The Pitfalls of the Indian IPO Process
The Indian IPO market has remained buoyant and resilient despite the devastating pandemic and whilst we wait for overseas listings to finally be permitted and watch the SPAC market develop, the Indian IPO market remains the primary form of exit for a number of foreign investments. This memorandum sets out some of the pitfalls of the Indian IPO process.
Eligibility
IPOs are governed by the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (the ICDR Regulations).
An issuer is not eligible to make a public offer if its promoters, any member of the promoter group or directors is debarred from accessing capital markets by the Securities and Exchange Board of India (SEBI) or if its promoters or directors are directors of a company that has been barred from accessing capital markets or if its promoters or directors are wilful defaulters or fugitive economic offenders.
This can sometimes be problematic if the issuer has appointed an individual as an independent director that is also a non-executive director of a company that has been declared as a wilful defaulter, particularly if this occurs after filing the draft red herring prospectus. The definition of “promoter group” is counterintuitive and is not confined to companies under common control or companies controlled by the issuer or that control the issuer – it includes companies in which the promoters own 20 per cent or more of the equity share capital or a company that owns 20 per cent or more of the equity share capital of a promoter – it also includes a company in which a group of individuals or entities own 20 per cent or more of the equity share capital where such group also owns 20 per cent or more of the issuer. In other words, the definition of promoter group will inevitably include entities that have no relation with the issuer and yet disclosures in respect of those entities will need to be made by the issuer, and orders against such entities will go to the eligibility of the issuer to make a public offer.
The issuer must also have (i) net tangible assets of Rs. 3 crores in each of the preceding three years; (ii) average operating profit of at least Rs. 15 crores in the preceding three years and must have an operating profit in each of these preceding years; and (iii) a net worth of at least Rs. 1 crore in each of the preceding three years[3]. Helpfully, companies that do not satisfy this criteria (and this is particularly helpful for newly incorporated companies, start-ups and e-commerce companies), are eligible to make a public offer if the issue is made through the book-building process and at least 75 per cent of the net offer is allotted (and not merely allocated) to qualified institutional buyers[4]. This is not a difficult condition to meet in practice.
Offer for Sale
Only shares that have been held for at least one year prior to the date of filing the draft red herring prospectus by a shareholder can be offered for sale in the offer for sale component of an IPO[5]. Useful for potential selling shareholders to bear this requirement in mind whilst planning an exit.
Selling shareholders should restrict their liability to information provided by them and should certainly resist any attempt to provide wider warranties, for instance, that they are not aware of any matters that are not included in the offer documents that may affect an investment decision or that their decision to sell is motivated by considerations that may be relevant to an investor in the IPO.
Promoter Contribution
The promoters of the issuer must hold at least 20 per cent of the post-issue share capital of the issuer[6] – this is locked in for three years as described below. Equity shares acquired from the revaluation of assets are not eligible for promoter contribution and neither are shares acquired in the preceding year at a price less than the issue price in the IPO[7]. This latter restriction can be problematic for newly incorporated companies or where the promoter has acquired shares of the issuer following an internal restructuring. The solution is to provide that the promoters will contribute an additional amount as subscription upon determination of the upper end of the price band prior to opening of the issue that is equal to the difference between the upper end of the price band and the initial subscription price paid by them.
Lock-in
The minimum promoter contribution is locked-in for three years from the date of allotment in an IPO[8]. The remainder of the shares held by the promoters are locked in for a period of one year. The entire share capital other than the minimum promoter contribution is also locked in for a period of one year from the date of allotment in the IPO[9], regardless of whether such shareholders are acting in concert with the promoter or are parties to a co-ordination or voting arrangement with the promoter or other shareholders. There are exceptions to this lock-in for shares held by employees pursuant to employee stock option schemes or following a transfer from an employee stock option trust[10]. There is also an exception for shares held by a domestic Venture Capital Fund (VCF) or a Category I or Category II Alternative Investment Fund (AIF) or a Foreign Venture Capital Investor (FVCI) registered with SEBI, provided these securities have been held for at least one year from the date of acquisition[11].
Accordingly, to the extent an investor has access to an FVCI, it is worth considering making an Indian investment through this FVCI for this reason alone.
Inconsistent Disclosure Standards
The ICDR Regulations adopt inconsistent disclosure standards for the offer documents. Regulation 24 requires “material disclosures which are true and adequate to enable the applicants to take an informed investment decision”. The format of the due diligence certificate set out in Form A of Schedule V to the ICDR Regulations that is required to be submitted by the book running lead managers to SEBI incorporates a similar standard except it requires material disclosures that are true and adequate to enable investors to make a “well informed decision” and not just “an informed decision” as required by Regulation 24. The “Issuer’s Absolute Responsibility” statement that is required to be set out on the cover page of the offer documents[12] adopts a different standard and requires the disclosure of “all information which is material in the context of the issue, that the information contained in the offer document is true and correct in all material aspects and is not misleading in any material respect, and that there are no other facts, the omission of which make this document as a whole or any of such information misleading in any material respect”. In addition, because the securities in an Indian IPO are offered to investors outside India pursuant to a private placement in those jurisdictions subject to compliance with selling restrictions applicable in those jurisdictions, book running lead managers also require warranties from the issuer and promoter that conform to the standard in Rule 10b-5 under the US Securities and Exchange Act of 1934 – the offer documents do not contain an untrue statement of a material fact or omit to state a material fact necessary to prevent the statements made from being misleading.
As a result, the warranties provided to the book running lead managers by the issuer and the promoters conform to all of these inconsistent standards.
The offer documents are required to be signed by all directors of the issuer and not just the whole-time directors and sign a declaration that all statements are “true and correct”[13]. There is no materiality qualifier. Since independent directors and nominee directors of investors will also need to sign this declaration they should be made aware of this requirement well before the date of execution and obtain the protection they require in order to sign this declaration.
Conversion of Convertible Instruments
Convertible instruments must be converted on or prior to filing the red herring prospectus[14]. A number of private equity investors link their conversion formula to the issue price in an IPO. The difficulty is that the price band in a book built issue[15] is usually only announced a few days after filing the red herring prospectus, and therefore, the conversion of convertible instruments must occur at a time when there is no certainty on the issue price or even the price band. Investors attempt to address this difficulty by becoming a part of the IPO sub-committee of the board of directors that is authorised to approve the price band or requiring the promoters to transfer shares to them prior to allotment in the IPO if they converted at a higher price but that has tax implications[16].
SEBI has in its observations to various draft herring prospectuses stated that all preferential rights provided to an investor must also terminate upon filing a draft red herring prospectus except perhaps the right to appoint a director if such appointment is approved at the first annual general meeting of the shareholders following listing. A failure to remove these preferential rights implies, so we are told, that such investors must also be classified as promoters. This means the shareholders agreement must terminate upon filing a draft red herring prospectus. Even though arguably it is no longer necessary to set out the terms of a shareholders agreement in the articles of association of an Indian company, these rights tend to be repeated in the articles of association. In addition, the articles of association of the issuer must comply with certain requirements specified by the stock exchanges. As a consequence, the shareholders agreement is amended to terminate upon consummation of the IPO, i.e. admission of the equity shares of the company to listing and trading on a recognised stock exchange. The articles of association are amended to provide that the provisions of the articles that reflect the terms of the shareholders agreement shall not be applicable from the date of filing the draft red herring prospectus, provided they shall be resurrected if the IPO is not consummated by a specified date.
SEBI Observations
The draft red herring prospectus is filed with SEBI together with a cover letter and requisite filing fees that are determined on an estimated issue size[17]. The problem with determining fees at this stage on the basis of an estimated issue size is that at the time of filing the draft red herring prospectus there is no price band and the number of shares to be issued or the amount to be raised may not be specified. As a result, the estimate applied for paying filing fees may be significantly different from the issue size once the price band is determined because of, for instance, the consequences of the pandemic on the business and financial condition of the issuer. SEBI requires refiling of the draft red herring prospectus (which means the timeline resumes from the beginning) if (i) in case of a fresh issue, the estimated issue size increases or decreases by more than 20 per cent; or (ii) in case of an offer for sale, either the number of shares offered for sale or the estimated issue size, increases or decreases by more than 50 per cent[18]. If this were to happen as a consequence of the estimate included in the cover letter for the purposes of determining the fees payable to SEBI, an exemption will need to be obtained from SEBI in respect of the requirement to refile the draft red herring prospectus.
SEBI is required to provide its observations to the draft red herring prospectus within 30 days of the later of (i) the filing of the draft red herring prospectus; and (ii) receipt of a satisfactory response from the lead managers to any clarification or additional information sought by SEBI[19]. SEBI usually seeks clarifications or requires additional information and consequently SEBI’s observations take closer to two months from the date of filing the draft red herring prospectus.
Although SEBI makes an effort to clarify that its observations do not in any manner imply any approval by SEBI of the offer document and requires a disclaimer to this effect to be incorporated in bold capital letters[20], SEBI does not rely merely on a confirmation that all of its observations have been incorporated, it requires the lead managers to submit an updated draft red herring prospectus that incorporates SEBI’s observations and highlights the changes made to the draft red herring prospectus. This inevitably increases the compliance and time period before a red herring prospectus can be filed with the relevant Registrar of Companies.
The draft red herring prospectus is required to be placed on the websites of SEBI, the stock exchanges where the equity shares are proposed to be listed and the lead managers[21]. The relevant regulation doesn’t merely state that it must be made available to the public but also states that public are “invited” to provide their “comments” in respect of the disclosures made in the draft red herring prospectus. I think the term “comments” is misplaced here since an offer document contains disclosures made by the issuer supported by appropriate warranties and not draft legislation that is open for public comment. There is a great distinction between an offer document being made available to the public to enable them to make an informed investment decision and inviting comments to the document.
As a result, perhaps, persons aggrieved with the issuer or the promoters or a member of the promoter group write unsubstantiated letters to SEBI and the lead managers alleging fraud, dishonesty and inevitably that the draft red herring prospectus allegedly contains material omissions and misstatements. There is no filtration process and SEBI and the lead managers simply forward the compliant to the issuer and expect the issuer to address the compliant or write a response to those persons and SEBI refuting the allegations. Quite often issuers end up conceding to the demands made by these persons regardless of how unreasonable or unjustified they may be.
Changes to share capital after filing the Draft Red Herring Prospectus
The issuer is not permitted to issue any additional shares, except pursuant to an employee stock option scheme and the shares proposed to be issued in the IPO, during the period between the date of filing the draft red herring prospectus and consummation of the IPO, unless full disclosure in respect of the aggregate number of shares or amount proposed to be raised from such further issue is made in the draft red herring prospectus[22]. In essence this means that unless a pre-IPO placement is contemplated in the draft red prospectus, no such placement can be made. The pre-IPO placement itself can be structured to provide for the issuance of shares at the IPO price simultaneously with allotment in the IPO where subscription proceeds are placed in escrow and adjusted once the IPO price is determined or the issuance and allotment of shares to pre-IPO investors prior to filing the red herring prospectus (as opposed to simultaneously with the public in the IPO) at a negotiated price agreed prior to the determination of the IPO price, and hence at a price that may be at variance with the IPO price that is determined subsequently.
Transfers by the Promoter and Promoter Group
The issuer is required to report any transfer of shares by the promoters and promoter group in the period between filing the draft red herring prospectus and consummation of the IPO within 24 hours to the stock exchanges on which the shares are proposed to be listed[23]. This requirement can be quite problematic because of the expansive definition of promoter group and potentially the inability of the issuer to monitor any transfers by members of the promoter group if the shares have been dematerialised.
Underwriting or the lack of it
The underwriting agreement is only executed after the closure of the bid/offer period even though it includes language to procure investors. Consequently, underwriting in an Indian IPO does not mean the underwriters have an obligation to subscribe or procure subscribers for an issue if it fails to cross the minimum subscription requirement of 90 per cent of the primary issue or if the subscription is less than 100 per cent.
All bids, other than those by anchor investors, in an IPO are required to be made through the ASBA process, which means that the bid amounts set out in the bid-cum-application forms are required to be supported by the blocking of equivalent amounts in the respective bidder’s bank accounts. Anchor bidders are required to pay the entire bid amount at the time of submissions of their application forms.
As a result, the underwriters are not even required to take payment risk of the bidders.
Endnotes
[1] Under the RBI Master Circular on Wilful Defaulters dated 1 July 2015, a wilful default must be “intentional, deliberate and calculated”. In practice, however, we are aware of instances where borrowers that have not siphoned off or diverted loan proceeds have also been classified as wilful defaulters and even though the Master Circular specifies that non whole time directors should only be classified as wilful defaulters in rare instances and only if it is established that the wilful default occurred with his or her consent or connivance, again, we are aware of instances where independent directors have also been classified, at least initially, as wilful defaulters.
[2] Regulation 5(1) of ICDR
[3] Regulation 6(1) of the ICDR
[4] Regulation 6(2) of the ICDR
[5] Regulation 8 of the ICDR
[6] Regulation 14(1) of the ICDR
[7] Regulation 15(1)(b) of the ICDR
[8] Regulation 16(1) of the ICDR
[9] Regulation 17 of the ICDR
[10] Regulations 17(a) and (b) of the ICDR
[11] Regulation 17(c) of the ICDR
[12] Part A of Schedule VI to the ICDR Regulations
[13] Part A of Schedule VI to the ICDR Regulations
[14] Regulation 5(2)(b) of the ICDR
[15] The vast majority of Indian IPOs follow the book-built approach for determining the issue price for regulatory and other reasons.
[16] See for instance, Section 56 of the Income Tax Act, 1961, as amended.
[17] Schedule III to the ICDR
[18] Paragraph 1(f) of Schedule XI to the ICDR
[19] Regulation 25(4) of the ICDR
[20] Part A of Schedule VI to the ICDR
[21] Regulation 26(1) of the ICDR
[22] Regulation 56 of the ICDR
[23] Regulation 54 of the ICDR
This material is for general information only and is not intended to provide legal advice. For further information, please contact: