Dealing With the Anti-IPO Sentiment

We usually come across reports of companies preparing or filing for IPOs in order to take advantage of listings on stock exchanges. On the other hand, companies also often display resistance for undertaking IPOs as they are accompanied by costs such as full-blown regulatory oversight and public scrutiny. This is so even when the companies have grown to a significant size and there is a vibrant private market created for their securities. In this post, we will examine this issue in the context of a high profile U.S. company and an Indian company that are testing the borders of securities regulation by staying outside the purview of public listing. 

In the U.S., speculation is rife as to whether Facebook will go down the route of offering its shares to the public. Apart from a private market having been created in its shares, Facebook recently raised monies from a special purpose vehicle of Goldman Sachs that in turn allows various Goldman clients to take indirect interest in Facebook shares. Steven Davidoff has an analysis of the implications of this transaction under U.S. securities regulation: 

Goldman Sachs’s investment in Facebook once again raises the issue of whether the Securities and Exchange Commission will force the social networking company into an initial public offering. In particular, this issue arises because of the special purpose vehicle that Goldman plans to create in order to allow its clients to invest up to $1.5 billion in Facebook. 

The reason lies on the technical shores of the federal securities laws. The Securities Exchange Act of 1934 sets forth certain requirements for companies to register their shares with the S.E.C. 

Specifically, Section 12(g) requires that a company register its securities with the S.E.C. if it “has total assets exceeding $1,000,000 and a class of equity security … held of record by five hundred or more … persons…”

… 

The issue comes with the 500-person requirement. This speaks only of shareholder-of-record ownership. Shares can be held “of record” or “beneficially,” but the rule is only set off based on the number of shareholders who hold shares “of record.” 

The S.E.C. defines “of record” for these purposes to mean securities held “by each person who is identified as the owner of such securities on records of security holders maintained by or on behalf of the issuer.” 

Record ownership is thus clear. It is the shareholders who are recorded as such on the books of the company that issued the securities.

…

We do not know the number of record holders of Facebook shares, but in the case of Facebook, this appears to be how Goldman is planning to get around the S.E.C.’s reporting rule. Goldman will form a special purpose investment vehicle for its super-wealthy clients to invest in Facebook. 

Technically, there would then be only one shareholder of record here, the investment vehicle. … 

Davidoff argues, however, that the use of such special purpose vehicles to overcome the 500-person rule “certainly appear[s] to be cutting it close”. Separately, Larry Ribstein comments on the underlying rationale for such structures and the factors that drive companies to maintain private markets for securities rather than public listings. 

Note that the key principle in U.S. securities regulation is the number of shareholders on record in a company. Once the threshold (set at 500) is breached, companies need to report their financial and other information to the SEC. Although companies are not compelled to do an IPO at this point, it nevertheless makes eminent sense for them to make a public offering as they are subject to the reporting requirements in any case and there is no merit in remaining as an unlisted company. 

The contemporaneous example in India relates to the Sahara group of companies, which has witnessed a number of legal developments within a short span of time (as discussed earlier - 1, 2, 3 and 4). The current position is that SEBI has issued a public notice to investors of two Sahara companies advising them to make their own decisions (and at their own risk) while investing in securities issued by those companies and cautioning that SEBI would not be able to provide any redressal if grievances do arise. 

The underlying legal principle in India for private markets is somewhat different. First, there is no concept of companies merely reporting their financial results to a regulator or the public without undertaking an IPO. In other words, companies which breach the limits are faced with only one consequence: to make an IPO. Second, the threshold for an IPO is defined differently from the U.S. The reference point is the proviso to Section 67(3) of the Companies Act, 1956 which reads: 

“Provided that nothing contained in this sub-section shall apply in a case where the offer or invitation to subscribe for shares or debentures is made to fifty persons or more.” 

The obligation to do an IPO arises when an “offer” is made to 50 persons or more. Under this method of reckoning, companies may make separate offers so long as each offer is made to less than 50 persons. Questions have been raised in the past whether this method can be subject to abuse because it is not entirely clearly as to what distinguishes one offer of securities from another when they are made by the same company. Is it the type of securities issued, the time-gap between two offers or involvement of separate processes? The answers are not readily available. Although it does not appear that Sahara has advanced the argument of separate offers (with each being to less than 50 persons), that could potentially be used as an escape to stay outside the purview of public offer requirements. 

That leaves us with the question as to whether the simple threshold of absolute number of shareholders (as in the U.S.) or a threshold based on the number of persons to whom each offer of securities is made (as in India) is more rationale and practical and therefore desirable. Both have their share of deficiencies. The rule involving absolute number of shareholders appears simple at first blush. However, it is capable of circumvention as we have seen in the Facebook case. Nevertheless, one way of addressing this would be to provide that the number of shareholders to be taken into account would include holders of record (i.e. legal shareholders) as well as those holding beneficial interests. As far as the scenario in India is concerned, far more clarity is required as to what constitutes an “offer” for purposes of Section 67(3), failing which there would be less certainty for companies issuing securities without public listings and also for investors taking up those securities.

Use Ex Parte Powers Abstemiously

An “ad interim, ex parte” order passed by SEBI, directing companies in the Sahara Group not to raise funds by way of placement of their debentures, led to a debate here over interim reliefs granted by courts, after the Allahabad High Court stayed SEBI’s order. The Supreme Court has now refused to stay the stay granted by the Allahabad High Court.

Sections 11 and 11B of the SEBI Act, 1992 confer extraordinary powers on SEBI to issue orders without hearing the parties that would be affected by the order – an exception to the general rule of natural justice. Courts have indeed held that a post-decisional hearing would remedy what would otherwise be considered to be a deviation from the settled principle of natural justice i.e. of hearing a party before condemning it. Therefore, these provisions in the SEBI Act should indeed be read as conferring on SEBI the power to step in and take urgent action.

Therefore, the key issue is: When would circumstances justify a bending of the principle of natural justice, and permit an ex parte regulatory intervention, to be remedied by a post-decisional hearing? In my view, putting a person out of the market, or asking him not to deal in securities, or not to carry on business of a certain nature, until further notice, is a serious intervention and therefore should not be lightly invoked.

These are interventions that may be well-intentioned, but whether they are necessary, is an issue that one should have to answer every single time. Over the past ten years, the practice of SEBI restricting a person’s constitutional right to carry on business and to lead life by way of ex parte orders has gained currency. For example, a few years ago, a fund manager was asked not to deal in securities until further notice. The reason used to justify the intervention was that the media reported that he had plans to start a mutual fund – an activity that in any case cannot be conducted without a license from SEBI, which itself entails a huge process of scrutiny by SEBI. Another example is the repeated assertion by SEBI that a particular depository was “complicit”, “negligent”, “fraudulent” and part of a “device” in the occurrence of what is called the “IPO scam”. Even requests for a hearing were ignored and more and more “ad interim” orders were passed. (Disclosure: both these examples are of clients represented by me).

Emergency powers are not unheard of. Even preventive detention of a person (impeding his constitutional right to move about the nation) has been upheld as constitutional but always subject to stringent safeguards. An economic equivalent of such detention, equally, ought to be subject to serious safeguards, and such powers should be used more as an exception to deal with exceptional cases, rather than as a norm, to be used routinely in all cases.

Any regulator or policeman or arm of the State should have very good reasons to put a person out of freedom without even hearing his side of the story. Ideally, regulators such as SEBI (other regulators too have similar powers – it is only SEBI that is thankfully subject to quasi-judicial review of its orders) should develop a transparent and publicly known policy on the parameters within which it would inflict a serious intervention into a person’s life.

Such power should be used in rarest of rare cases, and the regulator should demonstrate what harm would be caused to its regulatory constituency but for such intervention.

Supreme Court on the Sahara Case

While the earlier post analyzing the judgment of the Allahabad High Court generated an interesting debate, it has been reported today (here, here and here) that the Supreme Court refused to interfere with the High Court’s order.

Public Offering of Securities: Liability of Investment Bank

In order to ensure accuracy of disclosures in offering documents pertaining to public issue of securities, regulators tend to impose liabilities for misstatements on issuers as well as intermediaries. The intermediaries, referred to as “gatekeepers” perform an important role in the securities markets. In his book, Gatekeepers: The Professions and Corporate Governance, Professor John Coffee notes (on pp. 1-2):

What Are Gatekeepers? The term ‘gatekeeper’ has been used in many different settings across the social sciences usually in ways that are more metaphorical than precise. Typically, the term connotes some form of outside or independent watchdog or monitor—someone who screens out flaws or defects or who verifies compliance with standards or procedures.

Within the corporate context, the prior academic commentary has usually used the term ‘gatekeeper’ to mean an independent professional who plays one of two distinct roles, which tend to overlap in practice. First, the gatekeeper may be a professional who is positioned so as to be able to prevent wrongdoing by withholding necessary cooperation or consent. For example, an investment banking firm can refuse to underwrite the issuer’s securities if it finds that the issuer’s disclosures are materially deficient; similarly, an auditor or an attorney who discovers a serious problem with a corporate client’s financial statements or disclosures can prevent a merger from closing by declining to deliver an opinion that is a necessary precondition for that transaction in this first sense, the gatekeeper is a private policeman who has been structured into the process to prevent wrongdoing. By withholding its approval, it closes the gate, typically denying the issuer access to the capital markets. …

However, defining gatekeepers simply in terms of their capacity to veto or withhold consent misses what is most distinctive about the professionals who serve investors in the corporate context. Inherently, they are repeat players who provide certification or verification services to investors, vouching for someone else who has a greater incentive than they to deceive. Thus, a second and superior definition of the gatekeeper is an agent who acts as a reputational intermediary to assure investors as to the quality of the ‘signal’ sent by the corporate issuer. The reputational intermediary does so by lending or ‘pledging’ its reputational capital to the corporation, thus enabling investors or the market to rely on the corporation’s own disclosures or assurances where they otherwise might not. The gatekeeper has such reputational capital because it is a repeat player who has served many clients over many years. …

Consistent with theory, SEBI imposes liability for violation of securities laws directly on the issuers on the one hand, and also on various intermediaries (or gatekeepers) on the other hand. Among these intermediaries, investment banks are subject to immediate oversight by SEBI as they are registered with SEBI. In the context of public offering of shares, investment banks have a duty to conduct due diligence in order to ensure accuracy of disclosures in the offering document.

In this background, SEBI has recently issued an adjudication order imposing a penalty of Rs. 25,00,000/- on Enam Securities Pvt. Ltd., an investment bank, primarily in connection with the IPO of Yes Bank. The bone of contention of contention relates to whether the offering document should have disclosed Rabobank International Holding B.V. as the promoter of Yes Bank. The adjudicating officer found that the investment bank was in breach of its due diligence obligations in not disclosing Rabobank as the promoter in the offering document.

While the order is representative of SEBI’s initiatives in imposing liability on intermediaries as a means to ensure adequate disclosure, it also highlights difficulties in certain matters of interpretation under the disclosure guidelines. More specifically, the term ‘promoter’ has hitherto been defined differently in various regulations of SEBI (such as those relating to disclosures in offer documents, takeover regulations, etc.), although efforts have been made more recently to streamline those definitions. Nevertheless, this case highlights difficulties in nailing down entities as promoters for the purposes of offer documents.

On a separate note, SEBI’s efforts to impose liability on intermediaries are not confined to those registered with it. It has previously sought to exercise jurisdiction on auditors in the Satyam case, which approach has received concurrence of the Bombay High Court.