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CHAPTER 2: PRIMARY MARKET

2.1 INTRODUCTION

Primary market provides opportunity to issuers of securities, Government as well as corporates, to raise resources to me et their requirements of investment and/or discharge some obligation. The issuers create and issue fresh securities in exchange of funds through public issues and/or as private placement. They may issue the securities at face value, or at a discount/premium and these securities may take a variety of forms such as equity, debt or some hybrid instrument. They may issue the securities in domestic market and/or international market through ADR/GDR/ECB route.

2.2 MARKET DESIGN

The market design for primary market is provided in the provision of the Companies Act, 1956, which deals with issues, listing and allotment of securities. In addition, DIP guidelines of SEBI prescribe a series of disclosures norms to be complied by issuer, promoter, management, project, risk factors and eligibility norms for accessing the market. In this section, the market design as provided in securities laws has been discussed.

2.2.1 DIP Guidelines, 2000

The issues of capital to public by Indian companies are governed by the Disclosure and Investor Protection (DIP) Guidelines of SEBI, 2000. The guidelines provide norms relating to eligibility for companies issuing securities, pricing of issues, listing requirements, disclosure norms, lock-in period for promoters’ contribution, contents of offer documents, pre-and post-issue obligations, etc. The guidelines apply to all public post-issues, offers for sale and rights issues by listed and unlisted companies.

Eligibility Norms

Any company issuing securities through the offer document has to sat isfy the following conditions:

• A company making a public issue of securities has to file a draft prospectus with SEBI, through an eligible merchant banker, at least 30 days prior to the filing of prospectus with the Registrar of Companies (RoCs). The filing of offer document is mandatory for a listed company issuing security through a rights issue where the aggregate value of securities, including premium, if any, exceeds Rs.50 lakh. A company

cannot make a public issue unless it has made an application for listing of those securities with stock exchange(s). The company must also have entered into an agreement with the depository for dematerialisation of its securities and also the company should have given an option to subscribers/shareholders/investors to receive the security certificates or securities in dematerialised form with the depository. A company cannot make an issue if the company has been prohibited from accessing the capital market under any order or discretion passed by SEBI.

• An unlisted company can make an Initial Public Offering (IPO) of equity shares or any other security which may be converted into or exchanged with equity shares at a later date, only if it meets all the following conditions:

(a) The company has net tangible assets of at least Rs.3 crore in each of the preceding 3 full years (12 months each),of which not more than 50 % is held in monetary assets, provided that if more than 50 % of the net tangible assets are held in monetary assets, the company has made firm commitments to deploy such excess monetary assets in its business/project.

(b) The company has a track record of distributable profits in terms of section 205 of the Companies Act, 1956, for at least three (3) out of immediately preceding five (5) years. Provided further, that extraordinary items shall not be considered for calculating distributable profits in terms of section 205 of Companies Act,1956/

(c) The company has a net worth of atleast Rs.1 crore in each of the preceding 3 full years (of 12 months each).

(d) In case the company has changed its name within the last one year, at least 50% of the revenue for the preceding 1 full year is earned by the company from the activity suggested by the new name.

(e) The aggregate of the proposed issue and all previous issues made in the same financial year in terms of the size(i.e offer through offer document+firm allotment_promoters’ contribution through the offer document),does not exceed five (5) times its pre-issue net worth as per the audited balance sheet of the last financial year.

An unlisted company not complying with any of the conditions specified above may make an initial public offering (IPO) of equity shares or any other security which may be converted into or exchanged with equity shares at a later date, only if it meets the two conditions given below.

(a) The issue is made through the book-building process, with atleast 50 % of the net offer to public being allotted to the Qualified Institutional Buyers (QIBs) failing which the full

subscription monies shall be refunded OR the project has at least 15 % participation by Financial Institutions/Scheduled Commercial Banks of which at least 10% comes from the appraiser(s). In addition to this, at least 10% of the issue size shall be allotted to QIBs, failing which the full subscription monies shall be refunded.

(b) The minimum post-issue face value capital of the company shall be Rs.10 crores OR there shall be a compulsory market making for at least 2 years from the date of listing of the shares, subject to the conditions that a) Market makers undertake to offer buy and sell quotes for a minimum depth of 300 shares b) market makers undertake to ensure that the bid-ask spread (difference between quotations for sale and purchase) for their quotes shall not at any time exceed10 % c) the inventory of the market makers on each of such stock exchanges as on the date of allotment of securities shall be at least 5% of the proposed issue of the company.

• A listed company shall be eligible to make a public issue of equity shares or any other security which ma y be converted into or exchanged with equity shares at a later date; provided that the aggregate of the proposed issue and all previous issues made in the same financial year in terms of size (i.e offer through offer document+firm allotment+promoters contribution through the offer document) issue size does not exceed 5 times its pre issue net worth as per the audited balance sheet of the last financial year. Further, if there is a change in the name of the issuer company within the last 1 year (reckoned fro m the date of filing of the offer document), the revenue accounted for by the activity suggested by the new name is not less than 50 % of its total revenue in the preceding 1 full year period.

• Infrastructure companies are exempt from the requirement of eligibility norms if their project has been appraised by a public financial institution or infrastructure development finance corporation or infrastructure leasing and financing services and not less than 5% of the project cost is financed by any of the institutions, jointly or severally, by way of loan and/or subscription to equity or a combination of both. Banks and rights issues of listed companies are also exempt from the eligibility norms.

• For public and rights issues of debt instruments irrespective of their maturities or conversion period, it is mandatory to obtain credit rating from a registered credit rating agency and to disclose the same in the offer document. If the credit rating is obtained from more than one credit rating agency, all the credit ratings, including the unaccepted ones, need to be disclosed. .

Thus the quality of the issue is demonstrated by track record/appraisal by approved financial institutions/credit rating/subscription by QIBs.

Pricing of Issues

The companies eligible to make public issue can freely price their equity shares or any security convertible into equity at a later date in cases of public/rights issues by listed companies and public issue by unlisted companies. In addition, eligible infrastructure companies can freely price their equity shares subject to compliance of disclosure norms as specified by SEBI from time to time. The public and private sector banks can also freely price their shares subject to approval by RBI. A company may issue shares to applicants in the firm allotment category at higher price than the price at which securities are offered to public. A listed company making a composite issue of capital may issue securities at differential prices in its public and rights issue. Further, an eligible company is free to make public/rights issue in any denomination determined by it in accordance with the Companies Act, 1956 and SEBI norms.

Contribution of Promoters and lock-in

The promoters’ contribution in case of public issues by unlisted companies and promoters’ shareholding in case of ‘offers for sale’ should not be less than 20% of the post issue capital. In case of public issues by listed companies, promoters should contribute to the extent of 20% of the proposed issue or should ensure post-issue holding to the extent of 20% of the post-issue capital. For composite issues, the promoters’ contribution should either be 20% of the proposed public issue or 20% of the post-issue capital. The promoters should bring in the full amount of the promoters contribution including premium at least one day prior to the issue opening date (which shall be kept in an escrow account with a Scheduled Commercial Bank and the said contribution/amount should be released by the company along with the public issue proceeds). The requirement of promoters contribution is not applicable in case of (i) public issue of securities which has been listed on a stock exchange for at least 3 years and has a track record of dividend payment for at least 3 immediate preceding years, (ii) companies where no identifiable promoter or promoter group exists, and (iii) rights issues.

For any issue of capital to the public, the minimum promoter’s contribution is locked in for a period of 3 years. If the promoters contribution exceeds the required minimum contribution, such excess is locked in for a period of one year. Securities allotted in firm allotment basis are also locked in for a period of one year. The locked-in securities held by promoters may be pledged only with banks or FIs as collateral security for loans granted by such banks or FIs, provided the pledge of shares is one of the terms of sanction of loan.

Issue of Sweat Equity

The SEBI (Issue of Sweat Equity) Regulations, 2002 have been framed and the main provisions laid down therein for issue of sweat equity are (a) under the new guidelines, the Sweat Equity shares can be issued by a company to its employees and directors as well as promoters, (b) the pricing of the sweat equity shares should be as per the formula prescribed for that of preferential

allotment, (c) the sweat equity shares should be locked in for a period of 3 years from the date of Allotment. In case of a subsequent public issue being made, lock in shall be as per the SEBI (DIP) Guidelines, 2000.

Issue Obligations

The lead merchant banker plays an important role in the pre-issue obligations of the company. He exercises due diligence and satisfies himself about all aspects of offering, veracity and adequacy of disclosures in the offer document. Each company issuing securities has to enter into a Memorandum of Understanding with the lead merchant banker, which specifies their mutual rights, liabilities and obligations relating to the issue. In case of under-subscription of an issue, the lead merchant banker responsible for underwriting arrangements has to invoke underwriting obligations and ensure that the underwriters pay the amount of devolvement. It should ensure the minimum number of collection centres. It should also ensure that the issuer company has entered into an agreement with all the depositories for dematerialization of securities. All the other formalities related to post-issue obligations like, allotment, refund and despatch of certificates are also taken care by the lead merchant banker.

Book Building

Book Building means a process undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memoranda or offer document.

Book building is a process of offering securities in which bids at various prices from investors through syndicate members are collected. Based on bids, demand for the security is assessed and its price discovered. In case of normal public issue, the price is known in advance to investor and the demand is known at the close of the issue. In case of public issue through book building, demand can be known at the end of everyday but price is known at the close of issue.

In case of an issuer company makes an issue of 100% of the net offer to public through 100% book building process-

i) Not less than 35 % of the net offer to the public shall be available for allocation to retail individual investors.

ii) Not less than 15 % of the net offer to the public shall be available for allocation to non institutional investors i.e. investors other than retail individual investors and Qualified Institutional Buyers.

iii) Not more than 50% of the net offer to the public shall be available for allocation to Qualified Institutional Buyers.

Provided that, 50 % of net to public should be mandatorily allotted to the Qualified Institutional Buyers, in case the issuer company is making a public

issue. Further, in respect of issues made under Rule 19(2)(b) of Securities Contract (Regulation) Rules 1957, there should be 60% mandatory allocation to Qualified Institutional Buyers, and the percentage allocation to retail individual investors and non institutional investors should be 30 % and 10%

respectively.

In case an issuer company makes an issue of 75% of the net offer to public through book building process and 25% at the price determined through book building-

i) In the book built portion, not less than 25% of the net offer to the public should be available for allocation to non qualified institutional buyers and not more than 50% of the net offer to the public should be available for allocation to Qualified Institutional Buyers.

ii) The balance 25% of the net offer to the public offered at a price determined through book building should be available only to retail individual investors who have either not participated or have not received any allocation, in the book built portion.

Provided that 50% of net offer to public should be mandatorily allotted to Qualified Institutional Buyers in case the issuer company is making a public issue.

Out of the portion available for allocation to qualified institutional buyers in case when the company makes an issue through 100% or 75% book building, five percent should be allocated proportionately to mutual funds. Allotment to retail individual or non-institutional investors is made proportionately. In case of under subscription in any category, the unsubscribed portions are allocated to the bidders as per the proposed manner of allocation among respective categories of investors, in the event of under subscription. The book built portion, 100% or 75%, as the case may be, of the net offer to public, are compulsorily underwritten by the syndicate members or book runners.

Other requirements for book building include: bids remain open for at least 3 days, only electronic bidding is permitted; bids are submitted through syndicate members; bids can be revised; bidding demand is displayed at the end of every day; allotments are made not later than 15 days from the closure of the issue failing which interest at the rate of 15% shall be paid to investors. The 100% book building has made the primary issuance process comparatively faster and cost effective.

The DIP guidelines for book building provides that the company should be allowed to disclose the floor price, just prior to the bid opening date, instead of in the Red herring prospectus, which may be done by any means like a public advertisement in newspaper etc. Flexibility should be provided to the issuer company by permitting them to indicate a 20% price band. Issuer may be given the flexibility to revise the price band during the bidding period and

the issuers should be allowed to have a closed book building i.e. the book will not be made public.

On-line Initial Public Offers (IPO)

A company proposing to issue capital to public through on-line system of the stock exchange has to comply with Section 55 to 68A of the Companies Act, 1956 and SEBI (DIP) Guidelines, 2000. The company is required to enter into an agreement with the stock exchange(s) which have the requisite system for on-line offer of securities. The agreement should cover rights, duties, responsibilities and obligations of the company and the stock exchanges inter-se, with provision for a dispute resolution mechanism between the company and the stock exchange. The issuer company appoints a Registrar to the Issue having electronic connectivity with the stock exchanges. The issuer company can apply for listing of its securities at any exchange through which it offers its securities to public through on-line system, apart from the requirement of listing on the regional stock exchange. The stock exchange appoints brokers for the purpose of accepting applications and placing orders with the company. The lead manager would co-ordinate all the activities amongst various intermediaries connected in the system.

In addition to the above, the DIP guidelines also provide details of the contents of the offer document and advertisement, other requirements for issues of securities, like those under Rule 19(2) (b) of SC(R) Rules, 1957. The guidelines also lay down detailed norms for issue of debt instruments, issue of capital by designated financial institutions and preferential/bonus issues.

Book Building through On-line IPO System

Book building is basically a process used in IPO for efficient price discovery, wherein during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date. In it’s strive to continuously improve Indian securities market; NSE offers its infrastructure for conducting online IPOs through book building. It helps to discover price as well as demand for a security to be issued through a process of bidding by investors. The advantages of this new system are: a) the investor parts with money only after allotment, b) it eliminates refunds except in case of direct applications and c) it reduces the time taken for issue process. Though the guidelines for book building were issued in 1995, it is being used for IPOs from 1999.