Draft Offer Documents: Grounds For Rejection

Does your capital structure involve circular transactions to build up networth? Have the auditors qualified your audit report? Have you willfully concealed any litigation? Well if you are an issuer looking to raise public funds and if your response to these questions is in the positive, then chances are SEBI will reject your draft offer document. So says a new SEBI circular. And why not, after all it is SEBI's mandate to protect investor interests and ensure quality disclosures. All good then? Well not quite...because that circular also says your draft offer document can be rejected if the object of the issue is 'vague'...if the gap between raising funds and utilization is 'unreasonably' long or if your business model is 'exaggerated, complex of misleading'- words that could be interpreted widely. The circular has drawn severe flak. Payaswini Upadhyay finds out if this attempt to codify SEBI's scrutiny process will give issuers clarity or will it prove to be counterproductive?

Over 8000 listed companies on BSE and NSE combined. Compare this to the United States where the listed universe comprises of slightly over 5000 companies. Hong Kong is around 1400 and Singapore is 800.
Back home, SEBI was concerned about the quality of companies coming to the market, so it's primary market advisory committee suggested the market regulator consider some objective criteria to clear draft offer documents. Last week the regulator released a set of 16 broadly worded criteria that could lead to rejection of draft offer documents
Manan Lahoty
Partner, Luthra & Luthra
"Just to put things in perspective for this order, for some time now, SEBI has been criticized by media and the issuers that SEBI has not been very prompt in clearing the documents because the expectation under the ICDR regulations is SEBI must clear the document within 30 days of filing it. In most situations, you would've thought SEBI has cleared the document because they haven't been given the information as and when SEBI asked for it and as and when SEBI expected them to be in the offer document. So its pretty much codifying what SEBI has been asking banks and through banks the companies in the past."
For instance, an auto parts maker that went public in May this year was asked to submit details on types of related party transactions and their aggregate value in relation to the turnover of the company in past 3 years. SEBI has now made this as one of the conditions for rejection of draft offer documents saying that if the issuer enhances its prospects based on business with related parties, it could lead to rejection of offer document.
Last year, a school management company that went public was asked to disclose in its draft offer, details of loans, status of pending application for licenses etc. SEBI has now codified this by saying that critical licences, if not received, can become a ground for rejection.
Gesu Kaushal
Executive Director, Kotak Investment Banking
"At the back of this Circular, what investment bankers will do now is spend a mot more time with the company while the company is preparing for an IPO. If there were issuers in the past who were not forthcoming with a lot of information, it definitely gives bankers some ammunition in their hand to demand that information and disclose it correctly. A lot more deliberation about the objects of the issue, studying of financial statements- all of this will lead to better disclosures for sure."
Not just that. Some risks were earlier only required to be disclosed. Now sebi has added them as potential grounds for rejection. For instance qualified audit reports and major pending litigation
Gesu Kaushal
Executive Director, Kotak Investment Banking
"Let's assume there is a winding up petition against the issuer. In such a scenario one has to evaluate the merits of the case - so is that winding up petition serious, who is the person who has moved the court, is he a supplier who supplies a small component to the company. But finally, let’s assume that SEBI does believe that this is very critical, what they would probably advise is, look lets wait and see what the outcome of the petition is and then go ahead. Because what happens in the other case- suppose one goes ahead with the IPO with a mere disclosure and tomorrow indeed the company is told to wind up, what happens to the public investor who have come into the company." SEBI Circular- Grounds of rejection of Draft Offer Document: Existing litigation critical to issuer's survival
Manan Lahoty
Partner, Luthra & Luthra
"I think SEBI has been fairly consistent about what kind of disclosures you need to make of those qualifications. We've consistently disclosed them as a risk factor and probably one of the most prominent risk factors depending upon how material the qualifications are but in past, from what I understand, these have not been the reasons why someone was not allowed to do an IPO." SEBI Circular- Grounds of rejection of Draft Offer Document:  Qualified audit reports or reports where auditors have raised concerns over accounting policies
So more disclosures and stricter rejection criteria that amount to more effective investor protection. No one can complain about that. But the language used in some of the rejection conditions has perturbed a section of the market
For instance, a 'vague' object of the issue - an 'exaggerated, complex or misleading' business model  - direct or ‘indirect’ conflict of interest between issuer and merchant banker - can become grounds for rejection.
Sanjay Asher
Partner, Crawford Bailey
"In law, more adjectives you use, there is more room for interpretation. So words like vagueness or exaggeration, its possible to interpret it, its possible to distinguish that and in case SEBI has rejected an offer document on the basis if this, an issuer company surely can approach SAT distinguishing that there is no vagueness or exaggeration and please set aside the order of SEBI"
Besides increased litigation at SAT on the wording, experts say that some specific rejection conditions do not take into account the needs of certain businesses.
Sanjay Asher
Partner, Crawford Bailey
"For eg if there is a ship freight company which is raising money to buy ships- now I can't identify the ships at day 1 because the ship buying & selling market is fast changing that by the time the offer document is approved and go to the market to raise money, those particular vessels may not be available for buying or selling...in which event I may not qualify the criteria." SEBI Circular- Grounds of rejection of Draft Offer Document:  If object of the issue is vague & business model is misleading
Manan Lahoty
Partner, Luthra & Luthra
"If I was a company which was largely into manufacturing and if I enter into retail now, it was possible that so far I was not required to spend money on creating the brand of my retail product. But going forward, I will be required to. So this is something that SEBI will have to assess while looking at an individual case. SEBI Circular- Grounds of rejection of Draft Offer Document:  If utilization of major portion of issue proceeds does not create tangible asset
And that could be the reason why this order, as Menaka mentioned in the beginning, has drawn severe flak. Because bankers and issuers are concerned about the subjectivity this circular brings to the scrutiny of offer documents. On its part, SEBI has said that these16 conditions are illustrative and the mere triggering of any or a few criteria will not mean an automatic rejection of the offer document. So if SEBI’s attempt leads to enhanced due diligence by investment bankers, more disclosures and better prepared companies coming to the market, no one would have reason to complain. But if the broad wording of this order is used to reject offer documents without sound reason, it could make capital raising tricky because a rejection would disallow the issuer from accessing capital markets for at least one year and hence is unlikely to go uncontested. In Mumbai, Payaswini Upadhyay