[Subhasish is a student at Gujarat National Law University.]
The Securities and Exchange Board of India (SEBI) recently issued a directive dated 29 May 2024 to lead managers requiring the removal of special rights granted to private equity (PE) investors in initial public offering (IPO) bound companies upon the filing of the updated draft red herring prospectus (UDRHP). This directive necessitated the removal of the contractual privileges afforded to PE investors under the shareholders agreement (SHA) which is generally incorporated in the charter documents of the company. In response to the swift criticism against the directive, SEBI has withdrawn its earlier requirement for the removal of special rights before filing the UDRHP. In a subsequent advisory on 24 June 2024, SEBI clarified that special rights granted to such investors would cease only upon listing. This highlights the existing regulatory gaps in the exit rights of PE investors. The uncertainty relating to the expiration and validity of these rights is particularly concerning for the ease of doing business in India, a country striving to position itself as a global investment destination.
This article, first, aims to critically analyze SEBI's directive on the removal of special rights for PE investors, focusing on the rationale for the directive. Second, it examines the implications of exit uncertainty that may arise from this mandate. Finally, it proposes recommendations to bridge the current regulatory gaps for a balanced framework that protects investors’ rights while fostering a fair IPO market in India.
Decoding SEBI's Directive on Removal of Special Rights
The directive issued by SEBI mandates revocation of all special rights held by PE investors prior to the submission of UDHRP. Special rights refer to specific contractual privileges granted to PE investors under SHAs which are then incorporated into the articles of association (AoA) of the company. These rights, given to PE investors to cover for the risks they undertake in investing in the company, include various forms of governance and control that allow PE investors to exert influence over the company's key strategic and operational decisions to safeguard their investment. Common examples of such rights include board nomination, veto rights, information rights, anti-dilution rights, liquidation preference and exit rights. The rationale behind SEBI's directive appears to be twofold. First, it aims to create a level playing field among shareholders, ensuring that neither PE investors nor any other stakeholders hold any special or preferential rights over the public shareholders. Second, the directive is aimed at curbing the influence PE investors hold over pricing and critical IPO-related decisions. Decisions such as determining the pricing, selecting anchor investors, and allocating shares to those investors, occur during the sensitive phase between the filing of the UDRHP and the company's eventual listing. The new directive effectively removes any leverage PE investors may have held during this period through their special rights.
Regulatory Gaps in Exit Rights for PE Investors
The SEBI directive has precipitated further exit uncertainties for PE investors, exacerbating the risks that were already inherent in the regulatory framework due to ambiguities surrounding their exit rights. After the UDRHP is filed and approved by SEBI, the approval remains valid for 12 months, allowing the company time to list at any point within this timeframe. In the event of any unforeseen last-minute challenges or alterations in the IPO process such as regulatory hurdles, market volatility or internal management decisions, the investors would find themselves in a precarious situation with no access to their special rights. This creates an unnecessary disconnect between the removal of these rights and the actual listing of the company, leaving investors exposed to exit risks as without these rights, pre-IPO investors may face challenges in influencing company decisions to ensure a favourable exit. Although SEBI's recent revision on the lapse of special rights only at the timing of listing may appear to address the industry concerns, it still remains a duplicative effort in light of Regulation 31B of SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 (LODR Regulations), which already requires approval of special rights by shareholders through special resolution upon the listing of shares. This additional requirement risks redundancy without adding substantial value, as Regulation 31B of LODR Regulations already addresses the intended objective of safeguarding public shareholders. Such overlap could create confusion and operational inefficiencies, by presuming homogeneity in shareholder interests.
SEBI may have overstepped its authority by intervening in the private agreements between investors and the company creating special rights. The authority to approve the continuation of such rights should be left to the shareholders through internal decisions. The significant challenge that will encounter PE investors is not the timing of the termination of their special rights but the difficulty of restoring these rights should the IPO fail to materialize. The premature rescission of these rights from the SHA and AoA would make it very difficult to reinstate them. Reinstating special rights would require amendments to the company's AoA, which requires passing a special resolution with a supermajority of shareholder votes under Section 14 of the Companies Act 2013 (CA). This creates both procedural and legal hurdles, as the public shareholders and the unscrupulous promoters may be unwilling to reinstate rights that grant disproportionate power to PE investors. This also creates an unjustified inconsistency in the regulatory treatment of listed and "to-be-listed" companies without any logical basis, as the same provision for shareholder approval of special rights under Regulation 31B of the LODR Regulations for listed companies has not been extended to companies that are in the process of going public without any discernible rationale for this disparity.
Thus, SEBI's directive could result in an irreversible loss of control and governance protections for PE investors in the event the IPO is abandoned. The SEBI directive has also created a significant gap by not clarifying the status of the SHA after the removal of special rights from the AoA. While the SHA might still grant certain rights to PE investors, those rights would no longer be enforceable under the company’s charter documents. This inconsistency between the two governing documents can lead to litigation between the investors and the promoters where the investors may seek to enforce rights under the SHA but promoters or other stakeholders could argue that those rights have no legal standing since they are no longer reflected in the company's AoA, as required by the CA. This lacuna can be exploited by promoters to resist the reinstatement of special rights, which can lead to protracted litigation. Another major concern for PE investors holding substantial stakes in a company is their potential categorization as promoters under the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018 (ICDR Regulations).
The designation of a 'promoter' in the Indian IPO process, as mandated under Regulation 2(1)(za) ICDR Regulations, requires any major shareholder exercising control over a company, either through shareholding or management, to be identified as a promoter. This designation triggers a statutory lock-in period of up to 20% of the post-issue capital for 3 years, creating impediments to exit strategies for investors with significant shareholding whose preferred route of exit is an IPO. Therefore, the revocation of special rights (either pre- or post-listing), which are negotiated to protect such investors from being classified as promoters, would result in their capital being tied up in lock-in periods for three years, thus obstructing their investment objectives.
Recommendations: Mitigating Exit Uncertainties for PE Investors
To effectively address the exit uncertainties faced by PE investors in India, it is crucial to introduce legislative amendments and innovative investment structures to ensure that the interests of the PE investors are protected both pre and post-IPO.
First, a comprehensive regulatory framework could be established to explicitly outline the conditions under which exit rights can be preserved or restored in the event of cancellation of an IPO. It can include provisions stipulating the automatic reinstatement of special rights in the AoA in the event the IPO does not materialize, providing PE investors with a safety net against unforeseen market conditions or internal business decisions that might lead to an IPO cancellation. However, the likelihood of SEBI enacting such regulations appears minimal, given that such regulations could conflict with Section 14 of the CA which provides for a strict procedure for modifying AoA. Given these difficulties, it may be more prudent to advocate for legislative amendments to Section 14 of the CA to carve out an exception for reinstating special rights in the event of an aborted IPO without shareholder approval.
Second, SEBI could consider introducing provisions that define the circumstances under which PE investors retain certain exit rights, even if their special rights lapse temporarily. For example, transitional provisions could allow for conditional retention of IPO-related exit rights post-UDRHP filing up to the actual listing. This approach would mitigate the operational risks associated with the abrupt loss of governance influence, ensuring that PE investors maintain a degree of oversight on the key decisions related to the IPO, such as pricing, allocation of shares, and selection of anchor investors. This would reduce the risk of mismanagement or unfavorable decisions that could undermine the IPO's success or negatively impact their eventual exit strategy.
Third, PE funds itself should conduct a risk-reward analysis of investing in IPO-bound Indian companies by factoring in the regulatory uncertainty around the protective buffer of special rights post-IPO. PE funds can minimize this risk by negotiating alternative terms or assurances that could serve as protective safeguards. For instance, exit-linked covenants or performance-based covenants which are triggered upon the occurrence of predefined events, such as a failed IPO, could be introduced as replacements for special rights. Innovative investment structures that include structured equity arrangements where investors receive equity-linked returns or convertible instruments that provide greater control without requiring special rights in the AoA can be utilized by the investors.
Fourth, PE investors could negotiate an exit right in the form of a put option which requires promoters to buy-back the investors' shares upon the expiry of a certain time period. This mechanism provides a safety net for investors, allowing them to exit the investment if the anticipated liquidity event, such as an IPO is deferred indefinitely.
Finally, the blanket approach of Regulation 31B needs to be revised as it may undermine the original purpose of exit rights granted to PE investors. By imposing a uniform standard for all special rights, the regulation fails to recognize the diverse needs and expectations of various investors. A more nuanced approach should be incorporated in Regulation 31B which differentiates between governance-enhancing rights and those that may lead to disproportionate control.
Conclusion
A stable and predictable regulatory framework for the exit rights of PE investors is crucial for fostering investor confidence. Any uncertainty surrounding exit rights can deter future private equity investments in IPO-bound companies, ultimately hindering the growth of India's capital markets. To establish India as a global investment hub, it is imperative to address these regulatory gaps.
Therefore, the SEBI must strike a balance between safeguarding the rights of retail investors and facilitating capital formation. By doing so, SEBI can create an environment that not only reassures private equity investors but also supports the overall development of India's financial landscape.
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