Thursday, February 26, 2009

Is it time to sentence Share Warrants to Dishonorable Discharge?

(SEBI DIP Guidelines amendments Part 2)

Several amendments have been made to the SEBI DIP Guidelines as briefly highlighted here. I am sharing a few more thoughts on two areas, but in separate posts.

This post focuses on the increase of minimum deposit on Share Warrants from 10% to 25% of issue price. This amendment was the least unexpected, even too late. Too late because it has already been heavily misused and abused and also made at a time when Promoters are least likely to subscribe to Share Warrants.

In fact, there appears to be literally a flood of cases of Promoters allowing the 10% deposit on existing Share Warrants to be forfeited. I have even heard that advisors are straining their legal creativity in finding ways in which even this 10% could be returned to the Promoters! True, most I have heard of till now sound bird-brained but, considering the stakes involved, further efforts are on.

Coming back, let us quickly highlight some aspects of Share Warrants to place the recent amendment in context. Share Warrants are instruments that give a right and option to the holder to acquire shares within a specified time and at a specified price. They are thus similar to ESOPs and also to options traded in markets, though the latter represent private contracts where the listed company is not involved.

Share Warrants thus have several advantages. You don’t need to pay the full share price upfront. You can exercise the Share Warrants anytime. You even have the option to back out and let the deposit be forfeited. And so on.

For the Company, they were often useful as, for example, acting as sweeteners to otherwise unattractive Unsecured, Non-Convertible Bonds. They also had the weak justification, in the early years of globalization, of allowing Promoters to increase their stake to prevent hostile takeovers. However, they quickly degenerated to being used almost exclusively to enrich Promoters, at the cost of the Company and other shareholders.

Consider, from the point of view of the Promoters, the free lunch of Share Warrants.

You get the Share Warrants (earlier for free) by paying just 10% deposit. Even if this deposit is forfeited, you still get to share it to the extent of your holding (e.g., a Promoter holding 50% of the Company thus shares 50% of the forfeited deposit).

Even this deposit of 10% was an absurdly low amount – it barely covered the interest on the balance 90% for 18 months. But interest is obviously not the only factor. Often the bigger advantage is of the option. Having done and reviewed several valuations of options in context of ESOPs, I have found that in numerous cases, particularly in times of higher volatility, even the increased 25% deposit may be found to be too low.

Further, in case of market-traded options, the option premium is an additional cost and not part-payment of the purchase price. Thus, even if you decide to actually purchase the shares, you pay the full purchase price in addition to this premium. In case of Share Warrants, the deposit paid is adjusted against the issue price.

Till a recent prohibition, Share Warrants also represented simple arbitrage. Sell today and buy Share Warrants by paying 10% deposit. This also meant that the surplus cash could be used to acquire higher shares and raise the balance amount later.

It was also quickly realized by Promoters that Share Warrants could help avoid the creeping acquisition limits. Well planned, the Promoters could increase their holding by 15% over 18 months without violating the 5% creeping acquisition limits. All this by paying just 10% today and that too at today’s prices! Needless to say, this technique was widely used.

How sound was the deal from the point of view of the Company? Almost certainly a loss making one since if the same deal was offered to a third party, he would have paid a far higher amount. The public shareholders obviously also lost.

SEBI of course has been chipping away slowly at the anomalies. The early amendments included reducing the conversion to period to the current 18 months and the 10% deposit, increased to 25% now. There is a ban on preferential allotment to those who have sold in last six months. The lock-in has been effectively increased, as discussed separately here.  And so on.

Consider, though, from a different perspective, these very amendments over time which appear mainly intended to protect Share Warrants from misuse by Promoters. What was the result on Share Warrant itself as an instrument? How sound a financial proposition they appear to third party, non-Promoter investors? How attractive would Share Warrants sound, if one has to pay 25% upfront, if one has to convert them within 18 months, if one has to suffer double lockin, if the conversion price has to be a minimum one related to recent prices, and so on?

The latest amendment comes not only too late but also at a time when Promoters are least in the mood to acquire Share Warrants simply because the six monthly average prices are typically higher than the current market price.

What then is the justification for continuing to allow issuance of an instrument that is a win-win proposition for the Promoters and a lose-lose one for the Company and the public shareholders? Is it not time for, instead of making marginal improvements, simply sentencing Share Warrants to a dishonorable discharge, having led, far more often than not, a disgraceful existence?!

Alternatively, major changes are required if they are to be continued. Linking pricing and deposit for Share Warrants to past average prices is absurd. Share Warrants are equivalent to options and should be valued as such. Even a rudimentary version of the Black-Scholes formula would give a fairer price. Remember, this technique is already being used, albeit as an alternative, for valuing and accounting for ESOPs.

And, at the very least, it is this price that should be paid. The amount should be paid as a premium for being granted the Share Warrants and not as a deposit that is adjustable towards the issue price!

Also, at the risk of sounding petty, I would even suggest that if this amount paid by Promoters is to be forfeited, it should be distributed as a special dividend/bonus to non-Promoter shareholders! (as I said, sharp minds are hard at work, so I keep hearing, to find ways to return the forfeitable deposits to the Promoters on existing Share Warrants suddenly found to be out of the money).

There should also be a commercial justification for issuance of Share Warrants, especially from the point of view of the Company. The Company puts itself in a peculiar position when it issues Share Warrants. Other Potential investors are wary of the potential dilution and thus the Company becomes slightly unattractive to them. The Company may or may not receive the balance amount for the shares. And it may receive this balance price at any time the Promoters deem fit. Is it a commercially sound proposition for the Company to issue Share Warrants on such terms and where monies come in such uncertain manner and timing? Only if the answer is a clear yes, that the Share Warrants should be issued.

Another alternative is to ban issuance of Share Warrants to Promoters altogether, just as ESOPs are so banned.

-       Jayant Thakur

9 comments:

Don said...

Thanks Jayant for the nice, informative article. I have a question

1. When promoters convert warrants at a premium to current market price, is it a good thing or a bad thing (for non-promoter shareholders)?
e.g. Opto Circuits -the promoter VK Ramnani converted 5.4 lakh warrants in Jan 2009 at ~Rs.140 while market price was around Rs. 95 or so. More details here http://www.stock-picks-focus.com/opto-circuits-stock-valuation.html#warrant-conversion

2. What are possible reasons a promoter would convert shares at a premium?

Appreciate your feedback. Thanks. Donald

Jayant Thakur, CA said...

Hi Don,

Thanks for your point. I had read about the curious case you have referred to but I do not know any further facts. So let me theoretically speculate why the Promoters chose to convert the Share Warrants at a premium to the market price:-

- They could acquire a significant lot of shares which otherwise may not have been available.

- They could increase their percentage holding without attracting the takeover regulations in the current financial year (assuming that such quantity of shares were not otherwise available)

- They genuinely wanted to keep their commitment to the Company to infuse. Of course, this does not sound logically consistent in many ways. There is not really a commitment when the share warrants are by definition exercisable by option. Also, investment in the company is a commercial decision for the Promoters as for anyone else.

- The current market price is not really reflective of the real value of the company which they are aware of and, as in the case of earlier points, they may have found that other large shareholders also believe so and would not sell their shares to the Promoters.

Answering your first question, as to whether it is a good thing or not for the non-Promoter shareholders, much would again depend on facts. Is it a situation that the real value of the company is Rs. 95 or below? Then obviously the other shareholders benefit.

I may add that I have not done any survey on the issue but I have heard and read far, far more times of Promoters allowing their share warrants to lapse than of cases where they have exercise their share warrants when the market price is significantly lower than the exercise price of their Share Warrants.

Regards,

- Jayant Thakur

Don said...

Thanks Jayant. Trying to summarise my takeaways from your comments

1. Very few promoters do what Opto circuits MD has done -convert at much higher than market prices. Certainly not among those helping themselves to a free lunch a la the main emphasis of your post. Other such instances are promoters and large institutional investors in GTL Infrastructure, Havells India, Mascon Global as per this ET article
2. However, this is inconsistent with normal commerical sense
3. There has to be a good reason -most likely increasing promoter stake -means to which, otherwise may not be available
I will investigate this further for Opto Circuits.

As to whether Opto Circuits Intrinsic Value is indeed around Rs. 95 or below. Please have a look at my Opto Circuits stock valuation report Will take you only 5 mins:)

Anonymous said...

Hi friend a BSE listed co named Becon Industries is going to meet on 16 march to refund the intial 10% payment to promoters.Is it permitted under current law ?

Anonymous said...

not only Opto circuit,Pioneer Investcorp promoter also converted @Rs.110/-when mkt price is beloe Rs.30/-

Jayant Thakur, CA said...

@Anonymous, re Becon,

Under the DIP Guidelines, the 10% deposit needs to be forfeited on lapse of the share warrants. But, as I mentioned, creative minds are at work and let us see these structures.

Re Beckons Industries (to correct the typo in the name), the Board meeting states that it has received requests from the Share Warrants applicants for refund of the 10% deposit and this request is to be considered. It will be interesting to see what their Board decides.

I am sure though that any structure will see a struggle before SEBI, apart from bad press.

Thanks,

- Jayant

Don said...

Excerpt from Management Call -Opto Circuits -25 Mar 2009

Follow-up question: Mr. Ramnani, would you clarify why you chose to convert 5.4 lakh warrants at such a high premium. Our estimates show you could have picked up at Rs. 70 from the market

"Unlike how many people think, this was a no-brainer for me. From a principled standpoint, I wanted to honour the commitment. Had the market boomed at the time of warrant conversion, I stood to gain significantly. Why should it be different in the reverse case. The money would accrue to the company if I convert, but would go away to some 3rd party if I bought from the open market.

But be assured it made perfect sense from a financial standpoint as well. Purchasing such huge numbers from the market couldn't be done at prices you mentioned. The whole transaction would have taken prices to significantly higher levels. And don't forget the 10% paid on allotment would have been forfeited. So do you think you would do otherwise for some small gain of Rs. 20-30??"

Mr.Kool said...

How can a company originally issue warrants to promoters? The Companies Act only allows issue of warrants "in respect of fully paid up shares". If that is the case, there is no room for misuse, right?

Section 114 of the companies Act: http://indiankanoon.org/doc/874062/

CA Jayant Thakur said...

Mr. Kool...

Section 114 refers to and governs bearer warrants.