Informal Guidance on Preferential Allotment

SEBI has issued an informal guidance to Strides Arcolabs in connection with the company’s eligibility to issue securities to its promoters on a preferential allotment basis. The information guidance essentially pertains to the interpretation of Reg. 72(2) of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR), which reads as follows:

The issuer shall not make preferential issue of specified securities to any person who has sold any equity shares of the issuer during the six months preceding the relevant date.

…

Explanation: Where any person belonging to promoter(s) or the promoter group has sold his equity shares in the issuer during the six months preceding the relevant date, the promoter(s) and promoter group shall be ineligible for allotment of specified securities on preferential basis.

On 20-21 October, 2011, there was an inter se transfer of shares among the promoters of Strides. This was effected under the erstwhile Takeover Regulations of 1997 (and prior to the new regulations that came into effect on 22 October 2011), and appropriate reporting requirements were complied with. Strides now wishes to issue securities to certain promoters who were the sellers in that transfer, and sought SEBI’s view on the eligibility to issue securities by way of preferential allotment.

In SEBI’s view, the interpretation of Reg. 72(2) and its explanation would not permit Strides to make a preferential allotment of securities to the promoters who earlier sold shares in the inter se transfer among promoters. SEBI’s reasoning is as follows:

The said regulation and its explanation do not differentiate between inter-se transfers made to entities within promoter group and sales made to others. Hence, the term “any person who has sold any equity shares of the issuer” shall also include any person who has made inter-se transfers within the Promoter group. Thus, as per the extant Regulations, if there is any inter-se transfer among the promoter group entities in the prece[]ding six months, then all the persons/entities forming part of “promoter(s) and promoter group” shall become ineligible for allotment of specified securities on preferential basis.

Arguably, this represents a technical approach, and a more purposive interpretation could lead to different results. For instance:

1. The objective of the set of regulations that prescribe specific holding periods for preferential allottees is to prevent short-termism whereby certain investors can take advantage of price movements to sell shares and then obtain them through preferential allotment at more beneficial price. This particularly applies to promoters as they are in a position to control the allotments through their substantial shareholding. Such an objective does not appear to have a place in the context of inter se transfer among promoters because it is just a rearrangement of shareholding among the promoter group without a sale to persons outside the group. While a literal interpretation would lead such a transfer to be a “sale”, a purposive interpretation would not bring it within the mischief that the rule seeks to prevent.

2. The above broad objective of the regulations is also evident from the scheme of Reg. 72(2) and its explanation. For example, the explanation suggests that when there is a sale by any person belonging to the promoter group, then the promoter group itself is disqualified from obtaining shares through preferential allotment for a period of six month. The disqualification appears to operate not just to the individual or entity that sold shares, but to the entire promoter group. In other words, the attribution of an individual seller’s action extends to the entire group, thereby fortifying the position that the promoter group must be treated as a whole. In that case, transfers within the group should be of no consequence, and should not be treated as a sale at all.

3. This approach is not unique to the ICDR Regulations, but also to regulatory frameworks such as the Takeover Regulations that provide specific exemptions from mandatory open offers in case of inter se transfers among promoters so long as specified conditions have been complied with. Such compliances were adhered to even in the Strides case, but that seems to have held no water with SEBI while interpreting Reg. 72(2).

Preferential Allotment of Securities in Unlisted Companies

The Ministry of Corporate Affairs (MCA) has announced draft rules that will, when promulgated, substitute the Unlisted Public Companies (Preferential Allotment) Rules, 2003. This will make the process of issue of securities more stringent for unlisted public companies. The Indian Legal Space blog has a nice comparison of the existing rules and the proposed changes.

Some of the key features of the draft rules and their impact are as follows:

Disclosures

Unlike the existing regime, the draft rules require companies to issue an offer document with prescribed disclosures (Annexure I of the draft rules contain a list of 32 disclosures). This significantly enhances disclosure requirements for securities offerings by unlisted companies, and would make even private placements cumbersome and costly. While it increases overall transparency in offerings of securities, the need for such extensive disclosures for offerings of securities to specific individuals or institutions is perhaps overstated. Moreover, there is no clarity regarding the liability of the company and its directors for statements made in such offering document, although the Supreme Court has recently indicated the availability of criminal laws to deal with misstatements in offering documents in private placements.

The offer document is also to be approved by shareholders through a special resolution. This is also an onerous requirement as it might limit the flexibility of the company to alter the document once it has been approved by the shareholders. In addition, this will also impose complexities in timing and sequencing of compliances to effect a private placement transaction.

Timing

The draft rules stipulate two conditions regarding timing: (i) the gap between the opening and closing of the issue should be limited to 30 days; and (ii) the minimum gap between the closing of one issue and the opening of another issue must be 60 days. This is possibly intended to deal with ambiguities that exist in the definition of a private placement/offering in terms of section 67(3) of the Companies Act, 1956 where an offer is deemed to be made to the public if it is made to 50 persons or more. By setting time limits, the draft rules seek to impose more objective criteria to differentiate private placements from public offerings. For a greater discussion of this issue in the context of section 67(3), please see a previous post.

While objectivity is generally desirable, the idea of artificially delineating one private placement from another through timing may add to the confusion. For example, it may be possible for companies to structure successive private placements although the offering may cumulatively be made to a large body of investors.

Convertible Instruments

The draft rules make convertible instruments an unattractive option for public unlisted companies.

First, the pricing rules for warrants (that presumably apply to other convertibles as well) are rigid. The price for conversion of warrants must be determined before hand. In other words, the conversion price has to be stated up front, and it appears that neither a conversion formula nor a price band would be available. That removes all flexibility for conversion, which would effectively make warrants in public unlisted companies unattractive as an investment option. Note, however, that this is exactly contrary to the trend established by the FDI Policy of the Government of India which has recently moved from a fixed conversion price to a more flexible policy when it comes to investment in convertible instruments by foreign investors.

Second, for any issue of convertible instruments that results in a cumulative amount of Rs. 5 crores or more, the company is required to seek the prior approval of the Central Government. This is a retrograde step as it imposes hurdles to fund-raising activities of companies. It is also likely to evoke problems that existed in the days of the controlled economy prior to 1991, with the Controller of Capital Issues (CCI) acting as the authority that indulged in merit regulation by specifically approving fund-raising by companies. In fact, even the CCI regime applied only to public offerings where the interest of the investing community at large was at stake. The application of a similar regime under current conditions, and that too for private placements seems inexplicable. The draft rules buck the trend as other areas of corporate regulation have recently witnessed attenuation in government regulation.

Dematerialization of Securities

Here again, the flexibility of retaining securities either in physical form or demat form has been taken away, as all securities issued under private placement have to be kept only in demat form.

Overall, the draft rules make private placements in unlisted public companies an onerous task. This may seriously impact financing in such companies. Curiously enough, some of the requirements suggested in the draft rules go even beyond those prescribed for public listed companies where larger interests are affected. These include the requirement for shareholders to approve the offer document, restrictions on pricing for convertible securities, and the like.

It has been suggested that the draft could be the result of various scams involving unlisted companies and also instances of ambiguities in securities regulation (such as those witnessed in the Sahara episode previously discussed). While it is imperative that regulations be framed to address scams and frauds, the imposition of onerous requirements on the corporate sector as a whole to address a few bad apples imposes greater costs than the benefits it produces. The strategy of painting all public unlisted companies with the same brush will be counterproductive.