SEBI’s Reforms related to Promoters – A Step in The Right Direction?

[By Aman Jha & Anurag Shah

Aman Jha is a student at the National Law University, Delhi and Anurag Shah is a student at the School of Law, Christ (Deemed to be University). 

The Securities and Exchange Board of India (“SEBI“), in its board meeting dated 6th of August 2021, resolved multiple changes in the regulatory framework of the capital market in India. Two of the most notable include the reduction in the minimum lock-in period that has to be observed by a promoter following an initial public offering (“IPO“) and approving the principle of ‘Person in Control’ which would replace the concept of promoters in India. These changes have been resolved in pursuance of a consultation paper rolled out in May 2021, which proposed changes related to the promoter regime in India. This article analyzes these changes and the effect they would have on the capital market of India while also drawing analysis from different jurisdictions.

Reduction in mandatory promoter lock-in:

At present, Regulation 16 of the SEBI (Issue of Capital and Disclosure Requirements), 2018 (” ICDR“) provides that there should be a minimum promoter’s contribution of 20%, which should be locked in for 3 (three) years. The lock-in period starts from the date of commencement of commercial production or the date of allotment of the IPO, whichever is later. Further, ICDR also prescribes that a promoter holding more than the minimum requirement of 20% should have his excess holding subject to lock-in for one year starting from the date of allotment.

The rationale behind such a lock-in system can be attributed to the regulatory regime before the globalization era in India. Setting up companies before the globalization reforms required special permissions. The pre-condition for such permission was a minimum equity contribution by the founder until the money taken from the lender was paid off. This was done to ensure that the founders had their skin in the game during incorporating companies and raising money. This skin-in-the-game concept was retained even in post-globalization India in the form of mandatory promoter lock-in.

However, this requirement to have promoter’s skin in the game started becoming a hindrance for the capital markets since it also made going public difficult for the promoters. In the pre-globalization era, funds were raised to finance a project or for a Greenfield project which would be a new start, and thereby there was a lack of surety of the company’s performance. Having the promoter’s skin in the game would provide surety for the lenders in such a scenario. It would act as an incentive for the promoter to ensure the performance of the company. In today’s competitive start-up ecosystem, where companies going public are matured businesses and have gone through several series of funding, the promoters already have had their skin in the game. Therefore, a further lock-in would only make going public burdensome for the promoters.

In a bid to solve this issue, the SEBI decided to reduce the mandatory lock-in period for the promoter’s contribution from 3 (three) years to 18 (eighteen) months. Further, the board also resolved to reduce the lock-in for pre-IPO shareholders who were not promoters from 1 (one) year to 6 (six) months.

The transition from the concept of promoters to Person in Control:

Having understood the rationale behind promoters and mandatory lock-in, it becomes imperative to know why SEBI has resolved an in-principle shift from the concept of a promoter to Person in Control (“PIC“). The primary reason for this shift can be attributed to the change in the investment landscape in India. The Indian start-up market now is one of the most attractive investment markets, with multiple businesses raising huge capital from investors all across the globe. Unlike the pre-globalization era when companies raised money from family, friends, or lenders, the start-ups now focus on institutional investors such as private equity funds. This shift has also changed the dynamics in the board room of companies. Traditionally promoters used to have significant control over businesses even after listing. However, many institutional investors have considerable control over the board in today’s landscape through their representative directors. The latter is not considered promoters as a result of the definition provided under Indian law.

As a result of the aforementioned, situations arise wherein persons who do not have any controlling rights or are minority shareholders are still classified as promoters. This would have a two-faceted effect. Firstly, the responsibility and liability would be placed on the wrong party who does not control the decisions. Secondly, by virtue of being considered a promoter, the person may have disproportionate influence over the board. Therefore, the shift from promoter to PIC would ensure that the regulatory regime identifies the correct person and places responsibilities and liabilities on a person who has significant control over the board.

The prime benefit of this shift would be the improved and better quality of corporate governance in the Indian regulatory regime. Removing the concept of promoters would ensure that the shareholders can place trust in the board, which would constitute of PICs and independent directors to keep a check on the board. This would change the Indian regulatory regime from a promoter-based system to a professionally managed company system.

Keeping up with international standards:

The changes resolved by SEBI have been received positively by the stakeholders. These changes showcase how the regulator is trying to undertake progressive steps to ensure that the regulatory system is at par with international practices even in the post-pandemic economy. The concept of promoter has been unique to India as most of the other capital market regulators do not have a system of promoters, and they focus on control. A shift from a system of promoters to PIC would bring the Indian regulatory regime at par with different jurisdictions.

However, at present, SEBI has retained the idea of promoter lock-in and just halved the period. International practices concerning post-IPO lock-in have been to allow the market forces to decide the lock-in period. Most of the capital markets regulators leave the lock-in decisions with the underwriters, who decide the same based on the feedback they receive from the market with regard to the market sentiment. These underwriters are regulated entities that have a deep understanding of the market. Therefore they understand if a particular entity based on different factors like sector and performance requires higher promoter lock-in or a higher number of shares to be open for the public to maintain liquidity. Since the market forces decide the lock-in, the same establishes equilibrium on a case-to-case basis and affords the flexibility to businesses. In any case, the underwriters provide a minimum lock-in period post the IPO to ensure that stock prices do not get manipulated or fluctuate due to the dumping of shares.

Way forward:

The changes mentioned above that SEBI has resolved are a progressive step that would encourage more promoters to choose the IPO route now. The reduction in lock-in will boost the private equity investment sector in India, as a lesser lock-in ensures higher liquidity for the private equity investors post the IPO. This would also have the impact of reducing the extreme skin in the game that the promoters had post IPO even though they end up losing control of the business most of the time. The reduction in lock-in would ease the promoters while also working as an incentive to the investors. However, SEBI should also consider allowing market forces to decide the lock-in and remove the mandatory requirement. Doing so would enable lock-in periods to be decided on a case-to-case basis.

The resolution to shift from a promoter-based system to a PIC system would be the beginning of a new era in the Indian capital markets as it would allow better corporate governance. However, this is easier said than done as it would require re-writing several regulations as the concept of a promoter is deeply ingrained in the Indian regulatory framework. In its board meeting, SEBI has acknowledged this and proposed that this shift would be a gradual shift, and they would also co-ordinate with other regulators to bring about this shift. On the basis of merits, this shift would help ensure that people who have the board’s control are classified as the people running the company and are responsible.

However, the shift does have specific issues that SEBI would have to deal with. One such issue is the motive with which investments are made. Private Equity investors and venture capital investors undertake investments for-profit purposes; an IPO is one of the most sought-after exit routes for such investments. In case of a shift from promoter to PIC, the responsibilities, including lock-in period of investments and mandatory disclosures under the ICDR, would naturally shift to such investors. These might be cumbersome for the investors who are looking for profits and not to run the company. Such a burden might make IPOs less lucrative for investors.

It is also imperative to understand why the promoters tend to stick around and be in charge even after allotments, irrespective of their shareholding. Their prime objective is to keep the company a going concern, whereas investors look for an exit opportunity to profit. In such a case, replacing the promoters with such investors as in charge of the board might be tantamount to replacing the ship’s captain. This can be resolved by ensuring that the PIC stays a part of the company and looks after its goodwill for a considerable time post the allotment. This could be done by providing for a minimum lock-in for the PICs.

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