Full-service, discount, and the two kinds of underwriting
◈ 5 cardsAdvice or no advice; and in a new issue, who eats the price risk — the dealer in a bought deal, the issuer under best efforts.
Two kinds of dealer
A full-service dealer gives advice. Its representatives recommend securities, and because they recommend, the firm owes each client a suitability determination: it must know the client (objectives, horizon, risk profile, finances) and judge that each recommendation fits. Commissions are higher, because advice is part of what is being bought.
A discount or self-directed dealer — in the regulators' language an order-execution-only (OEO) dealer — gives no advice. The client decides; the firm executes. Because there is no recommendation, the CSA describes OEO dealers as dealers that do not make a suitability determination. Commissions are low. What does not change: an OEO dealer is still a registered investment dealer, still a CIRO member, and still covered by CIPF. The difference is advice and the obligations that come with it, not regulatory status.
Two kinds of underwriting
Underwriting is bringing a new issue to market — the primary market. There are two ways to do it, and the exam question is always who bears the price risk.
In a bought deal the dealer buys the whole issue from the issuer at a fixed price and resells it to investors. The issuer is paid regardless of what happens next. The dealer's profit is the gross spread between what it paid and what it sells at — and if the market slips before it has sold out, the loss is the dealer's. The dealer is principal.
Under best efforts the dealer acts as agent: it sells as much of the issue as it can, for a fee, and returns what it cannot sell to the issuer. The issuer bears the risk that the issue is not fully taken up. Best-efforts underwriting is what a smaller or riskier issuer can get when no dealer will commit its own capital.
Worked example — Lakehead Robotics issues 2,000,000 shares
Bought deal. Northshore Securities buys all 2,000,000 shares at $9.50 and offers them to investors at $10.00. If it sells out at that price:
Lakehead receives $19,000,000 either way. Now suppose sentiment turns and Northshore can only clear the shares at $9.30:
Northshore loses $400,000; Lakehead is unaffected. In Excel, one formula covers both cases: =(resale-purchase)*shares. At a $9.70 resale the spread is $400,000 — the same formula, the sign back to positive.
Best efforts. Northshore agrees to sell the shares at $10.00 for a 4 % fee. It places 1,600,000 and returns 400,000 unsold to Lakehead. Northshore earns its fee on what it sold and loses nothing on the rest; Lakehead raises $4,000,000 less than it hoped. The price risk sat with the issuer the whole time.
The two questions the paper asks
Who bears the price risk? Bought deal — the dealer. Best efforts — the issuer. In which is the dealer principal? Bought deal. The words "buys the whole issue" or "guarantees the proceeds" mean bought deal; "returns unsold securities" means best efforts. Investors bear price risk in neither — they only ever hold what they chose to buy at the offer price.