Friday, July 31, 2009

Issue of Banning Share Warrants to Promoters – SEBI order

I had written earlier on February 26, 2009 here on an issue titled “Is it time to sentence Share Warrants to Dishonorable Discharge?”. Essentially, I had argued that Share Warrants were heavily being misused by Promoters. They allotted, almost exclusively to themselves, Share Warrants at a price and terms that appeared to be absurdly below their fair value. The Companies would almost never have, had an really independent Board be deciding the issue in each case, allotted Share Warrants to an outsider on such sweet terms. Issuing Share Warrants to Promoters in this manner causes serious loss to the Company and its non-Promoter, i.e., public, shareholders.

Of course, while this issue was a concern for many years, the above post was in connection with the amendment by SEBI of its DIP Guidelines in February 2009 whereby the upfront non-refundable amount payable on Share Warrants was increased from 10% to 25% of the Conversion Price.

It did not help that Promoters of numerous companies gladly allowed their Share Warrants to lapse considering that the market price had fallen far below the Conversion Price of the Share Warrants and thus forfeited their 10% deposit. Many of them actually issued fresh Share Warrants paying the higher 25% deposit but on a Conversion Price that was far lower.

A public interest litigation was filed by Rajkot Saher/Jilla Grahak Suraksha Mandal in the Bombay High Court and the Hon’ble Court had directed vide order dated June 18th 2009 SEBI to hear the petitioner and pass appropriate orders within 6 weeks of the order. SEBI has passed an order dated July 30, 2009 on the matter.

SEBI has now passed an order dated July 30, 2009. In this 23 page order, SEBI has essentially concluded that there is nothing wrong in the current law and safeguards and there is also nothing wrong if Promoters have allowed their Share Warrants and deposits to lapse and even if they acquired fresh warrants paying higher upfront deposits.

Readers may go through this 23 page order for more detailed reasoning but I offer some quick comments.

SEBI, justifying the low 10% deposit amount on Share Warrants, says “I also note that in other jurisdictions, the option premium is generally in the range of 10% to 15% for trading of long dated options.”. I find this justification difficult to accept in the Indian context. The basic important elements of the Black-Scholes option valuation formula (who, I believe, got the Noble Prize for this) are interest rates and volatility. Is it plausible that interest, in India, is only 10% for a total period of 18 months? It is even less plausible – in fact consistently found untrue in every option valuation I have come across – to believe that the volatility is 10% over a 18 month period. And mind you, option value is at least the total of the interest and volatility (and a few other factors).

Then, SEBI says that, from just 8 companies listed, a sum of Rs. 1515 crores received as deposits from Promoters have been forfeited when they did not exercise the Share Warrants. SEBI seems to imply that far from the Company and the public losing, the Company has actually gained by such a huge amount – it says – “it may be incorrect to argue that the promoters stand to gain at the cost of the company and its shareholders.” But is not the reality exactly the opposite? In fact, this shows that the companies granted options to exercise Rs. 15150 crores since the deposit amount is just 10%.

Further, of these Rs. 1515 crores, effectively a significant portion goes back to the Promoters to the extent of their holding in the Company. If the average holding is, say, 50%, then Rs. 758 crores goes back effectively to the Promoters!

SEBI then goes on to say,

“It is also noted that of the 4934 listed companies, there had been 1108 preferential allotments since April 2007, of which only 360 were preferential allotment of warrants. Out of the said 360 cases, there were only 100 companies where promoters did not fully exercise the option on the warrants issued to them. Considering the total number of listed companies and number of preferential allotments made during the above period, it is seen that the instances of reissue of warrants to the promoters have not been significant or frequent.”

Again, I find it disturbing that as many as 360 companies allotted Share Warrants apparently to Promoters since April 2007. Further, in as many as 100 companies, the Promoters allowed their deposits and Share Warrants to lapse. While the 8 companies referred to earlier may be the larger of these companies, note that in just 8 companies, the amount lapsed was totally Rs.1515 crores!

On the request of the petitioner that issue of further securities should be only against full payment, SEBI says, “the same would discourage the companies to raise funds through the allotment of warrants and also indirectly restrict the issue of capital to only shares of the company. Considering the nature of the said instruments (warrants) and the fact that only few instances (as brought out in Para 10 above) were noticed where the warrants issued to the promoters had not been exercised, it would be a retrograde step to disable a product which is accepted universally as a fund raising tool. Such a restriction on issuance of warrants may also deprive the operational and capital structuring flexibility for Indian companies.”

I find it difficult to believe that there would be anything wrong in prohibiting issue of Share Warrants at a mere 10/25% deposit exclusively to Promoters – I find it even more difficult to believe it would be a retrograde step and would “deprive the operational and capital structuring flexibility for Indian companies”. What is wrong with a demand that if Share Warrants are to be issued, issue them to all shareholders – let each shareholder decide whether he wants to subscribe or not? Why are Promoters being preferred and given an exclusive deal and why banning such exclusive sweet deals will be a retrograde step?

In the end, SEBI does not find the circumstances warrant any immediate ban and has instead stated that it “initiate a consultative process….to suggest policy changes, if required..”.

All in all, while I personally feel SEBI has missed an opportunity to carry out a complete rehaul, it is also true that SEBI on its own cannot prevent every misuse. The misuse of such instruments is by the Promoters and as SEBI would close one route, another would be invented. It would be the Promoters who themselves would suffer in the long run if they lose their credibility and thus eventually the capital market as a whole. Having said that, isn’t retaining and restoring the credibility of the capital market the function of SEBI? Has it failed in this, at least as far as the question of issue of Share Warrants to Promoters is concerned?

- Jayant Thakur

Note:- I am really grateful to Mr. V. Umakanth for promptly drawing my attention to this SEBI order and sending me a copy for a quick post.

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