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Cos Act Ep#3: Prospectus Disclosures & Private Placements

Published on Mon, May 05,2014 | 19:34, Updated at Tue, Jun 03 at 16:35Source : CNBC-TV18 |   Watch Video :

Last week, we started our Chapter-wise analysis. This Week on 'Companies, Act' we discuss:

CH III: Prospectus & Allotment of Securities

CNBC-TV18's Menaka Doshi speaks to Manan Lahoty of Luthra & Luthra, VS Parthasarathy of M&M and TV Raghunath of Kotak Investment Banking
 
There are many firsts in Chapter III. For the first time it defines public offer. It also defines private placement and for the first time it includes not just listed companies but also companies which intend to get their securities listed.

PUBLIC OFFER
Section 23: Explanation
"public offer" includes initial public offer or further public offer of securities to the public by a company, or an offer for sale of securities to the public by an existing shareholder, through issue of a prospectus.

INTENDING TO LIST?
Section 24(1): The provisions contained in this Chapter, Chapter IV and in section 127 shall,—
(a) in so far as they relate to —
(i) issue and transfer of securities; and
(ii) non-payment of dividend,
by listed companies or those companies which intend to get their securities listed on
any recognised stock exchange in India, except as provided under this Act, be administeredby the Securities and Exchange Board by making regulations in this behalf;

Raghunath: Chapter III has achieved three things- one it has widened the disclosure and level of disclosure; enhancing transparency and accountability on the past of the company.

Second, alongside that, it has importantly widened the ambit of regulation dragging in some private companies, some intending to list companies. So it has widened all the types of instruments, it has widened the ambit of regulation. Third arising from that is obviously accountability from a different level of punitive to deterrent to criminal. There is a different league of regulation on penalties for non-compliance.

So if you look at it from that dimension; yes the new Act -Chapter III- has gone beyond what 1956 Act had covered. First and foremost, it does cover very explicitly, private companies and all kind of capital issuances by private companies. Secondly companies intending to list, which is an interesting new point in terms of law, will also be covered by SEBI but what it stopped short of clarifying is when is the intention relevant? Five years earlier my intension to list also brings me within the ambit of SEBI or I have a documented evidence that I am intending to list so when do you get trapped under SEBI?

Lahoty: Especially companies who would think of filing a DRHP to list and then eventually realizing that may be the market is not good enough for listing and they want to do a round of private equity. So is the intention to list no more there? What kind of documentation they need to have in place to actually rebut a presumption of intention to listing. I think it is definitely going to cause some problems. People have to be careful but more importantly this Chapter goes beyond intention to listing; it covers private companies. So I think those companies need to be careful anyway.

Doshi: Is that how you see it from an operational point of view when you read those words?

Parthasarathy: I think the scope is expanded. Certainly private companies come but it is not as if it has changed dramatically from that point of view. However as we talk about intention to list, it actually rings alarm bells. Now it is the interpretation of somebody sitting and you know what happens when interpretations are done later, post facto.

In the Companies Act, 1956, Schedule II listed all the disclosures to be made in a prospectus. The 2013 Act lists them in Section 26 and in the Rules. Combined, the two make for a long list of disclosures required including all sources of promoter funds.

DISCLOSURES IN PROSPECTUS
Section 26 - Rule 3(4)(i)
‘the details of any litigation or legal action pending or taken by any Ministry or Department of the Government or a statutory authority against any promoter of the issuer company during the last five years…’

RULES: Complete details of …
Name (SCROLL THESE PLEASE)
Address
Amounts raised as Loan
Amounts raised as Financial Assistance
Any other methods used
Own Sources

Parthasarathy: First and foremost, there are three broad categories where the disclosures and prospectus has become one. One is the source of fund. Second, litigations of five years and now that throws another set of issues on the table. Third is, ‘adverse remarks or reservations in financial statements.’

Take the first: sources of funds. Now if it is a body corporate, it is by and large a little better off because they will have traceability to where they borrow but if it is individual promoter what happens, how fungible is the fund and how are you going to do. Is it going to be self declaration, how are you going to do the due diligence. These are all the kind of questions to say that how do we make this happen.

The second one is litigation. Are we talking about every litigation being till it is cleared we are going to state it, what level of litigations are we talking about and there is more to it. And the last one is as a CFO or as an auditor nobody would remember the terms adverse remarks or reservations. We understand qualifications so none of these terms are very clear. So lot of ambiguity around here which needs lot more clarity and now SEBI and others will also get into the Act in terms of interpreting this. So this is a fairly complex one and a little onerous actually.

Raghunath: Let me give you a practical trouble that we will face. Full details of all sources of funds of a promoter is the language used. Imagine a company which is 50-70 years old - there are many unlisted government companies, there are some unlisted banks which are 70 years old. Now where will I go and trace, the bank which rooted that money even if it was through a bank will never be able to supply details for the merchant banker or the lawyer to sign off that this is full details of the source of promoter contribution. So how far authentication goes because it says full details of ones sources of funds especially if you are not talking of a young company.

Doshi: For young company it is reasonable because you are only five years old then there is not really much to worry about.

Raghunath: Yes the banking system may not have such records. So it is a huge procedural issue. In the same way litigations- earlier it used to be pending litigations however old it is but it should be pending. Now even a closed litigation- it may have started 20 years back. So you need to go back in the five years what all is pending even if it is closed hence it is going to elongate the level of diligence and disclosure requirements. So it is procedurally very challenging.

Lahoty: And think about punishments and suits.

Then let us get to punitive measures. Any contravention of Section 26 could result in fines and imprisonment of up to three years. Criminal liabilities for mis-statements in a prospectus include an up to 10 year prison term under Section 447. For every person who authorizes the issue of such prospectus but useful defenses are also provided for.

PUNITIVE MEASURES
Contravention of Section 26 (Disclosures in Prospectus)

Company  
Fine: Rs 50000- Rs 3 lakhs
Person
Fine: Rs 50000- Rs 3 lakhs
Imprisonment: Upto 3 years

PUNITIVE MEASURES
Mis-statements in Prospectus

Section 34
Every person who authorises issue of such prospectus
Criminal Liability: Upto 10 years imprisonment u/s 447

Defences
Statement/omission was immaterial
Reasonable grounds to believe statement was true

Section 35 says the company, its directors, promoters and even experts quoted in the prospectus are liable to pay compensation for all losses due to misleading statements in the prospectus. The defensives provided here are more limited. If an intent to defraud is proven, then the liability in such a circumstance is unlimited. The punishment for fraudulently inducing people to invest money also includes an up to 10 year prison term and then there is Section 37- the first provision in 2013 Act for a class action suit.

PUNITIVE MEASURES
Mis-statements in Prospectus

Section 35
Company + Director + Promoter + Expert…
Civil Liability: Compensate all loss or damage

Defences
Withdrew consent before issue of prospectus
Prospectus was issued without his knowledge/consent

PUNITIVE MEASURES
Mis-statements in Prospectus
Intent to Defraud

Company + Director + Promoter + Expert…
Unlimited Liability

PUNITIVE MEASURES
Class Action
Section 37: ‘A suit may be filed or any other action may be taken under section 34 or section 35 or section 36 by any person, group of persons or any association of persons affected by any misleading statement or the inclusion or omission of any matter in the prospectus.’

Parthasarathy: For the moment if we leave class section apart, I just wanted to throw this question- if you read Section 63 of the old Act, it had civil and criminal. So why is this unlimited and suits apart. Is there a major change?

Lahoty: Under the previous Act, Section 62 is more relevant because that is for civil liability. It also came with three-four very important defenses and one-two of them used to be directors or the promoters -whoever is litigated- against could prove a case of reasonable belief. So if you, as a director, have a reasonable belief that the statement was true or if it was made by an expert that this expert was a competent person to make such a statement, that was a valid defense; those two defenses have been taken out.

PUNITIVE MEASURES
Section 34: Criminal liability for mis-statements in prospectus
(refers to Section 447)

Section 35: Civil liability for mis-statements in prospectus

Section 36: Punishment for fraudulently inducing persons to invest money
(refers to Section 447)

Section 37: Class action suit

Parthasarathy: Therefore I was wondering to point out, it is not so much the change as the defense has been taken away.

Doshi: So there are only two defenses now if I understand that correctly, right?

Parthasarathy: Yes.

Doshi: That if he has withdrawn his consent before the issue of prospectus and that it was issued without his authority or concern i.e. the prospectus was issued without his knowledge or concern. Those are the only two defenses but the defense which you said might have been reasonable belief no longer exists. Does it exist under the Sec 447?

Lahoty: As an investor, if you want to go against the company and the directors, you would use Sec 35-36 and maybe 37 but I don’t think you would go under 447 for mis-statements because there is a specific remedy available in Chapter III itself. So your best case will be under Sec 35-36.

Doshi: In Sec 34 it says that every person who authorizes the issue of such prospectus shall be liable under Section 447.

Raghunath: There are two grounds on which an issuer - who is in the fault- can be prosecuted. One is the criminal side which is Sec 34 and the other is the civil side. Who can get prosecuted under Sec 34 which goes to 447 which includes criminal, it is a person who authorizes the issue of the prospectus and the regulator or the Ministry itself can take action. Sec 35 - anybody who suffers damages can go against any of the people listed in it; that includes experts and he can claim damages only.

Doshi: There is also that bit of unlimited liability?

Lahoty: That has always been there, fraudulent investments and it has kind of been used but it is more criminal in nature.

Doshi: There is nothing much to be alarmed of.

Raghunath: Firstly it talks of words again – recklessly- who judges a recklessness is a moot point. More importantly, it covers credit facilities also. Fraudulently and recklessly- somebody to make available credit facility also gets covered. So in a country which has a little bit of lapses in processes in the lending institution, this can play havoc.

Doshi: Any comment at the end of this on what the prospectus issue finally looks like in the 2013 Act versus 1956?

Lahoty: In terms of disclosures, what Companies Act has done is still given SEBI the primary role of deciding what should be disclosed. It has obviously brought in some new things that we just discussed but largely I don’t see the prospectus would change the way it looks. I think there will be some additional stuff for example, identification of promoters, sources of funds, of course liabilities - we have already discussed-  but the prospectus disclosure standard is not changing much. If anything, I think, it is slightly better than the previous Act because previous Act had a Schedule with three parts. I think we don’t have that level of details just now here. It could be notified in Rules going forward as well but that is not the case in the current rules.

Doshi: Your thoughts on prospectus?

Raghunath: There is an indirect issue which is emanated again, I guess unintentional- variation of objects at anytime - at any time being the keyword - vis-à-vis the purpose for which the prospectus was issued and variation of contracts. Firstly, it is at any time, secondly what is the level of variation in the objects that is within the bar and what is above the bar is unknown and third is variation of contracts, what is variation. You have a provision which says if you want to vary these, go for a special resolution; most important dissenting shareholders can exit but exit by whom?

VARIATION IN PROSPECTUS
Section 27
Any variation in terms of contract or objects
-Requires approval via Special Resolution
                   +
Dissenting Shareholders
-To be given exit offer
-By promoter/controlling shareholder
-Via SEBI prescribed method

Doshi: By the promoter.

Raghunath: Yes, why promoter because the company raised the money.

Doshi: This is not the first time that the shareholder exit appears in this Act. If you look at the…(Interrupted by Guest)

Raghunath: It is a bit of a conflict of solution versus objective because if the company raised the money and for valid reason, it is called a special resolution through -- if 75 percent agreed, then those dissented need to be compensated by whom- the promoter or the company.

Doshi: It is an argument we have been through before when we have discussed the first instance of shareholder exit where everyone said, if I have done a special resolution, why do I need to pay off the dissenting shareholders if the majority of this company is agreed to this change. Your comments on prospectus- better off, worse off?

Parthasarathy: So a lot of details to go into, onerous responsibility and directors and key personnel who are going to sign off that balance sheet and coming to Raghunath’s point, I think if it is a listed company, he has exits available, what is the exit that we are talking about and I am worried about what is the price fixation that will turn out to be. Those are all owners and if it is not listed, what are we talking anyways.

Raghunath: And to whom? The guy who originally invested, he may have sold.

Doshi: This argument - because shareholder exit is in 2-3 different places- will come up when we discuss M&A as well and I think the same argument holds for each instance saying if you have approval through a special resolution, if this is a listed company, a natural exit is available, why are we going through all this effort to get the promoter to give the dissenting shareholder an exit

The Companies Act 2013 defines private placement for the first time. A company can make any number of private placement offers in a year but to not more than a total 200 persons in a year for a type of security. This limit excludes QIBs and ESOPs. That is a big jump up from the limit of 49 persons in the 1956 Act.  

PRIVATE PLACEMENT
Section 42 Explanation II (ii)
"private placement" means any offer of securities or invitation to subscribe securities to a select group of persons by a company (other than by way of public offer) through issue of a private placement offer letter and which satisfies the conditions specified in this section.

What the 2013 Act is explicit in saying that if an offer is made to more than 200 persons- whether the company intends to list or not- the offer will be considered a public offer. There is more Sahara proofing, as I call it. The name of the offeree is to be recorded by the company prior to sending out the offer letter. The application form must also carry the investors name and the investment can be made only by the investor named on the form via his or her bank account. The minimum investment per person is Rs 20000 of face value. No cash payments, no advertising, no fresh private placement offer till the previous one is closed.

PRIVATE PLACEMENT
Need special resolution for every offer
Any number of offers in a year
To not more than 200 investors (aggregate)
Excluding QIBs and ESOPs
Limit applies individually to each type of security (equity, preference, debenture)
 
Lahoty: I think it is a much better position to be in than we were when we looked at the draft Rules. There were problems in the draft Rules which have been taken care of except for one. Now, there is a minimum application of Rs 20,000 in terms of face value. For example, if you had a company with a small face value but extremely high book value or market price, how do you go about this? You could actually talk about much more than Rs 20,000 and this compared to what the draft rules said- draft rules said investment size of Rs 50,000 which was a much better wording to use although not a legal term but still much better term to use than Rs 20,000 as face value.  

Doshi: But is that the only thorn in your side when it comes to private placements? You are mostly happy with everything else that has come in?  

Lahoty: On equity side, I am pretty okay. However, on the debt side, I am probably not because what they have done now is they have included all kind of securities and all kind of companies within private placement. So, while you could do a public offering of debentures without taking a special resolution, you can do a private placement of debentures without taking a special resolution that is probably a root killing; it was not supposed to be but that is how it has come out to be now.

Raghunath: I was applying my mind over the weekend on it- if I would apply this to the various placements we do be it private equity space, in a private company growth capital or a QIP, I see a lot of process bugs here.   

Doshi: Illustration.

Raghunath: Let me explain how a private limited company would do it- let us say M&M Group wants to raise growth capital. The bankers called he is going to first do what is called a teaser which explains the profile and scouts it amongst ‘n’ number of people. Out of that, let us say ‘n/2’ show interest and then with them you share what is called an information memorandum. Again no record of who you sent it to or at least you don’t bother to do it and then go through a diligence process- discover a price, negotiate a contract and then take it to shareholders. The discovery process including who the investor is and the pricing gets firmed up through a process of engagement. If you look at the Rules along with Section 42 what does it say? Every person I take it to I need to have a record of it. More importantly the placement letter or offer letter needs to be done after I get my shareholder resolution. I need to get a pre-resolution before I issue a placement letter or invitation to subscribe. Now, when does a document become an invitation to subscriber and when it is not is unclear. Is an information memorandum an invitation to subscribe? If I don’t have a price discovery, if you look at the disclosures for this special resolution, explanatory statement, I have to disclose who, who to, the pricing and the justification thereof but I am yet to discover all that. So, there is a huge sequencing issue here.  

Now, take it to QIP format. QIP gets trapped between a preferential issue of shares which is 62, that is non rights and 42 because it was a private placement. In QIP price discovery happens – as you launch the deal overnight it gets discovered.

Doshi: What happens to QIP now with all these processes that you need to follow?

Raghunath: I see process challenges as we execute this.

Doshi: You didn’t seem to think that they were going to be big killers?

Lahoty: If you come to think of it, the position the we had in the 1956 Act was only worse. For example, executing a QIP transaction because you could not go to more than 49 investors and just what everybody did. The way you do this is you breakdown the entire process into non-deal and deal process. When you are in the non-deal mode and that is when you do most of these conversations and don’t speak about the transactions really. That is when you don’t really invite any subscriptions. So, you need to break it down. I totally agree that there are process challenges and there will be with any new law coming in. It is very important also for the regulator to be on our side on some of these matters. I don’t think you can market any other way, you can't just identify one person from day one itself. So, you will need to speak to many more but you just need to be in non-deal mode versus deal mode.

Raghunath: The process challenge as I foresee in the law is not just the Rule; the Act says the allotment shall be completed within 60 days. What happens in situations where there are conditions precedent to closure? Regulatory permissions to XYZ clearance, CCI clearance for instance. So, it may or may not happen in 60 days and the Rules don’t change at 60 days nor does it give like in Takeover Code that the clock for closure is subject to the regulatory permissions being in place. It is a hard edged 60 days. So, what if I don’t get them in 60 days?

Doshi: Are you better off because as Manan said the 1956 Act didn’t really give us much to go with. So, this is a substantial improvement at least from the 200 point of view. The process issues remain, they could have been cleaned up but they still remain but we got around with 1956.

Parthasarathy: I go more with Manan. Whatever has been the intent and the practice which has been done over a period of time which is the practical one has been put in the form of legislation. So, broadly they are getting over towards the side where intent is being converted to in terms of law. However having said that, the procedural issue is where I think the SEBI etc coming and saying this is workable and so the first few cases are going to determine how good is  this Act and how much of a bottleneck it will prove to be. I am very hopeful it is going to be the former; it is going to be very smooth in the sense that SEBI is going to sit and look at it because some of these are SEBI's findings being incorporated into this rule.

Lahoty: I do tend to agree with Parthasarathy. I think lot of these concerns probably came in from SEBI’s comments. While a QIP transaction might be not really be affected in terms of the process; if anything it has just got better. A private equity which is not SEBI regulated probably will have more challenges given that we don’t really have a offer document before you go and start marketing. In a QIP you would have to upload it on the website of the company.

Parthasarathy: Date will be a little bit more challenging.

 
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