Are preferential allotments by promoters justified?

DEBATE

While preferential allotments can help raise capital, the 18-month gap for convertible warrants is skewed in favour of the promoter.

Manish Kanchan
Managing Director,
Sage Capital

"For a small shareholder, it's irrelevant whether the promoter is paying all the money upfront or over 18 months"

A promoter of a listed company is allowed to directly increase his ownership primarily through two mechanisms""creeping acquisition and preferential allotments. Preferential allotments are usually positive for the small investors. One, under the creeping acquisition route, a promoter can purchase a maximum of 5 per cent of the equity in a financial year through the stock exchange at the prevailing market price and the seller may or may not have the knowledge that he is selling to the promoter. However, a preferential allotment is announced to stock exchanges and investors are aware of the promoter's intentions.

Two, a preferential allotment has to be at least at the highest closing price of the previous 15 days and usually this represents fair valuation. Three, a preferential allotment envisages the promoter investing money in the company against fresh issue of shares. This is far superior to a promoter buying shares from an unsuspecting shareholder.

Four, preferential allotments can aid mergers and acquisitions or in raising capital. For example, when a company plans to enter into a joint venture with a strategic partner or raise capital through a financial investor, this results in a promoter's equity being diluted. A preferential allotment would allow a promoter to maintain his shareholding at a fixed price. This would encourage the promoter to go ahead with the proposed transaction. Such events and transactions usually add to shareholder wealth.

Five, a preferential allotment is a strong signal to the investment community of the company's future prospects. Recently, Mukesh Ambani increased his stake in Reliance Industries by 5 per cent through a preferential allotment at Rs 1,412. Investors were free to purchase shares at around this price from the stock exchanges for quite a while after the announcement was made. Similarly, if the terms of a preferential allotment are blatantly unfair, unwarranted or shareholder-unfriendly, investors can take a negative view and exit the stock.

In many cases, preferential allotments are made by way of convertible warrants. A convertible warrant is a security issued by the company which can be converted into equity at a fixed price any time over 18 months from the date of issue, usually at the option of the holder. Under Sebi regulations, a warrant holder has to pay a minimum 10 per cent of total consideration at the time of issue of warrants and the balance at the time of conversion. This structure allows promoters to increase their stake at a fixed price by paying just 10 per cent of the consideration and paying the balance over 18 months.

Prima facie, this does appear to be skewed in favour of the promoter or the warrant holder. However, for a small shareholder, it's irrelevant whether the promoter is paying all the money upfront or over 18 months. The small shareholder should look at the circumstances of the preferential allotment like intent and purpose, pricing and the promoter's track record and take a decision to buy, hold or sell.

In the case of Reliance Industries, the promoter has issued warrants to himself but this is not relevant to the shareholder, regardless of whether he is subscribing to fully-paid shares or through convertible warrants. Investors who looked at Mukesh Ambani's track record, intent and pricing and viewed the preferential allotment positively and purchased Reliance Industries' shares after the announcement of preferential allotments, doubled their money in eight months.

Anil Singhvi
Managing Director,
ICAN Advisors

"Since the period available to subscribe is 18 months, it gives promoters a huge opportunity to ride the stock market"

Corporate governance by listed companies in India has come a long way during the last 20 years. For a long time, most companies, though listed, were run as promoters' fiefdoms and little thought was given to the interests of minority shareholders, leave alone their rights.  It was during the early 1990s when the Controller of Capital Issues (CCI) was abolished that Indian companies started raising capital in a free market situation within India. Corporate governance took a new turn with companies like Infosys which demonstrated that good governance can earn the respect of minority shareholders and, in turn, increase valuation as well. Since then, listed companies in India have come a long way in improving their corporate governance practices. We have reached a stage where some of our listed companies have a market capitalisation of close to $100 billion. Unfortunately, however, the protection of minority shareholders has not kept pace with the valuations of Indian companies. One notable area is the issuance of equity warrants to promoters. The equity warrant is an instrument allowing a subscriber the option to buy shares in a company at a specified price at or before a future date. Thus, a warrant gives a right to the subscriber to buy a share but imposes no obligation, hence it is different from partly paid-up shares.  In the last five years, a number of listed companies have issued equity warrants to promoters. This is done basically to shore up the promoters' holding. It is a double whammy for minority shareholders: (a) they are denied participation at the same level as promoter shareholders; and (b) the promoters, while subscribing to the warrants, essentially get an option from the company to pay only 10 per cent of the equity warrant's value and an additional 18 months to pay the balance.  Moreover, the Companies Act has no definition of a warrant. In fact, the Act does not envisage the issue of shares without an increase in the share capital, but the practice followed in the case of equity warrants is to credit this amount to the share application account. Leaving aside the accounting treatment, it is disturbing that companies are issuing equity warrants without any legal backing of either the Companies Act or the Securities Contracts (Regulation) Act.  In most cases, equity warrants are fully paid only if the market price of a particular company's share is higher than the equity warrant's price. Since the period available to subscribe is fairly long (18 months), it gives promoters a huge opportunity to ride the stock market. Thus, there is a clear evidence of promoters profiteering by the issuance of such equity warrants.  There is another issue of conflict. As per the Takeover Regulation, promoters can increase their shareholding by buying the company's shares to the extent of only up to 5 per cent of the equity capital during a financial year. With promoters being issued equity warrants (in most cases, more than 5 per cent), they corner more shares by bypassing the Takeover Regulation and that too by paying just 10 per cent upfront. A rights issue of shares, allowing all shareholders to participate, would not have allowed them to disproportionately increase their holding in the company.  The issuance of equity warrants to promoters is done in connivance with the company over which they have complete control and, in most cases, this is shown to be done to meet the company's capital requirements. All classes of shareholders have the right to participate on an equal basis and any preferential allotment to a certain class of shareholders is a breach of the minority shareholders' trust. It is no less than a fraud and this practice needs to be stopped forthwith.