Definition of an Underwriter
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 Section 2), 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
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).
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 | Buys 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. Unsold shares are returned to 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 issuer knows exactly how much money it will receive at the time the registration statement becomes effective, because the underwriter has already purchased the entire issue
- 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.
The 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)
- The syndicate members each commit to selling a portion of the offering
- Beyond the syndicate, a selling group may be formed: additional broker-dealers that help distribute shares but do not take on underwriting 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 underwriters. They help distribute shares but do not take on underwriting liability. Only syndicate members share the financial risk.