In the context of the recent surge in IPOs in India, this note looks at certain key regulatory issues and matters that are relevant to pre-IPO investors of Indian investee companies.
The market for initial public offerings (IPOs) in India has seen a significant uptick in recent years. The financial year ended March 2024 witnessed as many as 76 Indian corporates raise nearly US$ 7.5 billion in main board IPOs. In addition to primary tranche issuances, the IPOs included a significant offer for sale (OFS) component involving secondary sale by existing investors. Going by the data for the months of April and May, the IPO boom looks all set to continue in the current financial year as well. This note serves to address a few issues which are frequently faced by pre-IPO investors in the context of IPOs by investee companies.
FDI or FPI, but not both in the same company
Any foreign investment in an unlisted Indian company will necessarily need to be under the foreign direct investment (FDI) route. A foreign investor which has invested in an Indian company under the FDI route cannot purchase additional shares of the same company under the foreign portfolio investment (FPI) route, either in the IPO or on the market following the company's listing. While this restriction under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the Non-Debt Rules) is relatively untested, the issue was in focus in the high-profile IPO of Zomato in 2021, where the Reserve Bank of India is reported to have advised custodian banks that the pre-IPO foreign investors who held shares under the FDI route could not purchase further shares in the IPO under the FPI route.
It is, however, worth clarifying that this restriction under the Non-Debt Rules will not preclude a separate group entity from investing as an FPI in a company in which another group member has invested under the FDI route. Equally, the same entity can make investments under the FPI and FDI routes in different investee companies subject to ensuring prior alignment with the custodian bank and clear demarcation between the FDI and FPI investments.
Participation in Pre-IPO Placement
The Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR), permit IPO bound companies to make "pre-IPO placements" between the date of filing of the draft red herring prospectus (DRHP) with the Securities and Exchange Board of India (SEBI) (i.e., which formally commences the IPO process with SEBI) and completion of listing, subject to relevant disclosures in this regard being made in the DRHP. These disclosures do not need to be definitive or set out the amount proposed to be raised or the number or percentage of shares that may be issued and may simply state that the issuer may carry out a pre-IPO placement. Such pre-IPO placements, which cannot exceed 20% of the size of the fresh issue in the IPO, are carried out either at a specified price or at the IPO price that is subsequently determined in the book building process as part of the IPO. Companies often undertake pre-IPO placements with the intention of eliciting interest in the IPO from large financial institutions as the participants in the pre-IPO placement will be named in the offer documents. All pre-IPO placements will need to be completed prior to the filing of the red herring prospectus (RHP) with the Registrar of Companies (i.e., which follows after the company has filed the updated draft red herring prospectus (UDRHP) incorporating any comments from SEBI on the DRHP). The price band is finalised shortly after filing the RHP. While the shares are not yet "listed" at such stage, it is common practice for companies to invite both FDI and FPI applicants to participate in such pre-IPO placements.
Following a pre-IPO placement at a specified price as opposed to the IPO price that is determined subsequently, in case the IPO does not materialize, the pre-IPO placement investors will be left holding shares in an unlisted entity. Apart from the liquidity issue that this creates, such a situation is especially tricky for FPI investors who by default are not allowed to invest in or hold unlisted equity instruments. To deal with this eventuality, the pre-IPO placement documents often include a mechanism which enables the investors to sell the shares back to the company (or a third party) in case the IPO does not proceed. An alternative is to require the pre-IPO placement shares to be issued simultaneously with the allotment of shares in the IPO as that avoids these issues.
In case of a successful IPO, the shares allocated pursuant to the pre-IPO placement are subject to the same lock-in restrictions applicable to other pre-IPO investors (i.e., six months from the date of allotment in the IPO).
Termination of Governance Rights
Pre-IPO investors are invariably entitled to various governance and other rights under the shareholders' agreement and the articles of association of the investee company. As part of the IPO process, there is usually a waiver / amendment agreement which effectively terminates these rights with effect from the date of RHP filing. However, in recent times, several underwriters have been insisting on these special rights being removed from the articles of association of the company prior to the filing of the DRHP with SEBI whilst permitting the amended shareholders' agreement (SHA) to provide for the termination of the special rights prior to filing the RHP. SEBI has recently issued a directive (SEBI Directive) which addresses this anomaly and now requires these special rights, whether under the articles of association or the SHA, to be terminated prior to the filing of the UDRHP (i.e., which precedes the RHP filing stage). This recent SEBI Directive means these special rights will be terminated even prior to the RHP.
In case the IPO is not completed by the specified long-stop date, the amendment to the SHA terminating these special rights will stipulate that these provisions will automatically be reinstated without any shareholder approval to reflect the position prior to the execution of the waiver / amendment agreement. While such reinstatement is meant to happen automatically, in practice, several SHA provisions can be implemented only once the entity has re-converted to a private company (which usually takes a few months).
Pre-IPO investors, unless named as "promoters" in the IPO documents, are unlikely to be able to retain any significant governance rights (including the right to appoint a nominee director or observer) following the listing. In any event, any such post-IPO special rights will be conditional on obtaining the approval of the shareholders (including the public shareholders) following the listing. Further, as per SEBI's listing regulations, the continuity of such special rights will be subject to obtaining shareholders' approval every five years.
Conversion of Convertible Instruments
As per SEBI's ICDR, all convertible instruments including any warrants held by the pre-IPO investors are required to be converted into equity shares prior to the filing of the RHP. However, in practice, several companies insist on all convertible instruments to be converted into equity shares at the stage of filing the DRHP itself, and certainly since the SEBI Directive, there is increasing pressure to convert the convertible instruments before filing the UDRHP. The terms of the convertible instruments sometimes provide additional rights to the holders of these instruments, so in case the IPO were to fail, the pre-IPO investors would stand to lose such protective provisions in perpetuity. One other issue is that in some cases, the conversion price is linked to the IPO price – that is then amended as neither the IPO price nor a price band in a book built issue will have been determined prior to filing the UDRHP or RHP at the time of conversion. While the parties could contractually require the company to restore the benefit (including the protective provision) of the convertible instruments to the pre-IPO investors, such reinstatement would be difficult to implement in practice, especially in the context of foreign investors who are subject to pricing and reporting requirements under the Non-Debt Rules.
Insider Trading Implications
While the information and inspection covenants under shareholders' agreements need to be waived only at the stage of the RHP filing, the information sharing and trading restrictions under SEBI's insider trading regulations will apply to a company from the date of filing of the DRHP. Therefore, once the DRHP is filed, all pre-IPO investors, especially those seeking to participate in a pre-IPO placement, OFS or purchase shares in the IPO, will need to be careful in handling information shared by the investee company. Pre-IPO investors will need to make sure to have robust and well documented information barriers in order to be able to rely on the "Chinese Wall" defence under the SEBI's insider trading regulations. To avoid the uncertainties of relying on such defence, institutional investors with multiple investment arms could also consider voluntarily waiving their information and inspection rights at the DRHP filing stage itself, and certainly by the RHP filing stage in any event.
Key Implications for Selling Shareholders
Confirmations and Undertakings
A selling shareholder participating in the OFS component of the IPO will need to ensure that it is not subject to any regulatory embargo either by SEBI or by a securities market regulator or any other authority / court in another jurisdiction. There are also several other confirmations that a selling shareholder will be expected to provide as part of the offer documentation (e.g., that it is not a wilful defaulter, fraudulent borrower or fugitive economic offender in India). A selling shareholder will be a party to the offer agreement (the other parties to such agreement being the issue company and the book running lead managers) and will be expected to provide certain warranties to the book running lead managers – ideally these will be restricted to the title to the shares, information relating to the selling shareholders and agreements entered into by the selling shareholders with the issuer. Book running lead managers sometimes insist on additional warranties. For instance, selling shareholders are often asked to warrant that they are not in possession of any information that has not been included in the offer documents, but which should be included to prevent the statements in the offer documents from being misleading or to prevent the omission of material information – such demands need to be resisted strongly.
Disclosure Standards
SEBI's ICDR require all directors to sign the offer documents and confirm that all the statements / disclosures made therein are "true and correct". SEBI does not make a distinction between executive and non-executive directors for such disclosures and accordingly, nominee directors appointed by the selling shareholders will also be expected to sign the offer documents. The promoters and issuer should provide a representation letter to the nominee directors appointed by the selling shareholders confirming the disclosures in the offer documents in a manner consistent with the warranties on disclosure have been provided to the book running lead managers in the offer agreement.
The ICDR, however, prescribes inconsistent standards for the disclosures required to be made by the issuer and the book run lead managers under the offer documents. Regulation 24 of the ICDR provides that the offer document should contain all material disclosures which are "true and adequate to enable the applicants to take an informed investment decision". Separately, the format of the due diligence certificate prescribed in Form A of Schedule V of the ICDR which is required to be provided by the book running lead manager also provides for similar disclosures to be made, except, such disclosures are made for the investors to make a "well informed decision". A different disclosure standard is prescribed under Part A of Schedule VI of the ICDR that requires an 'Issuer's Absolute Responsibility' statement to be made in the offer document, stating, inter alia, that all the disclosures in the offer document are true and correct in all material aspects and not misleading in any material respect and that the opinions and intentions expressed in the offer document are honestly held and that there are no other facts, the omission of which would make the offer document as a whole or any of such information or the expression of any such opinions or intentions misleading in any material respect.
Sale and Purchase Restrictions
The shares which are proposed to be sold in the IPO should be held by the selling shareholder for a period of at least one year prior to the filing of the DRHP with SEBI. Additionally, in certain cases, there are restrictions on the extent of shares which can be sold by selling shareholders participating in the IPO (e.g., in case of an IPO where the issuer does not fulfil the specified minimum net tangible assets, average operating profit or net worth criteria, a selling shareholder which, together with its persons acting in concert, holds less than 20% can offer to sell no more than 10% in the IPO).
A selling shareholder in an IPO will be prevented from buying shares in the same IPO. It is, however, worth noting that this restriction extends only to the relevant entity which is named as a selling shareholder in the offer documents, and not to other entities in the same investor group as the selling shareholder.
IPO Decisions
As mentioned above, a selling shareholder will be expected to sign up to the offer agreement and several other documents and provide confirmations in relation to the IPO. The IPO pricing will be determined through an elaborate book building process. The extent of influence that the selling shareholders have in fixing the price band would depend on the specific terms of the offer agreement as also their relationship with the issuer company. An alternative may be to include a nominee director of the selling shareholder as part of the IPO committee who will make such decisions, and also provide that such nominee director will form part of the quorum to ensure that all such IPO related decisions are unanimous, though it is worth noting that in recent IPOs, there has been increased scrutiny by SEBI in relation to the involvement of the selling shareholders in fixing the price band, and in some instances, there is resistance to even including the nominee director as a part of the IPO committee.
IPO Expenses
The expenses in relation to the IPO, which include fees and expenses of the merchant bankers, legal counsels, other intermediaries as well as advertising and marketing expenses, are usually shared between the company and all the selling shareholders on a pro rata basis, in proportion to the respective portions of the primary and secondary components in the IPO. SEBI appears to be taking the view that such expenses need to be shared proportionately even if the IPO is abandoned or withdrawn, which is a departure from its earlier position.
Post Listing Restrictions
Lock-in
The ICDR prescribe that all shares held by the non-promoter shareholders (other than certain exempt categories, such as shares issued pursuant to exercise of employee stock options or shares held by a venture capital fund or alternative investment fund (of category I or category II) or a foreign venture capital investor), including any shares which remain unsold in the IPO, are to be locked-in for a period of six months from the date of allotment of fresh shares pursuant to the IPO.
FPI groups capped at 10%
Under the SEBI (Foreign Portfolio Investors) Regulations, 2019, entities registered as FPIs and directly or indirectly having common ownership of more than 50% or common control, are treated as part of the same investor group and the investment limits of all the entities forming part of the investor group are clubbed and capped at the 10% limit (i.e., the investment limit applicable to a single FPI). If the total investment by an FPI along with its investor group exceeds the 10% threshold, the relevant FPI would have the option of divesting its excess holding within five trading days or re-classify its entire investment as FDI.
Insider Trading
In the unlikely event of an investor retaining a board nomination right following the IPO of an investee company, such director as well as the concerned investor will need to be conscious of SEBI's insider trading regulations, which restrict communication of unpublished price sensitive information (UPSI) and prohibit trading in securities while being in possession of UPSI. Accordingly, there will need to be appropriate information barriers to ensure that any UPSI in relation to an investee company available to one group entity (whether by virtue of a board seat or otherwise) is not disclosed to another group entity which seeks to invest in the same company. If an investor intends to slowly sell down its stake in the company following listing, it may be advisable to avoid retaining a nominee director or even agreeing to permit a nominee to stay on the board as a non-executive director as that may affect its ability to sell its stake.
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.