i. underwriting agreements

HOW TO PREPARE AN INITIAL PUBLIC OFFERING 2012
I. Underwriting Agreements
II. The FINRA Review Process
March 1, 2012
Presenter: Eileen Shin
Executive Director, Assistant General Counsel

I. UNDERWRITING AGREEMENTS
What is the purpose of the underwriting agreement
• It documents the agreement among the parties regarding the
economic and legal terms of the transaction
• Nature, amount and price of the securities being sold
• Type of transaction – primary, secondary or combination
• Nature of the underwriters’ commitment to purchase
• firm or best efforts
• each underwriter’s obligation to purchase is several and not joint with the other
underwriters’ obligations in order to limit each underwriter’s liability exposure
• Issuer’s and/or selling shareholders’ commitment to sell
• Allocation of liability among the issuer, any selling shareholders and
the underwriters
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I. UNDERWRITING AGREEMENTS
Parties, Form and Timing
• Parties: issuer, any selling shareholders and lead bookrunners on
behalf of the underwriting syndicate
• Negotiation is usually not an adversarial process
• Drafted by underwriters’ counsel, typically starting with the form
agreement of the lead left bookrunner
• Required to be filed as an exhibit to the registration statement because
it is a material agreement; however, a form may be filed
• Not executed until the pricing date, after the entire registration process
and most of the offering process is complete
• Until execution, there is no contractual arrangement between the issuer,
selling shareholders and underwriters
• Engagement letters negotiated at the time of mandate are not standard in the
U.S. market, although occasionally signed in the IPO context
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I. UNDERWRITING AGREEMENTS
Introduction, Purchase and Sale, Delivery and Payment
• Introduction – sets forth the parties to the transaction, a description of the
securities being sold and the number of shares being sold
• May include a description of related transactions, such as an acquisition being funded by
the proceeds
• Purchase and Sale – sets forth the price at which the underwriters agree to buy
the securities from the issuer/selling shareholders, reflecting a commission to
the underwriters in the form of a discount to the public offering price
• Sets forth the overallotment or “greenshoe” option
• Underwriters may sell more shares than they have agreed to purchase from the issuer
and/or selling shareholders in the base offering
• To cover the syndicate short position in a rising market, underwriters have an option to
purchase additional shares from the issuer and/or selling shareholders at the same price
as shares bought in the base offering
• Option is typically exercisable for 30 days after pricing by the lead bookrunners
• Amount of shares in the option are limited by FINRA rules to 15% of the base offering
• Delivery and Payment – sets forth settlement mechanics, typically occurring on
T+3
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I. UNDERWRITING AGREEMENTS
Representations and Warranties
• Issuer makes representations and warranties concerning:
• No material misstatement or omission in the registration statement and prospectus
• Accuracy of financial statements and independence of auditors
• Corporate authorizations and other representations that address the validity of the
transaction and securities being offered
• Various aspects of the issuer’s business, including compliance with various laws
• Areas specific to the issuer’s industry or jurisdiction (if outside the United States)
• Selling shareholders make representations and warranties, but the
scope will depend on their relationship to the issuer
• “Clean hands” representation
• Often heavily negotiated among external lawyers
• Negotiation of representations and warranties serves as a helpful
diligence exercise and can help all parties to focus on areas of
particular concern
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I. UNDERWRITING AGREEMENTS
Covenants
• Agreements of the issuer to maintain the accuracy of the prospectus, notify the
underwriters of certain events such as a stop order or the inaccuracy of any reps
and warranties, maintain a listing of the securities and refrain from activities that
stabilize or manipulate the price of the securities
• Lockup or “clear market” provision is by far the most negotiated covenant
• Issuer agrees not to sell shares or securities convertible into shares or make any public
announcement regarding such a sale, including through the filing of a registration
statement, for a period of time after the offering, usually 180 days for an IPO
• Issuer negotiates certain carveouts to this restriction such as issuances in connection
with employee compensation plans or in connection with M&A activity
• Selling shareholders may have a lockup provision in the underwriting agreement
or may sign up the form of separate lockup agreement that non-selling
shareholders, officers and directors sign
• Underwriters covenant not to use any free writing prospectus that would create
an issuer filing obligation
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I. UNDERWRITING AGREEMENTS
Conditions to the Obligations of the Underwriters
• Closing conditions are the conditions that need to be true or other
obligations that need to be met in order for the underwriters to be
obligated to purchase the securities and close the transaction
• Includes documents that need to be delivered to the underwriters,
such as certificates, opinions and comfort letters
• Includes condition that the representations and warranties are
accurate on the day of settlement and, in particular, that there be no
material adverse change in the issuer’s business
• If a condition is not met, the underwriters can either waive the
condition or terminate the agreement and unwind trades
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I. UNDERWRITING AGREEMENTS
Indemnification and Contribution
• Important to the underwriters because the underwriters undertake
potential statutory liability for alleged or actual misstatements or
omissions in the issuer’s disclosure document
• Case law has put the validity of indemnification of the underwriters in
doubt, citing public policy concerns
• Law firms will only opine as to the due authorization, execution and delivery
of the underwriting agreement and not as to its enforceability
• Generally comprised of three elements
• Indemnification by issuer (and any other sellers) for claims brought against
underwriters by third parties (and related expenses)
• Indemnification by underwriters for claims brought against issuer by third
parties (and related expenses)
• Contribution
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I. UNDERWRITING AGREEMENTS
Indemnification by Issuer and Other Sellers
• Covered persons
• Broadly defined to include underwriters and their affiliates, officers, directors,
employees and controlling persons
• Scope of coverage by issuer
• Limited to liabilities (and expenses incurred) arising from misstatements or omissions
from prospectus
• Exception for misstatements or omissions in respect of information furnished by
underwriters for inclusion in offering document
• Scope of coverage by any other sellers (e.g., selling shareholders)
• May be as broad as issuer’s indemnity (especially for parent or founder who is seller),
but:
• More often these days, limited to misstatements or omissions in respect of
information in offering document relating specifically to seller
• Obligation usually “several” vs. “joint and several”
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I. UNDERWRITING AGREEMENTS
Indemnification by Underwriters
• Covered persons
• More narrowly defined to include issuer, its directors and its officers
who sign the registration statement (and, if applicable, any other
sellers)
• Scope of coverage
• Limited to liabilities (and expenses incurred) arising from
misstatements or omissions in respect of information furnished by
underwriters for inclusion in offering document
• Underwriter-furnished information very limited; specifically crossreferenced
to paragraphs of offering document (“blood letter”
provisions)
• Obligation always “several” – not joint – and proportionate to
underwriting commitment
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I. UNDERWRITING AGREEMENTS
Indemnification Procedures
• Parallel provisions, regardless of who is the indemnifying/ indemnified
party
• Right of indemnifying party (but practically speaking, the issuer) to
assume defense of litigation with counsel of its choice (but reasonably
satisfactory to indemnified party) and to direct litigation strategy
• Other procedural aspects
• Indemnified party’s right to own counsel/conditions for reimbursement
• Consents necessary to settle claims
• The “hammer” – indemnified party can settle without indemnifying party
consent, if indemnifying party fails to reimburse expenses after 30 days from
written request
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I. UNDERWRITING AGREEMENTS
Contribution
• Provides remedy in “equity” rather than “at law” if indemnification
insufficient or not available for any reason
• Amount to be contributed by indemnifying party based on relative
benefits of the offering to the parties
• Look also to relative fault only if relative benefit not enforceable
• Limits on contribution amounts
• Underwriter – the gross proceeds of securities underwritten by it or,
alternatively, the offering fees received by it (consistent with several
vs. joint approach)
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I. UNDERWRITING AGREEMENTS
Expenses and Termination
• Expenses section – the issuer, and sometimes the selling shareholders,
covers all expenses of the offering, other than underwriters’ expenses
• Roadshow expenses are often subject to negotiation
• Caps on certain expenses may be negotiated
• Termination section – underwriters may terminate the underwriting
agreement before closing upon certain “market outs” or force majeure
events
• Underwriters can also terminate if there has been a material adverse
change at the issuer (the “company MAC out”) or a ratings downgrade
of the issuer’s debt securities
• Issuer and/or selling shareholders typically agree to reimburse the
underwriters’ expenses, including external counsel fees and expenses,
if the underwriters terminate for reasons allowed under the agreement
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I. UNDERWRITING AGREEMENTS
Miscellaneous
• Defaulting Underwriter – if one of the underwriters defaults on its
obligation to purchase, this section addresses how alternative
arrangements may be made, when the remaining underwriters must
step in to purchase their pro rata share of the defaulting underwriter’s
commitment or alternatively, when the agreement may terminate
• Survival – provides that the representations, warranties and
indemnities survive closing or termination
• “etoys” clause – makes clear that no fiduciary relationship exists
between the parties and that the transaction between the issuer, any
selling shareholders and the underwriters is being conducted on an
arms-length basis
• Additional general contractual provisions regarding notices, successors
and governing law
• Foreign issuers – appointment of agent for service of process, waiver
of immunity, judgment currency
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I. UNDERWRITING AGREEMENTS
Exhibits – Lockup Agreements
• Underwriters obtain contractual agreements from officers, directors
and major shareholders
• Time period is typically the same as for the company and selling
shareholders (180 days in an IPO)
• Typically negotiated in tandem with the underwriting agreement
• Receipt of executed lockup agreements is a representation or condition
to closing in the underwriting agreement
• In an IPO, underwriters will negotiate to have them executed far in
advance, usually before the marketing begins
• What is the purpose
• Give investors assurance that the market for the equity being issued will
not have to absorb additional supply coming from those locked up
• Facilitate the orderly distribution by preventing large blocks of stock
being dumped in the market while the distribution is in process or in the
intermediate after-market, particularly by insiders
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I. UNDERWRITING AGREEMENTS
Exhibits – Lockup Agreements (cont’d)
• Certain carveouts are highly negotiated while others are standard, such
as:
• Bona fide gifts or transfers to trusts for the benefit of the lockup signee or
his/her family
• Transfers by will or intestate succession
• Transfers to affiliates
• Transfers to the company to satisfy the exercise price and/or tax withholding
obligations upon exercise of currently outstanding stock options
• Insider sales are transparent to the market due to Form 4’s/5’s being
filed with the SEC
• Lockup arrangements, including negotiated carveouts, will be
described in the underwriting section of the prospectus
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I. UNDERWRITING AGREEMENTS
Exhibits – Lockup Agreements (cont’d)
• “Booster shot” extension – provides that if the company issues an
earnings release or announces material news toward the end of the
lockup period or anticipates that it will do so just after the lockup
period expires, the lockup period will automatically extend for an
additional couple of weeks
• FINRA rules prohibit the underwriters of an offering from publishing
research during the 15 days before or after the expiration or waiver
of a lockup, with certain exceptions
• By extending the lockup period, the booster shot extension allows
the research departments of the participating underwriters to
publish upon an earnings release or other material news
announcements without violating the FINRA rule
• Lead bookrunners will have the right to waive or terminate lockup
restrictions
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I. UNDERWRITING AGREEMENTS
Exhibits – Lockup Agreements (cont’d)
• Lead bookrunners will have the right to waive or terminate lockup restrictions
• Requires coordination with other syndicate members to ensure no research issues
under booster shot rule
• FINRA Rule 5131 – lockup agreements of officers and directors must provide
that lockup restrictions also apply to any issuer-directed shares acquired by
officers and directors
• If any waiver is granted, the lead manager will notify the issuer at least two business
days before the release and issue, or have the company issue, a press release
• Exception for release solely to permit transfers without consideration where the
transferee agrees in writing to be bound by the same lockup terms
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II. THE FINRA REVIEW PROCESS
Exhibits – Opinions
• External counsels of the issuer and the underwriters will deliver
opinions and negative assurance statements on the disclosure
• Counsels for any selling shareholders will also deliver a limited set of
opinions
• Negotiated in tandem with the underwriting agreement
• If the issuer is not a New York or Delaware incorporated entity, there
may be separate opinions being delivered by a local counsel or an
internal general counsel at the issuer
• If there is substantial disclosure regarding regulatory matters or
intellectual property, there may be separate opinions delivered by
special counsel on those issues
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II. THE FINRA REVIEW PROCESS
Overview
• The Financial Industry Regulatory Authority is the main self-regulatory
organization for securities firms in the United States
• All initial public offerings are subject to review by the Corporate
Financing Department of FINRA
• An offering may not proceed to pricing until a “no objections”
clearance by FINRA is issued
• Purpose of the review:
• To review relationships and arrangements between the issuer and each
underwriter, including underwriting compensation and all other “items of value”
received or to be received by each underwriter
• To determine whether the underwriting terms and conditions of the offering are
fair and reasonable
• To review compliance with the conflicts of interest rules under FINRA Rule 5121
• FINRA review process occurs in parallel with the SEC registration and
review process
• Initial filing with FINRA is essentially concurrent with the initial filing of the SEC
registration statement
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II. THE FINRA REVIEW PROCESS
Underwriting Compensation
In addition to the underwriters’ discount or commission, all “items of
value” received by the underwriters and related persons “in connection
with or related to the distribution of the public offering” are considered
underwriting compensation, including:
• Reimbursement of underwriters’ expenses, including fees and expenses of
underwriters’ counsel
• Finder’s fees, financial consulting and advisory fees
• Rights of first refusal to participate in future financings
All underwriting compensation must be disclosed in the underwriting
section of the prospectus
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II. THE FINRA REVIEW PROCESS
Underwriting Compensation (cont’d)
FINRA rules do not state a maximum amount of compensation that is
considered fair and reasonable, but for initial public offerings in recent
history, FINRA has expressed that the maximum should be 9%
FINRA rules also prohibit a variety of other terms and arrangements
considered unfair and unreasonable, such as excessively long dated “tail
fee” arrangements for deals done away from an engaged underwriter
In addition to the underwriting agreement, all letters of intent and
engagement letters entered into between the issuer and an underwriter
in the six months prior to the initial filing need to be submitted for
review
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II. THE FINRA REVIEW PROCESS
Lockup Requirements
• If an underwriter or “related person” acquires unregistered equity
securities of the issuer during the six months prior to the initial filing of
the IPO, the securities must be locked up for 180 days after the
effective date of the registration statement, with limited exceptions
• FINRA rules regarding underwriting compensation and lockups can
greatly complicate an underwriter’s ability to participate in an IPO for a
company in which an affiliated private equity arm or investment
management arm has made an investment
• Unrealized appreciation in the investment may be imputed as
underwriter compensation that, together with the underwriting
discount, exceeds what is considered fair and reasonable
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II. THE FINRA REVIEW PROCESS
Conflicts of interest
• The diligence process conducted by underwriters’ counsel through
FINRA questionnaires answered by all participating underwriters also
seeks to uncover any conflicts of interest that any underwriter may
have with the issuer at the time of the offering
• Most common circumstance giving rise to a conflict of interest is the
use of proceeds to repay debt held by the underwriters or their
affiliates
• If a conflict of interest is deemed to exist with an underwriter, that
underwriter may only participate if a “qualified independent
underwriter” (QIU) has also participated in the preparation of the
registration statement and prospectus, exercising usual standards of
due diligence, and if prominent disclosure is included in the prospectus
specifying the nature of the conflict of interest
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II. THE FINRA REVIEW PROCESS
Conflicts of interest (cont’d)
• Separate indemnification of the QIU for acting in that capacity will be
added to the underwriting agreement
• Underwriter acting as QIU must meet certain requirements:
• No conflict of interest with the issuer
• Served in at least three public offerings of a similar size and type in
past three years
• No legal/regulatory convictions or other disciplinary actions relating
to violations of the anti-fraud provisions of federal or state securities
laws within the past 10 years among personnel who are in a
supervisory capacity with respect to due diligence
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