SEBI Merchant Banking Amendments: The Liquidity Effect on Underwriting

[Aryan and Shaunak are students at National Law University Odisha and Institute of Law, Nirma University, respectively.]

Recently, the Securities and Exchange Board of India (SEBI) amended the SEBI (Merchant Bankers) Regulations 1992 (Regulations), which has been recently enforced via a circular. While the major point of discussion on the amendments was in relation to the limitations placed on permitted merchant banking activities along with other activities being conducted only via special business units at an ‘arms-length basis, a rather major regulatory introduction is that of a minimum liquid net-worth (LNW) requirement for merchant bankers (MBs) to meet in order to be registered with SEBI. 

This marks a decisive shift from the previous ‘static’ solvency-based capital adequacy requirement of INR 5 crores to one that distinguishes between different types of capital and attempts to meet the increasing complexity and volume of capital formation activities in India in its recent IPO boom. In this article, we shall be discussing this new eligibility criteria, exploring what it means and the implications for different market players, how it fares when benched against similar requirements in the other jurisdictions and how the regime can be further strengthened. 

About the New Categorization Architecture

Liquid net worth refers to those assets which can be readily converted to cash and are unencumbered (meaning have not been used as collateral to secure any loan). In fact, the explanation to Regulation 7A provides for a non-exhaustive list of securities which can be used to meet this requirement such as cash, fixed deposits, government securities, money markets instruments, treasury bills, repo on government securities and acceptable marketable securities with applicable haircut. 

Moreover, the amendment replaces both the ‘one-size-fits-all’ requirement along with the four categorizations. The new regime has only two categories, those who can act on all issues (Category I) and those who can act on all issues other than the main board (Category II), affirming the reality that most registrations take place for the previous Category I MBs only. Now, MBs can only register as per their liquidity adequacy (coupled with the increased capital adequacy requirement), thereby reducing the risk of oversized underwriting obligations. 

Further, SEBI, via a circular, has provided for a 2 year glide-slope approach of compliance for existing MBs to the new requirements, giving the MBs with a strict timeline, while simultaneously giving them required breathing space to continue operations with existing and liquidate or acquire enough assets for compliance. If the same is not adhered to, then the registration may be cancelled by SEBI via summary proceedings. 

Impact of the Amendments

The primary player: merchant bankers

The new amendments pose a significant financial obligation for the merchant bankers, who now have the dual obligation to comply with the existing RBI capital adequacy requirements along with the new SEBI requirements. The largest impact, other than eligibility to act on an issue, is upon the underwriting capacity of MBs. The amendments mandate that the maximum underwriting obligation that an MB can carry is 20 times the liquid net worth. This is a massive deleveraging event for the industry. 

Earlier, the Regulations provided for an underwriting cap of 20 times the new worth. This meant that if an MB had a net-worth of INR 100 crores (of which INR 20 crores is held in cash), then it could underwrite an issue up to INR 2,000 crores. However, under the new amendments, the MB can only underwrite up to INR 400 crores, which means that the underwriting capacity has collapsed 80% now. However, one can argue that this has happened for the better as there have been instances such as in Tommorrowland Limited v. Navoday Management Services Limited, where the underwriter did not fulfil their responsibility. The Delhi High Court observed that closure of issue does not discharge the underwriter’s duty, thereby it being necessary for the underwriter to have the capacity to underwrite when required. 

To increase the capacity, it must liquidate other assets or invest in the permitted liquid assets, which might prove to be difficult for the firm’s own financial health. This is because the firm would require to increase its investment in low-risk, low-return assets (such as government securities), moving away a substantial portion of their total net worth from high-risk, high-return assets (such as real estate or inter-corporate deposits). 

Moreover, the regulations prescribe that a MB which fails to meet the minimum net worth or liquid net worth requirement “shall not undertake any fresh permitted activity” until the requirement is met, and prescribes a phased path with semi-annual certification. However, no transition mechanism regarding ongoing mandates of MB that subsequently breaches the threshold has been given. Without an explicit issuer-facing transition mechanism, such as mandatory substitution, issuer companies face regulatory and transactional uncertainty midstream, especially for small and medium-sized enterprises (SMEs) with limited bargaining power and options.

Furthermore, by setting an aggregate underwriting limit of twenty times liquid net worth, Regulation 22B transforms a solvency-based constraint into one rooted purely in liquidity, uniform to all variations in issue type or underwriting structures. This means that the same limit is set on volatile main-board equity and relatively stable non-convertible debentures, securitized debt, government/municipal bonds, despite fundamental differences in the probability and severity of devolvement across these instruments. Moreover, it was argued that liquid net worth should be relevant primarily for hard underwriting, which is relatively rare in Indian primary markets, and that a uniform LNW cap would unjustifiably restrain underwriting activity even when the risks remain relatively low.

Lastly, the amendment is likely to trigger a ‘season of mergers’ among the smaller family-run MBs to stay afloat, especially with the drastically liquid net-worth requirements. For large bank-backed or institutionally owned MBs, this is an affordable balance-sheet cost but maintaining INR 2.5 crores or INR 12.5 crores in liquid, low-yield assets is a high barrier for a small family-run MB that relies on advisory fees.  

The framework resembles a blunt liquidity tax insensitive to scale or diversification, and, therefore, tends to promote consolidation, downgrades to Category II or even exit by marginal players.  

The always affected player: Issuer firm

While the amendments focus on merchant bankers, the effects ultimately leak upon the issuer firms as well. Since the MB acts as the point-of-contact between the firm and SEBI as well as the stock exchanges, any changes to the eligibility criteria and underwriting obligations of the MB will ultimately affect the firm in its most crucial phase as well. 

The new amendments will likely concentrate authority to be a MB to a few firms, especially with large institutional firms subduing smaller family-owned firms, who are restricted only to SME Board, private placement, buybacks, etc. With the new regime, most issuer firms will be forced to appoint only from among these few MBs. This might increase the leverage and role of MBs, over and above that of the issuer company, leading to a situation where conditions of the issue (such as price-band, allocation proportions, etc.) would be decided more and more by the MBs and not by the firm themselves, and if the issue fails, then it will directly affect the issuer firm and not the MB who might have made all the decisions. This is furthered by the season of mergers as mentioned earlier. 

Therefore, what can be inferred is that the new regime impacts the issuer firms negatively as well. Other jurisdictions can help us evolve solutions and therefore, a comparative analysis becomes important. 

Foreign Perspectives 

International regulations on underwriting capacity highlight a common feature for risk-sensitive capital metrics over rigid blanket liquidity thresholds. In the United States, the Securities and Exchange Commission’s net capital rule under Rule 15c3-1 mandates brokers-dealers to maintain minimum net capital while limiting aggregate indebtedness and off-balance sheet exposures, including firm commitment underwriting, within prescribed ratios to net capital. The firm commitment exposures are considered as “open contractual commitments” and attract capital charges and haircuts which are calculated on the basis of market and credit risk, such that greater volatility and size of positions result in higher capital consumption. The European Union’s Investment Firm Regulation/Directive (IFR/D) adopt a similar framework which connects underwriting capacity of investment firms and systemic institutions to own funds that must cover certain fixed overheads, market and concentration risk. The framework uses activity-based K-factors such as K-NPR (Net Position Risk) to proxy risk to client and markets. 

In the same manner, Capital Requirement Regulation/Directive (CRR/D) trading books also rely on risk-weighted assets and position volatility to determine capital. Therefore, both the US and the EU model show how underwriting exposure is embedded within a broader, dynamic assessment of risk rather than applying a flat-leverage like multiple. The SEBI’s amended framework prioritises static liquid net worth thresholds over dynamic risk metrics that differentiate between volatile equity issues and relatively stable debt instruments. While foreign frameworks uphold underwriting risk within calculated capital and K-factors, India’s approach currently operating as a blunt liquidity constraint may over-deter benign underwriting exposures and at the same time under-reward prudent risk management. 

Conclusion

SEBI’s shift toward liquid net-worth requirements prioritizes immediate solvency over dynamic, risk-weighted metrics used in the US and EU. While this deleveraging enhances market stability, it risks institutional consolidation and reduced SME flexibility. The main question remains whether India can eventually evolve from this “blunt” liquidity constraint to a more sophisticated, activity-based risk framework or not.