Background: History Repeats Itself
The Securities and Exchange Board of India (“SEBI”) has in recent year initiated actions pertaining to the alleged lack of accurate disclosures in prospectuses issued by companies in public offerings of securities. One high profile case involved the initial public offering (“IPO”) of DLF Limited wherein SEBI issued an order restraining DLF, its directors and CFO from buying or selling securities or otherwise accessing the capital markets for a three-year period. However, on appeal, in a divided verdict the majority members of the Securities Appellate Tribunal (SAT) quashed SEBI’s order, thereby overturning the ban imposed by SEBI.
In another IPO, this time involving Credit Analysis and Research Limited (“CARE”), a credit rating agency, SEBI raised concerns regarding non-disclosure of material information in the prospectus, but initiated actions against six merchant bankers involved in the transaction. An adjudicating officer (“AO”) of SEBI found violations by the merchant bankers of the provisions of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (the “ICDR Regulations”) and the SEBI (Merchant Bankers) Regulations 1992 (the “Merchant Bankers Regulations”) and levied a penalty of Rs. 1 crore on the merchant bankers. On an appeal preferred by the merchant bankers before SAT, history repeated itself in a way. In another divided verdict, the majority of the members of SAT overturned the AO’s order and the levy of the penalty.
Facts and Decision: Non-Disclosure Immaterial
Curiously enough, in this case the alleged failure to disclose did not pertain to any fact or matter involving the issuer company or the merits or risks of the investment itself. Rather, it pertained to the offering process and the questions of what type of foreign investors were eligible to invest in CARE’s IPO and on what terms. In a nutshell, it involved an interpretation of the provisions of the foreign investment policy and the regulations issued by the Reserve Bank of India (“RBI”).
In order to analyse the disclosures, it would be appropriate to briefly discuss the foreign investment policy articulated by the RBI. Under the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (the “FEMA Regulations”), the RBI permits various types of foreign investors to invest in shares of an Indian company. These include foreign direct investors (FDI) under Schedule 1, and several other types of investors (under various other schedules) such as foreign institutional investors (“FIIs”), non-resident Indians (“NRIs”), foreign venture capital investors (“FVCIs”) and qualified foreign investors (“QFIs”). Moreover, in the case of companies such as CARE that are classified as non-banking finance companies (“NBFCs”), there is an additional condition imposed in Schedule 1, which states that any FDI must be accompanied by the satisfaction of minimum capitalization norms of US$ 0.5 million.
For the IPO in question, the merchant bankers approached the RBI with a request to make the offering available to foreign investors. Although there was considerable amount of correspondence between the merchant bankers and the RBI after CARE’s red herring prospectus (“DRHP”) was filed with SEBI, of greater relevance is RBI’s A.P. (DIR Series) Circular No. 43 dated November 4, 2011, wherein the RBI announced its decision to permit a transfer of shares from a resident to non-resident without prior approval of the RBI, subject to two conditions: (i) no-objection certificates (“NOCs”) are obtained from the financial sector regulators of the transferor and transferee entities, and (ii) the relevant foreign investment policy such as sectoral caps and minimum capitalization norms are complied with.
Accordingly, the RBI permitted CARE to proceed in accordance with the Circular. However, CARE approached RBI again on the ground that obtaining an NOC from non-resident investors was not a viable option as the identity of such investors will not be known beforehand. After further correspondence, the RBI wrote back to CARE agreeing to exempt non-resident investors from the requirement of obtaining NOCs from their respective regulators, subject to the condition that the minimum capitalization norms were adhered to, and that certain other procedural requirements were complied with. Upon receiving this intimation from the RBI, CARE (along with its merchant bankers) decided to confine the offering to FIIs and NRIs, and to exclude other investors (such as FDI) falling within the purview of Schedule 1 to the FEMA Regulations since the minimum capitalization norms are applicable only investors coming in through FDI under Schedule 1. However, following meetings with RBI officials who indicated that the minimum capitalization norms would be applicable to investments by FIIs and NRIs as well, CARE sought for time from the RBI to comply with such norms for these investors as well, which were in fact complied with.
The issue at hand for which SEBI initiated action against the merchant bankers was that they “failed to ensure that full and complete disclosures were made in the RHP of CARE which amounts to suppressing material facts in the RHP and attempt to mislead investors into believing that RBI had unconditionally exempted non-residents from obtaining NOC from their respective regulators for participating in the offer of CARE.”
SAT commenced its analysis by consider the objective of disclosure in a public offering as follows:
6. Object of the disclosure provisions contained in the ICDR Regulations and Merchant Bankers Regulations is to ensure that the offer document contains all material disclosures which are true and adequate so as to enable the applicants permitted to participate in the offer to take an informed investment decision. In other words, the disclosures made in the offer documents must be those disclosures which are material to the applicants permitted to participate in the offer to take an informed investment decision.
Ultimately, the issue here boiled down to whether the conditions imposed by the RBI for exempting from the requirement of the investors obtaining NOCs, i.e. “strict compliance of minimum capitalization norms applicable to NBFCs was a material information required to be disclosed in the RHP so as to enable the investors permitted to participate in the offer to take an informed investment decision.” Here, SAT found that under the foreign investment policy and FEMA Regulations compliance with the minimum capitalization norms was required only for foreign investments made through Schedule 1 (i.e. FDI) and not through other methods such as FII and NRI investments. This position was not disputed by SEBI as a matter of law. Hence, “non disclosure of the information relating to compliance of minimum capitalization norms cannot be said to be failure to disclose material information, because the said information was not applicable to the investors permitted to participate in the offer of CARE to take an informed investment decision.” To that extent, SAT read RBI’s condition on minimum capitalization to mean that it applies only if an offer is made to investors specified in Schedule 1, but not otherwise.
In the present case, since the offer was not so made available, the question of compliance with such norms does not arise. SAT concluded: “In other words, non-disclosure of an information which is not at all material for the investors permitted to participate into an offer to take an informed investment decision would not amount to suppressing material information in the RHP.” SAT therefore found that the AO’s order imposing a penalty of Rs. 1 crore on the merchant bankers of CARE was no sustainable.
The dissenting member of SAT adopted a more strict view of the disclosure requirements. In his opinion, it was improper for the merchant bankers to have disclosed RBI’s exemption from the NOC requirement without disclosing the condition upon which it was granted (i.e. compliance with the minimum capitalization norms). Placing reliance on SAT’s decision in Almondz Global Securities, the dissenting view noted: “Even if the BRLMs are ever in doubt as to the materiality of information, they should opt to include such information in the offer documents, unless cogent and strong reasons exist for the merchant bankers to not disclose the information concerned. The standard to be applied is what a prudent merchant banker under similar circumstances would have done …”
Implications: Relevance of the Information
Ultimately, the decision (as well as the difference between the majority and dissenting opinions) hinged upon the materiality of the information that was not disclosed in the RHP. This was tested against the touchstone of whether that information was relevant to the investors in making an investment decision. In other words, SAT placed emphasis on the element of “relevance” (although not expressly). While there was non-disclosure, it related to a matter that was not relevant in the ultimate scheme of things because the persons to whom the information was relevant (i.e. foreign investors under Schedule 1) were not permitted to invest in the IPO in the first place.
The other take away from SAT’s decision is that this information had to do with the issue process rather than the merits of the investment itself. Although SAT has not explicitly addressed this in its decision, it may have had a bearing on the outcome. While it is not to say that disclosure of process related issues is unimportant, they could be looked at differently from the fundamentals of the company, unless the process related issues strike at the heart of the investment decision. Here it was only incidental.
 While SEBI’s actions in the DLF IPO were targeted at the company and its directors, here they were directed against the merchant bankers.
 RBI’s policy relating to transfer of shares from residents to non-residents was relevant for CARE’s IPO as it was effected by way of an offer for sale by existing shareholders.