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The author is Avantika, student at Campus Law Centre, Faculty of Law, Delhi University.
In a significant step towards creating a more business-friendly environment in India's financial sector, the Securities and Exchange Board of India (“SEBI”) recently released a consultation paper with the aim of facilitating ease of doing business. The Consultation Paper is based on the interim recommendations put forth by an Expert Committee which was tasked with facilitating ease of doing business, enhancing transparency, and harmonizing regulations within the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”) and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”) frameworks.
While the proposed changes to the ICDR regulations and LODR regulations are expected to foster a more conducive business environment, it is equally important to view these recommendations through the lens of investor protection. Striking a balance between facilitating ease of doing business and safeguarding investor interests is imperative in this ever-evolving financial landscape. This post explores key recommendations in the proposed ICDR regulation changes for listing, discussing the rationale and expressing concerns such as the dilution of promoter influence and potential conflicts of interest, while also suggesting safeguards. The author then delves into the proposed changes to the LODR regulations for listed companies, discussing the 'sunset clause' and alterations in ranking based on market capitalization, while highlighting concerns about frequent regulatory changes, potential manipulation of rankings, and their impact on investor perception.
Road to Listing Gets Easier
A significant recommendation in the consultation paper, aimed at easing the requirements for companies going public, is the proposal to allow non-individual shareholders who hold 5-10 percent of the post-offer equity share capital to contribute towards the Minimum Promoters’ Contribution (“MPC”) without being identified as promoters and to include equity shares obtained through the conversion or exchange of fully paid-up compulsory convertible securities and depository receipts in the MPC. As per the current norms under Regulation 14 of the ICDR regulations, the promoters of a company planning to go public are required to contribute at least 20% of the post-issue capital. This requirement is aimed at ensuring that the promoters have a significant stake in the company and thus, a vested interest in its success.
The recommendation is particularly beneficial for companies promoted by entrepreneurs who often undergo several rounds of funding prior to listing their equity shares on the stock exchanges, which may result in the promoters’ holding falling short of the MPC. However, this recommendation also raises significant considerations regarding its impact on the overall corporate governance and decision-making process within the company. The contribution of non-individual shareholders to the promoter’s stake could dilute the promoter’s stake and influence in the company, potentially altering the power dynamics within the company. While non-individual shareholders, such as institutional investors, may not be involved in the day-to-day business decisions of a company, they can significantly impact the company’s strategic direction like major investments and corporate governance, and play a crucial role in situations such as mergers and acquisitions, restructuring, or changes in the company’s management. This recommendation also raises concerns about potential conflicts of interest if these non-individual shareholders have other business interests. While the 10% cap on non-individual shareholders’ contribution towards the shortfall in MPC acts as a safeguard, SEBI should consider additional safeguards to protect the interests of all stakeholders. This could include restrictions on the voting rights of these non-individual shareholders and enhanced disclosure of their other business interests. In a consultation paper, SEBI has previously explored the concept of shares with Differential Voting Rights (“DVRs”) and emphasized that DVRs are an effective instrument that allows founders to raise capital and secure necessary funding without losing control. Thus, DVRs, coupled with enhanced disclosure norms, could provide a comprehensive solution to these concerns.
The proposed amendment to Regulation 15 of the ICDR regulations, which currently excludes equity shares acquired from the conversion of convertible securities within one year before filing the draft red herring prospectus, is a significant step towards providing more flexibility to promoters by broadening the types of capital that can be counted towards the promoter’s contribution. However, this proposal also raises concerns related to the valuation of convertible securities. Convertible securities are hybrid financial instruments that combine the features of both equity and debt. This dual characteristic introduces additional layers of complexity in their valuation as it needs to account for the price of the underlying equity, the conversion ratio, and the terms of the conversion. Given their complex nature, the valuation of convertible securities may not always accurately reflect the true value of the underlying equity shares, leading to potential discrepancies in the calculation of the promoter’s contribution. To address this, SEBI could consider mandating an independent valuation of the convertible securities to ensure a fair valuation. Furthermore, SEBI could contemplate introducing enhanced disclosure requirements for companies that include equity shares arising from the conversion of compulsory convertible securities in their promoter’s contribution. By requiring companies to disclose detailed information about the conversion terms, conversion ratio, and the price of the underlying equity, market participants would have a clearer understanding of the true value of these convertible securities. This would reduce the likelihood of discrepancies in the valuation of the promoter’s contribution, thereby ensuring a more accurate reflection of the company’s capital structure.
The consultation paper also proposes that the offer for sale size can be determined based on either the estimated issue size (in rupee value) or the number of shares as disclosed in the draft red herring prospectus, and not on both criteria. This is the only suggestion related to issue size and thresholds for an increase or decrease in issue size triggering re-filing of draft offer documents that has been accepted at this stage.
The suggestion to consider increasing the limit for a change in the size of the offer for sale from 50% to 100% and to consider increasing the limit for a change in the size of the fresh issue from 20% to a higher number (such as 35%) for re-filing of the draft offer has not been accepted yet and requires further deliberation due to their potential impact on investors, the additional due diligence required, and the potential effect on the objectives of the offering. SEBI could consider increasing the review period for the red herring prospectus to give investors more time to assimilate additional facts and make an informed decision. Additionally, SEBI could allow changes to the fresh issue size or the addition of selling shareholders in a phased manner rather than all at once to address the implementation challenge of additional due diligence to be carried out by merchant bankers. However, accepting these suggestions would necessitate increased regulatory oversight to ensure they are in the best interest of all stakeholders. Despite additional review and phased implementation, there will be concerns, like objects of the offer getting impacted, as identified by the expert committee, and there is a risk that ease will outweigh investor interest.
Easing the Compliance Burden
The current LODR regulations stipulate that once a company falls into a specific category (such as the top 100, 250, 1000, or 2000), it remains in that category indefinitely, even if its market capitalization decreases. This can impose a significant compliance burden on companies, especially those whose rankings subsequently fall and remain outside these categories. To alleviate this burden, the consultation paper has proposed the introduction of a “sunset clause." This means that if a company's ranking changes and it consistently remains outside the applicability threshold (not in the top 100/250/1000/2000) for three consecutive years, the relevant LODR regulations will no longer apply to it. This proposal is centred around the financial strain that companies face when they are required to maintain compliance over the long term, even when their market capitalization has decreased and consistently stays below the threshold of applicability. Despite their diminished market value, these companies are still obligated to meet the same regulatory standards as their larger counterparts under the existing rules.
While this proposal can ease the cost of compliance for these companies, potentially freeing up resources that could be used elsewhere in the business, the implementation of the sunset clause could lead to frequent changes in the company’s regulatory status. If the company is not subject to the same regulations as larger entities, investors may doubt the effectiveness of its management. This could increase perceived risk, deterring investors and impacting the company’s ability to attract investment. Another concern is the potential manipulation of rankings. Since companies would no longer be bound indefinitely to a specific category, they may manipulate their rankings to fall below the threshold, thereby evading regulatory requirements. While a high ranking is generally seen as a positive thing as it can enhance a company’s reputation and potentially attract more investors, it also entails increased regulatory scrutiny and compliance obligations. So, if the costs and resources required for compliance significantly outweigh the benefits of a higher ranking, a company might choose to manipulate its ranking.
The consultation paper also proposes a significant change in the method of determining the ranking of entities. Instead of basing the ranking on the market capitalization of entities as of 31st March, it has been proposed to determine the ranking based on the average market capitalization of listed entities during the preceding six months, from July 1 to December 31. A significant implication of this recommendation would be the greater impact of any company-specific event or market trend that occurs during this period on the ranking of a company. For example, if an event that affects the stock of a company occurs in September, it will significantly impact the ranking as it falls within the six-month period used to calculate the average market capitalization. In contrast, if the ranking was determined based on the market capitalization as of 31st March, the event might not have as significant an impact on the ranking. However, it is crucial to underscore that the proposed recommendation is favourable. The market capitalization of a listed entity experiences daily fluctuations based on market dynamics. By calculating an average over a reasonable period, the impact of short-term market fluctuations can be minimised. This leads to a more accurate representation of the entity’s market size and ensures that the ranking is reflective of the company’s performance over a more extended period rather than a snapshot of a single day.
Conclusion
In conclusion, while the proposed recommendations outlined in the consultation paper by SEBI undoubtedly aim to ease the business environment and compliance burden for companies, a nuanced approach is essential. Some recommendations, such as the introduction of a "sunset clause" and changes related to minimum promoters’ contribution present potential benefits but also raise concerns. Striking a delicate balance between promoting ease of doing business and safeguarding investor interests will be crucial in navigating the evolving financial landscape. Further deliberation and the implementation of additional safeguards may be necessary to ensure a harmonious alignment of regulatory changes with the diverse needs of stakeholders in the Indian financial sector.