Tag: Business Combination

Underwriting agreements in securities issuance can vary depending on the level of commitment made by the underwriter. The liability of underwriters in such contracts differs when the issue is fully underwritten versus partially underwritten, and further varies with or without firm underwriting.

Fully Underwritten Contract

In a fully underwritten contract, the underwriter or group of underwriters guarantees the entire issue. This means that regardless of how much of the issue is subscribed to by the public, the underwriter is liable to purchase the unsold portion of the securities at the agreed-upon issue price.

• Liability of Underwriters: The underwriter assumes full liability, meaning they are legally bound to purchase any remaining shares that investors do not subscribe to. The underwriter’s risk is significant, as they are committed to taking on the entire offering if necessary. This type of underwriting provides a capital guarantee to the issuer, ensuring they will raise the full desired amount of funds.

• Example: Suppose a company is issuing 1,000,000 shares, and the public subscribes to only 600,000. In a fully underwritten agreement, the underwriter would be responsible for purchasing the remaining 400,000 shares. If the shares are issued at a premium, the underwriter must pay the agreed price, regardless of how the market reacts.

Partially Underwritten Contract

In a partially underwritten contract, the underwriter agrees to guarantee only a portion of the securities being offered. The liability is therefore limited to the agreed-upon amount. The issuer may attempt to sell the remaining shares to the public or through other means, but if the public does not fully subscribe, the underwriter is only required to purchase their part of the issue.

• Liability of Underwriters: Underwriters are only liable for their specific portion of the offering. This means that if, for example, the underwriter has agreed to purchase 60% of the shares and the public subscribes to 40%, the underwriter will be liable for the 60% they committed to, and the remaining 40% will need to be managed through other channels.

• Example: In an offering of 1,000,000 shares, if the underwriter has agreed to underwrite 600,000 shares, and the public subscribes to 300,000, the underwriter’s liability would be limited to the 600,000 shares, even if the full offering isn’t subscribed.

Firm Underwriting

Firm underwriting involves the underwriter agreeing to buy a fixed number of shares from the issuer, even if the public does not fully subscribe. This type of underwriting involves a higher level of commitment than regular underwriting, and it’s typically used in situations where there is a need to ensure that the issuer raises the required capital.

• Liability of Underwriters: In firm underwriting, the underwriter is committed to buying a specific number of shares regardless of public subscription. This differs from non-firm underwriting where the underwriter may back out if the subscription level is too low. The underwriter thus takes on more risk, especially if market conditions are unfavorable.

• Example: If a company issues 1,000,000 shares and the underwriter commits to purchasing 500,000 shares on a firm basis, the underwriter must buy these 500,000 shares, even if the public subscribes to only 300,000 shares. This ensures that the issuer raises at least the required capital.

Non-Firm Underwriting:

Non-firm underwriting occurs when the underwriter agrees to purchase securities only if they are not subscribed to by the public. In this case, the underwriter has no obligation to buy the unsold portion if there is sufficient public subscription. Non-firm underwriting carries less risk for the underwriter as their liability is contingent upon the public’s interest in the offering.

• Liability of Underwriters: The liability for the underwriter is contingent on the amount of the offering that remains unsold. If there is over-subscription by the public, the underwriter has no responsibility to purchase additional shares. However, if the offering is undersubscribed, they may be required to step in and buy the unsold shares.

• Example: In an offering of 1,000,000 shares, if the underwriter agrees to underwrite 500,000 shares on a non-firm basis, and the public subscribes to 700,000 shares, the underwriter would have no further obligation to purchase any unsold shares.

Liability in Case of Over-Subscription and Under-Subscription

• Over-Subscription: When the offering is over-subscribed, meaning the public subscribes for more shares than are available, the underwriter may reduce their liability proportionally. In a firm underwriting, the underwriter still needs to buy the agreed-upon amount, but in a non-firm underwriting, they may reduce their commitment.

• Under-Subscription: In the case of under-subscription, the underwriter assumes liability for the unsold portion. In fully underwritten contracts, the underwriter is obligated to purchase all the unsold shares. However, in partially underwritten contracts, the underwriter only needs to buy their portion of the unsold shares, and the remaining unsold shares may be dealt with by other means, such as extending the issue period or reducing the offering.

When a company issues shares, the accounting treatment varies depending on whether the shares are issued at par, premium, or discount. Let’s explore each of these methods in detail, including examples and accounting entries.

1. Issue of Shares at Par

When shares are issued at par, the nominal value (face value) of the share is the same as the price at which the shares are issued. For example, if a company issues 1,000 shares with a face value of ₹10 each, they will be sold to investors at ₹10 per share, meaning no premium or discount is applied.

Example:

• Number of Shares Issued: 1,000

• Face Value: ₹10 per share

• Issue Price: ₹10 per share

• Total Capital Raised: 1,000 shares × ₹10 = ₹10,000

Accounting Entry:

• Bank Account Debit ₹10,000

• Share Capital Account Credit ₹10,000

This reflects the cash received in exchange for shares issued at par.

2. Issue of Shares at Premium

When shares are issued at a premium, the price at which shares are sold is higher than their nominal (face) value. The excess amount received over the face value is known as the securities premium and is credited to a separate account called the Securities Premium Account.

Example:

• Number of Shares Issued: 1,000

• Face Value: ₹10 per share

• Issue Price: ₹15 per share (₹10 face value + ₹5 premium)

• Total Capital Raised: 1,000 shares × ₹15 = ₹15,000

• Premium Received: 1,000 shares × ₹5 = ₹5,000

Accounting Entry:

• Bank Account Debit ₹15,000

• Share Capital Account Credit ₹10,000

• Securities Premium Account Credit ₹5,000

The above entry records the receipt of cash from investors for both the face value and the premium.

3. Issue of Shares at Discount

When shares are issued at a discount, the price at which shares are sold is lower than their nominal (face) value. This results in the company receiving less money than the nominal value of the shares. In most jurisdictions, issuing shares at a discount is restricted and often requires specific approvals from regulatory authorities.

Example:

• Number of Shares Issued: 1,000

• Face Value: ₹10 per share

• Issue Price: ₹8 per share (₹10 face value – ₹2 discount)

• Total Capital Raised: 1,000 shares × ₹8 = ₹8,000

• Discount Given: 1,000 shares × ₹2 = ₹2,000

Accounting Entry:

• Bank Account Debit ₹8,000

• Share Capital Account Credit ₹10,000

• Discount on Issue of Shares Account Credit ₹2,000

The Discount on Issue of Shares account is a contra-equity account that reflects the reduction in the total capital raised from the issue of shares at a discount.

Summary of Accounting Entries for Share Issues

Calls in Advance refers to the amount paid by shareholders on their shares before it is officially called or due by the company. This payment is made by shareholders in advance of the scheduled installment or call. The company records this amount as a liability until the call is formally made, at which point it is adjusted against the amount due. Calls in Advance do not carry voting rights until the actual call is due, and the company may pay interest on these amounts at a predetermined rate as compensation to the shareholders for their early payment.

Characteristics of Calls in Advance:

1. Prepayment by Shareholders

The fundamental characteristic of Calls in Advance is that shareholders voluntarily pay part or all of their outstanding share capital before the company makes an official call for the payment. This prepayment is often done to secure an investment or ensure prompt fulfillment of financial obligations related to their shares.

2. Recorded as a Liability

When a company receives Calls in Advance, it records this amount as a liability on its balance sheet. This is because the payment is considered unearned revenue until the company officially calls for the payment. The liability remains until the call is made, at which point the amount is adjusted against the due call.

3. Interest Payment

Companies may pay interest on Calls in Advance as a form of compensation to shareholders for providing funds earlier than required. The rate of interest is usually predetermined and is stipulated in the company’s Articles of Association. However, the company is not obligated to pay interest if it chooses not to, depending on its policies.

4. No Voting Rights

One significant characteristic of Calls in Advance is that shareholders who have paid in advance do not receive any additional voting rights based on their early payment. Voting rights are only granted based on the paid-up share capital when the call is actually due.

5. Adjustment Against Future Calls

The amount paid in advance is adjusted against the future calls made by the company. When the call is due, the company will deduct the amount already paid in advance from the total amount payable by the shareholder, reducing their financial obligation at the time of the call.

6. Temporary Use of Funds

The company can temporarily use the funds received as Calls in Advance for its operational or capital needs. However, this use is limited by the fact that the company must treat these funds as a liability, meaning they must be available when the call is officially made.

7. No Dividend Entitlement

Shareholders who pay Calls in Advance are not entitled to dividends on the amount paid in advance until it is officially called. Dividends are typically declared only on paid-up capital, which includes only those amounts that are due and payable.

8. Flexibility for the Company

Calls in Advance provide the company with flexibility in managing its cash flow. The early receipt of funds can help the company meet its immediate financial needs or invest in short-term opportunities. However, this flexibility comes with the responsibility of managing these funds carefully, as they are liabilities that must be settled when the official call is made.

Calls in Arrears

Calls in Arrears refers to the amount that shareholders have not paid by the due date on their shares, despite a formal request or “call” from the company. When a company issues shares, it may request payment in installments. If a shareholder fails to pay any installment by the due date, the unpaid amount is considered a call in arrears. The company records this as a receivable on its balance sheet. Interest may be charged on calls in arrears, and in severe cases, the company may forfeit the shares if the arrears are not cleared within a specified period.

Characteristics of Calls in Arrears:

1. Unpaid Amount

The primary characteristic of Calls in Arrears is that it represents an amount that shareholders owe to the company but have not yet paid by the deadline specified. This occurs when shareholders do not fulfill their financial obligation to pay the call on the due date as required by the company.

2. Recorded as an Asset

In the company’s financial records, Calls in Arrears are recorded as an asset. Specifically, it is shown as a receivable on the balance sheet, reflecting the amount that the company expects to collect from shareholders. This receivable remains on the books until the amount is fully paid by the shareholders.

3. Interest Charges

Companies often charge interest on Calls in Arrears as a penalty for late payment. The interest rate and terms are usually specified in the company’s Articles of Association. This serves as a deterrent to shareholders against delaying payment and compensates the company for the delay in receiving funds.

4. No Voting Rights

Shareholders with Calls in Arrears do not enjoy voting rights for the unpaid shares. Voting rights are typically granted based on the paid-up share capital. As a result, shareholders who fail to pay on time may temporarily lose their influence in company decisions until they settle their dues.

5. Possible Forfeiture of Shares

If the Calls in Arrears remain unpaid for an extended period, the company may initiate the process of forfeiting the shares. Forfeiture involves canceling the shareholder’s ownership of the shares, and the company may reissue or sell the shares to recover the unpaid amount.

6. Impact on Dividend

Shareholders with Calls in Arrears are not entitled to receive dividends on the unpaid shares. Dividends are typically declared on fully paid-up shares, so until the arrears are cleared, the shareholder forfeits any right to dividends on those shares.

7. Negative Impact on Shareholder Reputation

Calls in Arrears can negatively affect a shareholder’s reputation within the company and among other investors. Persistent arrears may lead to a loss of trust and potential exclusion from future investment opportunities within the company.

8. Legal Implications

If the arrears are significant and remain unresolved, the company may take legal action to recover the outstanding amount. This could involve court proceedings or other legal remedies to enforce payment, depending on the jurisdiction and the company’s policies.

Key differences between Calls in Advance and Calls in Arrears

Underwriting is a crucial aspect of the capital market, especially during public offerings like Initial Public Offerings (IPOs), Follow-on Public Offerings (FPOs), and Rights Issues. In the context of securities markets in India, underwriting refers to an arrangement in which a designated underwriter agrees to purchase shares from a company in case the public offering is not fully subscribed. The Securities and Exchange Board of India (SEBI), as the regulatory authority for the Indian securities market, has laid down certain guidelines and regulations for underwriting in order to ensure transparency, protect investor interests, and maintain market integrity.

Regulations on Underwriting by SEBI:

SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations)

Under the SEBI ICDR Regulations, which governs the process of public offerings in India, specific rules apply to underwriting arrangements:

• Appointment of Underwriters: Companies issuing securities must appoint one or more underwriters to ensure that they can raise sufficient capital even if the issue does not receive full subscription from the public. These underwriters may be financial institutions, banks, or other recognized entities with the necessary expertise and financial backing.

• Underwriting Agreements: An underwriting agreement is a formal contract between the issuer and the underwriter. The agreement must clearly specify the number of securities being underwritten, the terms of underwriting (including commission), and the conditions under which the underwriting agreement becomes effective.

• Underwriting Commitment: The underwriter commits to purchasing any unsubscribed shares, thereby assuming the risk of the offering’s under-subscription. They will purchase the unsold shares at the issue price. If the issue is fully subscribed, the underwriter does not need to purchase any shares. If the issue is not fully subscribed, the underwriter buys the remaining shares and may later resell them in the secondary market or hold them as an investment.

Minimum Underwriting Requirement:

Under the SEBI regulations, for a public issue to proceed, there is a minimum underwriting requirement, ensuring that the issuer will not be left with an unsubscribed portion that cannot be filled. The minimum requirement depends on the type of issue and its structure.

• Public Issues: If a company is making a public offering of equity shares, the minimum underwriting requirement is set at 100% of the portion of the issue that is to be underwritten. This means that underwriters must commit to purchase shares that are not subscribed by the public, ensuring that the company raises the necessary capital.

• Rights Issues: Under the SEBI regulations, rights issues (where existing shareholders are offered new shares) also require underwriting, especially when the company anticipates that not all shareholders will subscribe to the offer. In such cases, the company is expected to make underwriting arrangements to cover any unsold shares.

Role and Responsibilities of Underwriters:

• Due Diligence: Underwriters must conduct due diligence before agreeing to underwrite an issue. This includes evaluating the financial stability and business model of the issuing company to assess the risks involved in underwriting the issue.

• Subscription of Shares: If there is an under-subscription in the public issue, the underwriter must step in and subscribe to the remaining shares as per the underwriting agreement.

• Compliance with Disclosure Requirements: Underwriters must ensure that all necessary disclosures are made in the prospectus or offer document related to underwriting. They need to disclose the underwriting commitment, the percentage of the issue that is being underwritten, and any conflicts of interest.

• Handling of Underwritten Shares: If the issue is undersubscribed and the underwriter has to purchase the remaining shares, they can either hold or sell the shares in the secondary market. The underwriter has to disclose how these shares will be dealt with.

SEBI Guidelines on Underwriting Commission:

Under SEBI regulations, the underwriting commission is allowed, but it is capped to prevent excessive charges that may harm investors. The commission is typically paid by the issuer to the underwriter in return for taking on the underwriting risk.

• The maximum underwriting commission is determined based on the type and size of the issue. For example, for equity issues, the commission can range from 1% to 2% of the issue size, depending on the total amount being raised.

• The underwriting commission is generally lower for large offerings as the risk is spread across a larger number of shares.

SEBI Guidelines on Underwriter’s Liability:

Underwriters must ensure that they are financially capable of fulfilling their commitments. They are held responsible for purchasing the unsubscribed shares if necessary, and their ability to meet this responsibility is a critical factor in maintaining market stability.

• If the underwriter fails to fulfill its underwriting commitments, they may face penalties and enforcement actions from SEBI.

• The underwriter’s liability is typically limited to the agreed-upon underwriting portion of the issue and does not extend beyond this.

SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011:

Underwriting in cases of public takeovers is also governed by the Takeover Regulations, which ensure that any underwriting agreements in takeover bids comply with the broader framework of the takeover law. These regulations specify how underwriters may participate in or affect the offer.

Underwriting commission is a fee paid by a company to underwriters for their role in guaranteeing the successful completion of a public offering, such as an Initial Public Offering (IPO) or a Rights Issue. The underwriters are financial intermediaries who commit to purchasing the shares in case the public does not fully subscribe to them. This commission compensates the underwriter for taking on the risk of underwriting the issue and for their involvement in ensuring that the offering is fully subscribed.

Role of Underwriters in Public Offers:

In the capital markets, underwriting is a critical function. Underwriters perform due diligence, evaluate the financial health of the issuing company, and determine the pricing and risk associated with the offer. They then agree to purchase any unsold shares from the issue if the public subscription falls short of the total number of shares offered. By guaranteeing the issue’s success, underwriters ensure that the company can raise the desired capital even if public interest is insufficient.

Understanding Underwriting Commission

The underwriting commission is the fee paid to the underwriters for assuming the risk of purchasing unsubscribed shares. This commission is typically expressed as a percentage of the total capital raised from the issue and varies depending on the size of the issue, the risk involved, and the market conditions.

How Underwriting Commission Works:

1. Risk Compensation: The primary purpose of the underwriting commission is to compensate the underwriter for taking on the risk of purchasing any unsubscribed shares. If the public subscription is insufficient, the underwriter must buy the remaining shares at the offer price.

2. Cost of Services: Besides taking on risk, underwriters also incur costs related to the due diligence process, market analysis, pricing strategy, and preparing the necessary documentation, all of which contribute to the overall commission.

3. Market Conditions: In times of high demand for securities (bull market), the underwriting commission tends to be lower because the issue is likely to be fully subscribed by the public. In contrast, in bearish market conditions, when investor sentiment is lower, underwriting commissions may be higher due to the increased risk of an under-subscribed offering.

Regulations on Underwriting Commission in India:

In India, the Securities and Exchange Board of India (SEBI) regulates the underwriting commission, ensuring fairness and preventing excessive fees. The underwriting commission is capped under SEBI’s guidelines to protect investors and maintain transparency in the capital market.

SEBI Guidelines:

1. Maximum Commission: SEBI specifies the maximum underwriting commission based on the size of the issue. For example, the maximum commission for a public issue of equity shares is generally in the range of 1% to 2% of the total issue size. For smaller issues, the commission might be slightly higher.

2. Equity Issues: For equity-based public offerings, underwriters typically receive a commission of around 1% to 1.5% of the issue size, although this can vary depending on the complexity of the offer, the financial strength of the issuing company, and market conditions.

3. Debt Issues: For debt securities or debentures, the underwriting commission is usually lower than for equity issues. This is because the risk involved in debt underwriting is typically considered to be lower, as bondholders have a fixed claim on the company’s assets in case of liquidation.

4. Non-Equity Issues: Underwriting commissions for non-equity issues, such as preference shares or debentures, also fall under SEBI’s purview but tend to be lower than for equity issues due to their lower risk and fixed income nature.

5. Payment and Terms: The underwriting commission is usually payable by the issuer after the offer is completed. The terms and conditions of the commission payment, including the percentage and any performance-related clauses, must be disclosed in the prospectus or the offer document.

Factors Influencing Underwriting Commission:

Several factors determine the amount of the underwriting commission that the issuer and underwriter agree upon:

1. Issue Size: Larger offerings generally involve lower underwriting commissions because the risk is spread across a larger number of shares. In contrast, smaller offerings tend to carry higher commissions due to the higher relative risk for underwriters.

2. Risk Profile: The perceived risk of the offering affects the underwriting commission. If the issuing company is perceived to have higher risk or there is a general lack of investor confidence in the market, underwriters may demand a higher commission to compensate for the increased risk of undersubscription.

3. Market Conditions: During a bullish market, when investor sentiment is strong, underwriting commissions are often lower because public demand for shares is more predictable. Conversely, in bearish markets, where investor appetite is lower, underwriting commissions may rise as compensation for the potential risk of an under-subscribed issue.

4. Issuer’s Reputation: The financial health and reputation of the issuing company can also influence the underwriting commission. If the company is financially stable and has a good market reputation, the underwriting commission will likely be on the lower end of the scale.

Benefits of Underwriting Commission:

The underwriting commission is an essential mechanism in public offerings, benefiting both the issuer and the underwriter:

1. Issuer’s Perspective: The issuer benefits from a guaranteed capital raise, even in the event of an under-subscribed issue. They also receive the expert services of the underwriters, who manage the pricing and marketing of the offer.

2. Underwriter’s Perspective: The underwriter assumes the risk of buying unsold shares in exchange for the underwriting commission. This compensation reflects the expertise and financial backing needed to ensure the success of the offering.

3. Investor Protection: The regulatory cap on underwriting commissions ensures that the issuer is not paying excessive fees, thus protecting investors from higher issue costs that may be passed on to them through inflated prices.