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Securities Underwriting

Securities Lawyer Jonathan Kurta
By: Jonathan Kurta Author

“Underwriting” refers to taking on risk in exchange for a fee. It has applications in banking and insurance as well as the securities industry. Securities underwriting aims to determine the market-worthiness of a security. Investment banks may refuse to underwrite a security if it is determined that it carries too much risk. Underwriters are responsible for keeping overly risky investments issued by companies that are likely to fail out of the market.

The underwriter helps determine the price of shares. They do this in part by determining how much interest investors have in buying proposed shares of a company’s stock. Investment banks also take a close look at an issuer’s financial statements to determine the soundness of the company’s business practices.

Underwriters can purchase the first round of securities in an IPO for themselves. They then sell those securities in what is called a “primary offering.” In other cases, the underwriter may simply help the issuer sell shares by marketing them to their customers.

What Type of Company Underwrites Securities?

Investment banks often act as underwriters for new securities as well as their agents. In fact, underwriting is often a significant portion of certain financial institutions’ revenue. Underwriters might be motivated to overlook the risks associated with a security in their eagerness to bring the new stock to market.

Investment banks are not the same as brokerage firms. Brokerage firms are intermediaries that help place shares of stocks with retail investors. Investment banks work with institutional and corporate customers to raise capital with stock offerings. They may also be involved in alternative investments, like private placements.

Large financial institutions, like JP Morgan or Morgan Stanley, may provide both investment banking and brokerage firm services. In some cases, a brokerage firm may have a conflict of interest due to an incentive to offer the securities offered by their affiliate investment bank.

What Are the Differences Between Brokers and Underwriters?

Brokers interact with stock exchanges to execute securities transactions for investors. They may also recommend stocks. Underwriters evaluate registration statements to determine if the proposed offering should make its debut on the stock exchange.

Underwriters and Due Diligence

Underwriters research a stock issuer in order to determine the risk associated with the new investment. If they perform their due diligence, they should be able to weed out companies with uncertain financials.

Markets rely on underwriters to determine the accuracy of the issuer’s registration statement. Every public stock offering must register with the SEC, and the registration statement contains the following information:

  • Business operations
  • Financial condition
  • Audited financial statements
  • Results of operations
  • Risk factors
  • Management
  • Any other information required to avoid misleading investors

Under Section 11 of the Securities Act of 1933, underwriters may be held liable for securities fraud in the event the registration statement contains a misrepresentation.

The Due Diligence Defense  

Section 11 also provides circumstances that allow for a “due diligence defense.” Certain portions of the statement may require expert attention. For instance, an auditor is the relevant expert for the audited financial statement. An underwriter is considered a non-expert and may not necessarily be held liable for missing misleading financial information unless they have reason to believe the statement to be untrue. They must also have taken steps to independently verify the statements made by the issuer.

Morgan Stanley’s Alleged Failure to Perform Underwriting Due Diligence

Morgan Stanley faced numerous lawsuits and arbitration cases following its underwriting of Facebook stock. According to certain lawsuits, the firm knew or should have known that the Facebook IPO share price was too high based on internal projections for the company’s mobile performance. As Facebook moved to mobile devices, its advertisers faltered with new applications. This reduced the profitability of the company and hurt its share price.

The lawsuits tied to Morgan Stanley’s Facebook share underwriting didn’t end there — The Massachusetts Attorney General subpoenaed Morgan Stanley to determine whether the firm provided certain information concerning a revenue estimate to preferred investors and not retail investors.

Insurance Underwriters for Securities Firms

Securities underwriting should not be confused with insurance underwriting for financial institutions. Financial institutions pay for Errors & Omissions coverage to protect themselves financially in case of a customer claim. These underwriters offer insurance in case an investor brings a claim following broker negligence. This type of insurance does not cover crimes, as in Ponzi schemes perpetrated by brokers, but may cover related failure to supervise claims, depending on the specific policy language. 

Can Investors Recover When an Underwriter Fails to Perform Its Due Diligence?

If an issuer files for bankruptcy after an IPO, the investors will be left with worthless stocks. Investors may have grounds to recover in case the underwriter failed to perform their due diligence. Under Regulation Best Interest, brokerage firms are also required to perform due diligence before authorizing their representatives to recommend a security.

If you believe you lost money due to broker negligence or misrepresentation, you may have a case for a securities attorney. Contact (877) 600-0098 for a free case evaluation.

Securities Lawyer Jonathan Kurta
Written by: Jonathan Kurta

Jonathan Kurta is an accomplished securities attorney and a founding partner at Kurta Law.