1 READING MATERIAL Advanced Securities Law UNIT 2 Public Issues: Initial Public Offering- II
2 ADVANCED SECURITIES LAW 2 In the previous Unit we began our study of initial public offers ( IPOs ). We looked at what constitutes an IPO and understood the eligibility criteria to be fulfilled by an issuing company. In this Unit, we will look at the process followed by an issuing company in the run up to an IPO. As we go through the process, we will refer to the requirements laid down in the relevant provisions of the Companies Act, 2013 ( Companies Act ) and the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 ( ICDR Regulations ). Now that we are familiar with the conditions that an issuing company is required to comply with in order to undertake an IPO, let us delve into the process to be followed by such a company. Before moving forward, please note that the ICDR Regulations clearly lay out the process to be followed in case of a book- building issue in Part A of Schedule XI. You can access a copy of the ICDR Regulations at june26_p.pdf. Appointment of Merchant Bankers and Other Intermediaries One of the key participants in an IPO is the merchant bank or lead manger or, in the case of a book- building issue, a book- runner. 1 To broadly understand the key participants involved in an IPO, please do refer to our Programme on Introduction to Securities Law on mylaw.net.
3 ADVANCED SECURITIES LAW 3 Merchant bankers or lead managers are intermediaries that specialise in the marketing, selling, and research of securities. The ICDR Regulations mandate that an IPO must have at least one merchant banker, 2 though usually multiple merchant bankers are appointed in an IPO. The number usually depends on the size of the IPO and the ability of the merchant bankers to market it. In order to appoint the intermediaries, the company enters into an agreement with the merchant bankers, commonly known as the Issue Agreement. 3 This agreement in the context of the IPO, amongst other things, sets out the role of the lead managers, the term of their engagement, the terms of the issue, the responsibility of the company to provide information and documents to the lead managers, and the duties of the lead managers to appoint intermediaries. A format of this agreement is provided in Schedule II to the ICDR Regulations. If the IPO is a book- building issue, the company is also required to appoint syndicate members and bankers to the issue. 4 The company must also appoint a registrar to the issue, who cannot be the lead merchant banker. Investors can contact the registrar to the issue in case of any pre- issue or post- issue related problems such as non- receipt of letters of allotment, credit of allotted shares in respective beneficiary accounts, and refund orders. 5 Importantly, the company must only appoint intermediaries who are registered with the Securities and Exchange Board of India ( SEBI ). The allocation of responsibilities between the intermediaries is discussed in detail in Schedule I to the ICDR Regulations. The Offer Document: Draft Red Herring Prospectus to Final Prospectus We know that the primary document based on which an issuing company undertakes an IPO is the offer
4 ADVANCED SECURITIES LAW 4 document or the prospectus. In this section, we will delve into the nature, process of drafting, key components, filing, and registration of a prospectus. What is a prospectus? A prospectus is the final document released by an issuing company to the public. Investors in the public rely on this document to determine whether to invest in the issuing company and to what extent. The Companies Act defines a prospectus in Section 2(70) as any document that is issued or described as a prospectus. It covers any red herring prospectus, shelf prospectus, notice, circular, advertisement, or any other document that invites offers from the public for subscription to or purchase of any securities of a company. The issue of a prospectus is mandatory except: In the case of a rights issue; When the issue relates to shares which are in all respects uniform with shares previously issued and for the time being quoted on a stock exchange; or Where shares are not offered to the public, for instance when shares are placed privately to less than fifty persons. Please note that we will discuss rights issues and private placement in later Units. Illustration: StartMeUp Private Limited is a new private company launched by its promoter Mr. KV who holds 100 shares in the company. Mr. KV has started this company with the aim of changing the social media sector. He decides to bring in certain other stakeholders who have technical expertise in that field Mr. AG and Mr. DP. He offers them a stake in the company. The company issues fifty shares each to Mr. AG and Mr. DP. In such a scenario, the shares are being placed privately and no prospectus needs to be issued.
5 ADVANCED SECURITIES LAW 5 Components of a prospectus The prospectus must comply with both Section 26 of the Companies Act, which prescribes the broad contents of the prospectus and Chapter III of the ICDR Regulations, which contains a more detailed description of every item that a prospectus contains. Broadly, the Companies Act requires the disclosure of information regarding the issuing company, for instance its management, the projects that the company proposes to undertake, if any, and the financial statements of the company along with major risks that the company faces. Essentially, every prospectus is required to ensure that the issuing company is disclosing all the relevant details (including risks) about itself and its business. Thus, the general public has the required information to assess whether they would like to invest in the IPO and assume the risk that the company and its business carry. Further, the prospectus is also a document for the issuer to protect itself against liability. If the issuer discloses all material information in the prospectus, then it is protected from any fraud or misrepresentation claims by investors. Hence, it is in the interest of the issuer to ensure complete disclosure. Interestingly, under Indian law, in the case of a specific issuance by an Indian company to sophisticated investors the disclosure requirements and the requirement of a detailed prospectus are not present, as in the eyes of the regulator the risk involved here is lower since the issue is not proposed to be made to the general public. Now let us look at the factors that affect the drafting of the prospectus. Due diligence Before proceeding to the finer aspects of a due diligence, it will be useful to understand a lawyers role in an IPO. The lawyers work together with the issuing company and
6 ADVANCED SECURITIES LAW 6 merchant bankers throughout the IPO process. Typically, the main role of lawyers and merchant bankers is to ensure that the offer document is drafted in accordance with regulatory requirements, the information in the offer document is true and correct, and all material information for prospective investors have been included in the offer document. 6 A well- prepared and transparent offer document serves as an insurance policy for the issuer against allegations from investors with respect to the IPO. Due diligence forms the very basis for drafting a transparent offer document, which is true and correct. A due diligence process serves the following purposes: Verifying the statements made in the offer document: As far as possible the statements made in the offer document should be independently verified from the documents available with the issuing company. Identifying issues with regard to the IPO: The diligence is meant to raise all potential legal issues with respect to the issuing company and the IPO. Some of the common issues that arise: Consent required from third parties such as lenders; Breach of material agreements; Potential issues in material agreements such as unilateral right of termination by other parties; Important litigation that could prove, has proved, or could have proved to be harmful to the company; Necessary licenses or approvals not in place; and Breach of any law/regulations in the past, which have not been addressed or detected so far. Please note that while the lawyers carry out a legal due diligence, the lead managers carry out a commercial due diligence. This diligence addresses the financial performance and prospects of the issuing company.
7 ADVANCED SECURITIES LAW 7 As mentioned before, the offer document acts as liability insurance for the company and the lead managers. This is mainly because any investor should invest in the shares only after reading the full offer document. Therefore, it is deemed that any risk or potential future liability that is highlighted in the document is read and understood by the investor. The lead managers also run the risk of being sued by an investor and being imposed with sanctions by the SEBI for non- fulfilment of its duty of due diligence as a lead manager. A lawyer in charge of drafting the document should, therefore, be extremely careful in ensuring the accuracy of the offer document. Some of the key rules for drafting an offer document are as follows: No projections, forward- looking statements: A lawyer drafts the document based on the diligence done on the company. 7 While projections are prohibited by the regulations, forward- looking statements are generally frowned upon unless backed up by documents. Illustration: The company cannot state that it is planning to acquire Five hundred acres of land in Mumbai without back up documents such as a letter of intent or a memorandum of understanding. The only flexibility in this regard is provided in the strategy section of the offer document, as part of the chapter where the company discusses its business operations, where the broad strategies to be followed by the company, including strategies in the future, are provided. No superlatives should be used unless backed up by a third party independent source. Adjectives, which are superlative in nature, should be avoided.
8 ADVANCED SECURITIES LAW 8 Illustration: The issuing company cannot state that the product they are manufacturing is the best in the country unless they can cite an independent source as having made that determination or assertion. All issues identified in the diligence that can be a potential threat to an investment in the company should typically be highlighted in the offer document. Disclosure requirements There are mainly two types of disclosures in the offer document: Mandated by law, that is, the ICDR Regulations; and Disclosures driven by good practices of highlighting key issues. Part A of Schedule VIII of the ICDR Regulations deals, in detail, with the disclosures to be made. We recommend that you go through Schedule VIII before proceeding further. While this Unit does not cover the details of all the disclosures required to be made in the offer document, it is necessary to know the following important mandatory disclosures, which require an exercise of judgment on the part of the issuer, the lead managers and the lawyers: Risk Factors: This is one of the most important chapters in the offer document. It highlights all present and potential material risks in the company. The risk factors are usually of the following kinds: Risks pertaining to the company: These are the risks that have come out of the legal, financial, and business diligence. The financial and business due diligence are typically the same as a commercial diligence. These include risks with respect to the business model of the company and current or potential litigation risks. Risks associated with the industry: These include general risks that every company in that industry
9 ADVANCED SECURITIES LAW 9 faces, which may affect the investors decision to invest in that industry. Illustration: A company engaged in the passenger airlines sector would be affected by fluctuating fuel prices, as it would result in airfares increasing leading to a decline in travel and revenues for the company. External risks: These are more general risks that are applicable to all companies, such as strikes, terrorist attacks, war, and other similar scenarios. Risks relating to investing in equity securities: This section highlights the generic risks of investing in volatile securities such as equity shares. Objects of the Issue: The offer document must clearly detail the use of the proceeds of the IPO. Typically, a company shows that the funds would be used for capital expenditure, setting up of projects, or similar activities. A third party agency is usually appointed to oversee the use of proceeds. Identification of the Promoter, Promoter Group, and Group Companies: This is one of the key aspects of an IPO, as the public needs to know who the promoter behind the issuing company is. In addition, the ICDR Regulations require the disclosure of other promoter group entities, which also hold shares in the company, as well as group companies. To better understand the manner in which the promoter, promoter group, and group companies can be identified, please refer to Annexure 1 of the Supplementary Material for this Unit. Financial Statements: While the lawyers have very little role to play in the financial statements, it is important to know the following key aspects of financial information to given in the offer document: 8 The financial statements must be audited; The financial statements of last five years must be provided; The latest financial statements cannot be more
10 ADVANCED SECURITIES LAW 10 than six months old. Therefore, often audited financials of a quarter or half yearly financials are also included depending on the timing of the filing of the offer document; Financial statements must be restated, that is, brought in compliance with the applicable accounting guidelines. Importantly, financial statements must be capable of comparison across different years and quarters; and The ICDR Regulations mandate certain specific schedules such as borrowing details, which must be included. Other disclosures: Some of the other chapters that are contained in the offer document include: Capital Structure: Disclosure in relation to the allotments made by the company and the current shareholding of the promoters; Basis of Issue Price: Disclosure of the basis for the identified price band and issue price, including but not limited to earnings per share, price earning ratio, average return on net worth, net asset value per share, and comparison of such data with that of the peer group of the issuer company. Statement of Tax Benefits: Description of any special tax benefits for the issuer and its shareholders. Issuer s business: A description of the business undertaken by the issuing company. Industry: A description of the industry in which the issuing company operates along with an update on the recent relevant developments in that industry, if any. Issuer s management: A description of the board of directors, the board committees of the issuer company, and the key management personnel at a level below the board.
11 ADVANCED SECURITIES LAW 11 Regulations and policies in India: An overview of the regulations and policies applicable to the issuer company on account of the business conducted by the issuer company. History and certain corporate matters: A description of the history of the issuing company and its incorporation. Issuer s subsidiaries and other consolidated entities: A descriptive list of the subsidiaries of the issuing company and any other entities the results of whom are consolidated into the accounts of the issuing company. Management s discussion and analysis of financial condition and results of operations: Analysis on the results of operations, the factors that may effect the results of operations, comparisons of the most recent financial year with the previous financial years (at least last three financial years) on the major heads of the profit and loss statement including an analysis of reasons for the changes in significant items of income and expenditure. Outstanding litigation and material developments: Description of the litigation initiated by and against the issuer company, its subsidiaries and consolidated entities, its directors, promoters, and group companies. In order to add credibility to the representations and disclosures made in the offer document, the issuing company often includes statements from experts in the relevant fields for the purposes of the disclosure. Please refer to Annexure 2 in the Supplementary Material to this Unit to better understand the conditions stipulated in the Companies Act in relation to such expert statements. Filing of the offer document Once a draft of the offer document is prepared, it is referred to as the draft red herring prospectus ( DRHP ).
12 ADVANCED SECURITIES LAW 12 A DRHP must be filed, along with specified fees, at the stock exchanges where the securities are to be listed. The DRHP must also be filed with the SEBI at least thirty days prior to filing of the red herring prospectus or prospectus with the relevant Registrar of Companies ( RoC ). Illustration: If the DRHP is filed on June 30, 2011, then the red herring prospectus can be filed only after July 30, On a practical note, however, this should never be a problem as the process of receipt of observations on the DRHP, responding to them, and finalising the document necessarily takes longer than thirty days. On receiving the DRHP, the SEBI may issue its observations and suggest changes to the DRHP, within thirty days from the later of the following dates: The date of receipt of the DRHP; or The date of receipt of satisfactory reply from the lead merchant bankers, where the SEBI has sought any clarification or additional information from them; or The date of receipt of clarification or information from any regulator or agency, where the SEBI has sought any clarification or information from such regulator or agency; or The date of receipt of a copy of the in- principle approval letter issued by the recognised stock exchanges 9. The issuer then amends the DRHP to the satisfaction of the SEBI. In the case of a book- building issue, this revised document is a red herring prospectus, which is almost final, except for the number of shares and the price of the shares. This red herring prospectus is filed with the SEBI, along with a letter explaining the manner in which the SEBI s observations have been incorporated. 10 After the bidding process and fixing the price, the final prospectus is issued.
13 ADVANCED SECURITIES LAW 13 In the case of a fixed price issue, the revised DRHP becomes the prospectus straight away. Registration of a Prospectus The final prospectus must be filed with the SEBI, the stock exchange on which the securities are to be listed, and registered with the RoC. According to Section 26(4) of the Companies Act, a copy of the prospectus signed by every person named as a director or a proposed director or his or her duly authorised attorney must be registered with the RoC before the prospectus is issued to the public. The prospectus must be accompanied, amongst other documents, by the experts consent and all material documents enlisted in the prospectus. Section 26(7) further states that the RoC cannot register a prospectus unless the requirements of Section 26 of the Companies Act have been complied with. Note that these provisions have been discussed in the Supplementary Material to this Unit. Further the prospectus must be accompanied by the requisite consent in writing of the person, if any, named in the prospectus as the auditor, legal advisor, attorney, solicitor, banker, or broker of the company. In addition to this, a prospectus must be issued within ninety days of its registration with the RoC or a fresh registration would be required. 11 The offer documents filed with SEBI are available at dolistdept=yes&deptid=1 and you may find them interesting and also helpful in understanding this area of practice. With this we conclude our study of the process to be followed by an issuing company while preparing an offer document. In the next Unit we will continue to look at public issues and some other key aspects that must be borne in mind for IPOs and public issues in general.
14 ADVANCED SECURITIES LAW 14 Suggested Reading Articles Manendra Singh, Liability for Misstatement in Prospectus: Where to Stop, Legal India, accessed at for- misstatement- in- prospectus- where- to- stop. Court directs SEBI to probe DLF s misstatement in RHP, Economic Times, April 11, 2010 accessed at 11/news/ _1_red- herring- prospectus- dlfs- sebi. Statutes and Regulations Chapter III, Companies Act, Securities and Exchange Board of India, ICDR Regulations accessed at
15 ADVANCED SECURITIES LAW 15 Web pages Securities and Exchange Board of India, How to Read Offer Document and Invest in IPO page, accessed at /How- to- Read- Offer- Document- and- Invest- in- Initial- Public- Offers- IPO-. 1 Regulation 2(1)(g), ICDR Regulations. 2 Regulation 5(1), ICDR Regulations. 3 Regulation 5(5), ICDR Regulations. 4 Regulation 5(6), ICDR Regulations. 5 Regulation 5(7), ICDR Regulations. 6 Regulation 64, ICDR Regulations. 7 Clause 1(e), Part A, Schedule VII, ICDR Regulations. 8 Regulation 68, ICDR Regulations. 9 As required by Regulation 7, ICDR Regulations. 10 Regulation 6, ICDR Regulations. 11 Section 26(8), Companies Act.