Types of Underwriting Commitments

The specific obligations of an underwriter of a public offering depend on what type of underwriting commitment the underwriter has made to the issuer. The cachet of the issuer and the size of and predicted demand for the offering often determine the type of underwriting commitment used.

• • Firm commitment underwriting is the most common form of underwriting for large offerings. The general term “underwriting” is often used to refer specifically to firm commitment underwriting. In firm commitment underwriting, the issuer and underwriter agree on a price and the underwriter agrees to buy the entire issue at a discount and then distributes the shares to the public or to retail brokers at the fixed offering price. The underwriter is essentially acting as a wholesaler, and its profit is the spread between the underwriter’s purchase price and public offering price. Because the underwriter is making a “firm commitment” to buy the entire offering, the underwriter runs the risk that the offering may be undersubscribed, e.g., not fully sold. The lead manager usually forms a syndicate to spread this risk.
• • Competitive bid underwriting occurs when investment banks submit sealed bids to issuers. The issuer usually, but not always, selects the investment bank with the best pricing and most favorable terms. Competitive bid underwriting was traditionally used primarily by railroads and public utilities, but today is most commonly used for municipal securities. It is also used