This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
There are four distinct types of agreements between an underwriting syndicate and the corporation which puts out the underwritten issue. Possibly other variations from these basic types could be found.
1. The corporation may itself sell the issue and the syndicate may simply insure that the whole issue will be disposed of within a given time at a minimum price. The corporation, we will say, is bringing out an issue of $1,000,000 6% bonds, which it offers at par. The underwriting syndicate may agree that it will take any bonds left unsold at the end of the year at a special price of 90. The syndicate would receive a commission of 2 to 5% for making this agreement. If the issue were successfully sold, the syndicate would merely collect and distribute its commission and dissolve. If the issue at the agreed price were unsuccessful, the syndicate would take over the unsold balance and dispose of it. This type of agreement is now uncommon except when a corporation has given a subscription privilege to its own shareholders but is apprehensive that the offer will not be taken up in full.
2. A banking house may conclude an arrangement with a corporation to handle the sale of a block of securities and may afterward call in other banking houses to take over certain proportions of the risk and of the profits. The corporation, however, has no dealings with the syndicate, as such, but only with the original underwriter which becomes the manager of the syndicate.
3. The syndicate may be formed before a final agreement with the corporation is signed, and the agreement may be directly between the corporation and the syndicate, though the management of the whole transaction and the actual selling of the securities may be left in the hands of the one banking house which has taken the initiative. This banking house carries through the sale of securities and does not distribute them to the other members of the syndicate unless the sale is in whole or in part unsuccessful.
4. The agreement is made between the syndicate as a whole and the issuing corporation and the securities are at once distributed among the members of the syndicate in proportion to their participations. This form of underwriting is almost in the nature of a joint purchase, each of the banking houses being expected to act independently in disposing of its proportion of the issue. This is perhaps the most common and most useful type of agreement for handling large issues.
It is clear, from the brief descriptions above given that the term "underwriting" is used in a loose sense. It is, in fact, often difficult to distinguish in practice between underwriting a block of securities and purchasing a block of securities. Even when a single banking house takes over outright the complete security issue and pays to the corporation the agreed price for this issue, the transaction is commonly referred to as "underwriting".
Whatever the type of syndicate issue may be, there is always this common characteristic: that the active management is unreservedly in the hands of the banking house which organized the syndicate. In the published agreement, for example, of the syndicate which underwrote the retirement of United States Steel Corporation preferred stock in 1902, it is provided that:
J. P. Morgan and Company shall be sole managers of the syndicate, and in behalf of the syndicate they may make any and all arrangements, and may perform any and all acts, even though not herein provided for, in their opinion necessary or expedient to carrying out the provisions of this agreement; or to promote or to protect what they deem to be the best interests of the syndicate. The enumeration of specific powers in this or any other article of this agreement, shall not be construed as in any way abridging the general powers of this article intended to be conferred upon or reserved to J. P. Morgan and Company.
Throughout the agreement other reservations of the same general character abound, and in this respect the contract is typical of most underwriting syndicate agreements.
In return for its special efforts the managing house usually receives a commission as manager, which is deducted from the syndicate profits before distribution of the remaining profits is made among all the members of the syndicate. This payment to the managing house varies a great deal, depending on the profitableness of the transaction. It will probably average 1 to 2% on the par value of the block of securities.
It is very rarely the case that these syndicate agreements, no matter how informal they may be, give rise to serious misunderstanding or litigation. This is, no doubt, due primarily to the high standards of commercial honor which prevail among the bankers who are active in underwriting syndicates. One of the rare instances of litigation arose in connection with the syndicate formed to underwrite the bonds issued at the organization of the Mount Vernon-Woodberry Cotton Duck Company. This syndicate was managed by the Continental Trust Company of Baltimore. Two New York banks, the Merchants Trust Company and the Central National Bank, each of which had subscribed $300,000, sued the Continental Trust Company in the United States District Court for the return of their subscription. They alleged fraud and misstatements. They claimed that the mills were not worth what they were represented to be and were not earning what had been stated; further, they claimed that the Continental Trust Company, through its ownership of $1,000,000 of income bonds, had been especially favored under the terms of exchange that had been agreed to in forming the combination. The case was never brought to trial and was finally settled out of court.*
The commissions of underwriting syndicates may vary all the way from 1 1/2% to 10%, or even more. If the commissions are high, it is quite the custom to make them payable partly in securities. In 1910, for example, the newly organized International Cotton Mills Corporation was in need of working capital, which it secured by selling to Blair and Company $2,000,000 6% five-year notes at par, in consideration of a commission of $1,000,000 par value of the corporation's common stock. These notes were offered to the public by Blair and Company at 98. In 1898 the Union Pacific Railroad Company paid a syndicate $5,000,000 of preferred stock, then quoted at 59, for underwriting a subscribed capital of $15,000,-000. This amounted to a commission of 19%. † These examples, of course, refer to companies which at the time did not have a high credit standing, and are not to be taken as typical.