NISM Series IX Merchant Banking Study Notes: Chapter VI – Issue Management: General Obligations and Due Diligence (Part 3 of 3)

This study guide represents Part 3 of our 3-part comprehensive series covering Chapter VI: Issue Management — General Obligations of Merchant Bankers and Due Diligence. Having explored pre-issue due diligence in Part 1 and post-issue administrative and promoter obligations in Part 2, we now focus on the statutory mechanics that govern market access.

This final part covers the precise eligibility rules for public issues, the procedural framework for filing offer documents, financial guarantees (security deposits), bidding/pricing mechanics, the legal structures of underwriting, and the net public offer allocation rules under the SEBI ICDR Regulations.

1. Eligibility Conditions for Accessing the Capital Markets

Before a company can raise capital from the public, the Lead Merchant Banker must verify that the issuer meets the strict eligibility criteria set out under the SEBI ICDR Regulations.

A. General IPO Eligibility Framework (Regulation 26)

An unlisted issuer seeking an Initial Public Offer (IPO) must satisfy rigorous financial track records (such as net tangible assets, operating profits, and net worth) as on the date of filing the draft offer document with SEBI and registering the prospectus with the Registrar of Companies (RoC).

B. Further Public Offer (FPO) Debarments and Disqualifications (Regulation 102)

Even for listed companies, access to public equity through an FPO is restricted if certain governance defaults are present. An issuer is strictly ineligible to make a further public offer if:

1. Direct Debarment: The issuer, any of its promoters, promoter group members, directors, or selling shareholders are currently debarred from accessing the capital market by SEBI.
2. Indirect Debarment: Any promoter or director of the issuer serves as a promoter or director of any other company that is debarred from accessing the capital market by SEBI.
3. Willful Defaulters: The issuer or any of its promoters or directors is classified as a willful defaulter.
4. Fugitive Economic Offenders: Any promoter or director of the issuer is declared a fugitive economic offender.

The Debarment Exception: The market access restriction does not apply if the debarment period is already over as on the date of filing the draft offer document with SEBI.

C. Specific Rules for Willful Defaulters in Rights Issues

If a company or any of its promoters/directors is a willful defaulter, they are restricted from executing standard capital offerings but can make a rights issue subject to enhanced disclosures:

• Mandatory Disclosures: The issuer must make detailed disclosures as specified in Part G of Schedule VIII in the offer document and the abridged letter of offer.
• No Renunciation: The promoters or promoter group of such an issuer are prohibited from renouncing their rights, except to the extent of renunciation within the promoter group itself.

2. Offer Document Preparation, Filing, and Public Review Framework

The offer document is the cornerstone of disclosure. The process of preparing, reviewing, and publishing it is heavily regulated to protect investor interests.

A. Filing the Draft Offer Document

The issuer must file the Draft Offer Document with SEBI through the registered lead merchant banker along with the prescribed fees.

• SEBI's Review Window: SEBI may specify changes, modifications, or clarifications on the draft offer document within 30 days of receipt.
• Observation Compliance: The issuer and the Lead Merchant Banker must implement all changes and comply with SEBI’s observations before registering the Prospectus, Red Herring Prospectus, or Shelf Prospectus with the RoC, or before filing the Letter of Offer with the stock exchanges.
• Simultaneous Filing: A copy of the finalized document must be filed with SEBI and the stock exchanges simultaneously with its registration or before the opening of the issue.

B. Public Comments and Transparency (The 21-Day Rule)

To ensure complete transparency:

• Web Hosting: The draft offer document must be hosted on the websites of SEBI, the recognized stock exchanges where listing is sought, and the associated merchant bankers for at least 21 days to invite public comments.
• Public Announcement: Either on the date of filing or the following day, the issuer must make a public announcement in three newspapers (one English national daily, one Hindi national daily, and one regional daily at the place of the registered office) disclosing the filing and inviting public feedback.

3. Financial Guarantees & Listing Approvals: The 1% Security Deposit

To ensure that issuers and merchant bankers comply with post-issue obligations, SEBI requires a financial commitment before the subscription list opens.

A. The 1% Security Deposit Mandate (Regulation 7(1))

• The Rule: Before the opening of the subscription list, the issuer must deposit and keep deposited with the designated stock exchange(s) an amount calculated at the rate of one per cent (1%) of the amount of securities offered for subscription to the public.
• Refunding and Forfeiture: This deposit is refundable upon successful compliance with all issue-related formalities, but can be forfeited by the exchange/SEBI if the issuer defaults on allotment, refunding, or listing obligations.

B. Listing Permissions and Penal Interest

• Application Timeline: The issuer must complete pre-listing formalities and apply for listing to recognized exchanges within the timelines specified by SEBI.
• In-Principle Approval: The stock exchanges must grant or reject in-principle listing approvals within 30 days from receiving the application or a satisfactory reply to clarifications.
• Penal Consequences of Failure: If the issuer fails to apply for listing, fails to receive listing permission, or if SEBI’s Observation Letter is withdrawn:
  • The securities become ineligible for listing.
  • The issuer is liable to refund all subscription monies to allottees immediately.
  • Penal Interest: The issuer must pay penal interest for each day of delay at the rate of 15% per annum from the date of allotment.

4. Issue Opening, Closing, Bidding, and Pricing Mechanics

A. Issue Duration (The 3-to-10 Days Rule)

• Standard Window: An IPO on the Main Board must remain open for a minimum of three working days and a maximum of ten working days.
• Revision / Force Majeure Extension: If the price band is revised, or in the event of force majeure, banking strikes, or similar issues, the bidding period must be extended for a minimum of three working days, subject to the overall cap of ten working days.

B. Pricing Structures

1. Book Building Issue: The demand and price are discovered online on stock exchange terminals based on bids. The Red Herring Prospectus (RHP) contains a floor price or price band, and the final price is determined after bidding closes.
2. Fixed Price Issue: The Prospectus filed with the RoC contains a single, determined issue price. The total demand is only known after the subscription period closes.
3. Differential Pricing: An issuer may offer specified securities to different categories of investors (such as retail investors or employees) at different prices, subject to regulatory conditions.

C. Listing Timelines (T+6 and UPI Migration)

• Standard Rule: The issuer must list the securities for trading within 6 working days (T+6) from the close of the issue.
• UPI with ASBA: The introduction of the Unified Payment Interface (UPI) mechanism for retail individual investors has streamlined the blocking of funds and reduced manual steps, paving the way for a migration to a T+3 listing system.

5. Underwriting Obligations, QIB Sub-Subscription, and Minimum Subscription

Underwriting acts as a financial backstop to ensure corporate issues do not fail due to a lack of public demand.

A. Lead Manager Underwriting Obligations (Regulation 22)

• Minimum Backstop: For every public issue, the lead merchant banker must accept a minimum underwriting obligation of 5% of the total underwriting commitment or Rs. 25 lakh, whichever is lesser.
• Hard vs. Soft Underwriting:
  • Hard Underwriting: The underwriter agrees to buy their committed shares at the earliest stage, guaranteeing a fixed amount of capital to the issuer before pricing is finalized.
  • Soft Underwriting: The underwriter agrees to buy their commitment at a later stage, only after the pricing of shares is known through the book-building process.

B. The Critical QIB 75% Subscription Rule

In book-built public issues:

• No Devolution on QIB Portion: If the Qualified Institutional Buyers (QIB) category is under-subscribed, the undersubscribed portion cannot be underwritten, nor can it be allocated to any other category.
• The 75% Rule: If QIBs do not subscribe to at least 75% of the QIB portion in a book-built issue, the issue fails entirely. Underwriters cannot step in to rescue the QIB category.

C. The 90% Minimum Subscription Rule

• General Rule: The minimum subscription received must be at least 90% of the offer made through the offer document.
• Consequence of Failure: If the minimum subscription is not met, all application monies must be refunded to the applicants immediately.

D. Penal Interest on Refund Delays

If an issue fails and refunds are delayed, the issuer is subject to strict penalties:

• Non-Underwritten Issues: Refunds must be processed within 15 days of issue closure. A delay beyond 15 days carries an interest penalty of 15% per annum.
• Underwritten Issues: Refunds must be processed within 60 days of issue closure. A delay beyond 60 days carries an interest penalty of 15% per annum.

6. Net Offer Allocation Structures (Regulation 32 / Regulation 26)

The SEBI ICDR Regulations mandate how the net public offer is allocated among different investor classes to ensure fair distribution.

Table 1: Book Built Allotment Structures (Regulation 32 / Regulation 26)

Note: The unsubscribed portion in either the Retail or NII category can be re-allocated to applicants in the other categories.

Table 2: Fixed Price Allotment Structure

For public issues executed through the fixed-price route rather than book building, the allocation is structured to favor retail participants:

7. Formula Overview

These simple, single-line formulas are used by Lead Managers to calculate issue sizes and mandatory allocations:

• Net Public Offer = Gross Issue Size - (Promoter Contribution + Approved Employee/Other Reservations)
• Minimum Lead Underwriting Obligation = Lesser of (0.05 * Total Underwriting Commitment) or Rs. 25,00,000
• QIB Allocation Failure Point = Actual QIB Subscription < (0.75 * Total QIB Portion Offered)
• Standard Retail Share (Reg 26-1) = Net Public Offer * 0.35
• Alternate Retail Share (Reg 26-2) = Net Public Offer * 0.10

8. Key Terms & Concepts for the Exam

• Retail Individual Investor (RII): An individual investor who applies or bids for specified securities of a value of not more than Rs. 2 lakh.
• Anchor Investor: A Qualified Institutional Buyer (QIB) who applies for a value of Rs. 10 crore or more in a book-built public issue, with applications processed one day prior to the main issue open.
• Application Supported by Blocked Amount (ASBA): An application mechanism containing an authorization to block the application money in a bank account, ensuring investors continue to earn interest until allotment.
• Security Deposit: A mandatory deposit equal to 1% of the public offer size, kept with the stock exchanges as a compliance guarantee.
• T+6 Listing: The standard requirement to list shares on the exchanges within 6 working days from the close of the public issue.

9. Key Takeaways for Students & Professionals

1. QIB Under-subscription is Fatal: Unlike other investor categories, if QIBs do not subscribe to at least 75% of their allocated shares in a book-built issue, the entire issue fails, and all application monies must be refunded. No underwriting or category shifting can save the issue.
2. Strict Pricing Extensions: If an issuer revises the price band, they cannot keep the original closing date. They must extend the bidding period by at least 3 working days, ensuring the total period does not exceed the 10-day limit.
3. Defaulter Restrictions: Willful defaulters can only access the public markets via a highly disclosed rights issue. Promoters of such companies cannot renounce their rights to non-promoter entities, ensuring they do not cash out.