The principal legislations governing the Securities Market in India are:
- Securities and Exchange Board of India Act, 1992, as amended.
- Securities Contracts (Regulation) Act, 1956, as amended.
- Securities Contracts (Regulation) Rules, 1957, as amended.
- The Companies Act, 2013, and rules framed thereunder, each as amended (“Companies Act”).
- Rules and regulations framed by the Securities and Exchange Board of India (“SEBI”) from time to time including, amongst others, the following:
- SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, as amended.
- SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, as amended (“SEBI ICDR Regulations”).
- SEBI (Prohibition of Insider Trading) Regulations, 2015, as amended.
- SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, as amended.
An Offer refers to the raising of funds by issuing securities such as shares or debentures to proposed investors. An Offer can further be broadly categorized into (a) Public Offer; (b) Private Placement; and (c) Rights Issue.
The term “Public Offer” denotes an offer of shares or other securities to the public by the issuer company. This is typically done, though issue of a prospectus, in compliance with the provisions of the Companies Act and the applicable SEBI regulations. Section 23 to Section 40 of the Companies Act and the SEBI ICDR Regulations deal with the requirements in relation to “Public Offers”.
The term “Private Placement” as commonly understood is issuance of shares or other securities by the issuer company to certain identified investors on a private placement basis. Section 42 of the Companies Act and the SEBI ICDR Regulations (in case of listed issuer company) are applicable for issuance of shares on “Private Placement” basis.
If the issuer company is issuing shares to more than 200 persons in a financial year, in such a scenario the issuer company is required to comply with requirements in relation to “Public Offer”. Further issuance of shares to qualified institutional buyers or issuance of shares pursuant to exercise of stock options is exempted from the 200 persons limit specified above.
“Rights Issue” is an issuance of shares by the issuer company on a rights basis to the existing shareholders of the issuer company, in proportion to their shareholding in the issuer company. Section 62(1)(c) of the Companies Act and the SEBI ICDR Regulations (in case of listed issuer company) are applicable for issuance of shares on “Rights Issue” basis.
A public issue of shares and instruments convertible into shares can either be by way of an IPO, or a Further Public Offer.
An IPO means an offer of specified securities to the public by an unlisted issuer. This can either be achieved by way of fresh issue of such specified securities, or by way of an offer for sale of such specified securities by the existing shareholders, or through a combination of both.
The SEBI ICDR Regulations and the Companies Act deal with provisions in relation to the IPO of shares and instruments convertible into shares. Further, there are sector specific regulations which are required to be complied with in relation to an IPO.
In case of public offer of debentures, the provisions of the SEBI (Non-convertible Securities) Regulations, 2021, as amended, and the provisions of the Act are required to be complied with. Similarly, there are specific regulations framed by SEBI regulating manner and mechanism of public offering depending on the nature of securities.
Regulation 5 of the SEBI ICDR Regulations provides a list of events or circumstances under which an issuer cannot go public. The restrictions specified in Regulation 5 are listed below:
- If the issuer, any of its promoters, promoter group or directors or selling shareholders are debarred from accessing the capital market by SEBI.
- If any of the promoters or directors of the issuer is a promoter or director of any other company which is debarred from accessing the capital market by SEBI.
- If the issuer or any of its promoters or directors is a wilful defaulter.
- If any of its promoters or directors is a fugitive economic offender.
Further, an issuer shall not be eligible to make an Initial Public Offer if there are any outstanding convertible securities or any other right which would entitle any person with any option to receive equity shares of the issuer.
Furthermore, the stock exchanges also provide their own eligibility requirements for an issuer going public. The list of such requirements, amongst others, include (a) Minimum post-issue paid up capital of INR 10,00,00,000, (b) minimum issue size of INR 10,00,00,000, (c) minimum market capitalization of INR 25,00,00,000, (d) absence of referrals to the Board for Industrial and Financial Reconstruction, (e) absence of any winding up petitions admitted by a court.
As mentioned above, Regulation 5 deals with regulatory restrictions on an issuer to go public. Regulation 6 of the SEBI ICDR Regulations provides financial threshold criteria for an issuer to go public.
Regulation 6(1) of the SEBI ICDR Regulations provides that an issuer shall be eligible to make an IPO only if:
- The issuer has net tangible assets of at least three crore rupees, calculated on a restated and consolidated basis, in each of the preceding three full years (of twelve months each), of which not more than fifty per cent. are held in monetary assets. Provided further that the limit of fifty per cent. on monetary assets shall not be applicable in case the initial public offer is made entirely through an offer for sale;
- The issuer has an average operating profit of at least fifteen crore rupees, calculated on a restated and consolidated basis, during the preceding three years (of twelve months each), with operating profit in each of these preceding three years;
- The issuer has a net worth of at least one crore rupees in each of the preceding three full years (of twelve months each), calculated on a restated and consolidated basis;
- If the issuer has changed its name within the last one year, at least fifty per cent. of the revenue, calculated on a restated and consolidated basis, for the preceding one full year has been earned by it from the activity indicated by its new name.
In case the issuer fails to meet the financial threshold criteria as specified above, the issuer still can proceed with the IPO under Regulation 6(2) of the SEBI ICDR Regulations provided that the issuer ensures that 75% of the net offer is subscribed by qualified institutional buyers.
Key participants in an Initial Public Offering (“IPO”) are as set out below:
The Issuer Company
The Issuer Company (or the ‘Issuer’) is the principal participant in any offering. After all, it is the shares of the Issuer that are issued to the public. A key figure within the Issuer is the Board of Directors upon whom rests the duty of getting the approval for the decision of going public, and of getting the various documents (related to the issuance) approved. While it is the final authority to decide on matters regarding the issuance and the listing, it does also employ a number of professional advisors and experts to assist it with the IPO process. For e.g., merchant bankers when contracted acquire the title of Lead Managers which grants them the authority to manage the various aspects of an IPO.
Book Running Lead Managers (“BRLMs”)
The BRLMs are perhaps the most crucial cog in any Issuer Company’s plan for a successful IPO. They are responsible for conducting due diligence of all necessary disclosures mandated in the offer document. Once satisfied, they then submit a due diligence certificate; that goes alongside the offer document. They also play an active role in the appointment of intermediaries and are responsible for their coordination both amongst themselves as well as with the Issuer. Apart from administration, the BRLMs also handle the marketing of the IPO and underwriting obligations. Lastly, with respect to post listing obligations, they file monitoring reports with SEBI and ensure redressal of all investor grievances (including in relation to allotment, refunds, dispatches and ensuring payment of interest to the applicants).
The obligations of preparing financials under the Act rests upon the company. However, the auditors of a company, owing to their financial expertise, are tasked with preparing the financial reports of a company post their diligence and in accordance with the accounting procedures prescribed under the Companies Act, in tandem with the accounting standards prescribed by ICAI. Statutory auditors audit and deliver to the issuer a report of its financial statements for inclusion in the offer document on a standalone and consolidated basis. Such a report is required to include audited financial statements prepared/ restated in accordance with the disclosure requirements under the SEBI ICDR Regulations, and the Companies Act. They also provide a statement of tax benefits, which may be available to the Issuer and the investors, concerning the eligible securities that are to be offered pursuant to an IPO. Lastly, they also hand out “comfort letters” to the BRLMs at various stages of an IPO to confirm the validity of the financial data that gets included in the offer document.
The term “Designated Intermediaries” collectively refers to the Syndicate, sub-syndicate/ agents, registered brokers, depository participants, the registrar, and the share transfer agents.
Registrar to an Issue
One of the intermediaries associated with the process of issuance is the registrar whose primary job is to compare and reconcile the data that is received from the stock exchanges. Furthermore, they coordinate the process of share allotment and are required to keeps track of all bids.
Arguably considered to have the most pivotal role in the process, it is the Legal Counsel that undertake the responsibility of drafting the offer documents and the transaction documents in connection with an IPO. In addition to these intrinsic tasks, they advise the Issuer and the BRLMs on the applicable laws and subsequently ensure compliance with it, including the restrictions in place concerning the publicity of the IPO. Lastly, they also play an active role in other agreements (for e.g., syndicate agreements) and ancillary documents; ensuring that they are properly negotiated and drafted.
The timeline of an IPO can be broadly categorized into three phases:
First Phase: Period prior to the filing of the Draft Red Herring Prospectus (“DRHP”)
- The first step is to determine whether the Issuer meets the eligibility requirements as laid down in the ICDR Regulations. Pursuant to this stage,, corporate authorizations must be taken for undertaking the IPO. This includes passing of resolutions by the Board of Directors and the Shareholders. In case of an Offer for Sale, consent of the selling shareholders must be taken.
- Appointment of the BRLMs, the legal counsel(s), registrar to the issue, and an ad agency.
- Kick-off meeting is the first meeting between the management of the Issuer and the intermediaries wherein the management of the Issuer discuss details regarding its business and explain the objective of going for an IPO, to the BRLMs and the Legal Counsels. Furthermore, a tentative Issue timeline is also discussed in this meeting. The counsel begins due diligence, and a data room is prepared. The drafting of the DRHP commences along with commencement of due diligence exercise.
- Alongside the DRHP, the drafting and signing of other ancillary agreements and documents also takes place. The agreements in question include the Issue Agreement, the Registrar Agreement, and the Service Provider Agreement, whereas the documents consist of standard certificates (mostly on factual matters) and comfort letters from the respective authorities.
- Following the approval of all parties and the completion of all previous steps, the DHRP is then filed with SEBI along with the due diligence certificate issued by the BRLMs. Parallel to this entire process, the Issuer is instructed to apply to the stock exchanges for in-principle listing approval(s).
- SEBI may direct certain changes via interim observations in the DRHP. The counsel advising on the IPO and the merchant bankers draft responses to such observations along with the Issuer. The DRHP is updated based on the observations received from SEBI and the updated DRHP, post receipt of final observations, is filed with SEBI.
- The next step for the Issuer is to file the Red Herring Prospectus (“RHP”), post receipt of final observations from SEBI which is valid for period of 12 months from the date of receipt of final observations.
- The penultimate step begins with the signing of a Syndicate Agreement and an Escrow Agreement. If the issue size exceeds Rs. 100 crores, the Issuer is required to also appoint a monitoring agency. The standard certificates and comfort letters to be obtained from Auditors are updated, and necessary signatures are obtained.
- Once all of this done, the RHP is filed with the RoC and SEBI and the Issuer waits for the RoC’s approval.
- Once the RHP has been filed with the RoC, the BRLMs start actively marketing the offering. The onset of advertising also beckons the beginning of the bid issue opening period. The Issuer is required to announce the price band at least two working days before opening of the bid period for an IPO. The bid period lasts for a minimum of 3 working days and a maximum of 10 working days for all investors except anchor investors (who bid one working day prior to the bid opening date). All the bidders (other than anchor investors) are only permitted to bid through the Applications Supported by Blocked Amounts (“ASBA”) process. Once this is deposited, it stays locked until allotment is made after which it is either transferred to the account of the company or is returned back to the bidder.
- Once the bid period closes, allotment of shares, collection of money, and refunds begin. BRLMs are required to co-ordinate with the Registrar to the issue. The flow of applications is monitored- both from the collecting bank branches and other intermediaries collecting applications through ASBA. Once everything is completed, the Issuer makes a listing application to the targeted stock exchange which provides the final listing and trading approval; after which, the trading commences.
Second Phase: SEBI observations on the DRHP
Third Phase: Filing of the RHP and Listing of the Issuer
An Offer Document is a disclosure document containing all disclosures about the Issuer company, its subsidiaries, promoters, promoter group entities, group companies, directors, amongst others, and anything which is material for investor to make a well- informed investment decision in an IPO.
The SEBI ICDR Regulations and the applicable provisions under the Act specifies the disclosure requirements to be included in an Offer Document prepared in connection with the Issue which, amongst others, includes information on financial condition, assets, and business(es) of the Issuer company and material consolidated entities, material litigations, potential risks, terms, and description of the securities being offered. Additionally, the reasons for the Issuance must be disclosed.
The offer document to be issued by the company proposing to list its shares on the platform of stock exchanges shall be in the form of a ‘prospectus’, and the prospectus shall not contain any misstatements, untrue statements or omission to state to a material fact.
The SEBI ICDR Regulations as well as provisions under the Companies Act describe in great detail the specific matters that need to be included in a prospectus as well as the manner in which such information is to be included. The reason for the emphasis on disclosure is investor protection. There is an inherent asymmetry of information between the company issuing securities and the investing public as the company is always in a better position to know about itself than the investors. Disclosure requirements are, thus, a means to bridge this asymmetry by forcing the Issuer to disclose information about itself as a pre-condition for a public issue of securities.
Further, having specific rules to govern the content and manner of disclosure in a prospectus allows for a certain degree of uniformity in the disclosures across companies. This enables investors to comparatively analyze the disclosures made by different companies and also makes it harder for companies to hide information that they may prefer not to disclose.
It is important to note that the rules regarding disclosure not only mandate that certain items regarding the Issuer need to be disclosed but also set out where in the prospectus they need to be disclosed and with what level of prominence.
Closely related to the disclosure requirements for a prospectus, is liability. The prospectus is a liability document and the issuer company and its directors, promoters, amongst others, are responsible for its contents. The Act provides for both criminal and civil penalties for untrue or misleading statements or omissions. The rationale behind these liability provisions is that companies, their promoters and directors should exercise great care and diligence in ensuring that the information supplied in a prospectus is true and accurate given that investors would be relying upon this information in making their investment decision.
Sections 34, 35, and 36 read along with section 447 of the Act deal with provisions in relation to civil and criminal liabilities for mis-statements in the Prospectus.
Section 34 (Criminal Liability):
Every person who authorizes the use of a Prospectus that contains a misleading/false statement is liable under Section 447. However, such would not be the case if the person is able to prove either that such a statement was immaterial, or he had reasonable grounds to believe that such information was either true or the warranted omission at the time of such authorization.
Section 35 (Civil Liability):
This section attaches civil liability for mis-statements to Directors or future/prospective Directors, promoters, anyone who authorized the use of the prospectus, and lastly, experts as defined under Section 26(5) of the Act. The only defense available to the Directors is contesting that such prospectus was issued without their consent and knowledge or that it had been issued even after their revocation of consent.
Section 36 (Criminal Liability):
Criminal liability may be incurred in the event that one fraudulently induces a person to invest in the securities of a company by deliberately misleading them through false/deceptive information.
The prospectus is a liability document as explained earlier which contains statement of facts in relation to the Issue and the Issuer and its connected entities. Further, SEBI expects Merchant Bankers to act in fiduciary capacity in primary market offerings, with the key role of providing information about the Issuer to the potential investors and distributing the offered securities. This requires Merchant Bankers to develop a fair understanding of the various facets of the Issuer which can facilitate informed investment decision making through appropriate disclosures in the Offer Documents. DD process is a key step in making meaningful disclosures in the Offer Documents to assist the investors in making an informed investment decision.
The process of verifying the legitimacy of all relevant records and data, to authenticate an action on part of all/ one of the parties involved, is known as DD.
Specifically in the context of a public offering, one can construe diligence through two distinct perspectives- the Issuer’s and of the Underwriter’s. The Issuer conducts due diligence to not only achieve ‘full and complete disclosure’ but to also mitigate any risks that might occur from the lack of it.
In contrast, the Underwriter’s motivation for conducting due diligence mostly stems from upholding the notion of Caveat Emptor (let the buyer beware). Any potential investor should be aware of any possible gaps in the proposed issuance and the risks involved in a particular Issue before subscribing to the shares of the Issuer.
Methodology of Legal Due Diligence
The process of legal due diligence can be classified into two buckets. Firstly – review of documents for disclosure of information in the offer document, and secondly – review of documents for identification of any potential issues or risks or red-flags which would require attention of all the concerned entities. For instance – review of ‘material’ business licenses can be done for disclosure of such information in the offer document but if such license is not valid, there is a potential issue required to be addressed to the Issuer and the Merchant Banker by the lawyers considering that it is a material business license which is not valid.
Issue Agreement -- Issue Agreement is entered into amongst the BRLMs and the Issuer prior to the filing of the Draft Red Herring Prospectus with SEBI. It sets out, amongst other things, the roles and responsibilities of the BRLMs, the conditions precedent to the BRLMs’ obligations, representations and warranties from the Issuer and BRLMs, details of the indemnity provided by the Issuer to the BRLMs and provisions for termination of the BRLMs’ engagement. The obligations of BRLMs are several and not joint. The fee arrangement is typically governed by an engagement letter entered into between the Issuer and each BRLM. If the IPO has an offer for sale component, the selling shareholders are also a party to the issue agreement.
Escrow Agreement – It can be categorized into Cash Escrow Agreement and Share Escrow Agreement.
- Cash Escrow Agreement sets out the arrangement for collection of application/bid amount from Anchor Investors. This agreement is entered into amongst the Issuer, the BRLMs, the syndicate members, the escrow collection banks and the Registrar (and the selling shareholders, in case of an offer for sale). This agreement also provides for the arrangement by which the funds in the escrow accounts are transferred to the refund account or the public issue account, as applicable.
- Share Escrow Agreement – This agreement is entered amongst the Issuer, the Selling Shareholder and the Escrow Agent for deposit of shares offered by the Selling Shareholder in an offer for sale Issue. Such shares are typically transferred from the demat account of the Selling Shareholder to the escrow account two days in advance to the filing of the Red Herring Prospectus with the RoC.
Syndicate Agreement -- The Syndicate Agreement sets out the obligations between the BRLMs and the rest of the syndicate. This agreement lists out the role and obligation of each syndicate member. Syndicate members are entities contracted by the Issuer and the BRLMs to procure bids for the Issue; thereby also acting as underwriters and party to underwriting agreement. The Issuer (and the selling shareholders, if any) are confirming parties to the syndicate agreement.
Underwriting Agreement -- The Underwriting Agreement is entered into amongst the Issuer, the selling shareholders (if any) and the underwriters after the determination of the IPO price and allocation of equity shares, but prior to the filing of the prospectus with the registrar of companies. Under the terms of the underwriting agreement, the underwriters agree to ensure payment with respect to the equity shares allocated to investors procured by them and, in the event of any default in payment, the respective underwriter is required to procure purchasers for, or purchase the equity shares themselves to the extent of the defaulted amount. It also includes among other things, conditions precedent to the individual obligations, representations and certain covenants by the issuer and the indemnity provisions.
Registrar Agreement -- This agreement is entered into amongst the Issuer and the Registrar to the issue, whereby the Issuer appoints the Registrar for the Issue. This agreement sets forth the rights and obligations of the Registrar in the issue process.
Service Provider or Ad Agency Agreement -- This is an agreement entered into amongst the Issuer, the BRLMs and the service provider or advertising agency. It sets out the obligations of the advertising agency and the Issuer and the services provided by the advertising agency for advertising and media relations in respect of the IPO.
Is the issuer required to enter into an agreement with the SCSBs, the Registrar and Share Transfer Agents, the Collecting Depository Participants and Registered Brokers?
No, however, the issuer is required to take cognizance of the deemed agreements with the SCSBs, the Registrar and Share Transfer Agents, the Collecting Depository Participants and Registered Brokers.