Firm Commitment

Two issuers are bringing offerings to market. Wrenbury Foods engages an investment bank that purchases the entire issue from the company at a negotiated price and then resells it to the public. Calderwood Cider engages a bank that agrees only to use its reasonable efforts to sell shares to investors, returning any unsold portion to the issuer. How do the two arrangements allocate risk?

1. A.Both banks act as agents, so in each case the issuer bears the entire risk that shares go unsold.Incorrect. The Wrenbury bank buys the issue outright as principal and therefore bears the risk of unsold shares itself.
2. B.Both banks act as principals, so in each case the underwriter bears the entire risk that shares go unsold.Incorrect. The Calderwood bank acts only as agent and returns unsold shares, leaving that risk with the issuer.
3. C.Wrenbury has a firm commitment, in which the bank acts as principal and absorbs unsold shares; Calderwood has a best efforts deal, in which the bank acts as agent and the issuer bears the shortfall risk.Correct. The principal versus agent distinction determines who is left holding unsold securities.
4. D.Wrenbury has a best efforts deal and Calderwood has a firm commitment, since Calderwood bank made a definite commitment to try to sell the shares.Incorrect and reversed. A commitment to try is precisely a best efforts arrangement; buying the issue outright is the firm commitment.

Why: In a FIRM COMMITMENT underwriting the investment bank acts as a PRINCIPAL. It buys the entire issue outright and owns the securities, so if the offering is poorly received the bank is left holding the unsold shares and absorbs the loss. The issuer knows with certainty how much money it will raise the moment the agreement is priced, and the underwriter is compensated by the spread between what it pays the issuer and what it receives from the public. In a BEST EFFORTS arrangement the bank acts as an AGENT. It never takes ownership, undertakes only to use reasonable efforts to place the shares, and returns whatever it cannot sell, so the issuer bears the risk that the offering falls short of its target. Best efforts deals come in variants: all-or-none, in which the offering is cancelled and money returned unless the entire issue is sold, and mini-maxi, in which the deal proceeds only once a stated minimum is reached.

In a firm commitment underwriting, the underwriter:

1. A.sells as many shares as it can and returns the rest to the issuerWrong. That is a best efforts arrangement, in which the underwriter acts as agent and takes no inventory.
2. B.guarantees the market price of the stock for one year after the offeringWrong. No underwriter guarantees a market price. The commitment is to buy the issue, not to support it indefinitely.
3. C.buys the entire issue from the issuer and resells it, bearing the risk of unsold sharesCorrect. Firm commitment transfers the distribution risk to the underwriter and gives the issuer certain proceeds.
4. D.acts solely as the issuer agent and never takes ownership of the sharesWrong. That describes agency, which is the defining feature of best efforts, not firm commitment.

Why: The underwriter purchases the entire issue from the issuer and then resells it to the public. The issuer proceeds are certain, and the underwriter absorbs the loss on anything that does not sell or that sells below the offering price.

Brightwater Robotics is raising capital through a best efforts offering. The agreement provides that the deal closes only if at least 2,000,000 dollars of securities are sold, but permits the underwriter to sell as much as 5,000,000 dollars if demand supports it. This structure is a:

1. A.A mini-max offering.Correct. A floor that must be reached plus a ceiling that may not be exceeded is the defining shape of a mini-max.
2. B.A firm commitment offering.Wrong. In a firm commitment the syndicate buys the whole issue and bears resale risk. The stem describes a best efforts arrangement.
3. C.A standby offering.Wrong. A standby arrangement is used in a rights offering, where the bank agrees to buy shares existing holders decline to subscribe for.
4. D.An all-or-none offering.Wrong. All-or-none has a single threshold - the entire issue must sell or the deal is cancelled. There is no partial-close band.

Why: A MINI-MAX offering is a best efforts arrangement with both a floor and a ceiling: a minimum that must be reached for the offering to close and a maximum beyond which no more may be sold. Contrast an ALL-OR-NONE offering, which has only a single threshold - the entire issue must be sold or the whole deal is cancelled. Both are contingency offerings, so investor funds collected before the contingency is met must be held in escrow at an independent bank under SEC Rule 15c2-4 and returned if the contingency fails.

Under a best efforts arrangement, what happens to units the selling group cannot place by the close of the offering?

1. A.The selling firms must buy them at the public offering priceWrong. Best efforts firms are agents and take on no purchase obligation whatsoever.
2. B.The dealer-manager must buy them at the offering price less the concessionWrong. Inventing a residual obligation for the dealer-manager turns a best efforts deal into a firm commitment.
3. C.The whole offering is cancelled and all subscription funds are returnedWrong. That is the all-or-none result; an ordinary best efforts offering closes on whatever was placed.
4. D.They go unsold and the issuer simply raises less capitalCorrect. The residual is unraised capital for the issuer, not inventory for anyone.

Why: In a best efforts offering the selling firms act as agents of the issuer and undertake only to use their best efforts to place the units. Anything they cannot place is simply not sold, and the issuer raises correspondingly less capital. No firm is obliged to buy the remainder, because none of them took ownership of the units. This is the ordinary structure for direct participation programs, and it is why a program's actual size is not known until the offering closes.