Underwritings – Firm Commitment vs. Best Efforts

Underwriting and Private Placement Fraud and Misrepresentation Litigation and FINRA Arbitration Attorney, Russell L. Forkey, Esq.

What is the difference between a “firm commitment” and a “best efforts underwriting”? A lot. So much so that it could have a material impact on the success of the underwriting and a substantial impact on the issuer. The purpose of this post is to provide the reader with some general educational information, concerning the difference between the two and a minor description of a standby commitment. However, this information is not designed to be complete in all material respects. Thus, it should not be relied upon as legal or investment advice. If you have any questions relative to the following, you should discuss the same with a qualified professional.

Firm Commitment

This is an arrangement whereby an investment bank enters into a written agreement, with the issuer of the securities, to make an outright purchase from the issuer of securities to be offered to the public. The underwriter, as the investment banker, is required to make its profit on the difference between the purchase price — determined through either competitive budding or negotiation — and the public offering price. Firm commitment underwritings are to be distinguished from conditional arrangements for distributing new securities, such as standby commitments and best efforts commitments.

In a firm commitment underwriting, the issuer already knows, at the time the registration statement becomes effective how much money it is going to receive from the offering. Usually, firm commitment underwriting is only done for higher quality companies or where the investment bank as obtained indications of interest, which reflect that it will be able to resell the shares that it is purchasing from the issuer.

Best Efforts

In this type of offering, investment bankers, acting as agents, agree to do their best to sell an issue to the public. Instead of buying the securities outright, these agents have an option to buy and an authority to sell the securities. Depending on the contract, the agents exercise their option and buy enough shares to cover their sales to clients, or they cancel the incompletely sold issue altogether and forego the fee. Best efforts deals entail risks and delays from the issuer’s standpoint. For the most part, the best efforts deals that are seen today are handled by firms specializing in the more speculative securities of new and unseasoned companies.

Standby Commitment

This is an agreement between a corporation (the issuer) and an investment banking firm (the standby underwriter) whereby the latter contracts to purchase for resale, for a fee, any portion of a stock issue offered to current shareholders in a “rights” offering that is not subscribed to during the two- to four-week standby period. A right, often issued to comply with laws guaranteeing the shareholder’s preemptive right, entitles its holder, either an existing shareholder or a person who has bought the right from a shareholder to purchase a specified amount of shares before a public offering and usually at a price lower than the public offering price.