A merchant banker (MB) who had found a 'novel' way to comply with networth norms has been banned from managing public issues until further orders.
On October 23, the Securities and Exchange Board of India (SEBI) banned First Overseas Capital Ltd (FOCL) from managing public issues for not maintaining its capital adequacy (or networth of Rs 5 crore) for six consecutive years, from FY19 to FY24.
How did it manage this
One of the methods involved using an interesting accounting technique, going by the prima facie findings of the regulator.
The market regulator's investigations showed that FOCL, which was falling short of networth requirements, was used as a "pass through investment vehicle" to advance funds to two other entities, and then converting the loans into redeemable preference shares of one borrower entity.
Also read: PAC postpones meeting as SEBI chief Madhabi Puri Buch seeks exemption
In FY23, FOCL raised Rs 7.5 crore through the issue of preference shares to Satyen Dalal, the Chairman & Managing Director of FOCL and its holding company Chasam Investments & Leasing Pvt. Ltd.
This increased the company's networth from Rs 13.92 lakh in FY22 to Rs 6.4 crore in FY23.
FOCL then gave Rs 7 crore to two other companies — Rs 3.50 crore each to Boisar Realty and Falcon Recreational Activities — to fund construction projects.
According to FOCL, this was a loan extended to the two companies but SEBI's initial investigations suggested otherwise. The regulator asked the statutory auditor and the latter said that during the audit period, FOCL's management had said that the amount was intended for the acquisition of land to further a joint development project. The regulator found that correspondence between the three companies — FOCL, Boisar Realty, and Falcon — reflected what the auditor said.
No merchant banker other than a bank or a public financial institution can do business outside the securities market, as per Regulation 13A of the SEBI (Merchant Banker) Regulations, 1992.
Back to the networth question.
In FY24, there was another infusion of equity share capital of Rs 2.62 crore. With this, FOCL's networth that year rose to more than Rs 9.63 crore (Rs 7 crore from preference shares, plus the Rs 2.62 crore).
That would seem more than adequate than what is needed (Rs 5 crore), except the capital really didn't seem to be with the merchant bank.
The Rs 7 crore that FOCL had given as a loan had been converted into redeemable preference shares in Falcon in FY24, valued at Rs 11.37 crore.
But how well was Falcon's business really doing?
In FY23, according to information available on the Ministry of Corporate Affairs website, its revenue was zero and its expenditure was Rs 19.1 lakh (Rs 19 lakh for stamp duty and Rs 10,000 for audit fees).
As the SEBI order noted, the company thus had a net loss of Rs 19.1 lakh.
The order stated: "The MB was used as a pass-through investment vehicle for channeling the funds of Mr. Satyen Dalal and Chasam into the property development business, i.e., carrying out business other than in the securities market."
There were problems with the way networth was calculated in earlier years too.
In FY23, the merchant banker’s networth was Rs 6.4 crore, but as the statutory auditor noted, this included a Rs 3 crore loan extended to a certain Rajesh Mewawalla (in FY22). The auditor had treated this loan as “time-barred unsecured and doubtful loan/advance.” Adjusting for this, the networth for that fiscal dropped to Rs 3.4 crore.
FOCL informed SEBI that the loan was a fraud played on it and that an FIR had been lodged against Mewawalla, but added that it believed the loan could be recovered. It submitted a written undertaking by Mewawalla to back this, but SEBI noted that this was just a letter and not a legally binding document.
The auditor had also pointed out that FOCL had not made provisions amounting to Rs 1.28 crore for diminution in the value of the shares of a company (Nidan Laboratories and Healthcare Ltd) held by the MB. Taking this and the loan to Mewawalla into consideration, the MB’s networth in FY22, according to SEBI, came to a deficit of Rs 4.14 crore (this is Rs 13.92 lakh minus the debt of Rs 3 crore extended to Mewawalla, and the diminished value of shares at Rs 1.28 crore).
Also read: Sebi bans merchant banker First Overseas Capital from managing public issues until further notice
Why is an MB's networth important?
A merchant banker is required to have capital adequacy to meet its underwriting obligations. But, as the SEBI order noted, FOCL's investment in "a business unrelated to the securities market (the construction project) left it with inadequate financial resources, on account of lower networth" to meet this obligation.
The regulator's calculations showed that between FY22 and FY23, FOCL had underwritten issues of securities beyond prescribed limits (20X its reported networth), as shown below.
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