Sebi’s new rights-issue norm could dilute shareholder's stake without a vote, but proxy advisors welcome it

Proxy advisors believe that the regulator is rightly encouraging companies to choose rights issue over a preferential allotment. (Photo by Joshua Mayo: Pexels)

One of the new norms introduced to speed up a rights issue runs the risk of being used as backdoor entry for preferential allotment, legal experts say.

This means that shareholders could find that their stake has been diluted without their approval.

But proxy advisors told Moneycontrol that it is a welcome change. They say though the new norm could be abused by unscrupulous elements, it could help a company raise necessary funds while protecting shareholder rights.

In a press statement after a Board meeting on September 30, the Securities and Exchange Board of India (Sebi) released a set of  new norms for faster rights issue.

One of the changes allows the issuer company to allot the under-subscribed portion of the rights issue to any specific investor(s), provided appropriate disclosures are made through an advertisement.

Sandeep Parekh, founder of Finsec Law Advisors and former ED of Sebi, said that this could work like a preferential allotment without shareholder approval. In this case, it would dilute an existing shareholder's stake in the company without his/her approval and go against the company law, under which, to get third parties into the company, you need shareholder approval.

Mathew Thomas, Practice Head and Partner - Capital Markets at Saraf and Partners, said that the new provision may give rise to the possibility of a backdoor entry into preferential allotment. However, he added: "We must see whether any guidance on the process to be followed by the issuer for such an allotment will be stated in the proposed norm".

At this point, Thomas does not believe this option is in contravention of the Companies Act.

“The Companies Act always had the provision which said that the Board may dispose of the unsubscribed portion in such a manner which may not be disadvantageous to the shareholders. This, according to the view prevalent in the market, meant that the company would need to follow the process for preferential allotment for such allotment. In the press statement , Sebi has only said that the company can allot the unsubscribed portion to third-party investors. Accordingly, it may be presumed that such allotment shall be in accordance with the process prescribed under the Companies Act for preferential allotment," he said.

Moneycontrol has sent a query to Sebi in this regard and this report will be updated if the regulator responds.

Rights issue and preferential allotment are two ways through which a company raises money.

In the first, existing shareholders are given the option to buy shares at a discounted rate. The shareholder can exercise the right, sell the right forward in the secondary market or let the right expire. This method of fund-raising does not require the shareholder's approval. This is because the existing shareholder holding isn't diluted, since the post-issue holding (if the shareholder exercises the right) will be proportionate to the earlier holding. For example, if a shareholder holds 1 percent of the company before the rights issue, he/she will still have one percent of the holding, even if he/she exercises the right.

With preferential allotment, when the company offers its shares to select third-party investors at a discounted rate, the company needs shareholders's approval. This is because the shareholder holding gets diluted in this option since the number of shareholders will increase.

Proxy advisors Moneycontrol spoke to said that this is a welcome reform. According to them, these norms are meant to encourage companies to choose rights issue over preferential allotment, since a rights issue gives the shareholders an option to participate and the company ease-of-doing business.

JN Gupta, founder and Managing Director of Stakeholder Empowerment Services (SES) and a former ED of Sebi, said that he has been pushing for this norm for years.

According to him, with this, Sebi was only trying to reduce the cost and effort needed for a rights issue. The regulator has also introduced several other reforms, such as slashing the number of days within which the issue needs to be completed, from 317 days to 23 working days, allowing stock exchanges to give approvals and dispensing off with the need to appoint a merchant banker to oversee the issue.

“In a rights issue, a shareholder is offered the option to participate. A preferential issue’s allocation is non-transparent and therefore is vulnerable to manipulation,” said Gupta.

To emphasise how preferential allotment can be manipulated, he said, “in these issues, you will find the names of relatives, uncles, neighbours and neighbours’ dog.”

On the possibility that an issuer company or its promoters could even manipulate this option by getting the issue undersubscribed only to allot it to their ‘near and dear’ ones, Gupta said that any law of the land could be manipulated and that fear was simply being exaggerated.

InGovern’s Shriram Subramaniam pointed out that shareholders are protected since they are given the option to participate in a rights issue. “If the investor does not exercise that option,  the company’s fundraising would not be successful. If the rights issue is undersubscribed and the company falls short of funds, it will need to spend another few months to process a preferential allotment and get shareholders’ approval,” Subramanian pointed out.