Underwriting in Finance: Meaning, Importance, and Legal Aspects

When a company sets out to raise long-term finance by issuing shares or debentures to the public, it faces one big uncertainty: will investors actually subscribe to the full issue? A poor public response can leave a company short of the capital it planned for, stalling expansion or repayment of preliminary contracts. Underwriting is the financial safety net built to remove exactly this risk. It is a guarantee that the securities offered will be taken up, and it has become a standard feature of public issues in the Indian capital market.

What underwriting means in long-term finance 🔗

Underwriting is an agreement between a company (acting through its promoters or directors) and an underwriter, who may be an individual, a firm, or a financial institution. Under this agreement, the underwriter promises to take up the whole or a part of the shares or debentures that are not subscribed by the public. In return, the company pays the underwriter an underwriting commission, calculated as a percentage of the issue price.

The arrangement works very much like insurance. Just as an insurer protects you against a possible loss in exchange for a premium, an underwriter protects the issuing company against the failure of a public issue in exchange for a commission. If the public subscribes fully, the underwriter simply collects the commission and is not called upon to buy anything. If the public falls short, the underwriter must step in and absorb the unsubscribed portion. This is why the commission is payable even when the issue is fully subscribed – the underwriter is being paid for carrying the risk, not for actually buying the securities.

Who can act as an underwriter 🔗

Underwriting in the country is carried out by registered intermediaries, mainly merchant bankers and stock brokers. The activity is regulated by the Securities and Exchange Board of India (SEBI), and entities must obtain a certificate of registration before they can operate. Under the SEBI (Underwriters) Regulations, 1993, an underwriter is expected to maintain a prescribed minimum net worth and adequate infrastructure, and to follow a code of conduct. Stock brokers and merchant bankers who already hold valid SEBI registration can take on underwriting work without a separate licence.

What goes into an underwriting agreement 🔗

An underwriting arrangement is always set out in a written, signed agreement, because an oral promise cannot be enforced for something this significant. The agreement spells out the obligations of both sides clearly. Key terms usually include:

• Number of securities underwritten: the exact quantity of shares or debentures the underwriter has agreed to guarantee.
• Undertaking to absorb the shortfall: a firm commitment to take up whatever portion the public does not subscribe to.
• No change in issue terms: a condition that the company cannot alter the terms of the issue without the underwriter’s consent, since any change affects the risk being carried.
• Authority to allot: the power given to the company to allot the balance securities to the underwriter.
• Commission rate and mode of payment: the agreed rate and how it will be paid.

Because the agreement is a binding contract, an underwriter who fails to honour the commitment can be held liable for breach. This is what gives the company the confidence to proceed with preliminary contracts before the issue even closes.

Legal regulations under the Companies Act 🔗

Payment of underwriting commission is not left to free negotiation alone. It is regulated to make sure a company’s funds are not drained away in excessive commissions. The governing provision is Section 40(6) of the Companies Act, 2013, which allows a company to pay commission in connection with the subscription to its securities, subject to conditions prescribed under Rule 13 of the Companies (Prospectus and Allotment of Securities) Rules, 2014.

The role of the Articles of Association 🔗

The first condition is that the payment of commission must be authorised by the company’s Articles of Association. If the Articles are silent on the matter, the company cannot legally pay an underwriting commission. The rate paid can never exceed the rate that the Articles permit. This places the shareholders, who frame the Articles, in control of how much a company may spend on raising its capital.

Maximum commission rates 🔗

The law sets firm ceilings on the commission. For shares, the maximum is 5% of the issue price or the rate authorised by the Articles, whichever is less. For debentures, the maximum is 2.5% of the issue price or the rate authorised by the Articles, whichever is less. These are upper limits, not fixed rates, so a company is free to negotiate a lower commission with its underwriters. The rate agreed upon must be clearly disclosed in the prospectus, so that potential investors can see how the issue is being backed.

The commission may be paid out of the proceeds of the issue, out of the profits of the company, or out of both. A copy of the contract for payment of commission must also be delivered to the Registrar of Companies along with the prospectus, which keeps the arrangement transparent and on record.

SEBI and the regulation of public issues 🔗

For listed companies, underwriting must also satisfy SEBI’s framework, chiefly the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. Under this framework, an underwriter need not always subscribe to the securities personally; it can fulfil its obligation by arranging for other subscribers, provided the predetermined price is not lower than the issue price. SEBI has continued to refine these rules, with recent amendments aimed at making underwriting obligations clearer and more flexible. A company raising capital from the public therefore has to comply with both the Companies Act and the relevant SEBI regulations.

Why companies choose to underwrite an issue 🔗

Underwriting offers several concrete benefits that explain why it has become almost routine for public issues.

Assured availability of funds. The biggest advantage is certainty. Once an issue is underwritten, the company knows the required capital will come in regardless of how the public responds. This lets promoters move ahead confidently with land purchases, machinery orders, and other preliminary contracts without fearing a funding gap.

Expert advice. Underwriters study the company’s financing scheme before committing to it. Because their own money is at stake, they examine the proposal carefully and often suggest improvements in the structure, pricing, or timing of the issue. The company effectively gains professional guidance as part of the arrangement.

Public confidence. The backing of a reputed underwriter signals to investors that a credible institution has examined the issue and found it sound. This association builds trust and makes it easier to attract subscriptions, helping the company raise its finance smoothly.

The limitations and costs to weigh 🔗

Underwriting is valuable, but it is not free, and it has its drawbacks.

It adds to the cost of raising finance. The commission is an extra expense on top of the capital raised. A company must therefore earn a sufficiently high rate of return on the funds to comfortably absorb this additional cost; otherwise the burden eats into profitability.

Even strong companies cannot fully avoid it. Well-established and profitable companies might assume their reputation alone guarantees a successful issue. In practice, they too rely on underwriting for additional issues, because no issue is entirely free of market risk.

It can be heavy for smaller firms. Smaller and lesser-known companies often find the commission quite burdensome relative to the amount they raise, and they may also find it harder to secure favourable terms. The Indian underwriting system has historically been criticised for offering limited support to such small firms.

Key underwriting agencies in India 🔗

A wide range of financial institutions take part in underwriting business in the country. They broadly fall into four groups:

• Development banks: institutions such as the Industrial Finance Corporation of India (IFCI), the Industrial Development Bank of India (IDBI), the Industrial Credit and Investment Corporation of India (ICICI), and the State Financial Corporations (SFCs) have long provided direct financial support to new industrial ventures through underwriting.
• Investment institutions: the Life Insurance Corporation of India (LIC), the General Insurance Corporation (GIC), and the Unit Trust of India (UTI) deploy their large pools of funds in underwriting public issues.
• Commercial banks: major banks such as the State Bank of India, Central Bank of India, Bank of India, and Bank of Baroda engage in underwriting, often acting as managers to the issue alongside their lending activity.
• Stock brokers and merchant bankers: registered intermediaries who, after consulting the issuing company, take up underwriting commitments. As noted earlier, the establishment of SEBI in the late 1980s brought stricter discipline to merchant banking and underwriting, improving transparency and investor protection.

Together these agencies form the backbone of the underwriting market, channelling institutional money into corporate issues and giving companies the confidence to plan long-term investments around a guaranteed supply of capital.

What do you think? If you were advising a small, growing company, would the certainty offered by underwriting be worth the extra commission cost, or would you look for cheaper ways to raise capital? And do you think the legal ceilings on commission strike the right balance between protecting a company’s funds and fairly rewarding the underwriter for the risk it carries?

References

1. https://www.indiacode.nic.in/ViewFileUploaded?path=AC_CEN_2_11_00014_199215_1517807319932%2Fregulationindividualfile%2F&file=underwriters.pdf
2. https://corporatelawreporter.com/companies_act/section-40-of-companies-act-2013-securities-to-be-dealt-with-in-stock-exchanges/
3. https://ca2013.com/securities-to-be-dealt-with-in-stock-exchanges/
4. https://incometaxindia.gov.in/Rules/SEBI%20(Issue%20of%20Capital%20and%20Disclosure%20Requirements)%20Regulations,%202018/103120000000040613.htm
5. https://www.snrlaw.in/sebi-modifies-underwriting-framework-for-public-issues/
6. https://ksandk.com/corporate/key-insights-sebi-merchant-bankers-amendment/