Foreign investment in Indian mutual funds through unit confirmation receipts

In pursuance of the policy formulated by the Ministry of Finance, Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) have liberalized the investment route for foreign investors in mutual fund (MF) schemes. Until now only FIIs and sub-accounts registered with SEBI and NRIs were allowed to invest in MF schemes. Pursuant to circulars dated August 9, 2011 of SEBI and RBI, permission has been granted to certain other foreign investors termed as qualified foreign investors or QFIs to invest in equity and debt schemes of MFs. Such QFIs can invest through either of the following two routes viz. direct route (holding MF units in demat account through a SEBI registered depository participant) or indirect route (holding MF units via unit confirmation receipts).

The indirect route wherein a QFI invests through unit confirmation receipt (UCR) is a novel concept in the area of mutual fund investments and is similar to the mechanism of issuance of depository receipts by Indian companies under the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 (DR Scheme). The DR scheme is a common method adopted by Indian companies to raise foreign funds and is currently the only legal mechanism available to Indian companies to raise foreign funds through the depository receipt mechanism.

The issue structure in an issuance of depository receipt under the DR Scheme is as follows: an eligible Indian company issues shares or bonds which are held with a domestic custodian bank. These shares or bonds form the underlying security and are denominated in Indian currency. Against these underlying securities, an overseas custodian bank, upon being authorized by the Indian company, issues depository receipts which may be denominated in any freely convertible foreign currency. Thus the depository receipt is a financial instrument created by the overseas depository bank outside India and is issued to non-resident investors against the issue of ordinary shares or bonds of an Indian company.

The SEBI circular lays down a similar mechanism as above, for investment by the QFIs. Accordingly, the MF would issue rupee denominated units of the MF which would be held as the underlying by the custodian in India. Against this underlying the UCR issuer based overseas would issue UCRs to be held by the QFIs. Thus, as is the case under the DR Scheme, there are four parties involved via the foreign investor, the receipt issuer, a domestic custodian and the Indian issuer.

Maintenance of due diligence records by merchant bankers

The latest board meeting of the Securities and Exchange Board of India took place on July 28, 2011. As per the press release about the board meeting, one of the issues that was discussed and decision taken was due diligence records to be maintained by merchant bankers.

SEBI noted that the merchant bankers are required to exercise due diligence in the pre-issue and post-issue activities of issue management, takeover, buyback and delisting of securities. However at present, they are not required to maintain any records as to how they exercised due diligence. As a result, the merchant bankers follow different standards of compliance and the level of due diligence cannot be checked during inspection of merchant bankers by SEBI. Accordingly, SEBI approved amendment to Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992, requiring merchant bankers to maintain records and documents pertaining to due diligence exercised in pre-issue and post-issue activities of issue management, takeover, buyback and delisting of securities. These amendments are yet to be notified by SEBI.

The foregoing is a welcome step since it would clarify what the securities market regulator expects of the merchant bankers in matters of due diligence. Accordingly the merchant bankers can revise their internal policy on maintenance of records without being in a state of uncertainty. This would also assist the merchant bankers in establishing due diligence during SEBI inquiries. Due diligence by merchant banks in public offers, takeover and other similar capital markets transactions has been judicially well recognized and reference can be made to various orders of the Securities and Appellate Tribunal during the years 2004 and 2008.

Further recognition by SEBI that currently the merchant bankers are not required to maintain any records as to how they exercised due diligence also clarifies an uncertain aspect on due diligence which is whether there is currently a legal obligation to maintain such records. In the context of stock brokers, a similar issue was recently adjudicated upon by the Adjudication Officer, Securities and Exchange Board of India on July 27, 2011 in the matter of UBS Securities India Private Limited (UBS). SEBI had alleged that UBS had failed to provide required information (telephonic records, Bloomberg messages and emails) that SEBI had sought in relation to dealings in securities by UBS as a stock broker. UBS successfully argued that there was nothing under the Securities and Exchange Board of India Act, 1992 and the rules and regulations framed thereunder which required it to retain emails, messages and telephonic records for a particular period of time. Hence it would be guided by its internal policy which it had followed.

Legal nature of the bank account in public offerings- II

In an earlier post, I had analysed the legal nature of the bank account for collecting subscription money in public offerings. A decision of the Madras High Court in Commissioner of Income Tax v. Henkel SPIC India Limited, [2004] 120 Comp Cas 189 (Mad) offers further guidance on this issue. The facts of the case were that the assessee, a public limited company, had come out with a public issue of shares in January 1, 1992 and the issue was closed in February 3, 1992. The application money received by the company was deposited with collecting banks. The interest earned on such share application moneys was sought to be taxed by the assessing officer as income for the assessment year 1992-93. The court was asked to determine the assessment year in which the interest earned on short-term deposits of share application money by the assessee would be deemed to have accrued and formed part of income from other sources for taxation purposes.

Applying section 73 of the Companies Act, 1956, the Madras High Court held that a company which comes out with a public issue is not required to keep the money in a bank account which yields interest. There is, however, no prohibition against the money being kept in a bank account which yields interest. The interest so earned, however, cannot be regarded as an amount which is fully available to the company for its own use from the time the interest accrued, as that interest is an amount which accrues on a fund which itself is held in trust until the allotment process (viz. obtaining the listing and trading permission from the concerned stock exchange after making the allotment) is completed. No part of this fund, either principal or interest accrued thereon, can be utilised by the company until the allotment process is completed and money repayable to those entitled to repayment has been repaid in full together with such interest as may be prescribed having regard to the length of period of delay in the return of money to them. It is only after the allotment process is completed and all moneys payable to those to whom moneys are refundable are refunded together with interest wherever interest becomes payable, the balance remaining from and out of the interest earned on the application money can be regarded as belonging to the company. Thus the interest money would form part of the income of the company at the time when the entire allotment process as envisaged by section 73 and as outlined above would be completed. Accordingly, the Madras High Court rejected the stance taken by the assessing officer that the interest money would form part of ‘income from other sources’ in the assessment year 1992-93 and upheld the position of the assessee that it should form part of the subsequent assessment year in which the entire allotment process was completed.

Inconsideration to legal provisions by SEBI: Vaswani Industries IPO

SEBI had passed an order dated May 26, 2011 (link) stalling the listing of the shares of Vaswani Industries Limited after the completion of the IPO. The order was passed because on receipt of investor complaints and on the basis of a preliminary examination SEBI had found that the order book, while the IPO was open for subscription, may have been manipulated by artificially inflating it, thereby inducing innocent investors to subscribe to the issue. As a result, SEBI ordered a detailed investigation.

After the completion of the preliminary investigation, SEBI came to the conclusion that there was more than reasonable possibility that the investors were beguiled by the artificial trends in the subscription. A major part of the subscription was subsequently found to be bogus and untrue. Consequently, SEBI, through its order dated July 11, 2011 (link) directed the company and the book running lead manager to, inter alia, do the following.

1. Give withdrawal option to all the investors who had been allotted shares in the non-institutional investors category and the retail individual investors category for such number of shares by which the allotment ratio was impacted due to withdrawals/rejections.

2. On the closure of the withdrawal option, if the subscription level after such withdrawals falls below the minimum level of subscription as required by law, the sole syndicate member cum book running lead manager, Ashika Capital Limited, would underwrite and may purchase or arrange purchase through any investor(s) identified by it of such number of shares so as to ensure that the subscription does not fall below the minimum level of subscription. Non-compliance of such condition shall result in refund of entire subscription money to the investors and cancellation of all the shares so allotted by the Company.

3. The company shall cancel those shares, which have not been underwritten or taken by other investors identified by the lead manager.

These directions of SEBI raise interesting legal issues and may be in complete heedlessness to the legal provisions:

1. As per SEBI’s order, upon exercise of withdrawal option, if the percentage of allotment falls below the minimum subscription level, the sole syndicate member has to underwrite. It’s unclear as to the legal basis for such an underwriting since underwriting (soft or hard) as a process, both under the underwriting agreement and in accordance with SEBI (Underwriters) Regulations, 1993, happens prior to allotment when the requisite subscription has not been achieved. In Vaswani’s case, subscription and allotment for the entire issue is complete and the sole syndicate has not been found guilty of any wrongdoing.

2. As per SEBI’s order, if minimum level of subscription is achieved, the company has to cancel the allotted shares which have been rejected by the investors. It’s unclear what sort of corporate action will be followed by the company for cancelling such allotments. As per companies act, allotments are voidable or void under sections 71 and 73 respectively, which do not apply to this case. The other method of cancelling allotted shares would be through buy back, the conditions of which Vaswani Industries may not be able to meet.

3. SEBI’s order seems to have ignored the applicability of section 73 (1A) of the companies act. The IPO closed on May 3, 2011. By the time Vaswani Industries completes complying with SEBI’s directions, the ten week period would be over without Vaswani Industries having received the listing permission. So as per section 73 (1A), the entire allotment made pursuant to the IPO would become void.

The legality of assisting in IPO subscription by issuer through negotiation of cheap loans

The disinvestment of PSUs has not been successful particularly in the retail and employee reservation category and this is a matter of concern for the government if one is to go by the number of articles in business papers on this issue. Hence is it not surprising that Coal India, the country’s largest coal miner, is negotiating with some of the state-owned banks such as SBI to seek cheap loans for its employees so as to enable them to subscribe to the shares reserved for the employees in its upcoming initial public offering. (See link). While these efforts on the part of Coal India carry good intentions since its employees will become equity holders, the method might require adherence to certain specific provisions of the Companies Act and, pursuant to which, specific disclosure in the prospectus will have to made.

As per section 76 of the Companies Act, a company may pay commission to any person in consideration of, inter alia, his procuring or agreeing to procure subscription for any shares in the company subject to fulfillment of certain conditions such as the payment of the commission must be authorized by the Articles, the commission paid should not exceed a certain specified amount, the amount of commission and the number of shares must be disclosed in the prospectus and a copy of the contract for the payment of the commission is delivered to the Registrar at the time of delivery of the prospectus. Underwriting agreements are a classic example whereby the company pays commission to the underwriter for it to agree to subscribe or procure subscription of shares being offered in the public offer. As a result section 76 is complied with and necessary disclosures are made in the prospectus.

In this backdrop, the efforts on the part of Coal India may trigger section 76 since if a big company like Coal India is negotiating access to cheap loans from big banks like SBI, it is unlikely that no monetary consideration would flow from Coal India to SBI in the shape of commissions. And for cheap loans to be made available, SBI would have to come up with a new loan product meant for prospective employee investors of Coal India and market it. This may amount to ‘procuring subscription’.

In the alternative, negotiating of cheap loans for IPO subscription by employees could also come within the ambit of section 77 of the Companies Act, which, inter alia, permits the provision by a company, in accordance with any scheme for the time being in force, of money for the subscription of shares in the company for the benefit of the employees of the company. This is one of the exceptions to the general rule which prohibits public companies to give any financial assistance in connection with subscription of shares in the company.

Thus the act of Coal India might fall under section 76 or 77 and this will depend on the modality that is adopted by Coal India such as the size of the loan, whether Coal India has a scheme in place or not etc. However if it falls under section 76, it will require additional compliances as indicated earlier.

Misstatement in prospectus and the role of SEBI

A recent judgment by the Delhi High Court in Kimsuk Krishna Sinha v. SEBI (MANU/DE/0743/2010) throws interesting light on the role of SEBI in ensuring correct disclosure in offer documents and actions that SEBI can or should take in case there is misstatement in prospectus.

The case pertains to the IPO of DLF Limited in mid 2007. The case of the appellant was that a criminal case filed by him against one of the group companies was not disclosed in the red herring prospectus and the reply that the concerned company was not a group company was not satisfactory since the promoters of DLF Limited continued to be associated with the concerned company.

High Court disposed the matter by directing SEBI to undertake an investigation into the complaints filed by the appellant, and on its way to passing the final order made some interesting observations.

High Court observed that “the purpose of inserting Section 55A in the Companies Act was to empower the SEBI to take both corrective and preventive action. This is perhaps because as a regulatory body SEBI gets to see the draft prospectus preceding a public issue by a company even before the public gets to see the RHP. SEBI is enabled and empowered to examine the DRHP and insist on complete and truthful disclosure of all relevant facts therein. The very purpose of having an independent regulatory authority like SEBI, and vesting it with statutory powers of inquiry, is to enable it to take prompt action in matters relating to issue and transfer of shares. Particularly, SEBI is expected to be the sentinel, read the fine print of prospectuses keeping the investors' interests in view. It has both a preventive and corrective role to perform. Therefore, it is not possible to place a narrow interpretation on the words "issue and transfer of securities" occurring in Section 55-A of the Companies Act. Given the object and purpose of the provision, it should be broadly construed”. It also held that “…merely because the public issue was closed, SEBI could not be relieved of its statutory duty to conduct an enquiry into the complaint and into the veracity of the statements made in the prospectus (RHP). There are enough powers vested in it under the SEBI Act for this purpose” and that “SEBI Act expects SEBI to act as an institution accountable to the investor public and be both accessible and responsive to complaints.”

These observations make it compelling for one to analyse in greater detail as to what exactly is the nature and role of SEBI as a regulator. Should it just play a facilitative role by allowing issuers and investors to weed out the informational asymmetry that exists, and in case of any wrongdoing, leave the matter to be governed by sections 62 and 63 of the Companies Act in case of misstatements? Or should SEBI assume a much higher responsibility and “read the fine print of prospectuses”? To what extent is SEBI justified in relying on the due diligence carried on by the merchant bankers?

Listing of securities of small and medium enterprises in India

What is the legal framework for public offering of securities by SMEs?
The legal framework for the public offering of securities by SMEs is primarily contained in the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 (“ICDR Regulations”), SEBI press release dated November 9, 2009 and SEBI circulars dated April 26, May 17 and May 18, 2010.

Who can issue securities under the legal framework for public offering of securities by SMEs?
An issuer whose post-issue face value capital does not exceed ten crore rupees can issue securities in accordance with Chapter XA of the ICDR Regulations. An issuer whose post issue face value capital is more than ten crore rupees and upto twenty five crore rupees can also issue securities in accordance with Chapter XA of the ICDR Regulations. The second category of issuer may migrate its securities from the SME exchange to the ‘Main Board' (a recognized stock exchange having nationwide trading terminals, other than SME exchange) if its shareholders approve such migration by passing a special resolution through postal ballot to this effect and if such issuer fulfils the eligibility criteria for listing as laid down by the ‘Main Board’.

Further, an issuer listed on a recognized stock exchange other than a SME exchange and whose post-issue face value capital pursuant to further issue of securities of the same class does not exceed ten crore rupees will have option to make further issue of specified securities of same class in accordance with Chapter XA of the ICDR Regulations provided that its entire specified securities of the same class shall be listed on the SME exchange.

Where are securities, issued by SMEs pursuant to ICDR Regulations, listed?
Securities issued by SMEs pursuant to the ICDR Regulations are required to be listed on a SME exchange.

What is a SME exchange?
Regulation 106B (1) (c) of the ICDR Regulations defines SME exchange to mean a trading platform of a recognised stock exchange having nationwide trading terminals permitted by the SEBI to list the specified securities issued in accordance with chapter XA of the ICDR Regulation and includes a stock exchange granted recognition for this purpose but does not include the ‘Main Board’.

What is the legal framework for setting up of a SME exchange?
SEBI, through a circular issued in May 18, 2010 superseding a guideline issued earlier in November 5, 2008, laid down the framework for recognition and supervision of stock exchanges or platforms for SMEs. For the listing of securities issued by SMEs, either a dedicated stock exchange for SMEs can be set up or an existing stock exchange can set up platform for the SME sector. A new stock exchange or a platform can be set up after applying to Market Regulation Department, SEBI in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956 and Securities Contracts (Regulation) Rules, 1956 subject to the applicant fulfilling certain conditions such as corporatisation of the stock exchange, minimum balance sheet networth of Rs. 100 crores, nationwide trading terminals and an online screen based trading system etc.

What are the important differences in the process of offering of securities under the SME legal framework as opposed to offering of securities under the non-SME legal framework of the ICDR Regulations?
· The SMEs issuers, making a public issue or a rights issue, are not required to file the draft offer document with SEBI.
· While filing the prospectus with the SME exchange, they are required to file a copy with the SEBI on which SEBI will not issue any observation.
· The underwriting shall be for the entire hundred percent of the offer through the offer document and shall not be restricted upto the minimum subscription level
· The merchant banker shall underwrite at least fifteen percent of the issue size on his or their own account.
· The minimum application size in terms of the specified securities shall not be less than one lakh specified securities.

· Further no allotment shall be made pursuant to any initial public offer if the number of prospective allottees is less than fifty.

Further, SEBI has made the process of market making mandatory in a SME public offerings and the responsibility is on the merchant banker to ensure compulsory market making through the stock brokers of the SME exchange for a minimum period of three years from the date of listing of the specified securities. Pursuant to a SEBI circular dated April 26, 2010, SEBI has laid down the norms for the market makers involved in the process of market making such as registration of the market makers, the obligations and responsibilities of the market makers, risk containment measures and monitoring of market makers etc.

Is migration from a SME exchange to the Main Board and vice versa permitted?
The ICDR Regulations permits migration of companies to SME exchange or migration to the Main Board.

Is there a listing agreement in place for listing of securities on a SME exchange?
Pursuant to a circular dated May 17, 2010, SEBI specified the model SME equity listing agreement containing of listing for issuers seeking listing on SME exchange.

What are the differences in the model listing agreement for listing on a SME exchange upon comparison to the listing requirements in Main Board?
Some relaxations are provided to the issuers whose securities are listed on SME exchange in comparison to the listing requirements in Main Board, which inter-alia include the following:

· Companies listed on the SME exchange may send to their shareholders, a statement containing the salient features of all the documents, as prescribed in sub-clause (iv) of clause (b) of proviso to section 219 of the Companies Act, 1956, instead of sending a full annual report;
· Periodical financial results may be submitted on “half yearly basis”, instead of “quarterly basis” and
· SMEs need not publish their financial results, as required in the Main Board and can make it available on their website.