SEBI amends lock-in and other requirements

(1) SEBI has amended the DIP Guidelines vide Circular dated 24th February 2009 (available on http://www.sebi.gov.in/circulars/2009/ dip342009.pdf). It may be recollected that the SEBI DIP Guidelines provide for various requirements in connection with issue of shares and other securities by listed companies and for other matters. Some of the recent amendments are minor or consequential to other amendments while some have far-reaching impact. The amendments have been made to tighten up the schedule relating to IPOs and incidental matters. Some important amendments are highlighted here but two of them — those relating to Share Warrants and those relating to lock-in — are discussed in detail.

(2) Listing of equity shares with differential rights as to dividends, voting or otherwise :

    (a) Equity shares with differential rights as to dividends, voting, etc. are emerging instruments being tested in India. These are available globally. As they tend to protect and favour the Promoters/Founders, they are also criticised. However, many investors are happy with diluted voting rights if there are other sweeteners involved and hence such shares are often accepted as investments. The alternative is issuing shares with higher voting rights (but with lesser other rights) to the Promoters. It is also found in the West that even such a situation is acceptable. In India, amendments to the law permitting issue of such shares were made a decade back, but because of procedural hurdles and other reasons, these shares were not common in listed companies though recently some companies did experiment with such issues. SEBI has now made an amendment in the Guidelines to clarify some issues.

           (b) By an amendment, conditions for listing of such equity shares that are issued otherwise than by making an IPO have been laid down. Important substantive conditions are that such shares should be issued by way of rights/bonus to all existing shareholders and the Company should be compliant of minimum public shareholding norms for its equity shares already listed and also for the fresh issue.

(3) Listing of warrants offered along with NCDs under Chapter XIII-A (Qualified Institutions Placements) :

(a) Such warrants can now be considered for listing if there is a combined issue of NCDs/warrants and Chapter XIII-A is fully complied with for such issue.

(c) The application for listing of the equity shares with differential rights and warrants/NCDs shall be made through the designated stock exchange which will forward the application to SEBI with its recommendations.

(4) Increase of minimum deposit on Share Warrants from 10% to 25% :

    (a) Share Warrants can be issued on a preferential basis to selective investors. One of the conditions for such issue is that the investor should pay a minimum deposit of 10% of the issue price which has to be forfeited if the Share Warrants are not exercised. It was increasingly felt that (as discussed in more detail in latter paragraphs) that this 10% deposit is too low. Finally, now, the minimum amount payable with application for Share Warrants in case of preferential issues has been raised from 10% to 25% of the issue price.

         
    (b) Considering the ongoing debate on such low deposit amount since a long time now, this amendment was the least unexpected. In my opinion, the amendment has come too late, because Share Warrants have already been heavily misused and abused. The amendment is 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.

(c)    It is also worth  considering  the very rationale – in idealistic theory and in actual practice – of Share Warrants.

(d)    Let us first 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 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.

(e)    Share Warrants have several advantages. You don’t need to pay the full share price up front. You can exercise the Share Warrants anytime. You even have the option to back out and let the deposit be forfeited.

(f)    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 globalisation, 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.

(g)    Consider, from the point of view of the Promoters, the undue advantage Share Warrants offer them.

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

(ii)    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. Even if you do simple valuation of such Share Warrants, applying even the basic Black-Scholes or similar formula, it will be seen that particularly in times of higher volatility, even the increased 25% deposit would be too low.

(iii)    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 one decides to actually purchase the shares, one pays the full purchase price in addition to this premium. In case of Share Warrants, the deposit paid is adjusted  against the issue price.

(iv)    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.

(v)    It was also quickly realised 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.

(h)    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 also lost.

(i)    SEBI of course has been chipping away slowly at the anomalies. The early amendments included reducing the conversion period to 18 months. There is a ban on preferential allotment to those who have sold shares in the last six months. The lock-in period has been effectively increased, as discussed separately here.

(j)    Consider from a different perspective, these amendments over a period of time are mainly in-tended to protect Share Warrants from misuse by Promoters. How these amendments will impact Share Warrants as a financial 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% up front, if one converts them within 18 months, suffer double lock-in period,

• and if the conversion price has to be a minimum one related to recent prices?

(k)    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.

(1)    Share Warrants thus, the way they are generally issued now, result in profits to the Promoters at the cost of the Company and other shareholders. I would even go to the extent of recommending that they be simply prohibited.

(m)    Alternatively, major changes are required if they are to be continued. Linking their pricing and deposit for Share Warrants to past average prices is absurd. Share Warrants are equivalent to options and should be valued as ‘options’. 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.

(n)    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! At the risk of sounding petty, I would even suggest that if the amount paid by Promoters is forfeited, it should be distributed as a special dividend/bonus to non-promoter shareholders!

(o)    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 investment in the Company becomes slightly unattractive. The uncertainties involved are:

• the Company may not receive the balance amount.

• the balance price is to be received at any time the Promoters deem fit, though there is a time limit.

The question is :

‘Is it a commercially sound proposition for the Company to issue Share Warrants on such terms ?’

Unless the answer to the above issues is a clear yes, the Share Warrants should not be issued. I would suggest that there should be a ban on issuance of Share Warrants to only Promoters, just as ESOPs are banned.

(5)    Amendments clarifying lock-in of Share Warrants and shares arising out of exercise of Share Warrants:

(a) Readers  may recollect that in August  2008, the lock-in period relating to warrants, etc. were amended. There was controversy arising out of such amendment. SEBI has attempted to simplify the wording and make it internally consistent.

(b)    Let us again consider the background and con-text of this amendment. Securities issued on a preferential basis are typically locked in for 1 year from the date of allotment (Promoters face a lock-in for 3 years to some extent, but this aspect is not discussed here). Some of the securities such as Share Warrants, FCDs, etc. are convertible into equity shares. The requirement was that all securities so allotted should be locked in for one year and if convertible securities are converted into equity shares during such lock-in period, the shares so allotted would be locked in for the remaining period out of such one year. In other words, the shares allotted did not face a fresh lock-in period of one year but the period for which the convertible securities already suffered lock-in was netted of and the equity shares suffered lock-in for the balance period.

(c)    It was felt that Share Warrants were different from equity shares, FCDs, etc. since in case of Share Warrants, only a part of the amount was paid up front, there were other differences also. SEBI had amended the Guidelines in August 2008 whereby it intended to provide that the aforesaid rule of netting off shall not apply in case of Share Warrants. Thus, in case of Share Warrants, the shares allotted on exercise of Share Warrants will face a fresh lock-in period. However, the amendments were ambiguously worded – at least as opined by some experts
and so the latest amendments seek to make clarificatory amendments.

(d)    This has been done by. bifurcating the ambiguous clause relating to lock-in period of instruments/ shares into two parts.

(e)    The first part talks of lock-in period of instruments allotted to Promoter/Promoter Group and shares allotted to them on exercise of Warrants. Both shall be locked in for 1 year. These lock-in periods are obviously in addition to the 3-year period otherwise applicable for allotments to such persons, read with of course the 20% limit for the 3-year lock-in.

(f)    The second part is almost identically worded, except that it refers to instruments/shares allotted to persons other than such Promoters.

(g)    In clause (d), which refers to set-off of lock-in suffered by instruments, it is now provided that such instruments shall not include warrants.

(h)    The amended clauses are certainly worded better, if one compares only to the earlier wording, which was felt to be a little convoluted, being the result of redrafting exercises over time. However, despite such amendments and consistency in wording, certain basic ambiguities remain. Actually, the lock-in requirements are intended to be quite simple and the whole clause could have been redrafted, instead of focussing on the recent changes.

(6) The  Sat yam  amendments:

Several relaxations to pricing, disclosures, etc. are now provided for where SEBI has already granted exemption under the new Regulation 29A to the Takeover Regulations. Considering that Regulation 29A itself had, I think, effective applicability of one single case, the amendments will have similar shelf life. However, they will remain as part of Regulations and the DIP Guidelines till they are dropped.
 
(7)  Bonus shares:

These shall now be issued within 15 days of Board approval, where shareholder approval for such issue is not required. And the Board cannot change such decision. Where approval of shareholders is required as per the Company’s Articles of Association, the issue shall be made within 2 months of the Board meeting where such issue was announced.

(8)    The amendments made by these Guidelines are generally prospective but with two interesting exceptions.

(a)    The amendment increasing the minimum amount payable for issue of Share Warrants from 10% to 25% applies if the shareholders’ approval is obtained before 24th February 2009. This would affect all those cases (I presently do not know how many or if any) where notices are already issued and the general meeting is convened on 25th February 2009 or later.

(b)    It would be interesting to examine how the amendments relating to lock-in apply to issues made since the last amendment in August.