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.

SAT: Can "persons acting in concert" be inferred from close business association?

In Triumph International Financial India Limited v. SEBI, the Securities Appellate Tribunal (SAT) interpreted “persons acting in concert” in the context of persons with close business associations. Triumph had, inter alia, acted as a broker for some of the investment companies owned and controlled by Ketan Parekh and had acquired shares of the target company. The Adjudicating Officer (AO) concluded that Triumph had acted in concert with entities controlled by Ketan Parekh which had manipulated the securities market during the period from 1999 to 2002. Together with persons acting in concert, Triumph was found by AO to have violated Regulation 7 of the Takeover Code.

SAT noted that, “Persons acting in concert has been defined in the takeover code to mean persons who for a common objective or purpose of substantial acquisition of shares or voting rights pursuant to an agreement or understanding (formal or informal) directly or indirectly cooperate by acquiring or agreeing to acquire shares or voting rights in the target company. It is, thus, clear that before two or more persons can be said to be acting in concert with each other they must have a common objective and that common objective should be substantial acquisition of shares. The shares should then be acquired pursuant to an agreement or an understanding which could be formal or informal…Before a charge of acting in concert is levied, it has to alleged that the delinquent had a common objective pursuant to an agreement or understanding with another person for substantial acquisition of shares of the target company”

SAT then went on to reverse the AO order. The facts that were relied on by AO were found by SAT to indicate an association between persons. SAT held that, “Association between persons is one thing but their acting in concert with a common objective to acquire substantial number of shares in a company in pursuance to an understanding or an agreement between them is altogether different…Close business association between two or more persons does not by itself make them persons acting in concert.”

SAT: Powers of SEBI vis-a-vis the Companies Act

Securities and Exchange Board of India (SEBI) is empowered under section 55A of the Companies Act to administer certain provisions of the Companies Act as far as they, inter alia, relate to issue and transfer of securities. These provisions which SEBI administers cover a major aspect of public offering and transfer of securities in India so far as they are contained under the Companies Act. However, there might still be certain provisions of the Companies Act or some other legislation that touch upon public offering of securities in India but for which SEBI has not been empowered to act upon. Hence the question that often arises is how SEBI should act in such cases.

The answer to the question is found in sections 11 and 11B of the Securities and Exchange Board of India Act (SEBI Act). The functions of SEBI have been provided under section 11 of the SEBI Act which consists of general and specific set of functions. The Securities and Appellate Tribunal in Bank of Baroda v. Securities and Exchange Board of India has held that the duty and function of SEBI is contained in Section 11. It has been entrusted to take such measures as it thinks fit and in order to discharge this duty, the power is vested under section 11B. Thus section 11B is one of the executive measures available to SEBI to enforce its prime duty of investor protection. The Delhi High Court in M.Z. Khan v. SEBI, AIR 1999 Delhi 164 held that the power of the SEBI under section 11 and 11B is of a very wide nature and not hedged by any restriction. Similarly, the Bombay High Court in Ramrakh R. Bohra v. SEBI, [1999] 96 CompCas 623 (Bom) has endorsed such an approach and held that section 11B being an enabling provision must be construed so as to subserve the purpose for which it is enacted.

Thus SEBI can act under sections 11 and 11B, which are of a very wide nature as it speaks of investor protection, irrespective of the fact that the subject matter might also be covered under the Companies Act for which some other authority has been empowered to act. Overlapping of powers is not legally impermissible. The Supreme Court in Radhe Shyam Khemka v. State of Bihar, (1993) 3 SCC 54 found no problem with proceedings initiated under the Penal Code, where proceedings could also have been initiated under the Companies Act. However, power under sections 11 and 11B will have to be exercised independently of the provisions of the Companies Act.

In this context, another section to look at is section 32 of the SEBI Act which states that the provisions of the SEBI Act shall be in addition to and not in derogation of the provisions of other laws. This provision curtails the power of SEBI and in the event of a conflict between the provisions of an existing legislation and the SEBI Act, the provisions in the existing statute will prevail over the provisions of the SEBI Act. In other words, the provisions of the SEBI Act in its application will be only supplemental to the provisions of other existing legislations. The section does not empower SEBI to supplement the provisions of any other law, but refers only to the extent of operation of the provisions of the SEBI Act vis-a-vis the provisions of other statutes.

Legal nature of the bank account in public offerings

The previous year’s public offering trend suggests that it was the year where the average size of the capital raised by a company was the highest. And given the number of disinvestments lined up in 2010, this year is not going to be any different. Consequently, the monetary size of the bank account, which contains the money submitted by the subscribers of the shares and holds it till the company fulfills its statutory obligations, will be very big. Hence it becomes imperative to analyse the legal nature of the bank account and the parties involved to understand how the money can be handled.

The English court in Ballantyne v. Nanwa Gold Mines Ltd., [1955] 3 All ER 210, held that money deposited by the subscribers and maintained in the bank account are not part of the general assets of the issuer company or the bank. They are in the nature of a trust property. The Bombay High Court in Reserve Bank of India v. Bank of Credit and Commerce, 1992 (3) Bom CR 81 approved the foregoing English decision and went on to add that by virtue of sections 73 of the Companies Act, a statutory trust is created whether in the hands of the issuer company or the banks.

From the foregoing, one can conclude the subscribers will be deemed to be the beneficiary of the trust and applying the principles of trust law, any benefit that accrues out of the trust property viz. the bank account will be used for the benefit of the beneficiaries. Since the escrow amount does not form part of the general assets of the company or the bank, the creditors of the company or the banks cannot lay a claim on it in the event that the company or the escrow banks go into liquidation before the public offering is completed. The company and the banks will be acting in a fiduciary capacity when handling the money. One can also conclude that the trust would continue to exist until there is compliance with the statutory provisions such as making of the allotment of the shares to the subscribers and obtaining the permission from the stock exchange for the listing of the shares.

SAT: Locus standi before the SAT

Section 15T of the Securities and Exchange Board of India Act, 1992 (Act) provides for appeal to the Securities Appellate Tribunal (SAT). Section 15T, inter alia, states that any person aggrieved by an order of the Securities and Exchange Board of India (Board) or by an order made by an adjudicating officer under the Act may prefer an appeal to the SAT.

In CSX Members Welfare Association v. SEBI, decided on December 11, 2009, SAT interpreted the meaning of “person aggrieved” to address the preliminary issue of whether the appellant had the locus standi to file an appeal before the SAT. The facts in the CSX case were that the Board had ordered the suspension of certificates of registration of many brokers who had not paid their fee. Against this order, CSX Members Welfare Association, an association of stockbrokers on the Coimbatore Stock Exchange Limited and the Interconnected Stock Exchange of India Limited, had filed the appeal.

To resolve the issue, SAT relied on the test laid down by the Supreme Court in the case of Jasbhai Motibhai Desai v. Roshan Kumar and others, AIR 1976 SC 578. Briefly stated, the test laid down in the Jasbhai case is whether the appellant is the person “against whom a decision has been pronounced which has wrongfully deprived him of something or wrongfully refused him something, or wrongfully affected his title to something”. One must also see “whether the appellant has a special and substantial grievance of his own beyond some grievance or inconvenience suffered by him in common with the rest of the public”. To make it statute specific, the Supreme Court went on to hold that one must also look whether the statute “in the context of which the scope of the words person aggrieved is being considered, a social welfare measure designed to lay down ethical or professional standards of conduct for the community, or is it a statute dealing with private rights of particular individuals.”

Applying the above test, SAT held that CSX Members Welfare Association had no locus standi before it as it cannot be said to be a person aggrieved, and dismissed the appeal

Self-listing by the Indian stock exchanges: The regulatory challenges

Self-listing by the Indian stock exchanges has been on the cards for quite some time. Securities and Exchange Board of India (SEBI) in its annual report 2006-07 had referred to such a development. In fact a recent newspaper report suggests that SEBI has proposed setting up an expert body to look into the corporate governance and ownership structure of stock exchanges. One of the key issues that the committee will look at is the self-listing by a stock exchange.

Self-listing outside India is a common phenomenon. The Australian Stock Exchange, London Stock Exchange, Singapore Stock Exchange and New York Stock Exchange are all self-listed. However, since it is a novel phenomenon in the Indian context, it would be interesting to look at some of the legal and regulatory challenges that self-listing presents.

One of the primary challenges is conflict of interest. Since stock exchanges in general enjoy extensive regulatory powers, their organizational structure will need to be closely monitored. They might get diverted from fulfilling their regulatory duties and the trust with which they have been invested. It follows from the challenge of conflict of interest as to whether the stock exchange will continue to remain impartial and allow itself to remain under the same regulatory umbrella and be regulated as others. In order to boost trade in their own stocks, stock exchanges might misuse their broad powers over broker-dealers and other intermediaries.

Further, stock exchanges regulate issuers through the listing agreement. In case of self-listing, how will the stock exchange enter into a contract with itself? Even if one finds a way out of this, a new type of a listing agreement will have to drafted since most of the current listing rules cannot be literally applied to the stock exchanges.

In the light of the above, it would be interesting to see the views of the SEBI committee to restructure the legal and regulatory framework governing the Indian stock exchanges to combat the foregoing and the other challenges.

SAT: The menace of parallel proceedings under the SEBI Act

The Securities Appellate Tribunal (SAT) in a recent order dated December 30, 2009 in the matter of Opee Stock Link Limited and another v. SEBI has highlighted the menace caused by parallel proceedings under the Securities and Exchange Board of India Act, 1992 (Act).

The Act enables the Securities and Exchange Board of India (Board) to initiate parallel proceedings on the same set of facts against an offender for issuing directions by the Board under Section 11B of the Act on the one hand and adjudication proceedings by an adjudicating officer under Chapter VIA of the Act for the imposition of monetary penalty on the other. An adjudicating officer, in an adjudication proceeding under Chapter VIA of the Act, is a subordinate officer of the Board. As both sets of proceedings are independent of each other, there is a possibility of conflicting views on the same set of facts. For example, in the Opee Stock Link Limited case, while the Board had come to the conclusion that the unlawful gain made by the appellant was approximately Rs. 12 lakhs, the adjudicating officer had come to the conclusion that it was Rs. 24 lakhs.

In the Opee Stock Link Limited case, SAT has observed that such an anomalous situation, where conflicting views are arrived at, is not in public interest. It went on to observe that if only one enquiry is held against the offender and on the basis of the findings recorded therein, the same body is given the power to issue directions and impose monetary penalty as well, it would expedite the matter and resolve the anomaly. For this to happen, an amendment to the Act would be required.

From bookbuilding to auction: The winner is the Government

Securities and Exchange Board of India (SEBI), pursuant to a notification dated December 11, 2009, has introduced an additional method for allotment of securities, the Auction Method, in case of further public offers by amending the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009.

Briefly stated, under the Auction Method, the issuer shall disclose a floor price in the red herring prospectus and investors other than retail individual investors shall bid at any price above the floor price. The bidder who bids at the highest price shall be allotted the number of securities that he has bided for and then the bidder who has bided at the second highest price and so on, until all the specified securities on offer are exhausted. Allotment shall be on price priority basis for investors other than retail individual investors.

It seems that in the Auction Method, apart from the retail individual investors, other investors will be allotted securities at different prices depending upon their bids. Thus there will be no uniform pricing of securities as it is in the bookbuilding or a fixed price issue. This Auction Method can be contrasted with another auction method in public offering of securities in other jurisdictions popularly referred to as the “Dutch Auction”. In a Dutch Auction, the price is initially set high, and gradually lowers depending on the bids received. Investors bid on the offering by stating the number of shares they want to purchase and their preferred price. The price continues to lower until all the shares are spoken for. At auction's end, bidders get the number of shares they agreed to buy, but at the price bid by the last bidder. For details see, what is a Dutch auction IPO? Thus, even in a Dutch Auction, the selling price is uniform for all the bidders. This does not seem to be the case for the Auction Method.

The price and share allocation in Auction Method is determined by the investors as opposed to by the investment bankers and the company in the traditional bookbuilding method. Hence one can argue that in the Auction Method under pricing of securities will be much lesser that in the bookbuilding method. This is because in bookbuilding, inter alia, investment bankers tend to underprice so as to make the issue successful. On the other hand, when investors directly participate in setting up the market price, the real market price is arrived at. Thus Auction Method adds substantial gains to the issuer. This outcome will be of substantial importance to the Government of India which is planning a series of disinvestment in the coming months. Provided one develops the infrastructure for the Auction Method before the disinvestment- 2010 kicks in, Government will end up earning more money through the Auction Method than the bookbuilding method. From government’s standpoint, Auction Method is more beneficial than the Dutch Auction since every bidder is allotted securities at the price bid by him unlike in a Dutch Auction where allotment is made at the price bid by the last bidder.

Another point to note is the possible lacunae in the Auction Method. Since there is no uniform price for allotment, the amendment does not provide for the price at which underwriters will subscribe to the issue in case there is under subscription. One can argue that it would be left to the discretion of the company and the underwriters to arrive at a price, provided it is above the floor price.