Understanding Methods of Distribution in the Securities Industry
The methods of distribution in securities are crucial aspects that investment company representatives must grasp to effectively function within the industry. The methods provide structured pathways for how securities are offered and sold to the public or private investors. This article will delve into both best efforts and firm commitment underwriting agreements, equipping you with the essential knowledge needed for the FINRA Securities Industry Essentials® (SIE®) Exam.
Underwriting Agreements Explained
Underwriting is the process by which investment banks raise capital for companies and governments by selling new stocks or bonds to investors. There are two primary types of underwriting agreements: best efforts and firm commitment.
Best Efforts Underwriting
In a best efforts agreement, the underwriter, often an investment bank, agrees to sell as much of the securities offering as possible but does not guarantee the entire issue will be sold. The underwriter acts as an agent for the issuer, and the issuer bears the risk of the shares not being sold.
Example
Imagine a tech startup looking to raise $50 million. They enter into a best efforts agreement with an underwriter. If the underwriter manages to sell only $30 million worth of shares, the company will need to manage the shortfall; the underwriter is not obligated to cover unsold shares.
Firm Commitment Underwriting
In contrast, a firm commitment contract requires the underwriter to buy all of the securities from the issuer and resell them to the public. This shifts the risk to the underwriter, who must purchase any remaining shares not sold to the public.
Example
A well-established retail company plans a securities offering to raise $100 million for expansion. In a firm commitment arrangement, the underwriter purchases all $100 million in shares. If only $85 million of these shares are sold to the public, the underwriter retains the unsold $15 million, absorbing the financial risk.
Visual Aids
To better understand, visualize the relationships in a firm commitment underwriting agreement with this Mermaid diagram:
graph LR
Issuer -->|Sells securities| Underwriter
Underwriter -->|Sells to| Public
Summary Points
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Best Efforts: The underwriter sells as much as possible with no guarantee of selling the entire issue; the issuer bears the sale risk.
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Firm Commitment: The underwriter purchases all the securities, accepting the risk of any unsold shares.
Glossary
- Underwriter: A financial institution that fulfills the role of evaluating and assuming another party’s risk for a fee.
- Issuer: An entity that develops, registers, and sells securities.
Additional Resources
Enhance your preparation and knowledge with these resources:
Quizzes
Test your understanding with these preparation quizzes:
### What does a best efforts underwriting agreement imply for the issuer?
- [x] The issuer bears the risk of unsold shares.
- [ ] The underwriter buys all unsold shares.
- [ ] The risk is always split equally.
- [ ] The issuer has no risk.
> **Explanation:** In a best efforts agreement, the issuer is responsible for any unsold shares, as the underwriter does not guarantee a complete sale.
### Which type of agreement guarantees the sale of all offered securities?
- [x] Firm commitment
- [ ] Best efforts
- [x] Firm underwriting
- [ ] Guarantee contract
> **Explanation:** Both firm commitment and firm underwriting imply the underwriter guarantees the purchase of all securities from the issuer.
### How does risk allocation work in a best efforts underwriting?
- [x] Risk is on the issuer
- [ ] Risk is on the underwriter
- [ ] Risk is shared equally
- [ ] Risk is given to investors
> **Explanation:** In best efforts underwriting, the risk of unsold shares is borne by the issuer, not the underwriter.
### What does firm commitment underwriting involve?
- [x] Buying all securities
- [ ] Selling only profitable shares
- [ ] Rejecting risky securities
- [ ] Testing market waters first
> **Explanation:** Firm commitment involves the underwriter buying all securities offered by the issuer, assuming the sales risk.
### What is a key feature of firm commitment underwriting?
- [x] Shift of risk to underwriter
- [ ] Lower fees for the issuer
- [x] Guaranteed full sale
- [ ] Zero sales risk for all
> **Explanation:** The underwriter assumes the risk and is responsible for all unsold securities, ensuring a guaranteed full sale to the issuer.
### In a firm commitment, who absorbs the loss on unsold securities?
- [x] The underwriter
- [ ] The issuer
- [ ] The public
- [ ] A third party
> **Explanation:** The underwriter absorbs any losses tied to unsold securities in a firm commitment agreement.
### Why might an issuer choose a best efforts agreement?
- [x] Higher control and flexibility over the offering
- [ ] More guaranteed sales
- [x] Lower underwriter fees
- [ ] Shared risk
> **Explanation:** Issuers might choose best efforts due to perceived control over the pricing process and cost considerations, including typically lower underwriter fees.
### What does the term 'subscription' refer to in underwriting?
- [x] Signing up to purchase securities
- [ ] Receiving a newsletter
- [ ] Submitting an application
- [ ] Managing an account
> **Explanation:** The term 'subscription' in underwriting refers to the agreement to purchase and pay for securities.
### Can underwriters be both agents and principals?
- [x] True
- [ ] False
> **Explanation:** Underwriters can act as agents in a best efforts basis or as principals in a firm commitment offering.
### Should firm commitment underwriting be considered riskier for underwriters?
- [x] True
- [ ] False
> **Explanation:** Yes, because underwriters must cover the cost of any unsold securities, accepting the market risks involved.