Wednesday, June 22, 2011

Preferential Allotment of Securities in Unlisted Companies

The Ministry of Corporate Affairs (MCA) has announced draft rules that will, when promulgated, substitute the Unlisted Public Companies (Preferential Allotment) Rules, 2003. This will make the process of issue of securities more stringent for unlisted public companies. The Indian Legal Space blog has a nice comparison of the existing rules and the proposed changes.
Some of the key features of the draft rules and their impact are as follows:
Disclosures
Unlike the existing regime, the draft rules require companies to issue an offer document with prescribed disclosures (Annexure I of the draft rules contain a list of 32 disclosures). This significantly enhances disclosure requirements for securities offerings by unlisted companies, and would make even private placements cumbersome and costly. While it increases overall transparency in offerings of securities, the need for such extensive disclosures for offerings of securities to specific individuals or institutions is perhaps overstated. Moreover, there is no clarity regarding the liability of the company and its directors for statements made in such offering document, although the Supreme Court has recently indicated the availability of criminal laws to deal with misstatements in offering documents in private placements.
The offer document is also to be approved by shareholders through a special resolution. This is also an onerous requirement as it might limit the flexibility of the company to alter the document once it has been approved by the shareholders. In addition, this will also impose complexities in timing and sequencing of compliances to effect a private placement transaction.
Timing
The draft rules stipulate two conditions regarding timing: (i) the gap between the opening and closing of the issue should be limited to 30 days; and (ii) the minimum gap between the closing of one issue and the opening of another issue must be 60 days. This is possibly intended to deal with ambiguities that exist in the definition of a private placement/offering in terms of section 67(3) of the Companies Act, 1956 where an offer is deemed to be made to the public if it is made to 50 persons or more. By setting time limits, the draft rules seek to impose more objective criteria to differentiate private placements from public offerings. For a greater discussion of this issue in the context of section 67(3), please see a previous post.
While objectivity is generally desirable, the idea of artificially delineating one private placement from another through timing may add to the confusion. For example, it may be possible for companies to structure successive private placements although the offering may cumulatively be made to a large body of investors.
Convertible Instruments
The draft rules make convertible instruments an unattractive option for public unlisted companies.
First, the pricing rules for warrants (that presumably apply to other convertibles as well) are rigid. The price for conversion of warrants must be determined before hand. In other words, the conversion price has to be stated up front, and it appears that neither a conversion formula nor a price band would be available. That removes all flexibility for conversion, which would effectively make warrants in public unlisted companies unattractive as an investment option. Note, however, that this is exactly contrary to the trend established by the FDI Policy of the Government of India which has recently moved from a fixed conversion price to a more flexible policy when it comes to investment in convertible instruments by foreign investors.
Second, for any issue of convertible instruments that results in a cumulative amount of Rs. 5 crores or more, the company is required to seek the prior approval of the Central Government. This is a retrograde step as it imposes hurdles to fund-raising activities of companies. It is also likely to evoke problems that existed in the days of the controlled economy prior to 1991, with the Controller of Capital Issues (CCI) acting as the authority that indulged in merit regulation by specifically approving fund-raising by companies. In fact, even the CCI regime applied only to public offerings where the interest of the investing community at large was at stake. The application of a similar regime under current conditions, and that too for private placements seems inexplicable. The draft rules buck the trend as other areas of corporate regulation have recently witnessed attenuation in government regulation.
Dematerialization of Securities
Here again, the flexibility of retaining securities either in physical form or demat form has been taken away, as all securities issued under private placement have to be kept only in demat form.

Overall, the draft rules make private placements in unlisted public companies an onerous task. This may seriously impact financing in such companies. Curiously enough, some of the requirements suggested in the draft rules go even beyond those prescribed for public listed companies where larger interests are affected. These include the requirement for shareholders to approve the offer document, restrictions on pricing for convertible securities, and the like.
It has been suggested that the draft could be the result of various scams involving unlisted companies and also instances of ambiguities in securities regulation (such as those witnessed in the Sahara episode previously discussed). While it is imperative that regulations be framed to address scams and frauds, the imposition of onerous requirements on the corporate sector as a whole to address a few bad apples imposes greater costs than the benefits it produces. The strategy of painting all public unlisted companies with the same brush will be counterproductive.

3 comments:

Mandar Kagade said...

A very basic understanding of Berle-Means model should have sufficed for the MCA to avoid drafting rules such as these. In unlisted companies, ownership tracks control more densely than w/ listed companies where either the management or the majority owner has control, rendering the latter subject to agency problems. Not so, with respect to unlisted companies where the parties may protect themselves through SHAs and the like. So, it seems that motives other than economic efficiency ie political economy are the driving force behind these rules. Perhaps another instance of empire building among Indian regulators.

Also, note that the substantive content of the rules too seems to be devoid of logic--- to quote just one example, Issue of convertibles over 5 crores is subject to permission while issue of vanilla equity is not. The red tape might deter the investees from issuing convertibles in favor of vanilla equity--- which financial economics tells us, is most likely to issue at a discount (information asymmetry owing to the investees' unlisted status, as also the pecking order theory of corporate finance. In fact, thats why most would prefer issuing convertibles under ordinary circumstances) leading in most cases to more dilution than promoters would be inclined to have.

In summary, regressive step reflective of political economy of corporate regulation.

Lopamudra Mandal said...

Sir, my question is if in case of a unlisted public company there is private placement to less than 50 person but later on some people transfer these shares to 1000 people will it still remain private placement? is there any restriction on transfer of share in unlisted public company? i am in a great confusion!

V. Umakanth said...

@Lopamudra. That would depend on whether the subsequent transfer amounts to an offer for sale within the purview of section 64 of the Companies Act. As far as enforceability of transfer restrictions in an unlisted public company is concerned, it is quite a complex question, but a brief discussion can be found at http://indiacorplaw.blogspot.com/2010/12/shareholders-agreements-clauses-and.html.