The Underwriting Agreement: What it is and Why it is Important

There are a number of standard documents that lawyers must prepare for an initial public offering (IPO) of a company. The main document is the S-1 registration statement. The S-1 is filed with the Securities and Exchange Commission (SEC) and is publicly accessible on the SEC’s website. Other documents commonly involved in the IPO process include the underwriting agreement, the registration rights agreement, and the stockholder agreement. In terms of importance, the underwriting agreement falls pretty high up on the list.

An underwriting agreement is a contract between the group of banks, on the one hand, and the company issuing securities, on the other hand. The bank syndicate is the group of banks handling the transaction. The agreement outlines the various responsibilities and obligations of the company and its underwriters for the transaction. It also includes the agreed-upon purchase price, the initial resale date, and the settlement date.

The parties finalize the underwriting agreement prior to the roadshow. The roadshow refers to the series of presentations made by the company and underwriters to pitch the company’s upcoming IPO to prospective investors. The roadshow presentations take place in the period leading up to submission of the final prospectus to the SEC. The parties execute the underwriting agreement at the pricing stage of an IPO. Pricing typically occurs one day before the closing date of the IPO.

More Than One Type of Underwriting Agreement

Broadly speaking, there are two types of underwriting arrangements—firm commitment underwriting and best efforts underwriting. As the name suggests, in firm commitment underwriting, the banks definitively commit to purchase all the securities offered. This firm commitment means the banks must purchase all the securities offered even if they cannot sell them to investors. Underwriting a securities offering on a firm commitment basis can be risky for the underwriters if the markets take a sharp downward turn.

In a best-efforts underwriting agreement, on the other hand, the underwriters are not under a contractual obligation to purchase all the securities offered. The underwriters must only make a reasonable best effort to sell all the securities offered by the issuer company. If the underwriters are unable to sell a portion of the securities, the underwriters may return the unsold portion back to the company. In the firm commitment underwriting scenario, the underwriters would have to keep the unsold securities in their own account. Best-efforts underwriting arrangements often appear in the context of sales of high-risk securities.

The Greenshoe Option

The underwriting agreement also often contains a “greenshoe,” or over-allotment, option. This provision gives the underwriters the ability to sell investors more shares than initially planned. The greenshoe option normally states that investors may buy up to 15% more than the initial number of shares. The over-allotment option is particularly useful when demand for the company’s shares is higher than expected.

Key Provisions of the Underwriting Agreement

Many provisions of the underwriting agreement contain boilerplate language. But the paties often highly contest other provisions. In particular, the “Representations and Warranties of Company” and “Covenants of Company” sections are often highly negotiated in each deal.

The lead underwriter usually is able to exert the most control over the terms of the underwriting agreement in a given deal. Below is an overview of some of the key clauses underwriting agreements customarily contain.

Representations and Warranties of Company

Towards the beginning of the underwriting agreement is a section called “Representations and Warranties of Company.” A representation is an assertion as to the accuracy of facts. One party presents representations to the other party to induce them to enter the contract. A warranty is a promise of indemnity if the factual assertion turns out to be false.

The parties usually, and heavily, negotiate the representations and warranties sections of the underwriting agreement. A few examples of representations and warranties of the company include:

The company represents and warrants to and agrees with each of the underwriters that:

• • The S-1 Registration Statement filed with the SEC has become effective, and there is not stop order suspending its effectiveness
  • The company is not an “ineligible issuer”, as defined under the Securities Act
  • There has not occurred any material adverse change in the financial condition of the company

  Agreements to Sell and Purchase

  The “Agreements to Sell and Purchase” section states that the company agrees to sell to the underwriters, and that the underwriters will purchase securities from the company at the price specified in this section.

  Conditions to the Underwriters’ Obligations in the Underwriting Agreement

  The “Conditions to the Underwriters’ Obligations” section states in detail the conditions and obligations of the underwriters. These requirements include the delivery of certain other documents. One such document is a negative assurance letter. A negative assurance letter is a confirmation from the company’s auditor that certain facts are accurate. Another common document is an opinion by the law firm representing the underwriters. A law firm opinion letter attests to the validity of various legal descriptions. These opinion letters avoid costly litigation down the road.

  Covenants of the Company

  The “Covenants of the Company” section can be subject to heavy negotiation. A covenant is a promise to carry out or not carry out certain specified activities. Alternatively, a covenant can require meeting certain thresholds.

  A few examples of covenants of the company in an underwriting agreement include:

  The company covenants with each underwriter as follows:

  • • To comply with all applicable securities and other laws, rules and regulations in each jurisdiction in which the securities are offered
    • To furnish to the underwriters, without charge, signed copies of the S-1 Registration Statement
    • Before amending the S-1 Registration Statement, to furnish to the underwriters a copy of each proposed amendment and not to file any amendments that the underwriters reasonably object to