organizes the deal and forms an underwriting syndicate (a group of broker-dealers that share the financial responsibility)
- Each syndicate member assumes an allocated purchase commitment or other share of the underwriting liability, not merely a commitment to sell a portion of the offering
- Beyond the syndicate, a selling group may be formed: additional broker-dealers that help distribute shares without joining the syndicate and without taking on syndicate purchase liability
- The syndicate structure spreads risk across multiple firms and uses each firm's client relationships for broader distribution
Exam Tip: Gotchas
- Selling group members are not syndicate members and take on no syndicate purchase liability. They help distribute shares for a concession. Only syndicate members share the underwriting's financial risk.
What Should You Check on Exam Day?
- Can you define an underwriter by its role in a distribution, not by title?
- Do you know which party bears the risk of unsold shares under firm commitment versus best efforts?
- Can you explain that all-or-none is a variation of best efforts, not firm commitment?
- Do you know the difference between a syndicate member (shares underwriting liability) and a selling group member (distributes shares, no syndicate purchase liability)?
- Can you identify who forms the underwriting syndicate?