SEBI should clean up IPO norms

WITHOUT CONTEMPT

If there is one body of law that is in an urgent and crying need for a comprehensive review and re-draft, it is the SEBI (Disclosure and Investor Protection) Guidelines (DIP Guidelines).

The DIP Guidelines govern public issues (either initial public offerings or follow-on public offerings of securities), rights issues (securities offerings to existing security-holders), preferential allotments (out of turn allotments that is not offered to all existing shareholders) and private placements with qualified institutional buyers (QIBs).

The DIP Guidelines began in 1999-2000 as a consolidation of various circulars that had been issued by Securities and Exchange Board of India (SEBI) from the time to time right since 1991 when SEBI started regulating the market after the abolition of the Controller of Capital Issues (CCI).

A number of provisions in the DIP Guidelines have now come to represent a strong adherence to form with little regard for substance. A primary reason for such a situation is, of course, the manner in which the guidelines are administered.

By their very nature, guidelines are provisions that provide guidance and broad but clear direction on what is sought to be achieved.

In contrast, rules and regulations are provisions of law, the breach of which would have penal consequences, and therefore, have to be interpreted with a degree of strictness far more stringent than that used in interpreting guidelines.

Consider this: The DIP Guidelines mandate the existence of a "promoter" for every company that makes a public offering i.e. a person who is in control of the issuer company, or persons who are involved in the formulation of a plan for issuance of securities.

The promoter is required to have held at least 20 per cent of the issuer company's capital for three years. These shares, referred to as "promoter contribution", are also required to be "locked-in" (they are incapable of being sold or transferred) for a period of three years after completing the public offering.

However, at the time of filing of the draft red herring prospectus (DRHP), the promoter contribution shares have to be un-encumbered.

There are, of course, some clear exceptions provided. Despite the three-year lock-in, the promoter contribution shares may be pledged in favour of banks and financial institutions during the lock-in period. Such an enabling provision is indeed an acknowledgment of business reality.

It is quite normal to expect a company to have incurred financial obligations with third party security, and there is no real merit in imposing a prohibition on creating such a pledge, which would only benefit the issuer company.

However, the enforcement of the provision requiring promoter contribution shares to be free of encumbrance at the time of filing the DRHP is being read in a very queer manner. SEBI is known to have disallowed even filing of the DRHP, if any of the promoter contribution shares were pledged at the time of filing.

The prevalence of form over substance is so stark that companies have been forced to get lenders to lift the pledge between the filing of the DRHP and completion of the public offering.

No lender in his right mind, would lightly lift a pledge and either become unsecured or diminish his security interest. If the pledge over securities could be re-created immediately after completion of the IPO, there can be logic behind forcing lenders to give up security interest for the period between filing the DRHP and completing the IPO.

The situation can get so bizarre that, at times, there are long-drawn negotiations and consultations between merchant bankers and financial institutions over lifting the pledge at the time of filing the DRHP, to be re-created after filing the DRHP, only to be lifted again at the filing of the prospectus with the Registrar of Companies, with the pledge being re-created after such filing, and finally, lifting the pledge at the time of allotment of shares, and re-creating the pledge thereafter. In such situations, the intent behind the DIP Guidelines gets completely lost and logic becomes an alien concept.

Even the purpose for which the pledge may be created can get very complicated. The DIP Guidelines provide that the pledge should be for the same purpose for which the IPO is being made.

If the pledge over the promoter contribution shares indeed secures indebtedness of the issuer company, but for a project that is not being funded by the public offering, there would again be no basis to believe that the object and purpose behind the DIP Guidelines would get eroded.

If guidelines are interpreted like tax laws "" by the strict letter of the law "" the very purpose behind the guidelines would take the backseat, and absurd consequences would emerge.

Merely because several tens of thousands of crores have been raised in the primary market, it does not mean the DIP Guidelines are working perfectly fine. The pledge over promoter contribution shares is but an example. Many similar interpretations are abound.

The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.

somasekhar@jsalaw.com