An Overview of the Law & Regulations Relating to IPO. Balkrishna Parab

Transcription

1 An Overview of the Law & Regulations Relating to IPO Balkrishna Parab

2 An Overview of the Law & Regulations Relating to IPO CONTENTS What is a Public Offer?... 4 Assessing Readiness to Stage an IPO... 4 Advantages of Going Public... 6 Concerns of Going Public... 8 IPO Project Management Team The Law of IPOs General Conditions of Making an IPO Primary Eligibility Conditions Secondary Eligibility Conditions Other Requirements of an IPO Appointment of Issue Managers IPO Grading Pricing of the Issue Offer Document or Prospectus Road Shows In-Principle Approval of the Stock Exchanges Escrow Account Application Supported by Blocked Amount Minimum Subscription Monitoring Agency Lock In of Pre-IPO Equity Shares Promoters Contribution Minimum Offer to Public Reservation on a Competitive Basis Period of Subscription Advertisements Allocation in Net Offer to Public Steps in IPO Process balkrishnaparab@jbims.edu 2

3 An Overview of the Law & Regulations Relating to IPO Balkrishna Parab Many companies view the possibility of an Initial Public Offering (IPO) of their company s shares as the ultimate dream the fulfillment of years of hard work, expressed in terms of wealth, prestige, recognition, and power. To others, that dream represents a nightmare something to be feared and avoided at all costs, even at the expense of restricting the growth and potential of their company. In reality, the successful public sale of a part of the equity of a company is neither a fantasy nor a nightmare, but rather the objective of a strategic business decision made after detailed consideration of all the pros and cons. As with any major business transformation, going public requires extensive planning, preparation, and perseverance. There are more than 700,000 companies in India 1. Very few of these companies will graduate from the minor leagues of business (unlisted) to the major league of business (listed). This transformation from the minor league to the big league in business is 1 Actually, there are 1,066,102 companies on the Registry, of which 7,05,699 were active companies on December 31, 2011 (Annual Report of Ministry of Corporate Affair (2012)). balkrishnaparab@jbims.edu 3

4 called going public and it culminates when the company can finally sell its stock to the public; referred to as an Initial Public Offering or IPO. An initial public offering of stock can be viewed as the definitive sign of a company's success. For many growing companies, "going public" is more than just selling stock. It's a signal to the world that the business has made it. That's why undertaking an initial public offering (commonly known as an IPO) the first sale of stock to the public by an unlisted company has long been the ultimate goal for many an entrepreneurial business. An IPO can not only provide a company with access to capital to fuel growth and liquidity for founders and investors, but it provides the public market's unofficial stamp of approval. WHAT IS A PUBLIC OFFER? An IPO, or initial public offerings, are the way in which unlisted (privately held) companies issue shares of their stock to the public for listing on a stock exchange. This process or event is what's known as going public 2. An IPO is different from a private placement of shares in as much as an offer to the public signifies an offer made to the general public as distinguished from an offer made privately. In the words of Palmer (1942): An offer to the public signifies an offer made by an advertisement or circular to the general public or section thereof, as distinguished from an offer made privately, that is, to a select and small circle of friends, customers or connections 3. CA 1956 defines a public offer as: An offer shall be treated as public if the offer or invitation is calculated to result, directly or indirectly, in the shares or debentures becoming available for subscription by persons other than those receiving the offer or invitation 4. However, recognizing the fact that in today s world it is technically possible to make direct private offers to thousands of potential investors, through s, and SMS, the law prescribes that if a direct private offer is made to 50 or more entities it will lose its private character and it will be treated as a public offer. The term IPO is often also loosely used to describe other types of issues. For example, when an already listed company makes a further issue of its shares to the public it is often wrongly labeled as an IPO, when in fact the correct term is a further public offer, or FPO. In the USA, a public offer of securities by a listed company is called a seasoned equity offering, or SEO. ASSESSING READINESS TO STAGE AN IPO Many entrepreneurs view the process of going public as the epitome of financial success and reward; however the decision to go public requires considerable strategic planning and analysis from both legal and business perspectives. The planning and 2 This US usage is a little odd because many public limited companies in India are not listed. In the Indian context the term becoming listed would be more appropriate than going public. 3 Palmer (1942), Company Law Precedents, XVII Edition, Part I, Page Section 67 of the Companies Act, balkrishnaparab@jbims.edu 4

5 analysis process involves: weighing the costs and benefits; understanding the obligations of the company, its advisors and its shareholders once the company has successfully completed its public offering. Transforming an unlisted company into a listed company is an exhaustive and grueling process, requiring a massive effort in a relatively short period of time. In deciding whether to make an IPO, a corporation must determine whether it is realistically in a position to support a successful public offering. The following are some of the factors that should be considered in the decision-making process and are elements that could prove critical to the success of the offering. BUSINESS POTENTIAL While it is clear that ideal candidates for successful public offerings are companies with a consistent record of growth over several years, many development stage companies with innovative products and services (such as in the software, Internet or biotechnology sectors) have successfully raised funds based on the potential of their business and management. Thus, a company with a short financial history can attract investor interest by showing a strong momentum in sales and profits and by being able to identify anticipated growth opportunities and competitive advantages. SIZE A company must have a market value after the issue that is large enough to attract institutional investors. While public offerings may sometimes be structured for issues as small as a few millions, institutional investors and major underwriters may not show any interest in small issues. ASSETS A company must have either a solid net worth supported by tangible assets or, if technology based, solid proprietary intellectual property with strong business prospects. The quality of a corporation's patent portfolio and other intellectual property protection is critical. BUSINESS PLAN A company must think about its longer-term business goals and whether going public is the best way to finance its growth. Prospective investors, as well as securities regulators, will require that a company have a clear plan for the use of the proceeds from the issue. MARKET The going-public process is typically heavily influenced by precedent. Having a good grasp of a company s industry and market, as well as its competitive strengths and weaknesses, is critical to building a credible "case" with underwriters and potential investors. MANAGEMENT AND BOARD OF DIRECTORS A company's management must possess sufficient depth and experience to carry out a successful public offering. Prospective underwriters and investors are particularly interested in the strength of the management team. A company must therefore ensure that management is willing and able to assume the responsibilities involved in going public. In addition, changes to the board of directors and the establishment of appropriate committees of the board are very often required. Boards of directors play balkrishnaparab@jbims.edu 5

6 a significant role in both the management of public companies and in their public image. A company will often need to add to its board individuals with experience, expertise or the necessary independence. CORPORATE STRUCTURE AND GOVERNANCE A company must consider whether its existing corporate, capital, management and governance structures are appropriate for a listed corporation, as well as whether all of its corporate records and contracts are in order. INTERNAL CONTROLS A company must have internal controls, systems and procedures that are capable of supporting the demands associated with both the process of going public and the requirements to report reliable financial information to investors following the public issue. ACCOUNTING A company must determine early on whether there are any accounting issues that must be dealt with, and whether it is in a position to meet the financial disclosure requirements of a prospectus. Potential Accounting Size Internal Controls Assessing Readiness Assets Governance Business Plan Management Market ADVANTAGES OF GOING PUBLIC The going public process is an expensive consideration, and even more so for cashstrapped young companies. When a company is contemplating the process of going public, it must consider the pros and cons involved in making that decision. Additionally, there are new responsibilities involved when an unlisted company balkrishnaparab@jbims.edu 6

7 becomes a publicly-traded business. Although many benefits can ensue from going public and the related IPO services, the company must critically judge all the options and impending tasks of becoming a listed company. Unlisted companies in India choose to go public for many reasons such as raising of additional capital, enhancing the status and financial standing of the company, increasing public awareness and public interest in the company and its products. ACCESS TO CAPITAL Indian companies like companies in other jurisdictions mainly go public because of the financial benefit in the form of raising capital. An IPO is often used as a way to generate the capital needed to expand. This capital can be used to fund further growth, fund capital expenditure, or to pay off existing debt. BANKABILITY Listed companies find it much easier to obtain loans on favourable terms. Most banks offer a higher line of unsecured credit for listed companies. On the other hand, financial institutions impose more restrictive conditions on private companies, such as directors' personal guarantees, debentures and mortgages. MARKET SHARE IN PRODUCT MARKET Proceeds from an IPO can be used to swiftly gain or consolidate a strong market position. A high-growth company has only a small window of opportunity before competitors swarm in. Often it needs a large cash infusion to achieve a dominant strategic position. The IPO proceeds can be used to embark on a strong marketing campaign, open up new markets, build barriers to entry, diversify and expand research and development efforts, and deepen human resource capabilities. Many of today's giant companies, including Reliance Industries Limited, achieved their early dominant position, in part, as a result of a perfectly timed IPO. UNLOCKING SHAREHOLDER VALUE Going public is an excellent way of enabling your company s shares to be based on fair-market-value, whereby demonstrating its true value and creating a significant return on investment for its shareholders. ATTRACTING TALENT Listed companies usually attract key personnel who are experts in their field. Two reasons are often cited for this: firstly, the prestige of working for a well-funded public company by its very nature requires it to maintain a high profile. Secondly, their compensation package (including stock options and sweat equity) to key personnel is generally more attractive than that which most unlisted companies can offer. LIQUIDITY After making an IPO, the issuer company s shares are listed for trading on stock exchanges. This enables a shareholder to acquire more shares or sell the shares she is already holding. PRESTIGE, IMAGE AND VISIBILITY An IPO brings with it prestige, publicity and visibility. A public offering of shares can help a company gain prestige by creating a perception of stability. A company's founders, co-founders and managers gain an enormous amount of personal prestige balkrishnaparab@jbims.edu 7

8 from being associated with a client that goes public. Prestige can be very helpful in recruiting key employees and marketing products and services. People have a better perception of listed companies. This is particularly important in those industries, where customers' and suppliers' long-term commitments are essential to the company's success. IPOs often generate publicity by making the company's products known to a new group of potential customers. Publicly traded businesses are usually better known than private businesses. MERGERS AND ACQUISITIONS The company's share is valuable as cash and can be used in acquiring other businesses. Going public also creates a type of currency in the form of its stock. Companies can use this to make acquisitions. M&As Access to capital Loans Prestige Why IPOs? Market share Liquidity Attract talent Unlock Value CONCERNS OF GOING PUBLIC You must be wondering that when going public has so many advantages, who don t many more companies offer their shares to the public? This is because making an IPO also has significant drawbacks, some of which are discussed below: LOSS OF CONFIDENTIALITY Listed companies need to disclose a lot of information about its operations as they operate under a close scrutiny of its public shareholders and the regulating authorities. ADDED COST The cost of IPO offering as well as complying with on-going regulatory requirements can be very high. For example, IPO costs can climb to as much as 15 per cent of the balkrishnaparab@jbims.edu 8

9 offering deal. Some of the additional costs include the accounting fees, legal fees, and professional adviser fees. ADDED LIABILITY EXPOSURE There is an increased risk of exposure to civil liability for public companies, executives and directors for false or misleading statements in their prospectus. Officers may face liability for misrepresentations in reports filed with the regulatory agencies or for disclosing false information. LOSS OF CONTROL Listed companies are faced with the pressures of the market. This would likely cause them to focus more on short-term results rather than long-term growth. Furthermore, listed companies are at greater risk of takeover attempts due to its public trading of shares. REPORTING AND FIDUCIARY RESPONSIBILITIES Public companies must continuously file reports with the regulatory agencies and comply with exchange listing agreement and statutory requirements. This is not only costly but also provides information to competitors. TIME CONSUMING Converting into a listed company is also a tedious and time consuming process. Thus, business operations may be disrupted if senior management is too much caught up in the IPO process. Loss of Confidentiality Time Added Cost Concerns of IPO Reporting Responsibilities Added Liability Exposure Loss of Control balkrishnaparab@jbims.edu 9

10 IPO PROJECT MANAGEMENT TEAM An IPO involves an enormous number of details and innumerable tasks among multiple parties and organizations. Many companies find it helpful to designate a project manager usually drawn from the company s finance, legal, or business development groups to coordinate the overall IPO process. The project manager should be very familiar with the company, have ready access to the company s management and legal and accounting advisors, possess the internal authority and stature to make administrative decisions and prod others to act as needed, and be able to devote a substantial majority of his or her business time to the job. In the absence of a designated project manager, the company s CFO or general counsel often end up adding this role to their many other job responsibilities. THE LAW OF IPOS Principally, the law of IPOs is contained in CA, 1956 and in the SEBI (ICDR) Regulations, COMPANIES ACT, 1956 CA, 1956 provides the basic framework of governance of companies. It contains provisions relating to raising capital etc. SECURITIES CONTRACT REGULATIONS ACT (SCRA), 1956 The SCRA and the rules made thereunder provide for the requirements which have to be satisfied by companies for the purpose of getting their securities listed on any stock exchange in India. SEBI (ICDR) REGULATIONS, 2009 The regulations pertaining to disclosures and investor protection were first issued by the Securities and Exchange Board of India (SEBI) in 1992 in the form of guidelines. In the year 2000, these guidelines were completely overhauled and reissued as the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, These guidelines were repealed in August 2009 and were replaced by the SEBI (Issue of Capital and Disclosure Requirements) Regulations, The ICDR Regulations attempts to streamline the framework for public issues by removing unnecessary stipulations, introducing market-driven procedures and simplifying the clutter of legality. The Regulations cover many more areas than initial public offerings of equity shares. Apart from IPOs, it contains guidelines for further public offers (FPOs), rights issues, issue of bonus shares, and issue of Indian Depository Receipts (IDRs). 5 In this essay these regulations are referred to as Regulations. balkrishnaparab@jbims.edu 10

11 GENERAL CONDITIONS OF MAKING AN IPO The general conditions for making an IPO as stipulated by the Regulations include the following: Company Not Debarred Making Pre- Issue Shares Fully Paid General Conditions Listing Application Agreement with Depositories Firm Arrangement for 75% of Finance DEBARMENT FROM ACCESSING CAPITAL MARKETS The company desirous of making an IPO, or any of its promoters, promoter group or directors or persons in control of the company should not have been debarred from accessing the capital market by the SEBI 6. Further, a company cannot make an IPO if any of its promoters, directors or persons in control of the company was, or also is, a promoter, director or person in control of any other company which is debarred from accessing the capital market under any order or directions made by the SEBI 7. LISTING APPLICATION Listing means admission of securities of an issuer to trading privileges (dealings) on a stock exchange through a formal agreement. The prime objective of admission to dealings on the exchange is to provide liquidity and marketability to securities, as also to provide a mechanism for effective control and supervision of trading. An unlisted company desirous of making an IPO is required to make an application for listing of its securities on one or more stock exchanges, one of which must be a stock exchange having nationwide trading terminals 8. If the listing application is made 6 Regulation 4 (2) (a) of the SEBI (ICDR) Regulations, Regulation 4 (2) (b) of the SEBI (ICDR) Regulations, Regulation 4 (2) (d) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 11

12 to more than one stock exchange, the company should select one of the stock exchanges as the designated stock exchange. AGREEMENT WITH DEPOSITORIES A depository is an organization where the securities of an investor are held in an electronic form. Electronically-held securities are also called as dematerialized securities. The depository holds the electronic custody of securities and also arranges for the transfer of ownership of securities on settlement dates. Depositories are regulated by SEBI under the Securities and Exchange Board of India (Depositories and Participants) Regulations, Holding shares in an electronic form in a depository has many advantages over the earlier system where paper share certificates were used. Some of the advantages are as follows: Elimination of risks inherent in the transit of securities from one place of another. These risks involved loss in transit, theft, mutilation of securities etc. The transfer from one beneficial owner to another person is effected through the electronic medium. Thus, transfer of securities is fast, and frictionless. The company can save substantial amount which it is normally required to spend by way of printing certificates, postage expenses and reduction of legal complications. Improved liquidity due to increased transfer of shares. In view of the electronic book entry and national clearance system the stock exchange transactions become truly national and speedier. Every company making an IPO for a sum of Rs. 10 crores or more should necessarily issue the shares in dematerialized form 9. The Regulations require the issuer-company to enter into an agreement with a depository for dematerialization of securities already issued or proposed to be issued 10. In an IPO, the work of interacting with depositories is done by the registrar to the issue on behalf of the issuer company. Therefore, the registrar to the issue also has to be made a part of the agreement. Such an agreement is called as a tripartite agreement, the three parties being the issuer-company, registrar to the issue, and the depository 11. In India, we have two depositories: (i) National Securities Depository Limited (NSDL); and (ii) the Central Depository Services (India) Limited (CDSL). Therefore, the issuer-company has to enter into an agreement with both the depositories. MAKING SHARES FULLY PAID UP Partly paid shares are ones on which the full nominal or par value has not been paid. Partly paid shares are issued by some companies to inspire confidence; because they could always call on their shareholders for further funds if necessary. The holders of partly paid-up shares are liable for the unpaid amount whenever the company makes a call. Non-payment of the call will make the partly paid-up equity shares liable to forfeiture; and the amount paid may be confiscated, in terms of the articles of association of the company. Although, partly paid shares can be traded on the stock exchange, it creates a lot of complications. Therefore, the Regulations require that if 9 Section 68B of the Companies Act, Regulation 4 (2) (e) of the SEBI (ICDR) Regulations, Regulation 29 (2) of the SEBI (Depositories and Participants) Regulations, balkrishnaparab@jbims.edu 12

13 the issuer-company has any partly paid equity shares in its capital structure it should get these equity shares fully paid up, or forfeited 12. FIRM ARRANGEMENT FOR FINANCING An issuer-company can make an IPO only if it has made firm arrangements of finance through verifiable means towards seventy five per cent of the stated means of finance, excluding the amount to be raised through the proposed public issue. Alternatively, it should have made arrangements for finance through existing identifiable internal accruals 13. PRIMARY ELIGIBILITY CONDITIONS In the past a large number of fly-by-night operators were able to make an IPO, collect the proceeds and disappear without any trace. This resulted in huge losses to investors and also dented the confidence of retail investors. The primary eligibility conditions are designed to ensure that the company has a track record of a number of years running of business in a profitable manner. An unlisted company becomes eligible to make an initial public offering (IPO) of equity shares, only if it meets all of the specified conditions. These conditions are required to be fulfilled as on the date of filing draft offer document with SEBI and also as on the date of registering the offer document with the Registrar of Companies 14. NET TANGIBLE ASSETS The company should have net tangible assets of at least Rs. three crores in each of the preceding three full years (of twelve months each), of which not more than half of the net tangible assets is held in monetary assets 15. However, if more than fifty per cent of the net tangible assets are held in monetary assets, the issuer should make firm commitments to utilize such excess monetary assets in its business or project 16. Net tangible assets mean the sum of all net assets of the issuer, excluding intangible assets as defined in Accounting Standard AS 26 defines an intangible asset as: an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes 18. Monetary assets may be understood as: money held and assets to be received in fixed or determinable amounts of money 19. DISTRIBUTABLE PROFITS Distributable profits are the profits available for the distribution among the shareholders of a company as dividend. Divisible profits are calculated by reducing 12 Regulation 4 (2) (f) of the SEBI (ICDR) Regulations, Regulation 4 (2) (g) of the SEBI (ICDR) Regulations, Regulation 25 of the SEBI (ICDR) Regulations, Regulation 26 (1) (a) of the SEBI (ICDR) Regulations, Proviso to Regulation 26 (1) (a) of the SEBI (ICDR) Regulations, Explanation (I) to Regulation 26 of the SEBI (ICDR) Regulations, Paragraph 6 of the Accounting Standard (AS) 26, 'Intangible Assets'. 19 Paragraph 6 of the Accounting Standard (AS) 26, 'Intangible Assets'. balkrishnaparab@jbims.edu 13

14 the net profit as per profit and loss account by providing depreciation as per CA 1956 and after setting off any loss for the previous year(s) or the amount of depreciation for the previous year(s), whichever is less. The Regulations require that the issuer-company should have a track record of distributable profits for at least three out of immediately preceding five years. In case of an issuer which had been a partnership firm, the track record of distributable profits of the partnership firm shall be considered only if the financial statements of the partnership business for the period during which the issuer was a partnership firm, conform to and are revised in the format prescribed for companies under the Companies Act, 1956 and also comply with the following: Adequate disclosures are made in the financial statements as required to be made by the issuer as per Schedule VI of the Companies Act, 1956; The financial statements are duly certified by a Chartered Accountant stating that: (i) the accounts and the disclosures made are in accordance with the provisions of Schedule VI of the Companies Act, 1956; (ii) the accounting standards of the Institute of Chartered Accountants of India have been followed; and (iii) the financial statements present a true and fair view of the firm s accounts 20. NET WORTH The company should have a net worth of at least Rs. one crore in each of the preceding three full years (of twelve months each) 21. Net worth means: the aggregate of the paid up share capital, share premium account, and reserves and surplus (excluding revaluation reserve) as reduced by the aggregate of miscellaneous expenditure (to the extent not adjusted or written off) and the debit balance of the profit and loss account 22. CHANGE OF COMPANY NAME In case the company has changed its name within the last one year, at least 50 per cent of the revenue for the preceding one full year should have been earned by the company from the activity suggested by the new name 23. MAXIMUM SIZE OF THE ISSUE The aggregate of the proposed issue and all previous issues made in the same financial year in terms of size should not exceed five times its pre-issue net worth as per the audited balance sheet of the last financial year Explanation (III) to Regulation 26 of the SEBI (ICDR) Regulations, Regulation 26 (1) (c) of the SEBI (ICDR) Regulations, Regulation 2 (1) (v) of the SEBI (ICDR) Regulations, Regulation 26 (1) (d) of the SEBI (ICDR) Regulations, Regulation 26 (1) (e) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 14

15 Net Tangible Assets Issue Size Primary Conditions Distributable Profits Change of Name Net Worth SECONDARY ELIGIBILITY CONDITIONS The secondary requirements are invoked only if the issuer-company is not able to satisfy the primary conditions. SEBI has prescribed the secondary requirements for unlisted companies who are unable to satisfy one or more of the primary requirements of eligibility to make an IPO. We should remember that the secondary requirements come into play only if the unlisted company fails to comply with the primary requirements 25. The Regulations specify two secondary requirements, both of which must be satisfied by the unlisted company to become eligible to make an IPO. Both these secondary requirements have internal options. INSTITUTIONAL INVESTMENT CONDITION The fact the issuer-company is unable to satisfy the primary requirements, makes it clear that either the company does not have a track record of profitability, or has recently changed its name and its revenue don t justify the change, or the company wishes to make an IPO that is more than five times its pre-issue paid up capital. In such circumstances the company can be allowed to make an IPO only if some sophisticated investors like the Qualified Institutional Buyers (QIBs) invest in it to a substantial extent. Alternatively, the project should be appraised by a public financial institutions and the appraiser and other financial institutions make substantial investment in the equity shares of the company. Any one of the following requirements must be satisfied by the issuer: 25 Regulation 26 (2) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 15

16 The issue is made through the book-building process, with at least half of net offer to public being allotted to the Qualified Institutional Buyers (QIBs), failing which the full subscription monies shall be refunded 26 ; or The project 27 has at least 15 per cent participation by financial institutions or scheduled commercial banks, of which at least 10 per cent comes from the appraiser(s). In addition to this, at least 10 per cent of the issue size shall be allotted to QIBs, failing which the full subscription monies shall be refunded 28. Secondary Conditions Institutional Investment Route Liquidity QIB Route Project Appraisal Route Minimum Post- Issue Capital Arrangement with Market Makers LIQUIDITY CONDITION One problem with allowed company with an unproven track record to make an IPO is that its shares would not have enough liquidity, leading to hardship to investors. The second secondary condition is designed especially to address this problem. Any one of the following requirements must be satisfied by the issuer: The unlisted company should ensure that the minimum post-issue face value capital of the company is Rs. 10 crores 29 ; or The unlisted company should make arrangements for compulsory marketmaking for at least two years from the date of listing of the shares. The market making condition is subject to the following conditions: 26 Regulation 26 (2) (a) (i) of the SEBI (ICDR) Regulations, The term project has been defined to mean the object for which the monies proposed to be raised to cover the objects of the issue in Explanation (II) to Regulation 26 of the SEBI (ICDR) Regulations, Regulation 26 (2) (a) (ii) of the SEBI (ICDR) Regulations, Regulation 26 (2) (b) (i) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 16

17 The market makers should undertake to offer buy and sell quotes for a minimum depth of 300 shares; The market makers undertake to ensure that the bid-ask spread for their quotes shall not at any time exceed 10 per cent; and The inventory of the market makers on each of such stock exchanges, as on the date of allotment of securities, shall be at least 5 per cent of the proposed issue of the company 30. A market maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular company in order to facilitate trading in that share. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from her own inventory or seeks an offsetting order. A market maker is different from a regular broker in as much as a broker is an intermediary who has a license to buy and sell securities on a client's behalf. Stockbrokers coordinate contracts between buyers and sellers, usually for a commission. A market maker, on the other hand, is an intermediary that is willing and ready to buy and sell securities for a profitable price. OTHER REQUIREMENTS OF AN IPO These requirements are required to be satisfied by all issuer-companies, irrespective of whether they satisfy the primary and secondary requirements or not. OUTSTANDING WARRANTS An unlisted company desirous of making an IPO is required to extinguish all warrants (outstanding financial instruments) or any other right which would entitle the existing promoters or shareholders any option to receive equity share capital after the initial public offering 31. However, this regulation is not applicable in the following cases: A public issue made during the currency of convertible debt instruments which were issued through an earlier initial public offer, if the conversion price of such convertible debt instruments was determined and disclosed in the prospectus of the earlier issue of convertible debt instruments; Outstanding options granted to employees pursuant to an employee stock option scheme framed in accordance with the relevant Guidance Note or Accounting Standard, if any. 32. MINIMUM NUMBER OF ALLOTEES The issuer company cannot allot shares in case the number of prospective allottees is less than one thousand 33. This requirement is designed to ensure there are enough number of shareholders so that liquidity is not hampered. 30 Regulation 26 (2) (b) (ii) of the SEBI (ICDR) Regulations, Regulation 26 (5) of the SEBI (ICDR) Regulations, Proviso to Regulation 26 (5) of the SEBI (ICDR) Regulations, Regulation 26 (4) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 17

18 APPOINTMENT OF ISSUE MANAGERS An IPO involves tremendous amount of work and risk. As such the Regulations mandate the appointment of various issue managers or intermediaries. The various intermediaries that are appointed to manage the issue normally include: (a) Merchant bankers; (b) Underwriters; (c) Registrars; (d) Brokers; (e) Bankers to the issue; (f) Lawyers and Solicitors. Merchant Bankers Underwriters Registrar & Transfer Agents Issue Managers Lawyers Brokers Bankers MERCHANT BANKERS Merchant bankers, or investment bankers as they are called in the USA, are at the heart of an IPO. They provide advice, market the securities (after investigating the market s receptiveness to the issue), rope in various intermediaries, and underwrite the proceeds. Merchant banks are regulated by the SEBI under the Securities and Exchange Board of India (Merchant Bankers) Regulations, Merchant bankers are defined as: Any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities or acting as manager, consultant, adviser or rendering corporate advisory services in relation to such issue management. 34 In addition, merchant bankers have the responsibility of pricing fairly. When a company goes public the investors know relatively little about the company s operations. After all, it is unfair to expect a small investor to read the voluminous prospectus. Instead, the investor relies on the judgment of the merchant banker. But, 34 Regulation 2(cb) of the SEBI under the SEBI (Merchant Bankers) Regulations, balkrishnaparab@jbims.edu 18

19 would the merchant banker not abuse his position and set artificially high price? The answer is no, because the merchant bankers have a reservoir of reputational capital. Mispricing of IPOs is likely to reduce this reputational capital. The Regulations make it mandatory for the issuer company to appoint one or more merchant bankers; if more than one merchant banker is appointed to manage the issue, the issuer-company should designate one of them as lead manager 35. Further, in case the issue is managed by more than one merchant banker, the rights, obligations and responsibilities of each merchant banker (also called inter-se allocation of responsibilities) is required to be predetermined and disclosed in the offer document 36. The contract between the lead merchant banker and the issuer should be in the prescribed pro forma 37. The merchant banker plays a pivotal role in the IPO Process. The following is a broad sampling of the duties of a merchant banker: ROLE IN PRE-ISSUE ACTIVITIES Drawing up a marketing strategy for the issue Due diligence of company's operations, including management, business plans, and legal due diligence Drafting and design of offer documents, prospectus, statutory advertisements and memorandum containing salient features of the prospectus (abridged prospectus) Compliance with stipulated requirements and completion of prescribed formalities with the Stock Exchanges, Registrar of Companies (RoC) and SEBI Appointment of other intermediaries namely, underwriters, registrar(s), printers, advertising agencies and bankers to the offer The lead manager coordinates with the Registrar to ensure follow up so that that the flow of applications from collecting bank branches, processing of the applications and other matters till the basis of allotment is finalized. ROLE IN POST-ISSUE ACTIVITIES Manage escrow accounts. Escrow accounts where application money is deposited. The company can use this money only on allotment of shares. Coordinate non-institutional allocation Coordinate with the Registrar to ensure dispatch of security certificates and refund orders completed and securities listed. ROLE IN APPOINTMENT OF ISSUE MANAGERS The issuer-company is required to appoint other intermediaries in consultation with the lead merchant banker 38. Some of these intermediaries that are required to be appointed include: (i) syndicate members (in case of a book-built issue); (ii) bankers 35 Regulation 5 (1) of the SEBI (ICDR) Regulations, Regulation 5 (3) of the SEBI (ICDR) Regulations, Regulation 5 (5) of the SEBI (ICDR) Regulations, 2009 and Schedule II of the Regulations. 38 Regulation 5 (1) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 19

20 to the issue (in case of a non-book-built issue) 39 ; registrar to the issue having connectivity with all the depositories 40. Before advising the issuer on the appointment of other intermediaries, the lead merchant banker is required to: Verify that the intermediaries are registered with SEBI 41 Independently assess the capability and the capacity of the various intermediaries to carry out the assignment 42. Ensure that the issuer company enters into an agreement with the concerned intermediary in the prescribed pro forma 43. REGISTRAR TO THE ISSUE The registrars (sometimes called registrars and transfer agents, or RTAs) are independent financial institutions registered with SEBI. They are appointed by the issuer-company in consultations with the lead managers. The responsibilities of a registrar in an IPO include the following: Coordinating with the lead manager to ensure that the flow of applications from collecting bank branches Processing IPO applications Finalizes the list of eligible allottees Allocating shares to applicants based on the Regulations Processing refunds through ECS or cheque Transferring allocated shares to Demat accounts of investors Dispatch of refund orders BROKERS Companies making public issues appoint brokers to procure subscription. The managers to the issue distribute prospectuses and application forms to the brokers. These brokers form a very important link in the distribution value chain of financial products. BANKERS TO THE ISSUE Bankers to the issue play an important role in IPOs. They accept application form and money from the investors, maintain records of the applications received, and interact with the registrar in giving refunds to investors who could not be allotted all the shares they applied for. Bankers to the issue mean a scheduled bank carrying on all or any of the following activities, namely: Acceptance of application and application monies; Acceptance of allotment or call monies; Refund of application monies; Payment of dividend or interest warrants Regulation 5 (6) of the SEBI (ICDR) Regulations, Regulation 5 (7) of the SEBI (ICDR) Regulations, Regulation 5 (2) of the SEBI (ICDR) Regulations, Regulation 5 (4) of the SEBI (ICDR) Regulations, Regulation 5 (5) of the SEBI (ICDR) Regulations, Regulation 2 (aa) of the SEBI (Bankers to the Issue) Regulations, balkrishnaparab@jbims.edu 20

21 Bankers to the issue must be registered with the SEBI and are regulated under the Securities and Exchange Board of India (Bankers to the Issue) Regulations, In the context of an IPO, every banker to an issue is required to maintain the following records with respect to following matters and intimate to the SEBI the place where the records and documents are kept 45. The number of applications received, the names of the investors, the dates on which the applications were received and the amount so received from the investors; The time within which the applications received from the investors were forwarded to the body corporate or registrar to an issue, as the case may be; Dates and amount of refund monies paid to the investors 46. LAWYERS The company and the merchant bankers are represented by legal counsel. Internally, company counsel reviews the company's documents, records, and business to identify potential legal problems and make required disclosures in the prospectus. UNDERWRITERS The term underwriter derives from the Lloyd's of London insurance market in the United Kingdom. Financial bankers, who would accept some of the risk on a given venture (historically a sea voyage with associated risks of shipwreck) in exchange for a premium, would literally write their names under the risk information which was written on a Lloyd's slip created for this purpose. When a company makes an IPO, it has to receive applications for a minimum number of shares. The CA, 1956 requires that this minimum subscription be decided by the board of directors of the issuer-company. However, under the Regulations, the minimum subscription is 90 per cent of the issue. If an issuer-company receives applications lower than the amount of minimum subscription it has to return all the application money and declare the IPO as a failure. Companies enter into a contract with underwriters to ensure that they do avoid this risk. In the context of an IPO, underwriters promise the issuer-company that in case it receives applications lower than the minimum subscription, it would take up the shares as many shares as is required to meet the minimum subscription. Sometimes, a number of underwriters collectively stand behind the issue; they are called a syndicate or a consortium. The underwriters are remunerated by getting a commission; the commission can be at most 2.50 per cent of the amount underwritten by them. IPO GRADING IPO grades are given by credit rating agencies, which are registered with SEBI. The grade represents a relative assessment of the fundamentals of that issue in relation to the other listed equity securities. An unlisted company desirous of making an IPO is required to obtain a grade for its IPO from at least one credit rating agency. The expenses involved in such grading 45 Regulation 12 (2) of the SEBI (Bankers to the Issue) Regulations, Regulation 12 (1) of the SEBI (Bankers to the Issue) Regulations, balkrishnaparab@jbims.edu 21

22 should be borne by the issuer company. Further, the company is required to make disclosures in the offer document of all the grades obtained, along with the rationale and description furnished by the credit rating agency for each of the grades obtained. These conditions must be satisfied by the unlisted company as on the date of filing of prospectus with the ROC 47. The steps involved in grading IPOs is shown below: Issuer applies for grading Grading team analyses information Internal committee previews analysis Formal notification of IPO grade Issuer provides information Grading team interacts with issuer company officials Grading committee assigns grade IPO grades are assigned on a five-point point scale with a higher score indicating stronger fundamentals and vice versa as below: IPO Grade Indication 1 Poor fundamentals 2 Below-average fundamentals 3 Average fundamentals 4 Above-average fundamentals 5 Strong fundamentals 47 Regulation 26 (7) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 22

23 IPO grading has been introduced as an endeavour to provide additional information to investors in order to facilitate their assessment of equity issues offered through an IPO. The lpo grading process is expected to take into account the prospects of the industry in which the company operates, the competitive strengths of the company that would allow it to address the risks inherent in the business and capitalize on the opportunities available, as well as the company's financial position. IPO grade does not take into account the price at which the equity shares are offered in the IPO; the investor needs to make an independent judgment regarding the price at which to bid or subscribe to the shares offered through the IPO. PRICING OF THE ISSUE The price of a financial asset traded on the market is set by the forces of supply and demand. Newly issued stocks are no exception to this rule they sell for whatever price a person is willing to pay for them. The IPO price for the stock offering is determined based on perceptions in the marketplace. Normally, a company with a good track record in terms of finance and operations such as having a strong customer base, a strong management team, quality assets, as well as being involved in the right business will be able to price its IPO shares higher. Merchant bankers establish an initial price range by looking at similar companies in the public marketplace. Deciding the correct price at which equity shares will be offered to the investors is one of the most difficult aspects of an IPO. If the issue price is priced too high, it may be unsuccessful and be withdrawn. If the issue is priced below the proper price the issuer s existing shareholders will experience an opportunity loss. FREEDOM TO DETERMINE PRICE In the days before the advent of SEBI there were severe restrictions on the premium that a company would charge on the face value when the shares were offered to the public. The Regulations provide that an unlisted company eligible to make a public issue and desirous of getting its securities listed on a recognized stock exchange pursuant to a public issue, may freely price its equity shares or any securities convertible at a later date into equity shares 48. The Regulations give ample freedom to unlisted companies to charge as much premium as they wish. The logic for such freedom is that the investing public is smart enough to judge whether the premium is reasonable or otherwise. If the investors feel that the premium is unreasonably high, they would simply not apply for the shares and the issued would be a failure. DISCLOSURE OF PRICE The issuer may mention a price or price band in the draft prospectus (in case of a fixed price issue) and floor price or price band in the red herring prospectus (in case of a book built issue) and determine the price at a later date before registering the 48 Regulation 28 of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 23

24 prospectus with the Registrar of Companies. However, the prospectus registered with the Registrar of Companies shall contain only one price 49. If the floor price or price band is not mentioned in the red herring prospectus, the issuer shall announce the floor price or price band at least two working days before the opening of the bid in all the newspapers in which the pre issue advertisement was released 50. The announcement should contain relevant financial ratios computed for both upper and lower end of the price band and also a statement drawing attention of the investors to the section titled basis of issue price in the prospectus 51. The cap on the price band shall be less than or equal to one hundred and 20 per cent of the floor price 52. The floor price or the final price shall not be less than the face value of the specified securities 53. DIFFERENTIAL PRICING An issuer may offer specified securities at different prices, subject to the following: Retail Individual Investors Retail individual investors may be offered shares at a price lower than the price at which net offer is made to other categories of applicants. However, the difference shall not be more than ten per cent of the price at which specified securities are offered to other categories of applicants. A retail individual investor is an investor who applies or bids for equity shares for a value of not more than two lakhs rupees 54. Anchor Investors As the name suggests, an anchor investor or investors are the initial investors in any round of raising capital. Anchor investors provide subsequent investors a degree of confidence. Until you have the first investor, nobody wants to be the first one to take a bite. Once you have the first investors, others feel assurance that others are willing to invest. Companies making an IPO, thus, would persuade someone to become the anchor investor. The Regulations have for the first time recognized the concept of anchor investors in India. In the words of C. B. Bhave, Chairman of SEBI: "This provision has been made in response to requests from issuers that if some investor is ready to come in with prior commitment, it will enhance their ability to sell the issue and generate more confidence in the minds of retail investors. 55 " Thus, the anchor investor is a bridge between the company and the public in the run up to an Initial Public Offer (IPO). The IPO of Adani Power was the first in India to use anchor investors. Adani Power roped in six anchors to raise about Rs 500 crore 56. In case of a book built issue, the price of the specified securities offered to an anchor investor should not be lower than the price offered to other applicants. Anchor 49 Regulation 30 (1) of the SEBI (ICDR) Regulations, Regulation 30 (2) of the SEBI (ICDR) Regulations, Regulation 30 (3) of the SEBI (ICDR) Regulations, Regulation 30 (4) of the SEBI (ICDR) Regulations, Regulation 30 (5) of the SEBI (ICDR) Regulations, Regulation 2 (1) (ze) of the SEBI (ICDR) Regulations, Mampatta, Sachin P. (2009), "Sebi ushers in the 'anchor investor'", DNA, June 19, The six anchor investors were T Rowe Price, AIC, Ecofin, TPG (through CLSA), Legg Mason and Sundaram MF. balkrishnaparab@jbims.edu 24

25 investors are qualified institutional buyers making an application for a value of rupees ten crore or more in a public issue made through the book building process 57. OFFER DOCUMENT OR PROSPECTUS An offer document, or a prospectus, means any document described or issued as prospectus and includes any notice, circular, advertisement or other document inviting public for the subscription or purchase of any shares in or debentures of a body corporate 58. The prevailing thinking amongst capital market regulators around the world is that the issuer companies should be made to disclose a large amount of information so as to enable an investor to reach an intelligent decision of whether, or not, to invest in the securities being issued as a part of the IPO. The Regulations define an offer document as follows: Offer document means a red herring prospectus, prospectus or shelf prospectus and information memorandum in terms of section 60A of the Companies Act, 1956 in case of a public issue and letter of offer in case of a rights issue 59. The above definition lists different documents that are considered as an offer document by the Regulations. RED HERRING PROSPECTUS A red herring prospectus is defines as: a prospectus which does not complete particulars on the price of the securities offered and the quantum of securities offered 60. The red herring prospectus does not contain details of either price or number of shares being offered or the amount of issue. In case the book building mechanism is adopted for making an IPO, the price at which shares are offered is determined on the basis of bids tendered by the investors. Hence, such details are not shown in the red herring prospectus. In case the price is not disclosed, the number of shares and the floor price is disclosed. On the other hand, an issuer can state the issue size and the number of shares are determined later. On completion of the bidding process the details of the final price is included in the offer document. This offer document filed with the ROC is called a prospectus. It is unfortunate that the Regulations have used this term to refer to a document which in the West is called a preliminary or a pathfinder prospectus. Literally, a red herring is a fish, which, if dragged across a trail that hounds are following, it throws them off the scent. Thus, the term has come to mean something intended to divert attention from the real problem or matter at hand; a misleading clue. 57 Regulation 2 (1) (c) of the SEBI (ICDR) Regulations, Section 2(36) of the Companies Act, Regulation 2(1)(x) of the SEBI (ICDR) Regulations, Explanation to subsections (2), (3), and (4) of Section 60B of the Companies Act, balkrishnaparab@jbims.edu 25

26 SHELF PROSPECTUS Shelf prospectus means a prospectus issued by a financial institution or a bank for one or more issues of the securities or class of securities specified in that prospectus 61. Financial institutions, due to the nature of their business, needs to access the capital markets more frequently compared to other companies, sometimes many times during a single year. It would be cumbersome if these institutions have to draft, file, and issue a separate prospectus every time they access the capital markets. As a relaxation of the regulatory norms, the law allows public financial institutions, public sector banks, or scheduled banks whose main object is financing to file a shelf prospectus 62 and make as many public offers of securities within a period of 365 days from its filing. However, the company has to file updates on material facts, litigation and changes in financial position between the previous offering and the next one. These updates, called as shelf information memorandum 63, are required to be issued to the public along with shelf prospectus filed at the stage of the first offer of securities. INFORMATION MEMORANDUM A company often tries to ascertain the sense of the market before taking the plunge in making an IPO. In fact, the company may also collect advance subscription from investors in anticipation of making an IPO. The law allows a company to do so by circulating an information memorandum to the public before filing of a prospectus 64. This information memorandum should not be confused with the shelf information memorandum! A company inviting subscription by an information memorandum is required to file a prospectus prior to the opening of the subscription lists and the offer as a red-herring prospectus, at least three days before the opening of the offer. It is expected that the information memorandum would then be filed as it is as a red herring prospectus. However, if there are variations between the information memorandum and the red herring prospectus, then the company is required to individually intimate everybody to whom an invitation was made using the information memorandum. The persons from whom the issuer had received offers on the basis of circulation of the information memorandum will have the right to withdraw their offers within seven days of them being intimated about variations between the information memorandum and the red herring prospectus 65. ABRIDGED PROSPECTUS Earlier, every application form for shares in a public offer was accompanied by a prospectus. However, considering the size of prospectus and the heavy costs of printing it, it has become extremely expensive to do so. The law now requires that every application form should be accompanied by an abridged prospectus 66. An abridged prospectus means one containing memorandum containing such salient features of a prospectus as may be prescribed Explanation (b) to Section 60A of the Companies Act, Section 60A (1) of the Companies Act, Section 60A (3) of the Companies Act, Section 60B (1) of the Companies Act, Section 60B of the Companies Act, Section 56 (3) of the Companies Act, Section 2 (1) of the Companies Act, balkrishnaparab@jbims.edu 26

27 Red Herring Prospectus Prospectus Shelf Prospectus Abridged Prospectus CONTENTS OF THE OFFER DOCUMENT The rules regarding the contents of a prospectus are contained in Schedule II of the CA In addition to this requirement, the Regulations require that the issuer company also include certain other disclosures in the offer document. Schedule VIII of the Regulations prescribe the contents of the offer document. The provisions in the Regulations are in so much detail that it specifies the thickness of the cover page and the font size! Every prospectus must be dated. The date mentioned in the prospectus is taken as a prima facie evidence of the date of its publication 68. Before publication of any prospectus, it must be registered with the ROC. For registration, the prospectus must be signed by every person who is named as a director or as a proposed director of the company. The registration is valid of 90 days 69. FILING The Companies Act, 1956 (CA 1956) requires the issuer company to file a prospectus with the Registrar of Companies (ROC) before issuing it to the public 70. The Regulations goes beyond this stipulation: it requires that the issuer-company file a draft (offer document) with the SEBI at least thirty days prior to the filing of the prospectus with the ROC 71. The rationale of the above provision is that SEBI would vet the draft prospectus. If within this thirty day period before the issue of the prospectus, SEBI specifies changes or issues observations on the draft prospectus, the issuer company or the lead merchant banker to the issue is required to carry out such changes, or comply with the observations, before filing the prospectus with ROC Section 56 of the Companies Act, Section 60 of the Companies Act, Section 60 of the Companies Act, Regulation 6 (1) of the SEBI (ICDR) Regulations, Regulation 6 (3) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 27

28 The lead merchant banker is also required to file a copy of the draft offer document with the recognized stock exchange(s) where the equity shares are proposed to be listed 73. At the time of filing draft offer document with the recognized stock exchanges, the issuer-company is required to submit the Permanent Account Number, bank account number and passport number of its promoters to such stock exchanges 74. The draft offer document filed with SEBI is required to be made public, for comments, if any, for a period of at least twenty one days from the date of such filing, by hosting it on the websites of SEBI, recognized stock exchanges where specified securities are proposed to be listed, and merchant bankers associated with the issue 75. This 21 day period beginning from the day of filing the draft prospectus is filed with the SEBI is called as the quiet period. During this period the company is prohibited from distributing any information about the company not included in the prospectus. After expiry of the period given for receiving comments from the public, the lead merchant bankers are required to file with SEBI a statement giving information of the comments received by them or the issuer on the draft offer document during that period and the consequential changes, if any, to be made in the draft offer document 76. The draft prospectus is required to be filed through the lead merchant banker. The following documents are required to be submitted along with the draft offer document 77 : A copy of the agreement entered into between the issuer and the lead merchant bankers; A copy of inter-se allocation of responsibilities of each merchant banker, in case the issue is managed by more than one merchant banker; A due diligence certificate 78 ; A compliance certificate 79. ROAD SHOWS As indicated earlier, the prospectus is the primary tool for selling the IPO before potential investors. We also have to restrict our communications until such time as the registration is final. So the dilemma is how do we reach potential investors with a preliminary prospectus (red herring), but at the same time remain quiet about promoting the company. The answer resides in something called the road show. The road show is a series of face-to-face presentations to potential investors. Since the final registration is only weeks away from approval, the road show is very intense, compressed into a short few weeks before the company goes public. The road show must create a positive image of the company before large investors. The management team needs to be well prepared to answer questions about the company, industry and the competition. They need to focus on things like historic 73 Regulation 6 (5) of the SEBI (ICDR) Regulations, Regulation 8 (3) of the SEBI (ICDR) Regulations, Regulation 9 (1) of the SEBI (ICDR) Regulations, Regulation 9 (2) of the SEBI (ICDR) Regulations, Regulation 8 (1) of the SEBI (ICDR) Regulations, As prescribed in Form A of Schedule 6 of the Regulations. 79 As prescribed in Form D of Schedule VII of the Regulations. balkrishnaparab@jbims.edu 28

29 earnings growth, revenue growth, R&D expenditures, per cent gain in market share, growth in return on equity, growth in assets, and financial condition. IN-PRINCIPLE APPROVAL OF THE STOCK EXCHANGES The issuer must obtain in-principle approval from all the recognized stock exchanges in which the issuer proposes to get its specified securities listed 80. The rationale for this regulation is that the Companies Act, 1956 (CA 1956) requires the issuer company to refund the application money received from investors if it fails to obtain permission from the stock exchange for listing of its shares within ten weeks of the date of closing of the subscription list 81. Further, the Supreme Court has held that when a listing application is made to more than one stock exchange, and even one of them denies permission for listing of shares, the company has to refund the application money 82. Obtaining in-principle approval of the stock exchange at an early stage would minimize the risk involved in this regard. ESCROW ACCOUNT The application money paid by the investors does not belong to the issuer-company until the shares are allotted. As such, it would be improper for the issuer-company to use this money. The Regulations requires that the application money received by the issuer-company be deposited in a separate bank account, called escrow account 83. The escrow account should be with the bankers to the issue 84. The rationale for this requirement is that application money does not form part of the assets of the company 85. The money in the escrow account can only be used for specified purposes such as: Adjustment against allotment of shares, where the stock exchange(s) have accepted the listing application of the company; and Refund of application money, where the stock exchange(s) have not accepted the listing application of the company; or the company is required to refund the application for whatever reason 86. The company can be restrained if its directors proceed to use the application for any unspecified purpose 87. APPLICATION SUPPORTED BY BLOCKED AMOUNT Till recently, when an investor applied for shares in an IPO she had to pay money to the issuer-company. The issuer-company would deposit this money in an escrow account till the allotment was made. The investor would get refund from the issuercompany to the extent that the shares were not allotted to her. In any case, the 80 Regulation 7 of the SEBI (ICDR) Regulations, Section 73 (IA) of the Companies Act, Rishyashringa Jewellery Limited v. Stock Exchange, Bombay, (1996) 85 Com Cases 479: AIR 1996 SC Section 73 (3) of the Companies Act, Rich Paints Ltd. v. Vadodra Stock Exchange Limited (1998). 85 Re, Nanwa Gold Mines Limited (1955). 86 Section 73 (3A) of the Companies Act, Deccan Farms & Distilleries Ltd. v. Velabhai Laxmidas Bhanji (1979). balkrishnaparab@jbims.edu 29

30 investors would lose interest on the application money remitted to the issuercompany. SEBI has found a way to prevent the money from leaving the investor s account till the shares are allotted to her. This mechanism is known as ASBA, and was introduced by SEBI from January 1, 2010 for all investors other than Qualified Institutional Buyers (QIBs). ASBA (Application Supported by Blocked Amount) is an application containing an authorization to block the application money in the bank account, for subscribing to an issue. If an investor is applying through ASBA, her bank account is debited only if her application is selected for allotment after the basis of allotment is finalized, or the issue is withdrawn. ASBA is not mandatory; an investor, who is eligible for ASBA, has the option of making application through ASBA or through the existing facility of applying with cheque. However, the investor should decide whether she wants to use the ASBA facility or make payment through a cheque, but not both. If an applicant applies through ASBA as well as non ASBA then both the applications having the same PAN, will be treated as multiple application and hence rejected. Applying through ASBA facility has the following advantages: The investor need not pay the application money by cheque; the investor submits ASBA which accompanies an authorization to block the bank account to the extent of the application money. The investor does not have to bother about refunds, as in ASBA only that much money to the extent required for allotment of securities, is taken from the bank account only when her application is selected for allotment after the basis of allotment is finalized. The investor continues to earn interest on the application money as the same remains in the bank account, which is not the case in other modes of payment. The investor deals with a known intermediary: her own bank. ASBA can be submitted to a Self-Certified Syndicate Bank (SCSB) with which the investor is holding the bank account. A SCSB is a bank which is recognized as a bank capable of providing ASBA services to its customers. The list of SCSB is given in the ASBA application form. Names of such banks also appear in the list available on the websites of BSE, NSE, and SEBI. Issuer shall, in consultation with Lead managers, ensure the following: Registrar to issue has capability to comply with the procedures laid down by SEBI for ASBA and shall treat ASBA and Non-ASBA application at par. Sufficient number of physical ASBA application forms are printed and made available to all SCSBs. ASBA and Non-ASBA shall be treated at par and the selling commission shall be paid accordingly to Syndicate Members or SCSBs, as the case may be, for collecting ASBA. MINIMUM SUBSCRIPTION Minimum subscription is the minimum amount that a company should receive before it becomes entitled to allot the shares. The Companies Act, 1956 requires the board of balkrishnaparab@jbims.edu 30

31 directors of the issuer company to determine the minimum subscription on the basis of the following: 88 The purchase price of any property purchased, or to be purchased which is to be defrayed out of the proceeds of the IPO; Preliminary expenses company; Underwriting commission and brokerage payable in connection with the IPO; and Repayment of loans taken for the above purposes. However, the Regulations stipulate that the minimum subscription to be received in an issue shall not be less than ninety per cent of the offer through offer document 89. The offer document is required to contain certain mandated disclosures 90 regarding minimum subscription 91. In the event of non-receipt of minimum subscription, application moneys received by the issuer is required to be refunded to the applicants within the specified period 92. The specified period in case of a non-underwritten issue is fifteen days of the closure of the issue 93 ; and in the case of an underwritten issue it is seventy days of the closure of the issue, where minimum subscription including devolvement obligations paid by the underwriters is not received within sixty days of the closure of the issue 94. The regulations relating to minimum subscription are not applicable to: (a) offer for sale of specified securities; (b) public issue by infrastructure companies if the disclosures regarding the alternate source of funding of the objects of the issue have been made in the offer document 95. The term infrastructure company means, an enterprise wholly engaged in the business of (i) developing or (ii) operating and maintaining or (iii) developing, operating and maintaining any infrastructure facility 96. MONITORING AGENCY If the issue size exceeds 500 crores rupees, the issuer is required to make arrangements for the use of proceeds of the issue to be monitored by a public financial institution or by one of the scheduled commercial banks named in the offer document as bankers of the issuer 97. The monitoring agency is required to submit its report to the issuer in the specified format 98 on a half yearly basis, till the proceeds of the issue have been fully utilized 99. The regulation relating to monitoring agency is not 88 Section 69 (1) of the Companies Act, Regulation 14 (1) of the SEBI (ICDR) Regulations, The disclosures are specified in Part A of Schedule VIII of the SEBI (ICDR) Regulations, Regulation 14 (3) of the SEBI (ICDR) Regulations, Regulation 14 (2) of the SEBI (ICDR) Regulations, Regulation 14 (2) (a) of the SEBI (ICDR) Regulations, Regulation 14 (2) (b) of the SEBI (ICDR) Regulations, Regulation 14 (4) of the SEBI (ICDR) Regulations, Explanation to Regulation 14 (4) of the SEBI (ICDR) Regulations, Regulation 16 (1) of the SEBI (ICDR) Regulations, The format is specified in Schedule IX of the SEBI (ICDR) Regulations, Regulation 16 (2) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 31

32 applicable to an offer for sale or an issue of specified securities made by a bank or public financial institution 100. LOCK IN OF PRE-IPO EQUITY SHARES The entire pre-issue share capital of the issuer-company will be locked-in for a period of one year from the date of allotment in the proposed public issue 101. This lock in requirement applies to the share held by persons belonging to the non-promoter group. What this means is that the pre-ipo shareholders would not be able to deal with their shares in any way for one year. However, this regulation does not apply to: Equity shares allotted to employees under an employee stock option or employee stock purchase scheme of the issuer prior to the initial public offer, if the issuer has made full disclosures with respect to such options or scheme in accordance with Regulations 102. Pre-issue shares held by a Venture Capital Fund (VCF) or a Foreign Venture Capital Investor (FVCI), if the shares have been held by the VCF or the FVCI, for a period of at least one year from the date of filing of the offer document with the SEBI 103. PROMOTERS CONTRIBUTION In the past, it was observed that, many companies made IPOs and raised large sums of money from the public, but the promoters had themselves invested very little money of their own. To remedy this situation, the Regulations contain detailed stipulations regarding promoters contribution. WHO IS A PROMOTER? Although, the term promoter is used in the CA 1956 at several places, it has not explicitly defined it. However, from the allusions used in it we can infer that a promoter is a person who takes steps to bring the company into existence. The courts have also defined the term promoter as a person who takes steps to bring the company into existence. For example, Cockburn CJ defined the terms as follows in Twycross v. Grant (1877): A promoter is one who undertakes to form a company with reference to a given project and to set it going, and who takes necessary steps to accomplish that purpose. Alternatively, promoters may be thought as a person (or persons) who hold(s) majority of the shares of the company necessarily has control. But, even a minority interest may be controlling. The existence of a controlling interest is a factual question, and hence will differ from case to case. 100 Proviso to Regulation 16 (1) of the SEBI (ICDR) Regulations, Regulation 36 of the SEBI (ICDR) Regulations, Proviso (a) to Regulation 36 of the SEBI (ICDR) Regulations, Proviso (b) to Regulation 36 of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 32

33 The Regulations define the term promoter to include: (i) the person or persons who are in control of the issuer; (ii) the person or persons who are instrumental in the formulation of a plan or programme pursuant to which specified securities are offered to public; and (iii) the person or persons named in the offer document as promoters 104. However, a director, or officer of the issuer, or a person if acting as such merely in his professional capacity, is not deemed to be a promoter. Further, a financial institution, scheduled bank, foreign institutional investor and mutual fund shall not be deemed to be a promoter merely by virtue of the fact that ten per cent or more of the equity share capital of the issuer is held by such person. QUANTUM OF PROMOTERS CONTRIBUTION In a public issue by an unlisted company, the promoters are required to contribute not less than 20 per cent of the post issue capital 105. Promoters contribution should be computed on the basis of the post-issue expanded capital: (a) assuming full proposed conversion of convertible securities into equity shares; and (b) assuming exercise of all vested options, where any employee stock options are outstanding at the time of initial public offer 106. Promoters are required to bring in the full amount of the promoters contribution, including premium, at least one day prior to the issue opening date. This money should be kept in an escrow account with a scheduled commercial bank and this amount can only be released to the company along with the public issue proceeds 107. However, where the promoters contribution has already been brought in and utilized, the issuer shall give the cash flow statement disclosing the use of such funds in the offer document 108. If the minimum promoters contribution is more than one hundred crore rupees, the promoters shall bring in at least one hundred crore rupees before the date of opening of the issue and the remaining amount may be brought on pro-rata basis before the calls are made to public 109. The requirement of promoters contribution is not applicable in case of companies where no identifiable promoter or promoter group 110. COMPUTATION OF PROMOTERS CONTRIBUTION The following securities should not be counted for computing the promoters contribution: Shares Acquired for Non-Cash Consideration Where the promoters have acquired equity during the preceding three years, before filing the offer documents with the SEBI, such equity shall not be considered for computation of promoters contribution if it is: (a) acquired for consideration other than cash and revaluation of assets or capitalisation of intangible assets is involved in such transaction(s); or (b) resulting from a bonus issue, out of revaluation reserves or reserves created without accrual of 104 Regulations 2 (1) (za) of the SEBI (ICDR) Regulations, Regulations 32 (1) (a) of the SEBI (ICDR) Regulations, Explanation (I) to Regulation 32 of the SEBI (ICDR) Regulations, Regulation 32 (4) of the SEBI (ICDR) Regulations, First Proviso to Regulation 32 (4) of the SEBI (ICDR) Regulations, Second Proviso to Regulation 32 (4) of the SEBI (ICDR) Regulations, Regulation 34 (a) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 33

34 cash resources or against shares which are otherwise ineligible for computation of promoters contribution 111. Shares Acquired at a Price Below Offer Price In case of public issue by unlisted companies, securities which have been acquired by the promoters during the preceding one year, at a price lower than the price at which equity is being offered to public shall not be eligible for computation of promoters contribution 112. However, this ineligibility is not applicable if the promoters pay to the issuercompany the difference between the offer price and the price at he acquired the shares 113. The Regulations provide for some other exceptions to this rule 114. Shares Acquired on Conversion of Partnership into a Company In respect of companies formed by conversion of partnership firms, where the partners of the erstwhile partnership firm and the promoters of the converted company are the same and there is no change in management, the shares allotted to the promoters during previous one year out of the funds brought in during that period shall not be considered eligible for computation of promoters contribution unless such shares have been issued at the same price at which the public offer is made. However, if the partners capital existed in the firm for a period of more than one year on a continuous basis, the shares allotted to promoters against such capital shall be considered eligible 115. Pledged Shares Pledged shares held by promoters shall not be eligible for computation of promoters contribution 116. LOCK-IN OF PROMOTERS CONTRIBUTION In order to ensure that the contribution brought in by the promoters is not immediately withdrawn, the Regulations require that that promoters contribution would locked in for a minimum period of three years. The lock in period would start from the date of allotment in the proposed public issue and the last date of the lock-in shall be reckoned as three years from the date of commencement of commercial production or the date of allotment in the public issue whichever is later 117. In case the promoters of the unlisted company bring in a contribution in excess the stipulated minimum of 20 per cent, this excess contribution shall also be locked in for a period of one year Regulation 33 (1) (a) of the SEBI (ICDR) Regulations, Regulation 33 (1) (b) of the SEBI (ICDR) Regulations, Proviso (i) to Regulation 33 (1) (b) of the SEBI (ICDR) Regulations, Proviso (ii) and (iii) to Regulation 33 (1) (b) of the SEBI (ICDR) Regulations, Regulation 33 (1) (c) of the SEBI (ICDR) Regulations, Regulation 33 (1) (c) of the SEBI (ICDR) Regulations, Regulation 36 (a) of the SEBI (ICDR) Regulations, Regulation 36 (b) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 34

35 PLEDGE OF SECURITIES FORMING PART OF PROMOTERS CONTRIBUTION Locked-in equity shares held by promoters may be pledged as collateral security for loans, provided the pledge of shares is one of the terms of sanction of loan. Such securities may be pledged only if the loan has been granted for the purpose of financing one or more of the objects of the issue 119. INTER-SE TRANSFER OF LOCKED- IN SECURITIES Locked-in shares held by promoters are allowed to be transferred to and amongst promoter group or to a new promoter or persons in control of the company, subject to continuation of lock-in in the hands of transferees for the remaining period. Such transfers are also subject to the compliance of Securities and Exchange Board of India (Substantial Acquisition of shares and Takeovers) Regulations, INSCRIPTION OF NON-TRANSFERABILITY The securities which are subject to lock-in are required to a carry inscription `non transferable along with duration of specified non-transferable period mentioned in the face of the security certificate. In case such specified securities are in dematerialized form, the issuer shall ensure that lock-in is recorded by the depository MINIMUM OFFER TO PUBLIC The net offer to public in case of an initial public offer is required to be at least twenty five 122 per cent of the post-issue capital 123. In case the post issue capital of the company, calculated at offer price is more than four thousand crore rupees, then the minimum offer to public is required to be at least ten per cent of the issue, provided that the company brings the public shareholding to the level of at least twenty five per cent by increasing its public shareholding to the extent of at least five per cent per annum beginning from the date of listing of the securities, in the manner specified by the SEBI 124. RESERVATION ON A COMPETITIVE BASIS The issuer is allowed to make reservation on competitive basis out of the issue size excluding promoters contribution and net offer to public in favour of the following categories of persons: Employees Employees of the issuer including employees of the promoting companies in case of a new issuer 125. The aggregate of reservations for employees shall not 119 Regulation 39 of the SEBI (ICDR) Regulations, Regulation 40 of the SEBI (ICDR) Regulations, Regulation 35 (2) of the SEBI (ICDR) Regulations, This is subject to Rule 19 (2) (b) of Securities Contracts (Regulations) Rules, Regulation 41 (1) of the SEBI (ICDR) Regulations, 2009 and Rule 19 (2) (b) (i) of Securities Contracts (Regulations) Rules, Rule 19 (2) (b) (ii) of the Securities Contracts (Regulations) Rules, Regulation 42 (1) (a) and 42 (2) (a) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 35

36 exceed five per cent of the post issue capital of the issuer 126. The value of allotment to any employee in pursuance of reservation shall not exceed one lakh rupees 127. Shareholders Shareholders (other than promoters) of: (i) listed promoting companies, in case of a new issuer; and (ii) listed group companies, in case of an existing issuer. However, if the promoting companies are designated financial institutions or state and central financial institutions, the shareholders of such promoting companies are not eligible for the reservation on competitive basis 128. Reservation for shareholders shall not exceed ten per cent of the issue size 129. Associate Persons Reservation is allowed in case of associated persons, in case of an issue made through the book building process. Associate persons are those who, as on the date of filing the draft offer document with SEBI, are associated with the issuer as depositors, bondholders or subscribers to services of the issuer making an initial public offer 130. However, reservation for persons who have business association as depositors, bondholders and subscribers to services with the issuer is subject to a ceiling of five per cent of the issue size 131. However, the issuer cannot make the reservation to the issue management team, syndicate members, their promoters, directors and employees and for the group or associate companies of the issue management team and syndicate members and their promoters, directors and employees 132. PERIOD OF SUBSCRIPTION A public issue is required to be kept open for at least three working days but not more than ten working days. In case the price band in a public issue made through the book building process is revised, the bidding (issue) period disclosed in the red herring prospectus is required to be extended for a minimum period of three working days, provided that the total bidding period does not exceed ten working days 133. ADVERTISEMENTS With a view to imparting wide publicity to the IPO, the Regulations require that the issuer release advertisements at the time of filing of the prospectus with the RoC, opening of the issue, and at the time of closing of the issue. 126 Regulation 42 (4) (a) of the SEBI (ICDR) Regulations, Regulation 42 (4) (g) of the SEBI (ICDR) Regulations, Regulation 42 (1) (b) and 42 (2) (b) of the SEBI (ICDR) Regulations, Regulation 42 (4) (b) of the SEBI (ICDR) Regulations, Regulation 42 (1) (c) of the SEBI (ICDR) Regulations, Regulation 42 (4) (c) of the SEBI (ICDR) Regulations, Proviso to Regulation 42 (1) (c) of the SEBI (ICDR) Regulations, Regulation 47 of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 36

37 Advertisements are defined to include notices, brochures, pamphlets, show cards, catalogues, hoardings, placards, posters, insertions in newspaper, cover pages of offer documents, pictures and films in any print media or electronic media, radio, television programme 134. Any public communication including advertisement and publicity material issued by the issuer or research report made by the issuer or any intermediary concerned with the issue or their associates shall contain only factual information and shall not contain projections, estimates, conjectures, etc. or any matter extraneous to the contents of the offer document 135. PRE-ISSUE ADVERTISEMENT After registering the red herring prospectus (in case of a book built issue) or prospectus (in case of fixed price issue) with the RoC, the issuer is required to make a pre-issue advertisement in one English national daily newspaper with wide circulation, Hindi national daily newspaper with wide circulation and one regional language newspaper with wide circulation at the place where the registered office of the issuer is situated 136. The pre-issue advertisement should be in the prescribed format and should contain the prescribed disclosures 137. ISSUE OPENING AND CLOSING ADVERTISEMENTS An issuer may issue advertisements for issue opening and issue closing advertisements. Although, this is an optional provision, if the issuer decided to issue such advertisements, they should be in the prescribed formats 138. DISCLOSURES All public communications and publicity material issued or published in any media during the period commencing from the date of filing draft offer document with the SEBI till the date of allotment of securities offered in the issue, shall prominently disclose that: The issuer is proposing to make a public issue and has filed a draft offer document with the SEBI or has filed the red herring prospectus or prospectus with the Registrar of Companies or the letter of offer with the designated stock exchange, as the case may be. The draft offer document, red herring prospectus or final offer document, as the case may be, is available on the website of the SEBI, lead merchant bankers or lead book runners 139. POST ISSUE ADVERTISEMENT The issuer is also required to release a post issue advertisement giving details of the following: 134 Regulation 2 (1) (b) of the SEBI (ICDR) Regulations, Regulation 60 (1) of the SEBI (ICDR) Regulations, Regulation 47 (1) of the SEBI (ICDR) Regulations, Regulation 47 (1) of the SEBI (ICDR) Regulations, The format and the required disclosures are contained in Part A of Schedule XIII of the Regulations. 138 Regulation 48 of the SEBI (ICDR) Regulations, The formats are contained in Part B and C of Schedule XIII of the Regulations. 139 Regulation 60 (3) of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 37

38 Oversubscription Basis of allotment Number, value and percentage of all applications including ASBA Number, value and percentage of successful allottees for all applications including ASBA Date of completion of dispatch of refund orders or instructions to Self Certified Syndicate Banks by the Registrar Date of dispatch of certificates and date of filing of listing application The post-issue merchant banker shall ensure that the advertisement containing the above details is released within ten days from the date of completion of the various activities. The post issue advertisement is required to be released in at least one English national daily newspaper with wide circulation, one Hindi national daily newspaper with wide circulation and one regional language daily newspaper with wide circulation at the place where registered office of the issuer is situated 140. ALLOCATION IN NET OFFER TO PUBLIC The net offer to public depends on the type of offer, such as: (i) book built offer, generally; (ii) book built offer with an anchor investor; and (iii) a non-book built offer. BOOK BUILT OFFER, GENERALLY In an issue made through the book building process, the allocation in the net offer to public category shall be made as follows: Minimum 35 per cent to retail individual investors; Minimum 15 per cent to non-institutional investors; Maximum 50 per cent to qualified institutional buyers, five per cent of which shall be allocated to mutual funds 141. BOOK BUILT OFFER WITH ANCHOR INVESTORS The regulations require that anchor investors should be a qualified institutional body (QIB). Each of these investors have to make a minimum application for Rs 10 crore, of which they would have to pay 25 per cent upfront and the remaining 75 per cent within two days of the closure of the issue. Up to 30 per cent of the portion available for allocation to qualified institutional buyers is required to be available to anchor investor(s) for allocation. Anchor investors will not be able to sell their shares within the first 30-days of listing of shares Regulation 66 (1) of the SEBI (ICDR) Regulations, Regulation 43 (2) of the SEBI (ICDR) Regulations, Clause 10 of Schedule XI of the SEBI (ICDR) Regulations, balkrishnaparab@jbims.edu 38

39 NET OFFER TO PUBLIC IN A NON-BOOK BUILT OFFER In a non-book built offer net offer to public is required to be made as follows: Minimum 50 per cent to retail individual investors; Remaining to: (i) individual applicants other than retail individual investors; and (ii) other investors including corporate bodies or institutions, irrespective of the number of shares applied for. The unsubscribed portion in either of the categories specified in clauses (a) or (b) may be allocated to applicants in the other category. STEPS IN IPO PROCESS Balkrishna Parab is a member of the core faculty at Jamnalal Bajaj Institute of Management Studies (University of Mumbai). The essay was written as a basis for class discussion and should not be construed as managerial, administrative or legal advice. Contact details: Jamnalal Bajaj Institute of Management Studies, 164, DN House, HT Parekh Marg, Backbay Reclamation, Mumbai <balkrishnaparab@jbims.edu> Cell balkrishnaparab@jbims.edu 39