Scope of section 76 of the Companies Act, 1956
Section 76 of the 1956 Act deals with an important subject of payment of commission to subscribers and others who procure capital for the company. It is usual in the case of public companies, when shares are offered to the public for subscription, to make certain of obtaining the necessary capital by having the issue underwriting. Without an authority like the one provided by section 76 of the 1956 Act, it will not be lawful for a company registration to pay such commissions as are authorized therein, at any rate out of capital in as much as such payment will, in effect, amount to an unauthorized issue of shares at a discount.
Meaning of Underwriting
Regulation 2(f) of SEBI (Underwriters) Regulations, 1993 defines ‘underwriting’ to mean an agreement with or without conditions to subscribe to the securities of a body corporate when the already existing shareholders of the same body corporate or the public do not subscribe to the prevention provided to them.
Payment of underwriting commission
The word is not restricted to payment of money out of capital only: it includes payments from profits as well, affirmed by the supreme court on appeal. The fact that the agreement for the payment of commission mentioned other services of the company’s promoters would not take the case out of the mischief of section 75 of the 1956 Act. The percentage commission of 5 percent of the price in the case of shares, and 2 1/2 percent of the price in the case of debentures, fixed by the section only indicates the quantum, and not the source from which is to be paid, which may be out of capital or profits and out of share premium account also. By words ‘subscribing or agreeing to subscribe’ is meant entering into an agreement to take shares by means of a formal company registration application or in any other manner, under which there is a liability to pay for the shares.
Payment may be in cash or kind or in a lump sum or by way of percentage, but in no case should it go beyond the statutory prescription. If a director pays commission out of the company‘s money without disclosing it as required by the section, the company may recover the amount from him in action. A vendor or a promoter does not have a free hand to pay commission; he can pay only such commission as the company registration could have legally paid.
Underwriting commission by banking companies
In the case of banking companies, section 13 of the Banking Regulations Act provides: “Notwithstanding anything to in Sections 76 and 79 of the 1956 Act, no other banking company shall pay out directly or indirectly by way of commission, discount or remuneration in any form in respect of any shares issued by it any amount exceeding in the aggregate two and one-half percent of the paid-up value of the said shares”.
What is underwriting?
” To ‘underwrite’ as the expression is used in company matters, is a well-known business term signifying the entering into a contract by which a person (known as the ‘underwriter’) agrees (usually for a commission) that if the shares, debentures, or debenture stock about to be offered for subscription, or some specified portion thereof, are not, within a specified time, taken up by the public, or by that section of the public to which they are to be offered, he will himself take them up and pay for what the public do not take up, or some specified proportion thereof. Sometimes the contract binds the underwriter either to take up the shares or to find responsible persons to do so; it is nonetheless, in either case, called an underwriting contract. It is today though it was not always in the past the almost universal practice for one person, or firm, or company, to underwrite the whole issue, sometimes, however, with very big issues a consortium of bankers will share the underwriting between them in which case their arrangement will stipulate that the public subscriptions are to go in relief of all the underwriters liability rate-ably in proportion to the amounts underwritten by them respectively”.
“Underwriting is in the nature of an insurance against the possibility of inadequate subscription. A public company cannot proceed to allot shares offered to the public, unless the amount specified in the prospectus as the minimum subscription is raised by the issue of shares and an underwriter is entitled to enter into subsidiary agreements with which the company registration is not concerned. They are not required to be disclosed in the prospectus. The underwriting agreements being a contract that the underwriter will either himself purchase or procure purchasers for the shares underwritten by him, it is no concern of the company as to how the underwriter procures the purchasers.
Application by underwriters not necessary
The underwriting agreement has to be treated not merely as a guarantee but as an application for allotment of so many shares as could not be applied for by the public. A separate application for allotment is therefore, not required.
Authority for applying for shares on behalf of underwriters
Usually underwriting letters carry an authority to the other party to the agreement who may be either a promoter or a sub-underwriter that if the underwriter fails to apply for shares the other party will do so on his behalf. Such authority if properly conferred is effective and irrevocable. In some cases the authority is of conditional nature in the sense that in the first place the underwriter will be called upon to apply for the shares and if he fails to do so an application of company registration will be made on his behalf. In such cases an allotment without calling upon him to subscribe will be ineffective. If the authority is properly exercised, not only the underwriter, his executors will also be bound by the underwriting agreements and the consequent allotment. Where, the underwriter gave authority to the other party to apply on his behalf, he was held bound by an allotment through it had become impossible in the terms of the prospectus.
Underwriting by partnership firms
Where a partnership firm enters into an underwriting contract with a company and there is a development, the firm shall be liable to take up the number of shares unsubscribed and cannot avoid its liability on the ground that a firm cannot be allotted shares under the Companies Act. The partners of the firm acting in the firm’s name shall be liable to subscribe and be allotted the unsubscribed shares.
Withdrawal of underwriting letters
An underwriting letter is usually in the shape of an offer though it may carry a binding commitment without acceptance. If the letter is a mere offer it can be withdrawn at any time before acceptance and just by a word of mouth. The offer must be accepted within the time specified and if no time is specified, within reasonable time. Acceptance should be communicated to the underwriter. Up to the time of communication of acceptance, undertaking letters can be withdrawn unless, of course, they carry a commitment that the underwriter will be bound without the formalities of acceptance. If the underwriting is in the form of an application for shares, it cannot be withdrawn like other applications until the fifth day after the opening of the subscription list [section 72 of the 1956 Act]. Where an allotment was made after the period specified in the underwriting letters was already over but the underwriter questioned it after two years, he was stopped from doing so.
When an underwriter desires to take in a firm way the whole or a proportion of the number of shares he has underwritten, the effect will be that an allotment of that number would be made to him irrespective of whether the issue is over or under subscribed. The underwriter who takes on firm basis a given number of shares will be so far as the rest of the shares are concerned in the same position as other underwriters.
Revocation of underwriting agreement
An underwriting letter generally authorizes the company or persons acting for it, to apply in the name of the underwriter or the sub-underwriter for the shares in case they fail to apply when called upon to do so. This letter is an authority coupled with interest and, therefore, after acceptance by the promoter is irrevocable.
Variation of terms of draft prospectus
An underwriting letter generally empowers the company to vary the terms of the draft listing particulars or any offer document on which it is based before the offer is issued. This does not entitle the company registration to alter the terms on which the shares are offered, in any way which materially increases the risk borne by the underwriter. Where a company altered its draft prospectus by stating that the company might pay for the business it was acquiring by a lump sum out of the proceeds of the first issue, as originally stated, it was held that the company had exceeded its rights under a power in the underwriting agreement to vary the terms of the draft prospectus, and so the underwriter was released from his obligations. The safest course when negotiating underwriting contracts is to specify the variations which may be made, or to permit variations to be made only in order to correct or supplement the factual information, or more restrictively, to permit variations only with the consent of the underwriters.
Enforcement of underwriting agreement against legal heirs
The underwriting agreements can be enforced even against the executors of the deceased underwriter, because it has been held that the duty imposed for finding capital is not such a personal contract as would come to an end with the life of the contractor.
Conditions for payment of underwriting commission
The conditions are:-
- It should be authorized by the articles of the company: authority in the memorandum is not sufficient.
- It should not exceed 5 percent in the case of shares and 2 1/2 percent in the case of debentures; or any lesser amount as may be prescribed by the articles. If the articles authorize payment by a certain percentage, lump sum payment cannot be made;
- It should be disclosed in the prospectus or statement in lieu of prospectus, as the case may be, or in a statement filed with the Registrar before the payment of the commission; this would require a disclosure of the particulars of the main underwriting agreements and not those of the sub-underwriting;
- The number of shares or debentures which persons have agreed to subscribe absolutely or conditionally should also be disclosed as in (3) above; and
- A copy of the contract relating to the payment of the commission should be electronically filed with the Registrar;
- Commission is payable only when the shares are offered to public for subscription, in terms of sub-section (4A) of section 76 of the 1956 Act.
Payment of underwriting commission by private companies
Section 76 of the 1956 Act applies to all companies, private and public. Where a private company pays commission, it must fulfill the conditions prescribed in sub-section (1), and, in particular, it will have to file a statement before the Registrar as required by sub-section(1)(b) before paying the commission. As regards the payment of commission by a private company, says: “It is usual to empower the company to pay a commission to any person for his subscribing or procuring subscriptions for shares in the company. The power is useful if the company should require additional capital and have to get it from an outside source”.
Underwriter’s remedies against misrepresentation in prospectus
Where an underwriting is on the basis of a prospectus, which, unknown to the underwriter, contains untrue statements, the remedies of the underwriter of the company will generally be the same as those of any other subscriber. Where, however, the compliant was only in respect of the omission to disclose the statutory particulars, the underwriter could not get any relief because he was not able to prove that he did not know of the contract not disclosed, something, which would not have to be proved by an ordinary subscriber.
Underwriter’s remedy against Broker
A bank underwriting a whole issue to be made through private company placement engaged a broker to bring about a successful hundred percent placement. The letter of offer which were given to the broker did not carry any such condition. Broker communicated to his clients that the allotment was to go ahead only when there was hundred percent placement. But hundred percent placement could not be attained and therefore many clients withdrew their commitments. The underwriting bank was left with a heavy allotment resulting to a big loss to him. The broker was held liable for the bank’s loss.
The underwriter usually chooses to spread his risk by using sub-underwriters of the company who agree to take a certain number of shares for which they receive a commission. If the result of an issue to the public is a success, the underwriters receives their commission without having to take up any of the shares or debenture, but if it is a failure the underwriters and sub-underwriters have to be take up a large proportion of it.
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