It is common practice for listed and unlisted companies to borrow money from banks and other financial institutions to fund their ventures. Banks and financial institutions, which usually deploy public funds, would typically require promoters’ assets to be used as collateral for raising such funds, in the form of a pledge.
Problems may arise with existing lending arrangements of unlisted companies which intend to go public by way of an initial public offering. India does not have a single financial regulator and accordingly, while the lending transactions are regulated by the Reserve Bank of India (RBI), the listing of securities is primarily regulated by the Securities and Exchange Board of India (SEBI). Thus, there is an interplay of various regulations prescribed by SEBI and the RBI.
Regulations issued by SEBI are geared towards investor protection and SEBI requires the promoters of a company going public to retain a minimum portion of the post issue capital of the company for a certain period of time. In a public issue, shares held by promoters constituting the “minimum promoter’s contribution” (MPC) are required to be locked in for three years and shares in excess of the MPC are required to be locked in for one year, in terms of regulation 36 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR Regulations). Further, regulation 33(1)(d) provides that securities pledged with creditors are ineligible for the computation of MPC.
Although the ICDR Regulations do not permit pledged shares to be considered as eligible securities for computation towards MPC, the corollary is permitted, i.e. securities that have been locked in are permitted to be pledged in favour of scheduled commercial banks and public financial institutions, subject to certain conditions, as per regulation 39 of the ICDR Regulations.
Given this scenario, many promoters are asking scheduled commercial banks and public financial institutions to release their pledge prior to the public issue of shares in their companies and allow them to re-pledge their shares after the MPC lock-in is imposed post completion of the issue process. This leaves such banks and institutions at risk of not having adequate security until such time as the new securities are issued by the company, which can take four to six months and in certain cases even longer.
While banks understand this statutory requirement, certain banks and financial institutions have considered diluting their pledge requirements for the interim period to other forms of contractual protection, which would constitute an “encumbrance” within the meaning of the SEBI regulations (discussed below). However, some market participants seem to be taking a view that any sort of encumbrance on a share, not limited to a pledge, would render it ineligible for computation of MPC.
On a plain reading of regulation 33(1) it appears that the ineligibility of securities for the computation of MPC applies only to securities that have been “pledged”. SEBI itself in various regulations distinguishes between a “pledge” and an “encumbrance”.
A “pledge” has been statutorily defined under the Indian Contract Act, 1872, whereas an “encumbrance” has been defined by SEBI to include a pledge in the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (Takeover Regulations).
Reiterating its definition of encumbrance in the Takeover Regulations, SEBI has also clarified through an FAQ (albeit in the form of a non-binding guidance), that an encumbrance includes a pledge, lien or any such transaction, by whatever name called. In the ICDR Regulations, SEBI has stipulated different disclosures for “pledged” shares and shares that are “encumbered”. Further, for an initial public offer, the disclosure is for “pledged” shares, while for a rights issue, the disclosure is for “encumbered” shares. Hence it seems that wherever intended, SEBI has consciously chosen to distinguish between the term “pledge” and the term “encumbrance”.
Given the contrasting view and the absence of clarity, banks and financial institutions as well as issuers are facing additional transactional costs and delays as existing security arrangements over bankable liquid assets are being either replaced, or issuers are being compelled to issue further shares to pledge them in favour of banks and financial institutions.
It appears that any contractual restrictions (as diluted from pledge) put in place by banks and financial institutions would serve a dual purpose, i.e. not only to further the lock-in requirements stipulated by the capital markets regulator, but also to protect the interest of the publicly funded banks, without creating an additional (and usually unwelcome) economic burden for promoters and issuing companies.
Considering the dormant trend in the equity markets in the past few years, it is imperative for buoyancy to be restored by increasing the availability of bank finance and also by enabling them to tap the capital markets. To achieve this, it is important to have this issue clarified by the regulators such that banks and financial institutions and prospective issuers can take appropriate action.
Jeet Sen Gupta is a partner, Yogesh Chande is an associate partner and Nitin Gupta is an associate manager at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.
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