Underwriting, which involves the sale of new stock or bond issues to large investors, is one of the most profitable components of a securities business. As an underwriter, an investment brokerage assumes a fair amount of the risk of a new issue, because it agrees to pay the issuer a certain amount of money regardless of whether the stocks or bonds move in the market. To offset this risk, many firms will enter into syndication agreements, in which a group of underwriters agrees to share the risks and the rewards of underwriting a new issue. A western account, also known as a divided account, is one of the major forms of syndication agreement, in which each underwriter agrees to take on liability for only the portion of the issue that it takes into its own inventory. Under the terms of a western account, an underwriter is not liable for unsold portions of the issue in the inventories of other underwriters in the syndicate.
The other form of syndication agreement that is commonly used is the eastern account. Unlike the western account, syndicate members share the liability for the entire issue, including all unsold portions of each allotment. The syndicate apportions the liability for unsold stocks or bonds based on the participation percentage of each syndicate member. For example, Company A and Company B each agrees to a 50-percent participation in an underwriting syndicate. Although Company A sells its entire portion, it is still 50 percent liable for the unsold portions of Company B’s allocation.
In addition to sharing risks, other significant advantages to either the eastern or western account for an underwriter are that it allows smaller firms to produce enough pooled capital to purchase an issue and to expand the distribution streams to potential investors. Most syndicates are administered by one of the participating firms, and the most frequent arrangement is the eastern account. Although the risks are fewer with the western account, this form of agreement among underwriters (AAU) also curtails the substantial profits made from the difference between the buying and selling prices of the issue. If the underwriter can participate in an eastern account with a consortium of prominent investment companies with expertise in market valuation and securities trading on the secondary market, it can share in a percentage of the profits from the entire issue while advancing a relatively small amount of money in the investment.