[Aatman Shukla and Shreya Bhatnagar are students at National Law University, Delhi.]
Pre-emptive rights, recognized by the common law from as early as the 19th century, are granted to existing shareholders in a company, in proportion of the shares held by them, to participate in the new offer of shares by the company. The Companies Act 2013 (Companies Act) codifies this right, and such an issue of shares is commonly termed as the 'rights issue'. While the Companies Act does not specifically mention this, the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations (ICDR Regulations) define the term as an issue of shares by a listed company to its existing shareholders. Rights issue allows companies to raise capital when alternative sources of debt prove to be costly and unviable. This route of raising capital is preferred as it waives the need for shareholder approval, mandatory underwriting and the submission of prospectus. It is equally advantageous for shareholders who have been offered a chance to buy additional shares at a discounted price while preventing a dilution of control.[1]
Under the Companies Act, entitlement to further share of capital is accompanied by a right of renunciation, which allows shareholders to renounce all or part of their shares in favour of any person. These rights entitlements (REs) are often traded by the shareholders after the announcement of the issue and before its closing.
In May 2019, the Securities and Exchange Board of India (SEBI) released a discussion paper (SEBI Discussion Paper) outlining the process of rights issue as well as suggestions for reform. The paper highlighted ‘price risk’ as an impediment in a successful rights issue by a company. Price risk affects the value of a company’s stock as an announcement of further issue of shares sends a negative signal to both existing shareholders as well as prospective ones, causing the stock price to plummet. The perception of the investors towards such announcement is affected by several factors like the industry trends, the competitor’s strategy, the objects of the issue and the amount of discount offered.[2] For instance, after the rights issue of Vodafone’s shares was announced, with an issue price of INR 12.5, its stock price dropped to INR 16 from INR 33. This was primarily due to intense competition within the telecom industry and Vodafone being in debt for spectrum payment obligations. Announcement of issue of shares indicating the need for further capital only cemented the belief in the investors’ minds with regards to the deteriorated performance of the company.
Recent Amendments
The SEBI Discussion Paper highlighted the problems with a long drawn process of rights issue which cause higher exposure to price risk. Consequently, it suggested changes to the rights issue process under Chapters III and IV of the ICDR Regulations. In addition to expediting the process, it aimed at making it more efficient by suggesting electronic modes for fundraising and trading of rights, which used to be traded physically. As a result, SEBI implemented many changes to the relevant regulations in December 2019. The following table summarizes the amendments:
Future Considerations
To guide transitioning to electronic modes, SEBI issued a circular outlining the operational mechanism in relation to REs. After the aforesaid changes, the timeline reduced to approximately 31 days from the erstwhile 50-55 days. Interestingly, the requirement of a public newspaper advertisement has been retained to cater to the needs of investors not having internet access. While the changes are commendable, one needs to see the extent to which price risk will be contained in the duration of 30 days.
The increased amounts invested in the Indian equity market by institutional investors exposes them to greater chances of price risk, causing heavy losses. Therefore, the introduction of the ‘accelerated model of rights issue’, as practiced in Australia, in the Indian landscape can be a viable mechanism for all stakeholders. This accelerated rights issue model seeks to raise funds in two tranches.[3] It differs substantially from traditional rights offers as instead of a uniform offer to all holders simultaneously, the first tranche is open to institutional investors, with different offer period and allotment date for retail investors. In the first tranche, rights issue offers are made to institutional investors during a trading halt with a shorter window. In the second tranche, shares are offered to retail investors but subject to the unpredictability of active market trends. Therefore, to balance desire for speed with fairness, they have greater time to decide whether to invest or renounce their RE.[4] The typical timeline of an offer period in an accelerated rights issue model is as follows:
T - Institutional entitlement offer opens for institutional investors;
T+1/2 - Institutional entitlement offer closes; trading suspended for REs for making basis of allotment;
T+3 - Allotment of shares to institutional investors;
T+5 - Retail entitlement offer opens;
T+12/15 - Retail entitlement offer closes; trading suspended for REs for making basis of allotment;
T+16 - Allotment of shares to shareholders under retail entitlement offer;
T+18 - Listing and trading.
Accelerated rights issue models are beneficial for companies receiving a majority of funds from institutional investors, reducing the risk of a shortfall in subscription. This also makes it easier and cheaper to obtain underwriting while reducing the probability of price risk. However, if this model were to be introduced in India, it is only advisable for companies having a healthy mix of both institutional and retail investors, otherwise chances of under-subscription in either tranche increase. Thus, smaller companies primarily having a retail investor presence on the share register may not take recourse to this model.
The minimum offer period for the rights issue process is usually between 15 days to one month in most jurisdictions across the world. For example, in the USA, the offer period typically remains open for 15-20 days from the Record Date.[5] Similarly, in the UK, a minimum period of 21 days is statutorily prescribed. The minimum period in India is 15 days, prescribed in the Companies Act and in SEBI regulations. For a private company, the offer period can be less than what is prescribed if 90% of the members consent to it. This minimum period is necessary to strike a balance between the shareholders’ interests by giving them adequate time to decide and the company’s ability to raise capital without being affected by market sentiment and price risks. Therefore, any amendment reducing the duration of the offer must account for all stakeholders’ interests as well as global practices. Similarly, some jurisdictions have both renounceable and non-renounceable model of rights issue, whereas, in India, a non-renounceable rights issue has to be specifically provided for in the articles of the company.[6] Indeed, the possibility of allowing such a model can be explored so as to reduce the effects of fluctuations in the market price of a company. However, it must be noted that non-transferability of the pre-emptive right of shareholders can be disadvantageous to both the firm as well as shareholders. In situations where the investor sentiment towards the companies is positive to the announcement of rights issue, say, for reasons relating to the object of the issue, such a model could prove to be beneficial.
The path taken by SEBI is promising and cuts down time significantly from the erstwhile model but further steps can be taken to rationalise the process for Indian companies. The recent amendments have incorporated electronic processes both at time of issuing as well as allotment, reducing down on not only the time but also the costs and the efforts. Post issue, the shares are credited to the demat accounts, making the process more efficient. However, the requirement of post issue advertisement has been retained,[7] which only increases the costs of the companies, and could be disposed with as a further measure of rationalisation.
[1] Paul L. Davies and L.C.B. Gower, “Gower and Davies' Principles of Modern Company Law”, Sweet and Maxwell Ltd. (7th edn., 2003) at 635; Sangramsinh P. Gaekwad v. Shantadevi P. Gaekwad, (2005) 11 SCC 314.
[2] Mateus, Cesario & Farinha, Jorge & Soares, Nuno., “Price Discounts in Rights Issues: Why Do Managers Insist On What Investors Hate?”, 29(4) European Business Review (June 2017).
[3] “Corporate Actions and Events Guide for Market Capitalisation Weighted Indexes”, FTSE Russell, Vol. 4.5 (December 2019), 15.
[4] Australian Security Exchange, “Capital Raising in Australia: Experiences and Lessons from the Global Financial Crisis”, Information Paper (January 29, 2010), 26.
[5] NYSE Rule 703.03(E).
[6] Companies Act, Section 62(1)(ii).
[7] ICDR, Regulation 92.