Module 6 - Underwriting

Question 1

INVESTMENT BANKING

Answer 1

INVESTMENT BANKING is another name for UNDERWRITING. INVESTMENT BANKERS are firms that help corporations and municipalities raise necessary capital (money). In the case of a corporation, the money is used to fund growth and investment; in the case of a municipality, the money is used to build facilities or to improve services. The underwriting process or investment banking process matches corporations or municipalities that need money with investors who desire a return from their investment.

Question 2

SHORT- AND LONG-TERM UNDERWRITING

Answer 2

If corporations or municipalities want to issue a debt security for a SHORT period of time (under 270 days), they may bring the security to market
itself, or they may have a local firm sell the security through the money market sector of the securities market.

If the issue is a LONG-TERM DEBT of a municipality or corporation, or if it is an equity issue for a corporation, an investment banker is retained to UNDERWRITE the issue and bring it to market. These investment bankers are also called UNDERWRITERS, and usually form what is called a SYNDICATE of other brokers/dealers to help sell the issue to investors. The two major types of underwriting commitments from the
underwriter to the issuer are:
• Firm commitment
• Best efforts commitment

Question 3

FIRM COMMITMENT UNDERWRITING

Answer 3

A FIRM COMMITMENT UNDERWRITING involves the underwriter’s promise to sell all of the new issue. The underwriter buys the issue from
the issuer and then brings it to market to sell through the syndicate.

A variation of a firm commitment is a STANDBY UNDERWRITING.This is only used in a corporate offering of stock. Under this type of commitment, the underwriter is hired by the issuing firm to sell all the shares that are left over after a rights offering.

Remember, a rights offering is when the issuing corporation offers the new shares to existing shareholders first. Those shares not purchased by the existing shareholders in a rights offering are sold to the standby underwriter and brought to market.

Question 4

WHEN, AS, AND IF ISSUED stocks or bonds

Answer 4

WHEN, AS, AND IF ISSUED stocks or bonds, commonly known asWHEN ISSUED, are securities that are transacted on a conditional basis.
The securities have been authorized and sold to the public (issued), but the certificates have not been issued. When issued securities can trade in the secondary market. The settlement date for a when issued stock is a date that is set by the underwriter, or lacking such date, is a date agreed upon between the issuer and the underwriter. Full payment could be required with one-day’s written notice. The “when issued” contract is marked to the
market (the price is recalculated every day the market price of the bonds change) as provided for in the when issued contract. Stock splits and
Treasury securities can be issued on a when issued basis.

Question 5

BEST EFFORTS COMMITMENT (UNDERWRITING)

Answer 5

A BEST EFFORTS COMMITMENT(UNDERWRITING) for a new issue is when the issuer contacts either a single underwriter, or multiple underwriters, and asks them to sell the issue. The underwriter(s) or broker/dealers are not required to buy any shares they do not sell. The
single underwriter forms a syndicate of other broker/dealers and tells the issuer that they “will do their best to sell the issue.” In a Best Efforts
commitment underwriting, the issuer requires one of the following types of commitments from the syndicate:
• All or none
• “Minimum-maximum”

A best efforts underwriting is usually employed for two types of issues:
• Debt issues by a corporate issuer, where the corporation’s ratings
and credit are not very good.
• Stock issues, especially where the outstanding stock in the marketplace is not trading very well or the stock is a brand new issue, referred to as an INITIAL PUBLIC OFFERING (IPO).

Question 6

ALL OR NONE

Answer 6

In an ALL OR NONE underwriting commitment, the syndicate must sell the entire issue or the underwriting is cancelled because the entire amount
of securities (i.e., any stocks or bonds) is not sold. This is usually required by an issuer who needs all of the money to be raised, and anything less than
that amount will not help the issuer with its financial needs.
• If the syndicate is able to sell the entire issue, all parties are happy.
• If the entire issue cannot be sold, the syndicate must refund all the money to the investors in the issue. In this case, the syndicate charges the issuer a fee for its efforts.

Question 7

MINIMUM-MAXIMUM

Answer 7

In a “MINIMUM-MAXIMUM” underwriting commitment, the issuer sets both a minimum and a maximum amount of securities that they must sell.
This type of underwriting is used when the issuer absolutely needs a minimum amount of capital, but ideally would like a larger amount.
• Once the minimum amount of the issue is sold, the issue is considered completed. Of course, no more than the maximum can be sold.
• If the minimum is not sold, all investors receive a refund.
• This type of underwriting is common when raising capital in limited partnerships. All mutual funds are sold on a best efforts basis since broker/dealers do not buy any shares for their own account. Instead, they only sell what they can, which is the description of a best efforts underwriting. Usually numerous broker/dealers are involved in best efforts underwriting offerings.

Question 8

For every underwriting, except mutual funds, the MANAGING UNDERWRITER (also known as the LEAD UNDERWRITER) performs a DUE DILIGENCE review, which means that the manager researches the issuer to determine their financial health and standing in the community.

Due diligence includes research into the liquidity of the issuer (LIQUIDATION VALUE), as well as the ability of its securities to perform well for investors. The purpose of due diligence is to ensure that the issue is not fraudulent or of questionable value. The due diligence review is the responsibility of the LEAD or MANAGING UNDERWRITERS, for which
they receive the manager’s fee.

Answer 8

Remember for Test

Question 9

A MARKET OUT CLAUSE

Answer 9

A MARKET OUT CLAUSE (an escape clause) in the agreement between the issuer and the underwriter allows the underwriter to choose
not to bring the issue to market if marketplace conditions were such that the issue may not be able to be sold. The clause stipulates the
circumstances under which the underwriter is relieved of responsibility to bring the issue to market. Such circumstances may include sudden
bankruptcy by the company or a complete stock market crash. Under these circumstances, the issuer and the underwriter agree to withhold the issue, the underwriter is not required to forfeit the good-faith deposit, and the issuer is not held responsible for costs incurred by the underwriter. If the issuer misrepresents facts about the company or withholds critical information, the underwriter may be able to recover underwriting costs
from the issuer.

Providing that an investment bank broker/dealer engages in corporate and municipal underwriting, the major underwriting departments of the investment bank are the CORPORATE UNDERWRITING DEPARTMENT and the MUNICIPAL UNDERWRITING DEPARTMENT.

Question 10

CORPORATE UNDERWRITING DEPARTMENTS

Answer 10

CORPORATE UNDERWRITING DEPARTMENTS handle the issuing of stock or bonds by companies that want to raise capital for use in their business.

Question 11

MUNICIPAL UNDERWRITING DEPARTMENTS

Answer 11

MUNICIPAL UNDERWRITING DEPARTMENTS handle the issuing of bonds by municipalities in the form of GENERAL OBLIGATION BONDS
and REVENUE BONDS.
• GENERAL OBLIGATION BONDS are issued by municipalities and backed by the taxing power of that municipality. See Municipal Securities in Module 5 for a detailed discussion of
general obligation bonds.
• REVENUE BONDS are issued by municipalities and backed by the revenues of the facility for which the bond is issued. Again, see the Municipal Securities Module for a detailed discussion of
revenue bonds

Question 12

THE UNDERWRITING SYNDICATE

Answer 12

Underwriting can be opened up to a bid process in which different investment banks compete to be the underwriter for an issue. Once the underwriter is selected (either by using the competitive or negotiated method), the managing underwriter selects a number of other broker/dealers
to assist in the selling of the issue. This group is known as the SYNDICATE or SELLING SYNDICATE.

With large offerings by a municipality or corporation, the managers gather a group of broker/dealers that have large selling forces and form the syndicate.

With small offerings, the managers may only include one or two other broker/dealers to be in the syndicate.

A syndicate is made up of two groups:
• The underwriter or co-underwriters (including a LEAD UNDERWRITER)
• The selling syndicate

In addition to the syndicate is the selling group — the other broker/dealers who are able to sell the issue, but who are not financially committed.

Question 13

The LEAD UNDERWRITER

Answer 13

The LEAD UNDERWRITER of the syndicate is the broker/dealer firm in the syndicate that is managing the underwriting. Accordingly, the lead underwriter is also called the SYNDICATE MANAGER. The manager is responsible for performing many functions.

When co-underwriters are hired to help manage a large account, one of them is designated as the lead underwriter; this firm is now in charge of all
the other members of the syndicate. The lead underwriter manages the books of the underwriting account, acts on behalf of the syndicate in
dealings with the issuer, and manages the entire underwriting process. Typically, one or more individuals from the lead underwriting firm
manages all aspects of the underwriting, including communicating with the issuer.

When securities are underwritten, broker/dealers can advertise them with a tombstone ad, which is limited to the offering’s basic information. A tombstone ad also allows underwriting firms to list their names as participants in the underwriting.
• The tombstone ad identifies the name of the lead underwriter at the top of the list of participating firms.
• If there is more than one managing underwriter, the lead underwriter is listed on the top left, beside the other broker/dealer firms.

Question 14

SELLING SYNDICATE

Answer 14

The SELLING SYNDICATE is composed of one or more broker/dealers who are willing to commit themselves and large sums of money to bringing the securities issue to market. These broker/dealers
commit themselves financially, and they assist in the pricing of the issue. The selling syndicate uses information gathered from their sales forces on
the salability of the issue to help determine marketability and a good price for the issue.

The syndicate arranges to purchase shares or bonds from the issuer. The amount the lead underwriter allows the selling syndicate to sell is based upon the amount of financial commitment the selling syndicate makes. The lead underwriter takes the largest percentage of the issue to sell and the other members of the syndicate are allotted varying amounts, depending on their financial commitment.

Question 15

The SYNDICATE LETTER

Answer 15

The SYNDICATE LETTER outlines the terms under which the account will be managed, including:
• The amount of the issue each member is allotted
• The amount of money each member must contribute
• The basis for which the issue will be distributed in the case of being oversold
• The obligations of each syndicate member
• The type of participation under which the underwriting account will be based:
− An “eastern” account
− A “western” account

The members of the syndicate sign the syndicate letter, which binds them to underwriting the issue. The syndicate letter is signed prior to the release of
the issue.
• With respect to corporate issues, the syndicate letter is signed at the due diligence meeting the night before (or the morning of) the sale. This is the last opportunity for syndicate members to pull out
of the commitment.
• With respect to municipal issues, the syndicate letter is usually signed about two weeks before the actual issue of the bonds.

The syndicate letter is also known as the AGREEMENT AMONG UNDERWRITERS, the ACCOUNT LETTER, the SYNDICATE CONTRACT, or the SYNDICATE AGREEMENT.

When the underwriting is over, the syndicate manager analyzes the issue’s sales — the amount of securities sold by each, the amount of securities left over, and the amount of group net orders (and thus credit to all members).
• The manager then sends the final syndicate agreement with final numbers to each member — how much each member sold and how much sales charge they will receive.
• The final syndicate agreement that lists how much each syndicate member sold and how much sales charge each will receive is sent in the SYNDICATE SETTLEMENT LETTER.

Question 16

The SELLING GROUP

Answer 16

The SELLING GROUP is made up of all of the other broker/dealers who are not financially committed to the underwriting, yet are able to
sell parts of the issue. The selling group is formed as a separate group from the syndicate. Syndicate members receive verbal commitments from
these other broker/dealers to help sell the issue; however, the selling group participants do not have to make a commitment to sell a specific number of
shares.

Because the broker/dealers in the selling group do not make a financial commitment to the underwriting, they only participate in the selling of the issue and do not have a minimum amount to sell. They do not participate in the setting the issue’s selling price, nor do they benefit as much with the sales of the issue. The selling group reaps the smallest amount of profit from the sale of the issue.

Question 17

EASTERN ACCOUNT — UNDIVIDED ACCOUNT

Answer 17

If the syndicate is formed under an eastern account method (also known as an UNDIVIDED ACCOUNT), all the members have undivided selling responsibility and undivided liability in the issue.

Test-taking tip: “E” for eastern and “u” for undivided account are both vowels.

Undivided selling responsibility means all members of the syndicate must attempt to sell the whole issue (stock or bonds) until the entire issue is sold, regardless of each syndicate member’s commitment.
• The underwriters pool the whole issue, and each can sell as much as they want as long as part of the issue is available to sell.
• Each syndicate member gets credit and commission on what each sells; however, excess profits from these sales are divided based on
each syndicate member’s participation as outlined in the syndicate letter.
• In essence, each syndicate member may end up selling more (or less) than agreed to as outlined in the syndicate letter, based on what is available to sell.

Question 18

UNDIVIDED LIABILITY

Answer 18

UNDIVIDED LIABILITY means that if there is any unsold part of the issue at the close of the underwriting period, syndicate members are
each liable for their proportionate share of the unsold issue.
• This means that at the close of the selling period, syndicate members are required to buy a percentage of the unsold amount of the issue based on each syndicate member’s percentage of participation as agreed to in the syndicate letter.
• Even if a syndicate member sells as much as it committed to sell, or sells more than the firm committed to sell, the firm may still have to purchase additional stock or bonds if other syndicate members were unable to sell their allocation.

Question 19

WESTERN ACCOUNT — DIVIDED ACCOUNT

Answer 19

If the syndicate is formed under a “WESTERN” ACCOUNT METHOD (also known as a DIVIDED ACCOUNT), each syndicate member has undivided selling responsibility but divided liability.

Testtaking tip: “W” for western and “d” for divided are both consonants.

With divided liability, each syndicate member firm has undivided sales responsibility (just as in an eastern account method), meaning that the
firm has to sell until the whole offering is sold.
However, in the event that the whole issue is not sold, each syndicate member that sold all of the issue it had committed to is not liable for
the unsold part of the issue. This is how the western account method differs from the eastern account method. Only the syndicate members
that do not sell the amount they committed to sell must purchase their unsold portions for their own account.

Question 20

CORPORATE UNDERWRITING

Answer 20

Any new corporate issue that is sold to the public must be registered with the Securities and Exchange Commission (SEC) and sold through
either an underwriting or a private placement. (We are not concerned with private placements here since they are not on the test.)

Many times, when a company sells shares in an underwriting, a corporate officer or other investors who own stock in the company may wish to sell
some of their stock. These investors can add their shares to the underwriting, and then the underwriting is both a primary and a secondary
underwriting. The primary part of the underwriting is the stock from the company; the secondary part of the underwriting is the stock from the
selling stockholders.

Corporations may issue any of the following three types of securities: bonds, preferred stock, and common stock. These securities can be sold
through an underwriting that is led by a lead underwriter. The lead underwriter, with the assistance of a selling syndicate, sells the securities. In some instances an informal arrangement is made that resembles a selling
group. Broker/dealers who are not members of the syndicate contact the syndicate to see if they can get some of the issue.

Corporations negotiate with an underwriter to sell their securities to investors at the least cost to the corporation. Many times, corporations negotiate with a known underwriter who may have managed previous underwritings for that company.

Question 21

BLUE-SKYING

Answer 21

Registering the issue with the states in which it will be sold is called BLUE-SKYING the issue.

Question 22

WORK OF THE MANAGER

Answer 22

The underwriter helps the issuer decide on the best method to sell the securities.
• Once this underwriter is selected and an underwriting agreement is signed, the issuer’s responsibilities are reduced to providing
information for the prospectus and supplying the issue certificates.
• The underwriters perform all the work associated with registering the issue, selling the issue, and informing the public about the issue.
• While the underwriters are negotiating with the issuer, they will simultaneously begin forming a selling syndicate

The underwriter also registers the issue with the SEC and with any states where the issue will be sold.
• Registering the issue with the states in which it will be sold is called BLUE-SKYING the issue.

The underwriter writes the PROSPECTUS with help from the issuer’s attorneys. The purpose of the prospectus is twofold:
• To satisfy the SEC disclosure requirement
• To provide information for the selling broker/dealers to distributeto clients

The underwriter also helps the issuer make important decisions regarding when, and in what quantity, securities should be issued. For corporate
securities, such as stocks or corporate bonds, the underwriter handles all the work regarding registration of the issue, including:
• Registering the issue with the SEC.
• Making sure that the issue satisfies all the requirements of each state in which the issue will be sold. When an underwriter does this, it is said that the underwriter is blue-skying the issue, because the various state requirements are called blue-sky requirements.
• Determining which other broker/dealers will be part of the syndicate.

Question 23

REGISTERING THE CORPORATE ISSUE

Answer 23

The SEC reviews the registration statement that the underwriter files. Providing the registration statement is complete, the SEC releases the
issue to be sold. The date the issue is released to be sold is called the EFFECTIVE DATE.

The period of time between the filing of the registration statement and the EFFECTIVE DATE of the offering is known as a QUIET PERIOD or a COOLING OFF PERIOD. The quiet or cooling off period lasts at least 20 days and is required to allow:
• Time for the issuer to perform a final review of the issue
• The issuer to register with the respective states in which it will be
offered (blue-skying), performed by the underwriter
• The public to digest the news of the upcoming issue
• The SEC to review the prospectus for required information
• The underwriter to prepare for the sale of the issue

During the cooling off period, nothing other than a PRELIMINARY PROSPECTUS, which is more often called a RED HERRING, may be sent to the public to induce that person to buy the issue.
• No price will be shown in the preliminary prospectus.
• Anyone within the industry (i.e., anyone other than the general public) may receive any information about the issue without the same restrictions.
• The issue cannot be promoted or sold during the quiet period. Until the registration statement has been viewed and an effective date declared by the SEC, the underwriter’s communication with the public about the issue is limited.
• Until the effective date, no solicitations are permitted. Thus, no advertising information may be sent with a preliminary prospectus.

The underwriter and the syndicate members determine the price at which the issue will be offered to the public.
• The selling syndicate determines the price of the offering based on the current performance of the company and the value of the company in relation to the market at the time of the offering.
• To determine this, the selling syndicate reviews the corporate dividends and earnings, products offered by the company, other companies in the industry, and any other factors that may affect the
price that the public will be willing to pay for the securities.
• Selling group participants have no input on the offering price of the securities. These firms do not have a financial commitment to the sale of the securities.

Question 24

THE PROSPECTUS

Answer 24

The Securities Act of 1933 states that all new issues of stock and corporate bonds must be accompanied by a PROSPECTUS.

The prospectus accompanies the registration statement and the SEC reviews the prospectus before it can be released. The SEC does not approve or disapprove the prospectus; the SEC only reviews it to assure that all necessary information has been disclosed and that the information is complete.

Question 25

TOMBSTONE ADVERTISING

Answer 25

A TOMBSTONE ADVERTISEMENT, usually displayed in a newspaper, states that the underwriting broker/dealers are bringing a
new issue to market.
• Tombstone ads are generic and only state the issuer, the price of the issue, the syndicate underwriting the issue, and where an investor can obtain more information.
• Tombstone ads for corporate issues state who is selling the issue, for example, the corporation, a selling stockholder, or both.
• If the corporation is selling the securities to investors, the offering is defined as a primary issue.
• If a large stockholder is selling the securities to other investors, these transactions are considered a secondary distribtution.
• If both the corporation and a large stockholder are selling securities simultaneously, the offering is considered a split offering, or a primary and a secondary issue.

Question 26

PENALTY BID/STABILIZING BID

Answer 26

The syndicate letter includes other terms associated with the underwriting beyond the commitment on the part of the syndicate members and whether the underwriting account is either eastern or western. The syndicate letter also includes the following stipulations associated with the initial offering:
• The amount of the STABILIZING BID and when it will be used
• The order of settlement in the account for a sold-out issue
• The names of all the syndicate members and their participation amount
• The agreement among the underwriters, including whether the manager has full control over the syndicate and what entities are allowed into the syndicate
• The duties of the manager
• Any other pertinent information about the members of the syndicate
• The spread, which includes the manager’s fee, the concession, and the re-allowance in the corporate offering

Stabilizing the issue is required when the market price of the outstanding shares or bonds starts to fall below the offering price of the new issue.

If a new issue is not able to sell all of the offered shares, a secondary market may develop prior to the completed initial offering of the new issue.
If the price of the issue in the secondary market falls below the price of the new issue, the syndicate will have a difficult time finding investors to
partake in the new issue.

If the price of the issue becomes unstable, the syndicate manager may support the price of the issue in the secondary market by offering a
STABILIZING BID, or price, to anyone who wishes to sell the issue in the secondary market. The syndicate manager thus offers to repurchase the
issue.
• The stabilizing bid price (which is an offer to buy the stock or the bonds) is at either the same price as the new issue or just below it.

The stabilizing bid is also called the PENALTY BID. This is so named because a selling group member loses the commission on the sale of any issue that is repurchased by a syndicate manager; in this way, the selling group is penalized.

The purpose of the stabilizing or penalty bid is to prevent selling group members from generating excess commissions by selling the issue to
individuals who then simply sell the issue back to the syndicate manager without losing any money.

Question 27

If an issue is oversold (i.e., there are more buy orders than there are stocks or bonds), the syndicate manager determines the ORDER OF
SETTLEMENT, or priority in which the orders are filled. For corporate offerings that are oversold, the syndicate manager allots issues in the
following order:

Answer 27

1. GROUP NET ORDERS — these orders are sold at the PUBLIC OFFERING PRICE. Issues are first allotted to group net orders because these are orders where everyone in the selling syndicate
   receives part of the concession. Each member of the syndicate shares in the concession on the sale according to its participation, less any expenses charged to the underwriting. A GROUP NET
   ORDER is a large order to buy the new issue that is placed by one of the selling syndicate members, but all of the syndicate members get credit for the sale. Since all members of the syndicate receive part of the concession, these orders take precedence over designated orders.
2. DESIGNATED ORDERS — issues are allotted to DESIGNATED ORDERS after group net orders are filled. A designated order is an order to buy the new issue that is placed by one of the syndicate
   members; only that syndicate member, plus any other syndicate member who has been designated, is credited for the sale. Not all syndicate members receive credit for the sale. Securities are allotted
   based on the size of each order being considered. Usually, large blocks take priority. (A mutual fund or other institution usually places large orders.)
   – The syndicate manager has the authority as specified in the agreement. If a member of the syndicate places an order on behalf of a mutual fund, the order must be a designated order.

Issues allotted next are based on the size of each order being considered; usually, large blocks take priority.

Issues are also allotted based on criteria established by the lead manager, who may play favorites or fill orders on a first-come, first-served basis. Politics play a big part here.

Question 28

Greenshoe Clause

Answer 28

The GREENSHOE CLAUSE is a statement in the underwriting papers between the issuer and the lead underwriter allowing for a predetermined amount of extra shares to be offered if the whole issue is oversold.
• The number of extra shares can vary, but the issuer has agreed to allow for the extra shares.

Not every offering has a Greenshoe clause in the underwriting papers, but it is a benefit for the underwriter if the issue is oversold.

Question 29

The two types of municipal issues are:
• General obligation bonds
• Revenue bonds

Answer 29

Remember for Test

Question 30

GENERAL OBLIGATION BONDS

Answer 30

A GENERAL OBLIGATION BOND (also known as a GO bond) is issued by a municipality and backed by the taxing power of the municipality. Therefore, by law, selecting an underwriter to issue
general obligation bonds must always be done through a competitive bid process. In this way, the issue is underwritten for the least cost to the
municipality.
• The municipality most often places an advertisement in the BOND BUYER, an online newspaper well known by underwriters, asking for underwriting bids.

In its Bond Buyer advertisement, the municipality asks investment bankers to submit bids on their proposed issue. This advertisement requesting
bids is called a NOTICE OF SALE. If the issue is small, the municipality may only advertise in the local paper, hoping for a local bank to underwrite
it.

Question 31

The Notice of Sale provides all the information that the underwriters need to make a bid, including:

Answer 31

• The maturity date(s) of the bond
• The range of acceptable interest rates
• The call features
• The method by which the interest cost is to be computed, either under the NET INTEREST COST METHOD or the TRUE INTEREST COST METHOD
• Good faith deposit as outlined by the issuer
• Other items of importance

Question 32

COMPETITIVE BID PROCESS

Answer 32

When a competitive bid is issued, the process is as follows:
• Each prospective underwriter submits a sealed bid to the issuer, stating:
– The amount of money to be offered to the issuer as payment
for the bonds
– The interest cost per year
– The total interest cost to the issuer, either as a net interest cost or a true interest cost Each underwriter obtains a bid sheet from the Bond Buyer, called the NEW ISSUE WORKSHEET, which outlines the bidding procedures. Each sealed bid must be delivered by a certain time on a certain date (and usually arrives just minutes before the deadline).
• The issuer then opens the bids and chooses the underwriter that is offering the issue to the public for the least amount of interest cost to the issuer, and the greatest amount of money paid to the issuer.
• The underwriter must also be able to sell the minimum amount of bonds that the issuer requires.

Question 33

When an underwriter bids on a municipal offering, the following factors must be considered:

Answer 33

1. The current market interest rates as compared to the range of interest rates allowed by the issuer — the issuer always give a 2% to 3% window in which the underwriters must keep the interest. For this
   reason, the first item determined when making the bid is the SCALE, which is the interest rate combined with the price to determine the yield to the investor.
2. The interest rates, as found in one of the appropriate indexes for long-term bonds found in the Bond Buyer.
   • For revenue bonds, the syndicate looks to the REVENUE BOND INDEX (also known as the REV 30 INDEX).
   • The REV 30 INDEX is an index of the average interest rate on 25 revenue bonds with 30 years to maturity — very important in determining the interest rates for a new issue of revenue bonds. Revenue bonds are not rated since there is no way to determine if the revenue bond project will be able to make all interest and principal payments.
   • For general obligation bonds, the syndicate looks to the GENERAL OBLIGATION 20 YEAR BOND INDEX that closely mimics the ratings of the bond they will be underwriting.
   • The GO 20 Index is an index of the average of the interest rates on 20 general obligation bonds — very important in determining the interest rates for a new issue of general obligation bonds. It is equivalent to an A+ (A1) rating.
   • A 40 municipal GO Bond Index that is equivalent to BBB ratings and an 11 GO Bond Index that is equivalent to AA ratings are also available.
   • All these indexes are determined every week, on Thursday, and published in the Bond Buyer on Friday.
   • Remember, ratings are the determination of the ability of the issuer to make timely payments of principal and interest.
3. The 30-DAY VISIBLE SUPPLY — a weekly list of municipal bonds that will be offered through an underwriting during the next 30 days, published on Mondays in the Bond Buyer
4. Calculate the net interest cost or the true interest cost, depending on the requirement by the issuer
   • NET INTEREST COST is the amount of money the issuer actually pays over the life of the bond. Multiplying the face value of each bond by the interest paid over the life of the bond and adding that together determines the net interest cost. (You will not have to calculate this.)
   – If the bonds are bid at a premium, the net interest cost is calculated by subtracting the premium from the total interest cost.
   – If the bonds are bid at a discount, the net interest cost is calculated by adding the discount to the total
   interest cost.
   • TRUE INTEREST COST is more involved; in essence, it is the interest cost, taking into consideration the time value of money.
5. Any information on the tax-exempt status of the bonds, the financial condition of the issuer, or any other factors that may affect the interest rate and price of the bonds. The underwriter obtains this
   information by consulting with the issuer’s bond counsel.
   • The BOND COUNSEL is hired by the issuer to assess the taxexempt status of the bonds and to check existing laws regarding the issuance of the bond.
6. The underwriter also checks the placement ratio, which is found in the Bond Buyer every week on Mondays.
   • This ratio is the number of bonds sold in a given week divided by the number of bonds offered during that week, thereby providing an estimate of the performance of new municipal bond issue sales. The PLACEMENT RATIO is very important for underwriters because it shows whether people
   are buying bonds and whether higher rates are needed to sell the bonds.

Question 34

SUBMITTING THE BID

Answer 34

When a Notice of Sale has been placed by an issuer, the underwriters who want to enter a bid will download the New Issue Worksheet from the advertisement in the Bond Buyer.

This worksheet makes it easier for the lead underwriter and syndicate to determine a bid.

The underwriters fill in and complete the Bond Buyer New Issue Worksheet based on the information in the Notice of Sale.

After determining its bid, the underwriter submits it accompanied by a GOOD FAITH DEPOSIT, which is a check for the specified amount of money in the Notice of Sale.
• The good faith deposit is required by the issuer to ensure that the underwriter intends to fulfill its obligations as underwriter. All good faith deposits are returned to the losing bidders.
• The issuer keeps the deposit of the winning bid and, if all goes well, uses this money to offset payment for the bonds by the underwriter.
• All competitive bid underwritings are firm commitment underwritings, since the underwriter buys the issue outright from the issuer and then sells it to investors.

Financial advisers who work with the municipality cannot bid on competitive issues unless they get permission from the issuer. The Municipal Securities Rulemaking Board (MSRB) Rules forbid financial advisers from also acting as underwriters without permission. A potential conflict of interest may occur if financial advisers have information that
could give them an advantage in the bidding process. The financial adviser, working on behalf of the issuer, is trying to set the lowest possible interest rates for the bonds, while underwriters are trying to set an interest rate that is higher to make the bonds attractive for investors.

Question 35

SCALE IN A NEW MUNICIPAL BOND

Answer 35

When municipal bonds are issued with serial maturities, the pricing of new bonds is offered on a YIELD SCALE, not a dollar amount. The YIELD SCALE represents the yield to maturity for the serial bonds as they mature. In competitive bidding for municipal bonds, the yield scale is one of the first things to be determined by the underwriting syndicate. If necessary, review the previous module on Municipal Securities for a detailed discussion on serial bonds.

Remember that serial bonds have a certain amount of principal maturing each year, and the interest rates for each of these years can be, and usually
are, different. There are three types of OFFERING SCALES of new bonds. The OFFERING SCALE depends on the interest rate of each maturity date
and the price at which the bond is offered. The offering yield is also highly influenced by the present Treasury-bill yield curve. The yield scale follows the yield curve of other outstanding bonds very closely. Yield scales are graphically represented similarly to yield curves and are described as follows:
• A NORMAL YIELD SCALE occurs when bonds with early maturities have lower interest yields than bonds with later maturities. This is the most commonly occurring yield scale, especially with steady rates in the market.
• An INVERTED YIELD SCALE occurs when bonds with early maturities have higher interest yields than bonds with later maturities. This occurs very rarely, when rates are falling and are expected to stay low over a period of years.
• A FLAT YIELD SCALE occurs when bonds with early maturities have the same yield as bonds with later maturities. This is also a “rare occurrence.”

Question 36

REVENUE BONDS

Answer 36

A municipality issues a REVENUE BOND to fund a project or facility that eventually generates revenues to repay the bond issuance and ongoing
maintenance.

Because revenue bonds are not backed by the taxing power of the municipality, there is no requirement for competitive bidding by underwriters. Therefore, revenue bonds are most often underwritten on a negotiated basis, much like corporate bonds.

Question 37

NEGOTIATED UNDERWRITING

Answer 37

A municipality enters into a negotiated underwriting when the issuer is not required to seek out a competitive bid. The issuer usually negotiates
with the investment banker or underwriter of its choice to determine the cost of the issue, which may be even lower than if it went to bid.

Negotiated underwritings are usually managed by an investment banker with whom the municipality has dealt with in the past. The cost to the
issuer is negotiated with that investment banker. The underwriter negotiates the best price with the issuer, taking into account the expected market for the bonds once they are issued.

Negotiated underwritings of municipal and state issues are usually underwritten on a firm basis, although they can be underwritten on a best
effort basis. If underwritten on a best effort basis, the municipality usually executes it as an All or None underwriting (AON).

Question 38

LEGAL OPINION

Answer 38

Prior to a bond being issued, a municipality must obtain a LEGAL OPINION from a BOND COUNSEL, who is a lawyer knowledgeable in
the laws of municipal bonds. The legal opinion by the bond counsel, in effect, states that:
• The bond is a municipal bond as set forth by the laws in the area where the bond is being issued.
• The bond interest is exempt from taxes.
• No other legal matters will affect the value of the bond. (The bond counsel first determines if the bond interest is exempt from federal taxes and then if it is exempt from state taxes.)

In forming an opinion, bond counsels research the state and local laws to check into the requirements for a bond to have tax-exempt status. They may assist in getting favorable legislation passed in the locality if need be, and supply information to the underwriters for the official statement.

The opinions that bond counsels offer regarding the tax status of the bond can be one of the following:
• QUALIFIED LEGAL OPINION — the bond counsel gives a qualified legal opinion if some aspect of the issue may make the bond interest taxable or if it has a legal matter that may
affect its value.
• NONQUALIFIED LEGAL OPINION — the bond counsel gives a nonqualified legal opinion if no aspect of the issue could possibly prevent it from being tax-exempt.

You must also know:
• The bond counsel attests to the tax-exempt status of the bond.
• The IRS determines the tax-exempt status of the bond through the laws that have been passed.

***The last act of bond counsels prior to the bonds being issued is to review one of the certificates to determine that all of its wording and legal information is correct

Question 39

OFFICIAL STATEMENT

Answer 39

The OFFICIAL STATEMENT is the equivalent for a municipal bond as a prospectus is for a corporate issue. The underwriter prepares the official statement prior to the bonds being sold to the public. It is distributed to all purchasers and to other dealers upon request. Prior to the official statement, a preliminary official statement may be issued, but it does not include pricing information.

The official statement provides the most detailed financial analysis of the municipality. The official statement also sets forth:
• The purpose or use of the bonds
• How the funds will be used
• Call provisions
• Other information pertinent to the bond and desired by potential investors

Question 40

REGISTRATION AND THE OFFICIAL STATEMENT

Answer 40

Because municipal bonds do not have to be registered with the SEC, no cooling-off period is associated with their issuance. This allows them to
be presold by prospective underwriters during the bidding process or during the negotiations of the issue. The preselling can occur even before
an underwriter for the issue is selected.

The investing public needs to know all related information about a municipal bond before investing. The disclosure information that is vital
for an investor to make an informed decision includes:
• The per capita debt for general obligation bonds and, for revenue bonds within the municipality, the expected income from any facility built with the proceeds from the bond
• How the municipality or the facility will spend the money
• Information about any engineering related to any project being funded by the bond
• Any other important information

All this information is outlined in the official statement. A more detailed discussion about this can be found in the previous module, Municipal Securities.

Municipal bonds are exempt from the registration requirements under the Securities Act of 1933; therefore, the SEC does not require municipal
bonds to publish an official statement. However, since most purchasers are accustomed to receiving disclosure information in the form of a prospectus,
most bond issuers publish official statements. The official statement, which is not required by the SEC under the 1933 Act for municipal issues, is published primarily for marketing purposes and to satisfy the Municipal Securities Rulemaking Board Rules (MSRB).

Although you will not be expected to know the difference between a prospectus and an official statement, you will be expected to know the
following:
• A PROSPECTUS is published for corporate offerings.
• An OFFICIAL STATEMENT is published for municipal offerings.

Question 41

PRIORITY ALLOCATION OF ORDERS

Answer 41

Because municipal issues can be sold to buyers before the underwriter begins the underwriting process (i.e., the issues can be sold during the
presale period), all municipal underwritings must follow an order of settlement as established by the Municipal Securities Rulemaking Board (MSRB). The order of the allocation as to who receives bonds for reselling is set forth in the syndicate agreement. For municipal offerings, the syndicate manager allots issues in the following order:
• Presale orders
• Group net orders
• Designated orders
• Member orders at the takedown

Question 42

PRESALE ORDERS

Answer 42

PRESALE ORDERS are taken by the underwriter prior to the bid being made or the negotiated offering being settled. Institutional investors who buy issues without knowing the price or yield usually place presale orders. Because of this, underwriters presell a large amount of the
bonds at the lowest interest cost to the issuer. Underwriters actually solicit these large investors to buy before they submit the bid. The investors have
such faith in their underwriters that they buy without even knowing the interest rate or the price.

Question 43

GROUP NET ORDERS

Answer 43

GROUP NET ORDERS are large orders placed by selling syndicate members for institutional buyers during the order period where all members of the syndicate are credited with part of the sale. Often this type of order would be a designated order, except that the purchaser wants to allow all of the syndicate members to participate in the sale. The
purposes for group net orders include:
• To avoid favoritism — the buying institution knows all the syndicate members and wants to avoid favoring one or another. All the members share in the sale according to their participation.
• To put the buying institution in higher order to receive their requested bonds if the whole issue sells out. All members of the syndicate receive credit for the sale according to their participation, and receive the total takedown based on their part of the sale. This has nothing to do with selling group members.

Question 44

DESIGNATED ORDERS

Answer 44

DESIGNATED ORDERS are entered by a syndicate member, so that one or more syndicate members get credit for the sale. These issues are
allotted based first on the number of syndicate members credited with the order, (the order with the most amount of syndicate members is awarded the first bonds of their choice). Then, if there is the same number of syndicate members being given credit, the allotment is based second on the size of
each order being considered. Usually, large blocks take priority. (Mutual funds or institutions usually place large orders.) Here, politics and the percentage of the syndicate allocation take precedence and the manager has authority pursuant to the underwriting agreement to allocate orders. If a member of the syndicate places an order on behalf of an institutional investor with only that firm or a limited number of the syndicate
members getting credit for the sale, it is a designated order.

Question 45

MEMBER ORDERS AT THE TAKEDOWN

Answer 45

MEMBER ORDERS AT THE TAKEDOWN are orders submitted by one syndicate member after the order period has closed. These orders
are usually taken during the same time, and are on a first-come, first-served basis. Any designated orders for mutual funds for which the member is
also the sponsor must be placed as a member order at the takedown.

Only bonds left after presale orders, group net orders, and designated orders can be sold to the syndicate member’s own mutual funds. After all of these orders are filled, the offering is closed. Only after the offering is closed does the syndicate liability come into play.

When members of the syndicate are allowed to participate in an underwriting, the manager determines the amount each member is allowed
to sell. This is dependent on whether the firm has participated in the underwriting previously, how successful it was, and how the lead manager
values the firm. Underwriting allocations can be based purely on professional relationships.

Question 46

For municipal underwritings, remember the following:

Answer 46

• A NOTICE OF SALE is an advertisement from the issuer to the underwriter.
• A SYNDICATE AGREEMENT is a letter from the
underwriting syndicate manager to the syndicate members.
• A TOMBSTONE ADVERTISEMENT is from the underwriter to the public looking for buyers.
• An OFFICIAL STATEMENT is from the issuer to the public setting forth all the important information about the municipal issuer.
• A SYNDICATE SETTLEMENT LETTER is a letter from the syndicate manager outlining the amount of securities credited to each member.

Question 47

The UNDERWRITING SPREAD

Answer 47

The UNDERWRITING SPREAD is the compensation paid in an underwriting, and it is either negotiated with the issuer or built into the
price of the issue if the underwriting is bid on a competitive basis.

Question 48

Know the difference between the spread for a corporate issue and a municipal issue:

Answer 48

• For a corporation, the spread is the difference between the public offering price and the proceeds to the issuer.
• For a municipality, the spread is the difference between the RE-OFFERING YIELDS and the syndicate bid to the issuer.

Question 49

The amount of the underwriting spread:

Answer 49

• Is determined by the size of the issue, the size of the corporation and the industry it is in, or the size of the municipality. The amount of the spread is a fairly standard amount and is monitored by FINRA. However, the amount can vary among industries,
companies, and municipalities.
• Is reduced by the underwriter’s costs for advertising and registering (or blue-skying) the issue with various states. This is part of the manager’s fee.
• Will be divided among the syndicate members and any broker/dealer in the selling group that assists in selling the issue.

Question 50

THE SPREAD

Answer 50

The lead underwriter receives a part of the sales charge, called the manager’s fee, on every share of stock and bond that is sold.

The people who sell receive their part of the sales charge that is attributed to the sales, called the underwriting fee (for corporate securities) or total takedown (for municipal issues).

When a person who works for a syndicate member sells shares or bonds of a new issue, the lead underwriter receives a portion of the spread and the
person who sold the shares/bonds receives a portion as well.

The lead underwriter receives a part of the spread because that department has paid the expenses associated with the sale and has performed all of the work in registering and preparing the issue for sale. The amount that is received by the lead underwriter is called the MANAGER’S FEE, and is
the compensation for managing the underwriting, assuming the risk associated with the underwriting, and covering the costs incurred during the
underwriting.
• The manager’s fee is always a portion of the total spread on the issue, and it is the amount that is paid to the manager for the firm’s time and efforts in bringing the issue to market.
• The syndicate members receive the remainder of the spread in return for their sales efforts.

When a person who works for a syndicate member sells shares or bonds of the issue, that person receives a part of the spread. The amount the sales
people receive is greater per share or bond than the manager’s fee.
• You must remember, though, that managers receive the manager’s fee ON EVERY SHARE OR BOND sold, because they are the manager and have done all the preparation work. Those selling the shares or bonds receive only the portion of the spread on the shares or bonds they have sold.

If a selling group member sells the issue, the lead underwriter receives a portion of the spread, the selling group member executing the sale receives
a part of the sales charge, and the syndicate member with whom the group member is associated is also compensated with a part of the spread.
• When a syndicate member delegates any shares or bonds of the issue to a selling group member to sell, the syndicate member pays a portion of the spread to the selling group member, called the
CONCESSION.

Depending on whether the underwriting is for a corporate or a municipal issue, the amounts received by the syndicate members and the selling group members have different names, as explained in the diagram below. The manager’s fee is always termed the manager’s fee, regardless of whether
the underwriting is for a corporate issue or a municipal issue.

Question 51

CORPORATE SPREAD

Answer 51

The following is a breakdown of the underwriting spread on the sale of each share of stock or on each $1,000 bond.
• Syndicate managers receive the manager’s fee as
compensation for their work on the underwriting, regardless of whether they sell the securities or not.
• Syndicate members and the syndicate managers receive the “underwriting fee” for their sales of the issue.
– The UNDERWRITING FEE is the amount of the sales charge that is in excess of the manager’s fee.
– The underwriting fee is the largest part of the sales charge.
– If any of the syndicate members allow selling group broker/dealers to sell some of their shares, the selling group receives the concession for these sales.
– Because the syndicate members have made a financial commitment to sell the issue, they receive the remainder of the underwriting fee not taken in the concession. There is no name for this remainder, so we call it THE NO NAME.

Question 52

In a corporate underwriting, the syndicate member receives the underwriting fee and gives the concession to the selling group member.
(Remember, the selling group member is a nonsyndicate member.)

Answer 52

Remember for Test

Question 53

MUNICIPAL SPREAD

Answer 53

In a municipal underwriting, the syndicate member receives the total takedown and gives the concession to the selling group member,
keeping the additional takedown. (Yes, municipal and corporate underwritings are different; sorry, but you must know them!)

The following is a breakdown of the spread on the sale of each $1,000 bond:
• The syndicate manager receives a manager’s fee, regardless of whether the manager sells the bonds.
• The syndicate members and the syndicate manager receive the total takedown for their sales of the bonds.
• If any of the syndicate members elect to let the selling group sell some of the bonds, the selling group receives the concession for its sales. Because the syndicate members have made a financial commitment to sell the issue, they receive the additional takedown.
• The combination of the concession and the additional takedown make up the total takedown.

When a municipal issue is underwritten, the manager pays the municipality a set price (which, because of the spread, is less than the total offering). On the test, this is referred to as “buying the issue at a discount,” meaning a discount from the total price.

The manager then awards the bonds to the syndicate members at a price less the discount for the TOTAL TAKEDOWN. When syndicate
members sell to the public, they buy at a price equivalent to the discount of the total takedown and sell at the public offering price.

If the syndicate members allow the selling group to sell any bonds, they discount the price to the offering price less the concession. The selling
group sells the issue at the offering price and keeps the concession.

Remember:
Concession + Additional Takedown = Total Takedown

Question 54

TREASURY SECURITIES

Answer 54

TREASURY SECURITIES include TREASURY BILLS, TREASURY NOTES, and TREASURY BONDS. Treasury securities are all offered on
an auction basis with bids by both noncompetitive and competitive bidders. The prices of the Treasury securities are determined through this
competitive bid process. Competitive bidders are broker/dealers, large banks, and money centers who are invited to bid on the securities. They
must bid at least $1 million or more. No bidder, however, can bid for more than 35% of the amount offered by the U.S. government. Noncompetitive
bidders are the public investors, like you and me, as well as foreign investors.

The competitive bidder bids a dollar amount at a specific interest rate that falls within the interest rate range that the Federal Reserve Board (the Fed) desires.

Noncompetitive bidders, which bid much smaller dollar amounts, must purchase a minimum of $1,000 and a maximum bid of $1 million. The
noncompetitive bidders are always assured of getting their bonds.

All bidders receive their T-bills at the same yield, thus all pay the same price. Since 1998, the Treasury has had all of their T-bill, T-note, and
T-bond auctions as a “single-priced” auction. This means that all those that have winning bids receive their securities at the one set price as accepted by the Fed at the auction.

Treasury bill auctions are held on Mondays and Tuesdays and settle on the Thursday of the same week, provided it is not a holiday. If it is a
holiday, they settle on Friday, but generally this happens only once or twice a year. Settlement may be in cash (checks from an individual), federal
funds (usually with banks), or with a maturing Treasury security (called a ROLLOVER). Most often, individual purchasers either roll over maturing
T-bills or deposit a check prior to the auction date. Banks and other large buyers ($1 million or more) set up a federal funds account with the Fed and
make the payment to that account on the Thursday the payment is due.

Treasury notes are offered through an auction that is held on the second and fourth Wednesday, with payment due on the 15th or last day of the month,
depending on the auction. No prospectus or official statement is required when Treasury securities are
issued, because these securities are exempt from the registration requirements of the Securities Act of 1933. Federal agency issues are issued through an underwriting syndicate, much like municipal and
corporate issues. The underwriting for federal agency issues is a negotiated underwriting, and therefore, involves a lead underwriter and a selling
syndicate. No prospectus is required with federal agency issues because, like Treasury securities issues, federal agency issues are exempt from the
Securities Act of 1933. Federal agency issues are generally issued at a price that is very close to par, and interest rates for these issues are very
close to most Treasury security issues.