Underwriting of Shares and Debentures

When a company issues shares, it should receive the amount of minimum subscription as mentioned in the prospectus. According to the provisions of Section 69 (1) of the Companies Act, the minimum subscription should not be less than 90% of the issue value. It should be received within 120 days from the date of opening of the issue. Otherwise, all the amounts received by the Company should be refunded to the respective applicants. The said issue will have to be abandoned. In order to avoid such an awkward position, companies seek the help of Underwriters. In this chapter, all the factors relating to the underwriting of shares and debentures are discussed in detail.

Underwriting is an act of extending a guarantee to a company to ensure that the shares or debentures offered to the public are subscribed for within the stipulated period. Underwriting may be defined as, “a contract entered into by the Company with persons or institutions,
called underwriters, who undertake to take up the whole or a portion of such of the offered shares or debentures as may not be subscribed for by the public, in consideration of remuneration called underwriting commission”.

Salient features of underwriting are as follows:

• Underwriting is undertaking a responsibility (or) extending a guarantee. It is a contract between a company and persons or institutions, called underwriters.
• In case, if the shares or debentures are not subscribed for by the public, the underwriters should take up
the shares and pay for them.
• For such services, they are eligible to charge a commission called “underwriting commission”, as per the
provisions of the Act.
• The contract is enforceable by law.
• In case, if the shares are subscribed for fully by the public, underwriters need not take any share but are
entitled to the commission on the whole of the shares underwritten.
• The Articles of the Company should permit such payment on commission.

As already stated, the
underwriting commission is to be paid for the services (i.e., facilitating the task of achieving the minimum subscription quantum from the public when a company launches new issues of shares or debentures) rendered by the underwriters (persons or institutions). The commission is paid to the underwriters for the risks they undertake. Nowadays, the importance of underwriters has attained a level of vital importance. Because of this, some of the financial institutions of the central government take the role of underwriters, e.g., LIC, UTI, IDBI, SBI and commercial banks. The underwriting commission has to be paid to the underwriters as per the terms of the contract subject to the provisions envisaged in the Companies Act.
According to Section 76 of the Companies Act, payment of commission to underwriters will be subject to the following:
• The Articles of Association of the Company should authorize any commission on the issue of shares. In other words, a company cannot pay any underwriting commissions unless it is permitted by its Articles.
• Commission should not be paid to any person on shares or debentures that are not offered to the public for subscription as per Section 76 (4A).
• The amount or rate of percent of the commission should be disclosed in the prospectus or the statement in lieu of the Prospectus.
• The provisions of the Companies Act limit the commission in case of issue of shares to 5% of the issue price of shares or the rate authorized by the Articles, whichever is less.
• In case of issue of debentures, the commission should not exceed 2.5% or the rate authorized by its Articles, whichever is less.
• The following table shows the payment of the underwriting commission which is in accordance with the Guidelines issued by the Stock Exchange Division of the Department of Economic Affairs, Ministry of Finance—Ref. No. F14/1/SE/85:

  • Underwriting commission should not be payable on shares subscribed for by the promoters group, employees, directors, their friends and business associates.

An underwriter may seek the help of several underwriters to facilitate his task. But all such have to work under the principal underwriter—who had actually entered into a contract with the company. These underwriters are called “sub-underwriters.” Sub-underwriters have to work under an underwriter. Sub-underwriters are generally appointed by an underwriter. They are responsible only to the underwriter. In any case, sub-underwriters have no priority in the contract with the company. Their remuneration is in accordance with the terms of their contract with the underwriter. Sub-underwriters are entitled to receive remuneration from the underwriters, which, is called “overall commission”. The limit shown in the table includes the overall commission. Hence, the underwriters are not entitled to any extra claim for this purpose.

Brokers’ roles differ from those of underwriters. A broker’s job is to procure subscriptions for shares or debentures. A broker will not make any commitment, take responsibility, or even any risk. However, a broker is entitled to receive remuneration called “brokerage” to procure a subscription by him. The brokerage may be paid in addition to the underwriting commission, if any.

Section 76 (3) of the Companies Act provides for payment of brokerage. The Stock Exchange Division of the Department of Economic Affairs, Ministry of Finance vide their reference No. F14/1/SE/85 dated 7 May 1985, has laid down the following provisions with respect to brokerage:

• Brokerage applicable to all types of public issues of Corporate securities is fixed at 1.5% whether the issue is underwritten or not.
• The listed companies are allowed to pay brokerage on private placement of capital at the maximum rate of 0.5%.
• Brokerage should not be allowed in respect of promoters quota, including the amounts taken up by the directors, their friends, and employees; and in respect of the rights issues taken up or renounced by the existing shareholders.
• 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 undersubscription of the issues.

Companies are at liberty to appoint one or more agencies as their managers to the issue. They are entrusted with the entire matter relating to an issue of share or debenture from the planning stage till the completion of all required formalities with respect to the issue. They are paid for the services rendered. The aggregate amount payable as fees to the managers to the issue will be as follows:
(i) For issues up to 5 crore: 0.5% (ii) For issues above 5 crore: 0.2%.

A company has to issue to the public applications in the prescribed format to subscribe for shares/debentures. Such application forms may be issued by the company or by the underwriters or by both.

Marked Applications
Application forms issued by an underwriter or a broker are stamped with their name and address. Such applications are called “marked applications”. These marked applications facilitate the task of the company to identify and quantify the quantum of shares that have been applied through a particular underwriter or broker. The marked applications are deemed to be received through the underwriter or broker, even if they are sent to the company by the applicants. In case, if the whole of the issue has been underwritten by a sole underwriter, the applications need not get marked. All applications, whether submitted directly to the company or sent through underwriters, will be entitled to commission on the whole issue.

Unmarked Applications
Applications that do not bear the stamp of an underwriter or broker are called “unmarked applications”. It means that these applications were issued to the public directly by the company. They are otherwise called “direct applications”.

Firm-underwriting Applications
At times, the underwriters of an issue may agree to take up a specified number of shares in addition to the shares underwritten. Under such circumstances, the underwriters should fill up and submit the applications to the company, just like any other applicant, paying the needed application money. These applications which are filled and sent to the company by the underwriters are known as “firm-underwriting applications”

Pure Underwriting
Under this type of agreement, the underwriter’s liability is wholly contingent, whereby he agrees to subscribe for shares or debentures that are not subscribed for by the public. This may be divided into two types as follows:
(a) Complete underwriting
(b) Partial underwriting

Complete Underwriting
In case the whole of the issue of shares or debentures is underwritten (without imposing “fi rm” underwriting), it is called “complete underwriting”. The issue may be wholly underwritten by a single underwriter. In such a case, the underwriter agrees to take the entire risk.
The issue may be underwritten by more than one underwriter. In that case, each underwriter agrees to take risk only to a certain extent, and not the entire risk.

Partial Underwriting
In case only a part of the issue of shares or debentures of a company is underwritten, it is called “partial underwriting”.In partial underwriting, the issue may be underwritten by a single underwriter or more than one underwriter. In both situations, the underwriter agrees to take risk only to a certain limited extent.

Firm Underwriting
Under this type of agreement, the underwriter’s liability is partly contingent and partly definite. The agreement specifies a definite commitment to take up a specified number of shares, irrespective of the number of shares subscribed for by the public. In this case, the underwriter’s liability is determined in addition to the shares “firmly” underwritten. In other words, the underwriter has to take:
(i) The number of shares he has agreed for “fi rm”;
(ii) The number of shares he is obliged to take up on the basis of agreement.
In case, if the agreement includes an “Abatement Clause”, then that “fi rm” liability is to be adjusted
against normal underlying liability.
To illustrate, Mr. A. underwrites 60% of an issue of 1,00,000 shares. Besides, he applies for 10,000 shares “fi rm”. His marked applications are for 45,000 shares. Determine his liability.

Illustration 2.1
Model: Journalizing transactions entire issue underwritten by one underwriter ABC Ltd. issued 1,00,000 equity shares of `10 each at par. The issue was undertaken by Sure Shares & Co. for the maximum commission permitted by law. The public applied for and received 70,000 shares. Pass journal entries in the books of ABC Ltd. and also show how these items will appear in the balance sheet of ABC Ltd.



*1. Underwriting commission:
According to the Companies Act (Section 76), the maximum commission allowed is 5% on the issue value. However, according to SEBI Guidelines, the maximum commission permitted is 2.5%. The latest guidelines are to be taken into account. Hence, the underwriting commission will be:

Issue (Value) = 1,00,000 × 10 = 10,00,000 2.5% on10,00,000 = 25,000.

*2. No. of shares to be undertaken by Sure Shares & Co.:

No. of shares issued by the company: 1,00,000

No. of shares subscribed by the public: 70,000

Balance left out to be undertaken by Sure Shares & Co. = 30,000

Shares Value: 30,000 × 10 = 3,00,000

*3. Net commission payable to underwriter:

(or) Receipt of balance from underwriters after adjusting commission (As the case may be):

In this case, commission is less whereas his obligation to the company is more, that is, commission: only 25,000 whereas his liability to the company is: obligation – commission, i.e., 3,00,000 – 25,000 = ` 2,75,000

Underwriting of shares solved sums

Compiled as per MAKAUT BBA Hons updated syllabus 2023 from Pearson book of Corporate accounting.

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