1. INTRODUCTION

The Securities and Exchange Board of India ("SEBI") has recently started issuing observations to Initial Public Offering ("IPO") bound companies to ensure that the disclosures in their offer document for decisions with respect to 'offer price' and 'price band', are made in compliance with Part VII of Chapter II of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 ("ICDR Regulations"). 1 These observations stem from the market regulator's recent endeavour to curb the influence of Private Equity ("PE"), Venture Capital ("VC") and other selling shareholders (collectively with PE and VC the "Selling Shareholders") who intend to offload shares in the IPO.

The observations have been made by SEBI on draft offer documents which typically provide that certain decisions in relation to the IPO, including the price band, will be decided by the company and Selling Shareholders in consultation with book running lead managers of the IPO, i.e., granting decision making rights to the Selling Shareholders with respect to the IPO price. This move seems driven by an inclination to prevent the Selling Shareholders from influencing IPO pricing and subsequently affecting IPO performance considering the spate of underperformed tech IPOs, where SEBI seems to be assuming that such Selling Shareholders prioritise the maximisation of their return on investment, by pushing for a higher price, which impacts the broader interest of the IPO-bound company or the interest of the new incoming public investors.

LAW RELATED TO PRICING OF IPO

ICDR Regulations define an 'IPO' to mean an offer of specified securities by an unlisted issuer to the public for subscription and includes an offer for sale of specified securities to the public by any existing holders of such specified securities in an unlisted issuer. 2 The Selling Shareholders want to be involved in the IPO process because in most scenarios they are offering their shares for sale in the IPO through the offer for sale component. As a result, they are keen to actively participate in the IPO process, particularly in determining the share price, as their return-on-investment hinges on this pivotal decision. Even in instances where they might not be participating in the IPO, they might still want to have some say given that an IPO is an important valuation benchmarking event for the company.

As per Regulation 28(1) of ICDR Regulations, the determination of the IPO price is vested in the issuer, in consultation with the lead managers or through the book-building process, depending on the circumstances. In this context, the term 'issuer' has been defined in the ICDR Regulations to mean a company or a body corporate authorized to issue specified securities and whose securities are being issued and/or offered for sale.3 Therefore, it is the company going for the IPO which has to decide the pricing of securities and there is no explicit obligation to engage the Selling Shareholders in the decision-making process for setting the IPO price.

It is pertinent to note that in the repealed SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, ("Old Regulations"), the term 'issuer' was defined as any person making an offer of specified securities, 4 therefore being wide enough to include within its ambit the Selling Shareholders as they offer their shares in the IPO through the offer for sale component. However, this definition was modified in the ICDR Regulations because SEBI perceived that the disclosures in the offer document irrespective of primary or secondary issue, are made by the company whose securities are being listed. This updated definition thereby gave SEBI backing under law to make the observation to exclude Selling Shareholders from the price determination process.

However, it is noteworthy that there is no explicit prohibition preventing the Selling Shareholders from participating in this price determination process and in most cases, prior to when these observations started coming from SEBI, one way or another, i.e., through representation on board, shareholding percentage or through a contractual right, Selling Shareholders would almost always manage to get a say in the decisionmaking when it came to pricing and other important terms in relation to the IPO.

The most common way for a Selling Shareholder to achieve this influence is (i) through contractual rights under the Shareholders Agreement ("SHA"), and (ii) through its nominee directors on the board of a company. A nominee director remains bound by their fiduciary duty to act in the best interests of the company (and not just a particular shareholder) in accordance with Section 166 of the Companies Act, 2013 ("Companies Act"). Such a conflict may only be resolved where a director recuses himself on account of potential conflict or takes the argument that the interests of the company as a whole and the Selling Shareholders are aligned in relation to the relevant decision. 5

While the law is clear that the director should work in the best interests of the company, its employees, the shareholders, the community and for the protection of environment, and that the company interest will prevail over their nominator's interest, SEBI's recent observations goes to show their apprehensiveness, in so far as such observations do not even allow the Selling Shareholders to indirectly be involved in decision making, including through their nominee directors in the IPO committee.

One could argue that such observations stand contrary to the ICDR Regulations which mandate that the issuer shall determine the IPO price, as the issuer being a company or body corporate will have to act through its board of directors or a duly constituted committee of the board, i.e., the IPO committee. Even if a nominee director is present in the IPO committee, their obligation under Section 166 of the Companies Act would have ensured a balanced and objective decision-making which would be in the best interest of the company.6

WHY DO SELLING SHAREHOLDERS PARTICIPATE IN DECISION MAKING?

The Selling Shareholders who own a large enough stake in a company are often given special rights in the company and serve as long-term financial backers of a company, actively participating, to some extent, in managing and overseeing its operations. Their strategic efforts are of course, geared towards achieving a successful exit and maximizing returns on their investments.

Such Selling Shareholders' interest and their actions as shareholders of the company can be contradistinguished from their appointed nominee directors, as the law allows a shareholder to take a narrower approach and to take actions which will benefit them in their personal capacity even if they may not be in the long-term interests of the company.

In one scenario, Selling Shareholders with a vested interest in their reputation within the IPO market, may exert influence to ensure fair pricing of IPOs for companies they support. While there may be short-term gains from pricing the IPO above its intrinsic value, this strategy carries the risk of long-term losses by significantly tarnishing their standing with IPO investors and other financial market participants. Generally, the understanding prevails that the stronger the reputation of a Selling Shareholder, the greater their motivation to price equity in IPOs closer to its intrinsic value.

On the other hand, the Selling Shareholders who are not worried about their reputation in the IPO market and are not concerned about any long-term impact, may exert influence through their shareholding or contractual rights, to secure a higher IPO price by disregarding the negative consequences it can have on the company or public investors.

These distinct scenarios have profound implications for IPO pricing. The first scenario suggests that the Selling Shareholders are inclined to price IPOs closer to intrinsic value to safeguard their reputation in the IPO market. In contrast, the second scenario indicates that their primary goal is to secure the highest possible IPO price, leveraging their relationships with various market participants. If the mindset of the Selling Shareholders aligns more with the second scenario, the IPO pricing tends to be elevated, potentially impacting the broader interests of the company and post IPO investors, which raises concerns for regulatory bodies like SEBI.7

In recent times, these concerns have been solidified primarily due to a cluster of underperforming IPOs, which gave the Selling Shareholders a seat at the table, and are currently trading below their issue price, running the risk of eroding retail investor wealth and confidence.

To view the full article click here

Footnotes

1. Part VII: Pricing, Chapter II - Initial Public Offer on Main Board of the ICDR Regulations.

2. Regulation 2(w) of the ICDR Regulations.

3. Regulation 2(aa) of the ICDR Regulations.

4. Regulation 2(r) of the Old Regulations.

5. AES OPGC Holding (Mauritius) and Ors. vs. Orissa Power Generation Corporation Ltd. and Ors., MANU/CL/0103/2004.

6. Detailed analysis on duties of directors in India is available here.

7. Soumya G. Deb, Pradip Banerjee, Performance of VC/PE-backed IPOs: New Insights from India, GLOBAL BUSINESS REVIEW, 2020, at 2.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.