Contributed by Manisha Soni

Recently, the SEBI chief addressed concerns related to the rising frequency with which SEBI returns IPO documents due to minor omissions and errors.

Companies and bankers involved in the preparation of draft offer documents have shown concerns, as SEBI has implemented stricter scrutiny measures to ensure the integrity and safety of India’s capital markets. The author aims to explore the impact of SEBI’s informal advisories on the existing codified disclosure framework, highlighting both the challenges it poses to market participants and the potential benefits of these measures in protecting investor interests.

SEBI advisory undermining ICDR

The Securities Exchange Board of India (SEBI) has sent back four draft red herring prospectus (offer document) to the merchant bankers (bankers), citing a lack of compliance with Regulation 7(1)(a) of SEBI Issue of Capital and Disclosure Requirements Regulations 2018 (ICDR), which required the issuer company making the initial public offering (IPO) to obtain an in-principle approval from one or more stock exchanges. The SEBI instructed bankers to file for approval from stock exchanges for listing on the same day as filing the offer document for approval to SEBI. This instruction by SEBI came despite the lack of any such specific requirement under ICDR Regulations 2018.

In another incident, SEBI sent a letter containing a 31-point advisory on additional due diligence and disclosure requirements to be followed by bankers working on the draft offer document. This is not available to the public as it was sent informally through mail to only a few bankers. This came despite the existing broad and clear IPO guidelines. The most significant of these advisories are:

1. The Lead manager is to reveal information about the rights issue or preference share allotment in case of any pre-IPO placement, ensure that Employee Stock Option Plan allottees are only employees, disclose information about suppliers or customers if the company’s 50% or more supplies or revenue come from the top 10 suppliers or customers, provide details of acquisitions, mergers, and slump sales, including valuation information and any relationships with promoters or directors, and ensure there is no conflict of interest between suppliers, third-party service providers, and the company or promoters.
2. The funds raised by the company between the filing of the draft offer documents and the final offer documents are to be used for general corporate purposes, as disclosed in the draft documents. If the funds are to be used for another purpose, an auditor must certify how the funds will be deployed.
3. Any special rights given to an entity or person under the Shareholder’s agreement or in the Article of Association should be discarded before the draft offer document is filed. Such rights were previously discarded after the listing to ensure equal rights for all non-promoter shareholders. However, this new requirement could result in forfeiture of special rights enjoyed by private equity investors even before the IPO gets approval.

Although some advisories arise from past errors and inadequate disclosures by companies, implementing these rules by bankers before filing the draft offer document could streamline the approval process. However, the frequent issuance of such advisories risks undermining the current ICDR Regulations.

Impact of advisory on ICDR regulations

Despite not being legally binding, these advisories carry significant weight due to Sections 11A and 11B of the SEBI Act of 1992, which grant SEBI the authority to issue directions to intermediaries regarding offer documents to protect investors’ interests. SEBI can also provide specific observations and feedback on draft offer documents under Rule 26(4) of the SEBI ICDR Regulations 2018. As a result, market participants tend to follow SEBI’s guidance, even though it isn’t legally binding. This practice raises concerns about the lack of standardisation, as these informal, non-codified advisories create uncertainty and inconsistency for companies, undermining the ICDR Regulations. The ambiguity and variability of SEBI’s advisories from one transaction to another disrupt the standardisation that the ICDR Regulations aim to provide, creating a grey area for market participants. This situation places bankers in a challenging position where compliance is necessary despite the potential risk of regulatory overreach.

Additionally, when bankers have already prepared and filed draft offer documents with SEBI, the subsequent diktats issued by the regulator can lead to a sunk cost fallacy for companies and bankers. Having invested significant resources in the IPO process, bankers and companies often feel compelled to comply with SEBI’s informal directives to get their money and cognitive efforts’ worth. This inclination to adhere to SEBI’s requirements despite potential inefficiencies or burdens stems from the desire to ensure the IPO proceeds smoothly and to avoid the financial and strategic setbacks associated with abandoning the process.

Author’s remarks

The author believes that the increasing disclosure requirements mandated by SEBI are entirely justified. The details, such as clarity on the business model, growth strategy, key performance indicators, reliance on suppliers and customers, and specifics regarding pre-IPO placement, are standard in any private placements.

While these disclosures and SEBI’s subsequent requests for clarification may render the process cumbersome, it’s essential to recognise that the inconvenience to the issuer cannot take precedence over the need to protect investors.

Despite the increasing disclosure requirements, SEBI has significantly improved the average time to clear IPO from 123 days the previous financial year to 81 days this financial year, largely due to its new approach for processing draft offer documents. SEBI has shifted from outright rejection of draft offer documents to a ‘return instead of rejection’ strategy to ensure issuers resubmit documents in compliance with SEBI’s directions. This shift, alongside newly published guidelines advocating for clear and simple language in offer documents, aims to streamline the approval process and keep pace with the influx of new IPOs. The “troublesome” applications often block applicants in the queue who have done extreme due diligence and have submitted painstakingly drafted offer documents.

The author agrees that it is advantageous for companies to issue IPO when the market is favourable. However, it is crucial for the market regulator to assess the valuation of the IPO through key performance indicators and to understand how the company plans to use the money raised through the IPO. SEBI’s advisory is a step to ensure the bankers/legal advisors work to reflect crucial information adequately in draft offer documents. These guidelines, inspired by SEBI’s past experiences in failing to protect investors, are designed to expedite document processing and clarify regulatory requirements. While this approach is expected to protect investor interests, reduce the time needed for clarifications and speed up the overall process, it also increases the preparatory burden on bankers, underwriters, legal advisors, and auditors. Companies may face additional paperwork and time requirements when filing their draft offer documents, reflecting a trade-off between expedited approval and increased preparatory effort.

The SEBI is planning to address the abovementioned pitfalls in the regulatory approval mechanism by integrating AI into the IPO filing procedure. The inclusion of AI tools and fill-in-the-blanks form templates is poised to solve the problem. The introduction of standardised templates will simplify the IPO filing process, making it more accessible for younger companies. By structuring essential information, firms can expedite the review process, leaving only final approval to an officer. This streamlines IPO filings, ensuring swift and seamless processing. Although formalising these changes may take time, it will ultimately provide legal clarity, benefiting the market and maintaining investor confidence. Clear, consistent guidelines are crucial for the IPO market’s long-term health.

Conclusion

In conclusion, while SEBI’s increasingly stringent disclosure requirements and advisories have raised concerns within the investment banking and legal communities, they are necessary to protect investor interests and maintain the integrity of India’s capital markets. Although these measures may prolong the IPO approval process and increase the preparatory burden on companies and their advisors, they ultimately contribute to a more transparent and secure financial market. The integration of AI and the use of standardised templates hold promise for simplifying and expediting the IPO process, ensuring that the market remains accessible and efficient. As SEBI continues to refine its regulatory approach, balancing thorough scrutiny with streamlined procedures, the long-term health and stability of the capital market are likely to be strengthened, fostering greater investor confidence and market compliance.