Primary Market Activity: Underwriting and New Issues
Bringing a security to market
Primary market questions cover the roles of issuer, underwriter, and selling group, and the difference between a firm commitment and a best efforts underwriting. In a firm commitment, the underwriter buys the securities and bears the risk of unsold inventory. In a best efforts arrangement, the underwriter acts as agent and the issuer bears the risk.
Concepts to master
Understand the prospectus requirement and the exemptions available for institutional or private placements. Know the concept of a red herring and the prohibition on soliciting sales before the registration or prospectus is effective. Understand the stabilisation and overallotment concepts, and the rules restricting market activity during a distribution. Know the allocation process and the prohibition on allocating new issues to favoured clients in exchange for improper benefits - a practice often described as spinning.
Traps
A common trap is treating a firm commitment as riskless for the underwriter; the underwriter is exposed to market movement before the securities are sold. Another trap is confusing the issuer's disclosure obligations with the underwriter's due diligence obligations - both exist and neither replaces the other. Watch for scenarios where an underwriter supports the price after the offering; stabilisation is permitted only within narrow rules, and undisclosed support is manipulation.
Worked example
An underwriter commits to buy 10 million of bonds at a fixed price and resells them to clients. If the market moves against the issue, the underwriter absorbs the loss. A candidate who describes the underwriter as earning a fee without risk has confused firm commitment with best efforts.
Rule of thumb
Ask who bears the unsold inventory risk. That single question distinguishes firm commitment from best efforts in almost every scenario.