The Corner for March 14, 2014

This is the last of a two part series on investment banking.

The typical underwriting arrangement involves the purchase of a security issue from a corporation by an investment banking firm or a group of such firms (called an underwriting syndicate), and the sale of the issue to the general investing public, institutional investors as well as wealthy individuals. This procedure is followed in the case of bond issues of corporations as well as for stock issues which are not required by law or by decision of the board of directors to be offered first to old shareholders.

The first step in the originating of a new security issue is a conference between officials of the corporation and the investment banker to determine whether the issue is feasible. The buying department of the investment bank conducts a preliminary investigation and decides whether the assets and earning power of the corporation are such that it can recommend the securities of this company to its clients. This action is followed by conferences in which it is decided what amount and type of security is best suited to the corporation’s needs. When this has been accomplished the formal document in connection with the issue are registered with the Securities & Exchange Commission. Also a prospectus describing the security must be prepared and sufficient copies printed so that a copy may be given to each investor considering purchase. The arrangements between corporation and underwriters are set forth in a purchase agreement.

The underwriting and distribution of most security issues involves the organization of a syndicate of investment banking firms.

When a corporation puts out a $500 million bond issue no one investment banking firm usually takes on the whole project.

Therefore, the investment bank which initiates the issue with the corporation organizes a group of investment bankers to divide the liability for the purchase, with the originator acting as manager of the group. Each member of the purchase group agrees to take a specific part of the entire issue. This arrangement is formalized in a contract called a purchase group agreement, or agreement among underwriters.

Distribution of the issue is effected through sale to individual and institutional investors. Most syndicate firms have distribution facilities and are able to dispose of the portion of the issue they have underwritten. Frequently the market coverage which can be obtained by the members of the syndicate is deemed insufficient, so selected dealers are used to bring about a wider distribution.

These dealers are not members of the underwriting syndicate and they are obligated to sell only that portion of the issue they have subscribed for. Members of the syndicate pass along the securities to dealers at a reduction from the publicly offered price. This concession, as the reduction is called, reimburses the dealer for his or her expenses and provides him or her profit if the distribution is performed skillfully. When distribution takes place through dealers, the members of the syndicate may be thought of as wholesalers who purchase from the manufacturer (issuing corporation). Finally, these wholesalers sell some of the issue themselves to large consumers, particularly institutional investors, and sell the remainder to retail dealers who in turn sell to small investors.

Quote of the Week: “An optimist is a person who sees a green light everywhere, while the pessimist sees only the red stoplight … The truly wise person is colorblind.” – Albert Schweitzer

Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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