NVESTMENT BANKING

Table of contents :
Half Title
Title Page
Copyright
Dedication
Foreword
Preface
Architecture of the Book
Contents
PART I INTRODUCTION TO CAPITAL MARKET, INVESTMENT BANKING AND PRIMARY MARKETS
Chapter 1 Overview of Indian Capital Market
1.1 Introduction
1.2 Financial Markets
1.3 Historical Evolution of Capital Markets
1.4 Evolution of the Indian Capital Market
1.5 Capital Market Constituents
1.6 Capital Market Segments
1.7 Premier Stock Exchanges
1.8 Statutory Framework
1.9 Regulatory Authorities
1.10 Capital Market Intermediaries, Infrastructure and Service Providers
1.11 Important Developments in the Indian Capital Market
1.12 Road Head
Self-test Questions
Chapter 2 Introduction to Investment Banking
2.1 Introduction
2.2 Investment Banking and Merchant Banking Distinguished
2.3 Evolution of American Investment Banks
2.4 European Investment Banks
2.5 Global Industry Structure
2.6 Business Portfolio of Investment Banks
2.7 The Indian Scenario
2.8 Characteristics and Structure of Indian Investment Banking Industry
2.9 Service Portfolio of Indian Investment Banks
2.10 Inter-dependence between Different Verticals in Investment Banking
2.11 Regulatory Framework for Investment Banking
2.12 Regulatory Framework for Merchant Banking
2.13 Anatomy of Some Leading Indian Investment Banks
2.14 Recent Trends in Investment Banking
2.15 The Conflict of Interest Issue
2.16 Conclusion
Self-test Questions
Annexure I
Annexure II
Chapter 3 Primary Equity Market
3.1 Primary Equity Market
3.2 Fundamental Concepts on Equity
3.3 Overview of Valuation Methodologies for Equity Shares
3.4 Equity Issues in Primary Market
3.5 Primary Market Equity Issuers
3.6 Primary Market Equity Investors
3.7 Primary Market Intermediaries and Support Service Providers
3.8 Growth and Performance of the Primary Equity Market
3.9 Future Directions in the Primary Equity Market
Self-test Questions
Chapter 4 Primary Debt Market
4.1 Primary Debt Market
4.2 Fundamental Concepts on Debt Securities
4.3 Types of Debt Instruments
4.4 Recent Trends in Primary Debt Market
Self-test Questions
PART II MANAGEMENT OF PUBLIC OFFERS AND PRIVATE PLACEMENTS
Chapter 5 Initial Public Offers
5.1 The IPO Market
5.2 Significance of an IPO
5.3 The IPO Decision
5.4 Important Aspects of an IPO
5.5 Important Regulatory Provisions for an IPO
5.6 Contents of a Prospectus/offer Document for an IPO
5.7 Methodologies for Making Issues
5.8 Issues by Financial Institutions
5.9 Procedural Aspects of an Issue
5.10 Role of Merchant Banker in Issue Management
Self-test Questions
Annexure I
Annexure II
AnnexureIII
Chapter 6 Rights Issues and Secondary Public Offers
6.1 Considerations for Listed Companies
6.2 Rights Issue
6.3 Secondary Public Offer
6.4 Composite Issue
6.5 Role of Investment Banker in Listed Companies
Self-test Questions
Chapter 7 Public Offers of Debt Securities
7.1 Rationale for Public Offer of Debt Instruments
7.2 Pre-requisites for Issue of Debt Instruments
7.3 Additional Statutory Requirements for Debt Offers
7.4 Process Flow for a Public Offer of Debt Securities
7.5 Floatation of Institutional Bond Issues
7.6 Rights and Bonus Issues of Debt Instruments
7.7 Key Aspects for Merchant Bankers in Debt Issues
Self-test Questions
Chapter 8 Overseas Capital Market Issues
8.1 Introduction to International Financial and Capital Markets
8.2 The International Bond Market
8.3 The Depository Receipt Mechanism for Equity Offers
8.4 Indian Regulatory Regime for Global Market Floats
8.5 Overview of Regulatory Requirements in USA
8.6 Overview of Process Flow for an International Offering
8.7 Case Studies
Self-test Questions
Annexure I
Annexure II
Chapter 9 Exit Offers
9.1 Introduction to Exit Offers
9.2 De-listing Offer
9.3 Equity Repurchase or Share Buy-back
9.4 Buy-back by Unlisted Public and Private Companies
9.5 Buy-back by Listed Companies
9.6 Open Offers Under the Takeover Code
9.7 Strategic Issues in Exit Offers
9.8 Cases on Share Buy-back
Self-test Questions
Chapter 10 Private Placements of Equity
10.1 Overview of Private Issues of Equity
10.2 Venture Capital Finance
10.3 Raising Venture Capital
10.4 Raising Private Equity
10.5 Private Placements to Non-institutional Investors
10.6 Regulatory Framework for Raising Equity Privately
10.7 Process of a Deal
10.8 Recent Trends in Institutional Equity Deals
Self-test Questions
Annexure I
Annexure II
AnnexureIII
Chapter 11 Private Placement of Debt Securities
11.1 Overview of Privately Placed Debt Market
11.2 Deal Process and Role of the Investment Banker
11.3 Case Study on Private Placement
11.4 Need for Regulatory Intervention and Recent Developments
11.5 Future Directions
Self-test Questions
PART III CORPORATE ADVISORY SERVICES
Chapter 12 Business Advisory Services
12.1 Overview of Corporate Advisory Services
12.2 Business Advisory Services
12.3 Corporate Structuring
12.4 Joint Ventures
12.5 Foreign Collaborations
12.6 Foreign Investments in Indian Businesses
Self-test Questions
Annexure I
Annexure II
Chapter 13 Project Advisory Services
13.1 Introduction to Project Finance
13.2 The Project Financing Process
13.3 Project Advisory and Transaction Services Provided by Investment Banks
13.4 Financial Closures—Key Issues for Fund Raising
Self-test Questions
Annexure I
Annexure II
Annexure III
Annexure IV
Chapter 14 Financial Restructuring Advisory
14.1 Introduction
14.2 Debt Restructuring
14.3 Components of Debt Restructuring
14.4 Investment Banking Services in Debt Restructuring
14.5 Recent Cases in Debt Restructuring
14.6 Introduction to Equity Restructuring
14.7 Concept of Capital Reduction
14.8 Methods of Equity Restructuring
14.9 Rationale for Equity Restructuring
14.10 Cases in Equity Restructuring
14.11 Regulatory Mechanisms for Equity Restructuring
14.12 Role of Investment Banker in Equity Restructuring
Self-test Questions
Annexure I
Annexure II
Chapter 15 Mergers and Acquisitions Advisory
15.1 Overview of Corporate Re-organizations
15.2 Introduction to Corporate Restructuring
15.3 Restructuring through Split-up of an Existing Company
15.4 Corporate Re-organization through Integration of Companies
15.5 Mergers and Amalgamations
15.6 Process Flow for Restructuring and Mergers
15.7 Acquisitions and Takeovers
15.8 Role of Investment Banker in Corporate Re-organizations
15.9 Conclusion
Self-test Questions
Annexure I
Annexure II
Annexure III
Annexure IV
Chapter 16 Government Advisory
16.1 Introduction
16.2 Service Areas and Role of the Financial Advisor
16.3 Introduction to Disinvestment
16.4 Disinvestment Methodologies
16.5 Valuation Approaches in Disinvestment
16.6 Contemporary Concerns in Disinvestment
16.7 Contractual Issues and Documentation in Strategic Disinvestments
16.8 Disinvestment in State PSEs
16.9 International Experience in Disinvestment
16.10 Process Flow and Role of Investment Banker in Disinvestments
16.11 Role of Investment Banker in Bid Advisory
16.12 Case Studies in Disinvestment
16.13 Conclusion
Self-test Questions
Annexure I
Annexure II
PART IV Appendix
Appendix 1
Appendix 2
Appendix 3
Appendix 4
Appendix 5
Appendix 6
Appendix 7
Appendix 8
Appendix 9
List of terms/acronyms used in this book
Subject Index

Citation preview

INVESTMENT BANKING An Odyssey in High Finance

INVESTMENT BANKING An Odyssey in High Finance

PRATAP G SUBRAMANYAM

Tata McGraw-Hill Publishing Company Limited NEW DELHI

McGraw-Hill Offices New Delhi New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal San Juan Santiago Singapore Sydney Tokyo Toronto

Tata McGraw-Hill A Division of The McGraw-Hill Companies

Tata McGraw-Hill © 2004, Tata McGraw-Hill Publishing Company Limited No part of this publication can be reproduced in any form or by any means, without the prior written permission of the publishers. This edition can be exported from India only by the publishers, Tata McGraw-Hill Publishing Company Limited ISBN Published by Tata McGraw-Hill Publishing Company Limited, 7 West Patel Nagar, New Delhi 110 008 Typeset in Baskerville at EMBOSS, 9, ISEC Main Road, 3rd ‘A’ Cross, Nagarabhavi, Bangalore 560 072. Cover Design: Mesmerizers, Bangalore

The McGraw-Hill Companies

To My beloved father, Late Prof. P. Rabindranath Who held my hand, as I wrote for the first time ever, and to Dr. Prasanna Chandra Who held my thoughts, as I wrote this book.

Foreword Investment Banking has grown to encompass an important place in the field of financial services in India in the liberalized era. I find Pratap G. Subramanyam's initiative in writing a comprehensive book on this contemporary subject very timely and useful. I congratulate him on this effort. As a former investment banker and a person who has been through the thick of investment banking, I can state with conviction that this field of financial services can only become more important in the years to come. The increasing sophistication and deepening of the financial markets on one hand, and the fast transforming corporate landscape from a protective background to a globalised market place on the other, would lead to more complex corporate transactions and therefore, the role of investment bankers as transaction experts and advisers would become indispensable. There is utmost need at this point of time for organized learning of this field of financial activity through a systematic approach based on conceptual clarity. At the same time, complexity in transactions leads to the need for more regulation and would thus make the learning process difficult. I am happy to note that this book by Pratap G. Subramanyam approaches and handles both these imperatives extremely well. This book provides a strong conceptual foundation in the realm of investment banking and furnishes in-depth discussions on various topics with élan. The discussions are free flowing and are supplemented with illustrations and case studies. The coverage on difficult topics such as takeovers, restructuring and project advisory has been handled in a well-structured manner to make it easy on the reader. The depth of coverage, easy style and structured presentation, complete perspective on regulatory and procedural aspects and well compiled case studies are the hall marks of this book, thus making it a must for all academic and professional reading in investment banking. I am sure practitioners would find it as useful as students trying to grasp the subject. Considering its comprehensive coverage of the subject and

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thorough discussion on strategic dimensions of investment banking, this book would be a useful companion in corporate boardrooms as well. The pace at which Indian corporate landscape is transforming leaves no doubt in my mind that investment banking would grow into a larger service area in future. Indian corporates are steadily grappling with the globalised realities and coming out successful in various sectors. Cross border capital flows are becoming an imperative. Capital raising, consolidation and restructuring are the order of the day. The law makers and regulators are constantly engaged in providing the necessary bandwidth by enactment and amendment of corporate and securities laws and refining the statutory framework through periodical changes in guidelines, rules and regulations. I am glad to find that this book discusses the regulatory provisions governing investment banking in a comprehensive manner. Necessary fundamental inputs in taxation and accounting aspects have also been provided where relevant to make the discussions in the book wholesome. I wish the book all success in meeting its intended objectives and commend the endeavour of the author in producing such a voluminous work on this very important branch of financial services. I am confident that this book by Pratap G. Subramanyam would stand the test of time and stand out as a remarkable piece of professional literature on investment banking.

P.V. Narasimham Chairman

Credit Analysis and Research Ltd. Mumbai

Preface Background The Indian financial markets have been through a continuous process of historic transformation ever since economic liberalization set in 1991. In particular, the capital market has seen such landmark systemic changes that today, it ranks on par with the most developed markets in the world in terms of infrastructure and processes. From its small beginnings in the seventies and eighties, investment banking unfolded itself as a full-fledged service industry during this phase. From mere public floatation services such as issue management and underwriting, the investment banking industry has evolved to encompass many high profile corporate actions. A separate book focused on this area of financial services was thus felt necessary so as to provide the necessary perspective from the standpoint of the service provider.

Aim of the Book and Intended Audience This book is the culmination of several years of thought process, practical experience and data collection in the realm of investment banking in the Indian context. It is aimed at providing a strong conceptual foundation in the service aspects of investment banking keeping in view the regulatory and procedural requirements at every stage. The book is intended both for academic and professional use. For academic learning, it is primarily intended for the use of students at the post-graduate level in various MBA courses. But it would also to be of use to students pursuing professional courses such as CA, ICWA and ACS. At the professional level, the book provides considerable insights into procedures and practical issues in the backdrop of the regulatory framework under various securities laws. The relevant provisions of the Companies Act 1956, the Income Tax

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Act 1961, the Foreign Exchange Management Act 1999 and other laws have also been discussed insofar as they apply to the investment banking industry. Keeping in view the exhaustive coverage in the book, it would act as a useful reference for CFOs, professionals in investment banks, merchant banks, advisory firms, financial services companies, commercial banks, financial institutions and practitioners such as chartered accountants, company secretaries and cost accountants.

Pedagogy The book follows a discussion approach wherein the basic concepts are discussed before attempting to elaborate on the core issues in each chapter. The book has been written quite exhaustively from two angles—(a) the concepts have been given prime importance and the discussions have been supplemented with caselets, illustrations, tables and exhibits for easier comprehension and (b) every topic has been discussed quite elaborately from a procedural and regulatory perspective. The discussion of the regulatory framework is based on the current law in force (as in January 2004). In addition, detailed case studies have been provided for the topics under each chapter and extracts from specimen offer documents have been furnished separately as appendices. The discussion in each chapter is preceded by an overview of the chapter and concludes with questions for self-assessment. The architecture of the presentation in the book has been furnished separately.

Chapter Orientation The book has sixteen chapters and nine appendices. The first four chapters are meant to provide the reader with a complete understanding of the mechanics of the capital market, the investment banking service profile and the primary equity and debt markets. Chapters 5 to 11 are totally dedicated to various types of equity and debt offers in the primary market through the public issue as well as the private placement route. Chapter 5 deals with initial public offers and Chapter 6 with follow on offerings. Chapter 7 discusses debt issues in particular. Chapter 8 dwells on overseas offerings through the depository receipt mechanism as well as the bond issue route. Chapter 9 is all about reverse floatations in the nature of exit offers to the public. Chapter 10 deals with private equity and venture capital and Chapter 11 focusses on private placement of debt securities.

Preface

xi

Chapters 12 to 16 concern themselves exclusively with corporate advisory services provided by investment banks. Chapter 12 discusses providing business advisory services in the areas of joint ventures, collaborations and cross-border investment. Chapter 13 deals with project advisory services. Chapter 14 elaborates the entire gamut of financial restructuring covering both debt and equity capital. The restructuring of distressed companies is also covered adequately. Chapter 15 dwells on merger and acquisition advisory including the process of split-ups and hive-offs. Chapter 16 talks about the service profile for government advisory work in the areas of policy formulation, disinvestments and privatization. I must acknowledge that though I had cherished the thought of writing a book on investment banking for long, the idea took concrete shape only after my discussions with Dr. Prasanna Chandra, Director, Centre for Financial Management (CFM), Bangalore. I am grateful for his valuable time and insights in giving my thought process a proper direction and a definitive shape to the contents of this book. I wish to mention the advantage I had in writing this book after having worked closely with some well-known names in the financial services industry over the years such as Mr. P.V.Narasimham, Chairman, Credit Analysis and Research Ltd., Dr. Basudeb Sen, Former CMD, Industrial Investment Bank of India and Mr. G.P.Gupta, Former CMD, IDBI and UTI. I also express my sincere thanks to Mr. P.V. Narasimham for sparing his valuable time and writing the foreword for this book I have also benefitted immensely from my professional interaction with several fellow professionals and friends. Though the list is long, I would like to mention the names of Mr. K.Kannan, Former CMD, Bank of Baroda, Mr. G.V. Nageswara Rao, MD IDBI Bank Ltd, Mr. Utkarsh Palnitkar, Director, Ernst & Young and Mr. Premal Doshi, Associate Director, Anand Rathi Securities. I thank Premal for having provided valuable data on GDR issues. I express my sincere thanks to my publishers Tata McGraw-Hill for reposing their faith in this book. I am grateful to Ms. Deepa of TMH for having been a one-point interaction for me with my publishers in shaping this book. My thanks are also due to the technicians, editors and proof readers who have done a commendable job. I would also like to mention the support provided by Dr. Chandra, Pranav and the team at CFM. My thanks are due to my wife Vani, a fellow chartered accountant and a co-professional in investment banking for providing deep insights and constructive

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criticism which have helped me to refine the discussions in the book. I also thank her for sharing my professional and personal responsibilities while I was busy writing the book. Lastly, it would not have been possible for me to complete the book on schedule but for the immense patience shown by my little son Nirupam in forgiving my late hours at work and my not being around when he would have liked me to. I am aware that this is the first edition of a book of this size and therefore my efforts have been entirely focussed on providing meaningful coverage on various topics. This could have left room for further improvement in presentation and making the discussions more reader-friendly. While I appreciate that improvement is a continuous process and would continue to strive for it, it will not happen without receiving valuable feedback from readers. I would be grateful if necessary observations and suggestions are sent to me at [email protected] for making this book more meaningful and enhance its relevance to its intended audience.

27th July, 2004 Bangalore

Pratap G. Subramanyam

Architecture of the Book

Chapters 1 to 4

Part I

�

Capital Market and its constituents.

�

Evolution and growth of Investment Banking.

�

Anatomy of the Primary Equity and Debt Market.

�

Profile of offers, instruments, issuers and investors in primary market.

Chapters 5 to 11 �

Initial Public Offers, Follow on Offerings, Exit Offers, Offers in Overseas Capital Markets.

�

Private Equity, Venture Capital.

�

Conceptual analysis, description of process flow.

�

Equity and Debt Offers.

�

Role of investment banker.

Part II

Chapters 12 to 16

Part III

�

Business Advisory, Project Advisory, Financial Restructuring Advisory, Corporate Restructuring and M&A Advisory, Government Advisory.

�

Conceptual overview, regulatory issues and transaction process.

�

Role of investment banker..

Appendices 1 to 9

Part IV

�

Capital Market Statistics.

�

Extracts from Offer Documents for various types of offers and transactions—IPO, Rights Issues, Buyback, Open Offer, Hireoff and Merger.

�

Fundamental Financial Concepts.

Contents

Foreword Preface

vii ix

Architecture of the Book xiii �

PART I

INTRODUCTION TO CAPITAL MARKET, INVESTMENT BANKING AND PRIMARY MARKETS 1

Chapter 1 Overview of Indian Capital Market 1.1 Introduction 4 1.2 Financial Markets 7 1.3 Historical Evolution of Capital Markets 12 1.4 Evolution of the Indian Capital Market 16 1.5 Capital Market Constituents 19 1.6 Capital Market Segments 21

3

xvi

Contents

1.7 Premier Stock Exchanges 24 1.8 Statutory Framework 33 1.9 Regulatory Authorities 30 1.10 Capital Market Intermediaries, Infrastructure and Service Providers 42 1.11 Important Developments in the Indian Capital Market 53 1.12 Road Head 68 Self-test Questions 70 Chapter 2 Introduction to Investment Banking

71

2.1 Introduction 72 2.2 Investment Banking and Merchant Banking Distinguished 72 2.3 Evolution of American Investment Banks 73 2.4 European Investment Banks 75 2.5 Global Industry Structure 77 2.6 Business Portfolio of Investment Banks 77 2.7 The Indian Scenario 79 2.8 Characteristics and Structure of Indian Investment Banking Industry 81 2.9 Service Portfolio of Indian Investment Banks 83 2.10 Inter-dependence between Different Verticals in Investment Banking 86 2.11 Regulatory Framework for Investment Banking 88 2.12 Regulatory Framework for Merchant Banking 91 2.13 Anatomy of Some Leading Indian Investment Banks 92 2.14 Recent Trends in Investment Banking 99 2.15 The Conflict of Interest Issue 102 2.16 Conclusion 104 Self-test Questions 105 Annexure I 107 Annexure II 110

Contents

Chapter 3 Primary Equity Market

xvii 115

3.1 Primary Equity Market 116 3.2 Fundamental Concepts on Equity 117 3.3 Overview of Valuation Methodologies for Equity Shares 134 3.4 Equity Issues in Primary Market 144 3.5 Primary Market Equity Issuers 147 3.6 Primary Market Equity Investors 148 3.7 Primary Market Intermediaries and Support Service Providers 162 3.8 Growth and Performance of the Primary Equity Market 167 3.9 Future Directions in the Primary Equity Market 169 Self-test Questions 171 Chapter 4 Primary Debt Market

173

4.1 Primary Debt Market 174 4.2 Fundamental Concepts on Debt Securities 176 4.3 Types of Debt Instruments 182 4.4 Recent Trends in Primary Debt Market 205 Self-test Questions 207

�

PART II

MANAGEMENT OF PUBLIC OFFERS AND PRIVATE PLACEMENTS 209 Chapter 5 Initial Public Offers 5.1 The IPO Market 213 5.2 Significance of an IPO 214 5.3 The IPO Decision 216 5.4 Important Aspects of an IPO 221

211

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Contents

5.5 Important Regulatory Provisions for an IPO 228 5.6 Contents of a Prospectus/offer Document for an IPO 240 5.7 Methodologies for Making Issues 244 5.8 Issues by Financial Institutions 257 5.9 Procedural Aspects of an Issue 258 5.10 Role of Merchant Banker in Issue Management 271 Self-test Questions 276 Annexure I 277 Annexure II 281 AnnexureIII 283 Chapter 6 Rights Issues and Secondary Public Offers

287

6.1 Considerations for Listed Companies 288 6.2 Rights Issue 298 6.3 Secondary Public Offer 310 6.4 Composite Issue 315 6.5 Role of Investment Banker in Listed Companies 316 Self-test Questions 317 Chapter 7 Public Offers of Debt Securities 7.1 Rationale for Public Offer of Debt Instruments 320 7.2 Pre-requisites for Issue of Debt Instruments 321 7.3 Additional Statutory Requirements for Debt Offers 326 7.4 Process Flow for a Public Offer of Debt Securities 330 7.5 Floatation of Institutional Bond Issues 332 7.6 Rights and Bonus Issues of Debt Instruments 333 7.7 Key Aspects for Merchant Bankers in Debt Issues 335 Self-test Questions 337

319

Contents

Chapter 8 Overseas Capital Market Issues

xix 339

8.1 Introduction to International Financial and Capital Markets 340 8.2 The International Bond Market 341 8.3 The Depository Receipt Mechanism for Equity Offers 347 8.4 Indian Regulatory Regime for Global Market Floats 361 8.5 Overview of Regulatory Requirements in USA 372 8.6 Overview of Process Flow for an International Offering 377 8.7 Case Studies 381 Self-test Questions 388 Annexure I 389 Annexure II 404 Chapter 9 Exit Offers

413

9.1 Introduction to Exit Offers 414 9.2 De-listing Offer 414 9.3 Equity Repurchase or Share Buy-back 423 9.4 Buy-back by Unlisted Public and Private Companies 425 9.5 Buy-back by Listed Companies 427 9.6 Open Offers Under the Takeover Code 437 9.7 Strategic Issues in Exit Offers 449 9.8 Cases on Share Buy-back 452 Self-test Questions 459 Chapter 10 Private Placements of Equity 10.1 Overview of Private Issues of Equity 462 10.2 Venture Capital Finance 470 10.3 Raising Venture Capital 470

461

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Contents

10.4 Raising Private Equity 492 10.5 Private Placements to Non-institutional Investors 494 10.6 Regulatory Framework for Raising Equity Privately 495 10.7 Process of a Deal 499 10.8 Recent Trends in Institutional Equity Deals 513 Self-test Questions 516 Annexure I 517 Annexure II 520 AnnexureIII 520 Chapter 11 Private Placement of Debt Securities

529

11.1 Overview of Privately Placed Debt Market 530 11.2 Deal Process and Role of the Investment Banker 534 11.3 Case Study on Private Placement 538 11.4 Need for Regulatory Intervention and Recent Developments 540 11.5 Future Directions 546 Self-test Questions 547 �

PART III

CORPORATE ADVISORY SERVICES 549 Chapter 12 Business Advisory Services 12.1 Overview of Corporate Advisory Services 553 12.2 Business Advisory Services 555 12.3 Corporate Structuring 558 12.4 Joint Ventures 576 12.5 Foreign Collaborations 588

551

Contents

xxi

12.6 Foreign Investments in Indian Businesses 601 Self-test Questions 619 Annexure I

620

Annexure II 622 Chapter 13 Project Advisory Services

625

13.1 Introduction to Project Finance 626 13.2 The Project Financing Process 638 13.3 Project Advisory and Transaction Services Provided by Investment Banks 650 13.4 Financial Closures—Key Issues for Fund Raising 659 Self-test Questions 662 Annexure I Annexure II

663 666

Annexure III

668

Annexure IV

683

Chapter 14 Financial Restructuring Advisory 14.1 Introduction 698 14.2 Debt Restructuring 700 14.3 Components of Debt Restructuring 710 14.4 Investment Banking Services in Debt Restructuring 722 14.5 Recent Cases in Debt Restructuring 723 14.6 Introduction to Equity Restructuring 729 14.7 Concept of Capital Reduction 730 14.8 Methods of Equity Restructuring 731 14.9 Rationale for Equity Restructuring 734

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Contents

14.10 Cases in Equity Restructuring 737 14.11 Regulatory Mechanisms for Equity Restructuring 740 14.12 Role of Investment Banker in Equity Restructuring 743 Self-test Questions 744 Annexure I Annexure II

746 749

Chapter 15 Mergers and Acquisitions Advisory

757

15.1 Overview of Corporate Re-organizations 759 15.2 Introduction to Corporate Restructuring 765 15.3 Restructuring through Split-up of an Existing Company 766 15.4 Corporate Re-organization through Integration of Companies 773 15.5 Mergers and Amalgamations 774 15.6 Process Flow for Restructuring and Mergers 777 15.7 Acquisitions and Takeovers 791 15.8 Role of Investment Banker in Corporate Re-organizations 801 15.9 Conclusion 803 Self-test Questions 804 Annexure I Annexure II

805 809

Annexure III

818

Annexure IV

821

Chapter 16 Government Advisory 16.1 Introduction 831 16.2 Service Areas and Role of the Financial Advisor 832 16.3 Introduction to Disinvestment 833

829

xxiii

Contents

16.4 Disinvestment Methodologies 837 16.5 Valuation Approaches in Disinvestment 840 16.6 Contemporary Concerns in Disinvestment 843 16.7 Contractual Issues and Documentation in Strategic Disinvestments 848 16.8 Disinvestment in State PSEs 853 16.9 International Experience in Disinvestment 855 16.10 Process Flow and Role of Investment Banker in Disinvestments 857 16.11 Role of Investment Banker in Bid Advisory 864 16.12 Case Studies in Disinvestment 867 16.13 Conclusion 874 Self-test Questions 875 Annexure I Annexure II

876 879 �

PART IV

Appendix

885

Appendix 1

887

Appendix 2

897

Appendix 3

1001

Appendix 4

1055

Appendix 5

1071

Appendix 6

1087

Appendix 7

1107

Appendix 8

1119

Appendix 9

1149

List of terms/acronyms used in this book

1169

Subject Index

1179

Part I

Chapter 1 Overview of Indian Capital Market

Chapter 2 Introduction to Investment Banking

Chapter 3 Primary Equity Market

Chapter 4 Primary DEBT Market

Chapter

1

Overview of the Indian Capital Market

T

his chapter traces the origin and growth of the capital market in the context of the global market place in general and India in particular. It then goes on to describe the various constituents and segments of the Indian capital market. The overview of the functioning of the secondary markets, stock exchange trading mechanisms and role of intermediaries in such markets is also discussed. The Indian capital market has been going through rapid transformation for the past decade or so. Some of these changes are historic and unprecedented leading to a paradigm shift in the securities business in India. These developments are outlined. The discussion concludes with a note on the future directions in the transformation of the Indian capital market.

Topics to comprehend �

�

�

�

The evolution and growth of the capital market and its role in the economy. The constituents of the capital market and their respective functions. The regulatory framework of security laws in India. The sweeping changes that are shaping the future of the capital markets in India.

4

Investment Banking

1.1 Introduction The economy of a country functions on the fundamental mechanism of savings and investment of financial capital into economic activities that help in the creation of economic wealth. Economic wealth in turn creates a conducive atmosphere for consumption that creates economic demand for goods and services thereby stimulating production and further investment. Therefore, this continuous economic cycle leads to growth in the economy which is usually measured by the gross domestic product or the GDP. Economic growth when channelized optimally leads to economic development which is measured by the standard of living of the people and other parameters such as the availability of developed capital and money markets, the exchange value of the country’s domestic currency and the level of infrastructural development to sustain economic activity.

1.1.1 Generation of Capital With the above backdrop of broad economic considerations in mind, it is necessary to understand the role of economic capital and its movement in the economy. Economic capital is created through savings out of incomes earned by all types of economic activity. If the savings rate in an economy is not commensurate with its investment requirements, it becomes a high consumption economy and would therefore require to depend upon external resources for its investment requirements. This kind of external dependence beyond a point could lead to inflation, depreciation in the exchange rate of the domestic currency, burgeoning foreign debt and other long-term economic maladies. In India, it has traditionally been the household sector that has been a net saver (income exceeding expenditure), which has contributed to capital formation. The business sector (corporate and non-corporate) and the government sector have been negative contributors to savings with their expenditure exceeding their income. The gap in the requirement of savings and investment vis-à-vis the actual domestic savings is met by external resources. External resources are raised both through governmental and commercial borrowings from overseas either as loans or as mobilization of savings from non-residents. However, the more important longterm source of external resources for developing economies has been foreign investment in their domestic business. India had a precarious position as regards its external payments in 1991 due to which the government initiated the process of economic liberalization which has eased the foreign exchange position of India

Overview of the Indian Capital Market

5

since then. Presently, the country is grappling with a situation of managing its burgeoning foreign exchange reserves, which are in excess of $ 100 billion. The role of household savings in the country’s savings and investment pattern is captured in the Table APP 1.1. Readers may refer to this table in Appendix 1 at the end of the book.

1.1.2 Institutional Intermediation in Capital Flows Having appreciated the need to move capital from savings pool in the economy to the in�������� ����, �� ����� �� ��������� �� ���������� ��� ���� �������� ����� ���� ����� �����. ��� ���� ��� ������������� �������������� �� �������� �� ������� ������ �� ���������������. ������� �� ���������� �� ��� ������ �������� ������ ������ ���� ��� ���nnelized into productive uses that create it. Therefore, two things are paramount for sustained economic activity—(a) adequate domestic savings in the economy and more importantly (b) the movement of such capital saved to productive investments in the economy. The second aspect is extremely critical since real growth in an economy is achieved only if real investments are made leading to increased supply of goods and services. Institutional intervention in the economy not only channelizes savings into investments, but helps in moving investments from financial assets into real assets as well. If capital moves only within the orbit of one mode of saving to another, i.e. within the domain of financial assets without reaching the real investment channels, the economy would register financial growth but the real economy would suffer. This situation over a sustained period could once again lead to inflation and other economic maladies. Further, perhaps the biggest contribution of institutional intervention in the economy is in the allocation of available capital. This function is also of vital importance since the available capital may not be sufficient to meet all the envisaged investment requirements. By rationing capital to the most efficient productive uses, these intermediaries help in optimizing scarce and valuable economic capital. However, the extent to which institutional intervention can mobilize and allocate capital would depend upon the depth of the financial markets in the economy and the presence of a congenial legal and regulatory backbone to support such sophistication. The movement of capital in the economy from the savings pool to the investment pool is performed by two main platforms of institutional intervention—(a) the

6

Investment Banking

financial institution and banking framework and (b) the capital market framework. Banks mobilize funds by raising deposits from domestic investors and other sources of savings and help in re-deployment of these resources productively in the economy by advancing loans and other financial assistance to borrowers. Therefore, it can be said that banks perform the role of intermediation primarily through mobilization and deployment of debt capital in the economy. However, banks confine themselves largely to the sourcing and deployment of short and medium term debt capital. Financial institutions perform the bigger role of mobilizing and deploying long term capital through long term resource mobilization and term lending. Financial institutions can be further differentiated into term lending institutions, insurance institutions and investment institutions. The capital market comes into the picture to perform the other role—i.e. the primary role of a facilitator and an intermediary in raising and deployment of equity capital in the economy. Capital market brings the issuers of equity and the investors Banks and Financial/ Investment institutions (financial economy) Capital Mar ket/ Money Mar ket (financial economy) Investor s (generate savings)

For eign Exchange Mar ket (financial economy)

Business activity

Commodity futur es Mar ket (Financial economy) Real Estate/ Gold etc (real) economy)

� Figure 1.1

Capital flows in an economy

Pr oduction of goods and ser vices (real economy)

Overview of the Indian Capital Market

7

in equity together and helps the issuers of equity to raise capital for productive deployment in creating economic wealth. At the same time, the capital market offers investment avenues to investors with appetite for higher risks and returns as compared to the safe investment options with banks. From an issuer’s perspective, the capital market provides an alternative source of raising business capital and balancing the debt-equity mix in its capital structure. The capital market is helped in its task of institutional intervention by several capital market investment institutions and intermediaries. The respective places of each institution in the capital flows of an economy are depicted in Figure 1.1.

1.2 Financial Markets Having discussed the role of capital flows in an economy and the need for institutional intervention, it would be necessary to appreciate the structure of the financial markets. Both the banking institutions and the capital market are subsegments of the financial markets in which there are other segments that perform vital functions as well. Together, the segments in the financial markets, apart from capital flow intermediation, keep the economy vibrant and resourceful. The overview of the various segments in the financial market is depicted in Figure 1.2.

1.2.1 Capital Market Capital markets deal with raising finance through issue of publicly traded financial instruments in equity and debt which can be bought and sold at any time through dedicated market places called stock exchanges. Notwithstanding the clear roles played by banks and the capital market in the economy, the capital market also offers wide scope for raising long-term debt capital through issue of debt securities as distinguished from loans provided by banks and financial institutions. This kind of debt capital being in the nature of tradable securities is more flexible both from an investor and an issuer’s perspective. Therefore, the capital market becomes an agency of bank disintermediation in that it not only brings investors and issuers together on an alternative platform; it also helps in the movement of debt capital, a function that is primarily the domain of banks and financial institutions. However, banks and financial institutions on one hand and the capital market on the other continue to co-exist and perform their respective functions as it is not possible for each of them to completely substitute the other in

8

Investment Banking

FINANCIAL MARKETS CAPITAL MARKET Consist of the equity market, debt market and the derivative market. Major players are institutional and other high networth investors.

MONEY MARKET Consist of dealing in short and long term debt securities issued by both government and business entities. Major players are banks and primary dealers.

INSURANCE/PF/ PENSION Consists of the business of selling insurance products/retirement products and deploying such funds in investments. Major players are LIC in life insurance and GIC and its associates in non- life insurance. The insurance sector has been opened up to private sector companies recently.

� Figure 1.2

FE MARKET Consists of dealing in Foreign Currency and exchange transactions. Major players are banks.

LOAN MARKET Consists of commercial and retail loans to corporate and non corporate borrowers. Major players are financial institutions, banks and finance companies.

SAVINGS AND INVESTMENT MARKET Consists ofmobilisation of retail savings and providing investment options. Major players are the government small savings, banks, financial institutions and mutual funds.

Overview of Financial Markets (The Financial Economy)

taking care of the needs of the economy. However, considering the fact that the capital market has a wider role to play beyond merely being a catalyst for capital creation, a developed and vibrant capital market is the backbone of a healthy economy. It can thus be inferred that the capital market is the most important instrument for wealth creation in an economy. However, capital markets have had their times of turbulence as well. Historically speaking, capital markets have seen great crashes as in 1927, 1987, 1991 and 2001 wiping out each time, billions of dollars of wealth of investors.

1.2.2 Money Market An offshoot of the capital market is the money market, which is the marketplace for short-term debt capital. However, the money market is significantly different from

Overview of the Indian Capital Market

9

the capital market. In this market, the government, banks and other issuers raise short-term capital either through issue of short-term securities or through short-term borrowings. Typically, short-term instruments in the Indian context have a life not exceeding twelve months. The money market is also supported by several investment institutions that mobilize funds from investors to be deployed in this market. However, the money market is confined only to the short-term debt products such as treasury bills of the government, inter-bank short-term issuance such as overnight call money, repurchase options or ‘repos’ issued by the RBI and corporate instruments such as commercial paper. The money market is characterized purely by institutional players such as banks, financial institutions, investment institutions, insurance companies, mutual funds and the Discount and Finance House of India (DFHI). It is also supported by the network of primary dealers, a category of intermediaries set up by the RBI in 1995. The DFHI is a specialized institution set up by the RBI in 1988 with the support of financial institutions and banks to provide depth in the primary and secondary segments of the money market. Unlike the capital market, the money market does not have an organized trading market place such as the stock exchange for its primary issues and secondary market trades (primary and secondary segments of the capital market are discussed later under paragraph 1.6.1 of this chapter). The primary issues are subscribed by the market players through private placement and as far as the government treasury bills are concerned, these are auctioned by the RBI periodically. The secondary market functions mostly through the telephonic deals backed by suitable documentation. It is therefore an impersonal but un-organized market. The RBI is the regulatory authority for the money market. The RBI set up several committees such as the Sukhamoy Chakraborty Committee in 1985 and the Vaghul Committee in 1987 to revamp the money market. As a fall out of their recommendations, the money market has been spared of controls on interest rates and several instruments such as the 182 day treasury bills (1986), certificates of deposit, commercial paper and inter-bank participation certificates (1989), and 364 day treasury bills were introduced. In 1992, the RBI permitted mutual funds into this market by allowing them to float dedicated money market funds.

1.2.3 Foreign Exchange Market Foreign exchange markets comprise of banks and foreign exchange dealers who buy and sell for profit, foreign exchange and their derivatives in various currencies including the home currency. Foreign exchange markets are also closely linked to

10

Investment Banking

economic variables and can be much more volatile than capital markets. An adverse movement in the economy can affect the foreign exchange markets and vice versa. The South-East Asian crash in 1997 in the currencies of countries such as Thailand, Malaysia, Indonesia, Hong Kong, Taiwan and Korea bled their economies to near bankruptcy.

1.2.4 Loan Market Loan markets refer to the activities of banks and financial institutions that make available loans to business houses for various types of business activities which can be industrial, trading, manufacturing, infrastructure, service or financial. Loans can be long term or short-term depending upon business needs and these can be used for acquiring business assets such as buildings and equipment or in meeting day-today operational expenses or to meet the cost of stocks of raw materials and finished products. Banks and financial institutions raise their resources from the public by way of deposits and other instruments. They perform the important function of channelizing resources from investors into productive uses for business.

1.2.5 Insurance Market Insurance performs a very vital function in the financial markets in raising long term resources that can be deployed for long term uses in the economy. From a different viewpoint, insurance also provides the much needed risk coverage in the life and non-life segments. This risk coverage makes available funds for exigencies involving individuals, properties and businesses thereby ensuring their protection.

1.2.6 Retirement Savings Market Retirement savings are long term funds pooled from investors by provident funds, pension funds and superannuation funds. They perform the important function of providing resources to maintain the ageing population in the economy. These funds are accumulated over long periods of time and are therefore meant for being used to create financial security for investors upon their retirement. These funds being long term in nature, are ideal to be invested in long term economic wealth creation in the economy. In the developed countries, pension funds played a big role in the creation of infrastructure such as roads, ports, power and urban infrastructure. In India, this sector has been traditionally under government control through

Overview of the Indian Capital Market

11

compulsory savings schemes. Though the government has been reluctant to liberalize this sector, moves are on to let pension reforms set in into the country.

1.2.7 Savings and Investment Market This consists of several retail financial savings products available to the household sector to deploy in financial assets. Several types of investment institutions proliferate this market such as the government sector consisting of government savings schemes, the institutional segment consisting of mutual funds and banks, the corporate sector consisting of financial and investment companies and the unorganized sector consisting of chit funds, nidhis and mutual benefit societies. The data pertaining to household savings in the financial economy for the past four years is shown in Table APP 1.2. Readers may refer to this table in Appendix 1 at the end of the book.

1.2.8 Market Intermediaries In all the segments of the financial markets as detailed above, there exist several intermediaries whose main function is to act as facilitators to the functioning of the financial markets. In the capital markets, there are intermediaries such as broking houses, investment firms, mutual funds, underwriters, investment banks and merchant banks. In the foreign exchange markets, there are intermediaries such as foreign currency brokers, dealers, arbitrage operators and speculators and money changers. In the loan markets, there are debt syndicators and financial advisors. Insurance markets have intermediaries such as insurance advisors, financial consultants and distribution companies. To conclude the above discussion, it is clear that there are two parallel segments in the economy, i.e. the real economy consisting of demand and supply of goods and services and the financial economy consisting of demand for financial assets and supply thereof. Institutional intervention performs the dual function of (a) mobilizing savings to be converted into financial assets in the financial economy and (b) allowing capital flows from the financial economy into the real economy so as to provide economic growth. The capital market is the more important means of institutional intervention that has grown phenomenally over the centuries and has helped the cause of economic growth and development of several countries. At the same time, with the evolution of sophistication and depth in the financial economy

12

Investment Banking

and the development of regulatory framework to protect investors, capital markets across the world have become mature marketplaces wherein several sophisticated instruments including risk-hedged derivatives are traded day after day with the volumes of trades amounting to billions of dollars. Speculation on movement of stock prices and stock indices has come to stay as the main fuel that drives the capital market and keeps it buoyant. The capital market has also grown in stature to become one of the important barometers in assessment of the economic development of a country.

1.3 Historical Evolution of Capital Markets The capital market as has been mentioned earlier, is the marketplace for long term finance in equity and debt. Historically, the capital market has its beginnings in medieval Europe before the Industrial Revolution, but the structure of the market and the investment options were quite primitive. While the issuers of debt securities were primarily landowners and municipal bodies, the equity market was proliferated by small business houses. However, the fundamental issues that concerned regulators of capital markets have been the same right from those days, i.e. to reduce the level of risk on debt and ensure fair return on equity.

1.3.1 Pre-industrial Era Prior to the industrial revolution in Europe, the need for business capital was mostly for trade and commercial application which had anything but reliable cash flow. There was very little need for long term finance. Therefore, business houses did not enter the capital market for debt capital. On the other hand, the landowners and the government agencies which required deployment of long term finance, possessed reliable cash flow as well in the form of taxes and revenues. Therefore, they were the principal issuers of debt securities. The main instruments that were used in those times for debt financing were the ‘pignus’ or pawn, ‘hypothec’ and mortgage which in later centuries gave place to sale of rents and annuities. Sale of annuities was a very popular instrument in the debt market with municipalities and the government which had steady revenue streams in the form of taxes. These annuities were either life annuities linked to the death of a person or perpetual redeemable annuities. The main investors in these instruments were the wealthy and middle class citizens. Annuities served both as investment and as life insurance for such people. Municipal annuities were safe, liquid and freely transferable. Over a period

Overview of the Indian Capital Market

13

of time, municipal banks were set up to manage the municipal annuity debt. These banks managed the sale of fresh annuities and servicing of existing annuities. The ‘stadtwechsel’ or public bank in Basel played the role of an underwriter charging issue fees of 2% on fresh issues. As the issue sizes of annuities grew, a secondary market developed which was brokered by the ‘kassiers’. In Antwerp in Belgium, these kassiers also brokered new issues. While annuities were very popular debt instruments in Northern Europe, in Italy a different instrument known as the ‘compera’ evolved to fund major public expenditure. The compera can be likened to a primitive form of the modern day concept of ‘securitisation’. The compera consisted of a syndicate of investors who were vested with the ownership of a tax levied specially for that purpose. Over a period of time in cities like Venice, the compera gave place to forced loans called ‘imprestiti’. As these loans grew and the authorities found it difficult to keep track of them, Venice was the first to consolidate all its outstanding debt into a single fund called ‘Monte’. After such consolidation, existing claims were settled for shares in Monte and fresh issues were made in the form of Monte shares. Monte shares were fixed return instruments (5% payable semi-annually) and these were fully transferable by sale, gift or inheritance. The transactions in Monte shares were made through book entries recorded in special ledgers. The Monte grew in popularity with more cities in Italy such as Florence adopting the system. Trading in Monte shares was very active driven both by need for liquidity and speculative intent. These shares traded at market determined prices, which were generally below par value. This was because the carrying rate of interest at 5% was less than the expected rate for sale of these shares in the open market. Hence to improve the yield to the investor, these shares quoted below par. The trading market for Monte shares in Italy was well organized in the ‘piazzas’ which was conducted through brokers. The active Monte share market led to the evolution of merchant banks which acted as dealers and market makers in such shares to provide liquidity to investors and used to take speculative positions as well. Soon, the deposit banks joined the merchant banks in similar activity. While the debt market developed on the backbone of sustained and reliable tax cash flow, the business community could not tap the debt market for funds since they lacked the necessary cash flow strength. Since the capital market of those times lacked regulatory controls and legal protections, the issue of corporate governance (ensuring fair return and protection of interests of equity investors) was almost unaddressed. In order to overcome this hurdle, equity financing had to rely on a simpler mechanism of control, i.e. to wind up businesses periodically.

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Investment Banking

If the business yielded profits, these would be divided among shareholders and the business would be reconstituted for a fresh term, otherwise the investors withdrew their funds after apportioning the losses. The early business organizations were venture partnerships or ‘commenda’, which were used to finance maritime voyages in Italy. Subsequently, these were replaced by continuing partnerships called ‘compagnia’. While trade and commerce was being financed through the compagnia, banking and international trade finance had to rely more on debt financing. The deposit banks and merchant banks raised funds through long term deposits from the public. The compagnia were replaced by limited partnerships which had outside investors as passive partners with limited liability while the managing partners had unlimited liability. As businesses grew, the first forms of joint stock companies (known as ‘loca’) emerged in the ship construction industry. The main difference between loca and the partnership organizations was the free transferability of shares. As the joint stock company structure spread across Europe, it was seen in England in the sixteenth century. However, since there were no institutional mechanisms to protect corporate governance, shares were more personal rather than impersonal instruments. Shareholders had to necessarily take active involvement in the affairs of the company to protect their interests. Shareholders also had to rely on winding up as the mechanism to protect their interests.

1.3.2 Post-industrial Era The early corporate structures provided the foundation for the later day joint stock company with limited liability and wide impersonal spread of shareholding wherein shares were freely transferable and tradeable. The growth of the corporate form of organization in Europe was largely due to the requirement of huge capital investments to set up large industries after the industrial revolution. This meant raising significant investments from public investors who were hitherto investing into public debt securities. The capital market thus grew on the strength of sustained appetite for funds from company issuers on the one hand and the emergence of regulatory and institutional control mechanisms on the other. As investor confidence grew, the capital markets deepened and the role of merchant bankers who were primarily money market intermediaries till the sixteenth century, became that of being more of capital market intermediaries, thus transforming them into investment banks. In later years, with the emergence of the American capital market, investment banks in USA became very strong mobilizers of capital and managers of wealth emerging from the capital market. These aspects are dealt with in detail in Chapter 2.

Overview of the Indian Capital Market

15

The evolution of the twentieth century capital market was also helped by the transformation of the family run businesses that emerged in the seventeenth century post-industrial revolution which were the dominant business houses till the end of the nineteenth century. Payne (1983) in a historical survey of family businesses in Britain comes to the conclusion that the family business was “the vehicle whereby the Industrial Revolution was accomplished1.” Most of corporate America’s big family business houses such as the Carnegies, the Du Ponts, the Fords, the Rockefellers and the Morgans transformed themselves into publicly held corporations. The Chaebols of Korea and the Zaibatsus of Japan were all family businesses that have grown significantly after World War II.

1.3.3 Premier Global Stock Markets The New York Stock Exchange (NYSE) is the world’s biggest stock market in terms of market capitalization. It was started more than 210 years ago in 1792. It was registered as a national securities exchange with the US Securities Exchange Commission in 1934. In 1971, it was incorporated as a non-profit organization with a twenty five member Board of Directors. The NYSE over the long years of its existence has retained stringent entry criteria for companies to get listed on it and thereby maintains its premier position. The trading takes place on the trading floor through brokers and specialists. The specialists have a dual role to play on the trading floor, to trade on client account and to trade on own account, much like the jobbers in the Indian market. They provide two-way quotes and thus become market makers on a continuous basis for the companies for whom they act as specialists. They offer to buy from the public if suitable buy quotes are not available in the market and offer to sell in the absence of sellers in the market. As specialists, they deal only with other broker members and not with the general public. The trading in the NYSE happens even now in the physical mode on the trading floor at designated counters. Trading is based on the auction system, which allows the buyer and seller to meet at the agreed price without the intervention of other brokers. The buy and sell orders are immediately matched and any mismatches that may occur, are taken care of by the specialists. The London Stock Exchange (LSE), based on which the BSE was modeled, is also a very old exchange tracing its roots back to 1760. It was made into a stock exchange in 1773 and more than 200 years later, it became an incorporated company in 2000. It has switched over to screen based trading quite recently. Apart from the normal functions of a stock exchange, the LSE has been a very active

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Investment Banking

campaigner for investor awareness and runs a very successful program called Share Aware. The UK stock market went through radical reform in 1986 through integration of all stock exchanges in the UK into one unified International Stock Exchange of UK and Ireland based in London. This single stock exchange now functions across UK with trading terminals based on both an order-driven (SEAQ) system and a quote-driven (SEAF) system. Under the SEAQ, market makers provide two way quotes to traders. Under the SEAF, the orders are executed by matching principle. The unification process known as the ‘Big Bang’ has helped the growth of the UK stock market considerably. This process is already happening in India in an indirect way with the setting up of the Inter-connected Stock Exchange of India. The National Association for Securities Dealers Automated Quotation System (NASDAQ) which was founded in 1971, is the most popular second exchange in USA after the NYSE. It is also the biggest exchange in the world in terms of deal turnover. This is because the NASDAQ has been positioned as an exchange for knowledge intensive businesses providing sophisticated screen-based trading system which is unavailable on the NYSE even today. In addition it offers a friendlier approach towards listing of stocks as compared to the NYSE, whereby companies that are either young or that cannot fulfil the NYSE criteria can access the NASDAQ to raise capital. The NASDAQ works on the market maker mechanism and each scrip should have atleast two market makers. There are about 500 market makers on NASDAQ who unlike the specialists of the NYSE, do not specialize in particular stocks. The NASDAQ lists more than 4000 companies both from the USA and outside. There are more companies from the USA listed on the NASDAQ than on the NYSE.

1.4 Evolution of the Indian Capital Market The Indian capital market is one of the oldest markets in Asia having found its initiation nearly 200 years ago. While the early days were characterized mostly by dealings of the East India Company, the first deals in shares and securities were witnessed in Bombay in the 1830s. Stock broking was initiated at this time and by the 1860s the number of stock brokers was around 60. By 1874, native brokers started assembling in the famous Dalal Street in South Bombay to conduct transactions in shares and securities. The Bombay Stock Exchange, now known as the BSE was established in 1875 as ‘The Native Share and Stock Brokers Association’. It is older than the Tokyo Stock Exchange, which was established in 1878. It was constituted

Overview of the Indian Capital Market

17

as a voluntary non-profit association of brokers primarily to protect their interests in security trading business. The BSE is currently engaged in the process of converting itself into a demutualised corporate entity. It was the first stock exchange in India to have been granted permanent recognition in 1956 by the Government of India under the Securities Contracts (Regulation) Act, 1956. The SCRA was the culmination of a process initiated by the government to regulate the several stock exchanges that had proliferated during the Second World War. After independence, regulation of securities business and tock exchanges became a central subject under the Constitution. The SCRA was passed in 1956 to substitute all state level legislations on the subject.

1.4.1 The Growth of Stock Exchanges In the initial years Indian capital market was localized initially in Bombay and then in Gujarat primarily driven by the textile business. In 1894, the Ahmedabad Stock Exchange was established. Similarly, by the 1880s and 1890s, Calcutta was driven by the boom in jute, tea and coal busineses and in 1908, the Calcutta Stock Exchange in Lyons Range was established. As Indian industry grew in the twentieth century with the setting up of the The Tata Iron and Steel Company in 1907, there were several shares of Indian companies by around 1920 in the capital market. The Madras Stock Exchange came into existence in 1920, which went out of existence and was re-established in 1937. Since India followed a controlled regime in bullion, exchange and commodity trade, the interest in stock markets grew and several other stock exchanges such as the Uttar Pradesh Stock Exchange (1940), Nagpur Stock Exchange (1940) and the Hyderabad Stock Exchange (1944) and the Delhi Stock Exchange 1947 were established. Bangalore Stock Exchange was given recognition in 1963. In the 1980s several other stock exchanges were set up such as the Cochin Stock Exchange (1980), Uttar Pradesh Stock Exchange, Kanpur, 1982, Pune Stock Exchange (1982), Ludhiana Stock Exchange (1983), Gauhati Stock Exchange (1984), Canara Stock Exchange, Mangalore (1985), Magadh Stock Exchange, Patna, (1986), Jaipur Stock Exchange (1989), Bhubaneswar Stock Exchange (1989), Saurashtra Kutch Stock Exchange, Rajkot, (1989), Vadodara Stock Exchange, Baroda, (1990) and the more recent stock exchanges at Coimbatore and Meerut. With this, there are totally twenty three recognised stock exchanges in India excluding the Over The Counter Exchange of India Limited, the National Stock Exchange of India Limited and the Interconnected Stock Exchange of India Limited which have been formed on a nation-wide basis using sophisticated ringless trading mechanisms.

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Investment Banking

Though the Indian capital market had breadth in terms of geographical reach, the pattern followed was that of setting up regional stock exchanges with their own distinct existence as compared to the practice in developed markets, which had few large exchanges in each country. In terms of capital issues, post-independence, the activity of fresh capital issues both in equity and debt became heavily controlled processes under the Capital Issues (Control) Act 1947. There were very restrictive rules under this enactment that prevented companies accessing the capital market in accordance with their capital requirement. Every public offer required the approval of the central government and pricing of shares was subject to a restrictive pricing formula under the CCI Guidelines. The concept of ‘free pricing’ of a share was non-existent and the right of a company to charge a particular price for its share in the capital market was determined through an administrative clearance rather than through market validation. This regime led to very few Indian companies making issues and raising capital from the capital market. Most of them depended on the development financial institutions such as IDBI, IFCI and ICICI and the SFIs for their capital requirements and remained unlisted. The capital gearing of Indian companies was also high due to the fact that most of their capital comprised of long term loans from such institutions and commercial banks.

1.4.2 Transformation of the Capital Market In 1991, with the liberalization measures initiated by the Government of India, the setting was created for a capital market rebirth in the years to follow. The Capital Issues (Control) Act was abolished and a new regulatory authority called the Securities and Exchange Board of India was established under the Securities and Exchange Board of India Act 1992 to promote the orderly growth and development of the capital market. In the past eleven years after the advent of SEBI, the capital market in India has undergone a sea change both in terms of growth and development. Indian capital market presently has several features that compare favourably with some of the developed stock exchanges of the world such as the New York Stock Exchange, the NASDAQ, the London Stock Exchange, the Hong Kong and the Singapore Exchanges. The capital market has become the most important source of long term capital for the Indian corporate sector due to the increase in capital mobilization from investors on one hand and due to the decline of development banking activity of the financial institutions on the other. In addition, with the spread of the equity cult among larger sections of the society, the capital market has acquired both depth and resource capability. The growth of the market can be assessed from the fact that as against an average annual mobilization of about

Overview of the Indian Capital Market

19

Rs. 900 crore by Indian companies from the capital market in the seventies, the corresponding figure jumped to Rs. 21,600 crore in 1993–94. However, with the advancement in technology, the need for localized stock exchanges is virtually nonexistent today thereby pushing the regional exchanges to the brink of extinction. These aspects have been discussed further at appropriate places in this chapter and elsewhere. The growth of Indian capital market and that of listed Indian companies is furnished in Table APP 1.3. Readers may refer to this table in Appendix 1 at the end of the book.

1.5 Capital Market Constituents The discussion on the Indian capital market is best understood if the basic constituents are listed first. The basic constituents of a capital market are the five ‘I’s which are the following: �

�

�

Issuers of securities, are basically companies incorporated under the Companies Act, 1956. These companies can again be privately owned or owned by the government (either central or state). Apart from companies, other entities that can issue securities in the capital market are bodies corporate incorporated under special Acts of the Parliament or the State Legislature. The aspects relating to issuers have been elaborated further in Chapter 3. The Government can also raise finance from the capital market using the long-term debt route. This is the reason why a major portion of the debt being issued and traded in the debt market consists of dated government securities. Investors in securities can be either wholesale investors or retail investors. The wholesale segment primarily comprises of institutional investors such as mutual funds, investment institutions and others. The retail segment consists of households and other small investors. The different types of investors have been discussed in detail in Chapter 3. Intermediaries and service providers help in the mobilization of resources from the investors and provide other support services. Capital market intermediaries consist of brokers, merchant bankers and market makers. Support service providers include underwriters, custodians, depository participants, registrars and share transfer agents. Some of these services relating to stock

20

Investment Banking

Capital Mar ket

Issuer s

Investor s

� Figure 1.3

Inter mediar ies

Instruments

Infr astr uctur e

Constituents of the Capital Market

market trading have been discussed under paragraph 1.10 in this chapter while those relating to primary market issuances have been discussed at other appropriate places in this book. �

�

Instruments are floated in the capital market for the purpose of raising capital both in debt and equity. These include equity instruments such as equity shares, preference shares, convertibles such as fully or partly convertible debentures, warrants and pure debt instruments such as nonconvertible debentures and bonds. Debt instruments carry interest, which is usually fixed beforehand so that the investor knows the return that can be made in the investment. Equity instruments (called shares) are more like ownership in the underlying business of the company that issues such shares. Therefore shares do not carry any assured return and can either provide high returns in the form of share in profits of the business (known as dividends) or can wipe out the entire investment itself if the underlying business makes a loss. Thus equity instruments are perceived as risky and require thorough knowledge of the relevant businesses before one chooses to invest in them. For a full discussion on the different types of instruments readers may refer to Chapter 2. Infrastructure is required for the efficient functioning of the capital market, which consists of the stock exchanges, the depositories, the regulators and the necessary statutory framework. Moving further, since the capital market cannot function without the development of adequate infrastructure, the stock exchanges play a pivotal role in providing trading and settlement platforms backed by technology backbones that create efficiency in transactions. The stock exchanges also provide stock indices, which are the

Overview of the Indian Capital Market

21

barometers for judging which way the market will move and in taking up positions in stocks accordingly. In order to maintain the orderly functioning, growth and efficiency of the capital market, most economies have capital market regulators and a framework of law to instill confidence and legal protection among the players in the market. The distinction between the capital markets of the medieval era and that of the modern era is the presence of sophisticated default protection mechanisms and legal framework to prevent moral hazards and promote corporate governance. While the growth of stock exchanges in India has been discussed in the earlier paragraphs, a detailed description of the premier stock exchanges in India is provided in paragraph 1.7. An overview of the regulatory framework and the respective roles of each regulator is provided in paragraphs 1.8 and 1.9. There are currently two depositories functioning in India, the NSDL and CDSL. The role of these agencies is detailed in paragraph 1.10. Figure 1.3 depicts the various constituents of the capital market.

1.6 Capital Market Segments As has been mentioned in paragraph 1.2 of this chapter, the capital market is a resource for raising equity and long term debt capital while the money market deals with raising of short-term debt capital. Together, they constitute the securities market. In this paragraph, we deal with various sub-segments of the capital market. Figure 1.4 depicts the securities market in general and the capital market in particular.

1.6.1 Primary and Secondary Markets The main segments of the capital market in terms of the type of capital raised are (a) the equity market and (b) the long-term debt securities market. However, since the capital market broadly deals with raising of capital on one hand and providing liquidity and trading between investors on the other, a more important way of classifying it would be as primary market and secondary market segments. While the primary market consists of resource mobilization by issuers from investors by the issue of new equity and debt securities, the secondary market consists of providing trading mechanisms and institutional support to create liquidity in stocks and securities. The instruments that have been issued in the primary market are sold and purchased constantly in the secondary market providing the investors with a

22

Investment Banking

SECURITIES MARKETS

Capital Mar ket

Money Mar ket

(market for long term securities in equity and debt)

(market for short-term debt products such as government paper, inter bank products, corporate debt and repo market.)

Secondar y Mar ket

Pr imar y Mar ket

(thr ough stock exchange tr ading)

(thr ough issuances)

1) Companies 2) Other bodies corporate

1) Government Securities 2) Corporate Debt

Wholesale Segment (Institutional Investors)

� Figure 1.4

Der ivative Mar ket

Debt Mar ket

Equity Mar ket

(Exchange traded instruments) 1) Options market 2) Futures market

Retail Segment (small investors)

Overview of segments in Securities Market

ready market, transparent pricing mechanism and liquidity for the securities. As can be appreciated, the primary and secondary markets complement each other in their functionality and one cannot exist without the other. While the primary market creates marketable securities, the secondary market provides the infrastructure for putting such marketability to work. Therefore this classification of the capital

Overview of the Indian Capital Market

23

market into primary and secondary markets is very fundamental understanding its structure. Since investment banking is associated with the primary market issuances, the discussion on primary markets has been provided separately in greater depth in Chapters 3 and 4.

1.6.2 Derivatives Market A third sub-segment of the secondary markets which has been of recent origin is the derivative segment that deals exclusively with over the counter products such as futures and options. These are specialized instruments meant for trading exclusively on a futuristic basis and help in speculation on the price movements of the underlying equity shares. They are known as derivatives since they are not shares by themselves but are instruments that are derived from shares. With the advent of the derivatives market in India, the equity trading in the normal segment has been strictly converted into cash trading based on delivery. All speculative and forward trading has been shifted to the derivative segment. The main categories of derivatives traded are futures and options. Due to this reason, the derivative market is also known as the F&O segment. Futures contracts are basically standardized exchange traded forward contracts for buying or selling a particular underlying asset (usually a share or other financial interest, commodity or currency) at an agreed price on a particular date. In Indian stock market, the system of futures was not prevalent but forward contracts in shares was being practiced under the name of ‘badla’. Under this system dealers in stocks could carry forward their positions from one settlement date to the next settlement date by paying a badla charge, which was basically meant to represent interest cost to the person carrying forward. This system drew rampant support from specialized badla financiers who used to finance such badla transactions. Though the badla system contributed to the growth of the stock markets, it was also responsible for several unhealthy practices such as excessive speculation and unfair market practices that proved to the detriment of the common investors. Therefore, in order to bring about healthy practices into the market, the badla system was abolished in the late nineties. Options however, have a different history in India. Simply put, an option is ‘a right to buy or sell an underlying asset on or before a specified date at an agreed price’. Therefore the option owner has the choice to buy or sell depending on the type of option purchased without being obliged to do so. Option contracts in securities were prohibited in India under section 20 of the SCRA and therefore,

24

Investment Banking

such contracts in securities could not be entered into. However, by an amendment to the SCRA in 1995, this section was omitted and the concept of derivatives was allowed in the stock market. Under the new section 18A of the SCRA, derivatives are permitted in Indian stock market if these are exchange-traded derivatives. Thus was born the F&O segment, which is currently being offered on the NSE and the BSE. With the advent of the derivative segment on the stock exchanges, the markets have now been clearly made into water tight compartments. The equity segment in the market deals with shares strictly on cash basis for delivery at the end of each settlement and no carry forwards are allowed. The F&O segment deals only with derivative contracts in shares and stock indices and thereby allows only speculative trades in derivatives. The debt segment deals with all kinds of debt securities issued by the government and corporate issuers.

1.7 Premier Stock Exchanges As mentioned earlier, India developed a system of multiple stock exchanges with a geographical spread covering almost the whole country during the development phase of the capital market post-independence. However, considering the rapid technological developments and changes in market mechanisms that have taken place in the past decade, the importance of regional stock exchanges has diminished to a large extent. This phenomenon can be noticed from the fact that the first big six stock exchanges in India accounted for 99.88% of the total trading turnover in 2001–02 while more than twelve regional exchanges reported nil turnover during that period. However, in terms of trading volume, the average daily turnover on Indian stock exchanges has grown from about Rs. 150 crore in 1990 to over Rs. 12,000 crore in 2000 and has recorded more than Rs. 20,000 crore on certain days. The diminishing importance of regional stock exchanges is brought out in Table APP 1.4. Readers may refer to this table in Appendix 1 at the end of the book. The country’s premier nation-wide exchanges are the National Stock Exchange which is the market leader followed by the BSE. While the BSE, Ahmedabad Stock Exchange and the Madhya Pradesh Stock Exchange are organized as non-profit associations, the rest of them are organized as companies either limited by shares or by guarantee under the Companies Act. The NSE is the sole exception, which has not been constituted as non-profit company. Given the fact that the stock market and stock broking profession were traditionally a preserve of a closed community of people, most stock exchanges were

Overview of the Indian Capital Market

25

constituted as mutual organizations wherein the trading members of the exchange were also the owners and constituted the management of the exchange. This also has certain tax benefits under the Income Tax Act 1961. A stock exchange is governed by a board of directors, which is elected by the members and a few government nominees. The Board is headed by a President who is elected from among the Board members and also requires a government approval. The operational aspects and day-to-day management are looked after by one or more executive directors.

1.7.1 The National Stock Exchange The NSE is the culmination of the recommendations made by a high powered study group that was set up to examine the issue of establishment of new stock exchanges in the early 1990s. The NSE was promoted in 1992 at the instance of the Government of India as a sponsored institution of the financial institutions led by IDBI, insurance companies and commercial banks as a nation-wide stock exchange with the objectives of: (a) providing access on equal and fair basis to investors across the country through efficient and transparent securities trading system, (b) provide shorter settlement cycles and book entry settlements, (c) to provide international standards in market mechanisms through appropriate technology and (d) to activate and promote a deeper secondary market for long term corporate and government debt paper. NSE is a tax paying company unlike the other stock exchanges in India. NSE received recognition under the SCRA from the Government of India in April 1993. It has three main trading segments—(a) the wholesale debt market (WDM) that started operations from June 1994, (b) the capital market segment (CMS) that started operations from November 1994 and (c) the derivatives segment that started operations in June 2000. The NSE is a fully system driven and automated stock exchange that allows its members to deal from their own premises as it does not have the concept of a trading ring. The system is order driven and not quote driven and provides trading terminals all over the country linked via satellite communication device. The WDM caters to institutional debt investors such as financial institutions, mutual funds, banks and FIIs and it deals in fixed income securities consisting of both long term debt paper such as dated government securities, PSU Bonds, corporate debentures, bonds of financial institutions and short term debt paper such as treasury bills, call money, commercial paper, certificates of deposit and repurchase options (repos). The trading volumes on the WDM have not been to the extent desired though it has been showing increasing trend in the past few years. The NSE recorded its all time high turnover in the WDM segment of Rs. 13,911.57 crore on

26

Investment Banking

August 25, 2003 while its previous highest turnover was Rs. 10,470.92 crore recorded on July 25, 2003 (Source: www.nse-india.com press release). The CMS deals with equity and equity related instruments such as convertible debentures of companies that have made issues in the primary market either on the NSE or other stock exchanges. Trading volumes in the equity segment have been growing rapidly with the average daily turnover increasing from Rs. 7 crore in November 1994 to Rs. 6797 crore in February 2001 with an average of 9.6 lakh trades on a daily basis. During the year 2001–2002, NSE reported a turnover of Rs. 513,167 crore in the CMS accounting for a 57% market share. The CMS offers real time quotes to traders and provides vast information on trading systems, clearing and settlement and risk management. According to the NSE Newsletter for April 2003, there are about 818 companies listed on the NSE. The derivatives segment of the NSE (the F&O segment) commenced operations by offering exchange traded derivative instruments such as index futures and registered a modest turnover of Rs. 4018 crore in the first year. The volumes increased to Rs. 103,848 crore in 2001–02. Index options were introduced in June 2001 followed by stock options and stock futures on individual stocks in the same year. The volumes have since then shown a significant increase with the introduction of index options in June 2001, stock options in July 2001 and stock futures in November 2001. The NSE accounts for most of the turnover in the derivative segment in India. The only other exchange that offers derivative trading in India is the BSE. The NSE recorded its highest ever turnover in the derivative segment on October 21, 2003 of Rs. 12,519.55 crore which was higher than the volume recorded a week earlier of Rs. 12,506.53 crore. Index futures recorded a volume of Rs. 3460.88 crore. Index options recorded a volume of Rs. 259.13 crore, Options on individual securities recorded a volume of Rs. 1175.92 crore, Futures on individual securities recorded a volume of Rs. 7623.61 crore (Source: www.nse-india.com press release). The NSE for the first time launched interest rate futures on the derivative segment on June 24, 2003, which are now available as exchange traded instruments. The NSE follows the NSE-50 stock index for measuring the performance of the market based on trades made on the exchange. It is a very complexly constructed index that reflects the price movement of fifty selected scrips (which have a market capitalization of Rs. 50 crore each) with respect to the base value of 1000 which was set on November 3, 1995. It is a value weighted index that measures the stock price movements on the basis of market capitalization of the selected scrips. Since the NSE was set up collaboration with Standard & Poor, the rating agency based in

Overview of the Indian Capital Market

27

USA and CRISIL in India for introducing index based derivative business in India, the NSE-50 has been rechristened the S&P CNX Nifty. The NSE introduced two other indices, the NSE Junior Index for mid-cap companies which is now known as the CNX Midcap (CNX Nifty Junior) and a dollar denominated index called the Defty which is now known as S&P CNX Defty.

1.7.2 The Stock Exchange, Mumbai (BSE) The BSE which was the only nation-wide stock exchange for a long time until the setting up of the NSE and the OTCEI has evolved over the years from a ring based exchange into a ringless screen based exchange today. It currently provides efficient trading systems for equity, debt and derivative segments across the country. The BSE had recorded an average daily turnover of Rs. 3984 crore during 2000–01 which was down to around Rs. 1100 crore during the first quarter of 2003–04 mainly on account of the removal of the forward contract system in share trading and the dullness in the secondary markets. The BSE has been the biggest exchange in the country in terms of fresh capital issuances and the number of companies listed on it. It also enjoys the distinction of permanent recognition from the Government of India. According to the BSE Key Statistics for March 2003, there are about 7338 companies listed on the BSE. Keeping in line with technological developments and the setting up of the NSE as a competitor with screen based trading, the BSE switched over from physical ring-based trading to screen-based ringless trading under the name of Bombay On-line Trading (BOLT) in 1995 which is a quote-driven system unlike the orderdriven system of the NSE. By July 1995, all the scrips traded on the BSE were shifted to BOLT system and currently, the BOLT system offers trading in all the three segments, i.e. equity, debt and derivatives. The BSE operates two stock indices—the widely followed BSE Sensitive Index (popularly known as the BSE Sensex) and the BSE National Index. The BSE Sensex has for generations been the barometer of the stock market in India and measures the movement of thirty selected scrips with respect to the base value of these scrips in the year 1978–79. It is a value-weighted index and measures the aggregate market capitalization of the chosen shares on a particular day with respect to their average market value in the base year. The BSE Sensex continues to enjoy significant patronage in India. This index is shortly being reset using market float of the selected companies as one of the value weightages.

28

Investment Banking

The BSE National Index is based on a broader sample of 100 scrips that are actively traded in five important stock exchanges in India; namely the BSE, Kolkata, Chennai, Delhi and Ahmedabad. This index has been set up with the reference to 1983 as the base year and is computed on similar lines to the BSE Sensex. The BSE introduced two further indices, i.e. the BSE National Index 200 and the Dollex with the base year as 1989–90. The Dollex is meant for foreign investors in the Indian market since it represents current as well as base year values in US dollars. On July 8, 1999 the BSE introduced the BSE-500, a new index with the base year as 1999. It consists of all the scrips of other existing indices, i.e. the Sensex, the National Index 100 and 200 and represents 23 major industries and 102 sub-sectors in the economy. These scrips have been selected carefully keeping in view their market capitalization, trading frequency of at least 70% on all trading days in a period of six months and trading volumes of an average of at least five trades a day during the six months. In addition to the above, the BSE has introduced sector specific indices such as BSE Infotech Index, BSE FMCG Index, BSE Healthcare Index, and the BSE Capital Goods Index to help investors to track the performance of individual sectors on the market.

1.7.3 The OTCEI The OTC Exchange of India was conceptualized on the lines of the NASDAQ of USA for small companies to get listed and to develop the first screen based trading system in India. The OTCEI is promoted by the Unit Trust of India, the Industrial Credit and Investment Corporation of India, the Industrial Development Bank of India, the Industrial Finance Corporation of India among others and is a recognized stock exchange. The OTECI set up the first nation-wide automated ringless and screen based market in India for stock trading. As a market, the OTCEI offers certain exclusive features such as listing for small companies with paid-up capital starting from Rs. 30 lakh and above and compulsory market making in scrips that are listed on the exchange. Trading in the listed segment is through the OASIS system, incorporating a hybrid trading method that combines the best features of the quote based and order driven systems. Besides the OTCEI also has a permitted category wherein scrips listed on other stock exchanges ar permitted to be traded on it. In spite of the high expectations with which it started off, the OTCEI never managed to take off in a big way and by the late nineties, it became more or less a

Overview of the Indian Capital Market

29

dormant exchange. The reasons attributed to its volumes and listings were: (1) there were stringent market making norms for sponsors bringing listings to the exchange, (2) no room for speculative activity since it is a cash market, (3) restriction on bidask spreads and (4) lack of financing arrangements for compulsory market making. There were two committees set up to review its workings, the Dave Committee and the Malegam Committee. Based on the Dave Committee recommendations, the exchange has planned new initiatives such as introduction of trading in shares of unlisted companies. The market for unlisted securities is quite active in the overseas markets such as in USA (PORTAL). This avenue is expected to benefit investors in unlisted companies to make exit without waiting for full fledged listing on the main stock exchanges. This is in turn expected to boost the financing of start-up and small companies.

1.7.4 The ISE The latest entrant into the system of screen based online trading is the Interconnected Stock Exchange of India Ltd., which is being dubbed as a futuristic exchange and has been promoted by fifteen regional stock exchanges to provide cost-effective trading linkage/connectivity to all the members of the participating exchanges. With the advent of on-line trading from the NSE and the BSE, regional stock exchanges have been facing an issue of survival for which the ISE seems to be the answer. The objective of the ISE is to widen the market for the securities listed on the participating exchanges. ISE is a national-level stock exchange and provides trading, clearing, settlement, risk management and surveillance support to its traders and dealers. While the bigger exchanges such as NSE and BSE cater to the larger companies and their own members, the ISE aims to provide level playing field to smaller companies in particular and to the brokers acting on regional stock exchanges ISE also aims to provide adequate infrastructure in terms of connectivity, state-of-the-art trading systems and transparent mechanisms to member stock exchanges so as to optimise their existence and promote regional markets. The ISE has been in business since February 1999 and its current trader membership includes about 200 brokers from participating exchanges. In addition, the ISE has around 500 dealers across 70 cities other than the participating exchange centres. With the aim of providing wider access to its members and dealers outside the interconnected regional market, ISE has also floated a wholly-owned subsidiary,

30

Investment Banking

ISE Securities & Services Limited (ISS), which has taken up corporate membership of the National Stock Exchange of India Ltd. (NSE) in both the Capital Market and Futures & Options segments and in the BSE Equities segment. The ISE thus provides the investors in smaller cities a one-stop solution for cost-effective and efficient trading and settlement in securities. ISE has set up clearing house facilities at various locations for the convenience of its traders and dealers. Settlements on the ISE are guaranteed its own Settlement Guarantee Fund. It has also registered the Stock Holding Corporation of India as its registered custodian for institutional trades. ISE has also set up direct connectivity with NSDL to facilitate settlements of securities in physical and dematerialized form as well.

1.8 Statutory Framework The capital market in India is regulated under the broad statutory framework of the Companies Act, 1956, the Securities Contracts (Regulation) Act, 1956, The Securities and Exchange Board of India Act 1992 and The Depositories Act, 1996. Besides, the relevant provisions of the Foreign Exchange Management Act 1999 and the Income Tax Act 1961 apply to securities dealt with on the capital market. The securities business is also affected by the provisions of the stamp law, both under the central stamp law (the Indian Stamp Act 1899) and the relevant state legislations. Lastly, the relevant provisions of the Benami Transactions (Prohibition) Act 1988 also regulate certain types of transactions in securities. The Companies Act 1956 concerns itself with the basic framework of law pertaining to the working of companies all other attendant matters. The provisions of this Act in so far as they are relevant to the capital market are listed below in Table 1.1. The preamble of the SCRA states that it is ‘an Act to prevent undesirable transactions in securities by regulating the business of dealing therein, by providing for certain other matters connected therewith’. The main provisions of this Act are listed below in Table 1.2. The SEBI Act was passed in 1992 to bring into existence the SEBI and provide it with wide powers including the power of adjudication and making rules and regulations relating to the capital market, working of stock exchanges, intermediaries associated with the capital market and for investor protection. Since its inception, the SEBI has issued several directions under section 11B and

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31

regulations under section 30 of the SEBI Act for the orderly development of the capital market.

Section No.

Matters addressed

Sec 3

Definition of a private company and prohibition for a private company to raise capital through issue of shares or debentures to the public

Sections 55–81

Prospectus and allotment and other matters relating to issue of shares or debentures

Sec 82–123

Law relating to shares and debentures

Sec 124–145

Registration of charges

Sec 154

Closure of the register of members and debenture holders

Sec 205–207

Dividends and manner and time of payment thereof

Sec 293

Restrictions on the borrowing powers of the Board

Sec 372A

Inter-corporate loans and investments

Sec 621A

Composition of offences

629A

Penalties where no specific penalty has been prescribed

� Table 1.1

The Companies Act, 1956

Section No.

Matters addressed

Sec 2

Definitions of important terms such as ‘contract’, ‘derivative’, ‘option in securities’, ‘securities’, ‘spot delivery contract’ and ‘stock exchange’.

Sections 3–12

Recognition of stock exchanges and working of recognized stock exchanges

Sec 13–19

Contracts and options in securities

Sec 21–22F

Listing of securities by public companies

� Table 1.2

The SCRA, 1956

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The Depositories Act was passed in 1996 to enable securities to be held and transacted in a scripless dematerialized form through book entries in electronic form. The advent of dematerialization has revolutionized security trading on stock exchanges by removing several bottlenecks that existed with the system of holding securities in physical form. This Act also provides for the orderly development of the depository and participant business and regulates them suitably. This Act has also made consequential amendments to other laws such as the Companies Act, the Stamp Act and the Income Tax Act to enable creation, holding and trading in dematerialized securities. The FEMA was enacted in 1999 as ‘an Act to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India’. Therefore, the main concern of the FEMA is preservation and proper utilization of foreign exchange for which regulation is prescribed on transactions relating to foreign exchange. The provisions of FEMA in so far as they are relevant to the capital market are listed below in Table 1.3.

Section No.

Matters addressed

Sec 2

Definition of ‘security’ and ‘transfer’.

Section 6

Transactions on capital account pertaining to transfer or issue of securities, borrowing and lending in foreign exchange and issue or acceptance of guarantees.

Sec 13—15

Contravention and penalties.

� Table 1.3

The Foreign Exchange Management Act, 1999

The Income Tax Act prescribes tax liability on certain transactions relating to securities. These are listed in Table 1.4.

Overview of the Indian Capital Market

Relevant parts/ Sections/Chapters

33

Matters addressed

Sec 10

Incomes exempt from tax

Part E of Chapter IV

Income from Capital gains

Part F of Chapter IV

Income from other sources

Chapter VIA

Deductions from total income

Chapter XII

Determination of income in special cases such as long term capital gains, foreign investors etc.

Chapter XIIA

Special provisions relating to non-residents

Chapter XIID/XIIE

Tax on dividends distributed by domestic companies

Chapter XIIF

Income received from venture capital funds

Part B of Chapter XVII

Deduction of tax at source

� Table 1.4

The Income Tax Act, 1961

1.9 Regulatory Authorities The regulatory authorities for the capital market in India directly or indirectly are the SEBI, the Central Listing Authority, the Department of Company Affairs and Department of Economic Affairs under the Ministry of Finance, Government of India, the RBI and to a certain extent, the Stock Exchanges.

1.9.1 The DCA The Department of Company Affairs (DCA) is the main regulator for compliance under the Companies Act by all companies and for prescribing rules and regulations for all capital market transactions to be made by unlisted companies. Some of the main areas wherein the DCA administers compliance inter alia are with respect to incorporation of companies, annual reporting by companies, registration of charges, allotments and refunds, acceptance of deposits, maintenance of statutory books including the register of members and debenture holders, holding of shareholder meetings et al. The Department of Company Affairs has three tier organizational set-up for administration of the Act, namely, the Secretariat at New Delhi,

34

Investment Banking

the Regional Directors at Mumbai, Kolkata, Chennai and Kanpur and the Registrar of Companies in States and Union Territories.

1.9.2 The DEA The DEA has under it the capital market division and the stock exchange division. The various Acts administered by the DEA are the SEBI Act, the SCRA, the Depositories Act, the Unit Trust of India Act (now a specified undertaking) and section 20 of the Indian Trusts Act (eligible investments that can be made by trusts). The capital market division has been entrusted primarily with the responsibility of formulation of suitable policies for the development of the capital market in consultation, inter-alia, with SEBI, RBI and other agencies. It acts as the secretariat for the high level co-ordination committee on financial and capital markets and deals with all organizational matters relating to SEBI, including appointment of the chairman and members of the SEBI board. Under the SEBI Act, 1992, the Ministry of Finance is represented on the SEBI Board. The Ministry of Finance is also represented on the primary and secondary market advisory committees of SEBI. Inputs on policy issues related to capital markets are provided through these channels as well. The powers under SCRA are concurrently exercisable by SEBI. The day to day regulation or monitoring of capital markets is the primary responsibility of SEBI. However, the Government interacts with SEBI and other agencies concerned on a regular basis, to oversee the developments with a view to taking action that may be required at the level of the Government. The DEA also issues necessary approvals under the FEMA wherever applicable for transactions relating to the capital market to be made by issuers or investors.

1.9.3 The SEBI The SEBI is the primary regulator of the working of the capital market in terms of new issues, listing agreements with stock exchanges, trading mechanisms, investor protection and corporate disclosures by listed companies. It functions under a full time Chairman appointed by the Government of India, two members of its Board appointed by one each by the Ministry of Finance and the Ministry of Law, one appointee of the RBI and two other appointees of the Government of India. The SEBI is headquartered in Mumbai and has regional offices in metro cities. The SEBI has different divisions looking after various segments of the capital market such as the Primary Markets department, the Secondary Markets department, the Stock Market department etc.

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35

The functions and powers of SEBI are prescribed under sections 11 and 11A of the SEBI Act. Section 11 provides that ‘it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit’. In addition to this overall general responsibility, the areas listed out for regulation by SEBI specifically include, � �

�

�

� �

�

Regulating the business in stock exchanges and any other securities market, Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with the securities markets in any manner, Registering and regulating the work of depositories, participants, custodians of securities, foreign institutional investors, credit rating agencies and such other intermediaries as the Board may by notification, specify in this behalf, Registering and regulating the working of venture capital funds and collective investment schemes, including mutual funds, Promoting and regulating self-regulatory organizations, Prohibiting fraudulent and unfair trade practices relating to securities markets, Promoting investor’ education and training of intermediaries of the securities markets,

�

Prohibiting insider trading in securities,

�

Regulating substantial acquisition of shares and take-over of companies,

�

�

Calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds, other persons associated with the securities market, intermediaries and self-regulatory organizations in the securities market, Performing such functions and exercising such powers under the provisions of the SCRA as may be delegated by the Government of India.

Considering the wide powers conferred on SEBI as detailed above, it becomes the most important agency regulating the capital market in the country. Its powers

36

Investment Banking

encompass the primary and secondary markets, the equity, debt and derivative segments and corporate disclosures and trading mechanisms of stock exchanges. Over the years, the SEBI has contributed significantly to the orderly growth and development of the capital market. Some of the landmark steps taken by SEBI in the reformation of the Indian capital market are highlighted below: 1. SEBI has issued a number of guidelines concerning various areas of the capital market with a view to promote their orderly growth and development and to curb unhealthy and investor unfriendly practices. These steps are also aimed at bringing transparency into the working of the capital market. Some of the important guidelines issued by the SEBI are: a. SEBI (Disclosure and Investor Protection) Guidelines, which were originally issued in 1992 and consolidated in 2000. These guidelines have been historic in nature because of several first time concepts introduced in the Indian capital market including the most talked about free pricing of shares that led to a virtual boom in the primary market in the mid-nineties. The DIP Guidelines have been discussed in detail in relevant chapters of this book. b. SEBI (Merchant Bankers) Rules, 1992 and SEBI (Merchant Bankers) Regulations 1992 to provide for the orderly functioning of the profession of merchant bankers. c. Providing for registration and regulation of intermediaries associated with both the primary and the secondary markets such as registrars and share transfer agents, bankers to issue, underwriters, credit rating agencies, debenture trustees, custodians, depositories and participants, brokers and sub-brokers, portfolio managers and others through issue of regulations. d. Issue of regulations to provide for the registration and orderly functioning of the mutual fund industry, the venture capital industry and other investment related activities such as collective investment schemes. e. Regulation of the activities of foreign institutional investors and venture capital investors. f. Formulation of a statutory framework for the prevention of insider trading and unfair trade practices in the capital market.

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37

g. Formulation of a code of conduct for the orderly take-over of companies through the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations 1997. These have been discussed in chapter 16 of this book. h. Issue of suitable guidelines on preferential allotments, stock options and share purchase schemes initiated by listed companies. i. Providing for a framework under which listed companies can buy back their shares with a view to reduce their capital. 2. Providing for an overhaul of the working of the stock exchanges in the country including trading mechanisms, market surveillance, risk management systems, administration and controls and even their constitution through the process of demutualisation of stock exchanges. These developments have been discussed further in subsequent paragraphs. 3. Introduction of a framework for derivative trading in India and provision for suitable risk management systems therefor. 4. Providing for better corporate disclosures, adherences to accounting standards and for adoption better corporate governance practices by listed companies by suitable modifications to the listing agreement entered into by stock exchanges with respective companies. 5. Setting up several committees to examine the practices in the capital market and suggest suitable changes in policy and procedural matters for the development of the capital market in line with international best practices. SEBI’s Strategic Action Plan (STA) has identified four key spheres and has set strategic aims for each of the spheres as shown below: The salient features of SEBI’s STA as per the Annual Report 2002–2003 for the year 2003–04 include: �

Development of self-regulatory organizations in various segments of the market.

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Investment Banking

Key sphere

Strategic aim

Investors

Investors are enabled to make informed choices and decisions and achieve fair dealings in their financial dealings.

Firms (Corporates)

Regulated firms and their senior management understand and meet their regulatory obligations.

Financial Markets (Exchanges, Intermediaries)

Consumers and other participants have confidence that markets are efficient, orderly and clean.

Regulatory regime

An appropriate, proportionate and effective regulatory regime is established in which all the stakeholders have confidence.

Source: SEBI Annual Report 2002–2003.

� Table 1.5

SEBI’s Strategic Action Plan

�

Disclosures for private placements of debt (listed).

�

Comprehensive review of market intelligence and surveillance systems.

�

Disclosure norms for debt issues by international multi-lateral agencies.

�

Concrete measures to enhance liquidity in the market.

�

Disclosures by market participants.

�

� �

�

�

Certification for various intermediaries in the securities market to bring in higher levels of professionalism. Physical settlement of derivative products. Cross margining between cash and derivative segments to economize the use of capital of the participants in the market. Introduction of new financial instruments like fund of funds and real estate funds. Policy formulation for issue of Indian Depository Receipts.

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39

1.9.4 The CLA The Central Listing Authority is a new body constituted by SEBI for the purpose of delegating its functions with respect to vetting of offer documents for public offerings in the primary market and for other functions connected therewith. As per the SEBI (Central Listing Authority) Regulations notified in August 2003, the CLA would function from the date notified by SEBI in this regard. As per regulation 8, the CLA shall perform the following functions: �

�

�

To receive and process applications for letter precedent to listing from applicants and issue, if it deems fit, a letter precedent to listing to any such applicant; To make recommendations to SEBI on issues pertaining to the protection of the interest of the investors in securities and development and regulation of the securities market, including the listing agreements, listing conditions and disclosures to be made in offer documents; To undertake any other functions as may be delegated to it by SEBI from time to time.

In the years to come, the CLA is expected to set standards in disclosure and investor protection, a subject that is probably the main mandate for SEBI and more importantly, to improve the quality of paper that comes into the primary market so that the capital market becomes a source of funds only to issuers with high levels of corporate governance and financial health.

1.9.5 The RBI The Reserve Bank of India is more of a money market regulator than so much of a capital market regulator. However, it has an indirect influence on the capital market as well. The following are the broad areas wherein the policy regulations of RBI can affect the securities market. �

The RBI regulates the activities of banks and financial institution and other financial intermediaries in regulating their exposure to capital market instruments more particularly, equity related instruments and corporate debt. The RBI has fixed a norm of 5% of total advances as the maximum limit up to which banks can have exposure to capital markets.

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Investment Banking

�

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�

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The RBI fixes the norms for regulating the flow of funds from the banking system to the securities market. More particularly, it regulates the flow of funds from banks and financial institutions into the equity market through financing against shares and other securities, provision of working capital to stock brokers, market makers and for other stock market activities. The RBI determines the treasury operations of banks and other financial intermediaries by stipulating fund management and valuation norms for their investments in the securities market. The RBI regulates the capital flows in the money market as part of its monetary policy to regulate the liquidity in the financial system. This is done through the system of repurchase options or repos as they are popularly called, by which the RBI sucks out excess liquidity in the system. The RBI conducts the borrowing programmes of the Government of India in the long-term debt market and the money market. The RBI determines the bank rate which is the basic interest rate in the economy at which the RBI borrows from banks. The bank rate has a bearing on other interest rates in the economy including the rates at which the capital market and the money market instruments are traded. The RBI is the regulatory authority that supervises the compliance with the FEMA as per the jurisdiction given to it under that Act. One of the main areas of such regulation that affects the working of the securities market is the flow of foreign funds. The RBI fixes norms and guidelines and also grants administrative approvals for foreign investors to invest in Indian securities markets. While the SEBI has been given the powers to frame investment guidelines for certain categories of foreign investors in the capital market that would be registered with SEBI, the RBI under FEMA has the powers to decide on regulation of other categories of foreign investors as well as on other policy matters relating to foreign investment. These aspects have been discussed further in detail in Chapter 2 and other chapters as well.

1.9.6 The Stock Exchange Though the stock exchange is not a regulatory authority but is a market body that is recognized by the Government under the SCRA, by virtue of the agreement that

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Overview of the Indian Capital Market

it enters into with each of the companies that are proposed to be listed on it, it wields some influence on such companies. This agreement is called the ‘listing agreement’. Therefore, though the stock market cannot regulate the primary market as such, it promotes discipline and adherence to corporate governance by listed companies thereby protecting the interests of the primary market in general and investors in particular. However, since the listing agreement is not a law but a contractual arrangement between the stock exchange and a particular company, it does not have the teeth of law. Nevertheless, the stock exchange can take steps to initiate action against defaulters as provided in the listing agreement. In extreme cases, the stock exchange can also enforce compulsory de-listing by such companies if so provided, in the listing agreement. The other area wherein a stock exchange influences market practices is in the development of fair and also transparent trading mechanism and also in enforcing payments from market participants without any defaults and bankruptcies. Several steps have been taken in recent times in this direction by stock exchanges at the instance of SEBI. The current trading mechanism and surveillance systems and risk management practices of stock exchanges are outlined in the following paragraphs. The following diagram, Fig. 1.5, depicts the various roles played by regulators in Indian securities market. The DCA ( MoF )

The SEBI

The DEA ( MoF )

The RBI

The SEBI Act, SCRA, Depositories Act

St. Exch.

Regulates monetary policy and public debt

Companies Act The CLA

Capital Mar ket

Listing. Agreement/ Secondary market.

Flow of banking funds, foreign investment

Listing, disclosures etc. The SEBI Act and rules, regulations and guidelines framed there under.

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Money Mar ket

Figure 1.5 Regulators in Indian securities markets

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1.10 Capital Market Intermediaries, Infrastructure and Service Providers As mentioned earlier in paragraph 1.5, capital market intermediaries consist of brokers, merchant bankers and market makers. Support service providers include— underwriters, custodians, depository participants, registrars, share transfer agents and debenture trustees. The infrastructure providers are the depositories who provide electronic connectivity so that securities can be traded and held electronically without the need for physical scrips. In this paragraph, we discuss the functions of stock brokers and sub-brokers, depositories and depository participants, custodians, share transfer agents, debenture trustees, credit rating agencies and portfolio managers. The roles played by primary market intermediaries such as Merchant Bankers, Market Makers, Registrars to issues, Underwriters and others are also discussed further in subsequent chapters.

1.10.1 Stock Brokers and Sub-brokers Brokers are considered to be the primary link between the securities market and the investors. The association of stock brokers with the stock exchanges is more than a hundred years old in India. The function of a broker is to deal on behalf of his clients who are the actual investors in the market. This is because actual investors cannot trade on the stock exchange directly and they can do so only through brokers who are members of the stock exchange. The broker either buys or sells on client account for a brokerage fee which is charged for every such deal made. Therefore, a broker’s service is that of an intermediary and is non-fund based. There were a total of 9519 registered brokers with SEBI as on 31st March 2003 out of which 3835 were corporate brokers. The corporate brokers on the NSE, BSE and OTCEI together constitute over fifty per cent of the total corporate brokers present in India. According to Rule 8 of the Securities Contracts (Regulation) Rules 1957, in order to become eligible to the membership of a stock exchange (and thereby be a broker), a person should have fulfilled certain requirements. The notable among them are to be an Indian citizen and be a minimum of 21 years of age, he or she should not have been adjudged insolvent or convicted of an offence involving fraud or dishonesty and such person should not be in any other business or employment after being admitted as a member. A company incorporated under the Companies Act is eligible to be admitted as a member if:

Overview of the Indian Capital Market �

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�

43

Such company is formed in compliance of the provisions of section 322 of the Companies Act; A majority of the directors of such company are shareholders of such company and also the members of that stock exchange; and The directors of such company who are members of that stock exchange, have unlimited liability in such a company.

SEBI has stipulated additional requirements for corporate members to be admitted in stock exchanges. It is also possible for a member of one stock exchange to seek multiple memberships in other stock exchanges based on the relevant guidelines issued in this behalf by the Stock Exchange division of the MEA, Government of India. In addition to the requirements stated above, under section 12 of the SEBI Act, no stock broker is permitted to buy or sell or otherwise deal in securities except under, and in accordance with the conditions of a certificate of registration obtained from the SEBI. For this purpose, SEBI has promulgate the SEBI (Stock-Brokers and Sub-Brokers) Regulations 1992. These regulations inter alia cast a responsibility on the stock brokers to maintain proper books of account and other records and adhere to a code of conduct as prescribed therein. The books of stock brokers are subject to audit by the stock exchange and inspection by SEBI. Apart from these requirements, brokers should also maintain a client database and have individual broker-client agreements drawn up and executed in the prescribed format. In addition to the statutory requirements enumerated above, the members of the stock exchange are bound by the bye-laws of that exchange and trading systems stipulated therein. The stock broking profession has been under a tremendous pressure for some years now on account of increased regulation on one hand and dwindling trading volumes on the stock exchanges on the other. Therefore, several stock exchanges have seen their memberships reduce over the years. A membership card on a stock exchange has also dropped in value from the astronomical prices that they had commanded during the stock market boom in the early nineties. Apart from brokers, sub-brokers have also been brought under regulation by the stock exchange and SEBI. A sub-broker, unlike the main broker, functions under the broker mainly for the purpose of marketing securities or soliciting broking business. Therefore, by definition, sub-brokers are not members of any stock exchange and are therefore not bound by its bye-laws. Since many times, the

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actual investors are in contact with the sub-broker and not with the member of the exchange, it would be difficult to protect their interests. In order to bring the sub-brokers under regulation as well, the SEBI regulations referred to above, now prescribe compulsory registration for sub-brokers as well. Under section 12 of the SEBI Act, no sub-broker is permitted to buy or sell or otherwise deal in securities except under and in accordance with the conditions of a certificate of registration obtained from the SEBI. Every broker has to maintain records of sub-brokers working under him or her and an agreement made with each sub-broker specifying the scope of authority and the responsibilities of the stock broker and the subbroker. Sub-brokers are also bound by a code of conduct stipulated under the above said rules and regulations.

1.10.2 Depositories and Participants The depository system in securities dealing is the culmination of a long felt need in the securities market in India for a reliable and efficient way of handling security dealings. The securities markets in the developed countries have been on the ‘dematerialized’ mode for quite some time now while the lack of it in Indian market was perceived as a major infrastructural bottleneck for the future development of the market. For several decades, the Indian market was dependent on holding of securities and dealing in them through the physical form wherein certificates were printed and issued to investors evidencing their title to such securities. Whenever these were traded, they were sent to the issuing company for transfer in the name of the transferee along with a share transfer deed signed by the transferor. This system depended heavily on physical handling and transportation of securities through postal department and other means. This resulted in several bottlenecks such as delay in transit, bad deliveries due to non-matching of signatures or other technical errors, loss in transit and issue of duplicate share certificates, additional paper work in verification of signatures and other details and more importantly, the menace of duplicate share certificates floating in the market leading to loss of investors’ confidence in the system. The duplicate share scandal that rocked the stock market in the mid-nineties is a fall out of the physical handling system. One way of eradicating the ill-effects of physical handling of securities is to convert them into electronic form and deal with them through electronic transfers much the same way as electronic fund transfer has eliminated actual transportation and dealings in physical currency. Such a method of conversion of physical securities into

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electronic form is known as ‘dematerialization’. The conversion of it wherein electronically held securities are re-converted back into their physical form is known as ‘re-materialization’. Both de-materialization and re-materialization can be made possible with the existence of a ‘depository’, which is the central agency that maintains electronic records of securities. In the depository system, the holding and trading of the securities is in scripless form (without physical certificates). In addition, unlike in the physical system, in the depository system, the securities become fungible, i.e. the securities do not have individual existence through distinctive numbers. There are two types of depository models that are in existence—the de-materialization model and the immobilization model. While in the former method, physical certificates are completely destroyed and securities are held electronically, in the latter case, the physical securities are held in safe custody by the depository and the records of holdings and trades are maintained electronically. The de-materialization system being more cost efficient and convenient has been therefore adopted in India. Depository system was introduced in India with the passing of the Depositories Ordinance in 1995 which was later replaced with a full-fledged Depositories Act in 1996. This law provided the statutory framework under which depositories and dematerialized trading could take place. This law also provides for more than one depository to be set up in the country in order to promote healthy competition in the industry. However, since depositories are essentially public institutions that provide infrastructural support to the securities market, it would be essential for them to have shareholding upto 60% by stock exchanges, banks and other eligible sponsors. The eligible sponsors for a depository are a financial institution or a bank, a foreign bank operating in India, a recognized stock exchange, any body corporate promoted by the above institutions and providing financial services in which they hold not less than 75% equity, a foreign body corporate engaged in custodial or settlement services or financial services abroad and approved by the Govt. of India, a registered custodian, a clearing corporation or clearing house of a stock exchange and a registered stock broker. There is a cap of 20% for foreign shareholding. Considering the fact that depository business is capital and technology intensive, SEBI has fixed Rs. 100 crore as the minimum capital base for a depository. Presently there are two depository institutions functioning in India—the National Securities Depository Limited (NSDL) promoted by the IDBI, UTI and the NSE as a company under the Companies Act on June 7, 1996 and the Central Depository Services Limited promoted by the BSE and Bank of India in February 1999. Under

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the provisions of the Depositories Act, every depository has to be compulsorily registered with SEBI. For this purpose, SEBI has issued the SEBI (Depositories and Participants) Regulations, 1996. These regulations provide for registration of depositories and depository participants, rights and obligations of depositories, participants, issuers and beneficial owners and attendant matters. The Depository Act has also made consequential amendments to other laws affecting the securities business so as to enable electronic transfers of securities to be recognized under those laws. The electronic holding of securities under this system has also been exempted under the provisions of the Benami law. The Depositories Act provides for the following: 1. Creation of beneficial interest in a shareholder by the depository and the depository shall be treated as the registered owner of the shares for the purpose of effecting the transfer of ownership of the shares on behalf of the beneficial owner. 2. Voting rights shall still vest with the beneficial owner and not with the depository. 3. The beneficial owner continues to enjoy all the rights and liabilities on the shares. 4. The beneficial owner can create pledge or security on dematerialized shares. The depository shall create a record of such security creation on the shares which shall serve as a legal evidence. Under the depository system, all types of securities such as shares, bonds, stock, debentures or any other marketable security, units of mutual funds, collective investment schemes, venture capital funds, commercial paper, certificates of deposits, securitized instruments, money market instruments, government securities and unlisted securities. The Depository system works with the following structure: �

�

Depository (presently either NSDL or CDSL) which keeps the electronic ledgers for the securities of all issuers that are listed in the stock market. Depository Participant (DP) who acts on behalf of the depository as an agent and becomes the interface between the investor and the depository. According to SEBI guidelines, eligible institutions that can be registered as participants include financial institutions, SFCs, banks, custodians, clearing corporations of stock exchanges, stock brokers and NBFCs. The DP maintains

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individual transaction ledger of each investor who has opened an account with such DP for all security dealings made by such investor. In order to keep track of investors and DPs, each DP is provided with a unique identification number by the depository and each investor who opens a demat account with a particular DP is also provided a unique investor number. �

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�

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The Issuer company in the case of a fresh issue of securities and all existing listed companies in the case of existing securities need to enable dematerialized trading in their shares or other securities. For this purpose, they enter into an agreement with the concerned depository. The registrar to the issue in the case of a fresh issue should also enter into an agreement with the depository for enabling issue of the proposed securities in a dematerialized form. Usually, a tripartite agreement is drawn up involving the issuer, the registrar and the depository. Clearing members who are members of the clearing corporation that handles the clearing operations of security deals in an electronic form Clearing corporations that are institutions in the business of handling clearing operations for respective stock exchanges. The beneficial owners who are the real investors in securities. In the depository system, the depository is the registered owner of the shares in the register of members maintained by the issuer company while the real investors are the beneficial owners whose details are kept by the depository participants.

The process of de-materialization and re-materialization of securities and electronic dealing therein happens entirely through system connectivity in electronic medium between the market participants in the depository system such as the—Depository, the DPs, the clearing corporation of the stock exchanges, the registrars to new issues and the share transfer agents or the share transfer departments of respective issuers. While de-materialization is initiated through a de-materialization request form (DRF) by the beneficial owner, re-materialization happens similarly with the beneficial owner initiating the re-materialization request form. Similarly transfers resulting from buy or sell transactions or otherwise are initiated by the sellers by issuing a ‘delivery instruction’ which is an instruction to the DP to reduce the stated number of shares from the seller’s account. The delivery instruction thus becomes the basis on which the securities get transferred from the seller’s demat account to the buyer’s demat account (either with the same DP or another DP) by routing the transaction through the clearing corporation and the depository.

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1.10.3 Custodial Services A custodian as defined in the SEBI (Custodian of Securities) Regulations, 1996 is a person carrying on the business of providing custodial services which relate to the safekeeping of securities of a client and providing services incidental thereto such as: �

Maintaining accounts of securities of a client

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Collecting the benefits or rights accruing to the client in respect of securities

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Keeping the client informed of the actions taken or to be taken by the issuer of securities, having a bearing on the benefits or rights accruing to the client, and Maintaining and reconciling records of the services referred to above.

The Regulations provide for a minimum networth requirement of Rs. 50 crore for custodians and for compulsory registration. The other requirements include general obligations such as—adherence to the code of conduct, maintenance of separate accounts with respect to each client, entering into an agreement with each client, maintenance of records and documents and also furnishing of periodic information.

1.10.4 Share Transfer Agents Share Transfer Agents (STA) are service providers who maintain ledger records of all shareholders of a company and of transfers in shares arising out of day to day trades on stock exchanges with respect to such company’s shares on an on-going basis. The shares of a listed company are traded on a daily basis on the stock exchange which results in a frequent updation of records of shareholders and the register of members. Therefore, it becomes a specialized service and is often outsourced by several listed companies. The business of a STA is clubbed with that of an issue registrar by all the service providers since it is a logical extension thereof. However, this is not mandatory and these businesses can be carried on separately if so desired. The business of a STA is regulated by the SEBI (Registrars to an Issue and Share Transfer Agents) Regulations (1993). These regulations provide for compulsory registration, minimum capital adequacy requirements, general obligations and responsibilities such as maintenance of books and records and more importantly, appointment of a compliance officer. The role of a compliance officer of a STA is to monitor the compliance of all statutory requirements either issued by SEBI or the Government for addressing the investors’ grievances. The compliance

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officer has a reporting responsibility as well to SEBI, of any non-compliance observed in the operations of the STA.

1.10.5 Debenture Trustees The concept of trustees being appointed to address the interests of investors in debentures which are basically long term debt instruments issued by companies has been in vogue for sometime. Initially, it was the commercial banks which used to take up this function and later on financial institutions such as the ICICI (now ICICI Bank), IFCI and IDBI entered the fray as well. The task of a debenture trustee is shaped quite clearly and is essentially a support service function. Since debentures holders are normally many who cannot be expected to safeguard their rights individually, the trust structure is evolved whereby the assets that are required to be secured for the debentures are secured in favour of the trust. The debenture trustee is appointed to administer the trust mechanism in the interests of the debenture-holders who are made the beneficiaries to the trust. The whole structure is executed through a debenture trust deed or a trusteeship agreement which provides for terms and conditions that govern the issue of the debentures, creation of security, enforcement thereof in case of default and other provisions intended to protect the interests of the debenture holders. The debenture trusteeship business is regulated under the SEBI (Debenture Trustees) Rules 1993 and the SEBI (Debenture Trustees) Regulations, 1993. These provide for compulsory registration of persons acting as debenture trustees and for responsibilities and obligations thereof. There is also a code of conduct prescribed for the performance of this function. There were 35 debenture trustees in business as on 31st March 2003 as per SEBI Annual Report 2002–2003.

1.10.6 Credit Rating Agencies Credit rating is an independent third party assessment of a particular security issue by an issuer with the purpose of conveying to the investor the expected capacity and inclination of the issuer to service the issue obligations based on quantitative and qualitative appraisal of the issuer. In other words, credit rating assesses issuespecific default risk associated with an instrument to be subscribed to by an investor. Though internationally, credit rating services have been in vogue, they have been offered in India only in the past 15 years. Internationally, the US based Standard & Poor and Moody’s are the largest credit rating agencies. In India, credit rating was

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kicked off with the setting up of Credit Rating Information Services of India Ltd. (CRISIL) in 1988 as a jointly promoted company of ICICI, UTI, GIC and LIC. The other shareholders of CRISIL are the Asian Development Bank, SBI, the Mitsui Bank, Bank of Tokyo, HSBC and the HDFC. The second institution to come up in this service area was the IFCI which promoted the Investment Information and Credit Rating Agency of India Ltd. (now known as ICRA Ltd.) in 1991. Later on the IDBI promoted Credit Analysis and Research Ltd. as the third rating agency in 1993. Currently, two other foreign rating agencies, Duff & Phelps and Fitch offer their credit rating services in India. Credit rating is both a one-time and a continuing process as the rating is specific to certain parameters considered at the time of rating. Since most parameters are variable, the rating agencies usually have an annual review of the ratings issued by them for which an annual fee is charged. Rating can be specific to a financing instrument or a proposed financing structure. In the latter case, the rating is issued for the structured obligation. Ratings are designated through symbols adopted by each rating agency and these ratings have been made mandatory in several issues in the capital market by SEBI. Like any other capital market related service, credit rating is also regulated by the SEBI under the SEBI (Credit Rating Agencies) Regulations 1999. These regulations inter alia provide for the following: � �

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The credit rating agency shall be subject to compulsory rating from SEBI. The promoters of a credit rating agency shall be either a financial institution, a scheduled commercial bank, a foreign bank approved by the RBI in India, a foreign credit rating agency having a minimum experience of five years in this business and any other body corporate with a minimum networth of Rs. 100 crore. Rating agencies are subject to a code of conduct and the general obligations associated with the rating business as stipulated in the regulations. There are provisions to prevent conflict of interest by preventing a rating agency from rating of issues made by the promoter of such a rating agency.

1.10.7 Portfolio Managers The term ‘Portfolio’ means the total holdings of securities of a person which shall include shares, scrips, stocks, bonds, debentures, debenture stock or other

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marketable securities of a like nature in or of any incorporated company or other body corporate, Government securities and rights or interest in such securities. A Portfolio manager is a person who pursuant to a contract or arrangement with a client, advises or directs the client or undertakes on behalf of such client, the management or administration of a portfolio of securities or the funds of the client as the case may be. A discretionary portfolio manager means a portfolio manager who exercises or may, under a contract relating to portfolio management, exercise any degree of discretion in respect of the investments or management of the portfolio of securities or the funds of the client, as the case may be. The portfolio manager shall individually and independently manage the funds of each client in accordance with the needs of the client in a manner, which does not resemble a Mutual Fund. A non-discretionary portfolio manager shall manage the funds in accordance with the directions of the client. The portfolio manager charges a service fee by way of a percentage of the corpus managed which usually ranges between 100 basis points to 150 basis points. A Portfolio manager provides the following services: 1. Conducts in-depth research into corporate performance with a view to visualizing good investment opportunities. 2. Invests the clients’ money judiciously in a diversified portfolio of shares, debentures etc., to form a rewarding package for the client. Generally, portfolio managers target an annualized return of around 20–25%. However, the SEBI requirements expressly prohibit portfolio managers from promising assured returns to clients. 3. Monitors the portfolio and tracks corporate and market developments. 4. Arranges for lodging of securities for transfer and for custodial service in case of physical shares. In addition, he also maintains the file of the client’s investments with the background papers on all transactions which form the basis for filing tax returns. 5. Provides tax management services on investments. 6. In the case of portfolio management for non-residents, the portfolio manager takes care of the following additional matters as well: �

Obtaining permissions from the RBI whenever necessary on behalf of the client for making investments.

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�

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Opening and handling bank accounts under a General Power of Attorney in order to operate such accounts for the purpose of portfolio management. Arranging for repatriation of funds as and when necessary. Filing statutory returns with the authorities from time to time under the Income Tax Act and other laws.

Portfolio managers are subject to regulation by SEBI under the SEBI (Portfolio Manager) Rules 1993 and the SEBI (Portfolio Managers) Regulations 1993. Under the Rules, it is mandatory for every portfolio manager to be registered with SEBI as such, unless such person is already registered with SEBI as a category I or II Merchant Banker. Under the regulations, portfolio managers need to have a minimum capital base of Rs. 50 lakh. In addition, they are also subject to general obligations and responsibilities, maintenance of books of account and records, submission of information to the client and submission of financial results to SEBI on a halfyearly basis. The portfolio manager has to maintain separate accounts of each client with details of all transactions. The information to be furnished to clients shall be in the form of periodical reports (not exceeding 6 months) showing the composition and value of the portfolio with details of all securities, transactions undertaken in the period of reporting, details of beneficial interests received during such period, expenses incurred for the services rendered and also details of risk foreseen with respect to the scrips in the portfolio or those that are recommended by the portfolio manager. A portfolio manager, before taking up an assignment, shall enter into an agreement with the client. This agreement has to clearly define the inter se relationship between both the parties and shall provide for the following: �

The investment objectives of the client and the nature of services to be provided by the portfolio manager.

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Areas of investment and restrictions if any, imposed by the client.

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Attendant risks involved in the management of the portfolio.

�

Period of agreement and termination clause.

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Quantum of amount to be invested.

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Procedure for settling client’s account including form of repayment on maturity or termination of the contract.

Overview of the Indian Capital Market �

Fees payable to the portfolio manager.

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Custodial services.

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A portfolio manager shall, at the time of entering into the contract with his client, obtain from such client in writing, his interest in various corporate bodies which enables him to obtain unpublished price sensitive information about such corporate bodies. The portfolio manager shall maintain a separate bank account with a scheduled bank for all funds received from clients. The portfolio manager shall act in a fiduciary capacity with respect to the securities and the funds handled by him on behalf of the client. For e.g. any inter se dealings between the portfolio manager and the clients shall be made at market prices. The portfolio manager is also not allowed to surpass beyond the stipulated authority issued to him under the agreement with respect to the nature of securities he can deal with and the type of contracts he can enter into. For e.g. the portfolio manager cannot deal in derivative instruments unless expressly empowered to do so. In any case, derivatives have not been permitted under the PMS regulations so far.

1.10.8 Statistics of Intermediaries, Infrastructure and Service Providers The position of capital market intermediaries and service providers in India is provided in Table APP 1.5. Readers may refer to this table in Appendix 1 included at the end of the book.

1.11 Important Developments in the Indian Capital Market The Indian capital market has undergone a sea change in the past decade or so due to several structural changes brought about by the reformist regime post-1991 as well as due to the deepening of the securities market. The advent of SEBI has metamorphosised the role of capital market in the economy and the Indian capital market now stands comparable in some features to the developed markets of the world. Herein, we trace some of the important developments that have shaped the capital market in recent times.

1.11.1 Stock Exchange Reforms The process of stock market reforms got a major kickstart with the recommendations given by the High Powered Committee (G.S. Patel Committee) set up by the

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MoF, GoI in the eightees for making structural reforms in the constitution and other matters relating to stock exchanges and other wide ranging matters relating to capital market. The setting up of SEBI was also a result of the above initiative. After SEBI was set up, most of the reform activity has come within its purview by virtue of section 11 of the SEBI Act. One of the important concerns for SEBI has been the fact that most stock exchanges are owned, controlled and managed by the brokers. Corporatization of stock exchanges on a uniform basis all over the country is necessary so that ownership of the exchange, management and trading interests are separated. This process known as ‘Demutualization’ has gathered momentum after the Justice Kenia Committee appointed by SEBI laid out the roadmap. This process has also been given an impetus through tax breaks announced in the Budget for 2003–04. With this process, stock exchanges would be converted into companies under the Companies Act wherein shareholding, membership and management of the stock exchange would not be inter-linked. Preceding the constitutional change of the stock exchanges, an important change has taken place in the constitution of the broking businesses. Broking firms and sole proprietorship concerns have been given encouragement to corporatize themselves by converting into companies registered under the Companies Act. To facilitate this process, suitable changes have been brought about to the SCRA as well as to the byelaws of the stock exchanges and these have been backed up by tax breaks in terms of a one-time exemption from capital gains tax arising out of such a conversion. By March 2003, about 40% of the brokers registered with SEBI were corporate entities. Corporatization would make broking businesses more transparent and also enable them to function with the advantage of limited liability. Apart from this facility, multiple memberships of stock exchanges have also been permitted after the advent of SEBI. Another important development has been to allow Indian stock exchanges to set up trading terminals abroad for the benefit of non-resident portfolio investors. This would benefit the foreign institutional investors and non-resident Indian community to trade in Indian stocks from their own places on a real time basis. Other important developments in the area of stock exchange reforms have been the following: �

Regulating the business of all brokers and sub-brokers with compulsory SEBI registration, adequate documentation between brokers and clients

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and sub-brokers, maintenance of books and records, monitoring and inspection by the stock exchanges and adherence to a code of conduct. �

Capital adequacy norms for brokers.

�

Restructuring of the governing boards of stock exchanges.

�

Compulsory audit of the books of stock brokers.

1.11.2 Capital Market Reforms With the advent of SEBI, several landmark initiatives have been undertaken in reforming both the primary and the secondary markets. The markets are now more investor-friendly and technology-oriented thereby becoming transparent and responsive. The equity cult has spread far and wide and investor community has multiplied significantly so as to be reckoned as a major force in the capital markets. One of the main transformations that have been witnessed in the past decade has been the gradual institutionalization of the secondary market investor community. Today, the markets have significant institutional investors in the form of Mutual Funds, foreign institutional investors and others who form a community of informed investors. Due to their presence, market discovers better prices for securities based on fundamentals and economic factors rather than being driven by mere speculation based on the rumour mill or grapevine. The institutional market has also promoted tremendous amount of market analysis and research on a continuous basis to track every single development that can be price sensitive. The Mutual Fund industry that took shape in a small way before the advent of SEBI was provided an orderly growth with the introduction of the Mutual Fund guidelines by SEBI. Mutual Funds are now regulated in both fund raising and fund deployment by the SEBI. The Mutual Fund industry has now been pushed a step forward into off-shore markets by being allowed to float off-shore funds to invest in those markets. SEBI has been constantly trying to fine tune the working of this industry by setting up several committees to examine several aspects of their working. The P.K. Kaul Committee set up to examine the manner of discharge of responsibilities by the trustees of Mutual Funds is a case in point. SEBI has also brought the working of the collective investment industry under its regulation and set up the S.A. Dave Committee to frame the guidelines for collective investment schemes. This was also enabled by the necessary amendments made to the SCRA. Similarly, the advent of foreign institutional investors in the Indian capital market has been a landmark development as well. Currently, these investors have

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a strong influence on the market. A third dimension has been the re-invention of the venture capital industry with the formulation of fresh guidelines by SEBI to widen the horizon of activities by such investors. SEBI has also introduced mechanisms whereby foreign venture capital investors can invest in India. Based on the recommendations of the K.B. Chandrasekhar Committee, several changes have been made to the existing guidelines on venture capital activity. The market has also witnessed a significant number of investors in the private equity area. As far as primary market reforms are concerned, SEBI has brought in voluminous guidelines in the form of the DIP guidelines that prevent fraudulent and fly by night operators from accessing the capital market. Disclosure norms have been introduced so that investors can take informed investor decisions. In order to reward well-performing companies, free pricing was introduced in 1992 which spurted primary market activity thereafter. Price discovery mechanism has also been brought in through the process of book building. In order to move towards the next generation of stock issuances, public offers have been made compulsory in dematerialized mode and recently, guidelines have been issued for internet based public offers as well. On another footing, innovative structures such as employee stock options, employee share purchase and sweat equity have also been introduced. On the front of integration with global markets, Indian companies have been allowed to list on foreign bourses through the depository mechanism with two-way fungibility. De-listing of companies on their own volition has been made an investor-friendly mechanism by providing for compulsory exit route to investors on the basis of the recommendations made by the Dr. Chandratre Committee. Equity re-purchase or share buyback as it is popularly known, has been allowed for Indian companies which was a long standing demand of the corporate sector. Another important development that has had a major impact on the corporate sector and consequently on the capital market, has been the introduction of a framework for corporate takeovers and acquisitions. Prior to the SEBI introducing the ‘takeover code’ as it is popularly known as, corporate raids have been loosely regulated through clause 40 of the listing agreement with the stock exchange. Similarly, mergers between companies were unduly restricted under the MRTP Act. This situation led to very few corporate re-organizations and industry consolidations in India. However, with the advent of the takeover code, such activity has picked up and is being conducted in an orderly and investor-friendly manner. The above developments in the capital market have been discussed at length in subsequent chapters in this book.

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One of the most important structural changes that has been brought about in the secondary equity market has been the separation of the cash market from the forward market and the complete withdrawal of all deferral products from the equity segment in a stock exchange and transferring them to the derivative segment. The removal of the age old ‘badla’ system of forward dealing in the equity market has been an achievement of sorts since it had met with stiff resistance from the broking community and the market remained dull for a very long time after the withdrawal of the badla. By separating the cash market from the forward market in equities, a more congenial atmosphere has been introduced whereby investors can take clear positions based on their appetite for risk. Based on the recommendations of the L.C. Gupta Committee, derivatives have been introduced with suitable amendments to the SCRA. By the introduction of exchangetraded derivative products such as futures and options, a mechanism for trading in speculative instruments has been created with adequate institutional safeguards for risk and default. The market is also now largely supported by revolutionary changes in systems and communication technologies which support such large scale integration. Some of the important recommendations of the L.C. Gupta Committee for derivative trading that were accepted by SEBI are listed as below: �

� �

� �

�

�

Phased introduction of derivative products with stock index futures as the starting point. Amendments made to the SCRA to allow derivative trading. Permission given to stock exchanges for derivative trading based on their meeting the criteria relating to infrastructure requirements, on-line trading and surveillance systems and also having a minimum strength of 50 members for the derivative segment. Annual inspection of derivative traders by stock exchanges. Clearing corporation or clearing house to provide settlement facilities and absorb counterparty risk. There should be a two-tier membership for traders and clearing members and the clearing members should have stricter eligibility criteria. Model risk agreement to be in place and stock exchange should introduce certification training courses for the employees of dealers.

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�

Allowing institutional investors in the derivative segment based on approvals of their Boards and in the case of Mutual Funds, with adequate disclosures to investors.

Almost all market intermediaries such as Brokers and Merchant Bankers, supportservice providers such as—Registrars, Share Transfer Agents, Custodians, Underwriters, Portfolio Managers, Debenture Trustees, credit rating agencies and infrastructure providers such as—stock exchanges, depositories and participants have been brought under compulsory SEBI registration, capital adequacy and monitoring mechanism to regulate their activities. Despite the development of the market, there are many illiquid scrips in the market that are either traded thinly or not traded at all. A market maker is a person who provides liquidity in individual scrips by offering to quote bid or ‘buy’ price and ask or ‘sell’ price. Therefore, a market maker creates and sustains a market in securities by providing two-way quotes. To be a market maker, such a person has to be willing to buy or sell as the case may be, at all times despite there being no other such offers in the market. In the days of trading in the ring, this task of making the market was being performed by jobbers. However, since a jobber’s profits were made in the bid-ask spread, jobbers could not provide continuous market making. With the advent of screen-based order driven system, the role of jobbers is greatly diminished. Unlike the activities of the specialists in the NYSE, the jobbers in the Indian market have never been regulated. The SEBI set up the G.P. Gupta Committee to examine the issue of market making to provide liquidity for thinly traded shares. The committee recommended that the shares could be classified as liquid or illiquid and the market making facility should be adopted for illiquid shares. The committee felt the need for guidelines to be issued for market makers keeping in mind the risk exposures and capital adequacy for such market makers so that quotes could be generated by them on a continuous basis. Incidentally, the London stock exchange adopted a similar system when it switched over to screen-based trading. Among other things, SEBI set up a Committee in 1998 for the certification and testing of persons joining the capital market intermediaries. The objective is to improve capital market practices by stipulating entry barriers so that better qualified persons can enter capital market related activities. The committee opined that an examination-based certification was suited to the Indian capital market. These recommendations were accepted by SEBI. Presently all agencies in the capital market including

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the—SEBI, NSE, NSDL, AMFI (Association of Mutual Funds of India), FIMMDA (Fixed Income Money Market Dealers Association of India) and others require certification for capital market personnel. Others such as the AMBI (Association of Merchant Bankers of India) are putting in place such certification requirements.

1.11.3 Trading Mechanisms As far as trading mechanism in the Indian stock markets are concerned, there has been a paradigm shift in recent times. The two main features that have shaped the current stock market trading have been—(a) the introduction of ringless on-line screen based trading in all stock exchanges and (b) the dematerialization of securities so that scripless electronic trading can happen through the depository system. Currently, more than 99.8% of delivery based trades in the cash markets are being conducted in the dematerialized mode. As per the NSDL Newsletter dated 9th May, 2003, 4803 companies had signed up with NSDL out of which 4761 companies were on dematerialized mode. The system of on-line screen based trading was introduced for the first time with the setting up of the OTCEI and subsequently the NSE. Under the earlier system, stock exchanges had trading rings in which brokers used to make deals under the open outcry system by calling out their orders and matching them with replies received from the counterparty. For this purpose, there used to be trading counters where interested brokers could assemble for trading particular scrips. However, with the advent of the screen based system, trading rings have disappeared completely and brokers can now access the market from their offices nation-wide through their trading screens. The system followed for this purpose is order driven (electronic limit order book system) wherein an order can be placed for the purchase or a sale of a particular scrip by specifying the quantity and a particular price or at the best market price possible. The system then activates a search and automatically matches the given order to available alternatives. The unmatched orders are then displayed on the screen. In the BSE, online trading system called BOLT (Bombay On-Line Trading) was initiated on 14th March 1995. The process of switchover was completed within four months. The BOLT system is a quote-driven facility with an order book being used as an auxiliary function, which helps in—(a) retention of the order book until a suitable quote is available and (b) improving prices in the market. In the NSE, the on-line trading system is called NEAT (National Stock Exchange for Automated

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Trading) which is a nation-wide screen based order-driven system. It operates on the priority of price and time and does not disclose the identity of the traders. The trading screen provides real time information on all variables in the market. There are 7338 companies listed on the BSE (March 2003) and 818 on the NSE (April 2003) as per the stock exchange sources. Both the exchanges have continuous trading hours from 09.55 hours to 15:30 hours. On a different footing, the cost of transactions has come down drastically in recent years from the abnormally high brokerage costs and jobber’s spreads of earlier years. On an estimated basis, the transaction costs have come down from 5% to around 0.50% with the additional feature of the absence of any counterparty risk. SEBI has permitted trading on stock exchanges through the internet mechanism under the Order Routing System through registered stock brokers acting on behalf of their clients. Investors can trade from their computerized screens by logging on to trading facilities offered through internet websites. The brokers who offer such facilities have to ensure safety of the data and adopt suitable security systems through the encryption technology. Brokers have to enter into agreements with clients and prescribe trading limits for each of them. Stock exchange surveillance has to be ensured that brokers have adequate system controls to check exposure limits to each client.

1.11.4 Settlement Systems The word ‘settlement’ in the context of stock exchange trading represents the mechanism whereby the trading accounts of the brokers in the stock exchange are settled inter-se by squaring up mutual positions and making payments and taking delivery of shares for the net outstanding positions of each broker. The settlement process being lengthy and arduous was therefore conducted through the clearing house in the stock exchange wherein clearing members of the exchange used to conduct the process manually. In order to make the settlement process orderly, pre-fixed settlement dates and settlement numbers were used to identify the different settlement blocks from one another and their respective settlement dates. The settlement happens by the brokers depositing the scrips meant for delivery on the ‘Pay-in’ date and receiving their due amounts on the ‘Pay-out’ day. Since the cash market and the forward market were equal, a system of carry forward known as the ‘badla’ (referred to earlier) was being used to allow traders from carrying forward their positions from one settlement to another by paying a badla charge to the counterparty or to

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a badla financier. The badla charge could be either a ‘Contango’ or a ‘Backwardation’ charge depending upon whether the delivery of shares was to be given or taken. With the help of the badla, a trader could avoid either taking delivery of shares and paying for them on the delivery date or making delivery of shares sold and receiving the payment as the case may be. The badla was therefore considered a forward contract which was not an exchange traded or a guaranteed instrument as a future contract is. The badla was allowed only on the BSE for noninstitutional domestic investors as a measure of providing liquidity to the market. In the years prior to the advent of screen based trading, settlement periods were quite lengthy. In the BSE, the specified category shares which constituted the market movers, had a settlement period of 14 days (subsequently reduced to 7 days) and other scrips had a settlement period of 30 days. The ‘pay-in’ and ‘pay-out’ for each settlement period used to happen in about ten to fourteen days thereafter. Therefore, even in delivery based trading, a trader had about a month to take delivery or make delivery as the case may be. This was unduly long and resulted in excessive speculative trading on the exchange under which traders used to indulge in intra-settlement speculation and squaring off. This resulted in artificial heating of the market and prevented price discovery. The markets were choppy and common investors found them quite risky to handle. One of the historic developments in recent times as far as settlements are concerned is the drastic reduction in the duration of settlement periods which has made intra-settlement speculation almost redundant. In the BSE, with the introduction of on-line trading from July 3, 1995 to all scrips, there was scope to reduce the settlement periods and provide for a separate forward market as distinct from a cash market. SEBI took the initial step of modifying the badla system and thereafter in 2001, abolished the system altogether. The existing carry forward systems on the BSE and the NSE were scrapped and after July 2, 2001 no forward transactions were allowed. The BSE market was thus divided into separate cash segment and derivative segment. In the cash segment all scrips have been put under compulsory ‘rolling settlement’. Under the rolling settlement, every single day becomes a settlement period by itself and has to be settled under a (T+x) system where ‘x’ represents the maximum number of days from the trading day ‘T’ within which the settlement has to be completed through the clearing mechanism. In the NSE, trades in the cash market in both equity and debt segments have been brought under the rolling settlement system under the (T+x) format. SEBI introduced rolling settlement in a

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phased manner with a T+5 cycle on July 2, 2001 in respect of 251 active scrips which was shortened to T+3 from April 2002 and T+2 from April 2003. It is further brought down to T+1 from April 2004. This would make the cash segment truly a delivery based cash market quite distinct from the forward market. Both the BSE and the NSE provide settlement facilities through respective clearing houses. The NSE has floated the NSCCL as a separate body for providing settlement facilities for trades made on the NSE in all segments.

1.11.5 Risk Management and Market Surveillance Over the years several risk mitigation mechanisms have been put in place in stock exchanges to address the risk of defaults arising from market trades. SEBI had directed all stock exchanges to set up clearing houses or clearing corporations for the purpose of standing guarantee to market trades made on stock exchanges. On the NSE, the NSCCL (National Securities Clearing Corporation Ltd.) which commenced operations in 1996, assumes counter party risk and guarantees financial settlement for all market trades on the NSE in the cash segment. NSCCL has a large settlement guarantee fund which stood at Rs. 1781 crore as on 31st March 2002. Similarly, the clearing house of the BSE guarantees performance for market deals on the BSE cash segment so that the investors either get payment or the return of their securities. Apart from the BSE and the NSE, some other major and medium stock exchanges have also set up investor guarantee funds of their own. With the above measures, the main risk element in stock trading relating to counterparty default has been eliminated from the secondary cash market. In addition, other risk containment measures initiated in recent times have been—ensuring capital adequacy and limits on exposure and turnover of brokers (at 20 times their base capital requirement), margin requirements, indemnity insurance, monitoring and surveillance of the on-line trading system with automatic disablement features, etc. There are also systems to curb excess volatility and price manipulations. With a view to curb the practice of off-market deals and deals made after closing of trading hours, SEBI has also brought in such negotiated deals within the purview of the stock exchange surveillance mechanism. A negotiated deal has been defined as one that has been agreed to outside the order matching system of screen based trading. The cut-off limit fixed for reporting such trades to the stock exchange has

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been fixed at 10,000 shares or a value of Rs. 25 lakh at a single price. As per the recommendations of the committee set up to examine this issue, SEBI directed in 1999 that all negotiated deals should be executed only on the screens of the exchange in the price and order matching system just like any other market deal. The markets have also adopted price bands for curbing excess volatility and price fluctuations in intra day trading in compulsory rolling settlement system. Price bands have been fixed for the stock index as a whole and for individual scrips as well. A volatility of the of the BSE Sensex or the NSE Nifty index beyond the prescribed limits triggers off the circuit breaker which brings trading to a grinding halt on all segments of the market nation-wide. The freeze happens if either of the indices is breached first. Similar freeze happens for trading on individual scrips for excessive volatility beyond the permitted price band of 20% either way. Since it is possible to manipulate the prices of scrips that are more liquid than the others, while fixing the price bands a differential approach has been adopted based on the frequency of trading, average daily volumes, turnover and the number of trades carried out. With the introduction of compulsory rolling settlement, SEBI set up a committee to discuss the issue of risk management for equity markets and based on its recommendations, a margin system for trading has been introduced using the ‘Value at Risk’ (VaR) concept. The VaR would be calculated on both scrip-wise basis and as index VaR. The VaR based margin would be imposed on trades made on the next day and recovered on a T+1 basis from traders. This would be in addition to market-to-market margins that would be collected from time to time. As far as the derivative segment is concerned, the J.R. Verma committee on Risk Containment Measures in the Indian Stock Index Futures Market recommended margin requirements, methods for volatility estimation and capital adequacy norms for the clearing members. In order to improve market practices and curb the manipulation of prices, SEBI issued two sets of regulations—(a) SEBI (Prohibition of Insider Trading) Regulations, 1992 and (b) SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations 1995. The insider trading regulations define an ‘insider’ as any person who is or was connected with the company or is deemed to have been connected with the company and who is reasonably expected to have access to unpublished price sensitive information in respect of securities of a company, or who has received or has access

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to such unpublished price sensitive information. The regulations also define connected persons to the company as its directors, officers or employees. Apart from prohibiting insider trading, the regulations provide for a code of conduct to be adhered to by listed companies in dealing with price sensitive information and disclosure of interests of directors, officers and substantial shareholders. Price sensitive information has been defined as any information which relates directly or indirectly to a company and which, if published, is likely to affect the price of securities of the company. The following categories of information have been specifically deemed as price sensitive information under the said guidelines: �

Periodical financial results of the company

�

Intended declaration of dividends (both interim and final)

�

Issue of securities or buy-back of securities

�

Any major expansion plans or execution of new projects

�

Amalgamation, mergers or takeovers

�

Disposal of the whole or substantial part of the undertaking

�

Any significant change in the policies, plans or operations of the company

Under the guidelines relating to fraudulent and unfair trade practices, the manipulation of prices of securities or abetting or taking part in such manipulation is prohibited. In addition, making misleading statements of a material nature and unfair trade practices amounting to a fraud are also prohibited.

1.11.6 Investor Protection, Investor Education and Corporate Governance Corporate governance as a school of thought has been gaining tremendous support internationally in capital market circles and with the advent of SEBI, in India as well. Investor protection has been the prime driving force for SEBI in all its policy directives so far. SEBI has also been instrumental in directing issuers to address investor grievances expeditiously. Presently all the capital market regulators, namely the SEBI, DEA and DCA provide investor grievance cells wherein the investor’s complaints are registered and take up with the erring companies in an expeditious way. Companies that default in addressing investor grievances regularly are pulled up by SEBI. In addition, stock exchanges now maintain investor protection funds for claims arising

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from non-settlement of dues by stock exchange members for market deals so as to provide for default risk in addition to the other methods discussed above. Apart from the aspect of investor grievances, the other area of concern has been investor education. Extensive training camps and investor education courses are being conducted by stock exchanges, Indian Institute of Capital Markets, SEBI and others. SEBI has also encouraged the setting up of investor associations in various parts of the country and registers them. These associations are meant to spread investor awareness, conduct education programmes and address investor grievances. The Companies Act was amended to provide for the creation of an investor education and protection fund for the promotion of investor awareness and also protection of the interests of investors. This fund is being administered by the DCA. Further, on the subject of corporate governance, several steps have already been taken and are continuing to be taken everyday. Listed companies have now been subjected to several new compliance requirements from the perspective of corporate governance. These are a result of the implementation of the recommendations made by the Kumaramangalam Birla Committee on corporate governance set up by SEBI. Thereafter, SEBI has amended the listing agreement with the stock exchange repeatedly so as to provide for stiffer requirements to be met by the listed companies. The latest amendment made to clause 49 of the listing agreement in August 2003 has been kept in abeyance due to the proposed withdrawal of the Companies (Amendment) Bill 2003. The current important requirements on corporate governance and continuing disclosure requirements as applicable to a listed company are summarised below: �

�

�

Prior intimation has to be given to the stock exchanges where a company is listed on important decisions such as consideration of dividend and bonus issues at Board Meetings wherein such items were placed on the agenda. Similar requirements have been stipulated for notifying stock exchanges immediately after the board meeting (after trading hours) about dividend, rights and bonus issues et al. The company has to file with the stock exchange the shareholding pattern within 15 days from the end of each quarter in the prescribed format under this clause. The disclosure is quite elaborate providing for break up in terms of name, number of shares held and the percentage shareholding of all persons holding more than 1% of the paid up capital. In addition, the said information has to be hosted on the company’s web site.

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�

�

�

The company shall inform to all the stock exchanges where it is listed, all price sensitive information and other material information such as closures, disruption in operations, natural calamities, litigations et al. immediately. The company has to maintain the same amount of floating stock at all times post-listing as was offered to the public at the time of listing. In addition, those companies wherein such requirement is not being met at least to the extent of 10% of the total post issue capital by March 2002, need to buy back the shares from the public through a public offer as per the Takeover Code. Similarly, when any person acquires or agrees to acquire 5% or more of the voting rights or 15% or more in aggregate of the voting rights, all the relevant provisions of the Takeover Code have to be complied with by the acquirer and the company. The company has to monitor the shareholdings accordingly and inform the stock exchanges through half-yearly returns. Quarterly results need to be provided in the prescribed proforma within one month from the end of the quarter to the relevant stock exchanges immediately after the close of trading on the day of the relevant board meeting and published within 48 hours of the conclusion of the said meeting as prescribed. The prior notice for such board meetings to the concerned stock exchanges has been reduced to 7 days. However, with respect to the last quarter of the financial year, a company can choose to publish the audited results within a period of 3 months from the end of the financial year without publishing the quarterly unaudited results. The results for the first half of the financial year shall be subject to a ‘Limited Review’ by the Statutory Auditors and a copy of the review report should be submitted to the stock exchanges within a period of 60 days from the end of the half-year. If the above report shows a variation of more than 20% in the corresponding unaudited figures, an explanatory statement needs to be enclosed. Similarly, if the sum total of the unaudited figures of all the four quarters varies from the audited results for the year by more than 20%, explanations have to be furnished to the stock exchanges concerned. The company should also furnish quarterly results in compliance with the relevant Accounting Standards that is issued by the Institute of Chartered Accountants of India.

�

SEBI’s code of corporate governance has been enforced from the financial year 2000–2001 on listed companies, which are either in Group ‘A’ of the BSE or in S&P CNX Nifty Index as on January 1, 2000. For other listed companies

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with a paid up capital of Rs. 10 crore and above, or with a networth of Rs. 25 crore or above at any time during the life of the company, the deadline for beginning the implementation is March 31, 2002. For the residual category with a paid-up capital of between Rs. 3 and 10 crore, the relevant date is March 31, 2003. In addition, the implementation is mandatory from day one, for all companies seeking listing hereafter. The Takeover code has a mandatory section and a non-mandatory section. The mandatory section deals inter alia, with certain far-reaching reforms in terms of composition of the Board of Directors and also setting up of an Audit Committee. In addition, the Directors’ Report shall contain as a part of or as an addition thereto, a Management Discussion and an Analysis Report on matters concerning the Industry and about the performance of the company. The disclosures prescribed lay specific emphasis on the fiduciary position of the directors in the discharge of their duties. The company should also obtain a Certificate from the Auditors regarding compliance of conditions of corporate governance stipulated under this clause and annexe the same to the Directors’ Report. This certificate should also be sent to the Stock Exchanges along with the Annual Return filed with the concerned exchange. In addition to the requirements stipulated for listed companies on corporate governance and disclosures, the Companies Act was amended to provide for steps to implement corporate governance, the most notable thereof being the requirement to set up audit committees of the board of a company and for a directors’ responsibility statement to be included in the report of the directors to the members of the company. Since these requirements are mentioned under the Companies Act, they apply to both listed and unlisted companies. The Government of India is considering the recommendations of the N.L. Mitra Committee for having a separate legislation on investor protection. The broad recommendations of the Committee in this regard are as follows: �

�

�

There is a need to consolidate and codify under one enactment certain measures to protect the interests of investors in corporate investments. A judicial forum should be created to address investor grievances and award compensations. The investor protection fund should be de-linked from the Companies Act and brought under the purview of SEBI.

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�

�

SEBI should be made the sole regulator for the entire capital market consisting of the primary and secondary segments. Several additional powers have been recommended for SEBI including the setting up of standing committees on investor protection, market operation and setting of standards. The SCRA should be amended to provide for good governance of stock exchanges and mandatory corporatization.

1.12 Road Ahead Considering the pace at which the transformation has happened in the Indian securities market and the capital market in particular, it could arguably be considered as the fastest changing market in the world. However, SEBI has an unfinished agenda in the key areas that it has identified for future initiatives. The Government of India is also working hard on the reforms process in the area of keeping the corporate and security laws up-to-date with the changes taking place in the market place. In addition, the process of involving professional experts in the form of various advisory bodies and committees being set up on various issues concerning the capital market has gained significant momentum in the recent years. The broad areas of future direction in capital market development and functioning in the Indian context could be looked at as follows: �

�

�

Due to the sustained growth in the dependence on the capital market by the government and the corporate sector, there would be a gradual shift towards better quality paper accessing the market so as not to saturate it and at the same time whet the appetite of investors. The entry criteria into capital markets would get stiffer and continuing disclosures would cover more areas. The structure of stock exchanges in the country is geared for a facelift due to de-mutualization and corporatization. While regional exchanges could lose their former identity, they would continue to play the balancing role in servicing investors geographically through initiatives taken such as the Inter-connected Stock Exchange of India Ltd. and by taking direct memberships on nation-wide stock exchanges through their broking subsidiaries. The efforts towards ensuring optimal share of returns from corporate performance to equity investors, which is the underlying idea in the concept of corporate governance, would intensify to educate Indian corporates to follow international best practices.

Overview of the Indian Capital Market �

�

�

�

�

�

69

The investor community would grow at a healthy rate and get clearly segmented into risk-averse investors such as households and retail investors who are dependent on fixed income instruments, medium risk investors who are dependent on mutual funds and cash markets, and high risk investors looking at derivative markets. There would also be more institutionalization of the investor community through proliferation of Mutual Funds. Intermediaries in the capital market would become more organized and their quality of services would get better due to certifications, adherence to a code of conduct and regulation. The security laws in the country would get finer tuned to market requirements especially in the area of global integration and the regulatory overlaps in the roles of SEBI, DCA, DEA and RBI that may be presently existent, would get weeded out. Self-regulatory organizations would gain importance and play a bigger role with the initiatives taken from SEBI. The benefits of technology in the working of the securities markets would be reaped in terms of efficiency in transactions, transparency in markets and enabling integration with global markets. With the growth and maturity of the markets and the investor community, more rational market opportunities in terms of sophistication in instruments and dealing opportunities would be forth coming.

Notes 1. See ‘Capital Market and the Evolution of Family Businesses’ by Utpal Bhattacharya (Kelley School of Business, Indiana University) and B. Ravi Kumar (Tippie College of Business, University of Iowa)—May 1999, page 1.

�

Selected References 1. Indian Securities Market Review 2002 of the National Stock Exchange of India Ltd. 2. SEBI Annual Report 2002—2003. 3. Investment Analysis and Portfolio Management—Dr. Prasanna Chandra, TataMcGraw-Hill Publishing Company Limited, First Edition 2002. 4. Indian Financial System—H.R. Machiraju, Vikas Publishing House Pvt. Ltd., Reprint 2000.

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5. SEBI, Capital Issues, Debentures & Listing—K. Sekhar, Wadhwa and Company, Third Edition 2003. 6. Management Accounting and Financial Analysis—Final Course reading, Board of Studies, The Institute of Chartered Accountants of India. 7. The Capital Market before 1600—Meir Kohn, 1999. 8. An overview of the Securities Market in India—M.S. Sahoo, NSE Newsletter, October 2002. 9. Effect of reforms on Capital Market—An Evaluation—M.L. Soneji, NSE Newsletter, February 2003. 10. Effect of reforms on Capital Market—An Evaluation (PartII)—M.L. Soneji, NSE Newsletter, March 2003. 11. www.nse-india.com—the official website of the National Stock Exchange of India Ltd. 12. www.bseindia.com—the official website of the BSE, Stock Exchange Mumbai. 13. www.iseindia.com—the official website of the Inter-connected Stock Exchange of India Ltd. 14. www.otcei.net—the official website of the OTC Exchange of India Ltd.

� Self-Test Questions 1. What are the segments of the financial market and their respective functions? 2. What are the segments of the securities market? Differentiate between primary and secondary markets and explain their complementary roles. 3. Which are the regulatory bodies in India for the securities market and under which law do each of them perform? 4. How does dematerialization help the securities industry? Explain the process. 5. What are the functions of stock brokers, rating agencies and debenture trustees? 6. Explain the role played by SEBI as the regulator and developer of the capital market? 7. List out the important developments in the functioning of the stock exchanges that have taken place in the recent years?

Chapter

2

Introduction to Investment Banking

W

hile Chapter 1 gives an insight into the evolution, growth and development of the capital market, this chapter tries to achieve the same objective with regard to the business of investment banking. Investment banking is a term of much wider connotation than merchant banking as it implies significant fund-based exposure to the capital market. Internationally, investment banks have progressed in both fund-based and non-fund based segments of the industry. In India, the dependence has been heavily on merchant banking, more particularly with issue management and underwriting. However, downturn in the primary market has forced merchant banks to diversify and become full-fledged investment banks. The future for investment banking is bright with scope for more merchant banks to convert themselves into investment banks. The regulatory environment for such activities is also discussed in this Chapter.

Topics to comprehend �

�

�

�

The evolution and growth of the investment banking industry. The structure and business portfolio of investment banks in general and Indian investment banks in particular. The regulatory framework for investment banking in India. The contemporary trends and issues in investment banking.

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2.1 Introduction At a very macro level, ‘Investment Banking’ as the term suggests, is concerned with the primary function of assisting the capital market in its function of capital intermediation, i.e. the movement of financial resources from those who have them (the Investors), to those who need to make use of them for generating GDP (the Issuers). As already discussed in Chapter 1, banking and financial institutions on the one hand and the capital market on the other are the two broad platforms of institutional intermediation for capital flows in the economy. Therefore, it could be inferred that investment banks are those institutions that are the counterparts of banks in the capital market in the function of intermediation in resource allocation. Nevertheless, it would be unfair to conclude so, as that would confine investment banking to a very narrow sphere of its activities in the modern world of high finance. Over the decades, backed by evolution and also fuelled by recent technological developments, investment banking has transformed repeatedly to suit the needs of the finance community and thus become one of the most vibrant and exciting segment of financial services. Investment bankers have always enjoyed celebrity status, but at times, they have paid the price for excessive flamboyance as well.1 To continue from the above, in the words of John F. Marshall and M.E. Ellis, ‘investment banking is what investment banks do’.2 This definition can be explained in the context of how investment banks have evolved in their functionality and how history and regulatory intervention have shaped such an evolution. Much of investment banking in its present form, thus owes its origins to the financial markets in USA, due to which, American investment banks have been leaders in the American and Euro markets as well. Therefore, the term ‘investment banking’ can arguably be said to be of American origin. Their counterparts in UK were termed as ‘merchant banks’ since they had confined themselves to capital market intermediation until the US investment banks entered the UK and European markets and extended the scope of such businesses.

2.2 Investment Banking and Merchant Banking Distinguished At this stage, it would be relevant therefore, to draw a fine line of distinction between the terms ‘Investment Banking’ and ‘Merchant Banking’ as both these terms are extensively used in this book. ‘Merchant Banking’ as the term suggests, is the function of intermediation in the capital market. It consists of assisting issuers to raise capital by placement of securities issued by them with investors. However,

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merchant banking is not merely about marketing of securities in an agency capacity. The Merchant Banker has an onerous responsibity towards the investors who invest in such securities. The regulatory authorities require the merchant banking firms to promote quality issues, maintain integrity and ensure compliance with the law on own account and on behalf of the issuers as well. Therefore, merchant banking is a fee based service for management of public offers, popularly known as ‘issue management’ and for private placement of securities in the capital market. In India, the Merchant Banker leading a public offer is also called as the ‘Lead Manager’. On the other hand, the term ‘Investment Banking’ has a much wider connotation and is gradually becoming more of an inclusive term to refer to all types of capital market activity, both fund-based and non-fund based. This development has been driven more by the way the American investment banks have evolved themselves over the past century. Given this situation, investment banking encompasses not merely merchant banking but other related capital market activities such as—stock trading, market making, underwriting, broking and asset management as well. Besides the above, investment banks also provide a host of specialized corporate advisory services in the areas of project advisory, business and financial advisory and mergers and acquisitions. The activity profile of investment banks is discussed more in detail later in this chapter.

2.3 Evolution of American Investment Banks The earliest events that are relevant for this discussion can be traced to the end of World War I, by which time, commercial banks in the USA were already preparing for an economic recovery and consequently, to the significant demand for corporate finance. It was expected that American companies would shift their dependence from commercial banks to the stock and bond markets wherein funds were available at a lower cost and for longer periods of time. In preparation for a boom in the capital markets in the 1920s, commercial banks started to acquire stock broking businesses in a bid to have their presence made in such markets. The first of such acquisitions happened when the National City Bank of New York acquired Halsey Stuart and Company in 1916. As in the past, in the entire 1920s, investment banking meant underwriting and distribution of securities. The stock and bond market boom of the 1920s was an opportunity that banks could not miss. But since they could not underwrite and sell securities directly, they owned security affiliates through holding companies. However, they were not maintained like water tight compartments. The affiliates were sparsely capitalized

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and were financed by the parent banks for their underwriting and other business obligations. While the boom lasted, investment banking affiliates made huge profits as underwriting fees, specially in the segment called ‘Yankee Bonds’ issued by overseas issuers in US market. In the stock market, the banks mainly conducted broking operations through their subsidiaries and lent margin money to customers. But with the passage of the McFadden Act in 1927, bank subsidiaries began underwriting stock issues as well. National City Bank, Chase Bank, Morgan and Bank of America were the most aggressive banks present at that time. The stock market got over-heated with investment banks borrowing money from the parent banks in order to speculate in the bank’s stocks, mostly for short selling. Once the general public joined the frenzy, the price-earnings ratios reached absurd limits and the bubble eventually burst in October 1929 wiping out millions of dollars of bank depositors’ funds and bringing down with it banks such as the Bank of United States. In order to restore confidence in the banking and financial system, several legislative measures were proposed, which eventually led to the passing of the Banking Act 1933 (popularly known as the Glass-Steagall Act) that restricted commercial banks from engaging in securities underwriting and taking positions or acting as agents for others in securities transactions. These activities were segregated as the exclusive domain of investment banks. On the other hand, investment banks were barred from deposit taking and corporate lending, which were considered the exclusive business of commercial banks. The Act thus provided the water tight compartments that were absent before. Since the passing of this Act, investment banking became narrowly defined as the basket of financial services associated with the floatation of corporate securities, i.e. the creation of primary market for securities. It was also extended to mean at a secondary level, secondary market making through securities dealing. By 1935, investment banking became one of the most heavily regulated industries in USA. The Securities Act, 1933 provided for the first time the preparation of offer documents and registration of new securities with the federal government. The Securities Exchange Act, 1934 led to the establishment of the Securities Exchange Commission. The Maloney Act of 1938 led to the formation of the NASDAQ, the Investment Company Act, 1940, which brought mutual funds within the regulatory ambit and the Investment Advisers Act, 1940, which also regulated the business of investment advisers and wealth managers. After the passing of the Glass-Steagall Act of the 1930s, until the beginning of the 21st century, investment banking had been through several phases of transformation

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which had broken down the water tight compartments to a great extent. Due to the 1973 Arab oil embargo, world economies were under pressure and inflation and interest rate volatility became disturbing. It was at this time that institutional investors made their advent into securities markets. It was also the time when the industrial and financial service sectors were beginning to expand and globalize. Due to these developments, investment banking and commercial banking once again became constrained by the very legislation that was meant to clean up the system in the 1930s. This led to several relaxations over the years such as the Securities Acts Amendments, 1975 which had permitted commercial banks to have subsidiaries (called section 20 subsidiaries) that were allowed to underwrite and trade in securities. In 1990, J.P. Morgan was the first bank to open a section 20 subsidiary. Since the Glass-Steagall Act did not apply to foreign subsidiaries of US banks, they continued to underwrite in the Eurobond market and by 1984, they had a 52% market share in that business. But there was stiff competition from Japanese banks in this market and by 1987; they underwrote only 25% of the Eurobond issuances. During the economic growth and globalization of the 1980s, investment banking expanded to several new areas and services which had included currency trading, real estate, financial futures, bridge loans, mortgage-backed securities and several others. But the stock market crash of 1987 once again brought the focus back to core areas of specialization. Similarly, the ambitious expansion that took place on a global scale was also halted to some extent. However, due to the technological advancement in the 1990s and the availability of global access through the revolution in communication technologies fuelled the global growth again. But this time though, investment banking is no more restricted to underwriting new issuances and security dealing. The shift is more towards providing expertise in new products and sophisticated techniques for structured financial deal making and managing risks. Apart from these activities, investment banking also encompasses a considerable spectrum of advisory services in the areas of corporate restructuring, mergers and acquisitions and LBOs, fund raising and private equity. On the dealing and trading side, investment banks participate in derivatives market, arbitrage and speculation. In the area of structured finance, investment banks also provide financial engineering through securitisation deals and derivative instruments.

2.4 European Investment Banks In continental Europe (excluding UK), the concept of a ‘Universal Bank’ had been the undercurrent since the late nineteenth century, when most of these banks were

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set up. The term ‘universal banking’ meant the co-existence of commercial banking (lending activity) along with investment banking (investment and distribution activity). Their universality was in the sense of harnessing the vast retail customer base that these banks enjoyed to market security issuances by their investment banking arms. These issues were mostly in the local markets designated in the local currencies. France’s Banques d’affairs and Germany’s Universalbanken are good examples. The United Kingdom, which is considered as Europe’s largest investment banking market, had its own structure evolved from history. The oldest merchant bank in London was Barings Brothers which had played a prominent role in the nineteenth century. Securities distribution was the function of stock-brokers, secondary market trading was held by jobbers and advisory services were provided by merchant banks. The term ‘merchant bank’ was evolved so as to distinguish between commercial banks and those that provided capital market advice. However, the breaking down of such barriers in 1986 by allowing banks to own broking outfits led to a consolidation and most of the broking firms got absorbed by larger and diversified entities. Around the same time, the US too was witnessing the disappearance of distinction between pure broking entities restricted to secondary markets and investment banking entities involved with primary markets. The US investment banks with their integrated global business model entered UK and Europe and later into Japan. The introduction of the Euro currency in 1999, helped the US invasion further by neutralising the local currency advantages enjoyed by European universal banks. By 2001, the US bulge group garnered 29.7% of the investment banking fee generated in Europe as compared to 16.3% by the European universal banks. Post-1986, the merchant banks and commercial banks in UK could not match up to the US onslaught which ultimately led to the sale of SG Warburg, the leading merchant bank to Swiss Bank Corporation (which was acquired by UBS later) in 1995. In 1997, Natwest Bank and Barclays Bank exited investment banking business. Morgan Grenfell, a merchant bank was sold to Deutsche Bank in 1990. In this upheaval, niche players such as Drexel Burnham and Barings Bank also collapsed with internal deficiencies. This led to cross border M&A between European banks inter-se and their American counterparts to create bigger investment banks. UBS Warburg was born out of the merger of UBS and Swiss Bank Corporation which had earlier acquired SG Warburg. Deutsche Bank acquired Bankers Trust.

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2.5 Global Industry Structure The investment banking industry on a global scale is oligopolistic in nature ranging from the global leaders (known as the ‘Global Bulge Group’) to ‘Pure’ investment banks and ‘Boutique’ investment banks. The bulge group consisting of eight investment banks has a global presence and these firms dominate the league tables in key business segments. The top ten global firms in terms of their fee billings as in 2001 are listed in Table APP 2.1. Readers may refer to this table in Appendix 1 at the end of the book. Within the listing given in the table referred to above are the top ‘pure’ investment banks, i.e. which do not have commercial banking connections, which are Merrill Lynch, Goldman Sachs and Morgan Stanley Dean Witter. Listed therein are also the leading European Universal Banks that are called so due to their role in both commercial and investment banking. The five leading universal banks in the world and their important group affiliates are listed in Table APP 2.2. Readers may refer to this table in Appendix 1 at the end of the book. Therefore, the global investment banking industry ranges from the acknowledged global leaders listed above to a larger number of mid-sized competitors at a national or regional level and the rear end is supported by boutique firms or advisory and sectoral specialists.

2.6 Business Portfolio of Investment Banks Globally, investment banks handle significant fund-based business of their own in the capital market along with their non-fund service portfolio which is offered to clients. However, these distinct segments are handled either on the same balance sheet or through subsidiaries and affiliates depending upon the regulatory requirements in the operating environment of each country. All these activities are segmented across three broad platforms—equity market activity, debt market activity and merger and acquisitions (M&A) activity. In addition, given the structure of the market, there is also a segmentation based on whether a particular investment bank belongs to a banking parent or is a stand-alone pure investment bank. Figure 2.1, represents the broad spectrum of global investment activity. From this diagram, it may be appreciated that investment banking encompasses a wide area of capital market based businesses and services and has a significant financial exposure to the capital market. Though investment banks also earn a

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INVESTMENT BANKING CORE BUSINESS PORTFOLIO

Non-fund based

Fund based

Equity portfolio—Merchant Banking (Issue Management), private placements.

Equity portfolio—Underwriting, market making

Debt portfolio—Issue Management, private placement, structured finance issuances such as securitisation M & A—M & A advisory, corporate advisory, project advisory

Debt portfolio—Underwriting, market making

M & A portfolio—Investing in private equity, LBOs and MBOs

SUPPORT ACTIVITY PORTFOLIO

Non-fund based

Fund based

Equity portfolio—Equity broking, distribution, asset management, custodial services, wealth management (private banking), research and analysis

Equity portfolio—Proprietary trading and portfolio investing, managing private equity funds and asset management funds

Debt portfolio—Debt market broking, distribution, asset management, research

Debt portfolio—Trading, underwriting, market making and investing on own account in debt products and securitised instruments

Derivative portfolio—Derivative broking, risk management, custodial services.

Derivative portfolio—Proprietary trading, managing hedge funds.

� Figure 2.1

Investment Banking Spectrum

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significant component of their income from non-fund based activity, it is their capacity to support clients with fund-based services, which distinguishes them from pure merchant banks. In the US capital market, investment banks underwrite issues or buy them outright and sell them later to retail investors thereby taking upon themselves significant financial exposure to client companies. Besides, being such large financial power houses themselves, the global investment banks play a major role as institutional investors in trading and having large holdings of capital market securities. As dealers, they take positions and make a market for many securities both in the equity and derivative segments. They hold large inventories and therefore influence the direction of the market. Goldman Sachs, Salomon Brothers, Merrill Lynch, Schroeders, Rothschild and others are significant Market Investors both on their own account and on behalf of the billions of dollars of funds under their management. The global mergers & acquisitions business is very large and measures up to trillions of dollars annually. Investment banks play a lead advisory role in this booming segment of financial advisory business. Besides, they come in as investors in management buy-outs and management buy-in transactions. On other occasions, wherein investments banks manage private equity funds, they also represent their investors in such buy-out deals. In the case of universal banks such as the Citigroup or UBS Warburg, loan products form a significant part of the debt market business portfolio. Pure investment banks such as Goldman Sachs, Merrill Lynch and Morgan Stanley Dean Witter do not have commercial banking in their portfolio and therefore, do not offer loan products. Besides the larger firms, there are a host of other domestic players present in each country and mid-sized investment banks, which either specialize in local markets or in certain product segments. Some investment banks in the overseas markets also specialize in niche segments such as—management of hedge funds, bullion trade, commodity hedges, real estate and other exotic markets.

2.7 The Indian Scenario 2.7.1 Origin In India, though the existence of this branch of financial services can be traced to over three decades, investment banking was largely confined to merchant banking services.

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The forerunners of merchant banking in India were the foreign banks. Grindlays Bank (now merged with Standard Chartered Bank in India) began merchant banking operations in 1967 with a license obtained from the RBI followed by the Citibank in 1970. These two banks were providing services for syndication of loans and raising of equity apart from other advisory services. It was in 1972, that the Banking Commission Report asserted the need for merchant banking services in India by the public sector banks. Based on the American experience which led to the passing of the Glass Steagall Act, the Commission recommended a separate structure for merchant banks so as to distinct them from commercial banks and financial institutions. Merchant banks were meant to manage investments and provide advisory services. Following the above recommendation, the SBI set up its merchant banking division in 1972. Other banks such as the—Bank of India, Central Bank of India, Bank of Baroda, Syndicate Bank, Punjab National Bank, Canara Bank also followed suit to set up their merchant banking outfits. ICICI was the first financial institution to set up its merchant banking division in 1973. The later entrants were IFCI and IDBI with the latter setting up its merchant banking division in 1992. However, by the mid eighties and early nineties, most of the merchants banking divisions of public sector banks were spun off as separate subsidiaries. SBI set up SBI Capital Markets Ltd. in 1986. Other such banks such as—Canara Bank, BOB, PNB, Indian Bank and ICICI created separate merchant banking entities.

2.7.2 Growth Merchant banking in India was given a shot in the arm with the advent of SEBI in 1988 and the subsequent introduction of free pricing of primary market equity issues in 1992. However, post-1992, the merchant banking industry was largely driven by issue management activity which fluctuated with the trends in the primary market. There have been phases of hectic activity followed by a severe setback in business. SEBI started to regulate the merchant banking activity in 1992 and a majority of the merchant bankers who registered with SEBI were either in issue management or associated activity such as underwriting or advisorship. SEBI had four categories of merchant bankers with varying eligibility criteria based on their networth. The highest number of registered merchant bankers with SEBI was seen in the mid-nineties, but the numbers have dwindled since, due to the inactivity in the primary market. The number of registered merchant bankers with SEBI

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as at the end of March 2003 was 124, from a peak of almost a thousand in the nineties. In the financial year 2002–03 itself, the number decreased by 21.

2.7.3 Constraints in Investment Banking Due to the over-dependence on issue management activity in the initial years, most merchant banks perished in the primary market downturn that followed later. In order to stabilize their businesses, several merchant banks diversified to offer a broader spectrum of capital market services. However, other than a few industry leaders, the other merchant banks have not been able to transform themselves into full service investment banks. Going by the service portfolio of the leading full service investment banks in India, it may be said that the industry in India has seen more or less similar development as its western counterparts, though the breadth available in the overseas capital market is still not present in the Indian capital market. Secondly, due to the lack of institutional financing in a big way to fund capital market activity, it is only the bigger industry players who are in investment banking. The third major deterrent has also been the lack of depth in the secondary market, especially in the corporate debt segment.

2.8 Characteristics and Structure of Indian Investment Banking Industry Investment banking in India has evolved in its own characteristic structure over the years both due to business realities and the regulatory regime. On the regulatory front, the Indian regulatory regime does not allow all investment banking functions to be performed under one entity for two reasons—(a) to prevent excessive exposure to business risk under one entity and (b) to prescribe and monitor capital adequacy and risk mitigation mechanisms. Therefore bankruptcy remoteness is a key feature in structuring the business lines of an investment bank so that the risks and rewards are defined for the investors who provide resources to the investment banks. In addition, the capital adequacy requirements and leveraging capability for each business line have been prescribed differently under relevant provisions of law. On the same analogy, commercial banks in India have to follow the provisions of the Banking Regulation Act and the RBI regulations, which prohibit them from exposing themselves to stock market investments and lending against stocks beyond certain specified limits.

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Therefore, Indian investment banks structure their business segments in different corporate entities to be able to meet regulatory norms. For e.g. it is desirable to have merchant banking in a separate company as it requires a separate merchant banking licence from the SEBI. Merchant Bankers other than banks and financial institutions are also prohibited from undertaking any other business other than that in the securities market. However, since banks are subject to the Banking Regulation Act, they cannot perform investment banking to a large extent on the same balance sheet. Asset management business in the form of a mutual fund requires a three-tier structure under the SEBI regulations. Equity research should be independent of the merchant banking business so as to avoid the kind of conflict of interest as faced by American investment banks. Stock broking has to be separated into a different company as it requires a stock exchange membership apart from SEBI registration. A complete overview of the regulatory framework for investment banking is furnished later in this Chapter. Investment banking in India has also been influenced by business realities to a large extent. The financial services industry in India till the early 1980s was driven largely by debt services in the form of term financing from financial institutions and working capital financing by commercial banks and non-banking financial companies (NBFCs). Capital market services were mostly restricted to stock broking activity which was driven by a non-corporate unorganised industry. Merchant banking and asset management services came up in a big way only with the opening up of the capital markets in the early nineties. Due to the primary market boom during that period, many financial business houses such as financial institutions, banks and NBFCs entered the merchant banking, underwriting and advisory business. While most institutions and commercial banks floated merchant banking divisions and subsidiaries, NBFCs combined their existing business with that of merchant banking. Over the subsequent years, two developments have taken place. Firstly, with the downturn in the capital markets, the merchant banking industry has seen a tremendous shake out and only about a 10% of them remain in serious business as pointed out earlier. The other development is that due to the gradual regulatory developments in the capital markets, investment banking activities have come under regulations which require separate registration, licensing and capital controls. Due to the above reasons, the Indian investment banking industry has a heterogeneous structure. The bigger investment banks have several group entities in which the core and non-core business segments are distributed. Others have either one or more entities depending upon the activity profile.

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The heterogeneous and fragmented structure is evident even if Indian investment banks are classified on the basis of their activity profile. Some of them such as—SBI, IDBI, ICICI, IL & FS, Kotak Mahindra, Citibank and others offer almost the entire gamut of investment banking services permitted in India. Among these, the long term financial institutions are gradually transforming themselves into full service commercial banks (called ‘universal banking’ in the Indian context). They also have full service investment banking under their fold. Other entities such as NBFCs or subsidiaries of public sector banks mainly offer merchant banking and corporate advisory services. Some others specialize in merchant banking and other capital market services. There are also several others who are providing only corporate advisory services but prefer to hold merchant banking or underwriting registrations. Presently, there are no global Indian investment banks although there is a bulge bracket of investment banks in India that have some overseas presence to serve Indian issuers and their investors. At the middle level are several niche players including the merchant banking subsidiaries of some public sector banks. Some of these subsidiaries have been either shut down or sold off in the wake of the two securities scams seen in 1993 and in 2000. However, certain banks such as Canara Bank and Punjab National Bank have had successful merchant banking activities. Among the middle level players are also merchant banks structured as non-banking financial services companies such as Rabo India Finance Ltd., Alpic Finance etc. There are also in the middle level, some pure advisory firms such as—Lazard Capital, Ernst & Young, KPMG, Price Waterhouse Coopers etc. At the lower end are several niche players and boutique firms, which focus on one or more segments of the investment banking spectrum.

2.9 Service Portfolio of Indian Investment Banks The core services provided by Indian investment banks are in the areas of equity market, debt market and advisory services. These are profiled below:

2.9.1 Core Services Merchant Banking, Underwriting and Book Running The primary market which was quite small in India, was revitalised with the abolition of the Capital Issues (Control) Act 1947 and the passing of the Securities and Exchange Board of India Act, 1992. The SEBI functions as the regulator for the capital markets

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similar to its counterpart, the SEC in USA. SEBI vide its guidelines dated June 11, 1992 introduced free pricing of securities in public offers for the first time in India. Over the last ten years, there have been two distinct phases of primary market boom—the first between 1992–1996 and the second between 1998–2001. The third wave of primary market issues could shape up in the near future. This market is very closely regulated by SEBI. In the days when the public offers market is very vibrant, this area of service forms the main activity for most Indian investment banks. In the past few years, though public offers have been very few, the private placement market, especially in the debt segment has been very active and has served as an important source of funds for primerated corporates. Notable among such offerings are rated privately placed debentures issued by public sector corporations and leading private companies. Financial institutions have been raising funds via the public offer of unsecured bonds. Investment banks have been managing the public offers and hand holding them in the private placements as well. Once the private placement markets also come under regulatory stipulations, investment banks would have a wider role to play in such issuances.

Mergers and Acquisitions Advisory The mergers and acquisitions industry was pretty nascent in India prior to 1994 and continues to be tiny compared to the global scale of such transactions. However, two main factors that have given a big push to this industry are: �

�

The forces of liberalization and globalization that have forced the Indian industry to consolidate. The institutionalisation of corporate acquisitions by SEBI through its guidelines, popularly known as the Takeover Code.

One of the cream activities of investment banks has always been M&A advisory. The larger investment banks specialize in M&A as a core activity. While some of them provide pure advisory services in relation to M&A, others holding valid merchant banking licences from SEBI also manage the open offers arising out of such corporate events.

Corporate Advisory Investment banks in India also have a large practice in corporate advisory services relating to project financing, corporate restructuring, capital restructuring through equity repurchases (including management of buyback offers under section 77A of

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the Companies Act, 1956), raising private equity, structuring joint-ventures and strategic partnerships and other such value added specialized areas.

2.9.2 Support services and Businesses Secondary Market Activities Most of the universal banks such as ICICI, IDBI and Kotak Mahindra have their broking and distribution firms in both the equity and debt segments of the secondary market. In addition several other investment banks such as the IL & FS and pure investment banks such as DSP Merrill Lynch and JM Morgan Stanley have a strong presence in this area of activity. In the past few years, the derivative segment has been introduced in Indian capital market and this provides an additional avenue of specialisation for investment banks. Derivative trading, risk management and structured product offerings are the new segments that are fast becoming the areas of future potential for Indian investment banks. The securities business also provides extensive research offerings and guidance to investors. The secondary market services cater to both the institutional and non-institutional investors.

Asset Management Services Most of the top financial groups in India which have investment banking businesses such as the—ICICI, the IDBI, Kotak Mahindra, DSP Merrill Lynch, JM Morgan Stanley, SBI and IL & FS also have their presence in the asset management business through separate entities. As per the three layer structure propounded by SEBI, the parent organization acts as the sponsor of the fund and the fund itself is constituted as a trust. The trust is managed by an asset management company and a separate trustee company which oversees the interests of the unit holders in the Mutual Fund. The whole structure has an arm’s length distance from the sponsor’s other businesses and entities.

Wealth Management Services (Private Banking) Many reputed investment banks nurture a separate service segment to manage the portfolio of high networth individuals, households, trusts and other types of non-institutional investors. This can be structured either as a pure advisory service

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wherein the investment manager does not have any access to the funds or as a fund management service wherein the investment manager is given charge of the funds. In the former case, it becomes a non-discretionary portfolio and in the latter case, it becomes a discretionary portfolio. Such activity is regulated under the SEBI guidelines as already discussed in Chapter 1. In other cases, wealth management may be restricted to a research based activity wherein the investor is provided good investment recommendations from time to time.

Institutional Investing Institutional investors have been a recent phenomenon in the Indian capital market, which till then had the presence of a handful of public financial institutions such as the UTI and the insurance companies. The term lending institutions such as the IDBI and IFCI did not participate in secondary market dealing as a matter of policy. With the advent of liberalization, there are presently a large number of domestic institutional investors in the secondary market apart from approved foreign institutional investors. In addition, institutional investments have risen significantly in the primary markets through venture capital and private equity investments by investors in both the domestic and non-resident categories. Several of the leading investment banks either have dedicated venture funds or private equity funds that invest in primary market. In addition, they make proprietary investments in the secondary market through their dealing and market making activities. The business portfolio of Indian Investment Banks has been briefly explained in Fig. 2.2.

2.10 Interdependence between Different Verticals in Investment Banking As is evident from Fig. 2.2, there are different verticals in investment banking and they do enjoy synergies with one another. While some of the service or business segments form the core of investment banking, others provide invaluable support. This inter-dependence and complementary existence has been explained below. While merchant banking largely relates to management of public floatations of securities or reverse floatations such as the buy backs and open offers, underwriting is an inherent part of merchant banking for public issues. Similarly, bought out deals and market making are a part of the process of floating issues on the OTC Exchange of India. The concept of market making has now been introduced for

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CORE BUSINESS PORTFOLIO

NON - FUND BASED Mer chant Banking services for Management of Public offers of equity and debt instruments Open offers under the Takeover code. Buy back offers. De-listing offers. Advisory and Transaction service in Project Financing, Syndicated loans Structured Fianance Venture Capital Private Equity, Preferential Issues Private Placements of equity and debt Business advisory and structuring Financial restructuring Corporate re-organisations such as mergers and demergers, hive-offs, asset sales. sell-off and exits, strategic sale of equity. Acquisitions and takeovers Government disinvestments and privatisation Asset Recovery agency services (presently in take-off stage)

FUND BASED Underwriting Market Making Bought Out deals Investments in primary market

SUPPORT ACTIVITY PORTFOLIO

NON - FUND BASED Secondar y Mar ket ser vices Stock broking Derivative products Portfolio management Suppor t ser vices

FUND BASED Venture Capital Private Equity Asset Management Proprietary trading and dealing in securities

Sales and distribution Equity Research and Investment advisory Corporate reseach and information services

� Figure 2.2 Business Portfolio of Indian Investment Banks

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listing of certain scrips in the main stock exchanges as well. Advisory and transaction services have a close linkage with merchant banking as more often than not, such services culminate in a merchant banking assignment for a public issue or a reverse floatation. Such services also help in maintaining an enduring relationship with clients during those times when merchant banking is not a hot activity due to depressed market conditions. The other segment of primary market activity, i.e. venture capital and private equity has equal synergies with merchant banking. Being in venture capital business which enables identification of potential IPO candidates quite early, which helps not only in generating good fee income from merchant banking services, but also in good capital gains for the venture capital invested at earlier rounds of financing in such companies. Similarly, being in private equity business helps in harnessing the potential offered by later stage and listed companies, which may approach an investment bank primarily for merchant banking services. The support business verticals in the secondary market operations also have synergies with those in the primary equity and debt market segment as far as investment banking is concerned. Stock broking and primary dealership in debt markets nurture institutional, corporate and retail clients who can be tapped effectively for asset management, portfolio management, and private equity businesses. In addition, presence in the equity derivative and foreign exchange derivative segments can help in offering solutions in treasury management to clients. In addition, the advisory and transaction services vertical can draw expertize from such segments in providing structured financing solutions to its clients. All these verticals are driven by support services such as sales and distribution and also equity research and analysis. Lastly but more importantly, the capability in sales and distribution also determines the success of the merchant banking vertical. Thus, it may be seen that the growth and success of an investment bank depends on its strengths in each vertical and how well it combines them for synergies. To sum up, investment banking is a business that is very sensitive to the economic and capital market scenario and therefore, the broader the platform of its operations, the more is the likelihood of an investment bank surviving business cycles and sudden shocks from the market.

2.11 Regulatory Framework for Investment Banking As discussed above, investment banking in India is regulated in its various facets under separate legislations or guidelines issued under statute. The regulatory powers

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are also distributed between different regulators depending upon the constitution and status of the investment bank. Pure investment banks which do not have presence in the lending or banking business are governed primarily by the capital market regulator (SEBI). However, universal banks and NBFC investment banks are regulated primarily by the RBI in their core business of banking or lending and so far as the investment banking segment is concerned, they are also regulated by SEBI. An overview of the regulatory framework is furnished below: 1. At the constitutional level, all investment banking companies incorporated under the Companies Act 1956 are governed by the provisions of that Act. 2. Investment Banks that are incorporated under a separate statute such as the SBI or the IDBI are regulated by their respective statute. IDBI is in the process of being converted into a company under the Companies Act. 3. Universal Banks are regulated by the Reserve Bank of India under the RBI Act 1934 and the Banking Regulation Act which put restrictions on the investment banking exposures to be taken by banks. The RBI has relaxed the exposure limits for merchant banking subsidiaries of commercial banks. Till now, such companies were restricting their exposure to a single entity through the underwriting business and other fund based commitments such as standby facilities etc to 25% of their net owned funds (NOF). Therefore these companies are now on par with other investment banks which can do so upto 20 times their NOF. 4. Investment banking companies that are constituted as non-banking financial companies are regulated operationally by the RBI under Chapter IIIB (sections 45H to 45QB) of the Reserve Bank of India Act, 1934. Under these zections RBI is empowered to issue directions in the area of resource mobilization, accounts and administrative controls. The following directions have been issued by the RBI so far: �

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Non-Banking Financial Companies Acceptance of Deposits (Reserve Bank) Directions, 1998. NBFCs Prudential Norms (Reserve Bank) Directions, 1998.

5. Functionally, different aspects of investment banking are regulated under the Securities and Exchange Board of India Act, 1992 and the guidelines and regulations issued there under. These are listed below: �

Merchant banking business consisting of management of public offers is a licenced and regulated activity under the Securities and

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Exchange Board of India (Merchant Bankers) Rules 1992 and Securities and Exchange Board of India (Merchant Bankers) Regulations 1992. �

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Underwriting business is regulated under the SEBI (Underwriters) Rules, 1993 and the SEBI (Underwriters) Regulations 1993. The activity of secondary market operations including stock broking are regulated under the relevant by-laws of the stock exchange and the SEBI (Stock Brokers and Sub Brokers) Rules 1992 and the (Stock Brokers and Sub Brokers) Regulations 1992. Besides, for curbing unethical trading practices, SEBI has promulgated the SEBI (Prohibition of Insider Trading) Regulations, 1992 and the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations 1995. The business of asset management as mutual funds is regulated under the SEBI (Mutual Funds) Regulations 1996. The business of portfolio management is regulated under the SEBI (Portfolio Managers) Rules, 1993 and the SEBI (Portfolio Managers) Regulations, 1993. The business of venture capital and private equity by such funds that are incorporated in India is regulated by the SEBI (Venture Capital Funds) Regulations, 1996 and by those that are incorporated outside India is regulated under the SEBI (Foreign Venture Capital Funds) Regulations 2000. The business of institutional investing by foreign investment banks and other investors in Indian secondary markets is governed by the SEBI (Foreign Institutional Investors) Regulations 1995.

6. Investments banks that are set up in India with foreign direct investment either as joint ventures with Indian partners or as fully owned subsidiaries of the foreign entities are governed in respect of the foreign investment by the Foreign Exchange Management Act, 1999 and the Foreign Exchange Management (Transfer or issue of Security by a Person Resident outside India) Regulations 2000 issued there under as amended from time to time through circulars issued by the RBI. 7. Apart from the above specific regulations relating to investment banking, investment banks are also governed by other laws applicable to all other

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businesses such as the—tax law, contract law, property law, local state laws, arbitration law and the other general laws that are applicable in India.

2.12 Regulatory Framework for Merchant Banking Merchant Bankers are governed by the SEBI (Merchant Bankers) Rules, 1992 and SEBI (Merchant Bankers) Regulations 1992. According to the SEBI (Merchant Bankers) Rules, 1992 a Merchant Banker means ‘a person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager, consultant, advisor or rendering corporate advisory service in relation to such issue management’. Given the fact that Merchant Bankers are entrusted with the responsibility of issue management by law, the regulatory framework is designed to ensure that they have sufficient competence and exercise diligence in their work such that the issuers comply with all statutory requirements concerning the issue. At the same time, the merchant banker shall have high levels of integrity so that quality issues alone are brought to the primary market. Keeping these objectives in mind and investor protection as the paramount objective, the SEBI has laid emphasis on ensuring that merchant bankers fulfil the eligibility criteria on an on-going basis and has therefore provided for compulsory registration every three years. All Merchant Bankers need to have a valid registration certificate under the said rules to perform the role of Merchant Bankers to issues. In considering the application for registration, SEBI shall pay regard to the professional qualification in finance, law or business management, adequate office space, manpower, office equipment and other infrastructure, at least two support staff members who have the competence to be in the field of merchant banking business, existence of minimum stipulated capital and previous experience or past track record as Merchant Banker if any, particularly with reference to investor grievance redressal. The activities that a Merchant Banker is authorised to do are issue management and associated activities such as advising or providing consultancy or marketing services for the issue, underwriting of issues and portfolio management, though portfolio management alone requires additional registration under the relevant regulations (please refer to Chapter 1). Merchant Bankers are precluded from carrying on any business or fund-based activity other than that associated with the securities market. Merchant Bankers are also bound by the Code of Conduct prescribed under the Regulations. The main provisions of the code of conduct for merchant

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bankers are provided in the Annexure I to this Chapter. In addition, Merchant Bankers have to comply with general obligations and responsibilities under the Regulations. These are furnished in Annexure II to this Chapter. Presently there is only one category of Merchant Bankers prescribed by SEBI (Category I) and the minimum stipulated networth for such Merchant Bankers is Rs. five crore. Such Merchant Bankers holding valid certificates of registration are alone qualified to manage public offers. SEBI levies a one-time authorisation fee, an annual fee and a renewal fee from each Merchant Banker. Under the regulations, Merchant Bankers have also to submit periodical returns and any other additional information that SEBI might seek from time to time. SEBI also has a right of inspection of the books of account, records and documents of the merchant banker at any time if required. SEBI may suo moto conduct an enquiry or launch an investigation into the working of a Merchant Banker or on receipt of a compliant against such Merchant Banker. SEBI may even appoint an external auditor to inspect the books and report to SEBI. Based on the findings, SEBI is empowered to take appropriate action to award penalty points to the erring Merchant Banker based on the degree of the default or contravention in accordance with the SEBI (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty) Regulations 2002. The aggrieved Merchant Banker may prefer an appeal to the Central Government under the SEBI (Appeal to Central Government) Rules 1993. It may also be mentioned here that a Merchant Banker is deemed to be a connected person to the issuer under the SEBI (Prohibition of Insider Trading) Regulations, 1992.

2.13 Anatomy of Some Leading Indian Investment Banks. 3 2.13.1 ICICI Securities Ltd. (I-Sec).4 I-Sec is a part of the ICICI group whose parent company is the ICICI Bank, which till recently was a financial institution that converted itself into a universal bank by its merger with its own commercial bank, the ICICI Bank in 2003. I-Sec, which was initially a joint venture with J.P. Morgan of the US, became fully owned by ICICI after J.P. Morgan exited from the business. I-Sec is a full service investment bank that provides services across all the segments spanning—debt market, equity market, derivatives and corporate advisory services. It has support services in research and broking. The advisory business

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focusses on mergers and acquisitions, cross border acquisitions, equity and bidding for a number of reputed companies. The equity business offers research, sales and execution services to institutional investors in the secondary market and capital market related services such as execution of public offerings, structuring and regulatory and legal documentation services. In order to assist/provide corporate clients and institutional investors with investment banking services in the USA, I-Sec set up two US based subsidiaries namely, ICICI Securities Holdings Inc and ICICI Securities Inc. ICICI Securities Inc registered itself with the National Association of Securities Dealers Inc. as a broker-dealer, empowering it to engage in a variety of securities transactions in the US market. ICICI Brokerage Services Limited, a member of the National Stock Exchange of India Limited, is the domestic broking subsidiary of I-Sec. I-Sec’s distribution and secondary market services are handled by the broking company.

2.13.2 DSP Merrill Lynch Ltd.5 Originally incorporated as DSP Financial Consultants Ltd., its name was changed to DSP Merrill Lynch Limited (DSP-ML) in 1996 following its conversion into a joint venture with Merrill Lynch of USA, a leading international capital raising, financial management and advisory company. Merrill Lynch has a 40% equity stake in DSP-ML. DSP-ML is a part of the DSP group which has been in the securities and brokerage business for 130 years in the Indian market, thus pre-dating even the Bombay Stock Exchange. DSP-ML is a leading full service Investment Bank that provides services across debt market, equity market and corporate advisory segments. It also provides services to private customers on equity and debt products and wealth management. It has a full-fledged research team serving the needs of both its institutional and retail clients. The company is among the major players on proprietary account in the debt and equity markets and is also a registered primary dealer in government securities. The functional divisions at DSP-ML consist of the—Investment Banking Group, the Equity Sales Group, the Equity Trading and Dealing group, Debt Sales Group, the Mergers and Acquisitions Group, the Research Group and the Private Client Group. The investment banking group generates equity and debt products

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emerging from IPOs, secondary issues and debt market issues as well as private placements. It is also a leading underwriter in both equity and debt products. These products are distributed through the equity sales group and the debt sales group. Both the marketing groups serve a cross section of institutional clients, other noninstitutional clients such as trusts and investment companies, retail clients and overseas investors. The sales groups also distribute apart from their own products, the products emerging from other entities such as DSP Merrill Lynch Mutual Fund and other mutual funds. The sales groups are supported by a national distribution network comprising of approximately 8,000 sub-brokers and alliance partners. The trading and dealing groups support the broking activity in equities and the primary dealership activities in the debt market. DSP-ML, is one of the largest institutional broking firms in India. It is a founding member of The Stock Exchange, Mumbai (BSE) and is an active member of the National Stock Exchange (NSE) of India in both the equity segment and the wholesale debt market segment. It is an accredited primary dealer with the RBI and an active participant in the Government Securities/Treasury bill markets. As a primary dealer, it makes a market for debt securities by offering buy and sell quotes. These quotes are also available on wire services like Reuters, Crisil Market wire, Bloomberg and Dow Jones Newswires. The mergers and acquisitions advisory has been structured as a separate specialist group that offers their clients financial advice and assistance in restructuring, divestitures, acquisitions, de-mergers, spin-offs, joint ventures, privatisation, and takeover defense mechanisms. The research group offers products such as—sectoral reports, company reports and special theme analyses, daily, weekly and monthly market views as well as specific policy forecasts. The private Client Group offers depos-itory, broking and invest-ment advisory services to high net worth individuals, professionals, and promoters of business groups, corporate executives, trusts, and private companies. In 1996, the DSP group floated a separate equity broking company called DSP Securities Ltd. which is a member of the BSE.

2.13.3 JM Morgan Stanley Pvt. Ltd.6 JM Morgan Stanley ( JMMS) is a joint venture between the JM Financial Group and Morgan Stanley Dean Witter of the USA. In 1997, Morgan Stanley which was

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established in New York in 1935, had acquired Dean Witter, an investment bank founded in 1924 in San Fransisco. JM Morgan Stanley commenced operations in April 1999. However, the association of the two partners is limited only to the investment banking area. Both of them have separate asset management companies in India which run independent mutual fund businesses. Unlike DSP-ML and I-Sec which have an integrated structure, the JM group has separate companies handling various components of the capital market business. The core functions of investment banking are performed by JMMS. This company focuses on capital raising, mergers and acquisitions, private equity and advisory work for Indian corporations in both the international and domestic capital markets. The function of distribution and marketing of securities is handled by two of its wholly owned subsidiaries,—JM Morgan Stanley Retail Services Pvt. Ltd. ( JMRS) and JM Morgan Stanley Fixed Income Securities Pvt. Ltd. ( JMFI). JMRS provides equity distribution services for primary market products, mutual funds, equity sales and marketing support for the group broking activity and wealth management and portfolio management services to high net worth individuals. JMFI offers similar services in fixed income (debt) securities. A third company, JM Morgan Stanley Securities Pvt. Ltd. handles all the broking operations for the group and provides services to institutional clients and others. It also provides research support for both FII and Indian institutional clients.

2.13.4 SBI Capital Markets Ltd.7 Founded in 1986 as a hive-off of the SBI Merchant Banking division, SBI Capital Markets Ltd. (SBI Caps) is amongst the oldest players in the Indian capital market. It is a full service investment bank that provides investment, advisory and financial services. In 2001, SBI Caps started its sales and distribution activity along with equity and debt broking services. SBI Caps provides services across the following spectrum: �

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Mergers and acquisitions—This group provides advisory services with regard to disinvestments of the government, valuations, mergers and acquisitions in the corporate sector, financial and business restructuring and other areas. Project advisory and structured finance—It is arguably one of the leading groups in the company that provides services such as restructuring and

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privatization advisory for public utilities, policy advisory to Central and State Governments, regulatory bodies and government departments and organizations, project structuring and advisory to the private sector and arranging finance for such projects. SBI Caps has been a major player in governmental work and in the infrastructure sector. The project advisory services consist of hand-holding from the concept to commissioning stage involving project structuring, contract structuring, financial modelling, preparation of information memorandum, syndication of debt and equity and assistance in documentation and financial closure. Other services include appraisals for green-field and brown-field projects, techno-economic appraisal for banks and financial institutions for establishing the viability of corporate restructuring plans, and vetting of contracts, loan documents, project documentation etc. �

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Capital market—This group provides merchant banking services in connection with public issues, rights issues and public offers for buy-backs and open offers. It also advises clients on private placements, ADR and GDR issues and overseas bond issues by the SBI. Treasury and investments—This group deals with the proprietary investments of the company in the equity, debt and money markets. Resource mobilisation and management is also undertaken by this group. Broking of equity and debt—SBI Caps is a registered broker and a member of the NSE in the equity and wholesale debt segments and is also a member in the equity segment. The broking group caters to the secondary market needs of financial institutions, FIIs, mutual funds, banks, other corporates, high networth individuals, non-resident investors and retail investors. The company commenced wholesale debt market broking in 2001. The company expects to have a strong presence in institutional broking.The company plans to open a derivative trading desk soon. Sales and distribution of equity, debt and mutual fund products—SBI Caps has been a leading mobiliser of funds both for public offers and private placements. Research—This group provides the research support for in-house departments and for institutional clients. Besides regular updates on companies and industries, the research group brings out India Strategy, Debt market Review and Daily Debt Market Review which are circulated to SBI Caps investment banking and broking clients.

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In its annual report for the year ending March 31, 2002, SBI Caps reported that it has two business segments—(a) Fee based segment providing merchant banking and advisory services like issue management, underwriting, arranger, project advisory and structured finance. (b) Fund based segment which undertakes deployment of funds in leasing, hire purchase and securities dealing. However, as a result of SEBI directives, fresh lending under leasing and hire-purchase was stopped from 1st July 1998. For the period 2001–02, SBI Caps was ranked first among issue managers by PRIME Database.

2.13.5 Kotak Mahindra Capital Company8 Born in 1995 as part of a corporate re-organisation as an unlimited company. The Kotak Mahindra Capital Company (KMCC), is the investment banking entity belonging to the Kotak Mahindra Group. It is a strategic joint venture between Kotak Mahindra Bank Limited (KMBL) and the Goldman Sachs Group LLP of USA. KMCC is a full service investment bank whose core business centres on equity issuances and fixed income securities, mergers and acquisitions and advisory services. As an investment bank, KMCC is registered with the SEBI and is also registered as a non-banking financial company with RBI. It is also an active member of the Association of Merchant Bankers of India (AMBI). KMCC has two wholly owned subsidiaries,—(a) Kotak Mahindra (UK) Limited, which is registered with the Securities and Futures Association, UK and regulated by the Financial Services Authority, UK and (b) Kotak Mahindra Inc. based in USA, which is registered with the Securities and Exchange Commission, USA. KMCC is the first Indian investment bank to have sought such registrations in USA and UK. A third company called Kotak Mahindra (International) Ltd., based in Mauritius provides distribution and other client services to non-resident investors. In KMCC, the Equity Capital Markets group focuses on structuring and executing diverse equity financing transactions in the public and private markets for corporates, banks, financial institutions and the Government. Products include initial public offerings (IPOs), rights offerings, convertible offerings, private placements, and private equity for unlisted and listed companies. In the advisory business, the Structured Finance (Project Finance & Advisory Business) Group provides expertise in various vertical segments in the infrastructure sector including power, oil, gas, ports, automobiles, steel & metals and hotels, by offering structured finance solutions to its clients. The Fixed Income Securities group at KMCC advises PSUs, Government companies, financial institutions, banks and corporates on raising

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capital by way of public or private placement of debt. KMCC is credited with innovating on some bond structures in the Indian market. The advisory group on mergers and acquisitions provides complete solutions on strategy formulation identification of targets or buyers, valuation, negotiations and bidding, capital structuring, transaction structuring, assistance in legal documentation and acquisition financing strategies and implementation. KMCC is supported in its functions by Kotak Securities Ltd, a broking firm incorporated in 1995 that is also a joint venture with Goldman Sachs which handles all the broking, distribution and research business of the group. Kotak Securities is a member of the debt segment of the NSE and is also a member of the National Stock Exchange Members Association. Kotak Securities offers services to investors across the country ranging from provident funds, banks, corporate treasuries, financial institutions, mutual funds, religious and charitable trusts, insurance companies etc. The institutional business division has a comprehensive research cell with sectoral analysts covering all the major areas of the Indian economy. In the international arena, it provides brokerage services on Indian securities to institutional and other investors who are based outside India. Due to its overseas presence, the company has marketing interests in Indian GDR and ADR issues as well. The research products brought out by Kotak Securities include: �

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For the institutional clients, a product called AKSESS, which primarily covers secondary market broking. It caters to the needs of foreign and Indian institutional investors in Indian equities (both local shares and GDRs). The Daily Forex Monitor which tracks the Indian and international foreign exchange markets and opines on currency strategies on a daily basis. The Weekly Money Market Update which gives the details of the developments in markets and provides a short-term interest-rate view along with indicative pricing for Triple A credits. The CURRENCY WATCH captures the monthly developments in the Indian foreign exchange markets, analyses the key influencing issues, assesses future outlook and also recommends hedging strategies. Monthly FINSEC and FINSEC Focus.

Kotak Securities is also a registered primary dealer with the RBI in the government securities market. As a primary dealer, the company acts as a market maker and also provides two way quotes, acts as retailer and marketing agent, provides

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underwriting support on government securities issues and participates in auctions held by the RBI. Besides, the above companies, the Kotak Group includes the Kotak Mahindra Bank which was formerly a non-banking finance company that has recently been converted into a bank, the Kotak Mahindra Mutual Fund which is managed by the Kotak Mahindra Asset Management Co. Ltd, and the OM Kotak Life Insurance, which is a joint venture with Old Mutual Plc. of UK and the Kotak Mahindra Venture Capital Co. which manages the private equity fund of the group.

2.14 Recent Trends in Investment Banking One of the trends that has been developing in the past few years in the global and Indian investment banking arena, is the strong emergence of universal banks ahead of pure investment banks as market leaders. These universal banks have the additional financial muscle of their banking arms that add to their investment banking strengths. Pure investment banks have found it unmanageable to maintain leadership positions due to difficult market conditions and the economic downturn. The year 2002 has been dubbed as the watershed year in investment banking for over a decade. Globally, universal banks such as the—Citigroup, JP Morgan Chase and Deutsche Bank are emerging strongly against pure investment banks such as Goldman Sachs and Morgan Stanley. This trend could probably reappear in India as well with the emergence of SBI, ICICI, IDBI and Kotak Mahindra Bank as strong universal banks. However, in 2002, pure investment banks such as JM Morgan Stanley and DSP Merrill Lynch still occupied top positions in the investment banking league tables. Some recent developments in the investment banking industry as reported in some financial dailies and other press clippings are listed below: International �

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The Wall Street IPO market has seen the fewest number of issues since 1978 in the calendar year 2003, with just five in the first quarter. These have mostly been from insurance and financial services firms and four of them were IPOs. In 2002, there was a drop of 28% in global equity and equity related issuances according to Thomson Financial. IPOs were the main casualty

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with a drop of 34% to $60.6 billion. European markets saw a 53% drop in IPOs and 54% drop in convertible bond issuances. In Europe, the market focus has shifted from fund raising through IPOs and public issues to more of restructuring deals. These are termed as ‘rescue finance’ deals such as rights issues and fully convertible bond issues by troubled companies. Ericsson, Sonera and Zurich Financial Services are some companies that made rights issues in 2002. According to Dealogic, the volume of rights issues in Europe rose from $20.7 billion to $21.5 billion in 2002. The most popular instrument in USA and Europe has been the ‘mandatory convertible’ (fully convertible) bond which is considered as a forward share sales which is superior in nature to a rights issue. �

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The Citigroup was Wall Street’s top stock and bond underwriter in 2002. Citigroup affiliate Salomon Smith Barney arranged $414 billion of offerings with a 10.6% market share according to Thomson Financial. Merrill Lynch and CSFB were ranked second and third respectively. However, the total underwriting pie fell by 5% during the same year. The top IPO investment bank in 2002 was Salomon Smith Barney followed by Goldman Sachs. Goldman arranged the largest IPO of 2002, the $4.6 billion CIT Group Inc. (Tyco International Ltd) unit. The reported fee of American investment banks fell by 21% in 2002 to $14.1 billion. Salomon took the highest fee of around $2 billion followed by the other two with around $1.2 billion each. Since April 2001, 78,000 jobs were slashed in this industry in USA accounting for about 10% of the total strength. Global M&A market was also dull in 2002 witnessing a sharp fall of 47% to stand at $996 billion from $1,887 billion in the previous year. The biggest deals in 2002 were HP-Compaq, Amgen-Immunex Corp, AOL Time Warner—AOL Europe, Bayer—Aventis Crop Science, Comcast CorpAT&T Broadband, Philips Petroleum—Conoco, and Siemens Robert Bosch— Atccs Mannesmann. Some of the big universal banks such as JP Morgan Chase took major hits in their private equity businesses due to the technology meltdown. Incidentally, JP Morgan, which is one of Wall Street’s largest private equity operators with a fund base of $28 billion, generated $130 million in revenues in private equity in 2001 fuelled mainly by the IPO market boom in technology stocks. Due to the meltdown, many investment banks have felt

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it necessary to spin off their private equity operations into separate entities. BNP Paribas, Deutsche Bank, HSBC and Zurich Financial Services are some of those banks. �

American investors poured more money into debt mutual funds in 2002 amounting to $133 billion and there were few takers for public issues of equity, junk bonds and convertible bonds.

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During the year 2001, JM Morgan Stanley which acted as adviser to M&A deals worth Rs. 16,022 crore was rated the top investment bank in India. The other players in the big league were—ABN Amro (Rs 10,460 crore), DSP Merrill Lynch (Rs 7130 crore), Arthur Andersen (now part of E&Y, Rs 3532 crore), Kotak Mahindra (Rs 1719 crore), Rabo India Finance (Rs 833 crore) and Lazard Capital (Rs 536 crore)—(as reported in The Economic Times 21st November 2001). In 2002, there was only one GDR/ADR issue as compared to 6 in 2001 and 9 in 2000. This was made by Mascon Global which raised $10 million through issue of 2.5 million GDRs which are listed at Luxembourg Stock Exchange. In this market, Citibank was the leading depository bank according to Instanex Capital Consultants. This was followed by Bank of New York, Deutsche Bank and JP Morgan. In the M&A market, the year 2002 saw an increase of around 5% in the value of M&A deals in India. Among these, more than 50% were cross-border deals according to a survey conducted by KPMG Corporate Finance. The deals were mostly in the SME segment with average size not exceeding $25 million. The banking, finance and insurance sectors contributed almost onethird of the total volume. Privatisation deals also played a significant part. DSP-ML de-listed from the stock exchanges since its promoters, Hemendra Kothari and Merrill Lynch together held more than 90% of the shares. DSP was rated ‘The Best Domestic Investment Bank’ in India for 2000 by Finance Asia. Euromoney voted it ‘Best Domestic M&A House in India’ as well as ‘Best Domestic Equity House in India’ in 2000. This distinction has returned for three years in a row with DSP-ML being named as the ‘Best Domestic Securities House’ and ‘Best Domestic Investment Bank’ for 2002–2003 by Asiamoney (May 2003 issue) and The Asset ( January 2003 issue) magazine respectively.

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2.15 The Conflict of Interest Issue The most burning global issue in the investment banking industry is that of conflict of interest between investment bankers and their research analysis divisions. In the wake of the Enron, Worldcom and other corporate disasters, this issue has gained some significance. The Securities and Exchange Commission in the USA (SEC) have initiated investigations into instances of investment banks issuing over-optimistic research and steering shares in hot IPOs to important clients for vested interests. In such investigations, some of the banks have been imposed fines. Merrill Lynch paid up fines to the extent of $100 million in regulatory proceedings in 2002 brought against its misleading research reports. Citigroup’s Salomon Smith Barney is also in the dock and may find itself paying the heaviest fines. CSFB also finds itself in trouble with the regulators. Most of the other top investment banks such as—Goldman Sachs, Lehman Brothers, Bear Sterns, Deutsche Bank, JP Morgan Chase and others also found their names in the fines list in 2002. CSFB was fined for misleading investors on offerings in technology shares. JP Morgan on the other hand, has been under a cloud for its role in the infamous off-balance sheet partnerships it had crafted for Enron. Besides, investment banks have also been the target of several lawsuits filed by aggrieved investors. In late 2002, the French luxury goods leader LVMH filed a 100 million euro suit against Morgan Stanley alleging that its research report on LVMH was biased because of the investment bank’s close advisory relationship with LVMH’s arch rival Gucci Group NV. Morgan Stanley was also the underwriter of Gucci’s IPO in 1995. Both the NYSE and the NASDAQ came out with ‘research analysts conflict of interest rules’ in May 2002 which was subsequently approved by the SEC. Market observers have felt that this is a good development from the point of view of addressing conflict of interest, currently a burning issue in the industry. While an investment bank may be advising a client on a buy out, its private equity arm may be in the fray for its purchase. An example of this was the sale of the power storage business of Invensys in 2001 wherein Morgan Stanley was the advisor in the $505 million sale to EnerSys, a company owned by Morgan Stanley Capital Partners (Morgan Stanley’s private equity arm). So, how does the conflict of interest really arise? Most investment banks have in-house research divisions which act as a support function as discussed earlier. The research divisions perform vital functions of tracking corporates and making recommendations to their clients in the secondary market operations or to their

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own dealing rooms. They also issue reviews and ratings to new issuances hitting the market. The conflict could arise if the research analyst promotes a share, the public offering for which is being handled by the merchant bank. Alternatively, it could also be that the analyst is privy to insider information being provided by the merchant banking division and there upon issues recommendations that could amount to fraudulent deceit of investors or gains for select few. Over the years, the ethical wall between merchant bankers and research analysts melted especially in the heat of the IPO and the internet boom. The compensation patterns of the investment bankers and the research analysts were also getting complementary to an extent thus undermining their independence. A study was conducted by the SEC in 2001 on ‘full service investment banks’ in Wall Street focusing on these conflicting relationships. The study disclosed two main areas of conflict—(a) research recommendations tending to become marketing tools for merchant banking assignments by the same bank and analysts getting paid share of such investment banking gains, (b) ownership of stocks by research analysts in the companies that they recommend or research. The study disclosed that analysts leveraged their position in pumping up recommendations in companies that they are interested in when they went public. In the revised dispensation, one of the main provisions is that analysts have to disclose their interests in their recommendations. In addition, there is sought to be a water tight compartment in the working of the merchant banking departments and the research divisions. The third area has been the regulation of compensatory structures for research analysts based on the profits of the merchant banking divisions. The developments in the USA have also resulted in precautionary amendments to regulations made in India by SEBI though such instances of conflict of interest have not surfaced so far. SEBI has amended the regulations that have been in place for Merchant Bankers, Underwriters and for the prohibition of insider trading. As a result, analysts are barred from private trading in the shares they analyse. There is still room for more regulation in future in this area of importance for the survival of the investment banking industry. In conclusion, it can be said that the investment banking industry has been through difficult times. On one hand, the economic slow down and the crash of the markets that were propelled to dizzy heights by the new economy stocks have battered their bottom lines and led to a large scale cut back in its staff and operations. On the other hand, the role of investment banks in corporate scandals and their questionable business practices and ethics have taken a toll on their reputation and image. A large scale cleaning up has to take place in their methods of working and service offerings.

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Similarly a major resurrection of their confidence is required through the resurgence of the markets, whenever that happens. In the meantime, the industry has to live up to the challenge through appropriate restructuring and consolidation.

2.16 Conclusion Given the scope for investment banking in India, the future looks bright for the industry as a whole in India. Many more pure merchant banks and advisory firms could convert themselves into full service investment banks that would broaden the market and make the service delivery much more efficient. In addition, the technological and market developments shaping the capital market as discussed in chapter I would also provide an added impetus to the growth of investment banking. Better regulatory supervision and stricter enforcement of the code of conduct of market intermediaries would ensure that better quality issuers come to the market and existing issuers would follow enhanced standards of corporate governance. In the long run, all these developments would ensure fair return to investors, and bring back investor support to the market. This would augur well for the capital market in general and investment banking in particular.

� Notes 1. Interested readers could refer to the life stories of Michael Milken, Dennis Levine, Ivan Boesky, Nick Leeson and our very own Late Harshad Mehta and Ketan Parekh who were all victims of flamboyance beyond the borders of legality. While the first three were convicted in the USA on counts of insider trading, Nick Leeson was charged with bringing down the Barings Bank through rogue trading. Harshad Mehta and Ketan Parekh were accused of stock market scams in the Indian capital market in 1993 and 2000 respectively. 2. Investment Banking and Brokerage by John F. Marshall and M.E. Ellis, Probus Publishing. 3. The order of listing is not necessarily in the order of their size or position in the league tables. 4. Extracted from the official website of ICICI Securities Ltd. 5. Extracted from the official website of DSP Merrill Lynch Ltd. 6. Extracted from the official website of JM Morgan Stanley Pvt. Ltd.

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7. Extracted from the official website of SBI Capital Markets Ltd. and its Annual Report, 2001–2002. 8. Extracted from the official website of the Kotak Mahindra Group.

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Select References 1. Investment Banking Theory and Practice—Brian Scott-Quinn, Euromoney Books. 2. Investment Banking and Brokerage—John F. Marshall and M.E. Ellis, Probus Publishing. 3. Investment Banking in the Financial System—Charles R. Geisst, Prentice-Hall. 4. Investment Banking—Addressing the Management Issues—Steven I. Davis, Palgrave Macmillan. 5. Indian Financial System—H.R. Machiraju, Vikas Publishing House Pvt. Ltd., Reprint 2000. 6. Annual Report of SBI Capital Markets Ltd., 2001–02. 7. News Reports and articles in The Economic Times. 8. News Reports and articles in the Business Standard.

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Suggested Readings 1. High Finance in the Euro Zone—Competing in the new European Capital Market— Ingo Walter and Roy Smith, Financial Times-Prentice-Hall, Pearson Education Limited, 2000. 2. Inside Out—An Insider’s Account of Wall Street—Dennis B. Levine with William Hoffler, Random Century Group Ltd., 1992. 3. Investment Banking—Addressing the Management Issues—Steven I. Davis, Palgrave Macmillan.

�

Self-Test Questions 1. What are the core services offered by investment banks? How are the different business verticals inter-dependent?

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2. Distinguish between merchant banking and investment banking? How are full service investment banks more competent to deliver better value to their clients? 3. What are the main regulatory provisions of SEBI on merchant banking? Explain with reference to the constitution of merchant banks and their code of conduct? 4. Explain the ‘conflict of interest’ issue in investment banking? Why has it caught the attention of regulators worldwide?

� Annexure I

�

CODE OF CONDUCT FOR MERCHANT BANKERS

Important provisions of Schedule III to the SEBI (Merchant Bankers) Regulations 1992 1. A merchant banker in the conduct of his business shall observe high standards of integrity and fairness in all his dealings with his clients and other merchant bankers. 2. A merchant banker shall render at all times high standards of service, exercise due diligence, ensure proper care and exercise independent professional judgement. He shall wherever necessary, disclose to the clients, possible sources of conflict of duties and interests, while providing unbiased services. 3. A merchant banker shall not make any statement or become privy to any act, practice or unfair competition, which is likely to be harmful to the interests of other merchant bankers or is likely to place such other merchant bankers in a disadvantageous position in relation to the merchant banker, while competing for or executing any assignment. 4. A merchant banker shall not make any exaggerated statement, whether oral or written, to the client about the qualifications or the capability to render certain services or his achievements in regards to services rendered to other clients. 5. A merchant banker shall always endeavour to: (a) Render the best possible advice to the clients having regard to the clients’ needs and the environments and his own professional skill; and (b) Ensure that all professional dealings are effected in a prompt, efficient and cost effective manner.

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6. A merchant banker shall not: (a) Divulge to other clients, press or any other party any confidential information about his client, which has come to his knowledge; and (b) Deal in securities of any client company without making disclosure to the Board as required under the regulations and also to the Board of Directors of the client company. 7. A merchant banker shall endeavour to ensure that: (a) The investors are provided with true and adequate information without making any misguiding or exaggerated claims and are made aware of attendant risks before any investment decision is taken by them; (b) Copies of prospectus, memorandum and related literature are made available to the investors; (c) Adequate steps are taken for fair allotment of securities and refund of application money without delay; and (d) Complaints from investors are adequately dealt with. 8. The merchant bankers shall not generally and particularly in respect of issue of any securities be party to: (a) Creation of false market; (b) Price rigging or manipulation; (c) Passing of price sensitive information to brokers, members of stock exchanges and other players in the capital market or take any other action which is unethical or unfair to the investors. 8A.

(a) A merchant banker or any of his employees shall not render, directly or indirectly, any investment advice about any security in the publicly accessible media, whether real-time or non real-time, unless a disclosure of his interest including long or short position in the said security has been made, while rendering such advice. (b) In case, an employee of the merchant banker is rendering such advice, he shall also disclose the interest of his dependent family

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members and the employer including their long or short position in the said security, while rendering such advice. 9. A merchant banker shall abide by the provisions of the Act, rules and regulations and which may be applicable and relevant to the activities carried on by the merchant banker.

� Annexure II

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GENERAL OBLIGATIONS AND RESPONSIBILITIES OF MERCHANT BANKERS

Relevant extracts of the SEBI (Merchant Bankers) Regulations 1992 13A. Merchant Banker not to associate with any business other than that of the securities market. No Merchant Banker, other than a bank or public financial institution, who has been granted a certificate of registration under these regulations shall (after June 30th, 1998) carry on any business other than that in the securities market. Notwithstanding anything contained above, a merchant banker who prior to the date of notification of the Securities and Exchange Board of India (Merchant Bankers) Amendment Regulations, 1997, has entered into a contract in respect of a business other than that of the securities market, may, if he so desires, discharge his obligations under such contract. 14. Maintenance of books of accounts, records, etc. (2) Every Merchant Banker shall keep and maintain the following books of accounts, records, and documents namely: (a) A copy of balance sheet as at the end of each accounting period; (b) A copy of profit and loss account for that period; (c) A copy of the auditor’s report on the accounts for that period; and (d) A statement of financial position. (3) Every Merchant Banker shall intimate to the Board the place where the books of accounts, records and documents are maintained.

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(4) Without prejudice to sub-regulation (1), Every Merchant Banker shall, after the end of each accounting period furnish to the Board copies of the balance-sheet, profit and loss account and such other documents for any other preceding five accounting years when required by the Board. 15. Submission of half-yearly results Every Merchant Banker shall furnish to the Board half-yearly unaudited financial results when required by the Board with a view to monitor the capital adequacy of the Merchant Banker. 16. Maintenance of books of account, records and other documents The Merchant Banker shall preserve the books of accounts and other records and documents maintained under regulation 14 for a minimum period of five years. 17. Report on steps taken on auditor’s report Every Merchant Banker shall, within two months from the date of the auditor’s report take steps to rectify the deficiencies, made out in the auditor’s report. 18. Appointment of lead Merchant Bankers (2) All issues should be managed by at least one merchant banker functioning as a lead Merchant Banker: Provided that, in an issue of offer of rights to the existing members with or without the right of renunciation the amount of the issue of the body corporate does not exceed rupees fifty lakhs, the appointment of a lead Merchant Banker shall not be essential. (3) Every lead Merchant Banker shall before taking up the assignment relating to an issue, enter into an agreement with such body corporate setting out their mutual rights, liabilities and obligations relating to such issue and in particular to disclosures, allotment and refund.

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20. Responsibilities of lead managers (2) No lead manager shall agree to manage or be associated with any issue unless his responsibilities relating to issue mainly, those of disclosures, allotment and refund are clearly defined, allocated and determined and a statement specifying such responsibilities is furnished to the Board at least one month before the opening of the issue for subscription: Provided that, where are more than one lead merchant bankers to the issue the responsibilities of each of such responsibilities shall be furnished to the Board at least one month before the opening of the issue for subscription. (3) No lead Merchant Banker shall, agree to manage the issue made by any body corporate, if such body corporate is an associate of the lead Merchant Banker. 21. Lead Merchant Banker not to associate with a merchant banker without registration A lead Merchant Banker shall not be associated with any issue if a Merchant Banker who is not holding a certificate is associated with the issue. 22. Underwriting obligations In respect of every issue to be managed, the lead Merchant Banker holding a certificate under Category I shall accept a minimum underwriting obligation of five percent of the total underwriting commitment or rupees twenty-five lakhs, whichever is less: Provided that, if the lead Merchant Bankers is unable to accept the minimum underwriting obligation, that lead Merchant Banker shall make arrangement for having the issue underwritten to that extent by a Merchant Banker associated with the issue and shall keep the Board informed of such arrangement. 23. Submission of Due Diligence Certificate The lead Merchant Banker, who is responsible for verification of the contents of a prospectus or the Letter of Offer in respect of an issue and the

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reasonableness of the views expressed therein, shall submit to the Board at least two weeks prior to the opening of the issue for subscription, a due diligence certificate in Form C. 24. Documents to be furnished to the Board (1) The lead manager responsible for the issue shall furnish to the Board the following documents, namely:(i) particulars of the issue; (ii) draft prospectus or where there is an offer to the existing shareholders, the draft letter of offer; (iii) any other literature intended to be circulated to the investors, including the shareholders; and (iv) such other documents relating to prospectus or letter of offer as the case may be. (2) The documents referred to in sub-regulation (1) shall be furnished at least two weeks prior to date of filing of the draft prospectus or the letter of offer as the case may be with the Registrar of Companies or with the Regional Stock Exchange, or with both. (3) The lead manager shall ensure that the modifications and suggestions, if any, made by the Board on the draft prospectus or the Letter of Offer, as the case may be, with respect to information to be given to the investors are incorporated therein.

Chapter

3 Primary Equity Market

A

fter an overview of the capital market in Chapter 1 and investment banking in Chapter 2, the stage is set to begin the journey into the intricacies of the realm of investment banking. The focus of this chapter is to take the reader into the finer details of the primary equity market and its constituents. The various types of issuers and issues, investors and instruments, intermediaries and support services are discussed in detail. This chapter also traces the growth and performance of the primary market which has seen cycles of hectic activity followed by a lull in the past decade. The trends set by SEBI and some of the important policy changes that have shaped the primary market are also discussed.

Topics to comprehend �

Types of shares and equity related instruments that can be offered in the Indian capital market.

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Approaches to valuation of equity shares.

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Types of equity offers in the primary market.

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The categories of investors in the equity market, the routes available for investment and regulatory issues connected therewith.

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3.1 Primary Equity Market As already indicated in Chapter 1, the capital market has two main segments—i.e., the primary market and the secondary market. The primary market is the market place for fresh issuances of equity and long-term debt securities. An essential feature of the primary market is that it has to be driven by fresh ‘issues’ of securities by different issuers. Each issue made, adds to the floating stock of such securities in the secondary market. Unlike the primary market, the secondary market, is driven by, deals in floating stocks of securities. The primary market consists of two main segments—the equity segment and the debt segment. This chapter deals with the intricacies of the equity market, while the discussion on the debt market has been taken up separately in Chapter 4. Fig. 3.1 depicts the primary equity market.

PRIMARY EQUITY MARKET

PUBLIC ISSUES

RIGHTS ISSUES

Investor s Institutional investors/ other large investors/ retail Investors

Issuer s Companies under the Companies Act/ other statutory corporations

� Figure 3.1

Instr uments Equity Shares/ Preference shares/ convertibles/ units of mutual funds

PRIVATE PLACEMENTS (Elabor ated in Chapter 10)

Intermediaries Merchant Banker/ Underwriter/ broker

Constituents of the Primary Equity Market

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3.2 Fundamental Concepts in Equity The owned capital of a joint-stock company is represented by shares. Each share represents a unit of measurement of the capital and creates proportionate ownership in the capital of the company to the extent of its value. This value by which a share is designated is known as its nominal or ‘face value’. According to the Companies Act, a company can issue only as much shares as it has been authorized to by its Memorandum of Association (its charter document). Such capital is known as the ‘authorized’ capital. The actual amount of shares at their face value that have been issued to investors out of the authorized capital is known as the ‘issued’ capital. The actual amount subscribed to by the investors out of the issued capital by making commitments to pay for the shares and take delivery is known as the ‘subscribed’ capital. The amount that has been asked of the investors to be paid is known as the ‘called-up’ capital. The amount actually paid by the investors on the calls is called the ‘paid-up capital’. The amount that remains unpaid is known as ‘calls-in-arrears’.

3.2.1 Types of Shares The Companies Act defines a share as ‘movable property transferable in the manner provided by the articles of the company’. The Companies Act provides for the following types of shares that can be issued by a company registered under it: �

Equity shares or ordinary shares – They represent common ownership of the company without any special rights or privileges. Such shares have normal proportionate voting rights based on the capital they represent in the company. Equity shares represent the residual ownership of a company after all other types of capital contributors have been paid off on a winding up. Therefore, equity shareholders also carry a risk of not receiving anything at all in the event of an insufficiency of capital at the time of such winding up. Similarly, equity shares do not carry any guaranteed return. They may be paid a dividend based on the recommendation made by the board of directors of the company. The directors may do so at their own discretion based on the performance of the company and the availability of distributable profits from time to time.

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Equity shares with differential rights – These shares can be issued with variable or disproportionate rights as to dividends, voting or otherwise

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subject to the prescribed rules.1 As per the rules, such shares should not exceed 25% of the issued capital of the company and no inter-se conversion between such shares and ordinary equity shares would be permitted. The company issuing such shares should also be profit making for at least three preceding financial years. Such issue shall also be approved by the shareholders in the general meeting. The type and extent of differential rights that can be attached to such shares have been left to the discretion of the shareholders. �

Preference shares – The category of shares that has both a preferential right to be paid a fixed rate of dividend and a preferential right to repayment of capital on winding up of the company. The preference referred to herein is over equity shares.

3.2.2 Premium Value and Par Value Equity shares can be issued at par or at premium to their face value. The term ‘at par’ denotes that the issue price of the share is equal to its face value or nominal value. Under the current guidelines, each company may fix the face value of its shares as it may find desirable, provided such face value is equal to or greater than Re. One. The SEBI had modified the earlier guidelines in this regard with a circular in 1999 in order to provide flexibility to companies to adopt different par values to their shares, both for existing shares listed on stock exchanges and new shares proposed to be listed in future. The guidelines in this regard are as follows: �

The companies shall have the freedom to issue shares in any denomination to be determined by them. While doing so, the companies will have to ensure that shares are not issued in decimal of a rupee. In other words, a share cannot be denominated with say Rs. 3.50 as par value.

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The companies, which seek to change the standard denomination, may do so after amending the Memorandum and Articles of Association, if required.

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The existing companies, which have issued shares at Rs. 10/- or Rs. 100/-, may also change the standard denomination into any denomination other than decimal of a rupee by splitting or consolidating the existing shares after amending their Memorandum and Articles of Association. At any given time, there shall be only one denomination for the shares of a company.

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Only companies whose shares are dematerialized shall be eligible to alter the ‘standard denomination’.

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The companies desirous to avail of this facility would be required to adhere to disclosure and accounting norms as may be specified from time to time.

Therefore, it is now possible for each company to have a different face value for its shares. The most commonly used denomination for face value is Rs. 10 per share. However, companies whose shares are highly priced in the market have adopted lesser denominations such as Rs. 5 and Re. 1 to make their shares affordable to the retail investor. When shares are issued at a premium to their nominal value, the issue price of the shares would be in excess of the nominal value. Such excess of the issue price over the nominal value of a share is known as ‘share premium’. After the advent of free pricing under the SEBI guidelines, companies are free to price their shares according to their judgement of the market at par or at a premium when such shares are offered to the public. In the case of unlisted companies too, such companies are free to price their shares at a price they find appropriate if these shares are issued privately. However, the Companies Act prescribes certain restrictions for the usage of the share premium collected by a company on issue of its shares. Sub-section (2) of section 78 prescribes that share premium may be applied: (a) in paying up unissued securities of the company to be issued to members of the company as fully paid bonus securities; (b) in writing off the preliminary expenses of the company; (c) in writing off the expenses of, or the commission paid or discount allowed on, any issue of securities or debentures of the company; or (d) in providing for the premium payable on the redemption of any redeemable preference securities or debentures of the company. From the above requirements, it is evident that share premium collected on issue of shares shall be used only to meet certain specialized expenditures or being capitalized as bonus shares. It is not available to meet normal expenditure or for being paid out as dividend to shareholders.

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Illustration 3.1

Let us consider a company that issues 1000 shares of Rs. 10/- each at a premium of Rs. 20/- per share. In this case, the issue price of the share is Rs. 30/- and the total

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amount collected from the issue is Rs. 30,000/-. The company has to account Rs. 10,000/- as share capital and Rs. 20,000/- as share premium in its books. Now, let us assume that the company wishes to redeem 1000 existing preference shares of Rs. 100/- each at a price of Rs. 110/- per share. The company can utilize the share premium collected on the equity shares for the purpose of writing off the premium payable on redemption of the preference shares amounting to Rs. 10,000/-. Therefore, upon such redemption, the company would reduce its preference capital by Rs. 100,000 and its share premium account by Rs. 10,000. That would leave the company with Rs. 10,000 (20,000–10,000) in the share premium account. Let us now assume the company wishes to capitalize it as bonus shares to the equity shareholders. It could issue another 1000 fresh equity shares as fully paid bonus shares at par amounting to Rs. 10,000/- to its existing shareholders. The company would therefore exhaust the share premium collected earlier and transfer it to equity share capital. It may be noted that bonus shares are normally issued only at par and not at a premium. In other words, though the Companies Act or the SEBI guidelines do not specifically talk about pricing of bonus shares, the accepted practice for a company is that it should not create share premium out of a bonus issue of shares.

3.2.3 Listed and Unlisted Shares The next concept to be discussed is that of a listed share vis-à-vis an unlisted share. The word ‘listing’ refers to enabling a share to be included for trading in the secondary market in a stock exchange. Once a company’s shares have been listed, dealers can buy and sell such shares at market determined prices, which would be continuously reflected on the trading screens. Readers may refer to Chapter 1 on the aspect of screen based trading. The shareholders can buy or sell listed shares during the trading hours of the stock exchange without any restrictions at the prevailing market prices. In this respect, buying and selling of listed shares is an impersonal affair without the buyer or the seller knowing each other. The shareholders of listed companies are on the look out for market opportunities to make gains on trading which in turn drives the volume of shares traded everyday on the stock exchange. There are highly volatile scrips in the market and there are also scrips that drive the market trends. The investor demand for a particular share in the market determines its market price from time to time. The detailed procedure for listing a company is described in Chapter 5. Companies that have listed their shares on the stock exchange are called ‘Listed Companies’ while the rest are called ‘Unlisted Companies’.

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At this stage, it is pertinent to note that while a listed share is freely tradable in the stock exchange, an unlisted share does not have a secondary market and is to that extent, restricted in its transferability from one person to another. An unlisted share can be bought or sold between two persons only through a private arrangement that brings them together. Further, if an unlisted share belongs to a private company, its transferability is restricted by the articles of association of the company.

3.2.4 Properties of Equity Shares Equity shares are the common stock of the company that represent proportionate ownership in a company. However, since equity shares do not have defined returns, the equity shareholders do undertake a risk in such investments. At the same time, they enjoy the benefits as well if the company performs well either in terms of appreciation in the value of the shares or through receipt of periodic dividends. Keeping in view the position of equity shareholders, the Companies Act vests them with certain rights so that they are able to protect their interests. �

Equity shares carry voting rights at the general meetings of the company both in person and by proxy (except in a poll) and also by postal ballot. These rights are meant to provide shareholders the right of taking management decisions.

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The company law has several provisions relating to approval of shareholders by special resolution whereby such decisions cannot be taken unless there is a three-fourths majority in agreement.

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The company law expressly provides under section 293, certain powers which cannot be exercised by the Board. These are powers that can be exercised only with the approval of shareholders.

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Equity shares are eligible for distribution of profits as dividends or as surplus in the event of liquidation of the company.

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Since equity shares carry common ownership, these are the residual rights available on a company in the event of liquidation after all the outside creditors and preference shareholders have been paid off in full.

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The company cannot issue fresh equity shares to any person unless they are offered first to the existing equity shareholders as per the provisions of section 81.

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Equity shareholders can protect their rights under sections 107, 167, 186, 397, 398 and 399 of the Companies Act.

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Equity shareholders are entitled to receive the annual accounts of the company.

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Equity shareholders are entitled to the right of inspection of certain books and records of the company.

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Under the current income tax law, dividend on shares declared by domestic companies is free from tax in the hands of the shareholder. However, the company has to pay an additional distribution tax of 12.5% of the amount being distributed as dividend. Dividend received from non-domestic companies is taxable as income from other sources in the hands of the shareholder.

3.2.5 Properties of Preference Shares Preference shares, as mentioned earlier carry a right of preference over equity shares for receipt of dividend and capital. However, due to this preference, they carry a fixed rate of dividend unlike equity shares that have no fixed returns. Therefore, preference shares are ideal for investors whose risk appetite is limited. Based on the terms of issue of preference shares, they can be further categorized as follows: �

Cumulative shares – Preference shares are cumulative if the dividend receivable in each financial year can be accumulated if such dividend is not paid immediately on becoming due. Dividends become due on preference shares on the last day specified for the payment of such dividend if the company has earned enough distributable profit during a particular year. However, the articles of association of the company should authorize payment of arrears of dividend of earlier years, especially in circumstances of winding up of the company. In the case of non-payment of dividends for more than two years, cumulative preference shares shall carry voting rights as are available to equity shareholders. Non-cumulative preference shares are those that do not carry such accumulation rights and if the company has not earned enough distributable profit during a particular year, such dividends lapse. Non-cumulative shares also acquire voting rights upon non-payment of dividend either for two immediately preceding financial years or for three out of six preceding financial years.

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Participating shares – Participating shares carry a right to participate in either dividends or for repayment of capital on winding up on par with equity shareholders after their preferential rights have been satisfied. In other words, after receipt of dividend or capital on preferential basis, if a distributable surplus is available to equity shareholders, these preference shares would be eligible for such surplus along with the equity shares. The articles of association have to provide for issue of such participating shares.

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Redeemable shares – Preference shares by definition are redeemable in a period not exceeding twenty years from the date of their issue. Further, these shares can be redeemed at a premium to their face value if the terms of issue so prescribe. For e.g. a preference share of Rs. 100/- could be redeemed at a price of Rs. 110/-. The premium on redemption can be notwithstanding all other rights carried by such share. As per the Companies Act, preference shares can be redeemed only out of accumulated profits or from the proceeds of a fresh issue of shares of any type. However, as discussed earlier, the premium part alone can be met out of the share premium account if any, existing in the balance sheet. Further, the amount of accumulated profits that are utilized for redemption of preference shares have to be transferred to a special reserve known as the ‘Capital Redemption Reserve’.

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Coupon rate – Coupon rate on a preference share is the rate at which it is entitled to dividend every year. For e.g. a 12% cumulative preference share carries a right of dividend of 12% per year on a cumulative basis. The coupon rate is fixed on the basis of the post-tax return that an investor would expect. This would mean that the tax treatment of the dividend received by the investor has to be considered while fixing the coupon rate. Under the prevailing tax law, dividend from preference shares of domestic companies is exempt from tax in the hands of the shareholder. However, the issuer has to pay a distribution tax of 12.5%. Therefore, for a 12% coupon, while the post-tax return to the investor would remain at 12%, the cost to the company would actually be 13.5% [12% + (12.5% Ò 12%)]. Considering the fact that this payment by the company is dividend, it is not tax deductible since it is an appropriation of profit. If one were to factor in the loss of tax shield at an applicable tax rate of 35%, the comparable cost of the preference share would be 20.76% to the company on a pre-tax basis vis-à-vis a debt instrument on which interest payments are tax deductible. Therefore, the company has to also keep in mind the overall cost to itself while fixing the coupon rate on preference shares.

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3.2.6 Convertible Instruments By definition, the word ‘Convertible’ refers to the property of an instrument to get converted into equity share. The amount of conversion, the time of such conversion and other terms would depend upon the terms and conditions subject to which such convertible had been issued. Generally, instruments that are either in the nature of debt instruments or hybrids have the property of convertibility into equity shares. In the case of listed or to be listed companies, issue of convertibles has to comply with the SEBI guidelines. In the case of unlisted companies, there are presently no stipulated terms for issues of convertibles since the earlier guidelines issued under the CCI Act were repealed. The main advantage of convertibles lies in the fact that they can be structured so as to increase the equity capital at an appropriate time depending upon the earnings profile of the company. The disadvantage of a pure equity issue is that while it takes time for a company to make earnings out of the funds received from the issue, the equity capital is expanded instantly on the issue thereby leading to immediate impact on the EPS, RONW. A convertible smoothens out this process by staggering the conversion of the funds raised into equity capital so that there is no immediate impact on the EPS. When the company starts to earn out of the fresh funds raised from the issue, the bottom line would expand sufficiently to absorb the expansion in equity caused by the conversion. Another benefit of a convertible is in structuring the conversion price into equity. Since the conversion takes place after a conversion period, the conversion price could be pegged higher than the price existing on the date of issue of the convertible. All convertibles are issued with protection to the rights of the holders of such convertibles in matters concerning dividends, rights and pari passu status of the underlying shares upon conversion. This would mean that after the conversion takes place, the resultant equity shares would rank identical to other equity shares in the company and shall be entitled to all the rights and benefits that would accrue after the said conversion date. This pari passu status includes listing as well. In other words, if the existing shares are already listed, the company has to seek automatic listing for the shares resulting out of the above conversion. Convertibles can be broadly classified as debt convertibles and equity convertibles. While the former are debt instruments till the date of their conversion into equity, equity convertibles are not debt instruments till their conversion. They are near to equity instruments and can be structured with or without return till their

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conversion. Therefore, these are considered as equity in the computation of the debt-equity ratio of the company’s capital structure. This is a significant advantage as it enhances the leveraging capacity of the company further. While debt convertibles have been discussed in detail in Chapter 4, equity convertibles have been discussed in this chapter itself. There are basically two popular equity convertibles, namely convertible preference shares and equity warrants.

Convertible Preference Shares A preference share (either cumulative or non-cumulative) may be issued with a conversion option into an equity share. The conversion ratio (how many preference shares to how many equity shares) and other issues are defined by the terms of issue. These are hybrid instruments since they carry the preferential rights till the date of conversion and become equity shares on par with other equity shares after such a conversion. In the case of cumulative convertible preference shares, the outstanding dividend would also be eligible for conversion to equity. The convertibility of a preference share could also be structured so as to be optional on the investor. In such a case, the investor can decide on the stipulated date of conversion, if such option should be exercised or not. If the investor finds it desirable and the option is exercised, they get converted into equity shares. On the other hand, if the conversion is not exercised, they would continue to be preference shares to be redeemed as per the terms of issue. A convertible preference share can be made optional by providing a put option to the investor. An optionally convertible preference share has a dual advantage for the investor. While dividends received are exempt from tax (assuming the issuer is a domestic company), the option can be exercised if there is reasonable scope for appreciation in the underlying equity share based on the conversion price. As has been discussed earlier, the post-tax yield from a preference share is much higher due to its tax-free status.

Equity Warrants Warrants are instruments issued by a company that carry an ‘option’ for the holder to receive a particular benefit that the instrument carries as per its definition. Therefore, a dividend warrant carries the right to be paid dividend and an interest

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warrant carries a right to receive interest. An equity warrant carries the right but not the obligation to pay for and receive equity share(s). Equity warrants are useful instruments and are generally used in combination with other instruments. However, they can even be issued as separate instruments in isolation. Warrants are also used as a means to provide investors with the benefit of paying for and receiving equity shares at a later date at pre-determined conversion price. The time allowed for such conversion is known as the ‘exercise period’, which would also be equal to the life of the warrant. The option entitles the holder to three alternatives: �

To pay for and receive the equity shares in full based on the terms of conversion.

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To reject the offer in full.

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To pay for and receive shares in part and reject the balance.

The price at which the warrant entitles the holder to one or more equity shares is known as the ‘conversion price’ or the ‘exercise price’. For e.g. if a warrant entitles the holder to two equity shares of Rs. 10/- each at a premium of Rs. 20/- per share, the conversion price of the warrant is Rs. 30/- per share. Both the conversion price and the conversion ratio are defined by the terms of issue. The economic value of a warrant is the excess of the market price of the share on the date of conversion over the exercise price. In the above example, if the market price of the share is Rs. 40/- on the date of conversion, the economic value of the warrant is Rs. 20 (40 Ò>2 – 30 Ò>2). Warrants can be tradable and detachable. In other words, if the warrants have been issued in conjunction with any other instrument, the terms may stipulate that warrants are detachable and tradable separately. This would imply that if an investor acquires the warrant as part of another investment and finds that the option is not attractive, the warrant can be de-linked from the original instrument and sold off separately. In such a case, the original instrument remains with the investor while the warrant gets traded and converted in the hands of the person holding it on the conversion date. In order to enable such secondary market trading, detachable warrants can even be listed as separate instruments in the stock exchange. The market price of the warrant would be determined by the price of the underlying share and its own economic value. Warrants are mostly issued either by promoters for increase of their stakes at a later date or to make debt issues more attractive with warrants being the ‘sweeteners’. Some of the companies that have issued warrants along with other instruments in the past are—HPCL, Appollo Tyres, Phoenix International, Deepak

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Fertilizers and Petrochemicals, Escorts, Ranbaxy, Shriram Industies and others. Phoenix was a unique case wherein warrants were issued along with equity shares while in most other cases, they were issued with debt instruments as ‘sweeteners’. Phoenix made a premium equity issue in March 1994 at a price of Rs. 95 per share. The investors were offered equity warrants in the ratio of one warrant for every two shares. Each warrant was to be converted into an equity share at a price not exceeding Rs. 150 between June 1996 and January 1998. The warrants were listed separately and traded on the stock exchange. Investors willing to convert them into shares could look for a price arbitrage since the share was quoting in excess of Rs. 250 during the conversion period.

Statutory Provisions on Equity Convertibles a) As pointed out earlier, there are presently no stipulations on issue of equity convertibles by unlisted companies. b) If an unlisted company is in the process of making a public issue of equity convertibles such as convertible preference shares or warrants as part of its initial listing, the applicable provisions are contained in the DIP Guidelines. These are discussed at length in Chapter 5. c) If a listed company plans to issue equity convertibles to all existing shareholders through a rights issue or plans to make a secondary public issue, the relevant provisions are the same as in (b) above. These have been discussed at appropriate places in Chapter 6. d) If the issue of equity convertibles is being planned by a listed company selectively to a few persons or existing shareholders to the exclusion of other shareholders, such an issue is governed by Chapter XIII of the DIP guidelines relating to preferential allotments. These have also been discussed in Chapter 10.

3.2.7 Performance Indicators for Equity Shareholders The equity share being common stock and residual ownership in the company, would need to be seen from the shareholder’s perspective closely. There are several measures of how a company has performed for its shareholders. Some of the popular ratios are Earnings per Share (EPS), Return on Networth (RONW) and in the case of listed shares, the Price to Earnings multiple (P/E ratio). Apart from these,

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there are others such as Dividend Yield, Dividend Payout Ratio and Economic Value Added (EVA) and Market Value Added (MVA). These are explained in detail below: 1. EPS = Profit after Tax(PAT)/No. of equity shares outstanding. This ratio measures the earnings made by the company with respect to the face value of each share for a given financial year. For e.g. if the EPS on share of face value Rs. 10/- is Rs. 4.50, it would mean that the earnings capacity is 45% on the face value. This measure is also calculated on an annualized basis if the shares have been allotted during the course of a financial year. When a company has outstanding convertibles which would get converted into shares in future, the EPS can also be calculated as if the convertibles have been fully converted as of date. Such a measure taken on the basis of the fully expanded equity base is called ‘fully diluted EPS’. The EPS is a very popular measure of performance of a company seen from a shareholder’s perspective. 2. RONW = PAT/Networth wherein Networth = paid-up capital + accumulated cash reserves and surplus. The RONW measures the return generated by the company on the shareholders’ funds. It takes into account the operational, financial, depreciation and tax efficiencies of the company and is therefore, the ultimate measure of its profitability. If the RONW is significantly higher than the cost of equity, it would mean that the company is creating shareholder wealth. In such a case, the company is a high growth company and should adopt a low or no dividend policy to protect shareholder value. On the other hand, if the RONW is lower than the cost of equity, either the company’s business is unprofitable or the company is over-capitalized with equity. It could do well to increase the gearing in the capital structure to improve returns to equity shareholders. If the company has more capital overall than necessary, it would be necessary to return some of the capital to the shareholders through a high dividend payout policy or through return of capital. This step would protect the shareholder value. 3. P/E ratio = Current Market price of share (CMP)/EPS. This is a good measure to gauge the market expectation on the share. The P/E ratio indicates the number of times of the current EPS that the market is willing to pay for the share. Therefore, the higher the P/E multiple, the greater is the

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expectation on the future potential of the share. Well performing companies and industries enjoy high P/E multiples in the market as compared to their lesser-known counterparts. 4. Dividend yield = Dividend per share (DPS)/CMP. This ratio denotes how much return a shareholder makes by buying the share from the market before the dividend payout (cum-dividend) thereby becoming a recipient of such dividend. If the cum-dividend price in the market is low, the dividend yield is high and vice versa. Dividend yield is used as a tool by fund managers to improve upon their returns by looking at traditionally high dividend paying companies. 5. Dividend Payout % = Dividend/PAT. This measure denotes how much of current earnings are being paid out as dividend. It helps investors who have appetite for dividend income rather than capital gain to identify companies with high dividend payout as compared to those which are not. High dividend payout is a difficult policy to sustain since the funds go out of the company permanently. Most managements are conservative in dividend payout unless the industry has extraordinary margins and a long term stability as well. 6. EVA = NOPAT – (WACC Ò Capital Employed) where NOPAT = Net operating profit after tax WACC2 = weighted average cost of capital employed Capital employed = Shareholders’ funds (Networth) + Long Term borrowings The EVA is a very effective measure of shareholder value created by a company. It measures in absolute terms the surplus generated by the operations for a given year over the expected cost of equity and debt. The WACC is an average measure of the cost of debt and equity which when multiplied with the capital employed, results in the expected return to the long term capital providers in absolute terms. The excess of the NOPAT over such normal return is the EVA, which denotes the extraordinary return to the shareholder. The EVA is rapidly becoming an accepted measure of shareholder wealth creation. 7. MVA = Market capitalization – Capital Employed. While the EVA is measure of shareholder value from a flow approach, the MVA is a measure from a stock approach. The MVA tries to measure the excess of the company’s

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aggregate market value over the book value of its capital employed. The MVA can be linked to the EVA as the aggregate of the present values of all the future EVAs of the company. The MVA can be modified further to consider the book value of equity and market value of debt. From an individual shareholder’s perspective, the MVA is clearly the excess of the CMP of the investment in the company over the amount invested.

3.2.8 Investor’s Perspective of Equity Shares Equity shares are financial instruments with uncertain returns. The uncertainty is associated both with the return on investment and the return of the capital invested as well. The requirement of a regular return has to be met out of dividend income, which depends upon the dividend policy of the management. Investors looking for a regular return on equity investment should look for companies with a sound financial health and quality of management and a high dividend payout ratio. Dividend is presently tax-free in the hands of the shareholder and therefore provides a taxfree source of income. In addition to income, another important feature of equity investment is in its liquidity. The presence of an organized and active secondary market for a company’s share enables instant liquidity at any time. On the other hand, the attractiveness of equity investments lies in their capital appreciation through increase in market price over the invested capital. Most equity investors look for making capital gain on their investment, which when annualized would work out to a superior return over a fixed income security. The approach to make capital gain is also tax efficient since it is subject to concessional taxation under the Indian tax law. However, since market prices are subject to market forces, equity investors are always subject to certain market risks. One way to mitigate this risk is to manage one’s portfolio effectively. Investors who do not have the expertise to do so should rely on the expertise of fund managers and invest their funds in equity mutual funds. Historically, equity has been proved to be the best form of financial investment over longer terms as per several empirical studies.

3.2.9 Issuer’s Perspective of Equity Capital From an issuer’s perspective, equity capital is more expensive than debt capital. This is because an equity investor’s expected return is much higher than that of an

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investor in debt due to the risk attached to equity investments.3 Therefore, the issuer has to service equity at a higher cost as compared to debt. Secondly, the regular dividend payout to service an equity investor is much higher than the interest paid on debt due to the differential tax treatment of interest and dividend as deductible items. As has been shown earlier, a 12% post-tax return on equity paid by a company works out to an equivalent of 20.76% pre-tax cost on debt capital. This is unduly high and therefore, equity capital is undoubtedly more expensive to service. If the above argument holds good all the time, companies should refrain from raising equity and look at raising more debt. However, companies are all the time on the look out to raise equity in preference to debt capital. This is because, the benefits of equity capital far outweigh the additional cost of servicing equity. Some of the important benefits of raising equity are listed out below: �

Equity capital does not involve a committed cost in terms of regular servicing. Even the dividend payout is not an essential feature. If the company is listed, there is a secondary market that values the company based on its performance and is therefore willing to price it accordingly. If a company performs well, this would be reflected in its P/E multiple. An equity shareholder could look at exit through the secondary market and book capital gain as a return on investment. By this mechanism, the company ends up rewarding the shareholder through the market mechanism while conserving its own cash in the process. This is a significant advantage to a company.

�

Since equity capital does not involve a fixed servicing cost, it reduces financial leverage and brings down the fixed costs. This in turn reflects in better margins and profitability.

�

Equity capital reduces the debt-equity ratio by increasing the networth, thereby providing a cushion for future leveraging. Companies regularly employ this method of balancing debt and equity in their capital structure with respect to further fund raising. When debt capital is high, they raise equity, which in turn enables further debt in future.

�

The most important advantage of equity is in its pricing. By pricing equity at a premium, a company can shore up its balance sheet with further fund infusion as share premium. This has a twin advantage—(a) it significantly bolsters the networth and more importantly, (b) it does not increase the capital base. Therefore, the EPS gets computed only with respect to the share capital while the company enjoys the benefit of deploying the entire

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capital including the share premium in generating the earnings. Free pricing of equity is therefore the biggest factor in favour of an issuer provided the pricing is fair and the company can live up to it. The aspect of issue pricing has been discussed in detail in Chapter 5. �

Lastly, as long as a company lives up to its expectations, it need not look at the eventuality of returning equity capital to its shareholders. This argument holds good not only for the initial investment made by the shareholders but for the accumulated profits as well. Therefore, shareholders’ funds make up the permanent fund base of the company. The liquidity for the shareholder is provided by the secondary market. This is a win-win situation for both. While the company takes capital from the shareholder, the return of such capital is provided by the market. However, reasonable dividends are also declared from time to time to keep the shareholder happy with some periodic cash return from the company.

Notwithstanding the benefits listed above, an equity issuance results in the expansion of equity capital with an addition to the number of outstanding shares. Therefore, the company would face the immediate effect of dilution in its EPS, as the post-tax profit gets distributed over a wider equity base. Similarly, the return on networth (RONW) would also face pressure since the networth base of the company would rise as well. There could be repercussions on the market price of the share as a result of the dilution if the shares of the company are already listed. Due to this reason, companies have the tendency to raise as much equity capital as possible with as little dilution of the equity base as the situation permits through a premium valuation for their share. This method has the twin benefit of raising finance for the company on one hand and not putting the company’s EPS and RONW under pressure on the other.

3.2.10 Sweat equity, Employee Stock Option Plan (ESOP) and Other Incentive Schemes Sweat equity is a concept of recent origin in the Indian context mainly useful only for knowledge-based companies. Sweat equity has been given statutory recognition under the Indian law with the Companies Act inserting section 79A. Sweat Equity shares are defined in Explanation II to sub-section (1) of section 79A of the Companies Act as ‘equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called’.

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Employee incentive schemes can be by way of stock options, stock appreciation rights, or stock purchase schemes or any other such measures. These became extremely popular in the wake of the boom in knowledge intensive businesses and their valuations. Section 2(15A) of the Companies Act defines Employees Stock Option as ‘the option given to the whole-time directors, officers or employees of a company, which gives such directors, officers or employees the benefit or right to purchase or subscribe at a future date, the securities offered by the company at a

Sweat Equity

Stock Options

1. These are issued as consideration for creation or transfer of IPRs to the company or other value addition

1. These are in the nature of retention plans for employees, officers and working directors.

2. These can be issued to employees and directors (whether working or non-working) who provide IPRs or know how or services.

2. In start-ups and other unlisted companies, these can be issued to whole-time directors (whether promoters or not), officers and employees.

3. Companies that are not listed on a recog- 3. Companies that are not listed on a recognized stock exchange need to comply with nised stock exchange can issue stock options the provisions of section 79A and the by passing a special resolution under section relevant guidelines for the issue of sweat 81(1A) and complying with the preferential equity shares. Listed companies have to issue guidelines. Listed companies have to comply with the relevant SEBI guidelines. comply with the relevant SEBI guidelines. 4. Section 79A permits only issue of equity shares.

4. These can be issued as options, which are exercisable at a later date.

5. These shares can be issued at an issue price, 5. These options can be issued with converwhich could be at a discount to their face sion right at a pre-determined price. This value without complying with section 79. issue price can be less than the intrinsic value of the share but not less than their face value unless the procedure laid down in section 79 is complied with. 6. The consideration can be partly cash and 6. The consideration has to be paid in cash. partly IPRs/value additions or fully such non-cash consideration. 7. These are mainly intended to be issued to 7. These are generally issued based on a build up equity for directors or promoters scheme to be formulated by the company with technical capability but with meagre stipulating the eligibility criteria such as numfinancial resources. ber of years of service, employee grade etc.

� Table 3.1 Comparative Chart of Sweat Equity and Stock Options

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pre-determined price’. Based on the above definitions, a comparison between the two instruments can be drawn to be able to understand their applicability, Table 3.1. The tax treatment for sweat equity shares and stock options are the same—the difference between the exercise price (to be taken as nil in the case of shares issued freely) and the final sale price in the sale/transfer of such shares would be taxable as long term or short term capital gain depending upon the period of holding. The company cannot treat the discount on issue of such shares as business expenditure as per decided cases. Reliance Industries Ltd. adopted a Stock Appreciation Rights Plan. Under this plan, the employee does not incur any cash outflow to buy the shares. Instead, the employee will be paid the price appreciation that happens between the date of granting of the option and the date of exercise thereof. Zee Telefilms Ltd. implemented an ESOP wherein shares were issued at Rs. 212 when the ruling market price was around Rs. 4225. Several Indian companies in software, pharmaceuticals, banking and financial services have issued ESOPs. Apart from the above, there could be alternatives such as incentive plans, which are long term in nature, spin-off of business activities into companies in future to accommodate each core member at the helm, business outsourcing models etc. that can provide permanence in the structure. The bottom line is to establish the availability of the core team expertise to the business over a fair period of time.

3.3 Overview of Valuation Methodologies for Equity Shares An equity share in a way represents a right to receive a future stream of cash flow by way of dividends, which are not determinable in the present. However, one can take an approach to forecast such expected dividends. At the same time, an equity share is not just about receiving dividend. It represents proportionate ownership of a company due to which the financial interest extends even to profits that have been earned by the company but have not been distributed as dividends. These are known as ‘Retained Profits’. Therefore, an alternative way of looking at the value of an equity share is to consider the future earning potential of the company. A third way of approaching the issue is to consider that an equity share is worth what it represents in the value of the company at present. This would mean that an equity share represents a proportionate part of the assets of a company either

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considered at their book value or at their market value. The fourth way of approach is to consider the market value of the share. However, since market value is susceptible to change and volatility, it is not considered an efficient measure of the value of an equity share. A different dimension that is often not quantifiable in the valuation of an equity share is its right of vote in corporate decisions. Therefore, the strategic value of a share, though not exactly quantifiable is considered much more than its economic value measured in terms of any of the considerations specified above. From the above discussion it is clear that there are alternative approaches to the valuation of an equity share based on the consideration adopted. Based on the facts of a given case, valuers adopt different methods or a combination of two or more methods to make the methodology appropriate to the situation. An attempt has been made therefore, to discuss the main approaches to valuation and their methodologies. As has been mentioned above, the valuation aspect would be revisited in subsequent chapters about the suitability of a particular approach for a given situation. However, the discussion given below is only an overview and not an exhaustive one. For a detailed discussion on these aspects readers may refer to the publications mentioned in note 2 at the end of this chapter.

3.3.1 Dividend Discount Model According to this approach, if the expected future dividend is assumed to be constant, the value of the equity share is computed as: V = D/c where, the value ‘V’ is derived by dividing the amount of dividend ‘D’ by the cost of equity ‘c’. However, if it is assumed that the dividend declared would not be constant but would grow at an expected constant rate, the formula should be modified as V = D/c–g wherein ‘g’ represents the constant rate of growth of dividend. The second formula is known as the Gordon model.

�

Illustration 3.2

If a company pays a dividend of Rs. 4 on a Rs. 10/- share and the expected rate of dividend (cost of equity) is 20%, the value of the share would be, V= 4/0.20 = Rs. 20.

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If the company’s present dividend is expected to grow at 5% per annum, the valuation would then be, V = 4/0.20–0.05 = Rs. 26.67 It may be observed from the above valuation, that the dividend discount method has limitations in the valuation of a share as it does not consider the other factors mentioned earlier.

3.3.2 Earnings Capitalization/Transaction Multiple Method The second method is to capitalize the existing EPS at an appropriate P/E ratio so as to arrive at the value of a share. For e.g. if the current EPS is Rs. 5 on a Rs. 10/share, and the appropriate P/E multiple is 15 for the given company, the value of the share would be Rs. 75 (5 Ò> 15). Under this method, the difficult part is to attach an appropriate P/E ratio for a given case considering the industry and other parameters. The second method of relative valuation is to use a Price to Book Value multiple such as a multiple of 2 or 3. For e.g., If the book value of a company’s share is Rs. 50, the value of the share could be considered as a multiple of the same by say 2 times, at Rs. 100. This kind of valuation is a relative method and the multiple used in a particular case has to be considered carefully. Apart from earnings capitalization, other methods of arriving at a relative valuation using the multiples methodology include—sales multiple, EBIT multiple, PAT multiple or other such multiples depending upon the business model of the company being valued. Such methods are referred to as transaction multiple methods.

3.3.3 Discounted Cash Flow Method This is perhaps the most widely used method of equity valuation for several business transactions. Under the DCF method, the future estimated cash flows of the company are discounted at a risk adjusted discounted rate to arrive at an estimate of the value. This can be achieved either by estimation purely from the perspective of equity shareholder (known as Free Cash Flow to Equity or FCFE) and discounting the same by the cost of equity. It can also be arrived at by estimating the cash flow for the company as a whole (known as Free Cash Flow to Firm or FCFF) and

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discounting the same by the cost of capital of the company. Under the second method, the value of the company as a whole is derived using the FCFF. From such FCFF, the market value of the outstanding debt is deducted to arrive at the value of equity.

Valuation using the FCFE The value of equity under this method is the sum of—(a) the present value of the FCFE arrived at for each year during a discrete growth period, and (b) the present value of the terminal FCFE at the end of that period. Expressing this as an equation, it is as follows: Value of Equity = PV of FCFE during discrete period (FCFE1) + PV of terminal FCFE (FCFE2) Value of share = (FCFE1 + FCFE2)/No. of shares In the above computations, the FCFE = Net profit + Depreciation – Future additional Capital Expenditure – Future additional working capital requirement – Repayment of debt + additional expected future borrowings.

Valuation using the FCFF The value of equity under this method is the sum of—(a) the present value of the FCFF arrived at for each year during a discrete growth period, and (b) the present value of the terminal FCFF at the end of that period. Expressing this as an equation, it is as follows: Value of Company

= PV of FCFF during discrete period (FCFF1) + PV of terminal FCFE (FCFF2)

Value of Equity

= (FCFF1 + FCFF2) – market value of outstanding debt

Value of share

= Value of Equity/No. of shares

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the FCFF = FCFE + interest on long term borrowings (1–t) + Repayment of Debt–additional expected future borrowings + Preference dividend (wherein ‘t’ is the effective tax rate). Under the DCF methodology, the basic presumption is that all the value parameters of a company are captured in the estimation of future cash flow. However, in specific circumstances, if some of such growth or value parameters are not reflected in the cash flow estimates, the following techniques could be used: �

Value these parameters separately and add them to the DCF valuation.

�

Use higher growth rates for the free cash flow in the DCF valuation.

�

Alter the discounting rate (the cost of equity) to reflect qualitative features not captured in the cash flow.

�

Use an option-pricing model to value future opportunities and add such value to the DCF valuation.

�

Illustration 3.3

ABC Ltd. has the following information as at the end of the current financial year: Equity Capital

10,000 shares of Rs. 10 each

PV of free cash flow during discrete period (FCFE1)

Rs. 100,00,000

PV of terminal cash flow (FCFE2)

Rs. 50,00,000

The Value per share

150,00,000/10,000 = Rs. 1500.

3.3.4 Net Asset Value Under this method, the share is valued at its Book Value as per the values of assets and liabilities appearing in the balance sheet. Therefore, the BV per share = Equity Shareholders’ funds as per balance sheet/No. of equity shares

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The limitation of this method is in the fact that it considers only the historical value of the assets while the liabilities are considered at market value. Secondly, it does not attach any significance to the ‘going concern’ concept because it does not consider the future earning potential of the company. A modification of this method is the ‘Break-up Value’ method, under which the both the assets and liabilities are considered at their liquidation value. In such a case, Break-up value per share = Liquidation value of assets – outstanding debt

�

Illustration 3.4

ABC Ltd. has the following information as at the end of the current financial year: Equity Capital

10,000 shares of Rs. 10 each

Reserves and Surplus General Reserve

Rs. 50,00,000

Revaluation Reserve

Rs. 15,00,000

Capital Redemption Reserve

Rs. 25,00,000

Debenture Redemption Reserve

Rs. 20,00,000

Surplus in P&L Account

Rs. 5,00,000

Miscellaneous Expenditure not w/o

Rs. 10,00,000

Land and buildings and stock have been valued at Rs. 5 lakh more and Rs. 2 lakh less respectively to their book values.

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Computation of NAV Rs. Equity Capital

Rs.

100000

Cash reserves General reserve CRR DRR Surplus in P&L account

10000000

Total Cash networth

11000000

Less Misc. Exp not W/o

1000000

Tangible networth

10000000

No. of shares (nos.)

10000

NAV per share (Rs.)

1000

Computation of Break-up Value Rs. Equity Capital

Rs.

100000

Cash reserves General reserve CRR DRR Surplus in P&L account Revaluation reserve

11500000

Less Misc. Exp not W/o

1000000

Tangible networth

10500000

Add appreciation in land and buildings

500000

Less depreciation in stocks

200000

Break-up value No. of shares (nos.) Break-up value per share (Rs.)

10300000 10000 1030

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3.3.5 Valuation under the Erstwhile CCI guidelines The Controller of Capital Issues (CCI) under the erstwhile Capital Issues Control Act, 1947 had issued guidelines for the valuation of shares (popularly known as the CCI guidelines) on 13th July, 1990. Though these guidelines have become defunct since the repeal of the Act, these guidelines are still being followed for the purpose of valuation of shares of unlisted companies both by the SEBI and the RBI for various purposes. This methodology is discussed below: Valuation under the CCI guidelines takes into account the following parameters: �

Net Asset Value (NAV) – The NAV as per the latest audited balance sheet will be calculated starting from the total assets of the company and all deducting debts, dues, borrowings and liabilities, including current and contingent liabilities and preference capital if any. In other words, it should represent the true networth of the company after providing for all outside present and future liabilities. In computing the value of the assets, the capitalized value of intangibles, if any in the balance sheet shall be ignored. Similarly revaluation of assets made in the recent past (say less than five years) shall also be ignored. Among the components of networth, any reserves which have not been created out of cash profits (whether capital or revenue) shall be ignored.

�

Profit Earning Capacity Value (PECV) – For arriving at the PECV, it would be necessary to compute the average future maintainable profits of the company. While the past trends of profitability can serve as a guide, it should not be overlooked that the valuation is for the future and what needs to be arrived at is the future sustainable stream of earnings. All relevant factors that have a bearing on the future sustainability of the profits shall be taken into consideration. Averaging is normally done for the past three years.

The PECV is computed by capitalizing the future average maintainable annual profit as described above at the following rates: a) 15% in the case of manufacturing companies. b) 20% in the case of trading companies. c) 17.5% in the case of others. d) Lower rates or higher rates different from the above may be used in

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appropriate cases. The capitalization rates may also be varied based on the market price in the case of thinly traded shares. Based on the above two computations, the Fair Value of the share (FV) is calculated as shown below:

�

FV of share = (NAV + PECV)/2 Therefore, under the CCI method, the value of a share is arrived at by a combination of the NAV method and the Earnings Capitalization method without using the concept of discounting the cash flow. The CCI method results in a conservative estimate of valuation as it considers a maximum capitalization factor of 12.5 for the future profits. However, it is a balanced approach and gives equal weightage to the past accumulation of networth in the balance sheet as well as the future potential for generating profits.

�

Illustration 3.5

The following is the valuation of a company as per the CCI Guidelines:

Based on Assets From the Liability side Existing Equity Capital

Rs. Lakhs 1131.1

Share Premium

1235.19

Free Reserves

3051.44

Networth

5417.73

Less Miscellaneous expenses not w/o Adjusted Networth

10.96 5406.77

From the Asset side Fixed Assets

5701.21

Net Current Assets

5527.89

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Capital WIP

1266.25

Investments

151

Total Assets as per Balance Sheet

12646.35

Less Debenture Redemption Reserve

0

Long term liabilities

7239.58

Adjusted Networth

5406.77

Face Value of Proposed Capital

507

Proposed Networth

5913.77

Existing Shares

113.11

No. of new shares

50.7

Total no. of shares (post-issue)

163.81

NAV per share

36.10

Based on Earnings Operating Profit

PBT

WTS

WT. PBT

1990–91

212.25

1

212.25

1991–92

543.78

2

1087.56

1992–93

1397.4

3

4192.2

Average Profits

717.81

915.34

Tax at normal rate

274.60

Average PAT

640.73

Contribution from Fresh Issue

30.04

Expected Future Profits

670.78

Total shares (Post Issue)

163.81

EPS (post tax) PECV at 8% capitalization (Post tax)

4.09 51.19

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FAIR VALUE NAV per share

36.10

PECV (post-tax)

51.19

Average

43.64

Less Dividend Fair Value

2 41.64

In the above illustration, as may be observed, the valuation of the share has been made from both the methods, i.e., the NAV method using the balance sheet values and the PECV method using the past three years profits as a benchmark. The PECV profits have been computed on weighted basis attaching maximum weightage to the immediately preceding year. The weighted average PAT is enhanced with the increase in income expected from the deployment of the fresh funds received from the issue. This would result in the future expected profits, which are capitalized at 8% to arrive at the PECV value of the share. The capitalization rate was considered aggressively at 8% since the company was already well established and its ruling market price was much higher at that time. It is pertinent to note that under both the methods, the benefits that would accrue from the proposed issue were considered in fixing the price. This was a concept that was allowed under the CCI formula, which currently cannot be used as a justification for pricing under the SEBI guidelines.

3.4 Equity Issues in Primary Market An issue of equity involves the increase of the equity share capital by issue of fresh shares. The consideration for such shares can be received either in cash or in kind or through capitalization of reserves. The company law recognizes all the three modes of consideration. However, shares issued for consideration other than cash and by capitalization of reserves need specific disclosures in the financial statements. The various methods by which a company may issue shares are depicted in Fig. 3.2. In a public offer, shares are offered for public subscription through advertisement and issue of a public offer document. The final allotment of shares is made to the successful applicants based on established criteria. One of the essential features of a public issue is that the shares are listed on a stock exchange through the issue.

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TYPES OF EQUITY ISSUES

Initial Public Offer s

Public Issue

Offer for Sale

� Figure 3.2

Rights Issues

Public Issue

Secondar y Public Offer s

Offer for Sale

Composite Issue

Methods of making Equity Issues

As can be seen from the above diagram, broadly speaking, there are two types of public offers—Initial Public Offers and Secondary Public Offers. We will now discuss the various types of equity issues.

3.4.1 Initial Public Offer An initial public offer as the name suggests, is a public issue being made for the first time by a company to seek listing on a stock exchange. It implies that prior to the IPO, the company was unlisted. There are two methods of taking a company public—(a) through a public issue of fresh shares to be issued by the company and (b) by an offer for sale of the existing shares to be made by the existing shareholders to the public. Sometimes, a combination of the above two is adopted whereby a company goes public with a fresh issue of shares together with an offer for sale by some existing shareholders. Under the public issue method, the equity base of the company increases by the amount of new shares to be issued. Under the offer for sale method, the equity base of the company does not increase since no fresh shares are being issued except that existing shares are being sold by one shareholder to another. This implies that in a public issue, the company receives the funds while in an offer for sale, the seller receives the funds. The offer for sale method is ideal for a company that wishes to get its shares listed without increasing its equity base. It is also suited where an existing shareholder such as a venture capitalist plans to make an exit by selling off to public shareholders. A combination of both the methods is adopted when the company requires the funds partly and an existing shareholder

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wants to make an exit. According to section 64 of the Companies Act, an offer for sale has to comply with the same requirements of law as a public issue. IPOs are discussed in detail in Chapter 5.

3.4.2 Rights Issue In a rights issue, the shares are issued to the existing members of the company as appearing in its register of members as of a particular date fixed for this purpose. This date is known as the ‘Record Date’. Therefore, a rights issue is a restricted issue made only to the existing registered shareholders and to nobody else.

3.4.3 Secondary Public Offer A secondary public offer is an issue made by a company that has already gone public and has listed its shares through an IPO. The different types of secondary public offers are—(a) Public Issue (b) Offer for Sale and (c) Composite Issue. The distinction between a rights issue and a secondary public offer is that while in the former case, shares are offered only to the existing registered shareholders, in the latter case, it is a public issue made to the general public including the existing shareholders. Therefore, in a secondary public offer, there can be investors who are subscribing to the company’s shares for the very first time. A composite issue is a combination of a rights and a public issue at the same time and is also referred to as a ‘Rights Cum Public Issue’. Under this method, a company makes a rights issue to its existing shareholders while making a simultaneous public issue to other shareholders. Therefore, in such a composite issue, an existing shareholder has the following options: �

Take up the rights offered in the rights issue.

�

Take up the rights shares and also subscribe to the public issue on par with other shareholders.

�

Renounce the rights shares and opt for the public issue instead (an unlikely event since the rights shares are generally priced lower than shares being offered in a secondary public issue).

�

Renounce the rights and not subscribe to the public issue as well.

Rights issues and secondary public offers are discussed in Chapter 6.

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3.5 Primary Market Equity Issuers Primary equity market consists of public equity offers made by companies registered under the Companies Act as public companies limited by shares. Other entities that can make such primary market offerings are corporations that are incorporated under a special statute of the Central or the State legislature. These aspects are discussed below: �

Companies incorporated under the Companies Act – The Act prescribes that only a public company having a share capital can issue shares to the public for subscription. A public company has been defined as a company that is not a private company. Section 3(1)(iii) of the Act throws light on what a private company is. According to it, a private company is one that has the following restrictions in its articles of association. �

It restricts the right to transfer of its shares, if any;

�

Limits the number of its members to fifty not including former employee-members;

�

Prohibits any invitation to the public to subscribe for any shares in or debentures of the company;

�

Prohibits any invitation or acceptance of deposits from persons other than its members, directors or their relatives.

From the above, it is clear that a public company shall not have any of the above restrictions in its articles of association that shall preclude it from making a public offer of equity or debt. The second condition to be eligible for making a public offer is that a public company shall have a share capital. As per the Act, it is possible to incorporate companies that are limited by guarantee and not by shares. Such companies are ineligible to make public offers. Under the Act, companies can be privately owned or owned by the Government, either Central or State. Government companies, according to section 617 are those wherein not less than 51% of the paid-up capital is held by the central or a state government or a combination of both. A subsidiary of a government company shall also be deemed to be a government company. There are several instances of a government company that is listed in the stock market. The oil companies such as—IOC, BPCL, HPCL and others such as HMT are listed on the stock exchange though they have so far not made any public offers. This was possible by the government exempting them from the minimum public holding stipulated under the

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SCRA. Among other government companies that have made public issues are Maruti Udyog Ltd., SAIL, IPCL, ONGC etc. �

The other type of entities that can make public offer of shares are corporations incorporated either under a Central Act, or a State Act or a Provincial or Local law. Some examples of central corporations are the—IDBI, LIC, GIC, SBI, NTPC, Konkan Railway Corporation, National Power Corporation, National Highways Authority of India, Airports Authority of India and several others. State corporations are incorporated under respective Acts passed by state legislatures such as the transport corporations, urban development, infrastructure and housing corporations etc. Local and provincial bodies include municipal bodies and others that have a revenue collecting authority in a particular area. Several corporations such as the SBI, IDBI, IFCI etc. have made public issues in the past. In recent times, corporations such as IRBI and IFCI have been converted into companies under the Companies Act. The IDBI has also been approved for such a conversion. The public issue of BPCL has been delayed due to a recent judgement of the Hon’ble Supreme Court on the matter.

3.6 Primary Market Equity Investors Primary market investors can be basically differentiated into three categories—institutional investors, other large investors and small investors or retail investors. The institutional and the other large investors comprise of the non-retail category. The essential feature that distinguishes retail investors from the non-retail category is their status and the size and purpose of investment. While retail investors are mostly investment oriented, non-retail investors are mostly in the business of investments. All the three categories have been discussed below:

3.6.1 Non-retail Investors In common parlance, non-retail investors are those who invest large corpus of funds in the securities market either because they are investment institutions or corporates or because investing in capital markets is one of their core businesses. There are several categories of non-retail investors in the Indian capital markets, some of whom are institutional investors. The distinguishing feature of institutional investors that sets them apart from other large investors is their stature. Usually institutional investors are financial institutions that have an important role in the financial

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markets such as banks, institutions and mutual funds. The various categories of large investors are listed below: �

Domestic financial or investment institutions such as the UTI, LIC, GIC, IDBI, ICICI, SHCIL, IL&FS and others, commercial banks and mutual funds.

�

Domestic corporate investors such as—Non-Banking Financial Companies (NBFCs), investment companies, investment banks, underwriters, primary dealers, stock broking companies, portfolio management companies and others.

�

Foreign institutional investors (FIIs).

�

Venture capital investors (both domestic and foreign).

�

Foreign corporate investors who are not registered as FIIs.

3.6.2 Retail Investors The first ever survey of Indian investors was conducted in 1999 jointly by the SEBI and the National Council for Applied Economic Research (NCAER). According to this survey and as quoted in the Indian Stock market Review 2002 published by the NSE, the following picture emerges. About 7.6% of all Indian households are direct investors in equity or debentures in 1998–99 with an investor base of 19 million. This meant that more than 92% were non-investors in such instruments. However, about 15 million investors representing about 9% of the households were investors in mutual funds. This accounts for about 23% of the market capitalisation and compares poorly with that of developed countries where the comparative figure is more than double. The investor base in the urban areas is denser than in rural areas but the growth of investor households has been more pronounced in the nineties than in the eighties. However, the study finds that there are several factors such as market imperfections, lack of awareness and investor education that are responsible for the low penetration of the equity culture and mutual fund culture in India. Investors perceive equity as risky investment primarily because several retail investors have burnt their fingers with equity. Most Indian households prefer safer investment options such as bank deposits, LIC, government savings and corporate debt instruments. Among the equity investors, the study finds that there is very poor allocation of portfolio risk and the absence of a scientific method of investment. Among the retail investors, SEBI has floated the concept of retail individual investors, in relation to the primary market. A retail individual investor is one who

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applies for securities of a value not exceeding Rs. 50,000 in a public offer. In earlier days, most companies had a market lot of 100 shares, whereby a retail investor was one who applied for 1000 shares or less. But with the advent of dematerialized trading, the market lot concept is no longer relevant. Presently, the retail investor has been defined in terms of value of the application as stated above. In book-built public issues, a retail individual investor is one who put in a bid for a value not exceeding Rs. 50,000.

3.6.3 Criteria Applicable to Retail and Non-retail Investors As far as primary market investments are concerned, the large investors look at primary issues from the perspective of medium term growth while the retail investors look for short-term profit booking within the first 3–6 months after listing. The large investors are driven more by the fundamentals of the issue and are therefore keen to wait for appreciation in the market price over a longer time frame of 1–2 years. A lot depends on factors such as—the pricing of the issue, fundamentals at the time of issue, the company’s capability to live upto promises made in the issue, the level of identification and communication with the market post-listing, corporate governance etc. These factors determine the equilibrium price of the company’s share in the market that a large investor looks for. However, the retail investors are driven more by profit motive and arbitrage opportunities than by fundamentals. This is the reason why the retail demand in a scrip is driven by events such as dividend, bonus and rights announcements while the institutional investors look for more fundamental factors such as—industry growth, economic or government policy impacting the company, contracts and large orders etc. Most of the time, institutional demand in a particular issue scrip makes it a market favourite and the retail investors identify it as a profit making business opportunity.

3.6.4 Institutional Investing and Investment Banking As has been already discussed in Chapter 2, investing in the capital market is a fund-based activity that is often combined with other activities under the umbrella of investment banking. Institutional investing by some of the institutional investors described above is thus a segment that combines well with their business profile in investment banking. For e.g. commercial banks have investment banking subsidiaries while institutional investing can be part of the core banking operations. Similarly financial institutions invest as institutional investors while being in

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investment banking either directly or through group companies. Examples of such entities are banks such as SBI and ICICI and institutions such as IDBI. Therefore, institutional investing is a core vertical that combines with investment banking for universal banks and institutions. Apart from banks and institutions, the other categories of investors that are relevant for this discussion are mutual funds, venture capital funds and foreign investors. As discussed in Chapter 2, investment banks can have affiliate entities that are in the business of mutual funds or in venture capital/private equity funds. Therefore, it becomes necessary to look at their business procedures more closely. Mutual fund is more of a retail financial service and helps the investment bank to develop loyal retail clients and strengthen its sales and distribution network. This is the reason why most investment banks are found to be in the mutual fund business as well; examples being—DSP Merrill Lynch, Kotak Mahindra, ICICI with Prudential, JM, SBI, IL&FS and others. IDBI recently made its exit from the mutual fund business by selling off its stake to its partner Principal of the US. This practice is prevalent outside India as well. Merrill Lynch, Goldman Sachs and other leading investment banks have large mutual funds under its management. Apart from institutional investment banks, those that are in the category of NBFCs can be institutional investors as well. Several investment banks such as SBI Caps have a huge investment activity in both the primary and secondary markets. This activity helps them to manage their funds, develop investment skills and also in structuring financial products for their merchant banking activities. Venture capital is a corporate activity that is focussed on making gains out of building corporate businesses. Therefore, they invest in unlisted companies. Most investment banks both abroad and in India have floated separate venture and private equity funds. UBS Warburg, Citigroup, JP Morgan, Deutsche Bank and several others abroad and IDBI, ICICI, Canara Bank, IL&FS and few others in India are some instances of investment banks having their presence in institutional investing as venture capital and private equity funds. Venture capital and private equity funds can again be either domestic or foreign venture capital investors (FVCIs). Both these are regulated by SEBI. These aspects are discussed in the following paragraphs. Foreign investors for the purpose of institutional investing, can be FIIs or other foreign corporate investors who can invest in India under the prevalent Foreign Direct investment policy (FDI investors). Recently, the RBI has de-recognized overseas corporate bodies owned predominantly by non-resident Indians as a

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separate category of foreign investors in India in the wake of the security scams in the capital market. While FIIs have been allowed to invest both in primary and secondary markets, FDI investors can invest only in primary investments. Investment banks abroad intending to be institutional investors in India can invest in any of the above mechanisms depending on their status and scope of such activity in India. These aspects have also been explained in this Chapter.

3.6.5 Investment Routes in the Primary Market for Institutional Investors Investing in the primary market as an investment bank or as an institutional investor should be compliant with necessary regulatory requirements. Investments in primary markets can be made through the following routes: �

Subscribing to public issues either through firm allotments or through the general public offer.

�

Investment by taking up unsubscribed portions of underwritten commitments (devolvements), book building commitments, bought out deal obligations which are a part of merchant banking and underwriting activity.

�

Taking up of devolvements, renouncements or under-subscriptions in rights issues.

�

Subscribing to private placements and preferential allotments of listed and unlisted companies,

�

Investment in unlisted companies through the venture capital or private equity route.

More discussion on all the above are provided in appropriate subsequent Chapters wherein the operational aspects of public offers and private placements have been dealt with. Investments made through steps 1 & 2 are part of the merchant banking and underwriting activities and are therefore governed by the appropriate provisions under the SEBI guidelines. Private placements and preferential offers of listed companies are governed by SEBI guidelines and the Companies Act 1956, while those for unlisted companies are governed by the Companies Act. Venture capital and private equity investments in unlisted companies are governed by the Companies Act. Institutional Investing in Indian capital markets can be schematically represented as shown in Fig. 3.3.

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INSTITUTIONAL INVESTORS IN INDIAN CAPITAL MARKET

PRIMARY MARKET—SHARES AND OTHER SECURITIES UNLISTED AND TO BE LISTED

DOMESTIC FIs, INVESTMENT INSTITUTIONS, BANKS, MUTUAL FUNDS

MERCHANT BANKERS / UNDERWRITERS

OTHER DOMESTIC CORPORATE INVESTORS— NBFCs, INVESTMENT COMPANIES, PRIMARY DEALERS, STOCK BROKERS, PORTFOLIO MANAGERS AND OTHERS

SECONDARY MARKET— SHARES AND OTHER SECURITIES LISTED ON STOCK EXCHANGE

DOMESTIC FIs, INVESTMENT INSTITUTIONS, BANKS, MUTUAL FUNDS

MERCHANT BANKERS/ UNDERWRITERS

OTHER DOMESTIC CORPORATE INVESTORS — NBFCs, INVESTMENT COMPANIES, PRIMARY DEALERS, STOCK BROKERS, PORTFOLIO MANAGERS

VENTURE CAPITAL INVESTORS OVERSEAS CORPORATE INVESTORS—(FIIs/OCBS) OVERSEAS CORPORATE INVESTORS—(FIIs, FVCIs, FDI INVESTORS)

� Figure 3.3

Overview of Institutional Investing

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3.6.6 Regulatory Provisions for Primary Market Institutional Investors Universal Banks As discussed in Chapter 2, universal banks are regulated by the Reserve Bank of India under the RBI Act 1934 and the Banking Regulation Act which puts restrictions on the investment banking exposures to be taken by banks. Section 19(2) of the Banking Regulation Act puts restrictions on the stock market exposures of banks.The SBI and its subsidiaries are governed by separate statutes apart from the two mentioned above. The investment limits applicable to merchant banking entities have been mentioned in Chapter 2. However, in the case of banks that undertake merchant banking activity as a division of the bank such as Canara Bank, the situation is different. For such banks, the investing activity has to be within the overall ceiling for stock market and equity exposures prescribed by the RBI guidelines, which is presently 5% of their advances calculated with reference to the previous year. Therefore underwriting and other forms of primary market investing by such banks have to form part of all other equity exposures taken by the bank under the overall ceiling.

Financial and Investment Institutions Financial institutions and investment institutions are governed by their constitution and their activity. Institutions that are incorporated under a separate statute such as the IDBI, IFCI, UTI, LIC, GIC etc. are governed by their respective statutes. In addition, they are also regulated by the RBI for their investment exposures.

Mutual Funds Mutual Funds are retail financial pools that are invested for gains in capital markets. In India, mutual funds are allowed to raise funds by public offer of their units, which form the unit capital (corpus) of each Fund. In a particular Mutual Fund, there could be several schemes, each of which has a separate investment philosophy. Mutual Funds are structured as trusts wherein the unit holders are beneficiaries. The trust is safeguarded by a trustee company and the funds are managed by an asset

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management company. The share capital of the asset management company is mostly held by the sponsoring company of the mutual Fund. Mutual Funds are regulated in their investments in the primary market by the Securities and Exchange Board of India (Mutual Funds) Regulations 1996. Broadly, the important investment parameters under the regulations are as follows: �

Not more than 5% of the corpus as reflected by the Net Asset Value (NAV) can be invested in unlisted shares or convertibles.

�

Not more than 10% of the NAV can be invested in shares or convertibles of a single company.

�

The total investment in unrated debt instruments shall not exceed 25% of the NAV.

�

No Mutual Fund under all its schemes can hold more than 10% of a company’s share capital or voting rights.

Merchant Bankers/Underwriters Apart from the stipulations discussed above which govern exposure of universal banks to investment activity, specific guidelines have been prescribed by SEBI for underwriting business conducted by Merchant Bankers and pure underwriters. These are governed by the Securities and Exchange Board of India (Underwriters) Rules, 1993 and the SEBI (Underwriters) Regulations 1993. The underwriting provisions basically prescribe registration of all underwriters with SEBI, minimum capital adequacy norms, method of entering into underwriting agreements, general responsibilities and a cap on the maximum underwriting obligation at any given time, which currently stands at 20 times the networth of the underwriter. In the case of public offers which are underwritten, the lead manager has to undertake an underwriting obligation of at least 5% of the total underwritten component or to the extent of Rs. 25 lakh, whichever is less. Investment banks that are companies under the Companies Act either registered with the RBI as NBFCs or not, should also comply with section 372A of the Companies Act in making investments as part of their underwriting obligations. However, this section does not apply to companies that have investments as their principal objective. In the case of an investment bank, the primary business objective has to be merchant banking only.

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Other Domestic Corporate Investors Other domestic corporate investors such as—investment companies, NBFCs (which are not merchant banks), primary dealers, portfolio managers, co-operative banks, miscellaneous non-banking companies, residuary non-banking companies, provident funds and others are governed by their constitution and the relevant laws applicable thereto for making primary market investments.

Domestic Venture Capital Investors The only category of investors that is exclusive to unlisted and to be listed companies is that of venture capital investors. Under the present investment guidelines for venture capital, even later stage financing as private equity can also be made by venture capital investors as long as the company is unlisted or is to be listed. The emergence of the venture capital industry in India in a significant way has only been of recent origin. The Venture Capital Guidelines notified on 25th November, 1988 went on to define the scope of venture capital to mainly include assistance provided to enterprises where the risk element is comparatively high and/or the entrepreneurs being relatively new. The investment size was restricted to Rs. 10 crore and the technology was relatively new, untried or very closely held or being taken from pilot to commercial scale or which incorporates some significant improvement over the existing ones in India. Pursuant to the guidelines, several institutional Venture Capital Funds (VCFs) were promoted to provide VC assistance as per the eligibility norms. However, the main hindrance was the definition given to the scope of VC assistance so as to mean risky and start up technologies. VC was perceived as a high-risk high-return game. Therefore, the units that were supported were mainly the technocrat-promoted variety wherein, but for the assimilation of technology; the promoters were first generation entrepreneurs with a lack of business background and in particular, industrial experience. The traditional concept of VC being risk capital was broad-banded by SEBI in 1996 notifying a new set of regulations for the VC industry called the SEBI (Venture Capital Fund) Regulations, 1996. The concept of private equity was thus born for investment in later stage and turn around companies. Though the concept of

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private equity is essentially meant for investment in later stage companies, the VC funds operating in India have caught on to it in a significant way only after the dotcom bust in 2001. As far as the domestic VCFs are concerned, there is no regulation on the type of investee companies (Venture Capital Undertakings) in which VCFs can make investments except that they shall be domestic companies and unlisted at the time of investment by a VCF. Investments may also be made through the Prospectus of a to-be-listed VCU. VCUs may be engaged in any type of manufacture or service activity excepting those mentioned in the negative list. Therefore, hypothetically, VCFs may invest in sick and turnaround companies too, though there has not been any such interest from VCFs so far. There are further restrictions that 75% of the investible funds of a VCF shall be deployed in equity or equity linked instruments. Out of the balance 25%, a VCF may invest in pure debt instruments only as follow on funding in a VCU wherein it already has an equity exposure.

Foreign Venture Capital Investors (FVCIs) In the year 2000, foreign venture capital investors have also been brought under the purview of SEBI for such investments. A FVCI has been defined as ‘an investor incorporated and established outside India which proposes to make investment in Venture Capital Fund(s) or Venture Capital Undertaking(s) in India and is registered with SEBI under the SEBI (Foreign Venture Capital Funds) Regulations, 2000’. There are two types of foreign venture capital investments that are possible under the current regulatory framework of SEBI: �

By Foreign Venture Capital Investors (FVCIs) registered with SEBI under the SEBI (Foreign Venture Capital Funds) Regulations, 2000 investing in a domestic VCF that is registered with SEBI under the SEBI (Venture Capital Fund) Regulations, 1996. Under this route, the FVCI would take a one-time approval from RBI for making investment into the fund in India and all subsequent investments made by the fund shall be governed the same way as they are governed for domestic venture capital funds.

�

FVCIs registered with SEBI, directly investing in venture capital undertakings in India. These investments have to be made as per the norms

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Foreign Venture Capital Investor (FVCI) Means an incorporated body outside India which proposes to invest in Venture Capital activity in India. Needs to be compulsorily registered under the SEBI (FVCFunds) Regulations 2000. Can invest into a VCF or make direct investments into VCUs

Venture Capital Fund

Venture Capital Undertaking Means an unlisted company engaging in activities not in the negative list

Means a trust or a company or a domestic VCC / VCF

(a) The FVCI can subscribe up to 100% of the corpus of the trust / capital of the company. (b) The FVCI should apply to RBI through SEBI for grant of permission under FEMA. After approval of RBI, the investment can be made as equity, debt or as unit capital of the trust. The investment can be at a mutually agreed price. (c) The FVCI can exit its investments at mutually agreed prices after seeking approval for such sale from RBI. (d) The VCC/VCF can invest as stated below in VCUs. The price of such investments can be mutually agreed upon by the VCF and the VCU. (e) The trust / company cannot invest more than 25% of its corpus/capital in one VCU. (f) The balance 25% can be used to invest in IPOs with a lock-in of one year. (g) The balance 25% can also be used to invest in debt instruments or loans to VCUs that have already been funded through equity.

� Figure 3.4

(a) The FVCI can invest up to 25% of its India specific funds in each VCU. (b) The FVCI should apply to RBI through SEBI for grant of permission under FEMA for every investment in a VCU. After approval of RBI, the investment can be made as equity, debt or convertibles subject to SEBI guidelines as stated below. The price of such investments can be mutually agreed upon by the FVCI and the VCU. (c) Minimum of 75% of the funds shall be invested in unlisted companies. (d) The balance 25% may be used to invest in IPOs with a lock-in of one year. (e) The balance 25% may be also be used to invest in debt instruments or loans to VCUs that have already been funded through equity. (f) The FVCI can exit its investments at mutually agreed prices after seeking approval for such sale from RBI.

Investment routes for FVCIs

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prescribed under the SEBI (Foreign Venture Capital Funds) Regulations, 2000. The investment routes for FVCIs are given in Fig. 3.4.

FDI Investors Non-resident corporate investors who are not OCBs or FIIs registered with SEBI have been termed for the purpose of this discussion as FDI investors. These can be investment companies, financial houses, investment banks or other corporate investors including venture capitalists. These types of investors can invest in Indian primary markets according to the FDI policy prescribed under the Foreign Exchange Management Act 1999 and the rules made there under. This mechanism is useful for those investors who do not wish to come under the regulatory purview of SEBI by registering themselves either as FIIs or FVCIs. The disadvantage in this mechanism is that it is inflexible for regular investors and approvals would be required from RBI for every inward investment and every disinvestment. Approvals under the FDI mechanism are either given through the automatic route of RBI or through the Foreign Investment Promotion Board.

Foreign Institutional Investors (FIIs) Foreign Institutional Investors (FIIs) including institutions such as—pension funds, mutual funds, investment trusts, asset management companies, nominee com panies, universities, incorporated/institutional portfolio managers or their power of attorney holders (providing discretionary and non-discretionary portfolio management services) are those types of institutions that are eligible to invest in Indian capital market under the FII route. These investments are regulated by the SEBI (Foreign Institutional Investors) Regulations, 1995. All FIIs intending to invest in India through this route need to register with SEBI under the said guidelines. Under the guidelines, a domestic asset management company or a portfolio manager in India which is registered with SEBI can also register itself as an FII to manage sub accounts belonging to FIIs abroad. Under the guidelines, FIIs can invest in all the securities traded on the primary and secondary markets, including the equity and other securities/instruments of companies which are unlisted, to be listed or listed on the stock exchanges in India

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including the OTC Exchange of India. These would include shares, debentures, warrants, and the schemes floated by domestic mutual funds including the UTI, whether listed or not. They can also invest in dated government securities, treasury bills, derivatives, commercial paper and other debt instruments. SEBI can add further categories of securities from time to time. The investment parameters for FIIs in different instruments have also been defined. Generally, FIIs have to invest not less than 70% of their corpus in equity and equity linked instruments. However, FIIs can also register themselves as 100% debt funds in which case, the restriction of 30% on debt investments will not be applicable. Such FIIs would be treated as a separate category of FIIs. There would be no restriction on the volume of investment minimum or maximum for the purpose of entry of FIIs, in the primary/secondary market. Also, there would be no lock-in-period prescribed for the purposes of such investments made by FIIs. FIIs can invest up to 10% of the total issued capital of a company (5% in the case of corporate FIIs). The total FII holding of all FIIs in a company should not exceed 30% either through the primary or the secondary market or both. This limit can go up to 40% if a particular company passes a special resolution being passed to that effect by such a company. The maximum holdings of 30% or 40% as the case may be, will not include the following: �

Investments by NRIs/OCBs and PIOs

�

FDI Investments

�

Investments by FIIs through the following alternative routes—i.e. through GDR/ADR issues, euro convertibles and offshore single/regional funds.

Since there are foreign exchange controls also in force, for various permissions under exchange control, along with their application for initial registration, FIIs shall also file with SEBI another application addressed to RBI for seeking various permissions under FEMA, in a format that would be specified by RBI for this purpose. RBI’s general permission would be obtained by SEBI before granting initial registration and RBI’s FEMA permission together by SEBI, under a single window approach. Disinvestment will be allowed only through various stock exchanges in India, including the OTC Exchange. In exceptional cases, SEBI may permit sales other than through stock exchanges, provided the sale price is not significantly different from the stock market quotations, where available.

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Overseas Corporate Bodies Overseas Corporate Bodies (having a minimum of 60% non-resident Indian interest) were allowed to invest in Indian companies through the FDI route for investment in unlisted shares/securities and through the portfolio route in the secondary markets. In November 2001, the RBI had prohibited OCBs from the secondary markets for indulging in unhealthy market practice in the wake of the security scam. In addition, through a circular issued in 2003, OCBs have been de-recognized as a separate category of investors having a special status such as NRIs for future investments in India under the FDI route. The FEMA regulations have been amended to give effect to the same. However, the RBI has clarified that what has been de-recognized is only the special status to OCBs. They can still apply like other foreign investors under the FDI route for future investments in India. In such a case, approvals for OCBs under the FDI mechanism are given either through the automatic route of RBI or through the Foreign Investment Promotion Board.

3.6.7 Investments in Secondary Market Investments in the secondary market involve buying and selling of shares and other securities through the stock exchange. These are listed instruments and are therefore available to those institutional investors who are allowed to invest in them. As has been explained earlier, secondary market investments can be made by all investors who are eligible to invest in the primary market subject to the following: �

Domestic and foreign venture capital investors cannot invest in secondary markets. These investors are also not allowed to invest in fresh shares issued by listed companies.

�

FDI investors who can invest only in primary market through the FDI route are not allowed to invest in the secondary markets.

�

FII investors are allowed to invest in secondary markets within the overall ceiling prescribed for them for investments in both primary and secondary markets.

All secondary market investors are regulated in the same way by respective statute or regulations in the same way as they are regulated for primary market investments.

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3.7 Primary Market Intermediaries and Support Service Providers 3.7.1 Issue Managers The primary market intermediaries are the merchant bankers, underwriters to issues and brokers to issues. The merchant bankers as mentioned in Chapter 2 are the issue managers who bring the issues to the primary market investors. Issue management is an onerous job under the provisions of the SEBI guidelines and the Companies Act. Besides, only merchant bankers holding a valid registration with SEBI can act as issue managers. Issue management is a fee-based service. The detailed aspects of issue management are discussed separately in subsequent chapters.

3.7.2 Underwriters Underwriting is a fund-based service provided by a market intermediary, which consists of taking a contingent obligation to subscribe to an agreed number of securities in an issue if such securities are not subscribed to by the intended investors. If the issue is fully subscribed to by the investors, the underwriter has no fund obligation to the issue but collects the underwriting fee. However, if investors do not subscribe to the issue fully, the obligation devolves on the underwriter to the extent of the unsubscribed portion of the issue. However, the extent of devolvement on an underwriter also depends upon the extent of subscriptions procured by such an underwriter from the investors. If a particular underwriter has been able to market the issue and procure enough subscriptions to cover his or her underwriting completely, such an underwriter will not face any devolvement even if the issue has been under-subscribed.

�

Illustration:

ABC Ltd. makes an issue of 10,000 shares of Rs. 10 each at par aggregating to Rs. 100,000. The issue has been underwritten fully by two underwriters ‘X’ and ‘Y’ to the extent of Rs. 50,000 each. Since the issue is underwritten, ABC Ltd is assured of getting its funds either through the investors or in the event of undersubscription, from the underwriters.

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163

Now, let us consider the different possible outcomes of the above case. In the first instance, let us assume that the issue is fully subscribed. In such a case, ABC Ltd. gets its funds from the investors and the underwriters have no obligation to take up any shares. They receive underwriting commission on their respective components at the agreed rate. Thus, the underwriters have made income on a purely fee-based service. The second outcome could be that the issue is under-subscribed and on examination of the applications, it is found that both the underwriters have not been able to procure subscriptions to the extent of their full underwriting commitment. On further examination, it is found that the issue has been under-subscribed to the extent of 25% and the relative shares of such under-procurement attributable to A is Rs. 10,000 and to B is Rs. 15000. The underwriters will thus take up their underprocurements to the specified extent and make the issue fully subscribed. It may be noted that in an issue there would also be subscriptions from investors that come in directly, i.e. not through the marketing efforts of underwriters. Such subscriptions also go to reduce the devolvement of the underwriters in the same proportion in which they have underwritten the issue. The third outcome could be that the issue is under-subscribed to the extent of Rs. 25,000 and that one of the underwriters, B has been able to procure to the extent of Rs. 25000 while A has been able to procure to the extent of Rs. 50,000. In this case, the entire devolvement liability of Rs. 25,000 would fall on B while A gets underwriting commission without any liability. It may be added here that even underwriters who take up devolvements are entitled to underwriting commission in full the extent of their underwriting. In the given instance, B would also get an underwriting commission on Rs. 50,000. Underwriting is regulated in India under the SEBI (Underwriters) Rules 1993 and SEBI (Underwriters) Regulations 1993. Under the above provisions, underwriting business can be taken up by financial institutions, commercial banks, mutual funds, merchant bankers holding valid, stock brokers and NBFCs. All the above entities except merchant bankers having valid registrations, require to be registered as underwriters with SEBI. Underwriters have to comply with the following provisions: �

Underwriters have to enter into legally binding agreements with the issuer companies. In the case of book built issues, the lead book runner assumes the responsibility for the overall underwriting. The lead book runner would

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Investment Banking

in turn enter into back up underwriting agreements with the syndicate members. The aspects relating to book building have been dealt with, in Chapter 5. �

The underwriting agreements have to be approved by the stock exchange wherein the shares are proposed to be listed.

�

In the case of financial institutions, banks and mutual funds, the issuer company has to apply separately prior to finalisation of the issue for underwriting support.

�

Underwriting commissions cannot exceed 2.5% on equity shares and 1.5% on debt instruments as per the Government guidelines.

�

All underwriting contracts have to be classified as material contracts and disclosed as such in the offer document and filed with the Registrar of Companies prior to the issue of the offer document.

�

Sub-underwriting is permissible provided there are contracts to evidence the same.

�

All underwriters shall have necessary infrastructure, past experience, minimum of two employees and shall comply with the minimum capital adequacy requirement of Rs. 25 lakh and further comply with additional capital adequacy requirements of the concerned stock exchanges.

3.7.3 Registrars to Issues Registrars perform the back office functions for an issue by providing the necessary infrastructure and automated processing capability. The role of the registrar to an issue is invaluable considering the volume of applications that need to be processed for an issue within a very short span of time. The support services provided by a registrar to the issue include: �

Obtaining day-to-day collection figures from controlling branches of each bank and reporting the same to the lead manager and the company while the issue is in progress;

�

Processing the application forms received from various collecting bankers and other collection centers and arriving at appropriate classification;

�

Determining the valid applications and overall subscription to the issue and the over-subscription ration if any;

Primary Equity Market

165

�

Assisting the lead manager and the company in the allotment process;

�

Sending out allotment advices and refund orders;

�

Providing allotment of securities to individual allottees in de-materialized form via connectivity to the depository.

�

Providing support to the lead manager and the company in fulfillment of post-issue reporting to SEBI.

The services provided by a registrar are both capital and labour intensive. Therefore, in order to ensure that registrars provide quality service, SEBI has brought such activity under regulation through the SEBI (Registrars to an Issue and Share Transfer Agents) Rules, 1993 and the SEBI (Registrars to an Issue and Share Transfer Agents) Regulations, 1993. Under these provisions, registration with SEBI is compulsory to provide these services. The eligibility criteria include capital adequacy of Rs. 6 lakh for a category I registrar and Rs. 3 lakh for a category II registrar. The registration is subject to renewal after the initial eligibility period. Among the general obligations and responsibilities imposed on registrars, the notable provision relates to prohibition on the registrar acting in such capacity on behalf of an associate company making an issue. The registrar has to abide by the code of conduct as well. The other responsibilities include maintenance of books and records in the prescribed manner and making such books and records available for inspection by the authority appointed by SEBI and the appointment of a compliance officer.

3.7.4 Bankers to Issues Bankers to an issue perform a significant function in providing remittance facilities to applicants from various parts of the country in an issue through their collection branches. Applicants fill up the application forms for the issue and along with the instrument for payment, lodge the applications with the bankers to the issue at their various branches. The banker sends these instruments for collection, gets the funds cleared through the inter-bank clearing house mechanism, aggregates the funds and transfers it to the designated issue account maintained by the company with its bankers. While the issue is in progress, the bankers also provide daily collection figures through their controlling branches. A similar but opposite service is provided by the bankers for refunds to be made to unsuccessful applicants or partly successful applicants. Such a service is also

166

Investment Banking

known as ‘Refund Banking’. Refund bankers provide the facility of getting refund orders of the company encashed by the payees across the countries at par from the designated account maintained by the company with them. Bankers to issue are also regulated by SEBI on similar lines through compulsory registration, a prescribed code of conduct and observance of general obligations and responsibilities. These are contained in the SEBI (Bankers to an Issue) Rules, 1994 and the SEBI (Bankers to an Issue) Regulations, 1994.

3.7.5 Brokers to Issues Brokers to an issue are appointed specifically by the issuer to market the issue on its behalf with the investors. These brokers are the same stock brokers who operate in the secondary market as members of stock exchanges. By appointing them specifically to market an issue, the issuer ensures that there is adequate marketing support to promote the issue. Unlike underwriters, pure brokers to an issue do not have any financial commitment to the issue. Their renumeration is purely in terms of brokerage that is earned on the subscriptions received through them for the issue. If they cannot procure anything, they do not earn anything and neither do they have any guarantee obligation like the underwriters. Brokers usually have many subbrokers working for them through whom they market an issue and share the brokerage they earn from the issuer with them. As mentioned in Chapter 1, brokers and sub-brokers are regulated by the SEBI.

3.7.6 Support Service Providers The support service providers in the primary market include stationery printers, advertisement agencies, courier services, the press and the financial analysts. A public offer would require a huge amount of issue related stationery to be printed since most of the applicants prefer to apply through physical application forms. In addition, the offer document should also be printed in adequate numbers. Issue stationery printers are specialized in this job since they are familiar with the requirements. Apart from printers, courier agencies play an important role in ensuring that the issue stationery is dispatched to all the requisite centres in time and in good condition. The advertisement agencies prepare the media plan, organise meetings with the press, analysts and investor associations in important locations spread across the country. The importance of the advertisement agency in giving the issue

Primary Equity Market

167

a good coverage and taking care of organizational matters in such publicity campaign cannot be over-emphasized. Apart from the above, the press and the issue analysts play an important role from another perspective—i.e. in rating the issue from an investor perspective and providing suitable advise to investors. Since the issuer makes attempts to publicize the issue from its perspective, an impartial neutral pronouncement on the issue is very much necessary. This is where the press and the financial analysts play an important role. They examine the issue in detail for its merits and demerits and publicise their view so that investors may take appropriate investment decision.

3.8 Growth and Performance of the Primary Equity Market 3.8.1 Policy Changes The primary equity market went through historic changes starting with the abolition of the Capital Issues (Control) Act 1947 in 1991 and also the subsequent advent of SEBI as the capital market regulator with the passing of the SEBI Act in 1992. During the first decade of its regulation, the SEBI has brought in a paradigm shift in the Indian capital market and the primary market has had its share of reforms. Some of these are listed below: �

The most fundamental change in the primary market has been the introduction of free pricing of equity, which meant that issuers could price their shares based on market forces and their fundamentals without recourse to administrative clearance. SEBI has brought about significant improvement to this concept with the introduction of the book building mechanism that helps in better price discovery.

�

The second landmark change has been in the area of improving the disclosure requirements for issuers so that investors could take more informed investment decisions. The introduction of the DIP guidelines and their constant improvement in the past decade has also led to quite elaborate disclosure requirements. Prior to the DIP guidelines, the only disclosure requirements were in terms of section 56 read with Schedule II of the Companies Act. Apart from disclosures, the DIP guidelines have ushered in investor-friendly measures such as eligibility norms for issuers,

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Investment Banking

lock-in of shares, minimum contribution from promoters, compulsory rating for debt instruments, reservation in allotment for small investors etc. �

SEBI has also introduced statutory recognition to merchant bankers by making them responsible for issue management. The issue manager brings in his professional expertise to the entire process of a public offer.

�

SEBI has also brought the activities of all issue intermediaries under its purview through suitable regulation to improve the quality of primary market services.

�

The issue delivery mechanism has been brought in tune with technological improvements. SEBI has made it mandatory for all new IPOs to be made only in the dematerialized form. Similarly, the process of making an issue using the internet medium has also been introduced.

�

SEBI has considerably reduced the time between closure of an issue and listing of the shares. Currently it should not exceed thirty days and this could come down further in the future. The proposed provisions have been discussed in Chapter 5.

�

SEBI is working with several agencies including the stock exchanges on promoting the equity cult, providing investor education and better awareness of equity investments. In this connection, SEBI has already circulated a ‘risk disclosure document’ that investors have to be furnished by brokers while dealing with them.

3.8.2 Performance of the Primary Equity Market As pointed out in an earlier chapter, the primary market had two distinct boom phases—one, between 1992–1995 and the other, which was more of a technology boom between 1999–2000. During this time, the market also went through the maturity curve with stiffer entry norms to prevent unscrupulous issuers from entering the market. As a result of certain policy changes, general economic conditions and subdued secondary markets, the primary market went dry after 1995–1996 except for the short phase of information technology related issues as mentioned above. The subsequent meltdown of technology stocks in 2001 had its effect on the primary market in the following two years.

Primary Equity Market

169

The figures of mobilization of funds from the primary market over the years have been furnished in Table APP 3.2. Readers may refer to this table in Appendix 1 at the end of the book. It may be seen from the above that the primary market which was just a trickle at around Rs. 60–70 crore a year in the 1960s, around Rs. 100 crore in the 1970s, shot upto around Rs. 4000 crore by 1990 and reached a peak of over Rs. 26,000 crore in 1994–1995. These figures do not include funds raised by the government companies and the government itself. However, during the two years after the technology sector wave of 1999–2000, there has not been much of a volume of issues in the primary market. The mobilisation has been largely due to a few bigger issues, notably from the public sector banks and a few private sector companies. In 2001–2002, banks and financial institutions accounted for more than 84% of the fund mobilisation from the primary market as compared to around 68% in the previous year. The trends in the primary market equity issuances in recent years are captured in Tables APP 3.3 to APP 3.5. Readers may refer to these tables in Appendix 1 at the end of the book. According to the Prime Database, the other trend noted in public issues has been the reduction in the over-subscription ratio in recent years. During 2001–2002, no public issue was subscribed more than ten times. This was however, reversed in the recent issues of Maruti Udyog Ltd., Divi’s Laboratories Ltd. and subsequent bank issues made in 2003. In terms of underwriting patterns, after the introduction of optional underwriting by SEBI, several issues are not being underwritten. In 2002–2003, only 14% of the total number of equity issues were underwritten as compared to 42.5% in the previous year (Source: SEBI). The leading issue managers in 2002–2003 were SBI Capital Markets Ltd., Kotak Mahindra Capital Company and DSP Merrill Lynch Ltd. The leading registrars to issue were Karvy Consultants Ltd., followed by MCS Ltd. and Datamatics Financial Ltd. From the above trends, it can be appreciated that the primary equity market has been maturing over the coming years and the investors have become more discerning. This is largely due to the policy initiatives and reforms undertaken by SEBI and an improved investor awareness. The market is shifting away from a speculative and arbitrage oriented response to primary issues to a more mature long-term oriented investment decisions made by investors. Though the number of issues has come down due to stiffer entry barriers, the quality of issues hitting the market has vastly improved.

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Investment Banking

3.9 Future Directions in the Primary Equity Market The future is bright for the primary equity market and holds many more good years for the issuers and the investors. The maturing of the market would ensure that quality of issues is not compromised for volume and activity. Though this could mean decreased business for issue managers and intermediaries as well as support service providers, the market cannot be expected to grow at the expense of quality unlike in the past. Stiffer disclosure norms and continuing compliance by companies would deter issuers with low corporate governance standards from entering the market for fund raising. The primary market can no longer be perceived as a source of finance for every company in search of funds. Investors would see better returns on primary investments over a longer term. With the integration of India with the global market, one could see global companies listing in Indian capital market just as the reverse has already become a reality. SEBI is also working on the idea of allowing Indian companies to make concurrent floats on Indian and overseas markets. Though this idea has been discouraged presently, it could be implemented in the near future.

� Notes 1. Refer to Companies (Issue of Share Capital with Differential Voting Rights) Rules 2001. 2. For further discussion on this subject interested readers may refer to the following: a. Financial Management—Theory and Practice by Dr. Prasanna Chandra, Tata McGraw-Hill, Fifth Edition 1997, Reprint 2001, Chapter 5. b. Damodaran on Valuation—Ashwath Damodaran, John Wiley & Sons Inc., New York. c. Financial Statement Analysis and Security Valuation—Stephen H. Penman, McGraw-Hill International/Irwin 200, Part I. 3. For a complete perspective on the risk-reward relationship and measuring cost of equity through established models, please refer Investment Analysis and Portfolio Management —Dr. Prasanna Chandra, TataMcGraw-Hill Publishing Company Limited, First Edition 2002.

Primary Equity Market

�

171

Select References 1. Indian Securities Market Review 2002 of the National Stock Exchange of India Ltd. 2. SEBI Annual Report, 2002–2003. 3. SEBI, Capital Issues, Debentures & Listing—K. Sekhar, Wadhwa and Company, Third Edition, 2003. 4. Management Accounting and Financial Analysis—Final Course reading, Board of Studies, The Institute of Chartered Accountants of India. 5. Investment Banking and Brokerage by John F. Marshall and M.E. Ellis, Probus Publishing.

�

Suggested Readings 1. Investment Analysis and Portfolio Management—Dr. Prasanna Chandra, TataMcGraw-Hill Publishing Company Limited, First Edition 2002.

�

Self-Test Questions 1. What are the main features of equity shares and why should an investor look at them as an investment option? 2. What are the advantages to the issuer of equity shares as compared to raising finance through issue of debt instruments? How do offers of convertibles score over those of pure equity? 3. Distinguish between institutional and non-institutional investors? 4. What are the routes available for foreign investors to invest in the equity of Indian companies? What are their relative merits and demerits? 5. List out the various primary market service providers and the roles performed by them? 6. What is the significance of underwriting? How is an underwriter’s devolvement determined?

Chapter

4 Primary Debt Market

his chapter deals with the intricacies of the primary debt market. Unlike the primary equity market, the debt market is driven by a preponderance of government securities and bonds floated by public financial institutions, public sector corporations, local authorities and government companies. Private corporate debt issuers find the demand to be lacking in this market, especially in the retail segment. In this chapter, we take a look at the different types of debt securities that are offered in this market and the emerging new financial instruments. Besides, the recent trends in this market have also been dealt with.

T

Topics to comprehend �

�

�

Features of debt instruments and the different types of debt instruments used in Indian capital market. Regulatory framework for the issue of debt instruments. Issuer’s and investor’s perspective of debt instruments.

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Investment Banking

4.1 Primary Debt Market In Chapter 3, it has been indicated that the primary debt market is the market place for long-term debt securities. As in the case of the primary equity market, the primary debt market is also driven by fresh issues of debt securities, which add to its floating stock. The following diagram depicts the primary debt market, Fig. 4.1. The primary debt market consists of issues made by companies incorporated under the Companies Act, public sector corporations and local authorities which are incorporated under other statutes and securities issued by the Central and State Governments. While investment bankers pay an active role in the public offerings made by companies and other corporations, the government security market operates through auctions conducted by the Reserve Bank of India. These auctions

PRIMARY DEBT MARKET

RIGHTS ISSUES

PUBLIC ISSUES

Issuer s

Investor s Institutional investors / other large investors/ retail Investors

Companies under the Companies Act/ other statutory corporations/ government

� Figure 4.1

Instr uments Corporate debt (Debenures/ Bonds/ Convertibles)/ Government debt

PRIVATE PLACEMENTS (Elabor ated in Chapter 11)

Intermediar ies Merchant Banker/ Underwriter/ broker

Constituents of the Primary Debt Market

Primary Debt Market

175

introduce new issues of government securities from time to time into the secondary market. The primary market investors in the government security market are banks and financial institutions, specialized debt and money market institutions such as the Discount and Finance House of India and Primary Dealers approved by the RBI who create an active primary and secondary market for such securities. Since investment banks do not play a primary role in the floatation of government securities, the discussion on this segment of the primary debt market is outside the scope of this book. As compared to the primary equity market, the primary debt market, especially in the debt paper issued by companies under the Companies Act has traditionally been a market with less activity. This is because of a comparatively lesser retail demand for pure debt securities offered through public issues. Pure debt instruments have in the past suffered from illiquidity in the secondary market especially in the retail segment. As compared to naked debt instruments, those with sweeteners or debt convertibles and have seen better investor response. In the past decade, this market has seen activity predominantly from the institutional bond segment. These are unsecured notes issued by financial institutions. The aspects relating to various debt instruments have been discussed in subsequent paragraphs of this chapter. The types of issuances in the primary debt market are not as many as in the case of equity issues. Mostly debt offerings are public issues and though a concept of ‘rights’ is valid for a debt issue, it has not been seen on many occasions in the past. However, such issues are governed by SEBI guidelines. There have been simultaneous floats of debt and equity securities as well as two different types of debt securities in the past. The issues made by Essar Oil and the Noida Toll Bridge Company are cases in point. These have also been discussed in this chapter. Public issues of debt instruments are managed by merchant bankers just as in the case of equity issues. The intermediaries associated with a public floatation of debt instruments are the same as those in the case of equity offers. Among the support service providers, the agency that assumes critical importance in a debt issue is the credit rating agency. The rating of a debt instrument is mandatory in certain cases for a public issue while it makes a difference for institutional investors in a private placement. The different aspects relating to public issues of debt instruments have been discussed in Chapter 7. The various aspects relating to private placement of debt securities have been discussed in Chapter 11.

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Investment Banking

4.2 Fundamental Concepts on Debt Securities 4.2.1 Nature of Debt Securities A debt security is an instrument that evidences an amount owed by one person to another. Debt securities exist in different forms because of which they have different properties and are therefore treated with a different legal status. The simplest form of a debt security is a ‘promissory note’ which is an obligation undertaken by the drawer to pay the drawee a certain sum. A ‘Bond’ is an obligation whereby a person binds oneself to a debt or other obligation evidenced by such instrument. An extension of this concept is a ‘Bill of Exchange’ under which the drawer states that the drawee has to pay a certain sum for value received and the drawee accepts the same. A ‘Debenture’ is a corporate instrument that evidences the company’s debt obligation towards the person whose name is mentioned on the debenture certificate. Section 2(12) of the Companies Act defines a debenture in an inclusive way stating that it ‘includes debenture stock, bonds and any other securities of a company, whether constituting a charge on the assets of the company or not’. Debt instruments can also be distinguished by other features such as security and transferability. A debt security such as a bond or a debenture can be both secured as well as unsecured. A debt instrument can be secured by creating a charge on some property or assets so that if the debt due on the instrument is not repaid, the assets can be liquidated and used for satisfaction of the debt. A charge can be created either on fixed assets by a mortgage or on movable assets by a hypothecation or pledge. The creation of a security, especially on immovable property is expensive as it involves payment of stamp duty on the mortgage and registration charges in the case of a registered mortgage. The second aspect relates to transferability of a debt instrument. A debt instrument can be made transferable either by endorsement and delivery or by mere delivery or through execution of a transfer deed and subsequent registration. In the first case, the transferor has to sign on the instrument and endorse it to a third party as is the case with a bill of exchange. In the second case, the instrument is transferable by merely delivering it to another person. Such instruments are called bearer notes or bonds on which the name of the holder is not mentioned. Examples of such notes are some of the debt paper issued by the Government such as the Indira Vikas Patra and others. The third category of instruments are those that require to be registered in the name of the transferee to pass on the title. Examples of these are debentures and bonds issued by corporate entities that carry the name of the registered holders and can therefore be

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177

transferred only through transfer of title with the issuer through execution of an instrument for transfer. In the theoretical sense, though a company registered under the Companies Act can issue unsecured debentures and bonds for raising debt finance, in practice, it is seldom followed. This is because of the provisions of Section 58A of the Companies Act read with the Companies (Acceptance of Deposits) Rules, 1975. These provisions stipulate that any borrowing or deposit that is taken by a company is deemed to be a ‘Public Deposit’ unless it falls under the category of exempted borrowings as specified in Rule 2(b) of the said rules. If a particular borrowing gets attracted to these provisions, the company has to comply with all requirements relating to invitation of public deposits such as making public advertisements in the prescribed form, maintenance of liquid assets to service such borrowings, filing of periodical returns and a host of other compliances. Therefore, where a company wishes to raise funds through a debt security, it would not want to get the same classified as public deposits. In the context of a debenture or a bond, the following have been exempted from the above provisions: �

�

Amounts raised by issue of bonds or issue of debentures secured by mortgage of any immovable property of the company or with an option to convert them into shares in the company provided that in the case of bonds or debentures secured by mortgage of any immovable property, the amount of such bonds or debentures shall not exceed the market value of such immovable property. It has been clarified by the DCA that unsecured debentures with an option to convert a part of them into shares of the company do not fall under the category of exemptions under Rule 2(b). In other words, unsecured partly convertible debentures would rank as deposits to the extent they are non-convertible and the convertible part would be exempt. In addition, the convertible part would be exempted only till the conversion option is exercisable and if it has not been exercised or has lapsed, such convertible part would rank as an unsecured deposit thereafter and would fall within the purview of Section 58.

From the above discussion, it is clear that unsecured bonds and debentures issued by a company unless they are fully convertible would attract the provisions of Section 58A and thereby rank as unsecured deposits. There is however, an exemption provided to banking companies under Section 58(7) from the operation of Section 58A. Therefore, banking companies can issue unsecured bonds and debentures without

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Investment Banking

worrying about Section 58A. So in practice, banking companies and other corporate entities which are not registered under the Companies Act issue both unsecured and secured bonds and debentures while non-banking companies registered under the Companies Act issue only mortgage-backed debentures unless they are fully convertible into shares. Similarly, a debenture cannot be issued as a bearer instrument or an instrument transferable by mere endorsement and delivery. The issue of debentures is a power vested in a company under its memorandum of association and can be exercised by the board of directors only at its meeting under Section 292. Necessary approval of shareholders is also required under Section 293(1)(d) for exceeding the borrowing limits specified therein.

4.2.2 Features of Debt Securities Coupon Rate A debt security can be structured with several varying features such as coupon rates, tenor and cash flows. Coupon rate on a debenture or a bond is the rate at which the interest is computed on the amount of the debt instrument. In other words, it is the accounting rate that would be applied in the calculation of interest. For e.g., a 10% if a Non-convertible debenture is issued with a face value of Rs. 100, it means that the debenture would be entitled to a simple interest of 10% per year on Rs. 100, i.e. Rs. 10/-. The coupon rate on debt instruments are fixed, based on the credit rating of the issuer, interest rates in the economy and the prevailing market rates of interest for corporate debt. However, unlike dividend, in the case of interest, it is taxable in the hands of the investor. Therefore an investor has to reckon the post-tax interest as the return for making the investment decision. For e.g. a 10% coupon rate could translate into a 7% [10 Ò (1–0.30)] post-tax return for a person in the 30% tax bracket. This would lower even sfurther to 6.94% if surcharge on income tax is also considered. Therefore, while the coupon rate is indicative of the accounting rate of interest, the effective rate earned by the investor could be lower depending on the person’s tax status. Considering the above situation, the issuer is inclined to pass on some of the benefit of the tax shield earned on the interest payment to the investor by way of a higher coupon rate. This is because the borrower gets a tax break on the interest paid to the investor. Therefore, the effective cost to the borrower works out to 6.43% [10 Ò (1–0.357)] wherein the tax rate considered is 35.7% for a company. Since the post-tax cost is lower for the borrowing company, it can afford to pay a higher coupon rate to the investor to make the debt security more marketable.

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Primary Debt Market

Yield The second aspect wherein debt securities can be structured is in terms of their yields. Yield is the effective return earned on an investment taking into account the periodicity of the cash flows arising therefrom instead of the coupon rate. For the computation of yield, what is important is the timing of the investment outflow and the inflows arising from receipt of interest and repayment of principal on the debt security. Yield is calculated using the principle of ‘time value of money’. For more discussion on this topic please refer to Appendix 9 at the end of the book. The yield on a debt instrument is the internal rate of return that is generated by the given streams of cash flow. Therefore, for the same given coupon rate, the annual yield could be different based on the periodicity of the interest payment. The following example illustrates the above point.

�

Illustration 4.1

In the example given below, a bond with a face value of Rs. 100 and a coupon rate of 10% has been considered for computation of yield with different streams of cash flow. The tenor of the bond is one calendar year and the principal is repaid at the end of the twelfth month. However, the interest payments are varied in each case because of which the yields vary. In the first case, the interest flows are at the end of the year and therefore, the yield is same as the coupon rate. In the second case, the interest flows are half-yearly because of which the yield improves to 15.56%. If the interest payments are made quarterly, the yield improves further to 15.87% and on a monthly interest payment schedule, it rises further to 16.08%. Therefore, the faster the cash flows come back to the investor, the higher is the yield on the instrument. This is of course, under the assumption that the investor is in a position to reinvest the cash flows in other investment opportunities providing the same yield. The detailed computations are shown below. Bond Face Value

100

Coupon rate

15%

Time periods Y0

Annual –100

Bi-annual

Quarterly

Monthly

180

Investment Banking

(Contd.) 115

Y1

–100

Y0 HY1

7.5

HY2

107.5

Y0

–100

Q1

3.75

Q2 Q3 Q4

3.75 3.75 103.75

Y0

— 100

M1

1.25

M2

1.25

M3

1.25

M4

1.25

M5

1.25

M6

1.25

M7

1.25

M8

1.25

M9

1.25

M10

1.25

M11

1.25

M12

101.25

Basic Yield

15.00%

7.50%

3.75%

1.25%

Annualized Yield

15.00%

15.56%

15.87%

16.08%

Y0 denotes the time of investment. HY denotes half-year. Q denotes a quarter of three months. M denotes a calendar month.

� Table 4.1 Bond Yields

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Primary Debt Market

Tenor Tenor is the maturity period of a debt instrument. It is the period from the time of issue of the instrument to the full and final repayment of the principal and interest thereon. The longer the tenor, the coupon rate remaining the same, the yield is maintained for the entire duration. The following example illustrates the above point.

�

Illustration 4.2

Considering the same example as in Illustration 4.1 above, the yield calculations for various tenors are shown below: Bond Face Value

100

Coupon rate

15%

Tenor

1 year

2 years

3 years

4 years

Y0

— 100

— 100

— 100

— 100

Y1 Y2 Y3

115

15 115

15 15 115

15 15 15 115

Y4 Cum. Cash Inflow

115

130

145

160

Annualized Yield

15%

15%

15%

15%

� Table 4.2 Tenor and Yield

It may thus be observed that as far as the borrower is concerned, the longer the tenor of a debt instrument, the borrower is locked in servicing the same cost of borrowing. Therefore, in fixing tenor of an instrument, the borrower has to examine the necessity for using the borrowed funds, repayment capacity and the prevailing interest costs. As far as the investor is concerned, if the yield on the instrument is good, it would be better to lock it in for a longer tenor assuming that the credit rating of the borrower remains unchanged during that period.

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Fixed and Floating Rates Debt instruments can be structured with fixed or floating coupon rates. Under the fixed rate structure, the coupon rate is fixed for the entire tenor of the instrument while under the floating rate structure, the coupon rate keeps fluctuating with changes made in the base rate to which it is pegged. In India, the most common rate used is the MIBOR (the Mumbai Inter Bank Offer Rate), which is more of an overnight call money rate. Therefore it may not be a good benchmark term rate. The other term rate available is the prime lending rate of banks such as the SBI. In a floating rate structure, the coupon rate is pegged at a certain number of basis points above the base rate, for e.g. MIBOR + 150 basis points. The coupon rate gets reset at regular intervals based on movement in the benchmark rate.

4.3 Types of Debt Instruments The Indian capital market has seen a number of corporate debt instruments. As has been stated above, non-banking corporates issue secured debentures or bonds while banking companies issue both unsecured and secured bonds. The different types of corporate debt instruments are discussed below.

4.3.1 Non-convertible Debentures These are the most commonly understood and simple type of debentures that are issued with a specific coupon rate and tenor and the repayment is usually structured in one or more tranches. These are pure debt instruments and the yield depends upon the structuring of the cash flow streams from the instrument. NCDs have never been a popular instrument with investors in India primarily due to lack of a good secondary market for liquidity. In the pre-1991 era, most NCDs had a tenor of seven years and that made investors wary of getting locked in a particular interest rate for a fairly long term. For instance, in the year 1992, a NCD of East India Hotels (the Oberoi chain), was providing a yield of more than 17% but the market price of this Rs. 50 debenture was only Rs. 39 (as reported in the Economic Times dated 2nd August 1992). If an investor had to maximize the yield by buying the debenture at Rs. 39 from the market and encashing it at Rs. 50, there has to be an opportunity to be able to buy it in the secondary market. In such a case the yield would have risen to 34.8%. But the fact that the NCD was quoting at a steep discount was due to lack of demand in the secondary market. At that time, the NCDs of most

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leading companies such as Larsen & Toubro, Ashok Leyland, Raymonds, TTK Pharma and others were quoting at a discount of 10–50% to their redemption price. One of the reasons for a lacklustre secondary market for NCDs has been that the ordinary investor has regarded it much like a bank deposit and has never looked at the opportunity of rotating his investment. Due to the non-availability of NCDs in the secondary market, the opportunity of yield maximization is lost. With the advent of mutual fund debt schemes, the position of the secondary market for pure debt instruments has improved since institutional demand for pure debt securities keeps the market buoyant. In spite of it, many merchant bankers are of the view that pure debt instrument such as a NCD is a non-starter for a public offering. Therefore, NCDs have found more favour in the private placement market. The aspects relating to private placement of debt have been discussed in Chapter 11.

4.3.2 Partly Convertible Debentures PCDs have two portions—one convertible and the other non-convertible. The nonconvertible portion, which is also known as the ‘khoka’ takes the character of a NCD with a coupon rate and tenor for repayment. The convertible part gets converted into one or more equity shares depending upon the terms of conversion and is thus a convertible debt instrument. A PCD is usually perceived to have better saleability than a pure NCD. The convertible portion is usually bigger than the non-convertible part. Some issuers make arrangements to get the ‘khoka’ bought back from the issuer at some upfront discount upon allotment of the PCD itself so that the investor need not sail with it till its retirement. Such a facility is known as a ‘khoka’ buyback. The ‘khoka’ is usually bought back by involving a financial services intermediary who finances the buyback. The discount that the investor pays on the ‘khoka’ should be construed as a part of the conversion price of the share underlying the convertible part. The following example illustrates the point.

�

Illustration 4.3

ABC Ltd. issues a PCD of face value Rs. 100/- which consists of two parts ‘A’ and ‘B’. Part A of Rs. 40 is non-convertible and carries a coupon rate of 10% with a tenor of 2 years with interest payable annually. Part B of Rs. 60 gets converted at the end of three years into two equity shares at a conversion price of Rs. 30 per share. The investor has an option to surrender the ‘khoka’ immediately on allotment under a

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‘khoka’ buyback facility for Rs. 30. Otherwise, the investor can retain the ‘khoka’ and redeem it after two years. In the above example, the annualized yield on the ‘khoka’ works out to 10% since interest payments are structured annually. Therefore, if the investor is not satisfied with the yield, he or she could opt for the ‘khoka’ buyback on allotment and get back Rs. 30. Therefore, the net investment in the PCD would get reduced to Rs. 70. Since the investor gets two shares at the end of the third year on conversion of Part B, the effective conversion price works out to Rs. 35 per share under the ‘khoka’ buyback scheme. In other words, the discount on the ‘khoka’ of Rs. 10 gets pro-rated on the conversion price of the share. SEBI had issued directions that all such khoka buyback proposals should be disclosed in the offer document itself and the transaction shall comply with the provisions of the SCRA in terms of being treated as ‘spot contracts’. Therefore, the khoka buyback shall be completed as with cash payment immediately on receipt of the khoka instrument.

4.3.3 Fully Convertible Debentures These are basically debt convertibles that have the characteristics of debt till the date of conversion and equity after such a date. Since a FCD is fully convertible, the usual practice is to provide for a lower coupon rate during the time it is a debt instrument but to provide an incentive to the investor with a favourable conversion price. This way the company economizes on interest cost on a comparable pure debt instrument. FCDs are very popular debt convertibles and carry the same advantages as quasi-equity convertibles such as warrants and convertible preference shares.

4.3.4 Zero Coupon Bonds/Debentures Zero Coupon Bonds or ZCBs as the name suggests, do not offer any interest payment to the investor. Instead, they are issued at a discount to their face value and redeemed at par so that the return to the investor is built into the price differential. ZCBs originated in the USA with names such as Treasury Investment Growth Receipts, Certificates of Accrual on Treasury Securities. These were instruments created by investment bankers who bought large chunks of treasury securities and used them as underlying assets to issued the above said securities in smaller lots to retail investors.

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The implicit rate of return in a ZCB is computed as the yield on the redemption amount as compared to the initial investment since there is no coupon rate or regular interest payments. It is the rate at which if the face value of the bond is discounted over the term of the bond, it would be equal to the initial amount invested. This can be shown as follows:

Amount invested =

Face Value of the Bond (1 + r)n

wherein ‘r’ is the yield or the implicit rate and ‘n’ is the number of time periods of tenor. In India, ZCBs were introduced for the first time by Mahindra & Mahindra Ltd. in 1990. However, these were issued in combination with FCDs. The terms of the issue were as follows: �

�

The company issued secured 12.5% FCDs with a face value of Rs. 110 which would be converted into two shares on the basis of a two-stage conversion at a conversion price of Rs. 55 per share. The first conversion was to be made after 12 months and the second after 18 months. Alternatively the investors were offered secured ZCBs of face value Rs. 90 with a two stage conversion as in the FCDs but the conversion price was pegged at Rs. 45 per share since the investors did not enjoy the benefit of any interest during the holding period of the ZCBs.

For a comparison of two alternatives, the outflow on the ZCB can be equated to the conversion price proposed on the FCD and the interest earned during the intervening period. This equation yields a return of about 17.5% which is the intrinsic yield of the ZCB. This is superior to the yield on the ZCD which can be worked out as follows:

i.e.,

110

=

61.875 68.75 1 + (1 + r)1.5 (1 + r)

This works out to be around 14.96%.

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Investment Banking

4.3.5 Deep Discount Bonds and other Institutional Bonds An extension of the concept of a ZCB, the DDB is a very long tenor unsecured bond issued by financial institutions such as IDBI, SIDBI, ICICI and others that is issued at a discount and redeemed at its face value. The first ever DDB was floated by IDBI in 1992 at a face value of Rs. 2700 and is redeemable after 25 years for Rs. 100,000. The life of the bond was divided into blocks of five years each, at the end of each of which, there would be a ‘call’ and a ‘put’ option whereby either the issuer or the investor can exit the bond. The redemption prices at the end of each of the blocks is also fixed beforehand such that the longer the investor stays with the bond, the higher is the yield on the bond. The bonds were transferable by endorsement and delivery and they were listed on the stock exchange as well. Since then, SIDBI and ICICI have also issued these bonds and IDBI re-issued them with some modified features in 1996. Based on the principle of a discounted instrument such as the DDB, several types of bonds with varying features are being floated every year by the financial institutions and other corporations. The IDBI floats the Flexibond series, the ICICI floats the Safety Bonds series and IFCI had floated the Family Bonds. These bonds are issued in several varieties to suit each type of investment requirement. There are regular income bonds, tax saving bonds, discounted bonds and cumulated bonds. The discounted and cumulated bonds come with ‘wait periods’ during which time the investor does not earn anything. The longer the wait period, the higher is the yield on the instrument. Some of the bonds also had the feature of stepped up interest rate, i.e. the coupon rate gets increased progressively starting with a low rate based on the holding period of the bond. Therefore, the interest rate could be as low as 5% to start with and can get stepped up to even 20% so as to give a good yield to maturity over its entire life. A standard feature of all institutional bonds is that they are issued as unsecured bonds in the nature of promissory notes. IDBI and SIDBI have obtained stamp duty exemptions for their DDBs.

4.3.6 Other types of Corporate Debt Securities Apart from ZCBs and institutional bonds, several other innovative instruments have been tried out in the primary debt market in the past. One of the most talked about was the Secured Premium Note (SPN) issued by TISCO in 1992. Each SPN with a face value of Rs. 300 has four parts. Each part would be redeemed at a redemption price of Rs. 150 at the end of the 4th, 5th, 6th and 7th year respectively. The

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differential of Rs. 75 paid with each part would be broken down into interest component and premium on redemption and the investor has the option of choosing the relative components according to one’s tax status. In addition, each SPN comes with a detachable warrant, which can be converted, into a share of TISCO for an exercise price of Rs. 100 and the exercise period is between the 12th and the 18th month from the date of allotment of the SPN. The investor is also given the option at the end of the third year to return the SPN to the company and take back the initial investment of Rs. 300 without any return. In such a case the only entitlement would be that on the warrant. The SPNs are issued as listed instruments and are fully secured by mortgage.

4.3.7 Floating Rate Bonds ‘Floating Rate Notes’ or ‘Bonds’ as they may be termed, originated in the US markets in the 1970s but they are not new in the Indian debt market. Indian financial institutions such as the ICICI and the IDBI and banks such as the SBI floated similar instruments in the past. The SBI floating rate bonds were pegged to the bank’s medium term deposit rate with refixation done every six months. The spread offered was 3% over the benchmark rate with a minimum of 12% being the coupon rate. In the case of ICICI, the floating rate notes were pegged to the 91 day Treasury Bill rate with a spread of 3.5% and the interest rate was to fluctuate in a band with a floor of 10% and a cap of 15%. Interest was to be refixed on a quarterly basis. In the IDBI floating rate bond, the interest rate was pegged to the 364 day treasury bill rate with a spread of 2% and interest being reset half-yearly. All these bonds had ‘call’ and ‘put’ options to provide exit at periodic intervals.

4.3.8 Debt Convertibles, Sweeteners and Options Debt convertibles are basically debt instruments that are either fully or partly convertible into equity. Therefore, till the date of conversion they partake the character of debt and accrue interest on them. After conversion into equity, they lose the character of debt. FCDs and PCDs are examples of debt convertibles apart from others such as convertible bonds. The sweeteners would be the issue of warrants or conversion options to holders of debt instruments so that the investment in the non-convertible debt becomes attractive. Typically, the coupon rate on the nonconvertible debt is pegged at less than the market rate since the conversion of the warrant entitles the holder to equity at marginally reduced prices. Sometimes, the

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Investment Banking

debt instrument does not carry any interest at all and the return is built into the conversion price on equity. Some of the convertibles have been issued with certain novel features such as optional conversion and sweeteners in the past. Examples of such issues are those made by Reliance Petroleum, Essar Oil and Noida Toll Bridge Company. These issues are discussed below. Reliance Petroleum (now merged with Reliance Industries Ltd.) made a public issue of Triple Option Convertible Debentures (TOCDs) in 1993. Each TOCD had a face value of Rs. 60 split into three components—(a) an equity share, (b) another equity share and (c) a debenture. The split-up in face value was two equity shares of Rs. 10 each and a debenture of Rs. 40. Out of the three parts, the first equity share would entitle the investor for one equity share at par on payment of the allotment money on the TOCD of Rs. 20. The balance amount of Rs. 40 to be paid by the investor was also split into installments spread over a period of 36 months. If the investor chose to exercise the right for the second equity share at par, an amount of Rs. 10 had to be paid on it along with the balance amount due on the non-convertible third part. The investor was given a staggered payment schedule spread over 36 months in order to pay the balance amount of Rs. 40. After the receipt of the full amount, the company allotted two tradable equity warrants to the investor which could be exchanged for shares at par after the expiry period of five years. The nonconvertible part of the TOCD was not entitled to any interest for the first five years but it was possible to surrender it with the warrants while exchanging them for shares. If the non-convertible part was opted for continuation, it carried interest for the period after five years. The non-convertible part of the TOCD was to be redeemed in three installments in the 6th, 7th and 8th years. Thus in this case, the option to subscribe and take equity at par was optional upon the investor for which there was a sacrifice of interest on the non-convertible portion for five years. It may be observed from the above that in the TOCD, the investor had an option both on the equity portion and the debt portion. The debt portion could be retained for three years after the fifth year. It did not have a coupon rate but provided a yield in terms of the repayment amounts at the end of each year which resulted in an annualized yield of above 14%. Though the shares were being issued at par, in effect there was an in-built premium to the extent of the loss of interest on the nonconvertible part for the first five years. A similar instrument to the TOCD of Reliance was offered by Essar Oil. In 1995, Essar Oil came out with a simultaneous but unlinked issue of equity shares at premium with 12.5% secured redeemable optionally fully convertible debentures

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(OFCDs). Each OFCD had a face value of Rs.190 consisting of three parts—Part A of Rs. 40, Part B of Rs. 45 and Part C of Rs. 105. The payment schedule for all the three parts was divided as shown in Table 4.3: Rs.

Total

Part A

Part B

Part C

On application for the OFCD

47.50

17.50

10.00

20.00

On allotment

47.50

22.50

10.00

15.00

On first call

47.50

0.00

25.00

22.50

On second call

47.50

0.00

0.00

47.50

Total

190.00

40.00

45.00

105.00

� Table 4.3 Terms of payment Part A of the OFCD was compulsorily convertible to one share of Rs. 10/- at a premium of Rs. 30 on the date of allotment of the OFCD without any further act or application by the OFCD holder and the face value of the OFCD stands reduced to Rs. 150. On such a conversion, there would be a constructive receipt of Rs. 40 by the company from the OFCD holder and constructive payment of the same amount by the OFCD holder to the company towards the cost of one equity share. Part B would stand automatically and compulsorily converted into one equity share of the face value of Rs. 10 at a premium of Rs. 35 per share at the expiry of 16 months from the date of allotment of the OFCD without any further act or application by the investor and the face value of the OFCD stands further reduced to Rs. 105. Part C has the feature of optional conversion if so chosen by the investor. At the option of the investor, Part C gets converted into two equity shares of Rs. 10/- each at a premium of Rs. 42.50 per share at the end of the 32nd month from the date of allotment. For this purpose, a record date was proposed to be fixed to ascertain the entitlement of the investors and a letter of option was proposed to be sent by the company seeking the option from the investors. Part C carried interest at 12.5% from the date of allotment till the date of exercising the conversion option. If the investor did not propose the conversion, it carried interest thereafter at 14% till its redemption at the end of the 8th year as a bullet repayment.

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Investment Banking

Unlike the TOCD of Reliance, the OFCD of Essar did not offer optional equity to the investor in the first two parts. Therefore, an investor got two equity shares at a premium for the first two parts at a fixed price. In order to compensate the investor partly, the non-convertible part carried an interest from the date of allotment at 12.5%. This interest was enhanced to 14% if the conversion option was not exercised on Part C. In terms of structuring, the TOCD had better features since it apparently offered equity at par to the investor but the premium was extracted implicitly. Similarly, Reliance did not have to service any interest on the non-convertible part as it did not carry any interest till the date of conversion and thereafter, it was in the nature of a cumulative deposit. The Noida Toll Bridge Company came up with a simultaneous but unlinked issue of secured redeemable deep discount bonds (DDBs) and secured FCDs in 1999. The DDBs issued at a face value of Rs. 45,000 per bond were issued at a price of Rs. 5000 to be redeemable at par after 16 years. This works out to an annualized yield of 14.72% to maturity. The DDBs were also proposed to be listed and traded on the stock exchanges and transferable only by the execution of a transfer deed. In addition the investor in the DDBs could exercise a call option at the end of the 5th year at a price of Rs. 9500 and at the end of the 9th year at a price of Rs. 16,500. The FCDs, which had a face value of Rs. 1000, were to be fully and compulsorily converted into 100 equity shares at par at the expiry of 36 months from the date of allotment. Till the date of conversion, the FCDs carried a coupon rate of 14%. The FCDs were also proposed to be listed from the initial stage itself and upon conversion into equity, the resultant shares would continue to be listed and no separate listing application was proposed for such an equity. The FCDs as was the case with the DDBs, were transferable only through an instrument of transfer. In the case of this offer, the investor had the following options: � �

�

In investing in either the DDB or the FCD, or in both. In retaining both till the date of maturity or conversion as the case may be or in trading either one or both on the stock exchange. To offer the DDB by exercising the call option at the end of the fifth or the ninth year at the agreed exercise price.

�

To enjoy interest at 14% on the FCD and sell it before conversion at a profit.

�

To get the FCDs converted into shares and trade them at a profit.

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The Industrial Investment Bank of India (IIBI), issued a DDB that has a unique feature. It has a face value of Rs. 100,000 and an issue price of Rs. 16,000. The tenor of the bond is 25 years. However, as an added attraction, the DDB holder is entitled to the first four years of interest payment at the rate for Rs. 1430 per annum, which is stripped and issued as a separate zero coupon instrument. Therefore, there are four interest securities that are issued to the investor representing the annual interest payments. Since these have been stripped and issued separately, the DDB can be bought and sold without reference to the interest securities. The DDB is listed in the secondary market and is transferable through an instrument of transfer. Apart from the above issues, there have been several issues in the past with debt offerings tied to equity convertibles or equity options such as Garware Polyester NCD with warrants offering, Deepak Fertilizers secured FCDs with equity warrants offering, Gujarat Ambuja Cements NCD with warrant offering, the TISCO SPN offering (discussed above), MRPL NCD with equity warrant offerings and many more such issues. In most debt instruments structured with sweeteners, the warrants are detachable and tradable on their own so that the investor has the choice of retaining the warrant and also opting for conversion or to sell the warrant itself depending upon the conversion price. Most warrants sell at a premium price if the conversion date is closer and the conversion price is lesser than the ruling market price. In such a case, the investor can book profits on the warrant and improve the yield on the debt component. However, if the investor has an appetite for equity, the conversion option can be exercised and the equity can be held for trading or for investment gains carried on at a later date.

4.3.9 Securitisation Securitisation is a specialized financial transaction which involves packaging designated pools of mortgages and receivables in a company’s (often a lender) books and selling these assets with the underlying mortgages (collaterals) to investors in the form of securities that have income streams based on the original receivables. Securitisation is a form of structured financing wherein an entity seeks to pool together its interest in identifiable cash flows over time; transfer the same to investors either with or without recourse to further collaterals and enable the entity to achieve the purpose of re-financing those interests immediately. Though the endresult of securitisation is financing, but it is not ‘financing’ as such, since the entity

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securitising its assets is not borrowing money, but selling a stream of cash flows that would otherwise to accrue to it. Securitisation is a structured finance and a capital market product as well. While on one hand it enables financing based on receivables over a certain period of time, on the other hand, its objective is to create over the counter products for capital market investors to provide such financing. The OTC product referred to here means a financial claim which is generally manifested in form of a document, its essential feature being marketability. To ensure marketability, the instrument must have general acceptability as an instrument of value. Hence, it is generally either rated by credit rating agencies, or it is secured by a charge over substantial assets. Further, to ensure liquidity, the instrument is generally made in homogenous lots. Securitisation thus has the following characteristics: � �

� �

In its most basic form means repackaging of asset cash flows into securities. The asset cash flows are existing claims or expected claims over a period of time. The former are existing receivables and the latter are future receivables. The securities that are created can be Asset Backed Securities (ABS) or Mortgage Backed Securities (MBS). Asset backed Securities consist of receivables other than mortgage loans—they can be short term receivables such as credit card receivables, lease rentals, auto loans. Hire-purchase receivables, health care receivables, stock receivables etc. MBS are mostly in the form of Housing Loans, other mortgage loans or Project Loans wherein there is a mortgage of the underlying assets for the principal loans.

Benefits of Securitisation Securitisation as a form of financing has several benefits some of which are listed below: �

�

�

It unlocks assets which are existing in the form of receivables in the balance sheet and which are to be liquidated only over a period of time. Some of these receivables may even be sticky and the chances of recovery may be remote. It diversifies financing options by providing access to financing based on the security of current assets.—Asset Liability matching. The most important element in securitisation is to look for a structuring that would enhance the credit-worthiness of the receivables being

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Primary Debt Market

securitised. The underlying objective is to lower the cost of funds to the originator. �

�

It is a form of off-balance sheet financing since the assets existing in the form of receivables are being converted into liquid cash without creating additional liability. Since this form of financing affects only the asset side of the balance sheet, it becomes a form of off-balance sheet financing. By providing financing against receivables, securitisation helps in the redeployment of the funds in business thereby enabling them to earn a return instead of being idle as receivables in the balance sheet. This process enables additional capital turnover thereby increasing the return on assets and the return on networth.

Parties to a Securitisation Deal A simple form of securitisation transaction can be depicted as shown in, Fig. 4.2. The entity that securitises its assets is called the ‘Originator’, which signifies the fact that the entity was responsible for originating the claims that are to be ultimately securitised. There is no distinctive name for the investors who invest their money in the instrument and therefore, they are known only as ‘Investors’. The claims that the originator securitises could either be existing claims or expected claims over a period of time. In other words, the securitised assets could be either existing receivables, or receivables to arise in future. The latter, for the sake of distinction, is sometimes called ‘future flows securitisation’, in which case the Originator Loan Portfolio

Obligor

Purchase Consideration SPV

PTCs

� Figure 4.2

Debt Service Payments Collection A/C

Investors

Servicing of Investors

A basic securitisation transaction

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former is a case of ‘mortgage-backed’ or ‘asset-backed securitisation’. Asset-backed securities or ABS consist of receivables other than mortgage loans; i.e. they can be short-term receivables such as—credit card receivables, lease rentals, auto loans, hire-purchase receivables, health care receivables, stock receivables and others. Mortgage-backed securities or MBS are mostly in the form of housing loans, other mortgage loans or project loans wherein there is a mortgage of the underlying assets for the principal loans. The receivables of the originator are transferred to a special purpose vehicle or SPV formed for this purpose. The SPV is usually set up with a trust structure though a company under the Companies Act which may also be formed. In India, setting up a trust is recommended since it provides pass-through status for tax purposes. Though it is not essential to create the SPV all the time, it has its advantages, which can be listed out as follows: �

�

�

�

The SPV creates bankruptcy remoteness, i.e., to separate the risks of the newly created securities from the risk of the originator. Due to this process, the investors who take up the ultimate financing are protected from the business risk of the originator that could affect their prospects of recovering their dues. The SPV acts as a repository of the assets or claims that are being securitised, i.e., while the charge is held by the SPV, the beneficial interest is made into a marketable security. The function of the SPV in a securitization transaction could stretch from being a pure conduit or intermediary vehicle, to a more active role in reshaping the cash flows arising from the assets transferred to it. The SPV structure helps in creating suitable credit enhancements to make the structure more marketable and investor-friendly. The enhancements could be in the form of external financial guarantee or over-collaterisation, letter of credit or other such contractual obligations. The SPV structure helps in the identification of the risks attached to the underlying collaterals.

Since the underlying idea in securitisation is to create a bankruptcy remote structure to which there is a transfer of receivables by the originator, it has to be a legal transfer of title to such receivables and not merely a borrowing arrangement made on the security of the receivables. Therefore, the transaction is structured by way of an ‘assignment of receivables’ by the originator to the SPV. The assignment of

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195

receivables shall be without recourse, i.e. the transfer of receivables has to be a true sale of the receivables with all the attendant legal rights which are irreversible. There are two basic structures under which the SPV raises finance to fund the securitisation on the strength of the underlying receivables assigned to it. Under the first structure, it issues new securities to investors which represent a direct claim of the investors on all that the SPV collects from the receivables transferred to it. This structure, known as a ‘pass through certificate’ mechanism, implies a proportional beneficial interest in the assets held by the SPV. The second structure known as a ‘pay through structure’ is used when the SPV can re-configure the cash flows by reinvesting it, so as to pay to the investors on fixed dates, not matching with the dates on which the transferred receivables are collected by the SPV. Therefore, the securities which are popularly known as the PTCs can be issued either under a passthrough or a pay-through structure. The securities can also be named differently based on the structuring and other features attached to them to be able to enhance their marketability. The other service providers that are involved in a securitization transaction are the rating agency that provides a credit rating to the structure, the providers of credit enhancements such as a third party bank or an insurance company, collecting and paying bankers, recovery service provider, lead underwriters, investment bankers and law firms.

Global Scenario Securitisation started off with the mortgage-backed structure, which was widely popular before the advent of the asset-backed security structure. The first securitisation deal was executed with a pass through structure involving home loan mortgage receivables through mortgage-backed securities (GNMA—I) in 1970. MBS are very popular in the US and European markets which saw a large growth in the market mainly from fixed income retail investors between 1986–1998. The USA happens to be the largest market for MBS with outstandings of more than US$ 2.5 trillion in 1998. The European MBS market had outstandings of around US$ 130 billion during the same period. The asset-backed security market started off much later than the MBS market and the first ever ABS were issued in USA in 1985. Since then the USA has grown to be the largest market for ABS and the aggregate deals made in 1998 were upto

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Investment Banking

US$ 265 billion. About three-fourths of the ABS offerings have been through the public issue route. In Europe, ABS issues have been gaining ground and stood at US$ 38 billion in 1998.

Indian Scenario In the Indian scenario, while securitisation is still evolving in its full form, it is fast gaining acceptance as a form of structured financing and is increasingly being used in combination with other structures to enhance efficiency in fund raising for corporates. In addition, securitisation is being given an added impetus in its primary form, i.e. as a tool to restructure the balance sheets of banks. Banks securitise their stocky loans (non-performing assets) to special purpose companies known as asset recovery companies or ARCs which in turn create a business model of their own to recover such receivables. The first ARC has already been set up and it is building up its asset portfolio by purchasing the loan portfolios of other banks. As far as the aspect of securitisation being used as a structured finance mechanism is concerned, there have been several deals in recent years of this nature. One of the first structured financing deals was the India Infrastructure Developer (SPV for IPCL captive power plant) issue on Build-Operate-Lease-Transfer structure to institutional investors which was rated AA—(SO) by CRISIL. ICICI and the Department of Telecommunications (DOT) structured one of the first deals for securitising the receivables due to a cable supplier from DOT. ICICI purchased DOT receivables from one of its suppliers through the assignment (nonrecourse) route. In these transactions, there was no SPV. There was a Trust and retention account to pool the DOT receivables and there was a receiving and paying agent to monitor the account. The vendor was asked to create a Debt Service Reserve to manage shortfalls in DOT payments. A Bank Guarantee was also established to cover default risk, which would get converted into a loan on invocation. The guarantee bank held mortgage on assets. The guarantee was provided by ICICI itself. In another transaction, involving the hire-purchase receivables of TELCO, the future receivables from truck sales were assigned along with the ownership of assets to investors directly without an SPV. The deal was worth Rs. 343 crore. To make the deal non-recourse, TELCO opened a bank guarantee in favour of the investors.

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In the MBS market, NHB made the first transaction involving the receivables of HDFC and LICHF of about Rs. 100 crore wherein NHB acted as the SPV. It was placed to institutional investors on private placement basis. PTCs were issued as Trust Certificates without any recourse to the issuer (NHB) representing the undivided share of the receivable pool. The PTCs were divided into two pools—Class A and Class B. Class A was issued to the investors and Class B was subscribed by the originators themselves (HDFC and LICHF) thereby providing credit enhancement to Class A securities. The Pass through rate was 11.85%.

4.3.9 Statutory Provisions for Debt Instruments and Convertibles Debentures and Corporate Debt Instruments As already mentioned at the beginning of this chapter, Section 2(12) of the Companies Act defines a debenture to include bonds and other types of securities whether secured or unsecured issued by a company. Sub-section 2(45) further states that the word ‘security’ has the same meaning attached to it as under the SCRA and includes hybrids. The word ‘security’ has been defined under section 2(h) of the SCRA to include shares, scrips, stocks, bonds, debentures, debenture stock or other marketable security of like nature in or of any incorporated company or other body corporate. It also includes derivatives, government securities, units issued by mutual funds and other collective investment schemes and security receipts issued under a securitization contract. Therefore, it may well be understood that the word ‘security’ as used in the SCRA is of wider import than its usage in the Companies Act. This is because the Companies Act concerns itself with securities issued by a company alone while the SCRA recognises securities issued by any other body corporate or the government as well. There are two implications arising from the above. Firstly, it is possible for a company to issue securities that fall under the expanded definition of the word under the SCRA and in addition, they can issue hybrids subject to other requirements as specified in the Companies Act. Hybrids are essentially instruments that are either convertible into equity or rank as quasi-equity. Secondly, the definition of security under the SCRA is wider so as to enable a market being created for all types of securities issued by incorporated bodies and the government. The first important provision relating to debentures issued by a company is contained in Section 108 of the Companies Act, which states that a transfer of

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debentures cannot be registered except on production of an instrument of transfer except in the case of debentures being traded in a dematerialised form. In the case of demat trading, the delivery confirmation slip issued by the seller is sufficient for the debentures to be transferred to the electronic account of the buyer maintained with the DP. However, it goes to establish that a separate action is required from the seller to transfer the debentures and these are not transferable by endorsement and delivery. Unless the genuineness of the sale is verified, the instrument is not transferred to the account of the buyer. However, since this requirement extends only to debentures issued by a company, this requirement does not apply to other types of debt securities issued by other bodies corporate. For e.g. bonds issued by public sector corporations (PSU Bonds) need not comply with this requirement and can issue bonds that are transferable by endorsement and delivery. The power to issue debentures is a power that can be exercised only at a board meeting in terms of Section 292(b) of the Companies Act. Besides, if such borrowing, along with earlier borrowings, exceeds the paid-up capital and free reserves of the company, prior approval of the shareholders would be required for the issue of such debentures carriedon as per Section 293(1)(d). It may be observed that while Section 292 applies only to the issue of debentures, the provisions of Section 293(1)(d) apply to issue of all types of debt securities. Among other important provisions of the Companies Act relating to the issue of debentures is the requirement under Section 117C for a debenture redemption reserve to be created in the books of the issuer company from out of its profit so that adequate funds are available for the redemption of such debentures carried on in accordance with the terms of their issue. The other important provision relates to the registration of charges created on the company’s property for the purpose of securing the debentures. Such charges should be registered in accordance with the procedure and within the time limit prescribed in the Companies Act. The issue of debentures and convertibles through the public route are governed by the SEBI guidelines. These are dealt with in detail in Chapter 7. Issue of debt securities in the private placement market by companies is governed by the provisions of the Companies Act and the guidelines issued by the Department of Company Affairs. For further details on private placements, please refer to Chapter 11. The role of convertible instruments is quite effective in corporate finance. The popular forms of convertibles are FCDs, PCDs, convertible bonds and warrants.

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While the company law does not prescribe any guidelines on future conversions of such instruments, the SEBI has provided several requirements for the public issue of such instruments. These are mentioned in Chapter 7. However, it has to be borne in mind that if an unlisted company has outstanding convertibles on the eve of a public issue, the shares to be issued on such a conversion would require to be in tune with the requirements of SEBI guidelines on pricing and certain other matters. The tax issues relating to debt instruments are mainly about deductibility of issue and tax treatment on sale or transfer of such instruments. These are explained below: �

�

�

The tax treatment of pure debt instruments is a fairly settled matter in that the issuer gets a deduction of interest paid for the computation of business profits. Expenses incurred in connection with issue of debt instruments have been held to be revenue expenditure and are as such deductible in the year of issue or as per the accounting method regularly employed by the assessee. In case the issue has been made in connection with a new business, it gets covered under Section 35D of the IT Act. Tax has to be deducted at source on interest accruals of such instruments in accordance with the provisions of Section 193 of the IT Act.

Discounted Instruments Discounted debt instruments are treated on par with other debt instruments under the Companies Act and under the SEBI guidelines. Therefore, such instruments have to comply with the provisions of Company law as applicable to debentures as discussed above. In addition, if these are publicly issued, they have to conform to the SEBI guidelines on public offers of debt instruments. The tax treatment of discounted instruments such as the deep discount bonds, zero coupon bonds and others had been a contentious issue in the past. The CBDT issued a circular in 20022 which reviewed all the clarifications issued earlier and the problems that were encountered therefrom. This circular established the tax treatment as follows: �

Every investor holding a deep discount bond or other discounted instrument shall make a market valuation of the instrument as on the 31st of

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March every financial year (valuation date) and mark such bond to the market value. For this purpose, the market values of different instruments declared by the RBI or the Primary Dealers Association of India jointly with the Fixed Income Money market and Derivatives Association of India may be referred to. �

�

�

�

�

�

�

The difference between the market valuations as on two consecutive valuation dates will represent the accretion to the value of the instrument during the relevant financial year and will be taxable as interest income (where the bonds are held as investments) or as business income (if the bonds are held as trading assets). In case a bond is acquired during the financial year by an investor through a secondary purchase, the difference between the market value as on the valuation date and the cost of acquisition would be treated as interest or business income as the case may be, for that financial year. If the bond is sold or transferred before maturity date, the difference between the sale price and the value computed for tax as per the last valuation date preceding the sale shall be treated as short-term capital gains and taxed accordingly. Where the bond is redeemed by the original subscriber, the difference between the redemption price and the value as on the last valuation date immediately preceding the maturity date will be taxed as interest income in the case of investors or business income in the case of traders. Where the bond is redeemed by an intermediate purchaser, the difference between the redemption price and the value computed for tax as per the last valuation date preceding the maturity date shall be treated as interest income or business income as the case may be. In the case of STRIPS (Separate Trading of Registered Interest and Principal of Securities), the interest coupons are detached from a normal interest-bearing bond and traded separately. Such a mechanism creates discounted instruments out of the normal interest bearing bonds. Such discounted instruments shall be subject to the same tax treatment as discussed above. It has also been clarified that the process of stripping a normal interest bearing bond into its various components will not amount to a transfer within the meaning of the IT Act as it merely involves the conversion of the

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unstripped bond into the corresponding series of STRIPS. Similarly, the reconstitution of STRIPS to form a coupon bearing bond will not amount to a transfer. �

In the case of retail investors (holding bonds worth Rs. one lakh or less) who cannot determine the value of the bonds on every valuation date, option has been provided to follow the earlier tax treatment. Accordingly, the difference between issue price and redemption price would be treated as interest income thereby attracting normal tax and deduction of tax at source. Therefore, the investor can actually book the entire difference as interest income in the year of redemption and the issuer will deduct tax on such entire income at the time of making payment in the last year. However, if such bonds are transferred before maturity, the difference would be capital gain without indexation benefit if the investor had purchased them as investment. If these securities were bought as stock-in-trade, the gain or loss on such sale would be treated as business income or loss. Therefore, a transfer up to the date of redemption would result in capital gain and on the date of redemption would result in interest income.

For the issuer, the discount on such issue would be allowed as deferred revenue expenditure based on the method of accounting as per the judgement of the Hon’ble Supreme Court in Madras Industrial Investment Corporation Ltd. vs. CIT (1997) 225 ITR 802. ZCBs and other discounted instruments follow a similar pattern for the treatment of the difference between the issue price and the redemption price. As far as the issuer is concerned, such a discount would be allowed as business expenditure as mentioned above.

Securitisation and PTCs Security receipts arising from securitisation transactions (PTCs) have been added to the list of securities as per the SCRA in June 2002. Due to this provision, security receipts can be considered as securities in the capital market both in the primary and secondary segments. The law relating to securitisation has also been codified under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (Securitisation Act). As per this Act, securitisation ‘means the acquisition of

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financial assets by any securitisation company or reconstruction company from any originator, whether by raising of funds by such securitisation company or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise. A security receipt has been defined as ‘a receipt issued by a securitisation company or reconstruction company to any qualified institutional buyer pursuant to a scheme, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in the securitisation’. By a combined reading of the above definitions, it is clear that only PTCs with pass through structure have been recognized under the Act. Secondly, security receipts can be issued only to qualified institutional buyers under a private placement and they cannot be issued through a public offer. The Act also provides for the issue and transfer of PTCs to be exempt from the requirements of the Registration Act even though they involve mortgage of immovable properties (mortgage-backed securities). The Securitisation Act also provides legal sanctity for securitisation deals involving receivables of banks and financial institutions but does not deal in depth with securitisation of other corporate receivables whether present or future.

4.3.10 Investor’s Perspective of Debt Securities As far as an investor is concerned, a debt security offers a stable and assured return if the debt security has a fixed coupon rate. Even if the coupon rate is variable, the indicative interest in the short-term is predictable, though the investor undertakes an interest rate risk. In addition, if the security is adequately rated by a rating agency, it offers predictable safety on the principal amount as well. Therefore, debt securities are ideally suited for investors with a less appetite for risk. In addition, if the investors have no risk appetite at all, they can choose to invest in risk-free government debt securities and thus refrain from considering corporate debt securities. Under the present tax regime, interest from debt securities is fully taxable unless such securities fall under the category of tax-free securities, in which case, the income thereon is not taxable but is included in the income only to determine the applicable tax rate to the assessee. To this extent, debt securities compare unfavourably with equity and preference shares on which dividends are tax-free in the hands of the shareholders. Similarly, there is limited upside to the capital gain that can be made on debt securities since the secondary market for corporate debt

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is considered more an institutional market and not much of a retail market. Institutional investors make good yields in debt securities due to being active investors in a relatively closely-knit wholesale debt market. Corporate debt securities also suffer from limited liquidity as far as the retail segment is concerned. This is also true of securities that do not have prime rating. While ‘AAA’ rated paper has enough liquidity, lesser-rated securities find few takers in the retail debt market. There is however, a good demand for institutional and PSU bonds though these are mostly unsecured paper in the nature of promissory notes since they are perceived to be quite safe. As far as the issue of transferability is concerned, while the easiest to deal with would be those securities that are transferable by mere delivery, these are also quite unsafe. The safest are those that are transferable through execution of an instrument of transfer such as corporate bonds and debentures, which are registered in the name of the holder. As far as the decision to invest in a pure debt instrument vis-à-vis a convertible is concerned, the evaluation can be based on a ‘Net Present Value’ approach. The present value of the investment in the convertible should be compared to the present value of the exercise price/market price of the share as on the proposed date of conversion and the interest earned till the date of conversion. This would result in the NPV of the convertible. Similarly the NPV of the pure debt instrument can be measured taking into account the present value of the initial investment and the present value of future interest flows. The two NPVs can then be compared to provide an indication to the investor about a better investment alternative. This can be stated as follows: a) If NPVc \ NPVd, wherein NPVc represents the net present value of the convertible and NPVd represents the net present value of the pure debt security, investment in the convertible is a better option. b) If NPVd \ NPVc, wherein NPVc represents the net present value of the convertible and NPVd represents the net present value of the pure debt security, investment in the pure debt security is a better option. Securitized paper such as PTCs is the latest entrant in the primary debt market. Since PTCs are often credit enhanced, they are relatively a safe and good investment option for investors such as mutual funds and other institutions. Securitised paper has thus far been outside the purview of retail investors primarily because public offerings of PTCs are not yet in vogue since the regulatory framework is not in place.

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4.3.11 Issuer’s Perspective of Debt Capital and Debt Securities For an issuer, a debt security represents a lesser cost of capital as the debt capital is cheaper than equity capital due to its limited risk profile. In the case of fixed rate debt, the cost is also capped based on the coupon rate. Due to the fixed nature of the cost of debt capital, it provides disproportionate earnings to equity shareholders. This phenomenon is known as ‘Trading on Equity’. Most corporates prefer leveraging their capital to enable trading on equity. Apart from cheaper cost of debt, what makes debt more attractive is the tax break enjoyed on the interest paid on debt securities. While equity dividend is not tax deductible, it has an additional cost of distribution tax for the company paying the dividend. However, interest on debt being tax deductible, the post-tax cost of a debt security is much lower than the post-tax cost of equity capital. This point has already been explained earlier in this chapter. Perhaps the biggest advantage to an issuer of debt securities is in terms of the alternative of borrowing through a loan obligation. A loan contract is a private arrangement whereby the lender and the borrower are tied down to each other by the loan covenants. Therefore, if the lending agency wishes to spread its risk, it cannot do so unless the loan receivables are either assigned to a third party or securitised. However, if the borrower issues debt securities to start with, the risk is spread across several investors and therefore, the pricing can be finer. Therefore, in general terms, debt securities have to be cheaper than loan obligations. However, in the Indian capital market, a pure corporate debt security has not found much favour due to its limited marketability. Therefore, issuers are obliged to offer higher coupon rates or other sweeteners. A ZCB is better than a NCD since it does not have a servicing obligation and the return to the investor is factored into the redemption price though the tax shield on interest can be availed on accrual basis depending upon the method of accounting adopted by the company and its fairness from the tax point of view. This would entail a significant saving of cash flow in terms of periodical interest payments. The company gets enough time to earn a return on the funds raised and pool them up for meeting redemption requirements. The mechanism of a debt convertible offers the advantages of both debt and equity instruments seen from an issuer’s perspective. A PCD or a FCD can be used as a source of cheaper debt capital till such time that the company has created enough additional profits in the bottom line to absorb the expansion in equity base on conversion. Therefore, while the company enjoys additional capital with minimal cost,

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it also absorbs the equity expansion with a milder impact on its EPS. This factor makes a convertible superior to pure equity or pure debt securities. A ZCB with a conversion option is even better considering that during the pre-conversion period, the company does not suffer any cash outgo towards interest payments. The return to the investor is factored into the conversion price on the underlying share. In this way, the company is able to offset a revenue cash cost (interest) with a reduction in a capital receipt (share premium) that could have been charged on the share. Obviously, a ZCB that is fully convertible does not offer any tax shield to the issuer. Issue of securitised instruments such as PTCs is advantageous to an issuer to raise capital on the existing or future receivables at effectively fine rates. However, this is possible only if suitable structure has been created through good credit enhancements and a good rating has been obtained for the structure. The biggest advantage of securitising existing receivables is in unlocking liquidity, which is what makes it attractive to banks and other lending institutions.

4.4 Recent Trends in Primary Debt Market As mentioned earlier in this Chapter, the primary debt market is considered more of a government security, PSU and institutional bond market rather than a market for debt securities issued by private sector companies. This trend has been maintained even in the past four to five years especially since the primary market had been dormant for private issuers of equity and debt capital. During these years, it has been the financial institutions and the Government that have been effective raisers of debt capital. However, since the issue of government securities does not happen through public issues and through auctions conducted by the RBI, these need not be reckoned for the purpose of assessing the public issue debt market. Among the non-government issues, most of the activity has been in the private placement market in the recent years. The public issues of debt instruments have mostly been bonds floated by financial institutions. The trends in the primary debt market are captured in Table APP 4.4. Readers may refer to this table in Appendix 1 included at the end of the book. It may be observed from the above said table that the public issue market for both debt and equity has been quite inactive in the immediate past thereby accounting for only about 5% of the capital mobilised, out of which bonds issued by financial institutions have been the main component. The relative debt and equity capital raised from the primary market through public offers as a component of the

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total public issue capital is furnished in Table APP 4.5. Readers may refer to this table in Appendix 1 included at the end of the book. As may be seen from the above, debt securities dominated public offers between 2001–2002. These were predominantly bond issues by financial institutions. The trend continued even between 2002–2003. During the year 2002–2003, there has been only one public offer of a debt security—the FCD offer made by Ballarpur Industries Ltd. in May 2002. This was however a twin offer along with an equity issue. During the recent years, the public offer route for PSU bonds has also been inactive due to the activity in the private placement market. Most corporates have preferred to use the private placement route to place debt securities. More discussion on this issue is furnished in Chapter 11. The primary debt market will continue to be dominated by issuers other than privately owned companies under the Companies Act until there is a deepening of the secondary market for corporate debentures. There needs to be more of retail interest in rated tradable debentures as well as other innovative instruments issued by such companies. There is also a vast scope for further innovations in novel debt instruments that can be issued in this market.

� Notes 1. For a complete discussion on valuation of bonds and other fixed income securities, please refer to Investment Analysis and Portfolio Management—Dr. Prasanna Chandra, TataMcGraw-Hill Publishing Company Limited, First Edition 2002. 2. Please refer to Circular No. 2/2002 [F.No.149/235/2001—TPL] dated 15-022002 issued by the Control Board of Direct Taxes.

� Select References 1. Indian Securities Market Review 2002 of the National Stock Exchange of India Ltd. 2. SEBI Annual Report 2002–2003. 3. SEBI, Capital Issues, Debentures & Listing—K. Sekhar, Wadhwa and Company, Third Edition 2003. 4. Investment Banking and Brokerage by John F. Marshall and M.E. Ellis, Probus Publishing.

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Suggested Readings 1. Investment Analysis and Portfolio Management—Dr. Prasanna Chandra, TataMcGraw-Hill Publishing Company Limited, First Edition 2002.

�

Self-Test Questions 1. What are the main features of debt instruments? What are the distinguishing features of convertible debentures and zero interest debentures? 2. What are the types of debt instruments that can be issued by a company incorporated under the Companies Act? Are there any limitations to issue unsecured debt instruments? 3. What are floating rate instruments and how do these score over fixed rate instruments? 4. What are the underlying financial objectives in securitization? 5. What are the implications of discounted debt instruments vis-à-vis interest bearing debt instruments for issuers and investors? Examine them from the financial and regulatory angles?

Part II

Chapter 5 Initial Public Offers Chapter 6 Rights Issues and Secondary Public Offers Chapter 7

Public Offers of Debt Securities

Chapter 8

Overseas Capital Market Issues

Chapter 9

Exit Offers

Chapter 10

Private Placements of Equity

Chapter 11

Private Placements of Debt Securities

Chapter

5 Initial Public Offers

T

his is the first chapter of Section 2. This Chapter concerns itself with the first exposure of a company to the capital market—i.e. the Initial Public Offer (IPO). The initial public offer is unique in more ways than one since it permanently changes the profile of a company and the way the promoters and the management need to think thereafter. The responsibility of living up to the expectation of the market and the shareholders is a mammoth task. Given the fact that there is always a temptation for companies to look at the primary market as a source of finance through the IPO route, the regulator (SEBI) has evolved an IPO Code in the form of the SEBI (Disclosure and Investor Protection) Guidelines. SEBI has also brought in several structural improvements in the way public offers are made in the primary market. The IPO market is of special significance to investment banking since this is an area that provides statutory exclusivity to them as lead managers. At the same

Topics to comprehend �

Strategic and other issues related to the IPO decision.

�

The DIP guidelines and other regulatory aspects of an IPO.

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Alternative methods for making an IPO.

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Process involved in the management of an IPO and the critical functions of the lead manager and other intermediaries.

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Presentation of an Offer Document.

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time, the merchant banker managing an issue has onerous responsibility, and in that sense, it is a very demanding service area. This Chapter takes the reader through the conceptual framework and the mechanics of an IPO in the backdrop of the DIP Guidelines and the role played by the merchant banker. However, it may be noted that it is not intended to provide herein a comprehensive coverage of the operational aspects of issue management. Such an extensive coverage of issue management per se is an exhaustive subject by itself and therefore, is beyond the scope of the present discussion. This Chapter is primarily intended to provide a conceptual foundation and a perspective on public offers within the realm of an overall study on investment banking. Readers desiring to become issue managers need to develop expert knowledge of the operational aspects with reference to the DIP guidelines and other applicable laws.

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5.1 The IPO Market Between 1999–2000, at the height of the dotcom and technology boom and prior to that, between 1992–1995 period of the IPO boom when free pricing was introduced in the Indian markets, going public was a rage with corporates and those who had not listed during that period were considered to have missed the gold rush. However, the scene has transformed in recent times due to the subsequent technology meltdown, economic downturn and global slow down. In the USA, in 2002 alone, 66 companies de-listed according to Thomson Financial. In India several companies, mainly subsidiaries of multinational companies have also been taken private. Several others have also been queuing up to de-list from regional stock exchanges. The decision to list a company is often taken based on market trends. When the primary markets are very strong, there is a natural temptation to take a company public since the cost of raising such funds is very low. This is because, in a strong market, the company gets much more than its fair valuation. This ‘bubble valuation’ therefore makes the funds almost free of cost. Therefore, going public in a bull market is considered a prudent financial decision. However, this equation gets reversed when the secondary markets are caught in a bear phase and this has a cascading effect on the primary markets. For e.g. during the calendar year 2002, six companies came out with IPOs, the lowest since 1993. The major issues were made by four public sector banks. The other two issues were those of Bharti Televentures and i-Flex Solutions. Bharti’s issue was the largest for Rs. 834 crore (Rs. 45 per share), followed by Canara Bank Rs. 385 crore (Rs. 35 per share), Union bank of India Rs. 288 crore (Rs. 16 per share), i-Flex Solutions Rs. 210 crore (Rs. 530 per share), Punjab National Bank Rs. 165 crore (Rs. 31 per share) and Allahabad Bank Rs. 100 crore (Rs. 10 per share). Out of the above, while investors made good returns in three issues, the shares of Bharti had been trading at much below the offer price. Several mid-sized software companies that went public during the technology boom started quoting pathetically or not quoting at all. So also was the case with several well-performing companies that quoted at much below their book value (historical value) even. This phenomenon of a bear phase can be across the board in all companies regardless of which industry they belong to. However, ever since the secondary markets entered the bull phase again in 2003, there was a resurgence in the primary market and public offerings made in 2003 received an excellent response from investors, notably the bank issues and the IPO of Maruti Udyog Ltd. Several major IPOs are stated in 2004, notably some telecom companies, Patni Computers, Tata Consultancy Services, some media companies, the retail giant Shopper’s Stop, some public sector companies and some pharmaceutical companies such as Biocon Ltd.

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5.2 Significance of an IPO The facts mentioned in the above paragraph bring us to the discussion on whether the IPO decision is purely market driven or not. Before we discuss the determinants of the IPO decision, it is imperative to understand the significance of an IPO and what it does to a company. Every company when it is unlisted offers an ownership or equity opportunity to an outside investor which, for the purpose of the present discussion, has been termed as the ‘private window’. The investors who invest in an unlisted company are either the promoters or strategic long-term investors or pure financial investors who come in for a time bound period. The differentiator between a promoter, strategic investor and financial investor is in terms of the investment objective. A promoter’s prime concern is ‘control’ while that of a strategic investor is ‘business opportunity’. On the other hand, the financial investor looks at ‘return on investment’. These investors invest through the private window that cannot offer the facility of any time entry or exit into the company’s equity capital. The private window also does not provide any price validation for the company’s unlisted stock, which has to be derived from time to time through complex valuation methodologies. An outline of these methodologies has already been mentioned in Chapter 3. When a company makes an IPO, what it actually creates is a second ownership opportunity that can be termed as the ‘market window’. The market window, unlike the private window, provides any time entry and exit facility to investors from the company’s equity capital. Therefore, it is meant either for the retail investors who would wish to have instant liquidity for their investments or for speculators who intend to make profits through regular trading in the company’s stock. In order to serve the interests of retail investors, the market window also performs the function of validating the company’s worth on a continuous basis through an organized trading mechanism called the stock exchange which provides market quotes for the company’s stock. Being a continuous evaluation mechanism, the market window is market driven—it can be overheated at times or be completely indifferent to the company’s fundamentals. During times of frenetic market activity, the market window may overvalue a company’s share while in dull phases, the market price can be extremely low. Due to this phenomenon, though empirically speaking, the market price tends to conform to the trends in the intrinsic worth of a share in the long term, at any given point of time, it represents the instant entry or exit price for an investor. Unlike the market window, the private window need not be driven by the market price of a company’s share, though it has some influence in its determination.

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A strategic investor would be prepared to pay an entry premium for the company’s share, which may result in the company’s share being valued at much more than its current market price. The premium that a strategic investor would want to pay is arrived at based on long-term considerations that have more of a business perspective than a pure financial perspective. Similarly, the promoters of a company would be prepared to pay more than the current market price as their concern is about controlling stakes in the company. On the same count financial investors could pay more than the current market price since they wish to take a long-term view on their investment. Continuing on the same lines, wholesale investors may look for exit routes that are different from the market window available to retail investors. The private window provides exit routes such as a strategic sale to another wholesale investor, buy back by promoters and a merger with or takeover by another company. But in some cases, the market investors (primarily the financial investors) would wish to make use of the market window as an exit route. This is achieved by taking the company public through an IPO, which opens up the market window. Alternatively, the financial investors may exit by making an ‘offer for sale’ of their shares to the retail investors which also opens up the market window. Lastly, financial investors may just want the company to make an IPO and open up the market window which can be used by them from time to time to make gradual sale of their holdings at the best available market prices. This brings us to the discussion on how exactly an IPO should be perceived. Since an IPO is a significant milestone in the life of a company, it could have several implications such as the following mentioned below: �

It can be a source of finance if it is meant to finance a specified end use.

�

It creates a new ownership opportunity called the market window and a class of investors called the ‘retail investors’.

�

It can be a liquidity event since it creates an exit route for the existing and future investors of the company.

�

It creates market capitalization for the company, which is the aggregate value of all its issued shares as multiplied by the current market price.

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The market capitalization of the company can act both as an enhancement or a deterrent for future fund raising by the company in the equity route.

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�

Being listed can open up the gates for hostile takeover attempts on the company.

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It makes future acquisition of stakes in the company by the promoters quite expensive and cumbersome.

�

It brings with it additional costs of regulatory compliance, certain restrictions on future capital transactions and cumbersome procedures.

From the above implications, it is quite evident that an IPO can act as a doubleedged sword. In good times it enhances shareholder wealth but in difficult times, listed status can become a hindrance and a drag on the company’s performance and prospects.

5.3 The IPO Decision The moot point can therefore be stated thus—‘when does having a market window make sense to a company?’ This can be answered with reference to two stages— the pre-IPO stage and the post-IPO stage. The pre-IPO discussion relates to the timing of the IPO decision, while the post-IPO discussion is about continuance or discontinuance of the listed status. The timing issue has been discussed in the following paragraphs while the continuance issue has been discussed under the heading ‘Delisting’. Timing an IPO is a strategic, financial and merchant banking decision. The strategic decision to make is to determine whether listing fits into the company’s overall corporate philosophy and if so, whether the company is mature enough for it. The financial decision to make is to decide whether the company needs the capital proposed to be raised, how much is to be raised and how effectively it should be deployed. The merchant banking decision is made to determine the appropriate structure, pricing, timing and marketing strategy for the IPO.

5.3.1 The Strategic Dimension The strategic decision for an IPO is fundamental and needs sufficient introspection. A company may prefer to remain private if its business model allows it and there are no compelling reasons to go public. For e.g. in Germany and Switzerland, some of the largest companies are privately owned and have in recent times acquired

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publicly held companies. In India, Maruti Udyog has been the largest privately held company with a net sales of Rs. 92.71 billion which, after two decades of its existence, went public in 2003. The second largest company, Tata Sons with revenues of Rs. 33.28 billion has only recently decided to hive off TCS into a separate company and take it public after an equally long private existence. Some of the others such as—Hero Cycles (Rs. 9.34 billion), Nirma Consumer Care (Rs. 18.4 billion), TVS (Rs. 16.74 billion), Bennett Coleman (Rs. 12.15 billion), Cadila Pharmaceuticals (Rs. 4.20 billion) are all presently privately held companies. There are also several subsidiaries of multinational companies that are privately held. Prominent in this list are—LG Electronics (Rs. 17.66 billion), Compaq HP (Rs.14. 53 billion), Redington (Rs. 14.36 billion), Ford India (Rs. 10.65 billion), Samsung Electronics (Rs. 9.67 billion), Honda Siel (Rs. 7.20 billion) and General Motors (Rs. 5.18 billion)1. Therefore, whether to go public or not is primarily a matter of corporate philosophy. In the case of family owned companies that are conservative, going public may not be viewed with much favour. For multinational subsidiaries, going public may not be considered a good option since it would entail more regulation in foreign jurisdictions for no commensurate benefits. In the case of public sector undertakings, going public is a privatisation decision. Looking at the above list of companies, it might seem that going public is not a good idea at all if businesses can be built on equity sourced from private wealth and debt sourced from banks and the public. This is not entirely true since being a publicly listed and traded company has its merits as well. For a start, a company has better visibility and corporate image if it is listed. Market analysts and investors attach more credibility to well-performing listed companies since they have a market validation on one hand and a better regulatory scrutiny on the other. Listed companies are also more amenable to better corporate governance and therefore attract the best valuations and human resources. Lastly, IPO opens up the large market window with immense potential for fund raising if the company performs to the expectations of the market. Several corporate managements prefer to raise funds from the public issue market than through private or strategic route since it creates a large family of small shareholders as compared to having a few private or strategic shareholders with significant stakes. Managements find it difficult to push through decisions with private investors while getting public shareholder approval through general meetings is considered a much simpler task. From the above, it is evident that IPO can be a mixed bag for a company. Therefore, strategically speaking and given a choice, a company should go for an IPO only when it is mature enough for it. This would depend on the

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following factors: �

Does the company need the IPO as a liquidity event for its existing investors? In other words, are there no private exit options available so that the IPO can be pushed further into the future?

�

Has the company matured enough to unlock value? Every company eventually needs to unlock value by sharing its wealth with a wider section of investors and growing bigger with their support thereafter. This is probably the only way corporations grow to become citadels of wealth creation for a fairly long time.

�

Is the company’s business model retail-oriented with a strong brand presence so as to identify with the retail investor?

�

Is the company’s visibility in the market sufficient enough for investors to perceive its business model to the full extent and unlock value for its shareholders through the IPO?

�

Is the company confident of strong financial growth in the future so as to sustain the pressure of constant market validation after the IPO?

5.3.2 The Financial Dimension The next dimension of the IPO decision is a financial one. In some industries, going public may not be a decision of choice. In capital intensive industries such as cement, steel or shipping, in large industries such as heavy engineering, automobiles, infrastructure and refineries, in volume based industries such as pharmaceutical formulations, energy trading and transportation etc., the business model is so large that going public could become inevitable in order to maintain balance in the capital structure. Companies engaged in these kind of businesses need to go public sooner or later to finance their business plans. They would also require multiple rounds of public offers after the IPO to keep financing their growth and consolidation. Therefore, in such cases, IPO and public offers are more of financing decisions than strategic. The same is true of certain start-up businesses that need to look at an IPO more as a source of finance than as a strategic move. Though regulations have been brought in to prevent flimsy start-ups from making IPOs and going belly up thereafter, it is possible for fundamentally strong and well-conceived business plans to go public at the initial stage itself. Reliance Petroleum is a good case in point that went public even before the project was implemented.

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Initial Public Offers

The second financial aspect relating to the IPO decision is to evaluate if unlocking value through an IPO is the need of the hour or whether other options are available. As explained above, as long as a company has access to private equity that does not require a market exit route in the near future, the company can look forward to raising funds through strategic sale of equity and not through an IPO. Strategic sale of equity happens through the private window that realizes better value for the company than an IPO since private investors offer valuations significantly higher than what the company can command in the retail market. The reasons therefore have already been explained in the preceding paragraphs. This point is well illustrated in the recent case of Bharat Petroleum Corporation Ltd. While the Disinvestment Ministry in the Union Government maintained that a strategic sale to a private investor would realize a higher value for the privatisation, the Petroleum Ministry insisted on the public issue route for the privatization. However, in the case of Hindustan Petroleum Corporation Ltd., the petroleum ministry agreed to a strategic sale. The main argument in favour of a public issue in privatisation process is that it is more transparent and leads to better sharing of wealth. The following table2 lists out controlling premiums paid by strategic investors for taking stakes in a sample set of companies, Table 5.1. Acquirer

Company acquired

Gujarat Ambuja Cement

ACC

Dr. Reddy’s Labs

Stake acquired

Market Price Rs.

Offer Price

Premium

7%

215

370

72%

American Remedies

64.9%

89

175

97%

HLL

Rossell

100%

43

173

298%

British Gas

Gujarat Gas Co.

64.3%

125

270

117%

Alcan

Indian Aluminium

20%

93

200

116%

Swedish

Wimco

20%

20

35

74%

Delco

Sawhney Paris

57%

71

117

65%

Subra Holding

Silverline Tech.

51%

22

30

37%

Mach.

�

Table 5.1 Sample data on Strategic Premium

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Investment Banking

The third aspect of the financial dimension is to evaluate how much capital is proposed to be raised through the IPO and its deployment. Generally, IPOs that have well laid out investment plans sell better than those that do not have convincing application for the funds. Investors need to be shown an investment avenue in the company that can generate the expected return on their funds. Sometimes, the requirement of funds for the company could be too large to be raised through an IPO without causing too much dilution of promoter stakes. At such times, the company has to formulate an ideal issue structure in consultation with the merchant banker and prune down the size of the issue if necessary. Similarly, if the fund requirement is too small to warrant an IPO, it would not be prudent to go ahead with it.

5.3.3 The Merchant Banking Dimension Lastly, the IPO decision is also driven by merchant banking considerations. Merchant bankers take a call on the IPO proposal based on the business plan and financial position of the company, expected future performance, prevailing conditions in the primary market, expected issue pricing, size of the offer and post-issue capital structure. The key drivers for the merchant banker are the market conditions, own placement strength and the main selling points in the issue. For e.g. if the post-issue capital structure involves high dilution of the promoters’ stake, it may not be received well by the market. On the other hand, if the promoters are bringing in additional contribution in the issue at the same issue price, it adds to the marketability of the issue. Usually in strong market conditions such as between 1999–2000, merchant bankers tend to be aggressive and push companies to go public. The logic put forward in such times is that when there is money for the taking at good pricing, issuers should go ahead and make best use of the opportunity even if they have no use for the funds right away. For instance, in the technology boom, Indian software companies such as Infosys and Wipro raised significant funds from the US market and kept the liquid cash for future use. However, issue norms are getting more stringent and companies cannot expect to do this in future. In depressed markets such as the one that prevailed since 2001, it would be difficult for a company to plan an IPO and get a good pricing and response for the issue. It would even be difficult in such a market to find a merchant banker who would be confident of selling the issue comfortably. Therefore, most companies would

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defer their IPO plans even if they have matured enough and have a requirement for funds. Here again there are examples such as Biocon India and TCS, which had been looking for a favourable time to go public for sometime. To summarize and conclude the discussion on the IPO decision, the following points are prominent. � IPO creates a ‘Market Window’ for a company. Therefore it should be mature enough to handle it in the long term. � Timing is an important criterion in the IPO decision. Companies need to go public only when they have to unless the market conditions are irresistible. Till then, private and strategic sale of equity to wholesale investors gets better valuation than an IPO. � IPO is a mixed bag for a company. It is an irreversible process for a fairly long time. Even after that, backtracking involves a heavy cost. Therefore, the IPO decision should be taken considering the strategic, financial and merchant banking dimensions. � For certain projects and businesses, going public is an imperative. In such cases, the IPO should be structured to deliver best results.

5.4 Important Aspects of an IPO In the previous Chapter, it has been mentioned that an IPO can be made for listing a company either by a public issue, i.e. an offer of fresh shares to the public or through an offer for sale by the existing shareholders of the company to the public. Before discussing the various aspects of a public issue and an IPO in particular, it is important to know the key terms that are used in merchant banking parlance and their definitions.

5.4.1 Key Concepts At this point, it is important to familiarize oneself with certain important terms and concepts used in public issue parlance: IPO – Initial Public Offer is the first public issue of fresh equity or convertibles by a company due to which its share gets listed on the stock exchange.

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Essentially, in this Chapter, we discuss an IPO in terms of an offer of equity shares. Public Issue – An invitation by a company to public to subscribe to the securities offered through a prospectus. Offer for Sale – An offer of securities by existing shareholder(s) to the public for subscription, through an Offer Document. Rights Issue – An issue of capital under sub-section (1) of section 81 of the Companies Act 1956 to be offered to the existing shareholders of the company through a Letter of Offer. Rights issue has been discussed in Chapter 6. Preferential Allotment – An issue of capital made by a body corporate in pursuance of a resolution passed under sub-section (1A) of section 81 of the Companies Act, 1956. It essentially means an issue to a select group of investors to the exclusion of all other investors including some of the existing shareholders or debenture holders. Preferential offers are discussed in Chapter 10. Private placement – An offer made to select private investors known to the issuer through a private arrangement to the exclusion of the general public. In terms of section 67(3) of the Companies Act, the number of allottees should be less than fifty in any such particular issue. Private placements are also discussed in Chapter 10. Lock-in – A specified time period during which shares or other specified instruments cannot be sold, transferred, pledged or encumbered in any way. QIBs – Qualified Institutional Buyers shall mean public financial institutions as defined under section 4A of the Companies Act, scheduled commercial banks, mutual funds, foreign institutional investors registered with SEBI, multilateral and bilateral development financial institutions, venture capital funds and foreign venture capital funds registered with SEBI, insurance companies registered with the Insurance Regulatory and Development Authority, provident funds and pension funds with a minimum corpus of Rs. 25 crore and State Industrial Development Corporations. Offer Document – A Prospectus in case of a public issue or offer for sale and Letter of Offer in case of a rights issue. Book building – Process undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built up and the price for such securities is assessed for the determination of the quantum of such

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securities to be issued by means of a notice, circular, advertisement, document or information memoranda or offer document.

5.4.2 Issue Pricing The Securities and Exchange Board of India (SEBI) introduced free pricing of shares for public offerings in 1992. As per the current SEBI Disclosure and Investor Protection Guidelines 2000 (DIP Guidelines), every company either unlisted or listed, which is eligible to make a public issue can freely price its share. The first step in formulating an issue structure is pricing of the issue. Issue Pricing is one of the most important contributions of a merchant banker in a public offering. Appropriate issue price can not only ensure success of the issue but provide good returns to the prospective investors as well. This would build an investor friendly image for the company and make it a market favourite so that the company can come back to the primary market with subsequent issues from time to time. Therefore, proper issue pricing can be a win-win situation for the company and the investors as well. Notwithstanding the above, pricing is a sensitive issue for every company as the management usually has very high expectations. The merchant banker usually arrives at an approximate pricing for the issue and tries to carry the management of the company with him on the pricing. Over pricing an issue is an over kill that should be avoided even if it results in short term gain for the issuer and the merchant banker. At the same time the issue price should provide reasonable returns to existing investors in a company who wish to make an exit in the issue. Therefore, issue pricing is considered a trade off between immediate gains and long-term returns to the issuing company and its promoters. The merchant banker has to really weigh these expectations against market realities and then decide the best pricing. Pricing of a share for the purpose of a public issue is quite different from valuation of a share for other purposes. Pricing an issue is done keeping in mind the qualitative features, and by using select multiples as benchmarks than through the conventional approach of the discounted cash flow method. The usual parameters used are the Price to Earnings Ratio (P/E Ratio) and Price to Book Value Ratio. The P/E ratio on the proposed offer price based on the pre-issue Earnings Per Share (EPS) should correspond to the industry P/E currently existing in the market and leave room for the investor to make gains. Therefore, if the current industry average P/E of pharmaceuticals is 10, and the pre-issue EPS of a pharma company is Rs. 7.50,

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the ideal P/E to be adopted for the issue pricing would be about 6 times the EPS i.e. Rs. 45 per share. Assuming that the share would list at a P/E of 8, the opening price would be Rs. 60. Early sellers would make gains of around Rs. 5–10 before the selling pressure starts to bring the market price down. The price could ultimately settle between Rs. 45 and Rs. 50 between the first 6–12 months. This kind of a conservative pricing would ensure that in the immediate future after listing, the share does not quote below its offer price and erode investor wealth. Such erosion in the short term does not augur well for the prospects of the company’s scrip in the longer term.

Basis for Issue Price Every issue, irrespective of its pricing has to be justified for the proposed pricing based on the requirements of the DIP guidelines. Under Schedule XV of the DIP Guidelines, an illustrative method has been furnished for companies to disclose the basis for the issue price, which is reproduced below: BASIS FOR ISSUE PRICE3 1. Adjusted EPS (for past three years) (a)

Year1

Rs. 41.00

(b)

Year2

Rs. 8.39

(c)

Year3

Rs. 13.82

(d)

Weighted Average

Rs. 10.94

2. P/E Ratio in relation to Issue Price (a)

Based on Year3 EPS Rs. 37.63

(b)

Industry P/E Highest

61.2

Lowest

0.8

Average

25.3

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225

3. Return on Networth (a)

Year1

27.36%

(b)

Year2

28.77%

(c)

Year3

33.45%

(d)

Weighted Average

30.88%

4. Minimum Return on Total Networth after the Issue needed to maintain EPS at Rs. 13.82 14.65% 5. Net Asset Value (NAV) (a)

As at end of Year3

Rs. 46.40

(b)

After Issue

Rs. 94.29

(c)

Issue Price

Rs. 520.00

In the case of issues made in the book-building route, the disclosure mentioned at (4) above need not be made and the disclosure at (5) above should be furnished only as at the end of the last balance sheet. This is because, in the case of book built issues, the issue pricing is not decided beforehand and therefore the basis of the offer price related to the proposed offer price cannot be computed. In addition to the above disclosure, the following points have to be kept in mind: �

Projected earnings of the company cannot be used as a justification for the issue price in the offer document.

�

The accounting ratios disclosed as above in support of the issue price shall be calculated after giving effect to the consequent increase in capital on account of compulsory conversions outstanding, as well as on the assumption that the options outstanding if any, to subscribe for additional capital shall be exercised.

�

Comparison of all the accounting ratios of the issuer company as mentioned above has to be made with the industry average and with the accounting

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ratios of the peer group (i.e., companies of comparable size in the same industry). The source from which the industry average and accounting ratios of peer group have been taken has to be furnished. An illustrative approach to benchmarking the pricing of an issue has been furnished in Annexure 2 included in the end of this chapter.

5.4.3 Capital Structuring The Capital structure of the company post-issue has to be structured so as to reflect the desirable position for the company and for the marketability of the issue as well. The starting point for this exercise is the pre-issue capital structure. The following steps have to be followed in this regard in the case of a 100% retail issue. However, the below-mentioned process cannot be applied to a book built issue. Please refer to the separate discussion on book built issues in paragraph 5.7.2 in this chapter. 1. Taking into consideration the issue size and proposed pricing, the total number of new shares to be issued is determined. 2. Based on the pre-issue paid-up capital and the number of new shares determined under step 1, the total issued and paid up post-issue capital is arrived at. 3. The post-issue paid up capital is superimposed over the pre-issue capital structure to determine the post-issue capital structure. 4. The individual shareholder components in the post-issue capital are examined for regulatory compliance under the Companies Act, DIP Guidelines, the Securities (Contracts) Regulation Act, Foreign Exchange Management Act and the Listing Agreement of the stock exchange. In case these are not satisfied in full, the whole process is iterated till a satisfactory structure is arrived at. The important provisions among these relate to promoters’ contribution, lock-in of promoter shares, minimum public shareholding post-issue and non-resident shareholding. These aspects have been discussed under ‘regulatory aspects’. 5. The Merchant Banker has to be satisfied on the capital structure from the marketability aspect as well. Otherwise suitable changes are made within the permissible statutory parameters.

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5.4.4 Issue Structuring The issue structure refers to the following. Here again, the below-mentioned points apply to 100% retail issues and these have to be considered with suitable modifications made for book-built issues. Please refer to paragraph 5.7.2 for book-built issues: �

The face value (nominal value) of the share, the premium thereon and the final offer price. In book built issues, the final pricing is not done until after bidding is over, but a floor price is mentioned.

�

The minimum amount of subscription per applicant and the maximum.

�

The terms of the issue with regard to payment of the offer price and eligibility criteria for applicants.

�

Promoters’ contribution if any, in the issue and details thereof.

�

Firm allotments if any and any details thereof, as per applicable DIP guidelines.

�

Net Public Offer.

�

Underwriting, either mandatory or discretionary.

�

Cost parameters for the issue and an acceptable Issue Budget.

The main considerations in issue structuring are—(a) to see that the application size would not be too steep for the retail investor, (b) promoters’ contribution is structured as per the DIP guidelines and is investor friendly, (c) the firm allotments are being made to eligible investors as per norms these are value added investors who would take up their allotments comfortably, and (d) that the net public offer satisfies the listing norms. In addition, the merchant banker has to assess whether the issue structure permits sufficient floating stock for healthy trading in the market given the size of the company’s post-issue capital. For e.g. in the case of i-Flex Solutions Ltd., almost 70% of the post-issue capital was locked-in and about 20% was held by a financial investor. This left a floating stock of around 10% (the least required) in the market for trading. Some companies prefer low float in the market so that the price remains firm. There are also companies such as Larsen & Toubro and Reliance that sometimes suffer from a liquidity overhang in the market. The Issue Size and structure is determined as follows: �

The ‘Issue Size’ = Promoters’ quota + Firm Allotments + Net Public Offer.

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Investment Banking

�

Public Offer = Firm Allotments + Net Public Offer.

�

Net Public Offer = Issue Size – Promoters’ quota – Firm Allotments.

5.5 Important Regulatory Provisions for an IPO We now look at the core of the DIP guidelines with respect to public offers and more importantly for IPOs. The regulatory requirements under other statutes such as the Companies Act and the SCRA are also discussed. Basically, all public offers, irrespective of whether they are IPOs or secondary offers, have to comply with these provisions. However, there are specific provisions applicable to companies going public for the first time, which have been covered adequately along with the other generally applicable provisions in the following discussion.

5.5.1 Eligibility to go Public One of the most important provisions in the DIP guidelines is about the eligibility of a company to go public for the first time (i.e. an IPO) through a public issue or an offer for sale. As mentioned earlier, this is one of aspects that is vital to sustain the confidence of investors in the capital market over the long term. SEBI has over the years brought in several changes to the eligibility criteria to ensure that good quality issues are brought to the market. Therefore, the eligibility provisions are revised from time to time with the latest revision having been made in August 2003. The important provisions on eligibility criteria are listed below based on the currently applicable guidelines.

Mandatory Conditions for a 100% Retail Issue A company can make an IPO of pure equity or convertibles only if it only if it meets all of the following conditions. These conditions apply mutatis mutandis to an offer for sale as they apply to a public issue: �

The company has net tangible assets of at least Rs. 3 crore in each of the preceding 3 full years (of 12 months each), of which not more than 50% is held in monetary assets. Provided that if more than 50% of the net tangible assets are held in monetary assets, the company has made firm commitments to deploy such excess monetary assets in its business/project. ‘Project’ means the objects for which the funds are proposed to be raised through the IPO.

Initial Public Offers

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�

The company has a track record of having profits distributable as dividends as per the provisions of section 205 of the Companies Act out of its normal business activity without reckoning extra-ordinary profits, for at least three out of the immediately preceding five years.

�

The company has a net worth of at least Rs. one crore in each of the preceding 3 full financial years (of 12 months each).

�

In case the company has changed its name within the last one year, at least 50% of the revenue for the preceding 12 months is earned by the company from the activity suggested by the new name.

�

The aggregate size of the proposed issue and all previous issues made in the same financial year by the company does not exceed five times its pre-issue networth as per the audited balance sheet of the last financial year. For this purpose, the aggregate size of the issue should be reckoned the net public offer through the offer document + firm allotments + promoters’ contribution through the offer document.

Additional Conditions An unlisted company not complying with any of the mandatory conditions listed above may make an IPO of equity shares or convertibles only if it meets both the conditions (a) and (b) mentioned below: a) The issue is made through the book-building process, with at least 50% of the issue size being allotted to the Qualified Institutional Buyers (QIBs), failing which the full subscription monies shall be refunded. OR The project has at least 15% participation by Financial Institutions/Scheduled Commercial Banks, of which at least 10% comes from the appraiser(s). In addition to this, at least 10% of the issue size shall be allotted to QIBs, failing which the full subscription monies shall be refunded. AND b) The minimum post-issue nominal value of equity capital of the company shall be Rs. 10 crore.

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Investment Banking

OR There shall be a compulsory market making for at least 2 years from the date of listing of the shares subject to the following conditions: �

Market makers undertake to offer buy and sell quotes for a minimum depth of 300 shares;

�

Market makers undertake to ensure that the bid-ask spread (difference between quotations for sale and purchase) for their quotes shall not at any time exceed 10%.

�

The inventory of the market makers on each of such stock exchanges, as on the date of allotment of securities, shall be at least 5% of the proposed issue of the company.

The following additional points shall also be kept in mind as regards eligibility to make an IPO. �

In addition to being eligible to make an IPO as per the above norms, the IPO shall not be deemed successful and the company shall not make an allotment pursuant to the IPO unless the prospective allottees under the IPO are not less than one thousand in number.

�

No unlisted company shall make a public issue or equity shares or convertibles if there are any outstanding financial instruments or rights that would entitle existing shareholders to additional equity shares after the IPO. Similarly no partly paid shares shall be subsisting as on the date of the IPO.

�

An infrastructure company may go public even if it does not satisfy the above criteria if it has been appraised and/or funded by one or more of a public financial institution or IDFC or IL&FS or a bank which was formerly a public financial institution to the extent of at least 5% of the project cost either as loan or equity or both.

�

No company shall make an IPO unless firm arrangements of finance through verifiable means towards 75% of the stated means of finance, excluding the amount to be raised through proposed issue, have been made.

It may be appreciated from a reading of the above provisions that SEBI attaches a lot of importance to the quality of companies coming to the public issue market.

Initial Public Offers

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The mandatory conditions ensure that the company has a track record of at least 3 years with minimum networth and profit record. This would ensure that paper companies couldn’t go public just after incorporation making tall claims of future business potential. Similarly, there is a cap on companies making retail issues with unduly high premia. This is because under the free pricing regime, there is a tendency on the part of the issuers to make high priced issues. If such issues are allowed to go through the 100% retail route, there may not be a proper price validation. The share price may come down below the offer price after listing due to lack of buying support. Therefore, it has been stipulated that high priced issues beyond specified limits need to go through the book-building route or the appraisal route. Lastly, it has also been ensured that companies have a minimum post-issue capital so that there would be enough floating stock in the market. Alternatively, the market should be created through market makers.

Additional Conditions for Issue of Convertibles An unlisted company may make an IPO through a convertible instrument even without having to make a pure equity offer and getting its shares listed initially. However, it has to satisfy the normal eligibility criteria as stipulated above and in addition, comply with the following additional conditions mentioned below: �

The convertible must satisfy the provisions applicable for public issue of other pure debt instruments. Please refer to Chapter 7 for related discussion.

�

The issuer company in this case does not become listed until after the conversion of the convertible into shares. During the intervening period, since the company is unlisted, if it wishes to make a pure equity offer to the public, it has to comply with all the guidelines applicable for an IPO. In addition, the convertible issued earlier and still subsisting should have had a floor price, which was already disclosed in the offer document pertaining to such convertible.

�

The existing equity of the company would also be listed along side the listing of the shares arising from the convertible.

�

The company has to comply with Rule 19(2)(b) of the SCRA Rules for the shares arising out of the convertible so that they can be listed. For details on rule 19(2)(b) please refer to para 5.8 given below.

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Investment Banking

5.5.2 Promoters’ Contribution SEBI has also introduced the concept of minimum promoters’ contribution to be present in companies going public so that they become interested parties in preserving the interests of the shareholders. In terms of the DIP guidelines, the following are the main provisions that apply to promoters’ contribution in case of IPOs: �

In an IPO by way of a public issue or an offer for sale, the promoters’ contribution shall not be less than 20% of the post issue capital. For the purpose of reckoning, the 20%, shares acquired for consideration other than cash by capitalization of intangible assets or by any other means and bonus shares acquired by capitalization of non-cash reserves in the preceding three years shall be excluded.

�

For the purpose of reckoning, the 20% in case of IPOs, shares acquired by the promoters within the preceding one year for a price less than the IPO price shall be ignored.

�

In the case of an issue through a convertible instrument, the promoters may fulfill the 20% criterion on the fully diluted capital either through pure equity or through the proposed convertible at the same conversion price.

�

Promoters’ contribution where required to be brought in the issue to satisfy the 20% criterion shall be brought in one day before the issue opens.

�

The minimum promoters’ contribution criterion does not apply to companies with no identifiable promoters.

�

In the case of a convertible issue, the promoters may bring in their minimum contribution either in the form of the convertible or pure equity at their choice. However, the conversion shall be at the same terms as for the public. In case, the conversion is in stages, the promoters contribution brought in as pure equity shall not be at a price less than the weighted average of all the conversion prices.

5.5.3 Firm Allotments and Reservations Firm allotments and reservations in public issues are novel concepts that help in pre-marketing of a sizeable part of the issue thereby bringing down the risk in the issue. In a firm allotment, a particular investor or category of investors are approached in advance by the lead manager or the issuer company to subscribe to

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the issue on firm basis. The word ‘firm’ denotes being able to get the same quantity as is subscribed for in full. The investors have to put in the commitments to bring in their firm subscription even before the issue is floated. Based on their commitment, the offer document shows certain amount of shares being set aside to such investors and only the balance is available for public subscription. A modification of the above concept is a ‘reservation on competitive basis’ wherein certain categories of investors are provided a reservation in the issue without any advance commitments. If there is an over-subscription in that category, there would be a pro-rata allotment made. The provisions on firm allotments and reservations in public issues are as follows: �

The net public offer for issuing companies shall not be less than 25% of the post-issue capital, except in the case of IT and infrastructure companies for which, it can be 10%.

�

The issuer can make reservations on competitive basis or on firm basis for allotments to the following categories of persons: �

Permanent Employees (not exceeding 10% of the issue size)

�

Shareholders of group companies (not exceeding 10%, no firm allotments)

�

Mutual Funds

�

Foreign Institutional Investors

�

Banks and Financial Institutions and Multilateral Institutions

�

All firm allotments which have not been subscribed after filing of the prospectus with the ROC, shall be brought in by the promoters one day before opening of the issue and shall be treated as preferential allotments.

�

All reserved categories can be adjusted inter-se and with the net public offer as well. In other words, unsubscribed portion of one reserved category can be added to another category and the amount unsubscribed in all categories that remains unadjusted may be added to the net public offer.

5.5.4 Lock-in of Shares Lock-in of promoters’ shares and other share capital is also a novel concept brought in for the purpose of preventing such shareholders in making unfair gains or exits

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from the company and also for providing a stabilization period for a company’s scrip post-issue. The provisions on this concept are given as follows: �

The minimum promoters’ contribution of 20% shall be locked in for 3 years from the date of allotment of shares or from the date of commencement of operations by the company, whichever is later.

�

Excess contribution by the promoters in an issue over and above what is required to make up the 20% shall be locked in for one year.

�

Firm allotments made in any issue shall be locked in for one year. The amount brought in by the promoters to make good under-subscribed portion of firm allotments would also be locked-in for three years.

�

The entire pre-issue capital in case of an IPO shall be locked in for one year except the promoters’ contribution since it is locked-in separately. Similarly, shares held by venture capitalists and shares held for more than one year preceding the IPO and are being offered for sale in the IPO are excluded from lock-in provisions.

5.5.5 Differential Pricing and Price Band �

Any unlisted company making an IPO of equity shares or convertibles may issue such securities to applicants in the firm allotment category at a price different from the price at which the net offer to the public is made provided that the price at which the security is being offered to the applicants in the firm allotment category is higher than the price at which the net offer to the Indian public is being made.

�

A justification has to be furnished in the offer document on the price differential for the firm allotment category.

�

The issuer company can mention a price band of 20% (the cap should not be more than the floor by 20%) in the offer documents filed with SEBI and the actual price can be determined at a later date before filing of the offer document with the ROC.

5.5.6 Other Important Issue Requirements �

All new issues shall be in dematerialized form and can also be made through online interface following the necessary guidelines. For details please refer to para 5.7.3 below.

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�

The minimum application size shall be worth Rs. 2000. The maximum size of an application can be equal to the net public offer. The minimum tradeable lot for shares priced up to Rs. 100 shall be 100 shares. The minimum application money shall be 25% of the total amount.

�

In an offer for sale, the entire subscription amount shall be brought in at the time of application.

�

If there are calls on shares, they should be completed within 12 months of the issue.

�

Over-subscription of a maximum of 10% of the net offer to the public can be retained.

�

Underwriting of issues is optional. In case of underwritten issues, the lead manager shall take up a minimum of 5% or Rs. 25 lakhs whichever is less. Underwriting commission and brokerage on shares should not exceed 2.5% and 1.5% respectively as per the guidelines issued by the Ministry of Finance, Government of India.

�

Safety Net or buy back arrangements can be made with a minimum period of six months and for a maximum of 1000 shares per allottee.

�

Issues should be opened within 365 days from the date of SEBI approval or after 21 days of filing with SEBI if no observations are made.

�

IPOs shall be kept open for a minimum of 3 working days and a maximum of 10 working days. In the case of infrastructure companies, it can be kept open for 21 days. The opening and the earliest closing dates have to be mentioned in the offer document.

5.5.7 Additional Requirements Under the Companies Act �

Under the provisions of the Companies Act, no public issue shall be made without the issue of a prospectus or offer document. In terms of section 56, the prospectus shall contain the matters specified in Parts I and II of Schedule II of the Act. It may also be noted that the DIP guidelines have prescribed extensive disclosure requirements for offer documents in line with the provisions of the Companies Act. For a detailed discussion on contents of offer documents, please refer to paragraph 5.6.

�

Every application form inviting subscriptions from prospective investors shall be accompanied by a memorandum in Form 2A of the Companies

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(Central Government’s) General Rules and Forms, 1956 (also known as Abridged Prospectus). �

Every prospectus should be dated and such date would be deemed to be the date of its publication. In addition, every prospectus shall be registered with the Registrar before the date of its publication (Section 60). It should be signed by all the directors either in person or through their authorized agents. All prospectuses registered as above should be issued within 90 days of their publication.

�

Mis-statements in a prospectus can become civil and criminal offences.

�

Every company before opening an issue shall make an application to the stock exchange for listing the shares of the company. If permission is not received, the allotment is void. All the application money has to be refunded within 8 days without interest or with 15% interest thereafter (section 73).

�

All over subscriptions should be returned within 8 days of allotment without interest or with 15% interest thereafter.

�

No allotments can be made until the minimum subscription is received (section 69). In compliance of this requirement, the DIP guidelines provide that the company has to satisfy the designated stock exchange that 90% of the stated minimum subscription has been received before utilizing the issue proceeds. Otherwise, the entire issue proceeds have to be refunded.

�

No allotments can be made until the beginning of the fifth day of the issue of the Prospectus (section 72). All allotments should be followed by filing of a return of allotment with the Registrar within 30 days in the prescribed form (Form 2).

�

All the above provisions shall apply to offers for sale as they apply to public issues.

5.5.8 Statutory Requirements Under Other Laws Besides the DIP guidelines and the Companies Act 1956, the other important statutes that govern public issues are the SCRA and the FEMA. The provisions of these Acts are briefly discussed below in so far as they concern public issues.

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The FEMA After FEMA was promulgated in 1999, the separate mechanism of seeking approvals from RBI for issuing shares to non-resident investors in public issues has been disbanded. Foreign investments through the public issue route are also governed by the general FDI policy and that has been discussed in detail in Chapter 12. However, for the convenience of readers, the gist of the same has been reproduced below: �

The Foreign Exchange Management Act (FEMA), regulates the issue of shares, both preference and equity to non-residents under the Foreign Direct Investment Policy (FDI). There are two levels of clearances for FDI, one of which, is the automatic route regulated under FEMA. Under the automatic route which now applies to all sectors which are not in the negative list, that do not require an industrial licence, that conform to locational policy and that are within the defined sectoral caps. If an investment comes under the automatic route, no prior approvals are required. The investee company has to file a return with RBI within 30 days of the allotment of shares. Generally, all foreign investments require the remittance towards equity to be brought into India. Therefore proposals that seek to set off remittances against other services or capital goods imports or issue of shares for consideration other than cash require case specific approvals from RBI.

�

Investments that do not qualify under the automatic route have to seek clearance from the SIA under the Ministry of Industry or the FIPB, which is an inter-ministerial committee. These proposals are governed by the FIPB Guidelines.

�

Investments by Non-resident Indians and Overseas Corporate Bodies— NRIs and OCBs have a separate set of investment guidelines for investing under the FDI route for investments in shares and debt instruments floated by Indian companies. However, as mentioned elsewhere, OCBs were de-recognised as a preferential category of investors.

�

The RBI has capped the dividend on preference shares being issued to foreign entities at 300 basis points over SBI PLR. This cap covers all forms of preference share dividends. Generally the RBI and the Department of Industrial Policy and Promotion (DIPP) do not encourage such fund raising instruments and prefer equity or regular debt in the form of ECBs. Wilco International Systems Pvt. Ltd. raised preference capital by getting approval for dividend within 15% (which was at that time within the above ceiling).

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The SCRA and SCR Rules Section 21 of the SCRA prescribes that where securities are listed on the stock exchange on the application of any person, such person shall comply with the conditions of the listing agreement with that stock exchange. As per rule 19(1) of the SCR Rules, there is a list of information that has to accompany a listing application to the stock exchange. The important information asked for in an IPO is as follows: �

Copy of the prospectus or offer document for the IPO, the memorandum and articles of association and audited accounts for the past five years.

�

Copies of the resolutions under section 81(1A) of the Companies Act authorizing the company to make the issue. For a discussion on section 81(1A) please refer to Chapter 6.

�

Certified copies of all underwriting and broking contracts and subscription contracts with promoters and details of all commissions and brokerage paid or discounts offered for the issue.

�

Certified copies of all material documents and agreements referred to in the prospectus or offer document.

�

Certified copy of proof of filing the prospectus or offer document with SEBI and agreements with term lenders or secured creditors.

�

Information on pre-issue allotments and shareholding.

Apart from the above information, the most pertinent provision is contained in rule 19(2)(b) of the SCR Rules. According to the said rule read with the relevant DIP guideline, the minimum offer to be made by a company to the public (net offer to the public) at the time of listing should be 25% of the post-issue capital. However, the SEBI has provided exemption from this stipulation to companies in the information technology sector and reduced the requirement to 10% of the post-issue capital subject also to the conditions that (a) a minimum of 20 lakh securities have to be offered in the net public offer and (b) the size of the public offer should be a minimum of Rs. 50 crore. Similarly, infrastructure companies are also exempted from the 25% stipulation. Besides, any other company seeking exemption from the stipulation of minimum public offer as may be applicable may apply to SEBI through the concerned stock exchange with recommendation for relaxation of the rule. Readers may refer to paragraph 5.7.2 on book building for the listing guideline applicable to book built issues under rule 19(2)(b).

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The Stock Exchange Listing Agreement Compliance with the stock exchange’s listing guideline under its listing agreement is also important in order to be able to seek listing of the shares pursuant to an IPO. As has been pointed out earlier in the eligibility norms for issues, companies need to have a certain size of post-issue capital to make issues. In addition, each stock exchange has its threshold limits and conditions for admitting companies for listing. The conditions for listing shares by an unlisted company pursuant to an IPO on the BSE are listed as follows: 1. New companies can be listed on the Exchange, if their issued and subscribed equity capital after the public issue is equal to or more than Rs. 10 crore. In addition to this, the issuer company should have a post-issue networth (equity capital + free reserves excluding revaluation reserve) of Rs. 20 crore. 2. For new companies in high technology sectors (i.e. information technology, internet, e-commerce, telecommunication, media including advertisement, entertainment etc.), the following criteria will be applicable as threshold limits. i. The total income/sales from the main activity, which should be in the field of information technology, internet, e-commerce, telecommunication, media including advertisement, entertainment etc. should not be less than 75% of the total income during the two immediately preceding years as certified by the auditors of the company. ii. The minimum post-issue paid-up equity capital should be Rs. 5 crores. iii. The minimum market capitalization should be Rs. 50 crores. (The capitalization will be calculated by multiplying the post issue subscribed number of equity shares with the Issue price). iv. Post issue networth (equity capital + free reserves excluding revaluation reserve) of Rs. 20 crore. The conditions for listing of shares by an unlisted company pursuant to an IPO on the NSE are listed as follows: 1. New companies can be listed on the Exchange, if their issued and subscribed equity capital after the public issue is equal to or more than Rs. 10 crore. In addition to this, the issuer company should have a post-issue

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networth (equity capital + free reserves excluding revaluation reserve) of Rs. 20 crore. 2. For new companies in knowledge-based industries, the applicable capital criterion is Rs. 5 crore with a minimum market capitalization of Rs. 50 crore. The total income/sales from the main activity, which should be in the field of information technology, internet, e-commerce, telecommunication, media including advertisement, entertainment, pharmaceuticals etc. should not be less than 75% of the total income during the two immediately preceding years as certified by the auditors of the company. 3. The applicant company should have a track record of three years of existence. If the applicant company is promoted by another company, the promoting company shall have the minimum stipulated existence. 4. The application for listing in the case of an IPO shall be made within 6 months of the closure of the issue. 5. The project should have been appraised by specified agencies such as the all India financial institutions.

5.6 Contents of a Prospectus/Offer Document for an IPO The DIP guidelines provide exhaustive provisions for the presentation of prospectus/offer document since this is an important area of regulation for SEBI. Prior to the advent of SEBI, the disclosure requirements for a public issue were governed only by the provisions of Schedule 2 of the Companies Act, which in comparison are skeleton guidelines. The DIP guidelines, on the other hand have taken the disclosure requirements to the standard of international best practices thereby making the offer documents voluminous. For e.g. the prospectus for the Reliance Petroleum issue made in 1993 was in excess of 100 pages which was a trend setter of sorts at that time. Over the years, several new provisions have been added to the disclosure requirements thereby increasing the size of the offer documents further. The red herring prospectus of Maruti Udyog, a recent issue, ran into 331 pages. Some important highlights of this document are provided in Appendix 2 included at the end of the book. In the following paragraphs, we discuss some of the important disclosures in an offer document and their presentation as specified in Chapter 6 of the DIP guidelines read with Schedule II of the Companies Act. The prospectus consists of two sections, Part I and Part II.

Initial Public Offers

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5.6.1 Main Disclosures in Part I In Part I, the information has to be provided in as—(a) preliminary information that has to be provided in the cover pages and (b) information comprising Part I. Preliminary Information 1. The risk factors connected with the issue which are divided into the following: �

Risks in relation to first issue.

�

General Risk relating to investment in equity related securities.

�

Risk factors specific to the project and internal to the issuer company.

�

External risk factors beyond the control of the company that may affect the industry or the economy that may have an impact on the issuer company.

The risk factors have to be weighed in on the basis of their materiality for which the following points shall be considered: �

Some events may not be material individually but may be material collectively.

�

Some events may have material impact qualitatively instead of quantitatively.

�

Some events may not be material at present but may have material impact in future.

The risk factors shall appear in the offer document in the following manner: �

Risks envisaged by the management.

�

Proposal if any, to address the risks.

2. The front cover page shall also contain the clause on ‘Issuer’s absolute responsibility’ on the accuracy of the contents and disclosures in the prospectus. 3. An index of the contents should appear on the front inside of the cover page of the prospectus.

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4. The statement of inter-se allocation of responsibilities between issue managers in issues wherein more than one lead manager is appointed.

Important Information in Part I 1. Disclaimers to be included on behalf of SEBI, the stock exchanges and the issuer company. 2. The minimum subscription clause as required under Section 69 of the Companies Act in the specified format. 3. Capital Structure of the company and the notes to the capital structure have to be provided in detail disclosing the pre-issue and post-issue capital structure, the applicability of the lock-in provisions and all capital obligations on the promoters, promoter group and the company as stipulated in the DIP guidelines and how those have been met. 4. The terms of the issue specifying all the information relevant to the applicants on making the subscriptions and the methodologies to be adopted for applications, allotments, refunds and all incidental matters connected therewith as specified in the DIP guidelines. 5. The ‘objects of the issue’ shall be disclosed stating whether the company proposes to raise the funds for fixed asset creation or for rotation in working capital. In the case of asset creation, the clear break-up has to be provided. In the case of a project activity-wise break-up needs to be given. 6. The proposed means of financing the project plan together with the following points: �

An undertaking shall be given by the issuer company confirming that firm arrangements of finance through verifiable means towards 75% of the stated means of finance, excluding the amount proposed to be raised in the issue have been made.

�

The balance portion for which no firm arrangements have been made shall be disclosed separately.

7. The details of the company, management and the project, which inter alia include the following: �

History, main objects and present business of the company.

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�

A complete profile of the promoters, their education and background, experience in the line of business and other personal details as specified.

�

Particulars of key management personnel.

�

Complete prescribed details of the project.

8. The management discussion and analysis of the financial condition and results of operations as reflected in the financial statements. This is a very important disclosure requirement and represents the management’s view on the company and its immediate future for the next twelve months. 9. Financial details of other companies in the same business group as the issuer company for the previous three years based on audited financial statements. 10. Details of previous issues if any, made by the group companies including specifically the promises or claims made at the time of the issue and the actual performance thereof. 11. No future financial projections of the issuer company can be furnished in the offer document. 12. The basis for the issue price. The disclosure relating to this has already been discussed in paragraph 5.4.2. 13. Outstanding litigations or defaults made if any. The disclosure under this clause shall include litigation against group companies, promoters or directors of the issuer company and the group companies. The financial impact of the litigation and the likely adverse impact on the business of the issuer company needs to be mentioned. 14. The risk factors have to be presented here again as in the preliminary part of the prospectus. 15. Disclosure of the investor grievance and redressal system evolved by the company for the present issue and such systems evolved for group company issues in the past three years and the working system thereof.

5.6.2 Main Disclosures in Part II 1. General information relating to consents given by professionals, experts and other agencies associated with the issue to include their names in the

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prospectus in connection with the issue, authority given by the shareholders of the issuer company for the present issue and other prescribed details. 2. Financial Information on the issuer company by way of a specific certification by the auditors as provided in Schedule II of the Companies Act. The DIP guidelines stipulate extra disclosures by the auditors in their report including certification of specified accounting ratios. The auditors should also certify additional statements relating to assets and liabilities and profits and losses, a capitalization statement and statement of tax shelters in the prescribed format. 3. Financial Statements prepared on the basis of more than one system of accounting standards may be presented in the prospectus at the option of the issuer company together with a reconciliation of the differences between Indian accounting standards and other accounting standards followed. The management discussion and analysis statement (MDA) discussed earlier should however be based on Indian accounting standards. At its option, the issuer company may include MDA based on other accounting standards as well. 4. Statutory information on underwriting commissions, fees to lead managers, brokerage and issue expenses, issues of debentures or preference shares made by the company and subsisting as of date, properties purchased by the company, managerial remuneration and interests of directors and promoters in the company, revaluation of assets in the preceding five years etc. 5. The material contracts and documents of the company, a copy of each of which is made available for inspection at the time and the venue specified starting from the date of the prospectus till the closure of the issue. 6. Declaration and verification by the signatories to the prospectus together with signatures by themselves or through their constituted attorney.

5.7 Methodologies for Making Issues Over the years, SEBI has been working hard on the aspect of reducing the time element involved in public offers. In earlier days, an issue process used to take an inordinately long time during which, applicants used to suffer a loss of interest. The Companies Act or the SCRA did not provide for a maximum time limit for an issue process to be completed except that interest has to be paid from the eighth day onwards when an amount becomes payable to the investor. However, if allotments

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got delayed, since the amount did not become payable during such time, no interest became payable. Thereby, this provision did not serve the purpose of compelling issuer companies from making issues in an expeditious manner. Thus, this has been an area of concern for SEBI and the DIP guidelines have been targetting it. SEBI has introduced several novel features, which have brought down the time lag between the close of an issue and commencement of trading to the minimum. Under the DIP guidelines, the time lag between the closure of a public offer and listing of shares was brought down to a maximum of 30 days. Efforts have also been made to introduce a T+6 system for book-built issues. These aspects have been discussed further in the subsequent paragraphs. Under the DIP guidelines, it is possible to make an IPO in the form of a 100% retail issue, a book built issue or as a bought out deal either for listing on the main stock exchanges or on the OTC exchange. It is also possible to make an issue through the on-line screen-based medium without use of conventional channels to make issue applications and refunds. These different methods are discussed below.

5.7.1 100% Retail (Fixed Price) Issues Under this method, the issue is made by offering the same directly to the investors from the public that could include the retail small investors as well as other categories of investors. Using this method obviates the need to sell the issue initially to the wholesale investors and they in turn marketing it to retail investors. The disadvantage of this method is in terms of the floatation costs since the issuer company has to reach out to a wide cross section of the investor community through its marketing campaign. In addition, it requires lot more of issue stationery to be circulated. The other main limitation in this route is that it has to be made with fixed pricing. If the issue is under-priced, it could lead to a huge over-subscription increasing the refund costs. If the issue is over-priced, there is a possibility of a devolvement that would put some pressure on the underwriters or the promoters. The main advantage of this system is that it is possible to get a wide dispersal of shareholding among the retail investors that would add depth to the trading in the stock after listing. Secondly, this method does not require approaching QIB investors to subscribe to the issue, which could sometimes prove to be difficult, as these investors need to be thoroughly convinced. On the other hand, small investors can be persuaded easily if a reasonable short-term market opportunity is visible in the issue. Noting this trend, the DIP guidelines stipulate stiff entry norms

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for issuer companies in the 100% retail route. These norms have already been discussed above. Due to the apparent inflexibility in a fixed price issue, it has a lot of uncertainty attached to it in difficult market conditions. Therefore, after the introduction of the book built system of making issues, most companies prefer to use the book built route even if they are otherwise eligible for the fixed pricing route. The various aspects of book built issues are discussed below.

5.7.2 Book Built (Price Discovery) Issues Book built issue is a relatively recent phenomenon in India and was initially introduced for larger issues. SEBI has subsequently allowed this mechanism for all issues. A book built mechanism allows the issuer company to make a public issue through the process of ‘price discovery’ rather than through a price that is fixed beforehand. This mechanism, to a large extent, overcomes the deficiency in the fixed price mechanism of over-pricing or under-pricing an issue. It however operates on the basis of a ‘floor price’, which is fixed by the company in consultation with the merchant banker. The floor price for a book built issue is more or less determined in the lines of fixing the issue price for a 100% retail issue. However, the market response during the issue marketing is also taken into account unlike in a fixed price issue wherein the price is fixed even before the marketing of the issue can commence. Companies can now make an issue to the extent of 100% or 75% of the Net Public Offer as they may decide, through the book built route. If the 75% route were followed, the price applicable to the balance 25% under the retail route would be the issue price discovered under the book built portion. Under the 100% route, the entire issue happens through one bidding process applicable to both categories of investors, i.e., wholesale and retail. Under the 75% route, the bidding process is completed first for the 75% and thereafter within 15 days, the retail portion is opened for public. A company that does not fulfill the criteria for a 100% retail issue either through the normal route (track record and net worth stipulations) or through the appraisal route has no option but to make an IPO through the book built route by offering at least 50% to QIBs. However, companies that are eligible to make an IPO through the 100% retail route may at their option choose either the 100% retail route or the book building route.

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Applicable Provisions for a Book-built Issue In a book-built issue, reservation and firm allotment may be made only in respect of permanent employees of the issuer company/promoting company and shareholders of the promoting companies or their group companies to the extent permitted in the DIP guidelines. The other allocation norms for a 100% book-built issue are given as follows: �

Not more than 50% of the net public offer shall be allocated to QIBs.

�

Not less than 25% of the net public offer shall be allocated to non-institutional bidders.

�

Not less than 25% of the net public offer shall be available for allocation to retail investors, i.e. investors applying for upto 1000 shares.

As far as the allocation norms for a 75% book-built issue are concerned, for the book built portion, not more than 50% of the net public offer shall be allocated to QIBs and not less than 25% of the net public offer shall be allocated to non-institutional bidders. The balance of 25% offered through the retail route under fixed price mechanism shall be available only to retail individual investors who have either not participated or have not received any allocation in the book-built portion. In both types of book built offers, i.e., the 75% route and the 100% route, underwriting is mandatory for the entire net public offer except that for companies that have to compulsorily offer 50% of the net public offer to QIBs, underwriting is not required for that portion. Under a book built offer, if the following conditions are satisfied, the net public offer can be only to an extent of 10% of the post-issue capital so as to satisfy the requirements of rule 19(2)(b) of the SCR rules which are as follows: �

The net public offer shall consist of a minimum of 20 lakh shares.

�

The size of the public offer, i.e. the number of shares multiplied by the cut-off price is at least Rs. 100 crore.

�

The issue was offered to the maximum extent permissible (50% presently) to QIBs.

If the above conditions are not satisfied, even under a book built issue, the general conditions as enumerated earlier in paragraph 5.5.8 shall apply.

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Process Overview of Book Building Under the book building mechanism, issue is marketed on a wholesale basis through a team consisting of the Book Running Lead Manager (BRLM) and Co-BRLM if necessary who would form a syndicate with other marketing agents. The syndicate members, who have to be SEBI registered underwriters, are appointed by the BRLMs and they perform the function of generating bids for the public issue from investors. The primary responsibility of generating bids is that of the Lead BRLM. Underwriting is provided by the Book Running Lead Managers (BRLMs) to the company and they can in turn enter into sub-underwriting arrangements with the syndicate members at the pre-determined price. The BRLMs or the syndicate members shall appoint brokers of the exchange who are registered with SEBI for the purpose of accepting bids, applications and placing orders with the company and ensure that the brokers are financially sound and are also capable of honouring their commitments arising out of the defaults of their clients or investors if any. The BRLMs are responsible for making good the entire amount of underwritten commitment to the company irrespective of whether the syndicate members and the brokers have met their commitments or not. The company issues an offer document known as the ‘Red Herring Prospectus’. As per the definition provided in the Explanation to sub-section 4 of section 60B of the Companies Act 1956, a red herring prospectus is a prospectus which does not have complete particulars on the price of the securities offered and the quantum of securities offered. Therefore, the investors have to bid for shares in the issue based on the information provided in the red herring prospectus and a ‘floor price’ to be announced by the company prior to the opening of the offer or a price band within which the price can move. The company decides on the floor price based on the response received during the road shows for marketing the issue and the advice given by the BRLMs. The red herring prospectus would however have the information on the total size of the issue in terms of the amount proposed to be raised. If the red herring prospectus indicates a price band instead of a floor price, the lead BLRM should ensure the following points: �

The cap of the price band should not be more than 20% of the floor of the band.

�

The price band can be revised during the bidding period in which case, the maximum revision on either side shall not exceed 20%.

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249

Any revision in the price band should be widely disseminated through the stock exchange, press release and websites of all syndicate members.

The bidding period has to be held for a minimum of 5 days and a maximum of 10 days during which investors can bid for shares and revise their bids any number of times. However, QIBs shall not be allowed to withdraw their bids after the closure of the bidding process. In case of a revision in price band where applicable, the bidding period has to be extended by an additional 3 days up to a maximum of 13 days. Each bidder can furnish three options in his bid but the amount to be paid along with the bid would be the one applicable to the highest bid amount payable among the options. All the bids will be updated on a real time basis and the information would be available to investors. The bids would be received through the appointed brokers. Once the bidding period closes, the book running lead managers and the company decide the ‘Issue Price’ based on the bids received in consultation with the BRLMs. Those investors who have bid on or above the cut-off price shall be eligible to become allottees. The investors are intimated about their allotments. Once the cut-off price is determined, the number of securities to be offered shall also be determined by dividing the issue size by the cut-off price per share. The final prospectus with all necessary statutory disclosures as well as the issue price and the number of securities is then filed with the ROC and the issue process is completed. The trading shall commence within 30 days from the closure of the issue failing which interest at the rate of 15% p.a. shall be paid to the investors.

Determination of Cut-off Price—Case of Maruti Udyog Ltd. The issue of Maruti Udyog was an offer for sale by the Government of India of 72,243,300 equity shares of Rs. 5 each at the final issue price of Rs. 125 for cash aggregating Rs. 903.041 crore, which stood enhanced to 79,467,600 equity shares of Rs. 5 each at a price of Rs. 125 for cash aggregating Rs. 9933.45 million, after the Government of India exercised the option to retain over-subscription of 7,244,300 equity shares of Rs. 5 each. The offer was made through the 100% book building process wherein upto 40% of the offer was allocated on a discretionary basis to QIBs. Further, not less than 15% of the offer was allocated on a proportionate basis to non-institutional bidders and the remaining 45% of the offer was allocated on a proportionate basis to retail bidders. The company received 250,795 valid bids for 708,543,500 equity shared resulting in 8.92 times over-subscription. The valid demand (considering highest value

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bid in case of multiple bids) from institutional, non-institutional and retail bidder categories is given as under: Category

No. of valid Bids

No. of Shares Bid

357

446,941,800

14.06

3,336

170,896,400

14.34

247,102

90,705,300

2.54

Institutional Investors Non Institutional Investors Retail Investors

Subscription (Times)

A sample of the final demand at different bid prices is as under. Bid Price (Rs. per share)

No. of Shares

% to Total

Cumulative Shares

Cumulative %

501

200

0.000%

200

0.000%

400

900

0.000%

2,200

0.000%

250

3,400

0.000%

10,000

0.001%

200

30,500

0.003%

56,600

0.006%

150

363,000

0.037%

664,000

0.068%

140

646,200

0.066%

1,502,300

0.153%

135

2,286,400

0.233%

4,051,000

0.413%

130

31,063,400

3.168%

35,980,600

3.670%

125*

670,889,600

68.421%

717,458,300

73.171%

120

152,868,000

15.590%

902,425,700

92.005%

115

73,783,500

7.525%

980,527,200

100.000%

* Includes bids received at the cut-off price

The floor price fixed for the offer was Rs. 115 per share. As may be seen from the above, the maximum bids were received at the floor price of Rs. 115 per share, Rs. 120 and Rs. 125. The company received bids for a total of 717.46 million shares at the cut-off price of Rs. 125 and above making it an over-subscription by 9 times on an overall basis. If the company had adopted Rs. 120 as the cut-off, the oversubscription ratio would have climbed to 11.36 times and it would have been 12.34 times at the floor price.

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Determination of Cut-off Price—Case of i-flex Solutions Ltd. (i-flex) i-flex made an IPO through a combination of a public issue and an offer for sale. The total shares offered to the public were 3,961,700 of Rs. 5 each comprising of a public issue of 3,360,000 shares and an offer for sale of 601,700 shares. The floor price for the IPO was Rs. 530 per share. The issue was made under the 100% book-building route wherein at least 60% of the issue was allocated on a discretionary basis to QIBs. Further, not less than 15% of the issue was made available for allocation on a proportionate basis to non-institutional bidders and the remaining 25% of the issue was made available for allocation on a proportionate basis to retail bidders, subject to valid bids being received at or above the final issue price. The company received 10,879 valid bids for 9,898,540 shares resulting in a 2.5 times over-subscription. The valid demand considering the highest value bid in the case of multiple bids from institutional, non-institutional and retail bidder categories is given as under:

Category

No. of valid Bids

No. of Shares Bid

70

6,242,080

2.63

119

1,513,760

2.55

10,690

2,142,700

2.16

Institutional Investors Non Institutional Investors Retail Investors

Subscription (Times)

A sample of the final demand at different bid prices is given as under. Bid Price (Rs. per share)

No. of Shares

% to Total

Cumulative Shares

Cumulative %

800

460

0.01%

620

0.01%

700

1,780

0.02%

3,830

0.04%

650

4,640

0.05%

9,070

0.09%

620

27,960

0.28%

39,120

0.39%

610

14,170

0.14%

53,180

0.53%

600

202,340

2.00%

253,520

2.51%

252

Investment Banking

(Contd.) 590

7,920

0.08%

260,960

2.58%

580

98,160

0.97%

325,620

3.22%

570

121,620

1.20%

429,400

4.25%

560

146,770

1.45%

560,070

5.54%

550

755,880

7.48%

1,219,800

12.07%

540

1,228,890

12.16%

2,376,840

23.51%

530

8,142,490

80.54%

10,109,370

100.00%

In the above case, the bulk of the bids were received at the floor price of Rs. 530 per share and therefore, the company fixed Rs. 530 per share as the issue price. This is in contrast to the Maruti issue wherein the company had enough bids even at Rs. 10 above the floor price and therefore, the company fixed Rs. 125 as the issue price. It may thus be appreciated that book building is a mechanism whereby the price is allowed to be discovered during the marketing campaign so that the issuer prices the share according to its fundamentals and the mood of the market unlike in a fixed priced issue in which it is only a one-way mechanism. It is therefore considered to be efficient and investor-friendly and therefore, internationally accepted as a better method of making public offers than through a fixed price mechanism. Book building has in recent years, improved the quality of issue pricing and narrowed down the asymmetry between the expectations of the issuers and the investors. The floor price is essentially the least price that the issuer expects and is therefore fixed keeping a reasonable margin for the investor post-listing. If the final price is fixed closer to the floor price, the over-subscription ratio improves and there is a wider dispersal of shares. As the final price goes higher then the floor price, the investor who would have bid at the higher price would be lesser and therefore, the over-subscription ratio declines leading to a lesser dispersal of the shares. For instance, in the offer for sale made by the Government of India of the shares of Maruti Udyog, the floor price was Rs. 115 and the cut-off price was Rs. 125. It follows that in a book built issue, at the time of formulation of the capital structure and issue structure by the merchant banker, what can be estimated is only an approximate picture of the final position. The capital and issue structure gets a final shape only after the cut-off price is arrived at.

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Green Shoe Option The term ‘Green Shoe Option’ means an option of allocating shares in excess of the shares included in the public issue and operating a post-listing price stabilizing mechanism, which is granted to a company through a stabilizing agent (SA). The green shoe option can be exercised for a maximum of 15% of the size of the issue. If in an IPO through the book building route a company opts for a green shoe option, at the time of seeking approval from the shareholders for the issue, it shall also seek approval for allotting further shares to the SA after the stabilization period. The company has to appoint the lead BRLM as the SA who would be responsible for price stabilization. The SA will operate a separate demat account called the ‘Special Account for the GSO shares of …’ to which the promoters of the company would lend shares of their own equivalent to the green shoe option. When a green shoe option is exercised, the lock-in provisions do not apply to the extent of shares that have been lent by the promoters to a SA from the date of such lending till the date of their return back to the promoters. After the issue is complete, if the green shoe option is to be exercised, the allotment of the additional shares would be done from out of the GSO account. The additional shares would be allotted on a pro-rata basis to all investors. The amount received from the allottees for the shares under the green shoe option would be credited to a separate account called the ‘Special Account for the GSO proceeds of …’. After the trading commences, the SA would use the proceeds in the GSA account to buy shares from the market so as to suck the excess liquidity if any in the market and thereby stabilize the price. The shares bought would be credited to the GSA demat account. The stabilization period should be disclosed in advance in the offer document and it shall not exceed 30 days from the commencement of trading. After the stabilization period is over, the GSO demat account is examined and the difference between the total quantity lent by the promoters to the account initially vis-à-vis the amount of shares bought from the market during the stabilization period is ascertained as the shortfall. The company would proceed to allot fresh shares to the GSO demat account to the extent of the shortfall which would be paid for by the SA from the GSO proceeds account. The SA would return the entire shares to the promoters and square up the GSO demat account. To facilitate the allotment of fresh shares by the company to the GSO account after the company has been listed, it has been provided that such allotment would not be regarded as a preferential allotment and would therefore be exempt from such provisions. For

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details on preferential allotment, please refer to Chapter 10. There could be a balance in the GSO proceeds account depending upon the price at which the SA bought shares from the market. Such a balance if occurs, shall be transferred to the investor protection account and the account shall be closed. In the end analysis, under a green shoe option the following position emerges—if the SA buys shares from the market, to the extent of such purchase, the company does not make any excess allotment of shares to the promoters and the issue size does not go up. If the SA does not buy a single share from the market, the entire green shoe option becomes an increase in the issue size for which the company receives the funds and the equity capital would go up to that extent as well. The decision of buying shares from the market for the purpose of price stabilization is entirely left to the judgement of the SA who shall be primarily responsible for price stability.

5.7.3 On-line IPOs In an on-line IPO, the entire process of receiving applications and application proceeds as well as making allotments has been redesigned without the involvement of the banking channels and verification of applications by the registrar to weed out invalid applications. Instead, the brokers of the concerned stock exchanges have been involved as an alternative mechanism with electronic connectivity to the stock exchange so that the time element in the closing of the issue and the commencement of trading is reduced to as little as possible. A company intending to make an on-line IPO has to enter into a separate agreement with the concerned stock exchange, which has the requisite facility. The stock exchange shall appoint brokers registered with SEBI for the purpose of accepting applications from the public and placing orders with the company. The brokers would have computer terminals and be regarded as collection centres. The brokers should honour all the orders placed by them irrespective of whether the applicant pays them or not. They shall be paid brokerage by the company directly for the orders placed by them. The company shall also appoint a registrar having electronic connectivity with the stock exchange. The lead manager has to co-ordinate the activities of all the participants in the issue. After filing the prospectus with the ROC, the company releases a statutory advertisement in which the collection centres of brokers would be mentioned. The applicants have to approach these brokers for making an application for the issue. The broker accepts the order and places it in the system with necessary details.

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Alternatively, the applicants may also send the applications directly to the registrar enclosing the requisite payment. The rest of the process of the issue relating to receipt of application forms and allotment are discussed in paragraph 5.9.3 under the procedural aspects of an issue.

5.7.4 Bought Out Deals Bought Out Deals (BODs) were of common occurrence in the IPO boom in the early nineties during which several companies went public through a BOD and subsequent offer for sale route. BOD is an alternative to a straight IPO (retail or book built) whereby a company places certain amount of stock with private investors with the understanding that these investors would take the company public by offering their shares for sale within an agreed time frame. The investors in a BOD are typically investment banks and institutional investors such as mutual funds, nonbanking financial companies, banks and financial institutions. BOD is a recognized route for companies to go public on the OTC Exchange of India. BODs done to take companies public on other stock exchanges have to comply with the other requirements as applicable to normal IPOs. BODs were in vogue due to several advantages they offered to smaller companies in terms of saving in time and expenses of making retail IPOs. At the same time, the company is assured of funds from the investors that are not guaranteed in a public issue unless it is fully underwritten. Usually, the BOD is structured keeping in view the ultimate public offering so that investors are assured of an expected return with an exit within a given time frame. BODs done in the past had a normal maturity profile of around 6–12 months. However, after the markets collapsed in 1996, there were several BODs that could not reach their logical ending since the offers for sale could not be made. One such company was Divi’s Laboratories Ltd. which finally went public in 2003 through the 100% book built route.

5.7.5 OTC Issues Any company making an IPO on the OTC Exchange of India (OTCEI), is exempt from the eligibility norms applicable for other issuing companies which have been discussed earlier. However, they should fulfill the following conditions: �

The company should be sponsored by a member of the OTCEI.

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Investment Banking

Bought Out Deal 1. Enables a company to receive public issue funds in advance through private placement to a small group of investors. 2. Subscribed to by market players such as investment banks, mutual funds and other institutions who aim to make good returns in short time through the BOD. 3. Investors take a view based on the success factors for the issue and the exit price.

Private Equity 1. Enables a company to raise equity financing through private route. 2. Subscribed to by investors with a medium term view who wish to allow the company to mature or add significant value before looking for exit. 3. Investors take a view based on medium to long term growth prospects. No view is taken on probable exit price.

4. Maturity profile of not more than 12 months.

4. Maturity profile between 3–7 years.

5. BOD is structured along with the public offer. The expenses of going public are also shared by the company and the investors most of the time.

5. Private equity deals are structured to meet specific valuation and dilution requirements.

6. BOD investors usually exit completely in the issue by making an offer for sale of their shares.

6. Private equity investors may not exit fully, though that is usually the case.

�

Table 5.3 Comparative Chart of a Bought out Deal vis-à-vis Private Equity

�

It should appoint at least two market makers, one compulsory and one additional market maker.

�

An offer for sale being made out of a bought out deal registered with the OTCEI shall also be eligible for being listed on the OTCEI subject to satisfying the listing criteria of OTCEI.

�

The pricing of the IPO either through a public issue or an offer for sale can freely price its shares.

�

The minimum promoters’ contribution shall be 20% of the post-issue capital with a lock-in of 3 years from the date of allotment in the issue.

�

Unlike in a regular issue, for an issue made on the OTCEI, the offer document can contain the projections made by the sponsor and market maker in the appraisal made for the issue.

Initial Public Offers

257

The listing criteria of the OTCEI are furnished below. �

A company should have a minimum paid-up capital of Rs. 30 lakh and the minimum offer to the public should be 25% of the issued capital or Rs. 20 lakhs worth of shares in face value, whichever is higher. SEBI DIP guidelines will be applicable to all OTCEI issues.

�

Every company that intends to get listed has to be sponsored by a merchant banker (member/sponsor) of the Exchange. The Sponsor of the issue must arrange for market makers to give buy and sell quotes in the securities for an initial period of 18 months.

�

Companies need not fulfill any dividend paying track record as required under the listing criteria of other exchanges.

�

Bought out deals made by the sponsor can be listed on the OTCEI as per the above criteria.

5.8 Issues by Financial Institutions The DIP guidelines have provided a special status to IPOs made by public financial institutions, state level industrial development corporations and other approved financial institutions under section 36(1)(viii) of the IT Act, which includes housing finance companies. Such issues need to comply with a different set of provisions as compared to normal companies. The main issue related provisions that are applicable to such designated financial institutions (DFIs) are furnished below: �

There shall be no requirement of promoters’ contribution for any issue by DFIs.

�

Employee reservation in an issue can be upto 200 shares per employee subject to a maximum of 5% of the issue size. These shares shall be locked in for 3 years.

�

The issue can be priced feely subject to profit track record in 3 out of preceding 5 years with the last two years being included in the 3 years. However, such profit should be arrived at by excluding interest considered as income on loans that are unpaid for more than three years. This clause may actually be redundant since all DFIs have to follow the prudential income recognition norms of RBI that do not permit income being recognized on non-performing assets.

258 �

Investment Banking

Issues have to be kept open for a minimum of 3 days and a maximum of 21 days.

One of the unique features of the issues made by DFIs is the ‘shelf prospectus’. According to section 60A of the Companies Act, a DFI that files a shelf prospectus with the ROC shall not be required to file a prospectus afresh for every issue made by it within the validity period of the shelf prospectus. The company is only required to file an information memorandum on all material facts relating to the new charges created, changes in the financial position as have occurred between the first offer of the securities, previous offer of securities and the succeeding offer of securities within three months prior to making of a second or subsequent offer under the shelf prospectus. The shelf prospectus shall be valid for one year from the date of opening of the first issue under it. The information memorandum shall be issued to the public along with the shelf prospectus at the stage of first offer of securities. Where an update of the information memorandum is filed every time an offer for securities is made, such memorandum along with the shelf prospectus shall constitute the prospectus for complying with the requirements of law.

5.9 Procedural Aspects of an Issue Having discussed the conceptual and main regulatory requirements of an IPO in its various forms, we now take a brief look at the procedural aspects of making an issue in compliance with statutory provisions.

5.9.1 Summary Procedural Aspects of a 100% Retail IPO Pre-Issue Procedures 1. The first task is to hold a Board Meeting to consider the proposal for a Public Issue, authorise the Managing Director to do all the tasks relating to the Public Issue including key appointments and incur expenses for the issue. Alternatively, a Board Committee headed by the Managing Director can be formed for this purpose. The Board would also authorize the Company Secretary or the MD as the case may be to convene a general meeting for seeking the approval of the members for the issue.

Initial Public Offers

259

2. On the appointed day, the EGM is held and the shareholders pass a special resolution under section 81(1A) of the Companies Act authorizing the company to make the public issue. At the time of seeking this approval, it is customary to seek an enabling approval for a specified amount of funds to be raised through the proposed issue. 3. Before embarking on an IPO, the first task is to identify a good merchant banker who can be appointed as lead manager (LM) for the Issue. The details of the company’s project or fund raising plan are discussed with the merchant banker. After the discussions, the company finalizes the appointment and enters into a memorandum of understanding with the lead manager. If there are more than one LM for the issue, they have to finalize the inter-se allocation of responsibilities between them as well, for the issue. 4. The LM immediately on being appointed, starts a due diligence on the company. Usually, the LM goes through a check list of due diligence prepared by them with the company’s officials and checks all supporting documents, certificates and every relevant information for the issue. This process usually takes about 2–3 weeks. 5. In parallel, the LM starts preparation of the draft prospectus (in the case of a public issue) or the draft offer document (in the case of an offer for sale). All the disclosure requirements of the Companies Act and SEBI guidelines are to be filled in. Most of the information required from the company would serve the process of both the due diligence and the preparation of the offer document. The issuer company has to therefore, keep ready a separate due diligence file containing all the necessary documents and certifications required from the management, the company secretary, the auditors and the legal advisor of the company. 6. The LM advises the company in the appointments of other intermediaries for the issue. These are the registrar to the issue, bankers to the issue, the printer and advertising agency. The registrar and the bankers have to be registered with SEBI. These appointments are made by the management of the company. 7. The LM also draws up the issue budget estimated to be spent on the issue. The main components of these expenses are fees for LM, underwriters, registrar and bankers, brokerage, postage, stationery, issue marketing expenses and statutory costs such as increasing authorized capital etc. The management of the company has to approve the issue budget. It may be

260

Investment Banking

mentioned here that the guidelines issued by the Ministry of Finance on issue expenses have to be kept in mind while drawing up issue budgets. 8. The draft prospectus is finalized by the LM in all respects in consultation with the management and placed before the board of directors for approval so that it can be issued for filing. Once the draft prospectus is approved, it is filed with SEBI for their observations along with a soft copy on a floppy disk. The draft prospectus has to be accompanied by the memorandum of understanding signed by the LM with the company, the statement of interse allocation of responsibilities and the first due diligence certificate among other important undertakings to be furnished by the LM, the company secretary and the management of the company. SEBI would convey their observations, objections if any, within 21 days of filing of the draft prospectus. SEBI would also place the draft prospectus on their website for comments from the public. 9. Simultaneously, the company has to make listing applications to all stock exchanges where the shares are proposed to be listed accompanied by at least 10 copies of the draft prospectus. The draft prospectus should also be made available to the public by the LM. The draft document shall also be hosted on the websites of the LM and the underwriters. The LM should also obtain and furnish to SEBI, an in-principle listing approval of the stock exchanges within 15 days of filing the draft offer documents with them. 10. The Company should also enter into a tripartite agreement with the registrar and all the depositories—(presently NSDL or CDSL) for offering the facility of offering the shares on dematerialized mode. According to the current norms, all future IPOs can be traded in demat mode alone after listing. Investors have to be given the facility to receive allotments through any one of the depositories or in physical mode according to their option. 11. If the issue is proposed to be underwritten (it is optional in a retail issue and mandatory in a book built issue to the extent of the net public offer), the LM solicits underwriting from prospective underwriters by circulating the underwriting letters in the approved format. Underwriters can be financial institutions and banks, non-banking financial companies, other merchant bankers and brokers to the issue. All underwriters must be registered with SEBI. 12. Within 21 days, SEBI would come out with their observations on the draft prospectus. The stock exchanges would also vet the draft prospectus and

Initial Public Offers

261

prescribe necessary changes, if any. The company has to carry out all the modifications to the satisfaction of these authorities. The LM has to file a certificate with SEBI that all amendments and suggestions or observations made by SEBI have been incorporated in the offer document. In addition, the LM has to file a statement with SEBI providing a list of complaints received against the disclosures in the offer document and the proposed amendments to be made. 13. Once the draft prospectus is ready in its final form, a board meeting has to be held to approve the filing of the same with the ROC after being signed by all the directors. The board also approves the application form, underwriting contracts, allotment letters, share certificates and other important formats pertaining to the issue. 14. The filing with the ROC takes place on the same date as is mentioned in the prospectus. This filing should be accompanied by all the material contracts pertaining to the issue and the company and all other important documents as listed out in the prospectus. A second due diligence certificate has to be filed at this time with SEBI by the LM. 15. The prospectus after filing with the ROC shall have a validity period of ninety days within which it has to be issued. The LM and the company would then decide the plan for marketing the issue, release of advertisements, dispatch of stationery, finalizing the collection centres and date of opening of the issue. 16. The marketing of the issue is usually co-ordinated by the LM with the advertising agency. The marketing would be a combination of press meetings, brokers’ meetings and investors’ meetings in important centres, one-to-one meetings with journalists and main brokers and investor associations. 17. Advertisements are regulated by DIP guidelines and the rules of the Stock Exchange. As per these rules, there has to be a mandatory advertisement 10 days prior to the opening of the issue known as the ‘announcement advertisement’. The announcement advertisement has to conform to Form 2A, also known as the ‘Abridged Prospectus’. Apart from this, the company can make issue advertisements pertaining to the IPO subject to the following: �

The advertisements should not be misleading, suggesting guaranteed profits or talking of things that are not mentioned in the prospectus.

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Investment Banking

�

All advertisements shall carry the risk factors.

�

While the issue is open, no advertisement indicating the response to the issue so far can be issued.

�

Announcement regarding closure of the issue can be made only after the LM is satisfied about the receipt of the minimum subscription as mentioned.

�

No models, celebrities, pictures, drawings or marketing language can be used in the advertisements. Advertisements should conform to what is popularly known as the ‘tombstone’ style.

�

If any financial information is presented, it should contain the prescribed particulars.

�

The company can issue corporate advertisements within the issue period provided the risk factors are mentioned. Product advertisements should not make any reference to the issue.

�

The securities being issued may be branded describing their nature but not their quality. For e.g. IDBI’s Flexibonds, ICICI’s Safety Bonds, IFCI’s Family Bonds etc.

�

The LM is responsible for the observance of the advertisement code.

18. The mandatory collection centres are finalized as per SEBI guidelines in consultation with the bankers and the LM. These shall consist of the four metros and other stock exchange centres in the region where the company is situated. In addition to the minimum collection centres, as many others as necessary may be appointed. In addition, the company may appoint collection agents as may be found necessary. 19. The LM and the printer finalize the despatch schedule to all stock exchanges, SEBI, collection centres, investor associations, brokers and underwriters. The stationery should reach sufficiently in advance before the opening of the issue. Every application form shall be accompanied by the abridged prospectus. 20. The issuer company has to appoint a compliance officer who shall directly liaise with SEBI with regard to compliance with various laws, rules, regulations and other directives issued by SEBI and with regard to investor complaints.

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21. The marketing should be completed one week before the opening of the issue. 22. Immediately after the issue is opened, the LM files a certificate with SEBI that no corrective action is required on its part in the prescribed format. As mentioned before, the issue should be kept open for a minimum of 3 days and a maximum of 21 days except in the case of infrastructure companies. The LM has to file a fresh certificate after the issue has opened but before it is closed as per the prescribed format.

Post-Issue Procedures 1. In issues wherein there is more than one LM, it is usual to entrust the entire post-issue responsibility to one LM in the inter-se allocation. Generally, the LM who has a full-fledged office in the city where the company has its registered office is made in-charge of the post-issue formalities. 2. There are two reports that are required to be furnished to SEBI by the Postissue LM in case of an IPO in the retail route, i.e. the 3-day Report from the day of closure of the issue and the 78-day Report (i.e. 78 days from the closure of the issue or 3rd day from listing whichever is earlier) in the prescribed format. 3. The main task of a post-Issue LM is to co-ordinate the process of collection of subscription figures from the bankers to the issue, processing of applications by the registrar, despatch of allotment letters and refund orders to all the applicants within the prescribed time, attending to investor grievances expeditiously and ensuring the listing of the shares on the stock exchange(s). 4. If the issue is to be closed on the earliest closing date, the LM should ensure that the issue is fully subscribed before announcing closure. 5. In the case of devolved issues, the LM shall ensure that the underwriters honour their commitments within 60 days from the date of closure of issue. The LM has to furnish to SEBI a list of underwriters who have defaulted on their commitments in the prescribed format. 6. The LM has to ensure that all issue proceeds are kept in separate bank accounts as provided in the Companies Act and the funds are released to the company only after obtaining listing approvals from respective stock exchanges.

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Investment Banking

7. The LM has to release an advertisement announcing the closure of the issue on the last day. Care should be taken to ensure that the advertisement is given only after the actual closure of the issue. 8. The responsibility of finalizing the basis of allotment in a fair and proper manner lies with the executive director or the managing director of the designated stock exchange along with the post-issue LM and the registrar. The basis of allotment is arrived at as per the prescribed procedure on a proportionate basis according to the over subscription received for the issue. In arriving at the basis of allotment the following rules have to be adhered to: �

A minimum of 50% of the net public offer should be reserved for allotment to retail investors, i.e. applications for a value of Rs. 50,000 or less.

�

The balance 50% should be first allocated to non-retail individual applicants and then to other investors including corporate bodies etc. irrespective of the number of shares applied for.

�

All applications should be categorized based on the number of shares applied for. The total number of shares to be allotted to each category are calculated on proportionate basis by multiplying with the inverse of the over subscription ratio.

�

The unsubscribed portion of the net public offer to either of the categories as above, shall be made available to the other category.

�

Within each category, based on the over-subscription ratio, if the allotment to each person works out to less than 100 shares, a draw of lots is made to decide the allottees and the non-allottees such that the successful allottees are offered 100 shares each. For this purpose, the draw of lots shall be conducted in the presence of a member of the governing board of the designated stock exchange.

9. The post-issue LM shall ensure that the demat credit or despatch of share certificates and refund orders to the allottees is completed within two working days after the basis of allotment is finalized. The LM should also ensure that all steps for completion of all formalities for listing of the share at all the concerned stock exchanges within 7 days of the finalization of the basis of allotment. Thereafter, within 10 days of completing allotment formalities, an advertisement has to be issued furnishing details of basis of allot-

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ment and dates of completion of allotment procedures. The issue formalities have to be completed within 30 days of the closure of the issue. 10. The post issue LM is responsible for the completion of all formalities including the following: �

Refund of subscription money to all non-allottees.

�

Refund of excess application money to all allottees after due adjustment against allotment money, if any.

�

Issue of allotment advices with instructions for depository participants.

�

Attending to all investor grievances.

�

Sanction of listing and trading permission by the stock exchanges.

�

Filing of return of allotment by the company with ROC.

�

All issue formalities including stock exchange permission should be completed before the filing of the 78-day report with SEBI.

�

Appointments of Refund Bankers and ensuring that all refunds including interest as prescribed have been made to the applicants.

�

Attending to investor grievances expeditiously and ensuring that all the investors have been satisfied.

5.9.2 Summary Procedural Aspects of a Book Built IPO The procedural aspects of a book built issue follow the similar requirements stipulated above for a retail issue as far as the statutory requirements under Company Law, DIP guidelines and the stock exchange requirements are concerned. However, as far as the bidding for the book built portion is concerned, as distinguished from a retail issue, the DIP guidelines have now made it mandatory for the entire bidding procedure to be made on similar lines of an on-line IPO using the stock exchanges and broker interface. Given below are the steps involved in book-built issues in a sequential manner. 1. Shareholders’ resolution for the issue, appointment of Lead Book Running Lead Manager (Lead BRLM), other BRLMs and syndicate members is completed.

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2. The process relating to due diligence, appointment of other intermediaries, issue budgeting, filing of draft prospectus with SEBI and other authorities apply mutatis mutandis as in a retail issue. The only difference is that the draft prospectus would be a red herring prospectus that does not specify the issue pricing. It specifies either the number of shares or the total size of the issue in terms of amount. The red herring prospectus shall comply with the disclosure requirements given under the DIP guidelines. Where the red herring prospectus indicates the number of shares as the issue size, it has to make additional disclosure of the arrangement to deal with the deficit or surplus in the means of financing depending upon the cut-off price (final price) for the issue. 3. The steps relating to filing of listing applications, entering into agreements with the depositories and underwriting the issue are identical. The syndicate members may appoint sub-underwriters as also collecting brokers as mentioned earlier. Each of the collecting brokers would be treated as a collection centre for the purpose of the DIP guidelines. 4. The marketing for the issue precedes the fixation of the floor price for the issue. The road shows are made to ascertain the demand for the company’s issue and the comfortable price for the investors. Accordingly, the floor price is determined. 5. The steps involved till the issue opens for bidding are similar to those in a retail issue as discussed above. The major difference is with respect to filing of the prospectus with the ROC. In a book built issue, the filing is not made before the issue but after the bidding period is over. This is because the final prospectus needs to mention the final issue price that is determined as a cut-off price based on the bids that are received. 6. The issue announcement advertisement shall disclose the date of opening and closing of the issue, the method of making the bids, the process of allotment and the names, addresses and the telephone numbers of the stockbrokers and the centres for bidding. 7. Individuals as well as institutional investors have to place their bids only through the brokers who shall have a right to vet their bids. Therefore, the normal banking channels used in a retail issue cannot be used for the book built portion of an issue. The bidding has to be conducted electronically and at the end of each day of the bidding period, the demand shall be shown graphically on the terminals for information of the syndicate

267

Initial Public Offers

members and the investors. However, the identity of the institutional bidders shall not be disclosed. For the details on the process of bidding through the brokers using the electronic medium, please refer the discussion in paragraph 5.9.3. 8. The stock exchange shall, by the end of each day while the bidding is open, send the order data to the registrar and the BRLMs. This data shall consist of only the valid orders. On the date of closure of the issue, the final status of the orders received shall be sent by the stock exchange. 9. After finalisation of the cut-off price, the final prospectus complete in all respects is filed with the ROC. 10. Allotment to institutional investors in the bidding is made on discretionary basis and to the individual investors and non-institutional investors on proportionate basis as in the case of a retail issue.

Basis of Allotment—Case of Maruti Udyog Ltd. A) Allocation to Non-Institutional Bidders The basis of allocation to the bidders who bid for at or above the Issue Price of Rs. 125 per equity share, was finalized in consultation with the Stock Exchange, Mumbai, on a proportionate basis after rounding off to the nearest 50 shares. The total number of shares allocated in this category is 11,920,200. A sample of category wise details of the basis of allocation is given as under: Category No. of Applications

% of Applications

No. of % of Bid shares Applied

No. of Ratio shares Allocated

Total Shares Allocated

1,100

222

6.65%

2,44,200

0.14%

100 Firm

22,200

1,500

64

1.92%

96,000

0.06%

100 Firm

6,400

2,000

181

5.43%

3,62,000

0.21%

150 Firm

27,150

3,000

93

2.79%

2,79,000

0.16%

200 Firm

18,600

5,000

130

3.90%

6,50,000

0.38%

350 Firm

45,500

10,000

89

2.67%

8,90,000

0.52%

700 Firm

62,300

20,000

41

1.23%

8,20,000

0.48%

1,400 Firm

57,400

50,000

14

0.42%

7,00,000

0.41%

3,500 Firm

49,000

268

Investment Banking

1,00,000

45

1.35%

45,00,000

2.63%

7,000

Firm

3,15,000

10,00,000

3

0.09%

30,00,000

1.76%

69,750

Firm

2,09,250

40,00,000

1

0.03%

40,00,000

2.34%

2,77,000 Firm

2,77,000

1,08,36,500

1

0.03% 1,08,36,500

6.34%

7,52,850 Firm

7,52,850

B) Allocation to Retail Bidders The basis of allocation to the bidders who bid for at or above the issue price of Rs. 125 per equity share, was finalised in consultation with the Stock Exchange, Mumbai, on a proportionate basis after rounding off to the nearest 50 shares. The total number of shares allocated in this category is 35,760,500. A sample of category wise details of the basis of allocation is given as under: Category

No. of Applications

% of Applications

No. of % of Bid shares Applied

No. of Ratio shares Allocated

Total Shares Allocated

100

92,732

37.53%

92,73,200

10.22%

50 Firm

46,36,600

200

47,421

19.19%

94,84,200

10.46%

100 Firm

47,42,100

300

19,618

7.94%

58,85,400

6.49%

100 Firm

19,61,800

400

21,496

8.70%

85,98,400

9.48%

150 Firm

32,24,400

500

11,829

4.79%

59,14,500

6.52%

200 Firm

23,65,800

600

3,339

1.35%

20,03,400

2.21%

250 Firm

8,34,750

700

1,515

0.61%

10,60,500

1.17%

300 Firm

4,54,500

800

2,020

0.82%

16,16,000

1.78%

300 Firm

6,06,000

900

2,623

1.06%

23,60,700

2.60%

350 Firm

9,18,050

1000

44,509

18.01% 4,45,09,000

49.07%

350 Firm

1,60,16,50

C) Allocation to QIB Bidders Category No. of Shares Allocated

Fls/Banks 874,400

MFs

Flls

8,589,600

22,322,900

Total 31,786,900

269

Initial Public Offers

The proposed model time frame for a book built issue as provided in the revised Schedule XX of the DIP guidelines is as follows: T

T+1

Book Closed

�

Price Determination

�

Determination of offer size

T+2 �

�

Registrar draws the allocation list All entered bids assumed as valid

T+3 �

T+4

� Stock Exchanges approve the � basis of allocation

�

Final � prospectus printed and � dispatched

�

CANs sent to QIBs

�

Allocation details electronically communicated by Registrar/ Company to brokers

�

Pay–in (Only high-value)

T+5 �

Brokers account to be credited with shares

Bankers to confirm clearance of fund· � Broker to credit Board Meeting shares to Stock Exchanges the demat to issue the listaccount of ing and trading investors permission

T+6 �

Trading commences

Company to instruct NSDL/CDSL to credit shares to the demat account of brokers

11. The post-issue procedures of a book-built issue relating to other statutory compliance and addressing investor grievances are the same as in a retail issue. 12. If the issuer company has made a book built issue using the 75%-25% option, the 25% fixed price issue to the public shall open within 15 days from the date of close of the bidding for the 75%. It shall comply with the advertisement requirements and despatch of stationery to all necessary centres. This offer shall remain open for at least three working days. The allotment procedures of the 25% are identical to that in a retail issue.

270

Investment Banking

5.9.3 Summary Procedural Aspects of an On-line IPO In an on-line IPO, as is the case with the book building portion of an IPO, the entire process of receiving applications and application proceeds as well as making allotments has been redesigned without the involvement of the banking channels and verification of applications by the registrar to weed out invalid applications. Instead, the brokers of the concerned stock exchanges have been involved as an alternative mechanism with electronic connectivity to the stock exchange so that the time element in the closing of the issue and the commencement of trading is reduced to as little as possible. For book built issues, the time lag is now proposed to be reduced to just six days. Herein, we discuss how under the alternate arrangement, applications are made and proceeds are received. The rest of the issue procedures relating to on-line issues are identical to that of any other retail issue. As of now, while book building through electronic system is compulsory for all issues, on-line concept in a retail issue is discretionary on the issuer company. �

Any applicant wishing to subscribe to an issue on-line retail issue shall have two options—(a) fill up an application form and submit it to the broker along with the payment by cheque or draft. The broker sends it directly to the registrar for processing and collection. In this case, the broker acts only as a collection centre. (b) The applicant may place an order for shares through the on-line system of the broker. In this case, the application need not be submitted at this stage. For the book built portion of an issue, the first option does not exist. The applicant has to only put in an electronic bid.

�

If the applicant has chosen the second option, the broker may collect an amount of margin money from the applicant, which can be upto 100% of the application amount or the bid amount as the case may be before placing the order on the system.

�

The broker has to open a separate escrow account with the clearing house bank of the concerned stock exchange and deposit all margin monies collected into that account.

�

The broker shall send at the end of each day of the issue, figures of valid orders/bids to the registrar and the final position at the closure of the issue.

�

After the basis of allotment is finalized, the registrar sends the computer file of the allocation details of the successful applicants to the stock exchange. The stock exchange in turn generates the broker-wise funds pay-in obligation and shall send the same to the brokers. The brokers shall immediately

Initial Public Offers

271

inform the successful applicants/bidders who shall fill in the applications and remit the money to the broker. The margin money paid earlier shall be adjusted from the application money. The applications are then forwarded by the broker to the registrar through the stock exchange. The details of application money received and defaulting applicants shall be forwarded to the stock exchange. �

On the pay-in day, the broker remits account. The broker shall pay the of those successful applicants who bank debits this account and credits account.

the amount collected into the escrow application money even on behalf are defaulters. The clearing house the proceeds to the company’s issue

�

The registrar shall, after receipt of funds in the company’s account proceed with the allotment procedures. If shares are being issued in a demat form, the registrar instructs the depository to credit the escrow securities accounts of each broker. The broker in turn credits the respective accounts of the applicants by debit to the escrow account with suitable instructions to the respective depository participant. Thereafter, the broker has to issue confirmation to the registrar/BRLM that individual credits to the securities account of each allottee have already been completed.

5.10 Role of Merchant Banker in Issue Management Merchant bankers with valid registration certificates from SEBI have been provided with statutory exclusivity in managing public offers such as IPOs, rights and secondary issues of equity as well as issues of debt securities. Therefore, whenever there is an offer of securities to the public, the involvement of a merchant banker is mandatory, subject to minor exceptions. It goes without saying that SEBI and the statute place complete reliance on merchant bankers to ensure that compliance of law in issue matters is maintained. Apart from statutory compliance, SEBI also expects issue managers to perform their role with diligence and ensure quality of the issues that they bring to the capital market. Viewed from this perspective, the role of merchant bankers has profound significance to the long term growth and development of the capital market and for the sustenance of investor’s confidence. From a business perspective too, issue management forms the biggest chunk of revenues for investment bankers in those years when the primary market for public floatations is very vibrant.

272

Investment Banking

In the overall process of issue management, the merchant banker plays a variety of important roles as an expert advisor to the management of the issuer company, as an auditor who performs due diligence on the company, as an event manager and coordinator to ensure timely completion of the issue, as a watch dog for statutory compliance and as a person in fiduciary capacity for protection of the interests of investors. This multi-faceted role of the merchant bankers places a tremendous responsibility on them. During the issue, they become the interface between the issuer company and SEBI. Merchant Bankers are expected to explain any lapses, shortcomings or failure in statutory compliances on the part of the issuer in connection with the issue. SEBI has a system of awarding penalty points for erring merchant bankers for violation of the operational provisions of the DIP guidelines. Any merchant banker on whom four or more penalty points have been imposed may be restrained from filing any offer document or associating or managing any issue for a particular period. An additional dimension of merchant banking is to guard against conflict of interest at every stage with other assignments that may be taken up as investment bankers. Though the DIP guidelines provide certain restrictions on the conflict of interest issue, it is considered more of an area of self-regulation for merchant bankers. Readers may appreciate that the overlapping roles of merchant banking and investment banking have already been discussed in Chapter 2. Its fall out has resulted in heavy penalties on some leading names in the industry in and some recent legislative developments in the US market. Some of these legislative measures have already been furnished in Annexure 3 included in this chapter. We will now discuss the main areas of issue management and the various functions of the merchant banker: 1. Appointment, MOU and Inter-se allocation of Responsibilities The appointment of the merchant banker as lead manager has to be accepted very carefully. The DIP guidelines stipulate that a merchant banker ‘shall not lead manage the issue if he is a promoter or a director or associate of the issuer company’. Therefore, before taking up an assignment, the guidelines have to be interpreted and it has to be ascertained if the appointment is legal. The MOU with the company for the assignment has to be drawn up immediately since it defines the relationship and becomes a material document for inspection.

Initial Public Offers

273

In case there are more than one lead manager, the inter-se allocation of responsibilities has to be drawn up on a suitable basis. This statement becomes the basis on which the merchant banker becomes answerable to SEBI at a later date. Since this statement forms a part of the offer document as well, care has to be exercised in allocating responsibilities. Generally, the preparation of offer document and pre-issue compliance, marketing and syndication of underwriting and post-issue compliance can be the broad areas of division of responsibility. 2. Issue Structuring and Pricing As discussed in the earlier part of this Chapter, capital and issue structuring has to be made carefully assessing market factors, dilution of promoter equity, fulfillment of lock-in requirements, possibility of pre-marketing the issue through firm allotments and related issues. In a fixed price issue, the pricing is arrived at in conjunction with the issue structure. In a book built issue, the pricing is done before hand to more or less arrive at the possible structure but the floor price is announced only after the issue marketing is completed. 3. Due Diligence This is probably the most crucial aspect of issue management as it places a tremendous responsibility, the failing of which can have civil and criminal consequences under law apart from penalties imposed by SEBI. The due diligence has an implication on the disclosures in the offer document and the quality of the issue. It is customary for the merchant banker to issue a due diligence questionnaire to the company before the commencement of the process taking into account the standard requirements and the specific requirements of the issue in question. A due diligence document file is built up during this process which would also serve the purpose of filing the same with the ROC at a later date. Particular care has to be taken on outstanding litigation and the implications thereof. Suitable certifications have to be obtained from concerned experts in all technical, legal and accounting matters to the maximum extent possible to serve as a basis for statements made in the offer document. A format of the due diligence certificate to be filed with SEBI by the Lead Manager is provided in Annexure 1 of this chapter. 4. Preparation and Filing of Offer Document The offer document has to be prepared with care and craft as it not only has to conform to the statutory requirements but live up to the image of the issuer company

274

Investment Banking

as well. The main contents of this document have already been enumerated above. But the presentation skills of the merchant banker are put to test while writing the business section of the prospectus. The MDA has to be written well to discuss the important issues from a management perspective as it reposes the confidence of the investors. All the certifications required to be included in the offer document have to be obtained in the specific formats required. The filing of the offer document with SEBI has to be accompanied by several enclosures as explained already. 5. Pre-issue Compliance The pre-issue compliance work is laborious for the merchant banker in terms of several requirements of the DIP guidelines, tying up underwriting if required, selection and negotiation of terms of other intermediaries, formulating the issue budget and making preparations for roll out of the issue. While selecting underwriters, the lead manager has to ensure that the underwriters are not over-exposing themselves so that it may become difficult for them to fulfill their underwriting obligations. The lead manager shall assess the overall exposure of the underwriters belonging to the same group or management in an issue carefully. 6. Liaison with SEBI and Stock Exchange After the filing of the draft offer document with SEBI and the stock exchanges and making it public, the lead manager has to expeditiously attend to the modifications or amendments required at a short notice. The lapses in the due diligence would also come to light during this stage. Precious time cannot be lost at this stage in going back to the drawing board. Rejection of listing approval by the stock exchange can be disastrous for the issue. Since the new SEBI norms stipulate that trading has to commence on the sixth day after closure of the issue, the lead manager has to ensure that listing approval is in place before proceeding with the issue. 7. Co-ordination with other functionaries Issue management being a concerted team effort is performed with the help of several agencies and intermediaries apart from the lead managers. These are the following—registrars, bankers, advertisement agencies, brokers to the issue, underwriters to the issue, printers and couriers. Lack of co-ordination with printers and couriers can lead to increase in costs due to wastages or in the issue stationery not reaching all the required places in time. In addition, professionals such as auditors

Initial Public Offers

275

of the company, company secretary, legal advisors and experts whose opinions are included in the offer document also play important roles in the issue. It is customary for the issuer company to form a core team for the issue management including the key officials and the compliance officer and the merchant banker so as to do the back up work and to also complete all the issue related milestones on a time bound basis. 8. Issue Marketing Issue marketing includes road shows, pre-issue meets with journalists and media men, brokers, investor associations etc. The merchant banker’s presentation skills are put to test once again at this stage. The barrage of questions from various quarters needs to be answered professionally and skillfully. Proper homework needs to be done on the probable questions that may be posed including those on pricing, promoters, financial performance, competitor analysis etc. The merchant banker has to co-ordinate with the advertising agency to ensure that all the important persons attend the road shows and other issue meetings. The merchant banker has to ensure that no publicity material or report is issued with information other than what is contained in the offer document, no incentives other than underwriting commission and brokerage are offered through advertisement or by any other means, the advertisement code is strictly followed. 9. Functions during the Issue The main function during the issue is to ascertain daily figures from the bankers or the stock exchange as the case may be and to take decision on the closure of the issue based on the procurement of minimum subscription. The merchant banker should also carefully ensure that the issuer company or others associated with the issue do not publish any advertisement stating that the issue is over-subscribed or indicating investors’ response to the issue during the period when the issue is still open for subscription by the public. 10. Post-issue Compliance The DIP guidelines provide that the post-issue manager has to actively associate with the allotment, refund and despatch and shall regularly monitor the grievances arising therefrom. Close co-ordination has to be maintained with the registrar and the merchant banker has to depute its officers to the offices of the various intermediaries

276

Investment Banking

to monitor the flow of applications from collecting bankers, processing them and finalization of the basis of allotment and the intimations to investors are completed. The merchant banker shall accord high priority to redressal of investor grievances and take all preventive steps to minimize the number of complaints. SEBI has to be kept informed of the important developments about the issue during the intervening period of filing post-issue reports.

� Notes 1. All figures given are for the year 2001 as reported in Business Standard December 2002. 2. As reported by the Disinvestment Ministry. 3. The figures furnished are those provided in Schedule XV of the DIP Guidelines, which are meant for the guidance of issuers. These figures are representative and not meant to be correct.

� Self-Test Questions 1. What are the underlying factors to be considered for taking the IPO decision? Elaborate. 2. How many methods are there in making an IPO? What are their features? 3. How does the book building method score over the fixed price method? How is the issue price determined under the book building method? 4. What are the key responsibilities of a lead manager in issue management? 5. What is due diligence? What are the aspects to be examined by a lead manager in due diligence? 6. What are the most important sections of a prospectus? 7. Explain the procedural aspects of a book built issue? 8. Explain the concept and procedure for an online issue?

� Annexure I

�

FORMAT OF DUE DILIGENCE CERTIFICATE

To, Securities and Exchange Board of India Dear Sirs, Sub: Issue of ……….by……..Ltd. We, the under noted Lead Merchant Banker(s) to the above mentioned forthcoming issue state as follows: (1) We have examined various documents including those relating to litigation like commercial disputes, patent disputes, disputes with collaborators etc. and other materials more particularly referred to in the Annexure hereto in connection with the finalization of the draft prospectus/letter of offer pertaining to the said issue; (2) On the basis of such examination and the discussions with the company, its directors and other officers, other agencies, independent verification of the statements concerning the objects of the issue, projected profitability, price justification and the contents of the documents mentioned in the Annexure and other papers furnished by the company, WE CONFIRM that: (a) the draft prospectus/letter of offer forwarded to the Board is in conformity with the documents, materials and papers relevant to the issue; (b) all the legal requirements connected with the said issue as also the guidelines, instructions, etc. issued by the Board, the Government and any other competent authority in this behalf have been duly complied with; and

278

Investment Banking

(c) the disclosures made in the draft prospectus/letter of offer are true, fair and adequate to enable the investors to make a well informed decision as to the investment in the proposed issue. (3) We confirm that besides ourselves, all the intermediaries named in the prospectus/letter of offer are registered with the Board and that till date such registration is valid. (4) We have satisfied ourselves about the worth of the underwriters to fulfill their underwriting commitments. (5) We certify that written consent from shareholders has been obtained for inclusion of their securities as part of promoters’ contribution subject to lock-in and the securities proposed to form part of promoters’ contribution subject to lock-in, will not be disposed/sold/transferred by the promoters during the period starting from the date of filing the draft prospectus with the Board till the date of commencement of lock-in period as stated in the draft prospectus. Lead Merchant Banker(s) to the Issue With his/their Seal(s). Place: Date:

Annexure to the Due Diligence Certificate for the Issue of …….by……Limited 1. Memorandum and Articles of Association of the Company. 2. Letter of Intent/SIA Registration/Foreign Collaboration approval/ Approval for import of plant and machinery, if applicable. 3. Necessary clearance from governmental, statutory, municipal authorities etc. for implementation of the project, wherever applicable. 4. Documents in support of the track record and experience of the promoters and their professional competence.

Initial Public Offers

279

5. Listing agreement of the Company for existing securities on the Stock Exchanges. 6. Consent letters from Company’s auditors, Bankers to issue, Bankers to the Company, Lead Merchant Bankers, Brokers and where applicable, Proposed Trustees. 7. Applications made by the company to the financial institutions/banks for financial assistance as per object of the Issue and copies of relative sanction letters. 8. Underwriting letters from the proposed underwriters to the issue. 9. Audited Balance Sheets of the Company/Promoter companies for relevant periods. 10. Auditors certificate regarding tax-benefits available to the Company, Shareholders and Debenture holders. 11. Certificate from Architects or any other competent authority on project implementation schedule furnished by the company, if applicable. 12. Reports from Government agencies/expert agencies/consultants/company regarding market demand and supply for the product, industry scenario, standing of the foreign collaborators, etc. 13. Documents in support of the infrastructural facilities, raw material availability, etc. 14. Auditors’ Report indicating summary of audited accounts for the period including that of subsidiaries of the company. 15. Stock Exchange quotations of the last 3 years duly certified by designated stock exchange in case of an existing company. 16. Applications to RBI and approval thereof for allotment of shares to nonresidents, if any, as also for collaboration terms and conditions. 17. Minutes of Board and General Body meetings of the company for matters which are in the prospectus. 18. Declaration in Form 32 from Directors (for particulars of Directorship) or the Company Secretary’ certificate in this regard. 19. Revaluation certificate of company’s assets given by Government Valuer or any other approved Valuer.

280

Investment Banking

20. Environmental clearance as given by Pollution Control Board of the State Government or the Central Government as applicable. 21. Certificate from company’s solicitors in regard to compliance of legal provisions of the Prospectus as also applicability of FERA/MRTP provisions to the company. 22. Other documents, reports etc. as are relevant/necessary for true, fair and adequate disclosures in the draft prospectus/letter of offer (to give details). 23. True copy of the Board resolution passed by the issuer authorizing a representative of the Registrar to act on its behalf in relation to handling of stock invests. Lead Merchant Banker(s) to the issue With his/their Seal(s) Place: Date:

� Annexure II

�

ILLUSTRATIVE BENCHMARKS IN IPO PRICING

One of the key challenges in IPO pricing is to arrive at the future potential trading price band of the company’s share in the short-term post-listing. Since the market conditions are unpredictable, it would not be possible to forecast too much into the future. Nevertheless, going by the prevailing market conditions at the time of the issue, it would be possible to arrive at price benchmarks that would prove useful in fixing the price band for the issue. As the objective is to find out a reasonable price band, one has to decide on a conservative pricing at the lower end, and an aggressive pricing on the upper end. As this is purely a quantifying effort of the company’s fundamentals, it need not be reflective of the primary market sentiments. After arriving at this price-band, the upward or downward bias can be determined based on the market conditions. Generally speaking, most issue managers look at the EPS and the P/E ratio in determining the two points of the range. The EPS values can be moderated using the weighted average of the past three normal financial years with the weightage being biased towards the immediately preceding year. This is because the latest year is presumed to be representative of the earning potential in the near future. Consider the following illustration: Financial Year Earning Per Share (EPS)

2000–2001

2001–2002

2002–2003

7.10

4.59

2.68

Therefore, the weighted average EPS would be: (3H7.10)+(2H4.59)+(1H2.68)/6 = 5.52. The next step would be to ascertain the industry average P/E for the relevant industry to which the present company belongs. Let us consider the following illustrative figures.

282

Investment Banking

Price/Earnings multiple

Highest

Lowest

Average

32.5

3.50

8.60

Considering the average industry P/E of 8.60, and multiplying it with the weighted average EPS, one could arrive at the most conservative price or the lower end of the trading price band that the scrip of the issuer company can rule. This would work out to: 5.52H8.60 = 47.47. Looking at the EPS for similar, comparable companies in the industry, it is possible to find industry leaders whose scrips are quoted very well and others whose shares are not fancied by the market. It is possible that none of the PE figures reflect a true picture of the respective scrip. While the fancied scrips may quote at exorbitant PE ratios, the laggards would have a below industry average PE. Considering these variations, the P/E of the IPO candidate at its upper end can be pegged. If the company has made private placements or preferential issues in the past, that could also be a guiding factor as to how the investors mat perceive the company’s scrip. If on the basis of the above analysis, it is perceived that the company’s upper end P/E could be in the range of 10 to 12, the upper price limit can be found out by applying the company’s highest EPS in the period in question. Therefore, the most optimistic price would be as follows: Highest EPS = Rs. 7.10 Ò PER of 12 Thus, the upper price limit works out to Rs. 85.20. The price band thus arrived at ranges from 47 to 85 as shown above. Using this price band and considering other factors which have been discussed in the relevant paragraph of this chapter, the pricing bias can be determined. If the merchant banker prefers an upward bias, the price could be around the 75% mark of the price band. The final price for the issue is always decided in consultation with the merchant bankers, who being the experts in assessing the market conditions, can have a feel of the ‘market clearing’ price.

� Annexure III September 4, 2002

NASD Proposes New Regulations for the IPO Allocation Process In conjunction with both its historical concerns and the SEC’s current investigation into the issue, the NASD has proposed a new conduct rule, and an amendment to a current conduct rule, which would substantively regulate the process whereby broker-dealers allocate shares in an initial public offering. The NASD’s proposed rules would regulate the allocation of shares in an IPO in the following ways: �

Prohibition of Abusive Allocation Arrangements. The rule would prohibit NASD members from offering or threatening to withhold IPO shares as consideration or inducement for the receipt of compensation which is excessive relative to the services provided by the member to the recipient of the shares. This provision is not intended to prevent an NASD member from allocating IPO shares to a customer who is separately working with the NASD member on other matters.

�

Prohibition on Aftermarket Tie-In Arrangements. The rule would bar tie-in arrangements whereby a broker-dealer conditions receipt of IPO shares on the recipient’s agreement to purchase additional shares in the aftermarket. These arrangements are generally already prohibited by Rule 101 and 102 of Regulation M.

�

Prohibition of Spinning. The rule would prohibit an NASD member from ‘spinning’ or allocating IPO shares to an executive officer or director of a company, either on condition that the officer or director direct the company’s future investment banking business to the member, or as consideration for investment banking services previously directed by the company to the member. Since this prohibition will be viewed in hindsight, underwriters will need to be careful during IPO distributions-even where there is no condition for future business-that there is no transaction which creates an appearance of a violation of this provision.

284

Investment Banking

�

Restrictions on Penalty Bids. The rule would prohibit an NASD member from directly or indirectly recouping or attempting to recoup any portion of a commission or credit paid to an associated person of a member as a penalty for selling IPO shares to a customer that flips the shares, unless the managing underwriter also assesses a penalty bid on the syndicate member with which the individual is associated. The purpose of this provision is to eliminate the alleged practice where registered representatives for institutional customers generally are not penalized for customer flipping but representatives for retail customers are penalized for retail customer flipping.

�

Requirement for Procedures. The proposed rule would require each NASD member to adopt and enforce supervisory procedures to ensure compliance with the rule.

The NASD has also proposed requiring the managing underwriter of any public offering subject to NASD review to file a statement with the NASD regarding whether any executive officer or director of the issuer which has conducted the public offering has purchased IPO shares of any issuer from the managing underwriter during either the 180 day period immediately preceding the filing date of the company’s public offering or during the 180 day period immediately following the effective date of the public offering. If the executive officer or director has in fact received any IPO shares in the relevant time period, the managing underwriter would have to identify, among other things, the identity of the executive officer or director and whether he or she has participated in any capacity in the selection of the managing underwriter.

August 19, 2002 Sarbanes-Oxley Act of 2002: Cashless Exercises of Stock Options As of its effective date of July 30, 2002, the Sarbanes-Oxley Act generally made it unlawful for an issuer (which means not only traditional public companies but also companies with publicly traded debt and private companies as to which a registration statement has been filed) directly or indirectly to make personal loans to its directors and executive officers. The law explicitly prohibits an issuer from ‘extend[ing] or maintain[ing] credit’ or ‘arrang[ing] for the extension of credit’ on behalf of its directors and executive officers.

Initial Public Offers

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The broad language of the Act calls into question the legality of a public company maintaining cashless exercise programs on behalf of its directors and executive officers under its various stock option programs. The basis for the prohibition generally is that the company arranges for the extension of credit by (i) advancing to a broker shares, with a value equal to the option exercise price, which the broker sells into the market to raise the exercise price, or (ii) promising to deliver shares to the broker subsequent to the broker using its own inventory of company shares to raise the exercise price. Although we generally surmise that the Act did not intend to prohibit these arrangements, companies cannot continue them without risk. When the possible application of the Act to these arrangements was raised last week, a senior representative of the SEC staff refused to comment, saying that she was leaving this question to practitioners to decide. She also suggested that guidance from the SEC would not be issued in the near future. In light of this, subject to any guidance offered in the future, all public companies should immediately consider prohibiting directors and executive officers from participating in cashless exercise programs. Public companies have alternatives to consider. The Act should not prohibit socalled ‘stock-for-stock’ exercises, where the executive uses shares underlying the option to pay the exercise price and receives a net amount of option shares. The Act should also not prohibit the executive from paying the exercise price by tendering already owned shares. Under IRS rulings, the executive should not recognize gain on any appreciation in the shares tendered. However, both of these techniques may result in adverse accounting consequences depending on whether the relevant option plan will need to be amended to permit these techniques and/or to what extent the company utilizes APB 25 or FAS 123 to account for employee options. As to the use of third-party brokers, the only certainty appears to be that the company may confirm to the executive’s personal broker that the executive is in fact an optionee covering the relevant shares. Some have questioned whether the Act prohibits the executive from using the same broker that continues to administer the company’s cashless exercise program for non-executives on the grounds that the company has introduced or recommended to the executive a third party that advances its own shares to facilitate exercise of the option.

Chapter

6

Rights Issues and Secondary Public Offers

I

n the previous Chapter, the aspects relating to an IPO through a public issue and an offer for sale have been discussed extensively. In this chapter, we discuss the concepts, law and procedure relating to rights issues and secondary public offers. Secondary offers also known as follow on offering, consist of post-listing public issues, offers for sale and composite issues. A listed company has to consider many more aspects than an unlisted company in approaching its shareholders or the primary market for funds. The status of a listed company puts restrictions on pricing, timing and other issues considering that the ruling market price and prevailing market conditions always weigh in on such decision-making. Apart from market aspects, other issues relating to promoters’ stakes and dilution thereof have got to be considered as well. Lastly, there is the issue of market capitalization and floating stock that has to be kept in mind while assessing the post-issue scenario of such companies.

Topics to comprehend �

Considerations that apply to a listed company as distinguished from an unlisted in tapping the primary equity market for fund raising.

�

Concepts and procedural aspects of rights issues.

�

Composite issues and their relevance.

�

Procedural aspects of making secondary offers.

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6.1 Considerations for Listed Companies Listing, as already discussed in Chapter 5, is a mixed bag of opportunities and responsibilities for a company. As far as the opportunities go, the company has access to long-term funds that can reduce leverage and financial risk in the business. At the same time, by raising equity from the market, the company increases its capacity to absorb more funds in the form of fresh borrowings. There is a caveat in that opportunity as well, in that if a company raises funds without having the requirement to do so, it could lead to over-capitalization and consequent drop in the return on capital employed. In addition to raising funds, the company gets liquidity for its stock and a marketable value. All the above mentioned opportunities come with more than a fair share of responsibilities. These are broadly in the areas of periodical corporate disclosures, corporate governance and statutory compliance prescribed under the Companies Act, SEBI regulations and the listing agreement with the stock exchange. There are severe punitive measures prescribed for violation of compliance. From an investment banking perspective too, a listed company has a set of opportunities and limitations as compared to an unlisted company. Since a listed company has access to the retail market, it can structure suitable issues from time to time based on its requirement, financial performance and market conditions. These issues could have wide structuring options to manage the debt-equity mix in the company’s capital structure. Thereby, the cost of funds can be managed as well. However, a listed company has to consider and manage several parameters in order to be able to successfully tap the capital market from time to time and reap its benefits. These issues are elaborated in the subsequent paragraphs.

6.1.1 Market Capitalization One of the most important parameters for a listed company is the market capitalization which is the aggregate market price of all its issued shares, whether floating or not. The market cap keeps fluctuating based on the stock price in the market. In real terms, the market cap denotes the consideration that has to be paid to purchase the entire stock in the company. This brings us to the discussion on what could be the desirable market cap for a company. From a theoretical perspective, Value of the Firm = Value of Equity + Value of Outstanding Debt

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Therefore, Value of Equity = Value of the Firm – Value of outstanding debt Value of Equity > Market Cap = Under-valuation Value of Equity < Market Cap = Over-valuation The value of equity derived as above has a relationship with the market valuation in terms of the market cap. If the market cap is more than the value of equity, it denotes that the market has valued the share at more than the present value of its future earning capacity. This could be either due to overvaluation by the market of the company’s future potential or due to cyclical market trends. On the contrary, if the market cap is less than the value of equity, it denotes that the company is undervalued in the market, either due to insufficient information of its true potential or due to lesser expectation on its future capability or simply due to cyclical fluctuations. As already discussed earlier, a company need not be guided by temporary fluctuations in the market cap since the market price is only an instant exit price in the market window which need not correspond to the long term valuation of the company. However, if the market cap shows either a sustained over or under-valuation over long periods of time, its implications are as follows:

Over-Valuation �

An over-valuation could hurt retail investors if the company’s financial performance does not meet market expectations.

�

Over-valuation could tempt the promoters and significant stake holders to start dilution of their stakes with an intention to buy back at a later date when the market cap starts coming down in a correction. This could again hurt the retail investors.

�

Over-valuation could lead to over-pricing of a public offer.

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Over-valuation puts undue pressure on the company’s management to meet the expectations of the market with sustained financial performance.

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Over-valuation could lead the company into focus for a hostile takeover. This would not augur well for the shareholders of the acquiring company.

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Over-valuation could prove a hindrance for investment by investors if they perceive it to be unwarranted.

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From the above, it is evident that though over-valuation can boost the ego of the company’s management, it may not augur well for the company’s prospects if it goes beyond certain limits. Investors need to be cautious while dealing with such scrips.

Under-Valuation �

An under-valuation could prove a major bottleneck for raising equity capital due to the dilution effect. Considering that existing investors would not participate in future equity issues, the company may end up diluting their stakes significantly for raising a small sum of money from the market. If the stake of promoters starts to dilute, it would send wrong signals to the market.

�

Under-valuation erodes the wealth of existing shareholders and more importantly, the promoters of the company.

�

Due to under-valuation, a company may not be able to come out with a public offer in the fear of under pricing the issue. This essentially closes the doors on a long-term source of finance for the company.

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Under-valuation makes a company a very attractive target for a ‘buy in’ by a strategic investor or a competitor. In the past, undervalued companies have often become targets for hostile takeovers.

�

Under-valuation can prompt promoters of companies to resort to unethical means of price rigging, which hurts retail investors. Hurting investor sentiments could in turn lead to impairing the company’s future market prospects.

From the above, it can be appreciated that under-valuation is a more serious menace than over-valuation, which results either from an information gap in the market or due to the market not attaching enough credibility to such information. Either way, it requires investor education and market awareness to be created, so that the gap between the company’s intrinsic worth and its market cap is narrowed down. It may thus be concluded that a desirable and sustainable market cap for a company is one that is moderately higher than its intrinsic worth.

6.1.2 Equity Dilution Equity dilution is a concept that denotes the expansion in the subscribed capital of a company and the possible consequent reduction in the percentage shareholding of existing shareholders.

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�

Illustration 6.1

For example, a company having a post tax profit of Rs. 1 million on an equity base of 10,000 shares of Rs. 10 each has earning per share (EPS) of Rs. 100. Let us assume that the present capital is held by three shareholders A, B and C in the ratio of 30%, 30% and 40%. It is now proposed to bring in a fourth shareholder D by issuing 2000 fresh shares to D to the exclusion of the other shareholders. The impact of the same is shown below:

SCENARIO I Pre-issue

Shares

Capital

Post-issue

Shares

Capital

A (30%)

3000

30000

A (25%)

3000

30000

B (30%)

3000

30000

B (25%)

3000

30000

C (40%)

4000

40000

C (33.33%)

4000

40000

D (16.67%)

2000

20000

12000

120000

Total EPS Rs.

10000 100

100000

Total EPS Rs.

83.33

It may be noted that the respective shares of A, B and C have been diluted by 5%, 5% and 6.67% respectively to accommodate D’s share of 16.67%. The dilution in the EPS has been to the extent of Rs. 17.67 on the same profit after tax of Rs. 1 million. Now, let us consider another situation wherein, instead of fresh shares being issued to D, the existing shareholders divest their stakes in the ratio of their holdings to accommodate D. The scenario is shown below:

SCENARIO II It may be observed that the dilution of holding of existing shareholders in the second scenario is higher than in the first. However, the total capital base has not expanded since no new shares have been issued. Consequently, there is no impact on the EPS.

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Pre-issue

Shares

Capital

Post-issue

Shares

A (30%)

3000

30000

A (24%)

2400

24000

B (30%)

3000

30000

B (24%)

2400

24000

C (40%)

4000

40000

C (32%)

3200

32000

D (20%)

2000

20000

10000

100000

Total

10000

EPS Rs.

100

100000

Total EPS Rs.

Capital

100

The equity dilution concept may be summarized as follows: �

If the capital base is expanded, it leads to lesser dilution for existing shareholders than through a divestment of their stakes since in the latter case, new shareholders have to be accommodated on the same capital base.

�

If fresh shares are not issued, it does not impact the EPS, Return on Capital Employed (ROCE) and Return on Networth (RONW) since the capital base is not expanded. Consequently, the company does not receive any funds. The shareholders, who have divested their shares, receive the funds from the new shareholders. It may be observed that if shares are divested pro-rata by existing shareholders, their inter-se ratio of holding remains the same. However, if the ratio of divestment is not pro-rata, it could alter their inter-se holding pattern.

�

If fresh shares are issued, it impacts the EPS, ROCE and RONW adversely in the short-term since the company would take time to start servicing the expanded capital base. However, in this case, the company receives the consideration from the new shareholders for the shares allotted to them.

�

If fresh shares are issued pro-rata to all existing shareholders, with no new shareholders being brought in, it does not result in any change in the shareholding pattern though the capital base has been expanded. However, this impacts the EPS, ROCE and RONW.

Companies and their investment bankers keep the implications explained above in mind for planning either a fresh issue of shares or a dilution of holdings of existing shareholders. Accordingly, financial plans and issue structures are decided.

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6.1.3 Promoter Holdings Most promoters in India are wary of their holdings in their companies. It is a common practice for promoters to have significant stakes (in many cases, majority stakes) in their companies. This is to prevent hostile takeover attempts (though there have been few successful such attempts so far). There are few companies wherein promoters have less stakes or which have no identified promoters. Larsen and Turbo Ltd. is one such company that does not have an identified promoter group though the Aditya Birla group now holds close to 15%. The Tata group held just seven percent of group company ACC, which they eventually sold to Gujarat Ambuja Cement. The Tata group was criticized for its infamous rights issue in Tata Sons to the group companies, the funds from which were used by Tata Sons to consolidate its holding in group companies. In spite of it, the Tata holding company owns only 26% of its two flagship companies TISCO and TELCO. Most Indian companies, especially from the family promoted category, have significant promoter holdings, mostly in excess of 51%. There are several reasons for Indian companies to have significant promoter holdings. Firstly, Indian companies are largely assisted by all India financial institutions, which do stipulate minimum core promoter contributions in their companies. Before the SPV structure evolved, institutions felt comfortable if promoters held significant stakes and these shares were used to guarantee the loans. Secondly, there was no organized takeover code in India till 1996 and the protection accorded by clause 40A and 40B of the listing agreement as well as section 111 of the Companies Act was inadequate. Thirdly, until the advent of the preferential allotment guidelines in 1994, promoters could increase their stakes in listed companies at will using the weak mechanism of section 81(1A) of the Companies Act. However, with regulation coming in, the situation has changed for the better. As per the prevailing guidelines, once a company is listed, the promoters find it difficult to keep increasing their stakes since the cost of every such acquisition is quite high. Most promoters of listed companies find themselves in a conflict of interest with the company as regards its growth and the consequent dilution of their holdings. If the company’s financial needs grow faster than the rate at which the promoters can infuse fresh promoter capital, it leads to dilution of their stakes. Some promoters who do not like such dilution would therefore stifle the growth of the company. In other words, the promoters have to choose between holding a major stake of a smaller company vis-à-vis a moderate to minority stake in a bigger company. If

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Investment Banking

the former is chosen, the company tends to grow only at a pace at which the promoters feel comfortable assuming that the business environment is supportive of it. This brings up the discussion regarding dilution management and desirable promoter stakes. There is no straight formula to arrive at the desirable level of promoter holdings for a given company except that, as the company grows bigger, it is desirable to have a wider dispersal of shareholding to attain access to larger fund base and better levels of corporate governance. However, in certain situations, it may be required for the promoters to have majority shareholding. Some of those situations are explained below: �

In companies with high levels of intellectual property, it is better that the promoters retain majority stake since they drive the business through continuous enhancement of such intangible assets.

�

In companies that are floated as joint ventures, it may be necessary for the parties to the joint venture to continue to hold significant stakes to keep the joint venture operational.

�

Some companies are bound by contractual and legal obligations that do not permit promoters to dilute to a minority stake that would result in change in control or management. Such limitations could be private legal arrangements through creation of trusts or holding companies, or they could be through critical contracts or due to legal provisions.

�

In government companies and statutory corporations, there are restrictions on the shareholding of the government either directly or indirectly to go lower than 51%.

6.1.4 Dilution Management The next aspect to be discussed is dilution management of promoter stakes. Often investment bankers are faced with the task of coming up with solutions to consolidate promoter stakes in the most efficient way possible. This could sometimes be a prelude to an impending equity issue. In 2001, several Indian companies consolidated their stakes after a wave of hostile bids. Low promoter stakes are seen as a sign of weakness in Indian markets. Bombay Dyeing was a target for a hostile bid in which the promoter stake rose from 5% to 41%.

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The following options are available for consolidation of promoter stakes/dilution management in listed companies: 1. Rights Renounciation – A rights issue whereby some of the non-promoter shareholders are made to renounce their shares in favour of the promoters could be a possible route. It could also be that promoters subscribe to the unsubscribed part of the right issue thereby increasing their stake. The third alternative would be for the promoters to subscribe to the rights while some other shareholders abstain from subscribing. The third route was used in the case of Maruti Udyog Ltd. for increasing the share of Suzuki of Japan. These mechanisms would work out to be more cost effective than a preferential offer to promoters. However, this is a very limited option and is contingent upon the present market conditions, the pricing of the rights offer and the response to the issue from the investors. Between 2001–2002, the damp market conditions encouraged many companies to go for rights issue. Telco’s Rs. 672 crore rights issue, Arvind Mills’s Rs. 75 crore issue, SKF Bearings’s Rs. 88 crore issue, Gammon India’s Rs 19 crore issue are good examples. The underlying factor that triggered these issues was that considering the prevailing market conditions at that time, the issues were not expected to be subscribed, which gave the promoters an opportunity to take up those shares. The promoters of Arvind saw a sharp increase in their holdings. The issue, which closed in December 2001, resulted in the Lalbhai group doubling its stake to 35%. However, this may not always be the case. The SKF issue was oversubscribed with institutional support both in equity (Rs 50. crore) and NCD (Rs. 38 crore).1 2. Preferential allotment of shares to promoters – This is governed by SEBI guidelines. The promoters of 62 SMEs made preferential allotments of 643 million shares valued at Rs. 1063 crore during Jan–Sept 2002.2 Most of them were at a premium to market price and were meant to either increase the promoters’ stakes or gain control of companies taken over. In some cases, they were made to strategic partners in order to finance the company’s capital investment plans. Some of these companies are Abhishek Industries, Aurobindo Pharma, Colour Chips, Essar Shipping, IFB Industries, Milton Plastics, Jain Irrigation etc. The stock market resurgence of 2003 raised the popularity of preferential allotments once again with promoter groups to the extent that the SEBI is contemplating some more structural adjustments to its guidelines on preferential allotments. The provisions for preferential allotments have been discussed in Chapter 10.

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Investment Banking

3. Private Placement – A private placement through the preferential route is possible to persons forming part of the promoter group or to other types of investors (both private and institutional), some of whom could act in concert with the promoters. This would also be regarded as a preferential allotment. The Gramophone Company of India Ltd. (now called Saregama) made a private placement on preferential basis in February 2000 for Rs. 125 crore through the book-building route to a cluster of 28 FIIs and domestic institutional investors. The provisions for private placements have been further discussed in Chapter 10. 4. Issue of convertibles – Issue of convertibles to promoters such as warrants and convertible debentures whereby the conversion thereof is staggered into the future. This would give enough time to the promoters to come up with additional contribution at the time of the conversion for increasing their stakes. This aspect has also been discussed below. 5. Bonus Issue – A bonus issue prior to an impending public offer whereby the pre-issue equity capital is expanded is another alternative. The provisions relating to bonus issues have been discussed in Chapter 10. The idea in such a bonus issue is that the dilution due to the fresh issue would be lower on an expanded capital base. However this may not always be true as it would depend heavily on the prevailing market conditions and the pricing expected for the public issue on the expanded capital base. In the past, most companies going for IPO had used this technique. 6. Creeping acquisition – Creeping acquisition through secondary market purchases is a route available under the Takeover Code. Under the current Takeover code issued by SEBI (discussed in Chapter 15), promoters can buy shares in their companies from the secondary markets to the extent of 5% in any financial year. By this mechanism they can increase their stake over a period of time. Promoters and strategic investors acquired 109 million shares in 85 companies during the first half of 2002–03.3 These shares had a market value of Rs. 402 crore during that time. These shares were bought through market purchases for different purposes. Promoters did so to raise their stakes through creeping acquisitions in their own companies. Some other promoters used it as an acquisition route. Promoters hiking their stakes through creeping acquisitions between 2000–01 included the Tatas taking their stake in TISCO to 26.2% and TELCO to 26% and in Indian Hotels Ltd. to 39%, Aditya Birla group hiking its stake in Indian Rayon to 26.5% and the promoters in Bajaj Electricals Ltd. hiking their stake to 45%.

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7. Share Buyback – A buy back of shares from the public in compliance with section 77A of the Companies Act and the buy back guidelines (discussed in Chapter 15). Under this mechanism, the public shareholding is brought down thereby increasing the holding of the other shareholders including the promoters. GE Shipping, a takeover target, has seen its promoter stake rise to 21% as on June 30,2001. The company went in for a buy back during that year. 8. Open Offers – An open offer to the public under the Takeover guidelines by the promoters can lead to consolidation of promoter stakes. This route is similar to a buy back except that under this mechanism, the promoters buy shares from the public instead of the company. The open offer mechanism has been discussed further in Chapter 9. 9. Sweat Equity – Promoters contributing intellectual property or services to a company can get shares allotted to them as sweat equity. In the case of listed companies, apart from complying with section 79A of the Companies Act, the SEBI guidelines on sweat equity apply as well. These provisions have been detailed in Chapter 10. 10. Shares with Differential Rights – Companies can resort to issue of shares with differential rights as to dividend and voting under section 86 of the Companies Act in order to protect promoter interests. The issue of these shares has already been discussed in Chapter 3. 11. De-listing of Shares – Lastly, through a delisting of shares under the delisting guidelines whereby the company is taken private, the promoters may consolidate their stakes of the expense of the public shareholders. The delisting provisions have been discussed in Chapter 9. Promoters and investment bankers choose the appropriate options among the above alternatives, sometimes in a combination, for the management of promoters’ stakes. The choice of an alternative would depend upon the facts of each case and the considerations to be applied. Generally speaking, creeping acquisition is a convenient and positive step as compared to a preferential allotment, which does not find favour with the market. Similarly, an open offer by the promoters is a more positive step as compared to a buy back of shares that requires the use of the company’s resources to shore up promoter holdings. In this Chapter, we will discuss the various aspects of a rights issues and secondary offers. The other alternatives for dilution management have been discussed in various other chapters as already indicated under the respective headings.

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6.2 Rights Issue 6.2.1 Concept of Rights A rights issue is made to the existing shareholders of a company. The ‘right’ herein refers to the entitlement of a shareholder to apply for and receive additional shares in the company. Since the rights issue is made only to existing shareholders, such entitlement to apply for additional shares is also available to existing shareholders alone. However, the application for additional shares is only a right and not an obligation on the shareholder. For the purpose of ascertaining the right, a ‘record date’ is fixed. All persons whose names appear in the register of members of the company as of the record date are eligible for the rights. The entitlement is fixed on a proportionate basis according to the entitlement ratio fixed under the rights issue. For example if rights issue is being made in the ratio of 1:2, it denotes that for every two existing shares held by a shareholder, the entitlement would be one new share under the rights issue. Therefore, if a shareholder presently holds 500 shares in the company as of the record date, such person’s entitlement under the rights issue would be to apply for and receive 250 new shares in the rights issue. As has been mentioned above, the entitlement is only a prerogative of the shareholder and not an obligation. Therefore, under the terms of the issue, the shareholder would be given the right to subscribe for and receive the rights shares or to ‘renounce the rights’ in favour of any third person of the choice of the shareholders. Once the rights are renounced, the renouncee is entitled to subscribe for and receive the rights shares. However, if the shareholder neither applies nor renounces the shares, the rights entitlement lapses and to that extent the rights issue is under-subscribed. Normally, the promoters of a company seek the right to apply for and take rights shares to the extent of the under-subscription in the rights issue. Such right for the promoters should form part of the terms of the issue and be disclosed in the letter of offer sent to the shareholders. In a rights issue, if all the shareholders subscribe for their rights, the pre-issue shareholding pattern remains intact after the issue. However, if the issue is under-subscribed and to that extent, the promoters take up the rights, the stake of the promoters in the company post-issue goes up. In a rights issue, there can be a situation of oversubscription since every shareholder can apply to the extent of the entitlement or more. The letter of offer has to specify the right of shareholders to apply for additional shares. The concerned stock exchange may waive such requirement if

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the company proposes to dispose off the un-subscribed shares at the ruling market price or above. The allotment in the case of over-subscription would be made on pro-rata basis.

6.2.2 Pricing a Rights Issue and Value of a Right The next step to be discussed is based on the significance of the ‘right’ and when it makes sense to apply for it. A rights issue by definition, is to the existing members of the company to provide additional financial assistance to the company. In that sense, a rights issue is the primary source for a listed company to seek additional capital from the primary market. Since existing shareholders had provided funds to the company when it reached out to them in its IPO, it is but natural to consider them in future as the first option. However, hidden herein is also the fact that since they had financed the company in the past, the company has to provide them better terms to finance it a second time as compared to the terms it would offer to first time subscribers. In other words, a rights issue has to priced more favourably for an investor than a public issue. For a listed company, the market price becomes a ruling benchmark and if the rights issue is priced equivalent to or more than the ruling market price, the shareholder is better off buying the shares from the market than to subscribe to the rights. This factor has to be borne in mind for pricing a rights offer. This brings us to the discussion on how to price a rights issue. Unlike in an IPO, where the company has no prior record of a quoted market price, in the rights issue of a listed company, the market price plays a major factor in pricing the rights. Though the fundamentals such as the EPS, book value of share and industry related P/E ratios are important considerations, what is of primary relevance in pricing the right share is the ruling market P/E ratio of the company. If a company is quoting at a P/E multiple which is above its peers in the industry, the rights can be priced accordingly. However, if the company is under-valued in the market, the pricing of the rights is also impacted to that extent. The pricing of the rights would impact the capital structure and the post-issue equity base of the company as well. The quantum of funds to be mobilized in the rights issue should be determined in conjunction with the pricing of the rights as per the above criteria.

�

Illustration 6.2

Rights Limited furnishes the following particulars as of a recent date:

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Investment Banking

�

EPS = Rs. 7.50

�

Current Market Price (CMP) = Rs. 75

�

Book Value per share = Rs. 60

�

Industry average P/E ratio = 14

�

Total quantum of funds proposed to be raised = Rs. 40 crore

�

Present issued and paid-up equity capital = 5 million shares of Rs. 10 each

�

IPO price three years ago = Rs. 60 per share

Based on the above data, the implication of the rights issue may be determined as follows: Present equity capital (5 million shares) Present EPS = Rs. 7.50 CMP = Rs. 75 Company P/E = 10 Industry P/E = 14 Since the company is under-valued, the rights pricing has to be linked to the company P/E.

Rs. 500,00,000

Therefore if the rights pricing were fixed at a P/E of 5 or 6, the proposed price of the right share would be in the range of Rs. 37.50 to Rs. 45. Assuming that the price is fixed at Rs. 40, the capital structure would work out as follows. Total number of fresh shares to be issued under the rights issue (Rs. 40 crore/Rs. 40)

10 million

Increase in paid-up equity capital

Rs. 10 crore

Post-issue paid up capital

Rs. 15 crore

Expansion in equity capital as a percentage of pre-issue capital

200%

Post-Issue net worth (Pre-issue net worth + expansion in equity capital + proposed premium)

Rs. 70 crore

Return on post-issue net worth required to maintain pre-issue EPS

16.07%

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It may be noted from the above data that the company needs to earn at above 16% on its net worth in order to sustain the current market price in the medium term after the rights issue. This would depend on the proposed utilization of the funds. Similarly, the pricing of Rs. 40 for the rights issue looks attractive at a discount of almost 47% to the CMP. Considering the fact that the company has been undervalued in the market, the pricing of Rs. 40 could provide the required succour to the investors. The company had made a premium issue three years ago at a price of Rs. 60 and looking at the CMP, it may reasonably be assumed that the com-pany’s share may have quoted below its offer price in the past. Therefore, a rights issue at a pricing below the IPO pricing would be construed as an investor-friendly step taken by the management and the rights issue could receive an encouraging response from the shareholders. As mentioned in the earlier discussion, it is also important to understand the underlying objective in a rights issue, which could also determine the pricing as well. If the objective is to seek fund support from the shareholders, there is a need to carry them along and therefore, an investor-friendly pricing on the above lines may augur well for the company. However, if the rights issue is being made to seek consolidation of promoters’ stakes through the back door, it may have to be priced steeper to dissuade the shareholders from applying in the rights issue. However, in such a case, a choice has to be made between a direct entry for the promoters through the preferential allotment route vis-à-vis the rights issue. One implication could be that if promoters pick up the under-subscription in the rights issue, such shares are not subject to any lock-in whereas shares issued under the preferential route are subject to a lock-in of one year. This again may not be a significant factor for promoters. Preferential allotments however, are received by the market with scepticism. More discussion on preferential allotments is provided in Chapter 10. The next aspect of rights issue is the value of the ‘right’ to the shareholder. In Illustration 6.2, the CMP of the share is Rs. 75 while the rights shares is being offered at Rs. 40. Therefore, the economic value of the right with reference to the CMP works out to Rs. 35 per share. However this has to be seen from the perspective of what the shareholder proposes to do with the right. If the shareholder decides to subscribe to the rights, the average cost of acquisition of the entire holding would work out to Rs. 50 per share (Rs. 60 + Rs. 40) assuming the IPO price as the carrying cost of the earlier holdings. In effect, the value of the right in this case is in bringing down the cost of the holdings from Rs. 60 per share to Rs. 50 per share. On the contrary, if the right is renounced to a third party for a consideration of say Rs. 10 per share, the net amount received from the renounciation pro-rated over the carrying cost of

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the existing holding (Rs. 60) would determine as to what extent the cost of the existing holdings has been reduced due to encashment of the rights.

6.2.3 Considerations for a Rights Issue Considerations for Issuer Before embarking on a rights issue, the issuer company has to weigh in the implications vis-à-vis alternative methods to achieve its objectives. The evaluation could be in terms of the following: �

The primary objective of the rights issue—is to raise funds or to reward shareholders or to seek consolidation of promoters’ stakes?

�

If the objective is to raise funds, is the rights issue an adequate source of finance for the company’s fund requirement considering the likely price and desirable expansion in equity capital.

�

If the objective is to provide an incentive for shareholder loyalty, the rights option has to be evaluated vis-à-vis alternatives such as a bonus issue or a higher dividend payout. If the company prefers to retain cash, bonus issue is a better option. If the company proposes to raise funds while rewarding shareholders, a rights issue is a better option. However, rights issue involves floatation costs.

�

The overall conditions in the primary market and the likely response of shareholders to the issue at the proposed price.

�

The likelihood of the rights evoking a mediocre or poor response and its repercussions on the market price of the share.

�

Availability of alternate sources of raising equity capital such as private equity or private placement apart from opportunities to seek additional borrowings.

Readers may refer to a specimen letter of offer for a rights issue which is furnished in Appendix 2 included at the end of the book.

Considerations for Investor As far as an investor is concerned, a rights issue needs to be evaluated from a costbenefit perspective in the lines of the following:

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�

The cost of the rights share vis-à-vis the carrying cost of the holding or the cum-rights price in the market. If the investor is an existing shareholder, the entitlement is automatic. However, for a market investor, the entitlement to the rights is possible only if the company’s shares are acquired from the market at the cum-rights price (i.e. before the record date).

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The future prospects of the company and the proposed utilization of the funds.

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The medium term expectation of the company’s market performance considering that there would be a drop in the market price ex-rights and that it would take some time for the price to go back to the present levels or even more.

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The expansion in equity base and the consequent free float in the market. Since there would be an additional liquidity in the market, the market price could also be influenced by it in future. A well-performing company with less free float is likely to trade at higher levels. However, this is not sacrosanct since institutional investors normally prefer companies with higher free float. Companies with lesser free float may also suffer from lack of institutional buying support.

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The dividend and bonus track record of the company thus far and the prospects for realization of shareholder value.

6.2.4 Statutory Provisions for Rights Issues by Listed Companies As in the case of a public offer, the provisions concerning a rights issue are in terms of the Companies Act, the SEBI DIP Guidelines, the articles of association, the stock exchange listing guidelines and the provisions of the listing agreement. These are discussed as given below.

Provisions under the Companies Act The main provision of the Companies Act that affects a rights issue is section 81. This section inter alia provides under sub-section (1) as follows: �

If a company proposes to issue further shares at any time after the first allotment made after its formation or after the expiry of two years from the date of its formation, whichever is earlier, such further shares shall be offered to the existing shareholders in proportion to their existing holding.

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�

The offer shall be made with a minimum notice of 15 days by notice specifying that if the shareholder does not exercise the offer within the prescribed time, it shall be presumed to have been declined. This provision is however to be read in conjunction with the DIP guidelines for listed companies.

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The shareholder shall be given the right of renunciation unless the articles of the company provide otherwise. The renouncee need not be a member of the company.

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If the shareholder declines to accept the shares, these can be disposed off by the board of directors in the best interests of the company.

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The time limit for exercising of the option cannot be extended by the shareholder for the purpose of renunciation.

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The shareholder may be allowed to exercise the power of renunciation only once and not again under the pretext that the first renouncee has declined to accept the offer.

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The above provisions apply to issue of convertible instruments as much as they apply to pure equity issues.

The shares to be issued under the rights issue shall be identical in all respects to the existing equity shares and shall rank pari passu with the exiting shares for the determination of the rights of shareholders for all future events affecting shareholders such as declaration of dividends or bonus issue etc. In other words, the rights shares shall be identical to the existing shares and in the dematerialized form shall be fungible.

Important Provisions under the SEBI Guidelines The provisions of the DIP guidelines relating to public issues that have been discussed in Chapter 5, shall, to the extent relevant, be applicable to rights issues as well. In addition, there are certain provisions specifically applicable to rights issues that are listed below: 1. No listed company shall make any issue of securities through a rights issue where the aggregate value of securities, including premium if any, exceeds Rs. 50 lakh, unless the letter of offer is filed with SEBI, through an eligible merchant banker, at least 21 days prior to the filing of the letter of offer with the designated stock exchange. In the case of rights issues of an aggregate amount of less than Rs. 50 lakh, the company shall prepare the required

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letter of offer in accordance with the DIP guidelines and file the same with SEBI for its information and for being put up on the SEBI website. The issue shall be opened within 365 days from the 22nd day of filing of the letter of offer if no observations are received from SEBI. 2. As in the case of public issues, all rights issues shall be made by offering the shares in dematerialized form and the company shall give the option to subscribers to receive the security certificates or to hold the securities in dematerialized form. 3. A rights issue by a listed company is exempt from the eligibility norms that have to be fulfilled by companies going public either for an IPO or for secondary public offers. Therefore, such companies that do not fulfill the eligibility criteria are also entitled to make rights issues. 4. A company whose equity shares are listed on a stock exchange may freely price further offerings through a rights issue of its equity shares or any security convertible into equity at a later date. 5. As in the case of a public issue, the issuer company can mention a price band of 20% in the letter of offer filed with SEBI and the actual price can be determined at a later date the final letter of offer is dispatched to the shareholders. However, since the company is listed, the merchant banker associated with the issue shall ensure that a 48-hour notice is provided to the designated stock exchange about the meeting of the board of directors wherein the resolution for finalizing the price as per the price band would be taken. The final letter of offer shall contain a single fixed price. 6. The provisions relating to minimum contribution from promoters do not apply to rights issues made by listed companies, provided that the promoters disclose their shareholdings in the letter of offer and the extent to which they propose to participate in the rights issue. 7. No company shall make a rights issue unless firm arrangements of finance through verifiable means towards 75% of the stated means of finance, excluding the amount to be raised through the proposed rights issue have been made. 8. No company shall make a further issue of capital by any means from the time the letter of offer is submitted to SEBI till the securities are listed or the application money has been refunded to the subscribers. 9. An issuer company shall not withdraw a rights issue after the announcement of the record date. However if it is necessary to do so, the company

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shall not make any listing application to any stock exchange for a period of 12 months from the announced record date. However, shares arising out of convertibles issued prior to the announcement of such record date may still be listed during that period. 10. A rights issue shall be kept open for a minimum period of 30 days and a maximum period of 60 days. 11. The quantum of issue through the rights offer shall not exceed the amount specified in the letter of offer. Provided that 10% retention of oversubscription is allowed for the purpose of rounding off allotment in the case of an over-subscription. 12. Rights issues need not be underwritten. However, it is customary sometimes to seek stand by underwriting support if the circumstances require. In such cases, the underwriting requirements as applicable to a public issue would apply to the rights issue as well. 13. Unlike as in a public issue, no firm allotments and reservations can be made in a rights issue. 14. The issuer company may utilize the funds collected against the rights issue after satisfying the designated stock exchange that the minimum subscription of 90% has been received by the company.

Important Contents of the Letter of Offer The letter of offer for a rights issue has to comply with the requirements specified in Chapter 6 of the DIP guidelines. The important extracts of a specimen offer document are furnished in Appendix 3 included at the end of the book. The main provisions for preparation of the letter of offer are discussed below: �

The general information required to be put on the cover pages shall be similar to that furnished in a public issue prospectus. The main information provided herein relates to the particulars of the company, the merchant bankers and other agencies involved with the issue, dates of the issue and statutory declarations.

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The capital structure table showing the pre-issue capital, the size of the rights issue, post-issue capital structure, details of promoters’ holdings, lockin and promoters’ intention to subscribe to the rights issue.

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�

The terms of the issue relating to authority for the issue, terms of payment, procedure and time schedule for allotment and refunds, method of application, mode of payment, tax benefits available to the company and the shareholders.

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The objects of the issue, project cost and the means of financing.

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The details of the company, management, the project, group companies etc. and financial information disclosed in a manner similar to that of a prospectus in a public issue. However, care must be taken to see that as in the case of a public issue, no financial projections of the company’s expected performance are provided in the letter of offer. Past financial information for the previous five financial years based on audited statements shall be furnished. The audit report shall not be of a date preceding the date of the letter of offer by more than six months.

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Stock market quotations of the shares/debentures of the company, if any, in terms of the high/low prices in each of the past three years and monthly high/low prices in the preceding six months need to be furnished.

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Risk factors envisaged by the management and proposals if any, to address the risks.

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The management discussion and analysis statement of the financial conditions and results of the operations as reflected in the financial statements.

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Outstanding litigation, expert opinions, statutory and other information, material contracts and documents and time and place of inspection thereof.

Readers may refer to a specimen letter of offer for a rights issue furnished in Appendix 3 included at the end of the book.

Requirements of the Stock Exchange The company has to make an application to the stock exchanges where its shares are presently listed to list the additional shares being issued under the rights issue. Therefore, the company has to be complaint with its existing listing agreements and not be a defaulter on any of its duties vis-à-vis the stock exchanges. The new shares being issued shall rank pari passu with the existing shares and be similar in all respects; otherwise listing them in the same category is not possible. Some of the important requirements of the stock exchange in terms of the listing agreement

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are listed below: �

The fixation of the record date for the rights issue shall be in compliance with the listing agreement and the approval of the stock exchange. Presently, the record date has to be fixed with a notice of at least 30 days to the stock exchange.

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The company has to notify the stock exchange 7 days in advance of the date of the meeting of its board of directors at which the proposal of a rights issue is due to be considered.

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The shareholders shall be given reasonable time, not being less than four weeks, within which to record their interest and exercise their rights.

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The letters of allotment shall be issued within six weeks from the closure of the issue.

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The company shall obtain in-principle approval for listing the proposed shares from the stock exchange before the issue. For this purpose, the listing application has to be made along with the letter of offer as submitted to SEBI along with a certificate from the merchant banker reporting positive compliance by the issuer of the DIP guidelines. In this context, it may be noted that SEBI has issued a recent circular4 wherein it has been stated that if a company is listed on any stock exchange which is having nationwide trading terminals, it would be sufficient compliance if it obtains ‘in-principle’ approval from such stock exchange(s) for further issue of shares or securities. Where the company is not so listed on any stock exchange having nationwide trading terminals, it shall continue to obtain ‘in-principle’ approval from all the exchanges where it is listed.

The criteria for listing of shares by a company on the BSE and the NSE have already been furnished in Chapter 5.

6.2.5 Procedure for a Rights Issue and Role of the Merchant Banker A rights issue follows a simpler procedure as compared to a public offer primarily because it is an in-house affair between the company and its shareholders. Therefore, even in terms of the number of applicants and the work load involved, it is lighter on the company, the issue managers and the registrars. Another significant departure from a public issue is that in a rights issue, there is no requirement

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to file the Letter of Offer with the ROC before it is issued to the shareholders. This is because it is not a prospectus being issued to the general public. Therefore, the entire compliance requirement with section 60 of the Companies Act is not applicable. The process flow of a rights issue is discussed below: 1. The first task is to hold a Board Meeting to consider the proposal for a Rights Issue, authorize the Managing Director to do all the tasks relating to the Rights Issue including key appointments and incur expenses for the issue. Alternatively, a Board Committee headed by the Managing Director can be formed for this purpose. The Board would also authorize the Company Secretary or the MD as the case may be to convene a General Meeting for seeking the approval of the members for the issue. Notice has to be given to the stock exchange of the impending board meeting at least 7 days prior to its scheduled date. 2. After the board meeting, the stock exchange has to be communicated immediately about the decision of rights issue. 3. On the appointed day, the EGM is held and the shareholders pass a special resolution under section 81(1A) of the Companies Act authorizing the company to make the rights issue to anyone including the existing shareholders. At the time of seeking this approval, it is customary to seek an enabling approval for a specified number of share without specifying a particular price. 4. The record date for the rights issue has to be fixed in consultation with the stock exchanges with a notice of at least 30 days if the shares are in the dematerialized segment. 5. If the issue size is in excess of Rs. 50 lakhs, appointment of a category I merchant banker to the issue is mandatory. 6. The Lead Manager enters into a memorandum of understanding with the issuer company and where there is more than one merchant banker, an inter-se allocation of responsibilities is also drawn up. 7. The Lead Manager prepares the Letter of Offer (L of O) with the prescribed particulars including details of the rights offer. This draft L of O should be filed with SEBI six weeks prior to the proposed date of opening of the rights issue. Along with the L of O, other prescribed documents such as the MOU with the issuer, due diligence certificate and all prescribed undertakings by the issuer and the lead manager have to be submitted to SEBI.

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8. The observations made by SEBI if any have to be incorporated in the L of O if they are received within 21 days of the submission of the document. In case no observations are received within 21 days, the draft document is deemed to have been approved. 9. The draft L of O and the application form have to be approved by the designated stock exchange. Six copies have to be sent along with all the relevant enclosures so as to obtain an in-principle approval for listing of the right shares. 10. The final L of O as approved by SEBI has to be issued to the eligible shareholders within six weeks from the Record Date along with the composite application forms. The merchant banker shall ensure that the L of O is sent to the shareholders at least one week prior to the date of opening of the issue. 11. At least 7 days before the opening of the issue, the lead manager shall ensure to publish an advertisement in English, Hindi and the regional language as prescribed. The advertisement shall indicate the centres other than the registered office of the company where the shareholders may obtain duplicate copies of the application forms in case of non-receipt of the original forms. The advertisement should also state that in case duplicates are not also possible to be obtained, shareholders or applicants may apply on plain paper and send them directly with the requisite payment to the address mentioned in such advertisement. 12. The rights issue should be kept open for at least 30 days and not more than 60 days as mentioned earlier. The provisions in a public issue relating to minimum stock exchange area collection centres apply to rights issue as well. 13. The post-issue allotment procedures are similar to that of a public issue. The allotment advices shall be sent to the shareholders within six weeks of the closure of the issue. The post-issue monitoring reports to be filed with SEBI by the lead manager are the 3-day report and the 50-day report after the closure of the issue in the prescribed format.

6.3 Secondary Public Offer The term ‘secondary public offer’ is a misnomer since it does not have anything to do with the secondary market. A secondary public offer is a public offer that is

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made by a listed company. Therefore, any public issue or an offer for sale that is made after the initial public offer is a secondary public offer.

6.3.1 Considerations for a Secondary Public Offer A public offer made by a listed company is different from an initial public offer made by an unlisted company more in terms of the considerations involved rather than the process itself. A listed company has to take into account several additional strategic factors from time to time that have been explained in paragraph 6.1 of this Chapter in respect of its capital structure. The presence of a market price on a continuous basis for the company’s share makes the pricing and other decisions relating to the issue more difficult. Some of the major considerations in a secondary public offer are the following: �

The pricing of the offer has to align with the market performance of the share in the recent past. The factors that have a bearing on the pricing would be the market capitalization, expected future prospects for the company, the size of the issue, the addition to floating stock, the expected postissue price, the pricing of previous offers made by the company, investors’ experience with the company’s share in the past, the type of industry, the average industry price-earnings multiple and other relevant quantitative and qualitative criteria.

�

The choice of a secondary public offer as a means of finance for the company’s fund requirements needs to be assessed with respect to other alternatives in the equity and the debt route. Obviously, a secondary offer adds to the equity capital base of the company and would therefore impact the future market capitalization.

�

The extent to which the promoters can subscribe to the secondary public offer would also determine its size. This would largely depend on the pricing of the issue. The DIP guidelines allow free pricing of secondary public offers without any restriction. Since there is no minimum price criterion in a secondary public offer, it could sometimes be a cheaper and better way for promoters to hike their stakes in the company. It would also send a strong signal to the market if promoters contribute in the secondary offer. If promoters are not in a position to subscribe in the offer, it would mean consequent dilution in their stake post-issue. In such a situation, there would be a constraint on the size of the secondary offer. The dilution factor is also

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a function of the price of the issue. If the secondary offer is steeply priced, the dilution may not be significant, but the success of the issue may be in question. The merchant banker has to take all these factors into consideration and adopt a cautious approach that is best suited under the circumstances to meet the stated corporate objectives. �

The timing of the issue is also a significant factor that determines its size and pricing. In a strong primary market, the company may look at a secondary offer more favourably while the contrary is true in tough market conditions. The merchant banker has to take a call on the appropriate timing so that the issue goes through with a good pricing that leaves both the issuer and the investor satisfied.

To a large extent, a secondary offer is driven by similar considerations as an initial public offer. The pricing however, takes into account the market factor that is absent for an unlisted company. In this sense, it may be said that the pricing of a secondary offer is closer to reality than that of an IPO.

6.3.2 Statutory Provisions for Secondary Public Offers The statutory provisions applicable to secondary public offers are the same as those applicable for initial public offers, except to the extent provided otherwise in the DIP guidelines and other statutes. Therefore, it is necessary herein to discuss only the provisions that are applicable differently. These are listed below:

Eligibility to Make a Secondary Offer A listed company shall be eligible to make a public offer of equity shares or a convertible provided that the aggregate size of the proposed issue and all previous issues made in the same financial year by the company does not exceed five times its pre-issue net worth as per the audited balance sheet of the last financial year. For this purpose, the aggregate size of the issue should be reckoned the net public offer through the offer document + firm allotments + promoters’ contribution through the offer document. A listed company not satisfying the above condition may make an IPO of equity shares or convertibles only if it meets both the conditions (a) and (b) given below:

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a) The issue is made through the book-building process, with at least 50% of the issue size being allotted to the Qualified Institutional Buyers (QIBs), failing which the full subscription monies shall be refunded. OR The project has at least 15% participation by Financial Institutions/Scheduled Commercial Banks, of which at least 10% comes from the appraiser(s). In addition to this, at least 10% of the issue size shall be allotted to QIBs, failing which the full subscription monies shall be refunded. AND b) The minimum post-issue nominal value of equity capital of the company shall be Rs. 10 crore. OR There shall be a compulsory market making for at least 2 years from the date of listing of the shares subject to the following conditions: �

Market makers undertake to offer buy and sell quotes for a minimum depth of 300 shares;

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Market makers undertake to ensure that the bid-ask spread (difference between quotations for sale and purchase) for their quotes shall not at any time exceed 10%.

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The inventory of the market makers on each of such stock exchanges, as on the date of allotment of securities, shall be at least 5% of the proposed issue of the company

The following additional points on eligibility criteria shall be applicable to secondary public offers just as they apply to IPOs: �

The public issue shall not be deemed successful and the company shall not make an allotment pursuant to the offer unless the prospective allottees are not less than one thousand in number.

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No listed company shall make a public issue of equity shares or convertibles if there are any partly paid shares that shall be subsisting as on the date of the issue.

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�

An infrastructure company may go public even if it does not satisfy the above criteria if it has been appraised and/or funded by one or more of a public financial institution or IDFC or IL&FS or a bank which was formerly a public financial institution to the extent of at least 5% of the project cost either as loan or equity or both.

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No company shall make an IPO unless firm arrangements of finance through verifiable means towards 75% of the stated means of finance, excluding the amount to be raised through proposed issue, have been made.

Promoters’ Contribution In the case of secondary public offers, the promoters shall participate either to the extent of 20% of the proposed issue or ensure post-issue shareholding to the extent of 20% of the post-issue capital. In the event of the promoters intending to subscribe in the secondary offer beyond the required minimum of 20%, such excess contribution shall be subject to the preferential allotment guidelines if the issue price is less than the price applicable under those guidelines. In other words, the promoters have to bring in such excess contribution at the higher price even if the secondary offer is made at a lower price. As far as the lock-in provision is concerned, participation by the promoters in the secondary offer in excess of the required minimum percentage of 20% shall be locked in for a period of one year. The requirement of minimum promoters’ contribution and lock-in of excess contribution shall not be applicable in the case of a secondary offer by a company that has been listed on a stock exchange for a minimum of 3 years and has a track record of dividend payment for the immediately preceding three years. The requirement for promoters’ contribution also does not apply for companies where no identifiable promoter or promoter group already exists.

Other Provisions Secondary public offers can be priced freely under the DIP guidelines. In case of companies that are eligible for a fixed price issue according to the above-mentioned eligibility criteria, the secondary offer can be made either as a fixed price issue or as a book built issue according to the choice of the issuer company. The issuer company shall not make a further issue of capital by any means from the time the draft offer document is submitted to SEBI till the securities are

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listed or the application money has been refunded to the subscribers. As far the listing of shares of the secondary public offer are concerned, the net offer to the public shall satisfy the listing requirements under Rule 19(2)(b) of the SCR Rules to the extent of 25% or 10% as may be applicable. The other statutory provisions and procedural requirements for secondary public offers are identical to that of an IPO.

6.4 Composite Issue As already mentioned in Chapter 3, a composite issue is a simultaneous issue of a rights issue and public issue by a listed company and is therefore known as a ‘rights cum public issue’. In some cases, a company may prefer to raise a part of its fund requirement though a rights issue to its existing shareholders and the balance through a public issue to the general public. This is because the company may prefer to offer additional shares to its existing shareholders at a concessional price in appreciation of their shareholder loyalty. However, as far as the general public is concerned, the company may prefer to price it according to the value that the share can command. Recognising this fact, the DIP guidelines provide that a listed company making a composite issue of capital may issue securities at differential prices in the rights issue and in the public issue. In the public issue, differential pricing is allowed as in the case of an IPO between firm allotments and the net public offers. Justification of differential pricing has to be provided in the offer document for the public issue. In the case of a composite issue by a listed company, the promoters’ contribution shall, at the option of the promoters, be either 20% of the proposed public issue or 20% of the post-issue capital. In reckoning the post-issue capital for this purpose, the rights component of the composite issue shall be excluded. Other provisions under the DIP guidelines, the Companies Act, SCRA and the listing guidelines apply to composite issues as they apply separately to a rights issue and a public issue respectively. In the past several composite issues had been made by issuers. In some cases there were composite issues of a different variety i.e., as a simultaneous but unlinked issue of debt and equity instruments. Generally, in a rights-cum-public issue, the

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rights issue is opened first and kept open between 30–60 days. The public issue is opened and closed during the period the rights issue is still open. Thereafter, the rights issue is closed. This is because, if the public issue is opened after the rights issue has closed, the result of the rights issue may impact the performance of the public issue. On the contrary, if the public issue precedes the rights issue, the existing shareholders of the company might not response knowing that they have an opportunity in the subsequent rights issue at a lesser price. Therefore, strategically, it would be better to open the rights issue and keep the investors guessing while the public issue is open.

6.5 Role of Investment Banker in Listed Companies As can be appreciated from the discussion so far in this Chapter, listed companies have several areas where investment bankers play a significant role as advisors and issue managers. In some of these areas, apart from playing the statutory role of merchant bankers, they also take significant financial exposure in underwriting, providing safety nets, market making and in placement obligations to issuer companies. There are other areas as well, wherein the investment bankers guide listed companies, which are discussed in the respective chapters of the book. The functional areas for investment bankers in listed companies are thus listed below: �

Acting as advisers and arrangers in raising debt and equity finance through the capital market.

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Acting as advisers and arrangers for private placement of debt and equity.

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Acting as merchant bankers for transactions relating to secondary public offers, rights issues and composite issues.

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Advise companies on pricing and valuation for various types of offers.

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Advise companies on post-listing issues and offerings.

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Advise promoters and help in transactions relating to creeping acquisitions, dilution management, open offers and preferential allotments.

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Advise companies on delisting and act as merchant bankers for the delisting offers.

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Advise companies on buy backs and act as merchant bankers for such offers.

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�

Advise companies on market capitalization and related issues.

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Advise companies on issue of sweat equity, shares with differential rights, ESOPs and ESPS.

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Act as sponsor/merchant banker for private equity deals/bought out deals with subsequent offers for sale.

The above list is not intended to be exhaustive. However, it brings out the fact that the service areas are many insofar as listed companies are concerned. Full service investment banks come in with other strengths as well, such as in mergers and acquisitions, project finance, restructuring and other corporate advisory services. These are also discussed further in subsequent chapters.

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Notes 1. Source: The Economic Times dated 23 December 2001. 2. Source: Business Standard dated 13th October 2002. 3. Source: Data from BSE Ltd. 4. Please refer to Circular No. MRD/Policy/Cir—35/2003/29/09 issued by the Market Regulation Department of SEBI.

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Select References

1. SEBI, Capital Issues, Debentures and Listing by K. Sekhar, Wadhwa and Company, 2003 edition.

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Self-Test Questions 1. What are the main considerations for listed companies in deciding on rights issues and secondary public offers? 2. Draw a comparison between a rights issue and a secondary public offer. Does a composite issue provide the advantages of both a rights and a secondary public offer?

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3. What are the procedural aspects of a rights issue? In what respects is a rights issue different from a public issue? 4. What are the regulatory provisions for secondary public offers? How are they different from those that are applicable to IPOs? 5. The managing director of a company is worried that the shares of promoters that have to be locked in would keep increasing as the company makes successive public issues. Is this true? How does the lock-in mechanism work for listed companies?

Chapter

7

Public Offers of Debt Securities o far in Chapters 5 and 6, the discussion has centered on public offerings of equity shares and related instruments. In this Chapter, we will discuss exclusively the public offerings of pure debt instruments and debt convertibles such as PCDs, FCDs and convertible bonds. A separate discussion on the public offer of these instruments is merited primarily due to specific statutory provisions that regulate these offers. This is because investors need to be protected against down side risk in pure debt instruments and debt convertibles (until conversion takes place). In addition, they have to be serviced regularly with interest payments. The issuer company’s financial health could impact debt servicing. Recognizing these factors, the SEBI DIP Guidelines provide adequate safeguards against public offerings of such instruments. The Companies Act also provides for certain mandatory requirements to safeguard debenture and bond holders. All these aspects have already been dealt with in this Chapter. As far as the merchant banker is concerned, an issue of debt instruments involves additional responsibilities in terms of compliance and safeguards.

S

Topics to comprehend �

Requirements that are specific to the issue of debt instruments through public offers.

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Process flow for the public issue of debt instruments.

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7.1 Rationale for Public Offers of Debt Instruments Public offer route for debt instruments would mean making a public issue of pure debt instruments such as—bonds and non-convertible debentures (NCDs) and debt convertibles such as—partly-convertible debentures (PCDs), fully convertible debentures (FCDs), convertible bonds and fully convertible zero coupon debt instruments. It may be interesting to note some of the primary considerations for a company to look at raising funds through public offering of debt instruments. They are as follows: �

The issuer company requires debt finance for which accessing the capital market may be a better option than raising term loans from financial institutions and banks. This situation holds good in a buoyant primary debt market wherein the costs of a public floatation taken together with the coupon rate payable on the debt instrument works out cheaper than the interest and other costs payable on term loans. Secondly, the syndication process for a term loan may itself be a longer process than accessing the capital market if the chances of the public float meeting with an encouraging response are bright.

�

Accessing the public issue market is a better option than looking towards private placement of debt securities. Again, this condition would hold good only if the company finds that access to the retail debt market is a better option to raise large amount of funds rather than accessing primarily QIB investors in the private placement market. In the nineties, whenever huge amount of debt funds had to be raised from the primary market, issuers preferred the public issue market to the private placement route. However, as already explained in Chapters 3 and 9, over the past 2–3 years, it is the private placement market that has met most of the debt financing requirements from the capital market. Each of these routes has its own advantages. While the public offer route provides greater dispersal and liquidity for the instrument, its secondary market volumes may not be high if there is no significant retail trade. On the other hand, debt securities that are issued privately but listed subsequently are traded mostly in the wholesale debt segment of the market driven by institutional demand.

�

Sometimes, accessing the public issue market with a pure debt instrument or a convertible is triggered off since the company cannot afford to expand its equity base immediately with a public offering of pure equity. This happens in large capital-intensive projects wherein the gestation time for

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the project to yield good cash flow to equity is significantly long. Equity issues cannot be marketed in such cases with a promise to yield good returns in the distant future. Therefore, a debt convertible would be ideal in such situations by providing the investor with a coupon rate during the gestation period with the comfort of looking at the upside when the project begins to yield cash flow to equity. As far as the issuer company is concerned, its equity capital is expanded in stages so that the earnings per share is not unduly depressed in the initial phase. Secondly, during the initial years, if the instrument that has to be traded in the secondary market is pure equity, it would trade at low prices thereby jeopardising the company’s market capitalization. On the other hand, during such phase, if the company floats a debt instrument with a reasonable coupon rate, it may find some trading volumes. As detailed in chapter 3, in the past several major projects such as Reliance Petroleum, Essar Oil, MRPL and others had relied on the debt convertible route to raise funds from the public issue market.

7.2 Pre-requisites for Issue of Debt Instruments 7.2.1 Creation of Debenture Trust Under section 117B of the Companies Act, no company shall issue a prospectus or a letter of offer to the public for subscription to its debentures, unless the company has, before such issue, appointed one or more debenture trustees for the debentureholders. The debenture trustee shall not have any financial interest in the company by holding shares or in other specified positions of beneficial interest. Therefore, any company whether listed or unlisted, cannot make an issue of debentures to the public without constituting a trustee mechanism. The trustee has been given some statutory privileges under this section without prejudice to other recourse to law that debenture holders might have. These are as follows: �

To ensure that the assets of the company and each of the guarantors are sufficient to discharge the principal amount of the debentures at all times.

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To verify that the prospectus or the letter of offer does not contain any matter which is inconsistent with the terms of the debentures or with the trust deed.

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To ensure that the company does not commit any breach of covenants of the trust deed or the terms of issue of the debentures.

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To take all reasonable steps to remedy any breach of the covenants of the trust deed or the terms of issue of the debentures.

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To take all steps to call for a meeting of the debenture holders as and when such meeting is required to be held.

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To petition the National Company Law Tribunal at any time when the trustee has come to the conclusion that the assets of the company are insufficient to discharge the principal amount of the debentures as and when it falls due.

The debenture trustee is constituted by the registration of a private trust under the Indian Trusts Act 1881 under which the debenture holders are made the beneficiaries. The trust deed spells out the requirements under law as well as the rights of debenture holders under the trust. Schedule 4 of the SEBI (Debenture Trustees) Regulations 1993, lists out the points that need to be provided for in the trust deed, among which, the important ones are as follows: �

Time limit for creation of security for issue of debentures as specified in the DIP guidelines.

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Obligation not to create further charge or encumbrance of the trust property without the prior approval of the trustee.

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Rights of debenture holders in the event of default by the issuer company.

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Events of default and circumstances for enforcement of security.

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Terms of redemption of the debentures.

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Debt-equity ratio and debt service coverage ratio.

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Obligation to inform the trustee about any change in the nature and conduct of business by the company before making such a change.

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Quarterly updates to the trustee on information pertaining to the servicing of the debenture holders and the asset-liability profile of the company.

As already mentioned in Chapter 1, no person is eligible to act as debenture trustee without holding a valid certificate of registration from SEBI. The debenture trustee shall perform the duties listed in the SEBI (Debenture Trustees) Regulations 1993. Under the DIP guidelines, though it is provided that debenture trustee would need to be appointed for issue of debt instruments with a maturity period of more than

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18 months, in view of the provisions of section 117B stated above, all debenture issues would need the constitution of a debenture trustee. The other requirements under the DIP guidelines insofar as debenture trustee is concerned are as follows: �

The debenture trust deed shall be executed by the issuer company within six months of the closure of the issue.

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Trustees shall be vested with adequate power for protecting the interests of debenture holders including a right to appoint a nominee director on the board of the company in consultation with the institutional debenture holders.

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The debenture trustee shall ensure compliance with the following guidelines: o The lead financial institutions / banks shall monitor the progress of the project for which funds have been raised by the issue of debentures. o The lead working capital bank shall monitor the use of funds raised for working capital requirement through issue of debentures. o The trustee shall obtain a certificate from the auditors for the utilization of funds by the company during the implementation phase of the project. Similarly, in the case of working capital debentures, such a certificate shall be obtained at the end of each accounting year.

7.2.2 Credit Rating Under the DIP guidelines, no public or rights issue of debt instruments, including convertibles irrespective of their maturity or conversion period shall be made by a company unless credit rating from a credit rating agency has already been obtained and disclosed in the offer document. If the issue size exceeds Rs. 100 crore, two credit ratings from two different agencies have to be obtained. Where there are multiple ratings, all the ratings need to be disclosed in the offer document. In addition, all the ratings obtained for public or rights issues of debt instruments and convertibles during the three years preceding the current issue shall also be disclosed in the offer document. Therefore, while credit rating is mandatory for public issues of debt instruments, it would enhance investor confidence as well if the company’s instrument or issue structure is rated. It would help in fine pricing as well. Needless to say, the rating agency shall be registered with SEBI under the SEBI (Credit Rating Agencies) Regulations 1999.

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7.2.3 Creation of Debenture Redemption Reserve The creation of a Debenture Redemption Reserve (DRR) has been an age-old concept but has never had statutory backing until recent times. The creation of this kind of a reserve enables a company to conserve that much of cash resources from leaving its system through distribution of dividends. Therefore, companies transfer their distributable profits to the extent required to a separate account for the redemption of debentures as they fall due. The amount of the reserve is normally to the extent of the face value of the debentures to be redeemed and this is built up progressively year on year depending upon the terms of redemption schedule of the debentures. Under section 117C of the Companies Act, every company that issues debentures shall create a DRR to which adequate amounts shall be credited from out of its profits every year until such debentures are redeemed. The DRR shall not be used for any other purpose. According to the DIP guidelines, a company has to create DRR in case of debentures with a maturity period of more than 18 months. However, in view of section 117C, it is mandatory to create a DRR for every issue of debentures. The DIP guidelines prescribe further conditions for the DRR as follows: �

If debentures are issued for project finance, DRR can be created from the date of commencement of commercial production of the project. The DRR can be created either in equal installments or higher amounts as the profits may permit.

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In the case of NCDs, the DRR shall be created with respect to the entire redeemable value of the NCDs. In the case of PCDs, the DRR shall be created in respect of the non-convertible portion alone. In the case of FCDs, the DRR shall be created from the year the company starts to earn profits till the year the conversion option is exercisable.

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The DRR shall form part of the general reserve and therefore be available for being capitalized as fully paid bonus shares. However, drawal for distribution is possible only after 10% of the debentures have actually been redeemed.

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The quantum of DRR required is 50% of the redeemable value of the debentures to be in place before the redemption commences.

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DRR requirement does not apply to infrastructure companies.

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The trustee shall supervise the implementation of the conditions regarding creation of the debenture redemption reserve.

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7.2.4 Creation of Security As stated in Chapter 4, debentures to be issued by companies have to be secured against the assets of the company. Recognizing this need, the DIP guidelines stipulate that security shall be created within six months of the close of the issue of debentures. However, if the company cannot for any reason create security within 12 months from such date, it shall be liable to pay 2% penal interest on the debentures. If security is not created within 18 months thereof, a meeting of debenture holders has to be called for within the next 21 days to explain the reasons for non-creation of security and the date by which it would be completed. The debenture trustee shall supervise the implementation of the conditions regarding creation of security for the debenture holders. The charge creation is itself a prolonged process since it involves creation of an equitable mortgage or an English mortgage on the immovable properties of the company and hypothecation of the movable property. The usually preferred type of mortgage is by deposit of title deeds with the charge holders by a memorandum of entry evidencing such deposit. This type of a mortgage would save on stamp duty and registration costs since no conveyancing of property is envisaged. The company has to seek necessary approvals from the shareholders, income tax authorities, other charge holders such as lenders and trustees for earlier debenture issues for the creation of charge. Further, the title to each property has to be verified and no-encumbrance certificate has to be obtained till the date of registration of charge. The documentation shall be approved by the board of the company, the legal advisors and the debenture trustees. On the appointed day the charge is created and within 30 days thereof, the charge has to be registered with the ROC as provided under section 125 of the Companies Act. In the case of debentures with a life of less than 18 months, the DIP guidelines provide an option not to create security and treat them as unsecured deposits within the meaning of section 58A of the Companies Act. If the company chooses to exercise this option, it shall comply with all the requirements of the said section and the rules framed thereunder.2

7.2.5 Issue of Debt Convertibles The public offer of debt convertibles such as PCDs/FCDs/Zero coupon convertible bonds and other such instruments require to satisfy additional provisions made under the DIP guidelines. These are listed below as follows:

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In the case of convertibles issued by a listed company, the value of which exceeds Rs. 50 lakh and whose conversion price was not fixed at the time of making the issue, the holders of such instruments shall be given a compulsory option of choosing not to convert the same into equity capital.

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Conversion shall be made only in cases where the instrument holders have sent their positive consent and not on the basis of the non-receipt of their negative reply.

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In cases where issues are made with a cap price and justification thereof is disclosed at the time of the issue in the offer document, the necessity of giving a compulsory non-conversion option does not arise if the conversion is made at a final price within such cap.

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In cases where an option is to be given for non-conversion, the company shall redeem such debentures at a price that shall not be less than their face value, within one month from the last date by which the option was to be exercised. However, if the debentures have to be redeemed later on as per the original terms of issue, such terms shall apply.

7.3 Additional Statutory Requirements for Debt Offers 7.3.1 Requirements under the Companies Act The fundamental provisions relating to issue of debentures have already been discussed in Chapter 4. However, for the convenience of readers, these are listed below: �

The power to issue debentures is a power that can be exercised only at a board meeting in terms of section 292(b) of the Companies Act.

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Issue of debt instruments by a company adds to the borrowings of the company. Therefore, these borrowings must be made within the limits approved by the shareholders under Section 293(1)(d) of the Companies Act, 1956.

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Companies can issue debentures or other debt instruments only if these are secured, otherwise they would be treated as unsecured deposits, which cannot be issued without following the deposit rules prescribed under section 58A. Therefore, it is necessary for a company to secure the debt securities by way of mortgage of fixed assets or by any other means.

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Creation of security on the fixed assets of the company requires the approval of shareholders under section 293(1)(a) of the Companies Act, 1956. �

The other important provisions relating to creation of DRR, security and debenture trustee have already been discussed in the above paragraphs.

7.3.2 Requirements under the DIP Guidelines The additional conditions under the DIP guidelines that are common to all public offers of debt instruments and are in addition to those discussed above are listed below: �

Debenture issues by companies belonging to the same group shall not be permitted if the proceeds thereof are used for replenishment of funds (i.e. to provide loans) or for acquiring shareholdings of other companies belonging to the same group. Interestingly, there is no such restriction in the case of equity issues. As a corollary to it, this restriction does not apply to FCD issues as well, if the conversion is proposed within a period of 18 months.

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No debt instrument including convertibles can be issued either through public or rights issue unless it is rated by any rating agency.

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Companies may issue unsecured/sub-ordinated debt instruments and other obligations that do not fall under the definition of public deposits under section 58A of the Companies Act to QIBs and other investors.

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No convertibles with a conversion period of more than 36 months can be issued unless the conversion is made optional with ‘put’ and ‘call’ options.

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Conversion price and period of conversion shall be determined at the time of the issue and disclosed in the offer document.

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The interest rate for the debt instruments can be freely determined by the issuer company.

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In the case of a roll-over of a PCD/NCD by a listed company at the same coupon rates wherein the value of roll-over exceeds Rs. 50 lakh, the following conditions have to be complied with as given below: �

Compulsory option to debenture holders to redeem the debentures as per the terms of the issue shall be given.

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Roll over shall be only on the basis of positive consents and not on the basis of absence of negative replies.

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A fresh credit rating shall be obtained six months prior to any proposed rollover and communicated to the debenture holders.

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Fresh trust deed shall be executed and fresh security creation shall be made for the rollover unless the existing trust deed and security documents provide for continuance thereof.

7.3.3 Additional Disclosures in the Offer Document Apart from the normal disclosures to be made in an offer document that have already been discussed at length in Chapter 5, in the case of issues of debt instruments, additional disclosure requirements have to be met with. These are discussed below: �

The terms of conversion of a convertible instrument into equity such as the conversion price and time of conversion shall be disclosed.

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In the case of non-convertible debt or non-convertible portion of partly convertible debt, the redemption amount, period of maturity and yield to maturity shall be disclosed.

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Full information relating to the terms of offer, the effective price for the investor and name of the party proposing to purchase ‘khokas’ if any, shall be disclosed.

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The existing and future equity and long term debt ratio.

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Servicing behaviour on existing debentures, payment of due interest on due dates on term loans and debentures.

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Certificate from existing lenders stating that they do not have any objection to the creation of charge in favour of the trustees of the debenture holders for the proposed issue.

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The offer document shall specifically state the assets on which security shall be created and shall also state the ranking of the proposed charge. In the case of a subordinated or residual charge, the offer document shall spell out the risks associated with such charge.

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The offer document shall state the security cover to be maintained. The basis of computation of the security cover, valuation methods and periodicity of

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such valuation shall be disclosed as well. The security cover shall be arrived at after the reduction of liabilities having a first or prior charge in applicable cases.

7.3.4 Requirements under the Listing Guidelines/Agreement Under the procedure in vogue till 1996, it was not possible for an unlisted company to issue debt securities that would be listed on a stock exchange since it had to list its equity first before listing its debt securities. However, SEBI relaxed this restriction in 19961 whereby it is now no longer required for a company to list its equity before listing of its debt securities. The provisions of rule 19(2)(b) of the SCR Rules apply to the listing of debt instruments as they apply to equity. Therefore while making applications to list debt securities that are being offered through a public issue, the issuer company has to meet the listing requirements of the stock exchange, the conditions stipulated in the SCR Rules and the listing agreement. These aspects that are common to equity and debt securities have already been discussed in connection with equity issues in Chapter 5. The relevant extracts of some of the clauses in the listing agreement that have a bearing on the interests of the holders of debt instruments are furnished below:

Clause 21 The Company will fix and notify the stock exchange at least twenty-one days in advance, the date on and from which the interest on debentures and bonds and redemption amount of debentures and bonds will be payable. It shall simultaneously issue the interest warrants and cheques for redemption money of redeemable debentures and bonds, which shall be payable at par at such centres as may be agreed to between the exchange and the company and shall reach the holders of debentures or bonds on or before the date fixed for payment of interest.

Clause 36 The Company will promptly notify the exchange, the details of any rating or revision in rating assigned to any debt or equity instrument of the company or to any

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fixed deposit programme or to any scheme or proposal of the company involving mobilization of funds whether in India or abroad provided the rating so assigned has been quoted, referred to, reported, relied upon or otherwise used by or on behalf of the company.

Clause 43 The Company agrees that it will furnish on a quarterly basis a statement to the exchange indicating the variations between projected utilization of funds and/or projected profitability statement made by it in its prospectus or letter of offer and the actual utilization of funds and/or actual profitability. The statement shall be published in newspapers simultaneously with the unaudited/audited financial results. If there are material variations between the projections and the actual utilization/profitability, the company shall furnish an explanation therefor in the advertisement and shall also provide the same in the Directors’ Report.

7.4 Process Flow for a Public Offer of Debt Securities The process flow for a public offer of a debt security is much the same as that of a public offer of equity or preference shares. This has already been elaborated in Chapter 5. However, there are certain fundamental differences. Firstly, as far as the delivery of the public offering is concerned, pure debt securities may be offered through the 100% retail route since the use of the book-building route for price discovery is strictly not appropriate for a pure debt security. As far as convertibles are concerned, since most of the times, the pricing mechanism is disclosed in the offer document and not the exact conversion price per se, the use of book building is again not for the purpose of price discovery. However, adopting the book building route is definitely necessary in cases wherein the issue has to be marketed primarily to QIBs or if the conversion of the debt instruments gets attracted by the eligibility criteria of SEBI which stipulate compulsory book-building. Therefore, merchant bankers have to take the call on the method of delivery based on the eligibility criteria, nature of the security being offered, potential investors, listing criteria and market conditions. In addition, merchant bankers need to keep in mind the additional statutory requirements stipulated for debt offerings in the lines of what has been discussed above. The discussion on process flow for public offer of debt securities has therefore been intentionally kept brief so as not to repeat processes that are common to both

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equity and debt. Therefore, readers have to bear in mind that the below-mentioned discussion applies insofar as it is different from the process flow relating to an equity issue and the steps that have not been spelt out explicitly herein are those that apply mutatis mutandis. They are as follows: 1. The first step is to seek the necessary approvals for the debt issue by holding the board meeting under section 292(b) and authorizing the convening of the general meeting. If the company does not have the necessary powers under the Memorandum or the Articles, they need to be amended through appropriate resolutions. 2. On the appointed day, the general meeting approves the debt issue under sections 293(1)(a) and 293(1)(d) and other applicable provisions of the Companies Act. The company also seeks the approval of the shareholders for creation of debenture redemption reserve. 3. The merchant bankers after their appointment advise the company on the proposed offering and its structure. Based on it, the requirements for getting the instrument or the structure rated are listed down. With the help of the merchant banker, the rating process is completed and the final structure and terms of issue are recommended to the board of directors by the merchant banker. 4. In the meantime, the process to seek necessary approvals from existing lenders and charge holders or other interested parties such as lessors, Government, IT authorities etc. is begun. Since these approvals take time, it is generally customary to seek an in-principle approval to start the issue process. As per SEBI requirements, the final approvals need to be in place before the opening of the issue. 5. The debenture trust is incorporated and the trustees are appointed. The debenture trust deed and trustee agreement are put in place. 6. The draft offer document along with the additional documents required by SEBI in case of debt issues is filed in the usual way. The merchant bankers shall file with SEBI, apart from the usual documents and the draft offer document, certificates from their bankers that the assets of the company on which security is to be created are free from any encumbrances and the necessary permissions to mortgage the assets have been obtained. Alternatively, it has to be certified that a no-objection certificate from the financial institutions and banks for a second or pari passu charge has been

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obtained in case the assets are encumbered. The draft offer document is also furnished to the debenture trustee. 7. The relevant consent letters for creation of security shall be obtained and submitted to the debenture trustee before opening of the issue. 8. Once the issue process is completed, allotments have to be completed within the specified time (30 days in the case of 100% retail issues). 9. Within six months of the closure of the issue, the process of creation of security has to be completed. 10. In the case of roll-over of NCDs or non-convertible portion of PCDs, a letter of option has to be filed with SEBI containing disclosures with regard to credit rating, debenture holders’ resolution, option for conversion, justification for conversion price and such other terms which SEBI may prescribe from time to time.

7.5 Floatation of Institutional Bond Issues Floatation of institutional bonds such as the ICICI’s Safety Bonds, IDBI’s Flexibonds etc. by all India financial institutions and state level financial institutions (DFIs) has come to stay in the primary market. While some of these institutions offer these bonds on private placement, others offer them through public offers. The different aspects of private placement of debt securities have already been discussed in detail in Chapter 11. As far as public offers are concerned, the process is similar to that of a debenture float by a company except that there are additional specific provisions under the DIP guidelines. These are discussed below: 1. The offer document of the DFI shall contain specific disclosures in respect of the following: �

The present equity capital and the equity capital after conversion of convertible instruments being offered in the issue.

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Actual debt-equity ratio vis-à-vis the desirable debt-equity ratio of 12:1

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Notional debt service coverage ratio vis-à-vis the desirable minimum ratio of 1:2 to be maintained for each year. In computing the said ratio, a minimum provision of 10% of redemption value of the bonds shall be apportioned for each year even if the actual redemption terms are different. In the case of PCDs/FCDs optionally convertible beyond 18

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months, atleast 50% of their value shall be reckoned as probable redeemable debt and apportioned accordingly. �

Servicing pattern of existing bonds or debentures, term loans and fixed deposits.

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Outstanding principal, interest or lease rentals due from borrowers to the DFI based on the asset classification prescribed by the RBI, the accounting policies in respect of such loans and advances, provisions made for bad and doubtful debts all of which as certified by the auditors.

2. The trustee appointed to oversee the interests of the bond holders shall obtain a certificate annually from the DFI’s auditors in respect of the maintenance of the debt-equity ratio, the notional debt service coverage ratio and the provisioning made by the DFI. If the DFI fails to meet the debtequity ratio and the notional debt service coverage ratio requirements, it shall not declare dividend of more than 10% subject to the approval of the trustee. 3. DFIs issuing new financial instruments such as deep discount bonds, debentures with warrants, secured premium notes etc., shall make adequate disclosures, particularly those relating to the terms and conditions, redemption, security, conversion and any other relevant features of such instruments. All other requirements under the DIP guidelines apply in respect of issues by DFIs of debt instruments as they apply to those made by companies.

7.6 Rights and Bonus Issues of Debt Instruments 7.6.1 Rights Issues of Debt Instruments Under the DIP guidelines, there are no additional requirements for rights issues of debt instruments apart from those prescribed for equity shares. Therefore, the same requirements relating to ‘letter of offer’ and ‘record date’ besides other provisions apply to rights issues of debt instruments as well. However, it may be noted that in the case of issue of pure debt instruments such as NCDs, there is no requirement of passing a special resolution under Section 81(1A) of the Companies Act unlike in the case of equity shares. This is

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because section 81 does not apply to pure debt instruments. However, the requirements of Section 293(1)(a) and 293(1)(d) shall be complied with as enumerated earlier. In the case of convertibles such as FCDs or PCDs, section 81 does not apply only if: �

The conversion into shares is a part of the original issue of such convertibles which was approved by a special resolution, and

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The terms of the issue of such convertibles are in accordance with the Public Companies (Terms of issue of debentures and raising of loans with option to convert such debentures or loans into shares) Rules 1977. These rules prescribe inter alia, that the conversion shall not be at a premium exceeding 25% of the face value of the shares.

Since the above rules are very restrictive, it would be a better option to seek the approval of shareholders vide a special resolution in terms of Section 81(1A) in the case of the rights issue of convertibles.

7.6.2 Bonus Issues of Debt Instruments There is no specific provision under the Companies Act or under the DIP guidelines for the issue of pure debt instruments in a bonus issue. Since debt instruments by nature constitute loan capital with a fixed interest, they are quite different in character from bonus shares that can be issued by capitalization of reserves. The first instance of a bonus issue of debt instruments was seen in the case of Hindustan Lever Ltd, which issued bonus debentures to its shareholders. This can at best be treated as a dividend payout (since these debentures are repaid out of profits) at a future date. Therefore, such issue of bonus debentures becomes taxable as ‘deemed dividend’ in the hands of the debenture holders under the IT Act. As regards the statutory backing for the issue of such bonus debt instruments, in the absence of specific provisions in the Companies Act, recourse should be taken to Section 391 of the Companies Act, which provides for a scheme of arrangement to be effected with the approval of the NCLT. However, the provisions of Section 293(1)(a) and (d) will have to be complied with in the issue of such debentures. A bonus issue of convertible debt instruments such as FCDs has never been attempted before. Nevertheless, such issue would be tantamount to a bonus issue of

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shares with a future allotment date and as such would stand on the same footing as a bonus issue of shares.

7.7 Key Aspects for Merchant Bankers in Debt Issues 7.7.1 Structuring the Offer One of the key areas for a merchant banker is to assess the credit-worthiness of the issuer company in the context of its existing long-term debt obligations and the assets that have been offered as security for the same. There are two important considerations in raising debt—(a) the future expected cash flow generation that would need to service the future debt obligations and (b) the future financial cost that has to be met out of the future pre-debt servicing profits. If the financial costs were steep, the profits would take on the burden. On the contrary if the cash flows were not robust enough, the principal repayments would come under pressure. As has been discussed earlier, it is also imperative to create a DRR to the extent stipulated under the DIP guidelines. Keeping these factors in mind and the overall financial health of the company, the end use of the proposed debt issue and the security to be created to backup the debentures, the merchant banker comes up with the structure of the proposed debt issue. As has been discussed above, the debtequity ratio before and after the proposed offer, the debt service coverage ratio, the asset cover and interest cover play an important role in determination of the amount of debt that can be raised, the coupon rate, the yield to the investor, the accounting costs for the issuer company, tax breaks on the financial costs, redemption terms and other important parameters.

7.7.2 Structuring the Instrument While examining the instrument that has to be offered, the merchant banker keeps in mind the probable rating that the instrument may manage to get. If it is evident that the instrument would not get a good rating, suitable credit enhancements have to be built in so that the structure manages to get a rating better than that of the stand-alone instrument. The rating also determines the coupon rate and the yield that has to be built into the instrument. Apart from the return to the investors, other features such as the marketability of the instrument, its unit value, minimum lot, tax benefits that it can be entitled to etc., also need to be examined. If required, sweeteners such as a conversion option, step up rates, call option etc need to be

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provided so that the offer becomes attractive. Suitable exit options to the issuer company need to be factored in as well.

7.7.3 Marketing Plan The marketing of a debt instrument through a public offer is a challenge to the merchant banker in a good market situation where investors show an unsatiable appetite for equity. In such a situation, generating retail interest for a debt offering is difficult. On the contrary, if the market conditions are not very bright, it would be even more difficult to elicit response for a public offer from the retail investors. Keeping these various factors in mind, the target market has to be assessed and the issue positioned accordingly. If QIBs are the target, pre-marketing would be required through firm allotments and reservations. Similarly, if retail interest seems to be in doubt, suitable underwriting arrangements need to be tied up. The structure of the instrument should be based on the target investors and the marketing efforts need to be organized to access the target market through road shows and other means.

7.7.4 Statutory Compliance—Ensuring Trustee, Rating, Disclosures, Security, RBI Approval, Shelf Prospectus etc. Statutory requirements in a public offer of a debt instrument are much more onerous than those in a similar equity issue. The additional provisions relating to creation of a debenture trust, additional disclosures in offer documents, credit rating, security creation and seeking necessary approvals from the required persons has already been discussed above. These are an integral part of the responsibility of the merchant banker as much as they are of the issuer company. SEBI is particular of the fulfillment of these requirements so that investors are not put to any hardship at a later date. For e.g. if the company cannot create security due to legal hurdles after the completion of the issue, the interests of the debenture holders are jeopardised. At the same time, the debentures get attracted to section 58A of the Companies Act if they are unsecured thereby making them unsecured public deposits. This could put the issuer company into some difficulties. Therefore, statutory compliance is very critical to a debt issue and the mer-chant banker has to manage the entire issue process within the framework of the Companies Act, the DIP guidelines, the SCRA and other applicable provisions of law.

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Notes 1. See Press Release issued by SEBI vide ref No. PR 108/96 dated 29th October, 1996. 2. For details, please refer Companies (Acceptance of Deposits) Rules 1975.

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Select References 1. SEBI, Capital Issues, Debentures & Listing—K. Sekhar, Wadhwa and Company, Third Edition 2003.

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Self-Test Questions 1. What are the main statutory requirements for public offer of debt instruments? 2. How does a merchant banker evaluate a debt issue? What are the main structuring elements in an offer of debt instruments? 3. What are the key requirements under the DIP guidelines that are specific to debt offers?

Chapter

8

Overseas Capital Market Issues

T

he previous Chapters have provided an insight into the nuances of making public offers in the context of the Indian capital market. However, since the setting in of the liberalization process in 1991, the window of foreign capital markets has been made available to Indian corporates. This avenue to raise finance has been tapped by several reputed Indian corporates, but the potential is still vastly untapped. Though there was a flood of overseas capital market offerings in the initial few years by Indian corporates, the process was stymied by the South-East Asian crisis in 1997 and thereafter by the global economic meltdown post 2000. However, these are passing phases and the roadmap for more Indian companies to go shopping for funds in international capital markets is fairly well laid out. This Chapter therefore, deals exclusively with fund raising by Indian corporates with floats of debt and equity offerings in international capital markets, notably the American and European markets. Firstly, the features of the overseas bond markets are discussed followed by a discussion on the ‘depository receipts’ mechanism for equity offers. The process of making such issues with suitable case studies has also been discussed for better understanding of the entire subject.

Topics to comprehend �

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International bond markets and features of bond offerings. The depository mechanism for offering equity shares in international markets. Regulatory framework in India for international capital market offerings. Process flow for an international capital market offering and the role of the investment banker.

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8.1 Introduction to International Financial and Capital Markets The international capital market is only a part of the larger international financial market that may broadly be defined as a financial market that transcends national geographical boundaries. In other words, in the international financial market, funds are raised from lenders or investors in a country by borrowers or issuers from another country or conduct transactions in currencies other than the domestic currencies of respective countries. Considering this character of the international financial market, it can be outside the regulatory purview of any single country. The international capital market consists of the global bond and equity markets and the bond market includes convertibles as well. Besides, there is also a huge derivative market with the underlying assets ranging from stocks to commodities, foreign currencies and other exotic varieties. The segments that are relevant to the present discussion are the bond and equity markets. The importance of the global capital market can be assessed from the magnitude of finances raised in such a market. As discussed in Chapter 1, the basic function of the capital market is to perform the function of capital intermediation from investors to issuers of financial securities. The American and European capital markets have performed this function for several decades in the previous century. The need for raising global finance from external capital market arises due to the imbalance in global capital flows over a period of time due to which, the excesses in certain economies need to be diverted to the deficit and more needy economies. These imbalances are reflected in the current account balances of each country in its trade with its global trading partners. If cross border global capital flows do not happen, the trade imbalances will deepen and bring global trade to a standstill. Post Second World War, given the dependence of the world on oil from the OPEC countries, these countries built up huge surpluses. Given the consumption economy that the USA had been, its trading partners such as Japan and Germany built up vast current account surpluses. By the mid-eighties, investment opportunities in the developed economies were becoming lesser requiring the investors to look elsewhere for growing their money. The huge infrastructural and development projects undertaken in the developing economies and the opening up of their economies to global investors provided the answer to this. The economies of the ‘Asian Tigers’ provided a huge growth opportunity till the south-east Asian crisis in 1997 came in between and reversed the fortunes. The emerging markets such as China, Latin America and India are the other markets that attracted global capital flows, though the India’s share therein had not been as significant as that of China.

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It is important to appreciate the necessity of free capital flows across economies of respective countries for the development of an international capital market. Most developed economies such as the USA, the UK, Germany and Japan had removed restrictions on capital flows. The eighties and nineties saw a greater integration and cross-border floats in the international capital market. Despite the growth and sophistication in this market, it is far from being a perfect market. Market inefficiencies give rise to arbitrage opportunities for global investors. Historically, beginning with the fifties, a truly international financial market developed in Europe, mainly centered in London. What led to the establishment of the international financial market in a big way was the creation of the ‘euro’ market in the fifties and sixties. The euro market is a market in which financial instruments—both short and long term that are denominated in a variety of currencies other than the domestic currency of the host country where they are transacted. Gradually, the financial markets of other developed countries such as the USA, Canada, Switzerland, France, Japan and Australia opened up to offshore investors through the euro market. The concept of a euro market in the context of the bond market is discussed further in the subsequent paragraphs.

8.2 The International Bond Market As mentioned earlier, the international capital market has three main segments—the debt market, the equity market and the derivatives market. Within the debt market, the bond market is very vibrant and is an integral part of the sources of debt capital for foreign issuers. The international bond market has the following sub-segments—(a) the Domestic Bond market of certain countries, (b) the Foreign Bond market and (c) the Euro Bond market. The domestic bond market is useful to raise funds primarily from domestic investors though, to a certain extent, foreign investors may invest in them as well, depending upon local regulations. Foreign bonds are useful for an issuer to raise funds from the overseas capital market by floating them for subscription in a foreign country. Foreign bonds do have the limitation of addressing the local regulatory requirements in the country of issue and therefore cannot be issued simultaneously in more than one country. But the true international bond market is the euro bond market that allows issuers to address investors from several markets. From a fund raising perspective, Indian companies have depended on the euro bond market as it serves their requirements the best. All these categories have been discussed in detail further below.

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8.2.1 Domestic Bonds These are bonds issued by domestic companies in a particular country mainly to domestic investors. Participation by overseas investors in such bonds is possible in countries such as the US, Japan, France etc. wherein foreign investors are allowed to invest only in such bonds floated by domestic companies. Domestic bonds are denominated in the currency of the country of issuance and are usually fixed-interest, fixed maturity instruments with tenors ranging from 1–30 years. These are issued either through a public offer or through private placements. The issue of these bonds is subject to domestic regulations of the country of issuance such as disclosure requirements, filing of offer document and payment of domestic taxes. These can be unsecured bonds, asset backed bonds or mortgage bonds as the case may be depending upon local regulations. Apart from USA and Great Britain, the domestic bond market in other countries has not been a big source of raising finance from foreign investors. The domestic bonds in the Indian market are those issued by PSUs, financial institutions and banks and companies. These have been discussed in Chapters 7 and 9. However, as a source of overseas finance, domestic bond issues in India have not been important for Indian issuers though they have seen some interest from FIIs.

8.2.2 Foreign Bonds 1 Foreign bonds are issued within the domestic capital market of a country by a foreign issuer for subscription exclusively by domestic investors. For instance, if an Indian company such as ICICI Bank or Reliance issues a dollar denominated bond in the US market or a Euro denominated bond in the EU market for subscription by local investors, it is a foreign bond in those markets. The main requirement for the issue of these bonds is that the local regulations of the host country need to permit such issue. USA, Japan, Germany, Switzerland and UK are the largest markets for foreign bonds not including others such as France, Belgium and Sweden etc. Bonds issued by foreign issuers in such markets are called by different names such as—Yankee Bonds in USA, Samurai Bonds (through public issue), Shibosai Bonds (through private placement), Shogun Bonds (non-Yen denominated) in Japan, Bulldogs in UK, Matador Bonds in Spain, Rembrandt Bonds in Netherlands etc. One of the main features of the issue of foreign bonds is the compliance with local regulations in the country of issue since these are domestic issues made in the respective countries by foreign issuers. For instance, the public issue of Yankee Bonds requires compliance with local listing requirements of the SEC in the US, which

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include stringent disclosure requirements apart from compliance with US GAAP accounting. An alternative to the public issue of a Yankee Bond is provided in the USA through what is popularly known as the 144A route. Rule 144A adopted by the SEC in 1990, provides a safe haven for bonds issued on a private placement basis to QIBs from the stringent listing requirements under the Securities Act, 1933. Under US regulations, QIBs are those investors that have invested not less than a hundred million dollars in non-affiliate investments. Bonds issued under the 144A route can be traded between QIBs under the permitted dealing systems of the NYSE (System 144A), NASDAQ (Portal) and the AMEX (Situs). The opening up of the 144A window ballooned the offerings by non-US issuers in the US market in the nineties and approximately $8 billion of securities were issued by 118 issuers in the first four years itself as compared to just five non-US issuers participating in the US private placement market in the ten years preceding the amendment to Rule 144A. The limitation of this route is that it allows the issuers to tap only the QIB investors in USA. On the whole, the US market for foreign bonds both through a public issue and through the 144A route offers long tenors to issuers and access to huge fund base with the US investors, especially the QIBs. However, this is primarily a market for high quality paper and the appetite for paper from issuers in the emerging markets is relatively small. The Japanese market for foreign bonds opened up in the eighties after de-regulation and reforms made by the Japanese government. The Samurai Bonds offered through a public issue have been tapped by several issuers successfully, including the IDBI in 1984 and again in 1990. However, these are also subject to stringent Japanese requirements on rating, size and maturity periods, underwriting and documentation. The Japanese Ministry of Finance lays down the guidelines that have to be conformed to in this regard. Even the Shibosai Bonds issued through private placement route are subject to certain stipulations of the Ministry and these can be offered to banks and other institutional investors. The Swiss, UK, French and the Dutch markets for foreign bonds are also active and have varying requirements. In the Swiss market, private placements are not very popular and for public offers, the compliance requirements include approval from the Swiss National Bank.

8.2.3 Euro Bonds Perhaps the most important segment of the international bond market is the euro bond market. These are issued and sold in a jurisdiction outside the country of

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denomination. Unlike domestic bonds and foreign bonds that are issued in the same denomination as that of the country in which they are issued, euro bonds are in a different currency. For example, a dollar denominated bond issued by a non-US issuer in USA is a foreign bond while the same bond issued outside of US would be an euro bond. Other than the denomination aspect, what makes an euro bond different is also the fact that since it is issued outside the regulatory jurisdiction of the country of denomination, it is not entirely regulated by the local laws of that country. Euro bonds represents direct claims on the issuer but denominated in the currency of a country to which the issuer may not belong. Therefore, these bonds are external to the domestic market of the country of denomination and they are not tied down to any particular location or individual domestic markets. The euro bond is a culmination of the process of finding an alternative to the regulatory load of domestic and foreign bond issues in the US markets. The regulatory constraints on size, disclosures, accounting and listing requirements etc. in the US markets on foreign bonds led to the emergence of the euro bond in 1964. Apart from regulatory requirements, the incidence of tax played an important part as well. In the US, the Interest Equalization Tax was imposed on foreign bonds that lowered the post-tax yield to investors on foreign bonds to make them comparable to domestic bonds. However, over the years, domestic bonds and euro bonds have compared almost similar in returns. Similar regulatory constraints were present in other markets leading to the growing importance of the euro bond. However, it is not entirely correct to assume that euro bonds are unregulated offerings. There are regulations in several countries that govern the issuance of euro bonds denominated in their currencies. As far as the primary issues of euro bonds are concerned, most governments and regulatory authorities have in conjunction with their central banks issued regulatory guidelines on the issue processes, underwriting, size of issues etc. The reason for such regulation is to ensure that excessive claims on the country’s currency do not create a payment crisis that could impact the value of the denominated currency. Secondly, since these securities are not subject to stringent national law, the governments find it to be obligatory on them to shield their domestic investors to a certain extent from such securities. Secondary market trades in euro bonds are largely self-regulated under the auspices of the International Securities Market Association. Most issuers prefer to bring their issues under the jurisdiction of English law or the law of the country of denomination under the terms of the issue. As far as the US market is concerned, a public issue of eurodollar bonds (dollar denominated bonds issued outside the US) cannot be made to US investors unless

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the issue is registered in the USA under the Securities Act 1933. Therefore euro dollar issues are made with the statutory declaration ‘These securities have not been registered under the United States Securities Act 1933 and may not be offered, sold or delivered, directly or indirectly, in the United States or to US persons as part of the distribution of securities’. Once the issue is completed, there would be a ‘cooling-off’ period of 90 days during which time no secondary market trades are allowed. After the cooling-off period, the investors are allowed to undertake secondary market deals provided they furnish suitable declarations to the effect that they are not US citizens or agents for US citizens. During the cooling-off period, no individual bond certificates are issued. Only a representative nontradable share of a ‘global bond certificate’ is issued to each investor. The global bond certificate represents the entire issue. After the cooling-off, the representative shares are exchanged for individual bond certificates. Though euro bonds cannot be sold to US citizens via a public offer outside the US, it is always possible for a US investor to purchase these securities in the secondary market after they start trading. Most euro bonds are listed on stock exchanges such as Luxembourg or London but the secondary trades are almost always on OTC basis between bond dealers. Euro bonds can be issued in the US market using the 144A route whether they are listed outside the US or not. In other words, euro dollar bonds can be issued by way of a public offer and listed on a stock exchange outside the US with a private placement thereof being made to QIBs in the US using the 144A route. Alternatively, euro dollar bonds can be issued entirely using the private placement route both in US and outside but ensuring that they are subscribed to only by QIBs in the US. However, the 144A route has to be adhered to very strictly as per the SEC norms. Investment banks that manage euro bond issues are well aware of the nuances of offering them through a public issue and through a private placement. Using the flexibility of the private placement route, these bonds are generally underwritten and marketed privately through underwriting syndicates and network of banks that have linkages to investors. In addition, bulk of the marketing is made across countries other than the currency of denomination. In addition, since trade in the country of issue could result in withholding taxes for the investors, the bonds are structured to neutralize incidence of withholding tax on income distribution and capital gains. This is usually accomplished by floating an intermediary vehicle in a tax friendly state or a zero-tax jurisdiction such as the British Virgin Islands or Netherlands Antilles, and using this vehicle for making issues of euro bonds.

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Eurobonds provide the best window for Indian issuers to raise debt finance from overseas capital market as they can be issued in markets as wide as Europe, USA (through the 144A route), Middle East and Asia either with or without listing using the underwriting syndicates. The pricing is very fine and the floatation costs are minimum under the private placement route. In addition, the euro bond also offers access to US QIB investors without going through the stringent listing requirements under US law. Therefore, in many respects euro bonds score over foreign bonds as a better alternative to raise pure debt funds from overseas investors.

8.2.4 Bond Structures As far as the structure of foreign bonds and euro bonds are concerned, there can be plain vanilla bonds that have a fixed coupon rate and redemption terms. There can also be exotic structures depending upon the regulations in each country. In this respect, euro bonds offer more flexibility since they are not tied down to a particular regulatory regime. Most euro bonds are issued without any security and therefore they are in the form of promissory notes. They mostly offer bullet repayment of principal and can be made exotic by embedding features such as call and put options as well as interest rate derivatives. Similarly, the coupon rates can be fixed or floating depending upon investor appetite and the judgement of the investment banker. The pricing of bonds is made in the same fashion as they are made for domestic bond issues either in India or abroad using a suitable benchmark rate. In the case of floating rate euro bonds are pegged to the treasury rates in the country of denomination or other suitable international reference rate. Though rating is not a must for euro bonds, it does help in fine pricing and easier placement of the bonds. The tenors of euro bonds are typically between 8–10 years though the tenor patterns keep fluctuating with market trends. Eurobonds have also gone through innovations such as asset backed euro bonds that have structures, which are rated. Suitable credit enhancements such as overcollaterisations are provided to get better ratings. Other euro bond structures include bonds with currency or equity warrants (either fixed or detachable), convertible euro bonds and bonds with an embedded index derivative. Other structures include zero coupon bonds, deep discount bonds and dual currency convertible bonds. Floating rate notes were very popular during 1984–85 when interest rate volatility was at its peak. Perpetual floating rate notes are another structure that was very popular with banks in UK as they qualified as Tier I capital. Bond structures are becoming more sophisticated and are often structured to suit the

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requirements of a given set of investors. Similarly the corporate vehicle of issue is also structured based on tax considerations.

8.2.5 Medium Term Notes The bond route including euro bonds can also be tapped using the improved structure of a medium term note or MTN programme. This structure is useful for issuers who need to tap the overseas bond market frequently. Instead of floating separate floatations of bonds, these can be clubbed under a MTN programme. A MTN programme allows for a standardized documentation platform to tap the bond market and makes it flexible for issuers to manage their financing requirements efficiently and cost effectively across a wide variety of maturity patterns and a diversified investor base. Under the MTN programme, several tranches of bonds may be issued either in the same currency or different currencies, different coupon rate structures and other features. The timing of each tranche can be tailored to the market opportunity and the entire documentation and regulatory approvals need to be put in place only once for the whole programme. In the past financial institutions such as ICICI (now ICICI Bank) had used the MTN route to take one-time approvals from the Government of India and make several tranches of bond issues under a single programme.

8.3 The Depository Receipt Mechanism for Equity Offers 8.3.1 Background The concept of ‘depository receipts’ for underlying shares (also known as depository shares) has been in existence since 1927 in the capital market in USA. Originally, they were designed as an instrument to enable US investors to trade in securities that were not listed on US exchanges. These were known as American Depository Receipts or ADRs. Simply stated a depository receipt is a security that represents ownership in a foreign security. Therefore, they are negotiable securities in a foreign jurisdiction that generally represent a company’s publicly traded domestic equity. Although typically denominated in U.S. dollars, depository receipts can also be denominated in Euros. Depository receipts are eligible to be traded on all US stock exchanges as well as on many other European stock exchanges. In the context of USA, depository receipts, which include—ADRs, GDRs, EuroDRs (Euro Depository Receipts) and NYSs (New York Shares), allow non-US

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companies to offer dollar-denominated and euro-denominated securities to investors around the globe. The market for depository receipts was largely investor driven till the mid-eighties and the depository banks often issued them without even the consent of the concerned issuers. However, it was in 1983 that for the first time, the SEC made certain disclosure requirements mandatory for ADR issues. During this period, there was also an additional problem. Due to the SEC regulations, it was not possible to issue depository receipts to US investors without getting them registered under the Securities Act 1933. Therefore, issuers had to issue one set of ADRs to US investors and another set of depository receipts called IDRs (International Depository Receipts) to investors outside the US. With the amendment to Rule 144A in 1990 as explained earlier, it was possible to make private placement of depository receipts to US investors without SEC registration. Thus was born the GDR (Global Depository Receipt), which could be issued as a single instrument outside the US and simultaneously, using the 144A route, in US as well. Therefore the current position is that depository receipts can be issued as GDRs in USA and outside without compliance with US law provided they are issued through the 144A route in USA. However, if they are issued through the public issue route in USA, they need to be ADRs that comply with US securities law. The first GDR issue was reportedly made by Samsung Co. Ltd., the South Korean major in December 1990. It had issued a single depository receipt to raise capital both in US and Europe simultaneously.

8.3.2 Depository Receipt Mechanism The depository receipt mechanism works in the following way. For the purpose of this discussion, both ADR and GDR are included under the term ‘depository receipts’. The depository receipt mechanism is a very useful way of listing and trading of the shares of a company on a stock exchange. It is an indirect mechanism without directly inviting investors to buy the shares and thereafter listing them on the stock exchange for trading in the secondary market. Therefore, it can be regarded as an indirect issue of shares in a foreign jurisdiction with a surrogate listing mechanism. This is accomplished by the issue of intermediary securities called depository receipts that actually front-end the underlying shares against which they have been issued. In other words, the depository receipts represent a mirror image of the underlying shares. The actual extent of representation would depend upon the terms of the issue, i.e. how many depository receipts represent how many shares.

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Using the depository mechanism, a company in one jurisdiction can issue depository receipts in other jurisdictions where such issues are permitted. The investors in the other jurisdictions subscribe to the depository receipts, which are issued with the support of an agency that acts as a global depository. The depository’s function is to administer the depository receipts for the individual investors, and related work such as transfers arising from secondary market trades, dividend distribution, recovery of withholding tax, conversion of the depository receipts into shares etc. The depository receipts are listed and then traded on the exchanges where they are listed and in the OTC market in other financial centres. As far as the issuer company is concerned, it issues the requisite shares underlying the depository receipts in its domestic jurisdiction to a domestic custodian against receipt of cash from the investors for the depository receipts. These shares represent the issued capital of the company against which capital has been raised by issue of the depository receipts. However, these shares are not allowed for trading in the domestic market of the issuer company since the depository receipts representing them are already under trade in other markets. Therefore, the depository receipt mechanism creates two distinct pools of securities,—one pool being that of the issued shares and the other being that of the depository receipts representing those shares. This relationship is represented in Fig. 8.1.

Shar es under lying the Depositor y Receipts

Depositor y Receipts 1. These are issued in jurisdictions other than the issuer’s domestic jurisdiction.

1. These are issued in the local jurisdiction of the issuer company.

2. These are listed and traded on stock exchanges and the OTC market.

2. These are not tradable in the domestic market since they are held by the custodian.

3. These are administered through a global depository. 4. The investors subscribe to and are allotted these instruments. 5. These instruments are issued against the underlying shares issued by the company in the name of the depository. 6. The holders of these instruments are not members of the company; therefore they do not have direct voting rights.

3. These are administered through the domestic custodian.

� Figure 8.1

4. The global investors are not issued these instruments.

5. These are issued against the cash received from investors. 6. Shares are issued in the name of the global depository.

The Scheme of Depository Receipts

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The schematic representation of an issue of depository receipts is presented in Fig. 8.2. Foreign Jurisdiction

Investor s

Maintains individual accounts, dividends, bonus etc

Domestic Jurisdiction

Issuer company Remit subscriptions, surrender DRs for conversion

Global depositor y (usually a bank). Administer s the

Issues shares

Custodian (holds non-tr adable shar es)

Issue proceeds are remitted in convertible foreign exchange.

tr adable DRs. Uses

inter national clear ing systems.

For eign Investment Banker s Lead Manager s to the Issue. (Book r unner s and lead syndicate member s for under wr iting and mar keting)

� Figure 8.2

Domestic Investment Banker s Indian adviser s to the company on the over seas DR issue.

Schematic Representation of an Issue of Depository Receipts (DRs)

The question that arises from the above diagram is why should there be such a complicated structure of issuing a pool of depository receipts in another jurisdiction which replicate the function of the shares themselves, instead of issuing shares directly to investors? In other words, what is the need for depository receipts if foreign investors are allowed to invest directly in the shares of the issuer company? Taking the Indian example, into consideration, since most Indian companies are allowed to issue shares to foreign investors, why should Indian companies look at the issue of depository receipts in overseas markets as opposed to issuing shares directly to non-residents?

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These questions can be answered with a comparative analysis of depository receipts vis-à-vis direct investment by foreign investors in shares of the issuer company. They are: 1. Firstly, even if direct issue of shares is permitted to non-resident investors in the parent country of the issuer, the shares can be listed only on the domestic stock exchanges. Therefore, foreign investors need to trade in those shares only in the domestic markets. This difficulty is obviated by the issue of depository receipts that are traded on foreign exchanges and OTC markets. 2. Sometimes, the regulatory regime in the parent country does not allow a foreign floatation through a public issue. For example, an Indian company cannot make an issue of its shares abroad to the foreign public and list these shares directly on global exchanges. The only way it can make a public issue of shares to non-residents is by allotting them to registered FIIs and NRIs in a domestic public issue in India. Therefore, if an Indian company wishes to raise capital from overseas investors at large, it would not be possible except through the depository receipt route. 3. Foreign investors can invest in issue of depository receipts of an Indian company without getting themselves registered with SEBI or seeking individual approval under the FDI policy. They cannot do so if the investment is in shares directly. 4. Since the investors hold and trade depository receipts, there is no tax incidence in India for capital gains made on such trades abroad. Otherwise, if the shares were sold in India, the capital gain would be subject to withholding taxes in India as per the prevalent law. The same would be true of other countries as well where capital gains are taxable. 5. Since the foreign investors are not direct shareholders and members of the issuer company in India, they do not exercise direct voting rights in India. Otherwise, the company has to seek their consent for all decisions requiring shareholders’ approval, which would be extremely difficult considering that these investors could be spread out anywhere across the world. 6. Settlement of transactions in depository receipts happens through international settlement systems like DTC in USA and Euroclear or CEDEL in Europe while transactions in shares have to be cleared in domestic clearing houses in India. Therefore, for a foreign investor, international clearing systems are more convenient.

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7. Payment of dividend and repatriation of capital on direct investment in shares involves exchange risk since shares are designated in rupees. Even through the GOI has permitted hedging of investment exposures in India in convertible foreign currency that would involve complex derivative transactions. In comparison, depository receipts are designated in foreign currency such as the dollar, euro, yen and pound sterling. 8. Lastly, compliance with FEMA and RBI approvals would not be required for sale of depository receipts by foreign investors abroad. However, sale of shares by non-residents to residents to residents requires prior approvals under FEMA and is also subject to price considerations. Though the above comparatives are not intended to be an exhaustive list, the point being made herein is that depository receipts offer the mechanism of floating multi-currency instruments in euro markets and are therefore useful in tapping investors across national borders. It is especially useful for countries like India that do not have free convertibility of currency on capital account. Using the depository receipt mechanism Indian companies could tap the vast investor potential in Europe and USA in the past.

8.3.3 Fungibility of Depository Receipts The next important aspect of the discussion on depository receipts is about their fungibility. This is a very important concept as it forms the very core of the depository mechanism. ‘Fungibility’ makes depository receipts homogenous and convertible into the share underlying them. By making this possible, the foreign investor is given a two-way exit route—i.e. the exit can be either through the sale of the GDR in the overseas market or through the sale of the underlying share in the domestic market. If fungibility is allowed, it makes the prospects for the investor better since the price differential between the depository receipt and the underlying share can be used to advantage. As mentioned earlier, the ADR became fungible in US market in 1990. As far as the Indian scenario is concerned, the GOI initially prescribed a two-year lock-in period for GDRs to become fungible. However, this restriction was removed later on. Nowadays, the investment bankers acting as issue managers prescribe a cooling-off period during which the depository receipts are not fungible. This period could be between 45–180 days depending upon the market conditions and the size of the issue. After the cooling-off period, an investor may if desired, opt for conversion of GDRs/ADRs into underlying ordinary shares and hold them. If these shares are required to be sold at a later date, they can be sold only in the domestic market in India as per the procedure which is described as follows.

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An investor in depository receipts intending to use the fungibility route for exit has to approach the global depository directly or through a foreign broker for the cancellation of the depository receipt. The depository then directs the domestic custodian in India to release the shares to the counter party broker in India. The custodian informs the issuer company, which in turn would instruct the STA to release the shares. If the shares have been issued in dematerialized mode in India, suitable instructions have to be passed on through the domestic depository (NSDL or CDSL) by the STA. The counter party broker receives the credit of shares in its DP account, which are then sold in the secondary market. The proceeds received in rupees are remitted in foreign exchange to the foreign broker by the Indian broker. The foreign broker pays off the investor upon receipt of the proceeds. The net effect of the transaction would be that the total stock of depository receipts gets reduced by the amount that has been converted into shares. It also means that the stock of tradable shares of the company in the domestic market in India goes up by the same extent. Therefore, the property of fungibility of depository receipts could lead to a change in the respective floating stock of the company’s tradable equity in domestic and foreign bourses. The following exhibit represents the implications of fungibility of deposit receipts (Fig. 8.3).

For eign J ur isdiction

Total pool of tr adable DRs

Domestic J ur isdiction Non-tr adable pool of shar es under lying the DRs which ar e held by the domestic custodian

Investor opts for conversion and sale of DRs in domestic market

Release of shares from non-tradable pool into tradable free float One-way fungibility of DRs into shares

Reduced pool of tradable DRs for overseas trading

� Figure 8.3

Increased free float of tradable shares for domestic trading

Fungibility of Depository Receipts (DRs)

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From the above diagram, it is evident that one-way fungibility of DRs into shares can cause a long-term structural modification to the floating stock in the domestic market that can have a price implication. In the context of a country that has a fully convertible currency this structural change can be used for a reverse arbitrage, i.e. domestic investors can arbitrage a higher price for the DRs in the overseas market by opting for conversion of their shares into DRs and trading in the overseas market. However, in the Indian context, such reverse arbitrage is not possible on an on-going basis. However, acknowledging the situation, the GOI has allowed limited two-way fungibility. These aspects have been discussed further in the following paragraph.

8.3.4 Two-way Fungibility of Depository Receipts Two-way fungibility of DRs implies that DRs and their underlying shares are convertible both ways inter-se but within their respective jurisdictions. Therefore, an overseas investor may convert DRs into shares but these can be traded only in the domestic market. Similarly, a domestic investor may convert shares into tradable DRs but these can only be traded in markets wherein the DRs are listed. The RBI came out with separate guidelines for limited reverse fungibility of shares into DRs through two distinct methods—(a) a re-issue of ADRs/GDRs in the overseas market through secondary market purchase of shares in India and (b) through a sponsored ADR/GDR issue whereby Indian investors can hope to encash some of the gains of a higher price in overseas market. Under the first mechanism, individual foreign investors may, at their option, seek issue of DRs, which would be issued by purchase of shares in the domestic market in India. This is purely a demand driven mechanism operated through the secondary market. Under the second mechanism, the domestic investors in India would be given an opportunity to surrender their shares to the issuer company, and these shares would then be pooled and converted into DRs to be sold as a public issue of DRs in the overseas market. This would be a process wherein the issuer company would also be involved. The proceeds thereof would be remitted to the domestic investors in India. Therefore, through the issuer company does not receive any funds in the process, the domestic shareholders have the opportunity to make arbitrage gains. Simply put, the sponsored ADR/GDR issue is an offer for sale of existing domestic shares as DRs in the overseas market. Both the above mechanisms are discussed further in the following paragraphs issued in the light of the operative guidelines issued by the RBI.

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Re-issue of ADR/GDRs 2 Re-issue of ADRs and GDRs that have been surrendered by foreign investors for being converted into domestic shares. This is permitted to the extent of ADRs/GDRs which have been redeemed into underlying shares and sold in the domestic market. The arrangement is demand driven with the process of reconversion emanating with the request for acquisition of domestic shares by non-resident investor for issue of ADRs/GDRs. The following provisions have to be complied with as stated below: 1. The re-conversion has to be within the overall FDI caps permitted by the RBI under FEMA as these are not treated as part of FII investments. For this purpose, the domestic custodian is also required to verify if the total cap is being breached if there is a percentage cap on foreign direct investment. 2. The transaction will be effected through SEBI registered stockbrokers as intermediaries between foreign investors and domestic shareholders. A general permission has been conveyed by Reserve Bank of India (RBI) through a Notification No. FEMA.41/2001-RB dated 2nd March 2001 authorising such stock brokers to acquire domestic shares on behalf of the overseas investors for being placed with the domestic custodian. The domestic custodian who is the intermediary between overseas depository on the one hand and Indian company on the other will have the record of the ADRs/GDRs issued and redeemed and sold in the domestic market. The domestic custodian will also be required to ascertain the extent of registration in favour of ADR/GDR holders/non-resident investor based on the advice of the overseas depository. Based on such information, the domestic custodian instructs the company for the underlying shares being transferred in the name of the non-resident on redemption of the ADRs/GDRs. 3. On request by the overseas investor for acquisition of shares for re-issuance of ADRs/GDRs, the SEBI registered Broker will purchase a given number of shares after verifying with the custodian whether there is any Head Room available. 4. Head Room = Number of DRs originally issued minus number of DRs outstanding further adjusted for DRs redeemed into underlying shares and registered in the name of the non-resident investor(s). The domestic custodian would then notify the extent up to which re-issuance would be permissible— the redemption effected minus the underlying shares registered in the name

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of the non-resident investor with reference to original DR issue and adjustment on account of sectoral caps/approval limits. 5. The Indian Broker would receive funds through normal banking channels for purchase of shares from the market. The shares would be purchased in the name of the overseas depository and the shares would need to be purchased on a recognised stock exchange. 6. Upon acquisition the Indian broker would place the domestic share with the custodian; the arrangement would require a revised custodial agreement under which the custodian would be authorised by the company to accept shares from entities other than the company. 7. Custodian would advise overseas depository on the custody of domestic share and that corresponding DRs may be issued to the non-resident investor. Based on such advice, overseas depository would issue corresponding DRs to the investor. 8. A monthly report about the ADR/GDR transaction under the two-way fungibility arrangement is to be made by the Indian custodian in the prescribed format to RBI and SEBI. 9. The Broker has to ensure that each purchase transaction is made only against delivery and payment thereof received in foreign exchange. The Broker will submit the contract note to the Indian custodian of the underlying shares on the day next to the day of the purchase so that the Custodian can reduce the Head Room accordingly. A copy of the Contract Note would also need to be provided by the custodians to RBI and SEBI. The Broker will also ensure that a separate rupee account will be maintained for the purpose of buying shares for the purpose of effecting two-way fungibility. No forward cover will be available for the amounts lying in the said rupee account. The authorized dealer will be permitted to transfer the monies lying in the above account on the request of the Broker. 10. The custodian of the underlying shares and the depositories would coordinate on a daily basis in computing the Head Room. Further, the company secretary of each individual company would provide details of non-resident investment at weekly intervals to the custodian and the depository. The custodian would monitor the re-issuance and furnish a certificate to both RBI & SEBI, to ensure that the sectoral caps are not breached. RBI would monitor the receipt of certificates from the custodian to this effect.

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11. The re-issuance would be within the already approved/issued limits and would only effectively mean transfer of ADRs/GDRs from one nonresident to another and accordingly no further approval mechanism be insisted upon. 12. In the limited two-way fungibility arrangement, the company is not involved in the process and is demand driven i.e request for ADRs/GDRs emanates from overseas investors. Consequently, the expenses involved in the transaction would be borne by the investors, which would include the payments due to overseas intermediary/broker, domestic custodians, charges of the overseas and domestic brokers. 13. The tax provision under Section 115 AC of the Income Tax Act 1961, which is applicable to non-resident investors investing in ADRs/GDRs offered against issue of fresh underlying shares would extend to nonresident investors investing in foreign exchange in ADRs/GDRs issued against existing shares under these guidelines, in terms of the relevant provisions of the Income Tax Act 1961.

Sponsored ADR/GDR Issues3 Based on the Ministry of Finance circular4, the RBI has also allowed a company to sponsor a ADR/GDR issue based on underlying domestic shares through an appointed Lead Manager, the domestic custodian and an overseas depository. The price for buy back of domestic shares for the purpose of the sponsored issue would be determined by the lead manager based on ‘head room availability’. Suppose the ADR of a company is currently quoted at the equivalent of Rs. 8000 in the overseas market and the underlying share in India is quoting at Rs. 6000, the lead manager would be able to make an offer of a price ranging between these two prices. The lead manager buys them from the local market at prices slightly higher than the prevailing market price and sells them at a slightly lower price in the overseas market than the prevalent ADR price. This mechanism helps to bring down the gap in prices in both markets and promotes price parity. In addition, it will help companies going to the overseas markets for the first time through the sponsored route. By the end of 2003, two companies had come forward with proposals for a sponsored ADR issue—Infosys and i-Flex. Sponsored ADR issues should also be approved by the Ministry of Finance under the Euro Issue Guidelines 1993. Extracts of the Offer Letter for the sponsored ADR issue by Infosys Technologies Ltd. is provided in Annexure II included in this Chapter.

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The sponsored route would be available to all shareholders of the company. The company will give an option to the shareholders indicating the number of shares to be divested and the mechanism of how the price will be determined under the ADR/GDR norms. If the shares offered for divestment by domestic shareholders exceed the number to be divested, shares would be accepted on pro-rata basis as in the case of a normal buy back of shares. The following are the operative provisions of the scheme announced by the RBI for sponsored ADR/GDR issues: 1. Divestment by shareholders of their holdings of Indian companies, in the overseas markets would be allowed through the mechanism of Sponsored ADR/GDR issue in respect of: a. Divestment by shareholders of their holdings of Indian companies listed in India; b. Divestment by shareholders of their holdings of Indian companies not listed in India but which are listed overseas. 2. The process of divestment would be initiated by such Indian companies whose shares are being offered for divestment in the overseas market by sponsoring ADR/GDR issues against the block of existing shares offered by the shareholders under the provisions of these guidelines. 3. The sponsoring company, whose shareholders propose to divest existing shares in the overseas market through issue of ADRs/GDRs will give an option to all its shareholders indicating the number of shares to be divested and the mechanism how the price will be determined under the ADR/GDR norms. If the shares offered for divestment are more than the pre-specified number to be divested, shares would be accepted for divestment in proportion to existing holdings. 4. The proposal for divestment of the existing shares in the ADR/GDR market would have to be approved by a special resolution of the company whose shares are being divested. 5. The proceeds of the ADR/GDR issue raised abroad shall be repatriated into India within a period of one month of the closure of the issue. 6. Such ADR/GDR issues against existing shares arising out of the divestment would also come within the purview of the existing SEBI Takeover

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Code if the ADRs/GDRs are cancelled and the underlying shares are to be registered with the company as shareholders. 7. Divestment of existing shares of Indian companies in the overseas markets for issue of ADRs/GDRs would be reckoned as FDI. Such proposals would require FIPB approval as also other approvals, if any, under the FDI policy. Such divestment inducting foreign equity would also need to conform to the FDI sectoral policy and the prescribed sectoral cap as applicable. Accordingly the facility would not be available where the company whose shares are to be divested is engaged in an activity where FDI is not permitted. Each case would require the approval of FIPB for foreign equity induction through offer of existing shares under the ADR/GDR route. 8. Other mandatory approvals such as those under the Companies Act, etc. as applicable would have to be obtained by the company prior to the ADR/GDR issue. 9. The issue related expenses (covering both fixed expenses like underwriting commissions, lead managers charges, legal expenses and reimbursable expenses) for public issue shall be subject to a ceiling of 4% in the case of GDRs and 7% in the case of ADRs and 2% in case of private placements of ADRs/GDRs. Issue expenses beyond the ceiling would need the approval of RBI. The issue expenses shall be passed onto the shareholders participating in the sponsored issue on a pro-rata basis. 10. The shares earmarked for the sponsored ADR/GDR issue may be kept in an escrow account created for this purpose and in any case, the retention of shares in such an escrow account shall not exceed 3 months. 11. If the issues of ADR/GDR are made in more than one tranche, each tranche would have to be treated as a separate transaction. 12. After completing the transactions, the companies would need to furnish full particulars thereof including amount raised through ADRs/GDRs, number of ADRs/GDRs issued and the underlying shares offered, percentage of foreign equity level in the Indian company on account of issue of ADRs/GDRs, details of issue parameters, details of repatriation, and other details to the RBI within 30 days of completion of such transactions. 13. The tax provision made under Section 115 AC of the Income Tax Act 1961, which is applicable to non-resident investors for ADR/GDR offering against issue of fresh underlying shares would extend to non-resident investors investing in foreign exchange in ADRs/GDRs issued against

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disinvested existing shares, in terms of the relevant provisions of the Income Tax Act, 1961. 14. Resident shareholders divesting their holdings will be subject to capital gains tax under the Income Tax Act, 1961. 15. Under the liberalised scheme of RBI, it has been decided to permit resident shareholders of Indian companies, who offer their shares for conversion to ADRs/GDRs, to receive the sale proceeds in foreign currency. However, in such cases, the conversion to such ADRs/GDRs should have the approval of Foreign Investment Promotion Board (FIPB). Further, the sale proceeds, so received by residents, are also permitted to be credited to their Exchange Earners’ Foreign Currency/Resident Foreign Currency (Domestic) [EEFC/RFC(D)] accounts or to their Rupee accounts in India at their option. 16. Disinvestment proceeds under the scheme, receivable by residents, who have since became non-residents, would also be eligible for credit to their foreign currency accounts abroad or any of their accounts in India at their option.

8.3.5 Issue of Bonds Convertible into Depository Receipts Apart from straight issue of depository receipts, a company can issue bonds that are convertible into depository receipts at a later date. These are known as Foreign Currency Convertible Bonds or FCCBs in India. The issue of such bonds has the same advantages as that of a convertible debenture issue in India in that it does not lead to an immediate expansion of equity. When such bonds are issued in the euro market, they are known as euro convertibles. Euro convertibles would help in realizing better value for the company’s share and is better marketable than a euro nonconvertible bond. The Indian regulatory provisions for the issue of euro convertible bonds by Indian companies are further discussed in Paragraph 8.4.

8.3.6 Indian Scenario in GDRs/ADRs/Convertible Bonds Indian companies began to tap the euro market through the issue of GDRs and FCCBs immediately after the opening up of the overseas capital markets for Indian issuers by the GOI in 1993. These issues are known as euro issues since Indian companies preferred to float instruments in the euro market initially. This was because they were quite unprepared to float public issues in the US market due to

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its stringent listing requirements and mandatory accounting as per US GAAP. Some of the euro issues made in the early nineties are listed in Table APP 8.1. Some of these were partly offered in USA under the 144A route as well. With the passage of time and the technology boom in the late nineties, Indian companies came forward with ADR and ADS issues via public offers in the US markets as well. These are listed in Table APP 8.2. Indian issuers have also used the 144A route to make private placements of depository receipts and bonds in the US market. Some of these are listed in Table APP 8.3. Readers may refer to all the above mentioned tables in Appendix 1 included at the end of the book.

8.3.7 Indian Depository Receipts (IDRs) The concept of a depository mechanism for issue of shares in a foreign jurisdiction has been used to usher in a new era in the Indian capital market with the introduction of the ‘Indian Depository Receipt’ or IDR recently. Under the IDR mechanism, an eligible foreign company which is incorporated outside India may make an issue of IDRs in the Indian capital market to raise funds. These IDRs would be issued by a domestic depository in India against shares of the issuing company, which are held by an overseas custodian bank. Therefore, the IDR mechanism is exactly the inverse of an ADR/GDR mechanism that applies to Indian companies to raise capital from overseas markets. The IDR enables a foreign company whether it has any business operations in India or not, to raise capital from the Indian capital market without actually issuing its shares directly in India. The IDRs would be listed and traded in India like any other domestic shares issued by Indian companies. The issue of IDRs is subject to the guidelines issued by the GOI in this behalf, which are discussed in paragraph 8.4.5 below.

8.4 Indian Regulatory Regime for Global Capital Market Floats Global public issues and private placements of depository receipts, bonds and convertibles by Indian corporates are governed by the provisions of the Companies Act, FEMA and the guidelines issued by the Ministry of Finance, GOI in particular apart from the applicable provisions of the SCRA, IT Act and other laws. These are broadly listed below. An Indian company may issue rupee denominated shares to a person resident outside India being a depository for the purpose of issuing Global Depository

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Receipts or American Depository Receipts. It can also issue Foreign Currency Convertible Bonds that can be converted into underlying shares in India but which continue to be traded in the depository route overseas. If an overseas investor wishes to convert depository receipts into shares, this is possible as per the fungibility norms discussed earlier under paragraph 8.3.3. Overseas capital market issues by Indian companies need to conform to the following guidelines: �

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The issue shall be in accordance with the scheme for issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme 1993 as amended from time to time. Such issues also need to conform to the FDI policy of the government. Under this scheme, Indian companies whether listed in India or not are allowed to float overseas issues. However, unlisted companies that get listed on overseas stock exchanges under the ADR/GDR route need to comply with listing requirements in India within three years of starting to make profits. The issue should comply with the provisions of the Companies Act, SEBI guidelines, SCRA and the listing agreement insofar as it relates to the underlying issue of shares or convertible instruments. However, as per the guidelines, companies will not be permitted to issue warrants as part of their overseas capital issues. Therefore, bonds with attached warrants or pure equity warrants cannot be issued. The company satisfies other conditions prescribed in Schedule 1 to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000.

The above provisions are discussed in detail in the following paragraphs:

8.4.1 GOI Guidelines on Issues of Depository Receipts and FCCBs The government guidelines on issue of GDRs and FCCBs through euro issues and private placements as well as public issues of ADRs/ADS in American capital market are covered under the Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 and notifications issued pursuant to the scheme. These guidelines have gone through several amendments over the years offering better flexibility to issuer companies. The provisions discussed below are based on the modifications made to the guidelines in January 2000.5 Under these provisions, it is possible for an Indian issuer to issue FCCBs and

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GDRs against equity shares. A GDR has been defined to mean ‘Any instrument in the form of a depository receipt or certificate (by whatever name it is called) created by the overseas depository bank outside India and issued to non-resident investors against the issue of ordinary shares or FCCBs of issuing company’. Therefore, any type of depository receipts including ADRs and ADSs come under the above definition. Indian companies raising money through ADRs/GDRs through registered stock exchanges would henceforth be free to access the overseas capital markets through an automatic route without the prior approval of the Ministry of Finance, Department of Economic Affairs. Private placement of such securities shall also be covered under the automatic route provided such placement is lead managed by an investment banker. For this purpose, an investment banker managing such an issue shall be registered with the SEC, USA, or under the Financial Services Act in UK or with the appropriate regulatory authority in Europe, Singapore or Japan. In all cases under the automatic route, mandatory approvals under the relevant FDI policy, other approvals under the Companies Act, approvals under FEMA for utilisation of the proceeds of the issue in foreign currency etc. need to be taken before proceeding with the issue. The RBI requirements in this matter have been discussed in paragraph 8 4.5. No end use pattern has been specified for proceeds raised from overseas issues of ADRs/GDRs/FCCBs except that these cannot be used for stock market operations and for real estate activity. As per a recent decision taken by the GOI, proceeds from ADR/GDR/FCCB issues can be used to purchase shares of the Government offered under the disinvestments programme of the GOI as also to finance the open offers if any, required under the Takeover Code of SEBI pursuant to such purchases.6 Issue related expenses covering both fixed expenses like underwriting commissions, lead managers’ fee, legal expenses and other reimbursable expenses shall be subject to a ceiling of 4% of the issue size in the case of GDRs and 7% in the case of listing on American stock exchanges. For issue expenses to be incurred beyond the above ceiling, approval of the RBI would be necessary. After completing the issue, the concerned issuer company would be required to furnish full particulars thereof including the amount of ADRs/GDRs issued, number of underlying fresh equity shares issued, percentage of foreign equity level in the Indian company on account of the issue (stating whether under the automatic approval route or under the FIPB approval route) and detailed issue parameters to the Ministry of Finance, Department of Economic Affairs and the Exchange Control Department of the RBI within 30 days of completion of the issue.

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The other provisions of the GOI scheme mentioned above are as follows: �

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The FCCBs shall be denominated in any freely convertible foreign currency and the ordinary shares of an issuing company shall be denominated in Indian rupees. When an issuing company issues ordinary shares or convertible bonds, it shall deliver the ordinary shares or bonds to a domestic custodian bank that will, in terms of agreement, instruct the overseas depository bank to issue depository receipts or certificate to non-resident investors against the shares or bonds held by the domestic custodian bank. A GDR may be issued in the negotiable form and may be listed on any international stock exchanges for trading outside India or OTC exchanges or through book entry transfer systems prevalent abroad and such receipts may be purchased, possessed and freely transferable by a person who is a nonresident within the meaning of FEMA subject to the provisions of that Act. The provisions of any law relating to issue of capital by an Indian company shall apply in relation to the issue of FCCBs or the ordinary shares of an issuing company and the issuing company shall obtain the necessary permission or exemption from the appropriate authority under the relevant law relating to issue of capital. A GDR may be issued for one or more underlying shares or bonds held with the domestic custodian bank. The FCCBs and GDRs may be denominated in any freely convertible foreign currency. The ordinary shares underlying the GDRs and the shares issued upon conversion of the FCCBs will be denominated only in Indian currency.

The following areas of the issue will be decided by the issuing company in consultation with the Lead Manager to the issue, namely: �

Methodology of the issue—through public or private placement.

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Number of Global Depository Receipts to be issued.

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Issue price.

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Rate of interest payable on FCCBs.

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Conversion price, coupon, and the pricing of the conversion options of the FCCBs. The conversion period of the FCCB is also flexible but the non-converted portion shall have a minimum average tenor of five years.

Overseas Capital Market Issues �

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There would be no lock-in-period for the GDRs/ADRs issued under the GOI scheme. Dividend distributions on the depository receipts shall be sent to the overseas depository bank, which shall distribute them to the non-resident investors proportionate to their holdings of depository receipts evidencing the relevant shares. Dividends would be paid out by the company in rupees that would be converted at the applicable rates for remittance to the depository bank. A non-resident holder of GDRs may transfer those receipts, or may ask the overseas depository bank to redeem those receipts. In the case of redemption the depository bank shall request the domestic custodian bank to get the corresponding underlying shares released in favour of the non-resident investor, for being sold directly on behalf of the non-resident, or being transferred in the books of account of the issuing company in the name of the non-resident. In case of redemption of the GDRs into underlying shares, a request for the same will be transmitted by the depository bank to the domestic custodian bank in India, with a copy of the same being sent to the issuing company for information and record. On redemption, the cost of acquisition of the shares underlying the GDRs shall be reckoned as the cost on the date on which the depository bank advises the domestic custodian bank for redemption. The price of the ordinary shares of the issuing company prevailing in the BSE or the NSE on the date of the advice of redemption shall be taken as the cost of acquisition of the underlying ordinary shares. For the purpose of conversion of FCCBs, the cost of acquisition in the hands of the non-resident investors would be the conversion price determined on the basis of the price of the shares at the BSE or the NSE on the date of conversion of FCCBs into shares. As far as taxation of FCCBs is concerned, interest payments on the bonds, until the conversion option is exercised, shall be subject to deduction of tax at source at the applicable rates. Presently since there is no tax on dividends distributed by domestic companies, such payouts shall not be subject to withholding tax in India. Conversion of FCCBs into shares shall not give rise to any capital gains liable to income-tax in India. Transfers of FCCBs

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made outside India by a non-resident investor to another non-resident investor shall not give rise to any capital gains liable to tax in India. �

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All transactions of trading of the ADRs/GDRs outside India, among nonresident investors, shall be free from may liability to income tax in India on capital gains therefrom. If any capital gains arise on the transfer of the underlying shares in India to the non-resident investor, he or she will be liable to income tax under the provisions of the Income tax Act. If the aforesaid shares are held by the nonresident investor for a period of more than twelve months from the date of advice of their redemption by the overseas depository bank, the capital gains arising on the sale thereof will be treated as long-term capital gains and will be subject to income-tax at the rate of 10 per cent under the provisions of Section 115 AC of the Income tax Act provided the proceeds on sale are remitted back in foreign exchange. If such shares are held for a period of less than twelve months from the date of redemption advice, the capital gains arising on the sale thereof will be treated as short-term capital gains and will be subject to tax at the normal rates of income tax applicable to non-residents under the provisions of the Income-tax Act. During the period of fiduciary ownership of shares in the hands of the overseas depository bank, the provisions of avoidance of double taxation agreement entered into by the GOI with the country of residence of the overseas depository bank will be applicable in the matter of taxation of income from dividends from underlying shares and interest in FCCBs. During the period, if any, when the redeemed underlying shares are held by the non-resident investor on transfer from fiduciary ownership of the overseas depository bank, before they are sold to resident purchasers, the avoidance of double taxation agreement entered into by the GOI with the country of residence of the non-resident investor will be applicable in the matter of taxation of income from the dividends from the said underlying shares, or interest on FCCBs, or any capital gain arising out of transfer of underlying shares. The holding of the depository receipts in the hands of non-resident investors and the holding of the underlying shares by the overseas depository bank in a fiduciary capacity and the transfer of the depository receipts between nonresident investors and the overseas depository bank shall be exempt from wealth tax.

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8.4.2 Bonus and Rights Issues and Business Re-organizations In the case of business re-organizations such as mergers, amalgamations, hive-offs and subsidiarizations, there would be a need for exchange of holdings of the investors. The Indian law prescribes equal treatment for holders of depository receipts vis-à-vis equity shareholders in conferring the benefits of exchange of holdings under a business re-organization. Therefore, based on the approved exchange ratio, the holders of ADRs/GDRs would also be offered new ADRs/GDRs or shares as the case may be, in exchange for their existing holdings. Under the GOI scheme, it has been provided that if equity shareholders of company ‘A’ become entitled to shares of another company ‘B’ as a consequence of a genuine business re-organization which is duly approved by the High Court under section 391–394 of the Companies Act, then the GDR/ADR holders of company ‘A’ also mature under the same entitle men of shares of company ‘B’. For this purpose, the company would need to issue and place equity shares with the domestic custodian against which the overseas depository would issue corresponding ADRs/GDRs to the ADR/GDR holders. A similar provision has been made in the case of rights and bonus entitlements that arise on equity shares from time to time. ADR/GDR holders are placed on par and would accordingly receive their rights and bonus entitlements in terms of additional ADRs/GDRs. The GOI scheme provides the automatic route for issue of ADRs/GDRs on bonus or rights entitlements and consequent upon business re-organizations. Therefore, companies need not seek any prior approvals for such issues made to their ADR/GDR holders.

8.4.3 Issue of DRs Consequent to ESOPs In order to promote the Indian knowledge based industry, the GOI approved the issue of ADR/GDR linked stock options to employees in companies engaged in such businesses under the automatic route without seeking government approvals. The sectors eligible for this purpose are software and information technology. A software company has to earn at least 80% of its revenues from software to be eligible for this purpose. This scheme is available to both unlisted and listed Indian companies. The stock options shall be available to resident and non-resident permanent employees of the company including Indian and overseas working directors.

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However, promoter directors and their relatives who are employees are excluded for this purpose. The issuing company would be entitled to issue options not exceeding 10% of its issued and paid-up capital. The stock options may be issued at a discount of not more than 10% to the market price of the ADR/GDR at the time of issue of the options. The ADRs/GDRs acquired on exercise of the options shall be freely transferable though the options themselves are not. Such ADRs/GDRs shall be eligible for concessional tax treatment under section 115AC of the IT Act. The eligible employees can remit upto $50,000 in a block of five financial years for the acquisition of the ADRs/GDRs. Upon sale of such securities in the overseas market, the proceeds should be repatriated into India by residents unless RBI approval is taken for their retention or use abroad. Similar to the above stock options, employees of Indian software companies may acquire shares in the overseas joint venture or wholly owned subsidiary of the Indian parent in the software field. Remittances for such shares shall not exceed $10,000 per employee in a block of five years. Further, the shares so allotted shall not exceed 5% of the paid-up capital of the overseas company. An additional condition would be that as a result of the acquisition of shares by the Indian employees, the holding of the parent company in the overseas company together with the shares issued under the ESOP shall not be allowed to reduce from the level of shareholding existing prior to the said ESOP.

8.4.4 Overseas Acquisitions and Stock Swaps All companies that have made an ADR/GDR issue earlier and are listed on an overseas stock exchange, would be entitled to the facility of overseas business acquisitions using the ADR/GDR stock swap route. The issue of fresh ADRs/GDRs consequent to such acquisition is covered under the automatic route. The overseas companies that are acquired under this route shall be in the same core activity as the Indian company as stipulated in the ODI guidelines. The ODI guidelines are further discussed in Chapter 12. Companies that have not made an ADR/GDR issue earlier need to approach the special committee of the RBI for approval under this acquisition route as provided in the ODI guidelines. The ADRs/GDRs issued under this route have to be fresh securities and not re-issued securities. The automatic route is subject to the overall FDI limits applicable to a particular sector. The acquisition has to conform to valuation norms as per the recommendations of the investment banker, which in the case of a listed company shall be based on

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its market capitalization. The market capitalization shall be computed on the basis of the monthly average trading on the overseas exchange, for three months preceding the month in which the acquisition is committed to. The premium would be based on the recommendation of the investment banker taking into account the due diligence report. In the case of an unlisted company, such valuation has to be on the recommendations of the investment banker. For this purpose, an investment banker managing such issue shall be registered with the SEC, USA, or under the Financial Services Act in UK or with the appropriate regulatory authority in Europe, Singapore or Japan. The complete details of the transaction has to be reported to the RBI and the Ministry of Finance within a period of 30 days of the completion of such transaction. As far as the monetary ceilings are concerned, acquisitions upto an aggregate value of $100 million per year shall be allowed without any approvals from the GOI/RBI if these are funded entirely out of fresh issue of ADRs/GDRs. For acquisitions beyond $100 million per year, the special committee of the RBI needs to be approached for approval to make the acquisition.

8.4.5 GOI Guidelines on IDRs The issue of IDRs is governed by the Companies (Issue of Indian Depository Receipts) Rules, 2004 issued by the GOI. Under these guidelines, an issuer of IDRs can only be a company incorporated outside India. An IDR has been defined as ‘any instrument in the form of a depository receipt created by a domestic depository in India against the underlying equity shares of the issuing company’. A company incorporated outside India has to satisfy the following eligibility criteria to be able to make an issue of IDRs in India. �

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Its pre-issue capital and free reserves should be at least US$ 100 million and its minimum average turnover during the three preceding financial years should be US$ 500 million. It should be profit making for the past five years with dividend declarations of at least 10% during the said period. Its pre-IDR issue debt equity ratio should not be more than 2:1. The quantum of IDRs issued in any particular financial year shall not exceed 15% of the paid-up capital and free reserves of the issuing company.

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It should satisfy additional eligibility criteria that may be specified by SEBI in this behalf from time to time. Prior approval of SEBI would be required to make an issue of IDRs in India. Application seeking such approval has to be made to SEBI at least 90 days prior to the proposed opening date in the requisite format on payment of the prescribed fee. Additional approvals under FEMA and other applicable laws in India need to be obtained as may be required in individual cases. IDRs shall be designated in Indian rupee.

The other important operative provisions for an IDR issue are mentioned below: �

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The issuer company shall appoint an overseas custodian bank, a domestic depository in India and a merchant banker in India to manage the IDR issue. The issuing company shall deliver the underlying equity shares to the overseas custodian bank and the said bank shall authorize the domestic depository to issue the IDRs. The draft prospectus or letter of offer as the case may be, shall be filed with SEBI through the merchant banker. The company would receive observations if any, from SEBI in 21 days which need to be addressed. The final offer document shall be filed with SEBI and the Registrar of Companies in New Delhi prior to the opening of the issue. The filing of the offer document shall be done by the merchant banker on behalf of the issuing company along with all other prescribed documents under these Rules. The issuing company shall obtain in-principle permission from one or more stock exchanges in India having nation wide trading terminals for the purpose of listing the IDRs. The issuing company may if required, appoint underwriters registered with SEBI to underwrite the IDR issue. The repatriation of proceeds on issue of IDRs shall be subject to FEMA as applicable from time to time. Similarly, the redemption of IDRs by an Indian IDR holder into the underlying shares shall also be subject to the provisions of FEMA. In case of a redemption request, the domestic depository shall request the overseas custodian bank to get the corresponding equity shares released in

Overseas Capital Market Issues

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favour of the resident Indian for the purpose of being sold directly on his behalf or being transferred in the books of the issuing company in the name of the resident India. Therefore, the Indian IDR holder has the option of either (a) getting the underlying shares sold in the overseas market and receiving the proceeds either in foreign currency or in rupees or (b) getting the foreign equity shares registered in his or her name with the issuer company abroad. These options are however subject to the applicable provisions of FEMA.

8.4.6 RBI Guidelines on ADR/GDR/FCCB Issues Issue of ADRs/GDRs is presently under the automatic route without prior approvals from the GOI or the RBI as detailed under paragraph 8.4.1 to paragraph 8.4.4. To give effect to these provisions initiated by the GOI, the RBI issued necessary amendments7 to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations 2000. These regulations now provide for the making of these issues on automatic route subject to overall FDI caps and procedural formalities of the RBI. The proceeds have to be repatriated into India within one month unless exempted by the RBI from time to time or pursuant to a specific approval sought by the issuer. As far as the issue of FCCBs is concerned, these are not covered under the automatic route of the GOI/RBI without any ceiling. The RBI issued a circular in 20028 according to which, an Indian company or a body corporate, created by an Act of Parliament may issue FCCBs not exceeding US$ 50 million in any one financial year to a person resident outside India under the automatic route, without the approval from Government or the Reserve Bank. Such issue has to be reported to the RBI through the designated branch of an authorized dealer. The further conditions attached to issue of FCCBs under the automatic route as provided in the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations 2000 as amended in 2002 are as follows: � �

FCCBs have to conform to the overall FDI caps under FEMA. Public issues of FCCBs shall be made only through reputed investment bankers in international capital markets. In the case of private placements, the placement shall be with banks, multilateral or foreign financial institutions, foreign collaborators, foreign equity holders having a minimum holding of 5% of the paid up capital of the issuing company. Private placement with unrecognized sources is not permitted.

372 �

�

�

�

�

�

Investment Banking

The maturity of the FCCB if not converted before such time shall be a minimum of 5 years. Call and put options shall not be exercised within that period. Issue of FCCBs with attached equity warrants shall not be permitted under the automatic route. The ‘all-in’ cost of the FCCBs shall be 100 basis points less than those prescribed for ECBs. The all-in cost shall include coupon rate, redemption premium, default payments, commitment fee, front-end fee etc but shall not include issue-related expenses such as legal fee, lead manager’s fee and out of pocket expenses. FCCB proceeds can be used for purposes for which ECBs can be used but not in investments in stock market and real estate activities. For discussion on ECBs please refer to Chapter 13. As in the case of ADRs/GDRs, the proceeds have to be repatriated into India within one month unless exempted by the RBI from time to time or pursuant to a specific approval sought by the issuer. The issue related expenses should not exceed 2% of the issue size in the case of a private placement and 4% in the case of a public issue. Reporting requirements to RBI have to be complied with in 30 days from the completion of the issue.

8.5 Overview of Regulatory Requirements in USA 8.5.1 Regulatory Requirements The main regulations that govern securities listing in the US are The Securities Act 1933, the Securities Exchange Act 1934, the stock exchange listing requirements and the security laws of the respective state (known as the Blue Sky laws). The requirements are similar whether a company lists ADRs or shares on the stock exchange. Non-US companies listing on US capital market must first register with the Securities Exchange Commission (SEC), which is the chief regulatory authority for the capital market in the US. This may involve filing a Form 20-F registration Statement—which is a detailed report of the company’s business activities and financials. The SEC has to approve the registration statement as a first step towards the public offer. The procedure may require the companies to file Form F-1

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(the prospectus) followed by the Form 20-F incorporating particulars not falling beyond six months from the close of the financial year. The Form 20-F registration statement would include detailed disclosure regarding the issuer, including financial statements and a reconciliation to US GAAP set forth in a note to the financial statements. The registration statement would be subject to a full review by the SEC, which generally takes 30 days or longer depending on the nature and extent of the SEC’s observations. The prospectus and the supplementary financial information that comprises the second part of the registration statement are reviewed both by the SEC and the NASD Regulations Inc. (NASDR), which is a subsidiary of the National Association of Securities Dealers Inc., the largest self-regulatory organization for the securities industry in the US. The NASDR regulates the activities of the brokers and dealers in the NASDAQ and the OTC industry. While the SEC reviews the prospectus for disclosure standards and compliance with law, the NASDR reviews the underwriter compensation portion of the prospectus. Within the SEC, the Division of Corporation Finance will review the registration statement for accuracy in all material facts and information that would affect investment decisions. Generally, IPOs are scrutinized more closely than secondary public offers. If an offer has a complex structure, the issuer company may even request for a pre-filing conference with the SEC staff so as to make them appreciate the structure and the review becomes smoother. The SEC attaches a lot of emphasis on the Management Discussion and Analysis (MDA) section, the risk factors and management compensation. The disclosure on management compensation should be for each individual in the management team. The NASDR concentrates on the fairness of underwriting compensation and the terms and conditions of underwriting. In the US, the NASDR Corporation Financing Rule has developed complex methods of arriving at fairness in underwriting compensations and remuneration for the risks assumed by investment bankers. For this purpose, underwriting is categorised according to the level of risk assumed by the investment banker. The NASDR guidelines stipulate the maximum amount of underwriting compensations that can be paid for different types of public offers. As in India, under the US law, the issuer company cannot circulate any information other than the prospectus to the investing public. The directors of the company and its management are solely responsible for mis-statements or false claims in the prospectus. In preparing the prospectus, the lawyers are engaged to draft the language and narrative as per law, the accountants prepare the specific financial statements that are part of the financial disclosures and the investment

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bankers provide the underwriting details. Therefore, in the US, a large part of the prospectus preparation is in the hands of the lawyers. The next major requirement would be to state the financial statements included in the filing documents in compliance with US GAAP. For non-US companies, this would require a re-statement of their financial statements as per US GAAP. The areas of divergence between the Indian and US GAAP have to be identified and a reconciliation statement has to be prepared for the purpose of the restatement by the independent auditors who are engaged for this purpose. This can be a very tedious process and therefore, it should be started quite early in the process leading to the issue. The summary of the important minimum listing standards of three American exchanges as observed in 2001 for IPOs are as follows: Criterion

NASDAQ Standard 1

NASDAQ Small Cap

NYSE

AMEX Standard 1

Shareholders’ Equity

$15 million

$5 million

$60 million

$4 million

Pre-tax profits (in the latest year apart from other requirements)

$1 million

$750,000

$2.5 million

$750,000

Public float (minimum public shares)

1.1 million

1 million

1.1 million

500,000

Issue size

$8 million

$5 million

$60 million

$3 million

Minimum Issue price per share

$5

$4

NA

$3

Market Makers

3

3

NA

NA

Unlike IPOs that require registration of prospectus with the SEC under the above said US securities law, floating of a euro issue of GDRs or other private placements under rule 144A are exempted from such registration requirements. The listing of such securities can be made outside the US either in London or Luxembourg stock exchange.

8.5.2 Types of Depository Receipts Issuers in USA have four types of depository receipt facilities, which are discussed below:

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1. Un-sponsored Depository Receipts – As mentioned earlier, depository receipts may be issued by the depository even without the involvement of the company concerned. These are unsponsored depository receipts issued in response to market demand, but without a formal agreement with the company. Presently, these are more or less extinct in the US market due to lack of transparency in the whole mechanism. 2. Sponsored Level 1 Depository Receipts – These are the simplest and the fastest growing segment of the sponsored depository receipt programmes in the United States. All sponsored ADRs are issued through a service contract between the issuer and the depository bank and are therefore eligible to be listed in the US stock exchanges. The Level 1 ADRs and are traded in the US over-the-counter (‘OTC’) market and on some exchanges outside the United States. Therefore, compliance with US GAAP is not necessary and SEC requirements on listing are limited. Level 1 is suitable for companies looking at listing in the US markets with trading facilitiy on the electronic OTC market without complying with stiff SEC norms. However, these securities cannot be listed or traded on a US national securities exchange such as the NYSE or over NASDAQ. Since these are sponsored ADRs based on existing freely tradable shares of the company, the company cannot seek to raise any fresh capital from listing of Level I ADRs. Establishing a Level 1 program would require: � �

�

The Depository Agreement. The issuance of the ADRs must be registered with the SEC under the Securities Act 1934. The issuer company should obtain an exemption from registration and reporting requirements under the Securities Exchange Act of 1934 from the SEC pursuant to Rule 12g3-2(b) issued under that Act.

3. Sponsored Level 2 Depository Receipts – As in the case of Level I, the issuer company cannot raise capital under Level II ADR programme. However, the ADRs issued under this programme can be listed on the US stock exchanges without complying with the SEC listing requirements. Therefore, in addition to seeking registration of the ADRs, the respective listing requirements of the stock exchanges should also be satisfied. Moreover, for listing on an exchange or quotation on NASDAQ the issuer must register under the Exchange Act by filing with the SEC a registration

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Investment Banking

statement on Form 20-F. The Rule 12g3-2(b) exemption discussed above is not applicable to a listed Level II program. 4. Sponsored Level 3 Depository Receipts – These are classified as Level III since they require to comply with the full SEC listing requirements. In addition, compliance with US GAAP is mandatory. Level III ADRs are meant for issuer companies wanting to raise capital from the US market. The ADRs issued under this programme can be listed on NYSE, AMEX and the NASDAQ provided they meet the respective listing requirements. The listing requirements have already been discussed above. The incentive for a company to raise the levels would be in terms of credibility and visibility among the investor community and the analysts in the US capital market and in its ability to raise capital. In a typical Level III offering, the issuer deposits shares with the depository in exchange for ADRs, which it then sells to the relevant underwriters. In the context of Indian companies, the shares are deposited with the domestic custodian. 5. Rule 144A Depository Receipts – As explained earlier in this Chapter, this route is a private placement route for securities in USA. A Rule 144A ADR program is similar to a Level III program in that the issuer is seeking to raise capital in the US through the offering of ADRs, usually through one or more US investment banking firms. These ADRs do not constitute a public offering within the meaning of the Securities Act and are made pursuant to the exemption from the registration requirements of the Securities Act provided by Rule 144A. Therefore, no registration is required with the SEC by filing any forms. In addition, the issuer is not subject to any ongoing reporting requirements. An issuer under a Rule 144A ADR program will need to obtain the Rule 12g3-2(b) exemption from the SEC. In Rule 144A security offerings, the investment banker acting as the arranger purchases the shares on a firm commitment basis. In this respect, it is similar to a bought out deal in India. Thus, a Rule 144A offering is quite different from a conventional private placement in which the investment banking firm acts solely as an arranger for a fee and has no fund obligation to take the securities on its books. The Rule 144A offer document is not filed with the SEC nor is it subject to SEC review. The Rule 144A route is generally very convenient for a global offer of GDRs. Conventionally, it has been seen that after the completion of a Rule 144A offering of ADRs, issuer companies in the USA are encouraged by investment bankers to upgrade to a Level 1 program to help satisfy secondary market demand. Currently, the SEC requires a cooling-off period of at least 40 days after completion of the

Overseas Capital Market Issues

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Rule 144A offering before the Form F-6 for the Level 1 program can be filed. Moreover, the Deposit Agreement with the depository for the Level 1 program is subjected to a detailed review to satisfy that the securities from the 144A program are not being improperly brought into the Level 1 program.

8.6 Overview of Process Flow for an International Offering The most important part of the process of an overseas floatation of securities is to put in place the issue team. The investment banker is the most important entity in the issue team. Globally, there are several varieties of investment banks ranging from full service international firms to local specialized firms. These aspects have already been discussed in Chapter 2. While selecting the investment bank careful assessment has to be made about the size and status of the issuer company and the relative importance of its mandate to the proposed investment bank. The main criterion would be the distribution capability of the investment banking team. In the case of private placement of euro bonds and 144A securities, such distribution strength has to be mainly with institutional investors while in public offers, it has to extend to retail investors as well. Since the investment banker and the other syndicate members perform the role of underwriters, their financial standing and past track record needs to be assessed as well. For non-US companies, the investment banking team should have the additional experience of listing foreign companies in the US markets. Indian companies generally appoint a domestic investment banker to act as an advisor to the issue from India who would advise and help in identification of the foreign investment bank that would lead manage the issue. The other important issue team members are the lawyers, the accountants, the depository bank and the domestic custodian bank. Selecting each of these team members would generally be done in consultation with the investment banker who would be the lead manager for the issue. Domestic custodian bank is generally selected on the basis of their presence in the custodial business and their working relationship with the proposed global depository bank abroad. The law firm plays a very vital role in being the issuer’s attorney to deal with the SEC, the NASDR, the stock exchange and the local state securities authorities. Unlike in India where the investment banker prepares and files the offer document with SEBI and interfaces on behalf of the company, this function is performed for a global issue by the issuer’s attorney. It would be advisable to hire a full service law firm that has capabilities in not just public issue regulations but in attendant matters such as intellectual

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Investment Banking

property protection, labour and environmental law, industry and corporate law, state and local regulations, tax matters etc. The accounting firm for a US public offer has to be a member of the American Institute of Certified Public Accountants (AICPA) and additionally be a part of the AICPA’s SEC Practice Section. One of the important documents furnished by the accountants apart from re-statement of accounts as per the relevant GAAP would be to furnish ‘Comfort Letter’ on the unaudited financial data appearing in the prospectus and its compliance with the relevant GAAP. The depository is usually a large banking corporation or a trust company. The Bank of New York is the leading depository bank in USA managing substantially more depository receipt programs than any other depository bank. The other important steps in floating of an overseas capital market offered by an Indian company are listed below: 1. The first step would be to get the proposal for an overseas issue approved by the board of directors and seek necessary approval from the shareholders in general meeting under the relevant provisions of the Companies Act. For the issue of euro bonds and FCCBs, the provisions are similar to the issue of debentures. The requirements for equity issues have already been discussed in Chapter 5 and for debt issues in Chapter 7. 2. The next step is to seek regulatory clearances in India if required. For the issue of bonds and FCCBs, necessary approval is required based on the applicable policy for ECBs in force at that time. These aspects have already been discussed. For the issue of ADRs/GDRs, approval would be required only if they do not fall under the automatic route discussed earlier in this Chapter. The approval from the RBI/GOI would be subject to conditions that may be prescribed in the approval which need to be complied with, for proceeding with the issue. 3. Other approvals that would be required are as follows: �

�

�

The stock exchanges would have to be informed of the euro issue/US public issue before the board meeting, after the board meeting and on completion of the issue so that the fresh issue of underlying shares can be made to the domestic custodian. A copy of the euro issue prospectus should be filed with SEBI for the purpose of record. No RBI approval would be required for issue of shares and receipt of remittances from abroad on the ADRs/GDRs if these are covered under

Overseas Capital Market Issues

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the automatic route under FEMA as discussed in paragraph 4.5. Otherwise, suitable approvals need to be taken for the same. �

Approval from the DCA would be required for FCCBs under section 81(3)(b) of the Companies Act and for issue of shares to the domestic custodian without the issue of a prospectus in India in terms of section 56.

4. The next step would be to appoint the lead managers for the offer abroad and advisors in India. In parallel, the other issue team members such as colead managers or underwriters, issuer’s attorney law firm, independent auditors and depository bank need to be appointed. The issuer company and the lead manager have to sign a letter of intent stating the issue parameters, fee structure and other details as required. 5. The preparation of the registration statement has to be commenced at the earliest. As stated, the law firm has to be involved completely on the drafting of the narrative with vital information being provided by the company and the lead managers. The company’s business details, the MDA, the offer structure and other important sections need to be drafted as per the requirement of the SEC on one hand and from the marketability of the issue on the other. It may be appreciated that the prospectus is also the only marketing literature for the issue. 6. While the attorneys are busy with the preparation of the prospectus, the investment banker and the accountants conduct the process of due diligence for the issue. The investment banker will examine the company’s management, nature of business and operations, financial position, past performance, competitive strengths and the stated business plan for the future. Incidental issues such as supply chain dynamics, customer relationships, labour relations etc. would also be examined since they have a bearing on the performance of the company. The accountants will examine financial information and all material supporting documents such as contracts, invoices, legal agreements, vouchers and other evidence in assessing the fairness of the accounting statements. Accounting policies and adherence to the relevant GAAP is examined in great detail. 7. After the filing of the registration statement (preliminary prospectus) with the SEC in the case of a US public offering, it would be available for circulation among potential investors. The syndicate members are then assembled for a closed-door meeting to assess their interest and the extent

380

Investment Banking

of allocations that need to be made. This meeting will establish the marketability of the issue as well. 8. The road shows are commenced with the help of the investment banking team and a series of meetings are held with potential investors and analysts in all key financial centres where the issue is being floated or where the potential investors are located. The road show usually consists of formal presentations and question answer sessions, followed by oneto-one interactive meetings set up by the investment bankers and their affiliates. 9. The prospectus has to be then revised according to the observations made by the SEC and the NASDR. Upon the completion of this process, the SEC would state that the registration statement can be made effective from a particular date. The preliminary prospectus would then be circulated at least two days before such effective date and thereafter; the final prospectus goes into print. 10. Unlike in India where the public offer is priced at its cut-off before filing with the ROC, in the US the offer is priced a day before the effective date upon the recommendations of the investment banker. The pricing is a function of the response to the road shows, the timing of the issue, the economic and market conditions and the company’s selling points. The law firm of the issuer files the final registration statement with the SEC by including the offer price. The accounting firm delivers the final comfort letter. The investment banker and the syndicate of underwriters sign the underwriting contracts. 11. On the opening day, the trading of the company’s securities begins. The prospective investors are given a fixed time usually, five to seven days for responding to the offer. Based on the responses received, the subscriptions lists are drawn up and the over-subscription is determined. The allocations are made on a proportionate basis. The first closing happens around the fifth day from the opening date and the second closing by the eighth day. Based on the subscriptions received, the accounting firm delivers the ‘bring-down’ comfort letter to re-affirm what is stated in the comfort letter issued earlier. The lead manager transfers the amounts received from subscriptions to the issuer company after deducting underwriting and selling commissions. The law firm has to update the closing documents.

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8.7 Case Studies 8.7.1 Offer Structure of Videsh Sanchar Nigam Ltd.—Offering of GDRs Representing Equity Shares (US$ 527 mn GDR Issue) 1997 The Offering9 The Offering

32,130,000 GDRs representing 16,065,000 Offered Shares (assuming that the Managers’ Option is not exercised) are being offered outside India. Of such aggregate number of GDRs, 24,330,000 GDRs representing 12,165,000 Offered Shares are being offered by the Company and 7,800,000 GDRs representing 3,90,000 Offered Shares are being offered by the Government of India. The Offered Shares represented by the GDRs being offered by the Government of India are registered in the name of the President of India. GDRs are being offered in the United States only to QIBs as defined in Rule 144A under the Securities Act in reliance on Rule 144A and outside the United States and India in offshore transactions in reliance on Regulation S under the Securities Act. GDRs are not being offered in India.

The Shares

Equity shares of the Company, face value Rupees 10 per share.

The GDRs

Each GDR represents one-half of one share. The GDRs will be issued by The Bank of New York, as depository ( the ‘Depository’) pursuant to the Deposit Agreement, dated as of March 27, 1997 (the ‘Deposit Agreement’), to be entered into between the Company and the Depository. The Offered Shares will be deposited The Industrial Credit and Investment Corporation of India Ltd. as the custodian for the Depository (the ‘Custodian’). The deposited shares may not be withdrawn from the depository facility until 60 days after the later of the commencement of the Offering and the last issue date of the GDRs, subject to certain limited exceptions. Once withdrawn, Shares cannot be re-deposited under the Deposit Agreement. The effect of such transaction will be to reduce the number of outstanding GDRs. In addition, Shares acquired in the open market may not be deposited under the Deposit Agreement. GDRs sold in reliance on Regulation S under the Securities Act (the ‘Regulation S GDRs’) will be represented by a Master Regulation S GDR (the ‘Master S Regulation GDR’) and GDRs sold in reliance on Rule 144A under the Securities Act (the ‘Rule 144A GDRs’) will be represented by a Master Rule 144A GDR (the ‘Master Rule 144a GDR’) and together with the Master Regulation S GDR (the ‘Master GDRs’). Except in limited circumstances described herein, GDRs in definitive

382

Investment Banking registered form will not be issued in exchange for interests in the GDRs represented by the Master GDRs. Subject to the terms of the Deposit Agreement, interests in the terms of the Deposit Agreement, interests in the Master Rule 144A GDR may be exchanged for interests in the corresponding number of GDRs represented by the Master Regulation S GDR and vice versa. The GDRs and the Offered Shares represented thereby are subject to restrictions on transfer.

Price

US$ 13.93 per GDR

Manager's Option

The Company has granted to the Managers an option, exercisable from the date of closing of this Offering Memorandum until 30 days after the Closing Date, to acquire upto 5,670,000 additional GDRs, representing 2,835,000 additional shares.

Equity Shares Issued and Fully Paid

Before the Offering: 80,000,000 Shares

After the Offering: 92,165,000 Shares, assuming the Manager's option is not exercised. Use of Proceeds

The net proceeds of the Offering (after deduction of the applicable management and underwriting commission and selling concession, stamp duty and estimated expenses payable by the Company) are estimated to be approximately US$ 434,975,000 assuming the Manager's option is not exercised. The Company intends to use its share of the net proceeds of the Offering (estimated to be approximately US$ 329,255,000 assuming the Manager's option is not exercised) to expand its international services and other telecommunications infrastructure and to make additional investments in telecommunication projects, principally under its Ninth Five Year Plan, as well as for general corporate purposes. The Company will not receive any proceeds from the GDRs offered by the Government of India.

Lock-up Period

The Company and the Government of India have agreed to certain restrictions on their ability to issue or dispose off Shares and certain related securities during a period of none months following the date of the Underwriting Agreement (as defined herein). Such restrictions do not apply to contemplated offerings by the Government of India of upto 690,000 Shares in the domestic market and of upto 600,000 Shares to employees of the Company, both scheduled to take place in 1997.

Dividends

Holders of GDRs will be entitled to receive dividends with respect to the underlying Offered Shares to the same extent as the holders of outstanding Shares except that holders of GDRs will not be entitled to any dividend for the financial year ending 31st March 1997. Cash dividends, if any, on the Offered Shares will be paid to the Depository in Rupees

Overseas Capital Market Issues

383

after deduction of applicable withholding taxes and except in certain circumstances, will be converted by the Depository into Dollars and paid to the holders of the GDRs (less the Depository's fees and expenses). Voting Rights

Holders of GDRs will have no voting rights with respect to the Offered Shares while they are represented by such GDRs. The Depository will, if permitted by law and subject to certain other conditions, exercise voting rights with respect to Shares represented by GDRs in accordance with the direction of the Board of Directors of the Company as conveyed by the Chairman thereof. Registered holders of Shares withdrawn from the depository facility will be entitled to vote and exercise other direct shareholder rights in accordance with applicable Indian law, subject to certain restrictions.

Listing and Trading

Application has been made to list the GDRs on the London Stock Exchange. The GDRs are expected to be eligible for quotation through SEAQ International and in the PORTAL market. The outstanding Shares (including the Offered Shares being offered by the Government of India) are listed on the Indian Stock Exchanges. Application has been made to list the Offered Shares being offered by the Company on the BSE and the other Indian Stock Exchanges. The Company has received approval in principle to list such offered Shares on each of these exchanges.

Settlement

The Master Regulation S GDR and the Master Rule 144A GDR will be registered in the name of Cede & Co., as nominee of DTC (Deposit Trust Company). The Master Regulation S GDR wil be held by DTC for the accounts of Euroclear and Cedel Bank. The Company will request that DTC not effect book-entry deliveries of Regulation S GDRs evidenced by the Master Regulation S GDR (except deliveries to or between DTC participant accounts maintained by the banks that act as depositories for Euroclear and Cedel Bank or to or between such accounts and the Depository) during the 40 day period beginning on the latest of (i) the commencement of the Offering, (ii) the original issue date of the GDRs and (iii) the issue date with respect to the additional GDRs, if any, issued pursuant to the Manager's option in connection with the Offering (the 'Restricted Period'). Each person owning a beneficial interest in the Master Rule 144A GDR or the Master Regulation S GDR must rely on the procedures of DTC and institutions having agreements with DTC ('DTC Participants'), including Euroclear and Cedel Bank, to exercise or to be entitled to any rights of a Rule 144A GDR holder or a Regulation S GDR holder, as the case may be. So long as any GDRs are traded through DTC's book-entry system or unless otherwise required by law, ownership of beneficial interests in the Master Regulation S GDR or the Master Rule 144A GDR will be shown on, and transfer of such ownership will be effected only through, records maintained by DTC or its

384

Investment Banking

nominee (with respect to DTC Participants’ interests) or DTC participants including Euroclear and Cedel Bank. It is expected that the GDRs will be accepted for clearance through the facilities of DTC, Euroclear and Cedel Bank.

8.7.2 Offer Structure of Sterlite Industries (India) Ltd.—Offering of 3.5% Convertible Bonds due 1999 convertible into GDRs (US$ 100 mn FCCB issue) 1993 The Offering10 The Issue

US$ 90,000,000 Convertible Bonds due 1999 are convertible into GDRs each representing one equity share with nominal value of Rs. 10 each of the Company. The Company has granted to Robert Fleming on behalf of the Managers an option, to cover over-allotments, exercisable on or before the business day prior to the Closing Date, to subscribe for additional Bonds in the aggregate principal amount of US$ - 000,000. The Securities have not been and will not be registered under the Securities Act and are being offered and sold in the United States exclusively to a limited number of persons reasonably believed by Robert Fleming to be QIBs within the meaning of Rule 144A under the Securities Act and outside the United States by the Managers in reliance upon Regulation S thereunder.

Conversion Period From 22nd March, 1994 up to and including 31st May, 1999. Conversion Price11 Rs --, subject to adjustments for, among other things, sub-division or consolidation of Shares, bonus issues, rights issues and other dilutive effects. Negative Pledge

The Company will give a negative pledge relating to itself in relation to Relevant Debt. ‘Relevant Debt’ means any present or future indebtedness of the Company or any other person which is in the form of, or represented by, bonds, notes, debentures, loan stock or other securities which are for the time being or are capable of being quoted, listed or ordinarily dealt in on any stock exchange, over-the-counter or other organized securities market and which is denominated or payable or confers a right to make or receive any payment in or by reference to any currency other than Rupees.

Final Redemption Unless previously redeemed, purchased and cancelled or converted, the Bonds will be redeemed on 30th June, 1999.

Overseas Capital Market Issues

385

Redemption at the option of the Company

The Bonds may not be redeemed by the Company prior to 30th June, 1996 (except in an event of default or for tax reasons) and may only be redeemed thereafter if the Closing Price of the Shares on the BSE has been at atleast 130 percent of the Conversion Price for a period of 30 consecutive days prior to redemption.

Tax Redemption

The Company may redeem all, but not some only, of the Bonds at their principal amount plus accrued interest, in the event of certain changes in Indian taxation which would require the Company to gross up for payments of principal or to gross up for payment of interest at a rate exceeding 10 percent.

Form and Denomination

The Bonds will be in registered form in the denomination of US $ 5000. A single Global Certificate, registered in the name of the Common Depository or its nominee, will be issued in respect of the Bonds and will be deposited on the Closing Date with the Common Depository. Title to the Bonds will be registered in the name of the Common Depository. The issue of Bond Certificates evidencing registration of title to the Bonds in a name other than the Common Depository will be permitted only in very limited circumstances. The GDRs will be in registered form represented by a European Master GDR, registered in the name of the Common Depository or its nominee and an American Master GDR registered in the name of DTC or its nominee.

Listing of Bonds, The existing issued Shares are listed on the BSE (the main trading mar GDRs and Shares ket for the Shares) and three other stock exchanges in India - the Stock Exchanges of Ahmedabad, Calcutta and Delhi. The Company will apply to have the Shares arising on conversion of the Bonds listed on such stock exchanges. Application has been made to list the Bonds and the GDRs on the Luxembourg Stock Exchange. Governing Law

English Law.

Trustee

Bankers Trustee Company Limited.

8.7.3 Offer Structure of Dr. Reddy’s Laboratories Ltd.—Offering of American Depository Shares representing Equity Shares (US$ 115.46 mn ADS issue) 2001 The Offering American Depository Shares Offered by us...........

11,500,000 American depository shares.

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ADSs……………

Each American depository share represents one half of one equity share, par value Rs. 10/- per Share. American depository shares represent ownership interests in securities that are on deposit with the depository. The American depository shares will be evidenced by American Depository receipts. See ‘Description of Equity Shares’ and ‘Description of American Depository Shares’.

Equity shares outstanding after the offering……

37,338,780 equity shares

Use of proceeds……….

We estimate that the net proceeds from this offering without exercise of the over-allotment option will be approximately US$ 106.1 million. We intend to use these net proceeds as follows: �

Approximately US$ 30 million for drug discovery and development.

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Approximately US$ 75 million for acquisitions and/or the establishment of marketing operations. We plan to acquire a US generic pharmaceutical company or establish marketing operations to strengthen our presence in the US generic market and/or acquire one or more Indian pharmaceutical companies, and

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the balance for working capital and general corporate purposes.

Risk factors

See ‘Risk Factors’ and other information included in this document for a discussion of factors you should carefully consider before deciding to invest in our ADSs.

NYSE symbol……….

‘RDY’

The number of equity shares outstanding after the offering assumes that the underwriters’ over allotment option is not exercised. If the over-allotment option is exercised in full, we will issue and sell an additional 862,500 equity shares in the form of 1,725,000 ADSs.

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8.8 Conclusion With more and more countries getting integrated into the global economy either partially or fully, the growth of the international capital in size and importance seems certain in the years to come. Its importance for India and Indian investment banks cannot be over-emphasized. There would be more Indian companies going overseas for listing and raising capital from overseas capital market both in the debt and equity routes. Indian investment banks would do well to look for strengths and synergies in providing comprehensive issue management and ancillary services to Indian companies for overseas capital market offers in the years to come.

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Notes 1. For a complete discussion on Foreign Bonds, please refer to Global Capital Markets: Shopping for Finance by P.R. Joshi, 2001, Tata McGraw-Hill Publishing Co., New Delhi. 2. AP (DIR Series) Circular No. 21 dated February 13, 2002 issued by the RBI. 3. AP (DIR Series) Circular No. 52 dated November 23, 2002 issued by the RBI. 4. Circular No. F. No. 15/7/99-NRI dated 16th April 2001 issued by the Ministry of Finance, Department of Economic Affairs. 5. Press Note from Ministry of Finance, Department of Economic Affairs (Investment Division) Ref. F. No. 15/7/99-NRI dated 19-1-2000. 6. Press Note F. No. 15/4/2002-NRI dated 8th July, 2002 issued by the Ministry of Finance, Department of Economic Affairs, Investment Division. 7. Circular No. FEMA. 41/2001-RB dated 2nd March 2001 issued by the RBI. 8. AP (DIR Series) Circular No. 29 dated March 11, 2002 issued by the RBI. 9. Extracted from the Offering Memorandum dated March 24, 1997. 10. Extracted from the Preliminary Prospectus dated 7th December, 1993. 11. Since this extract is from the Preliminary Prospectus, the pricing is not mentioned. The issue was made at a price of US$ 17.88 per FCCB.

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� Select References and Suggested Readings 1. Global Financial Markets—Ian H. Giddy, Houghton Mifflin Company, 1997 published in India by A.I.T.B.S. Publishers and Distributors. 2. Going Public and Listing on the U.S. Securities Markets—Official publication of The NASDAQ Stock Market, Inc.- 2001. 3. High Finance in the Euro Zone—Competing in the new European Capital Market— Ingo Walter and Roy Smith, Financial Times-Prentice Hall, Pearson Education Limited, 2000. 4. International Finance—P.G. Apte, Tata McGraw Hill Publishing Company Ltd., 2003. 5. SEBI, Capital Issues, Debentures & Listing—K. Sekhar, Wadhwa and Company, Third Edition 2003. 6. Management Accounting and Financial Analysis—Final Course reading, Board of Studies, The Institute of Chartered Accountants of India. 7. Interested readers may refer to www.adrbny.com which is a leading source for international ADR and GDR market intelligence and investor information.

� Self-Test Questions 1. What is the eurobond market? What are the other segments of international bond markets? Which is the segment that is most suitable to Indian corporates? 2. What is Rule 144A market? Is it beneficial to issuers? 3. How is a GDR different from an ADR? Can a ADR be issued in the Rule 144A market? 4. How does the depository mechanism function? What is fungibility and reverse fungibility and how do these work? 5. What are the operative guidelines in India for fungibility and reverse fungibility of ADRs/GDRs? 6. What is the process flow for an overseas capital market float from India?

� Annexure I

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EXTRACTS FROM THE OFFER DOCUMENT OF Dr. REDDY’S LABORATORIES LTD. ADS ISSUE Description of American Depository Shares

American Depository Receipts Morgan Guaranty Trust Company has agreed to act as depository for the American depository shares that we are offering. American depository shares are commonly referred to as ADSs and represent ownership interests in securities that are on deposit with the depository. ADSs are normally represented by certificates that are commonly known as American depository receipts, or ADRs. Each ADS will represent an ownership interest in one-half of share which we will deposit with the custodian, as agent of the depository, under the deposit agreement among ourselves, the depository and yourself as an ADR holder. In the future, each ADS will also represent any securities, cash or other property deposited with the depository but not distributed by it directly to you. Morgan Guaranty Trust Company’s office is located at 60 Wall Street, New York, New York 10260. You may hold ADSs either directly or indirectly through your broker or other financial institution. If you hold ADSs directly, by having an ADS registered in your name on the books of the depository, you are an ADR holder. This description assumes you hold your ADSs directly. If you hold the ADSs through your broker or financial institution nominee, you must rely on the procedures of such broker or financial institution to assert the rights of an ADR holder described in this section. You should consult with your broker or financial institution to find out what those procedures are. Because the depository’s nominee will actually be the registered owner of the shares, you must rely on it to exercise the rights of a shareholder on your

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behalf. The obligations of the depository and its agents are set out in the deposit agreement. The deposit agreement and the ADSs are governed by New York law. The following is a summary of the material terms of the deposit agreement. Because it is a summary, it does not contain all the information that may be important to you. For more complete information, you should read the entire deposit agreement and the form of ADR which contains the terms of your ADSs. You can read a copy of the deposit agreement which is filed as an exhibit to the registration statement of which this prospectus forms a part. You may also obtain a copy of the deposit agreement at the SEC’s Public Reference Room which is located at 450 Fifth Street, N.W., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-732-0330.

Share Dividends and Other Distributions We may make various types of distributions with respect to our securities. The depository has agreed to pay to you the cash dividends or other distributions it or the custodian receives on shares or other deposited securities, after deducting its and custodian expenses. You will receive these distributions in proportion to the number of underlying shares your ADSs represent. Except as stated below and to the extent the depository is legally permitted, it will deliver such distributions to ADR holders in proportion to their interests in the following manner.

Cash The depository will distribute any US dollars available to it resulting from a cash dividend or other cash distribution if this is practicable and can be done on a reasonable basis. The depository will attempt to distribute this cash in a practicable manner, any may deduct any taxes required to be withheld, any expenses of covering foreign currency and transferring funds to the United States and other expenses and adjustments. In addition therefore making a distribution the depository will deduct any taxes that may be withheld.

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Shares In the case of distribution in shares, the depository will issue additional ADRs to evidence the number of ADSs representing such shares. It will only issue whole ADSs. The depository will sell any shares which would result in fractional ADSs and distribute the net proceeds to the ADR holders entitled to them.

Rights to Receive Additional Shares In the case of distribution of rights to subscribe for additional shares or other rights, if we provide satisfactory evidence that the depository may lawfully distribute such rights, the depository may arrange for ADR holders to instruct the depository as the to exercise of these rights. However, if we do not furnish that evidence or if the depository determines it is not practicable to distribute the rights, the depository may; �

sell the rights if practicable and distribute the net proceeds as cash, or

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allow the rights to lapse, in which case ADR holders will receive nothing.

We have no obligation to file a registration statement under the Securities Act in order to make any rights available to ADR holders.

Other Distributions In the case of a distribution of securities or property other than those described above, the depository may either. �

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Distribute those securities or property in any manner it deems equitable and practicable, To the extent the depository deems distribution such securities or property not to be equitable and practicable, sell those securities and distribute any net proceeds in the same way it distributes each, or Hold the distributed property, in which case the ADSs will also represent the distributed property.

Any US dollars will be distributed by cheques drawn on a bank in the United States for whole dollars and cents (fractional cents will be wished without liability for interest and added to future cash distributions).

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The depository may choose any practical method of distribution for any specific ADR holder, including the distribution of foreign currency, securities or property, or it may retain those items, without paying interest on or investing them, on behalf of the ADR holder as deposited securities. The depository is not responsible if it decides that it is unlawful or impractical to make a distribution available to any ADR holders. We cannot assure you that the depository will be able to convert any currency at a specified exchange rate or sell any property, rights, shares or other securities at a specified price, or that any of those transactions could be completed within a specified time period.

Deposit, Withdrawal and Cancellation The depository will issue ADSs upon the deposit of shares or evidence of rights to receive shares with the custodian. In the case of the ADSs to be issued under this prospectus, we will arrange with the underwriters named in this prospectus to deposit the shares. Except for shares that we deposit, no other shares may be deposited by persons located in India, residents of India or for, or on the account of, such persons. Under current Indian Laws and Regulations, the depository cannot accept deposits of outstanding shares and issue ADRs evidencing ADRs representing these shares without prior approval of the Government of India. However, an investor in ADSs who surrenders an ADS and withdraws shares will be permitted to redeposit those shares in the depository facility in exchange for ADSs. In addition, the depository will be permitted to accept deposits of outstanding shares and issue ADSs representing those shares, but only in a number that does not exceed the number of underlying shares that have been withdrawn from and not redeposit into the depository facility. Shares deposited in the future with the custodian must be accompanied by documents, including instruments showing that such shares have been properly transferred or endorsed to the person on whose behalf the deposit is being made. After the closing of the offering to which this prospectus relates, unless otherwise agreed by the depository and ourselves and permitted by applicable law, only the following may be deposited with the depository or custodian:

Overseas Capital Market Issues �

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Shares issued as a dividend or free distribution in respect of deposited securities, Shares subscribed for or acquired by holders from us through the exercise of rights distributed by us to such persons in respect of shares, and Securities issued by us as a result of any change in par value, subdivision, consolidation and other reclassification of deposited or otherwise.

We will inform the depository if any of the shares permitted to be deposited do not rank equally with the shares issued in this offering and the depository will arrange for the ADSs issuable with respect to such shares to be differentiated from those issued in this offering until time they rank equally with the shares issued in this offering. The custodian will hold all deposited shares (including) those being deposited by or on our behalf in connection with the offering to which this prospectus relates for the account of the depository. ADR holders thus have no direct ownership interest in the shares and only have the rights set out in the deposit agreement. The custodian will also hold any additional securities, property and cash received on or in substitution. The deposited shares and any such additional items are referred to as ‘deposited securities’. Upon each deposit of shares, receipt of related delivery documentation and compliance with the other provisions of the deposit agreement, including the payment of the fees and charges of the depository and any taxes or other fees or changes owing, the depository will issue an ADR or ADRs in the name of the person entitled to them evidencing the number of ADSs which that person is entitled. Certificated ADRs will be delivered at the depository’s principal New York office or any other location that it may designate as its transfer office. You may not surrender ADRs for withdrawal prior to 45 days after the final closing of the transactions to which this prospectus relates. After that period, when you turn in your ADRs at the depository’s office, the depository will, upon payment of applicable fees, charges and taxes, and upon receipt of proper instructions, deliver the underlying shares at the custodian’s office. At your risk, expense and request, the depository may deliver deposited securities at other places that you may request.

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The depository may only restrict the withdrawal of deposited securities in connection with: �

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Temporary delays caused by closing our transfer books or those of the depository or the deposit of shares in connection with voting at a shareholders’ meeting or the payment of dividends, The payment of fees, taxes and similar charges, or Compliance with any US or foreign laws or governmental regulations relating to the ADRs or to the withdrawal of deposited securities.

US securities laws provide that this right of withdrawal may not be limited by any other provision of the deposit agreement. Unless applicable law changes, once you have withdrawn shares, you may not redeposit them under the deposit agreement. If you withdraw the shares evidenced by your ADSs, you will be charged a stamp duty which is currently 0.5% of the market value of the shares you will be charged of such withdrawn shares. However, you will not be required to pay that stamp duty for transfer of shares held in dematerialized form. Any subsequent transfer of shares you make after withdrawal will require the approval of the Reserve Bank of India, which approval must be obtained by the person you sell to under provisions of the Foreign Management Regulation Act, 1999 unless the transfer is made on a stock exchange or in connection with an offer under the Indian takeover regulations.

Voting Rights If you are an ADR holder and the depository asks you to provide in with voting instructions, you may instruct the depository as to how to exercise the voting rights for the shares which underlie your ADSs. After receiving voting materials from us, the depository will notify the ADR holders of any shareholder meeting or solicitation of consents or proxies. This notice will describe how you may instruct the depository to exercise the voting rights for the shares which underlie your ADSs. For instructions to be valid, the depository must receive them on or before the date specified. The depository will try, as far as is practical, subject to the provisions of the underlying shares or other deposited securities, to vote or to have its agents vote the shares or other deposited securities as your instruct. The depository will only vote or attempt to vote as you instruct. The depository will not itself exercise any voting discretion. Neither the depository not its agents are responsible for any failure to carry out any voting instructions, for the manner in which any vote is cast or for the effect of any vote.

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We cannot guarantee that you will receive voting materials in time to instruct the depository to vote and it is possible that you will not have the opportunity to vote. If you hold your ADSs through brokers, dealers or other third parties, you will have even less time to instruct the depository to vote.

Record Dates The depository may fix record dates for the determination of the ADR holders who will be entitled. � �

To receive a dividend, distribution or rights, or To give instructions for the exercise of voting rights at a meeting of holders of ordinary shares or other deposited securities.

Reports and Other Communications The depository will make available for inspection by ADR holders any written communications from us which are both received by the custodian or its nominees as a holder of deposited securities and made generally available to the holders of deposited securities. These communications will be furnished by us in English.

Fees and Expenses The depository will charge ADR holders a fee for each issuance of ADSs, including issuance resulting from distributions of shares, rights and other property, and for each surrender of ADSs in exchange for deposited securities. The fee in each case is US$ 5.00 for each 100 ADSs (or any portion thereof) issued or surrendered. The depository may also charge ADR holders or persons depositing shares: � �

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Stock transfer or other taxes and governmental charges, Cable, telex and facsimile transmission and delivery charges incurred at your request. Transfer or registration fees for the registration of transfer of deposited securities on any applicable register in connection with the deposit or withdrawal of deposited securities, and

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Expenses of the depository in connection with the conversion of foreign currency into US dollars.

We will pay all other charges and expenses of the depository and any agent of the depository (except the custodian) pursuant to agreements from time to time between us and the depository. The fees described above may be amended by the depository from time to time.

Payment of Taxes ADR holders must pay any tax or other governmental charge payable by the custodian or the depository on any ADS or ADR, deposited security or distribution. If an ADR holder owes any tax of other governmental charge, the depository may: � �

Deduct the amount thereof from any cash distributions, or Sell deposited securities and deduct the amount owing from the net proceeds of such sale.

In either case the ADR holder remains liable for any shortfall. Additionally, if any tax or governmental charge is unpaid, the depository may also refuse to effect any registration, registration of transfer, split-up or combination of deposited securities or withdrawal of deposited securities (except under limited circumstances mandated by securities regulations). If any tax or governmental charge is required to be with held on any non-cash distribution, the depository may sell the distributed property or securities to pay those taxes and distribute any remaining net proceeds to the ADR holders entitled to them.

Reclassifications, Recapitalizations and Mergers If we take actions that affect the deposited securities, including (1) any change in par value, split-up, consolidation, cancellation or other reclassification of deposited securities or (2) any recapitalization, reorganization, merger, consolidation, liquidation, receivership, bankruptcy or sale of all or substantially all of our assets, then the depository may choose to: �

Amend the form of ADR,

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Distribute additional or amended ADRs,

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Distribute cash, securities or other property it has received in connection with such actions, Sell any securities or property received and distribute the proceeds as cash, or Take no action.

If the depository does not choose any of the above options, any of the cash, securities or other property it receive will constitute part of the deposited securities and each ADS will then represent a proportionate interest in that property.

Amendment and Termination We may agree with the depository to amend the deposit agreement and the ADSs without your consent for any reason. ADR holders must be given at least 30 days notice of any amendment that imposes or increases any fees or charges (other than stock transfer or other taxes and other governmental charges, transfer or registration fees, cable, telex or facsimile transmission costs, delivery costs or other such expenses or affects any substantial existing right of ADR holders. If an ADR holder continues to hold an ADR or ADRs after being notified of these changes, the ADR holder will be considered to have agreed to such amendment. Notwithstanding the foregoing, an amendment can become effective before notice is given if this is necessary to ensure compliance with a new law, rule or regulation. No amendment will impair your right to surrender your ADSs and receive the underlying securities. If a governmental body adopts new laws or rules which require the deposit agreement or the ADS to be amended, we and the depository may make the necessary amendments, which could take effect before you receive notice of them. The depository may terminate the deposit agreement by giving the ADR holders at least 30 day prior notice, and it must do so at our request. After termination, the depository’s only responsibility will be (i) to deliver deposited securities to ADR holders who surrender their ADRs, and (ii) to hold or sell distributions received on deposited securities. As soon as practicable after the expiration of six months from the termination date, the depository will sell the deposited securities which remain and hold the net proceeds of such sales, without liability for interest, in trust for the ADR holders who have not yet surrender their ADRs. After making those sales, the depository shall have no obligations except to account for the proceeds of sale and

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other cash. The depository will not be required to invest such proceeds or pay interest on them.

Limitations or Obligations and Liability to ADR Holders The deposit agreement expressly limits the obligations and liability of the depository, ourselves and our respective agents. Neither we nor the depository nor any such agent will be liable if: �

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A change in law or regulation governing the deposited securities, an act of God, war or other circumstances beyond our control prevent, delay or subject to any civil or criminal penalty any act which the deposit agreement or the ADRs provide shall be done or performed by any one of us, We exercise or fail to exercise any discretion under the deposit agreement or the ADR, We perform our obligations without gross negligence or bad faith, We take any action or inaction in reliance upon the advice of or information from legal counsel, accountants, any person presenting shares for deposit, any registered holder of ADRs, or any other person believed by it to be competent go give such advice or information, or It relies upon any written notice, request, direction or other document believed by it to be genuine and to have been signed or presented by the proper party or parties.

Neither the depository nor its agents have any obligation to appear in, prosecute or defend any action, suit or other proceeding in respect of any deposited securities or the ADRs. It and its agents are only obligated to appear in, prosecute or defend any action, suit or other proceeding in respect of any deposited securities or the ADRs, which in its opinion may involve it in expense or liability, if indemnify satisfactory to it against all expense (including fees and disbursements of counsel) and liability is furnished as often as it requires. The depository will not be responsible for failing to carry out instructions to vote the deposited securities or for the manner in which the deposited securities are voted or the effect of the vote. The depository may own and deal in deposited securities and in ADSs.

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Disclosure of Interest in ADSs We may from time to time request you and other holders and beneficial owners of ADSs to provide information as to: �

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The capacity in which you and other holders and beneficial owners own or owned ADSs. The identity of any other persons then or previously interested in such ADSs, and The nature of such interest and various other matters.

You agree to provide any information requested by us or the depository pursuant to the deposit agreement. The depository has agreed to use reasonable efforts to comply with written instructions received from us requesting that it forward any such requests to you and other holders and beneficial owners and to forward to us any responses to such requests to the extent permitted by applicable law. We may restrict transfers of the shares where the transfer might result in an ownership of shares in contravention of or exceeding the limits under the governmental approval which we received from the Indian government in connection with this offering, applicable law or our organizational documents. In such cases, we reserve the right to require you to deliver your ADSs for cancellation and withdrawal of the shares underlying such ADSs.

Additional Information and Reports to Security Holders We have filed with the Commission a registration statement on Form F-1 (including all amendments) of which this prospectus constitutes a part, under the Securities Act, with respect to the ADSs and the underlying shares we are offering. This prospectus does not contain all of the information set forth in the Registration Statement and the exhibits and schedules to the Registration Statement, certain portions of which have been omitted pursuant to the rules and regulations of the Commission, Statements made in this prospectus as to the contents of any contract, agreement or other document are not necessarily complete. With respect to each contract, agreement or other documents filed as an exhibit to the Registration Statement, reference is made to that exhibit for a more complete description of the matter involved, and each statement is qualified entirely by the reference.

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When the Commission declares the registration statement effective, we will be subject to the periodic reporting and other informational requirements of the Exchange Act, and accordingly will be required to file and furnish reports including annual reports on Form 20-F, reports on 6-K and other information with the Commission. The registration statement (with exhibits), as well as the reports and other information filed by us can be inspected and copied at the public reference facilities maintained by the Commission at Judiciary Plaza, 450 Fifth Street, N.W., Room 1024, Washington, D.C. 20549, and at the regional offices of the Commission at Seven World Trade Center, 13th Floor, New York, New York 10048; and at Northwestern Atrium Center, 500 West Madison Stre, Suite 1400, Chicago, Illinois 60661-2511. Copies of the materials can be obtained from the Public Reference Section of the Commission, 450 Fifth Street, N.W., Washington, D.C. 20549 at prescribed rates. The Commission also maintains a web site at http://www.sec.gov. that make electronic filing with the Commission. As a foreign private issuer, we will be exempt from the rules under the Exchange Act prescribing the furnishing and content of proxy statements, and our executive offices, directors and principal shareholders are exempt from the reporting and short-swing profit recovery provisions contained in Section 16 of the Exchange Act. Under the Exchange Act, we will not be required to publish consolidated financial statements as frequently or as promptly as United States Companies. However, we intend to furnish the depository with annual reports, which will include annual audited consolidated financial statements prepared in accordance with US GAAP, and quarterly reports, which will include unaudited quarterly consolidated financial information prepared in accordance with US GAAP. The depository has agreed without that, upon our request, it will promptly mail the reports to all registered holders of ADSs. We will also furnish to the depository all notices of shareholders’ meetings and other reports and communications that are made generally available to its shareholders. The depository will arrange for the mailing of these documents to record holders of ADSs.

Requirements for Depository Actions We, the depository or the custodian may refuse to �

Issue, register or transfer an ADR or ADRs.

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Effect a split-up or combination of ADRs.

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Deliver distributions on any such ADRs; or Permit the withdrawal of deposited securities (unless the deposit agreement provides otherwise) until the following conditions have been met: The holder has paid all taxes, governmental charges, and fees and expenses as required in the deposit agreement; The holder has provided the depository with any information it may deem necessary or proper, including, without limitation, proof of identity and the genuineness of any signature; and The holder has complied with such regulations as the depository may establish under the deposit agreement. The depository may also suspend the issuance of ADSs, the deposit of shares, the registration, transfer, split-up or combination of ADRs, or the withdrawal of deposited securities is closed or if we or the depository decides it is advisable to do so.

Books of Depository The depository or its agent will maintain a register for the registration, registration of transfer, combination and split-up of ADRs. You may inspect such records at the depository’s designated office during regular business hours. The depository will also maintain facilities to record and process the issuance, cancellation, combination, split-up and transfer of ADRs. These facilities may be closed from time to time, to the extent not required by law to remain open.

Pre-release of ADSs The depository may issue ADSs prior to the deposit with the custodian of shares (or rights to receive shares). This is called a pre-release of the ADSs. A pre-release is closed out as soon as the underlying shares (or other ADSs) are delivered to the depository. The depository may pre-release ADS only if: �

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The depository has received collateral for the full market value of the pre-released ADSs; and Each recipient of pre-released ADSs represents in writing that he or she

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Owns the underlying shares,

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Assigns all rights in such shares to the depository.

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Holds such shares for the account of the depository, and

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Will promptly deliver such shares to the custodian as soon as practicable, if the depository so demands.

In general, the number of pre-released ADSs will not constitute more than 30% of all ADSs outstanding at any given time (excluding those evidenced by pre-released ADSs). However, the depository may change or disregard such limit from time as it deems appropriate. The depository may retain for its own account any earnings on collateral for pre-released ADSs and its charges for issuance thereof.

The Depository Morgan Guaranty Trust Company of New York, a New York banking corporation, is a commercial bank offering a wide range of banking and trust services to its customers in the New York metropolitan area, throughout the United States and around the world.

Shares Eligible for Future Sale Sales of a substantial number of shares into the public market following the offering (whether on the Indian Stock Exchanges or into the United States market by conversion of outstanding shares into ADSs, if permitted in the future by the Government of India) could adversely affect the market price of the ADSs. Upon completion of the offering, 37,338,780 shares will be issued and outstanding, including 5,750,000 shares represented by 11,500,000 ADSs issued in connection with the offering. Of the 31,588,780 shares issued and outstanding prior to the issuance of the ADSs, holders of approximately 9.946,047 shares (including all shares held by directors and their families and executive officers) have agreed not to offer, sell, contract to sell, grant any option to purchase or otherwise dispose of, or agree to dispose of, any of these shares for a period of 180 days following the date of this prospectus. Merrill Lynch & Co. may release the shares from the lock-up in its sole discretion at any time and without prior public announcement. Substantially all of the shares that are not subject to lock-ups, will be freely tradable in India immediately all of the shares will be available for sale on the Indian stock exchanges. Sales

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of substantial amounts of shares, or the availability of the shares of sale, could adversely affect the market price of the ADSs. The equity shares underlying our GDSs may be traded freely pursuant to US securities law, although the GDSs may not. We are in the process of terminating the GDS facility, and the equity shares represented by GDSs may in the future become represented by ADSs.

� Annexure II

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EXTRACTS FROM THE INVITATION TO OFFER DATED JULY 12, 2003 TO THE EQUITY SHAREHOLDERS OF INFOSYS TECHNOLOGIES LIMITED THE TRANSACTION

On February 03, 2003, the Foreign Investment Promotion Board approved our sponsorship of the Offering as described herein. In addition, at an extraordinary general meeting held on February 22, 2003, our Equity Shareholders granted us the authority to sponsor the Offering described herein. You may offer any portion or all of your equity Shares, Provided such Equity Shares are free from any charge, lien or encumbrance of any kind whatsoever. You may participate in this Invitation, i.e. Offer as a Selling Shareholder by: (i) Submitting to Karvy Consultants Limited i.e. the Register, at its office in Bangalore, or to the collection centers of ICICI Bank Limited listed later in this Invitation, all the documents described in this Invitation, i.e. the Office Documents, that will constitute a valid Offer during the Offer Period as detailed in the Section entitled Procedure for Offer of Equity Shares, and (ii) Transferring such number of Equity Shares as you wish to Offer, to the dematerialized account, i.e. Escrow Account, opened by ICICI Bank Limited, i.e. the Escrow Agent. The Escrow Agent, will hold such Equity Share in trust on your behalf in accordance with the Escrow Agreement. On verification of the Offer Documents submitted by you, the Registrar will either retain or, in the case of improper Offer Documents, reject the Equity Shares tendered by you i.e. the Deposited Equity Shares and advise the Escrow Agent accordingly. The rejected Equity Shares will be returned to you. The decision of the Registrar in this regard will be final and binding on you. The Deposited Equity Shares retained by the Escrow Agent under this invitation will form the underlying Equity Shares for the Offering. If the total number of Deposited Equity Shares exceeds the number of underlying Equity Shares

Overseas Capital Market Issues

405

representing the ADSs actually sold in the offering, the Equity Shares to be accepted in the Offering will be determined on a proportionate basis using a formula based on RBI Guidelines, i.e. the Proportion Formula, and any excess Deposited Equity shares will be returned to you. The Offering will be registered with the US Securities and Exchange Commission, i.e. SEC, in accordance with the US Securities law requirements. A copy of the Preliminary Prospectus used by the underwriters to make the Offering and as filed with the SEC is available for inspection as detailed in the Section entitled Documents for Inspection. Equity Shareholders are cautioned that the information contained therein is not complete and may be modified. Upon the pricing of the Offering, the representatives of the underwriters to the Offering, Goldman Sachs (Asia) L.I.C., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Citigroup Global Markets Inc., i.e. collectively the Underwriters, will enter into an agreement on the terms and conditions therein, with us and you as the Selling Shareholders (represented by the Escrow Agent as your Attorney-in-Fact) i.e. the Underwriting Agreement, which will set forth the terms and conditions upon which the Offering will be conducted. The Offering will be co-managed by Deutsche Bank Securities and UBS Warburg. Upon pricing of the Offering, the Escrow Agent will deliver the Deposited Equity Shares to ICICI Bank Limited i.e. the Domestic Custodian, TO HOLD ON BEHALF OF Deutsche Bank Trust Company Americas, i.e. the International Depository, with instructions to the International Depository to issue ADSs to the Underwriters for the purposes of the Offering. Upon the delivery of the ADS investors and the Optional ADS (see the Section entitled Terms and Conditions of this Invitation), i.e. the Closing the Underwriters will remit the proceeds of the Offering less discounts and commissions charged by and expenses incurred by the Underwriters in connection with the Offering and this Invitation, to the Escrow Agent. The Escrow Agent will distribute such amounts (after deduction of applicable tax at source and other expenses incurred in connection with the Offering and this Invitation). i.e. the Consideration to you in proportion to the number of Deposited Equity Shares accepted in the offering. (See the Section entitled Terms Conditions of this invitation). To facilitate the process, we have entered into a Registrar and Transfer Agent Agreement dated May 14, 2003, i.e. the R & T Agent Agreement, with Karvy Consultants Limited as the Registrar, and an Escrow Agreement dated May 14, 2003 i.e. the Escrow Agreement, with the Registrar and ICICI Bank Limited as the Escrow Agent.

406

Investment Banking

The Escrow Agent, pursuant to the power of attorney contained in the enclosed Letter of Transmittal, will act as your ‘Attorney-in-Fact’ and will. (a) Enter into the Underwriting Agreement and execute such deeds or documents on your behalf as may be required in connection with the Offer and the Offering. (b) Deliver the Deposited Equity Shares held in the Escrow Account on your behalf to the Domestic Custodian and subsequently instruct the International Depository to issue ADSs to the Underwriters for purposes of the Offering, and (c) Upon the receipt of the Consideration from the under writers, distribute it amongst all the Selling Shareholders after such deductions in accordance with the terms of this Invitation and the Underwriting Agreement. (See the Section entitled Terms and Conditions of this Invitation). A copy of all documents mentioned above and other material documents will be available for inspection by you during the Offer Period, to enable you to make an informed decision. (See the Section entitled Documents for Inspection).

Terms and Conditions of this Invitation Persons Eligible to Participate All our Equity Shareholders holding fully paid up Equity Shares free from any charge, lien or encumbrance, of any kind whatsoever, and whose names appear on our register of members or on the register and index of beneficial owners maintained with the depository as on the date shareholders participate in this Invitation and Offer their Equity Shares in the manner prescribed under this Invitation. As the Equity Shares are in compulsory dematerialized, i.e., Demat, form, only Demat Equity Shares can be offered. Equity Shareholders in physical/certificate form should first convert their Equity Shares into Demat form. Such Equity Shareholders are requested to fill out the additional forms (sent only to Equity Shareholders holding Equity Shares in physical form) required to open Demat accounts and dematerialize their Equity Shares, and also provide details of their bank accounts. The Equity Shareholders should approach Karvy Consultants Limited to avail of this facility.

Overseas Capital Market Issues

407

Minimum Lot There is no minimum lot that has to be offered by you.

Offer Period To avail the facility in this Invitation, you may Offer your Equity Shares, together with the Offer Documents during business hours on business days during the period between the Offer Opening Date, and the Offer Closing Date, being the Offer Period. We may, in consultation with the Underwriters, change the Offer Opening Date or the Offer Closing Date or extend the Offer Period. Offer Documents received after the Offer Closing Date or Equity Shares credited into the Escrow Account after the Offer Closing Date, will be rejected.

Size of the Offer The minimum size for the entire Offer is 20,00,000 (twenty lakh) Equity Shares and the maximum size for the entire Offer is 30,00,000 (thirty lakhs) Equity Shares. Subject to the terms and conditions of the Underwriting Agreement and the maximum offer size of 30,00,000 Equity Shares, the Underwriters will have the option, i.e., the Over allotment Option, to buy additional ADSs representing up to 4,50,000 additional Equity Shares, i.e., the Optional ADSs. The Over allotment Option may be exercised within 7 days of the date of the final Prospectus being delivered with respect to the Offering. If any Optional ADSs are purchased, the Underwriters will pay the same price for those Optional ADSs as they paid for the initial number of ADSs sold. No assurances can be made that any Optional ADSs will be sold. The Underwriters may exercise the Overallotment Option to purchase any or all of the Optional ADSs entirely at their discretion.

Proportion Formula If the aggregate number of valid Deposited Equity Shares is equal to or less than the number of Equity Shares underlying the ADSs finally sold in the Offering, then all the valid Equity Shares Offered will be accepted. If the aggregate number of valid Deposited Equity Shares exceeds the size of the offering as determined by the Underwriters or the maximum offer size or the number of Equity Shares underlying the ADSs finally sold in the Offering (in the ratio

408

Investment Banking

of 2 ADSs being represented by 1 underlying Equity share), as the case may be, the Registrar will be entitled to apply the Proportion Formula in the following manner: i. Compute the Existing Shareholding of each Selling Shareholder as on the Offer Closing Date (including the Deposited Equity Shares you have tendered together with the valid Offer Documents to the Registrar during the Offer Period); ii. Determine the Proportion each Selling Shareholders’ Existing Sharehold-ing bears to the aggregate existing shareholding of all the Selling Shareholders as on the Offer Closing Date, i.e., such Selling Shareholder’s Proportion; iii. Compute the Proportionate Allocation i.e., the number of Deposited Equity to be accepted from each Selling Shareholder. This will be the rounded off product of (x) each Selling Shareholders’ Proportion and (y) the size of the offering as determined by the Underwriters or the maximum offer size or the number of Equity Shares underlying the ADSs finally sold in the Offering, as the case may be; iv. Subtract from the Proportionate Allocation, the shares in excess of the Deposited Equity Shares, i.e., the Excess Allocation Shares, of such selling Shareholders who, by virtue of their relative Proportion, have received a Proportionate Allocation in excess of their relative Proportion, have received a Proportionate Allocation in excess of their full Deposited Equity shares; v. Repeat steps (ii) through (v) in respect of the Excess Allocation Shares resulting after each round of allocation among the remaining Selling Shareholders whose Deposited Equity shares have not been accepted in full, till the size of the offering as determined by the Underwriters or, the maximum offer size or the number of Equity Shares underlying the ADSs finally sold in the Offering, as the case may be, is allocated among the Selling Shareholders. vi. The Proportionate Allocation in each round of allocation will be computed as the rounded-off product of (x1) the remaining Selling Shareholders’s Existing Shareholding bears to the aggregate existing shareholding of the remaining selling shareholders as on the Offer Closing Date and (y1) the Excess Allocation Shares available for such round of allocation. vii. Any resulting fractions will be rounded off to the nearest integer. If such rounding off results in the number of Equity shares accepted being more or less than the number of Equity Shares to be accepted, then the Escrow Agent will apply such rounding off the fractions, to the Offers of the

Overseas Capital Market Issues

409

Selling Shareholders, in the order of their Proportion, till the aggregate rounding off tallies with the number of Equity Shares to be accepted. viii. If the Underwriters exercise the Overallotment Option, then the proportion formula will be applied in case of the Equity Shares underlying the Optional ADSs from out of the unallocated Equity Shares following the determination of the Equity Shares to be accepted for the Equity Shares underlying the initial issue of ADSs. The determination by the Registrar shall be final and binding on all the Selling Shareholders. Below is an exampe of how the Proportion Formula will be determined.

Withdrawal Your Offer of Equity Shares under this Invitation is irrevocable and cannot be withdrawn.

Price The Underwriters will determine the price of the ADSs being sold under the Offering depending on prevailing market conditions. The proceeds of the Offering, after deduction of the expenses incurred in connection with the Offering and this Invitation, as described under Registration and Other Expenses, will be distributed to you in proportion to the number of Equity Shares accepted in the Offering.

Registration and Other Expenses The total expenses, i.e., the Expenses, of this invitation and the Offering, include underwriting discounts and commissions totaling up to 3.5% of the proceeds of the Offering and other expenses including printer’s fees, professional fees, Director’s and Offers insurance premium related to this offering, etc., are estimated to be between $1–3 million. The Expenses will be deducted from the proceeds of the Offering, and only the net amount of the Consideration will be paid to you. The final expenses incurred shall be audited by Bharat S. Raut & Co. Such Expenses, once audited, shall be final and binding on all the Equity Shareholders.

-

4,007

500

600

800

900

3,600

300

8,900

C

D

E

F

G

H 8,600

-

3,600

900

800

600

500

1,200

1,000

Existing Holding

100%

0.0%

41.9%

10.5%

9.3%

7.0%

5.8%

14.0%

11.6%

Proportion

Second Round of Allocation

3,000

-

1,256

314

279

209

174

419

349

179

-

-

-

179

-

-

-

-

7,800

-

3,600

900

-

600

500

1,200

1,000

100.0%

0.0%

46.2%

11.5%

0.0%

7.7%

6.4%

15.4%

12.8%

179

-

83

21

-

14

11

28

233

3,000

-

1,338

335

100

223

186

446

372

1,007

-

1

244

-

133

71

330

228

ProportTotal Excess Existing Adjusted ProportTotal ionate Accepted Returned Allocation Holding Propor- ionate tion Allocation Allocation

Excess Allocation

Please note that the aforesaid computation is for illustrative purposed only.

1,339

579

100

356

257

776

1,200

B

600

1,000

A

Investor Holding on Tendered Offer closing date

First Round of Allocation

410 Investment Banking

Overseas Capital Market Issues

411

In the event that this Invitation is withdrawn or is not otherwise implemented, then all expenses incurred in relation to the Offering and this Invitation shall be borne and paid for by us as approved by the Equity Shareholders by way of special resolution in the extraordinary general meeting held on February 22, 2003.

Underwriting Agreement/Selling Shareholder Liability The Escrow Agent, as your Attorney-in-Fact, will enter into the Underwriting Agreement on your behalf with us and the Underwriters and also will sign any other documentation on your behalf in relation to the Offering as may be necessary. As a party to the Underwriting Agreement and a participant to this Invitation, you will be liable for certain provisions in the Underwriting Agreement as well as certain portions of the Registration Statement filed with SEC, which are summarized below. As a party to the Underwriting Agreement, a Selling shareholder will make certain representations and warranties to us and the Underwriters. These representations and warranties primarily relate to the following: �

The receipt and execution of this Invitation and the Letter of Transmittal (and the power of attorney contained in the Letter of Transmittal);

�

The deposit of Equity Shares with the Escrow Agent;

�

The due authorization, execution and delivery of the Underwriting Agreement;

�

�

The fact that no consents, approvals, authorizations, orders, clearances, registrations or filling by any governmental agencies are required; The fact that the deposit of Equity Shares and sale of the ADSs will not conflict with any agreements to which the selling Shareholders are parties;

�

The fact that the Selling Shareholders have valid to the Equity Shares;

�

The transferability of the ADSs;

�

�

�

The fact that the Selling Shareholders have not taken actions to stabilize or manipulate the price of our securities; The truthfulness of statements related to the Selling shareholders in the registration statement; The fact that no stamp paper or other issuance or transfer taxes or duties and no capital gains, income, withholding or other taxes or duties are payable with respect to the Equity shares;

412 � �

Investment Banking

The expenses to be borne by the Selling Shareholders; and The legality, validity and enforceability of the Underwriting Agreement, this Invitation and the Offer Documents.

The Underwriters retain the right to terminate the Underwriting Agreement between the time of signing the Underwriting Agreement and the Closing of the Offering if certain events occur before Closing. These may include: � �

� �

�

Suspension in trading of the subject security; General suspension or limitation of trading on designated stock exchanges (including but not limited to the New York, NASDAQ, American Stock Exchanges, BSE and NSE); Declaration of a general banking moratorium by Federal or State authorities; Outbreak of major hostilities or declaration of war or any similar event or occurrence which, in the judgment of the representatives, of Underwriters makes it impractical to proceed with the Offering; and Breach of any representation or warranty or covenant set out in the Underwriting Agreement made by us or the Selling Shareholders.

If the Underwriting Agreement is terminated for the reasons set forth above, or for any other reason as set forth in the Underwriting Agreement, then the Invitation and the Offer will be void and ineffective, and the Deposited Equity Shares will be returned to you. We are not providing any assurances that you will be able to complete the sale of your Equity Shares in the form of ADSs to the Underwriters. The above are only some of the salient features of the Underwriting Agreement. For a better understanding of your rights and obligations under the Underwriting Agreement please read the entire text of the form of the Underwriting Agreement a draft of which is included herewith. Equity Shareholders who participate in the Offer will be subjecting themselves to potential liability under US federal securities laws. Section 12 of the US securities Act of 1933, as amended, imposes liability on any person who offers or sells a security by means of a prospectus or oral communication that contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made, and are not misleading.

Chapter

9 Exit Offers

T

his chapter deals with the process and management of exit offers of a company, i.e. public offers through which investors are given an exit from the company as distinguished from exit through the secondary market. Exit offers are triggered off either by law or due to a voluntary action. This Chapter deals with three types of exit offers—de-listing offer, share buyback and an open offer under the Takeover Code. In all these exit offers, it is mandatory for the company to appoint a merchant banker to conduct the whole process as per the statutory framework. Therefore, management of exit offers forms an important portfolio of merchant banking activity. It would be pertinent to note that in a public issue, while investors should be provided adequate disclosure of information and a level paying field as far as issue pricing is concerned, the considerations are similar in exit offers; i.e. the disclosure of information and a fair and equal opportunity in exit pricing.

Topics to comprehend �

�

� �

�

Concept and types of exit offers permitted under the current regulatory policy. Distinctive features of each exit offer and its implication for the issuers and investors. Pricing of exit offers. Process flow of each type of exit offer and the role of the merchant banker. Strategic issues in exit offers.

414

Investment Banking

9.1 Introduction to Exit Offers Exit offer is a new concept in the Indian context. Essentially it refers to a sale option for a shareholder of shares in a company otherwize than through the secondary market. Till recently, Indian companies were not allowed to buyback equity shares from their shareholders. So the only exit option that was open for the common investor was to sell through the secondary market. With the recent amendments to the Companies Act, companies are allowed to buyback their shares subject to certain restrictions. Therefore, buyback has become an exit route that companies can provide to their shareholders as an additional option. Apart from it, when companies wish to voluntarily exit the stock market and go private or they are directed by the stock exchanges to do so, the public shareholders are to be provided an exit option. Therefore, the company has to make a de-listing offer to the public. Thirdly, when an acquirer makes a substantial acquisition in a company, a compulsory open offer has to be made to the public within the terms of the Takeover Code of SEBI. This constitutes a third exit option to investors. All these offers are in the nature of reverse offers or exit offers since the shareholders are asked to surrender their shares for consideration. While buyback as an exit offer has become a reality through amendments to the Companies Act, the exit offer arising due to a substantial acquisition, which was hitherto a part of the listing agreement, has been given the force of law with the promulgation of the Takeover Code. The de-listing offer has been introduced recently to curb companies from using the buyback as a route for de-listing. In exit offers, the merchant Banker plays a very significant role not only in pricing issues but in ensuring compliance with law and in advising the company at every stage as well. Each of the exit offers is now taken up for detailed discussion.

9.2 De-listing Offer 9.2.1 Introduction to De-listing De-listing is a process by which a company whose shares are listed on a stock exchange is taken private once again by getting its publicly held shares bought over by private shareholders and terminating the listing agreement with the stock exchange. As a result, there can be no public shareholding after de-listing and the shares cannot be traded on a stock exchange. De-listing can be either compulsory

Exit Offers

415

or voluntary. Compulsory de-listing happens when the stock exchange penalizes a company through de-listing its shares for non-payment of listing fee, violation of the listing agreement or for any other statutory violations such as non-filing of accounts etc. Voluntary de-listing is a process initiated by a promoter or an acquirer or any other person other than the stock exchange. There has been quite a concern for the policy makers as regards de-listing and its legitimacy considering that it would deprive the capital market of depth if well-performing companies opted to de-list. There is no provision in the Companies Act or the SCRA that provides for de-listing by companies. The Dr. K.R. Chandratre Committee set up in 1997 prescribed criteria for de-listing of loss-making companies and other provisions. Later on, further examination was made of this issue, which led to the framing of the SEBI (De-listing of Securities) Guidelines 2003. The current thinking is to allow de-listing as a natural process since the listing agreement is primarily a contractual relationship between the issuer and the stock exchange and therefore, it should have an exit option subject to the interests of the investors being protected. De-listing also offers a right balance for companies to look at the capital market as a source of capital as and when necessary and not as an obligation that becomes counter-productive in times of depressed market conditions. Secondly, companies need to protect themselves from time to time from unwanted intrusions through the secondary market route, especially when their market capitalization is unduly depressed. In such times, voluntary de-listing offers a strategic alternative.

9.2.2 Recent De-listings De-listing has become a common occurrence in India due to the depressed market conditions. Most multi national companies, which prefer 100% subsidiaries to listed companies, have been active in de-listing their Indian subsidiaries. Till recently, government policies prevented this route but with the opening up of 100% FDI in many sectors, they are now preferring this route. Some examples are Carrier Aircon, Otis India, Philips India, Coates Viyella, Castrol India, ITW Signode, and Wartsila India which have all been delisted between 2000–01. In the USA, 66 companies went private in 2002 as compared to 35 in 1999 according to Thomson Financial. Bausch & Lomb Eyecare India, a subsidiary of the US based Bausch & Lomb Opticare has bought over the 20 shares of its resident shareholders to convert itself

416

Investment Banking

into a 100% subsidiary. The shares were bought by Bausch & Lomb South Asia. In 1999, as part of a global acquisition, the Luxottica group had acquired the sunglasses business of Bausch & Lomb USA, for $ 640 million. The takeover of the Indian operations was part of this deal. So while the eyewear business went to Luxottica, the eyecare business remained with Bausch & Lomb.

9.2.3 Case for De-listing The validity of the concept of de-listing has to be examined on the same grounds on which the company went for listing. These have been discussed earlier under the various heads of strategic, financial and investment banking considerations. If the cost of remaining listed outweighs the benefits sought to be received, it would not make sense for the company to remain listed. According to a study conducted by Scott Larson, a professor at National – Louis University in Chicago (as reported in the ‘Economist’), there are two components of cost for a company to stay listed—(a) the cost of regulatory compliance, (b) the cost of equity which is higher than the cost of risk-free debt. Together, these two elements constitute the cost of public equity. In order to decide on de-listing, this cost of public equity should be compared to the return demanded by private equity investors. In good market conditions, private equity is more expensive since private investors pay a strategic or control premium and therefore demand a higher return. Secondly, private equity is illiquid which also increases the return expectations. However, the return expected by public equity investors would be lower since it entails liquidity. To sum up, in a good market, cost of private equity is higher than that of public equity and therefore, the company should remain listed. However, in a weak market, the argument is reversed. The return expectations of public equity increase due to the absence of an exit route in the secondary market. In addition, if the cost of regulatory compliance increases, it adds to the increased cost of servicing public equity. On the other hand, the return expectations of private equity investors get moderated since they can acquire good stakes at attractive valuations. Secondly they would be privy to inside information and decision making which can guide them on their investments. For e.g. if the company has been approached for a strategic merger or a stake, the private equity investors by virtue of being on the board, would participate in the decision making. Therefore, in a weak and highly regulated market, the cost of public equity overtakes that of private equity.

Exit Offers

417

The company should also consider the fact that due to the weak market conditions, it may not be able to raise further funds through issues in the near future. Due to the prevailing low market cap, the company may even find it difficult to raise private equity on reasonable terms. In such situations, de-listing could be the way out. There is always an option for the company to come back to the market when the conditions improve. However, de-listing could also be an expensive affair since the retail investors would want to make the best of an exit opportunity that comes their way after a long time. According to Prof. Larson’s study, US companies that de-listed in 2003 had to pay on an average about 40%–80% premium on the prevailing market prices of their shares to buy them back. In India, most companies, especially the MNCs were using the buy-back route to de-list their stocks, which has recently been plugged. The regulatory framework for de-listing is now prescribed under the SEBI (De-listing of Securities) Guidelines 2003. The main change that has been brought about is that hereafter companies cannot de-list using the fixed price buy back route. Instead, they need to go through a process of price discovery.

9.2.4 Regulatory Requirements for De-listing We will now go on to discuss the provisions of the SEBI (De-listing of Securities) Guidelines 2003 (de-listing guidelines), which apply to all types of de-listing whether voluntary or compulsory. The de-listing guidelines apply to all kinds of delisting mechanisms but more specifically to the following: � �

� �

�

Voluntary de-listing sought by the promoters of a company. Any scheme of arrangement consequent to which the public shareholding falls below the minimum limit required for the company to stay listed. Promoters seeking to de-list a company from some of the stock exchanges. Consolidation of holdings by a person in control of the management in a manner in which the public shareholding falls below the minimum limit required for the company to stay listed. Compulsory de-listing of companies by the stock exchange.

418

Investment Banking

Not included in the above are the following situations: 1. When a company makes a buyback of shares in such a way that the public shareholding falls below the minimum limit required for the company to stay listed. 2. An open offer made by an acquirer pursuant to the Takeover Code due to which the public shareholding falls below the minimum limit required for the company to stay listed. In both the above mentioned cases, the company would not be allowed to use these routes in order to de-list the company. In other words, the company cannot use its own funds through the buyback route for de-listing itself. Similarly, a fixed price open offer under the Takeover Code cannot also be used to de-list a company because the objective of the de-listing guidelines is to provide the shareholders a fair exit opportunity. While structuring a share buyback, the company should do so in a manner which does not infringe on the minimum public shareholding as prescribed in the listing agreement. Clause 40A of the listing agreement prescribes the conditions for continued listing of a company as follows: �

�

�

The company agrees that in the event of the application for listing being granted by the Exchange, the company shall maintain on a continuous basis, the minimum level of non-promoter holding at the level of public shareholding as required at the time of listing. Where the non-promoter holding of an existing listed company as on April 01, 2001 is less than the limit of public shareholding as required at the time of initial listing, the company shall within one year raise the level of nonpromoter holding to at least 10%. In case the company fails to do so, it shall buy-back the public share holding in the manner provided in the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997. The company agrees that it shall not make preferential allotment or an offer to buy back its securities, if such allotment or offer result in reducing the non-promoter holding below the limit of public shareholding specified under the SEBI (Disclosure and Investor Protection) Guidelines, as applicable at the time of initial listing or the limit specified in sub-clause (ii) for the existing listed company, as the case may be.

As per rule 19(2)(b) of the SCRA Rules read with the DIP guidelines, the minimum offer to be made by a company at the time of listing should be 25% of the post-issue

Exit Offers

419

capital with suitable relaxations permitted for information technology and infrastructure sector companies, for which the said percentage could be reduced to 10%. Therefore, as per clause 40A stipulation, for an existing listed company as on April 01, 2001, a buyback of shares should not be made to reduce its public holding to less than 10%. For companies listed after that date, a buyback should not reduce the public shareholding to less than 25% or 10% as the case may be depending upon the industry to which they belong. As far as the Takeover Code is concerned, it has been specifically provided in clause 21(3)(a) of the Takeover Code that if the public offer results in the public shareholding being reduced to 10% or below of the voting capital of the company, the acquirer shall make an offer to buy the outstanding shares remaining with the shareholders in accordance with the de-listing guidelines. The other provisions of the de-listing guidelines are given as follows:

Voluntary De-listing A company would be allowed to de-list voluntarily provided it has been listed for at least 3 years prior to that date on any stock exchange. Such de-listing would be permitted by obtaining approval of the shareholders in a general meeting and making a public announcement of a de-listing offer. Before making the public announcement, a merchant banker who is unrelated to the promoter shall be appointed to administer the buy back of shares from the public for the purpose of de-listing through a public offer. For the purpose of the public announcement, the ‘floor price’ of the offer has to be determined as the average of 26 weeks traded price quoted on the stock exchange where the shares of the company are most frequently traded during such period. There would be no maximum price or ‘cap’ for the offer. In the case of infrequently traded shares, the floor price shall be arrived at as provided in the Takeover Code (explained later) and this may require independent certification by a Merchant Banker if SEBI requires so. The public announcement shall contain information on the floor price, the trading centres and trading members for the purpose of putting in the bids, the time table of the bidding process, the stock exchanges from where de-listing is sought, complete details of all material facts and other necessary details as prescribed. The promoter or acquirer should also open an escrow account and deposit therein 100% of the amount required to purchase the full quantity of shares required

420

Investment Banking

under the de-listing offer calculated at the floor price. The shareholders who wish to put in their bids should do so through the trading members for placing the offers on the screen based on-line electronic system. The bidding period should last for at least three days and the bidders have the option to revise their bids before the bidding period closes. The final price of the offer would be discovered through a reverse book building process as the price at which the maximum number of shares have been offered by the shareholders for sale. The de-listing guidelines provide the following illustration.

Offer quantity

Offer Price

Remarks

50

120

Floor Price

82

125

108

130

27 5

135 140

Final Price (as quantity offered is maximum)

The promoters or acquirers shall have the option to accept the price or not. If the final price is accepted, the promoter or acquirer shall be bound to accept all the offers upto and including the final price but may not accept the higher priced offers if so desired. If the final price is not accepted, no de-listing application should be made. After the de-listing offer is closed, a second public announcement has to be made within two days of the final price being discovered by the book building process and whether or not, the promoter or acquirer has accepted the price and the same should be communicated to the stock exchange. If the final price is accepted, the promoter or acquirer has to then make a de-listing application to the concerned stock exchange(s) along with all the necessary details and seek the approval of such exchange(s) for de-listing subject to certain terms and conditions that are imposed by such exchange(s). If the quantity eligible for acquiring shares at the final price does not result in public shareholding falling below the required level for continuous listing, the company shall continue to remain listed. Therefore, under these guidelines, there can be two instances when the offer can fail and the company remains listed—(a) if the promoter or acquirer does not accept the final price and (b) if the required minimum quantity of bids are not put in by the public. The guidelines provide that

Exit Offers

421

wherein the second situation is fulfilled, the promoter or acquirer shall not acquire any shares and the offer should be cancelled. In case the de-listing offer is cancelled as above or the promoters or acquirers opt out of it as the case may be, the public shareholding has to be brought up to the required minimum within six months. The promoter or acquirer shall do so either through an offer for sale, or a new issue of shares or through a transparent sale in the secondary markets. In case the promoter or acquirer is unsuccessful in doing so within six months, an offer for sale to the public would then need to be made according to the price determined by the CLA. The consideration shall be settled in cash for all the bids accepted and the offer formalities should be completed. However, the acquirer shall allow a further period of 6 months for any of the remaining shareholders to tender the securities at the same price. The other conditions necessary for voluntary de-listing are as follows: �

�

Where a company has any convertibles outstanding, de-listing shall not be permitted unless the conversion process is completed or the exercise period of the conversion option has lapsed. A de-listing offer need not be given in cases where securities continue to be listed in a stock exchange having nationwide trading terminals. For this purpose, presently the BSE and the NSE are reckoned.

Case on Voluntary De-listing In the first ever case of voluntary de-listing under the reverse book building guidelines, Digital GlobalSoft India was de-listed using the reverse book building under the de-listing guidelines. Digital India, which began in 1988 as a joint venture between Digital Equipment Corporation of USA (DEC) and Hinditron, later became a subsidiary of Compaq when the latter acquired DEC in a global acquisition. After Hewlett Packard (HP) took over Compaq, Digital India (now called Digital GlobalSoft) became the subsidiary of HP. HP announced a voluntary de-listing so that Digital India could become a 100% subsidiary of the parent company. The de-listing offer was made at a price of Rs. 750 per share, which nearly worked out to a 50% premium on the 26-week average price formula. The reverse book-building offer opened in the month of January 2004. The response from the investors was good but the most number of offers were received at Rs. 850 a share which amounted to almost 21% of the total shareholding in the company. This

422

Investment Banking

meant that HP had to increase its offer price to Rs. 850 thereby incurring an additional cost. The final deal size worked out to about Rs. 1418 crore as opposed to the earlier size of around Rs. 1000 crore at Rs. 750 per share. This made it the largest exit offer till then in India.

Compulsory De-listing Stock exchanges may de-list companies which have been suspended for a minimum period of six months for non-compliance with the listing agreement. At the same time, the stock exchanges may assess the need for compulsory de-listing based on the stipulated norms, which are listed in annexure III of the de-listing guidelines. The stock exchange shall serve a show cause notice on the company with a fifteenday period for filing replies. The de-listing decision shall be taken by a specially constituted panel of the stock exchange and notice of the termination of the listing agreement needs to be given to the company. The de-listing should also be publicised and displayed on the trading systems. The decision of the stock exchange to de-list has a right of appeal to SEBI. Where a company has been compulsorily de-listed, the promoters of such a company shall buy back the shares from the public at their option, at the fair price to be determined by the arbitrator. The consideration for the shares should be settled in cash.

De-listing Pursuant to a Right Issue In the case of a rights issue, promoters or persons in control of management are allowed to subscribe to the unsubscribed part of the rights issue or to the rights renounciation even if such a step results in the public shareholding falling below the required minimum if such an intention was disclosed in the letter of offer. In such an event, such promoters have to buy out the balance shareholders also at the rights price and apply for de-listing. If de-listing is not contemplated, such promoters have to make an offer for sale to the public to bring the public shareholding up to the required minimum. If in a rights issue, there is under-subscription in the public category due to which the public shareholding falls below the required minimum, the promoters need to de-list the company giving an exit opportunity to the public shareholders at the rights price. Alternatively, the promoters can also make an offer for sale of their

Exit Offers

423

holdings to the public within 3 months to bring up the public shareholding to the required minimum.

9.2.5 Re-listing Re-listing of securities can be permitted by a stock exchange after a cooling period of two years. However, re-listing shall be as per the terms and conditions applicable at the time of re-listing and is further subject to the clearance from the CLA.

9.3 Equity Re-purchase or Share Buyback Equity repurchase by a company was not allowed under the Indian law until 1999 when the Companies Act was amended to provide for limited repurchase of its shares incompliance with section 77A that was newly introduced with effect from October 1998. This section applies to all types of companies intending to all types of companies and all types of shares and other securities that may be bought back as specified from time to time by the government. In addition to section 77A, which has universal application across companies, unlisted companies have to comply with the regulations issued by the Department of Company Affairs. Similarly, listed companies intending a buy back of shares need to comply with the SEBI guidelines on the subject. All these aspects have been discussed hereafter.

9.3.1 Common Provisions Applicable to all Companies The salient features of buy-back of securities that all companies have to comply with in terms of the provisions of sections 77A and 77B of the Companies Act are listed below. They are as follows: �

� �

These provisions shall apply to shares of all types including ESOP shares and other securities as may be specified from time to time. The buy-back shall be approved by a special resolution in general meeting. The buy-back by the company has to be financed out of free reserves or securities premium account or from proceeds of earlier issue of dissimilar shares or other securities.

424 �

�

�

�

�

�

�

�

�

Investment Banking

The buy-back has to be permitted under the articles of association and the requisite authority has to be accorded by a Board resolution if the quantum of buy-back does not exceed 10% of the paid-up capital and free reserves and through a special resolution in general meeting if it exceeds 10%. The buy-back in value terms of shares or any other securities shall not exceed 25% of the total paid-up capital and free reserves of the company. Free reserves for this purpose shall mean all reserves that are available for distribution as dividend as per the latest audited balance sheet of the company and shall also include the securities premium account but not any share application money pending allotment. Buy-back of equity shares shall not exceed 25% of the paid-up equity capital in any given financial year. The residual debt-equity ratio shall not exceed 2:1 after the buy-back. The equity for this purpose has to be reckoned as paid-up capital and free reserves. The maximum time allowed for the completion of the buy-back process is 12 months from the date of the relevant resolution. Buy-back can be made from the existing security holders on proportionate basis, or from employees and directors out of the ESOP shares or sweat equity shares or through open market purchases. A declaration of solvency has to be filed with the ROC and the SEBI (where applicable) with a verification through an affidavit by the Board of Directors of the company that they believe that the company would remain solvent for a period of 12 months from the date of such declaration. All securities that are bought back have to be destroyed within seven days from the date of conclusion of the buy-back programme. However, it has been reported that the government planned to exempt MNC JVs without public shareholdings from extinguishing shares bought back in case the foreign equity already equals the foreign sectoral cap in that sector. Government officials view this as reverse FDI where the foreign holding in a company goes up without corresponding inflow of FDI. This is required since the partners in such JVs are held in a rigid position and cannot make use of the buy back provisions. (The Economic Times dated 22nd November 2001). No company shall make a public issue of the same kind of securities that have been bought back within a period of six months from the conclusion

Exit Offers

425

of the buy-back programme except through issue of bonus shares or through conversion of outstanding convertible instruments. �

�

�

Two buy-back programmes shall be separated by a period of 365 days even if they are for dissimilar securities. The buy-back should be a direct purchase made by the company and not an indirect purchase through its subsidiaries or group investment companies. The buy-back cannot be made if the company is a subsisting defaulter on debentures, public deposits, term loans, preference shares or in the payment of dividends.

9.4 Buyback by Unlisted Public and Private Companies Unlisted companies that are either private or public companies are governed apart from the provisions of the Companies Act discussed above, by the Private Limited Companies and Unlisted Public Companies (Buy-back of Securities) Rules 1999. An overview of the framework of such buy-back is given below. A company may buy-back its shares by either of the following methods: �

�

From the existing shareholders on a proportionate basis through private offers, By purchasing the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity.

There are no specified pricing guidelines and the Board or the company is free to fix the price as found appropriate. The notice sent to the members for convening the general meeting wherein the special resolution has to be passed for the buyback shall contain all the necessary particulars as specified in the Rules. These particulars inter alia relate to justification for the buy-back, method of buy-back proposed, the maximum amount required and the source of funds for the same, basis for the buy-back price, proposed time frame, complete details of promoters’ holdings and transactions in the shares of the company in the preceding six months, the proposed buy-back for promoters’ shares, no-due confirmation on liabilities, declaration of solvency to the shareholders and an auditor’s report to the Board confirming the quantum of buy-back and whether the directors are reasonable in their views on the solvency of the company.

426

Investment Banking

The company after receiving the approval of the members, has to prepare and file with the Registrar of Companies a Letter of Offer (L of O) containing the specified particulars under Schedule II of the Rules along with a Declaration of Solvency in Form 4A. The L of O has to be carefully drafted in compliance with the required particulars and should not contain any mis-statements or untrue statements. Specifically, the main details to be furnished are as follows: �

� �

�

The information provided in the notice as detailed above on the proposed offer with elaborate details on capital structure, shareholding pattern and the basis of arriving at the quantum and price of the proposed buy-back. All material facts relevant to the buy-back offer. Audited financial information for the previous three years together with specified financial ratios pre and post buy-back. Management discussion and analysis on the likely impact of buy back on the company's earnings, shareholding pattern and any change in management structure.

�

The Declaration of Solvency

�

Auditors’ Report addressed to the Board as stated earlier.

For a specimen L of O under the fixed price tender offer please refer to Appendix 4. For a specimen L of O under the open market purchase method, please refer to Appendix 5. Both appendices are included at the end of the book. Within 21 days of the filing of the L of O and the Declaration of Solvency with the Registrar, the L of O has to be despatched to all the members. The buy-back offer has to be kept open for members not less than 15 days and not more than 30 days from the date of such a despatch. The buy-back offer has to be accepted on proportionate basis in case of over-subscription by the shareholders. The company shall complete the verifications of the offers received within 15 days from the date of closure of the offer and the shares lodged shall be deemed to be accepted unless a communication of rejection is made within 21 days from the closure of the offer. The Company shall immediately after the date of closure of the offer, open a special bank account and deposit therein, such sum as would make up the entire sum due and payable as consideration for the buy-back in terms of the Rules. The

Exit Offers

427

company shall within seven days of the specified time, make payment of consideration in cash or bank draft/pay order to those shareholders whose offer has been accepted or return the share certificates to the shareholders forthwith. The company shall extinguish and physically destroy the share certificates so bought back in the presence of a Company Secretary in wholetime practice within seven days from the date of acceptance of the shares.

9.5 Buyback by Listed Companies Listed companies are governed in addition to the provisions of the Companies Act, by the SEBI (Buy-back of Securities) Regulations, 1998 and the provisions of the Listing Agreement with the stock exchange. An overview of the framework of such buy-back is given below. Under the Regulations, a company can buy back securities under the methods described below:

Fixed Price Tender Offer Under this method, the shareholders on record of the company as of a record date are invited to tender their shares for re-purchase by the company at a fixed price arrived at by the company and disclosed in the notice, public announcement and the L of O. This method is simpler to understand but may not realize the best price for the shareholders.

The Book Building Method This method prescribes a reverse book building to be applied for purchases from the open market whereby shareholders are invited to put in bids for re-purchase of their shares. The board resolution or the special resolution as the case may be, shall specify the maximum price at which the securities shall be bought back by the company. The company would make a public announcement based which shall specify the maximum price and quantity of securities as fixed by the Board and the method by which shareholders can put in bids for their securities to be bought back by the company. The company fixes the buy-back price based on the highest price bid received from the shareholders. The bidders who bid at lower prices would also be eligible to receive the highest price. Therefore, this method is beneficial to

428

Investment Banking

the shareholder since it allows the highest bid price to be received by them instead of a price fixed by the company as in the Tender Offer method. However, as far as the company is concerned, it helps in making a more efficient pricing as compared to the Tender Offer since this method allows for price discovery.

Open Market Purchase through Stock Exchange Mechanism Under this system, as in the case of the reverse book building method, the board resolution or the special resolution as the case may be, shall specify the maximum price at which the securities shall be bought back by the company. However, the method of re-purchase is different. In this method, the company buys back the shares directly from the secondary market using the electronic trading system and placing buy orders in its own name. Therefore, within a specified period, the company buys the shares from the market at varying prices based on the prevailing market price but subject to the maximum price and quantity already approved. This method is transparent and the company may actually end up buying the shares at an average price, which could be lesser than the maximum price approved. This method is suitable when promoters wish to consolidate their stakes by letting the company to mop up shares for buy-back from the secondary market. The drawbacks of this system are that the promoters cannot sell their own shares since the system is transparent. Secondly, if the company does not enjoy a good free float, the company may not be able to get sufficient quantities for buy-back. Apart from the above methods of buy-back, the company is prohibited from any other modes of buy-back such as through negotiated deals, or through spot transactions or through off-market private deals.

9.5.1 Process of Making a Buy-back Under the SEBI buyback Regulations, it is mandatory to engage a Merchant Banker to prepare the L of O and manage the buy-back offer. The Regulations also do not fix any pricing mechanism, which has been left free to the Board or the company to determine on its own. However, the guidelines prescribe the requirement of an escrow account to be opened under the Tender Offer and the Book Building methods to the extent specified under the Regulations. The escrow mechanism has to be either by deposit of cash with a scheduled commercial bank or through a bank guarantee in favour of the Merchant Banker managing the buy-back offer or a

Exit Offers

429

combination of both. In the case of the Fixed Tender Offer, the escrow is based on the fixed price and the maximum quantity of the shares to be bought back while in the case of the Book Building method, it shall be with reference to the maximum price announced and the maximum number of shares proposed for buy-back. The offer has to be commenced with a public announcement made followed by despatch of the L of O to all the members as of a Specified Date (record) date under the Tender Offer method. The offer shall open not before seven days and not after thirty days from the specified date and shall be kept open for a minimum of fifteen and a maximum of thirty days. The offer is accepted on a proportionate basis and the amounts are settled in cash to the shareholders. Under the Book Building method, the bids are invited in the same way as in a tender offer, except that the bids have to be received electronically through the terminals at the bidding centres. Under the Open Market Purchase method, there is no need to receive any tenders or bids from the investors. The company buys back securities directly from the market on an order driven system and settles the payment through the stock exchange clearing mechanism.

9.5.2 Pricing a Share Buy-back Since under both the SEBI Regulations and the DCA guidelines, the pricing aspect for the buy-back has been left open and it is for the company in consultation with the Merchant Banker to fix the price. In the case of listed companies, while the fixed price has to be decided beforehand by the company under the tender offer method, the maximum price has to be determined under the book building and the stock market purchase method. This brings us to the discussion on pricing of securities for buy-back. The following factors need to be considered in determining buy-back price: �

� �

� �

Price is to be fixed at a premium over the current market price (CMP) to prevent fall in CMP after the buy-back. Lower the current P/E multiple, the higher the company can pay. Lower the future return on networth (RONW), higher can be the premium over CMP. Price should not be lower than original issue price. If a company does not have too long a history of listing (for e.g. not more than ten years), it is better to work out a decent IRR for the shareholder

430

Investment Banking

based on original issue price at the time of the IPO after averaging it with the bonuses and rights given in the intervening period. Form the above, it is evident that there is a relationship between the current RONW and consequent EPS and the current price to earnings ratio (PER) in determining the premium that can be paid by the company over its ruling market price. The premium is inversely proportional to the RONW and the current PER. This relationship can be expressed by the following equation, P = 1/(RONW Ò PER) – 1 wherein P is the premium that can be paid over the ruling market price.

�

Illustration 9.1

Therefore, if the current EPS is Rs. 5 per share and the current P/E multiple is 8, the current market price would be Rs. 40. If the present RONW is 10%, the premium that can be paid would be, P = 1/0.10 Ò 8 – 1 = 25% Thus the premium that can be paid according to the above calculation is Rs. 10 over the current market price of Rs. 40, i.e. an offer price of Rs. 50. Under the above approach, it would be clear that if either of the two variables, the RONW or the PER is healthy, the premium to be paid would be negative. In other words, if the RONW is healthy, the shareholder would be better off retaining the share since it protects the opportunity cost. Similarly, if the PER is healthy, it means that the shareholder has a good exit mechanism with the current market price. However, under the above formula, if the premium has to be negative, both the RONW and the PER need to be reasonably good enough; otherwise, one could be pulled down by the other. For e.g. in the above illustration, if the RONW is 20% and the PER is 4, the company would still be required to pay a premium of 25% on Rs. 40. The next aspect to consider in buy-back pricing is the issue of post buy-back P/E. Normally, the trend in post buy-back P/E is an increase due to the increase in the EPS on the reduced capital base. However, this has to be weighed in together with the reduced returns on account of capital reduction. The capital reduction in turn

431

Exit Offers

would depend on the exit price paid to shareholders. If the exit is over-priced, the capital reduction would be substantial. This could lead to a fall in EPS even on a reduced capital base. Therefore, if the shareholders find that the loss of returns is more than off-set by the reduction in the capital base, the post buy-back P/E would increase. On the contrary, if the EPS is expected to fall, it would have a compounding effect since the P/E would also tend to fall. The issue of whether the RONW would remain constant or vary would depend upon the efficiency of capital utilisation post buyback. Keeping in view the above factors, pricing becomes critical in a buy-back proposal.

�

Illustration 9.2

Given – current P/E = 5, current EPS = Rs. 10, RONW = 10%, capital employed = Rs. 100 million, paid up capital = Rs. 10 million consisting of 1 million shares of Rs. 10 each. The company proposes to buy back 25% of its paid-up capital. The other requirements of the law have not been considered for this illustration such as residual debt-equity etc. Based on the formula as above, the maximum price that can be paid for the buy-back works out to 100% of the existing price, i.e. Rs. 50. The impact of the exit price on the post-issue EPS and P/E is shown as below: Buy-back price = Rs. 50

Buyback price = Rs. 75

Number of shares bought back

250000

Number of shares bought back

Capital reduction amount Rs.

12500000

Capital reduction amount Rs.

Reduced capital base Rs. Reduced number of shares

7500000 Reduced capital base Rs. 750000

Reduced number of shares

Buyback price = Rs. 100

250000 Number of shares bought back

250000

18750000 Capital reduction 25000000 amount Rs. 7500000 Reduced capital base Rs. 750000 Reduced number of shares

7500000 750000

432

Investment Banking SCENARIO – I (RONW remaining constant)

Post buy-back RONW % Post buy-back Return to shareholders Rs.

10 8750000

Post buy-back RONW % Post buy-back Return to shareholders Rs.

10 8125000

Post buy-back EPS Rs.

11.66

Post buy-back EPS Rs.

10.83

Post buy-back P/E Post buy-back market price

5 58.30

Post buy-back P/E Post buy-back market price

5 54.15

Post buy-back RONW % Post buy-back Return to shareholders Rs. Post buy-back EPS Rs. Post buy-back P/E Post buy-back market price

10 7500000

10.00 5 50

SCENARIO – II (RONW increasing) Post buy-back RONW % Post buy-back Return to shareholders Rs. Post buy-back EPS Rs. Post buy-back P/E Post buy-back market price

12 10500000

14.00 7 84.00

Post buy-back RONW % Post buy-back Return to shareholders Rs. Post buy-back EPS Rs. Post buy-back P/E Post buy-back market price

12 Post buy-back RONW % 9750000

13.00 6 78.00

Post buy-back Return to shareholders Rs.

12 9000000

Post buy-back EPS Rs. 12.00 Post buy-back P/E Post buy-back market price

5 60.00

SCENARIO – III (RONW falling) Post buy-back RONW % Post buy-back Return to shareholders Rs. Post buy-back EPS Rs. Post buy-back P/E Post buy-back market price

8 7000000

9.33 5 46.65

Post buy-back RONW % Post buy-back Return to shareholders Rs. Post buy-back EPS Rs. Post buy-back P/E Post buy-back market price

8 8125000

10.83 4 43.32

Post buy-back RONW % Post buy-back Return to shareholders Rs. Post buy-back EPS Rs. Post buy-back P/E Post buy-back market price

8 7500000

10.00 3 30.00

Exit Offers

433

In the above illustration, in scenario I, since the RONW is expected to be constant, the P/E is also assumed to be constant. It may thus be observed that the maximum premium that can be paid is 100% on the existing price so as not to impact the price post buy-back. If the premium paid is less than the maximum that is allowable, the market reacts favourably by pricing the share above its existing price. Therefore it may be observed that if the buy-back price is fixed at Rs. 75 instead of Rs. 100, the expected market price post buy-back would be Rs. 54. In scenario II, the RONW is expected to rise, the P/E is also assumed to have an increase if the buy-back price is favourable. Therefore, even if the premium paid is 100% over the existing market price, the post buy-back price is expected to be more than the existing market price. In scenario III, since the RONW is expected to fall, the P/E is also considered at lower levels than the existing 5. Therefore, it may be observed that the market price is expected to be lower than the existing market price under all the pricing alternatives. It means that when the RONW is expected to fall post buy-back, the company should not resort to a buy-back; otherwise the market would react adversely.

9.5.3 Quantum of Buyback The quantum of securities that a company can buy-back is governed by the provisions of section 77A of the Companies Act, which have already been discussed above. In terms of those provisions, there are three essential conditions that determine the quantum of buy-back. They are as follows: �

�

�

The buy-back in value terms of shares or any other securities shall not exceed 25% of the total paid-up capital and free reserves of the company. Free reserves for this purpose shall mean all reserves that are available for distribution as dividend as per the latest audited balance sheet of the company and shall also include the securities premium account but not any share application money pending allotment. The Buy-back of equity shares shall not exceed 25% of the paid-up equity capital in any given financial year. The residual debt-equity ratio shall not exceed 2:1 after the buy-back. The equity for this purpose has to be reckoned as paid-up capital and free reserves.

434

Investment Banking

As per the above provisions, it would be necessary to work out the quantum of a buy-back through the following steps: 1. Work out the aggregate paid-up capital and free reserves of the company as on the date of the balance sheet that is within six months preceding the proposed buy-back offer. 2. One-fourth of the aggregate of such paid-up capital and free reserves arrived at forms the absolute limit on the quantum of the buy-back that has to be maintained at all times irrespective of the number of buy-backs made by the company. This absolute limit applies cumulatively to all types of shares—preference, equity and others. 3. The third step would be to determine whether the application of the entire available limit as arrived at in (2) above in the buy-back would result in the residual debt-equity ratio exceeding 2:1. If it so increases, the quantum available under (2) above should be restricted to the amount that would not allow the residual debt-equity ratio to exceed 2:1. 4. In the case of a buy-back of equity shares, the next step would be to ensure that the buy-back does not exceed 25% of the paid up capital in nominal terms in the relevant financial year. In case it exceeds, it has to be limited to 25%. 5. The next step would be to divide the absolute limit available under (3) above with the total quantity of shares to be bought back under (5) above in order to arrive at the maximum price payable per share under the buy-back. 6. In the case of a Tender Offer, the next step would be to arrive at the pricing for the buy-back offer using the principles stated above and determine whether the desirable price falls within the price arrived at under (5) above. 7. In case the desirable price exceeds the maximum price arrived at under (5) above, the company has to scale down the size of the offer so as to arrive at the desirable pricing within the given parameters. 8. In the case of open market and book built offers, the company can decide based on the available funds if it wishes to buy back the entire allowable limit. In such a case it has to quote the price arrived at under (5) above as the maximum price and take necessary approvals for the same.

435

Exit Offers

�

Illustration 9.3

Buy-back Ltd. has the following financials as per the recent audited balance sheet.

Particulars Paid-up equity capital 20,000 shares of Rs. 10/- each Share application money pending allotment

Amt (Rs) 200000 20000

Reserves and Surplus General Reserve Share Premium Account

500000 1000000

Capital Redemption Reserve Account

250000

Profit and Loss Account

100000

Debenture Redemption Reserve

150000

Long-term borrowings (exceeding one year)

3000000

The company's current EPS is Rs. 20 and the market price is Rs. 40. The company earned a profit after tax of Rs. 4 lakh for the relevant financial year. On the basis of the above information, keeping in view the norms on quantum of buy-back and the principles of pricing as discussed above, the quantum can be computed as follows:

Particulars

Amt (Rs)

Aggregate amount of Paid-up equity capital and Free Reserves Paid-up capital (share application money not considered)

200000

Reserves and Surplus General Reserve Share Premium Account

500000

436

Investment Banking

Particulars

Amt (Rs)

Profit and Loss Account (Capital Redemption Reserve and Debenture Redemption Reserve are not considered since they are not available for distribution as dividend)

1000000 100000

Total aggregate (T) 25% of the above (A) Total amount of shares that can be bought back (25% of the total number of shares)

(B)

The maximum price per share that can be offered for the buy-back (in Rs. per share) – (A)/(B)

500

The residual debt-equity ratio if the total quantum is bought back =

90

450000

Residual Debt (C) Residual Equity (1800000 - 450000)

3000000

Residual DER = (C) / (D)

1350000

Since the residual DER cannot exceed 2:1, the residual equity cannot be less than 1500000

2.22

Therefore, the maximum aggregate that can be utilised for the buyback out of (T) above = (1800000 - 1500000) (M) Therefore, the maximum price per share that can be paid if all the permissible shares have to be bought back in Rs. per share = (M) / (B) The company earned a PAT of Rs. 4 lakh for the previous year yielding a RONW of 10%.

300000

60

Therefore, the maximum premium that can be paid as per the formula on pricing = 1 / .10 x 2 – 1 Since the current market price is Rs. 40, theoretically, the company can offer up to a price of Rs. 200 per share. If the company wants to pay Rs. 200 per share, it can buy back only 1500 shares forming 7.5% of the paid-up capital.

1800000

400%

Exit Offers

437

(Contd.) However, the company can also pay Rs. 60 per share and buy back the entire allowable quantity of 5000 shares. Between the above two extremes, the company can decide on a suitable price and accordingly fix the quantum of buy-back within the maximum permissible limit of (M) above.

9.6 Open Offers under the Takeover Code An open offer has to be made under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (the Takeover Code) by an acquirer whenever there is a substantial acquisition. The applicability of the Takeover Code for various types of substantial acquisitions and takeovers as well as the exemptions there from have been discussed in Chapter 15 in the context of acquisitions and takeovers. Herein we will discuss the operational aspects of making the open offer as per the provisions of the Takeover Code and the requirements to be complied with. An open offer under the Takeover Code is also an exit offer for the shareholders since the acquirer would offer to buy their shares at a stipulated price subject to other terms and conditions. The entire process and requirements are discussed below.

9.6.1 Appointment of Merchant Banker The first requirement upon triggering off the open offer requirement under the Takeover Code is the appointment of a merchant banker by the acquirer. The merchant banker shall have a valid certificate of registration and shall not be an associate of or group of the acquirer or the target company. Before making the public announcement in connection with the impending public offer, the merchant banker shall ensure that: � �

�

�

The acquirer is able to implement the offer. The provision relating to the escrow account (discussed later) has been complied with. Firm arrangements for funds through verifiable sources to fulfil the payment obligations under the offer have been made. The public announcement is being made in compliance with the Takeover Code.

438

Investment Banking

9.6.2 Public Announcement A public announcement regarding the acquisition and the impending open offer shall be made by the merchant banker not later than four working days of entering into the agreement for the acquisition of the shares or voting rights or deciding to acquire shares or voting rights exceeding the respective trigger limits. In the case of a disinvestment, the four days shall be reckoned from the date of signing of the share purchase agreement with the Government. In the case of transfer of control, the public announcement shall be made not later than four working days after the change of control is decided to be made. In the case of indirect acquisition or change in control, the announcement shall be made within three months of the consummation of the acquisition, change of control or restructuring of the parent company or the holding company. The public announcement has to be made in all editions of one English and one Hindi national daily with a wide circulation and a regional daily of the place where the registered office of the company and the main stock exchanges are situated. A copy of the announcement shall be submitted by the merchant banker to SEBI, to the stock exchanges and sent to the registered office of the target company. The public announcement shall contain all the prescribed particulars, the most important of which are the following: �

� �

�

�

The total number and percentage of shares proposed to be acquired from the public, subject to the statutory minimum. The minimum offer price and the mode of payment of consideration. Complete information of the acquisition such as the identity of the acquirer group, the agreement reached with the sellers, objects and purpose of the acquisition, future plans and implementation thereof etc. The highest and the average price paid by the acquirer or persons acting in concert for the shares of the target company in the preceding twelve months prior to the date of the announcement. An undertaking that the acquirer shall not sell, dispose off or encumber any substantial assets of the target company except with the prior approval of the shareholders.

Exit Offers � �

� �

�

439

Details of the offer, proposed time-table thereof. Disclosure to the effect that firm arrangements for meeting the financial requirements of the offer are already in place, including the details of the sources of funds. Statutory and other approvals required if any, for the acquisition. Statement on whether the offer is subject to a minimum level of acceptance from the shareholders. Specified date for the purpose of determining the shareholders eligible for the offer.

9.6.3 Letter of Offer Within fourteen days from the date of the public announcement, the acquirer shall, through the merchant banker, file with SEBI, the draft of the letter of offer to be sent to the shareholders containing the necessary disclosures and in the prescribed format as provided in Annexure 8 to the Takeover Code. The draft letter of offer should be submitted to SEBI along with a ‘Due Diligence Certificate’ of the merchant banker in the prescribed format. The merchant banker should also ensure that the draft letter of offer has been prepared in compliance with the Takeover Code and that the contents of both the letter of offer and the public announcement are true, fair and adequate and is also based on reliable sources, quoting such sources wherever necessary. The merchant banker also has the responsibility that the open offer complies with all other statutory requirements of other applicable law. Within the said 14 days, the acquirer shall also send a copy of the draft letter of offer to the target company at its registered office for being placed before its Board of Directors and to all the stock exchanges where it is listed. The letter of offer shall be despatched to the shareholders not before 21 days of its submission to SEBI after incorporating the changes if any, specified by SEBI. In cases wherein the circumstances necessitate, SEBI may even call for a revised letter of offer. In any case, the final letter of offer complete in all respects should reach the shareholders within 45 days of the public announcement. A specimen Letter of Offer is provided in Appendix 8 at the end of this book. A copy of the final letter of offer shall be sent to holders of convertible instruments in the target company as well, if such conversion is due to happen during the period of the open offer.

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9.6.4 Open Offer Price The offer price shall be paid to the shareholders surrendering their shares in (a) cash, (b) by issue, exchange and transfer of shares (other than preference shares) of the acquirer if such acquirer happens to be a listed body corporate, (c) by issue, exchange or transfer of secured instruments of the acquirer company with a minimum ‘A’ grade rating from a credit rating agency registered with SEBI and (d) a combination of any of the above. However, if the consideration is proposed to be paid through issue of fresh securities as stated above, the acquirer shall obtain the approval of its shareholders within 21 days from the date of closure of the open offer. In case such an approval is not obtained, the offer will remain valid and the consideration would be paid in cash. The price applicable for purchase of shares of the shareholders under the open offer scheme shall be arrived at on the basis of the highest of the following: 1. In the case of a negotiated acquisition, the price negotiated for the acquisition by the acquirer from the promoters or other shareholders of the target company. 2. In other cases, the price paid by the acquirer or persons acting in concert for purchase of shares in the primary or the secondary market during the 26 week period prior to the date of the public announcement. 3. The average of the weekly high and low of the closing market prices of the shares of the target company in the most frequently traded stock exchange during the 26 weeks prior to the date of the public announcement. 4. The average of the daily high and low of the closing market prices of the shares of the target company in the most frequently traded stock exchange during the two weeks prior to the date of the public announcement. In the case of public sector disinvestments, the reference date shall be the day before the date of opening of bids by the Government instead of the date of public announcement. If the shares of the target company are infrequently traded, the price shall be determined by the merchant banker taking into account the factors mentioned at (1) and (2) above along with other parameters such as the book value of share, return on networth, EPS, the price-earnings multiple of the company visà-vis the industry average etc. In cases found necessary, SEBI may direct for an independent valuation by another merchant banker or a chartered accountant with a minimum of ten years’ professional standing or by a public financial institution.

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There are certain exceptions to the general principles for arriving at the open offer price as stated above. These are as follows: �

�

�

�

In the case of public sector disinvestments, the minimum price shall be the price paid by the successful bidder to the Government. If the acquirer has acquired any shares of the target company by any means after the date of public announcement, then such a price if higher than any of the above, would become the open offer price. However, the acquirer cannot make any such acquisition within the last seven working days from the closure of the open offer. If the consideration is payable in securities, the pricing thereof shall also be arrived at on the basis of (3) and (4) stated above. Such valuation needs to be certified independently in the same manner as described above. In the case of indirect acquisitions, the open offer price arrived at for the parent company has to be compared to the open offer price arrived at for the target company and the higher of the two becomes applicable for the open offer of the target company.

The basis of arriving at the open offer price should become a part of the disclosures in the letter of offer.

9.6.5 Minimum Shares to be Acquired The minimum quantity of shares to be acquired in an open offer to the shareholders of the target company shall be 20% of the voting capital of such a company. If this stipulation results in the public shareholding in the company coming down to 10% or less of the voting capital of the company, the acquirer shall buy off the remaining shareholders in accordance with the de-listing guidelines. Alternatively, the acquirer shall make an offer for sale to the shareholders within a period of 6 months from the closure of the open offer so as to raise the public shareholding to more than 10%. A third option for the acquirer would be to cause a public issue by the target company to the public within the said six months. The letter of offer issued to the shareholders shall specify the option being considered by the acquirer. It may be noted here that the requirement of a minimum of 20% is only with respect to the offer to be made by the acquirer to the public. If the public response to the offer were to be less than 20%, it would be sufficient compliance with the Takeover Code if the acquirer

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purchases all the shares that have been offered by the public in the open offer. But in order to be able to acquire less than 20%, the acquirer has to deposit 50% of the total consideration payable in the open offer in a designated escrow account in cash before the open offer is made. Considering a different situation, if the open offer were to be over-subscribed, the acquirer would have complied with the Takeover Code by acquiring 20% from the shareholders proportionately on the basis of the over-subscription ratio. This has to be done in consultation with the merchant banker. The acquirer also has the facility of making a conditional open offer under the Takeover Code. The condition is with respect to the minimum level of acceptance of the offer by the public to make it binding on the acquirer. Such minimum level can be less than the 20% stated above. For e.g. an acquirer may state in the letter of offer that the offer shall be acceptable only if the public have accepted it to the extent of at least 25%. In case the public response is less than 25%, the acquirer has the following options: �

�

�

�

The acquirer may decide not to proceed with the offer. This is possible only if the acquirer has already deposited 50% of the total consideration payable under the open offer in the escrow account in cash and is prepared to forfeit the entire deposit as a penalty. In such a case, since the acquirer would not be acquiring any shares from the public, the shares acquired earlier through the negotiated route shall also be rescinded. However, if the original acquisition was through the market route, the acquirer can keep such shares even though the conditional offer did not go through. The acquirer may decide to accept whatever shares the public has tendered provided they are more than 20%. In such a case the Takeover Code has been complied with though the acquirer has not got the desired level of holding. The acquirer may decide to accept whatever shares the public has tendered which are less than even 20%. This again is possible only if the acquirer has already deposited 50% of the total consideration payable under the open offer in the escrow account in cash prior to the offer. In case the acquirer has not deposited the required 50% of the consideration as stated above, the option allowed under the Takeover Code for the acquirer is to acquire 20% from the public whether the public response has been

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443

to that extent or not. The Takeover Code does not explain how the shortfall has to be acquired except to say that no such shares can be acquired by any means during the period of the offer. Therefore, it appears that the acquirer can acquire such shortfall from the market after the offer has closed and satisfy SEBI that the minimum of 20% has been acquired. The same situation could arise in a normal open offer which has been under-subscribed and wherein no condition was stipulated. The same solution seems to be applicable in such cases as well. �

The last option available to an acquirer so as not to acquire the open offer shares would be to apply to SEBI for withdrawal of the offer by explaining the merits of the case and do so upon receiving SEBI’s approval.

9.6.6 Counter-offers and Revisions The Takeover Code allows for counter-offers to be made as competitive bids by any person other than the acquirer by means of a public announcement within 21 days of the public announcement made by the acquirer. No competitive bids are allowed after the said 21 days. Any competitive bid which is made shall be for such number of shares which when taken together with such competitor’s existing holdings, will be equal to or more than the holding of the acquirer including the open offer. For e.g. if the acquirer presently holds 18% and has made an open offer for 20%, the total holding of the acquirer post-open offer would be 38%. A competitor who presently holds say, 10% has to bid for a minimum of 28% (38–10) in the competitive bid. Upon the announcement of the competitive bid, the acquirer shall have the option to make an announcement to revise the open offer. The announcement for a revision shall be made within 14 days of the announcement of the competitive bid. If the revision is not made in such a time, the earlier offer shall be valid and binding on the acquirer except that the date of closing the offer shall stand extended to the date of closure of the public offer under the last subsisting competitive bid. The competitive bids shall also follow the same stipulations of the Takeover Code as the original open offer. An acquirer who has made an open offer, shall irrespective of whether there is a competitive bid or not, have the option of revising the offer at anytime upto seven working days prior to the date of closure of the offer. The revision can be with respect to the price of the offer and the number of shares to be acquired. The acquirer can

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change the mode of payment of the consideration consequent upon such revision. The revision has to be through another public announcement followed by communication to SEBI, the stock exchanges and the target company.

9.6.7 Other Important Requirements under the Open Offer 1. The date of opening of the open offer shall not be later than the 60th day from the date of the public announcement. The offer shall be kept open for 30 days. A shareholder who has tendered shares under the offer shall have a right to withdraw upto three days prior to the date of closure of the offer. 2. No public offer once made can be withdrawn unless—(a) the acquirer being a natural person has died, (b) statutory approvals have been refused under any other law and (c) with the express consent of SEBI. In case of a withdrawal, the merchant banker or the acquirer shall make a public announcement and inform SEBI, the stock exchanges and the target company. In such a case, the acquirer is prohibited from making another open offer for a period of six months. 3. An acquirer who does not fulfill the obligations under the Takeover Code is debarred from making another open offer for any listed company for a period of 12 months from the date of closure of the offer. 4. Every acquirer making an open offer shall open an escrow account with a bank a sum equal to the stipulated percentage of the total consideration payable under the offer according to a graded scale. In the case of conditional offers wherein the acquirer proposes to acquire less than 20%, the escrow deposit shall be in cash to the extent of 50% of the total consideration. The total consideration shall be reckoned with respect to the entire 20% to be acquired. In case the offer has differential pricing, the computation shall be made at the highest price. 5. The escrow can be in terms of cash, a bank guarantee in favour of the merchant banker or deposit of acceptable securities with the merchant banker with suitable margin. If the escrow consists of a bank guarantee or securities, the merchant banker shall not return the same till the completion of all formalities under the offer. In case of an upward revision in the terms of the offer, the escrow shall be increased to the extent of atleast 10% of the revised total consideration. The escrow would be utilized in meeting the

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445

obligations of the offer and appropriated as stipulated under the Takeover Code. 6. Within 21 days of the closure of the offer, the acquirer has to open a special bank account to meet the payments under the offer and deposit therein the balance cash required taking into account 90% of the escrow cash deposit already made. After meeting all the obligations, unclaimed balance if any in this account shall be transferred at the end of 3 years to the investor protection fund of the applicable regional stock exchange. 7. The target company is bound by the Takeover Code to co-operate in all respects with the acquirer in terms of furnishing the particulars of shareholders, verification of the securities tendered under the open offer by the shareholders, in allowing the transfer of all shares acquired by the acquirer to the respective names and consequent change in the board and management control of the company. This is subject to the confirmation by the merchant banker that all the requirements under the open offer have been complied with by the acquirer. 8. The acquirer shall within a period of 30 days from the date of closure of the offer, complete all the procedures relating to the offer including payment of consideration to the shareholders who have accepted the offer. If such completion was not possible due to pending statutory approvals, SEBI can grant further time to the acquirer upon payment of interest to the shareholders as may be determined. This is subject to the condition that the approvals have been delayed for reasons beyond the control of the acquirer. 9. Upon fulfillment of the obligations by the acquirers under the Takeover Code, the merchant banker shall cause the escrow to be released back to the acquirer and send a final report to SEBI within 45 days from the date of closure of the offer in the prescribed format.

9.6.8 Time Table of an Open Offer Based on the requirements of the Takeover Code as detailed above and the time frames mentioned therein, the following illustrative time charts Table 9.1 and Table 9.2 are shown below for an open offer under two different situations—(a) without a competitive bid and (b) with one competitive bid.

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Date

Event

Zero date (D0)

Acquisition completed or understanding reached for change in control.

D1

Appointment of merchant banker.

D4

Public Announcement.

D18

Last date for filing of draft letter of offer along with the due diligence certificate with SEBI by the merchant banker. Send the draft letter of offer to the target company and the stock exchange(s).

D25

Earliest date for despatch of the final letter of offer to the shareholders.

D49

Last date for letter of offer to reach shareholders.

D64

Last date for opening of the public offer by the acquirer.

D87

Last date for any revision in offer by the acquirer.

D91

Last date for a shareholder to withdraw tender from the open offer.

D94

Earliest date for closure of the public offer from the last date of opening.

D115

Last date for opening of special bank account by the acquirer.

D124

Last date for completion of offer procedures.

D139

Filing of 45 day Report with SEBI. Release of Escrow by the merchant banker.

D1219

Transfer of unclaimed funds from the special account to the investor protection fund of the stock exchange.

�

Table 9.1 Time Chart for an Open Offer under the Takeover Code without any competitive bid

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Exit Offers

Date

Event

Zero date (D0)

Acquisition completed or understanding reached for change in control.

D1

Appointment of merchant banker.

D4

Public Announcement.

D18

Last date for filing of draft letter of offer along with the due diligence certificate with SEBI by the merchant banker. Send the draft letter of offer to the target company and the stock exchange(s).

D25

Earliest date for despatch of the final letter of offer by acquirer to the shareholders. Last date for public announcement for a competitive bid by a competitor.

D39

Last date for revision of offer by the acquirer in response to the competitive bid

D49

Last date for letter of offer of the acquirer to reach shareholders.

D64

Last date for opening of the public offer by the acquirer.

D70

Last date for the letter of offer of the competitor to reach shareholders.

D85

Last date for opening of the open offer of the competitor under the competitive bid.

D108

Last date for any further revision in offer by the acquirer or the competitor.

D112

Last date for a shareholder to withdraw tender from the acquirer's or the competitor's offer.

D115

Date of closure of both open offers of the acquirer and the competitor.

D136

Last date for opening of special bank account.

D145

Last date for completion of offer procedures.

D160

Filing of 45 day Report with SEBI. Release of Escrow by the merchant banker.

D1240

Transfer of unclaimed funds from the special account to the investor protection fund of the stock exchange.

�

Table 9.2 Time Chart for an Open Offer under the Takeover Code with one competitive bid

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Investment Banking

9.6.9 Assessment of the Takeover Code The Takeover Code has brought in a regulatory framework under which the corporate consolidations and takeovers can be made in a transparent, efficient and investorfriendly manner. The Takeover Code is being continuously monitored by SEBI and any discrepancies are being continuously plugged. In addition, SEBI is also reviewing the Takeover Code based on past experience and there has been more than one overhaul in the past seven years of its working. The Takeover Code places an onerous responsibility on the merchant banker in complying with the law and more importantly, in arriving at the offer price. By pegging the open offer price to the prevailing average market price, SEBI has ensured that the common investor benefits from any upward movement in the price of the scrip due to speculation before the public announcement is made. By making an escrow mechanism mandatory and putting the responsibility on the merchant banker, SEBI has also ensured that there are no vexatious attempts to frustrate the existing management and the shareholders of the target company. There are also stringent penalties on the acquirer for failing to live up to the obligations under the Takeover Code. After the amendments to the Takeover Code in 2002, withdrawal of an offer once made has also been extremely difficult except in select circumstances or with the prior approval of SEBI upon being satisfied that there are circumstances to justify the same. The Takeover Code also provides for takeover battles to be fought through the mechanism of competitive bids. The promoters of the target company are given an opportunity to successfully defend their company through this mechanism. By introducing the bidding mechanism, it has been ensured that the public shareholder can benefit from upward revisions in the offer. Corporate acquisitions and takeovers are a very sensitive issue and therefore, the Takeover Code has tried to address it in the most equitable manner possible. Administration of the Takeover Code and vigilance on acquirers is a tough job considering that there are several dates for meeting various milestones. Though the merchant banker has the primary responsibility, in the past it has been seen on a few occasions that there have been lapses on disclosure by acquirers. Moreover, the merchant banker comes into play only on being appointed prior to the public announcement. Till then, the onus lies entirely on the acquirer for timely and proper disclosure. However, there has been a lot of maturing of the market in the years after the Takeover Code has been introduced. As acquirers, managements and shareholders get used to the working mechanism of the Takeover Code, compliance is bound to improve in the future.

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9.7 Strategic Issues in Exit Offers It may be appreciated from the discussion made so far in this Chapter that exit offers involve complex regulatory mechanisms and therefore need to be carefully planned. Promoters, acquirers and company managements would do well to plan their strategy based on the requirements of the situation keeping in mind the regulatory provisions at each stage. Listed below are some strategic considerations in exit offers. 1. Under the current regulatory framework, the mechanism of buy-back of shares cannot be used to its full extent in strategic financial management. However, there is room for some flexibility in using it effectively in capital structuring decisions. Equity share buy-back is allowed up to 25% of the equity paid-up capital in a given financial year and there can be a buy-back offer in every financial year as per the provisions of Section 77A. Similarly, the company can make an issue of similar shares that have been bought back after a period of six months from the date of the earlier buy-back. These two provisions can be used in tandem to buy-back shares when the markets are depressed and to re-issue capital when the markets look up. However, care has to be exercised to ensure that the proceeds of an earlier issue are not utilized in a subsequent buy-back as such practice is prohibited under the law. 2. The buy-back mechanism allows for a company to purchase its shares from the open market within a specified period. In a depressed market, this is a cost-effective tool to consolidate promoter holdings rather than an open offer by the promoters. An open offer is based on fixed pricing with reference to the benchmark market price as per the stipulated guideline, while an open market buy-back can be at different market prices. Secondly, promoter open offers would require fund mobilization by the promoters while in a buy-back, the company’s resources could be utilized. 3. Open offers are to be used only when a de-listing or a strategic acquisition is on the cards since the law prohibits de-listing through a buy-back route. For all other strategic financial decisions involving equity capital reduction through return of shareholder capital, buy-back is a very positive and effective tool. 4. Buy-backs can be used to a limited extent to offset dilution or expansion of equity base consequent upon bonus issues, conversion of convertibles, stock splits etc. It can also be used effectively to curb the phenomenon of liquidity overhang in companies that have a significantly large free float.

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Investment Banking

5. De-listing can be used strategically when the market is depressed and there is no fund raising contemplated from the market in the medium term. However, the difference between de-listing and a buy-back offer is that in the former case, the promoters have to pool in funds from their resources to buy out the public shareholding. In such situations, it would be better to offer a stake to a financial investor such as a private equity fund to buy out the public stake. Once the company is de-listed, there would be future opportunities to list it again at higher market capitalization by timing the reentry appropriately. The guidelines allow for re-listing after two years. The re-listing could be through an offer for sale by the private equity investor so that an exit route is created for such an investor as well. Companies can use this strategy in a limited way to beat the negative effects of depressed markets on their fund raising capabilities. 6. The de-listing guidelines can be used in two situations—(a) wherein a de-listing is contemplated and (b) when due to an open offer under the Takeover Code, the public shareholding falls below the statutory minimum. In both these cases, the reverse book-building route has to be adopted. Therefore a situation could arise in a takeover open offer when there has to be an open offer initially for 20% and a residual de-listing offer for the balance. Since the second offer would be through reverse book building, it could be at a higher price than the open offer. 7. The acquirer in an open offer has to be clear about the percentage of acquisition being aimed at. If there is a strategic minimum quantity required which would be in excess of the minimum 20% stipulated under the offer, it would be worthwhile to make the offer for the percentage required. For e.g. if the acquirer requires a strategic minimum of 32%, the offer can be made for 32% instead of the minimum 20%. In order to ensure success of the offer, it may be necessary to peg the offer price at higher than the statutory minimum price. An alternative to this would be to make a conditional offer with a 50% cash escrow. But this may not serve the purpose since the acquirer has to acquire 20% anyway if the escrow is not to be forfeited. 8. Those acquirers who do not wish to acquire 20% but are making the open offer to meet the statutory requirements, may deposit 50% of the consideration in cash in escrow so that the right to accept less than 20% is retained. The offer should also be made at the statutory price. This strategy may work if the offer is under-subscribed. However, this strategy could prove to be an expensive proposition if the offer has been received well by the shareholders. In

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such a case there is a risk of the deposit being forfeited for non-compliance. 9. Acquisitions under the Takeover Code are designed for acquirers rich in cash since there is not enough time available from the time the open offer is triggered off to the date of making the public announcement. In addition, escrow requirements make it stringent upon the acquirer to have adequate resources at hand. Considering that most takeover attempts start with open market purchases by the acquirer, a strategy has to be put in place for the ultimate stake aimed at including the open offer and the financing thereof. Given below is a comparative chart of the scheme under the three exit offers.

Buy-Back

Open Offer

Applies to equity shares, pref- Applies to acquisition of voterence shares and other speci- ing rights or control. fied securities. Governed by section 77A/77B Applicable for listed compaand respective guidelines by nies alone. Governed by Takeover guidelines of SEBI DCA / SEBI and stock exchange requirements. Pricing determined by the company as Fixed Price/Book Built Price/Open Market Price. There is no concept of a minimum price.

Company cannot use proceeds generated from earlier issues to finance buy-backs.

Applies to equity shares, preference shares and other specified securities. Applicable for listed companies alone. Governed by delisting guidelines of SEBI and stock exchange requirements.

Price to be determined only Price determined as a Fixed through book building. Price not below a particular minimum arrived at as per the guidelines.

Quantum of buy-back restrict- Quantum of open offer to be for a minimum of 20% of the ed to specified amounts. paid up capital. Company uses its funds to buy-back.

De-listing Offer

Quantum of shares bought back shall be the residual public shareholding to enable the company to de-list.

Acquirers (including promotAcquirers (including promoters) use their personal sources ers) use their personal sources of funds to buy shares. of funds to buy shares. No restriction on sources of funds since these are brought from outside the books of the company whose shares are being acquired.

No restriction on sources of funds since these are brought from outside the books of the company whose shares are being de-listed.

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Investment Banking

(Contd.) Buy back cannot be used for de-listing a company.

�

Can be used for de-listing in combination with de-listing guidelines.

To be used only if de-listing is contemplated.

Table 9.3 Comparative Scheme of Exit Offers

9.8 Cases on Share Buyback Sterlite Industries Sterlite Industries conducted a controversial buy-back programme which had raised several eyebrows due to the manner and price at which it was conducted. The objectives for the buy-back were—to restructure its capital and to attain an appropriate valuation in order to tap the overseas markets for which an optimal capital structure would be of substantial benefit. Sterlite which intended to repurchase 50% of its equity, offered to pay Rs. 150 per share of a face value of Rs. 5 under the buy-back offer. This included a cash component of Rs. 100 and a non-convertible debenture of Rs. 50. The debenture portion of Rs. 50 carried a coupon rate of 10% and was redeemable at the rate of 35%, 35% and 30% in the third fourth and fifth years respectively. The buy-back price was at a premium of around 43% over the average prevailing price of the past six months. The price was however at a steep discount of around 50% to it book value which was around Rs. 300 at that point of time. The company considered the offer a good exit opportunity for the retail investors if they wished to exit the company since the risk profile of Sterlite had changed after the acquisition of BALCO and Hindustan Zinc Ltd. which were disinvested by the Government of India. Sterlite intended to de-list from the bourses as well, if the retail shareholding fell below the 10% mark after the buy-back. Unlike going through the buy-back route as stipulated under section 77A of the Companies Act and the SEBI guidelines, Sterlite decided to buy-back shares much in excess of the 25% allowed under section 77A. Therefore, the company had to take the route of a court order for the buy-back since it amounted to a capital reduction. Therefore, Sterlite filed an application under sections 100, 391 (arrangement) and section 394 of the Companies Act. The scheme was approved in a court convened

Exit Offers

453

meeting and court order was received for the capital reduction. The Department of Company Affairs also approved the buy-back offer. However, the offer raised a controversy due to the manner in which the whole process of the buy-back was conducted. Under normal circumstances, any company would first send out the buy-back offer and request the shareholders to tender their shares for buy-back if they so desire, to the Registrar. The Registrar would sort out all the applications, arrive at the over-subscription ratio and then send out the cheques to individual investors based on their entitlement. Therefore, the investors would receive payment only for the number of shares that have been bought back by the company. In the case of Sterlite, the company sent out cheques for the cash component of Rs. 100/- per share along with the offer letter to the shareholders. The shareholder had only to fill up a form of non-acceptance that was enclosed along with the cheque and return the cheque along with such form in case the offer was being refused. Otherwise, if the cheque was encashed, it would be presumed that the shareholder accepted the offer. This left the investors with no option but to tender their shares for the buy-back since the entire onus of non-acceptance lay on the shareholder. At the same time, by sending out the cheques in advance, the offer was confusing to the investors since it could be presumed that they had no choice but to encash the cheques. In addition, the short time given to the investors was one of the factors which also raised the controversy. The Investors Grievances Forum filed a complaint with the Department of Company Affairs that the scheme was coercive and against the interests of the shareholders and was also against the Depositories Act. An objection was also raised on the offer price of Rs. 150 which was way below the book value. The SEBI also referred the matter to the DCA. Later on, the SEBI moved the Bombay High Court to quash the scheme citing the interests of shareholders. Sterlite in its defence cited several other buy-back offers as precedents such as Century Enka, Mather & Platt India, Hindustan Dorr-Oliver, Sierra Optima, Jai Corp. Ltd., Hardcastle & Waud Manufacturing Company, P & G Distribution Company and Mahindra-Gesco for the procedure followed in sending the cheques in advance. It also quoted about twenty other issues wherein the buy-back price was less than the book value of the share. The Bombay High Court ruled in favour of the company and dismissed the petition. The buy-back offer was successful and 25% of the equity had been accepted for buy-back with about 4000 retail investors had rejecting the offer. However, the rejection represented only a meagre 1.5% of the Rs. 28 crore of equity capital. The financial institutions, which held about 7.7% of the equity, decided not to take part in the

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buy-back since they did not approve of the buy-back per se. These included the LIC UTI and the GIC. The company however, could not achieve its objective of de-listing since the promoter holding remained below 90%.

Indian Rayon With the need to earn money on invested capital, if you have too much cash, you can’t do it. Ultimately, you’re responsible to the shareholder. For a company, the possible way out is a share buy-back. Companies burdened with having so much cash but very few options are the probable candidates for buy-backs. Companies operating under various sectors like cement, textiles, steel, etc., which were grappling with recession and overcapacity, had the option of going for share buy-back. But they had to satisfy their shareholders that there were no other promising investment avenues left. And also that sitting on the cash pile was not going to result in any addition to the shareholder’s wealth. Indian Rayon is a case in point. Indian Rayon, an A.V. Birla group company, during September 1999, implemented a share buy-back program through the book-building method. The holding of the promoters in Indian Rayon after the buy-back had possibly risen to around 29% of the total equity, from the pre-buy-back level of around 21.5 percent . The bids were invited from shareholders in range of Rs. 75–85 a share through this process. The offer price range was at a premium over the average traded prices of the company’s shares on stock exchanges in the past. As per the share’s closing price of Rs. 72.65 on September 17, 1999, it was at a premium of 3.2 percent at the minimum offer price of Rs. 75 per share and 17 percent at the maximum offer price of Rs. 85 per share. The two-week average price was Rs. 72 per share, which was at a discount of 4.2–18.1 percent to the indicated price range for buy back. The 26week average price of Rs. 58.20 was at a discount of 28.9–46 percent and the 52week average of Rs. 54.50 was at a discount of 37.6–56 percent to the range of Rs. 75–85 per share. The outflow from the company to buy-back 25 percent of the equity was expected to be Rs. 127 crore at the minimum price of Rs. 75 per share and Rs. 144 crore at the maximum price of Rs. 85 per share. In view of the under utilized plant capacities and no major capital investments envisaged in the next 2–3 years, share buy-back offered a good option to return the money to the shareholders. The company's move was also influenced by the fact that it expected to continue enjoying a healthy cash flow from its current businesses. The company felt it feasible to return up to Rs. 144 crore to its shareholders through the

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buy-back process. Further it hoped that the buy-back would also push up the earnings per share of the company in the future and create a long-term shareholder value. The buy-back is unlikely to cause any material impact on the profitability of Indian Rayon, except to the extent of loss of interest income on the amount to be utilized for the buyback. However, the market was not happy over the deal between Indian Rayon and Grasim, regarding the transfer of some of the assets including cement division. This to a considerable extent affected the buy-back program. However, given the fact that no growth opportunities were available which could justify investments, it was a correct decision made on the part of Indian Rayon to go for share buy-back.

Bajaj Auto Sometimes complicated cross holdings of the ownership in a company make it difficult for the market to value the true worth of the company. Share buyback provides good opportunities for those companies, which are having such problems, to unlock the true worth of the company. The buy-back announced by Bajaj Auto Ltd. is a case in point. Bajaj Auto, in a bid to clear up cross-holdings, approached the promoters of Bajaj Tempo to transfer its 9 percent stake in Bajaj Auto, valued at around Rs. 400 crore at current prices. In return, Bajaj Auto would transfer its 23 percent holding in Bajaj Tempo to the Firodias. The Bajaj Auto management was keen that the Bajaj Tempo promoters subscribe to the buy-back offer of Bajaj Auto. The company has given the Bajaj Tempo promoters a proposal to clear up the cross-holdings. However, there were some contentious issues. Firstly, the two parties were to agree on the transfer price. Bajaj Auto’s transfer of its holding in Bajaj Tempo would give the latter's promoters the crucial majority control. However, the same was not true for the transfer of the Bajaj Auto shares. While the Bajaj Tempo promoters were the largest shareholders in Bajaj Tempo with a 40 percent stake, the shareholding of the promoters in Bajaj Auto aggregated to 23 percent. A second problem area was that the holding of the Firodias in Bajaj Auto, at current market price, was valued at around Rs. 400 crore, which was close to seven times the valuation of Bajaj Auto's holding in Bajaj Tempo. The possibility of the settlement of the issue through a stock swap, however, did not seem to be possible. It was a good move on part of Bajaj Auto to propose the clearance of cross-holdings. This could help improve the valuation of the stock which had languished for a long time for several reasons, important among them have been the sluggish sales, lack of

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attractive investment avenues, huge reserves, etc. However, the buy-back was meant only for 1.8 crore shares of its existing equity base of 119 crore. Whether such a token gesture of buy-back would help improve returns to shareholders is a matter of doubt. The company’s announcement to buy-back its share at a price of Rs. 400 plus helped the stock price move up from its six-year low of Rs. 257 to around Rs. 370 level. The share buy-back was perceived to improve the market sentiment in the stock on several counts. Firstly, it would reduce the capital base. Secondly, the expense incurred on buy-back could have some positive impact in terms of reducing the enormous amount of cash available with it. Bajaj Auto was estimated to hold about Rs. 1,800 crore in the form of loans & advances, debt/equity investments and cash in hand. In sheer size, this portfolio would match the core business investment of the company. On the other hand, this component, which was partly invested in low-yielding instruments, resulted in an estimated pre-tax earning of 12.5 percent which became a drag on the 40 percent pre-tax return of the core-business, thereby restricting overall pre-tax earning to a weighted average of 21–22%. The company once even mulled the idea of starting a portfolio management to manage its excess cash reserves but the idea was later dropped due to the prevailing unstable interest rate regime and low earnings profile for gilt securities.

Reliance Industries RIL’s share buy-back program was triggered off due to the under-valuation of the company’s stock vis-á-vis the BSE Sensex, which was one of the reasons cited by the RIL management to initiate steps to correct the pricing anomaly. As per the statistics for the past five years, the stock had been trading at a discount to the Sensex's P/E, which the company thought was unfair given its consistent financial performance over this period. The company generated a compounded annual growth of 15 percent on EPS (Earnings Per Share) during the last five years. RIL's P/E relative to the Sensex had ranged between 43 percent on March 31, 1996 to 85 percent on March 31, 2000. The Sensex's P/Es was based on the old BSE Sensex. RIL's current P/E at the time of the buy-back announcement was 66 percent of the recast Sensex. The stock outperformed the Sensex by 38 percent between January 1, 2000 and April 11, 2000. The stock outperformed the Sensex by 135 percent in one-year time frame, by 21 percent in two-year time frame, by 105 percent in 3-year time, by 90 percent in 5-year timeframe and by 409 percent in ten-year time frame. Hence despite consistently outperforming the Sensex over these timeframes, the stock had been trading below its perceived intrinsic value.

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The buy-back move aimed to achieve certain objectives including supporting the stock price in the face of undervaluation. The company wanted to return the money to shareholders in large measures in a tax efficient and investor friendly manner without sacrificing growth opportunities and within the overall capital allocation framework. The company proposed to buy-back its shares up to a price of Rs. 303 aggregating Rs. 1100 crore, which was 25 percent of its free reserves as per the legal provisions on share buy-backs. According to the company, the share buy-back would help to optimize its weighted average cost of capital thereby enhancing its overall global competitiveness, also improve financial parameters such as return on equity, reduce floating stock and enhance overall long-term price performance. As per the share buy-back regulations, shares that were bought back, had to be compulsorily written down and cancelled immediately. This reduced the floating stock. The company expected that the buy-back would help improve valuation to a considerable extent and also enable it to use its stock as currency for any M&A activities in the future. The company aimed to achieve a re-rating for the RIL stock by sending a powerful signal on the perceived under-valuation from time to time. In addition, this could also help increase the RIL's market capitalization thereby adding to the shareholder’s wealth. These were some of the key objectives that RIL aimed to achieve through its share buy-back plan. The buy-back was also meant to give a signal to the speculators that if the stock gets hammered below the floor price, which the company had set at Rs. 303, it would enter the market to push it up by mopping up the excess floating stock from the market.

ONGC The Oil and Natural Gas Corporation considered buying back its shares held by Indian Oil and the Gas Authority of India. The deal was expected to improve ONGC’s fundamental valuation, though it would further reduce liquidity in the stock. The buy-back was also being perceived as a way to use the roughly Rs. 8,000crore surplus funds that the cash-rich company was sitting on. IOC and Gail together held 12% of ONGC shares, 84% equity was with the government, and the remaining 4% was with the public and the institutional shareholders. SEBI’s buy-back norms did not allow negotiated deals between companies. But Government companies could do negotiated deals, without making an open offer to general shareholders through requisite government approvals. The two options considered for the buy-back were either for IOC and GAIL to sell their stake in the market or for ONGC to buy-back its shares from them. The net

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effect would be a reduction in the market float and an increase in market capitalization. ONGC would be required to extinguish its shares to the extent of the buy-back. Earlier, ONGC had written to the ministry of petroleum, opposing IOC’s and GAIL’s move to offload their respective stakes in the market. The company management said there was a danger of creeping acquisition by players, who could use the float to corner shares in a company that has been declared ‘strategic’ by the government. It could have led to the acquirer having a seat on the ONGC board as well. The company was also concerned about such a move leading to excess liquidity, and the ONGC stock taking a beating on the bourses. The ministry had subsequently said that IOC could only sell half of its ONGC holding. The buy-back did not seem appropriate at that time because ONGC shares were trading at a high price of around Rs. 350. The price was moving in tandem with the global crude prices, that were touching new highs because of an imminent war in the Gulf on the Iraq issue. The buyback however, was a positive development for IOC, which has been waiting to offload its ONGC holding. The oil refining company has a majority of its receivables tied up in seven-year government bonds, and with refinery margins slipping, it is facing a bit of a cash crunch. IOC stood to gain roughly Rs. 4,800 crore, if it sold its entire stake at the ruling market price. The company had, in ‘99, acquired 9.6% in ONGC for Rs. 2,225.2 crore and 4.8% in GAIL for Rs. 245 crore as part of a cross-holding scheme drawn up to shore up the government kitty. In return, ONGC picked up 10% in IOC for around Rs. 1,700 crore and 5% in Gail for Rs. 245 crore.

Multi-national Companies MNCs in India have used the buy-back route with an objective to de-list themselves from the Indian stock exchanges. This superseded the primary objective of a buyback which was to enhance shareholder value. Recent examples include buy-back plans of Cadbury, Phillips and Carrier Aircon which shelled down Rs. 875 crore, Rs. 234 crore and Rs. 115 crore respectively. Otis Elevators and Industrial Oxygen also spent Rs. 104 crore and Rs. 109 crore respectively. The depressed markets provided the perfect environment for such buy-backs by MNCs. They preferred the listing of only their holding or parent companies to avoid the cumbersome disclosure and regulatory norms.

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Select References 1. Delisting of Shares—Mitu Sinha and Golaka C. Nath, NSE Bulletin. 2. SEBI, Capital Issues, Debentures & Listing—K.Sekhar, Wadhwa and Company, Third Edition 2003. 3. News Reports and articles in the Economic Times. 4. Select issues of ‘Analyst’ published by the ICFAI Press.

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Self-Test Questions 1. What is a share buy-back? How is it different from de-listing? 2. How does a company decide between a buy-back and a de-listing offer to the shareholders? How do they compare? 3. How is the pricing determined under an open offer, buy-back and de-listing offer? From the purchaser’s point of view, what are the implications? 4. What are the important requirements of the Takeover Code for open offers? What is the strategic advise that a merchant banker can provide in an open offer? 5. What are the requirements as regards the quantum of a buy-back offer? What is the rationale for such quantitative restriction? 6. What are the procedural aspects of making a buy-back, de-listing offer and an open offer? Are the procedural requirements different and if so, in what respect?

Chapter

10 Private Placements of Equity

E

quity capital can be raised through public offers or through private issues. In the previous Chapters we have seen the process by which equity can be raised in the public route. In this Chapter, we discuss the different modes of raising equity in the private route. Depending upon the category of investors being looked at and the status of the investee company, the private market for raising equity can be broadly classified as institutional and non-institutional private placements. The institutional investors discussed in this chapter are venture capital funds and private equity funds. Venture capital is institutional risk capital that has the mandate of investing in young companies. Private equity funds on the other hand, are larger investors investing in later stage companies. The noninstitutional investors include high networth investors and others interested in both unlisted and listed equity. This Chapter deals on these segments of the private placement market in detail. It also discusses the process of making private placements and the service domain of the investment banker in such transactions.

Topics to comprehend �

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The mechanism of private placement of equity as distinguished from public issues. Types of private placements and investors in privately placed shares. Venture capital and private equity and the process of raising both types of equity capital. Considerations for issuers and investors in private placements. The role of investment banker in private placements.

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10.1 Overview of Private Issues of Equity Most companies, both in the listed and unlisted categories, make issues of equity shares to different shareholders without making a public offer. Such issues can be clubbed under the term ‘private issues of equity’. The term ‘private issue of equity’ has to be interpreted in terms of issue of equity shares in the non-public route either through a private offering or by other means. The various issues of equity that are possible in the non-public offering route are depicted in figure 10.1.

10.1.1 Preferential Allotment and Private Placement Preferential allotments are those that are made to select investors or existing shareholders on preferential basis to the exclusion of everyone else. In a company, if the promoters wish to increase their stake by subscribing to a fresh issue of equity shares by the company, the company makes a preferential allotment of such shares exclusively to the promoters without involving the other shareholders. Similarly, preferential allotment is required to be made whenever there is an issue of shares on private placement basis so that select investors have to be issued shares to the exclusion of other existing shareholders or the general public. The terms ‘preferential allotment’ and ‘private placement’ are sometimes used interchangeably though they have a subtle distinction. The difference between a private placement and a preferential allotment is that in the case of the former, the investors may not be known at the time of the issue while in the case of the latter, the Pr ivate Placements of Equity

Pr ivate Issues thr ough pr efer ential allotments / pr ivate placements a) Preferential offers to promoters and their group of investors b) To Institutional Investors c) To non-institutional investors.

� Figure 10.1

Bonus Issue to shar eholder s by capitalisation of r eser ves

Issues to employees / pr omoter s and wor king dir ector s a) Employee Stock Option Scheme b) Employee Share Purchase Scheme c) Sweat Equity

Overview of Private Placements of Equity

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investors would be known beforehand at the time of seeking necessary approvals from shareholders. Preferential allotments are generally made to promoters, persons belonging to the promoter group, collaborators, joint venture partners and strategic investors. Private placements on the other hand, are made to institutional and non-institutional investors. The different aspects and various process involved in making private placements are discussed in the subsequent paragraphs of this Chapter. Under the institutional category of investors a separate discussion has not been provided on banks and financial institutions, investment institutions, mutual funds, FIIs and OCBs as these have been adequately explained in Chapter 3. Venture capital and private equity investments merit a deeper understanding and are therefore taken up for discussion in this Chapter.

10.1.2 Bonus Issues Bonus issues of equity shares are made by companies as a means of rewarding shareholders and creating a means for liquidation of value locked up in the reserves. As a company performs well and makes profits, the reserves of the company swell and despite the distribution of cash dividends from time to time, there could still be considerable reserves that are available as distributable surpluses. However, the company may not wish to distribute the whole of such reserves as dividends since that option has the potential to deplete the company of cash that it may require in the immediate future. At the same time, looking at it from a shareholder’s perspective, it may not serve any purpose to keep the shareholder value locked up in the business of the company. A bonus issue strikes the right balance in such cases. It rewards the shareholder through issue of additional shares by the capitalization of reserves. The accumulated reserves are then converted into share capital without the receipt of any consideration by the company. These additional shares are listed and rank pari passu with the existing shares of the company. The shareholder may then liquidate these shares in the market in order to unlock the value. However, it has to be realized that the share price of a company often drops in the short-term after a bonus issue to adjust for the excess liquidity in the market. Therefore, a shareholder may have to wait for a suitable opportunity to realize a good price. Nevertheless, the fact remains that a bonus issue creates an opportunity to encash the built-up value in a company. Before making a bonus issue of shares, the effect thereof on the share capital of the company should also be considered carefully. Since a bonus shares increases the

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issued capital, it depresses the EPS. In addition, there could also be a short-term selling pressure as some shareholders try to liquidate the bonus shares since they were issued to them free of cost. These developments could also slow down the fund raising by the company. Though the company’s networth is not impacted, due to the changes in market capitalization, fund raising through the equity route could be affected in the short-term. By capitalizing free reserves, the company actually reduces its distributable surplus, which is available to pay dividends. This could even impact the future dividend payouts, as the company may not be in a position to dip into its reserves for the payment of dividends. However, a bonus issue is a tremendous tool for rewarding shareholders both psychologically and in actual terms without any cash outflow for the company. As such it is a very popular tool for managements. Several Indian companies habitually reward shareholders through this route. Bonus issues can be made out of revenue reserves or capital reserves as long as they are unencumbered and are received in cash. Therefore capital reserves not earmarked for any specific purpose such as capital profit on sale of an asset, share premium account etc. are available for being capitalized as bonus shares. However, reserves whether revenue or capital, created out of book entries and not received in cash are not available for issue of bonus shares. The SEBI DIP guidelines are very specific on this issue stating that bonus issues shall be made only out of free reserves built up out of genuine profits or share premium collected in cash only. Revaluation reserves created by revaluing fixed assets are not allowed to be capitalized. Similarly, for unlisted companies, the Guidance Note issued by the ICAI states that revaluation reserves cannot be used for issue of bonus shares and in such cases, the auditors have to qualify their reports. Bonus issues can be made both by listed and unlisted companies. Unlisted companies are governed by the provisions of the Companies Act and the articles of association, while listed companies have to follow section XV of the DIP guidelines as well. As per the DIP guidelines, a listed company proposing a bonus issue shall comply with the following additional conditions: �

�

There shall not be any exclusion of FCDs/PCDs (pending conversion into shares) for the purpose of reckoning the eligibility to receive bonus shares. The bonus entitlements on such shares should be kept separately and allotted at the time of conversion of such FCDs/PCDs. The bonus issue shall be made only out of free reserves built up through profits or share premium received in cash.

Private Placements of Equity �

Bonus issue in lieu of dividend should not be made.

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Bonus issue on partly paid shares is not allowed.

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The company should not be in default of servicing fixed deposits, debentures and statutory dues. The articles of association of the company should authorize a bonus issue. After approval by the Board and announcement of the bonus issue, the company must implement the decision within six months and shall not have the option to reverse the announcement. Bonus issue shall be preceded by an increase in authorized capital if so required.

10.1.3 Sweat Equity and ESOPs/ESPS The concept of sweat equity and stock options and other schemes of rewarding employees, working directors and promoters for their contribution of intangible property or specialized know-how or value addition to the company has already been explained in Chapter 3. Herein we discuss the methodology and the regulations governing the issue of such shares.

Sweat Equity The issue of sweat equity in unlisted companies is governed under section 79A of the Companies Act and under the Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003. The main requirements under these provisions concerning the issue of sweat equity shares are listed below: �

�

�

The issue can be made not before one year from the date of commencement of business. For private companies, the date of commencement is the date of incorporation but for public companies such date is the date of obtaining the certificate to commence business. The issue has to be approved by the shareholders by way of a special resolution. The notice issued for the shareholders’ meeting has to disclose inter alia the following details — The reasons/justification for the issue and particulars of the issue, including the pricing of the shares for the issue based on a valuation report

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submitted as made by an independent valuer to the company. The valuation shall be made on the basis of a fair value for the share. The cash or other consideration for the shares, shall also be specified. �

�

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Diluted earning per share pursuant to the issue of securities to be calculated in accordance with the Accounting Standards specified by the Institute of Chartered Accountants of India. Approval of shareholders by way of separate resolution in the general meeting shall be obtained in case of issue of shares to identified employees and promoters, during a year, equal to or exceeding 1% of the issued capital (excluding outstanding warrants and convertibles) of the company at the time of issue of the sweat equity shares. The company shall not issue sweat equity shares for more than 15% of total paid up equity share capital in a year or shares of the value of Rs. five crore, whichever is higher except with the prior approval of the Central Government. The Directors’ Report of the company shall disclose the prescribed particulars with regard to the issue of the sweat equity shares. Where a company proposes to issue sweat equity shares for consideration other than cash, it requires an independent valuation of the intellectual property, know-how or other value addition, which is being provided as consideration for the shares. Such pricing justification shall be provided to the shareholders. Sweat equity shares issued to employees or directors shall be locked in for a period of three years from the date of allotment.

Issues of sweat equity in listed companies is governed both by the provisions of section 79A and the SEBI regulations on sweat equity. Broadly, the scheme for listed companies is discussed below: �

�

�

Such equity shares can be issued to directors (promoters or non-promoters, working or non-working) and permanent employees. Issue of sweat equity to promoters has to be approved by the other shareholders specifically by a special resolution. Such shares shall be issued at a price equivalent to the higher of the average market price for the past six months or for the preceding two weeks which should be calculated as prescribed.

Private Placements of Equity �

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The valuation for the intangible assets such as intellectual property, know how or other value addition should be carried out by a merchant banker. This should further be certified by a chartered accountant for compliance with accounting standards. Sweat equity shares would be locked in for three years from the date of allotment. Such issue is subject to the takeover regulations for listed companies. Therefore, promoters holding more than 15% but less than 75% in a company should take care to see that the issue of sweat equity does not exceed 5% in any financial year. Other allottees cannot take up more than 15% of the issued capital of the company without triggering off the Takeover Code.

Sweat equity in unlisted company

Sweat equity in listed company

1. To comply with section 79A and the guidelines for unlisted companies.

1. To comply with section 79A and SEBI regulations

2. Shares can be issued at discount to face value. For e.g. A share of 10/- face value can be issued for Rs. 5/-.

2. Shares can be issued only at the price calculated as prescribed by SEBI. However, it is possible for the issue price so arrived at to be below face value.

3. Valuation of non-cash consideration needs to be certified by an independent valuer. Compliance to be certified by the auditor.

3. Valuation has to be certified by a merchant banker. Additional certification by chartered accountant on compliance with accounting standards.

4. Quantitative restrictions under the guidelines.

4. Subject to the provisions of the Takeover Code.

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Table 10.1 Comparative Chart of Sweat Equity

Stock Options and Other Schemes Stock options, stock purchase and other such schemes in unlisted companies are not governed by any specific guidelines on the subject but since these shares have to be allotted to the employees, they rank as preferential allotments and are hence governed by the Unlisted Public Companies (Preferential Allotment) Rules, 2003.

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The guidelines for preferential allotments have been discussed separately in paragraph 10.6.1 of the chapter. However, in the case of stock options, there are no stipulations for unlisted companies. Therefore, stock options can be issued at agreeable terms both to the directors and employees prior to the investment by outside investors. However, it is customary to propose the issue of stock options at the time of VC investment so that the investors are comfortable with the terms of the issue. Employee Stock Option Plans (ESOPs) in listed companies are governed by the SEBI regulations. These regulations provide for either ESOPs or granting of shares directly under the Employees Share Purchase Scheme (ESPS). The main feature of these regulations is that promoter-directors, directors or employees who are related to the promoters or holding 10% or of the paid up capital either directly or indirectly are not eligible under ESOPs. However, non-working independent directors can become a part of ESOPs. Therefore, the essential eligibility criterion is that promoters and their relatives should not be beneficiaries under ESOPs. The other main provisions are as follows: �

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There is no restriction on the size of ESOPs or ESPS that can be granted by a company. SEBI has allowed free pricing of ESOPs and ESPS. However, this cannot be used as an opportunity by companies to issue shares at less than their face value by circumventing section 79 of the Companies Act. There is no lock-in for shares acquired under ESOP but for those under an ESPS, a lock-in period of one year has been prescribed if these are issued at concessional prices. If however, ESPS shares are issued as part of a public issue at the same issue price, there would be no lock-in. Under ESOP, the employee would be granted the option to subscribe to his entitlement of shares but these cannot be applied for till the completion of the ‘vesting period’. After the vesting period is over, the employee can exercise his option by applying for the shares during the ‘exercise period’ which usually starts immediately after the vesting period is completed. The company should take shareholder approval to determine the eligibility criteria, vesting period, number of shares under ESOP and the pricing formula. The company shall constitute a committee of the Board consisting of independent directors in majority, which will administer the scheme and fix

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other terms such as the exercise period, resignations and other issues. This committee is known as the compensation committee. �

�

The accounting value (which is the aggregate option price of all the shares issued under ESOP/ESPS) should be written off as employee cost over the vesting period uniformly. The option price can be determined either by the Black Scholes model or as the difference between the market price at the time of granting of the option and its exercise price.

ESOPs in unlisted company

ESOPs in listed company

1. There is no specific regulation thus far. 1. To comply with SEBI regulations. Preferential allotment guidelines have to be adhered to since allotments have to be made exclusively to select persons. 2. The scheme can be used to grant shares to 2. Promoters are excluded under such employees and directors including promoters. schemes. 3. The scheme can be administered by the Board. 3. The scheme has to be administered by a compensation committee with independent directors in majority. 4. Accounting of the option price or the discount 4. The option price or the discount has is governed by accounting standards and generto be recognised as employee cost and ally accepted accounting principles. written off during the vesting period uniformly. 5. No restrictions on shares granted under ESOPs 5. Shares acquired under ESPS at concesor ESPS. sional prices are locked in for one year.

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Table 10.2 Comparative Chart of ESOPs

There is no restriction on the quantum of the total capital that can be subscribed through the stock option route. However, it should be commensurate to the benefit received or to be received by the company from the allottees of such shares. Most companies nowadays prefer to issue stock options as a part of the compensation package for employees and therefore initiate an Employee Stock Option Plan. It is found that companies generally prefer to have about 5-10% of their issued capital under the category of ESOP till the IPO stage is reached.

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10.2 Venture Capital Finance The introduction to venture capital and its Indian overview has already been discussed in Chapter 2. Herein, we discuss the operational issues of raising venture capital. Venture capital is used in the context of ‘risk capital’ necessary to kickstart a business idea into a commercial reality. Therefore a venture capitalist invests early, invests gradually in phases and looks for bigger returns. Recognising this profile of venture capital, the SEBI (Venture Capital Fund) Regulations, 1996 stipulate that venture investments shall be only in unlisted companies either privately or through the prospectus when they go for IPO. In other words, venture investors cannot invest in secondary offers or in any other route after a company is listed. However, they can subscribe to a rights issue by virtue of their permitted earlier investments and receive bonus shares upon such issue being made by an investee company. We now look at the life cycle of a start-up company, structuring the company to raise venture capital and issued connected therewith.

10.3 Raising Venture Capital As mentioned above, venture capital is meant for young companies that evolve from a start-up stage. The term ‘start-up’ typically refers to the early stage in the life of a company that has been formed to set up a technology backed business venture or a technology development venture with an intent to commercialise the same. The tag of ‘start-up’ remains with a company till it has sufficiently advanced from a concept stage to being a business that has been sufficiently accepted by the market and its commercial feasibility has been proven.

10.3.1 The Start-up Firm vis-à-vis a Green-field Project Generally, the start-up stage of a company begins with the germination of a concept or a ‘business idea’ and lasts till it has been able to successfully commercialize the idea for the first stage of its launch. Once the first stage of commercial operations has been achieved, the milestone of completing the start-up stage is reached. However, one needs to clearly distinguish the type of businesses that go through the start-up phase and those that are set up as green-field projects. Green-field projects are set up from grass-root level with significant project risks and without the existing business linkages made either by promoters with previous business

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experience or by first generation entrepreneurs. Such projects, though involving a start-up stage, have to be looked at with a different perspective since all the business and financial risks are taken upfront. The following exhibit differentiates between the two types of business ventures.

START-UP BUSINESS Business Structure

GREEN-FIELD PROJECT Business Structure

1. Generally associated with a technology venture.

1. Generally associated with a commercial venture.

2. Venture to be backed by technology that has been created or is to be created.

2. Project based on commercially proven and established technology.

3. Requires product development/technological and/or market validation.

3. Requires setting up of a manufacturing or industrial facility.

4. Product has to be successful at lab scale/ prototype level before it is commercially launched.

4. Technology and product should be well established and there should be an existing market for the product.

5. Test marketing or phased marketing is required since concept selling is involved. 6. Business to be ramped up in phases. 7. Business risks are taken in phases.

Financial Structure 1. Start up firms go through rounds of financing starting from the seed stage to pre-IPO stage. 2. Financial risk is taken in phases. The highest risk reward relationship is at the seed stage and the risks and rewards go down progressively as the business gets de-risked in each subsequent round of financing. 3. Promoters may or may not have sufficient financial resources. Their technology is valued and allowed to be capitalised as stock. Alternatively, investors are prepared to pay a high premium on their stock.

5. Market to be defined clearly and marketing to be well-structured either directly or through strategic tie-ups. 6. Requires a minimum economic scale of operations to be set up. 7. Business risks are taken upfront.

Financial Structure 1. Projects are structured with a minimum level of investment based on the industry, product demand and economies of scale. 2. Financial risk is taken upfront. The risk is the highest at the implementation stage of the project and thereafter goes progressively down. 3. Promoters need enough financial strength to bring in the contribution required from them. No cognisance is generally taken of intellectual capital.

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(Contd.) 4. More suitable for financing through equity since the business model may not be able to support debt financing.

4. Requires more of debt financing since it is capital intensive.

5. Tangible asset creation would be less since there is a high component of intellectual property creation.

5. Requires high level of tangible asset creation as security for the debt financing.

6. Involves significant amount of cash burn in terms of product development and validation expenditure and seed marketing expenses.

6. Cash burn is in terms of pre-operative expenses and one-time project related expenditure. Generally, the level of cash burn is not very high as a percentage of total investment in the project.

7. The business model should have the potential for very high returns to investors since the risk level is also very high. The risks are clearly understood through a Due Diligence process and assumed by the investors.

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7. Financial risk is sought to be minimised through contractual and financing structures.

Table 10.3 Structure of a Start-up vis-à-vis a Greenfield Project

10.3.2 The Start-up Cycle As stated above, the start-up stage of a company begins with the germination of a concept or a ‘business idea’ and lasts till it has been able to successfully commercialize the idea for the first stage of its launch. Therefore, the start-up life cycle of a company consists of the following phases: �

Conceptualizing the business idea.

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Validation of the business idea

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Forming the core team.

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Appointment of outside agencies.

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Floating the business entity.

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Formulation of the Business Plan

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Seed Financing/Angel Round Financing

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Proof of Concept/Product Validation

Private Placements of Equity �

Making key statutory filings

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Early stage/First round financing

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Commercial launch and market validation.

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Each of these stages is discussed below:

Business Idea There are two types of business ideas; the first category are pioneering ideas that create and launch a ‘concept’ and the second category are those that are based on the identification of a ‘business opportunity’. Technology product companies often belong to the first category such as Microsoft that launched the Windows platform, Hotmail that launched the first web based free e-mail service or Intel launching a new generation computer chip. The second category of ideas germinates from those persons who have a keen sense of spotting a business opportunity where it exists and the entrepreneurship to take up a commercial risk. These business ideas may relate to concepts that are already in vogue but are better packaged to cater to an unaddressed segment of the market or simply to meet the supply gap in the existing market. For instance, Compaq was born to address what its founders, Canion, William H. Murto and James M.Harris thought was a gap that existed in the PC market. Dr. Reddy’s Laboratories was born due to the clear business opportunity that Dr Reddy perceived in the existing bulk drugs and formulations industry.

Validation of the Business Idea The business idea is then put to test through discussion with friends and associates and technology and business experts. At this stage, the business idea is not publicized too much but just enough to get the initial reactions so as to fine tune it further or drop it altogether if it is found to be unworkable.

Forming the Core Team If the initial validation of the business idea looks encouraging, the next phase would be to put in place the core team for implementation of the proposed business. In most situations wherein technology and /or product development is involved, the business idea is generated by a few technology experts who conceptualize it. These

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persons are hands-on experts in their chosen area and have a sound understanding of the technological backbone surrounding the business idea. However, for the take off of the commercial venture, it would be necessary to have persons with some experience in commercial operations such as marketing and business development, sales and distribution and business management. Mostly, these various disciplines have a close relation to business domain and therefore, persons who are experienced in the relevant business should be preferred. For instance, manufacturing business is quite distinct from software or IT business. Within IT, hardware business is quite different from that of software. Within software, commercial application software is different from scientific or embedded software and so on. Therefore, the initial team of founders must be persons with a relevant background in technology, business contacts and also having management skills. This is probably the clincher in determining the future of a start-up company. It is very important to mention here that it is also necessary for some of the core team members to have a financial commitment to the proposed business. This would help in building up some equity into the company till the stage that the outside investors are roped in. This very early stage financing is necessary to start off the initial cash burn such as meeting administrative expenses, travel, buying technical or trade journals or soliciting such information, membership fee for technical or professional bodies, setting up a small office, hiring an incubator facility or a laboratory, hiring a few technicians and an accountant etc. However, it is not necessary to have the entire core team in place even before the venture has taken off from the concept stage. In order to keep the organisation lean and minimise cash burn, it is customary to find that some of the core team members (or all of them in some cases) are in whole-time occupation elsewhere and working on the start-up idea. However, there has to be an understanding between them to come on board the start-up at the appropriate time. The right time for such induction is normally at the stage of the first round of venture capital financing.

Appointment of Outside Agencies It is also necessary to identify and appoint a few key resource professionals for undertaking important assignments for the start-up. The first could be a technical consultancy organization or a laboratory that may be required to undertake certain development work or testing and technical validation for the products or services. The next agency that may be required is a market research agency for validating

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the potential market for the company’s business plan. The third is a Chartered Accountant who would help in incorporating the right kind of company and takes care of the audit work. The fourth would be a practising Company Secretary who needs to certify compliance reports for the company if the paid up capital of the proposed company would be less than Rs. 20 million. At a later stage, if the company were to cross this limit, it would need to appoint a whole-time company secretary. The proposed company may also require the services of a legal advisor or a solicitor depending upon the type of business and the various issues involved. The other important appointment required at this stage would be that of an investment banker or a financial advisor who will help the company in formulation of the Business Plan and guide the company in structuring and negotiations with investors. Normally bigger investment banks do not associate with start-up companies unless the size of the funds to be raised is quite large. However, the boutique investment banks and financial advisory firms do associate with such companies especially where fund raising either through the equity or the debt route is involved. Sometimes, the company would have a management advisor who is an individual to advise the company during the seed stage who would continue to exist either as an advisor or as a member of the Board once the company is formed. It is customary to find such appointments nowadays especially in view of the recent guidelines on corporate governance. When the investment banker is appointed at a later stage, the advisor continues to share the place of the management and voices his view so that the investment banker can act accordingly. Examples of such advisors could be individuals such as professionals like bankers and financial experts, practising chartered accountants etc.

Formation of the Company The start-up company needs to be incorporated at this stage so as to proceed further with its objective. Under the existing framework of law, it is possible to incorporate it as a company under the Companies Act 1956, either as a private company or a public company limited by shares. The type of company chosen would depend upon the scale of business proposed, the amount of investments required and proposed sources therefor, the type of contractual relationships required to be entered into and relevant provisions of law. In some cases, it is beneficial to incorporate the company as a private limited company to begin with and convert it later into a public limited company at a later date. The company has to be registered with an initial authorized capital. Since the incorporation fee for the company would depend on the size of the authorized capital, it would be necessary to peg it down

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to the bare minimum at this stage. This would save some initial costs at the time of incorporation. The bare minimum would depend on what is statutorily required as also the initial investment from the core promoters. The authorized capital can be increased successively at later stages as and when required. The other important aspect in incorporating the company would be to carefully draft the objects clause of the memorandum of association and to decide on the appropriate State for incorporating the company. Both these are important since changing them at a later stage could involve complications and delay. The objects should be defined as widely as possible based on the future scope for expanding the business. The incidental objects should also be widely defined so as to empower the company to enter into financing transactions. The registered office of the company should be situated in the State where the company would be based. This would depend upon the domicile of the promoters, the place of operations, the industrial promotion policies and business climate in each State and other relevant factors. The name of the company should be appropriately chosen to strike the right chord in the mind of every person who would deal with it. It should also convey the business of the company quite clearly. It should also be easy to remember and amenable to be abbreviated into an acronym such as TISCO, BALCO, TELCO etc. Once the company is incorporated, it would be necessary to open bank accounts in the name of the company wherever required. This would require signatories to be nominated by a resolution of the Board of Directors of the company. It would be necessary thereafter to deposit all funds into the company’s accounts and expend the same through cheques. At the same time, suitable books of account need to be opened to account for all the transactions that the promoters have made on behalf of the company till its incorporation and to record all the transactions that would be entered into thereafter on a daily basis.

Formulation of the Business Plan The Business Plan comprises of a thorough understanding of the business model and its constituents for the execution of the business idea and the commercial feasibility of the said model. The commercial feasibility is determined in terms of the roll out plan for the products or services as the case may be, the volume of operations envisaged in the initial phase of the roll out, identification of the revenue and cost streams for the operations and developing the financial model that establishes

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both the profitability and the financial viability of the business based on certain critical assumptions and scenarios.

Financing the Seed Stage This is the most critical phase in the life of a start-up and determines whether or not the company’s plans take off. Seed financing typically has to fund the company’s cash burn till such time that the commercial validation of the company’s business model has been achieved. For a technology start-up, the validation is made in terms of product development and also demonstrating the proof of concept prototype (beta version) for a customer. For a manufacturing start-up, the validation is in terms of achieving pilot scale operations and test marketing the same successfully. For a trading or a services company, the validation is in terms of achieving the cash flow model successfully. Seed capital normally has to be financed by the core promoters who have founded the company and intend to remain significant shareholders. In case the core promoters do not have sufficient financial resources, they need to borrow from their friends and associates on personal account and invest the funds into the company. In the case of companies that are eligible for venture capital financing, the VCs would be inclined to finance the major portion of the seed stage and the first phase of commercialization by a combination of debt and equity financing with the balance to be brought in by the promoters. In certain technology start-ups there could be an angel financing for the seed stage and thereafter the first round of VC financing. Angels are high networth investors either with or without related business experience but with sound business acumen and a penchant for undertaking risks.

Proof of Concept/Product Validation The demonstration of the proof of concept vindicates the faith of the promoters in the product or service idea and also paves the way for the commercial launch thereof after evaluating the commercial aspects. The proof of concept in a technological product or service would lie in demonstrating it successfully either at a lab scale or in a limited version (beta version). It may also be necessary to get it certified either by a governmental or an international agency if there is such a requirement. Sometimes, the product may be validated by launching it in a test market on a limited scale. The proof of concept should be backed up by an endorsement from the test market on the usefulness of the product or service, its pricing and affordability, its positioning against similar competing products and its market potential.

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Making Key Statutory Filings At this stage, it becomes important to make all the key statutory filings required to take the business forward. The most fundamental among them is the protection required for intellectual property (IP) creation. If the IP is in terms of an invention or technology such as know how, designs or drawings or a life science discovery or a drug or an ayurvedic formulation, it could be protected in terms of a patent made under the Patents Act or a filing with the Drug Controller or such other authorities. If it is commercial IP such as a trademark or an emblem it can be protected under the Trade Marks Act. If it is a software, literary, architectural or a music product, it would require protection under the Copyright Act. Sometimes, if the product or service is proposed to be launched in international markets, it would be required to seek IP protection in the respective countries as well. The company should also make use of the services of the lawyer to ensure that adequate legal protection is available to its IP and to enforce it when necessary. Inadequate IP protection could become an issue for VC investment later on. Similarly, the company would also require approvals and licences while operating in India or abroad when it makes use of IP protected by others. In such cases, it would be necessary to ensure legal compliance. The company would require services of lawyers in the respective countries to ensure it is on safe ground. Apart from IP protection, other necessary filings for registrations are required with the Secretariat of Industrial Approvals under the Ministry of Industry of the Central Government, the Directorate of Industries in the relevant State, under the Factories Act (for an industrial unit), Pollution Control Acts, Software Technology Parks Scheme (for software units), EOU scheme (for export oriented units), Central Excise (for manufacturing units), Customs and DGFT (where capital import licence or exports and imports are envisaged), SSI registration (for small scale industries), Central and Local Sales Tax (for product sales), Service Tax (for services), Income Tax filing for allotment of a Permanent Account Number, Shops and Establishments Act (for setting up commercial activity in urban area), Professional Tax (for collecting professional tax from employees), Provident Fund Act (if the number of employees exceeds the specified minimum), ESI Act (where there are industrial workers) and the Reserve Bank of India for foreign currency remittances under exchange control regulations (where necessary). The company should also take the assistance of the auditor or the company secretary to get all the necessary filings done and thereafter maintain statutory compliance in terms of periodical returns, approvals and related documentation.

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Early Stage/First Round VC Financing The term ‘First Round Financing’ refers to the first equity fund raising through institutional investors, more popularly known as venture capitalists since they specialize in early stage investments that have a considerable risk profile. A venture capitalist invests early in a company’s life so as to benefit from the significant value creation that could happen later on. At the same time, the venture capitalist stands to lose heavily if the company’s business plan does not materialize. The attributes that a VC looks for before investing in a company are generally one or more of the following: �

� �

�

�

�

�

�

�

�

�

�

An industry or space that is currently a sunrise sector that promises to create a paradigm shift. An exciting concept that has the potential for an uninhibited market. A concept that significantly improves the existing processes or applications and therefore finds a vast replacement market. A business or idea that has potential for spin off businesses or revenue streams or significant possibilities for future scale up. A start-up business that has the potential to become an attractive proposition for strategic acquisition in future by a market leader. A firm that has the caliber to become an industry leader in due course with the right inputs. A business that is in a cutting edge technology that could become an industry benchmark. A company that has sufficient technology and management bandwidth to reach and sustain the leadership position that it promises to attain. A business or technology that has a first mover advantage which can be harnessed adequately before competition catches up. A business that has significant entry barriers for the competition either in technology or in business variables that can largely be sustained. A firm that has an unfair advantage to begin with which could remain long enough before it is diluted by competition or regulation. A firm that offers possibilities for multiple exit options.

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Looking at the above list of attributes, it is clear that not many firms would fit into them and that explains why venture financing should not to be construed as a source of business finance for everyone. Venture capitalists play a high-risk high return game and are therefore very selective in their investments. Despite such stiff investment criteria, the mortality rate in VC funded firms is very high. There are many other types of start up firms that do not qualify for venture capital as they do satisfy the investment criteria of VC investors. These could be more of commercial ventures in manufacturing, trading and services that either address a commodity or a mass market, small scale market, or engaged in the business of volumes with thin value addition or in a generic product or service market with little technology backbone. Such businesses do not find favour with VC investors and would therefore need to be financed differently. There are also another category of investors known as the corporate VCs that are primarily off-shoots of an existing large conglomerate. Such VCs encourage either spin-offs of its parent or ventures that can have close linkages or synergies with their parents. Examples of such VCs are General Electric, Intel, Citigroup etc. In India, Infosys and Wipro are known to have financed start-ups set up by their employees. The table below compares the financing patterns of VC financed start-up companies and those financed by alternative routes.

Commercial Launch/Market Validation The start-up status of a company gets completed once the following milestones are reached: �

The production facility or development centre as the case may be gets commissioned successfully.

�

The trial runs or commercial scale capability is established.

�

Technical certifications or approvals are obtained for commercial launch.

�

The production or operation has been commenced at commercial scale as envisaged.

�

The market launch for the product or service is made.

�

The product or service receives market validation.

�

The company’s cash flow cycle begins to work.

Private Placements of Equity

VC financed Start-ups

481

Other Start-ups

1. Financing is more through the equity route. Some part of the initial financing could be a convertible or a soft loan to prevent excessive dilution of promoters' equity. Most VCs do not provide loans and prefer convertibles.

1. Financing is invariably through a combination of debt and equity. Currently, start-ups are financed on a 1:1 debt to equity ratio.

2. Sources of finance are equity from Promoters, strategic partners, VC investors and marginal borrowings for working capital from banks.

2. Sources of finance are equity from promoters and partners, development loans or soft loans, grants or subsidies from governmental sources, and commercial loans for capital costs and working capital from banks and financial institutions.

3. Promoters' equity is more in intellectual capital and stock options than in hard cash.

3. Promoters have to bring in between 30-50% of the first round of financing.

4. Financing is generally linked to pre-set milestones either in terms of financial projections or strategic achievements.

4. Lenders are comfortable in projecting the entire capital costs requirements for the first phase at the time of sanctioning of the loan.

5. VCs are open to financing significant soft costs in the project plan that do not result in creating tangible assets. In other words they are not security oriented in the financial structuring.

5. The financing structure should result in an asset cover of at least 125% for the lenders. The structuring does not permit too much of soft costs in the project. If they were inevitable, to that extent, the equity content in the financing would be increased so as not to dilute the asset cover on the loans.

6. VCs are amenable to financing working capital requirements if that would mean a saving in financial costs and thereby improve margins.

6. All initial and future requirements for working capital have to be met out of the working capital borrowings and cash accruals of the company. In the event of inadequacy, the promoters have to bring in fresh contribution as equity or soft loans.

7. No collaterals need to be created for VC financing.

7. Collaterals such as personal assets of promoters or personal guarantees of persons with high networth are insisted upon.

8. No restrictions are placed on allocation of funds for working capital.

8. Working capital financing is subject to sub-limits on each component and strict vigil is maintained on its utilization.

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(Contd.) 9. Monitoring is more of mentoring, with the VC appointing its nominees on the board of the company to bring in significant value addition apart from protecting its interests.

9. Monitoring is more with a watchdog approach through periodic returns and statements and satisfaction of objective criteria.

� Table 10.4 Comparative Financing Pattern

10.3.3 Key Elements in Business Structuring of a Start-up The structuring of a start-up company’s business involves several key elements that are comprised in the following areas:

Formulation of Business Strategy and Corporate Structure The most important starting point for a start-up in its commercial life is the formulation of the business strategy. A well-thought out strategy could actually add value even to a seemingly mediocre business idea. However, even a brilliant business idea could falter if the strategy is not well laid out. In formulating the overall business strategy, the business model has to be kept in mind and individual aspects relating to positioning, marketing, pricing, delivery, customer relationship management, technical support and up-gradation and mechanisms for continuous enhancements have to be evolved. A well-structured strategy could be an important determinant in the valuation of a start-up by prospective investors. For instance, the valuation of some of the internet companies in 19992000 was purely based on their business model such as India World acquired by Satyam Infoway for Rs. 4990 million, Chaitime.com valued at $120 million and so on. Though such fancy valuations now belong to a bygone era, they vindicate the fact that step up valuations are possible based on the strength of the business model and its strategy. The corporate structure of a start-up should be transparent and simple to understand. Structures that involve distribution of the value chain over two or more group companies, inter-company transactions, plans to spin off subsidiaries etc are viewed with scepticism by investors since the structures become difficult to understand.

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Value creation has to be concentrated in the company that is being invested into. In certain cases, it may be necessary to distribute value in two or more entities for various strategic or regulatory reasons. For e.g. a pharmaceutical company may wish to manufacture bulk actives in one entity and finished dosage forms in another due to drug regulatory issues. In such cases, the corporate structure needs to be created through a 100% subsidiary structure so that investors investing in the parent company are fully deriving the value of the subsidiary. Therefore, the main intention is to avoid cross-holdings and diverse holding pattern that vitiate confidence and dilute value.

Key Commercial Contracts Key commercial contracts are those that drive the business model. These could be marketing contracts, purchase contracts, manufacturing contracts or infrastructure related contracts. The structuring of these contracts in the form of several layers of agreements not only requires careful drafting but legal expertise in envisaging adequate protection of interests as well. Most of these contracts are fundamental to the existence of the start-up and should therefore envisage all the upside and downside possibilities and provide appropriate treatment therefor. Usage rights on commercial assets have to be well-defined in contracts involving lease of property and infrastructure. In marketing contracts, there should be clear understanding on clauses relating to territorial jurisdiction, pricing, underwriting minimum off-take, ‘use or pay’ and such other critical areas. The contracts should also provide flexibility in amendments, extensions, exit and dispute resolution. Any unaddressed area of understanding could lead to vexatious litigation in future. Investors and lenders are normally wary of contracts that are poorly drafted and they tend to avoid staking their funds in such situations.

Composition of the Board The Board of Directors is considered the face of the company and should therefore be crafted to perfection. A well-constituted board reposes confidence in whatever goals the company sets out to achieve. There are different theories and philosophies to define what a well-constituted board is. It is customary for a start-up to seek a non-executive external Chairman such as an industry or corporate personality or a retired government official. It is advisable to avoid appointing political personalities as it could act as a double-edged sword. The Chairman should be a person of good

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character and have a sound business acumen and he should also possess demonstrable value that he can pass on to the company either in terms of management inputs, contacts or vision. The other members of the board may be drawn from the promoters, nominees of VCs or lenders as the case may be, working directors and independent directors. In the case of a start-up it is better not to pack the board with too many directors. A board with around six members is ideal with a mix of two promoter-directors holding executive positions, a non-executive chairman and three professional independent directors. The Companies Act 1956 is moving towards stipulating a majority of independent directors on the board.

Management Structure The management structure should be well defined to address various critical functions of the business. Today, several organizational models exist ranging from a pyramidical structure to completely flat organizations. The organizational structure has to be chosen based on the type of prevalent industry work culture and business dynamics. It is necessary for a start-up to identify key executive positions at the time of drawing up the business plan. These are generally the positions of a Chief Executive Officer (CEO) or Chief Operating Officer (COO) and Chief Financial Officer (CFO). Some technology intensive firms also appoint a Chief Technology Officer (CTO). Sometimes the Board consists of a Managing Director who also acts as the CEO and a whole-time director in the place of a COO. It is not necessary to fill up the organizational slots completely before the financing is completed. The core team consisting mainly of the strategic members can be identified and the operating positions including that of the CFO may be filled up later on. It is also found that certain investors require the CFO to be appointed of their choice.

Key Employment Contracts This is a critical dimension in business structuring as it defines the commitment of the core team members to the company and thereby lays the foundation for the success of the business plan. Investors and lenders do not appreciate divided attention from the core team and therefore it is essential to demonstrate their commitment solely to the company. At the same time, the employment contracts should provide enough

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room to show that since their commitment to the company is undivided, their interests are well taken care of. Most importantly, the contracts should also cement a long term relationship between the company and the core team. There are several ways to achieve this objective; the financial tool for cementing a long term relationship is provision ownership rights on the company. This is accomplished in two ways—(1) through issue of sweat equity shares and (2) through issue of Employee Stock Options. These are elaborated further in subsequent paragraphs in this chapter.

Intellectual Property Protection and Management Most companies, knowledge intensive or otherwise, have some amount of IPRs in their businesses. These could be technological property such as proprietary technology or process know-how or copyrights which are created either by the promoters or within the company or acquired from outside and commercial rights such as licences, assignment rights, brands, domain names and trade-marks. These are intangible assets for the company and therefore need to be safeguarded just as tangible assets are. A start-up company needs to legally safeguard these rights through appropriate registrations under the relevant IPR law in India or even abroad. Not all IP is recognized for protection under law. However, as far as business is concerned, any technology or know how that can create or realize value is IP which requires to be harnessed through appropriate contracts. The second aspect of IPR protection is in ensuring that these rights are not diluted in key commercial contracts that the company may enter into either for acquiring such rights or for exploiting them. Most investors are particular of a due diligence on the IPRs of a company to inquire into their FTO (Free to Operate) status. Several early stage companies bind themselves in key contracts that might inhibit the FTO status of their IPRs and actually diminish their value even before they begin to encash it. Issues such as ‘first right of opportunity’, ‘joint development rights’, encumbrance of assets are good examples of areas wherein FTO rights can be encumbered. Start-up technology companies have to particularly ensure that their IP is not bound by the absence or dilution of FTO rights. Since IPRs are a significant driver of valuation, it would be worthwhile for the company to engage a lawyer with specialisation in IP law to vet all critical agreements on the FTO aspect before they are executed. FTO status is the minimum that a VC looks for but it may not be sufficient in all cases. For e.g. if another entity has a dominant IP position in the same space, it would be difficult to convince investors. FTO may be sufficient given patent protection, large markets and other strengths. However, generally

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speaking a broad IP position is what investors like though it may not be offensive enough to be a long-term entry barrier. Last but not least is the aspect of intellectual property (IP) management for most knowledge intensive businesses and those that have a knowledge component. IP creation and protection are a must to create value and sustain it over a period of time. As far as possible, IP should rest with the company that seeks to attain maximum value creation. This would be looked at as an investor friendly model as opposed to a structure wherein the IP is privy to those who create it and remains exclusive to them. Therefore, if IP is external to the company, it has to be acquired by the company quite early in its life. Similarly, if the company possesses non-strategic IP, this needs to be harnessed outside the company through appropriate partnerships, alliances or outright sale. In case of strategic IP, the company has to put in place IP management systems to ensure that they are properly documented, protected and transmitted with proper succession.

Corporate Governance Start-up companies may find it too premature to address the issue of corporate governance but it is never too early to implement it. A good corporate governance ethos enhances the value and trust reposed by investors and it has a direct impact on its growth. It is better to be ahead in corporate governance than the minimum statutory standards. One of the important provisions on corporate governance applicable to start-up companies is mentioned under Section 217 (2AA) of the Companies Act which provides for a Directors’ Responsibility Statement to be included as part of the Directors’ Report every year. The second provision that is applicable only to public companies with paid up capital in excess of Rs. 50 million is about the constitution of an audit committee of the board under section 292A. There are also several other provisions to address issues relating to conflict of interest and corporate disclosures. Though the law provides the broad contours for corporate governance, individual companies would do well to maintain transparent business practices and shareholder wealth maximization as the paramount objective above all other conflicting goals.

10.3.4 Key Elements in Financial Structuring of Start-ups The financial structuring of a start-up company has to be very carefully thought out and planned as it would have long-term impact on the company’s prospects.

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Some of the important elements thereof are discussed in the following paragraphs:

Estimation of Fund Requirement The first and foremost exercise is to forecast as closely as possible, the financial requirements to meet the setting up of the business or the project as the case may be, in terms of the following elements: � �

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�

�

Capital cost of fixed assets and intangible assets. Deferred revenue expenses to be incurred upfront such as product development costs, seed marketing expenses, legal filings etc. Pre-operative expenses to meet the cash burn till the project starts to generate revenue. Working capital requirements to finance the operations for the first twelve months. Financing required to meet cash losses to be incurred until cash break-even is attained.

Capital Structuring for Equity Financing Capital structuring is done at two levels—firstly for the total funds deployed in the company and secondly, for the equity component thereof. Generally speaking, knowledge intensive or service-based businesses such as IT, software, communication and media companies are not capital intensive and therefore cannot be financed significantly by debt at their inception. Secondly, most of the fixed assets used in such businesses are at the higher end of technology with very specific applications. Lenders find it difficult to accept them as comfortable security that can be liquidated in case of a recovery proceeding. However, as these companies grow and stabilize a cash flow model, it would be possible to raise debt finance on the strength of their cash flow. Alternatively, the promoters have to come up with large chunks of collaterals that most start-up promoters cannot. Therefore, the capital financing for such start-ups is mostly done through equity and convertibles or hybrids raised through private sources and venture capital. Once the company is sufficiently capitalized through the equity route and has a predictable cash flow, debt financing is resorted to in the subsequent rounds of financing to prevent expansion of equity base and consequent dilution of promoter equity.

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In early stage financing for start-ups, generally, the promoters are allowed to subscribe to the equity at par value while the VC investors step into the company at a premium to the par value. The valuation of the company to arrive at the premium would depend on several value drivers in the business model as outlined earlier. Another route to shore up promoter equity in technology intensive businesses is to allow promoters to get sweat equity in return for their technology contribution to the company. In companies that are not technologically intensive, instead of sweat equity, stock options can be issued to the core team members including the promoters so that they can get additional shares at a concessional price. In addition, VCs stagger the conversion of their investment into equity by adopting different financing structures such as cumulative convertible preference shares, convertible debentures or soft loans, equity warrants or options. The idea is to prevent excessive dilution of promoter equity due to the infusion of funds by the VC investors. The use of all these mechanisms is regulated to a certain extent by statute. The provisions do not recognize start-up companies as a different category but club them under the classification of unlisted companies. The regulations for unlisted companies are different from those applicable to listed companies. The regulations that are applicable to sweat equity and stock options have already been discussed in paragraph 10.1.3 in this chapter. As per the provisions of section 79A of the Companies Act, since a start-up has to wait for a year to issue sweat equity if it so desires, the terms thereof have to be crystallised before hand through a special resolution. These terms could then be taken into account by investors who are investing in the company during the first year. Otherwise, the company may have a problem if it brings up the issue of sweat equity after the initial round of financing is done.

Capital Structuring for Debt Financing Companies that can avail debt financing at the start-up stage need to structure their capital base to the satisfaction of the lenders with a suitable mix of debt and equity. In the case of companies setting up a project or manufacturing facility, the longterm debt component has to cover about half of the total project cost and margin money for working capital. The balance project cost has to be contributed through equity route by the promoters and through private sources. Companies are also required to raise financing for meeting the working capital requirement. This is usually undertaken by banks that finance units on stocks and receivables. For non-manufacturing entities, financing is mostly for receivables and to a certain extent for operating expenses. The company has to forecast its working capital requirement comfortably so as not be strapped for liquidity. Banks usually finance up to 75% of the net working capital requirement of companies. The balance is

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called margin money, which has to be financed either out of equity or long-term debt. Some of the knowledge intensive or service-based businesses such as software development are also financed for working capital by commercial banks based on an assessment of their working capital gap. In such cases, a suitable estimation of the cash flow of the firm has to be drawn up to project the cash flow deficit. The company would then be eligible to draw up to the projected peak cash flow deficit in the relevant period. The following illustrations bring out a comparison between the financing structures for a start-up company vis-à-vis a manufacturing company.

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Illustration 10.1 ILLUSTRATIVE FINANCING STRUCTURE FOR A START-UP COMPANY IN SOFTWARE PRODUCT DEVELOPMENT

Cost of the Project (up to Round I Financing)

Rs. Million

Means of Finance

Rs. Million

Promoters' Equity Seed Expenses in incorporation, lab scale development, testing etc.

2.50

Through cash fully paid up at per

4.0

Product development costs including IP protection

7.50

Sweat Equity issued at par for consideration other than cash

7.0

Employees' equity Fixed Assets for development centre, office space

5.00

Pre-operative Expenditure

5.00

Seed Marketing and promotion costs

2.50

Cash flow deficit for first 9 months

4.00

Total

26.5

Employee Stock Options at par

3.0

VC Investors' equity 19.5 Equity Investment made by investors at agreed valuation

26.5

Note: Sweat Equity of Rs. 7.0 million would be excluded to compute fund requirement since it is issued for consideration other than cash.

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Illustration 10.2 ILLUSTRATIVE FINANCING STRUCTURE FOR A START-UP COMPANY SETTING UP A MANUFACTURING PROJECT

Cost of the Project (up to Round I Financing)

Rs. Million

Means of Finance

Rs. Million

Promoters' Equity Land and Site Development

2.50

Through cash fully paid up at par

Buildings and Civil Works

20.00

Private Placement of equity

Plant and Machinery

40.00

with friends, associates and relatives

7.50

Preliminary and Pre-operative Expenses

0.50

ESOP to working directors and employees at par

Pre-operative Expenditure

10.00

Debt Financing

Contingency Provision

7 50

Secured Term Loans from Financial Institution/ Commercial Bank

Margin money for working capital

5.00

Unsecured loans from promoters

Cash flow deficit for first 10 months

7.00

Working Capital gap excluding margin money Total

15.00

Employee Equity

Miscellaneous Fixed Assets

Total

25.00

5.0

48.00

7.00

100.00 15.00 115.00

Working Capital loans from commercial bank

15.00 115.00

Private Placements of Equity

491

10.3.5 Investment Banking Services for Raising Venture Capital The investment banker plays a key advisory role in formulating the business of a start-up company and also helps it to raise its finances. The key area wherein the investment banker plays an important role in transaction services, which in the context of a start-up is essentially in fund raising and allied functions. Broadly, the following services can be delivered by the investment banker to a start-up company: �

�

�

�

�

�

�

Strategy and business advisory services in formulating the business model for the company’s stated business objective. Perform a study of the industry landscape and competitor analysis, product pricing strategy and SWOT analysis. Conduct a preliminary due diligence and advise the company on the necessary steps to be taken to make the business model credit worthy and investor friendly. These aspects relate to the business and financial structuring of the company, which have already been discussed earlier in this chapter. Formulate the investment offering to be made by the company, which comprises of valuation and deal structuring. Prepare the business plan and the Information Memorandum or the Project Report as the case may be for the company’s fund raising including the detailed financial modelling and other promotional materials for the purposes of dissemination to prospective debt financiers and investors. Act as the arranger for the company’s debt or equity financing as per the financial plan that includes representation and negotiations. Raise financing for the company in the most efficient way possible.

In the course of performing his functions, the investment banker has to also work closely with other professionals both inside and outside the company such as the CEO, CTO, CFO, the Company Secretary, the auditor, the legal advisor and the financial advisor. Considering the fact that investment banks provide transaction-oriented services, it is found that most of the top line investment banks do not prefer to work with start-ups in pure advisory role unless the company’s business plan is large enough to their liking. This is because most of them would want to have a minimum deal size (fund raising) that would justify the time spent on the assignment and the fee

492

Investment Banking

charged to the client. It also does not make sense for companies with smaller deal sizes to appoint larger investment banks, as their fee would make the exercise unremunerative. However, there are several mid-sized and smaller investment banks, financial companies and consultancy firms that handle proposals relating to start-up companies. Since most start-up companies raise funds from private and institutional sources, no public offering of debt or equity is involved. This makes it convenient for arrangers without a merchant banking licence from the SEBI to handle such proposals for fund raising. Some of the larger consulting firms also deliver advisory and fund raising services to start-up companies.

10.4 Raising Private Equity The Indian and foreign institutional equity funds operating in India are moving more towards the ‘private equity’ model from being venture capital investors. Some of the traditional VC investors have made policy statements to this effect. This phenomenon has been partly trigerred off by the aftermath of several start-up dotcom financings made during the technology boom of the late nineties. These investments were typically in very young companies without a revenue stream and the valuations were made on improbable assumptions. Most of these start-ups died a natural death and some others could not receive any follow-on funding from VCs. On their part, the institutional equity investors have realized that a narrow focus on information technology alone makes their business model quite unsustainable. On the other hand, the past few years have thrown up several good opportunities for private equity investments. ‘Private equity’ by definition is more of a financing activity whereby equity investors identify good investment options in well performing companies, either listed or unlisted and look at larger deal sizes. The valuations are on more established lines based on the cash flow model and in the case of listed companies, these are benchmarked to the prevailing market capitalization. Therefore, it may be said that private equity market is all about investors who invest later, invest more, prefer reasonable stakes and expect superior to market returns. Over the past few years, the Indian industry has been going through consolidation in various sectors and companies have been ramping up rapidly mostly through the acquisition route. This has thrown up some good opportunities in other industry sectors apart from information technology. Banking, cement, retailing pharmaceuticals and others have become favourite hunting grounds for later stage investments, some of them in the nature of acquisition financing.

Private Placements of Equity

493

10.4.1 Investment Banking Services for Raising Private Equity In the area of private equity financing, the role is more transaction oriented than in venture capital fund raising. This is because, the business model of the company is more established, the organisation is fully in place and the cash flow model is proven. Therefore, the value addition of the investment banker in such deals is in valuation and transaction advisory. However, there are certain caveats that the investment banker has to be fully aware of while raising private equity for listed companies. These primarily relate to the disclosure of information to potential investors, some of which can be classified as price sensitive information. While SEBI guidelines on disclosure of price sensitive information of a listed company are quite stringent, these are more in the context of insider trading or fraudulent manipulation of market price. However, in a private equity deal, the disclosure is for the purpose of enabling the potential investor to take an informed investment decision. In this context, the whole process has to be handled with extreme confidentiality and through suitable documentation by way of non-disclosure agreements so that none of the connected parties are put to hardship at a later date. However, there being no specific SEBI guidelines on private equity investment in listed companies, information disclosure in connection with it is largely a grey area at this point of time. The investment banker has to structure the offer literature including the information memorandum keeping this issue in mind. Secondly, the offer literature has to captures the true value proposition of the company and provides an investor friendly offer structure. While the value capture helps the company to get an appropriate valuation for the deal, the offer structure helps in striking the right chord with the investors. Usually, the mandate letter for an investment banker spells out the scope of the ‘engagement’ in detail so that there are no exclusions or lack of understanding. The ‘engagement’ in connection with a private equity transaction can be summarized in the words of an investment banker as follows: �

�

�

“Identify and initiate contact with prospective investors, including arranging road shows, and following up as necessary; Represent or accompany the company in meetings, presentations and ensuing negotiations with prospective Investors; Review the outcome of such meetings with the company, and recommend to the company further action as may be required;

494 �

� �

�

Investment Banking

Assist the company in coordinating an information dissemination and due diligence program; Review and advise on proposals/offers from prospective investors; Oversee the orderly and timely execution of each financial transaction, in cooperation and coordination with other professional parties appointed by the company and/or the investors, and the various regulatory authorities including the Securities and Exchange Board of India (SEBI) and the Reserve bank of India (RBI); and Provide such other services deemed necessary to ensure a successful outcome to this engagement.”

10.5 Private Placements to Non-institutional Investors Apart from institutional equity in the nature of venture capital or private equity that is raised from dedicated equity funds, there can be other sources to raise equity in the private placement route. These could be, family sources or associates of promoters, private high networth investors (called HNIs), seed stage venture investors (also called ‘angel’ investors), financial and investment companies, other corporates, stock broking companies, portfolio investors, institutional market investors such as mutual funds and, foreign institutional investors and non-resident Indians. Therefore, if equity is raised from any of the above mentioned sources without a public offer, it is simple referred to as a ‘private placement’ as distinguished from venture capital or private equity. Private placements in the non-institutional category are generally made through close sources. However, sometimes, a company may float a limited private placement offer. A confidential information memorandum or a letter of offer is sent out to prospective investors. Such kinds of limited private offers are generally made by appointing a suitable agency that can facilitate the fund raising. Herein, there seems to be a distinct segmentation in the market. While some investment banks specialize only in raising venture capital and private equity, others that have strong investor relationships especially in the HNI category, offer private placements to non-institutional investors as a service. These are boutique investment banks that are often an extension of stock broking houses. Using their extensive investor contacts directly and through sub-brokers, these investment banks are in a position to offer limited private placement offers through a marketing effort.

Private Placements of Equity

495

10.6 Regulatory Framework for Raising Equity Privately The regulatory framework for raising equity through venture capital, private equity and through other types of private placement can be discussed separately with special reference to unlisted and listed companies.

10.6.1 Unlisted Companies Private issue of equity in unlisted companies is governed by the provisions of the Companies Act, the memorandum and articles of association, the Unlisted Public Companies (Preferential Allotment) Rules, 2003 and the FEMA. The general company law provisions governing equity shares have already been discussed in Chapter 3. The most important provision in the context of private issue of equity is contained in section 67 of the Companies Act. The proviso to sub-section (3) of this section read with sub-section (1) stipulates that where an offer or invitation is made to fifty persons or more who subscribe to shares in the company, such an offer shall be deemed to be a public issue and all the provisions of the Act will apply accordingly. Therefore it is imperative for a private offer to raise equity to be made for a maximum of 49 persons including legal entities. Otherwise it would attract the requirements of a public issue. Apart from section 67, the other important provision is contained in section 81. As already discussed in Chapter 6, any further issue of equity share capital after the initial allotment of shares made after the formation of the company requires the approval of the existing equity shareholders under section 81(1A) by a special resolution. The provisions of FEMA apply in so far as the issue of shares is for non-resident investors. The detailed provisions affecting such issue by unlisted companies are explained in Chapter 12. One important feature for private placements in unlisted companies to is that there are no guidelines on pricing of such shares if the issue is being made to resident investors. However, for issue to non-residents, The pricing guidelines of RBI apply. Unlisted companies should also comply with the provisions of the Unlisted Public Companies (Preferential Allotment) Rules, 2003 as stated above. The important provisions of these rules are listed below: �

These rules shall be applicable to all unlisted public companies in respect of preferential issue of equity shares, fully convertible debentures, partly

496

Investment Banking

convertible debentures or any other financial instruments, which would be convertible into or exchanged with equity shares at a later date. �

�

�

�

�

A preferential issue shall include issue of shares on preferential basis and/or through private placement made by a company in pursuance of a resolution passed under sub-section (1A) of section 81 of the Companies Act, 1956 and issue of shares to the promoters and their relatives either in public issue or otherwise. No issue of shares on a preferential basis can be made by a company unless authorised by its articles of association and unless it is passed by a special resolution of the members. The special resolution shall be acted upon within a period of 12 months. Where warrants are issued on a preferential basis with an option to apply for and get the shares allotted, the issuing company shall determine before hand the price of the resultant shares. In case of every issue of shares/warrants/fully convertible debentures/ partly convertible debentures or other financial instruments with conversion option, the statutory auditors of the issuing company/company secretary in practice shall certify that the issue of the said instruments is being made in accordance with these Rules. Such certificate shall be laid before the meeting of the shareholders convened to consider the proposed issue. The notice convening the general meeting of shareholders shall disclose the following: �

The price or price band at which the allotment is proposed;

�

The relevant date on the basis of which price has been arrived at;

�

The object/s of the issue through preferential offer;

�

�

�

The class or classes of persons to whom the allotment is proposed to be made; The intention of promoters/directors/key management persons to subscribe to the offer; The shareholding pattern of promoters and others classes of shares before and after the offer;

�

The proposed time within which the allotment shall be completed;

�

Whether a change in control is intended or expected.

Private Placements of Equity

497

It may be noticed from the above provisions that in the case of unlisted companies, preferential issues are not restricted by any guidelines on pricing except that the pricing shall be disclosed to the shareholders at the time of approving such an issue.

10.6.2 Listed Companies Listed companies have to comply with the provisions of section 67 of the Companies Act as stated above. In addition, the issue of shares has to be approved by the existing shareholders vide a special resolution in terms of section 81(1A) of the Companies Act in the manner applicable to an unlisted company. In addition to the above requirements, in the case of listed companies, the relevant provisions of the SEBI DIP guidelines also apply. Chapter 13 of the SEBI DIP Guidelines prescribes that ‘any issue of equity shares by listed companies whose equity share capital is listed on any stock exchange, to any select group of persons under section 81(1A) of the Companies Act on private placement basis shall be governed by these guidelines.’ Therefore, as far as the SEBI guidelines are concerned, they do not make any distinction between a preferential allotment and a private placement. Any type of issue of equity share capital in the private route by a listed company, irrespective of its nomenclature is captured under the head ‘preferential issue’ if such issue is made to select group of persons. The basic philosophy of the DIP guidelines on preferential issues is that these should not be to the detriment of the common investors by being priced advantageously to a select group of investors. Therefore, the guidelines inter alia, prescribe the following conditions for preferential issues:

Issue of Shares �

�

The pricing of the shares shall not be less than the higher of the following— (a) the average of the weekly high and low of the closing prices of the share during the six months preceding the date which is thirty days prior to the date of the shareholders’ meeting or (b) the average of the weekly high and low of the closing prices during the two weeks preceding the date of the shareholders’ meeting. In the case of issue of shares to non-residents, the price should not be less than the price arrived at as detailed above as also the price arrived at under the erstwhile guidelines issued by the controller of capital issues.

498 �

�

�

�

�

Investment Banking

The shares issued under this mechanism to promoters of the company or their group shall be locked in for a period of three years from the date of allotment of such shares. This is subject to the overall cap on lock-in of 20% of the total issued capital of the company. In other words, if 20% is already locked up for 3 years, the shares issued under the preferential issue would be free from lock-in. Preferential issue to any other category of investors shall be locked in for one year from the date of allotment. The shares issued on a preferential basis pursuant to a scheme of corporate Debt Restructuring under the framework of the RBI guidelines shall also be for a period of one year from the date of allotment (if the shares are fully paid up) and from the date they are made fully paid up (in the case of partly paid up shares). The entire pre-preferential paid up capital held by the investors in the company shall be under lock-in from the relevant date (generally the date on which the resolution for preferential allotment is passed) upto a period of six months from the date of the preferential allotment. Shareholders in the company who have sold their shares during the six months period prior to the relevant date would not be eligible for the preferential allotment.

Issue of Convertibles �

�

�

In the case of a preferential issue of convertible instruments such as FCDs, PCDs and warrants, the relevant date for determining the price would be the date 30 days prior to the date of the shareholders’ meeting or 30 days prior to the date of conversion of the warrants, at the option of the issuer. The resolution passed under section 81(1A) shall specify clearly the relevant date for determining the price for the preferential issue. An amount equal to at least 10% of the price arrived at on the basis of the average market price as stated above shall become payable on the date of allotment of convertible warrants. This would be adjustable against the amount receivable at the time of conversion. The advance amount of 10% shall be forfeited if the conversion option is not exercised.

Private Placements of Equity �

�

�

499

The currency of the convertible instrument shall not exceed 18 months from the date of allotment. The lock-in period for shares arising out of the convertibles shall be reduced to the extent the convertible instrument was locked up. Therefore, if a convertible has been issued on non-transferable basis for one year, the shares arising on conversion thereafter shall be free from lock-in. A certificate from the auditors has to be placed before the shareholders certifying that the requirements of the guidelines have been met with.

Common Provisions �

�

�

�

The explanatory statement issued to the shareholders for seeking approval under section 81(1A) shall specify the objects of the preferential issue, the intention of the promoters and other key management personnel to subscribe to the offer, the shareholding pattern before and after the offer and the proposed time within which the allotment shall be complete. The allotment of the preferential issue shall be completed within a period of fifteen days from the date of the shareholders’ resolution. Otherwise, a fresh consent would be necessary. There are however, certain exceptions to this rule. The utilization of funds received out of the preferential issue shall be disclosed under a separate head in the balance sheet of the company. The preferential issue guidelines shall not be applicable to issues made pursuant to orders by the High Court for a merger or orders by the BIFR.

10.7 Process of a Deal The deal-making process for a private issue of equity either through venture capital, private equity or a private placement has to follow the steps discussed herein. At the outset, it may be said that raising venture capital or private equity is a tougher process than other private placements since it involves a lot more of paper work and due diligence. Hence, the process described herein is more in line with the requirements of venture capital and private equity investors.

500

Investment Banking

10.7.1 Seeking a Mandate The investment banker seeks to be appointed by the company (the issuer) with an appropriate mandate to raise the funds through the offering. The mandates given for such transactions are usually on exclusive basis, as it does not serve the interests of the company to appoint more than one investment bank for the same deal. In addition, investment banks do insist on overriding fee in case the company after appointing them seeks to raise funds elsewhere. This is to safeguard the investment bank’s interests and also to establish the commitment from either side to the mandate.

10.7.2 Perform a Limited Due Diligence The investment banker on being appointed conducts a limited due diligence with the following objectives: �

�

�

�

�

To understand the company’s business model and value proposition so as to present it properly in the Information Memorandum. To arrive at a check-list of information to be furnished, documents to be put in place and steps to be taken or milestones to be accomplished by the company with reference to the proposed deal. This check-list helps in two ways— (a) it guides the company to comply with all the necessary requirements, (b) it helps the investment bank to complete the information memorandum and prepare the company for due diligence by the investors at a later date. To vet the business plan, financial model and supporting assumptions that form the basis for the company’s case. To understand the financial requirements properly and advise the company in suitably structuring the deal. To arrive at benchmark valuation that would help in deal structuring and negotiations.

10.7.3 Financial Modelling The next step would be to develop a complete financial model for the proposed offering and the company’s projected financials. This would involve business forecasting and thus converting this forecast into estimates of profitability and cash flow. The financial modelling has to be backed by detailed assumptions, supporting

Private Placements of Equity

501

tables and computations and spread sheet analysis. The projected financial statements, i.e. the income statement, cash flow statement and the balance sheet have to be prepared. The financial model becomes the basis to arrive at a numerical valuation for the company based on valuation methodologies.

10.7.4 Arriving at the Proposed Valuation The benchmark valuation for the deal is arrived at using the financial model through established methodologies and other relevant subjective criteria. The methods used to value normal growth closely held companies focus either on the tangible assets or on the stream of future earnings over a time horizon. These methods do not work for valuing entrepreneurial companies with high growth potential because these are idea-based and growth-based rather than asset-based. Valuation methodologies for private equity deals can be broadly-based on the following two approaches: 1. The multiplier approach which uses certain capitalization factors such as revenue or Profit after tax or Operating profit (EBITDA) or a market multiple such as the Price/Earnings ratio (in case of listed companies) to arrive at the present valuation for the company. This approach is suited for companies that do not have a consistent basis to project future cash flow or there is a considerable element of subjectivity in the valuation using subjective factors such as intangible assets, market potential or human capital. Revenue multipliers are used as a primary valuation method more in the early stages of investment—seed stage, first stage or A round, second stage or B round and third stage or C round. Since companies at these stages have either negative profits or sub-optimal profit margins, it would be appropriate to look at valuation techniques that are oriented towards the top line (revenues) than the bottom line (profits). However, as the company moves towards later stage, it may be possible to get a better picture of the true profit margins in the business and look at bottom line multipliers to value the company. In pure knowledge based companies at the seed stage, it is just the idea that is valued based on its market potential. 2. The Discounted Cash Flow method tries to arrive at the present value of a company based on estimated future cash flows discounted at the expected rate of return for the private equity investors. This method is appropriate for later stage companies with a stabilized cash flow model and a consistent

502

Investment Banking

basis for computing future projections. If this approach is used, the multiplier method may then be used just as a cross check to ensure that the cash flow valuation is not over-optimistic. The investment banker has to bear it in mind that no two venture or private equity investors have the same approach to valuing a company and therefore what is required is to arrive at a preliminary valuation that could also correspond to a fair valuation. The investment banker has to draw upon his experience in similar deals and current market trends and then arrive at a valuation that can be marketed to investors. Ultimately, the efficiency of the investment banker is judged by the valuation and terms negotiated for the client.

Valuation vs. Pricing At this stage it is necessary to appreciate the subtle difference between valuation and pricing a share. For unlisted companies raising venture capital, what is of relevance is the equity valuation arrived at and not what it translates into as price per share. Price per share is not important till the company reaches the stage of an IPO and is proposing to make an offer to the public. The retail considerations such as minimum application size, minimum investment etc. will become important at the IPO. Such considerations do not matter to private equity investors as long as the valuation is in agreement. The following illustration, further illustrates the point.

�

Illustration 10.3 Value in Rupees

Company A

Company B

Pre-money Capital Shares with face value Rs. 10/-Fully are paid up

10,000

20,000

Current Earnings

25,000

25,000

25

12.5

500,000

500,000

1,000,000

1,000,000

Number of new shares

500

1000

Equity dilution

50%

50%

Price per share

1000

500

Current EPS Amount being raised Equity Valuation

Private Placements of Equity

503

It may be observed from the above illustration that though the valuation of the two companies is the same, the price per share varies since the issued capital of both the companies at the pre-money stage is different. Consequently, the fresh shares to be issued would also be different. The price per share is not a correct indicator of value as explained above. However, it becomes a relevant issue at the time of an IPO from a marketing and free float perspective.

10.7.5 Preparation of Offer Literature The Information Memorandum (IM) forms the main part of the ‘offer literature’ floated by the company in connection with the proposed deal. The Information memorandum would set out the statement that the company wishes to make to prospective investors, the detailed and complete information necessary for the investors to take informed investment decision, the offering summary and the deal structure. The IM goes out in the name of the investment banker but usually with disclaimers to protect the investment banker from third party liabilities. In such IMs floated for private equity deals, the investment banker has to be careful not to violate the provisions of the Companies Act 1956 and the SEBI guidelines. These statutory provisions stipulate severe punishment for faulty floatation of offer documents if they can be construed as public offer documents. This issue has already been pointed out above. Therefore, it is customary to mention clearly on the cover page of the documents words to the following effect: “Strictly for private circulation only. No part of this Information Memorandum shall be construed to be an Invitation to the Public within the meaning of Section 2(36) of the Companies Act 1956, for the purpose of subscription to the Investment Option detailed herein. This Information Memorandum is strictly meant for private investors and the information contained herein has been provided for the purpose of enabling the intended investors to make an informed investment decision”. The Information Memorandum along with other necessary documents such as Company Brochures, product catalogue and Profile, Press cuttings, Executive Summary and a Power Point presentation together form the preliminary offer materials. An illustrative template of an IM is provided in Annexure II to this Chapter. There are different ways of presenting the offer in an Information Memorandum. One approach is to present only the fund requirement and the instrument being floated and leave the valuation and deal structure open for the negotiation stage.

504

Investment Banking

This approach is adopted more by start-up and early stage companies that project more of qualitative features as valuation benchmark than quantitative features. The second approach is to present a proposed offer structure and valuation methodology adopted for the proposed offering. This approach is used for later stage financing and private equity deals by companies that have a strong performance record to show. This approach helps in keeping only the serious investors in the race for the deal.

10.7.6 Offer Formulation If it is decided that the Information Memorandum should be presented with the proposed deal structure, it would be necessary to formulate the same. In this context, it would be necessary to discuss certain concepts and terms used in private equity deals. They are as follows: �

�

�

Pre-money Valuation – This is equal to the post-money valuation of a company at a financing round minus the amount raised at that round. For e.g. a post money valuation of Rs. 500 million after raising Rs. 200 million implies a pre-money valuation of Rs. 300 million. Step-up in Value – The increase in a company’s pre-money valuation between two financing rounds. It is calculated as the pre-money valuation at a round divided by the pre-money valuation at a prior round. For e.g. a company with a valuation of Rs. 100 million in the fourth round and Rs. 25 million in the third round has achieved a step up valuation of 4 times between the two rounds. Return on Capitalisation – The percentage annualized change in the premoney valuation between two financing rounds. This, to some extent represents the annualized return on investment for the investors if the dilution in his stake from the previous round to the next round is not considered.

To arrive at an appropriate offer, it is important to determine the following parameters: �

�

The pre-money valuation for the current round of financing. This could be based on the valuation approaches discussed above. The approximate returns to the investors in that round based on the period of holding from the date of investment till the proposed date of a liquidity event such as an IPO or a buy out.

Private Placements of Equity � �

�

�

505

The amount of funds being raised in the current round. The present value of the company’s valuation at the date of liquidity event. This would be based on any of the valuation approaches discussed above. The amount of further funds that may have to be infused through the equity route through subsequent rounds till the liquidity event happens. The stake that has to be offered to the investors in the current round so as to meet their return expectations.

The investment banker while structuring the offer has to keep ready a projected investor return model based on the criteria discussed above with suitable assumptions to back the model. The stake that an investor needs to hold is always calculated with reference to the post-money valuation by the following formula: Investment proposed % stake

=

-----------------------------------------------------------Pre-money valuation + Investment proposed

Therefore,

Investment proposed % stake =

-----------------------------------------------------------Post-money valuation

The post-money valuation has to be calculated in present value terms if the investment is proposed to yield returns to the investor over a given holding period. Therefore, Investment proposed % stake =

-----------------------------------------------------------Present value of the company’s future valuation

506

Investment Banking

Which is, Investment proposed % stake =

-----------------------------------------------------------Future Valuation/Present Value Factor

Which is, Investment proposed % stake =

-----------------------------------------------------------------Future Valuation/(1+ Discount rate)^

No. of years

The discount rate to be considered in this case would be the expected rate of return that an investor would look for in the given circumstances. This method of arriving at the deal structure is known as the ‘Conventional Venture Capitalist Method’.

�

Illustration 10.41

From the following details, the stake to be offered to a VC under the Conventional VC method is shown below. 1. The current level of earnings (R) = Rs. 2 million 2. The expected annual growth rate of revenue (r) = 50% 3. The required capital at present round = Rs. 2.5 million 4. Expected holding period = 5 years 5. Expected Profit after tax margin at liquidity event = 11% 6. Expected P/E ratio = 15 7. Expected rate of return (d) for the VC = 40% �

�

The first step is to extrapolate the revenues at the end of five years at a CAGR of 50%. This comes to Rs. 15.19 million which forms the top line at the end of year 5. The PAT thereon @ 11% works out to Rs. 1.67 million.

507

Private Placements of Equity �

The PAT capitalized at a P/E ratio of 15 yields a valuation of Rs. 25.06 million

�

The required present value factor = (1+0.40)^5 = 5.378

�

The present value of the company = 25.06/5.378 = Rs. 4.66 million.

�

The stake to be offered to the VC = 2.5/4.66 = 53.7%

A variation of the above method is the First Chicago Method wherein three scenarios, the best, the worst and the survival scenarios are plotted to get three different valuations. These are assigned appropriate weights to arrive at a weighted average valuation. This weighted valuation is discounted to arrive at the present value and the stake that is to be offered. The computations under the above method get complicated if there are any proposed future rounds of financing wherein the investor in the current round may or may not participate. If the current investor does not participate in future rounds, to that extent, based on the valuations adopted in such future rounds, there would be a dilution of such an investor’s stake. Therefore, when a future valuation is being made under this method, it is difficult to estimate what would be the extent of future equity financing that may be required to achieve such valuation and the consequent dilution. The following illustration explains the point further.

�

Illustration 10.5

In the illustration below, the promoters float the business with a capital of Rs. 5 crore and support from a VC to the extent of a further amount of Rs. 5 crore. Thereafter, the company goes for two more rounds of financing and an IPO. The changing profile of investor returns is explained by the following table and the discussion thereafter. Year1

Year2

Year3

ROUND 1

ROUND 2

ROUND 3

Pre-money value Rs. 5 crore

Pre-money value Rs. 20 crore

Pre-money value Rs 60 crore

Capital invested Rs 5 crore

Capital invested Rs 10 crore

Capital invested Rs 20 crore

Year4 OFFER FOR SALE

Pre-money value Rs. 100 crore

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Investment Banking

(Contd.) Post-money valueRs 10 crore

Post-money valueRs 30 crore

Post-money valueRs 80 crore

Investor VC1

Investor VC2

Investor VC3

Stake offered = 50% of post money valuation

Stake offered = Stake offered = 25% 33.33% of post-money of post money valuation valuation

Post-money shareholding pattern

Post-money shareholding pattern

Post-money shareholding pattern

Post-issue shareholding pattern

Promoters – 50%

Promoters – 33.33%

VC1

VC1

– 33.33%

Promoters – 5% Public – 75%

VC2

– 33.33%

Promoters – 25% VC1 – 25% VC2 – 25% VC3 – 25%

– 50%

Annualised return to VC1 = 133%

Annualised return to VC2 = 75%

Post-money valueRs 100 crore

Annualised return to VC3 = 25%

The annualized return above has been computed on the basis of the period of holding. For e.g. VC1 holds the investment of Rs. 5 crore for a period of 3 years before selling it off in the IPO for Rs. 25 crore. Therefore, VC1 makes a return of Rs. 20 crore which works out to 400% in 3 years or an annualised return of 133% and so on. It may be observed from the above illustration that the holding of VC1 has diluted from 50% at round 1 to 25% at the liquidity event. If this holding had remained at 50%, VC1 would have earned an annualised return of 333%. However, this hypothesis may not be correct since the valuation of Rs. 100 crore after 3 years would not have been possible without the capital infusion of Rs. 40 crore in all. Therefore, the company has achieved a non-monetary value enhancement (step-up in value) of Rs 60 crore (100-40) at the IPO stage. VC1 actually gets a share on the step up value of Rs. 60 crore. If one were to take a weighted average approach, the return profile can be worked out as shown in the Table below: The above calculation shows that the weighted average return for all the investors is the same at 85.7%. However, in reality, they do not get this return. They get returns that are either superior or inferior to the mean returns. For e.g. in the above case, the promoters and VC1 end up getting superior returns by 47.6% each (133.33–85.73) while VC2 makes gets a return that is inferior by 10.73% (85.73–75.00) and VC3 gets an inferior return by 60.73% (85.73–25.00).

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Rs. crore

Investment

No. of years

Product

Share of step-up value

Annualised Return %

Rs. crore Promoters

Investment 5

No. of 3

Product 15

Share of i.e. 15/70H60 = 12.86

Annualised =12.86H100/5H3 = 85.7%

VC1

5

3

15

i.e. 15/70H60 = 12.86

=12.86H100/5H3 = 85.7%

VC2

10

2

20

i.e. 20/70H60 = 17.14

=17.14H100/10H2 = 85.7%

VC3

20

1

20

i.e. 20/70H60 = 17.14

=17.14H100/20H1 = 85.7%

Total

40

70

60

This phenomenon is due to the combined operation of several factors affecting the investor’s interests. These are—(a) the Valuation Effect (VE), (b) the Dilution Effect (DE) and (c) future capital infusion. While DE and capital infusion act to the detriment of an investor, VE has to neutralize the adverse effect of these two factors. Though the DE is indirectly determined by the VE, if the business requires an infusion of equity capital at regular intervals, the DE could surpass the VE and thus result in inferior returns. This entirely depends on the movement of the VE and DE post-investment and the requirement of further capital during the investment time horizon. The broad parameters that affect returns to investors over a time horizon are depicted in figure 10.1 below. In the above diagram it has been assumed that valuation grows with the life of the firm and additional capital investment. It may be observed that for investments made at P1 and P2, the returns are superior. At P3, the investor makes average return since the VE has been balanced by the DE. Any investment made after P3 would yield inferior return. However, it may be extremely difficult to envisage in earlier rounds how much future investment would be required to achieve a target at the proposed time of exit. Therefore, investors usually keep a margin on their initial estimated return to factor

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Investment Banking

Shareholding %

Valuation

VE Re

tur

ns

Capital Infusion Weighted Average Return

DE P1

P2

P3

P4

Investment Horizon � Figure 10.2

Returns to Investors and determinants thereof

in the possibility of future dilution. For e.g. if the ultimate return should be an annualized 25% per year approximately, the investor may discount the future valuation by 50% to factor in the dilution element depending on the facts of the case. The other way to accomplish this is to subscribe to a convertible instrument in the earlier rounds such as a convertible preference share, which would be converted just before the liquidity event takes place. Usually convertibles are converted in the ratio of 1:1. Therefore, it may be possible to arrive at a pre-liquidity event holding structure that becomes acceptable before the conversion takes place. Venture capitalists usually construct an ‘Exit Table’ to arrive at the future possible exit and expected returns. There are also other contractual ways by which investors guard against the dilution effect. These are discussed under the heading ‘Term Sheet and Negotiation’.

10.7.7 Investor Presentations After the deal structure is formulated and the Offer Materials are complete in all respects, the next stage would be to finalize the list of VCs/private equity investors

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to be approached. Usually the investment banker provides expert advice in the category and other specifics of investors to be approached based on his market intelligence and past experience. It is important that all investors are approached through identical fashion and that is through the investment banker. Generally, in private equity transactions, one-to-one presentations are the norm. Preliminary presentations are always short and crisp having just enough information to excite the investors on first impressions. Thereafter, based on the responses, the entire offer materials are provided. It is a usual practice to sign Non-disclosure Agreements (NDA) with investors before parting with the confidential information sought during the detailed discussions.

10.7.8 Term Sheet and Negotiation A term sheet is a broad statement of the deal structure that the investor proposes to make with the company for a given offering. It is not a binding offer on either side and both the parties are free to terminate it if the deal is not proposed to be carried through at any stage during its validity. The term sheet outlines the details of the investment together with the deal specific conditions. The following are the typical contents of a term sheet: �

� �

Number of shares or other instrument proposed such as a convertible preference share and the issue price Conversion price and conversion ratio in case of a convertible Anti-dilution formulas such as ‘equity claw backs’ and ‘liquidity preferences’ for the investors. These are contractual clauses that safeguard the investors against future dilution effect discussed above. For e.g. if the company does not achieve the stated financial performance, it could affect future valuation. Therefore, investors put in milestone conversion price mechanisms and if the milestones are not reached, they are entitled to additional equity so as to neutralize the reduction in valuation. Similarly, if in a subsequent round, new investors have to be allotted equity at a price lower than in the current round, the current investors have to compensated through issue of fresh equity to neutralize the dilution effect. Anti-dilution clauses also include suitable adjustment for stock splits, conversion of outstanding options, warrants, mergers and other such events that may lead to dilution.

512 �

Investment Banking

‘Equity Earn outs’ or carve outs for the promoters if they better the financial performance as projected. These are rights that will entitle the promoters to additional equity (usually in the form of sweat equity) as a reward for their performance.

�

ESOP equity pool for other employees and working directors.

�

Proposed exit options and terms thereof.

�

Affirmative rights on major corporate decisions such as sale or disposal of undertakings or substantial assets, dividends, capital issuance, long term borrowings, managerial remuneration, technology transfers etc.

�

One or more Board seats depending on the level of proposed investment.

�

Provision of financial information and requirements thereof.

�

Tag along rights in case of exit through strategic sale by the investor. The tag along right binds the promoters to offer some of their shares as well so that the incoming investor gets a sizeable stake and would therefore be willing to pay a strategic premium.

�

Conditions precedent to the proposed investment.

�

Deal closing expenses.

�

Due diligence requirements.

�

Expected date of closing.

�

Exclusivity period after signing the term sheet.

�

Other terms specific to each case.

The investment banker has a crucial role to play in the negotiations with the investors. While the investors usually try and peg down the valuation to their advantage, investment bankers start off with aggressive pricing to ensure that even if it is watered down during negotiations, they achieve an attractive pricing for their client. However, valuation is not the only negotiation point. The term sheet has to be read and understood completely in all its implications. Generally, term sheets tend to become restrictive as the investor looks for a strangle hold on the company for future adversities. The anti-dilution clauses, veto rights, tag along rights, non-disposal undertakings and right of first refusal on sale are major issues that need to be negotiated with the investors wherein the investment banker’s expert knowledge and negotiation skills are put to test. The overall objective should be to achieve a reasonable term sheet that offers good valuation, enough leg room to the management

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in operational matters, flexibility on strategic issues and is not too restrictive in exit mechanisms. An illustrative term sheet is provided in Annexure III to this Chapter for the guidance of readers.

10.7.9 Deal Closure ‘Closing’ of a deal happens with the following events: � �

�

�

�

Finalization and execution of the term sheet. Completion of Due Diligence to the satisfaction of the investors. Due diligence could throw up issues which can lead to a revision in the term sheet or even in its termination. Satisfaction of conditions precedent by both the parties. Most of the conditions precedent have to be satisfied by the company. Vetting of the documentation (subscription agreement or share purchase agreement as the case may be and other documents) by the legal counsel or company secretaries of both parties. Final execution of documents for the deal.

After the deal closure is achieved, the investor releases the funds against allotments to be done by the company. The investment banker’s role in the transaction generally concludes with the closing.

10.8 Recent Trends in Institutional Equity Deals 1. CDC Capital Partners, formerly known as the Commonwealth Development Corporation, picked up 26% stake in Asset Care Enterprise (ACE), the asset reconstruction company floated by IFCI. CDC had also shown interest in picking up a stake in the divestment of Punjab Tractors and PNB Gilts, the primary dealer subsidiary of Punjab National Bank. CDC also expressed interest in picking up a 6.8% stake in Larsen & Toubro Cement, the proposed demerged cement company of Larsen & Toubro Ltd.

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2. CDC along with Credit Lyonnais Securities Asia picked up a minority stake in the Mumbai based FMCG company Jyothi Laboratories for close to Rs. 1 billion. (The Economic Times dated January 27, 2003) 3. CDC was also looking at picking up a stake in Shasun Chemicals and Drugs based in Chennai at an expected firm valuation of Rs. 2.5 billion against the market capitalisation of Rs. 1.1 billion then. This works out to a pre-money valuation of about Rs. 250 per share. 4. Delhi based Chrys Capital finalized a deal with Global Vantedge, a BPO firm. After financing the first round of $8 million in 2002 out of which Chrys Capital contributed $7 million, the second round is estimated about $ 5 million. With the second round infusion, Chryscapital’s stake would go up from a 78% pre-money to 90% post-money. The rest is held by OSI, a US based company that contributed $1 million in the first round. ChrysCapital has also invested $10 million in first round financing in Ephinay, a startup finance and accounting services BPO company based in Gurgaon. 5. The Citigroup Venture Capital looked at investing in Lupin Laboratories at a valuation of 40% premium over its market price making it a $40 million investment. The total private equity round was envisaged at $80 million. 6. Private equity funds such as General Atlantic Partners (GAP) looked at acquiring a stake in Hughes Software Services, a Delhi based networking and telecommunications software company. However, GAP’s $107 million deal in Mumbai based Patni Computer Systems (PCS) emerged as one of the largest private equity deal in the Asia Pacific region in 2002. The largest deal in the banking sector was the infusion of $272.6 million by Government of Singapore Investment Corporation in ICICI Bank. Zee Telefilms, Sony Entertainment and UTV were the companies in the limelight in the media sector. 7. The total private equity capital in the year 2000/2001 in India was reported at around $2 billion. However the deal flow receded due to the difficult market and economic conditions in India and abroad. According to The Asian Venture Capital Journal, in terms of deals, India continues to be ahead of countries like China, South Korea and Japan though Australia happens to lead the Asia Pacific region. India in 2001 was the third in terms of investment flow. South Korea lead with $2.65 billion followed by Japan with $1.29 billion. However, due to the downturn, there was a steep fall of almost 60%

Private Placements of Equity

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in start-up and early stage investments. VCs presently prefer later stage investments and the average deal sizes have also risen to around $ 7–8 million. In 2002, India clocked the highest funding in Asia Pacific at $ 406 millon after Australia’s $ 450 million. China was way behind at $ 162 million according to Thomson Venture Economics. The Indian market saw 33 deals in 2002 and software accounted for the top deals. Communication and media were also favourites but other sectors like pharmaceuticals and biotechnology have not fared well. India could garner only $ 60 million in biotechnology to date in the past decade. 8. According to the IVCA survey done in October 2002, the VC outlook for the next 2–3 years is fairly evident from the highest funded sectors in 2002, i.e. banking and finance, media, IT services, telecom, BPO, pharma and internet. Much of the post-dotcom era investing has been driven by private equity funds and not venture capital. Even funds such as Chrys Capital (Chrysalis) and ICICI Ventures (TDICI) that were venture funds have turned more of private equity investors. Going by the survey, funds are no longer sector focused but look for low risk later stage deals. The VC game of high risk-high return is not finding favour to a large extent.

�

Notes 1. Adapted from Venture Capital Financial Analysis by James L.Plummer. 2. © 1998 with the Elselvier Science Inc., 655, Avenue of the Americas, New York, NY10010.

�

Select References 1. High Tech Start Up by John L. Nesheim, The Free Press. 2. ESOPs by Jayant M. Thakur, Snow White Publishing. 3. The Pricing of Successful Venture Capital-Backed High-Tech and Life Sciences Companies—A study by Houlihan Valuation Advisors/Ventureone, San Francisco, California, USA. 4. Venture Capital Financial Analysis by James L. Plummer 5. News Reports and articles in The Economic Times. 6. News Reports and articles in the Business Standard.

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Investment Banking

� Self-Test Questions 1. What are the main different types of raising equity finance through the private route? What should be the considerations for an issuer to decide on the appropriate route? 2. How is the pricing determined under venture capital financing? How is it different from an issue pricing in the public route? 3. What are the key issues in business and financial structuring of companies intending to raise venture capital? 4. What are anti-dilution measures? How does a venture capitalist protect against excessive dilution? 5. What are the important stages in the raising of capital through private issue of shares? What is the role of the investment banker?

� Annexure I

� VALUATION OF VC DEALS IN HIGH TECH AND LIFE SCIENCES COMPANIES 2

A study was conducted for more than 18 months by Houlihan Valuation Advisors and VentureOne (SanFrancisco, California, USA) into the aspect of valuation of high tech and life sciences companies. In particular, they attempted to explain changes in the value of venture capital backed high technology and life sciences companies between the initial round of financing, interim financing rounds and their IPO. The research was based on VentureOne’s repertoire of such investments to identify key factors involved in the valuation of venture capital investments in these companies. This study examined the financing of such companies that successfully completed their IPOs between 1993–1997. These were all primarily product companies in high technology (electronics, semi-conductors, software and communications) and life sciences (biotechnology and medical devices) domains. The study divided the life span of companies into the following stages of development—start-up, product development, product shipping and profitability. Start-up represents the earliest stage at which the entrepreneur has the concept or idea and has a team of people willing to work on it with a goal: developing a marketable product. Product development stage follows next: the company is developing products but has not yet begun to ship or test them with customers. At the product shipping stage, the company is shipping at least one product for which it is receiving revenues, regardless of the number of other products still in development or testing. The profitability stage assumes that the company is shipping products from which it derives revenues and is profitable at least on an operating basis. These categories and their descriptions are consistent with VentureOne’s proprietary database classification of development stages. In addition, the database includes one more stage: Product in Beta Test/Clinical Trials. Beta Testing is the intermediate stage between product development and product shipping stage and constitutes a rather brief period prior to product roll out, especially in high tech firms. The study has also segregated financing rounds. Seed stage is the initial equity funding by a venture capital investor. For a round to be called seed round, the amount of financing cannot exceed $2 million, the company should have been in

518

Investment Banking

business for less than 2 years (it cannot be significantly into product development or shipping) and the development stage must be start-up, otherwise it is considered as first round. First, second and third rounds follow chronologically. A mezzanine round is usually the last round prior to a public offering and typically closes within 12–24 months prior to an IPO. The summary findings of this study are furnished below: �

�

�

�

�

Among all the high tech companies, life science companies have been found to be faster in reaching each financing round to the IPO. The next were the software companies and the rear was brought up by electronic and semiconductor companies. Life Sciences companies require higher funding levels than other high-tech companies due to a longer product development period. Life Science companies can afford to go public at earlier stages of product development and raise higher amounts of capital required to fully develop a product or technology and start generating revenues. High-tech and life sciences companies show similar pre-money valuations for earlier rounds, but valuations vary widely in later stages. High-tech companies generally get lower valuations than do life science companies at product development and profitability stages. High-tech companies tend to raise less capital than life sciences companies at all financing rounds except IPO. The closer life sciences companies get to the IPO, the higher are the amounts they raise. This reflects that life sciences companies spend a greater amount of time in product development than do other companies. High-tech companies on the other hand, attract more capital at start-up and profitability stages. Communications companies are the leaders in fund raising followed by biotech companies. Price-to-trailing revenues multiples are much higher for the life sciences companies than for other high-tech firms since most of the former either have lower revenues than the latter or only begin to generate revenues near the time of their IPOs. A majority of the high-tech companies completed their IPO during the product shipping stage, by which tine they already had product revenues. Conversely, most life science companies went public during the product development stage, characterised by heavy R&D expenditure and a lack of revenues. Companies that were priced higher by venture capitalists at earlier rounds went public at higher than average multiples.

Private Placements of Equity

519

This led to over-pricing in instances where the stocks did not perform well post-listing. The multiples generally declined from shipping stage to profitability stage for life sciences, semiconductors and software companies but for the others, the multiples increase from product to profitability stage. �

�

�

High-tech companies obtained higher step-ups in value than life sciences companies, between the seed and first financing rounds to IPO. As the financing rounds get closer, the step up in value drops. The lowest step up between rounds typically happens in the middle stage, i.e. between the second and the third round or the mezzanine round. Nevertheless, as companies progress to profitability stage, the step up increases. The more quickly a company reaches milestones for subsequent funding, the greater is the reward in the step-up in value. Generally, step-ups are higher for high-tech companies than life science companies. Similarly, valuations are higher for later rounds as compared to earlier rounds, regardless of the stage in the life cycle of the company. As venture capitalists’ estimates of potential market for the products of high-tech companies increase, they are willing to pay more for these firms. However, start-up companies generally have higher step-ups than developmental stage companies which in turn generally have higher step-ups than profitable companies. Like-wise younger companies have higher step-ups than older companies and companies raising less money in a round have higher step-ups than their higher funded counterparts. Valuations are also dependent on the timing of the investment vis-à-vis the inflow of funds to venture capitalists from their investors. Lastly, step-ups are influenced by market conditions under which the company goes public. However, the year in which a company could go public is not important in predicting valuations. The main determinants are the type of the round, location, type of industry and the business stage of the company.

� Annexure II

� ILLUSTRATIVE TEMPLATE OF AN INFORMATION MEMORANDUM

SECTION Preliminary

PARTICULARS Cover Page Details of Issuer and the Issue Team Disclaimers and Statutory declarations as may be applicable Vision Statement and Mission Statement where applicable Executive Summary

Section I

Historical perspective of the Company Ownership and Management Structure Write-up on Key Management Personnel

Section II

Overview of the Company's technology and business processes

(Technical Section)

Description of the technical competence, production, R&D and other facilities available with the company, intellectual property created/acquired by the company, key technical strengths which would ensure the company's positioning.

Section III (Market Section)

Overview of the Company's Business Portfolio, key brands, customer segments, marketing infrastructure, sales force and other key details. Discussion on Industry perspective and Company's positioning Market Analysis and Prospects

Private Placements of Equity

521

(Contd.) Section IV

Details of group companies and affiliates. Inter-company relationships to be clearly defined.

Section V (The Project)

Present Investment Plan—Project Cost and proposed Means of Financing Justifications for the Project Plan Implementation Status Status on Financial Closure

Section VI (Financial Section)

Summary Past financial performance in terms of the Operating Statement, Cash Flow Statement and the Balance Sheet. (These should be based on audited figures for the respective years). Management Discussion and Analysis on the financial performance and the key financial indicators.

Section VII analy(The Value Statement)

USP of the company, entry barriers if any, competitor

Section VIII (The Offer)

The Offer and its Structure including the size of the offer Type of instrument and investor related information Justifications and basis of valuation and pricing if disclosed. Time frame for the offer

Annexures (Usually furnished as a separate volume)

Necessary additional details such as Memorandum and Articles, List of statutory approvals in force, annual reports, technical brochures, copies of essential certificates etc.

sis and competitive advantages, SWOT analysis, drivers for future value creation.

� Annexure III

� REPRESENTATIVE TERM SHEET FOR PRIVATE PLACEMENT OF EQUITY Dated --------, 20--The Private Equity Investors/Venture Capital Funds (hereinafter referred to as 'Investors') are interested in making an investment in -------------------- Ltd. promoted by Mr. A, Mr. B and Mr. C (hereinafter "Promoter/s") on the terms and conditions stated below. This confidential term sheet summarises the proposed principal terms of Equity Share offering. This confidential term sheet is not a formal commitment to invest, however, and is conditional upon the completion of due diligence, approval of the Board/Management Committee of the Investors and documentation that is satisfactory to the Investors and the Company. A. Issuer

-------------------------------------------------- Ltd. ("the Company")

B. Definitions & General Provisions 1. Promoters

Mr. A, Mr. B and Mr. C

2. Investors

Private Equity Funds/Venture Capital Funds (hereinafter "Investors")

3. Securities to be Issued

Fully Convertible Debentures (FCDs) issued by the Company.

4. Aggregate Proceeds

Rs. ------------ crore.

5. Conversion Terms

The FCDs shall be converted into such number of equity shares of the Company which shall result in a post-money valuation equivalent to a P/E multiple of 8.5 times the Profit After Tax (PAT) for the period April 1, 20--- to March 31, 20--- subject to a minimum valuation of Rs. 70 crore and a maximum valuation of Rs. 100 crore. The conversion shall happen within three months from the date of announcement of the results for the period April 1, 20-- to March 31, 20-- of the Company.

Private Placements of Equity

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6. Valuation

The post-money valuation, inclusive of ESOP, shall be equal to a P/E multiple of 8.5 times the Profit After Tax (PAT) for the period April 1, 20-- to March 31, 20-- subject to a minimum valuation of Rs. 70 crore and a maximum valuation of Rs. 100 crore. The Profit After Tax used for the above computation shall be after excluding all non-operating income and after accounting for all expenses. The company shall not capitalise any revenue expenditure and the company's accounts shall be audited as per Indian GAAP by a Big 4 Audit firm.

7. Proposed Transaction

Name Investors

Investment (Rs. crore) 150

Shareholding (Min%) Max%) 15.00 21.00

8. ESOP

As may be decided by the Board of Directors of the Company, subject to a minimum of 10% of the equity share capital of the company and will be non dilutive to the stake of investors mentioned above.

9. Expected Financial Closing Date

December 31, 20---

10. Preemptive Rights, IPO Participation

Investors shall have the right to purchase pro-rata portion of any securities offered by the Company in the future.In addition, the Investors shall have the option to purchase upto 5% of the shares offered in the Company's IPO.

11. Investment in subsidiaries

In the event of any division of the Company being spun off as an independent entity, the Investors shall have the first right of refusal in any capital infusion into such entities at a mutually acceptable valuation.

12. Transfer of Shares

The Investors shall have the unrestricted right to transfer their ownership interests, along with all rights pertaining thereto, among any of their affiliates.

13. Liquidation Preference

Investors shall have liquidation preference over the Promoters/or any other investors who have invested in the Company prior to the current round of funding.

14. Anti-Dilution

Full weighted average dilution protection for any further issuance of shares or other equity instruments at a price per share less than the purchase price paid by the Investors. Proportional adjustment in the event of share splits, equity dividend, reclassifications and the like.

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Investment Banking

15. Board seat

The Investors shall have a right to nominate one or more Directors on the Board of the Company and/or its Subsidiaries immediately on the signing of the Investment Agreement.

16. Exit

Through sale to public/other investors or through buy back of shares. If the Promoters decide to sell their stake, the Investors will have the right to tag along at the same terms and conditions for the entire shareholding of the Investors. The investor shall also have a first right of refusal on any such sale of shares by the Promoters. In the event of the Investors not being provided an exit through IPO/other means by December 31, 20---, the Investors will have standard drag along rights.

C. Conditions Precedent

The proposed investment is subject to : A. Due Diligence Completion of due diligence on the business plan of the Company. The Investors will have the right to appoint auditors to conduct financial and legal due diligence of the Company, the scope of which may be decided by the Investors at their own discretion. The Company shall bear all costs incurred in connection with the financial and legal due diligence review although estimated costs of such due diligence will be discussed and agreed with the Company prior to commencement of the due diligence. The due diligence shall also cover the Company's operations till September 30, 20--. The Company's Profit After Tax for the period April 1, 20-to September 30, 20-- shall not be less than Rs. 4.7 crore as per the due diligence. B. Approvals Receipt of all regulatory and statutory approvals and approval of the Board/ Management Committee of the Investors for investment in the Company. C. Documentation Completion of Investment Agreement and all other required documentation to the mutual satisfaction of both Parties including the due diligence exercise.

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D. ESOP The Company will authorize by a resolution of the Board, prior to the Investment, the creation of an ESOP, on terms agreed to with the Investors for the management (excluding the Promoters) and employees of the Company. It is understood that the actual implementation of the ESOP will not occur until after the Investment, but that it will be implemented as soon thereafter as practical.

D. Voting Rights, Protective Provisions and Other Rights

E. F.

The Company shall undertake to implement a structure satisfactory to the Investors for inter-company transactions and accounting between its subsidiary and itself to ensure that revenues and profits of the Company are not adversely affected.

G.

No material or adverse changes in the information submitted by the Company.

The Company agrees that inter alia the following actions will be done only with the prior approval of the Investors:· �

Equity or preference share financing, or any other form of capital restructuring·

�

Dividend payments and buyback of shares·

�

Debt/lease financing and capital expenditure over Rs. * crore. ·

�

Change in management of the Company·

�

Acquisitions or sale/lease of any asset over Rs. * crore. ·

�

Sale, transfer, lease, license in respect of any intellectual property/ intangible asset·

�

Significant inter-Company financial transactions and investment by the Company in any other Company or business·

�

Any changes in Memorandum of Association and Articles of Association·

�

Appointment of any sole selling agent·

�

Increase in remuneration of any Director or any scheme of profit sharing for the benefit of any employee·

�

Any change of statutory auditor ·

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Investment Banking �

The pricing and timing and all other terms and conditions of an IPO or an offer for sale of shares·

�

The acquisition of any other business, diversification or expansion·

�

Any major changes in the Company's financial year or in its accounting policies

The above covenants shall be approved by the Board and reflected in the Articles of Association.

E. Copy rights, Trademarks and other Intellectual properties F. Other Covenants

The ownership of all the existing businesses, databases, Copy Rights, Trademarks, Brand names and other intellectual properties shall be transferred to the Company.

�

The Company shall modify its Memorandum and Articles of Association in consultation with and to the satisfaction of the Investors.·

�

The Company agrees to broad base its Board of Directors and finalize/strengthen the management set-up in consultation with and to the satisfaction of the Investors.

From the accounting year 20-- - 20-- and onwards :�

The Company's accounting year shall end on March 31 each year;-

�

There shall be no change in the Company's accounting policies without the prior approval of the Investors;

�

The Company shall declare the audited financial results within 45 days of the closing of accounts for the year;

�

The Company agrees to appoint reputed firms of Chartered Accountants as statutory and internal auditors in consultation with and to the satisfaction of the Investors; (and)-

�

The Company shall finalize its audited accounts in accordance with Indian GAAP (Indian Generally Accepted Accounting Principles)

The Investors shall also receive standard information rights including audited annual financial reports, unaudited monthly and quarterly financial reports, annual budget and business plan, board packages, as well as standard audit/inspection rights.

Private Placements of Equity

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The Company shall introduce a management information system in consultation with and to the satisfaction of the Investors.· The Promoters agree not to engage in any other business besides that of the Company. G. Front-end Fee

The Company shall pay to the Investors a front-end fee of 1.05% of the subscription amount before the subscription from the Investors becomes effective.

H. Exclusivity

The Company shall not offer this transaction to anyone else until December 31, 20-- and agrees to complete this transaction if the Investors make this offer.

I. Confidentiality

The Company agrees to keep the contents of this term sheet confidential.

For the Investors

For the Company.

Name :

Name:

Designation :

Designation :

Date :

Date :

Chapter

11

Private Placement of Debt Securities

The private placement market for debt securities, unlike in the case of equity is quite vibrant and active. Traditionally, the private placement market has seen more funds being raised than its counterpart in the public issues. As has been explained in Chapter 3, public issues of debt instruments do not go down well with investors unless they are offered with sweeteners. However, the private placement market is dominated by institutional investors who do not see listing as a major advantage. This chapter dwells on the segments of the private placement market in debt securities and traces the recent trends therein. The role of the investment banker in placing private debt securities is also discussed.

Topics to comprehend �

Segments of private market for debt instruments.

�

Process flow and role of investment banker.

�

Nature of regulatory intervention and reasons therefore.

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11.1 Overview of Privately Placed Debt Market The private placement market for debt securities essentially consists of medium to long-term debt securities such as debentures and bonds being placed privately with select investors. It is important for several reasons than one. Firstly, it is an important source of funds both for companies under the Companies Act and other types of entities such as public sector corporations, financial institutions and banks. Secondly, in India, the private placement of debt securities is preferred to public issues since the placement costs are lower and the investors are mostly financial institutions. Thirdly, debt securities issued through private placement can also be listed on the stock exchange to provide them with liquidity. This way they are as good as publicly issued instruments but can be placed easily saving a lot of time and floatation costs. Therefore, as far as issuers are concerned, private placement is a more convenient and an efficient way of raising finance as compared to loans or public issues. Traditionally, in India, the private debt market has been dominated by government securities and the minor share went to other entities. The lack of depth in the secondary market for listed corporate debt securities also contributed to the preference for privately placed structured debt obligations.

11.1.1 Market Segments The private placement market for debt securities consists of the segments as depicted in the exhibit shown below (Fig. 11.1). The below segmentation in the private placement market is based on the type of corporate entity issuing the securities. Each segment is taken up for discussion separately in this Chapter.

Privately placed Debt Securities

PSU Bonds

� Figure 11.1

Institutional Bonds

Cor por ate Debt Secur ities

Market Segments of Privately Placed Debt Securities

531

Private Placement of Debt Securities

11.1.2 Recent Market Trends In the past few years starting with the second half of the nineties, while the primary debt and equity market were quite dormant, the private placement market for debt securities has been very active. As has been pointed out in Chapter 4, the private placement market for debt securities has in fact ballooned in recent years due to the dormancy of the primary market, to the extent that it became the mainstay of corporate financing in 2000–2001. While the private placement market contributed 28.62% of the total funds raised from the capital market in 2001–2002, the corresponding figure for the previous year was higher at 32.8%. This consisted mostly of debt issues by financial institutions. The balance funds raised were mostly through issue of government securities. Therefore, it can be said that as far as the supply of funds for the government and the other non-government sectors was concerned, it was mostly fed through private placement of debt securities. This is also supported by the fact that taking into consideration the government security market, private placements accounted for over 91% of the funds mobilized from the primary market in 2000–2001 as compared to around 39% in 1995–1996. The demand side of the private debt market was fuelled by the emergence of several category of new investors such as the mutual funds which floated pure debt and balanced schemes, commercial banks that found private placement to be a good way to improve credit off-take by the corporate sector and the new insurance companies that have been floated in the private sector. The supply side was driven by the financial institutions that were deprived of their conventional sources of long-term funds and public sector undertakings and corporates, especially in the infrastructure sectors. Table 11.1 provides year-wise data on private placement of debt securities.

Year

No. of Issues

Amount raised (Rs. crore)

1994–1995

73

10035

1995–1996

204

18391

1996–1997

252

30983

1997–1998

445

38748

1999–2000

711

54701

2000–2001

881

62462

Source: Prime Annual Report 2000–2001

� Table 11.1

Market Segments of Privately Placed Debt Securities

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Investment Banking

Despite the strong emergence of the privately placed debt market as an alternative source of finance, in the non-government category, it has been mostly dominated by institutional and public sector undertakings (PSU) bonds. This is evident from the fact that in 2000–2001, the all India financial institutions and banks raised 41% of the funds (41% also in 2001–2002). While the financial institutions raised operational funds, banks raised long-term funds with maturities of 5–7 years mostly for meeting their tier II capital requirements. State level financial institutions raised an additional 26% and PSUs raised about 15%. The private sector corporate debt raised was about 17% (24.2% in 2001–2002). In the year 2001–2002, the corporate sector raised Rs. 59,127 crore out of which more than 78% was for maturities more than a year. Some of the issues ranged even till 18 years in maturity. There were totally 558 issues in 2001–2002, which was a decline in terms of funds raised as compared to the previous year. The dependence of the corporate sector on private placements peaked in 2001–2002 when about 89% of their total funds mobilized was from this route. On the whole, more than Rs. 2600 billion have been raised through private placement of debt securities between 1995–2002. Another interesting trend has been with respect to the type of instruments and terms of offer. Most instruments have been structured obligations privately negotiated with a few or sometimes a single investor. Instruments have also had several structured payment options customised to the requirements of the investors. In 2000–2001, more than 50% of the total issues were rated out of which 20% were rated as structured obligations. However all of the ratings were for investment grade and above. In addition, about 25% of the total issues in that year were proposed to be listed. In 2001–2002, the proportion of rated issues rose to 86%. The investors were high networth individuals and institutional investors such as mutual funds, financial institutions, banks, FIIs, insurance companies, provident funds and pension funds.

11.1.3 Market Segments As pointed out above, the private placement market consists of the PSU bond market, the institutional bond market and the private corporate sector debt securities market. This segmentation is without reckoning the government security market, which falls outside the scope of this book. The PSU bond market consists of debt securities issued by public sector corporations set up under separate statutes, government companies incorporated under the Companies Act, local authorities and municipal bodies that float debt securities

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533

for raising funds. Many well-known names such as the NTPC, Power Finance Corporation, Konkan Railway Corporation, Sardar Sarovar Narmada Nigam, Rural Electrification Corporation and other Central and State Government undertakings had raised funds through private placement route. The essential difference between PSU bonds and other corporate debt is the constitution of the PSUs. In most of them, the Government is the main shareholder though many of the PSUs do not have credit-worthy balance sheets. In order to increase their fund raising capability, many of the PSU bond issues are made with the credit enhancement of a guarantee by the government. For e.g. the bond issue made by Krishna Bhagya Jala Nigam Ltd was guaranteed by the State Government of Karnataka. This kind of a structure not only helps the PSU to raise funds but raise them at competitive rates as well. The institutional bond segment consists of all India and state level financial institutions and commercial banks that raise funds through issue of SLR and non-SLR bonds. SLR bonds are called so since they fulfill the requirements of the statutory liquidity ratio. SLR bonds constitute an inter-bank offering whereby the bonds issued by a financial institution or a bank are subscribed to by other banks. Financial institutions do not subscribe to SLR bonds since they do not have to maintain any statutory liquidity ratio. The non-SLR bonds are issued to other investors mainly to augment the fund base of the financial institutions and banks. Financial institutions have been forced to depend on the market for their fund requirements after their traditional sources of funds have exhausted. Similarly, banks need to augment their five-year requirements through issue of bonds as an alternative to retail deposits. Over the years, financial institutions have been raising money through issue of bonds both in the public issue and private placement market while banks have been doing so exclusively in the private placement market. The corporate debt market consists of private sector companies that issue privately placed debentures to financial institutions, banks and other investors to raise funds through the debt route as a substitute for long-term borrowings through term loans. These debentures offer better advantages to corporates since these are easy to float and if these are rated, they become an easier option to raise funds than through term loans that go through long drawn appraisals. Secondly, the paper work is minimal as compared to a public floatation and is speedily executed. Therefore corporates can take advantage of interest rate movements and raise funds when the interest rate curve is favourable. Since many of these debentures are placed with select investors, suitable credit enhancements can be made to get a good rating for the structured obligation and thereby place them at finer coupon

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Investment Banking

rates. Corporates engaged in the infrastructure sector can raise funds through issue of tax free debentures to financial institutions, commercial banks and co-operative banks as the income on such investments is exempt from tax under section 10(23G) of the IT Act. Reliance, Hindalco, Raymond are few names out of several prime rated companies that tap the private placement market for debt. In recent times, a new segment of privately placed corporate debt that has come into play is securitized paper (PTCs) being issued as part of securitisation deals. As of now, pass through certificates cannot be issued through the public route but they make very good investment opportunity for institutional investors. PTCs usually come with credit enhancements as structured obligations and are rated. Therefore, the investors are comfortable to get investment grade paper at good coupon rates. With the setting up of asset reconstruction companies, the volumes in this segment are bound to increase in future. In recent times, several reputed corporates raised funds from privately placed debt securities including securitised paper. Details of some securitisation deals have been furnished in Chapter 4. The deal that generated a lot of interest was that of Raymond Ltd. which raised Rs. 50 crore at the lowest ever rate for a AAA rated company in early 2003. The company placed five year debentures with a put/call option at the end of three years at an annualized coupon rate of 6.1% with plain vanilla bullet redemption. The placement was done through a book building on private placement basis for Rs. 25 crore with a green shoe option for another Rs. 25 crore. The debenture was rated AA+ by Crisil. At the prevailing rates of interest at that time, the coupon for this debenture worked out to 40 basis points over the annualised yield from 3-year government securities which was 5.72%. DSP Merrill Lynch and Citibank were involved in this deal as arrangers and book runners.

11.2 Deal Process and Role of the Investment Banker The private placement debt market involves issue of debt securities to select investors, mostly institutional or high networth private investors. As of now, the private placement market which is considered as a market for the informed investor and the placement being made in a closed loop, has been hugely popular due to its simple and quick deal process, lack of elaborate disclosures and regulatory clearances. Some of these instruments do not even get listed subsequently. Therefore, there are three main constituents in this market—the issuers, the investors and both these are brought together by the investment banker who acts as the arranger to the placement.

Private Placement of Debt Securities

535

The deal process typically starts with the issuer rolling out a plan to raise funds through the private placement route. The first step in this direction would be to appoint the investment bank as an arranger to the whole placement. Arrangers are typically those who share strong relationships with the investors in this market. Therefore, pure advisory firms do not normally enter this market. It is mostly served by investment banks with a universal banking background or pure investment banks with strong institutional broking background. The arranger or the placement agent, as the investment banker may be called, is short-listed and finalized usually through talks and invitation of quotes. In larger public sector undertakings, there is even a process of calling for ‘expression of interest’ from investment banks through advertisements. The issuer then furnishes a brief profile of itself and the proposed fund raising programme. Based on such information, the investment banks put in bids for raising the funds quoting their fees for the same. The arranger is finalized based on the bid and other qualitative parameters. The first step for the investment banker is to ascertain that the company has taken the necessary approvals from its board, shareholders and existing lenders for the proposed debt and has the necessary powers under its memorandum and articles of association, Section 293(1)(a) and 293(1)(d) of the Companies Act. These aspects have already been discussed in detail in Chapter 7. The arranger has to then become familiar with the company’s business, the industry space, the financials of the company and the financing requirements. Usually a check-list of the required information is prepared and the information is put together in the form of a private placement memorandum. Since there are no regulations on the information to be furnished, the memorandum may be prepared by the investment banker as appropriate to the situation. All the necessary back-up papers and documents are also compiled and kept ready for the requirement of investors. One of the important tasks of the investment banker is to arrive at the instrument in offer and the deal structure. The investment banker has to use his conventional wisdom, ingenuity and market intelligence to arrive at the coupon rate and suitable enhancements if any, required for the instrument. Credit rating is an important process in the deal as it enhances the possibility of closing the deal early by providing all the necessary comfort to investors. The rating process usually takes a slightly longer time if it is being made for the first time as it has almost the same appraisal mechanism that is used for sanction of credit assistance by term lenders. If rating is contemplated, this process should precede the placement. Therefore, as soon as the structure has evolved, the rating process may be started off. If the

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Investment Banking

structure involves a guarantee to be issued either by a bank or another corporate or the Government, the structure has to be put in place before approaching the rating agency. The placement campaign starts off after obtaining the rating for the issue. During this time, it would also be necessary to decide on the issue of listing the instrument depending upon the need to create liquidity for the instrument. This would largely depend upon the tenor of the instrument and the type of investors being considered. If listing is being contemplated, a listing application has to be made ready so that it can be filed as soon as the issue is placed and allotment gets completed. If the issue does not satisfy the requirements of Rule 19(2)(b) of the SCR Rules, suitable exemption needs to be obtained for listing the privately placed debt. The placement part of the deal itself is a limited purpose exercise that has no road shows or publicity campaign as in a public issue. It is largely accomplished through the network of the investment banker and the strength of the relationships with the investor community. The private placement memorandum is circulated among a closed set of appropriate potential investors. The meetings are largely one-to-one among the investors and the company, with the investment banker leading the process. Sometimes depending upon the size of the issue, there could be investor presentations made by the investment banker and the company. The institutional investors process the proposal internally and take approvals from their credit committees or investment committees or their board of directors as the case may be, before issuing the commitment letters. In the case of unrated paper, institutional investors have to process the proposal through their internal rating system and this is why such deals take longer time to be closed. The appraisal process of financial institutions and banks for privately placed debentures is identical to that done for credit appraisal. However, there could be a difference in terms of the standing of the issuer, end use of the funds and whether the instrument is rated or not. If the issue is proposed to be made as part of project financing, the viability of the project is assessed in detail. However, if the issue is to fund general corporate objectives including long-term working capital requirements, it would be appraised more from a financial point of view. Similarly, if the issuer is an established company or a company belonging to an established group, the lenders do an appraisal both from the company and a group perspective. The overall exposure to the company or the group by a single lender is also assessed since most lenders have exposure norms. However, if the company is a stand-alone, the lenders try to assess the strength of its balance sheet and its past performance. If the company is a start-up company or a green-field project, the appraisal of the

Private Placement of Debt Securities

537

lead institution is insisted upon. If the instrument or the structure is already rated, the credit appraisal will be for the limited purpose of taking internal credit decision by the lenders. The normal financial parameters such as debt-equity ratio, debt service coverage ratio, interest cover, coupon rate and yield of the instrument, redemption terms etc., are assessed and also they are compared to alternative investment options to justify the proposed investment. After receiving commitment, letters are received from all the investors, the issue is treated as closed and the issuer puts up the letters of intent for consideration by its board of directors. The letters on intent usually stipulate the general terms and conditions and the special conditions applicable to the particular sanction. These special conditions relate to security for the instrument, creation of a redemption reserve or other such conditions specific to the proposal. The investment banker has to scrutinize the letter of intent before it is put up to the company’s board for possible conditions that may be difficult to implement. For e.g. the lender may stipulate charges on certain assets that may already be encumbered or otherwise not available as security. There may be certain pre-disbursement conditions that could take a long time to satisfy and therefore delay the availability of funds to the company. Wherever there are difficult issues, these need to be taken up with the lender immediately and if necessary, apply for alteration of clauses in the letter of intent. After the board of the company accepts the letter of intent, the company proceeds with the documentation. The documentation for a private placement of debentures consists of entering into a subscription agreement, which would be common if there is more than one lender. This is because, the security has to be created in common and therefore, a common subscription agreement is created with all the lenders and also the issuer. The next step in this process would be to make allotments and receive the funds from the investors by complying with the procedure prescribed under the Companies Act. The listing application if required, is also simultaneously filed with the stock exchanges. The company should also start work on creation of charge on the security being offered to the investors. If the issue structure involves a trustee mechanism, the trust has to be created and a trustee (usually a bank) is appointed for this purpose. The charge is created on the securities in favour of the trust directly and the trustee is also kept well informed of the filing of charges with the ROC. In this connection, it may be important for readers to revisit the discussion on the nature of secured instruments issued by corporates vis-à-vis unsecured notes issued by institutions in Chapter 4. The creation of charge and attendant matters are already discussed in Chapter 7.

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The role of the investment banker usually ends with the receipt of commitment letters from the investors and the acceptance thereof by the issuer. The post-sanction formalities are normally handled by the in-house professionals of the company, their auditors or its practicing company secretaries.

11.3 Case Study on Private Placement The following are the details of the private placement of ‘toll bonds’ structured on a private placement basis in 1996 by Infrastructure Leasing and Financial Services Ltd. (IL&FS) for MP Tolls Ltd for the Rao-Pithampur Toll Road Project. IL&FS acted as the sole arranger and placement agent for the issue. This project was the first surface transport project in India to be built, owned and operated on a commercial format. The project comprised of a road and a bridge network that connects Pithampur Industrial Estate with the city of Indore in Madhya Pradesh. The project was conceived by the Madhya Pradesh State Industrial Development Corporation and its regional subsidiary Madhya Pradesh Audhyogik Kendra Vikas Nigam (Indore) Ltd. In 1990, IL&FS was invited to play the dual role of both project sponsor and developer. Since at that time, infrastructure projects on a commercial basis were a new concept in India, all the three parties who had developed both legal and commercial formats were required to provide the concept an optimum degree of financial efficiency and risk mitigation. The project was to be implemented through a SPV by the name—MP Tolls Ltd. Under the terms of concession provided by the Government of Madhya Pradesh, IL&FS, as project sponsor and developer was entitled to recovery of the project cost along with an assured return of 20% per annum. This recovery is effected through a charge of toll on the users of the infrastructure created in the project. The concession period envisaged was 15 years. On reaching the end of the concession period, the project reverts back to the government. IL&FS financed the project at Rs. 10.14 crore through its internal accruals given the nature of the project and the need to demonstrate commercial viability before approaching the capital market for re-finance. The issue of toll bonds was structured by the project company so as to provide refinance to the project. The main features of the bonds, which were placed privately with institutional investors, as stated in the private placement memorandum issued in 1996, were as follows.

Private Placement of Debt Securities

Issuer

539

MP Tolls Ltd

Purpose

To part-finance the discharge consideration for acquiring the operational and toll collection rights of the Rao-Pithampur Toll Road and acquiring related project assets on lease for 15 years.

Total amount offered

Rs. 7 crore

Total number offered

70,000 toll bonds

Face value

Rs. 1000 each

Tenor

Upto 10 years

Coupon rate

Interest at an accelerating rate will be payable from the date of issue on the outstanding principal amount at half-yearly rests in arrears. The yearly coupon rates are as under. Year1 Year2 Year3 Year4 Year5 Year6 Year7 Year8 Year9 Year10

– – – – – – – – – –

15% 15% 18% 18% 18% 18% 18% 18% 18% 18%

Interest would be paid on the outstanding principal amount and the outstanding interest if any, on the following dates of each year—30th June and 31st December. Bonus Interest on redemption

Redemption interest equal to Rs. 100 per bond, i.e. 10% of the face value will be payable at the end of the 10th year from the date of allotment.

Redemption

The bonds would be redeemed in three equal tranches at the end of the 8th, 9th and the 10th year from the date of allotment.

Early redemption

In case the project cash flows exceed the estimates, the issuer will have the option to accelerate/prepone the redemption of the toll bonds along with the bonus interest on redemption. This would enhance the yield to maturity of the bonds, the extent of which cannot be determined at the time of issue. The redemption of the bonds would be made subject to availability of sufficient cash flows, net of operational and maintenance expenses.

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Investment Banking

The prepayment of the toll bonds as stipulated above would be the responsibility of the Trustees who would ensure the appropriation of the toll revenues as per the stipulated priority. Principal security

The bonds would be collateralised for all principal payments, interest payments and payment of other charges on the cash flows emanating out of the toll collection on the project.

First loss coupon cover

IL&FS covenants to provide full cash flow cover upto 2.5 years coupon payments to support any shortfalls in the cash flows of MP Tolls Ltd.

Tax implication

The interest payable to the bond holders would be eligible as a tax deductible expense to the issuer MP Tolls Ltd. Public companies/Government companies who are eligible for benefit under section 36(1)(viii) of the IT Act would be entitled to a rebate of 40% of the total income derived from investment in the bonds, provided the said amount is transferred to a special reserve. The said rebate ceases to be applicable when the aggregate amount credited to the above reserve in the books of the investor exceeds twice the investor's paid-up capital and free reserves.

Yield

The yield to maturity on the bonds would be 17.33% per annum. After considering the tax benefit under section 36(1)(viii) of the IT Act, the investors earn an effective rate of return of 20.52% per annum at the current maximum marginal tax rate.The yield on the bonds would however improve if the bonds are redeemed earlier than the stated redemption dates.

Listing

The toll bonds would be listed on the NSE.

Credit rating

The toll bonds have been rated by Credit Analysis and Research Ltd and have been given the rating 'AA(SO)' which means high safety, indicating a high degree of certainty regarding timely payment of financial obligations on the instrument.

Market making

IL&FS directly or through its associates, will undertake market making in the bonds subject to all statutory approvals being received.

11.4 Need for Regulatory Intervention and Recent Developments Private placement of debt has largely been an unregulated area of corporate finance, which in recent times has caught the attention of both regulators and

Private Placement of Debt Securities

541

policy makers alike. One of the prime reasons for this has been the growth in the size of this market as explained in the initial part of the discussion. During 2000–2001, this market was the mainstay of fund raising for corporates. The support for regulatory intervention gathered momentum due to the fact that such huge amount of fund raising without norms on disclosures and investor protection makes a mockery of the public issue norms especially since the public issue market was hardly in the reckoning in recent years. In fact, the Indian Securities Market Review 2002 published by the NSE has a separate discussion on the policy debate concerning private placements. It makes a strong claim for a regulatory framework to be in place expressing a serious concern for the lack of transparency and knowledge on the quality of issues in this market. As it says, there is no screening mechanism provided for private placements as in the case of public issues. Though about 86% of the issues were rated in 2002, the figure was only around 50% for the previous year. In addition, through many of the issues are listed, many of them remain unlisted and therefore, do not even enter the radar screen. It is also difficult to keep track of the utilization of funds raised through private placement as has been pointed out earlier in several quarters. This raises the question of moral hazard besides lack of transparency and disclosure by the corporates. If this market has to sustain the confidence of investors in the long term, there have to be norms in place to protect the interests of investors. Considering the fact that institutional investors raise public funds on their own balance sheets, their accountability becomes vulnerable if their investments in privately placed debt are not protected. The third dimension of the necessity to regulate this market is to ensure that there is enough liquidity created in the secondary debt market with more issues being listed. If many privately placed issues do not even get listed, it would precipitate a structural deficiency and lack of depth in the debt market. Keeping in view the above considerations, an opinion had been gaining ground in SEBI and the RBI to come out with regulations for this market. While SEBI as the regulator of the capital market, could regulate the private placement market, RBI as the banking and financial regulator, could regulate the investors in this market. The first step in this direction was taken by SEBI in its circular1 dated 30th September 2003. The extracts of this circular are furnished in Annexure I to this Chapter. This circular assumes importance due to the fact that it is the first regulatory step in the private placement market. It provides regulatory stipulation for all privately placed debt securities that are listed on a stock exchange. This circular applies to all listed companies and contains inter alia, the stipulations given as follows: 1. The company making the issue shall make full disclosures (initial and continuing) in the manner prescribed in Schedule II of the Companies Act,

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Investment Banking

1956, SEBI (Disclosure and Investor Protection) Guidelines, 2000 and the Listing Agreement with the exchanges. However, if the privately placed debt securities are in standard denomination of Rs. 10 Lakhs, such disclosures may be made only through web sites of the stock exchange where the debt securities are sought to be listed. With this requirement, the private placement memoranda need to carry all the information that a public issue offer document has to carry for a public issue. This would increase the preparatory work for a private placement manifold and prolong the process. This requirement could also neutralise the main advantage of a private placement in terms of taking advantage of market opportunities quickly. 2. The debt securities shall also carry a credit rating of not less than investment grade from a Credit Rating Agency registered with the Board (SEBI). 3. The company shall appoint a debenture trustee registered with SEBI in respect of the issue of the debt securities. This could increase the costs of floatation as also the procedural requirements. 4. The debt securities shall be issued and traded in demat form. 5. The company shall sign a separate listing agreement with the exchange in respect of debt securities and comply with the conditions of listing. SEBI has already finalized a separate draft listing agreement for all types of debt securities whether issued in the public or the private route. This would be introduced in due course of time. 6. All trades with the exception of spot transactions, in a listed debt security, shall be executed only on the trading platform of a stock exchange. 7. The trading in privately placed debts shall only take place between Qualified Institutional Investors (QIBs) and High Networth Individuals (HNIs), in standard denomination of Rs. 10 lakhs. 8. The requirement of Rule 19(2)(b) of the Securities Contract (Regulation) Rules, 1957 will not be applicable to listing of privately placed debt securities on exchanges, provided all the above requirements are complied with. This requirement is basically in terms of the minimum amount of securities that have to be issued to the public in order to seek listing. 9. If the intermediaries registered with SEBI associate themselves with the issuance of private placement of unlisted debt securities, they will be held accountable for such issues. They will also be required to furnish periodical

Private Placement of Debt Securities

543

reports to SEBI in such format as may be decided by SEBI. This is to ensure that data on such issues is available to SEBI. Following closely on the heels of the SEBI circular, the RBI issued guidelines2 for banks and separate guidelines3 for financial institutions for their investments in nonSLR securities, which essentially include corporate debt. The guidelines emphasized in particular, on privately placed debt. The main provisions of the guidelines for banks are given as follows: 1. These guidelines cover banks’ investments in non-SLR securities issued by corporates, banks, financial institutions, State and Central Government sponsored institutions, SPVs etc. These guidelines will, however, not be applicable to investments in securities issued directly by the Central and State Governments, which are not reckoned for SLR purpose, and investments in equity shares. The guidelines will apply to investments both in the primary market as well as the secondary market. 2. Banks should not invest in non-SLR securities of original maturity of less than one-year other than commercial paper and certificates of deposits which are covered under RBI guidelines. 3. Banks should undertake usual due diligence in respect of investments in non-SLR securities. Present RBI regulations preclude banks from extending credit facilities for certain purposes. Banks should ensure that such activities are not financed by way of funds raised through the non-SLR securities. 4. Banks must not invest in unrated non-SLR securities. 5. While making fresh investments in non-SLR debt securities, banks should ensure that such investment are made only in listed debt securities of companies which comply with the requirements of the SEBI circular dated September 30, 2003, except to the extent indicated below. 6. Bank’s investment in unlisted non-SLR securities should not exceed 10 per cent of its total investment in non-SLR securities as on March 31, of the previous year. The unlisted non-SLR securities in which banks may invest up to the limits specified above, should comply with the disclosure requirements as prescribed by the SEBI for listed companies. 7. Bank’s investment in unlisted non-SLR securities may exceed the limit of 10 per cent, by an additional 10 per cent, provided the investment is on account of investment in securities issued by SPVs for Mortgage Backed

544

Investment Banking

Securities (MBS), securitisation papers issued for infrastructure projects, and bonds/debentures/Security Receipts/Pass Through Certificates issued by Securitisation Companies and Reconstruction Companies set up under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and then registered with RBI. In other words, the investment exclusively in securities specified in this paragraph could be up to the maximum permitted limit of 20 per cent of non-SLR investment. 8. Since non-SLR securities are mostly in the form of credit substitutes, banks have to (i) subject all their investment proposals relating to non-SLR securities to credit appraisal on par with their credit proposals, irrespective of the fact that the proposed investments may be in rated securities, (ii) make their own internal credit analysis and rating even in respect of rated issues and that they should not entirely rely on the ratings of external agencies, and (iii) strengthen their internal rating systems which should also include building up of a system of regular (quarterly or half-yearly) tracking of the financial position of the issuer with a view to ensuring continuous monitoring of the rating migration of the issuers/issues. The main provisions of the guidelines issued for the financial institutions (FIs) for their investments in such securities are as follows. 1. These guidelines apply to the FIs’ investments, both in the primary market (public issue as also private placement) as well as the secondary market, in debt instruments issued by companies, banks, FIs and State and Central Government sponsored institutions, SPVs, etc., but do not apply to government securities and securities which are in the nature of advance under the extant prudential norms of RBI. 2. The FIs must not invest in unrated debt securities but only in rated ones, which carry a minimum investment grade rating from a credit rating agency registered with SEBI. 3. The investment grade rating should have been awarded by an external rating agency, operating in India, as identified by the IBA/FIMMDA. 4. The FIs should not invest in debt securities of original maturity of less than one-year other than commercial paper and certificates of deposits, which are covered under the RBI guidelines. 5. The FIs should undertake usual due diligence in respect of investments in debt securities.

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545

6. The FIs should ensure that all fresh investments in debt securities are made only in listed debt securities of companies, which comply with the requirements of the SEBI circular dated September 30, 2003, except to the extent allowed under the present provisions. 7. The Board of Directors of the FIs should fix a prudential limit for their total investment in debt securities (other than government securities and those in the nature of advance) and sub-limits for investments in debt securities. 8. The total investment of the FI in unlisted debt securities should not exceed 10 per cent of the FIs’ total investment in debt securities (other than government securities and others to which these directions do not apply) as on March 31 ( June 30 in case of NHB), of the previous year. However, the investment in the following instruments will not be reckoned as ‘unlisted debt securities’ for monitoring compliance with the above prudential limits: (a) Security Receipts (SRs) issued by Securitisation Companies/ Reconstruction Companies registered with RBI in terms of the provisions of the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002; and (b) Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS) which are rated at or above the minimum investment grade. 9. The unlisted debt securities in which the FIs may invest up to the limits specified above should be rated and disclosure requirements as prescribed by the SEBI for listed companies should be followed by the issuer company. 10. Since the debt securities are very often a credit substitute, the FIs are advised to follow the below guidelines: (i) Subject all their investment proposals relating to debt securities to the same standards of credit appraisal as for their credit proposals, irrespective of the fact that the proposed investments may be in rated securities; (ii) Make their own internal credit analysis and assign internal rating even in respect of externally rated issues and not to rely solely on the ratings of external rating agencies; and (iii) Strengthen their internal rating systems which should also include building up of a system of regular (quarterly or half-yearly) tracking of the financial position of the issuer with a view to ensuring continuous monitoring of the rating migration of the issuers/issues.

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11. As a matter of prudence, the FIs should stipulate, with the approval of the Board, minimum ratings/quality standards for acquiring exposure in debt securities (other than government securities and those in the nature of advance) and industry-wise, maturity-wise, duration-wise, issuer-wise, etc., exposure limits to address the concentration risk and the risk of illiquidity. It has been clarified later by the RBI that the above guidelines issued to banks and financial institutions do not apply to units of mutual fund schemes with equity exposures and investment in venture capital funds but apply to all types of institutional and PSU bonds. Investment in the following securities will not be reckoned as ‘unlisted non-SLR securities’ for computing compliance with the investment limits prescribed in the above guidelines. �

Security Receipts issued by Securitisation Companies/Reconstruction Companies registered with RBI.

�

Investment in Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS), which are rated at or above the minimum investment grade.

�

Investment only in units of such mutual fund schemes, which have an exposure to unlisted securities of less than 10 per cent of the corpus of the fund, will be treated on par with listed securities for the purpose of compliance with the investment limits prescribed in the above guidelines.

11.5 Future Directions The private placement market for debt securities, hitherto an unregulated territory, received a jolt with the series of policy announcements made in late 2003 as discussed above. Though the directions were deferred till April 2004, it was basically made to allow time for the transition. These measures are targetted from the end of the issuers to make them more accountable and provide better disclosures. At the same time, they are also directed towards investors so that they do not take excessive exposures to such investments. With the RBI stipulating that financial institutions and banks can invest only in privately placed listed securities, it has essentially sounded the death knell for unlisted privately placed debt securities. There could be similar restrictions in future on mutual funds, insurance companies, provident funds and pension funds. This is a long expected policy step taken in the right direction. Though this would mean a tailspin in the market in the short term, the market is bound to adjust to working under a regulated environment over a period of time. This has been the case with all types of policy reforms in the capital market. During the transition period, both

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SEBI and the RBI would be sympathetic to the market and make necessary amendments and concessions to the stipulations. In the long term, the market needs regulation in the lines introduced as discussed above so that investor confidence is sustained and large-scale market defaults can be avoided. The stipulation of listing privately placed debt is the only way to create depth in the debt market and ensure trading volumes. Expectedly, the market made a knee-jerk reaction to the guidelines with several reputed issuers putting off or deferring their debt issues immediately after the announcements. According to the Prime database, as compared to Rs. 23,275 crore worth of issues made in six months prior to the SEBI circular, only Rs. 1,700 crore worth of issues were made in the two months succeeding the circular.

�

Notes 1. For the full text of the circular please refer to circular no. SEBI/MRD/SE/AT/36/ 2003/30/9 dated September 30, 2003 issued by SEBI. 2. For the full text of the circular please refer to circular no. DBOD.BP.BC.44/ 21.04.141/2003–2004 dated 12th November 2003 issued by the RBI. 3. For the full text of the circular please refer to circular no. DBS.FID.No. C-11/ 01.02.00/2003–2004 dated January 8, 2004 issued by the Financial Institutions Division, Department of Financial Supervision, RBI.

�

Select References 1. Indian Securities Market Review 2002 of the National Stock Exchange of India Ltd. 2. Private Placements: Markets or Institutions—M.K.Datar, a paper submitted at The Fifth Capital Market Conference, December 20–21, 2001. 3. SEBI, Capital Issues, Debentures & Listing—K.Sekhar, Wadhwa and Company, Third Edition 2003. 4. Private Placement Memorandum issued by M.P.Tolls Ltd. on the Rao-Pithampur Toll Road Project, March 1996.

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Self-Test Questions 1. What are the types of issuers in privately placed debt markets? Why has this market become an important source of corporate capital in recent times?

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2. What is the process flow of a transaction in private placement of debt securities? What is the role played by the investment banker? 3. Why did regulators become concerned with the booming private market for debt securities? What are the types of restrictions that were being imposed on this market in the past?

Part III

Chapter 12 Business Advisory Services Chapter 13 Project Advisory Services Chapter 14 Financial Restructuring Advisory Chapter 15 Mergers and Acquisitions Advisory Chapter 16 Government Advisory

Chapter

12 Business Advisory Services

Corporate advisory services are one of the fastest growing non-fund service areas for investment banks. While these services are spread over a vast spectrum of corporate activity, some of them are ideally suited for investment banks while the rest are also rendered by other specialist advisory firms. The core service area in corporate advisory for investment banks relates to business advisory, restructuring advisory, project advisory, M&A advisory and government advisory. This chapter introduces the reader to the need and scope of corporate advisory services and goes on to discuss at length the gamut of business advisory services. It may be borne in mind that since this book focusses on investment banking per se, the discussion is oriented to suit an investment banking perspective. Consequently, the discussion on tax, accounting and regulatory aspects is not comprehensive. In addition, it may be appreciated that joint ventures and business collaborations are very vast topics by themselves and cannot be captured

Topics to comprehend �

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�

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Scope of corporate advisory services and the positioning of the investment banker therein. Various facets of business advisory services and the issues concerning corporate structuring and business planning. Joint ventures—scope, structuring, regulatory issues and documentation issues. Collaborations—types, issues in structuring collaborations, regulatory aspects.

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justifiably within the realm of this book. Readers need to refer to the suggested readings given at the end of this chapter for further advanced and comprehensive discussion on such topics. The other service areas in corporate advisory are discussed in the succeeding chapters. Business advisory services include several aspects relating to the structuring of modern corporate business groups as well as to provide advise in specialised relationships that a company enters into with other bodies corporate. Business advisory services encompass a wide spectrum of activity ranging from preparation of feasibility plans, formulation of corporate and entry strategies and corporate structuring to advising on joint ventures, alliances, collaborations and cross-border investments. The issues concerning these activities and the scope of such advisory services are discussed herein. Some of these assignments require a multi-disciplinary approach due to which, investment banks have to work very closely with other skilled professionals such as chartered accountants and legal professionals to provide complementary skills. However, sometimes investment banks need to live upto competition as well in business advisory services from other specialists.

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Foreign investments in India—structuring and regulatory aspects. Indian cross border investments—structuring and regulatory framework. Role of investment banker in business advisory services.

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12.1 Overview of Corporate Advisory Services 12.1.1 Need for Corporate Advisory Services The term ‘Corporate Advisory Services’ is an umbrella term that includes specialised advice rendered to corporations by professional advisers such as investment banks, practitioners in accountancy and law and other such service providers. The need for corporate advisory services arises on the following counts: �

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A company has several complex business processes that result in transactions and contractual relationships with a vast number of other bodies corporate. Most of these transactions or contracts need to be examined from various business and legal angles so as to arrive at an optimal structure that further the interests of the company and also of the other contracting party. The requisite amount of expertise for such in-depth examination is not always available within the portals of a company. Therefore, there arises a need for a specialist external adviser to render proper advice to the company. Thirdly, there are several areas wherein a company requires specialist advice before initiating a particular business plan. These could relate to initial feasibility studies on the proposed plan in the area of technology and market survey, cost assessment and other considerations. If the proposed plan involves setting up a start-up business in a foreign market, a suitable entry strategy needs to be devised for the same, keeping in view the local market and regulatory environment in such a country. These are specialised jobs, which can only be handled by professionals with standing in such areas of service. A company during the process of its expansion, would like to enter into strategic alliances, mergers and acquisitions with other business partners or competitors so as to further its business objectives. Most of the times, such transactions need to be initiated through proper discussions and negotiations. Therefore, there is a perceived need for a specialist intermediary to be the catalyst in identification of the other party to the proposed transaction and to be able to bring about acceptable deal structure that would meet the above stated objectives. There are several instances wherein a company needs to restructure its operations or its balance sheet in order to revamp the existing state of affairs or to bring about an orderly change in the way it functions. Many a time, restructuring is driven by financial compulsions. This kind of restructuring

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would need to be looked into from the perspective of business and financial considerations as well as from a legal standpoint. Corporate advisers are thus brought in to incorporate a restructuring scheme that would address these considerations.

12.1.2 Scope of Corporate Advisory Services As already mentioned above, corporate advisory services encompass a wide spectrum of specialised advice rendered to a corporate body such as company or a corporation. These services not only relate to a wide range of corporate objectives as briefed above but they also necessitate a multi-disciplinary approach as well. Therefore, these services are rendered by a variety of professionals, all of whom can be classified under three broad categories as given below: (a) Investment banks and other financial services companies possessing merchant banking licences. The core advisory services provided by investment banks and merchant banks relate to business advisory, restructuring advisory, project advisory and M&A advisory and government advisory. The expertise that investment banks lend to such service areas is needed from the deal making perspective rather than the regulatory angle. While some full service investment banks retain their legal and accounting professionals in their organizations so as to develop the complete expertise within, most of them also work with outside professionals on assignments so as to benefit from their complementary skills. In such cases, the company that gives the mandate to an investment bank also hires legal and accounting professionals who offer such expertise in vetting the legal, tax and accounting aspects of the deal made by the investment bank as well as in the documentation thereof. (b) Professional firms such as chartered accounting firms, law firms, company secretaries, chartered engineers, etc. that offer corporate advisory services. As mentioned above, the services of these firms are mostly two fold: (1) They provide complete solutions in assignments that relate exclusively to their area of core competence such as tax advice, legal vetting, drafting and documentation work, legal and financial due diligence, valuation of business or shares or other assets, statutory compliance work, etc. and (2) They provide complementary services wherein investment banks provide the transaction support. For e.g. if a merger deal has been struck between two companies which is being advised by investment banks from either side, accounting firms may be roped in to provide their valuation and due diligence services

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while a law firm assists in drafting the scheme and also getting the necessary approvals from the court (presently the tribunal) and other such authorities. (c) Pure advisory firms also provide diverse corporate advisory services. Such firms mostly specialise in a few verticals. For e.g. there are firms that specialise in advice on corporate strategy. Mckinsey & Co., Boston Consulting Group, etc. are strategy consulting firms that advise corporates and governments on strategy and policy issues. Similarly there are firms that are specialised in marketing, technology, human resources, information technology, foreign exchange, risk management and other such verticals. Some of these consulting firms also tread into the territory of investment banks in providing advice on M&A, joint ventures and collaborations, business plan formulation, financial restructuring, etc. Examples of such firms are the consulting arms of multi-national accounting firms. These entities provide all types of transaction support that an investment bank can provide due to their global reach and expertise in handling such transactions. Besides, they also possess the necessary complementary skills in accounting and law that provide an edge in such assignments. Though investment banks face stiff competition from such consulting firms in their area of advisory competence, they do have an added advantage in terms of being able to handle the merchant banking assignments that are embedded in the advisory services. For instance, in an acquisition deal, there could be a need to make an open offer to the public, which only a registered merchant bank can manage. Similarly in a financial restructuring, there could be a need for an equity repurchase offer to be made to the public, which again has to be managed only by a registered merchant bank. Due to these exclusivities and complementary skills, it is found that in the real world, there is place for all the three categories of corporate advisors listed above to co-exist and work independently or complement each other as the situation may demand. Having already discussed the broad canvas of corporate advisory services and the core advisory areas concerning investment banks, we will now examine each of such core areas more closely and the role played by investment banks. The first area that is discussed in this chapter is business advisory services.

12.2 Business Advisory Services Business advisory services relate to advising a company on its present and future businesses from a strategic and financial perspective. Such services can encompass

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the areas as given below: �

�

�

Entry Strategy Plans: Entry strategy advice is required when a company plans to start a new business initiative either in a new area of business or in a new market whether geographically or otherwise. The entry strategy could be in terms of a corporate structure or a product and pricing strategy, target market segment, strategic alliance or in other such definitions. For e.g. a multi-national company wanting to set up shop in India could require an entry strategy to be formulated for the roll out of its business in India. The entry strategy recommendation in terms of corporate structure for such a company can be a decision between establishing a wholly owned subsidiary in India vis-à-vis a joint venture with an Indian partner. Generally formulation of entry strategy plans requires looking at the business and financial aspects, regulatory and tax aspects of an envisaged business keeping in mind the existing corporate and business structure. One other major consideration in the formulation of an entry strategy is the visa policy of the relevant State and the residential status of the concerned individuals who would be operating in the other country. Project Feasibility Plans: These relate to setting up of new businesses wherein the viability of the proposed business from a business, technology and financial perspective needs to be examined. Unless the commercial feasibility and financial viability is well established beyond doubt, projects normally do not go for fund raising. Therefore, a feasibility study is often being undertaken before proceeding along with other steps in implementing a project. Investment banks are ideally placed to conduct such feasibility studies from a business and financial perspective since they have in-depth information on each industry space. In some cases wherein a market survey needs to be done or a specialised technology needs to be assessed, the investment bank teams up with the relevant specialists concerned. Corporate Plans: Companies require to formulate medium to long-term corporate plans that define their expansion and business strategy. While many established companies have in-house corporate planning departments, they also believe in getting the same formulated or vetted by an external agency such as an investment bank or a consulting firm. Formulation of corporate plans requires in-depth examination of the industry and business of the client, identification of growth drivers, market positioning, product policies, diversification strategies, corporate and group structure and other parameters. At the same time, the strategic financial

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aspects relating to fund requirement for future growth and financing thereof, the long-term holding structures and shareholding pattern, scope for further fund raising from the capital market, shareholder value creation and investor perspective, spinning off subsidiaries, entering into new business alliances, cross-border investments or acquisitions, etc. need to be explored and incorporated into such corporate plans. Investment banks are competent to handle such assignments due to the fact that they are well versed in strategic financial issues. �

�

Business Alliances: Business alliances relate to joint ventures, collaborations and other such strategic relationships between two corporate entities that are brought about due to business compulsions or for harnessing synergies and complementary strengths. Business alliances form an important service area for investment banks as they involve transaction support in terms of identification of partners with complementary strengths or synergies. Such deals also involve due diligence and valuation aspects apart from negotiation and deal making. Usually, if an investment bank is representing a client, it does not perform the support services in due diligence or valuation as that would amount to a conflict of interests. In such deals, therefore, more than one advisor will be involved to handle different aspects of the assignment. In addition, the legal due diligence and documentation or certification of financial statements, etc. may also need to be outsourced from various professional firms. Cross-Border Investments: Cross-border investments are made by a corporate in one country across other countries. Strategic business investments could be made in foreign entities owned or controlled by the investing corporate in the parent country or in other foreign entities. Cross-border investments may also be made without creation of a separate legal entity in the foreign country. As far as India is concerned, foreign investments in India are governed by the FDI policy of the Government of India from time to time. Similarly, overseas investments by Indian companies are also governed by government policy. Investment banks may advice either the investing company or the investee company depending upon whom they represent in the transaction. In providing such advice, an in-depth examination of the financial and regulatory issues is necessary to arrive at the optimum size of the investment, valuation methodology, investment structure and taking necessary regulatory clearances.

As may be appreciated from the above, business advisory services relate to considerations involved in corporate structuring, joint ventures and collaborations and

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cross-border investments. Therefore, these topics have been taken up for detailed discussion in the subsequent paragraphs. The aspects relating to corporate structuring based on strategic financial and regulatory considerations has been discussed in detail in paragraph 3. The various considerations and aspects that are relevant to structuring business alliances are also discussed in subsequent paragraphs.

12.3 Corporate Structuring Corporate structuring refers to organization of the businesses of a particular group in one or more corporate entities. The need for corporate structuring arises due to expansions and diversifications in corporate businesses as part of their natural growth process. Business advisory services, more often than not involve issues relating to corporate structuring as part of the development of a strategy or corporate financial plans. Investment bankers need to be fairly conversant with the considerations that need to be incorporated into such structuring. Therefore, an elaborate discussion on this topic has been considered relevant in the context of a wider discussion on business advisory services which is furnished below.

12.3.1 Emergence of Diversified Corporate Groups Diversified groups consist of several corporate and non-corporate entities that engage in various business activities that are either complementary or independent of each other. Diversified corporate groups have several businesses spread over different corporate vehicles within the group that either complement each other or help in diversifying risk for the promoters. The individual business entities in the group could at the back end be held by a common set of individuals, families, trusts, investment companies and other entities on behalf of a specified promoter group. Each diversified group is identified by the promoter group to which it belongs and each group company is identified as part of the group by virtue of its shareholding pattern. Though a diversified group may consist of both corporate and noncorporate business entities, the discussion for the purpose of this module is restricted to companies incorporated in India or outside. Diversified groups evolve over time, usually as a result of a flourishing business in one industry or business segment. Typically, a start-up company could grow into a later stage company that goes public and continues to grow thereafter. In order to allow the company to expand in its line of business, there would be a need to fledge

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the business into allied areas so as to capture a greater segment of the value chain. Over a period of time, the promoters look for opportunities beyond value chain integration in the existing business so as to diversify into unrelated businesses. This happens because of the following reasons: �

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Without diversification to some degree, the business could become heavily concentrated in one industry, thus increasing business risk. Therefore, there is a need to look for interests in other businesses in order to mitigate business risk. The existing business may have grown sufficiently large reducing the scope to expand it further. There could be regulatory or other issues involved which could make further expansion counter-productive. There could be excess of free cash flow generating from the existing business line that may need to be gainfully employed in other business, which yield better returns than to park it in safe investments. If this is not done, retaining the funds in the same business in excess of requirements would lead to over-capitalization and erode shareholder value. On the contrary, if the excess capital is returned to the shareholders on a regular basis, the company’s balance sheet starts to shrink and could send wrong signals to investors on its future prospects. Diversification not only helps in mitigation of business risk but helps in corporate growth as well. If new businesses and projects are initiated on a regular basis by identifying business opportunities, the free cash flow from existing businesses can be channelled profitably. In addition, raising external funds through debt and equity route for such new initiatives would swell the asset growth of the group as a whole much faster than through pure organic growth. This is because most projects are predominantly financed through external debt from financial institutions, banks and equity from the capital markets. To illustrate the above further point, let us consider a company that has an asset base of Rs. 100 million and growing its assets presently at a rate of 10% CAGR. It would take the company over 7 years from now to double its asset base to Rs. 200 million growing in the same business. Let us now consider a situation wherein at the end of two years from now, the company initiates a new project either for expansion of existing business or for diversification into a new area of business. The new capital investment required would be about Rs. 100 million. The company contributes Rs. 25 million towards

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the capital contribution for the new business and raises the balance of Rs. 75 million by way of term loans from financial institutions. If the project is implemented in a year thereafter, by the end of the third year from now, the company would have an asset base of Rs. 200 million. The asset expansion would have largely been caused by external financing through term loans to the extent of Rs. 75 million. This would not have been possible but for the new business initiative by the company. In this way, periodical exploitation of emerging business opportunities leads to inorganic asset growth which in turn sets off an exponential growth rate for the company and the group as a whole. �

There can be no better illustration of this phenomenon in the Indian context than the Reliance group that has grown at a scorching pace from the time it took Reliance Industries Ltd public almost three decades ago. The promoters set-up related businesses in the petrochemical value chain and further set-up Reliance Petroleum (which has since been merged with Reliance Industries Ltd) as the largest single location refinery in the world. Thereafter, the group started to diversify into unrelated businesses in infrastructure, telecom, information technology, communications and retailing. The asset growth of the group could not have been so phenomenal but for the huge external capital raising periodically to finance their projects.

Due to the above considerations, expansions and diversifications have now become a part of the growth of every corporate group. Though the original company may drive the main business and remain the flagship company for the group activities, many a time, the latter companies may grow much faster or overtake the parent company in size. This brings us to the discussion on the implications of implementing diversifications in the same company vis-à-vis setting them up in separate group companies. Business diversification is possible in two ways: (1) by setting up each business segment as a separate division in the same company, (2) by setting them up in separate group companies. A third strategy could be a combination of the above two strategies by implementing the diversification as a separate division in the same company to begin with and at an appropriate later date, spin it off into a separate company. While later stage spin-offs have been discussed separately under the head ‘Corporate Re-organizations’ in Chapter 15, the issue of ‘divisionalisation’ vs. ‘subsidiarisation’ has been further discussed below.

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12.3.2 Divisionalisation vs. Subsidiarisation Setting up a separate business as a division of an existing company can be termed as ‘Divisionalisation’ while setting up the same in a separate subsidiary is known as ‘Subsidiarisation’. The considerations underlying this decision are explained as given below: �

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The foremost consideration to be taken is the capture of shareholder value. The existing shareholders of the parent company would need to benefit from the diversified business if the funds of the parent company are being used to capitalise the new business. For e.g. if the parent company which is engaged in cement manufacture, is setting up a separate business in construction activity and the capital contribution for the same is being financed through the cash accruals of the cement business, the spoils of the new business have to be shared with the shareholders of the cement company. This can be accomplished in two ways: (a) by setting up the construction business as a separate division in the cement company or (b) by formation of a separate company to handle the construction business as a 100% subsidiary of the cement company. However, the distinction between the two methods would be that in the first alternative, the shareholders have a direct hold in the matters relating to the construction business since it is a division of the cement company. Therefore for any strategic decision relating to the cement business that requires shareholder ratification under law, the management has to seek direct approval from the shareholders. However, under the second method, the shareholders indirectly benefit from the subsidiary since it is held to the extent of 100% by the parent. Therefore, though the shareholders cannot directly decide upon matters pertaining to the cement business, they can exercise their hold indirectly through the parent company. Based on the above considerations, the decision of keeping a new business as a division or in a separate 100% subsidiary has to be decided. Since the setting up of a new business or a subsidiary by an existing company requires shareholder approvals, appropriate rationale has to be built up before seeking such approvals. Generally speaking, setting up of a 100% subsidiary is considered as a transparent and investor-friendly mechanism from a shareholder perspective if the new business has to be kept separate from the parent company for other reasons. If the question of shareholder value is not the only issue to be considered, there could be a need for a ‘structured subsidiary’. This would mean that the

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subsidiary could be held by the parent to the extent of 51% or beyond but less than 100%. This issue could arise if other interests such as a new set of shareholders are brought into the picture. To continue with the above illustration, if a techno-financial partner is being inducted into the construction business, some part of the equity in the subsidiary would be issued directly to such partner by the subsidiary. The parent company would hold the rest and to that extent, the shareholders of the parent company would not have complete ownership in the subsidiary. �

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The issue of a structured subsidiary has to be evaluated from a perspective of value enhancement for the shareholders of the parent company. The sacrifice of complete ownership in the subsidiary by the parent company is justified only if it can lead to value enhancement for its shareholders on the remainder of its holding in the subsidiary. In this context, it is necessary to discuss the aspect of a back door increase in promoters’ stake through a structured subsidiary. In the above example, if the subsidiary is structured to be held by the parent company to the extent of 75% and the balance 25% by the promoters of the parent company, it would amount to a back door entry for the promoters without going through the need to enhance their stake through the parent. Usually, if the parent company is listed, any fresh equity subscribed to by the promoters has to be priced according to the Preferential Offer guidelines issued by SEBI whereby the cost could be higher. However, if the promoters come into the subsidiary directly, they could do so at any price (even at par) since the subsidiary would be unlisted. Therefore, to the extent of such direct entry, promoters would have made a cost effective entry into the subsidiary’s business. Structured subsidiaries that allow such unfair entry to promoters are not regarded to be investor-friendly and ethical in nature. The third issue for consideration would be that of ‘inter-se transactions’ between the existing business of the parent and that of the new business. If the position is that there would be considerable inter-se transactions, it may be necessary to retain the new business as a division in the existing company itself. This could obviate the need to satisfy the revenue authorities on inter-firm pricing issues. If the new business happens to be situated overseas, the tax regime prescribes onerous procedures on ‘transfer pricing’ between the two companies. Regulatory issues could also arise under the indirect tax law and the foreign exchange law. These aspects need to be looked into

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before deciding on whether the new business should be in a division of the existing company or be in a separate company. �

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Fourthly, if the new business does not have synergy with the parent and if the promoters of the parent wish to invest fresh capital of their own and other kinds of external finance such as borrowings and equity from a different set of investors into such business, it would not be advisable to integrate the same with the parent either through divisionalisation or through subsidiarisation. Such businesses can be kept distinct from the existing businesses of the parent by allowing the shareholding pattern to be structured accordingly. This way the promoters can build up their stakes cost effectively in the new business without having to meet preferential pricing norms. All said, and done, the promoters are not under any obligation to the outside shareholders to make them a part of all their business ventures. Such new group companies can have their growth structured according to their needs and can remain independent of the parent company. They can raise finance periodically on their own strength or of the promoters and they can also be taken public at the appropriate time based on relevant considerations.

12.3.3 Key Considerations in Corporate Structuring There are several diversified and well-performing groups in India, but with liberalisation and the consequent need to be competitive in the global marketplace, most diversified groups have been re-inventing themselves through proper corporate structuring and re-organization. Investment banks have been hand-holding Indian business groups in these efforts through complex advisory and transaction services. This module focuses on the financial and regulatory aspects involved in corporate structuring, de-mergers, spin-offs and other type of intra-group re-organizations as also new initiatives through joint ventures and collaborations. Chapter 15 discusses external re-organizations through mergers and acquisitions. Corporate structuring in diversified business groups needs to address the following objectives: �

To facilitate the attainment of business objectives in the long-term.

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To optimise the benefits offered under statute or government policy.

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To generate, concentrate and distribute shareholder value in the best possible manner.

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To facilitate growth of the business through fund raising on a constant basis, and through partnerships, diversifications, consolidations and sub-divisions. To facilitate easy entry into and exit from various businesses of the group for shareholders for the purpose of business portfolio management.

While the above objectives are paramount, business groups need to adapt constantly to changing operating environment to attain them on a sustained basis. Therefore, the corporate structure plays an important role in determining largely, the success of a particular business. The structure is largely driven by strategic, financial, regulatory and investment banking considerations backed by relevant statutory framework. The key areas of corporate structuring are discussed below keeping the above-mentioned considerations in mind.

(a) Promoters’ and Strategic Shareholding The strategic considerations underlying shareholding structures in diversified groups are primarily in the areas of promoter holdings and management control and flexibility in change of shareholding patterns through entry and exit of stakeholders. Holding patterns in diversified groups are mostly driven by the holding and subsidiary company relationship or through cross holdings between group companies. The promoter stakes in group companies are held either directly or through promoter holding companies or through several complex investment companies and other entities. Two illustrative structures are depicted below (Fig. 12.1). In terms of section 4 of the Companies Act, 1956 a company can be a holding company of another either by virtue of a majority shareholding (51%) either directly or indirectly or by controlling its management (the Board of Directors). Therefore, A is a subsidiary of B if its Board is appointed by A or if B holds 51% or more of A’s voting powers either by virtue of its direct shareholding in A or through a third company C. In other words, if A is a subsidiary of B and B is a subsidiary of C, then A would be a subsidiary of C. In terms of promoter holdings, they can be structured through the flagship company as in Structure I or the promoter holdings can be kept independent of the functional group companies as in Structure II. In India, most of the industrial groups are structured in such a way that the promoters have majority control in their group companies. In some cases where majority shareholding is not possible, they at least aim to be the single largest shareholder group in the company. In some

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STRUCTURE—I Flagship Company (handling businesses of its own) Holding Company of other group companies

Group Company I Can be a subsidiary /have cross holdings/direct promoter holdings

Group Company II

Group Company III

Can be a subsidiary/ have cross holdings/direct promoter holdings

Can be a subsidiary/ have cross holdings/ direct promoter holdings

STRUCTURE—II Promoters' Holding Company (Normally one or more pure investment companies with no business of their own) Promoters hold stakes in group companies through this company

Group Company I May have cross holdings

� Figure 12.1

Group Company II May have cross holdings

Group Company III May have cross holdings

Basic Models of Corporate Holding Structures

other cases, where even such a status is not feasible, they like to retain a 26% stake so that no significant decisions can be taken without their concurrence. This is because under the Companies Act, several significant corporate decisions need the approval of the shareholders through a special resolution that requires a majority vote of 75%. Therefore by having a 26% stake, promoters can effectively block all special resolutions if they are not in favour. For e.g the Tata group had restructured

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their shareholdings in the mid-1990s so as to have at least 26% for the group holding company (Tata Sons) in two of their flagship companies—TISCO and TELCO. As far as promoter and strategic holdings are concerned, having them in a separate holding company often has tax benefits as well. Resident Indian promoters can plan the residential status of the holding company in a separate foreign jurisdiction so as to minimise incidence of tax. Similarly foreign investors can channelise their investments into India through holding companies for tax avoidance or minimization. This process has been described later in this module. In addition to tax benefits, holding companies help in preserving the identity of individuals and families who form part of the promoter group or strategic investors since the shareholdings would be held by the holding company. The holding companies are generally structured as private companies in order to preserve their privacy. These holding companies can also facilitate mobilisation of resources on their own which can be deployed to increase promoter stakes in respective group companies. Most importantly, holding companies facilitate flexibility in transfer of shareholdings in group companies between the promoters and third parties. This is because the shareholding of the holding company can be altered to allow entry or exit of stakeholders without altering the shareholding pattern of the group company. To illustrate the above point further, let us consider the following example. ABC Investments Pvt. Ltd. is a holding company of the promoters of PQR Constructions Ltd. The promoters through ABC hold 75% of the share capital of PQR. ABC does not have any other business of its own except for holding and managing promoter shares. They now intend to bring in a strategic partner—XYZ Ltd with a 24% stake in PQR. The entry is to be accomplished without any fresh issue of capital by PQR. The above arrangement can be accomplished in two ways—(1) either by ABC selling off 24% of its stake in PQR to XYZ whereby the latter gets to hold 24% in PQR or (2) by the promoters selling off 32% of their stake in ABC whereby XYZ indirectly gets to hold 24% of PQR (32% of 75% equals 24%). The difference in the two methods lies in the fact that under the first method, XYZ gets a direct entry into PQR with a 24% voting power while under the second method, it can exercise its voting power in PQR indirectly by controlling 32% of ABC. This means that with a 24% stake in PQR, XYZ would not be able to block special resolutions but with 32% stake in ABC, XYZ may be able to influence decision making through ABC. Therefore, it is possible through a holding company mechanism to create an upper level of shareholding which is outside the companies in which such holding

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is held. This mechanism is found useful in several ways for management of promoter and other strategic holdings. Therefore, to conclude the above discussion, two types of holding companies are possible—(a) holding companies for other group companies, (b) holding companies for promoter and other strategic stakes in group companies. The former would, in most cases, be the flagship business entities of the group while the latter would generally be purely investment vehicles. Such investment vehicles can also become fund raising entities for the promoters so that they could invest such funds into their business entities. Both these types of holding companies can co-exist in a group corporate structure. The discussion on promoter holding companies (HCs) can be summarised as follows: �

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Holding companies are created to park their investments in group companies for promoters and strategic investors. These companies may or may not have any other business activity. In most cases, their main business activity is to hold shares in other companies. Generally, such companies are incorporated as private limited companies. Formerly, HCs were being formed as investment companies to hold shares for promoters in a fragmented way so as to minimise the incidence of wealth tax. Presently, fragmented ownership is no longer necessary but consolidation of promoter holdings is in vogue. HCs are used for this purpose. By not having direct stakes in companies, many promoters avoid significant disclosures of their holdings in the operating companies of the group. Since HCs consolidate holdings, the exact stake of promoter group in each operating company can be ascertained. This information is vital for strategic investors. Most strategic investors prefer formation of HCs to keep their stakes in companies. This would enable them to participate in more than one business of a group. HCs eliminate the need for cross-holdings which is considered investor and regulator unfriendly. Since HCs consolidate holdings, it is possible to have tax efficiency by planning its residence as distinct from its shareholders. Most HCs are formed in tax havens to minimise their tax and consequently to their shareholders.

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Since HCs conduct the business of holding and disposing off their shares in other companies, they could classify their profits as business profits and not capital gains. This has certain tax advantages.

(b) Special Purpose Vehicles The next important aspect of group corporate structuring is the formation of Special Purpose Vehicles (SPV) to initiate a business or to hive off existing businesses. SPV’s need to be distinguished from other companies since they normally have a specific mandate to their creation. The following are broadly some of the considerations to set up SPVs: �

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To run a particular business or to set up a new project. In this case, the SPV performs the function of creating bankruptcy remoteness from the existing businesses or entities of the promoters. By having the new business or project in the SPV, it would have its own defined set of assets and liabilities that are distinct from those of other businesses in the group. In addition, it provides limited liability to the promoters only to the extent of their stake in the SPV. This structure is usually resorted to in financing projects on a nonrecourse/limited recourse basis. This type of SPVs are also common in structuring joint ventures and collaborations. To manage a set of liabilities with a given pool of assets. This type of SPVs have a limited life until such time that the liabilities are paid off from the available assets. A classic example in recent times of this kind of a SPV is the Unit Trust of India (UTI). When UTI ran into problems with its flagship US64 scheme, it was decided to hive off all existing well performing schemes to a new entity called UTI Mutual Fund. The residual UTI thus became a SPV (known as the Specified Undertaking) which only had the mandate to settle its liabilities form its available assets. Therefore, the specified undertaking thus has a limited life and function until its liabilities are fully extinguished. This type of SPVs are also common in transactions involving securitisation of assets. In the case of securitisation of receivables of banks and financial institutions, SPVs known as asset reconstruction companies are set up. The third type of SPVs are investment vehicles that are set up to channel investments so as to obtain tax efficiency or to provide a corporate veil for the actual investors. This structure is increasingly resorted to in channelling

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ROUTE I Foreign Investor in home country making investment or loan into India

Indian Company which receives the investment or loan

ROUTE II Foreign Investor in home country making investment or loan into India

Investment company (s) in third party territories (this can be a long chain)

Indian Company which receives the investment or loan

� Figure 12.2

Illustrative Investment Structures

foreign investment into India by making use of an SPV set up in a tax haven or in a country that has a favourable taxation treaty with India. The above exhibit illustrates the point in a simplistic way (Fig. 12.2). Under Route I, the foreign investor directly receives the income or capital gain arising out of the investment from India in his parent country. If this income is taxable both in India and his home country, there would be a withholding tax that would be deducted in India before the income or capital gain is remitted to him. This tax paid in India would be eligible to be set off against the tax liability in the home country if there is a double taxation avoidance agreement (DTAA) to that effect between the two countries. In the absence of a DTAA, this set off may not be possible. Under Route II, the investment is routed through a third country by using a SPV route. If the SPV is formed in a tax friendly country, there could be no or concessional taxation on the income earned by the SPV from its Indian

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investment. In such cases, the only tax payable would be the withholding tax in India. If such third country also has a DTAA with India whereby the income is taxable in that country, the income may escape tax altogether due to the tax neutral status of such income in that country. Similarly, if the income is not chargeable to tax in India (for e.g. dividends), the income to that extent would be exempt from tax altogether. �

One other reason for formation of SPVs could be to shift certain liabilities from the parent balance sheets whereby as per the reporting requirements, these need not be reflected as liabilities in the parent balance sheet. This kind of structuring is adopted in certain cases to avoid regulatory provisions relating to capital adequacy in a particular business segment or to prevent elaborate disclosures under the regulatory requirements. After the Enron episode in USA, new accounting regulations have been put in place by the FASB to capture the impact of SPVs into parent balance sheets with wider connotations.

(c) Private vs. Public Company Structure An important dimension of corporate structuring is also with respect to formation of private companies and public companies. Under the Indian company law, private companies have a special status and are exempted from several onerous legal and compliance requirements. Two important privileges associated with a private company are: (1) restricting the transferability of its shares and (2) keeping its financial statements out of public domain. However, private companies also have certain limitations, meaning that they cannot raise funds from the public through equity or debenture issues or through public deposits. However, in certain cases, it is possible that the public are indirectly interested in a private company if it happens to be the subsidiary of a public company. In such cases, the public company can raise resources from the public and pass them on to the private company. In order to plug such loopholes, the law provides that private companies that are subsidiaries of public companies shall be deemed to be public companies and would lose all the privileges associated with ‘pure’ private companies. An exception is provided to private companies, which are subsidiaries of foreign public companies. Such private companies would continue to be pure private companies in India if their capital is held entirely by one or more foreign public companies. Due to these provisions, 100% Indian subsidiaries of foreign public companies can be pure private companies in India and they can enjoy the privileges available under law.

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The above position in law becomes an important consideration in formation of companies for new business ventures. In most joint ventures involving strategic partners, the issue of management control and pre-emptive rights are common. Preemptive rights are in the nature of restricting the transferability of shares by each party in the joint venture company. In such cases, it may be necessary to form the venture as a private company to avoid legal complications. In some situations, shares with differential voting rights could be issued to preserve the character of a pure private company so that the other restrictive covenants in shareholder agreements can be made effective.

(d) Company with Limited Liability vs. Unlimited Liability In floating new vehicles for implementing projects in India involving foreign investors, JV partners or foreign parent companies, it is important to keep in mind the tax structure of the country of residence of such persons and the provisions of the tax treaties entered into by such country with India if any. This aspect has also been discussed earlier. This aspect becomes relevant even in planning the liability structure of the Indian entity. There are two examples that can be cited in this context with respect to the US tax law, i.e. the Dabhol Power Company floated to implement the power project set up by Enron, General Electric and Bechtel of the USA and the Kotak Mahindra Capital Company, an investment banking joint venture between Kotak Mahindra Finance Co. Ltd of India and Goldman Sachs of the USA. In both the cases, the Indian entity was floated as an unlimited company under the Companies Act. This has been done to take advantage of the tax deferral mechanism available under the IT Act in India and benefit the US investors. This process is explained below. The US parent companies would be taxable on their global income in the US even if such income accrues to them through offshore vehicles incorporated in tax havens or tax friendly countries across the world if such vehicles distribute dividends to such parents whether in US or outside. If the Indian entity does not pay any tax in India due to tax deferral benefits, such US parents do not get the benefit of any set-off against their US tax liability arising from dividend distributions from India. However, if such dividends are paid by foreign partnership firms or corporations with unlimited liability and restricted transferability of shares, such dividends get classified as distributions of profit by a partnership entity under the US tax law. Such distributions are not taxable in the USA. Therefore, by structuring the Indian entity as a private company with unlimited liability, the objective is effectively achieved.

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(e) Listed vs. Unlisted Company Structure The other important determinant of corporate structures in a group is the listing status required for a particular group company. As has already been explained in Chapter 5, there are both advantages and disadvantages in a company going public. In a diversified group, the IPO strategy has to be carefully planned out to take the best company public as it would help the other companies in the group to follow with their own listings. However, once the group companies become listed, there are certain restrictions that are applied to them by law. Therefore, the strategy should be to aim at the right mix of listed and unlisted companies in the group so as to unlock shareholder value and at the same time, retain some flexibility. One of the main aspects of the flexibility mentioned above is in increase or transferability of shareholding. If a company is listed, an increase of shareholding by any shareholder to the exclusion of other shareholders attracts the Preferential Allotment guidelines and is therefore subject to a pricing formula. Similarly, in a listed company, an acquisition of shares to the extent of 15% or above triggers off the ‘Takeover’ guidelines. In addition, new public offers or private placements of equity in listed companies are regulated by respective guidelines. Due to these restrictions, shareholding patterns in listed companies have to be managed carefully. However, as long as a group has unlisted companies, there would be flexibility in attracting new investments in their equity capital from strategic and private equity investors. In addition, promoters can hike their stakes in such companies without attracting the preferential allotment or other related guidelines.

(f) Group Financial Management The next important factor in determining corporate structure is the fund raising capability of the group. Most diversified groups require financing from time to time both through the debt and equity route to manage their growth in different businesses. However, there could be differences in the rate of growth of each business due to which, there could also be varying degrees of strength in each balance sheet in the group. It may even happen that some of the group companies could be making losses while the others could be making profits. In order to bail out the loss making companies, the well-performing companies may have to take the burden on their balance sheets. This could impair their fund raising capabilities. For example when ITC Classic Finance, an ITC group company was facing insolvency, the parent company (ITC Ltd) had to spend more than Rs. 8 billion to bail it out of

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trouble. Similarly when ITC Bhadrachalam, another group company was facing trouble due to recession in the paper industry, ITC had to pump in another Rs. 1.5 billion into that company. There have been several instances of group companies being bailed out from finances raised by well-performing companies. Shaw Wallace had as many as 14 subsidiaries most of whom were using funds raised by Shaw Wallace. In the past companies such as Shaw Wallace, JCT and JK Corp landed themselves into difficulties by excessive bailing out of group companies. All the above experiences point to the fact that group financial management plays a significant role in determining corporate structure. If some companies are not performing well within the group, these cannot depend on the healthy companies to bail them out for eternity as this would put the future of even the healthy companies in a jeopardy. Therefore for constant fund raising from the debt and equity markets, it is important to cut losses in group companies through restructuring or sell-offs and maintain a healthy growth in the well-performing companies. Sometimes, intra-group mergers could be required to save on costs and achieve synergies. The overall debt burden of the group needs to be managed as well, if the loans have been raised with recourse to other companies in the group. As far as fund raising for new business initiatives is concerned, it may sometimes be necessary to structure them through the non-recourse route which would require the setting up of separate companies. Sometimes, there could be a different set of lenders and specific charges required for a fund raising transaction that would necessitate a separate balance sheet. Continuing on the above lines, fund raising for existing businesses may also require innovative structuring whereby the credit rating for a particular fund raising programme could be improved through suitable credit enhancements using the balance sheets of other group companies. These kind of structured financing transactions are increasingly being resorted to in recent times. Lastly, in companies that go through debt restructuring, certain unlocking of assets may be required through hive offs and dissolutions. These processes could in turn change the group structure.

(g) Forward and Backward Integration and Diversification In continuation of the discussion earlier in this module on subsidiarisation wherein the strategic issues were discussed, there could also be financial issues in determining such

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structures. One of the important determinants for spinning off separate companies in a group could be to achieve forward or backward integration and to provide complementary businesses for the main line businesses of the group. While setting up such group companies, more often than not, the main consideration is to raise finances separately for each such company since the lenders and the asset pools could be different. Secondly, the promoters would not want to combine all components of the value chain to be combined into one entity as it would increase its leverage and consequently lead to a financial risk. Similarly, diversified groups have their presence in several businesses which may be unconnected with each other. In such circumstances they are kept in separate companies so that each company can grow independently and based on its rate of growth, it can look for its own finances. This strategy of maintaining arm’s length distance between group companies helps in protecting the well-performing companies from those that are not. There could also be other considerations in keeping certain segments of business in separate companies. For instance, if the risk profile of a particular segment is quite high as compared to the others, it may be advisable to structure it as a separate entity; otherwise it could be a drag on the whole business. One such example is that of pharmaceutical business wherein research and development for new drug molecules is an expensive and high risk activity that can not only fail but requires risk capital as well. Such activity should therefore be in a separate entity so that the parent company is not affected by its failure. Therefore, bankruptcy remoteness could be a key determinant in group structuring.

(h) Consolidated Reporting and Disclosure Requirements Lastly, disclosure and accounting requirements would also influence the structuring of group businesses in determining whether they should be ‘On-balance sheet’ or ‘Off-balance sheet’ structures. Under the Indian Generally Accepted Accounting Principles (including the Companies Act 1956 and the Accounting Standards issued by the Institute of Chartered Accountants of India), the following accounting treatment is prescribed with respect to various corporate relationships: �

A holding company should attach to its balance sheet prescribed particulars with respect to each of its subsidiary along with a statement of the holding company’s interest in the subsidiary (section 212).

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The holding company has to present consolidated financial statements of itself with all its subsidiaries as part of its annual reporting requirements. For this purpose, a subsidiary would be one wherein the holding company has more than 50% of the voting power either directly or indirectly through other subsidiaries. Such requirement is also attracted where control is exercised on composition of the Board of Directors of the other company. The consolidation is required with respect to both Indian and foreign subsidiaries of an Indian holding company (AS-21). In respect of joint venture companies with other strategic partners ( JV companies), if the interest of one party is more than 50% in the JV company, it should be ranked as a subsidiary of that party. Accounting for JV interests is mandatory in the books of the venturers if it is a jointly controlled operation. Accounting is required for the assets controlled, liabilities and expenses incurred and share of profits earned from the JV. In the consolidated financial statements of each venturer, the interests in jointly controlled JVs have to be accounted for either by the proportionate consolidation method or by the equity method. JV companies in which there is no joint control, but one party has significant influence should be ranked as ‘Associates’. JV companies in which there is no joint control nor significant influence should be treated as mere long-term investments in the books of such a party. An associate is a business entity in which the investor has significant influence, but which is not a JV or a subsidiary. Significant influence is the right to participate in policy making but no control on the entity. Control is achieved either by holding more than 50% share capital or by being able to constitute the Board of Directors. Significant influence may be achieved through shareholding, agreements or by statute. It is deemed to be present if shareholding of 20% or more exists for an investor in an investee entity. Significant influence is represented in the following ways: �

By one or more Board seats

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Consultation in policy making

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Material transactions with the investee

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Common or interchangeable managerial personnel

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Providing technical or business know-how.

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Accounting for associates has to be done by the Equity method alone unless there is long-term impairment to the investment. In such a case, the accounting should be done as if the investment is merely a long-term investment. The equity method is appropriate only till such time that the significant influence exists or there is no permanent impairment. In addition to accounting issues, each company has to disclose details of transactions entered into with related companies and other entities (including associates and joint ventures) — AS-18.

By studying the above requirements, it is evident that there are three levels at which reporting requirements have been prescribed. They are as follows: �

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A holding and subsidiary relationship under which consolidated financial statements are mandatory. Therefore, all assets, liabilities and contingent liabilities of all subsidiaries get reported as part of the balance sheet of the parent holding company. This is the maximum level of integration prescribed. This level of integration is also mandatory for all relationships that tantamount to a holding — subsidiary relationship. At the second level is a relationship that has between 50%–20% shareholding by one company in another. Such relationship is an ‘Associate’ relationship for which only a net accounting method (equity method) has been prescribed without any need for consolidation. At the third level are relationships with less than 20% shareholding. Such relationships do not require any specific integration. They can be shown as any other long-term or short-term investment (as the case may be) in the books of the investing company.

These levels of reporting requirements obviously influence corporate relationships in group companies and outside. If two businesses are intended to be core activities, they could be combined into a holding–subsidiary or a JV relationship. Non-core businesses may be kept as associates since they need not be reported on a consolidated basis. Fringe businesses may be kept as off-balance sheet businesses or disclosed as long-term investments.

12.4 Joint Ventures A Joint Venture ( JV) can be incorporated as a company or operated as a special purpose association with separate books and bank accounts. In the former case,

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it is called an Equity JV since the separate company would be capitalised with the capital contribution from both the parties. In the latter case, it is a contractual arrangement between two parties and therefore it is known as a Contractual JV. Whatever the constitution of a JV, the essential feature is the exercise of joint control. JVs are entered into with specific objectives such as entry into a foreign market with local support, access to ready markets and other strategic considerations such as technological support, branding and harnessing intellectual property. JVs are generally favoured over the creation of a new subsidiary or the acquisition of an existing company, owing to strong commitment from the partners, flexibility in operation and structuring investments and saving in capital and operational costs. The selection of the right partner therefore, is of vital importance and represents one of the most delicate stages in the creation of a joint venture. The three essential common criteria in the selection process are as follows: �

The perception of common interests between partners.

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Their respective competence which is dependent on their strategic resources.

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The complementary nature of their respective contribution to the joint venture.

Partners often have differing views on their respective contributions to the joint venture, each tending to attribute greater value to its own management contribution. Therefore, it would be necessary to sort out all critical issues before entering into the JV. However, some of the principal problems encountered in the operation of a JV over a period of time are as follows: �

Adapting to local culture in the case of overseas JVs.

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The lack of effective integration between the JV partners.

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Divergent strategic objectives.

Therefore, the success of a JV is built on a common strategic vision, strong partner commitment and genuine business complementary elements in business. Historically speaking, contrary to popular belief, joint ventures are generally successful with majority of the objectives being either achieved or surpassed. In addition, another aspect to be considered is that the majority of JVs function more on the basis of a balance of power than on the dominance of a particular partner. Generally, the JV CEO is designated either jointly or by the majority shareholder.

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Some companies also opt for a rotating leadership such as in Maruti Udyog Ltd., a JV between the Government of India and Suzuki Motor Co. of Japan.

12.4.1 Joint Ventures in the Indian Context Most of the JVs in India of recent origin have been merged as a fall out of the liberalisation policies followed by the government since 1991. These have been in the nature of foreign companies entering India through the JV route pursuant to the liberalised Foreign Direct Investment (FDI) policy. In the first phase of FDI investments into India post-1991, JV was a preferred route as compared to setting up of 100% subsidiaries by foreign companies since in most sectors, the maximum FDI was restricted to 51%. However, in later years, some sectors were opened up for 100% FDI whereby foreign investors set up their own 100% subsidiaries or converted existing JVs into 100% subsidiaries. In the Indian context, access to new markets has been the general priority of the foreign partner while access to technology and domain knowledge has been the main driver for the Indian partner. An example in this context is the joint venture between the Maharashtra Electricity Supply Board (MSEB), Enron, General Electric and Bechtel which went on to create the Dabhol Power Company in Maharashtra. MSEB looked at the technology, global experience, resourcefulness and global size of Enron, GE and Bechtel. GE and Bechtel in parts had the know-how in the equipment and construction of power plants respectively while Enron as a global energy generator and trader wanted access into the vast market for electric power and gas consumption in India. Joint ventures can be found in all leading industry sectors. In the automotive sector (e.g. TVS-Suzuki, Maruti ), chemicals, financial services (e.g. Prudential-ICICI, DSP-Merrill Lynch) , engineering(L&T-Komatsu) and many other sectors. Maruti Udyog Limited (MUL) was established in February 1981 through an Act of Parliament to meet the growing demand of a personal mode of transport caused by the lack of an efficient public transport system. Suzuki Motor Company was chosen from seven prospective partners worldwide. It was not only their undisputed leadership in small cars but was also their commitment to be an active participant in terms of bringing in contemporary technology and its Japanese management practices that prompted the government to choose Suzuki. Japanese management

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practices had catapulted Japan over USA to the status of the top auto manufacturing country in the world. The objectives of MUL then were as follows: �

Modernization of the Indian automobile industry.

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Production of fuel-efficient vehicles to conserve scarce resources.

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Production of large number of motor vehicles, which was necessary for economic growth.

A Joint Venture agreement was signed with Suzuki Motor Company (now Suzuki Motor Corporation of Japan) in October 1982, by which Suzuki acquired 26% share of the equity in MUL. A manufacturing licence was also issued for the manufacture of passenger cars. Suzuki subsequently increased its equity to 40% in 1989 and further to 50% in 1992, converting Maruti into a non-government company. December 1983 heralded a new revolution in the Indian car industry. MUL produced the first affordable car for the average Indian. Maruti entered the Indian car market with the avowed aim to provide high quality, fuel - efficient, low - cost vehicles. Its cars operate on Japanese technology, adapted to Indian conditions and Indian car users. At this time, the Indian car market had stagnated at a volume of 30,000 to 40,000 cars for the decade ending 1983. It was in the same year that Maruti took over to attain a leadership position in the passenger car market. A decade later, the sales figure for the year 1993 had reached close to 200,000. The company reached a total production of one million vehicles in March 1994 becoming the first Indian company to cross this milestone. It crossed the two million mark in 1997. To fend off growing competition, Maruti completed a Rs. 4 billion expansion project which increased the total production capacity to over 3,20,000 vehicles per annum by 1997. Thereafter the company modernised the existing facilities and expanded its capacity by a further 1,00,000 units to exceed a production capacity of 4,00,000 vehicles per year. Lately, the Indian JV sector is slowly tapering off after a spate of JVs with MNCs was launched post-liberalisation. Primarily, all JVs were started to rope in new technology and expertise into Indian businesses or to provide an entry strategy to the foreign partner. These reasons have however lost their relevance after a decade of reforms. The only driver that still exists for JVs between foreign companies and their Indian counterparts is the continuing sectoral caps on FDI. However, the FDI factor is also getting diluted gradually with the opening up of many industrial sectors to 100% foreign investment. Several proposals that have sought government approval in recent times have been for multi-national companies to set up their 100% subsidiaries

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in such industrial sectors. In 2002 alone, almost 300 proposals were filed with the Foreign Investment Promotion Board for either setting up 100% subsidiaries or for MNCs to hike their stakes in their JVs eventually making them 100% subsidiaries. The second reason for the pace of JVs to have slowed down is the experience of the JVs formed so far. The Indian JV experience has not been an encouraging story so far with several JVs having seen the partners parting ways. This has been due to the increasing divergence in business objectives and the inability to strike the right balance by both parties. In other cases it has been due to strategic exit decision taken by one of the JV partners. The duration, success and failure of a JV is largely dependent on the business climate and the operating environment. While some JVs end on a bitter note, some others are settled amicably either by the foreign partner buying out the Indian partner or the foreign partner exiting through a sell-off to the Indian partner. Among the JV exits in India are TVS-Suzuki in the two-wheeler segment, Government of India (GOI)-Suzuki in passenger cars, JP Morgan-ICICI and Merrill Lynch-DSP in investment banking and several others. One other example of a buy out is that of J.C. Bamford Excavators which had sought to buy over the entire stake of Escorts Ltd in their JV Escorts JCB Ltd, a construction and material handling company for a total consideration of Rs. 105 crore over a period of time and had sought the approval of the Government for the same. JV partners generally view JVs from a long-term perspective. Therefore, though most JV agreements envisage an initial period of association, the intent of both parties would be to renew the association for subsequent blocks of time. The JV between the Hero group and Honda of Japan for the manufacture of motorcycles had a fixed duration while that of the GOI and SUZUKI did not. The GOI-SUZUKI JV ended with the disinvestment decision by the government and one of the reasons for this decision is the decline in market shares of the company in the face of stiff competition in the passenger car market. Yet another area of concern for foreign investors has been the restrictive covenant issued vide Press Note No. 18 in 1998 by the Secretariat for Industrial Assistance, Department of Industrial Policy and Promotion, Ministry of Commerce and Industry. This press note prescribed that the automatic route for foreign investment is not open for those foreign investors who have/had a previous financial/technical/trademark collaboration in an existing domestic company engaged in the same or allied activity. All such proposals are considered by FIPB on merits. In addition, for the FIPB approval, *(Source: The Economic Times dated 14th December 2002.)

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a no-objection certificate (NOC) was required from the existing Indian partner. This requirement was also to be fulfilled if the foreign partner wanted to increase his stake in the JV. This created problems for companies such as Kennametal, whose open offer for Widia was struck down since its Indian promoter Yash Birla refused to issue a NOC. Similar was the experience of TCL, the Chinese electronics major whose reentry through another tie-up has been stalled due to its earlier association with Baron of the Mulchandanis. In a subsequent case however, the FIPB struck down the stand of Graphite India, which was objecting to the entry of a Saudi Arabian company, Amiantit in pipe technology citing an earlier agreement between the two parties The Kirloskar group proposed to increase its stake in their JV with Toyota Industries Corporation called Kirloskar Toyota Textile Machinery to its original level of 10.62%. Earlier Toyota had upped its stake in the JV to 94.4%. The Kirloskars now wish to buy back certain equity from Toyota to restore their holdings to the earlier level. This was proposed through RBI approval.

12.4.2 Structuring Joint Ventures Structuring JVs would require not just an understanding of the business objectives of both the parties but other issues which are financial and regulatory. In cross border JVs involving an Indian and a foreign partner, the issues could be more complex. At the macro level, Equity JVs can be structured either—(1) by setting up a new company for the purpose of the JV or (2) by conversion of an existing company of the Indian party into a JV company. The conversion of an existing company under the second alternative could again be through the ‘equity route’ or the ‘asset route’. All the above two alternatives used are discussed below: �

If the structure is to set up the JV in a new company, the new company has to be formed accordingly either as a private or a public company with the required objectives and the equity investment of both the parties has to be brought in as capital contribution into the new company. However, this would be preceded by a complete understanding of the relationship through the execution of a JV agreement by both the parties. The essential areas of importance in a JV agreement are discussed separately later. The equity investment by both parties in the new JV company has to be routed

*(Source: The Economic Times dated April 15th 2003.) † (Source: The Economic Times dated July 29th 2003). ‡ (Source: The Economic Times dated 14th December 2002.)

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appropriately based on the tax status and other considerations of both parties. If one of the partners happens to be a foreign company, the investment may have to be routed through a tax neutral country. This aspect has already been discussed earlier. In addition, the foreign investors may require approvals from the Indian regulatory authorities for the investment. This aspect has been discussed separately. In addition, the capital structure of the new company has to be formulated keeping in mind the size of the investment, inter-se understanding between the parties, pricing of the share of the JV company (if it is envisaged be above par value) and the capital mix if any between pure equity, preference capital, unsecured soft loans and other hybrids. One of the considerations in capital structuring would be to ensure that the equity capital base is not too large since the company would be new and would require further capital expansion in future. If the equity base is large to begin with, it could affect the Earnings Per share adversely, thereby affecting its pricing for future equity issuances. �

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If the JV is proposed through conversion of an existing company into a JV, the mechanism for such a conversion needs to be thought out. The conversion could be through the equity route by inviting the other partner to become an equity partner in the existing company. This is the general route adopted which is easier since there is no reorganization of the existing balance sheet. The main issue that arises in the equity route is on the valuation of the existing company for the purpose of investment by the new partner. This needs to be assessed from a regulatory perspective as well. In case, the existing company is a listed company, the pricing of the share for the purpose of seeking investment by the new partner cannot be less than the price that would be arrived at under the Preferential Allotment guidelines. Therefore, if the valuation of the company results in the price of the share being less than the preferential price, the latter has to be adopted. In the case of unlisted companies, the pricing of the share should be based on the valuation of the company as arrived at by a third party (usually the investment banker or a chartered accountant) and certified accordingly. The methodology for such valuation would usually be on a ‘going concern’ basis using the widely accepted ‘Discounted Cash Flow’ method with bench marks from other methods such as the Net Asset Value method and the Market Multiple method as may be found appropriate in each given situation. With respect to an existing company that is listed but thinly traded on the stock market, the pricing of the share has to be arrived at using market based

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multiples such as Price/Earnings multiple or on the basis of the Net Asset Value. This pricing has to be certified by the investment banker or chartered accountant. However, if the total deal value for the investment does not exceed Rs. 2 million, it is not necessary to get the pricing certified through an independent third party. An auditor’s certificate based on the above lines of pricing would be sufficient to establish the basis for the said deal. �

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For this purpose of agreeing on the fair price for the deal, it is however customary for the valuation to be conducted by both the sides through independent investment bankers and/or accountants. This would also be subject to a due diligence review before the investor puts in the money. A JV may also be formed through a reorganization of the existing balance sheet. Under this method, the JV is formed by hiving off a part of the existing company into a separate wholly owned subsidiary. The subsidiary would then issue shares to the JV partner and thereby the JV is constituted. The hiving off may either be through a ‘demerger’ or through a ‘structured spin off’. These aspects have been elaborated separately under the head ‘Corporate Reorganizations’. In either case, the hive off method is relevant if the JV is intended only for a part of the existing business that would not include all the assets and liabilities of the existing balance sheet. For instance, if an existing automobile manufacturing company which has its presence in domestic and commercial vehicle segment intends to float a JV for the manufacture of tractors alone with a strategic equity partner, this would require hiving off of the tractor business separately so that the JV can be constituted. In other words, out of the existing balance sheet, those assets (and liabilities if required) belonging to the tractor business need to be culled out into a different balance sheet. The transfer of such assets (and liabilities) can be done at book values to a separate balance sheet which would then become the JV vehicle for the tractor business. A variation of the existing reorganization method could be to sell an existing business to a specially constituted SPV. The SPV will be infused with capital contribution from both parties to the JV which shall then become the JV company. The sell off could also as in the case of the spin-off discussed above be a ‘structured sell-off’ whereby select assets (and liabilities) may be sold off to the new vehicle to constitute a separate balance sheet. This would be done for a purchase consideration by the SPV. The consideration could be shares in the SPV to the parent company or partly by cash and partly through issue of shares. The SPV would also issue a stake to the new JV

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partner and generate the cash to pay for the assets acquired. The entry of the new partner could again be at a price determined through a valuation process for the SPV. �

The constitution of the JV can also be through the equity method or the reorganization method at the level of parent companies or holding companies whereby a change of shareholding or a merger between such companies could result in the formation of a JV at the level of the subsidiary.

From the above discussion, the structuring issues for constituting a JV may be summarised as shown below: �

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JVs can be constituted by setting up new companies or by reorganization of existing companies into JV companies. Setting up of new companies is recommended for proposed businesses while conversion method is more appropriate for existing businesses. New companies provide bankruptcy remoteness to the JV from the existing businesses of the JV partners and vice versa. Reorganization method can be accomplished either through the equity route or through the asset route. The equity route is appropriate if the JV partners to be inducted into the existing company are intending to be a part of the entire business of the existing company. If the incumbent partners are in joint venture for a select segment of the existing business alone, the asset method of constitution is appropriate. Under this method, the assets (and liabilities if required) can be hived off either through a demerger or a structured spin off at book values to another balance sheet which can then become the JV vehicle. The incumbent partners would take equity stake in the other balance sheet. The other balance sheet could be that of a new company formed for this purpose (a SPV) or an existing company. The asset transfer can also be accomplished through a ‘sell-off’ at a purchase consideration to the SPV.

12.4.3 Joint Venture Negotiations and Agreement The crucial stage in a joint venture after the conclusion of the partner search is in negotiation of terms for the joint venture, structuring and documentation. A lot of professional help and handling would be required in unraveling these issues wherein the investment banker plays a vital role. In arriving at acceptable and legal

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solutions, the investment banker often works closely with other professionals such as legal advisors and chartered accountants. The main areas of negotiation and documentation in a joint venture are—shareholding pattern, board and management structure, transferability of stakes, voting power and protection of minority rights, non-compete clauses, deadlock and dispute resolution, termination and conditions precedent. These aspects have been dealt with as mentioned below: �

The shareholding pattern of the JV becomes a crucial point of negotiation since most JV partners prefer majority holding. Broadly speaking, there can be three possibilities to ownership patterns—majority holding (more than 50%), minority holding (less than 50%) and equal ownership (50:50). Theories abound on the relative merits and demerits of these structures but no clear position has emerged. However, it is to be understood that majority ownership comes with a premium in terms of higher cost of acquisition and higher risk taking from the majority partner. Therefore, strategic business issues need to be well planned before positioning oneself as a majority or a minority partner. Minority position can even be with a strategic stake of 26% so that all special resolutions cannot be passed without the concurrence of the minority partner. The advantage of a majority– minority structure is that it reduces transaction costs in day-to-day decision making. The mid-way structure of a joint ownership (50:50) entails consensus and combined decision-making. The pitfall in such a structure is the possibility of deadlocks and delayed decision-making due to protracted discussions on each issue. Therefore, this structure is suitable only if the partners have significant business experience in their own right in the same markets and there are no cross cultural issues.

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The next issue is about the board composition and management structure. It is customary for the Board of Directors to be constituted according to the level of investment and voting power of each partner. The minority partner gets one or more board seats depending on his role in the JV and the extent to which he perceives an involvement in day-to-day affairs of the JV company. Generally, the majority partner appoints the managing director/CEO while the chairman could be a consensus candidate. The presence of the minority partner’s nominees in executive positions would depend on such partner’s contribution to the business. In mid-way ownership structures as

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mentioned above, the strength of the board and the executive board positions are generally split equally. �

The third aspect is about transferability of stakes of each partner and preemptive rights on such transfers. By definition, joint ventures are meant to be more like partnerships and therefore, each party would not want the other to exit the joint venture through free transferability as available under law. Therefore, JV agreements provide for restrictions on free exit which are known as ‘pre-emptive rights’. Pre-emptive rights could make it necessary for one party to offer its stake firstly to the second party if it wishes to exit the JV. This right is known as the ‘first right of refusal’. If the second party is not intending to buy such stake, it can then be offered for sale to third parties. However, the third party buyer must be acceptable to the second party. In addition, there could be ‘call’ and ‘put’ options on the stakes of each party set for future dates whereby the capital structure and the transferability of stakes can be influenced. Further hike in the stakes of respective partners after the commencement of the JV would be subject to such provisions. An illustrative provision in a JV agreement on the above issue is reproduced as given below: “Any further increase in capital by the JV Company shall be offered to existing shareholders in proportion to their shareholdings at the time of such issue. No further increase in capital nor preferential allotment shall be made to a third party unless Party B is also made such an offer to preferentially subscribe and prevent its shareholding from diluting below 20% at all times”. An illustrative pre-emption provision concerning a lock-in period on the stakes of the parties to the JV as provided in a JV agreement is shown as given below: “Unless otherwise provided specifically in this agreement, neither of the parties shall until five years from the commencement of this agreement, sell, assign or dispose off any shares of the company to any person and shall not, in any manner whatsoever affect the ownership and title to its shares of the company”. Section 82 of the Companies Act provides that shares shall be movable property transferable in the manner provided by the articles of the company. Courts have in the past held that the articles of association of a company have to explicitly provide for pre-emptive rights; otherwise such rights even if contained in contracts cannot be enforceable. Keeping in view the above position of law, it would be necessary for the JV company to amend its articles to provide for pre-emptive rights wherever required.

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In this context, it would also be necessary to differentiate between the law as applicable to a private company and a public company as mentioned before. A private company by definition has the right to restrict the right of transfer of its shares by its articles, whereas a public company has to explicitly provide for it. Secondly, a private company, which is a subsidiary of a public company, would be a public company as per section 3(1)(iv) of the Companies Act. Therefore, in the context of a joint venture, if a SPV is formed by two existing public companies, the SPV would be a public company if one of the parent companies owns 51% of its capital. If the JV Company becomes a public company by this definition, the enforceability of pre-emptive options could be in doubt. So, one way to avoid such a situation would be to ensure that the majority partner in the JV holds not more than 50% and the rest is held by another company that is not its subsidiary. �

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The issue of minority protection also needs to be addressed through JV agreements. Minority partners could be at a disadvantage if major decisions are taken without their concurrence. One way of obviating such situations is for the minority partner to hold at least 26% in the JV company. However, sometimes it may not be possible for the minority partner to hold 26% if the JV if formed by a consortium. In such situations, the minority partners could be given veto powers on major strategic and management issues by specifically providing for the same in the JV agreement. Since some of these provisions could be in conflict with the provisions of the articles of association, it would be necessary to amend the articles in line with the JV agreement. Deadlocks and disputes in corporate decision-making are a distinct possibility in the context of a joint venture, especially in joint ownership structures. The JV agreement should provide for redressal of such situations through alternate dispute resolution. Arbitration should be made through institutional arbitration and at an acceptable location to both parties. JV agreements also provide detailed provisions on rules governing board meetings, resolutions and shareholder approvals. To the necessary extent, as mentioned before, these provisions have to be aligned with the Articles of the company and the specific provisions of Indian company law. JV agreements also provide for non-compete clauses, tying in arrangements, price fixation clauses and other such restrictive clauses protect the interests of the JV company, the foreign partner or the Indian partner. Similarly, there are clauses to the effect that neither party should be in businesses that are in the nature of competing businesses to that of the JV company.

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However, these provisions have to be drafted carefully since most of them could be considered as ‘restrictive trade practices’ followed under the monopoly law (the MRTP Act and Competition Act in India) and therefore considered illegal. In this context it is relevant to mention that many other countries also have their respective anti-trust laws to protect their domestic interests. Internationally, the Paris Convention for the Protection of Industrial Property Rights 1883 had recognised restrictive practices as being contrary to ‘honest’ practices and therefore being detrimental to fair competition. The UNCTAD Code of Conduct on Transfer of Technology and other such treaties or conventions as may be entered into from time to time as well applicable international law need to be considered carefully in stipulation of clauses that may amount to restrictive or unfair trade practices. �

One of the important provisions in JV agreements is to identify and provide for ‘conditions precedent’ to investment in the JV company by both parties. These would generally relate to compliance issues and statutory approvals required to commence the JV’s business operations. In some cases, there could be conditions precedent that could take a long time to be met such as removal of encumbrance on any asset, repayment of an existing liability, etc.

12.5 Foreign Collaborations Foreign collaborations are associations between resident Indian companies and their foreign counterparts for exchange of technical and/or financial inputs for mutual benefit. Several Indian companies and other ventures sought foreign collaboration in the past to bring in contemporary technology or necessary investment into their industrial projects in India. Foreign collaborations can be envisaged by new and existing companies as well. In the case of new companies, such a collaboration could be in connection with setting up of a new project or business that could require new technology, equipment sourcing, fabrication and erection of the main plant, product standardisation and in some cases, even receiving marketing support or buy back support. In the case of existing companies too, such collaborations could be envisaged either in the existing business or for a new business initiative. There could also be pure licensing and/or marketing alliances between Indian and foreign companies without any technology transfer. Typically, foreign collaborations fall under three broad categories as explained below in Fig. 12.3.

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Foreign Collaborations

Techno-financial

Technical

Franchize/Marketing

Collaborations

Collaborations

Arrangements

� Figure 12.3

Types of Foreign Collaborations

12.5.1 Techno-financial Collaborations Techno-financial collaborations involve a wide gamut of transfer of inputs from the foreign collaborator to the Indian counterpart in the following areas—(a) Transfer of scientific technology, designs and drawings, technical specifications, skills in equipment or process handling, know-how and other forms of technical and scientific intellectual property, (b) contract for training of the technicians and other experts of the Indian party by the foreign technicians or supply of trained manpower or consultants from abroad, (c) supply or fabrication or help in sourcing of critical equipment, plant and machinery, components, raw materials and other critical production inputs and (d) investment in the equity of the Indian company through cash or through supply of capital goods or through technology transfer or through a combination of all the above three elements.

12.5.2 Technical Collaborations Unlike techno-financial collaborations, technical collaborations are confined in their nature to the limited relationship of transfer of technology by the foreign collaborator to the Indian company. The transfer of such technology could be in any of the areas mentioned under (a), (b) and (c) above depending upon the facts of each case. Some of them are limited to a one-time transfer of technology while others could provide for a continuing basis of such a transfer. The consideration for foreign collaborations is structured depending upon the type of collaboration, its extent and duration, the technology involved and

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Area of collaboration

Consideration

Transfer of technical know-how, designs and drawings and other intellectual property.

Lumpsum technical fee and/or royalty on sales for a specified period.

Supply of capital equipment such as plant and machinery, equipment, and consumables such as tools, spares, raw material etc.

Invoice value of the materials supplied as per negotiation Technical fee or salaries for technicians.

Technical services such as training, deployment of consultants, on-site support, after sales service.

Preference capital would be paid agreed rate of dividends.

Investment by way of equity or preference shares.

Dividends as and when paid. Equity could be backed by buy back agreement.

Investment by way of supplier's credit/loans.

Interest as negotiated.

� Table 12.1

Consideration in Foreign Collaborations

the transfer terms and services provided under the collaboration. Usually, the consideration is structured in the following lines as explained in Table 12.1.

12.5.3 Franchise/Marketing Agreements Foreign collaborations could also be limited associations that neither envisage a transfer of technology or foreign investment. These could be in the nature of franchising agreements for products and services or for commercial exploitation of intellectual property such as copyrights or commercial rights such as brands and trademarks. For example agreements between a foreign company and an Indian company for publishing of the former’s books in India by the latter is a licensing agreement. Similar examples can also be had in the pharmaceuticals, fast moving consumer goods and other industries. The consideration for such agreements could be structured on the basis of royalty or franchise fee for the usage of rights and/or a lumpsum fee.

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These could also be marketing alliances formed without any licensing rights but limited to territorial representation of one party by another. For example appointment of marketing agents in Europe by an Indian manufacturer of garments is a marketing alliance that does not envisage any transfer of technology or other rights. This would be merely a commission-based arrangement based on the orders procured by the marketing agent. In some cases, marketing agreements are a part of a larger collaboration wherein the foreign collaborator either agrees to create a market for the Indian goods or undertakes to buy back the goods either in full or in part.

12.5.4 Regulatory Framework for Foreign Collaborations and Technology Agreements With the liberalisation measures adopted by the Government of India (GOI) since 1991, one of the major changes in policy with regard to foreign collaborations has been the de-linking of financial collaborations from technology transfer, thereby creating a window for pure technical or financial collaborations. This provision is contained in para 39(B)(iii) of the Statement on Industrial Policy 1991. The GOI however, looks for the following features in approving a foreign collaboration. They are: �

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The GOI would permit foreign investment with or without technology collaboration. Similarly, the GOI has maintained a stand that there can be no restrictions on the sourcing of capital goods and other materials, pricing policies and selling arrangements, sub-licensing of technical know-how, product design, etc. and export of products to other countries. The collaborations should be in an area where there is no progress in India and it would take inordinate time to do so which could hamper the development and availability of such technologies. There should be adequate provision for training of Indian technicians, research and development, technology absorption and indigenisation. Foreign collaboration shall be subject to Indian law.

Basically, foreign collaborations and technology agreements are approved in India under a two-tier system. At the higher level it is examined and recommended by the Foreign Investment Promotion Board (FIPB) to the Ministry of Industry for approval. In the case of large projects, the projects have to be cleared by the Cabinet Committee for Foreign Investment (CCFI). The applications for government approval need to be made to the Secretariat for Industrial Assistance (SIA)

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under the Ministry of Industry, GOI. Government approval mechanism is applicable to proposals that do not meet the conditions specified for automatic approval. Therefore, a case-by-case examination of such proposals is necessary. For all proposals meeting the automatic approval criteria, the approvals are accorded by the RBI, which clears proposals administratively based on the conformation to the set criteria.

Approval of Technical Collaborations The scheme of approval for foreign technical collaborations and technology agreements is contained in para 39C of the Statement on Industrial Policy 1991 read with the Press Notes issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, GOI and the Notifications issued by the RBI from time to time. In the past twelve years, several amendments and liberalisations have been made to the original provisions. The current position of these provisions is summarised as given below: �

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Automatic permission would be issued by the RBI for foreign technology agreements in high priority industries (wherein foreign investment is allowed upto 51% or above popularly known as Annexure III industries) upto a lumpsum payment of US$ 2 million and a royalty not exceeding 5% for domestic sales and 8% of export sales. Prior to the liberalization announced in 20031 the payment of such royalty was without any restriction for wholly owned Indian subsidiaries of foreign parent companies. For other technology agreements, the payment of royalty was subject to a ten-year period from the date of agreement or seven years from the date of commencement of commercial production, whichever is earlier. This condition has recently been relaxed to provide a level playing field to Indian companies such royalty may now be paid for any period at the discretion of both parties. For the purpose of calculating royalty and lumpsum amount payable, these shall be reckoned net of Indian taxes payable. Applications in the prescribed format should be filed with the RBI for seeking automatic approval. After the RBI’s approval under the automatic route is obtained, the applicant company should approach the authorised dealer for the release of foreign exchange along with a copy of the technical collaboration agreement. For the payment of royalty on regular basis as stated above, prior registration with the RBI is essential so that remittances may be made through the authorised dealer.

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Royalty should be calculated on the basis of the ex-net factory sale price of the product exclusive of excise duties minus the cost of the standard bought out components and landed cost of imported components irrespective of the source of procurement, including ocean freight, insurance, customs duties, etc. The payment of royalty will be restricted to the licensed capacity plus 25% in excess thereof for such items that require industrial licence. In such products if there is excess production, royalty on such excess can be paid only with prior approval from the Government. Royalty would not be payable beyond the term of the technical agreement except in case of goods that have been put in production before the termination of the agreement. In addition, there should be no minimum guaranteed royalty in the agreement. Royalty may also be paid upto 2% on exports and 1% on domestic sales under automatic route in respect of use of trademark and brand name of the foreign collaborator in cases where there is no technology transfer. In such cases royalty should be calculated as a percentage of net sales, viz., gross sales less agents’/dealers’ commission, transport cost, including ocean freight, insurance, duties, taxes and other charges, and cost of raw materials, parts, components imported from the foreign licensor or its subsidiary/affiliated company. The lumpsum fee shall be paid in three instalments unless otherwise approved—(a) first instalment of one-third after the agreement is filed with the RBI and the authorised dealer, (b) second instalment on delivery of the technical documentation and (c) the third and final payment on commencement of commercial production or four years from the date of filing with the RBI, whichever is earlier. The lumpsum can also be structured in more than three instalments subject to the above milestones being achieved. In respect of proposals in non-high priority industries (non-Annexure III industries), these can be approved through the automatic route if the capital and other imports, lumpsum consideration and royalty payments do not exceed the above-said limits and there is no outgo of free foreign exchange from the collaboration. In other words, no foreign exchange would be released by the authorized dealer for payments to be made under such collaboration agreements. These payments can be met through export earnings from the project or these payments should be capitalised as equity of the foreign collaborator in the Indian project.

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Any other technical collaborations that do not conform to the monetary ceilings on lumpsum payment or royalty or any other conditions stipulated above, shall have to be approved through the SIA route. Applications for this purpose need to be submitted to the SIA in the Ministry of Commerce and Industry for consideration and recommendation by the Foreign Investment Promotion Board (FIPB) or other body performing similar functions. Extension of foreign technical collaboration agreements would also require approval through the SIA route. The automatic route of the RBI for technical collaboration is not available to those foreign companies who have or had any previous joint venture or technology transfer or collaboration or trademark or other licensing agreements in the same or in an allied field in India.2 Such proposals envisaging technical collaboration or joint venture including usage of trademarks, brand names or other intellectual property rights need to be referred to the SIA for the consideration of the FIPB. Such applications need to elaborate and justify the reasons for setting up a new joint venture/collaboration or technology transfer agreement. The onus in such cases is on the foreign party to provide the requisite justification and proof to the satisfaction of the FIPB that the new technology would not in any way jeopardise the interests of the existing joint venture or technology/trademark partner or other stakeholders. It will be at the sole discretion of the FIPB to either approve the application with or without conditions or to reject it in toto duly recording the reasons for its rejection. No separate permissions would be required for hiring foreign technicians and for testing of indigenous technologies on foreign soil either as part of a collaboration agreement or not. The necessary payments for such expenses can be made in foreign exchange under blanket approvals of the RBI. However, the blanket approval is subject to the following conditions: o The duration of the engagement of foreign technicians does not exceed 12 months by a company in a year, with no single technician exceeding 3 months.Hiring of foreign technicians to be in India for more than three months requires prior clearance from the Ministry of Home Affairs. o The payment to the foreign technician does not exceed US$ 500 per day, regardless of whether the local costs on boarding and lodging and other items are met by the Indian company or not.

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o In the case of company-to-company payments, such payment does not exceed US$ 50,000 in a year. o As far as foreign travel for Indian technicians is concerned, the RBI now permits foreign travel on a liberalised basis for Indian technicians. �

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Import of machinery, equipment, components and raw materials as a result of the collaboration shall be governed by the import policy of the Government from time to time. Presently most items of import can be brought in freely under the Open General Licence subject to payment of customs duty as may be applicable. Generally a period of two years is given for the applicant after receiving the necessary approval from the SIA to incorporate the conditions stipulated in such approval in the collaboration agreement and file it with the RBI and the authorised dealer. Other issues arising out of technical collaborations relate to payment of consultancy fee to outsiders in connection with the erection or fabrication of equipment or other incidental matters. Under the current account liberalization policy of the RBI, a recent circular3 permits payments upto US$ 1 million per project, towards consultancy services procured from outside India subject to the applicant furnishing documents to the authorized dealer’s satisfaction. In a recent liberalization measure4, an Indian company has been allowed to issue equity shares against lump-sum fee and royalty already due for payment, subject to meeting all applicable tax liabilities and compliance with the procedures prescribed. The issue of shares against lump-sum technical know-how fee and royalty, whether under automatic route or SIA/FIPB route, is subject to the pricing guidelines of Reserve Bank and SEBI. These pricing guidelines have been discussed later in this Chapter.

Approval of Techno-financial Collaborations Techno-financial collaborations are guided by a combination of the criteria applicable for pure technology collaborations as detailed above and those applicable to foreign direct investment (FDI). Accordingly, the approval mechanism would be either through the RBI or the SIA (FIPB) as applicable in each case. If the criteria under automatic route have been met for the technology agreement but not for the FDI in a given case, the proposal would still need to be approved by the SIA. Similarly if the criteria for automatic approval have been met only for the FDI and

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not for the technology transfer, the proposal would need the SIA approval. Only if the criteria for automatic approval have been satisfied both for the FDI and the technology transfer would the proposal be cleared under the automatic route. While the criteria for technology transfer and collaboration approvals have been discussed above, those applicable to the financial aspects of investment under the FDI route are discussed under the para Titled—‘Foreign Investments in Indian Businesses’ later in this chapter. The criteria mentioned above for technical approvals and those applicable for financial approvals for the FDI clearance together constitute the entire gamut of applicable policy on techno-financial collaborations and joint ventures. However, pure financial collaborations and joint ventures need to comply only with the FDI norms either under the RBI or the SIA (FIPB) route. In techno-financial collaborations involving foreign investment and qualifying in the automatic route, the foreign equity component need no longer cover the foreign exchange requirements for the import of capital goods envisaged under in the project. It is only necessary to ensure that the plant and machinery proposed to be imported is new and not used. In addition, such import is subject to the import policy from time to time. Free foreign exchange can be availed for such import payments once the RBI approval under the automatic route is obtained.

Approval of Franchise/Marketing Agreements Franchise agreements and marketing agreements that form part of a larger technical or techno-financial collaboration are approved as a part of such collaboration. No separate approvals would be necessary in such cases. The payment of consideration to the foreign collaborator in such cases, would cover the payment for use of brands, licences and other commercial rights. However, stand-alone franchise agreements without any technology transfer that envisage payment of lump-sum licence fee have to conform to the criteria set forth for technology agreements as discussed earlier. For payment of royalty for use of brands, trademarks and other commercial rights in such agreements without any technology transfer, payment of royalty upto 2% on exports and 1% on domestic sales is allowed under automatic route as mentioned earlier. Pure marketing agreements involving payment of marketing commissions would not need prior approvals since these payments are allowed through general permission of the RBI.

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12.5.5 Important Issues in Foreign Collaborations Identification of Collaborative ‘Technology’ One of the prime considerations that is necessary for a foreign collaboration is to identify precisely the technology requirement and the extent to which such a technology has to be imported through a foreign collaboration. The term ‘technology’ has wide import and can relate from mere technical support to a broad spectrum of technical know-how, supply of plant and machinery, designs and drawings, on-site support and technology upgradation from time to time. It is important for the importer to understand the needs of its business and to identify the form and content of the technology required. This would depend upon the type of industry of the importer, extent of technology available in-house or from other indigenous sources, nature of the products to be manufactured under the proposed technology, the marketability of products manufactured through such technology, competitive pricing and other such factors. Technology identification would also mean finding justifications for the proposed collaboration for import of technology so that regulatory approvals are obtained easily. This could be in terms of evaluating alternative indigenous technologies and finding reasons as to why such technology cannot be used under the circumstances. Such a process would be more relevant in cases where alternative indigenous technology is already available. If no indigenous technology is available, it has to be seen whether there would be a potential market for such technology in India, what could be the pricing of such products and whether there would be buyers available at that price. These are important considerations for the regulators in approving such collaborations as they would involve a significant outflow of foreign exchange. Technology can relate to a process to be used in the manufacture of a particular product or to a general know how related to a line of manufacture or service. For example technology can be imported for the manufacture of an automobile, which would be specific to a class of a product or alternatively, know-how could be obtained for a process such as automatic fuel transmission which can be used in any automobile. Another approach could be to identify whether technology is required at the critical component level or at the finished product level. Continuing the above example, technology can be collaborated for the manufacture of the design and construction of a particular model of an automobile as a whole or for a critical

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component such as the cylinder block. The importer has to decide on the right methodology in seeking technology. The above discussion is relevant in the context of the exact definition of the technology being contemplated under the collaboration, which has to find a precise description in the collaboration agreement.

Identification and Evaluation of Collaborator Identification and evaluation of a collaborator is as important as identification of the appropriate technology. Often, multiple choices exist in choosing the collaborator for a particular technology. Though the major consideration is more often than not the cost factor, other issues need to be examined as well. The collaborator’s standing in the international market, size of operations, financial standing, prior track record in successful collaborations, understanding of the Indian market space, flexibility in customization of technology, terms for technology transfer, technical support services, the successful working of the concerned technology, pace of technology upgradation by the collaborator, cross cultural issues and other factors are the non-financial considerations that go into zeroing in on the appropriate collaborator. Usually, a lot of efforts go into short-listing the probable collaborators based on the above criteria, with whom a dialogue can be initiated at a future date.

Technology Transfer One of the most important elements in a foreign collaboration is ‘technology transfer’ from the foreign collaborator to the Indian counterpart. For the purpose of foreign collaborations, the term ‘Technology’ has a wide import and consists of intellectual creation that provides a legal right of property to the creator as also technology that may not be eligible for such a legal right. The term ‘know-how’ as applied in the context of technology may thus mean both protected know-how and unprotected knowhow. Protected know-how could be in terms of patents on inventions, copyright on designs and drawings, trade marks, brands and other such rights. Unprotected knowhow could be in terms of process technology, technical specifications and trade secrets that have no elements in them which can be legally protected. Considering the above position in law, technology transfer would generally include provision of technical know-how together with the necessary plant and

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machinery or equipment sourcing that would be required to fabricate, erect and commission the envisaged production facility. Therefore, technology transfer can take any of the forms of transactions as given under: �

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A techno-financial collaboration with cash consideration and part capitalization of such consideration as equity of the collaborator. A joint venture whereby significant equity is offered to the foreign partner for the technology transfer. The distinction between a joint venture and a techno-financial collaboration is that the former is a more involved and long-term relationship by virtue of which the foreign partner would be looking at strategic business involvement and realization of his consideration more in terms of profit-sharing and therefore, gets a bigger stake. In a techno-financial collaboration, the technical partner’s interest lies primarily in the transfer of technology for cash consideration but a part of it could be capitalized as investment to provide a long-term commitment to such technology support. A technical collaboration with outright purchase of technology and knowhow for cash. This could be a one-time acquisition or an on-going relationship but strictly for cash consideration. Through a turnkey contract whereby equipment, technology and technical services are integrated to provide a complete solution. Through a sell-off of equity by the promoters of the collaborating company whereby the purchaser of the technology gets to acquire the technology through the equity route. This can happen if the company seeking the technology is much larger than the technology provider. Through a licensing arrangement wherein limited technology transfer is envisaged on an on-going basis. Marketing arrangements or franchise relationships that envisage transfer of commercial rights alone and not technology transfer in its absolute sense.

Intellectual Property Issues Collaborations generally involve several complex intellectual property and confidentiality issues. As explained above, not all technology is legally protected knowhow. As far as protected technical know-how is concerned, the understanding has to be reduced into writing in the collaboration agreement whereby the exact rights

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of the transferee of such protected rights such as patents, copyrights and trademarks etc. are well defined. The assignability of such rights to third parties, exclusivity of use and other restrictions have to be drafted carefully so as not to infringe on free flow of technology and trade; otherwise, these could be set aside by the courts. Therefore, in the case of unprotected know-how the collaborator has to ensure that there is no scope for wrongful exploitation by the purchaser. Over the years, protection of such confidential information such as process know-how or trade secrets has evolved in terms of non-disclosure agreements and confidentiality clauses in collaboration agreements. These clauses provide for a contractual understanding by which certain legal remedies are possible to correct wrongful exploitation of such intellectual property. As in the case of protected know-how, these clauses may apply restrictions on their usage so that such information does not become public domain.

Evaluation of Costs One of the main drivers in negotiating foreign collaborations is the cost factor of importing such technology. Technology costs vary widely depending upon the complexity and availability of such technology and the stature of the technology provider. Costs could also be driven by strategic considerations of both the collaborator and the purchaser. In pure technical collaborations, the costs are mostly front-ended with the collaborator intending to be paid for the technology transfer mostly through lump-sum technology fee. Sometimes, the consideration is split into a combination of technical fee and royalty. In technical collaborations, the collaborator has a one-time interest in the deal and therefore, the scope for negotiations is relatively limited. In techno-financial collaborations, the costs are more staggered with a combination of purchase price for equipments or plant and machinery, licence fee or technical fee, professional fee for technical services, royalty and dividends or interest on investment. Therefore, in such collaborations, there is scope for structuring the consideration appropriately through negotiations. Such collaborations, apart from the financial impact of the collaboration, should address investment issues such as repatriation of the investment and returns thereon, the return to be provided on the investment and so on. Apart from pure equity, preference capital and convertibles could also be used to structure the investments of the foreign collaborator to yield better results.

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12.6 Foreign Investments in Indian Businesses Foreign investment in Indian businesses is not a new concept although in the days of the Foreign Exchange Regulation Act, there were very stringent provisions on the extent of foreign investment in India. With the advent of liberalization and the subsequent advent of the Foreign Exchange Management Act 1999, foreign investment has been allowed in many sectors in Indian business but the rigours have been eased as well. Some of these have become attractive business opportunities for foreign investors and corporations since the current policy allows majority stakes for foreign entities in such sectors coupled with the vast market potential. As a corporate entry strategy, foreign companies can look at the following routes for making a business presence in India. They are: �

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By acquiring strategic stakes in existing Indian companies either through the collaboration route or otherwise. By setting up new joint ventures companies in India with Indian partners or by converting existing Indian companies into JVs by picking up majority or substantial stakes.

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By setting up wholly owned subsidiaries.

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By setting up liaison offices or branches of the parent companies in India.

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Through cross-border merger of an Indian company with a foreign company.

Under first alternative above, the foreign company looks for a strategic stake in an Indian business without seeking management control or involvement in the Indian business except to the extent agreed to under the terms of the understanding. This could usually take the form of a Board seat for the foreign investor. The strategic stake is meant to provide an indirect presence for the foreign company in the Indian market. The strategic position could either be a long-term strategy or merely meant as a launch pad for more involved initiatives at a later date. Under the second alternative, the foreign company looks at a more committed business presence in the Indian market after having analysed the business opportunity and identifying the Indian company to partner with. This would be driven by both the partners with a substantial managerial involvement and exchange of skill sets. Joint ventures can be initiated by both parties setting up a separate JV vehicle or by conversion of an existing Indian company into a JV company. These aspects have already been addressed in the discussion on ‘Joint Ventures’.

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In the above cases, where a foreign entity acquires a majority or a strategic stake in an existing Indian company, this could trigger off the Takeover Code if such company is a listed company and the acquisition gives the foreign shareholder a stake of 15% or more in the Indian company. In such cases, apart from taking the strategic stake, the foreign company would be mandatorily required to acquire an additional 20% in the Indian company from the Indian public through an open offer. The wholly owned subsidiary route is probably the most convenient corporate structure for foreign companies intending to have a long-term presence in India. Such wholly-owned subsidiaries (which are held to the extent of 100% by a foreign parent and its nominees or other group companies) in India would be regarded as private companies as per sub-section (7) of section 4 of the Companies Act. In other words, such subsidiaries have a special status under Indian company law despite the fact that similar such companies which are not subsidiaries of foreign companies are considered to be public companies section 3(1)(iv) of the Companies Act. Therefore, such wholly-owned foreign subsidiaries in India can enjoy the special privileges conferred on private companies such as privacy in publishing of their accounts and limited extent of regulatory compliance. However, this exemption is available only till such time that they retain the four conditions in their articles of association in terms of section 3(1)(iii) of the Companies Act. Foreign companies can also look at a limited presence without incorporating separate corporate vehicles in India. In cases where the foreign company is not envisaging a production facility or investments in India, such liaison offices or branches could be a viable alternative. Branches of foreign companies in India that have business operations in India would be treated as companies in India under Part XI of the Companies Act and therefore they also have to comply with registration and compliance under that Act. However, liaison offices that do not conduct any business transactions in terms of income generating activities do not get included under this part and hence do not need any registration. However, all liaison offices and branch offices need to comply with the provisions of the FEMA whereby they have to seek the approval of the RBI if required under that Act. Cross-border merger of an Indian company with a foreign company would result in the foreign company having an Indian presence without having an incorporated entity in India. The merger process has been discussed in greater detail in Chapter 15. However, in the present context, what is important is to note is that the Indian operations of the foreign company post-merger would be reckoned as a company requiring registration in India under Part XI of the Companies Act mentioned above.

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Apart from structuring the entry into Indian business through any of the above vehicles, foreign investors need to structure the routing of the investment into India as well. This would require an in-depth examination of the prevalent tax laws in the parent country of the foreign company, the relevant tax law in India applicable to such foreign investment in India, the provisions of a tax treaty if any, between both the countries and the scope for reducing the incidence of global tax paid by the foreign parent and its Indian subsidiary or group company. Most of the times, the tax regime prevalent in the host country of the parent determines the structure evolved for routing the foreign investments into India. In addition, if India has a favourable tax treaty with a third country such as Mauritius, the routing of the foreign investment into India through an investment vehicle in the third country could reduce the incidence of global tax on the parent. In some other cases, some foreign parents prefer to invert their holding structure whereby they become the subsidiaries of foreign holding companies located in tax havens such as Bahamas, Cayman Islands and others. In such a structure, since the ultimate global income gets to reside in the tax haven country, it reduces the incidence of global tax paid by the foreign parent. This usually applies in cases where the foreign parent is in a highly taxed country and its global income is captured for tax in that country. However, in order to use such ingenious methods of shifting the incidence of taxation to a tax haven, the ownership of the shares in the foreign parent has to be shifted to the holding company created in such tax haven. This could involve complications both in terms of recognition of capital gains for the shareholders of the foreign parent and in terms of the provisions of the local tax law in curbing such inversion of holding structures. The second aspect of structuring the routing of foreign investments is to determine whether the foreign holdings would be directly routed into India or through a local holding company in India, which would in turn hold strategic stakes in the operating Indian companies. This structure could be beneficial in two ways—firstly the local holding company would retain the character of a private company under the Indian company law. Secondly, its downstream investments into local operational companies could be structured according to the FDI policy with local ownership to the extent necessary. Under the prevalent Government policy for allowing foreign holding companies, these holding companies have to be set up as NBFCs which can be formed with 100% foreign shareholding. The holding company can form step-down subsidiaries to undertake businesses in various sectors in India provided there is a minimum of 25% resident domestic equity in such companies. In other words, the maximum foreign equity that would be allowed in such step-down subsidiaries is 75% subject to sectoral FDI caps in each sector. Therefore, it is possible that even in a sector wherein 100% foreign equity is

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allowed, the downstream subsidiary may end up with a maximum holding of 75% by its holding company. The other question that arises for such downstream investments is about the nature of approval required. Till a few years ago, all such investments had to be approved under the Government approval route and the automatic route was not available. However, under the liberalized regime, the following provisions now apply to investments by foreign holding companies in downstream activities. They are: �

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Automatic route for downstream investments is applicable only if the downstream investments are in Annexure III activities and such investments may be made within foreign equity levels permitted for different activities under the automatic route. The increase in equity level resulting out of expansion of equity base of the existing/fresh equity of the new joint venture company is allowed if it conforms to the overall FDI cap in the respective activity. Automatic route is not available for downstream investments involving setting up of an EOU/STP/EHTP project or items involving compulsory licensing; SSI reserved items; acquisition of existing stake in an Indian company by way of transfer or buyback from Indian partners. Such proposals require prior approval of FIPB/Government. The holding company to notify the Secretariat for Industrial Assistance of its downstream investment within 30 days of such investment even if shares have not been allotted. Such disclosure has to be made along with the modality of investment in new/existing ventures (with/without an expansion programme). Proposals for downstream investment by way of induction of foreign equity in an existing Indian Company to be duly supported by a resolution of the Board of Directors supporting the said induction as also a shareholder’s Agreement and consent letter of the Foreign Collaborator. The issue/transfer/pricing/valuation of shares shall be in accordance with SEBI/RBI guidelines. Foreign owned holding companies would have to bring in requisite funds from abroad and not leverage funds from domestic market for such investments. This would, however, not preclude downstream operating companies to raise debt in the domestic market.

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Case of Star Group The Rupert Murdoch controlled and Hong Kong based Star Group has its presence in the media business in India. Its Indian subsidiary Star India Pvt. Ltd. is the holding company for all its operating companies in India and the functional companies are structured based on the concerned sector and the applicable FDI policy. For example in the radio broadcasting sector based on the FDI policy of 20% cap on foreign shareholding, the radio licence is held by Music Broadcast Pvt. Ltd. an Indian company in which Star India holds 20%. This functional company belongs to the P.K. Mittal group. The operations of Radio City, the service provided by this venture, are managed by Digiwave Infrastructure and Services Pvt. Ltd., another downstream company belonging to the Star Group. In the Direct-to-Home segment, Space TV is the functional company held in majority by two Indian nationals, which was floated to implement the DTH services. In the news channel segment wherein the FDI policy allows for only 26% foreign shareholding for all news channels uplinking from India, Star Group floated Media Content and Communication India Pvt. Ltd. as the functional company. Star India would hold 26% of this company and the balance of 74% would be divested to the resident Indians.

12.6.1 Regulatory Mechanism for Foreign Direct Investment Foreign investments in Indian businesses are approved under the Foreign Direct Investment route as determined by the FDI policy in vogue from time to time. The FDI route is applicable to all foreign investors who do not fall under the other available routes, which are the FII route, the FVCI route and the NRI route. Foreign FDI investors need to comply with the provisions of the foreign investment and foreign exchange policy for the following transactions: �

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Fresh investments in Indian businesses under the FDI route including allotment of shares. Repatriation of income or investment made under the FDI route from time to time. Increase of FDI investment in a company in which the initial investment was made under the FDI route.

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Sale of FDI investments in India and corresponding exit from India.

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While the FDI policy falls within the purview of the Government of India which is spelt out in the Press Notes issued by the Ministry of Commerce and Industry, the attendant foreign exchange policy and procedural matters are governed by the RBI under the FEMA and regulations made thereunder. The RBI also issues A.P. (DIR Series) notifications from time to time to address these matters and provide for further liberalization.

Fresh Investments in the FDI route All clearances obtained for investments made under the FDI route either through the automatic route or the special approval route would be approved for repatriation of income and investment to the investor’s home country subject to the specific conditions of such an approval. Just as in the case of foreign technical collaborations, FDI approval mechanism is also under an identical two tier system. At the higher level it is cleared by the FIPB, which is the inter-ministerial committee that recommends FDI proposals for approval. The proposals for FIPB clearance are routed through the SIA that provides single window clearance for techno-financial collaborations both for the technology agreement and the foreign investment. At the lower level is the automatic approval mechanism of the RBI under which if a proposal conforms to the given criteria, FDI can be brought in freely without any prior approvals. As in the case of foreign technical collaborations, foreign investments have also been defined with set criteria for qualifying under the automatic approval route. Presently, the automatic route for foreign investment applies to all sectors except for the following: �

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Those sectors that are in the negative list of the government for foreign investments. Those sectors that require an industrial licence for setting up a business unit. An industrial licence is mandatory if the product involved requires an industrial licence under the Industries (Development & Regulation) Act, 1951; or the FDI portion is more than 24% of the equity capital of units manufacturing items reserved for small scale industries; or if the product manufactured requires an industrial licence in terms of the locational policy of the government.

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The FDI proposed is in excess of the defined sectoral caps prescribed for each sector though such activity falls under the automatic route in Annexure III. FDI is proposed in a sector where it is not permitted. Such proposals cannot be cleared either by the RBI or the FIPB. All foreign investments proposals in which the foreign party is in technical collaboration with the Indian party and such foreign collaborator has a previous joint venture or tie-up in India. Such proposals would also require a no-objection certificate from the existing Indian partner or associate. This aspect has already been explained above under the approval mechanism for foreign collaborations. This requirement however, does not apply to the information technology sector. Similarly, these provisions do not apply to international institutions like the Asian Development Bank (ADB), International Finance Corporation (IFC), Commonwealth Development Corporation (CDC), Deutsche Entwicklungs Gescelschaft (DEG), etc., which may invest in domestic companies through the automatic route, subject to SEBI/ RBI regulations on pricing of shares and sector-specific caps on FDI.

The government has been constantly liberalizing the automatic route for FDI investments and the sectoral caps stipulated in each activity. If an investment comes under the automatic route, no prior approvals are required. The investee company has to file a return with RBI within 30 days of the allotment of shares. Generally, all foreign investments require the remittance towards equity to be brought into India. Therefore proposals that seek to set off remittances against other services or capital goods imports or issue of shares for consideration other than cash require case specific approvals from the FIPB. For the complete list of conditions applicable to foreign investments cleared by the RBI under the automatic route, please refer to Annexure I to this chapter. Dividends can be paid to the foreign shareholder in foreign currency provided the outflow on account of such dividends in foreign exchange is matched by an inflow of foreign exchange through exports for a period of seven years from the date of commercial production. The ‘dividend balancing’ can also be done by export earnings in the years prior to the payment of dividend or during the years of such payment. No requirement for balancing of dividend through export earnings exists after the first seven years. This condition of dividend balancing now exists only for 22 consumer goods industries. For the rest of the industries, no dividend balancing restrictions are imposed currently. Dividend balancing condition does not apply to investments made by international institutions specified above. Similarly, it does not apply to units that were not in the list of 22 industries when

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they were set up initially. The investments that do not qualify under the automatic route have to seek clearance from the FIPB through the SIA. In larger projects it goes for final approval to the CCFI with the recommendations of the FIPB. These proposals are cleared based on the general guidelines applicable to all case-to-case approvals given by the FIPB Guidelines. These guidelines are furnished in Annexure II included in this chapter. While giving such approvals, the FIPB clears even composite proposals involving techno-financial collaborations, setting up of EOUs etc. as compared to mere foreign investment proposals.

Case of Coca Cola Coca Cola commenced its Indian operations through its Indian subsidiary Hindustan Coca Cola Beverages Pvt. Ltd. (HCCB) and had invested over Rs. 33 billion in its Indian operations. HCCB is held by Hindustan Coca Cola Holdings (HCCH), which is its 100% holding company in India. As per the condition of divestment stipulated by the FIPB in 1997, HCCB had to divest 49% of its equity to Indian shareholders in a period of five years. In order to comply with the abovesaid divestment, HCCB approached the government (Department of Company Affairs and the FIPB) for restructuring its capital base prior to the divestment. It also sought an extension of time till February 2003. According to the restructuring plan, the company planned to write-off its accumulated losses of about Rs. 21 billion against the share premium account standing with the company. The capital was thus brought down from Rs. 33 billion to Rs. 4 billion and the balance amount of Rs. 8 billion was converted into preference capital to be held by HCCH. By this mechanism, the divestment amount was brought down to 49% of Rs. 4 billion, which was accomplished by divesting the shares in favour of trade partners, employees and other strategic investors with the help of investment bankers. The restructuring was done with a view to correct the over-sized capital in the balance sheet in the face of accumulated losses and thereby bring down the divestment amount.

Increase of Foreign Investment and Infusion of FDI into Existing Indian Companies In addition to proposals involving fresh FDI for the first time, the present policy guidelines also allow FDI in existing Indian companies and follow on investments by the foreign investors to increase their existing stakes in companies wherein such

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investors had made initial investments in the FDI route through the RBI/FIPB route. These are taken up for discussion herein. As far as FDI in existing Indian companies is concerned, if such a company is engaged in Annexure III activities, this can be perceived in three ways. They are: �

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Companies that are engaged in Annexure III acitivities envisaging foreign equity for financing an expansion programme — such companies are already covered under the automatic route and can hence invite foreign equity within the specified sectoral caps. The investee company has to file a return with RBI within 30 days of the allotment of shares. However, the following additional conditions would apply for such FDI to be eligible under the automatic route. Companies that are engaged in Annexure III acitivities envisaging foreign equity without an expansion programme—such companies can raise foreign equity within the sectoral caps only if (a) the proposed FDI must result in fresh issue of shares by the company and lead to an expansion of the equity base of the company and (b) the consideration should be remitted in foreign currency through approved banking channels. Companies that are engaged in non-Annexure III activities, may also avail of the benefit of the automatic route for foreign investment if they embark upon an expansion programme predominantly in the areas covered under Annexure III activities, subject to the condition that the additional foreign equity raised is utilized for such an expansion.

The Government has also reviewed the applicability of dividend balancing condition on increase in foreign equity and has decided that where dividend balancing was not applied in the first instance as per the then prevalent policy, it would be applicable in the case of subsequent infusion of foreign equity only to the extent of the incremental foreign equity in cases where dividend balancing is subsequently applicable as per existing policy. This would also apply in the case of secondary market acquisition as also preferential allotment/transfer of shares to the extent of foreign equity infused in the first instance in case the activity attracts the condition of dividend balancing as per existing policy. The applicable date will be the date of commencement of commercial production in the case of new ventures and the date of allotment of shares in the case of existing ventures. Proposals for inviting FDI in existing Indian companies that do not comply with the above parameters would need to seek FIPB clearance.

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As far as increase in FDI in companies wherein such foreign investors had made initial investments in the FDI route through the RBI/FIPB route is concerned, the issue is decided based on the following factors: �

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In cases wherein the original foreign investment was made under the automatic route, follow on investments can be made to increase the foreign equity under the automatic route within the overall sectoral FDI cap applicable. However, if the sectoral cap is proposed to be pierced, the proposal has to seek FIPB clearance. In cases wherein the original foreign investment was made under the FIPB route, henceforth there would be no need for obtaining prior approval of FIPB for increase in the amount of foreign equity within the percentage of foreign equity already approved in all cases in which the original project cost was up to Rs. 600 crore. Therefore, such companies can henceforth infuse additional funds by way of foreign equity as a result of financial restructuring (provided there is no change in the percentage of foreign equity) and notify the same to the Secretariat of Industrial Assistance (SIA) within thirty days of receipt of funds as also allotment of shares to nonresident shareholders. The company has to file an intimation of intent for inward remittance with the SIA and thereafter bring in the funds. This facility is available to joint venture companies set up with foreign investment as well as to foreign holding companies in India wanting to increase stakes in downstream subsidiaries. The above facility would not be available to companies wherein the original foreign investment was made under the FIPB route, if as a result of the follow-on investment, the percentage of foreign equity is proposed to be raised. For e.g. if the originally approved level is 30% and as a result of the proposed investment, the level of non-resident holding is increased to 40%. In all such cases, prior approval of the FIPB is essential. Similarly, for projects costing more than Rs. 600 wherein the initial approval was accorded by the CCFI, any proposal for further FDI investment needs prior approval from the CCFI.

For approving proposals for increase of FDI, the overall non-resident holding is reckoned and not just the equity of the FDI investor who had brought in the original investment. In other words, if there had been investments by non-residents through routes other than the FDI route, such holdings are aggregated to arrive at the maximum permissible non-resident equity in the company.

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The proposal for increase of stakes by non-resident investors in existing companies is also regulated by price considerations. In the case of listed companies, such increase in stakes to the exclusion of other investors amounts to a preferential allotment and is therefore, regulated by the SEBI pricing guidelines on preferential allotments. These guidelines have been discussed in detail in Chapter 6. Currently the RBI follows the same pricing guidelines for approval of foreign investment in existing companies as prescribed by SEBI for preferential allotments. Besides, the company should pass a special resolution under Section 81(1A) of the Companies Act. These pricing guidelines apply to all issue of equity to non-resident investors either under the automatic route or the FIPB route. The shares allotted under this basis are locked-in for a period of five years commencing from the date of allotment. In the case of unlisted companies, the RBI has prescribed a pricing guideline based on the ‘fair price’ of the share which is to be computed in accordance with the method stipulated under the erstwhile CCI guidelines and certified by a chartered accountant. The CCI guidelines have already been dealt with in detail in Chapter 3.

Sale or Transfer of Foreign Shareholdings A foreign shareholder is allowed to freely transfer shareholding in Indian companies to another foreign shareholder without prior approvals if and only if such other shareholder does not have an existing venture or tie-up in India through the FDI route or through a foreign collaboration or through a technology transfer or any other such route in the same field or allied field in which the Indian company whose shares are being transferred is engaged in. A foreign shareholder may also transfer his shares in an Indian company to a resident Indian shareholder with prior approval of the RBI. If the Indian company in question happens to be a listed company and the sale happens at the prevailing market price, such sale transactions should be effected through a SEBI registered merchant banker or stockbroker. If the price fixed for the transaction is other than the prevailing market price, such price should not exceed more than 5% of the prevailing market price, except in cases where management control is being passed on, in which case, it could be raised by upto 25%. With respect to transfer of shares held by a foreign shareholder in an existing company that is listed but thinly traded on the stock market to an Indian resident, the

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pricing of the share has be arrived at using the following methodology: 1. Proposals for disinvestment of shares by non-residents in favour of residents will be cleared on automatic basis if the gross sale consideration is less than or equal to Rs. 20 lakh per seller per company per annum at the mutually agreed price based on any valuation methodology currently in vogue. 2. If the transaction value as specified above is more than Rs. 20 lakh, the following options are available: (a) To sell the shares with the prior approval of the RBI at higher of the prices based on the current EPS linked to a P/E multiple and that based on the current NAV linked to a book value multiple. (b) To sell the shares with prior approval of the RBI on the stock exchange at the prevailing market price in small lots so that the entire holding is sold in not less than five trading days on screen based mechanism. (c) To sell the shares with prior approval of the RBI at a price based on two independent valuations. One valuation need to be made by the statutory auditor and the other by an independent chartered accountant or SEBI registered merchant banker giving a reasoned report in support of the price. The RBI may clear the proposal on the lower of the two valuations. The decision of the RBI shall be final. If the transfer pertains to shareholdings in unlisted companies, for transactions within the value of Rs. 20 lakh as stated above, any mutually agreed valuation would be considered. For transactions above the value of Rs. 20 lakh, either of the methods specified under 2(a) or 2(c) above may be adopted.

2.7 Indian Overseas Investments Overseas business investments by Indian companies (hereafter referred to as ‘Overseas Direct Investment’ or ODI are typically a post-liberalization phenomenon whereby the companies that are incorporated in India acquire business interests abroad. There are several reasons for this phenomenon. Firstly, Indian companies, as a consequence of the taking over of market forces in the domestic market, have started seeking global business opportunities in overseas markets. Secondly, export-oriented companies in India preferring a long-term presence in their target markets abroad require to set up corporate entities or acquiring stakes in local

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companies in such countries. Thirdly, with the competitive edge displayed by Indian companies in global information technology markets in the late nineties, this sector has also seen several Indian companies forming business alliances and other relationships abroad to execute on-site consulting projects for their overseas clients. Fourthly, several foreign companies, mostly from the USA have formed inverted holding structures with their Indian counterparts for tax advantages whereby the Indian company becomes the holding company and the US parent becomes its subsidiary. This structure has also been adopted by several non-resident Indians in USA who, for strategic reasons, made their Indian companies the holding companies for their US business companies. The corporate entry for Indian companies overseas is similar to those available for foreign companies in India. These routes are made in the following way. They are: 1. By acquiring stakes in foreign companies 2. By setting up joint ventures abroad 3. By increasing stakes in the entities under (1) or (2) above 4. By setting up of wholly owned subsidiaries abroad 5. Through a cross-border merger of a foreign company with an Indian company. Indian companies are governed by the current ODI policy, which is part of the overall foreign exchange regime under the FEMA for making investments in overseas ventures. Specifically, ODI investors need to comply with the provisions of the foreign exchange policy for the following transactions: �

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Fresh investments in overseas businesses under the ODI route including receiving allotment of shares in foreign companies. Repatriation of income or investment made under the ODI route to India from time to time. Increase of ODI investment in a company in which the initial investment was made under the ODI route. Sale of ODI investments abroad and corresponding exit from overseas ventures.

Overseas investments by resident Indian persons in joint ventures and business partnerships as well as by companies in their wholly owned subsidiaries are permitted

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only to the extent specified by the ODI guidelines periodically. Under the current guidelines, automatic route is available for ODI upto $100 million in any financial year by a resident business entity subject to the condition that cash investment can be upto 100% of its networth. The above ceiling will include contribution to the capital of the overseas JV company or subsidiary, loan granted to such JV company or subsidiary and 50% of any guarantees issued to or on behalf of such JV company or subsidiary. The overseas entity can be engaged in any business activity excepting banking and real estate businesses. The investment should be in a foreign entity engaged in the same core activity as that carried on by the Indian company or any other bonafide business activity. The investment can be made either through a fresh issue of shares or by market purchases of existing shares. In cases where the applicant company is a new company and does not have the requisite export performance/exchange earnings, credit may be given to the parent company's exports/exchange earnings, provided the applicant company is either a wholly owned subsidiary of the exporting/exchange earning company, or the latter owns at least 51% of shares in the former. In case of exports being routed through subsidiaries set up exclusively for international business, credit may be given to the parent company for the exports or exchange earnings of its subsidiary. This general permission under the automatic route does not include investment proposals, which envisage setting up a holding company, or a special purpose vehicle abroad, which would in turn, set up one or more downstream subsidiaries as operating units. Such investment proposals through two-tier structure and other proposals that do not meet the criteria for automatic approval have to pass through a Special Committee route for a case-by-case approval from the RBI. In approving proposals on a case-by-case basis, the Special Committee of the RBI shall have regard to the following considerations: �

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The financial position, standing and business track record of the Indian and foreign parties. Experience and track record of the Indian party in exports and its external orientation. Quantum of the proposed investment and the size of the overseas venture in the context of the resources, net worth and scale of operations of the Indian company.

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Repatriation by way of dividends, fees, royalties, commissions or other entitlements from the foreign concerns for supply of technical know-how, consultancy, managerial or other services within five years with effect from the date of first remittance of equity to the foreign concern or the date of first shipment of equity exports or the due date for receipt of entitlements which are to be capitalized, whichever is earlier. Benefits to the country in terms of foreign exchange earnings, two way trade generation, technology transfer, access to raw materials, intermediates or final products not available in India. Prima facie viability of the proposed investment proposal.

The approved sources for financing investments in the ODI route are as follows: �

�

�

Balances held in Export Earners’ Foreign Currency accounts from time to time by the Indian companies. Drawal of free foreign exchange from an authorized dealer in India upto the extent of 100% of the Indian company’s net worth as on the date of the last audited balance sheet. Utilization of proceeds of foreign currency funds raised through ADR/GDR issues made by such Indian companies in the overseas markets.

If an Indian company avails the financing of its overseas investment through the EEFC account or through proceeds from the ADR/GDR issues made earlier, the requirement that the overseas company should be in the same core activity as that carried on by the Indian company would not be applicable. As an additional means of investing through the ODI route, Indian companies are also eligible to capitalise exports of plant and machinery, software and other goods, fees, royalty, commission and other entitlements as equity in the overseas ventures. Similarly, Indian software exporters are permitted to receive 25% of the value of their exports to an overseas software company in the form shares without entering into Joint Venture Agreements with the approval of the Reserve Bank. As a further boost to such investments under the ODI route, the automatic route has been made available to investments made by way of a shareswap with the foreign company. Under the share swap mechanism, the Indian company would issue fresh ADRs backed by underlying fresh shares in India in exchange for shares in the overseas company. However, for such share swap under the automatic route,

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the resident company’s ADRs/GDRs must be already listed abroad and fresh issue should be for the ADR/share swap. In addition, as a result of the share swap, the foreign holding in the Indian entity should not cross the specified sectoral limits under the current FDI policies of the government. The total value of the transaction under the share swap route should not exceed higher than $100 million or an amount equivalent to ten times the export earnings of the Indian company during the preceding financial year as reflected in its audited balance-sheet. The valuation of shares for the purpose of investments under the ODI mechanism would be as follows: �

�

�

As per the recommendations of the merchant banker if the shares are not listed on any stock exchange; or Based on the current market capitalization of the foreign company arrived at on the basis of monthly average price on any stock exchange abroad for the three months preceding the month in which the share acquisition is committed and over and above, the premium, if any, as recommended by the Investment Banker in its due diligence report in other cases. In the case of investments in existing unlisted companies abroad, the valuation of the shares of such company shall be certified by a chartered Accountant.

An Indian company with a proven track record, which has exhausted the permissible limit under the automatic route may make also an application to the Reserve Bank for Block Allocation of foreign exchange for overseas investments. No transfer of shares held in a foreign company to a resident or non-resident by the Indian company is allowed unless it is approved by the RBI. In approving such proposals, the RBI has to be satisfied about the genuineness of the valuation of the share based on the pricing parameters specified above and the valuation made by the investment banker or chartered accountant as the case may be.

12.8 Role of Investment Banks in Business Advisory Services Investment banks are used extensively in business advisory services relating to corporate structuring of business groups and in deal making for business alliances such as joint ventures, collaborations, foreign investments and other such strategic

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associations. Typically, the following roles are played by investment banks in each service area as discussed in this chapter. They are: �

�

�

Addressing the strategic issues involved in corporate structuring of a business group so as to arrive at an appropriate group structure for long-term enduring value. For example the Tata group went through such a process of metamorphosis by realignment of group holding structures and creation of a Group Executive Office to spearhead group strategy. In such assignments, investment bankers are involved to assist in the identification of strategic issues, suggest optimal solutions, prepare a structuring report and handhold the necessary execution thereof. Some of these assignments would involve complex tax, accounting and reporting issues that need in-depth examination by experts in relevant areas. In such assignments, the investment bankers work closely with other professionals such as chartered accountants, company secretaries and legal experts to create comprehensive solutions. In the area of setting up of business alliances, investment bankers provide complete solutions. The assignment would include identification of business requirements, valuation of the business and deal structuring, preparation of information memorandum and other necessary literature, partner search in national and international levels, representing client in negotiations and closing with appropriate documentation. In this kind of assignments, legal experts are involved in drafting of the agreements between both the parties and the investment banker interfaces with them to ensure that the business intentions and interests of his client are adequately addressed in the agreements. Accounting firms are also used to perform due diligence if the investment banker is not in a position to do so due to conflict of interest. Handling entry strategy assignments on behalf of foreign companies intending to set up business in India. Under this kind of assignments, the investment bankers prepare an initial business plan for their overseas clients, which would address the critical issues of validating the business potential, target market segments and financial projections of the proposed business. This plan would also identify the optimal corporate structure and address the important issue of entry strategy. The entry strategy could be in terms of a joint venture or other forms of business alliance or on individual basis by the foreign company. If an alliance is envisaged, the investment banker performs his role in partner search and advisory in similar lines as indicated above. Some advisory firms also handle the initial business processes for the foreign client such as incorporation of its local company in India, setting up

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of the office, identification and recruitment of key management personnel and regulatory compliance. �

With respect to Indian corporate investments abroad, investment bankers handle the assignment in similar lines as they handle for foreign clients setting up business in India. With the help of their global reach and knowledge of business environment in the foreign country, the top line investment banker is placed in a position to be able to provide expert advice to his Indian client on the business potential, market segments, appropriate entry strategy, regulatory issues and financial modeling for the proposed overseas investments. The second stage would be to assist in appropriate partner search if required and help in negotiations and deal closure. If no partner search is envisaged, the investment banker could also help his client in setting up of the business in the foreign country through his affiliate offices in such a country.

� Notes 1. Please refer to Press Note No. 2 (2003 Series) issued by Government of India, Ministry of Commerce and Industry, Department of Industrial Policy & Promotion, SIA (FC Division) and A.P. (DIR Series) Circular No. 5 dated July 21st, 2003 issued by the RBI. 2. Please refer to Press Note No. 18 (1998 Series) issued by Government of India, Ministry of Commerce and Industry, Department of Industrial Policy & Promotion, SIA (FC Division). 3. Please refer to A.P. (DIR Series) Circular No. 33 dated November 13th, 2003 issued by the RBI. 4. Please refer to Press Note No. 3 (2003 Series) dated July 29th 2003, issued by Government of India, Ministry of Commerce and Industry, Department of Industrial Policy & Promotion, SIA (FC Division) and A.P. (DIR Series) Circular No. 34 dated November 14th, 2003 issued by the RBI.

� Select References and Suggested Readings 1. Rajiv Jain’s Guide on Foreign Collaborations—Policies and Procedures—India Investment Publication, 6th Edition, 1995. 2. Joint Ventures—Law and Management—Bharat Publishing House, 1st Edition, 2002.

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3. Foreign Collaborations and Joint Ventures—Policies and Procedures—The Institute of Company Secretaries of India, 1999.

� Self-Test Questions 1. What are the main issues in corporate structuring? What is the role played by holding companies? 2. How can companies remove cross-holdings and what are the issues to be considered in this process? 3. What are the structuring issues in joint ventures and how are these addressed in joint venture agreements? What is the advice that an investment banker can provide in structuring joint ventures? 4. What are the types of foreign collaborations? What are the regulatory aspects of structuring foreign collaborations and investments? 5. What are the types of transactions involving non-resident investments that require to be studied from a regulatory angle? Explain with suitable examples. 6. How are overseas investments by Indian companies considered by Indian regulators? What is the policy framework followed in this regard?

� Annexure I

� FDI APPROVAL UNDER THE AUTOMATIC ROUTE BY THE RBI: GENERAL TERMS AND CONDITIONS (Extracted from Notification No. FERA 188/98-RB dated 11.11.1998) 1. This notification applies to all FDI brought into companies engaged in Annexure III activities and to trading companies primarily engaged in exports and are registered as Export/ Trading/Star Trading Houses with the Ministry of Industry and Commerce. However, it does not apply to FDI from foreign banking companies. It also applies to other investments through the FDI route for which the automatic route applies. For details refer to discussion in this chapter. 2. The automatic route is available subject to the overall sectoral FDI cap prescribed from time to time under the Press Notes issued by the Ministry of Commerce and Industry. Provided that in respect of the activity of generation and transmission of hydro and thermal power, the foreign investment shall not exceed Rs. 1500 crore in the form of pure equity or convertible preference shares. 3. Special resolution should be passed under section 81(1A) of the Companies Act. 4. The pricing of the shares shall be in conformity with SEBI guidelines with respect to listed companies and certified by the statutory auditors to that effect. In the case of unlisted companies, such pricing shall be in conformity with the erstwhile CCI guidelines and certified by an independent chartered accountant. 5. Necessary statutory approvals for the project shall be obtained by the company. 6. The rate of dividend on preference shares shall not exceed the SBI Prime Lending Rate by more than 300 basis points with respect to the date of the relevant Board meeting for considering the investment proposal.

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7. The distribution of dividend on equity shall be subject to the dividend balancing condition as may be applicable. 8. No transfer or disinvestments of such shares by the foreign investor shall be made without the prior approval of RBI. 9. The consideration for the shares (investment proceeds) should be received through approved banking channels or from the FCNR/NRE account balances of the investor(s) maintained in India if such investors are NRIs and OCBs. 10. The company shall furnish to RBI within 30 days of receipt of remittance from the investors, a report containing the following: a. Name of the foreign investor. b. Country of incorporation (for a body corporate) or residence. c. Date of remittance and the amount expressed in INR. d. Name of the authorised dealer (bank) through which the remittance has been received. 11. Within 30 days of the allotment of shares, the company shall file with RBI the prescribed return FC(RBI) along with the required supporting details. 12. In the case of approvals received from the SIA/FIPB, for the allotment of shares and export of shares outside India to the foreign investors, the company need not apply to RBI again. However, such general permission is subject to the condition that the company complies with the conditions stipulated by the Government in granting such approval for foreign investment along with all the above conditions to the extent applicable.

� Annexure II

� GUIDELINES FOR THE CONSIDERATION OF FDI PROPOSALS BY THE FIPB

(Extracted from Press Note No. 3 (1997 Series) issued by the Ministry of Commerce and Industry) 1. All applications should be put forward before the FIPB by the SIA within 15 days and it should be ensured that comments of the administrative ministries are placed before the Board either prior to/or in the meeting of the Board. 2. Proposals should be considered by the Board keeping in view the time of 6 weeks for communicating Government decision (i.e. approval of the Ministry of Commerce and Industry/CCFI or rejection as the case may be). 3. While considering the cases and making recommendations, the FIPB should keep in mind the sectoral requirements (FDI caps) and the sectoral policies vis-à-vis the proposal(s). 4. FIPB should consider each proposal in its totality (i.e. if it includes apart from foreign investment, technical collaborations/industrial licence) for composite approval or otherwise. However, the FIPB’s recommendation would relate only to the approval for foreign financial and technical collaboration and the foreign investor will need to take other prescribed clearances separately. 5. The Board should examine the aspects relating to the source and nature of technology envisaged and the proposed terms of payment, the applicable guidelines for dividend balancing, royalty payments, etc. 6. In the case of induction of equity into existing Indian companies, the modalities thereof and adherence to the RBI/SEBI pricing guidelines. 7. In respect of proposals falling under Annexure III activities, wherein approval under the automatic route is accorded by the RBI, the FIPB may consider recommendation of higher level of FDI than permitted under the sectoral caps keeping in view the special requirements and merits of each case. 8. In respect of proposals in non-Annexure III activities, the Board may consider recommending the level of FDI based on the considerations of each case such as the extent of capital required for the project, the nature and

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quality of technology, the requirements of marketing and management skills and the commitment for exports. 9. FIPB may consider and recommend proposals for 100% foreign owned holding companies/subsidiary companies based on the following criteria: �

�

where the holding company performs only the holding operation and all downstream activites would be carried out with prior approval of the Government; where proprietary technology is sought to be protected or sophisticated technology is to be brought in;

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where atleast 50% of the production is to be exported;

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proposals for consultancy; and

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proposals for power, roads, ports and industrial model towns/industrial parks or estates.

The present policy allows for payment of royalty by 100% subsidiaries being set up by foreign companies in India to their holding companies under the automatic route upto 8% on export sales and 5% on domestic sales. Payment of royalty exceeding these limits would be looked into by the FIPB. 10. In special cases, where the foreign investor is unable initially to identify an Indian joint venture partner, the Board may consider and recommend proposals permitting 100% foreign equity on a temporary basis on the condition that the foreign investor would divest to the Indian parties (either joint venture partners or general public or both) at least 26% of its equity within a period of 3–5 years. 11. Similarly, in case of a joint venture where the Indian partner is unable to raise resources for expansion/technology upgradation of the existing industrial activity, the Board may consider and recommend increase in the proportion/percentage (up to 100%) of the foreign equity in the enterprise. 12. In respect of trading companies, 100% foreign equity may be permitted in the case of the activities involving the following: �

exports

�

bulk imports with export/expanded warehouse sales

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� �

cash and carry wholesale trading other import of goods or services provided atleast 75% is for procurement and sale of goods and services along the companies of the same group.

Retailing of goods imported from outside manufacturing bases in India by trading entities is not permitted. 13. In respect of companies in the infrastructure/services sector where there is a prescribed cap for foreign investment, only the direct investment should be considered for the prescribed cap and foreign investment in an investing company should not be set off against this cap provided the foreign direct investment in such investing company does not exceed 49% and the management of the investing company is with the Indian owners. 14. No condition specific to the letter of approval issued to a foreign investor would be changed or additional conditions imposed subsequent to the issue of a letter of approval. This would not prohibit changes in general policies and regulations applicable to the industrial sector. 15. Where in case of a proposal (not being 100% subsidiary) FDI has been proposed up to a designated percentage of foreign equity in the joint venture company, the percentage would not be reduced while permitting induction of additional capacity subsequenty. In the case of approved activities if the foreign investor(s) concerned wished to bring in additional capital on later dates keeping the investment in such approved activities in view, the FIPB would recommend such cases for approval on automatic basis. 16. As regards proposals for private sector banks, the application would be considered only after ‘in principle’ permission is obtained from the RBI. These guidelines are meant to assist the FIPB to consider the proposals in an objective and transparent manner. These would not in any way restrict the flexibility or bind the FIPB from considering the proposals in their totality or making recommendations based on other criteria or special circumstances or features it considers relevant. Besides these are in the nature of administrative guidelines and would not in any way be legally binding in respect of any recommendation made by the FIPB or decisions to be taken by the Government in cases involving FDI. These guidelines are issued without prejudice to the Government’s right to issue fresh guidelines or change the legal provisions and policies whenever considered necessary.

Chapter

13 Project Advisory Services

P

robably one of the most fascinating areas in corporate finance is project finance, not only because of its complexity but because of its profound economic significance as well. Project financing has traditionally been a term-loan based activity, where investment banks had very little to do unless an element of capital market financing was involved. However, it has now become an integral part of the advisory service portfolio of leading investment banks, especially of those with a universal banking background. Project advisory services relate to all facets of project finance, which begin at the stage of project conceptualization and extend till the completion of financial closures and beyond. This chapter introduces the reader to the project financing perspective and encapsulates the broad facets of project advisory services and the role of investment banks therein.

Topics to comprehend �

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Distinguishing elements of project finance as compared to other forms of corporate financing. Project financing structures and process flow. Role of investment banker in project advisory services.

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13.1 Introduction to Project Finance Project Finance is a specialized area in corporate finance that deals with the financing of an economic vehicle which can generate economic returns to its stakeholders. From a lender’s perspective, project financing can be defined as the financing of an economic unit, based on an assessment of such unit’s capacity to service the loan and interest thereon, out of the profitability and cash flow generated by the proposed project. The assets proposed to be created in the project would be used to collaterise the loan. Peter K. Nevitt (Project Financing, 1983) defines it as ‘a financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan’.

13.1.1 Differences Between Project Financing and Other Forms of Financing 1. Under project finance, the lender primarily depends upon the ability of the project to perform and generate returns to service the loans. The creation of asset security is only a standby to be enforced in extreme circumstances, since in most cases, the lenders cannot recover their entire dues through sale of assets. Therefore, project financiers make money only if the project makes money. This is quite different from pure asset financing by way of a loan or conditional sale, where the lenders look for financing an asset based on its value and a comfortable margin thereon, so that the lender can at any time, foreclose the loan and sell the asset. 2. Financing of a project creates an economic entity, which can be commercially used only if it is used in its entirety. Therefore, though technically the project assets are secured to the lender, it is not easy for them to sell the whole unit. If the assets are stripped and sold individually, they may not yield enough for the loans to be recovered in full. In asset financing, this problem is minimal since the assets being financed are easy to identify and sell separately. 3. In project financing, the level of risk assumed by the lender is two-fold: �

The business risk associated with the business of the borrower.

�

The financing risk in lending to the specific borrower.

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4. In asset financing, since the lender has the right to the asset at any time, and the asset is financed with adequate margin and further collaterals, the risk involved is only the financing risk. The financing in such cases is thus purely oriented towards the asset financed. 5. In project financing, unlike in venture financing, the financial risk is taken upfront in its entirety. This is because projects need to be configured to their optimum size despite the fact that their market may remain untested. Since the investment has to be sunk in to set up the project, the risk is manifold.

13.1.2 Relevance of Project Finance Project finance performs a significant role in the economic development of a country. When India attained independence in 1947, there was a serious requirement of industrial development to rebuild the nation. For this reason, various financial institutions such as IFCI, IDBI, ICICI, and state-level financial institutions such as the State Financial Corporations and State Industrial Development Corporations were established to administer project finance to proposed projects in various parts of the country. In the past 50 years, project financing has provided yeoman service to the industrialization of the country and in attaining economic development. In the next few decades, project finance will play a crucial role in creation of adequate infrastructure in the country. The main source of project finance in India is financial institutions and commercial banks. For larger projects, foreign banks and multilateral institutions are sometimes involved. While the principal business of financial institutions has been project financing, commercial banks have been more into asset financing by way of term loans and leasing.

13.1.3 The Project Financing Framework in India The following exhibit (Fig.13.1) represents the broad framework of project financing institutions in India. �

The all India term lending institutions or AFIs as they are known as, originated in the backdrop of the first Industrial Policy Resolution in 1948, which spoke of industrialization being of paramount importance for a free India. Pandit Nehru called industries the ‘temples of modern India’. The Industrial

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PROJECT FINANCING INSTITUTIONS

All India Financial Institutions (AFIs) • Traditionally the largest project financiers in India • IDBI, IFCI and ICICI are the oldest term lending institutions. IDBI is also the largest refinancing institution for SFIs . • They are going through a phase of transformation. • Investment institutions such as LIC/GIC and UTI were marginal lenders and equity investors in projects. • New generation financial institutions that have specialised functions include Exim Bank, IL&FS and IDFC. • The erstwhile IRBI which was meant to rehabilitate sick units has become a multi purpose lending institution in its reincarnation as IIBI. • The SIDBI was culled out of IDBI to perform the development financing functions for small scale units.

� Figure 13.1

State Level Financial Institutions (SFIs) • These are development financing institutions in each State. • Each State usually has a State Industrial Development Corporation (SIDC) and a State Financial Corporation (SFC). • The SIDCs were more of refinancing and development institutions to promote joint sector projects in the licensing era. • Currently they are more of term lending institutions. • The SFCs finance small projects typically in the small scale sector though they need not confine only to SSIs. . • The SFCs and SIDCs get refinancing support from IDBI. • Depleted financial health due to bad loans has been the main feature of most SFIs in India.

Commercial Banks • Commercial banks are marginal players in the term lending market. • Their main focus is to provide working capital. assistance to new projects as well as existing units. • Their term loans are usually for asset financing. • They usually take small stakes in projects funded by AFIs. . • There are a few large banks such as the SBI which have the strength to be lead financing agencies for projects. • Banks suffer from paucity of long term funds to be bigger players in the project financing market. • Banks also support projects with fee based activities such as Letters of Credit, guarantees etc. just like the AFIs.

Project Financing Framework in India

Finance Corporation of India was set up as the first specialized industrial financing institution under the IFCI Act 1948 as a corporation. The Industrial Development Bank of India, a division of the RBI assigned to perform the role of development financing, was hived off as a separate corporation in 1964 under the IDBI Act, 1964. The Industrial Credit and Investment Corporation of India Ltd. (now ICICI Bank Ltd.) was set up as a company under the Companies Act, with shareholding by the financial institutions. IDBI had the largest mandate to play the development banking role not only in direct financing but also in refinancing of SFIs. IDBI is also

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the nodal agency for the implementation of all government schemes and for multi-lateral lines of credit from international financing institutions such as the IBRD, ADB, etc. IFCI and ICICI were more of direct financing institutions. Together, the traditional AFIs had the mandate to provide long-term financing for projects being set up by industrial undertakings both in the private and public sectors. In the past five decades after 1948, these institutions have done yeoman service to the cause of industrialization of the country by providing project financing. The project financing function of the AFIs is dependent upon the supply of long-term finance to them. �

�

�

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The Industrial Reconstruction Bank of India was set up as a specialized financial institution with the mandate of reviving sick units through financial rehabilitation and assistance. This was necessitated due to the large number of sick industries in the country which were accumulating as non-performing asset portfolio in the books of the term lending institutions. IRBI took up chronically sick cases for suitable rehabilitation to bring them out of bankruptcy. Exim Bank is a specialized financial institution mandated to develop export financing and promotion schemes as also to help Indian businesses set up their presence in overseas markets. The Infrastructure Leasing and Financial Services Ltd (IL&FS) and the Infrastructure Development Finance Company Ltd (IDFC) are later entrants into the field of project financing. IL&FS was originally intended to focus on financing the infrastructure sector with specialised lending and other financial services. The IDFC, which was formed in the post-reform era, has been mandated to exclusively focus on the development of financing options for the infrastructure sector, which has been identified as a priority sector for economic development. The SFIs are state-level financial institutions, such as the Industrial Development Corporations (IDCs) set up as companies, and State Finance Corporations (SFCs) which are set up under the SFC Act. They perform the function of assisting industrial units in the respective states through term lending and other financial assistance. However, the financing capabilities of these agencies are limited. Generally SFCs can perform direct financing functions of upto Rs. 250 lakh and IDCs upto Rs. 500 lakh. Beyond these limits, financing can be done only by the AFIs. The state-level institutions avail refinancing from the AFIs. SFIs also perform the refinancing role for direct financing made by commercial banks.

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Apart from the AFIs and the SFIs, there are investment institutions such as the UTI, LIC, GIC and its four subsidiaries, which also perform residual project financing functions by participating in projects that are financed by the AFIs. Though they can sponsor projects on their own as lead financial institutions, they rarely do. Scheduled commercial banks perform term financing functions more in the nature of asset financing than project finance. One of the main limitations for banks to finance projects is their limited access to long-term funds. Traditionally, the main source of funds for banks has been time and demand deposits with maturities upto five years. The financial and risk-taking capability of banks to perform project-financing functions is limited, except for a few large banks such as the SBI. This is because, project financing by banks could lead to asset–liability mismatch on their balance sheets unless they have sufficient access to long-term funds. In recent times, structures such as ‘take-out financing’ have been devised, so that the financing role of banks can be restricted to a limited period of time in the life of a long-term loan. However, banks have an important role to play at the secondary level by providing working capital assistance to new projects as well as existing units. Since working capital forms a significant part of any project plan, the role of banks in financing it cannot be forgotten. Lastly, there is the Small Industries Development Bank of India (SIDBI), which was culled out of IDBI by shifting the small-scale industry’s direct and refinancing portfolio into a separate balance sheet. Thus SIDBI was set up as a separate institution exclusively to cater to the needs of the smallscale sector. SIDBI performs direct financing function up to around Rs. 200 lakh but more importantly, performs refinancing functions for loans lent by banks and SFIs to the small-scale sector.

13.1.4 Development Banking to Universal Banking As stated above, project financing is viable as a business model, solely based on the commercial success and viability of the projects financed, which would then be in a position to service their long-term borrowings. However, if such a commercial approach had been taken initially, the term lending institutions could not have lent funds to several first-time projects which had a high start-up risk, and the commercial viability thereof could have only been established after the projects had gone on stream. Therefore, project financing was traditionally treated as a development

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financing activity, which required subsidised long-term funds so that more projects could be given a better chance to become viable. The term lending institutions, which had to sustain themselves primarily on the project financing model, had to therefore be assured of a continuous supply of cheaper, long-term funds which would be on lent to projects. The main sources of funds for the AFIs were (a) RBI’s Long-Term Operations Funds at cheap rates of interest, (b) subscription to SLR Bonds issued by institutions to commercial banks on private placement basis, (c) external commercial borrowings, (d) lines of credit from the Government and (e) multi-lateral lines of credit from international development and financing institutions. The IDBI was the nodal agency to act as a source of finance for the SFIs to on-lend to smaller projects at the state and SSI level. On the other hand, commercial banks had to raise the bulk of their finances via time and demand deposits from the market and could therefore finance their borrowers for working capital at cost plus rates fixed by the RBI. This mechanism caused an anomalous situation whereby long-term financing in India was more often than not, cheaper than working capital financing. There was also a watertight distinction between a financial institution and a bank; while the former specialized in long-term financing, the latter focused on working capital financing. The above financing framework was relevant in the era of development banking, wherein the focus was on project financing being a catalyst for industrial growth and development. In the post-reform era, there have been certain fundamental shifts in the paradigm of development banking in general and project financing in particular. In the market economy, projects can be financed only from a commercial perspective and not otherwise. Projects need to stand the test of sustenance and viability in the wake of competition, albeit with a global market opportunity. Therefore, the fundamental variables in a project such as its size, target market, project logistics, strength of project sponsors, etc. need to be addressed from a commercial angle and not purely from a development angle. Development financing institutions have had to address the new paradigm from their individual standpoint. They have been hit by defaults and bad loans over the years, which have eroded their financial health. They need revitalisation and a new agenda to suit the times. On the resources front, project financing institutions have had to take recourse to market borrowings through unsecured bond offerings in recent times. But their ability to raise such funds from time to time is dependent on factors such as interest rates, their own credit rating and competition from other financial products in the market, apart from other macro-economic issues.

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The removal of cheap and guaranteed source of long-term finance for financial institutions has put them on the same pedestal as commercial banks, but in a much weaker position due to their lack of a retail network. Thus, after about five years of market borrowing mechanism, it is seen that the average cost of funds of the IDBI, which was around 6.5% in the pre-liberalization era, has gone up to around 10% presently. Due to a combination of all the above factors, project financing as a business activity has been reduced to a trickle in recent years. At another level, the SFIs have also been having a resource crunch due to their poor financial health. Financing of start-up projects has virtually dried up, and the few fresh sanctions that are being accorded are to bigger projects, mostly in the infrastructure sector. Project loans are presently offered by each institution at interest rates linked to their respective prime lending rates. The concept of a lead institution appraisal has also been more or less disbanded and each lending agency does its own appraisal, based on its risk assessment. Project loans are also not shared in inter-institutional committees as used to be the practice in earlier days under the Project Finance Participation Scheme. Therefore, project loan syndication has become a mammoth task involving multiple appraisals by different lending institutions and banks each differing with risk perceptions about the project, and consequently, with differing appetites for exposures and scheme of interest rates. The stage has therefore been set for the transformation of development banking institutions of the protected economic era to commercial institutions of the market era. The pure lending institutions have looked at a transformation of their identity from development financing institutions to multi-product financial houses which would address corporate and retail lending and other financial products and services. The conversion is itself a complex process involving a plethora of regulatory, policy, and organizational issues that each institution has to contend with and come out successfully from. ICICI, the erstwhile financial institution, lead the way to this transformation by recently converting itself into a universal bank with a merger of itself with ICICI Banks Ltd, its commercial banking arm. Corporate lending now forms just another business area for ICICI Bank and project finance is no longer the main focus. IFCI converted itself into a company under the Companies Act in an attempt to restructure its balance sheet and look for a new identity. IDBI has also looked at a similar agenda and the bill to repeal the IDBI Act has been passed by the Parliament. However, the Government is of the view that IDBI should continue with its development financing role as otherwise, there would be no financial institution left that can look at encouraging new entrepreneurs and greenfield projects. At the State level, efforts are on to revamp the working of the SFCs by restructuring their balance sheets with the help of SIDBI as the co-ordinating agency. A similar exercise would be required to re-define the role of the IDCs.

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Thus, the winds of change in the industrial and economic climate of the country have had their effect on the future of development banking. Project financing has graduated from a development financing product offered by specialized term lending institutions to a market related product that can be offered by any kind of lender (an institution or a bank) that has the relevant skills and appetite for project lending. The lending is not from a development perspective with in-built subsidies, but a commercial loan that has to stand the test of servicing capacity, based on the cash flow generation and sustained viability of the project in a globalised setting. The future could narrow down the divide between financial institutions and banks as far as project financing is concerned. There could be a time when a set of strong universal banks would perform the roles of both term lenders and working capital bankers for projects.

13.1.5 Full Recourse and Limited Recourse Project Financing Structures As discussed, project financing now revolves around the viability prospects of a given project. Therefore, the financing risk of the project has to be addressed on two fronts: (a) a detailed appraisal to establish the viability prospects and (b) mitigation and dissipation of risk through suitable financing structures. There are primarily two project financing structures that have evolved over the years.

Full Recourse Structure In the development banking era, project financing products used to be in the straightforward structure of ‘full recourse asset-backed lending’. The following are the broad features of a full recourse project structure: 1. The project for which the financing is envisaged can take the character of a greenfield project of a new company set up for this purpose or a project set up in an existing company, either for the purpose of expansion of capacity, or for diversification into new areas of business. Irrespective of the nature of the project envisaged, under the full recourse structure, it can be implemented as part of the same company. 2. If a new company is setting up the project, the proposed borrowings in the project are fully secured by first charge on all existing and future fixed assets

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of the borrowing company, by way of mortgage of immovable assets and hypothecation of movable assets. 3. If the project happens to be an expansion or diversification in an existing company and there are existing lenders with charges on assets, the new project lender gets a pari-passu charge on the entire block of assets including the proposed project assets. In other words, the existing and the proposed assets are thrown into a common pool on which the new and the existing lenders acquire rights proportional to the components they have financed. In case of a recovery proceeding, all the lenders stand on equal footing to the extent of their unrecovered amounts, irrespective of when they have financed the company. 4. Though the project viability is assessed on stand-alone basis, the servicing capacity of the company is assessed on an overall basis, i.e. the cash flow pool from existing as well as proposed activities is reckoned for the purpose of servicing the existing and proposed debt obligations. 5. In addition to the asset securities as specified above, the project sponsors hold unlimited liability for debt servicing in their personal capacity. In other words, the corporate veil would be pierced for the purpose of recovery of the loan to get to the promoters behind the company. This would be done by way of additional guarantees to be signed by the project promoters, apart from the loan agreement to be executed on behalf of the company by its management. Further, if the lenders find it necessary, a corporate guarantee from a group company may also be insisted upon. The full recourse structure is depicted in Exhibit 13.2.

Limited Recourse Structure The advent of larger projects, especially in the infrastructure industry, which are typically conceived either in joint participation by the private sector and the Government or the public sector, or on a project consortium basis has changed the way projects are looked at for the purpose of financing. In India, post liberalisation, several sectors that were the exclusive preserve of the public sector were thrown open to private sector participation. These sectors had to be looked at from a commercial perspective so that private projects could be financed through institutional financing. Infrastructure financing in India began with power projects wherein the exclusive buyers of private power were the State electricity boards whose financial standing was suspect. In the other infrastructure areas such as

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Project Lenders Piercing the corporate veil through personal guarantees

Term lending

Primary asset security

PROJECT COMPANY (Existing or new with asset collaterisation )

Project Sponsors or Promoters (liable in personal capacity)

� Figure 13.2

Full Recourse Asset Backed Financing Structure

telecom, roads and ports too, suitable legislative changes have been introduced such as in the Electricity Act, the Major Ports Act, the Highways Act and others to bring about a climate wherein such projects can be made creditworthy and commercially viable on a stand alone basis. Taking a cue from international experience, these projects are structured on limited recourse, cash-flow based financing model. The features of this structure are elaborated below: 1. The project is structured in a separate company floated for this purpose, called a Special Purpose Vehicle (SPV). The SPV will not handle any other business activity without the prior approval of the lenders. 2. The project is sponsored by the promoters who would put in place a consortium of other partners (both equity and implementation partners) to bring in various kinds of competence (technical and non-technical) into the project. 3. The project may be jointly promoted with the Government or a statutory authority though this is not mandatory. In case it is so formed, the project rights vest with the promoters during a certain period. This period, known as the concession period is the time during which the promoters have to exploit the commercial opportunity and get back their return on investment.

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After the expiry of the concession period, the project vests back with the Government or such authority. 4. The project viability is assessed and the financing risk is taken based purely on the cash flow potential of the project. Other suitable collaterals are not physical assets to the full extent. They could be contractual arrangements which act as credit enhancements. This is the reason why this structure is called cash-flow based lending. 5. The most important feature is that of limited recourse of the lenders to the sponsors and their other businesses. The project risk is shared by the consortium and the lenders and the promoters are required to assume only a defined risk. Mostly, the promoters would be subject to recourse till the implementation of the project is completed and thereafter, the project is on non-recourse basis. 6. The SPV being a separate entity, is bankruptcy remote from the other businesses of the promoters. The limited recourse structure is depicted in Exhibit 13.3. Financing Consortium

Limited recourse to sponsors (generally till completion of implementation)

Loans/Guarantees/ Equity

PROJECT COMPANY (A SPV with assets exclusive to the project which may not provide sufficient cover for the borrowings)

Project Consortium (shares the risk in the project)

� Figure 13.3

Structured security package

Equity/other support

Government/ Statutory Authority Transfer of project after concession period

Limited Recourse Cash Flow based Financing Structure

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From the above discussion, it may be appreciated that there are fundamental differences in both the project structures. Under the conventional structure (also known by the name ‘direct financing’), the project can be set up in a company that can have several lines of business or several revenue streams co-existing in the same entity. The assets would be thrown into a common pool of assets to generate a common pool of cash-flow that originates from the different economic activities conducted in the company. There can be different lenders for different activities in the same company, each of them either with specific charges or parri passu charges on assets. The common cash-flow pool is used to service the total secured borrowings of the company. This kind of co-existence of business activities and different lenders within the same company does not pose any problems, since each lender has a charge on a portion of the assets (or sometimes exclusively on certain assets) as recourse to the loan exposure. The lending is not based merely on the cash-flow capability of the company, but with enough asset coverage on the outstanding loans. Thus, under this structure, the lenders take a balance sheet risk based on the general creditworthiness of the entity and its promoters, which is further backed by the common asset pool. Under the cash-flow based lending model, the lenders primarily make an assessment on the cash flow strength of the project since they do not have sufficient asset cover or unlimited recourse to the project sponsors. Since the primary project risk is based on its cash flow, there is a need to make the project into a distinct legal entity, often a special purpose vehicle. The project cash flows have to be segregated through a separate balance sheet so as to capture them exclusively for the creation of contractual rights to safeguard the lenders. The project assets and project-related contracts are also created exclusively through the SPV so as to bind the project sponsors to the project and the lenders in a defined legal relationship. Due to this reason, the asset cover may not be sufficient and since the recourse to other businesses of the promoters is limited, in case of a shortfall in security cover, there can only be contractual rights for the lenders to invoke. Since the project is structured primarily on the strength of its cash flow, the risk becomes too much for the lenders to assume it all by themselves. Therefore, the project risks are identified and allocated suitably to the various parties in the project consortium, so that the lenders assume only the residual risks in the project that cannot be allocated to others. Thus, under the second method, the financing structure is designed to allocate risks and returns in the project more efficiently than in direct financing. In limited recourse financing, the lenders have recourse to the sponsors generally during the implementation and commissioning stage of the project. In practice,

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most projects are with limited recourse to the sponsors and other key players in the project. This is because non-recourse financing, in its pure form, becomes an inefficient and expensive financing structure, since the cumulative risk premium to be charged by the lenders for all the uncertainties in the project would be prohibitive. Therefore limited recourse is applied to bring down the financing cost and dissipate the risk. The extent of recourse necessary in a specific project is determined by the risk profile of the project and the safeguards perceived as necessary by the lenders. Therefore, the project sponsor assumes some uncertainty in the project in return for a reduction in the risk premium otherwise payable to various contracting parties in the project. This technique is also known as ‘Structured Project Financing’.

13.2 The Project Financing Process Project financing is a long and complex process, which begins with conceptualization of the project and ends with the repayment of the long-term project-related borrowings in full. The requirements are therefore quite onerous and are aimed at satisfying the requirements of lenders, statutory provisions under relevant laws, and that of the project sponsors, other investors, and interested parties in the project. These can be discussed under the following heads:

13.2.1 Project Conceptualization The primary requirement for any project is a sound concept backed up by a business opportunity and revenue model. Project financing, unlike venture capital backed businesses, requires bankability from a lender’s point of view. A project becomes bankable only when it has a technology that is established, perceivable commercialization capability and a definite revenue model. It is not necessary that all projects that go for financing should be backed with the empirical experience of other similar projects. However, it is that much more difficult to convince institutions on project viability if the project happens to be the first of its kind. Ideally, the project should be in an industry space that has potential for future growth, scale-up possibilities for existing as well as new players, and fulfill a perceived gap in supply. In addition to the above, the project should satisfy current policy requirements of the government and the lending institutions and banks. Therefore, it should preferably be in an identified growth industry or a thrust industry under the industrial policy, or the current lending norms. More importantly, the project should not be

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under the negative list of industries such as liquor, tobacco etc., that cannot be financed by financial institutions.

13.2.2 Project Structuring The project structuring should address key concerns on location, operational model relating to procurement, production and distribution, technology identification and transfer to the project, marketing and commercial issues, management bandwidth and promoter resourcefulness. The structuring should be to focus on mitigation of project risks that are identified in the above areas. From the point of view of mitigation of risk, the project sponsors have to keep in mind the fact that of late, lenders are not inclined towards financing first generation promoters. Similarly, they are not supportive of green-field projects except those set up by established promoters, or those set up in the infrastructure industry. Even in the infrastructure industry, most projects are being awarded to consortia that fulfil stiff eligibility criteria. Project lenders are placing increased emphasis on the track record of the project sponsors in taking up projects for financing. Therefore, it would not be prudent for first generation entrepreneurs to try to establish large projects without putting in place a strong consortium. Usually, a new company (incorporated under the Companies Act) is floated to implement the project which is referred to as the SPV (special purpose vehicle). The idea in floating a SPV is to insulate the project from the sponsors and other parties involved in the project and make it bankruptcy remote. The SPV would have a separate balance sheet and clearly defined cash flows that would determine the assets and liabilities of the project from time to time. The RBI has issued detailed guidelines1 on non-recourse/limited recourse project structuring, extracts of which are reproduced below: a. In a limited/non-recourse structuring, the sponsor commits to provide standby support for cost overruns in the project, provided the quantum of such support has crystallized prior to the financial closure. In the event of any cost overrun in the project, it is met from such standby support. In case the overrun exceeds the amount of such support, while there will be no obligation on any party in view of the exposures already taken, all the players can negotiate the quantum and terms of additional funding requirement.

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After satisfactory completion of the project, no recourse would be available to the project sponsors for any shortfall in the revenue projections unless specifically agreed to between the parties. b. SPVs have a security structure that is generally more stringent than for normal projects. The security package generally includes a registered mortgage/hypothecation of all assets, besides pledge of sponsor holdings in the SPV and an assignment in favour of institutions of all project contracts and documents as also a charge on future receivables. c. The cash flows of the SPV are captured by way of a TRA arrangement. Such an arrangement provides for the appropriation of all cash flows of the company by an independent agent (acting on behalf of the security trustee). This is then allocated in a pre-determined manner to various requirements including debt servicing and it is only after all the requirements are met, that the residual cash flow is available to the project company. Thus the lender would have the security of the cash flows in addition to the assets of the company. d. The payment risk in some projects is further mitigated by a State or Central Government guarantee.

13.2.3 Project Consortium One of the main features of a well-structured project is a strong project consortium as discussed above. A project consortium consists of the project sponsors (called promoters or sometimes a promoter group), technology providers or collaborators, equipment suppliers or EPC Contractors (Equipment Procurement and Construction Contractors), O&M Contractor (Operations and Maintenance), strategic investors, a joint venture partner, a public sector partner or investor such as the state or central government, a public sector undertaking, a state or local authority or corporation, a developmental agency or any other such institutions. Depending on the nature and size of the project, the consortium could consist of any combination of the above parties with the promoters. Therefore, soon after the project has been conceptualized, formation of the project consortium is of utmost importance. A strong consortium that can boast of technical, financial and managerial competence to handle the project can drastically cut down the time required to achieve financial closure of the project. Usually, the following broad guidelines can be adopted to set up a good consortium.

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If the promoters happen to be an established business group with a sound financial base, it may be possible for them to bring in the promoters’ contribution required for the project. Otherwise, if the promoters lack the required financial strength, it would be necessary to bring in strategic partners into the consortium. If the project is in the joint sector with private and public sector partnership, the government or any other quasi-governmental agency would be a part of the consortium with equity participation. If the project happens to be one wherein the government or such agency is acting as a facilitator alone, it may have token participation in the project but may be the deciding authority that awards the project to a particular consortium based on certain eligibility criteria. Most infrastructure projects in the road and port sectors fall under this category wherein the governmental agency (NHAI or the Roads & Buildings department of the State Government or the respective Port Trust) acts as the facilitator and awards the project, based on the bidding route to the eligible consortium. If the project involves specialized technical skills or know-how, suitable technical partners need to be made a part of the consortium. In most nonrecourse projects, the EPC contractor becomes a key consortium partner, as the risk of project cost overrun and project completion is assumed by the EPC Contractor. In projects that involve a high level of technology transfer, a suitable foreign collaborator or know-how provider is involved. This could even extend to equipment supply where the key plant and machinery has to be imported from abroad. The whole aspect of foreign technical and financial collaboration is discussed more in detail in Chapter 12. In projects floated as joint ventures either between two Indian promoters or between an Indian and a foreign promoter, the joint venture company would require foreign investment approvals before the foreign party can invest in the Indian company. The detailed discussion on joint ventures is also furnished in Chapter 12.

13.2.4 Key Project Contracts One of the main aspects of project structuring is to put in place the key contractual arrangements that constitute the project structure and the project consortium. After

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all, at the pre-implementation stage, the project is nothing but a concept backed by a set of critical contracts that make up the project on paper, based on which funds for its implementation are raised. As pointed out earlier, non-recourse financing is all about financing a project based on an assessment of the cash flows. These cash flows are to be generated from contractual relationships that constitute the project, and the market demand for the products or services emanating from the project. Project contracts are assessed more importantly from a cost and risk perspective than a revenue perspective. This is because the maximum risk that a project carries is during its implementation. If cost escalations and time overruns sabotage its implementation, the project more often than not, finds itself in a state of unviability, thereby jeopardising the financial interests of the lenders and other interested parties. Similarly, during its operational stage a project could be seriously hampered by fluctuation in input costs and timely availability of such inputs. Due to these reasons, key project contracts are necessary to structure the roles of the consortium players and to dissipate risk. Needless to say, the key project contracts do not include financial contracts that have to be entered into for raising finance for the project from lending agencies and other outside investors. In other words, key project contracts are those that need to be in place before the project company enters into financial contracts. Some of the key contracts in infrastructure and other projects are listed below. �

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The Shareholders’ Agreement among the promoters and other investors — This is the primary project contract that defines the inter-se equity shareholding pattern among members of the promoter group and outside investors who could be strategic or financial investors. The shareholders’ agreement is fundamental to the project without which other agreements cannot be entered into. The Concession Agreement/Licence Agreement — this is the agreement between the government agency and the project consortium, where applicable, by virtue of which the project is awarded to the consortium. This agreement clearly defines the scope of the project, contracted costs to be paid to the government authority, product pricing, capacity of the project and roles to be played by both the parties. Assignability of licence or concession rights, dispute resolution, termination clauses and payments, rights, and liabilities of each party and allocation of risks and responsibilities have to be clearly spelt out in the agreement. In the case of power projects, the state electricity boards or companies enter into agreement to purchase the power generated by the project (called the Power Purchase Agreement or PPA).

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The EPC Contract — It virtually defines about 50% of the cost of the project. If the contract is a turnkey, it would include civil costs as well. This is a mechanism of wedding the EPC contractor to the risk in project execution. Apart from the EPC contract, an equipment supply agreement is also generally entered into to provide for the equipment sourcing by the project from the EPC Contractor. The Fuel Supply Agreement/Procurement Contract —This is found mostly in power projects. In other projects it could be a procurement contract for key raw material. Procurement contracts for key raw materials or feedstock are entered into on a long-term basis with proposed suppliers, to cover the risk of non-availability of raw materials. Water Supply Agreement — In projects that are water intensive or in the case of hydro-electric power projects, a clear and dependable source of water is essential, with a concrete estimate of the quantity of water that would be available to the project. This purpose is sought to be accomplished through this agreement. Operations & Maintenance Agreement —The O&M contractor who is also an important consortium member, enters into this contract with the project company. This contract provides for the regular maintenance of the plant or facility and the risk of technical breakdowns to be borne by the O&M contractor. Product Buy Back or Usage Agreement — In most projects envisaging an infrastructure or manufacturing facility, a suitable usage agreement or a buy back agreement is envisaged from the user of the project output so as to set up a predictable revenue model for the project. Commercial contracts from proposed customers, who would use the product or service provided by the project, are often entered into on a cost plus basis so as to de-risk the inflation factor in cost of inputs. This becomes a complex issue in infrastructure projects such as power and telecom, where product pricing is regulated by tariff regulators. In power projects, there is a two tier tariff system with a fixed and a variable component. In the road sector, a new system of fixed annuity payments by the National Highways Authority of India (NHAI) during the concession period is being used for highway projects. Foreign Collaboration and Technology Transfer Agreements – These agreements are required wherein foreign collaborations are envisaged. These are to be approved by the government under the current technology policy and

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foreign exchange regime. For a detailed discussion on these agreements please refer to Chapter 12. �

Joint Venture Agreement — This is required in the case of joint venture projects wherein the mutual understanding between the JV partners is spelt out. Therefore in JV projects, it substitutes for a shareholder agreement. For a detailed discussion on these agreements please refer to Chapter 12.

13.2.5 Project Financing Through Long-Term Debt Domestic Rupee Term Loans For financing projects, the most common mode of financing is medium to long-term loans from domestic financial institutions and commercial banks. Project assistance from Indian Financial Institutions can be either Rupee loans or designated Foreign Currency loans or guarantees. Each loan can again be at fixed interest rate or floating interest rate pegged to a benchmark rate. Term loans are contractual obligations between borrowers and lenders and are therefore governed by the law of contract and the specific provisions of the Banking Regulation Act and other laws as applicable to banks and financial institutions. In India, term loans (whether for project or non-project financing) have traditionally been secured loans with first charge in favour of the lender on the assets being financed. Term loans have an inherent drawback of separating ownership and usage of an asset in that, the lender owns the asset but it is the borrower who has possession thereof and enjoys the benefits of its usage. In order to make it easier for the lender to take possession of the asset in case of default in repayment of the loan by the borrower, the impugned asset is charged to the lender by way of a first and paramount charge in super session of all other creditors of the borrower. Project loans go a step further and bring all immovable and movable assets of the borrower, both present and future under a blanket first charge.

External Commercial Borrowings2 Term loans can also be raised for project financing and other long-term requirements from sources outside India. These are called External Commercial Borrowings (ECBs) as they add to the external debt of the country. The sources for

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these borrowings could be the loan markets or the securities markets. ECB loans can be raised from multilateral institutions such as the IFC (private financing arm of the World Bank), the Asian Development Bank, CDC, AFIC, KFW of Germany, Exim Bank of USA or Japan and similar institutions, other financial institutions and commercial banks abroad, suppliers and collaborators and NRI sources. The securities markets are the Yankee Bonds, Rule 144A placement, private placement, MTN program (all in the USA) the Euro Bond market (outside USA) and the Samurai Bond market. The issuance of debt securities in overseas markets using the ECB route is discussed in Chapter 8. Therefore, we restrict the discussion here to loans raised under the ECB route. In order to raise long-term loans through the ECB route, the project company has to comply with the current ECB regulations of the Government of India. The last comprehensive ECB policy was issued in 1999–2000, which has since been amended from time to time. The present discussion is based on the ECB policy as existing in December 2003. Under the ECB policy, an ECB is defined to include ‘commercial bank loans, buyers’ credit, suppliers’ credit, securitised instruments such as floating rate notes, fixed rate bonds, etc., credit from official export credit agencies, and commercial borrowings from the private sector window of multilateral financial institutions such as the IFC, ADB, AFIC, CDC, etc.’ ECBs are permitted to be raised by Indian corporates for expansion of existing capacities and for fresh investments as well. ECBs can be raised from any internationally recognized source such as banks, export credit agencies, suppliers of foreign equipment, foreign collaborators, foreign equity holders, international capital markets, etc. ECBs from unrecognized sources are not allowed. ECBs can be raised by all kinds of entities except individuals, trusts, and non-profit organizations subject to satisfaction of necessary conditions. However, financial intermediaries such as banks, financial institutions and nonbanking financial companies have been temporarily prohibited from raising ECBs under all the available windows due to India’s burgeoning foreign exchange reserves which are currently more than the $100 billion mark. The second restriction that has recently been imposed is that no financial intermediary (viz. a bank, DFI or NBFC) will be allowed to provide guarantees in favour of overseas lenders, on behalf of their constituents for ECBs being raised by them. There are three policy windows under which ECBs packaged as loans from overseas lenders can be raised—(a) the automatic route, (b) the RBI approval route and (c) the Government approval route. The automatic route is available to all eligible corporates without any prior approvals for raising ECBs from the RBI. The domestic borrowers are entitled to

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enter into loan agreements with overseas lender(s) for raising fresh ECB with average maturity of not less than 3 years for an amount upto $20 million and for refinancing an existing ECB, provided it is in compliance with both the ECB guidelines framed by the Ministry of Finance, Government of India, and the regulations/directions/circulars issued by Reserve Bank in this regard. The corporate shall ensure that they raise ECB from an internationally acceptable and/or recognized lender, such as export credit agencies, suppliers of equipments, foreign collaborators, foreign equity holders, international capital markets, reputed international banks and financial institutions, etc. Further, the loan should be organized through a reputed merchant banker registered with the regulatory authorities of the host country, viz., USA, Japan, EU countries, Singapore and such other countries as may be notified from time to time by the Government of India. The lenders should be recognized and registered in the host countries for the purpose of extending international finance. Under the automatic route, the borrower has the sole responsibility to ensure that the ECB is raised in conformity with the ECB guidelines and the Reserve Bank regulations/directions/circulars. Corporates will also be permitted to make necessary drawdowns under the automatic route without prior permission from the Reserve Bank. Under the automatic window, the borrowers may utilize the funds for general corporate objectives without any end-use restrictions excepting investments in stock markets and in real estate sectors. However, ECBs raised for project related rupee expenditure must be brought into the country immediately except as allowed to be parked outside India by the RBI. The RBI allows the funds to be parked in a designated account abroad and utilized for the foreign currency requirements under the proposed end use. Opening of such foreign currency accounts for parking ECB proceeds temporarily, pending utilization, will require prior approval of the RBI. Similarly, ECBs meant to finance import of capital goods should be utilized for such purpose at the earliest. The automatic route is available for ECBs in the range of $20 million to $500 million with a minimum average maturity of 5 years. The Exchange Control Department of the RBI is empowered to sanction approvals under this window. The RBI approvals are governed by the Foreign Exchange Management (Borrowing and Lending in Foreign Exchange) Regulations, 2000, as amended from time to time. ECBs exceeding $500 million will be permitted for the following end uses only: (a) financing import of equipment and (b) to meet foreign exchange needs of infrastructure projects. The following sectors have been recognised as ‘infrastructure sectors’ under the ECB guidelines for this purpose—(a) power, (b) telecommunications, (c) railways, (d) roads including bridges, (e) ports, (f) industrial parks and (g) urban infrastructure consisting of water supply, sanitation, and sewage projects.

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For ECBs exceeding $500 million, the special approval route of the RBI has to be adopted. For this purpose applications need to be made to the RBI and these would be cleared by an Empowered Committee. The end use restrictions as mentioned above apply to ECBs approved under this route as well. Long-term ECBs with eight years of average maturity will be outside the quantitative ceilings though such borrowings have to go through the approval mechanism as stated above. Funds raised under this window will not be subject to end-use restriction other than that relating to investment in stock market and real estate activity. All ECBs shall be subject to the following revised maximum spreads over six months LIBOR, for the respective currency in which the loan is being raised or the applicable benchmark(s), as the case may be:

Type of ECB

All-in cost ceilings over six month LIBOR

Automatic Route Three to five year maturity

200 basis points

More than five year maturity

350 basis points

Approval Route Three to five year maturity

200 basis points

More than five year maturity

350 basis points

Corporates are eligible to raise ECB loans for project finance relating to infrastructure and other greenfield projects, up to 50% of the project cost as appraised by a financial institution or a bank. Higher allocation may be considered for infrastructure projects on the merits of each case. Similarly, in the case of projects set up as 100% EOUs, the allocation is higher at 60% of the project cost. In addition, the promoters of a project and their holding companies can raise ECBs to the maximum extent of $200 million to finance their equity investments in a subsidiary/joint venture company for implementing infrastructure projects. These ECBs can be used even to finance pure rupee expenditure on the projects and not necessarily the foreign exchange component. In cases where ECBs have been raised for meeting rupee expenditure under automatic route, the authorized dealer has to ensure at the

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time of drawdown that the forex exposure of the borrower is hedged, unless there is a natural hedge in the form of uncovered foreign exchange receivables. In continuance of the above, ECBs can also be packaged for the purpose of rupee denominated structural obligations as credit enhancements from international banks, financial institutions, JV partners and others. In case the debt is to be raised by more than one promoter for a single project, the total quantum of loan by all the promoters should not exceed $200 million. The average maturities of ECBs shall be as follows: �

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Minimum average maturity of 3 years for ECBs under the automatic route, except in the case of 100% EOUs. Average maturity of at least 5 years in other cases.

The average maturity shall be computed as the weighted average of all disbursements, taking each disbursement individually and its period of retention by the borrower. ECBs packaged as suppliers’ credit, i.e. short-term loans where the credit for imports into India is extended by the overseas supplier for a period of more than six months, requires prior approval of the Reserve Bank. Similarly, buyers’ credit, viz., where short-term loans for payment of imports into India is arranged by the importer from a bank or financial institution outside India for maturity of less than 3 years, also requires prior approval of the Reserve Bank. However, these can be approved by authorized dealers provided: � �

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The credit is being extended for a period of less than 3 years The amount of credit does not exceed US $20 million, per import transaction The ‘all-in-cost’ per annum, payable for the credit does not exceed LIBOR + 50 basis points for credit upto one year and LIBOR + 125 basis points for credits, for periods beyond 1 year but less than 3 years, for the currency of credit Transactions not meeting the above criteria have to be approved by the RBI.

Until the RBI recently brought in restrictions, ECBs in the past had mostly been structured as foreign currency loans from overseas lenders, backed by financial guarantees from domestic lenders. This is so because, the foreign lenders are averse

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to credit risk on Indian borrowers with the collaterals being situated in India. If the Indian lender assumes the credit risk, the overseas lender performs the financing function. This also enables finer pricing of the ECB due to the credit enhancement from the Indian lender. Under the new policy guidelines, no financial intermediary (viz. a bank, financial institution or NBFC) will be allowed to provide guarantees in favour of overseas lenders, on behalf of their constituents for ECBs being raised by them.

Debentures and Other Debt Securities Project financing through debentures, bonds, and other debt securities is possible in some cases. While term loans are provided by financial institutions and banks, debentures and other debt securities can be placed privately with institutional investors or issued through private placement or through a public offering, as per the guidelines of the Securities and Exchange Board of India. The terms for issue of such debt securities through the public issue route are discussed in Chapter 7 while that through private placement is discussed in Chapter 11. Such securities can also be issued through the ECB route in overseas capital markets. These aspects are discussed in Chapter 8.

13.2.6 Project Financing through Equity The primary source of equity for a project are the ‘promoters’, which term includes the promoting companies, group companies, other business entities owned or controlled by the promoters, family, friends, relatives, and associates of the promoters. Financial institutions and banks stipulate a minimum level of promoters’ contribution in order to finance a project. Other sources of equity finance for a project include consortium partners, strategic investors, collaborators, JV partners, and qualified institutional buyers who are in the nature of financial investors. Financial investors who finance projects through equity route could be institutional investors such as Indian and foreign financial institutions, multi-lateral institutions such as IFC Washington, Exim Bank of US, Exim Bank of Japan, and other organizations, domestic and foreign venture and private equity funds, other foreign investors, non-resident Indians and others. Equity may be issued to investors under the public offer route or the private placement route. Public offers are discussed in Chapter 5 and private placements are discussed in Chapter 10.

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13.3 Project Advisory and Transaction Services Provided by Investment Banks Investment banks have a significant practice line in project advisory and transaction services though it may be given a different nomenclature in each bank. Most projects in recent times have used the services of investment banks in this area of high finance. Broadly, the range of services entails the following. �

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Bid advisory services in projects wherein the project is awarded to a particular consortium through a bidding process Advise in formation of consortium and structuring consortium agreements Advising in shareholder agreements, subscription agreements and equity shareholding pattern

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Advise in entering into other key project contracts

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Structuring the means of finance for the project

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Conduct a preparatory internal due diligence for commencement of fund raising process for the project Preparation of Project Report, loan applications and associated documents Act as ‘arranger’ on behalf of the client for representation and negotiations with lenders and equity investors Management of private placements/public offers of debt or equity Achieve financial closure with the best terms and in the best possible time for the project.

The above mentioned service areas are elaborated below:

13.3.1 Bid Advisory Services Bid advisory is a significant service area not only because it involves depth of advisory work but from an investment banking perspective, it helps in associating with a client quite early in a project plan. Investment banks practice bid advisory services from both sides of the coin, i.e. they can advise a potential bidder for a particular project or they can be advisers to the agency that has called for the bids. If they represent a potential bidder, the assignment continues for provision of project

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advisory services, if the client succeeds in the bid. If the bid is unsuccessful, the assignment could get terminated at that stage unless there are alternate plans. If the investment bank represents the institution that has called for the bids, it becomes an assignment specific to the bid process but is more involved than advising a potential bidder. Both these aspects are discussed below. If the investment bank is advising the institution calling for the bids, the scope of work would involve, to start with, looking at the policy issues and examining the statutory implications of the proposed project. Sometimes, legislative amendments may have to be brought in or a government notification under the existing framework of law may be warranted. In some other cases, an exemption from income tax/sales tax liability or special subsidies and other incentives may be required to promote a particular sector and make it attractive for private investment. The investment bank would be required to advise its client accordingly. This could involve liaison with government departments or with the concerned administrative ministry. Suitable presentations have to be made to the officials concerned, to impress upon them the need to create a suitable policy and statutory framework for the project. Once the policy and fiscal issues are sorted out, the project has to be suitably structured for private sector participation. In cases where the government or the institution promoting the bids has to put in an equity contribution to build the confidence of the private partner, it has to be advised accordingly. The total structural framework for the project either on a BO/BOO/BOT/BOOT or other appropriate model, cost parameters, revenue model, revenue sharing or other appropriate mechanism for private participation, licence fee, completion time, eligibility criteria for private bidders and other important parameters of the project need to be finalized in consultation with the client. The investment banker has to bring in his rich experience in similar projects white advising his client on these critical areas of project structuring. The next area of work would be in connection with the bidding process. This would require preparation of the following documents and other essential information: �

�

A preliminary information memorandum calling for ‘Expression of Interest’ (EOI) that spells out the eligibility criteria for enabling interested parties to put in the EOI. The detailed Information Memorandum that would be provided to all eligible bidders who have put in the EOI, providing enough details on

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the project so as to enable all eligible bidders to bid appropriately for the project. �

�

�

The ‘Bid Document’ that provides for all the information regarding the bid to be submitted by each eligible bidder. A draft Licence Agreement that the successful bidder would be required to enter into with the institution calling for the bid. Making ready the ‘Data Room’ that would contain all other material documents, due diligence files, and information that have to be made available for inspection by eligible bidders before they put in the bids.

The preparation of the above documents requires careful analysis of the project variables to bring out the requirements as envisaged by the client. Firstly, it requires in-depth financial modelling to arrive at the appropriate financial mechanism to invite quotes for the bid. In addition, the licence agreement would require careful legal drafting so that all the critical issues are addressed adequately and the rights of either party are protected. This agreement being a key project contract needs to stand the test of scrutiny later on by financial investors in the project. For this purpose, the investment bank either uses in-house legal expertise or outsources the same from a law firm to draft the licence agreement. The bidding process itself requires, to start with, calling of EOIs, examination of the EOIs and providing the Bid Document and other materials to eligible bidders. Thereafter, eligible bidders who have put in the EOI are allowed to access the data room for due diligence so as to satisfy themselves in all respects with sufficient information before putting in the bids. Sometimes, a pre-bid conference is held by the institution to clarify the doubts or provide additional information on a one-to-one basis. The opening of bids is conducted in an open house, shortly after the time for submission of bids has expired. Thereafter, the bids are opened and on the advice of the investment banker, the client announces the successful bidder. This requires detailed examination of the bid documents with regard to bid price, which is conducted by the investment banker. Thereafter, the documentation by both parties is completed, which concludes the assignment for the investment banker. On the other hand, if the investment bank is advising a potential bidder, the profile of work would be different as it comes in from the opposite side. The assignment would begin with a detailed scrutiny of the EOI to ascertain eligibility criteria and other conditions for bidders. In many cases, bid advisory would also involve

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putting in place a consortium to meet the eligibility criteria in terms of minimum net worth, past track record, technical and managerial competence. This would require a partner search on behalf of the prime bidder so as to build the consortium. Therefore, the investment banker takes on the primary task of partner identification and consortium building before the bid advisory work begins. This would entail an elaborate process of inviting expression of interest by private floatation of finely crafted information literature on the project and the prime bidder. Thereafter, the potential partners are short-listed and through detailed negotiations, one or more suitable partners are finalized. Appropriate shareholder agreement/collaboration agreement and other necessary documents are then drawn up, keeping in mind the requirements for the bid and the inter-se understanding between the consortium partners. The investment banker plays a critical role in working out shareholding patterns, mutual rights and obligations among the consortium partners, exits and termination clauses, management pattern and pre-emptive rights of shareholders mutually. These clauses are critical in all shareholder agreements and would require expert drafting and legal advice apart from investment banking inputs. The investment bank could work closely with a law firm in putting together these critical documents. In most projects involving global bidding, consortium building involves extensive work for the investment banker as some of the consortium members have to be identified from other countries. In addition, the agreements for foreign investment and/or technology transfer would require prior approvals from the Government of India. The next step in bid advisory for a potential bidder would be to advise the client on the financial parameters that would become decisive for the bid to be successful. This requires a due diligence to be conducted on behalf of the client by visiting the ‘data room’ and examining all the information provided therein about the project. The investment banker has to use his business savvy in ascertaining the mood of the institution that has invited the bids and their expectations. At the same time, the bid should make financial sense to his client. Also, the bid should be competitive enough to make it successful. Keeping all these factors in mind, a bidding strategy is developed and the bid document is prepared accordingly. If the bid is successful, it leads the investment bank to the next stage of advisory services, i.e., to provide project advisory services for implementation of the project. This is discussed subsequently. However, in some cases, successful bidding could lead to another type of transaction wherein one consortium partner looks to exit the venture. Here again, the services of the investment banker would be required to identify a suitable new partner to replace the exiting partner and to work out an agreeable deal for the sell off.

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13.3.2 Project Advisory Services Project advisory services commence from the stage of project conceptualisation. However, in the case of projects that are awarded through a bidding route, if the investment banker has already represented the successful consortium at the bid advisory stage, some of the project advisory work would have already been completed. This relates to work in putting the project consortium in place and completion of documentation for some of the key project contracts. In projects wherein bidding is not involved, the investment banker starts his assignment with partner search and consortium building if necessary, or with advice on concluding key project contracts. Normally, as soon as the assignment is mandated, the investment banker does a quick review of the project to ascertain the gaps in project structuring from a fund raising point of view and starts to advise the client from there. This would also require an examination from a statutory standpoint to list out all the key statutory clearances required for the project and determine at what stage each of such clearances becomes mandatory to proceed further in the project implementation. This advice is critical since some of these clearances are a pre-requisite for attaining financial closure. Therefore, the client needs to be advised well in advance to commence work on this front so that they would be in place by the time financial commitments become forthcoming for the project. The next stage after putting in the proper project structure would be to prepare a check list of information required for preparing the fund raising literature and offering materials. This check list is provided to the client and with the help of personnel from the client’s office, all the required information is collated. As a part of this exercise, the financing plan for the project is finalized to be put forward to lenders and investors. The following points need to be kept in mind with regard to the financing plan. �

The financing plan should be in line with institutional norms on promoter contribution including core promoter contribution, permissible debt equity ratio keeping in view the industry and specifics of the project, and regulatory issues that would govern the debt and equity finance proposed to be raised for the project. Institutions and banks have internal guidelines and industry specific norms that govern their appetite for term lending in general and the quantum of debt acceptable in a project in particular. Presently all greenfield projects with the exception of infrastructure projects are being looked at with a debt–equity ratio (DER) of 1:1. In infrastructure projects the DER can go up to 2.33:1 depending on the risk perception

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and projected financials. Even in infrastructure projects, if the promoters do not profess a creditable track record, the acceptable DER may not exceed 1.5:1. �

�

The statutory provisions governing various sources of finance have to be considered while drawing up the financing plan. In recent times, corporate law has seen a host of new developments to keep pace with the changes in financial markets resulting from liberalization and rapid strides in technology. The comparative advantages and disadvantages of debt and equity financing have to be evaluated, including the tax implications thereof. The third dimension which is of particular relevance to investment bankers is to package the debt and equity suitably through appropriate structuring of the instruments to be offered. If the debt is to be financed otherwise through term loans, suitable debt instruments such as floating rate notes, zero coupon bonds, convertible debentures, etc., can be devised. If such instruments are proposed to be offered through market floatation, SEBI parameters also need to be kept in mind. In all such cases, the tax and stamp duty implications have to be taken into account as they tend to influence the cost of debt. Similarly, equity would also need to be structured appropriately into equity shares, preference capital, long-term unsecured loans (quasiequity) and non-voting shares (where necessary).

Once the necessary information and financial plans are available, the required documents for fund raising need to be prepared. It is normally necessary in project financing to prepare a Project Feasibility Report backed up by technology report, market survey and feasibility, environmental impact and assessment and other necessary reports that are specific to each project. These reports need to be enclosed with the relevant Loan Application form so that all the details necessary for appraisal are furnished. During the course of appraisal, several documents and other information should be furnished as well, depending on the appraisal requirements of the lender. Some of the common information to be furnished is provided in the Annexure to this module. If the fund raising has to be done from overseas markets, a separate set of fund raising literature needs to be prepared, based on the type of fund raising and the compliance requirements in the relevant markets. In the fund raising program, the investment bank could be the ‘arranger’ for raising debt or equity or both for the project. In larger projects involving significant overseas debt, it is customary to appoint a global arranger for the foreign currency debt and a domestic arranger for the domestic debt. In some cases, there could be

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the same investment bank for both segments of debt fund raising if necessary expertise is available in both markets. The overseas debt, known as ‘external commercial borrowing’ can be raised either through the ‘syndicated loan’ route or through a bond offering in the overseas market. If the quantum of such debt raising is quite substantial, there could be a ‘lead arranger’ with other syndicate members who together underwrite the entire loan or the bond issuance. In other words, between themselves, they arrange the loan through other lenders and to the extent they cannot do so, they step in to the shoes of lenders to the project. Therefore, underwritten loans can only be arranged by universal banks that are in the loan business as well. In bonds raised through public offering, the global merchant banker manages the offer according to the local laws in the respective markets. In the case of raising of equity, the process could be either private or public. If private equity is envisaged, the process is as described in Chapter 10 and if public issue is envisaged, it has to comply with several parameters. These are discussed in detail in Chapter 5. If domestic debt has to be raised through Indian financial institutions and banks, it would require representing the client in the appraisal process till the loan sanctions are received. Most application forms of financial institutions and banks, for seeking term loan assistance, contain provisions for furnishing detailed information about the borrower company’s business aspects and the purpose of the loan. In case of project assistance, the format covers all important aspects such as the following: 1. Promoters’ background and experience 2. Details of group companies, if any 3. Board of Directors and management structure 4. Project location and details of the proposed site 5. Existing and proposed products, potential users and competing products in the market 6. Installed capacity or proposed capacity 7. Proposed technology and manufacturing processes to be adopted 8. Technical arrangements, availability and arrangements for utilities such as power, water, steam, compressed air and effluent treatment, environmental factors and other technical details

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9. Proposed marketing and selling arrangements 10. Details of cost of the project and the break-up thereof 11. Proposed means of financing 12. Financial details of the company with projections for five years postimplementation of the project. A lot depends on the preparedness of the investment banker and his client company in the appraisal process to determine the time involved in financial closures. If the critical issues are anticipated well in advance and suitably addressed, financial closures can be much faster than they would be otherwise. The investment banker plays a critical role in every stage of the syndication process, in getting the best terms for his client and in assisting the lenders and equity investors in their appraisal and due diligence process.

RBI Guidelines on Appraisal and Financing of Infrastructure and Other Projects 1. Banks and financial institutions should satisfy themselves that the projects financed by them have income generation capacity sufficient to repay the loans together with interest. They should also satisfy themselves that the projects financed by them are run on commercial lines, i.e., involving commercial considerations such as identifiable activity and cash flow considerations. 2. Banks and financial institutions should have requisite expertise for appraising technical feasibility, financial viability and bankability of projects, with particular reference to risk analysis and sensitivity analysis. In financing of projects structured as SPVs, identification of various project risks, evaluation of risk mitigation through appraisal of project contracts and evaluation of credit-worthiness of the contracting entities and their abilities to fulfil contractual obligations will be an integral part of the appraisal exercise. 3. Often, the size of funding requirement would necessitate joint financing by banks and financial institutions or financing by more than one bank under a consortium or syndication arrangements. In such cases, participating financial institutions and banks may, for the purpose of their own assessment, refer to the appraisal report prepared by the lead bank or financial institution or have the project appraised jointly. Banks and financial institutions

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should, however, ensure that the appraisal in all cases is completed within a time bound period and repetitive and sequential appraisals by several institutions are avoided. 4. Banks may finance projects by way of rupee term loans, deferred payment guarantees, foreign currency loans, etc. or investment in infrastructure bonds issued by the project promoters or financial institutions. Banks can also issue financial guarantees in favour of other banks or financial institutions for the loans extended by them, provided that the issuing bank also takes a financing share in the project and the amount of the guarantee does not exceed twice such share. 5. Banks and financial institutions may finance a project upto a maximum limit of 25% of the net worth of the borrower company and further restricted to a group exposure of not more than 50% of the cumulative net worth of all the group companies. A relaxation of 10% in the group exposure norm is provided for infrastructure projects. 6. There is no generally prescribed debt–equity ratio for project financing. Banks have to evolve them specific to each bank or each project based on the appropriateness. There is also no prescribed maturity for term loans. Individual banks are free to fix them based on their liability profile. The financial institutions address lender’s risk in a project through a suitable security mechanism after the project has been appraised and found to be viable to their satisfaction. During the appraisal the key project contracts are verified to ensure that the rights of the project company vis-à-vis third parties are adequately protected and that appropriate degree of risk has been dissipated to the relevant consortium members. More specifically, the following clauses would inter alia be examined: �

Duration of contract/renewal

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Payment mechanism

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Liquidated damages

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Force majeure (Act of God)

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Dispute resolution mechanism

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Termination provisions

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Permission to assign the contracts

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Management issues/shareholders rights.

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The security package would address the issue of limited recourse to the project promoters as well. Generally, the security package consists of all or some of the following agreements and contractual arrangements. �

Special conditions for the sanction of financial assistance

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Agreement for common documentation among all lenders

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Issue of power to attorney/letter of authority in favour of the lead institution

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Execution of common documents such as Loan Agreement, Deed of Hypothecation and Equitable Mortgage by deposit of title deeds

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Escrow Agreement and Hypothecation

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Trust and Retention Account

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Guarantee from sponsors/state and central government guarantees

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Sponsor Agreement — This agreement defines the recourse to be applied to the promoters for providing support to the project in addition to their financial stake in the project. The responsibility of achieving financial closure, bringing in promoters contribution, financial guarantees or contingent equity support, and meeting cash losses in initial years are generally the additional risks assumed by the promoters.

To sum up, the overall assessment of an investment banker’s performance in project advisory services is to assess the cost and terms at which funds have been raised for the project, the profile of the lenders and equity investors and the time element involved in the attainment of financial closure. The investment banker role in project advisory services usually comes to a close on attaining financial closure and receiving commitment letters from all lenders and equity investors.

13.4 Financial Closures—Key Issues for Fund Raising 3 ‘Financial close’ is a term used to denote the completion of tying up the funds required for a project. This is a key milestone in the implementation of a project. In large sized projects, financial closures take a long time due to several factors that come in the way of making the project structure fundable. Most of these relate to finer aspects of contractual arrangements between various parties related to the project. Some of these issues need to get sorted out at a policy level by the government or other statutory agencies that may be associated with the project. Therefore,

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the financial commitments by institutions get held up until the required arrangements are put in place. In present times, financial closures are known to be take an unduly long time especially in the infrastructure sector where a lot of policy matters are still being evolved. For example, it took nearly three years for the institutions to come up with a model power purchase agreement to be signed by all independent power producers with the respective state electricity boards. Similarly, the restructuring of state electricity boards is now identified as a pre-requisite for a viable alternative for producing power in the private sector. These issues can take a very long time to get resolved and till such time that the industry scenario becomes more understandable, financial closures would get affected. Generally speaking, for effecting timely financial closures, the following points may be kept in mind. �

�

�

�

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In structuring the means of finance for the project, it would be advisable to look at a solution that would be a trade off between a financing mix that would bring about complete optimization of cost of funds and a mix that would be the quickest to financial closure, albeit at a much higher cost. The feasibility of a particular financing mix needs to be kept in mind in terms of its acceptability with institutions, the cost of raising such finance and the time involved. In some cases, a prior rating for a particular structure by an independent rating agency would become mandatory before the structure can be funded. In the financing structure, there could be a need to provide credit enhancements that would de-risk the financing institution and make the project more attractive. Such mechanisms greatly increase the bankability of the project and reduce the time involved in financial closure. If the financing structure involves market related offerings such as private placement of equity or structured debt, rights or public issue, the market conditions and appetite for such instruments from investors, as well as the timing of such floatation, has to kept in mind to determine the time required for financial closure. Market related offerings carry the risk of devolvement leaving a gap in the financing of the project. Suitable underwriting or other back up arrangements would be required in such cases. These would involve additional cost and time to get tied up.

Project Advisory Services �

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Financial closures and disbursements often get bogged down mid-way in the implementation due to cost overruns or reappraisals, leading to increase in the originally envisaged costs. To a large extent the resourcefulness of the promoters, both in terms of their own liquid resources and their capability to raise funds play a major role in effecting faster financial closures. Debt financing through institutional sources often involves a lot of time. It is better to start the process early. At the same time, it should be ensured that the project is not too premature for the institutions to take a view on the same. In some cases, it may be necessary to approach more than one lending agency and get the project appraised in parallel. This process has the benefit of a better success rate as it also ensures that if syndication of the debt is required, it would be faster, since more than one lender has appraised and taken a favourable view on the project.

Notes 1. Please refer to IECD Circular No. 26 issued in April 1999. 2. The external commercial borrowing policy of the Government of India is subject to frequent changes based on the economic outlook and other parameters. Readers are advised to read the discussion given in this book in the context of subsequent changes, if any. The discussion herein is based or A.P. (DIR Series) Circular No. 60 dated January 31, 2004 issued by the RBI. 3. From ‘Project Financing—Perspective on Structuring and Institutional Appraisal’— Pratap G. Subramanyam, part of the course material for the CFM Programme conducted by the Center for Financial Management, Bangalore. 4. Source : The Economic Times dated 14th February and 11th May 2003. 5. This case study has been prepared by the author from a collection of published information including press reports on the Dabhol Project from various sources spanning a period of almost three years between October 2000 and June 2003.

�

Select References 1. International Project Analysis and Financing by Gerald Pollio, Macmillan Press. 2. Project Financing, Asset-Based Financial Engineering by John D. Finnerty, John Wiley and Sons.

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3. The Law and Business of International Project Finance by Scott L. Hoffman, Kluwer Law International. 4. Long-Term Debt Financing by Pratap G. Subramanyam and Vani Pratap, KSCA Publication. 5. Project Financing—Perspective on Structuring and Institutional Appraisal by Pratap G. Subramanyam for the CFM course conducted by Centre for Financial Management, Bangalore. 6. Issues of ‘Analyst’ published by the ICFAI Press. 7. News Reports and articles in the Economic Times and other published sources.

� Self-Test Questions 1. What are the main project financing structures? How are these different from other forms of corporate financing? 2. List out the key areas of project structuring and discuss the key project contracts that shape a project structure. 3. Explain a ‘financial close’ for a project. What are the sources of project finance? 4. What are the elements of project advisory services? How is an investment banker positioned with regard to such services? 5. What are bid advisory services? How are they different from project advisory services?

� Annexure I

� INFORMATION TO BE FURNISHED FOR TERM LOAN APPRAISALS ALONG WITH THE PROJECT REPORT/INFORMATION MEMORANDUM

Most of the financial institutions both at the state and national level have very detailed application forms which seek elaborate details of various aspects of the borrowing company, the promoters and the project. The loan application can be prepared by attaching additional enclosures wherever necessary or by preparation of a separate Project Report to the particular columns in the application form. The standard information to be furnished by the borrowing company is as follows:

Particulars a. Name of the company, constitution, registered office, list of the promoters, shareholding pattern, paid up capital, licences and installed capacity, name of auditors, bankers, location and particulars of production facilities, number of employees etc.

Enclosures 1. Memorandum & Articles 2. List of Directors 3. IT and WT returns for the past three years of the company and promoters 4. Banker's references 5. Board resolutions 6. Shareholder resolutions for 293(1)(d)

b. Details of the present activities of the company, past financial performance, details of associated companies and their performances

1. Past audited accounts for three years of the company and associated entities 2. Details of existing term loans ,unsecured loans and existing charge holders 3. Group company details with Annual Reports

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c. Promoters and Management structure and profiles of whole time directors and key management personnel

1. Details of Shareholders agreement and copies thereof 2. Details of Board of Directors, management and organizational set-up 3. Copies of Joint Venture/technical collaboration agreement, if any 4. Banker's report on Foreign Collaborator 5. Employment contracts with MD/Whole time directors 6. Documents to substantiate the proposed promoter's contribution 7. Names of promoters who would furnish personal guarantees and net worth statement of promoters

d. Particulars of the project 1. Cost break-up 2. Proposed financing pattern 3. Products and uses 4. Key raw materials and sourcing arrangements 5. Location and justification 6. Technology arrangements and equipment sourcing 7. Manpower requirement and availability 8. Details of utilities and arrangements 9. Schedule of implementationStatutory approvals obtained and to be obtained.

1. Copies of Statutory approvals such as RBI/FIPB approval, industrial license if required 2. Clearance from the Ministry of Environment and Forests for larger projects costing above Rs. 1500 crore 3. Other regulatory clearances from CEA/ TRAI/ERC or other such authorities 4. State level government approvals and application for NOC from Pollution Control Board 5. Key documents such as title deeds of land, location map, copies of key project contracts, collaboration or technology agreements

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6. Back-up documents justifying the estimation of cost of the project such as civil work estimates, quotations for machinery, etc. 7. In case of second hand machinery, a chartered engineer's certificate regarding the residual life of the machines 8. Fuel supply/raw material sourcing agreement 9. Details of tie-up for marketing, firm enquiries if any and buy-back agreements 10. Sources of market information 11. Details of orders on hand, supply schedules, etc. 12. Details of effluents produced and measures for treatment and discharge e. Financial workings for the project justifying the viability of the project

1. Detailed basis of assumptions made for the workings and back-up statements.

� Annexure II

� CASE STUDY—PETRONET LNG4 Petronet LNG Ltd (PLL) is one of the biggest grassroot projects being set up in India presently. PLL is setting up India’s largest import and re-gasification terminal for Liquified Natural Gas (LNG) at Dahej in Gujarat. PLL was created to participate in the development of infrastructure for the import of LNG and upstream and downstream projects in the LNG value chain. Once commissioned, it is expected to make a huge impact on the economics of power generation business in India and in fertiliser pricing. The company’s initial mandate is to set up two LNG terminals, at Dahej (5 mmtpa) and at Cochin (2.5 mmtpa). PLL is the SPV company set up to implement the projects. PLL has signed a 25 year contract with Ras Laffan Liquified Natural Gas Company for the supply of LNG, which is the procurement contract for the project. Mitsui & Co. of Japan would be acquiring two large LNG tanker vessels to transport the LNG across the sea to India at Dahej where the LNG will be re-gasified. Thereafter, the existing Rs. 3000 crore HBJ pipeline belonging to GAIL will be upgraded to evacuate the gas from the Dahej terminal over a 610 km stretch to reach its customers as far north as Uttar Pradesh and Punjab. Fertilizer majors KRIBHCO and IFFCO would also tap LNG from the pipeline in between. For the pricing of LNG supplies, though it depends on the JCC index, PLL is negotiating for supplies with a floor price of $16 per tonne to a cap of $22 per tonne. The project is expected to commence operations in 2004. The main promoters of PLL are the giants of the Indian oil and gas industry, i.e. Indian Oil, BPCL, GAIL and ONGC and the foreign partner is RasGas of Qatar. The government of Gujarat is also an equity investor in the project apart from Gaz de France and other financial investors. The total project cost estimated to be around Rs. 2700 crore would be financed in the debt–equity ratio of 70:30. Out of the total equity component of Rs. 800 crore, the four Indian oil company promoters, who hold 12.5% each in the project equity, have brought in Rs. 132 crore by May 2003. The other investors have brought in about Rs. 132 crore for a total equity in excess of Rs. 250 crore.

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The Lead Arranger for the company’s debt raising programme is SBI Capital Markets Ltd (SBI Caps), one of India’s leading investment banks. SBI Caps was also mandated to arrange the $210 million Letter of Credit facility to PLL towards gas supply payments for the project. SBI Caps had earlier provided PLL with Rs. 325 crore of short-term loan for the project. The debt syndication including the working capital tie-up has been completed. The lead institution for the debt component is the Housing and Urban Development Corporation Ltd (HUDCO). The total long-term debt component for the project is Rs. 1900 crore. HUDCO was expected to take a share of Rs. 500 crore in the project, its single largest exposure in project finance so far. The balance debt has been tied-up with a consortium of Rs. 19 banks led by State Bank of India. The total loans tied-up so far amount to Rs. 2145 crore including a working capital component of Rs. 250 crore to meet the requirements for LNG payments. There is also a Rs. 750 crore stand-by Letter of Credit facility for discharging payment obligations for the purchase of gas and ship charter charges. The long-term loans amounting to Rs. 1900 crore would carry an interest rate of 9.25%. The loans would be repayable over a period of 12 years with an initial moratorium of 30 months. The project so far has been implemented to the extent of 70% of the construction through short-term loans amounting to around Rs. 1400 crore, which would be repaid out of the long-term loans. SBI Caps proposes to convert its short-term loan exposure into a long-term loan. The work on the project started in 2001 and PLL could not tie up the long-term debt immediately. The proposed lenders wanted to see some real structures before committing themselves to a longer period of exposure. Therefore, pending financial closure for the project, PLL went ahead and raised short-term loans to begin the construction work. After two years, with a good project structure and with substantial progress in construction and that too marginally ahead of schedule, PLL has been able to achieve financial closure.

� Annexure III

� CASE STUDY—DABHOL POWER COMPANY5 (Corporate India’s most controversial project and India’s most well-engineered and syndicated project financing deal)

Background In 1992, pursuing a policy of economic liberalization, the Government of India, under the then Prime Minister Mr. P. V. Narasimha Rao, announced it would open up the power and electricity sector to foreign investment. Houston (in Texas, USA) based Enron Corporation was invited to set up a power project in India as part of the liberalization drive. In the 1980s, Enron was a regional Texas company providing pipelines for transporting natural gas. Traditionally viewed as a natural gas and oil company, it began to develop power projects as an outlet for its natural gas in the early 1990s. Within a short period Enron was a global industry leader in the development of energy infrastructure.

The MoU for Dabhol Project On a three-week trip abroad, during May and June 1992, a senior delegation of the Government of India (GOI) met with Enron officials and thereafter announced that the company was interested in building a power plant in India. On June 10, 1992, almost immediately after the delegation’s trip, the GOI’s Power Secretary informed the Maharashtra State Electricity Board (MSEB) that a group of Enron officials was coming to survey land along the coast of Maharashtra for a proposed power project. Five days later, representatives of Enron and General Electric arrived in New Delhi and met with officials of the Union Government. Two days later, the company delegation arrived in Mumbai and reviewed sites along the coast. Following their survey, they met with representatives of the Government of Maharashtra (GOM), and on June 20, 1992, a Memorandum of Understanding (MoU) with the GOM was signed to build the Dabhol Power project.

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The Dabhol Power Corporation The Dabhol Power Corporation (DPC), was started as a 100 percent foreign-owned, private limited liability company incorporated in India by Enron, Bechtel Enterprises Holdings and General Electric Capital Structured Finance Group. The three partners controlled DPC through a chain of companies based in Mauritius, a tax haven. Enron held 80 percent of the shares in DPC, while Bechtel and GE holding 10 percent percent each. In November 1998, the MSEB bought 30% equity in the DPC for $137 million. The MSEB raised most of the money through two bond issues. Its option to buy the stake had been a part of the renegotiated agreement in 1995. With MSEB joining the DPC, Enron’s stake dropped to 50 percent, with the remainder shared equally between GE Capital and Bechtel Enterprises (10 percent each). The MSEB’s investment was made through Maharashtra Power Development Corporation Ltd (MPDCL), a company launched by the MSEB earlier in 1998. The board purchased the equity from Enron Mauritius Company, the investment company of Enron International. However, after the financial closure for the second phase of the Dabhol project, the MSEB’s stake in DPC was diluted to about 15 percent, with Enron’s stake increasing to 65 percent.

The Dabhol Power Project Dabhol Power Corporation (DPC) was the SPV set up to implement the integrated power project promoted by Enron Corporation of the US with General Electric and Bechtel as the equity partners. This was by far the most ambitious and controversial project in India so far in the power sector. One of the nine mega power projects announced under the fast track route after the opening up of the power sector for private participation in 1992, Dabhol was the first project to be given a counterguarantee by the GOI. Enron US, which declared bankruptcy under Chapter 11 in late 2001, was interested in the project, and agreed with the GOM to develop and maintain the power plant. The development involved a BOO model in which ownership of the facility would be retained for 20 years, with an option for the government to acquire it at that time at a negotiated price. The Dabhol power project, located on the Maharashtra coast approximately 180 kilometers south of Mumbai, has been Enron’s flagship project in India. Dabhol

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Phase I, generating 740 MW of power, began operating in May 1999. When Phase II which was supposed to be completed at the end of 2001 would be ready, Dabhol will generate 2,450 MW of power to become the world’s largest independent natural gas-fired power plant. The DPC project had many firsts to its credit: �

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Fuelled by natural gas, the cleanest fossil fuel available for power generation, the DPC project was to be the single largest power station in India to date, as well as the world’s largest, independent gas-fired power station. It was to see the development of India’s first LNG terminal, including re-gasification, fuel unloading and storage facilities.. It was the first instance in India of the private promoter bearing the fuel supply risk by taking full responsibility for providing the primary fuel and an alternate fuel. DPC was also the first to guarantee operating efficiency over 20 years in advance. It was the first instance of a promoter giving performance guarantees (in this case an average availability Plant Load Factor of 90%) and undertaking to pay penalties if those standards were not met. The project, which was financed on a 70:30 debt:equity ratio, was the first non-recourse project financing in the Indian power sector.

The first phase of the project completed financing in December 1996. A multi-fuel facility, the plant is capable of using either naphtha or distillate in the first phase and was to use natural gas once the second phase was completed.

Enron’s Associated Projects in India Enron India Private Limited (EIPL) is the wholly-owned subsidiary of Enron Corporation, USA. Set up in late 1997, EIPL was engaged in building an integrated energy and communications business in India. The focus was primarily on the four states of Maharashtra, Karnataka, Andhra Pradesh, and Gujarat. Enron was the largest single foreign investor in India’s energy sector. LNG terminal at Dabhol: In 1993, the GOI approved Enron’s $250 million development of a LNG terminal at the Dabhol Power plant site. In 1997, Enron

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received permission to expand the terminal, which would process 5 million metric tons of LNG per year. Enron would transport the re-gasified LNG to its affiliate, Dabhol Power Corporation, for use in its power plant, and the remainder to other bulk users. Enron planned to use the terminal as a base from which to develop a LNG distribution business throughout industrial western India via a pipeline network. Enron held 20-year contracts for 2.1 million tons per year of LNG with Oman LNG (1.6 million tons per year) and Abu Dhabi Gas Liquefaction Company Ltd. (Adgas) (480,000 tons per year). LNG deliveries were expected to commence from the fourth quarter of 2001. Metgas pipeline project: Enron was in the early stages of developing a natural gas pipeline project in Maharashtra. Through its marketing and pipeline affiliates, MetGas would import and re-gasify LNG into the Dabhol terminal. The proposed pipeline would then transport natural gas from Dabhol to customers north of Dabhol. Gas supply agreements (GSAs) were being concluded with industrial and commercial users in Maharashtra. LNG vessel construction joint venture: In January 1999, an Enron affiliate and Mitsui OSK Lines, Ltd. (MOL) signed a joint venture agreement to construct, own and operate a 135,000 cubic meter LNG carrier. The Shipping Corporation of India (SCI) acquired 20 percent equity in the venture in January 2000. The vessel was to be dedicated to LNG supply from the Middle East to Dabhol. The first LNG deliveries were expected in the fourth quarter of 2001. Mitsui was to manage the vessel together with the SCI.

Phase II of the Dabhol Power Project Enron’s financing package for Dabhol Phase II, a complex transaction totalling $1.87 billion, has won international praise as one of the best international project financing deals ever put together. Enron said they faced many obstacles due to India’s uncertain political and economic climate. The $1.87 billion financing includes five loans totaling $1.414 billion and an equity investment totalling $452 million. Indian financial institutions, with the Industrial Development Bank of India (IDBI) acting as lead arranger, provided rupee loans equivalent to $333 million. The participants in the rupee loans are IDBI, ICICI Ltd, State Bank of India (SBI), the Industrial Finance Company of India Ltd and Canara Bank.

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Commercial banks, acting as global coordinators for a $497 million syndicated loan are SBI, ABN AMRO, Credit Suisse First Boston (CSFB), ANZ Investment Bank and Citibank N.A. Canara Bank, Bank of America, Development Bank of Singapore and Credit Lyonnais acted as senior lead arrangers for this loan. The Overseas Private Investment Corporation (OPIC) also provided $60 million in project finance loans. An export credit loan of $433 million was arranged by the Japanese Exim Bank ( JBIC) providing $258 million and commercial banks providing $175 million. The commercial banks are insured by the Japanese Ministry of International Trade and Industry (Miti). Fuji Bank is the agent for the $433 million loan from the Japanese Export Credit Agencies (ECA). In addition, an export credit of $90.8 million was provided by a syndicate loan of $90.8 million from commercial banks. This loan is insured by Office Nationale du Ducroire, Belgium (OND), and ABN AMRO is the agent for the commercial banks providing this loan. Both export credits were provided guarantees by Indian financial institutions. The Phase II of the Dabhol Power Project set many precedents in India: �

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It is the first power project in the country to involve importing liquefied natural gas (LNG) as a fuel source and constructing an LNG terminal. It is the largest cross-border loan transaction executed in India involving the country’s financial institutions, Belgian and Japanese export credit agencies and a number of commercial banks. Altogether more than 40 lenders were involved in the project. It is the largest external commercial borrowing ($1.082 billion) sanctioned by India’s Ministry of Finance. It is the first time Indian banks, such as the State Bank of India and Canara Bank, made loans of US$ 225 million in both dollars and rupees and made guarantees to a project finance venture in India.

Chronological Turn of Events for DPC Although the MoU signed by Enron with the GOM was not a legally binding document, the deal-making process was criticized for its haste, its lack of transparency and the absence of competitive bidding. The process would form the basis for a widespread belief later on that high level maneuvering played a role in the project’s speedy clearances.

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On August 29, 1992, Enron had submitted its detailed application to the GOI’s Foreign Investment Promotion Board for a $3.1 billion project to generate 2,550 MW of electricity fuelled by LNG. The plan had envisaged that the power plant would go on-line in December 1995. On December 12, 1992, the Foreign Investment Promotion Board notified Enron that its project would have to be scaled down to 1,920 MW and split into two phases. The price would be $2.65 billion as opposed to the original $3.1 billion. The company agreed to these terms. On February 3, 1993, the GOI intimated to Enron that its project had been approved and that the GOI would apply for financing to the World Bank and other institutions. The World Bank, however, turned down financing on April 30, 1993. It determined that the project was ‘not economically viable’. It also advised that the project did not satisfy the test of least cost power and it was too large for the power demands of Maharashtra. Despite grave concerns, the Central Electricity Authority (CEA) on November 26, 1993, gave a provisional clearance to the project which would allow it to be finalised. The GOM took this as a final clearance and within a week the final contract—the power purchasing agreement (PPA), was signed between the GOM and the DPC to last for 20 years. Of much concern was the fact that the tariff for power was denominated in US dollars. Thus, regardless of fluctuations in the dollar–rupee exchange rate, the project would always earn the same amount. The agreement guaranteed the company a steady income for the life of the PPA, regardless of demand. Also, the GOM waived sovereign immunity in its counter-guarantee. This meant that if the GOM was unable to pay DPC, the company could potentially seize any state assets in repayment of arrears. Moreover, the GOI extended a similar counter-guarantee in the event the GOM defaulted on its payments to DPC. A counter-guarantee was signed on September 9, 1994, by the Government of India, which by separate action also waived sovereign immunity. Detailed criticism of the MoU was provided in the GOM’s 1995 Report of the Cabinet sub-Committee to review the Dabhol Power Project, which stated: ‘Thus, in a matter of less than three days, a MoU was signed between Enron and MSEB in a matter involving a project of the value of over Rs. 10,000 crore [almost $3 billion at that time], with entirely imported fuel and largely imported equipment, in which, admittedly, no one in the government had expertise or experience. In fact, the file [on the project] does not even show what Enron was—what its history is, business or accomplishment. It looked more like an ad hoc decision rather than a considered decision on a durable arrangement with a party after obtaining adequate and reliable information. Neither the balance sheet and annual accounts of Enron,

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nor any information about its activities, area of operation, its associates, etc., was obtained by the government then, or even later’. After the MoU was signed, the GOM requested that the World Bank review the project to determine what would be required by the companies and the government and to evaluate the MoU. The World Bank team found many irregularities in the agreement and noted that the GOI had not set up an overarching framework within which to privatize power in India. The World Bank’s analysis determined that the government had not provided an ‘overall economic justification of this project’ and, in particular, noted that the MoU required the MSEB to pay the DPC within 60 days, but the company had no limitations on actual supply of electricity, importing fuel, construction, or financing. In other words, the MSEB would have to pay the company for electricity at a prescribed rate, regardless of whether the electricity was actually available. The World Bank thus determined that the MoU was ‘one-sided’ in favour of Enron and encouraged the GOM to ‘verify Enron’s experience’ as an electricity generating company before proceeding with the project. The World Bank’s doubts were echoed by the GOI’s Central Electricity Authority (CEA), whose experts conducted their own analysis of the MoU and also noted many irregularities. Among their findings, they reported that the MoU did not provide specific details about the cost of the project, which was required under Indian law; that the MoU did not specify when the 20-year contract (and its associated payments) would begin, when the electricity would be available, or when the contract was signed; the structure of payments was a ‘departure from existing norms’; the price of power was high; there was no provision to audit the project over time to ensure that the price MSEB paid to the company was commensurate to the actual cost of electricity; the MSEB had agreed to a guaranteed minimum fuel purchase while the fuel supplier was not concurrently bound to provide a minimum quantity of fuel; and the MSEB had not verified whether the price of fuel was economical. Consequently, the CEA concluded that the "entire MoU was one sided" in favour of Enron and its partners. Under the PPA which was re-negotiated in 1995 after the criticism of its first version, the MSEB had to pay the DPC a minimum of $220 million a year for 20 years whether it needed the power produced or not. The contract, which was controversially counter-guaranteed by both the GOM and GOI, threatened to bankrupt the MSEB and the state exchequer itself. The PPA was also designed to pass on the effects of rupee devaluation and rises in international petroleum prices to the MSEB.

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Summary of Concerns From its inception, the Dabhol Power Project had raised controversy. Some of the accusations included the following: �

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There was no competitive bidding for the project—the deal was negotiated exclusively between the GOM and Enron; The project costs and power tariffs were higher than other power projects in India, and the cost of electricity from the DPC project would significantly inflate prices in other areas; The MSEB promised to buy all the high-priced power produced by the DPC, whether there was demand or not, and even if cheaper power was available from its own generating plants. These contracted annual payments to the DPC would amount to half of Maharashtra’s entire budget expenditure; The DPC was assured a post tax return of 16 percent on capital investment, and there was no limit on the capital expenditure DPC could make. Indian economists calculated that the after-tax rate of return would actually be 32 percent, about three times the average rate in the US; There were counter-guarantees from the GOM and the GOI for payments which would have been due to DPC from the MSEB. However, the PPA shielded DPC from Indian jurisdiction as all disputes were to be arbitrated under English law in England;

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An assurance was given that the project would not be nationalized;

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The project authorities carried out no environmental impact assessment;

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Enron paid $20 million as ‘educational gifts’. Critics consider these payments to be graft to get the clearances for the project; The PPA between the DPC and MSEB was initially kept confidential.

In May 1997, the Supreme Court dismissed a petition calling for re-examination of the manner in which the project was cleared by the government. The judges held that it was not in the public interest to go into the validity of the project and the related contract. However, the court did not address the petitioners’ main plea on whether the project’s promoters had obtained the Central Electricity Authority’s statutory clearance as required under the Electricity Supply Act.

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The CEA in 1993 did not clear DPC’s project because its tariff formula violated the stipulated two-part structure. It left the matter to the finance ministry, but the ministry washed its hands off the issue. Nobody cleared it, not even when it was renegotiated. By refusing to open the issue, without stating its rationale in detail, the court in effect put its seal of approval on the largest contract in India’s history. Enron responded to the criticism with a release: ‘We were not surprised that people would have questions and concerns. This was the first foreign private sector power project in India and so we expected that there would be a good deal of debate concerning the project. However, we have worked hard to advise interested parties about the plant, its benefits and Enron, and feel that now there is significant support for the project.’

Human Rights Concerns On January 25, 1999, international watchdog organisation Human Rights Watch published a 166-page book alleging Enron’s complicity in human rights abuses connected with the DPC. A DPC company spokesperson was subsequently quoted in the press as saying that all the problems at the plant had been ‘put to rest’. Opposition to the project has been on various grounds. These include issues relating to land resettlement, compensation to affected fishermen and pollution control measures, as well as to the terms of the deal itself. Villagers who protested faced imprisonment on trumped up charges and protesters outside the gates were beaten by police, the report said. ‘Through misuse of law and abuse of power, the police have crushed an open and organized dissent against the company.’ ‘Although the vast majority of protests were peaceful and protected under international standards safeguarding freedom of expression and assembly, the state chose to silence dissent against the Dabhol Power project through arbitrary arrests, beatings, and targeted harassment of opposition leaders, rather than honestly or responsibly addressing their concerns. The state government is not the only factor responsible for human rights violations. The DPC paid abusive state forces while they committed human rights violations against opponents of the company’s project, and the company directly benefited from the human rights violations,’ the report said. The issue pitted local people against a global energy corporation, generated endless controversy, including protest rallies, environmental concerns, and charges of human rights abuses, court cases, and political skullduggery.

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The Face-off that Led to Termination of the PPA Interestingly, the DPC drama took an about turn in October 2000 with the MSEB not paying the bill for that month, then the next, and the next, and so on, eventually forcing DPC to serve termination notice later on in 2001. More importantly, what better opportunity for Enron—which was primarily a trading company—to walk out of their investment in a power project, which otherwise would not have been possible as the power contracts tied them down for a certain time period. In fact, all the problems DPC faced began when the MSEB failed to pay for the power purchased from it. On January 9, 2001, the GOM averted an immediate crisis by coughing up US$ 24 million for the MSEB to pay some of the money it owed the DPC for the purchase of electricity. The release of the money to the cash-strapped MSEB had temporarily defused what was threatening to blow up into a major dispute between the DPC and the state authorities. The DPC, which was at that stage, majority-owned by a subsidiary of Enron, and operated the Phase I, 740 megawatt (MW) combined-cycle power plant, also served as its fuel manager. The MSEB had not paid the DPC since October 2000. Even after the payment of dues for October 2000, it still owed $48 million in arrears for November and $34 million for December. The DPC invoked the guarantee of GOM in early 2001 for the dues of December 2000, despite the MSEB paying up some part of the dues for November 2000. The GOI was involved in the crisis from then on and the DPC was in dialogue with the Centre to honour its commitment under the counter-guarantee. As a strategy, the DPC did not invoke the stand-by Letter of Credit of Rs. 135 crore of the MSEB which would have given it some funds, since it wanted the GOI to be involved. However, the GOI took a tough stand and wanted the GOM to resolve the crisis through negotiations with DPC. While Enron was using pressure tactics on the GOI, even threatening to initiate sanctions against India by the United States, its own bankruptcy and subsequent ignominy of corporate scandal have kept the DPC out of the international limelight. However, the crisis was not yet over as the GOM formed a high-powered committee to review the PPA for Phase II of the project, which was already under construction by then. According to the state’s chief minister, the decision was taken because the price of power supplied to the state electricity board by the DPC was too high. Power from the DPC averaged more than double the price of power the MSEB bought from other suppliers in the state. The continued default by MSEB forced DPC to serve an asset transfer notice on the MSEB as a step towards termination of their PPA. This halted the construction

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on the 1444-megawatt Phase II of the project. MSEB found the power supplied by DPC too costly and uneconomical to distribute. This factor put off some of the companies which showed interest in bidding for DPC at that stage, after Enron had backed out. The French energy major, Totalfinaelf, which was one of the potential bidders, excused itself out of the deal, finding the project unviable.

Observations of the High Power Committee The Energy Review Committee entrusted with the task of in-depth scrutiny of the Enron PPA came out with some shocking revelations and bold recommendations. It is essential to note that these were unanimous recommendations of a group of eminent and highly experienced experts such as Dr. Madhav Godbole (exChairman MSEB and Former Union Home Secretary), Dr. E.A.S. Sarma (exUnion Power Secretary) and Mr. Deepak Parekh (Chairman, Infrastructure Development and Finance Corporation). The following is a gist of the committee’s observations. The Committee, on in-depth analysis of the PPA and related documents, pointed out excessive and undue payments to DPC from MSEB of about Rs. 930 crore per year on the following counts: �

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Undue burden of Re-gasification Facility — Even though the power plant required only 42 percent of the re-gasification capacity (even at 90 percent PLF), DPC was charging the full cost to MSEB. This implied overcharging by about Rs. 253 crore per year. Undue recovery of Shipping and Harbour Charges — Even though the cost of these facilities was included in the capital recovery charge, DPC was charging approximately Rs. 233 crore per year for these facilities. Excluding the reasonable cost of the shipping charter, DPC was charging over Rs. 100 crore per year extra to MSEB. Undue recovery of O&M Charges — DPC was charging O&M expenditure much higher than the norm stipulated by GOI for similar projects. O&M charges as per the Government of India norms was around Rs. 214 crore per year whereas DPC’s PPA fixed it at about Rs. 460 crore per year. This implied excessive charge to MSEB of Rs. 246 crore per year. Undue charge through inflated claims of fuel consumption — As per the existing PPA, fuel cost was based on fuel consumption at 1878 kCal/kWh,

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but the actual fuel consumption rate guaranteed by the equipment manufacturer was much (~9%) less. The Committee’s analysis indicated that DPC earned additional revenue of around Rs. 332 crore per year. Thus, the calculations made by the committee indicated that even within the framework of the existing PPA, it could be claimed that DPC was overcharging MSEB by Rs. 930 crores per year. This had to be compared with DPC’s claimed equity of Rs. 3500 crore. Other observations included the following: �

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There were instances of undue and excessive payments such as continuation of the same tariff (dollar-linked) even after loan repayment was over. These were not separately quantified in the report. Further, benefits on account of inflated capital cost were not considered here. Possibility for reductions up to 50 percent in tariff and liability after restructuring. The Committee had recommended several guidelines for reducing the tariff and liability of the DPC project. These included: (i) adhering to tariff notifications and norms of the Government of India (GoI); (ii) restructuring and de-dollarisation of equity and debt; separation of regasification and associated facilities; (iii) change over from ‘take-or-pay’ to ‘pay-as-use’ principle for LNG contract; lowering PLF to the level of 30 to 50% in the initial years. (iv) as per assessment of the Committee, these guidelines would reduce fixed charges by as much as 50 percent and would also result in reduction of total payments by as much as 50 percent.

Current Status of the Project The Dabhol Power plant has been idle since June 2001 after MSEB stopped drawing power from the plant, citing exorbitant power tariffs. The power plant was almost complete when construction on the 1,444 MW Phase II was halted after MSEB fell $240 million behind in payments for power provided. Enron, which filed for Chapter 11 bankruptcy protection late in 2001 in the USA, owned 65 percent stake in DPC, while General Electric Co. and Bechtel Corp each held 10 percent, and MSEB owned the remaining 15 percent at that stage.

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Enron and its American partners had since expressed their desire to exit DPC by selling their 85 percent stake to either the Indian Government or a private power company. At the same time, Enron went ahead with its plan to terminate its PPA with MSEB. IDBI-led Indian financial institutions had provided about Rs. 61.94 billion to the power project, while Enron, General Electric and Bechtel Corp. had invested $1 billion. After two years of intense negotiations both at the government level and between the financial institutions and other lenders in India and abroad, the matter remains unresolved. In the meanwhile, the DPC plant in Phase I has been rusting while the almost complete Phase II has been languishing. General Electric, the other equity partner in the project, has been negotiating with the National Thermal Power Corporation on the modalities to restart the DPC plant at the earliest. Currently discussions are still on at various levels by the GOI, GOM, MSEB, Indian lenders led by IDBI, GE and Bechtel to find a workable solution to the imbroglio. The discussions also figure the issue of GE’s request for return of their equity of $120 million (10%) in the DPC. At this time, the chances of the plant restarting at an early date look impossible due to the physical condition of the unit. Though the main plant has been taken care of by Punj Lloyd, other individual units such as the naphtha plant and jetty have to be examined.

Financial Scenario DPC’s foreign lenders filed for arbitration proceedings in 2003 in London against their Indian counterparts, led by IDBI as they feel they have been blocked from exercising their rights embodied in the financing documents. After two years of intense negotiations, this brings India’s hitherto best engineered project financing deal into the court rooms. The Indian lenders had sanctioned Rs. 6194 crore ($1.24 billion) to the Dabhol Power Project out of which, more than 90 percent was disbursed. This includes $730 million of non-fund guarantees to exposures taken by overseas banks and export credit agencies (ECAs). The break-up of the exposure was IDBI Rs. 2121 crore, ICICI Rs. 1473 crore, SBI Rs. 1749 crore, IFCI Rs. 454 crore and Canara Bank Rs. 407 crore. The concerned ECAs are US Exim Bank for Phase I and Japanese Exim Bank ( JBIC) and OND of Belgium for Phase II. The bulk of the guarantee exposure for the Indian lenders, amounting to around $524 million, is for Phase II and about $200 million for Phase I as shown below.

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Financing Details (Debt sanctioned) Rupee loans from Indian financial institutions and banks (five in total)

Phase I$ million

Phase II$ million

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333

150

272

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Overseas Private Investment Corporation

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60

ECAs

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524

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Dollar Commercial Loans from off-shore banks Dollar commercial loans from Indian banks

$ conversion at Rs. 43

For Phase I, the guarantee covers a large part of the US Exim Bank’s loan. For Phase II, the guarantee primarily covers $258 million of direct exposure by JBIC, while the rest is firstly guaranteed by Miti (an associate of JBIC) and then by the Indian lenders. If Miti fails to pay up, the guarantee devolves on the Indian lenders. On October 1, 2001, DPC started to default on its interest payments to JBIC, following which JBIC threatened to invoke the guarantees. To avoid this, the Indian lenders, on behalf of the DPC, made a payment of $9 million to JBIC. Thereafter, they negotiated with the JBIC for a forbearance pact in 2001 under which it would refrain from encashing the guarantee for six months. Thereafter, an all lenders meet was held in Singapore in September 2002 to negotiate similar deals with the other foreign lenders. The foreign lenders’ exposure for Phase I is counter-guaranteed by the GOI to the maximum extent of $300 million. As against this, the outstandings for Phase I stood at $ 180 million in 2002. However, the counter-guarantee cannot be invoked easily since the PPA, on which it was based, had been challenged by the MSEB in court. The Indian lenders also brought a stay in the Bombay High Court to prevent different parties taking different action which would deepen the crisis. The idea was also to prevent DPC from serving a final termination notice to MSEB which would have pre-empted third party sale of Enron and the other shareholders’ stakes in DPC. As per the PPA, if a final termination notice is served, MSEB has to buy back the plant entirely and then it would be responsible to the lenders. The lenders would then have had little options with a cash starved entity like the MSEB.

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The key question to be addressed is about the bankruptcy remoteness of the SPV (the DPC) from the bankruptcy proceedings of the parent company Enron and its subsidiaries. Indian lenders maintain that the foreign liquidator cannot attach Enron’s holding in DPC which is pledged to the Indian lenders. In the meantime, since the defaults of DPC are mounting, the lenders have to look for an alternative buyer, restart operations, restructure the loans and carry the foreign lenders through the whole exercise. This would not be possible without large-scale government intervention. Surely, the curtains have not come down yet on the most controversial corporate show in recent times in India.

� Annexure IV

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RBI CIRCULARS ON PROJECT FINANCING

Sanctioning of loan to SPVs/Public Sector units, EWS housing etc. on the strength of State Government guarantees DBOD No. BC. 45/21.04.141/2003-2004 November 17, 2003 All Commercial Banks/Specified Financial Institution Dear Sir, Sanctioning of loan to SPVs/Public Sector units, EWS housing etc. on the strength of State Government guarantees 1. Reserve Bank of India has been advising banks, from time to time, that while financing projects under-taken by both public sector and private sector undertakings they should ensure that these are technically feasible, financially viable and bankable. In respect of financing of projects backed by state Government guarantees also, banks/Financial Institutions should exercise due diligence on the viability of the projects and State Government guarantees should not be taken as a substitute for satisfactory credit appraisal. Banks have been advised to ensure that the individual components of financing and returns on the project are well defined and assessed and appraisal requirements are not diluted on other considerations. In this connection we invite your attention to paragraph (4) of Annexure to our circular DBOD No. BP. BC. 67/21.04.048/2002-2003 dated February 4, 2003, wherein the banks were advised in detail to adhere to the above norm while extending infrastructure finance to Government owned entities. 2. It has again been reported that requests for credit facilities to SPVs/Public Sector units, EWS housing and urban infrastructure etc. backed by State

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Government guarantees received by banks/FIs are sometimes approved in order to meet social lending targets and solely based on the strength of State Government guarantees. The Government of India has expressed its concern over the incidence of such practices by banks/FIs, which result in build-up of State Government guarantees beyond sustainable levels of debt. A Committee constituted by Government of India to assess the fiscal impact of the State Government guarantees given in recent past has viewed unfavourably, the tendency of banks/FIs rolling over their defaults to unbankable projects on the strength of guarantees and has recommended that the banks/FIs should eschew such practices. The Government has accepted the recommendation of the Committee. 3. We, therefore, reiterate that that banks/FIs should appraise credit proposals received from SPVs/Public Sector units, EWS housing and urban infrastructure etc. on commercial basis with respect to viability and in accordance with the credit policy laid down by the Board instead of relying solely on the strength of State Government guarantees.

Yours faithfully, Sd/(C. R. Muralidharan) Chief General Manager-in-charge

DBOD. No. BP. BC. 67/21.04.048/2002–2003 February 4, 2003 All Scheduled Commercial Banks (excluding RRBs & LABs) and All India Financial Institutions Guidelines on Infrastructure Financing In view of the critical importance of the infrastructure sector and high priority being accorded for development of various infrastructure services, the matter has been reviewed in consultation with Government of India and the revised guidelines on financing of infrastructure projects are set out as under:

(a) Definition of `Infrastructure Lending’ Any credit facility in whatever form extended by lenders (i.e. banks, FIs or NBFCs) to an infrastructure facility as specified below falls within the definition of ‘infrastructure lending’. In other words, a credit facility provided to a borrower company engaged in: �

developing or

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operating and maintaining, or

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developing, operating and maintaining

any infrastructure facility that is a project in any of the following sectors: � �

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a road, including toll road, a bridge or a rail system; a highway project including other activities being an integral part of the highway project; a port, airport, inland waterway or inland port; a water supply project, irrigation project, water treatment system, sanitation and sewerage system or solid waste management system;

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telecommunication services whether basic or cellular, including radio paging, domestic satellite service (i.e., a satellite owned and operated by an Indian company for providing telecommunication service), network of trunking, broadband network and Internet services;

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an industrial park or special economic zone;

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generation or generation and distribution of powe;.

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transmission or distribution of power by laying a network of new transmission or distribution lines; Any other infrastructure facility of similar nature.

(b) Criteria for Financing Banks/FIs are free to finance technically feasible, financially viable and bankable projects undertaken by both public sector and private sector undertakings subject to the following conditions: �

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The amount sanctioned should be within the overall ceiling of the prudential exposure norms prescribed by RBI for infrastructure financing. Banks/FIs should have the requisite expertise for appraising technical feasibility, financial viability and bankability of projects, with particular reference to the risk analysis and sensitivity analysis. In respect of projects undertaken by public sector units, term loans may be sanctioned only for corporate entities (i.e. public sector undertakings registered under Companies Act or a Corporation established under the relevant statute). Further, such term loans should not be in lieu of or to substitute budgetary resources envisaged for the project. The term loan could supplement the budgetary resources if such supplementing was contemplated in the project design. While such public sector units may include Special Purpose Vehicles (SPVs) registered under the Companies Act set up for financing infrastructure projects, it should be ensured by banks and financial institutions that these loans/investments are not used for financing the budget of the State Governments. Whether such financing is done by way of extending loans or investing in bonds, banks and financial institutions should undertake due diligence on the viability and bankability of such projects to ensure that revenue stream from the project is sufficient to take care of the debt servicing obligations and that the repayment/servicing of

Project Advisory Services

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debt is not out of budgetary resources. Further, in the case of financing SPVs, banks and financial institutions should ensure that the funding proposals are for specific monitorable projects. �

Banks may also lend to SPVs in the private sector, registered under Companies Act for directly undertaking infrastructure projects, which are financially viable, and not for acting as mere financial intermediaries. Banks may ensure that the bankruptcy or financial difficulties of the parent/sponsor should not affect the financial health of the SPV.

(c) Types of Financing by Banks In order to meet financial requirements of infrastructure projects, banks may extend credit facility by way of working capital finance, term loan, project loan, subscription to bonds and debentures/preference shares/equity shares acquired as a part of the project finance package which is treated as ‘deemed advance’ and any other form of funded or non-funded facility. �

Take-out Financing Banks may enter into take-out financing arrangement with IDFC/other financial institutions or avail of liquidity support from IDFC/other FIs. A brief write-up on some of the important features of the arrangement is given in para 3.9.2(f). Banks may also be guided by the instructions regarding takeout finance contained in Circular No. DBOD. BP. BC. 144/21.04.048/2000 dated 29 February 2000.

�

Inter-institutional Guarantees Banks are permitted to issue guarantees favouring other lending institutions in respect of infrastructure projects, provided the bank issuing the guarantee takes a funded share in the project at least to the extent of 5 percent of the project cost and undertakes normal credit appraisal, monitoring and follow up of the project. For detail instructions on inter-institutional guarantee please see para 3.10.

�

Financing promoter’s equity In terms of our Circular DBOD. Dir. BC. 90/13.07.05/98 dated 28 August 1998, banks were advised that the promoter’s contribution towards the equity capital of a company should come from their own resources and the bank

688

Investment Banking

should not normally grant advances to take up shares of other com-panies. In view of the importance attached to infrastructure sector, it has been decided that, under certain circumstances, an exception may be made to this policy for financing the acquisition of promoter’s shares in an existing company which is engaged in implementing or operating an infrastructure project in India. The conditions, subject to which an exception may be made are as follows: (i) The bank finance would be only for acquisition of shares of existing companies providing infrastructure facilities as defined in paragraph 1 above. Further, acquisition of such shares should be in respect of companies where the existing foreign promoters (and/or domestic joint promoters) voluntarily propose to disinvest their majority shares in compliance with SEBI guidelines, where applicable. (ii) The companies to which loans are extended should, inter alia, have a satisfactory net worth. (iii) The company financed and the promoters/directors of such companies should not be defaulter to banks/FIs. (iv) In order to ensure that the borrower has a substantial stake in the infrastructure company, bank finance should be restricted to 50 percent of the finance required for acquiring the promoter’s stake in the company being acquired. (v) Finance extended should be against the security of the assets of the borrowing company or the assets of the company acquired and not against the shares of that company or the company being acquired. The shares of borrower company/company being acquired may be accepted as additional security and not as primary security. The security charged to the banks should be marketable. (vi) Banks should ensure maintenance of stipulated margin at all times. (vii) The tenure of the bank loans may not be longer than seven years. However, the Boards of banks can make an exception in specific cases, where necessary, for financial viability of the project. (viii) This financing would be subject to compliance with the statutory requirements under Section 19(2) of the Banking Regulation Act, 1949. (ix) The banks financing acquisition of equity shares by promoters should be within the regulatory ceiling of 5 per cent on capital market exposure in

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relation to its total outstanding advances (including commercial paper) as on March 31 of the previous year. (x) The proposal for bank finance should have the approval of the Board.

(d) Appraisal �

�

In respect of financing of infrastructure projects undertaken by Government owned entities, banks/Financial Institutions should undertake due diligence on the viability of the projects. Banks should ensure that the individual components of financing and returns on the project are well defined and assessed. State Government guarantees may not be taken as a substitute for satisfactory credit appraisal and such appraisal requirements should not be diluted on the basis of any reported arrangement with the Reserve Bank of India or any bank for regular standing instructions/periodic payment instructions for servicing the loans/bonds. Infrastructure projects are often financed through Special Purpose Vehicles. Financing of these projects would, therefore, call for special appraisal skills on the part of lending agencies. Identification of various project risks, evaluation of risk mitigation through appraisal of project contracts and evaluation of credit worthiness of the contracting entities and their abilities to fulfill contractual obligations will be an integral part of the appraisal exercise. In this connection, banks/FIs may consider constituting appropriate screening committees/special cells for appraisal of credit proposals and monitoring the progress/performance of the projects. Often, the size of the funding requirement would necessitate joint financing by banks/FIs or financing by more than one bank under consortium or syndication arrangements. In such cases, participating banks/FIs may, for the purpose of their own assessment, refer to the appraisal report prepared by the lead bank/FI or have the project appraised jointly.

(e) Prudential Requirements �

Prudential credit exposure limits Credit exposure to borrowers belonging to a group may exceed the exposure norm of 40 per cent of the bank’s capital funds by an additional 10 per cent (i.e. up to 50 per cent), provided the additional credit exposure is on account of extension of credit to infrastructure projects. Credit exposure to single borrower may exceed the exposure norm of 15 per cent of the bank’s capital funds

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Investment Banking

by an additional 5 per cent (i.e. up to 20 per cent) provided the additional credit exposure is on account of infrastructure as defined in paragraph 1 above. �

Assignment of risk weight for capital adequacy purposes Banks may assign a concessional risk weight of 50 per cent for capital adequacy purposes, on investment in securitised paper pertaining to an infrastructure facility subject to compliance with the following: a) The infrastructure facility should satisfy the conditions stipulated in paragraph 1 above. b) The infrastructure facility should be generating income/cash flows which would ensure servicing/repayment of the securitised paper. c) The securitised paper should be rated at least ‘AAA’ by the rating agencies and the rating should be current and valid. The rating relied upon will be deemed to be current and valid if: (i) The rating is not more than one month old on the date of opening of the issue, and the rating rationale from the rating agency is not more than one year old on the date of opening of the issue, and the rating letter and the rating rationale is a part of the offer document. (ii) In the case of secondary market acquisition, the ‘AAA’ rating of the issue should be in force and confirmed from the monthly bulletin published by the respective rating agency. (iii) The securitised paper should be a performing asset on the books of the investing/lending institution.

�

Asset–Liability Management The long-term financing of infrastructure projects may lead to asset–liability mismatches, particularly when such financing is not in conformity with the maturity profile of a bank’s liabilities. Banks would, therefore, need to exercise due vigil on their asset–liability position to ensure that they do not run into liquidity mismatches on account of lending to such projects.

�

Administrative arrangements Timely and adequate availability of credit is the pre-requisite for successful implementation of infrastructure projects. Banks/FIs should, therefore, clearly delineate the procedure for approval of loan proposals and institute

Project Advisory Services

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a suitable monitoring mechanism for reviewing applications pending beyond the specified period. Multiplicity of appraisals by every institution involved in financing, leading to delays, has to be avoided and banks should be prepared to broadly accept technical parameters laid down by leading public financial institutions. Also, setting up a mechanism for an ongoing monitoring of the project implementation will ensure that the credit disbursed is utilised for the purpose for which it was sanctioned.

(f) Take-out Financing/Liquidity Support a. Take-out financing arrangement Take-out financing structure is essentially a mechanism designed to enable banks to avoid asset–liability maturity mismatches that may arise out of extending long tenure loans to infrastructure projects. Under the arrangements, banks financing the infrastructure projects will have an arrangement with IDFC or any other financial institution for transferring to the latter the outstandings in their books on a pre-determined basis. IDFC and SBI have devised different take-out financing structures to suit the requirements of various banks, addressing issues such as liquidity, asset-liability mismatches, limited availability of project appraisal skills, etc. They have also developed a Model Agreement that can be considered for use as a document for specific projects in conjunction with other project loan documents. The agreement between SBI and IDFC could provide a reference point for other banks to enter into somewhat similar arrangements with IDFC or other financial institutions. b. Liquidity support from IDFC As an alternative to take-out financing structure, IDFC and SBI have devised a product, providing liquidity support to banks. Under the scheme, IDFC would commit, at the point of sanction, to refinance the entire outstanding loan (principal + unrecovered interest) or part of the loan, to the bank after an agreed period, say, five years. The credit risk on the project will be taken by the bank concerned and not by IDFC. The bank would repay the amount to IDFC with interest as per the terms agreed upon. Since IDFC would be taking a credit risk on the bank, the interest rate to be charged by it on the amount refinanced would depend on the IDFC’s risk perception of the bank (in most of the cases, it may be close to IDFC’s PLR). The refinance support from IDFC would particularly benefit the banks which have the requisite appraisal skills and the initial liquidity to fund the project.

Guidelines on Fair Practices Code for Lenders DBOD. Leg. No. BC. 104/09.07.007/2002–2003 May 5, 2003 All Scheduled Commercial Banks/All India Financial Institutions (Excluding RRBs and LABs) Dear Sir, Guidelines on Fair Practices Code for Lenders 1. On the basis of the recommendations of the Working Group on Lenders’ Liability Laws constituted by the Government of India, we have examined, in consultation with Government, select banks and financial institutions, the feasibility of introducing the Fair Practices Code for Lenders. The guidelines have since been finalised and banks/all India Financial Institutions are advised to adopt the following broad guidelines and frame the Fair Practices Code duly approved by their Board of Directors. 2. Guidelines

(i) Applications for loans and their processing (a) Loan application forms in respect of priority sector advances up to Rs. 2 lakhs should be comprehensive. It should include information about the fees/charges, if any, payable for processing, the amount of such fees refundable in the case of non-acceptance of application, pre-payment options and any other matter which affects the interest of the borrower, so that a meaningful comparison with that of other banks can be made and informed decision can be taken by the borrower. (b) Banks and financial institutions should devise a system of giving acknowledgement for receipt of all loan applications. Time frame within which

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loan applications up to Rs. 2 lakhs will be disposed of should also be indicated in acknowledgement of such applications. (c) Banks/financial institutions should verify the loan applications within a reasonable period of time. If additional details/documents are required, they should intimate the borrowers immediately. (d) In the case of small borrowers seeking loans up to Rs. 2 lakhs the lenders should convey in writing, the main reason/reasons which, in the opinion of the bank after due consideration, have led to rejection of the loan applications within stipulated time.

(ii) Loan Appraisal and Terms/Conditions (a) Lenders should ensure that there is proper assessment of credit application by borrowers. They should not use margin and security stipulation as a substitute for due diligence on credit worthiness of the borrower. (b) The lender should convey to the borrower the credit limit along with the terms and conditions thereof and keep the borrower’s acceptance of these terms and conditions given with his full knowledge on record. (c) Terms and conditions and other caveats governing credit facilities given by banks/financial institutions arrived at after negotiation by lending institution and the borrower should be reduced in writing and duly certified by the authorised official. A copy of the loan agreement along with a copy each of all enclosures quoted in the loan agreement should be furnished to the borrower. (d) As far as possible, the loan agreement should clearly stipulate credit facilities that are solely at the discretion of lenders. These may include approval or disallowance of facilities, such as, drawings beyond the sanctioned limits, honouring cheques issued for the purpose other than specifically agreed to in the credit sanction, and disallowing drawing on a borrowal account on its classification as a non-performing asset or on account of non-compliance with the terms of sanction. It may also be specifically stated that the lender does not have an obligation to meet further requirements of the borrowers on account of growth in business etc. without proper review of credit limits. (e) In the case of lending under consortium arrangement, the participating lenders should evolve procedures to complete appraisal of proposals in the time bound manner to the extent feasible, and communicate their decisions on financing or otherwise within a reasonable time.

694

Investment Banking

(iii) Disbursement of Loans Including Changes in Terms and Conditions Lenders should ensure timely disbursement of loans sanctioned in conformity with the terms and conditions governing such sanction. Lenders should give notice of any change in the terms and conditions including interest rates, service charges, etc. Lenders should also ensure that changes in interest rates and charges are effected only prospectively.

(iv) Post Disbursement Supervision (a) Post disbursement supervision by lenders, particularly in respect of loans upto Rs. 2 lakhs, should be constructive with a view to taking care of any ‘lender-related’ genuine difficulty that the borrower may face. (b) Before taking a decision to recall/accelerate payment or performance under the agreement or seeking additional securities, lenders should give notice to borrowers, as specified in the loan agreement or a reasonable period, if no such condition exits in the loan agreement. (c) Lenders should release all securities on receiving payment of loan or realisation of loan subject to any legitimate right or lien for any other claim lenders may have against borrowers. If such right of set off is to be exercised, borrowers shall be given notice about the same with full particulars about the remaining claims and the documents under which lenders are entitled to retain the securities till the relevant claim is settled/paid.

(v) General (a) Lenders should restrain from interference in the affairs of the borrowers except for what is provided in the terms and conditions of the loan sanction documents (unless new information, not earlier disclosed by the borrower, has come to the notice of the lender). (b) Lenders must not discriminate on grounds of sex, caste and religion in the matter of lending. However, this does not preclude lenders from participating in credit-linked schemes framed for weaker sections of the society. (c) In the matter of recovery of loans, the lenders should not resort to undue harassment viz. persistently bothering the borrowers at odd hours, use of muscle power for recovery of loans, etc.

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(d) In case of receipt of request for transfer of borrowal account, either from the borrower or from a bank/financial institution, which proposes to take over the account, the consent or otherwise i.e., objection of the lender, if any, should be conveyed within 21 days from the date of receipt of request. 3. Fair Practices Code based on the guidelines outlined in the paragraph 2 above should be put in place in respect of all lending prospectively, but not later than 01 August, 2003. Banks and financial institutions will have the freedom of drafting the Fair Practices Code, enhancing the scope of the guidelines but in no way sacrificing the spirit underlying the above guidelines. For this purpose, the Boards of banks and financial institutions should lay down a clear policy. 4. The Board of Directors should also lay down the appropriate grievance redressal mechanism within the organization to resolve disputes arising in this regard. Such a mechanism should ensure that all disputes arising out of the decisions of lending institutions’ functionaries are heard and disposed of at least at the next higher level. The Board of Directors should also provide for periodical review of the compliance of the Fair Practices Code and the functioning of the grievances redressal mechanism at various levels of controlling offices. A consolidated report of such reviews may be submitted to the Board at regular intervals, as may be prescribed by it. 5. The adoption of the Code, printing of necessary loan application forms and circulation thereof among the branches and controlling offices should also be completed latest by end of June 2003. The Fair Practices Code, which may be adopted by banks and financial institutions, should also be put on their website and given wide publicity. A copy may also be forwarded to the Reserve Bank of India. 6. Please acknowledge receipt.

Yours faithfully, (M.R. Srinivasan) Chief General Manager-in-Charge

Chapter

14

Financial Restructuring Advisory

I

n the life of a body corporate, there are times when a physiological restructuring becomes necessary. This could be caused by business reasons or financial factors. In this chapter we look at the gamut of financial restructuring so as to understand the advisory role that an investment banker has to play therein. In the discussion that follows, financial restructuring has been interpreted to mean capital restructuring of a company incorporated under the Companies Act. This would include restructuring of both debt capital and equity capital. More often than not, financial restructuring is triggered off by financial compulsions than for strategic reasons. This chapter discusses the predicament of companies that do it both out of compulsion and as a measure of financial strategy. The legal framework and the whole process that governs debt and equity restructuring have been explained in detail in this chapter since they form a core advisory service for investment banks.

Topics to comprehend �

�

�

�

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Rationale for restructuring.

financial

Types of debt and equity restructuring and processes involved. Financial restructuring for financially sick companies. Regulatory overview of the debt and equity restructuring processes. Role of investment banker in financial restructuring.

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Investment Banking

14.1 Introduction ‘Financial restructuring’ as the term denotes is the art of restating the financial position of a company as reflected by its balance sheet as on a given date. In order to achieve such restatement, a complex financial and legal process is involved as it concerns several conflicting interests. Financial restructuring can be triggered off either from the asset side of the balance sheet or the liabilities’ side. If the asset side is to be restated, it involves revaluation of the assets, so as to arrive at their true values, and restate the asset side accordingly. Once the asset side is restated, the corresponding adjustment is made on the liabilities’ side to arrive at the restated balance sheet. Such adjustment would depend upon whether there is a net increase or decrease in the value of the assets upon revaluation. If the net total on the asset side is an increase, it results in an increase in the ‘reserves’ so as to equate the liabilities’ side and vice versa. Financial restructuring is triggered off from the liabilities’ side as well. This happens due to a change in the status of the outside liabilities of a company either due to negotiations or statutory provisions or any other reason. In contrast, a change in the values of the shareholders’ funds is necessitated normally due to a change in the values of assets as discussed above. Therefore, financial restructuring encompasses restructuring of debt capital (outside liabilities) as well as equity capital. In this chapter, we discuss both these processes separately since the factors that lead to such restructuring and the statutory framework thereof are different. The overall effect of financial restructuring on a balance sheet in very simple terms is illustrated below (Illustration 14.1).

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Illustration 14.1

The following is the balance sheet of Restructure Ltd., as of a recent date. Liabilities Share Capital

Rs. 200

Assets Net Fixed Assets

Rs. 1000

Reserves and Surplus

475

Investments

250

Long Term Borrowings

950

Current Assets and Loans and Advances

650

Current Liabilities

500

Miscellaneous Expenditure not written off

225

Total

2125

Total

2125

699

Financial Restructuring Advisory

The above balance sheet is to be recast on the following basis: � �

�

�

�

�

The fixed assets have to be written up by Rs. 100 to reflect their true value. The investments have to be written down by Rs. 50 to provide for depreciation in their value not provided for. Current assets and loans and advances have to be written down by Rs. 100 to reflect their realizable value. Miscellaneous expenditure not written off is basically accumulated losses of the past three years that needs to be written off in full. Decrease in long-term liability has been achieved to the extent of Rs. 150 through negotiations. Current liabilities have come down by Rs. 25 after reconciliation of accounts.

The recast balance sheet of Restructure Ltd. on the above lines is furnished below. Liabilities

Rs.

Assets

Rs. 1100

Share Capital

200

Net Fixed Assets

Reserves and Surplus

375

Investments

50

Long Term Borrowings

800

Current Assets and Loans and Advances

550

Current Liabilities

475

Miscellaneous Expenditure not written off

Total

1850

Total

0

1850

Working Note: Increase in assets Fixed assets

Rs. 100

Decrease in assets Investments

Rs. 50

Current Assets and Loans and Advances

100

Miscellaneous Expenditure not written off

225

Net decrease

275

700

Investment Banking

(Contd.) Decrease in liabilities

Increase in liabilities 0

Long Term Borrowings

150

Current Liabilities

25

Net decrease

175

The decrease in assets is in excess of the decrease in liabilities by Rs. 100. Therefore, in the recasted balance sheet, the liability side of the balance sheet has to come down by an additional Rs. 100, which has been reduced from the Reserves and Surplus. In other words, the overall effect of the financial restructuring is a reduction in the reserves to the extent of Rs. 100.

14.2 Debt Restructuring1 14.2.1 Introduction Restructuring of debt refers to that part of the reconstruction of a balance sheet insofar as it relates to the borrowing obligations of a company. Debt restructuring can form a component of the overall financial restructuring exercise undertaken by a company, which might include inter alia, reduction of capital or other forms of equity restructuring. But in several instances debt restructuring could be the only financial restructuring undertaken by a company. This could be so because equity restructuring is a more profound exercise and is not undertaken unless the circumstances warrant it. However, debt restructuring is a much more routine process and can be triggered off even as a financial management tool. One of the main functions of a finance manager is to optimize the cost of capital of the company. In order to do so, he needs to constantly look for increasing the efficiency of borrowing and reduction of financing costs. This would call for continuous review of the debt portfolio and recycling the same to maximize efficiency. Debt restructuring in India has been an age-old practice triggered off partly by the high-cost funds of yesteryears and more importantly, due to industrial sickness. In the early days, prior to the passing of the Sick Industrial Companies (Special Provisions) Act 1985, debt restructuring was undertaken by the term lending institutions and banks in their capacity as secured creditors. The Industrial Reconstruction Bank of India was established primarily to rehabilitate sick units requiring relief and financial support through restructuring of their balance sheets without the intervention of courts. With the advent of the Board for Industrial

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701

and Financial Reconstruction, sick industrial units came under the purview of this board with the financial institutions and banks acting as the operating agencies. This mechanism still left out a large number of units which required debt restructuring as the definition of sickness under the Act was very narrow. Over the years, the RBI and the institutions and banks have evolved several mechanisms for debt restructuring of such units. Similarly, under the BIFR mechanism, operating agencies have evolved different methods of rehabilitating sick units through suitable debt restructuring. These aspects have been dealt with further in this chapter.

14.2.2 Rationale for Debt Restructuring As stated above, debt restructuring can take several shapes and happen in different circumstances. Broadly, all these situations can be brought under the following three major heads: �

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Scenario I: A healthy company would want to restructure its debt portfolio by substituting existing high-cost debt with fresh low-cost borrowings. Scenario II: A company without servicing capacity and liquidity problems would want to restructure its debt portfolio to reduce the cost of borrowing and improve working capital position. Scenario III: A company that is insolvent would need a wholesale restructuring of its debt portfolio to rehabilitate it and make it solvent.

14.2.3 Debt Restructuring for a Financially Healthy Company As mentioned above, well-performing companies would look at opportunities to constantly reduce their cost of borrowing by tapping market opportunities. One of the hallmarks of a good financial manager is to be able to borrow at fine rates. However, the pre-condition for getting fine rates from lenders is a good credit rating for the borrower. Most top-of-the-line companies in India target an ‘AAA’ rating so as to be able to churn their debt portfolio. Indian Oil Ltd. has even pierced the sovereign rating of the country in its external borrowing programme. Illustration 14.2 explains the effect of debt restructuring on a healthy company’s financials.

702 �

Investment Banking

Illustration 14.2

Good Health Ltd. has the following details to offer as at the end of a financial year: Particulars Rupee Term Loans Outstanding (Weighted Average rate of borrowing 17.5% p.a.)

Amount (Rs. Lakh) 2500.00

Earnings Before Interest and Taxes

540.00

Interest on Long Term Borrowings p.a.

437.50

Tax Rate applicable

35%

The company is looking at two options to restructure its long-term borrowings. 1. Substituting the high-cost long-term rupee borrowings with low-cost fixed rate rupee loan of Rs. 2500 lakh at 13% p.a. Upfront fee would amount to 1% of the new loan amount and arranger’s fee would be 2.5%. Prepayment premium and other costs would amount to Rs. 10 lakh. The loan is spread over 5 years, repayable in fixed, quarterly installments. 2. Substituting the existing loans with a foreign currency borrowing of US$ 5 million at a floating rate of LIBOR + 2.5%. The processing fee would be 1%, arranger’s fee 3%, other costs Rs. 25 lakh. The loan is repayable in ten equal semi-annual installments. Assuming an annual depreciation of the rupee by 5% with a present rate of Rs. 50 to a dollar and LIBOR of 3%, which would go up by 10% on a year-on-year basis, the two alternatives have to be compared. The company is not contemplating any forward cover on its foreign exchange exposure. Both the alternatives have been evaluated in the following table: It may be observed from the above table that the foreign currency borrowing is more expensive though its interest rate is much lower than that of the rupee borrowing. This is due to the fact that the currency depreciation of the rupee against the dollar has outweighed the savings in interest cost. Therefore, in debt restructuring for the purpose of cost reduction, what is necessary for decision making is a comparison of the all-in cost of the proposed borrowing vis-à-vis the existing borrowing and not just a comparison of the two rates of interest.

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Financial Restructuring Advisory

ALTERNATIVE 1 Rupee Loan Amount (in Rs. Lakh)

2500

Interest Rate p.a.

13.00%

Repayment

5 years on quarterly basis

Amortisation Schedule

Year0

Opening balance Instalment Closing balance Annual Interest

0

Upfront Fee 1%

25

Arranger's Fee 2.5%

Year1

Year2

Year3

Year4

Year5

2500

2000

1500

1000

500

500

500

500

500

500

2000

1500

1000

500

0

300.63

235.63

170.63

105.63

40.63

62.50

Legal and Other Costs

10

*Annual Cost of Borrowing

97.50

300.63

235.63

170.63

105.63

40.63

Discount Factor

1.000

0.884

0.783

0.693

0.613

0.542

Present Value

97.50

265.75

184.49

118.24

64.75

22.02

Year4

Year5

Net Present Value

752.76

ALTERNATIVE 2 FC Loan Amount (US$ million)

5

Repayment

5 years on half-yearly basis Year0

Year1

Year2

Year3

5.50%

5.80%

6.13%

6.49%

6.88%

52.50

55.13

57.88

60.78

63.81

Instalment Payment in Rs. Lakh

525

551

579

608

638

Annual Loss in Instalment Payment

25

51

79

108

138

Interest Rate Rupee Conversion Rate Per One $

50.00

704

Investment Banking

Amortisation Schedule

Year0

Year1

Year2

Year3

Year4

Year5

Opening Balance

5

4

3

2

1

Instalment

1

1

1

1

1

Closing Balance

4

3

2

1

0

Annual Interest (in US$ million)

0.26

0.21

0.15

0.10

0.04

261250

206250

151250 96250

41250

131

113

92

64

30

25

51

79

108

138

Processing Fee 1% (in US$)

50000

Arranger's Fee 3% (in US$)

125000

Legal and Other Costs (in US$)

50000

Annual Cost of Borrowing* (in US$)

225000

Annual Cost of Borrowing (in Rs. Lakh)

113

Cost of Rupee Depreciation on Instalment Repayment Total Cost

113

156

165

170

172

168

Discount Factor

1.000

0.943

0.889

0.839

0.792

0.747

Present Value

113

147

146

143

136

126

Net Present Value

810.38

* Interest has been calculated on written down balances assuming repayment at the end of the quarter or half-year as the case may be.

14.2.4 Debt Restructuring for a Company Without Debt Servicing Capacity Most cases of debt restructuring fall under this category. The main driver for debt restructuring in such companies is their inability to adhere to the due dates for payment of interest and principal on their borrowings. Initially, the problems are more of a short-term nature and could be mistaken for a tight liquidity position. At this stage, the lenders try to help by releasing ad hoc sanctions or ad hoc deferments. However, as time passes by and the situation worsens, the debt burden keeps

705

Financial Restructuring Advisory

mounting and cash flow deficit widens. The loan account of the borrower slips into the category of a non-performing asset in the books of the lenders and its working capital limits would be irregular. It becomes evident that the company is incurring cash losses and any further assistance from the lenders would amount to financing of losses. At this point, the lenders step in to save the company from insolvency by restructuring its debt portfolio. The following illustration amplifies the point.

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Illustration 14.3

Problems Ltd. has the following details to offer as at the end of a financial year:

Particulars

Amount (Rs. Lakh)

Equity Share Capital

150.00

Long Term Borrowings (including overdue interest and other charges)

550.00

Bank Borrowings for Working Capital (overdrawn by Rs. 25 lakh)

225.00

Reserves and Surplus

125.00

EBIT

78.00

Interest on Long Term Borrowings

96.00

Interest on Bank Borrowings

38.00

Tax Rate Applicable

35%

The company is presently incurring cash losses and is not able to service its debt commitments. However, the company has the potential to improve its EBIT to at least Rs. 150 lakh immediately if it has sufficient working capital. In order to bring the company back into black and improve its working capital position, the management has negotiated for a debt restructuring with its lenders. The salient features of the package are as follows. �

�

Enhancement of working capital limit to Rs. 250 lakh to improve its working capital position. The promoters are bringing in fresh interest free loan of Rs. 100 lakh to beef up the long-term resources of the company.

706 �

�

Investment Banking

The long-term lenders are rescheduling Rs. 200 lakh to be repaid after a moratorium of two years and the rest of the loan amounting to Rs. 350 lakh with a moratorium of one year with a revised instalment schedule. The interest on the long-term borrowing is proposed to be reduced to 15% and on working capital to 16%.

The comparative table for the impact of the debt restructuring on the company’s financials is shown below. Rs. Lakh

Rs. Lakh

Before Restructuring EBIT

78.00

Less Interest on Long-Term Borrowings Interest on Bank Borrowings

96.00 38.00

Profit Before Tax

134.00 (56.00)

Interest Cover (times)

0.58

Debt–equity Ratio (DER)

2.00

Interest/EBIT (%)

172%

After Restructuring 150.00

EBIT Less Interest on Long-Term Borrowings Interest on Bank Borrowings

82.50 40.00

122.50

Profit Before Tax

27.50

Provision for Tax @ 35%

0.00*

Profit After tax

17.87

Share Capital

150.00

Unsecured Loan

100.00

Long Term Borrowings

550.00

Bank Borrowings

250.00

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(Contd.) Earnings per share (Rs.)

1.19

Interest Cover (times)

1.23

Debt–equity ratio

1.40

Interest/EBIT (%)

81.67%

After the restructuring, the company’s cash flow would improve significantly due to the following reasons: �

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�

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The servicing of long-term loan has been rescheduled with a revised repayment schedule that gives the company enough time to increase its earnings and to reduce the debt burden. The bank limit has been enhanced by Rs. 50 lakh so as to regularize the overdrawn amount and provide Rs. 25 lakh additionally thereby increasing liquidity. The company is able to generate post-tax profit, which would improve over a period of time to add enough cash for the servicing of loans. The company has brought in Rs. 100 lakh as unsecured interest free loan, which would augment its cash flow.

14.2.5 Debt Restructuring for an Insolvent Company Insolvent companies by definition, cannot service their existing financial obligations with the assets available with them. This is because the capital employed would have shrunk considerably, due to operational losses. The primary task would therefore be to establish the future viability of such companies. Thereafter, a rehabilitation package is drawn up proposing sacrifices from lenders and equity shareholders. Additional financing requirements are also estimated and a financing plan is drawn up. In this category of companies, debt restructuring becomes a part of the overall revival plan for the company. The following illustration examines this situation.

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Illustration 14.4

Poor Health Ltd. has the following details to offer as at the end of a financial year:

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Particulars Equity Share Capital Long Term Borrowings (including overdue interest and other charges) Bank Borrowings for Working Capital (overdrawn by Rs. 100 lakh) Reserves and Surplus

Amount (Rs. Lakh) 500.00 1050.00 350.00 (650.00)

EBIT

105.00

Interest on Long Term Borrowings

183.75

Interest on Bank Borrowings Tax Rate applicable

63.00 35%

The company has been incurring cash losses for the past four years due to which its capital has been completely eroded. The company has been defaulting on long-term loans, which have piled up significantly. The working capital limits are irregular due to interest debits from time to time. Though the company is in operation, due to the huge financial burden, the company would soon be put up for liquidation. A restructuring has been worked out as follows to keep the company afloat and solvent. �

�

�

�

�

There would be a capital reduction to write off the existing capital completely against the accumulated losses to the extent of Rs. 500 lakh. There would be fresh capital contribution of Rs. 500 lakh, which would be partly used to write off the balance accumulated loss of Rs. 150 lakh. The long-term loan would be written down by 30% and would carry an interest rate of 12%. There would be a moratorium of eighteen months for principal repayment. The working capital limit would be regularised to the present level of Rs. 350 lakh with interest rate reduction for the past four years at 12.5%. This would release additional working capital to the company of around Rs. 75 lakh. The company is looking at a revival business plan by cutting costs, diversifying portfolio and aggressive marketing strategy, as also better recovery

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management. It hopes to make EBIT of Rs. 250 lakh on existing scale of business without the need for fresh capital investment in the medium term. The comparative table for the impact of the debt restructuring on the company’s financials is shown below. Rs. Lakh

Rs. Lakh

Before restructuring 105.00

EBIT Less Interest on long term borrowings Interest on bank borrowings

183.75 63.00

246.75 (141.75)

Profit before tax

0.42

Interest Cover (times)

Negative

Debt–equity ratio (DER)

235

Interest/EBIT (%)

After restructuring 250.00

EBIT Less Interest on long term borrowings (735 H 12%) Interest on bank borrowings (350 H 12.5%)

88.20 43.75

Profit before tax Provision for Tax @ 35% Profit after tax Share capital Long term borrowings Bank borrowings Earnings per share (Rs.) Interest Cover (times) Debt–equity ratio Interest/EBIT (%) * Due to accumulated losses, current losses there would be no tax liability for some years.

131.95 118.05 nil 118.05 350.00 735.00 350.00 3.12 2.27 1.57 43.98

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It may be observed from the above illustration that the nature of restructuring required in this case is much wider than a pure debt restructuring. It involved capital reduction, write off of existing debt to some extent and interest rate relief and other concessions to make the company viable and financially solvent. It must be understood that in these kind of circumstances, it is normally the viability of the business that is determined first before any financial restructuring is undertaken. It has to be assessed with reasonable certainty that, given some financial breathing space the business has a future potential to turn the company around. Otherwise, lenders are usually unwilling to extend reliefs and concessions and would rather cut losses by enforcing foreclosure and winding up. These aspects are further discussed later in this chapter.

14.3 Components of Debt Restructuring Since a company’s loan portfolio usually consists of several types of borrowings having different terms, it would be necessary to classify debt restructuring into the following components for the purpose of facilitating a closer examination of the issues involved. �

Restructuring of secured long-term borrowings

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Restructuring of unsecured long-term borrowings

�

Restructuring of secured working capital borrowings

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Restructuring of other short-term borrowings

14.3.1 Restructuring of Secured Long-Term Borrowings Long-term secured borrowings can be either in the form of mortgage backed loans provided by commercial banks and financial institutions or mortgage backed securities such as debentures issued either through private placement or through a public offer. Loans from commercial banks are usually to finance the acquisition of specific machinery, vehicles or other assets and are therefore in the nature of equipment finance loans. These loans are secured by a specific charge in the nature of hypothecation of the assets financed in favour of the bank. In such financing, the bank would have the right of attachment and sale of the concerned equipment, in order to recover its dues should the borrower default in servicing the loan.

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Equipment financing can also be sought through non-banking finance companies, in the form of hire-purchase transactions. Under these transactions too, the hirer has the right of re-possession and sale of the hired equipment or other assets, as a mode of recovery of dues. On similar lines, companies can have loans with specific charges on certain immovable properties, which are earmarked to secure the concerned borrowings. Usually such charges are created as mortgage to secure the lender. Such loans can be normal business related loans or for creation of specific assets such as land and buildings. In addition to borrowings with specific charges as discussed above, long-term secured borrowings can be with an omnibus charge of immovable and movable assets such as land and buildings, plant and machinery, and other categories of assets, both present and future. Such loans are usually given to create an entire project or business activity of a company and are therefore popularly known as Project Financing. These loans are traditionally given by financial institutions both at allIndia level (called AFIs such as IDBI, ICICI Bank Ltd, IFCI Ltd, etc.) and at the respective state level (SFCs and SIDCs). Project Financing forms the major gamut of long-term secured borrowings in most Indian companies. Long-term secured borrowings can again be both rupee denominated or in foreign currency from Indian lending agencies. In the past few years, the government has opened up another window for Indian companies in the form of foreign currency loans from lending agencies abroad, popularly known as external commercial borrowings (ECBs). However, there are very few instances of ECBs which have been lent as mortgage backed loans and therefore these are not being discussed separately in this chapter. Term loans are contractual obligations between borrowers and lenders and are, therefore, governed by the law of contract, specific provisions of the Banking Regulation Act, and other laws as applicable to banks and financial institutions. In India, term loans (whether for project or non-project financing) have traditionally been secured loans, with first charge in favour of the lender on the assets being financed. Term loans have an inherent drawback of separating ownership and usage of an asset in that, the lender owns the asset but it is the borrower who has possession thereof and enjoys the benefits of its usage. For e.g. if a loan is secured by a mortgage of a building, the lender has legal rights on the property till the loan is repaid in full. However, it is the borrower who is in actual possession of the building

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and enjoys the benefit therefrom. In order to make it easier for the lender to take possession of the asset in case of default in repayment of the loan by the borrower, the impugned asset is charged to the lender by way of a first and paramount charge, in super session of all other creditors of the borrower. Project loans go a step further and bring all immovable and movable assets of the borrower, both present and future under a blanket first charge. The need for restructuring long-term secured borrowings can arise in any of the categories of borrowers mentioned above under para (1) for the following reasons: (A) to reduce the cost of capital, (B) to improve liquidity and cash flow for a potentially sick company or (C) to enable rehabilitation of a sick company. Each of these cases has been dealt with separately below.

14.3.2 Reducing Cost of Capital for Healthy Companies Where loans with specific charge are concerned, such as in the case of equipment financing, recycling costlier loans with cheaper loans is not very difficult if there is a new lender who is ready to step into the shoes of the earlier lender at a lesser cost. The outstanding part of the loan is taken over by the new lender, based on revised repayment terms and interest cost, and the old lender is paid off in full to retire his dues. Accordingly, the charge on the equipment is shifted in favour of the new lender by the borrowing company, by satisfaction of the earlier charge and creation of a new charge. This process is quite simple and can be easily accomplished, provided the borrower is up to date in his payment record with the earlier lender. In the case of project loans which are secured by entire blocks of assets, if there is a single lending agency, the loan restructuring becomes more difficult and long drawn since there has to be a new lender in the nature of another project financing institution which is willing to swap the loan at a lesser cost. In earlier days, this practice was not resorted to as most of the project financing agencies were offering fixed rate loans and more often than not, at the same rates of interest. Therefore, institutions observed the unwritten law of not treading on each other’s path in trying to do loan swapping transactions. However, with the advent of liberalization, financial institutions and banks have been at loggerheads in competing with each other to get a share of the loan market pie. Therefore, in the present context, borrowers with a good payment

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track record have the flexibility to choose their lenders on the basis of their competitive pricing of the loans. Lenders are more than willing to do a loan swap with good borrowers even if that would mean taking a cut in their interest income. The process involved in this type of debt restructuring is much the same as in the case of equipment financing since there would be a substitution of one lender with another with corresponding modification of charge in favour of the lender coming in. The matter is much more complicated if project loans have been advanced as consortium loans with common underlying security as is the case with most Indian companies in the large and medium sectors. This is so because of an earlier practice that existed prior to liberalization wherein lending agencies distributed their risks by sharing project loans with each other thereby leading to fixed rate consortium lending. This was accomplished through the concept of a lead financial institution, which would take a major share of the loan, and other participating institutions that would chip in with their share under a mechanism called Project Finance Participation Scheme. Though this practice has been discontinued post liberalization, the problems associated with restructuring consortium loans are equally applicable wherever there are multiple lenders with a common security pool through a pari passu charge. In the case of such consortium loans, restructuring has to address the following issues: �

�

�

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�

Is it a case of ‘Loan Swapping’ where an existing lender(s) is being substituted with a new lender(s) or is it a case of ‘Loan Substitution’ wherein a new lender is brought in after the existing loan is retired? If it is a case of loan swapping, are all the existing lenders being replaced by a set of new lender(s) or is it proposed to replace specific lenders? Is the payment track record of the borrower identical with all existing lenders or is there disequilibrium in servicing of existing lenders? Is the borrower’s loan account classified as a standard asset in the books of all existing lenders? A loan account is classified as a standard asset if it is not in default of interest or principal payment for more than 180 days at a given time (this time limit is proposed to be reduced to 90 days by the Reserve Bank of India in line with international norms). Is the new lender(s) willing to take over the entire loan or is he prepared to make a fresh lending to replace a part of the earlier loans?

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Investment Banking

Is the consequent reduction in interest cost sufficient enough to go through the laborious process of restructuring the existing consortium borrowing?

If the above considerations facilitate a debt restructuring, a dialogue has to be initiated with the existing lenders who are sought to be replaced. Normally it is the prerogative of the existing lenders to decide on pre-payment of their existing loans, which have an unexpired life. Usually, the loan agreements provide for the lenders to charge a pre-payment premium from the borrower, to compensate for their opportunity loss of interest due to the pre-payment. If the terms are agreeable and the loan swapping makes financial sense after factoring in the cost of the pre-payment premium, the borrower agrees to pre-pay the loan and accordingly, the terms are negotiated with the lenders. In order to facilitate such a transaction, the new lenders are usually careful and insist on routing the fund disbursement directly to the old lender to retire its dues, so that the borrower does not misappropriate the funds. In certain other cases, if the borrower insists on non-disclosure of the identity of the new lender, it may so happen that the new lender would disburse the funds by way of a demand draft or cheque drawn in favour of the old lender and hand over the instrument to the borrower for submission to the old lender. The debt restructuring transaction is completed after the following steps are accomplished: �

A fresh sanction is obtained from the new lender(s) for retirement of earlier high cost borrowing after establishing the payment track record and categorization of the loan in the books of the existing lenders.

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A new loan agreement is entered into with the new lender(s).

�

Loan disbursement is made by the new lender in favour of the old lender.

�

�

�

The old lender(s) gives a certificate of satisfaction of dues, which is submitted by the borrower to the new lender as a proof of retirement of the earlier loan. The satisfaction of charge is recorded for the earlier loan and a fresh creation of charge is made for the new borrowing. The new loan(s) would have fresh repayment schedules and even an initial moratorium period as may be agreed to with the new lenders, even if it means just an extension of the earlier loans with a reduced interest rate.

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14.3.3 Restructuring Debt Obligations for Companies Facing Bankruptcy or for Potentially Sick Units In the case of bankrupt or potentially sick companies, the fundamental issues that are different from the situation described in (A) above are the following: �

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�

In most cases debt restructuring in these type of companies does not mean loan swapping. It refers to negotiations for restructuring the terms with the existing lenders, both on account of interest and repayment period. This is commonly known as debt restructuring. Debt restructuring in some cases could mean a Negotiated Settlement (NS) or a One Time Settlement (OTS). A negotiated settlement is entered into when the due amount is negotiated and crystallized to be paid over an agreed period, usually not more than 18 months. An OTS is made when the dues are crystallized and paid immediately, i.e. in a period not exceeding three to six months. In both these cases, the borrower has to work out the source of funds to meet the commitments, which could include a fresh borrowing. Normally, the classification of the loan in the books of the existing lender will be as a ‘Non-Performing Asset’ account which means that interest and principal are not being serviced as per the terms of the loan. This is the reason why loan swapping becomes a sticky process, since the new lender would be reluctant to take over a NPA into his books.

Debt Restructuring through Refixation of Terms Debt restructuring in existing loans is primarily done through refixation of the terms of the loan and through reliefs and concessions on present as well as future dues. The primary consideration, to enable a debt restructuring through this mode, is the inability of the borrower to service the existing terms of the loan due to business reasons. This needs to be established to the satisfaction of the lenders by substantiating the reasons for liquidity crisis and cash flow problems. The common reasons attributed are recovery problems for the borrower from his customers, demand recession, reduced margins, increased operating costs and low capacity utilization. The kind of reliefs and concessions looked at usually encompass the following: �

Interest Rate Relief – A reduction in the contracted rate of interest is considered if the company is not in a position to reach cash break-even point.

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Investment Banking

However, if the Profit and Loss Account shows coverage of interest on the term loan adequately, the lenders are usually not willing to look at interest rate reduction. The proof of burden in such cases would lie squarely on the borrower to establish that non-payment has resulted from cash flow problem and not due to willful default. �

�

�

Deferment of Past Interest Due – The interest due from the company upto the date of restructuring is usually aggregated and deferred with a fixed repayment schedule spread over a period of time. Waiver of Penalties for Non-Payment – All dues in the nature of compound interest and liquidated damages levied for non-payment of dues on time are usually waived to provide relief to the company. Reschedulement of Loan – The repayment schedule originally fixed is reworked, based on a detailed assessment of the cash flow of the company. In doing so, the lender ensures a satisfactory debt service coverage ratio of 1.5 or above, so that there is reasonable comfort in the proposal.

Under this category of debt restructuring, the lenders follow the guidelines issued by the Reserve Bank of India for restructuring such loans, and their categorization in the books of the lender after the restructuring. The RBI has provided detailed guidelines for treatment of loan accounts by the lender in its books, based on the status of the account and the security available against it. These guidelines are known as the Corporate Debt Restructuring (CDR) Guidelines. The CDR Scheme is available for restructuring of large loan accounts (Rs. 20 crore and above), which are under a consortium financing. This scheme helps in restructuring consortium loans through a specialized mechanism, which would be a non-judicial process by creation of a legally binding Debtor–Creditor agreement (DCA) and an Inter-Creditor Agreement (ICA), which has to be ratified by lenders holding at least 75% of the loan portfolio. In 2003, the CDR scheme was extended to cover even good accounts with banks. In other words, companies that are performing well or are not in default to their lenders can also avail of the CDR scheme, so as to benefit from reduction of financial costs if the lenders agree to their proposal. The complete guidelines on the CDR scheme are furnished in Annexure II to this chapter. Apart from term loans, other categories of secured debt include debentures, bonds, collateral loans, lease and off-balance sheet financing which a company undertakes as part of its business activity. Debentures are usually secured through

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a trust mechanism if they are publicly traded. The SEBI comes into play for issue of publicly traded debt instruments. In order to restructure the terms of such securities, it would be essential to comply with the provisions of the Companies Act and the directions issued by SEBI, based on the terms of the original issue as disclosed in the offer document. In the case of non-publicly traded debt, the contractual terms have to be renegotiated with the lenders and this assumes the character of a private transaction.

Debt Restructuring through Negotiated Settlement (NS) or One Time Settlement (OTS) Debt restructuring through NS or OTS can be done by the lenders for loans that are not covered by the CDR Scheme or if the CDR is not feasible due to lack of sufficient support by the concerned lenders. The primary consideration for a NS or an OTS as mentioned above, is the availability of funds to meet the obligation, since there would be a need to repay all the outstanding dues (subject to negotiation) within a short period of time. In assessing such proposals, the lenders look for comforts such as availability of fresh financing for the company by way of additional promoter contribution, fresh private borrowings and internal accruals from operations during the settlement period. In addition, the lenders insist on a substantial down payment of at least 30% of the crystallized dues on acceptance of the NS or OTS by the borrower. Normally NS/OTS terms are provided as follows: �

�

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Waiver of past interest due – The interest due from the company up to the date of settlement is usually waived by a certain percentage and the balance becomes payable under the settlement. Waiver of penalties for non-payment – All dues in the nature of compound interest and liquidated damages levied for non-payment of dues on time are usually waived completely. Payment of principal outstanding – The total loan outstanding as on the date of settlement is payable under the settlement along with the settled amount of interest due as described above. This amount is called the Settlement Amount or the crystallised dues which shall be payable over a period of time as stipulated by the lender. The lenders usually charge a simple interest based on their prime lending rate for amounts due under the settlement till they are paid.

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Investment Banking

An important feature of all NS or OTS proposals is the right of the lender to revert back to the earlier terms of a loan if the settlement fails due to any reason. In other words, in doing a settlement of this nature, the lender does not dilute any of his rights under the respective loan agreements for recovery of his dues as would have accrued if the loan has continued under the earlier terms. The NS or OTS is only a private arrangement between two parties to settle the transaction under agreed terms, without invalidating the loan agreement. In the event of the borrower not being able to settle the loan completely under the NS or OTS, the covenants of the loan agreement would apply and all terms of settlement, including the concessions given, would stand withdrawn. Under this category, the RBI has issued detailed guidelines for banks and financial institutions to work out NS/OTS arrangements for advances up to Rs. 50 million. For loans beyond this limit individual lenders are free to devise their own guidelines and work out the settlements accordingly. The complete guidelines on the Negotiated Settlement scheme are furnished in Annexure I to this chapter.

14.3.4 Debt Restructuring for Sick Companies Sick companies fall under the following categories: (1) those that fall under the definition of a ‘Sick Industrial Company’ as per Section 2(o) of the Sick Industrial Companies (Special Provisions) Act 1985 (SICA). (2) those that fall under the description of a ‘Potentially Sick Company’ under Section 23 of SICA. For those companies falling under (1) above, debt restructuring becomes a statutory process under the Board for Industrial and Financial Reconstruction (BIFR) set up under SICA. As per the provisions of SICA, BIFR has wide powers in framing rehabilitation schemes for companies that have become sick. All existing loan obligations of a borrower get suspended once SICA becomes applicable and the BIFR process takes over. In restructuring companies under this route, it is vital to establish the future viability of the business of the company to the satisfaction of the BIFR. The BIFR mechanism has been dismantled by the repeal of SICA and a new body called the National Company Law Tribunal (NCLT) has been set up to administer restructuring or winding up of sick companies. The entire provisions relating to sickness and rehabilitation have been shifted to the Companies Act.

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Those companies falling under the category ‘Potentially Sick Company’ as defined by SICA (see (2) above), are required to get their debt restructuring done through a package formulated by the respective financial institution or bank, after establishing the future viability of the company to the satisfaction of the lender. This process is more or less the same as described in (B) above. If the company fails to do so and becomes a sick company, the company gets covered under the definition ‘Sick Industrial Company’ (see (1) above).

14.3.5 Recovery Laws and Restructuring of Secured Long-Term Borrowings While conducting a debt-restructuring programme for long-term secured borrowings, the company and the investment banker have to be aware of the recovery laws that empower lenders to proceed against the company legally to recover their dues. In India, debt restructuring can happen in two ways—either through the negotiation (out of court) route or through the court route, under Section 391 of the Companies Act 1956. If debt restructuring is proposed under the first route, it would require that the borrower has to approach lenders well in advance before proceedings are initiated by them under the recovery laws that are available. It is, however, possible to negotiate a restructuring even after legal proceedings are initiated by lenders, subject to the leave of the concerned statutory authority. The court route is preferred only if the negotiations with lenders are not feasible; but the court has to be approached prior to the lender taking recovery action or the company becoming sick. The advantage of using the court process for debt restructuring is that after the approval by the court, it becomes binding on all creditors, including the dissenting creditors. There is however, a requirement that those lenders representing at least 75% in value should agree to the restructuring. Usually, debentures are restructured by alteration to their terms of issue through the court route, since the number of debenture holders would be large and it may not be feasible to negotiate through meetings and seek their approval successfully. However, in the case of term loans, the common route adopted in the past was for the lenders to approach the court for a winding up order under Section 433(e), which meant that the company was unable to pay its debts, or for an order under Section 391 for a compromise. However, these routes are long drawn and the lenders have to wait for an unduly long time to recover even a part of their dues. Therefore, in 1985, the BIFR mechanism was introduced under SICA, whereby

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orders for rehabilitation or for winding up could be obtained much faster after a company became sick. However, the SICA has failed to meet expectations due to (a) delay in BIFR proceedings as much as in civil courts and (b) being unavailable to companies that are not covered under the definition of sickness under SICA. Therefore, in recent years, secured lenders prefer the out-of-court route for companies that are not under the sick category, either through the CDR route or through the OTS route so that the accounts can be settled faster than through the court route. There are basically the following recovery laws governing debts due to banks and financial institutions in India. 1. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Popularly known as the Securitisation Act, this law empowers lenders to attach and sell mortgaged assets to recover their loans without intervention of any court or other judicial body. Under Section 13(2) of this Act, lenders can issue recovery notices and after a period of sixty days, if the borrowers do not pay up, can exercise their powers as defined in Section 13(4) of that Act. This Act has been caught in a judicial quagmire with a slew of court cases against such sweeping powers having been given to lenders. After the final judgement of the Hon’ble Supreme Court in the Mardia chemicals case, it could be amended with a toning down of the powers given to lenders or providing more defences to borrowers in default. 2. The Recovery of Debts due to Banks and Financial Institutions Act, 1993. Under this law, special recovery courts called Debt Recovery Tribunals (DRTs) have been set up to help administer speedy recovery of debts from defaulting companies. The DRTs have powers to restructure debts or order winding up of defaulting companies, as found appropriate. 3. Sick companies are covered under the SICA as already explained above. 4. Lenders can also take recourse to common law by filing a civil suit for recovery of their dues from the defaulting companies through attachment and sale of mortgaged assets. This route takes a long time and is not preferred after the enactment of the Securitisation Act referred to above. 5. Lenders can also petition the court for winding up of a defaulting company under Section 433(e) of the Companies Act, 1956 on the ground that the company is unable to pay its debts. However, this route is also a tedious and long drawn one for lenders.

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14.3.6 Restructuring of Long-Term Unsecured Borrowings Long-term unsecured borrowings can be in the nature of public deposits, private unsecured loans and privately placed, unsecured bonds or debentures. In the case of public deposits, the terms of the deposit can be renegotiated, provided the scheme is approved by the appropriate authority. Here, the appropriate authority would depend on the type of company. For banking and non-banking financial companies, the appropriate authority is the RBI. For unlisted non-financial companies, the appropriate authority is the Department of Company Affairs set up under the Ministry of Finance. For listed companies, non-financial companies, the appropriate authority is SEBI. In the case of private borrowings, these have to be negotiated on a case-by-case basis.

14.3.7 Restructuring of Secured Working Capital Borrowings Working capital borrowings encompass credit limits from commercial banks in the nature of cash credit, demand loan, bill discounting, overdraft facilities, and commercial paper. These are secured by first charge on inventory and book debts and second charge on other assets. Restructuring of working capital borrowings from commercial banks is more or less on the same lines as in the case of term loans, and all the criteria that are applied for determining the reliefs and concessions are more or less the same. Banks normally do not consider waiver of past interest dues for well performing companies having temporary cash flow problems. Loan swapping through switch over from one bank to another is possible provided the existing banker is willing to let go. If the company’s track record has been satisfactory, the existing banker is normally reluctant to agree for a loan swap and would examine ways and means of helping in debt restructuring within the existing loan parameters. However, if the borrower company were a NPA, the bank would be glad to let go. It may however be difficult for such companies to find a new banker to take over the existing loans. There is no bar on a fresh bank taking over the existing NPA loan account of a bank. However, the loan account would have to be categorized as NPA in the books of the new bank for a period of one year from the date of take over. The process involved is much the same as has already been discussed. The question of restructuring commercial paper does not normally arise since these are short-term instruments issued at fine rates by borrowers with high credit standing.

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14.3.8 Restructuring of Other Short-Term Borrowings Other short-term borrowings include inter-corporate deposits, clean bills and other acceptances and clean overdrafts. These are normally not restructured since they are very short term in nature. Instead, they may be rolled over with fresh terms being renegotiated. The process involved is more of negotiation and does not entail complex restructuring.

14.4 Investment Banking Services in Debt Restructuring Investment bankers, of late, have developed a service area in advising and representing companies in debt restructuring programmes. The various steps involved are as follows: 1. The first stage would be to formulate a viability plan for the company. For this purpose, the investment banker has to understand the business model, present financial position, existing borrowings and their carrying cost, future business opportunities and the resulting cash flow therefrom. 2. Once the company’s viability and future operating plan have been formulated, the next step would be to float the ‘Debt Restructuring Scheme’. The DRS has to comply with statutory norms and applicable guidelines issued by the RBI. The investment banker has to use his expert knowledge and prior experience in formulating the scheme, so as to envisage workable terms of sacrifice from lenders and attractive terms of liability and cost reduction for his client. 3. The next step would be to present the DRS to lenders and represent the client in discussions and negotiations with the consortium of lenders or individual lenders as the case may be. This would require detailed presentations, site visits by lenders and establishing the future viability of the company’s business beyond doubt, after taking into account the proposed debt restructuring. Of utmost importance is the justification for the proposed terms of the restructuring and the sacrifices if any, being sought from the lenders. 4. In most debt restructuring proposals involving either bankrupt or sick companies, suitable contribution is also expected from the borrowing company to establish its commitment to the proposal and to re-capitalize the company

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to improve its net worth. The additional capital infusion requires financing either through sale of some assets by the company or from external sources, since the company would hardly be in a position to generate funds from internal accruals. The external sources could be additional promoter contribution, rights issue to existing shareholders, bringing in a strategic or financial investor, or through a suitable merger or acquisition transaction with or without change in the existing management. In all such situations, the investment banker plays an additional role in providing transaction services, which becomes crucial for meeting the stipulated requirements. 5. After the proposed DRS is approved in principle, it is to be ratified by the approving authorities in each lender’s organization. Thereafter, the borrower is issued confirmation of the terms and sanction for the scheme. The investment banker’s role would then be to provide transaction services to generate the necessary funds, to meet the requirements stipulated for the borrower. The mandate generally extends till such time that the transactions are completed and the DRS goes through smoothly. 6. Debt restructuring services would involve a lot of compliance and legal work for which the investment banker works closely with other professionals such as the CFO, auditor, company secretary and legal advisor of the borrowing company.

14.5 Recent Cases in Debt Restructuring 14.5.1 Arvind Mills Ltd.2 The biggest debt restructuring in Indian corporate history was accomplished in 2001 in the case of Arvind Mills Ltd. an Ahmedabad based denim manufacturer, which boasts of a capacity of 110 million metres per annum, the world’s third largest capacity. The entire capacity was built up between 1987 and 1997, during which time the company leveraged its balance sheet heavily with a mix of domestic loans and ECBs, which included a $125 million FRN issue. Arvind’s troubles started with the decline in denim prices in 1998–1999 and since it was a global commodity, Arvind had no control on the price trends. In addition, the prices of naphtha, the feedstock for Arvind’s captive power plant, doubled during this time, thereby further damaging its prospects. What made the Arvind debt restructuring a landmark was the sheer number of lenders in the reckoning—a staggering figure of 85 domestic and international

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lenders, with a cumulative exposure of a whopping Rs. 2700 crore. The mammoth task of making 85 lenders agree to a common plan was the most challenging element in the whole process. The debt restructuring plan was spearheaded by two entities–KSA Technopack, which prepared the ‘Market Study and Due Diligence of Business Plan of Arvind’, that laid the foundation for the whole exercise, and Jardine Fleming Singapore Securities, which being one of the lenders, headed the steering committee of lenders that drew up the debt restructuring plan. The steering committee represented 60% of Arvind’s total borrowings. Based on a future cash flow assessment, the plan provided for writing off 40% of the total debt commitments of Arvind. Three banks that were not happy with the verdict of the steering committee approached the Gujarat High Court, petitioning for foreclosure. The Court dismissed the petition and directed the dissenting lenders to fall in line with the others. This led to the debt restructuring process being accepted by all the lenders, which basically consisted of paying up 60% of the total dues over a staggered phase with reduction in interest rate for the future. The restructuring helped Arvind come back into the black with a reported post-tax profit of Rs. 10 crore for the first quarter of FY 2002–03, the first profit in three years.

14.5.2 Haldia Petrochemicals Ltd. Haldia Petrochemicals Ltd. (HPL), located in Haldia, West Bengal, was promoted as a joint sector project with significant shareholding by the Government of West Bengal through the West Bengal Industrial Development Corporation (WBIDC). The private partners are the Tata group and the Purnendu Chatterjee group (Chatterjee group). While the WBIDC holds 43%, the Chatterjee group holds 43% and the rest is held by the Tata group. The project had problems since inception and went through time and cost overrun in its implementation, as a result of which the project cost escalated to more than double of the original estimates, to Rs. 51.7 billion. After commercialization, the project had not been able to service its debt burden and due to accumulated losses and interest dues, the debt–equity ratio of the company was very adverse. Due to the capitalization of the losses and interest dues, the project cost swelled to Rs. 60 billion. As of March 2002, the company had an equity base of Rs. 11.53 billion and an outstanding debt of Rs. 40 billion, making the debt-equity ratio very unfavourable at 3.47:1.

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In order to come out of the financial crisis, HPL envisaged a debt restructuring proposal whereby the debt-equity ratio was sought to be brought down to around 1.5:1. However, this meant that the financial institutions and other lenders had to agree to the debt restructuring proposal. The lenders on their part, insisted that the promoters of the company should bring in additional funds as equity or quasi-equity to re-capitalize the company. The debt restructuring package envisaged extension of moratorium period for the loans, reduction in interest rate and conversion of some of the existing institutional debt into preference capital. Though HPL was also trying to bring in a strategic partner, Indian Oil Corporation (IOC), the management control and other issues were unresolved at that stage. The proposal for restructuring the debt of HPL was ultimately approved by the consortium of lending financial institutions in September 2002, under the CDR scheme. The package envisaged that the company’s promoters should bring in additional contribution of Rs. 7 billion as fresh capital into the company. On their part the financial institutions agreed to provide reduction in the interest rate from 14.5% to 11% and to convert Rs. 4 billion of loans into equity and preference capital. The package also included funding of accrued interest of around Rs. 3.5 billion into long-term debt. This would result in reduction of the annual interest outgo from Rs. 4.5 billion to Rs. 3 billion and the debt–equity ratio to decline to 2:1. The promoters were to bring in their contribution either by roping in IOC as a partner (which was willing to pump in Rs. 4 billion for a 26% stake) and through Gas Authority of India, which was willing to bring in Rs. 5 billion for a strategic stake. The financial institutions also stipulated that the losses and unpaid interest of the project amounting to Rs. 9 billion would be shared by all concerned, i.e. the promoters, financial institutions and unsecured creditors.

14.5.3 Mangalore Refineries and Petrochemicals Ltd. Mangalore Refineries and Petrochemicals Ltd. (MRPL) went through a major debt restructuring to bring it out of a staggering debt burden of Rs. 55 billion. This was a pre-cursor to the exit of the Aditya Birla group from the company by selling off their entire stake of around 37.5% to ONGC Ltd. Under the debt restructuring package, about Rs. 4 billion of rupee term loans were converted into equity, and interest on the foreign currency loans and balance rupee loans were slashed significantly. This was enabled by the fact that after the

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proposed acquisition by ONGC, the company would become its subsidiary, thereby significantly improving its credit rating. The commissions payable on deferred payment guarantees provided by financial institutions were also lowered. ONGC was expected to pay around Rs. 6 billion, which was proposed to be used to repay part of the loans, thereby reducing the total outstanding debt to Rs. 35 billion. About Rs. 10 billion worth of debt consisting of public debentures and working capital borrowings were not considered for restructuring in that scheme. The reduction in interest rates were from 13–13.5% to about 8% on rupee loans, LIBOR + 2.1% to LIBOR + 1.4% on foreign currency loans and from 1.6% to 1% on deferred payment guarantees.

14.5.4 Southern Petrochemical Industries Corporation Southern Petrochemical Industries Corporation (SPIC), a part of the A.C. Muthiah group, has been on a restructuring drive to bring down the average interest cost on rupee loans from 14% to less than 8%. The company has a debt burden of about Rs. 11.74 billion. SPIC’s restructuring package also includes a buy back of $72 million worth of Floating Rate Notes at a substantial discount and repayment of 50% of the balance of $48 million after 12 years. The remaining 50% would enjoy a moratorium of four years till 2007 after which the lenders would get 5% and 10% per annum on two tranches of repayment. The promoters have proposed to sell off their stakes in other businesses to bring in funds for the buy back of the FRNs. SPIC has been in trouble for the past several years due to high cost debt, which was reduced from 19.5% to 14% in 1997–1998. This was not sufficient and subsequently, the company underwent a restructuring of debt under the CDR scheme in 2002, whereby interest rates were further reduced. This was also found to be insufficient to make the company viable. The latest debt restructuring proposal is also under the CDR scheme. The total debt of Rs. 11.74 billion has four tranches of repayment, consisting of Rs. 1.34 billion payable in 5 years with an interest rate of 4% p.a., Rs. 2.88 billion payable in 7 years at 6%, Rs. 3.35 billion payable in 9 years at 8% and Rs. 4.17 billion payable in 12 years at 11%. This works out to an average cost of 7.61% p.a. over the entire period. The sacrifice from the lenders and debenture holders was estimated at Rs. 2.81 billion on reduction of interest rates.

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The package includes SPIC raising Rs. 5.65 billion from divestment of its investments in subsidiaries and associate companies and exiting businesses like pharmaceuticals and biotechnology.

14.5.5 Kirloskar Group In a unique case, the Bangalore based Vijay Kirloskar group restructured its flagship company, Kirloskar Electric (KEC), through a court process to reduce its debt burden and put the company back on track. The company, which had a debt burden of Rs. 3.15 billion, was proposed for a three way split to unlock its asset value and turn its net worth positive. While KEC would continue, its rotating machinery division would be spun off as Kaytee Switchgear. The plan also envisaged setting up a special purpose vehicle (SPV) which would carry with it Rs. 1.48 billion of debt. This consists of Rs. 1.21 billion of KEC’s debts and Rs. 270 million for consideration payable to KEC for the restructuring and other commitments. The SPV’s assets would be land worth about Rs. 1.26 billion. The SPV plans to sell the land and repay its debts. The SPV would be a self-liquidating company and would cease to exist once the debts are repaid. It would be owned 99% by financial institutions and banks and therefore, the debt of the SPV would not carry any interest. The lenders would also be eligible to retain profits but would be responsible to sell the land belonging to the SPV. The debt restructuring through this route was spearheaded by ICICI Bank. The debt restructuring was done through the court route after it was approved by 75% of the creditors, shareholders and unsecured creditors. The scheme was approved by the court in early 2003 after which it became effective and the transfer of assets took place from KEC to the SPV. Under the new structure, both KEC and Kaytee would be net worth positive. Kaytee would carry the residual debt of Rs. 1.9 billion and would be owned 71% by KEC and 29% by financial institutions and banks. The residual KEC would be held to the extent of 60% by the promoter group. KEC had a turnover of Rs 5.25 billion in 1996, but ran into rough weather in 1998–1999 and lost its entire net worth in 2000–2001. It was essentially hit by recession in the capital goods and infrastructure industry, which are the prime users of its products. While the company’s prices fell 30% in two years, the high level of debt taken to finance a component unit, excess labour, and high receivable position led the company to incur losses.

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14.5.6 Steel Sector Restructuring One of the biggest debt restructuring packages put together in recent times has been for the ailing steel sector in India. Essar Steel, Ispat Industries, Jindal Vijaynagar Steel, Mukand, Malvika, SJK and other companies have been on the restructuring mode under the CDR scheme so as to make them financially viable. In respect of Essar, Ispat and Jindal, the financial institutions agreed to write off 40% of the paid up capital of each company, and converting a part of the existing loans into equity. The writing down of share capital would amount to reduction of share capital under Section 100 of the Companies Act and would require, apart from shareholders’ and creditors’ approvals, the sanction of the High Courts concerned. Apart from the above, there would be reduction in the rate of interest and extension in the repayment period of the loans. A portion of the loans would also get converted into preference capital at 0% dividend. Of the total debt, 40% would be converted into foreign currency loan with a 8% fixed rate of interest. On the balance 60% of the loan, the lenders would charge a fixed rate of 14%. The loans would have a tenure of 15 years with an initial moratorium of 2 years. As a result of this restructuring, the weighted interest cost for each company would be reduced to 11.6%. As a part of the conditions for restructuring, the promoters of each company have to pledge the 60% of their ownership shares in respective companies with the lenders (since 40% is written off) and should also open a trust and retention account with a specified bank to monitor the cash flow. In the meantime, Essar also proposed to redeem its FRNs at huge discount or a roll over through issue of fresh notes at a very low coupon rate as against LIBOR+2% for the original notes. The proposed new notes at a coupon rate of 0.25% would be redeemed in 15 years in 2018. With regard to Indian holders of the FRNs, Essar has offered a conversion of the same into rupee denominated notes. J.P.Morgan Chase Bank is the trustee for the FRN issue. Essar’s troubles started in 2001 when the company began to post losses due to the global recession in the steel industry. It appointed KPMG to advise on strengthening its operations and reduction of losses. Thereafter, it approached the lenders and other creditors for a ‘standstill’ agreement on repayments for a limited period. This proposal meant deferring the repayment obligations of the company to its creditors during the standstill period. Since then the restructuring proposal for its debt burden had been hanging fire, until it was resolved in early 2003.

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14.5.7 Other Companies 1. Indo Rama Synthetics Ltd, promoted by the O.P. Lohia group went in for a debt restructuring with the financial institutions in 2001–02 with IFC Washington, who was the overseas lender to the company. This was achieved after IFC had filed a suit for recovery of its dues against the company an year earlier in Nagpur. The suit was accompanied by an application for appointment of a receiver and to restrain the company from disposing off its assets. 2. The BPL group kicked off a major restructuring in 2003 in an effort to bring down the debt burden of the group that had seen a liquidity crunch for the previous two years. The group was facing problems in its core businesses of consumer appliances, electronics and white goods. The electronics business had slipped into the red in 2002 and the appliance manufacturing companies were making losses. The restructuring plan envisaged a merger between group companies manufacturing white goods and electronics with the parent company BPL Ltd. and offering a strategic stake in the combined entity to Sanyo of Japan to the extent of around 40%. The funds raised through this sale were proposed to be used to retire some debts and reduce the debt burden. In addition, it was proposed to offer equity to financial institutions, sell off certain non-core businesses and hypothecate additional assets to raise funds for working capital requirements. 3. Jindal Strips Ltd. ( JSL), a part of the O.P. Jindal group, is a profit making company, which went in for debt restructuring as a part of its cost cutting exercise. In early 2002, the company restructured its Rs. 5 billion long-term loans and Rs. 2 billion of short-term loans by bringing down the interest rates from 16% to 11.5% and 14% to 10.5% respectively. The earlier loans in the range of 15–18% were taken from IFCI, LIC and Bank of Nova Scotia. The company was also reported to be looking at the ECB route to raise funds at 3% per annum in dollar terms.

14.6 Introduction to Equity Restructuring Equity restructuring refers to the process of alteration of the structure of the shareholders’ funds. In other words, it is the re-organization of the share capital and/or the reserves appearing in the balance sheet of a company. Shareholders’ funds

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include paid up equity share capital, preference capital (if any), reserves and surplus and all other liabilities of a company that are not in the nature of debt obligations owed to outsiders. In other words, shareholders’ capital includes all types of capital provided by the owners of the company and all accumulations in the balance sheet that belong to them. In this module, the term ‘equity restructuring’ has been used in the context of a restructuring of shareholders’ funds (shareholders’ capital). Restructuring of shareholders’ funds is often termed as ‘equity restructuring’ since more often than not, it involves inter alia, restructuring of the paid up equity capital appearing in the balance sheet. While alteration of reserves alone is not strictly considered as equity restructuring in the legal sense of the term, a restructuring of the equity share capital is a much more complex and legal mechanism. Notwithstanding this difference, alteration of reserves has to be done with due consideration to the distinction between ‘general reserves’ and ‘specific reserves’. General reserves are available for utilization in a way that the shareholders feel appropriate and therefore, these can be appropriated with necessary resolutions passed in shareholder meetings. However, specific reserves need to be handled more carefully by examining the purpose for which they were created in the first place. These reserves can only be used in fulfilling the objects of their creation and if such objects were stipulated under law, appropriation to any other purpose would require statutory clearance. Examples of reserves with specified modes of utilization are ‘Securities Premium’, ‘Capital Redemption Reserve’, ‘Debenture Redemption Reserve’, etc. Equity restructuring involving the equity or preference share capital of a company is a much more complex process which invariably involves a process of law. Conceptually, restructuring of the share capital involves variation in shareholder interests and is therefore, a closely regulated area. Regulators are particularly interested in ensuring that indiscriminate equity restructuring does not lead to undermining the confidence in the corporate system. This leads us to the discussion on the concept of ‘capital reduction’.

14.7 Concept of Capital Reduction In all financial restructuring exercises involving restructuring of shareholders’ capital, the concept of ‘capital reduction’ has to be recognized and observed diligently. The term ‘capital reduction’ refers to any of the following—(a) decrease of share capital by virtue of a return of such capital in cash to the shareholders or (b) variation or extinguishments of the shareholders’ right of return of such capital from the

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company or (c) the reduction or waiver of amounts due from shareholders to the company towards capital commitments. Conceptually, the equity share capital subscribed by the shareholders is considered as permanent capital of the company till it is wound up. The profits and other gains made by the company from time to time add to such capital and become part of shareholders’ funds. However, if the company runs up losses from time to time, such losses diminish the shareholders’ capital. In the case of companies making profits, these profits can be paid back to the shareholders from time to time by way of dividends, only to the extent it represents accumulated profits. Any payment beyond the level of accumulated profits would amount to return of share capital and hence becomes capital reduction. In short, while payment of dividends out of accumulated profits does not amount to capital reduction, payment of dividends in excess of or in the absence of profits amounts to capital reduction. Share capital is a very important aspect of corporate law as it is fundamental to the existence of the corporate form of organization. Therefore, equity restructuring is governed by stringent provisions of company law and wherever such equity restructuring amounts to a capital reduction, the relevant provisions of law have to be followed in implementing such restructuring programmes.

14.8 Methods of Equity Restructuring Restructuring of shareholders’ capital has different connotations based on the manner in which it is executed: (1) Share capital can be restructured by repurchase of shares from the shareholders for cash. This reduces the liability of the company to its shareholders, amounting to a capital reduction by way of return of share capital while the company is still a going concern. Legally, equity shareholders are entitled to a return of their capital from the company only on its winding up and that too, after all the outside liabilities and preference share holders have been paid off in full. Preference shareholders are entitled to a return of capital on redemption of preference shares or on liquidation of the company after the outside liabilities have been met. Therefore, any return of such share capital without going through a process of winding up or redemption as the case may be, would amount to fraudulent preference unless it is done within the framework of law.

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A different method under the same category would be to convert equity capital into loans or redeemable preference shares, so as to be paid off at a later date. Such write-back of equity capital consisting of shares allotted and fully paid up would also amount to fraudulent preference if not undertaken as per statutory provisions. (2) Equity may also be restructured to reduce the share capital by means other than refund of cash. This is done by writing down the equity share capital through appropriate accounting entries. This type of equity restructuring amounts to extinguishments or reduction in the shareholders’ capital entitlements from the company and therefore falls under the second definition of capital reduction mentioned earlier. The effect of this exercise would be to reduce the amount owed by the company to its shareholders, without actual return of such equity capital in cash. (3) The third way of equity restructuring is the process whereby the liability of the shareholders to meet their capital commitment is diminished or extinguished. In other words, the amount due from shareholders to the company on account of the share capital they had subscribed to is either reduced or waived totally. Such restructuring is possible by cancellation of unpaid calls on shares or by making partly paid shares as fully paid shares so that the amount due from shareholders need not be paid. Since this amounts to reducing the liability of the shareholders to the company for capital committed by them, it amounts to capital reduction. (4) Equity restructuring through re-organization of shareholders’ capital can be achieved by any of the following means: a. Re-organization of share capital by consolidation or sub-division of shares. b. Expansion of share capital by conversion of convertible instruments such as convertible debentures, convertible preference shares, equity warrants and others. c. Diminution of share capital through cancellation of authorized capital. d. Cancellation of unissued capital. e. Capitalization of reserves by issue of bonus shares. f. Conversion of loans into equity.

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All the above methods of re-organization of capital are merely a re-arrangement in the capital structure without any financial implication. Therefore, they do not satisfy any of the criteria mentioned earlier to fall under the ambit of capital reduction. However, consolidation or division of existing shares are included in the definition of the term ‘arrangement’ under Section 390(b) of the Companies Act. In view of this, such mechanisms may also be enforced through a judicial mechanism under Section 391 by reference to the National Company Law Tribunal. The regulatory aspects of equity restructuring have been discussed later. (5) Equity restructuring involving a change in the ‘reserves and surplus’ alone without alteration to the share capital can be done from time to time by a company. This process of equity restructuring could be done in the following ways: (a) by writing down the amount of accumulated profits and other revenue reserves in the balance sheet, (c) by writing down the amount of capital reserves in the balance sheet, (c) by writing down the non-cash reserves appearing in the balance sheet and (d) by a combination of any of the above. In this type of equity restructuring, the moot point is that the rights of shareholders are affected only to the extent of the reserves and not the share capital. Due to this reason, this does not amount to a capital reduction in the legal sense. However, since the rights of shareholders are being varied, it would require appropriate resolutions to be passed by the shareholders. Generally speaking, writing back of non-cash reserves is more of an accounting process while write back of cash reserves has to be triggered off by a larger consideration. These aspects are discussed more in detail later in this module. Restructuring of shareholders’ capital thus encompasses various degrees of equity restructuring under a variety of methods, some of which are usually used in combination to achieve a specific objective. This discussion can be summarized as follows: �

�

Restructuring of shareholders’ capital is a term of wider import. It encompasses a restructuring of equity share capital, preference or other share capital, reserves and accumulated profits and losses. Therefore, it is a term that extends to any component of restructuring of the entire shareholders’ funds appearing in the balance sheet. Restructuring of share capital (either equity or preference) can either be a process of capital reduction or mere re-organization of capital. While capital

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reduction is regulated under law, re-organization is an internal process in a company which can be approved by shareholders. �

Restructuring of the reserves without alteration of share capital would require a careful examination of the nature of such reserves and their intended application. This process can be approved by the shareholders as it does not involve capital reduction.

14.9 Rationale for Equity Restructuring Equity restructuring like other forms of financial restructuring is driven by strategic financial considerations such as optimization of capital structure and cost of capital, restructuring of the balance sheet, etc. These considerations can be discussed under the following categories: Correction of over-capitalization — Well-performing companies that enjoy good margins and high recovery rates from customers are generally left with surplus liquid cash and cash equivalent assets that are in excess of their long-term requirements. The pitfalls of having excess liquidity are many; it could be misdirected into ill-conceived ventures and if not profitably employed, it would reduce the return on capital (ROCE) generated by the company. The fall in such return has serious repercussions in terms of fall in the return on net worth (RONW) and consequent adverse impact on the market price of the share. In order to correct a condition of over-capitalization, a company can resort to a repurchase of equity shares (and preference shares too if the terms of issue so permit) for payment in cash from the shareholders. This is also popularly known as a buy-back of shares by the company. Through this process, the company reduces its capital and excess liquidity in its business. As a result, the shareholders’ funds are decreased and the equity capital is trimmed of the excess flab. The reduction in capital has a positive impact on the ROCE and RONW, and the pruning down of equity share capital has a positive effect on the earnings per share (EPS). This would lead to improved perception in the stock market and a consequent increase in market capitalization. However, buy-back of equity is not advised for companies that have high growth rates and market capitalization. In such companies it would be advisable to retain the capital in business and reduce borrowings so as to bring down the current cost of capital and improve profitability and liquidity. Similarly, in companies that have

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high debt–equity ratios, excess capital should be used initially to repay existing borrowings rather than to buy-back equity. Lastly, share buy-back is also not recommended for companies with reasonable debt–equity ratios but with a long cash cycle or with unpredictable cash flow patterns. Such companies would do well to retain excess capital in liquid assets to meet contingencies or to retire debts and reduce financial leverage. Shoring up management stakes — Equity buy-back can also be used as an effective measure for increase of promoter stakes in a company. Company managements normally look out for such opportunities during times of depressed market conditions during which, buy-back of shares from the public shareholders could be made at attractive price by the promoters. This would be a cost effective way of consolidation of promoter interest in a company. Exit mechanism — Equity buy-back is an investor-friendly measure in times of depressed markets wherein the retail investor is locked in the share due to its low market price. If the company can support a buy-back with enough liquidity, the investor gets a respectable exit from the share during such times. Shareholder value management – Equity buy-back would be required in times when the company is not able to generate enough return on the surplus capital in its businesses to offset the opportunity cost to shareholders. If it continues to keep such funds in the business, it would destroy shareholder value. Therefore, a buyback at such times helps in unlocking the excess capital and the shareholders would be free to deploy such funds elsewhere. In the same context, it is necessary to mention that the buy-back has to be priced appropriately so that it does not erode value for the shareholders who are left behind after the buy-back. For detailed discussion on pricing of buybacks readers may refer to Chapter 9. Re-organization of capital to achieve better efficiency – Re-organization of capital does not have any financial implications since the overall shareholder funds remain unchanged. However, this process is undertaken to achieve certain efficiencies. For example, sub-division of shares into smaller units can bring down the market price of a highly priced share so as to provide more floating stock and bring the share within the reach of the common investor. Similarly consolidation may be necessary on account of re-grouping different classes of shares into one uniform category. Bonus issue of shares through capitalization of reserves amounts to rewarding shareholders for their loyalty with additional shares at no extra cost. This process adds to their stock of marketable shares, which could yield better returns to the

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shareholders rather than through distribution of reserves as dividends. Bonus shares also add to the floating stock and therefore, to the company’s market capitalization. Wiping out accumulated losses – One of the most important drivers for equity restructuring over the years has been to restructure balance sheets of financially troubled companies and reduce their equity capital that is unrepresented by assets. Financially unviable companies lose their capital in business rapidly due to mounting operational losses. These losses initially eat into the reserves and if allowed to continue, they wipe out even the share capital. In such a situation, the shareholders’ funds appearing in the balance sheet are, in effect, fictitious. They no longer represent any assets since they are more than offset by the accumulated losses. In the process of reconstruction of such loss making companies, it becomes imperative to write off the accumulated losses against the shareholders’ capital so as to make the balance sheet representative of the actual financial position before such reconstruction. This would be necessary to arrive at the exact asset-liability position and work out a rehabilitation package for reviving the company. Writing off of unrecognized expenditure – Balance sheet restructuring by writing down the equity capital or the reserves may also be necessary to write off fictitious assets or deferred revenue expenses to the extent not written off against revenue. This would make the balance sheet more realistic and represent the true financial position of the business. Maintaining debt–equity ratio – Balance sheet restructuring would also be necessary to rectify an imbalanced debt–equity ratio. In some situations, if the company does not have enough debt servicing capacity, the debt liability mounts and creates an unfavourable debt equity ratio. In order to arrive at a more favourable debt–equity ratio for the company, a suitable debt restructuring may be done which could include conversion of debt into equity. This would alter the debt–equity structure by increasing the equity component, with a corresponding decrease in the debt component. Revaluation of assets – Equity restructuring could also be a result of writing down or writing up some assets of the company to reflect their true values. If assets are written up in their values, such gain is recognized as permanent capital not available for distribution as dividend, since it is a non-cash reserve. Such reserve is usually shown as a part of the shareholders’ capital under the head ‘revaluation reserve’. Similarly, if assets are written down, the consequent loss is written off firstly against any previously existing revaluation reserve if any, and the balance is written off against accumulated

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profits. Apart from revaluations, there could be other capital gains or losses that are reflected from time to time by restructuring the shareholders’ capital. To raise fresh financing – Balance sheet restructuring could be also to induce fresh financing by way of debt or equity. Prior to the proposed fund raising, the balance sheet could be restructured to correct structural anomalies in the equity and debt capital. This way the balance sheet becomes more favourable for financing. If the proposed financing is through the debt route, it could be raised at better rates than possible prior to the restructuring. If the proposed financing is through the equity route, restructuring could increase the prospects of fresh equity and that too at an attractive price. If equity is trimmed, it would increase the gearing and in turn, the cost of capital of the company. Therefore, any such restructuring made with a fund raising programme in mind has to take into account the prevailing market conditions and scope for further fund raising. Impending corporate re-organization – In many cases, balance sheets are restructured in preparation for an impending hive-off, demerger or merger of companies. Such restructuring has a larger objective of arriving at the proper asset liability profile of the company before such transaction. This would help not only in arriving at a fair valuation for the transaction but would facilitate in providing a realistic balance sheet as well after the transaction is completed. From the above discussion, it is evident that equity restructuring is a non-recurring process of financial restructuring that is done out of strategic, financial and regulatory considerations. Many a time, it is a part of a larger balance sheet restructuring done by the company. The considerations driving such restructuring can come up from time to time for profit making as well as loss making companies. For profit-making companies, it is more often a case of over-capitalization or a bloated equity base while in the case of loss-making companies it is invariably triggered off due to under-capitalization or unrepresented assets in the existing balance sheet.

14.10 Cases in Equity Restructuring 14.10.1 Tamilnadu Newsprint Ltd. (TNPL) TNPL, a company with a high equity base of Rs. 981.8 million, underwent an equity restructuring programme in 1995. This was because, even though the

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company was able to generate the highest margins in the industry at that point of time, due to its over-sized equity base, the earnings per share were modest. Due to the high equity base, the company had also not been paying high dividends until then. Therefore, when the company fell short of Rs. 2 billion for its expansion project towards equity requirement, it had to restructure its equity base so as to attract fresh equity. The strategy was to reduce the existing equity base so as to be able to project higher earnings per share and better rates of dividend than what the company paid till then. The restructuring was done by reducing the equity base by Rs. 481.8 million by a buy-back of shares worth Rs. 212.5 million and converting Rs. 269.3 million worth of equity into non-convertible debentures with a coupon rate of 17.5%. The debentures were redeemable in four annual instalments at a premium of 10% on their issue price. Having trimmed the equity capital base to Rs 500 million, the company made a public issue in 1995 of 20 million equity shares at a price of Rs. 110 per share thereby raising Rs. 2.2 billion from the market. The objective was thus achieved through the equity restructuring which was partly helped by the huge amount of reserves that existed in the balance sheet prior to the restructuring.

14.10.2 Gramophone Company of India Ltd. GCI (now renamed as Saregama Ltd.) This RPG group company was a classic case of a turnaround as it was in the red for a long time and underwent rehabilitation under the auspices of the Board for Industrial and Financial Reconstruction. So when the primary markets were strong in the mid-nineties, GCI underwent an equity restructuring plan to trim its equity base, increase earnings per share and dividend payout, thereby making itself an attractive candidate for a public offer. The public issue was meant to fund its capital plans for a diversification project. The equity restructuring consisted of writing down the nominal value of exising equity shares from Rs. 10 per share to Rs. 4 per share. After this, the company replaced the old equity shares of Rs. 4 each by consolidating them into shares of Rs. 10 each in the ratio of 2 new shares for 5 old shares held by shareholders. By this process, the equity capital was reduced from Rs. 181.7 million to Rs. 72.7 million. This reduction in capital was utilized to write-off accumulated losses to the extent of Rs. 109 million.

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14.10.3 Bank of Baroda (BOB) and the Industrial Development Bank of India (IDBI) In other cases of equity restructuring on the threshold of a public offer, BOB restructured its capital base in 1996, being one of the larger financial restructuring cases in the banking industry. The restructuring was driven by considerations of trimming the equity base so as to be able to project a good earnings per share and be able to attract a good pricing for the public issue. Prior to the issue, BOB returned a part of its capital to the Government of India (GOI). The total reduction in equity capital was to the extent of Rs. 5.45 billion, partly by transfer of Rs. 1.63 billion from capital account to capital reserve and a return of Rs. 3.81 billion to the GOI. In a similar exercise, the IDBI which went public in 1995, had an equity base of Rs. 7.53 billion prior to the public offer which was held entirely by the GOI. In order to raise funds at attractive pricing, the equity base was trimmed to Rs. 5 billion by conversion of equity capital worth Rs. 2.53 billion into 16% redeemable preference capital to be held by the GOI. Therefore, IDBI was able to go public at a significant premium of Rs. 120 per share. In recent years several banks such as Canara Bank, Andhra Bank, Corporation Bank and others have returned equity capital held by the government in order to trim their equity base.

14.10.4 Loss Making Companies Several loss making public sector companies such as the Steel Authority of India, HMT, etc., and loss making banks such as Dena Bank, UCO Bank, Bank of India and IFCI had over the years been restructured. Bank of India restructured its capital prior to going public in 1996. It had a capital infusion from the GOI against which accumulated losses were set off so as to be left with a net equity base of Rs. 4.89 billion. Dena Bank underwent a similar exercise setting off losses to the extent of Rs. 1.36 billion against capital prior to the public issue. On a trimmer equity base of Rs. 1.46 billion, it was successful in raising equity at a premium of Rs. 20 per share. Steel Authority of India underwent a massive financial restructuring programme in 1997–98. Loss making banks such as UCO Bank and IFCI are in the process of financial restructuring.

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14.11 Regulatory Mechanisms for Equity Restructuring As mentioned earlier, the regulatory mechanism for equity restructuring is based on the principle of capital reduction. If a process of equity restructuring amounts to capital reduction, it is to be executed under legal surveillance. However, if it does not amount to a capital reduction, it can be done with appropriate shareholder resolutions and following the provisions of the Companies Act and the Articles of Association of the company. The following types of equity restructuring are possible under various provisions of the Companies Act and other Acts: 1. Capital reduction u/s 100 2. Variation of shareholder rights u/s 106 3. Write-off of securities premium against purposes other than those specified in section 78(2). 4. Arrangement and compromises u/s 391-93 5. Equity repurchase u/s 77A 6. Restructuring under SICA 7. Restructuring of Public Sector Corporations

14.11.1 Capital Reduction Capital reduction, in terms of Section 100 of the Companies Act, by a company in a way as described earlier has to be sanctioned by the National Company Law Tribunal (NCLT) set up under the Companies Act. An application made in this behalf by the company would be heard by the Tribunal with a view to address objections from creditors and other interested parties to the proposed capital reduction. The Tribunal would dispose off all objections in a manner it deems fit and the company has to comply with such directions. The Tribunal would then pass an order to confirm the capital reduction upon which it becomes effective. The provisions relating to capital reduction apply mutatis mutandis to government companies as they apply to non-government companies.

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14.11.2 Variation of rights of shareholders Rights of shareholders can be varied if a majority of not less than 75% of such shareholders approve of such variation (Section 106). This can be an internal mechanism without the approval of any external authority, if not more than 10% of such shareholders do not object to such variation. In other words, if the proposal enjoys more than 90% vote, it can be put through even if the balance shareholders are in dissent. Otherwise, it has to be confirmed by the NCLT.

14.11.3 Write-off of securities premium Securities premium is the amount received by a company on issue of a share or other security in excess of it face value. For example, if a share with a face value of Rs. 10 is issued at a price of Rs. 50, the difference of Rs. 40 between the issue price and the face value becomes premium on the share. As per the provisions of the Companies Act, such securities premium can be applied only for specified purposes as mentioned in Section 78 of the Act. These are—(a) issue of bonus shares, (b) writing off preliminary expenses, (c) writing off commissions, discounts and expenses of an issue and (d) writing off any premium on redemption of securities. In the event such premium has to be applied to purposes other than those specified, it would amount to a capital reduction and the provisions mentioned earlier would apply.

14.11.4 Arrangements and Compromises The Companies Act provides a judicial mechanism by approaching the NCLT under Section 391 whereby a compromise or arrangement with the members or any class of members (where there are more than one class of issued shares) can be made by the company, so as to provide for changes in their rights or the terms of the original issue of such shares. This mechanism needs to be used by a company that cannot, for any reason, convene a meeting for such class of members to seek the requisite majority, in terms of Section 106 mentioned above. However, Section 391 has a wider import in terms of compromises and arrangements that are not limited to variation of rights as contemplated in section 106. This route was used effectively by Sterlite Industries Ltd. for buying back its shares from the public without complying with the conditions of a buy-back stipulated under the Company Law and by SEBI. The aspects relating to buy-back as well as this case have been discussed later.

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14.11.5 Equity Re-purchase This is probably the most important and widely used form of equity restructuring familiar to investment bankers as it involves a buy-back from the public shareholders in several cases involving listed companies. Merchant bankers have been mandated with the task of managing such reverse public offers by SEBI. This is the most important aspect of equity restructuring that has direct relevance to merchant bankers since it involves the making of an exit offer to the public shareholders. This topic has been elaborately discussed in Chapter 9.

14.11.6 Restructuring of Sick Companies Restructuring of loss making companies that have been declared sick under the Sick Industrial Companies (Special Provisions Act), 1985 was till 2003, administered under the framework of that Act by the Board for Industrial and Financial Reconstruction. As indicated earlier, this Act was repealed and the powers of restructuring sick companies were transferred to the NCLT under the Companies Act. The SICA had the power to override the provisions of Company Law for restructuring companies (which includes equity restructuring). The NCLT has the necessary powers to make any kind of equity or other restructuring necessary for a company that has been declared sick. Therefore, the other provisions of company law on equity restructuring do not apply in such cases.

14.11.7 Restructuring of Public Sector Corporations Apart from the above, restructuring of public sector corporations set up under separate Acts of the Central or the State governments is governed by the provisions of the respective Acts. These are outside the purview of the Companies Act. Depending on the specific provisions of the charter of a particular corporation, equity restructuring could be done differently for each of them. Examples of such corporations are SBI, LIC, UTI, IDBI, GIC, SFCs and others. A recent instance of such restructuring has been that of the UTI, which has been restructured to hive off all schemes other than the US-64 to a separate mutual fund set up under the mutual fund guidelines, to be called the UTI Mutual Fund. The original UTI would continue only as a specified undertaking, to be wound up eventually after its liabilities have been liquidated.

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14.12 Role of Investment Banker in Equity Restructuring The investment banker plays an important role in the equity restructuring of a company, in the area of share buy-back. More often than not, companies that intend to restructure their equity capital are listed on the stock exchange and therefore, such restructuring may need to comply with the relevant provisions of the SEBI guidelines. However, the real need for an investment banker in equity restructuring is to play the role of a merchant banker for a proposed share buy-back if any, as part of the restructuring programme. Since SEBI guidelines stipulate that share buybacks have to comply with SEBI guidelines and a merchant banker holding a valid licence should manage the offer, it becomes imperative for the company to appoint a merchant banker as manager to the offer. The major contribution that the merchant banker makes in such assignments, apart from managing the offer, is in advising the company on the proper method to be adopted for the buy-back among all the methods allowed, and to price the buy-back accordingly. The pricing becomes critical because if the buy-back is under-priced, the offer may not be successful. On the other hand, if the buy-back is over-priced, it may erode shareholder value for those who remain with the company post-buyback. Pricing also has its bearing on the market capitalization of the company. Therefore, the role of the merchant banker becomes extremely important. Apart from helping the company with the buy-back, the merchant banker has to offer expert advice in structuring the equity capital pre- and post-restructuring, according to the provisions of the Companies Act and other statutory provisions. However, all necessary accounting work, statutory approvals and representation before judicial authorities is handled by other appropriate professionals.

14.13 Conclusion In conclusion, it can be said that financial restructuring is a complex financial cum legal process and involves various stages depending upon the type of company being restructured and the status of the capital in the books of the company and its creditors. It may also be appreciated that secured borrowings from institutional sources are the most difficult to restructure, followed by debt raised through public issues. Often the process is very time consuming for consortium loans under parri passu charge of a common pool of assets. With the introduction of the CDR scheme, the RBI has institutionalized a mechanism for restructuring the debt of companies which, though undoubtedly viable, are going through liquidity

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problems. For sick companies, the process is long drawn, though with the setting up of the NCLT mechanism under the Companies Act, a faster process is envisaged. For healthy companies using debt restructuring as a corporate finance tool, things have become easier with liberalization and competition among lenders. The climate is presently conducive for faster restructuring through loan swapping and negotiated settlements. Similarly, under the equity route, the necessary statutory framework has been created for using share buy-back as a tool of strategic financial management. However, the extant guidelines are restrictive and defensive in nature as of now offering limited scope for companies to fix their own buy-back programmes.

� Notes 1. The discussion on debt restructuring in this chapter is largely based on ‘Restructuring of Debt—Problems and Practices’—Pratap G. Subramanyam, which is a part of the course material for the CFM Programme conducted by the Center for Financial Management, Bangalore. 2. Arvind’s Near Death Experience—Businessworld, 13th May 2002.

� Select References 1. News reports and articles in The Economic Times. 2. News reports and articles in Business Standard. 3. The CDR Scheme announced by the Reserve bank of India vide DBOD Circular No. BP.BC.68/21.04.132/2002-03.

� Self-Test Questions 1. Is financial restructuring a voluntary or a compulsory process under law? Under what circumstances does it become a statutorily driven process? 2. What are the financial considerations for different types of companies to restructure their debt portfolio? 3. What are the regulatory issues concerning debt restructuring? 4. What is capital reduction? How is it different from capital restructuring?

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5. What are the different methods for equity restructuring and which among them constitute capital reduction? 6. What are the regulatory provisions for equity restructuring? 7. Elaborate the advisory role of an investment banker in debt and equity restructuring.

� Annexure I

� REVISED GUIDELINES FOR COMPROMISE

SETTLEMENT OF CHRONIC NON-PERFORMING ASSETS (NPAS) OF PUBLIC SECTOR BANKS (vide DBOD.BP.BC.65/21.04.117/2002-2003 dated January 29, 2003) The revised guidelines will cover NPAs (below the prescribed ceiling) relating to all sectors including the small sector. The guidelines will not, however, cover cases of willful default, fraud and malfeasance. The banks should identify cases of willful default, fraud and malfeasance and initiate prompt action against them. Accordingly, in modification of guidelines set out in Circular of 27th July 2000, revised guidelines for compromise settlement of dues relating to NPAs of public sector banks in all sectors are given below:

(A) Guidelines for compromise settlement of chronic NPAs up to Rs. 10.00 crore [i] Coverage (a) The revised guidelines will cover all NPAs in all sectors irrespective of the nature of business, which have become doubtful or loss as on 31st March 2000 with outstanding balance of Rs. 10.00 crore and below on the cut off date. (b) The guidelines will also cover NPAs classified as sub-standard as on 31st March 2000, which have subsequently become doubtful or loss. (c) These guidelines will cover cases on which the banks have initiated action under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and also cases pending before Courts/DRTs/BIFR, subject to consent decree being obtained from the Courts/DRTs/BIFR. (d) Cases of willful default, fraud and malfeasance will not be covered.

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(e) The last date for receipt of applications from borrowers would be as at the close of business on 30th April 2003. The processing under the revised guidelines should be completed by 31st October 2003.

[ii] Settlement Formula—amount and cut off date (a) NPAs classified as Doubtful or Loss as on 31st March 2000 The minimum amount that should be recovered under the revised guidelines in respect of compromise settlement of NPAs classified as doubtful or loss as on 31st March 2000 would be 100% of the outstanding balance in the account as on the date of transfer to the protested bills account or the amount outstanding as on the date on which the account was categorized as doubtful NPAs, whichever happened earlier, as the case may be.

(b) NPAs classified as sub-standard as on 31st March 2000 which became doubtful or loss subsequently The minimum amount that should be recovered in respect of NPAs classified as sub-standard as on 31st March 2000 which became doubtful or loss subsequently would be 100% of the outstanding balance in the account as on the date of transfer to the protested bills account or the amount as on the date on which the account was categorized as doubtful NPAs, whichever happened earlier, as the case may be, plus interest at existing Prime Lending Rate from 1st April 2000 till the date of final payment.

[iii] Payment The amount of settlement arrived at in both the above cases, should preferably be paid in one lump sum. In cases where the borrowers are unable to pay the entire amount in one lump sum, at least 25% of the amount of settlement should be paid upfront and the balance amount of 75% should be recovered in installments within a period of one year together with interest at the existing Prime Lending Rate from the date of settlement up to the date of final payment.

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[iv] Sanctioning Authority The decision on the compromise settlement and consequent sanction of waiver or remission or write-off should be taken by the competent authority under the delegated powers.

[v] Non-discretionary Treatment The banks should follow the above guidelines for compromise settlement of all NPAs covered under the revised scheme, without discrimination and a monthly report on the progress and details of settlements should be submitted by the concerned authority to the next higher authority and their Central Office. Banks should go for wide publicity and also give notice by 28th February 2003 to the eligible defaulting borrowers to avail of the opportunity for one time settlement of their outstanding dues in terms of these guidelines. Adequate publicity to these guidelines through various means must be ensured.

[vi] Reporting to the Board The banks should submit a report on the progress in the compromise settlement of chronic NPAs under the revised guidelines every quarter to the Board of Directors. A copy of the quarterly progress report should also be sent to us.

(B) Guidelines for compromise settlement of chronic NPAs over Rs. 10.00 crore As already advised in our earlier circular dated 27th July 2000, CMDs should personally supervise the compromise settlement of chronic NPAs on case to case basis, and the Board of Directors may evolve policy guidelines regarding one time settlement of NPAs not covered under this circular as a part of their loan recovery policy.

(C) Deviation only by Board of Directors Any deviation from the above settlement guidelines for any borrower should be made only by the Board of Directors.

� Annexure II

� IMPORTANT PROVISIONS UNDER THE REVISED CDR SCHEME

(vide DBOD.BP.BC.68/21.04.132/2002–2003 dated February 5, 2003)

1 Background One of the main features of the revised guidelines is the provision of two categories of debt restructuring under the CDR system. Accounts, which are classified as ‘standard’ and ‘sub-standard’ in the books of the lenders, will be restructured under the first category (Category 1). Accounts, which are classified as ‘doubtful’ in the books of the lenders, would be restructured under the second category (Category 2).

2 Objective The objective of the Corporate Debt Restructuring (CDR) framework is to ensure timely and transparent mechanism for restructuring the corporate debts of viable entities facing problems, outside the purview of BIFR, DRT and other legal proceedings, for the benefit of all concerned. In particular, the framework will aim at preserving viable corporates that are affected by certain internal and external factors and minimize the losses to the creditors and other stakeholders through an orderly and coordinated restructuring programme.

3 Structure CDR system in the country will have a three tier structure: �

CDR Standing Forum and its Core Group

�

CDR Empowered Group

�

CDR Cell

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The CDR Empowered Group will consider the preliminary report of all cases of requests of restructuring, submitted to it by the CDR Cell. After the Empowered Group decides that restructuring of the company is prima-facie feasible and the enterprise is potentially viable in terms of the policies and guidelines evolved by Standing Forum, the detailed restructuring package will be worked out by the CDR Cell in conjunction with the Lead Institution. However, if the lead institution faces difficulties in working out the detailed restructuring package, the participating banks/financial institutions should decide upon the alternate institution/bank which would work out the detailed restructuring package at the first meeting of the Empowered Group when the preliminary report of the CDR Cell comes up for consideration. The CDR Empowered Group would be mandated to look into each case of debt restructuring, examine the viability and rehabilitation potential of the Company and approve the restructuring package within a specified time frame of 90 days, or at best within 180 days of reference to the Empowered Group. The CDR Empowered Group shall decide on the acceptable viability benchmark levels on the following illustrative parameters, which may be applied on a case-by-case basis, based on the merits of each case: �

Return on Capital Employed (ROCE),

�

Debt Service Coverage Ratio (DSCR),

�

Gap between the Internal Rate of Return (IRR) and the Cost of Fund (CoF),

�

Extent of sacrifice.

The decisions of the CDR Empowered Group shall be final. If restructuring of debt is found to be viable and feasible and approved by the Empowered Group, the company would be put on the restructuring mode. If restructuring is not found viable, the creditors would then be free to take necessary steps for immediate recovery of dues and/or liquidation or winding up of the company, collectively or individually. All references for corporate debt restructuring by lenders or borrowers will be made to the CDR Cell. It shall be the responsibility of the lead institution/major stakeholder to the corporate, to work out a preliminary restructuring plan in consultation with other stakeholders and submit to the CDR Cell within one month. The CDR Cell will prepare the restructuring plan in terms of the general policies and guidelines approved by the CDR Standing Forum and place for consideration

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of the Empowered Group within 30 days for decision. The Empowered Group can approve or suggest modifications but ensure that a final decision is taken within a total period of 90 days. However, for sufficient reasons the period can be extended up to a maximum of 180 days from the date of reference to the CDR Cell.

4 Other Features 4.1 Eligibility Criteria The scheme will not apply to accounts involving only one financial institution or one bank. The CDR mechanism will cover only multiple banking accounts/syndication/consortium accounts with outstanding exposure of Rs. 20 crore and above by banks and institutions. The Category 1 CDR system will be applicable only to accounts classified as 'standard' and 'sub-standard'. There may be a situation where a small portion of debt by a bank might be classified as doubtful. In that situation, if the account has been classified as ‘standard’/‘substandard’ in the books of at least 90% of lenders (by value), the same would be treated as standard/substandard, only for the purpose of judging the account as eligibile for CDR, in the books of the remaining 10% of lenders. There would be no requirement of the account/company being sick, NPA or being in default for a specified period before reference to the CDR system. However, potentially viable cases of NPAs will get priority. This approach would provide the necessary flexibility and facilitate timely intervention for debt restructuring. Prescribing any milestone(s) may not be necessary, since the debt restructuring exercise is being triggered by banks and financial institutions or with their consent. In no case, the requests of any corporate indulging in willful default, fraud or misfeasance, even in a single bank, will be considered for restructuring under CDR system. The accounts where recovery suits have been filed by the lenders against the company, may be eligible for consideration under the CDR system provided, the initiative to resolve the case under the CDR system is taken by at least 75% of the lenders (by value). However, for restructuring of such accounts under the CDR system, it should be ensured that the account meets the basic criteria for becoming eligible under the CDR mechanism.

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BIFR cases are not eligible for restructuring under the CDR system. However, large value BIFR cases, may be eligible for restructuring under the CDR system if specifically recommended by the CDR Core Group. The Core Group shall recommend exceptional BIFR cases on a case-to-case basis for consideration under the CDR system. It should be ensured that the lending institutions complete all the formalities in seeking the approval from BIFR before implementing the package.

4.2 Reference to CDR System Reference to Corporate Debt Restructuring System could be triggered by (i) any or more of the creditor who have minimum 20% share in either working capital or term finance, or (ii) by the concerned corporate, if supported by a bank or financial institution having stake as in (i) above. Though flexibility is available whereby the lenders could either consider restructuring outside the purview of the CDR system or even initiate legal proceedings where warranted, banks/FIs should review all eligible cases where the exposure of the financial system is more than Rs. 100 crore and decide about referring the case to CDR system or to proceed under the new Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 or to file a suit in DRT, etc.

4.3 Legal Basis CDR will be a non-statutory mechanism which will be a voluntary system based on Debtor–Creditor Agreement (DCA) and Inter-Creditor Agreement (ICA). The Debtor–Creditor Agreement (DCA) and the Inter-Creditor Agreement (ICA) shall provide the legal basis to the CDR mechanism. The debtors shall have to accede to the DCA, either at the time of original loan documentation (for future cases) or at the time of reference to Corporate Debt Restructuring Cell. Similarly, all participants in the CDR mechanism through their membership of the Standing Forum shall have to enter into a legally binding agreement, with necessary enforcement and penal clauses, to operate the System through laid-down policies and guidelines. The ICA signed by the creditors will be initially valid for a period of 3 years and subject to renewal for further periods of 3 years thereafter. The lenders in foreign currency outside the country are not a part of CDR system. Such lenders

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and also lenders like GIC, LIC, UTI, etc., and other third parties who have not joined the CDR system, could join CDR mechanism of a particular corporate by signing transaction to transaction ICA, wherever they have exposure to such corporate. The Inter-Creditor Agreement would be a legally binding agreement amongst the creditors, with necessary enforcement and penal clauses, wherein the creditors would commit themselves to abide by the various elements of CDR system. Further, the creditors shall agree that if 75 per cent of creditors by value, agree to a restructuring package of an existing debt (i.e., debt outstanding), the same would be binding on the remaining creditors. Since Category 1 CDR Scheme covers only standard and substandard accounts, which in the opinion of 75 per cent of the creditors, are likely to become performing after introduction of the CDR package, it is expected that all other creditors (i.e., those outside the minimum 75 per cent) would be willing to participate in the entire CDR package, including the agreed additional financing. However, in case for any internal reason, any creditor (outside the minimum 75 per cent) does not wish to commit additional financing, that creditor will have the option. At the same time, in order to avoid the ‘free rider’ problem, it is necessary to provide some disincentive to the creditor who wishes to exercise this option. Such creditor can either (a) arrange for his share of additional financing to be provided by a new or existing creditor, or (b) agree to deferment of the first year’s interest due to him after the CDR package becomes effective. The first year’s deferred interest as mentioned above, without compounding, will be payable along with the last installment of the principal due to the creditor.

4.4 Stand-Still Clause One of the most important elements of Debtor-Creditor Agreement would be ‘stand still’ agreement binding for 90 days, or 180 days by both sides. Under this clause, both the debtor and creditor(s) shall agree to a legally binding 'stand-still' whereby both the parties commit themselves not to taking recourse to any other legal action during the ‘stand-still’ period, this would be necessary for enabling the CDR System to undertake the necessary debt restructuring exercise without any outside intervention, judicial or otherwise. However, the stand-still clause will be applicable only to any civil action either by the borrower or any lender against the other party and will not cover any criminal action. Further, during the stand-still period, outstanding foreign exchange forward contracts, derivative products, etc., can be crystallized, provided the borrower is agreeable to such crystallization. The borrower will additionally

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undertake that during the stand-still period the documents will stand extended for the purpose of limitation and also that he will not approach any other authority for any relief and the directors of the borrowing company will not resign from the Board of Directors during the stand-still period.

4.5 Additional Finance The providers of additional finance, whether existing lenders or new lenders, shall have a preferential claim, to be worked out under the restructuring package, over the providers of existing finance with respect to the cash flows out of recoveries, in respect of the additional exposure.

4.6 Exit Option As mentioned in paragraph 4.3.3 above, the proposals for restructuring package should provide for option to a particular lender or lenders (outside the minimum 75 per cent who have agreed for restructuring) who for any internal reason, does/do not fully abide by the CDR Empowered Group’s decision on restructuring. The lenders who wish to exit from the package would have the option to sell their existing share to either the existing lenders or fresh lenders, at an appropriate price, which would be decided mutually between the exiting lender and the taking over lender. The new lenders shall rank on par with the existing lenders for repayment and servicing of the dues since they have taken over the existing dues to the exiting lender. In addition, the ‘exit option’ will also be available to all other lenders within the minimum 75 per cent, provided the purchaser agrees to abide by the restructuring package approved by the Empowered Group. The existing lenders may be allowed to continue with their existing level of exposure to the borrower provided they tie up with either the existing lenders or fresh lenders for taking up their share of additional finance.

4.7 Conversion Option The CDR Empowered Group, while deciding the restructuring package, should decide on the issue regarding convertibility (into equity) option as a part of restructuring exercise whereby the banks/financial institutions shall have the right to convert a portion of the restructured amount into equity, keeping in view the statutory

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requirement under Section 19 of the Banking Regulation Act, 1949 (in the case of banks) and relevant SEBI regulations. Exemptions from the capital market exposure ceilings prescribed by RBI in respect of such equity acquisitions should be obtained from RBI on a case-to-case basis by the concerned lenders.

4.8 Category 2 CDR System There have been instances where the projects have been found to be viable by the lenders but the accounts could not be taken up for restructuring under the CDR system as they fell under ‘doubtful’ category. Hence, a second category of CDR is introduced for cases where the accounts have been classified as ‘doubtful’ in the books of lenders, and if a minimum of 75% (by value) of the lenders satisfy themselves of the viability of the account and consent for such restructuring, subject to the following conditions: (i) It will not be binding on the creditors to take up additional financing worked out under the debt restructuring package and the decision to lend or not to lend will depend on each creditor bank/FI separately. In other words, under the proposed second category of the CDR mechanism, the existing loans will only be restructured and it would be up to the promoter to firm up additional financing arrangement with new or existing lenders individually. (ii) All other norms under the CDR mechanism such as the standstill clause, asset classification status during the pendency of restructuring under CDR, etc., will continue to be applicable to this category also. No individual case should be referred to RBI. CDR Core Group may take a final decision whether a particular case falls under the CDR guidelines or it does not. All the other features of the CDR system as applicable to the First Category will also be applicable to cases restructured under the Second Category.

Chapter

15

Mergers and Acquisitions Advisory

M

ergers and acquisitions (M&A) have traditionally been the forte of investment banks world over. In the earlier era of investment banking, Topics to comprehend M&A advisory constituted the only advisory area and accounted for the second largest revenue stream of � The nuances of corporate re-organization and the their business. This service warrants high decibel skill drivers thereof. in the art of financial deal making that investment banks specialize in. It has become an important advi- � Types of corporate restructuring and the process sory area at a time when Indian industry is passing involved. through a transformation to meet the demands of globalization. In this chapter we initially discuss the � Mergers and amalgamations — features, regulatory various facets of corporate re-organization. We then and process overview go on to discuss the M&A scenario in India against a regulatory backdrop and the role that investment � Acquisitions and takeovers — features, regulatory and banks play therein. The Indian M&A industry has process overview. grown relatively large in the past decade or so after the famous sale of Tomco by the Tatas to Hindustan � Role of investment banker in corporate re-organizaLever Ltd. In the past decade, especially when the tions. public issue market went dry, M&A advisory constituted the mainstay for investment banks. As it may be

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appreciated, M&A advisory involves multi-specialization skills in deal making, valuation, due diligence, law, accounting and taxation apart from the soft skills required to manage pre-and post-merger human issues. Thus, in practice, M&A practice involves the collective effort of investment banks and other professionals with complementary skills, an aspect that has been highlighted even in the earlier discussions. The focus of this chapter is on the investment banking perspective of M&A rather than on the theoretical issues or in-depth examination of the accounting and legal aspects associated with such activity. The investment banking domain in M&A advisory is mainly in partner search, negotiations and deal structuring, valuation, due diligence and deal closure. However, a broad coverage of the regulatory issues is also furnished herein to give the reader a complete understanding of all such dimensions of M&A. As is the case with other corporate advisory services that do not involve merchant banking, M&A advisory is also an area wherein investment banks face competition from pure advisory and professional firms and financial services companies. However, in acquisitions involving listed companies, only merchant banks are allowed to manage open offers.

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15.1 Overview of Corporate Re-organizations 15.1.1 Introduction and Industry Perspective Corporate re-organizations consisting of restructuring, mergers and amalgamations are by far, the most important business segment for investment bankers after management of public offers. Globally, in the traditional days of investment banking, this business segment, popularly known as M&A, contributed to a significant share of the bottom line of investment banks, sometimes becoming the largest revenue stream. USA and Europe have traditionally been the favourite hunting grounds for mergers and acquisitions and over the decades, they influenced the growth and transition of corporate America and transnational corporations. The M&A segment received a further boost with the popularity of junk bonds and leveraged buy-outs, or LBOs in the US market in the eighties. The biggest of them all was the LBO of RJR Nabisco in 1998, valued at $24.6 billion. Between 1986 and 1989, LBOs had accounted for about a one-fifth market share in the total M&A industry. The M&A activity was further spurred on in the nineties by the increased global capital flows. It continued to grow and touched about $3.5 trillion dollars per annum by the start of the new millennium. During this time the LBO market went through a correction and by 1999, LBOs represented only 4% of the market. In addition, over the years, individual deal sizes have gone up considerably. Some of the biggest deals made towards the end of the nineties were all in excess of $50 billion such as MCI Worldcom—Sprint, Exxon-Mobil, Travelers Group—Citicorp and several others. The new millennium saw big ticket deals such as AOL-Time Warner and HP-Compaq. This pattern indicates that while the trend in the eighties was that of buying companies through cash deals financed considerably through leveraging, the trend in the past decade or so has been more towards predominantly stock deals. The first eleven months of 2003 produced deals worth $1,334 billion as compared to $1,271 billion in the whole of 2002. The global league table1 of Investment Banks in M&A activity is shown in Table 15.1. The Indian M&A scenario is much more modest both in terms of the size of the industry and the number of deals. Partly, this has been due to regulatory hurdles such as the MRTP Act that curbed companies from growing, both in terms of assets and in terms of control. The second major bottleneck was the lack of a structured mechanism for takeovers in India. The M&A activity got a boost, post-liberalization, due to the consolidation wave sweeping Indian industry and due to

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Name

Rank

Volume in $ Million

No. of deals

Market share %

Goldman Sachs & Co.

1

85,772.5

107

17.34

Merrill Lynch & Co.

2

80,755.5

72

16.33

Citigroup

3

72,460.6

85

14.65

CSFB

4

68,884.0

127

13.93

J.P. Morgan

5

68,628.8

126

13.87

Deutsche Bank A.G.

6

65,255.5

86

13.19

Lazard LLC

7

50,020.9

77

10.11

Morgan Stanley

8

49,013.4

92

9.91

UBS

9

46,497.0

90

9.40

10

40,820.5

69

8.25

Lehman Brothers

�

Table 15.1 Global League Table of Investment Banks in M&A

the introduction of a structured code on takeovers. There were more than 400 open offers under the Takeover Code of SEBI in the five years after it was introduced in 1997. Cases of consolidation through mergers have been quite a few in recent years such as the HLL mergers, TOMCO, Godrej Group, AV Birla Group, Idea Cellular (Birla-Tata-AT&T), India Cements-Raasi-Vishnu, Gujarat Ambuja-ACC, Nicholas Piramal group, Lafarge, all the bank mergers, etc. In terms of investment banks handling M&A, the league tables2 are much smaller in deal sizes in India. The position for the half-year ended June 30, 2003, is shown in Table 15.2. In the annual rankings, JM Morgan Stanley was in top position in 2002–03 with a combined deal volume of Rs. 2053 crore. In 2003–04, upto the period ended November 2003, ICICI Securities was leading with a total deal value of Rs. 272. crore. DSP Merrill Lynch came second with Rs. 223.9 crore followed by HSBC Securities and Capital Markets (India) with Rs. 118.2 crore. Kotak Mahindra Capital was fourth with Rs. 111.3 crore and JM Morgan Stanley was in fifth position with Rs. 93.4 crore3. In terms of market size, the Indian M&A market grew considerably in the late nineties and peaked in 2002–03 with deals worth Rs. 33,929 crore. In terms of number of deals, that year saw 978 acquisitions and 345 merger deals4. The new trend that has been seen in the past few years is that of cross-border

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Advisor

No. of Deals

Rank

Volume (US$ mn)

Ernst & Young

13

1

114.74

Merrill Lynch

7

2

55.01

Citigroup

5

3

407.52

Ambit Corporate Finance Ltd

5

4

73.67

MAPE Advisory Group

4

5

54.88

Morgan Stanley

4

6

32.70

ICICI Securities

3

7

47.53

Rabobank International

2

8

132.88

Rothschild

2

9

100.02

Lazard LLC

2

10

86.72

ABN Amro Bank

2

11

69.2

CSFB

1

12

194.67

WestLB AG

1

12

194.67

ING Group NV

1

14

87.02

KPMG International

1

15

62.68

�

Table 15.2 Indian League Table of Investment Banks in M&A

M&A by Indian companies in buying foreign companies. The year 2001–2002 saw 45 such deals, followed by 35 in 2002–2003 and 39 in 2003–2004, till November 2003. The future of the Indian M&A market will be driven by the winds of consolidation and shake-out in various sectors and the drying up of reliable sources for financing green field projects. Green field projects have also become few in number due to the increasing volatility of the business environment and consequent change in the risk profile. M&A on the other hand offers a quicker route to growth by harnessing existing project facilities more optimally. The availability of several units available at attractive prices, offering good manufacturing facilities, brands and distribution infrastructure, apart from suitable manpower has increased. Therefore M&A offers quick alternative options to setting up green field ventures.

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However, the growth of M&A in India would also be dependent on the M&A industry overcoming some structural deficiencies. Firstly, financing takeovers is yet to evolve into an accepted area of business for banks, financial institutions and equity investors. In the past, financial institutions and banks had shown aversion to funding takeovers. In the past few years, they have shown more positive inclination to such proposals especially where they are interested parties as creditors to the target firms. Secondly, the relatively higher cost of domestic debt, coupled with the restrictions on debt-equity ratios by lenders would ensure that leveraging acquisitions is a limited option in the Indian context. The capital markets have also not been used so far by intending acquirers with the stated objective of raising takeover finance. Financing instruments for takeovers (such as the Junk Bonds of the US in the 1980s) are not available in the Indian market. Similarly, the ADR/GDR route that has been thrown open for overseas acquisitions is available only to the top rung corporates. Thirdly, the regulatory framework is still not conducive to M&A activity in a big way due to several stiff provisions for claiming exemption from income tax and incidence of stamp duty in certain states. The working of the recently enacted Competition Act (India’s anti-trust legislation) needs to be watched as well since it could complicate or unduly delay M&A if not implemented carefully.

15.1.2 Rationale for Corporate Re-organizations Mergers, acquisitions and corporate restructuring are a part of business portfolio reorganization by companies that happen on a continuous basis to handle business dynamics. Restructuring is the process by which companies respond to changes in the operating environment and is often a tool for change management. The objectives of corporate restructuring could be many and based on the objective, the method of restructuring varies. Given below is an illustrative list of some corporate objectives that trigger corporate re-organization, and related examples in the Indian context. 1. To create long term holding structures. The Tata Group conducted a group restructuring some years ago to build cohesiveness in group structure and corporate objectives. 2. To grow at a rate faster than an organic growth rate. An acquisition strategy is often driven by the objective of attaining faster inorganic growth. The Nicholas Piramal group is an example.

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3. To enter a new market or grow beyond a saturated market. Sometimes mergers and acquisitions help in becoming an entry strategy. The acquisition of Tetley in UK by Tata Tea Ltd. is a good case in point. 4. To capture forward and backward linkages in the value chain. Often group company mergers are triggered off to provide a complete value chain within the same company (known as vertical mergers). Similarly, such mergers are also possible in companies with complementary strengths. The group company mergers in the Reliance group (the latest being that of Reliance Petroleum with Reliance Industries) and the mergers in the Hindustan Lever Group (Brooke Bond, Ponds, Lipton) are examples. 5. To attain control on a larger fund/manufacturing base. Mergers and acquisitions are also triggered off for larger market shares or economies of scale (popularly known as horizontal mergers). At a time when the Indian industry is going through the consolidation phase in several sectors, these mergers and acquisitions are many. Examples are those made by the cement industry, the telecom mergers, bank mergers, pharma mergers, etc. The formation of Novartis, Glaxo SKB, UBS Warburg, ICICI Ltd—ICICI Bank, Times Bank and HDFC Bank merger, India Cements acquisition of Raasi Cements and Vishnu Cements, Hindalco’s acquisition of Indian Aluminium etc., are specific cases in point. 6. To attain or better utilise tax covers. Harnessing tax efficiencies through mergers of profit-making and loss-making companies (Section 72A mergers/reverse mergers) has been an age-old technique of tax planning which continues to thrive. 7. To facilitate distribution of assets and family settlements. Restructuring of companies through splitting existing companies is necessitated due to family splits or settlements. Indian industry goes through such phases whenever there is a succession in a group. Some of these result in acrimonious battles such as those in the Chhabria group, the Modis, the Apollo Tyres Group, etc. 8. Achieve synergies of operations (Novartis, GlaxoSKB, UBS Warburg, ICICI- ICICI Bank). 9. To exit non-core businesses. In times of increased competition and business volatility, companies look for sustenance in areas of core competence. This could mean increased investments in such areas for which funds are raised through divestiture of non-core businesses. Examples are the sale of TOMCO, Times Bank, TISCO’s cement business, etc.

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10. Bail-out mergers and acquisitions are common when a company is in trouble and seeks financial strength. For e.g. Centurion Bank’s takeover by the Rana Talwar group, GTB’s merger with OBC are cases in point. 11. Strategic divestitures. These are instances where a company is nurtured with a strategic sale in mind. Many a time, venture backed companies are looked at as good exit vehicles for venture capitalists if they make good candidates for strategic sale at a later date. Sale of Customer Asset to ICICI, Spectra mind to Wipro, India World to Satyam Infoway are examples. 12. To facilitate the entry or exit of business partners. Corporate reorganizations may be necessary when there is an entry or exit of a JV partner. Businesses may have to be hived off into separate entities to accommodate the partners in sucwh ventures as distinct from the other businesses in the group.

15.1.3 Types of Corporate Re-organizations As indicated above, corporate re-organizations take the form of (a) corporate restructuring of an existing company or a group of companies or (b) through the integration process of M&A. The entire spectrum of corporate re-organization is mapped in the exhibit below (Fig. 15.1). In the following paragraphs of this chapter, we discuss in detail each facet of corporate re-organization as shown above. Types of Corporate Re-organizations

Restructuring of an existing company with or without a split balance sheet

Integration of existing companies

Through transfer of assets � Merger � Amalgamation

Through transfer of equity � Acquisition � Takeover

� Figure 15.1 Types of Corporate Re-organization

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15.2 Introduction to Corporate Restructuring The term ‘corporate restructuring’ connotes the entire process through which an existing company re-orients itself, as a response to changing business environment and operational dynamics. Therefore, corporate restructuring encompasses several facets of change according to the circumstances and different methods are adopted for such change to achieve different objectives. Corporate restructuring can be internal to a company without a change in its legal entity or as an external process with the creation of one or more new entities or by the split-up of the existing balance. Internal restructuring consists of (a) operational restructuring, (b) financial restructuring and (c) divisionalization. Operational restructuring is either a technical exercise such as a business process re-engineering or a managerial initiative such as a change in the organizational structure. The other commonly executed internal restructuring is financial restructuring, which entails a change in the capital structure of a company. This topic has been discussed at length in Chapter 14. Divisionalization refers to setting up separate divisions within the same company for better operational control and accountability. The discussion on divisionalization has been provided in Chapter 12. The current chapter concerns itself with corporate restructuring associated with the split-up of an existing company’s balance sheet or through a change in its shareholding pattern resulting in a change in ownership. Figure 15.2 illustrates the different types of corporate restructuring. Types of Corporate Restructuring

Internal Restructuring (No change in corporate structure)

External Restructuring

� Financial Restructuring— Debt (debt swap, bailouts, etc.) or Equity (Capital reduction and other methods) � Operational Restructuring � Divisionalisation or setting up of SBUs

� Figure 15.2

Through transfer of assets � Subsidiarisation � Hive off � De-merger Through transfer of equity � Divestiture (Sell-off) � Spin-off � Equity Carve Out

Types of Corporate Restructuring

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Investment Banking

Types of External Restructuring

Through transfer of assets

Through transfer of equity

Subsidiarisation � Held 100% by the parent company � Usually the subsidiary sets up a new business with capital contribution from the parent.

De-merger It is a combination of a hive-off and a spin- off wherein the shareholders of the transferor company are given shares - prorata in the transferee company from inception.

Divestiture (Sell- off) The transferor retains no future interest in the business or assets sold off. Consideration is usually settled in cash or securities. The buyer is an outsider. Spin-off (De subsidiarisation)

The parent company's holding in the subsidary is distributed pro-rata to shareholders of the parent.

� Figure 15.3

Hive - off � An existing business segment or division is sold off to a new company or another existing company. � The transferee need not necessarily be a subsidiary of the transferring company though the transferor retains strategic interest. � Involves transfer of assets (and liabilities if chosen) from the transferor to the transferee.

Carve-out IPO of the subsidiary through an Offer for Sale/ Issue .

Types of External Restructuring

We now move on to examine external corporate restructuring in detail. Figure 15.3 explores the different types of external restructuring.

15.3 Restructuring through Split-up of an Existing Company As indicated in Fig. 15.3, the split-up of an existing company can be broadly achieved either through the transfer of equity route or transfer of asset route. These options are discussed below:

15.3.1 Methods under the Equity Route The common method under this route is the formation of a 100% subsidiary followed by a spin-off with or without equity carve out. Under this method, the parent

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company forms a 100% subsidiary to handle a new segment of business with a startup capital. This might be necessary since the business has a different growth path and risk profile. Such subsidiaries are also required when the parent wishes to operate in different jurisdictions and limit its liability in each jurisdiction. These aspects have already been discussed in Chapter 12. The start-up capital for the subsidiary’s business in such cases is entirely subscribed to by the parent company. Therefore, though the subsidiary is a separate company, its ownership at the first stage of subsidiarization remains with the parent company. At a later date, if it is felt that the parent company needs to let the subsidiary grow independently, it has the following options: �

�

�

�

�

It could relinquish control through induction of a strategic partner and therefore convert the 100% subsidiary into a JV company. This is usually accomplished through fresh issue of equity by the subsidiary so that the funds can be used for its business. If no strategic partner is envisaged, the subsidiary can make an IPO and start diluting the stake of the parent. This would also help the subsidiary to raise funds for its business. If the parent finds it appropriate, it can relinquish ownership of the subsidiary through strategic sale of its equity holdings. By this process, the parent can encash its efforts in growing the subsidiary till that stage. The parent company can go for a spin-off whereby the shareholders of the parent company are offered direct holding in the subsidiary and the parent company ceases to hold any shares in the subsidiary. This is achieved by substituting the shares held by the parent in the subsidiary, with allotment of shares directly to the shareholders of the parent company. This process does not increase the share capital of the subsidiary since no new shares are being issued. The names of the respective shareholders are recorded in the place of the parent company in the Register of Members of the subsidiary. By this process, it is possible that the subsidiary gets listed if the parent company is already a listed company. The subsidiary can make an IPO after a spin-off (a process known as equity carve out), and bring in a fresh set of public shareholders. Alternatively, the IPO can also be accomplished as an offer for sale by the existing shareholders.

A second process that is not connected to the above discussion is ‘disinvestment’ which is a sell-off of the stake held by a promoter in a company to other outsiders

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Investment Banking

or to the public. This is normally construed as an exit mechanism for promoters of a company. The Government of India has been making disinvestments of its shareholdings in public sector companies in order to exit such businesses. The aspects related to government disinvestments are discussed in Chapter 16.

15.3.2 Methods under the Asset Route Hive-off A hive-off is a separation of some of the assets and liabilities, or only assets belonging to a company, from its balance sheet into the balance sheet of another company. The basic objective in a hive-off is to separate businesses or a group of assets that are distinct from other businesses in the company and wherein a new strategic interest needs to be created. Usually hive-offs are made to induct a new partner such as a collaborator or a strategic investor. The parent company retains a significant stake and the new investors hold the balance. The shareholders of the parent do not directly hold stakes in the hived off entity. Sometimes a hive-off is merely done to separate non-core assets or surplus assets that can be sold off at a later date. Essentially, the connotation of the term ‘hive-off’ is that though there is a separation of a division or some assets from the company, the company continues to retain the ownership of the hived off division or assets until they are sold or liquidated through other processes.

Subsidiarization through Hive-off Under this method, the hive-off happens into a 100% subsidiary of the parent company. Such subsidiary could be an existing company with or without any business activity or a new company formed exclusively for this purpose. This kind of subsidiarization is different from the one discussed under the equity method above. Under the equity method, subsidiarization is possible only for future business activity, whereas under the asset method, even existing business can be subsidiarized through a hive-off. Essentially subsidiarization through a hive-off entails transfer of assets from the parent company to the subsidiary.

Demerger A demerger is a method of hive-off under which the shareholders of the parent company are given direct representation in the business that has been de-merged,

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in the proportion in which they hold shares in the parent. Therefore, instead of the consideration for the transfer of assets (shares in the subsidiary) being passed on to the parent company, these are issued directly to the shareholders of the parent company. Effectively, this process would mean that a mirror image of the shareholding pattern that exists in the parent would be created for the business that has been demerged. The business that has been transferred can be in a new company or in an existing company, which would be called the ‘resultant’ company. The parent company thereby shrinks in size and is called the demerged company. The demerged company retains the same shareholding pattern but with a contracted size of the balance sheet. The difference under a de-merger as compared to a normal hive-off is that the shareholders of the parent company get the same direct representation in the de-merged business as they had in the combined business before such demerger. Under Section 2 (19AA) of the IT Act, a demerger should conform to the following: �

�

�

�

�

�

All the property of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger. All the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger. The property and the liabilities of the undertaking or undertakings being transferred by the demerged company are transferred at values appearing in its books of account immediately before the demerger. The resultant company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis. The shareholders holding not less than three-fourths in value of the shares in the demerged company become shareholders of the resulting company by virtue of the demerger. The transfer of the undertaking is on a going concern basis.

A structured de-merger occurs when a de-merger is not done in its entirety. Therefore, in a structured de-merger, it is possible that the parent company directly holds a stake in the de-merged entity and the balance is held by the shareholders of the parent company in proportion to their holdings in the parent company.

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Investment Banking

Divestiture A divestiture is a sell-off of assets or businesses that are no longer considered core to the business. Such sell offs could be direct or though a two stage process involving a hive-off. A divestiture can also be an exit mechanism for the company from a particular business. Based on the above discussions, the alternative split-up and exit strategies for a company under the equity route and the asset route are mapped in following exhibit Fig. 15.4.

Existing Parent Company

Hive -off to a new or an existing company

Form a 100% subsidiary

De subsidiarisation

Divestiture by company

De-merger/ Structured de-merger

Strategic sale of equity by parent

� Figure 15.4

Take the company public through a spin-off

Disinvestment by promoters

Exit by parent through disinvestment

Induct new strategic investors

Take the company public through equity carve out

Take the company public through equity carve out

Alternative Split-up and Exit Strategies for a Company

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15.3.3 Statutory Recognition for Corporate Restructuring Involving Split-up The processes described above for split-up of a company are not recognized uniformly under the statutory provisions of the Companies Act and the IT Act. A brief overview of the framework of law as regards split-up of a company is furnished below. �

�

�

The provisions of the Companies Act do not define various methods of corporate split-ups. The omnibus term that is used is ‘arrangement’ under Section 390(b), which has an inclusive definition. In other words, it includes all processes that are in the nature of an arrangement. Over the years the courts have held the meaning of this term in the widest connotation possible. Therefore, all processes that are in the nature of corporate split-ups, by whatever name called, would fall under the ambit of the definition of an ‘arrangement’ under the Companies Act. The Act provides an option for companies contemplating such restructuring to approach the court and make it a judicial process. However, this is only an option. Such restructuring may also be done by taking necessary shareholder approvals under Section 293(1)(a) of the Companies Act. However, the non-judicial route is never adopted in practice because it is quite expensive, attracting stamp duties and registration charges on transfer of assets between companies. Secondly, shareholder approvals if not obtained in full, would mean that the dissenting shareholders can apply for relief under Section 397 of the Companies Act, which could complicate the process further. However, under the court route envisaged under Section 391 of the Companies Act, if the approval of the requisite majority of shareholders is obtained and the court confirms the process by passing an order, it becomes binding on the dissenting shareholders. Therefore, all corporate split-ups are normally passed through a sanction by the court (now Tribunal). More discussion on the procedural aspects of this method are discussed later in this chapter in connection with mergers and amalgamations. If a corporate split-up is envisaged through the transfer of equity route, it does not require shareholder approvals or a confirmation through court. Therefore, these can be put through easily. However, such a transaction may fall under an ‘acquisition’ if the transfer is through a strategic sale and if the company is listed, it attracts the Takeover Code. These aspects are discussed later in this chapter.

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The third dimension is about the provisions relating to Income Tax. Under the provisions of the IT Act, only a demerger as defined under Section 2(19AA), is recognized for the purposes of allowing income tax benefits. The benefits allowed under the IT Act pertain to exemption from capital gain tax on transfer of assets and the benefit of carry forward of business losses from the demerged company to the resultant company. In order to avail these benefits, a corporate split-up in the nature of a demerger, under the definition prescribed in the IT Act alone is eligible. Therefore the following aspects need to be borne in mind for a demerger to benefit from the exemptions provided under the IT Act. (a) The hive-off has to satisfy the conditions stipulated under Section 2(19AA). Demerger under the Income Tax Act is defined as the reverse of an amalgamation. (b) Both assets and liabilities have to be transferred to a new or existing company. Transfer of individual items not constituting a business activity is not a demerger as per IT Act. (c) Transfer shall be at book values alone and no other values are approved for this purpose. The book values to be reckoned are those existing immediately before the merger. Consideration shall be paid in shares of the resulting company and by no other means. (d) Revaluation of assets before the demerger shall be ignored for reckoning book values. (e) There can be one or more resultant companies. (f) 75% of the shareholders of the demerged company shall be shareholders of the resultant company. This allows scope for a structured demerger to the extent of 25%. (g) General liabilities that cannot be identified specifically shall be transferred in the proportion of assets being transferred.

�

�

All other types of corporate split-up are not recognized under the IT Act. Therefore, if such methods are adopted, the incidence of capital gain tax and the denial of carry forward benefit for losses and unabsorbed depreciation can arise. There are no benefits under the IT Act from exemption of capital gain tax for split-ups made under the equity route. Therefore, if such split-ups are

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made, there can be incidence of capital gain for the recipient shareholders based on the valuation of such shares.

15.4 Corporate Re-organization through Integration of Companies Having discussed the various aspects of corporate restructuring through split-up of a company, it is now appropriate to look at the second branch of our discussion on corporate re-organization, which is the integration of companies. As indicated in Fig. 15.1, integration of companies can also be achieved through two routes—(a) through the asset route and (b) through the equity route. The asset route is adopted to physically integrate the balance sheets of two or more companies. ‘Merger’ and ‘amalgamation’ are the common terms associated with this method of integration. Under the equity route there is no integration at the balance sheet level but at the shareholder level. The shares of a company change hands from one shareholder to another thereby bringing such company into the fold of the person acquiring such shares. Therefore, it needs to be understood that the equity route may not always integrate companies but more often than not, it does. The various routes of integration are depicted in Fig. 15.5. Methods for Integration

Merger/Amalgamation � Integration through the asset route. � Merger is the absorption of one company by another. The absorbed company is dissolved. � Amalgamation is the merging of more than two companies into one of themselves or to form a new company. Amalgamation includes merger. � Involves transfer of assets (and liabilities if chosen) from the transferor to the transferee. � The consideration is settled through stock swap between the transferor and the transferee company. � Requires valuation of both the companies on a going concern basis to fix share swap ratio. � Regulated by the provisions of the Companies Act. � Usually involves a judicial process to avoid stamp duty on transfer of assets.

� Figure 15.5

Acquisition/Takeover

� It is a process of integration at the shareholder level through the transfer of shareholding. � Does not involve transfer of assets or liabilities. � No change in the balance sheet of the company. � Acquisition need not be to get controlling interest or to be in charge of day-to-day management. It can be for strategic reasons. � Compliance with the Takeover Code of SEBI is mandatory if the acquisition is in a listed company. � No judicial process involved. � Takeover is a term used to denote a hostile acquisition wherein the acquirer aims to get management control.

Methods for Integration of Existing Companies

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15.5 Mergers and Amalgamations As described above, a merger is a term associated with the integration of one company into another. The merging company would exist thereafter and all its assets and liabilities get legally vested in the merged company. This is the most common form of asset-based integration between two companies. An amalgamation is used in the context of two or more companies merging into one of them or into a new company formed for this purpose. Therefore, it may be appreciated that amalgamation is a just a wider term that includes a merger of two companies. The consideration for the transfer of assets by the transferor company is settled by shareholders of the transferor company acquiring shares in the transferee company. For this purpose, both the companies are valued separately and a suitable share-swap ratio is arrived at. Based on such exchange ratio, the shareholders of the transferor company are issued shares in the transferee company. This route is adopted if the deal is an all-stock deal. However, if the deal happens on all-cash basis, the shareholders of the transferor company are paid the agreed value of their shares in cash and settled. Sometimes, the deal would be partly a cash deal and partly a stock deal. In such cases, the shareholders of the transferor company get some cash and some shares in the transferee company as consideration.

15.5.1 Statutory Recognition for Mergers and Amalgamations The Companies Act The Companies Act does not define an amalgamation or a merger. Therefore, these terms are interpreted as being included in the term ‘arrangement’ as defined in Section 390(b). This is vindicated by the fact that Section 394 talks about arrangements that are in the nature of amalgamation of two or more companies. It is possible under the Companies Act for two or more companies to amalgamate using the shareholder approval route under Section 293(1)(a) though such a route is never adopted for reasons already cited above. The more accepted route is to get a court order under Section 394 of the Act, which has been specifically enacted to enable amalgamations. The process of a merger/amalgamation is discussed separately.

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The IT Act Under the IT Act, the word amalgamation has been defined. According to Section 2(1B), amalgamation in relation to companies means the merger of one or more companies with another company or the merger of two or more companies to form one company so that: �

�

�

All the property of the amalgamating company or companies immediately before the amalgamation becomes the property of the amalgamating company by virtue of the amalgamation. All the liabilities of the amalgamating company or companies immediately before the amalgamation become the liabilities of the amalgamating company by virtue of the amalgamation. Shareholders holding not less than three-fourths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company by virtue of the amalgamation and not otherwise.

The benefits available under the IT Act as far as amalgamations as defined above are concerned, relate to (a) carry forward and set off of losses and unabsorbed depreciation belonging to the transferor company by the transferee company, (b) capital gains if any, arising to shareholders of the transferor company on account of the share swap and (c) the write-off of expenses of the amalgamation by the transferee company. These are discussed below. The carry forward and set-off benefit is allowed, provided the provisions of Sections 2(1B), 72 and 72A are satisfied. The provisions of Sections 2(1B) have already been discussed above. The other conditions are as follows: � �

�

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Set off of business loss can only be against business income Upto assessment year 1999—2000, carry forward is allowed only if the concerned business is continued in the year of loss being brought forward. From assessment year 2000–2001, losses of a discontinued business can be carried forward and set off against profits of a running business. The same assessee can claim carry forward and set off of losses (except as provided in Section 72A). Carry forward is allowed for 8 years (1+7).

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The amalgamated company should hold continuously for a period of 5 years, at least 75% of the book value of the assets. The amalgamated company continues the business of the parent company for a period of 5 years from the date of restructuring. Fulfils other conditions prescribed under Rule 9C of the IT Rules.

The capital gains arising on transfer of shares by a shareholder, in a scheme of amalgamation, is exempt from capital gains tax under Section 47(vii) if the consideration is received as shares in the amalgamated company and such amalgamated company is an Indian company. In other words, capital gains are exempt if the consideration is received completely through a share swap. Secondly, the amalgamation has to satisfy the provisions of Section 2(1B). Thirdly, the amalgamated company has to be an Indian company. This requirement would exclude from the purview of exemption, cross border mergers wherein Indian companies merge into foreign companies. Therefore, the shareholders of such Indian companies have to pay tax on the capital gains that could accrue out of the shares received from the foreign company. The last issue relates to write-off of expenses relating to the amalgamation. These relate to the statutory costs of seeking court approval, stamp duty, professional fees and other expenses. These expenses are normally allowed to be written off over a period of five years for tax purposes.

The Competition Act Mergers and amalgamations in India are hereafter proposed to be regulated under the Competition Act by the Competition Commission that has replaced the MRTP Commission. The emphasis is on regulation of anti-competition practices rather than on control of growth of enterprises. The Act proposes three areas of regulation out of which one pertains to mergers and acquisitions. The Act makes it mandatory for mergers or acquisitions to seek the approval of the Competition Commission, set up as a regulatory authority under the Act, if such business combinations through mergers and acquisitions (both by shares and by control) result in a combined asset value of more than Rs. 1000 crore (US$ 500 million) or a turnover of Rs. 3000 crore (US$ 1500 million). This requirement would be in addition to all other existing statutory requirements.

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15.6 Process Flow for Restructuring and Mergers 15.6.1 Formulation of the Plan Corporate Restructuring For a corporate restructuring through a hive-off or through other methods discussed to split-up a company, it is necessary for the management of the company to formulate the necessary strategy and examine the implications of each method that can be applied. Usually an investment banker is brought in at the initial stage itself to prepare the restructuring plan after consideration of the corporate objectives and the needs of the given situation. The investment banker has to take into account the business realities of the given situation and the most appropriate method of restructuring for the same. If a subsidiarization is on the cards for a proposed business, there has to be enough justification as to why it has to be made into a separate subsidiary and cannot be retained as a division within the same company. If a hive-off is being contemplated for the floatation of a joint venture, other simpler alternatives such as conversion of an existing company into a joint venture company through dilution of existing holdings or issue of fresh equity have to be considered before a particular method is applied. SEBI’s Takeover Code should be kept in mind if a preferential allotment is being considered. Necessary regard should also be given to the relevant provisions of corporate law and tax implications of the proposed restructuring methodology. The next step after the formulation of the restructuring plan would be to identify the steps involved including identification of a suitable buyer or investor for divisions or assets to be hived-off or divested. In all corporate re-organizations, the investment banker provides transaction service acting as a catalyst for the entire deal. Usually this process can be handled in two ways:(a) if there are several potential parties that have to be tapped, the investment banker prepares a preliminary corporate profile with brief details of their client and the particulars required from the other party. A suitable paper advertisement may be placed so that the corporate profile can be issued to interested parties. Before the appointed date, all interested parties put in their ‘expression of interest’. The investment banker scans through the applications and short lists the parties who can be furnished a detailed Confidential Information Memorandum and other details, so that the deal can be negotiated and concluded with the right party. An alternative to this route would be wherein the potential parties would not be many and direct discussions could be had with them,

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without any need for seeking an expression of interest from them. In such a case, the investment banker initiates the discussion and at the appropriate stage, furnishes the Confidential Information Memorandum. If the restructuring plan does not involve a transaction with an outside party and is merely contemplated to bring in financial and operational efficiencies, there would not be any need to prepare a Confidential Information Memorandum. The restructuring plan is presented to the senior management of the Company by the investment banker and after discussions and necessary modifications if any, the plan is put up to the Board of Directors for their approval. The Board deliberates on the proposal and if found acceptable, the restructuring plan is approved. Following this, the authority is provided to the concerned directors or a committee of the Board to take necessary steps in seeking shareholder and statutory approvals required to give effect to the scheme.

Merger A merger in practice, may be slightly different from an amalgamation though as per the legal definition, amalgamation includes a merger. Many a time, a merger involves the marrying of companies from different business groups, which could sometimes even be from different countries. On the contrary, an amalgamation is usually an intra-group process necessitated more as a means of re-organization of the group. For example, ICICI Ltd. had to amalgamate two of its group companies along with itself into ICICI Bank Ltd., on the directions of the RBI. Therefore, while amalgamation is more of an intra-group possibility, a one-to-one merger between two companies is the more common occurrence both between intra-group companies and inter-group companies. A merger between intra-group companies is very much a similar process as a corporate restructuring through a split-up. Since no outside interests are to be involved, there is no partner or investor search by the investment banker. The merger of the group companies is studied in depth and all the ramifications are discussed and detailed in the presentations that are prepared by the investment banker. In the case of inter-group mergers that are mostly in the nature of a buy-out through a merger, the investment banker comes in either from the buy side or the sell side depending upon which side has initiated the transaction. If the transaction were to be initiated by the party wanting to merge or sell out, the task of the investment banker

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would be to find the company that wants to buy out and merge the selling company into itself. The contrary would be the case wherein the transaction is initiated by the company that is looking for suitable target companies that it can buy out and merge with itself. In all merger deals, there would generally be two investment banks representing each side so that the negotiations are on even keel.

15.6.2 Valuation and Deal Structure An integral and probably the most important aspect of mergers, demergers and hive-offs is the aspect of valuation of the companies, divisions or assets involved. In most such cases, excepting in the hive-off of selective assets, the transfer is envisaged on a ‘going-concern’ basis. Therefore, if the business being transferred is fairly established with a good future potential, it is valued under the discounted cash flow method. If it is a case of merger of two listed companies, their market capitalization is also taken into account for arriving at the appropriate valuation. The tangible value of assets and intellectual property are also considered in appropriate cases. Intellectual property and human resource valuation become key factors in valuation of knowledge intensive businesses. Sometimes, if the business is nascent and cash flow is yet to stabilize, other methods such as the multiples method are chosen. In some other cases, where there is a buy-out through a merger, the replacement cost of setting up a like business may be considered in arriving at a suitable valuation. In many cases, the valuation is made as a benchmark so as to bid for a company. In such cases, the valuation is arrived at by one or more of the above methods such as the Net Asset Value, DCF Value and Market Value to arrive at the price band for the purpose of bidding. Some of the established methods of valuation of equity have already been discussed in Chapter 3. However, it maybe appreciated that valuation being a subjective exercise, a combination of two or more methods may be used for arriving at an appropriate value for a particular deal. In addition, there could sometimes be deal specific methods depending upon the uniqueness of a particular case. In buy-out transactions, a strategic premium is also often paid to get management control. Such premium could be based on several factors such as the quality of manufacturing facility and manpower, distribution network, brands, etc. For example, Nicholas Laboratories bought over Roche mainly because Roche had a well-trained sales force that could complement Nicholas's business. Hindustan Lever Ltd. acquired Brooke Bond since it had 17 well-known brands in the tea business. Other examples of strategic pricing are:

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Coca Cola offered a price to Parle Soft drinks equal to its current turnover, i.e. a multiple of one on sales. The Khaitans of Williamson Magor paid a price of Rs. 290 crore to Union Carbide for Eveready Ltd. The Rs. 290 crore included Rs. 150 crore for future earnings, Rs. 100 crore for brand value and Rs. 40 crore as control premium. Whirlpool Corporation paid Rs. 300 crore for its 51 percent stake in Kelvinator India. The share price was fixed at Rs. 197.16 per share, which was the average price of the share over the previous six months. SRF paid a sum of Rs. 325 crore for acquiring Ceat’s nylon tyre cord plant. A new plant of the same capacity would have cost Rs. 450 crore and a gestation period of 18 months. In the case of TOMCO’s sale to Hindustan Lever Ltd., the share swap ratio was fixed at 2X15 in favour of HLL. The valuation was done using the dividend yield method, the net asset value method and the market value method giving appropriate weightage to each method in arriving at the final ratio.

In the case of inter-group company mergers, usually, the valuation is conducted by the respective companies through their investment bankers or through other professionals such as chartered accountants and company secretaries. The mutual valuations are then put forward for acceptance by the opposite party. In some cases, a third independent valuer is appointed to vet the mutual valuations. In any case, two things are important about valuation—(a) it plays a very significant part in deal structuring and (b) the investment banker who is representing the client in the deal making does not also do the valuation since that would amount to a conflict of interest. Therefore valuation is always conducted by independent valuers. Some examples that can be cited are: �

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In Bayer India’s acquisition of ABS, the independent valuers were C.C. Choksi & Co., ICICI Securities Ltd and S.R. Batliboi & Co. In the amalgamation of ICICI Ltd along with its two group companies with ICICI Bank Ltd., the share swap ratio was arrived at through a valuation process undertaken by JM Morgan Stanley for ICICI and DSP Merrill Lynch for ICICI Bank. In addition, a third valuer, Deloitte, Haskins & Sells was appointed jointly by both ICICI and ICICI Bank to recommend the final share exchange ratio. The valuation was done using the relative market prices, dividend discount approach and net asset values methods.

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In the hive-off of its insulator division by Indian Rayon and Industries Ltd. into a separate company, the valuation was made by an independent valuer, M/s Bansi S. Mehta & Co. In the HLL-TOMCO case, the valuation was done by Mr. Y.H. Malegam of S.B. Billimoria & Co., Chartered Accountants, which was confirmed by two other reputed CA firms, namely A.F. Ferguson & Co. and N.M. Raiji & Co. This valuation was upheld by the Hon’ble Supreme Court in a review petition filed by the complainant against the judgement of the Bombay High Court supporting the valuation.

As far as deal structuring is concerned, it could be made in either of the following ways: �

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Company ‘A’ and Company ‘B’ will be valued and based on mutual valuation, a share swap ratio is fixed. Under this arrangement, there is no purchase consideration in the form of cash or other assets. This method is usually followed for mergers and is known as the ‘Pooling of Interests’ method. Company A arrives at a ‘Deal Price’ for Company B. This would be settled either by shares in A or in cash or partly by both. This method could be adopted whether the undertaking of B is being acquired in full or in part. This method is called the ‘Purchase Consideration’ method. It is usually followed for buy-outs of one company by another. In an all cash buy-out deal, valuation of Company A is not necessary.

15.6.3 Negotiations and Management Approval The negotiations for a merger are begun by looking at the strategic issues and after the broad contours of the deal structure are arrived at, valuers are appointed to determine the share swap ratio. Therefore the negotiation aspects centre mainly around the how mutual interests would be served through the merger. The investment bankers play a major role in structuring the deal to serve common interests. After the merger deal is struck, the share swap ratio is arrived at and the deal is then taken for approval to the Boards of the respective companies for approval and subsequent public announcement. The company also issues a notice to the stock exchanges about the impending board meeting wherein the merger proposal would be discussed. In a buy-out negotiation, the negotiations are usually initiated with a benchmark valuation as arrived at by the respective valuers from both sides. Since a buy out

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involves a strategic interest, the negotiations determine the ultimate price at which the deal gets concluded. Here again, the investment bankers play a crucial role in bridging the gap in price expectations of both the parties and closing the deal. After the deal is closed, the process of seeking management approval is the same. The respective boards of both the acquirer and the seller companies meet and approve the transaction and announce it to through the press.

15.6.4 Due Diligence All schemes of mergers and buy-outs involving outside interests are closed with a term sheet subject to a due diligence review by independent agencies so as to verify the veracity of the claims made in the Information Memorandum and the discussions and negotiations leading to the closure of the deal. The due diligence is handled by independent third party investment banks or professional firms of repute. The points arising out of the due diligence are put forward to the other party and the issues are thrashed out. Sometimes, the due diligence could lead to an alteration in certain parameters leading to a revised valuation and share exchange ratio. In extreme cases, if the due diligence brings out objectionable issues, the deal may even be called off. Therefore, the due diligence process assumes a lot of significance as it could make or mar the whole deal.

15.6.5 Seeking the Court (Tribunal) Approval After the proposed hive-off, divestiture or merger has been agreed upon and the deal structure has been finalised with respect to the valuation and other parameters as per the term sheet, the next step is to proceed with seeking the necessary shareholder and statutory approvals for the same. The standard approvals required for all such proposals is to make an application to the High Court of competent jurisdiction (now the National Company Law Tribunal) under Sections 391–394 seeking directions to convene shareholders’ and creditors’ meetings for seeking their approval. For this purpose, the ‘scheme of arrangement’ is drafted based on the proposed deal structure. The scheme of arrangement would provide all the details of the transaction, the consideration therefore, the economic and business rationale for the same, the suitability of the other party to the transaction and all other necessary details, especially those concerning the shareholders. Extracts of a scheme of an amalgamation are furnished in Appendix 6 and that of a hive-off are furnished in Appendix 7 at the end of the book.

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After receiving the directions of the Court for the meetings, notices are issued along with explanatory statements, enclosing the scheme of the arrangement for holding the meeting on the appointed date, at the given venue. Meetings held in pursuance of the directions of the Court under Section 391 have to pass the scheme of arrangement with a three-fourths majority in terms of value of outstanding creditors and members representing three-fourths in value of the share capital carrying voting rights. After the scheme is so passed, an application is made to the Court again to seek an order for confirmation of the scheme. The Court passes the necessary orders after due hearings and taking into account any modifications based on conflicting interests. The scheme so confirmed by the order of the Court, becomes binding on all parties concerned. If the scheme of arrangement involves an amalgamation (including a merger), the court passes consequential orders under section 394 for the transfer of undertaking of the transferor company to the transferee company, whereby all legal rights and liabilities on such undertakings vest with the transferee company from the effective date of the scheme. The Court’s order under section 394 also provides for dissolution of the transferor company (in merger or amalgamation) without the process of winding up. As regards the incidence of stamp duty on mergers and amalgamations which are settled through exchange of shares, since it is a judicial process, most states do not levy any stamp duty on such transfers. However, of late some states have enacted amendments to their State Stamp Acts for levying such duty on mergers and amalgamations. The Maharashtra Government levies stamp duty at the rate of 7% on the total value of shares issued, subject to a cap of Rs. 25 crore. The West Bengal Government also levies a duty on mergers and amalgamations. In a related case challenging the levy of stamp duty in corporate re-organizations, the Supreme Court upheld the right of levy of stamp duty on court orders for such re-organizations. As regards schemes of arrangements involving buy-outs and hive-offs through the purchase consideration method, since these are settled not through share swap but by actual payment of cash, stamp duty would be attracted. After the Court order is received, it has to be filed with the respective ROC by both the companies within 30 days for the order to become operational from the effective date of the scheme of arrangement. Thereafter, the consequential allotment of shares by the transferee company in exchange for shares in the transferor company, as well as settlement of cash consideration are effected. After the allotment of the new shares, the transferee company files the return of allotment with the ROC within 30 days of such allotment. Simultaneously, application is made to the concerned stock exchange for listing of the new shares, if the company is already listed.

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15.6.6 Other Statutory Approvals Apart from complying with the provisions of the Companies Act and other corporate laws as may be applicable, it may be necessary to seek further approvals under other Central or State enactments. This would depend upon the industry segment and whether closure of a unit with retrenchment of workers is envisaged or not. For instance, if a merger of banks is envisaged, it requires the approval of the RBI under the Banking Regulation Act. Similarly, closure of unit or retrenchment has to be cleared by the labour court under the concerned Central or State labour law. The closure of a unit would require approvals under the Industries (Development & Regulation) Act in the case of licensed industries. A merger or buy-out through merger by an Indian company of a foreign company would require approvals under FEMA and the FDI policy, either from the Government of India or from the RBI for allotment of shares to non-residents, if it does not fall under the automatic route. The merger of sick companies is governed under the provisions of SICA and these companies need not make any reference to the Court under Section 391 of the Companies Act. With the transfer of such functions under SICA to the NCLT, set up under the Companies Act, hereafter the NCLT, would be the quasi-judicial authority for sanctioning schemes relating to sick companies and also for other companies under Section 391–394 of the Companies Act. Since, the process of seeking the court’s approval is a judicial process it is handled through legal practitioners. However, with the powers now being vested with the NCLT, such petitions can also be presented before the Tribunal by other practitioners such as chartered accountants and company secretaries. Other statutory approvals and subsequent compliance matters are usually handled by the secretarial departments of the respective companies. Therefore, the investment banker’s role effectively comes to an end with the closure of the deal and confirmation of the due diligence.

15.6.7 Accounting Aspects The discussion on the accounting treatment of corporate restructuring and amalgamations is important from an investment banking perspective as it has an impact on the resultant balance sheets. Accounting treatment can affect the future financial prospects of such balance sheets and therefore these aspects have to be considered by the investment banker in formulation of the re-organization plan. The

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accounting discussion can be broken down into two components: �

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Under the prevalent accounting norms in India, amalgamations (including mergers) which have been included under the term ‘arrangement’ under the Companies Act are to be accounted for as per the provisions of Accounting Standard 14 on ‘Accounting for Amalgamations’ issued by the ICAI. This standard also prescribes the accounting treatment for buy-outs in the nature of mergers. Apart from mergers and amalgamations, other asset-based methods such as hive-offs and subsidiarization through hive-offs have to be accounted as per the accounting treatment prescribed for buy-outs in the above Accounting Standard. Demergers are the reverse of mergers and should therefore be accounted for as prescribed under AS-14 for amalgamations. Restructuring through the equity method either through a spin-off or other methods does not involve any transfer of assets or liabilities from one balance sheet to another and therefore does not require any special discussion on its accounting treatment.

Brief Provisions of AS-14 AS-14 defines amalgamations as those pursuant to the provisions of the Companies Act or any other statute, which may be applicable to companies. Therefore, it applies to all transactions that come under the purview of sections 391–394 of the Companies Act that relate to integration of two or more companies. AS-14 categorizes amalgamations into two categories: (a) amalgamation in the nature of merger and (b) amalgamation in the nature of purchase. An amalgamation falls under the former category if: �

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All the assets and liabilities of the transferor company become after amalgamation, the assets and liabilities of the transferee company. Shareholders holding not less than 90% of the face value of the equity shares of the transferor company (excluding shares held by the transferee company), become the equity shareholders of the transferee company by virtue of the amalgamation.

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The consideration for the amalgamation, receivable by those equity shareholders of the transferor company who agree to become equity shareholders in the transferee company, is discharged wholly by issue of shares (except for fractional shares that may be settled in cash). The business of the transferor company is intended to be carried on by the transferee company. No adjustment is intended to be made to the book values of the assets and liabilities of the transferor company when they are incorporated in the financial statements of the transferee company except to ensure uniform accounting policies.

An amalgamation that does not satisfy one or more of the above conditions is an amalgamation in the nature of a purchase. On a close examination of the above, it can be appreciated that the above conditions are similar to those stipulated for amalgamations under Section 2(1B) and for demergers under Section 2(19AA) of the IT Act. Therefore, it can be concluded that wherein amalgamations, mergers and demergers are made for the pooling or de-pooling of business interests fulfilling the above conditions, these need to be accounted for using the “pooling of interests’ method prescribed under AS-14. However, if asset transfers are made pursuant to transactions such as hive-offs, divestitures, buy-outs through mergers and subsidiarization through hive-offs, such transactions need to be accounted for under the ‘purchase method’ as prescribed under AS-14. Under the pooling of interests method, the assets and liabilities are aggregated at their book values in the combined Balance Sheet. Similarly, the reserves appearing in the balance sheet of the transferor company would be carried forward in identical fashion into the balance sheet of the transferee company. The difference in capital arising due to the share swap ratio would be adjusted in the reserves of the transferee company either through an increase or decrease. Under the purchase method, the difference of purchase consideration paid over the net book value of assets over liabilities taken over, would be recorded as goodwill or capital reserve in the books of the transferee company. Therefore, the reserves appearing in the books of the transferor company are not carried forward. If the transaction results in goodwill, it should be written off to revenue in not over five years. The accounting implications of the above are explained below with a simple illustration.

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Illustration 15.1

Mergo Ltd. wishes to merge with Amalgam Ltd. The following are the Balance Sheets of both the companies as on the effective date for the scheme. Liabilities

Amalgam. (Amt. Rs)

Mergo (Amt. Rs)

Share Capital Equity shares of Rs. 10 each

10,000

2,100

Share Capital

10,000

2,100

Reserves and Surplus

Assets

Amalgam (Amt. Rs)

Mergo Amt. Rs.

Net Fixed Assets

14,000

6,500

Net Fixed Assets

14,000

6,500

Investments

4,500

500

Share Premium

2,000

500

General Reserve P&L Account

8,000 1,500

2,000 400

Long-Term Borrowings

6,000

3,500

Current Assets

12,000

3,000

Current Liabilities

4,000

2,000

Miscellaneous Expenditure

1,000

500

Total

31,500

10,500

Total

31,500

10,500

Under the scheme of the merger, the share swap ratio has been fixed at 1:3 whereby one share in Amalgam would be issued for every three shares held in Mergo. The balance sheet of Amalgam post-merger under the pooling of interests method would appear as follows.

Working Notes The Capital Reserve of Rs. 1400 is the gain on the merger to Amalgam Ltd., which is computed as follows:

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Liabilities

Amt. Rs.

Assets

10,700

Net Fixed Assets

Capital Reserve Share Premium General Reserve P&L Account

1,400 2,500 10,000 1,900

Investments

Long-Term Borrowings

9,500

Current Assets

15,000

Current Liabilities

6,000

Miscellaneous Expenditure

1,500

Share Capital Equity shares of Rs. 10 each

Amt. Rs.

20,500

Reserves and Surplus

Total

42,000

Total

42,000

Total Issued Capital of Mergo Less value of shares issued in Amalgam to shareholders of Mergo in the ratio of 1:3

2,100

Net gain to Amalgam (capital reserve)

1,400

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5,000

700

Illustration 15.2

Now, let us try and work out the same example given in Illustration 15.1 under the purchase method using the additional details given below. The assets and liabilities of Mergo have to be considered as per the revaluation shown as under: Fixed Assets

-

5800

Investments

-

400

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Current Assets Current Liabilities

2,700 -

2,100

Long Term Liabilities -

3,700

The balance sheet of Amalgam Ltd after the merger, using the purchase method would be as follows: Liabilities

Amt. Rs.

Assets

10,700

Net Fixed Assets

Capital Reserve Share Premium General Reserve P&L Account

2,400 2,000 8,000 1,500

Investments

4,900

Long-Term Borrowings

9,700

Current Assets

14,700

Current Liabilities

6,100

Miscellaneous Expenditure

1,000

Share Capital Equity shares of Rs. 10 each

Amt. Rs 19,800

Reserves and Surplus

Total

40,400

Total

40,400

Working Notes The Capital Reserve of Rs. 2,400 is the gain on the merger to Amalgam Ltd., which is computed as follows: Total value of assets of Mergo Ltd. at their agreed values (Fixed Assets + Investments + Current Assets) Less total value of outside liabilities

–

8,900

--

5,800

(LT Liabilities + Current Liabilities) 3,100

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Less purchase consideration paid to shareholders of Mergo in the ratio of 1X3 Net gain to Amalgam (capital reserve)

700 2400

Let us now try to analyse the implications of both the methods using the above illustration as basis. 1. Firstly, under the pooling method, the assets and liabilities of Mergo including its reserves would be stated as they are in the balance sheet of Amalgam. This would result in Amalgam increasing its share premium account by Rs. 500, general reserve by Rs. 2000 and P&L account surplus by Rs. 400. This is a total increase of Rs. 2900 to reserves. In addition, there is a capital reserve of Rs. 1400, which is the excess of Mergo’s existing share capital over the fresh issue of capital by Amalgam. Therefore, the total accretion to the reserves of Amalgam as a result of the merger under the pooling method is Rs. 4300. This is partly off-set by the increase in miscellaneous expenditure to the extent of Rs. 500 on the asset side, thereby resulting in a net increase of Rs. 3800 to the reserves (Rs. 4300–500). 2. In contrast, under the purchase method, the net increase in reserves is only to the extent of Rs. 2400, i.e. a reduction of Rs. 1400 as compared to the pooling method. This is because under the purchase method, the loss on revaluation of assets and liabilities of Mergo has been recognised. The net asset value of Mergo as per its balance sheet values is Rs. 4500 but after revaluation, it is Rs. 3100 thereby resulting in a loss of Rs. 1400. 3. Due to the reason explained above, under the pooling method, the merged balance sheet is overstated as the assets and liabilities are being carried at their book values. 4. Under the purchase method, the entire gain is shown as capital reserve while under the pooling method, it is distributed among the existing reserves. This has resulted in the increase of distributable reserves to the extent of Rs. 2900 under the pooling method. The pitfall of this method is, therefore, in making available an amount of Rs. 2900 for distribution as dividends, while the whole profits that have accrued are all capital profits and that too, only to the extent of Rs. 2400.

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From the above analysis, it is clear that the pooling method suffers from systemic deficiencies. The purchase method is definitely superior from an accounting perspective and from a disclosures point of view as well.

15.7 Acquisitions and Takeovers After having discussed the entire spectrum of issues relating to re-organizations through the asset route, let us now turn our attention to re-organizations that happen at the shareholder level. Acquisitions and takeovers are two mechanisms by which companies change hands and through transfer of ownership of shares or transfer of control. While both these words are used almost interchangeably, there is a subtle distinction between the two. Acquisition means the purchase of or getting access to significant stakes in a company, often making such acquirer a major shareholder or force in the company. Therefore, acquisition need not be with the intent to seek management control. Many a time, acquisitions are strategic initiatives without a motive for controlling the management of affairs. However, the word ‘takeover’ has more of a negative connotation that conveys the intent to displace the existing management and seek control of affairs through acquisition of shareholding or by other means. A takeover can therefore be through friendly means, in which case it is with the consent of the existing management. However, it can also be through the hostile route whereby the existing management is forced into submission to hand over charge to the acquirer. The word ‘acquisition’ is many a time used to connote a friendly takeover as well.

15.7.1 Historical Perspective Takeovers are not alien to the Indian corporate landscape. There have been several takeover battles in the past, notably the famous takeover bid by Lord Swraj Paul on DCM and Escorts in the early eighties, and much later, the Ambanis’ bid for Larsen & Toubro. Prior to the liberalization era, such attempts were few and far between and therefore made headlines. Post-liberalization, with the setting up of a statutory mechanism for such corporate raids and friendly takeovers, they have become more accepted as a part of vibrant corporate sector. Historically, takeovers were sought to be regulated by the listing agreement of the stock exchanges. Clauses 40A and 40 B of the listing agreement with the BSE contained provisions to the effect that a person acquiring 25% or more of the voting

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rights of a listed company should make a public offer. This threshold limit was lowered to 10% in 1990. In addition, Section 111 of the Companies Act and provisions under the SCRA gave unfettered right to the board of directors of a company to refuse transfer of shares in favour of any person if such transfer meant a change in management control that would be detrimental to public interest. In addition, there were restrictive provisions under the MRTP Act that restricted free transferability of shares to and from persons having substantial interest in companies. These restrictive clauses have since been transferred to the Companies Act. However, the listing agreement was a weak legal mechanism with no penalties for violation other than penalizing the company through de-listing of its shares, which was prejudicial to the interests of the shareholders. The restrictions in the MRTP Act, Companies Act and the SCRA were ominous to the extent of deterring any attempt for a corporate raid. Therefore, takeovers were more or less not possible in that era.

15.7.2 The Advent of the Takeover Code and Current Framework For the first time, after the advent of SEBI, there was a concerted attempt at formulation of a comprehensive framework under which acquisitions and takeovers could be made in existing listed companies. The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations (popularly known as the Takeover Code), introduced in 1994 providing a regulated procedure for takeover bids for listed companies, including mechanisms for counter offers and counter bids in a transparent manner. The Regulations were overhauled in 1997 and again in 1999. However, the Takeover Code does not apply to unlisted companies that continue to be regulated by the provisions of the Companies Act. After the amendment to Section 111, the Board of Directors no longer enjoys the privilege of refusing transfer of shares in favour of a particular person on the basis of grounds that are stipulated by law. Therefore, as far as unlisted public companies are concerned, the company may refuse transfer by citing the reasons to do so but the aggrieved person can approach the Company Law Board (now the NCLT) for redressal. As far as private companies are concerned, the transferability of shares is restricted by virtue of the provisions in the articles of association and therefore, such companies can refuse transfers on that basis. Therefore, with respect to acquisitions and takeovers, we concentrate on the discussion relating only to listed companies. Listed companies are currently governed by the provisions of the Takeover Code, clauses 40A and 40B of the Listing Agreement with the stock exchange (now more or less redundant since compliance with the Takeover Code is mandatory) and Sections 108B and 108D of the Companies Act as regards acquisitions and takeovers.

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Under the provisions of Section 108B, every body corporate or bodies corporate under the same management holding whether singly or in the aggregate, 10% or more of the nominal value of the subscribed equity share capital of any other company shall, before transferring one or more such shares, give to the Central Government an intimation of its proposal to do so with the prescribed details. The Central Government may, under such circumstances, pass the necessary order not to effect such a transfer, if it is of the opinion that such transfer may cause a change in the composition of the board of directors of the company, which could be prejudicial to public interest. Section 108D provides similar provisions wherein the Central Government can act suo moto on any transfer of a block of shares in a company. The provisions of the above two sections were transferred from the MRTP Act and are intended to curb monopolies being formed through the shareholding route. However, in the current scenario of economic liberalization and the policy of regulation rather than control of economic power, the Central Government hardly invokes this power to stop acquisitions and takeovers that otherwise comply with the law. As far as clauses 40A and 40B of the Listing Agreement are concerned, the current provisions insofar as acquisitions and takeovers are concerned are as follows: 40. A(v): The company agrees that the following shall also be the condition for continued listing. a. When any person acquires or agrees to acquire 5% or more of the voting rights of any securities, the acquirer and the company shall comply with the relevant provisions of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997. b. When any person acquires or agrees to acquire any securities exceeding 15% of the voting rights in any company or if any person who holds securities which in aggregate carries less than 15% of the voting rights of the company and seeks to acquire the securities exceeding 15% of the voting rights, such person shall not acquire any securities exceeding 15% of the voting rights of the company without complying with the relevant provisions of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997.

40. B — Takeover offer: A company agrees that it is a condition for continued listing that whenever the takeover offer is made or there is any change in the control of the management of the company, the person who secures the control of the

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management of the company and the company whose shares have been acquired shall comply with the relevant provisions of the SEBI (Substantial Acquisition of Shares and Take-over) Regulations, 1997. Therefore, the above clauses have been modified in harmony with the Takeover Code and to ensure compliance with the Takeover Code both by the company and the acquirer of substantial stakes in the company.

15.7.3 Broad Framework of the Takeover Code The SEBI Takeover Code brought in several new features into the acquisition law which were not present in clause 40 A and 40B. The basic theme of the Code is to provide for fair play and transparency in acquisitions and takeovers but at the same time to ensure that they are not stifled into extinction. The fair play is provided in terms of stipulation of a public offer to be made whenever there is a substantial acquisition or takeover so that the other shareholders get an equal exit route as well. The transparency is sought to be brought in through mandatory disclosures and guidelines on the conduct of the public offers. The Takeover Code has been broadbanded over the years based on two rounds of recommendations of the Justice Bhagwati Committee. The following discussion details the important concepts and provisions under the Code.

Important Definitions 1. An ‘acquirer’ means any person who directly or indirectly acquires or agrees to acquire shares or voting rights or control over the target company, either alone or together with persons acting in concert. Therefore, acquisition can be through equity shares or equity convertibles or shares with disproportionate voting rights. 2. ‘Control’ includes the right to appoint majority of the directors or to control the management or policy decisions, either individually or through persons acting in concert. Such control can be by virtue of shareholding or voting rights or management rights through shareholder agreements or other arrangements. 3. ‘Persons acting in concert’ mean persons with a common purpose of substantial acquisition of shares or voting rights or gaining control over a target

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company. The Code lists out certain categories of persons who would be deemed to be persons acting in concert, such as companies under the same management as the acquirer and their directors, their merchant bankers, their stock brokers and other specified categories. 4. ‘Promoter’ used in the context of the Code has a wide meaning and includes persons named as promoters in any offer document issued by the company or persons in control of the management of such company either directly or indirectly, includes their relatives and related firms and companies.

Main Requirements under the Code 1. Any acquirer who acquires shares or voting rights in a company (hereinafter called holdings), which when aggregated with the existing stock of such holdings of the acquirer in the company exceed 5%, 10% and 14% of the total, shall disclose at every stage the aggregate of the holdings to the company and to the concerned stock exchange(s). The stock exchanges shall put such information under public display immediately. The company also has a responsibility to report such information to the stock exchange. 2. No acquirer shall acquire holdings, which when aggregated with the existing stock of such holdings of the acquirer in the company equal or exceed 15% of the total, unless such acquirer makes a public announcement to acquire shares through a public open offer to the extent stipulated under the Code. 3. No acquirer together with persons acting in concert can acquire more than 5% of holdings in any financial year ending 31st March without complying with the open offer requirements, if the existing holdings are between 15% and 75%. In other words, such acquirer who already has more than 15%, can do a creeping acquisition of up to 5% per year without triggering off the open offer requirements. However, any such purchase or sale transaction amounting to 2% or more of the share capital of the target company shall be reported within two days in the same manner as described in (1) above. 4. No acquirer together with persons acting in concert can acquire any more holdings in the target company without complying with the open offer requirements, if the existing holdings have already reached 75%. 5. No acquirer shall gain control of a target company without making a public offer, unless such control has been vested through a special resolution passed by the members voting through a postal ballot.

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6. The above requirements apply both to direct acquisitions of holdings or control in listed companies or through indirect acquisitions through holding companies whether listed or unlisted and whether in India or abroad. 7. The open offer requirements apply to first time acquisitions made through disinvestments of public sector undertakings by the Government. But they do not apply to subsequent disinvestments in the same company subject to certain restrictions. 8. In the case of bailout of financially weak and sick companies, the Code prescribes a special procedure under Chapter IV of the Code. The acquirers of such companies would be exempted from the open offer requirements on a case-by-case basis.

Exemptions from Open offer Requirements The open offer requirements specified above do not apply to the following acquisitions: �

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Allotments made in pursuance of a public issue. If there is a firm allotment in the issue to an acquirer, proper disclosures are necessary. Allotments made through a rights issue within the trigger limits specified above and without change in management control. Existing promoters may however take up unsubscribed portion of the rights by stating so in the letter of offer. Allotments pursuant to underwriting agreements. Inter-se transfers between persons belonging to the promoter group, Indian promoters and foreign collaborators, etc., subject to conditions. Inter-se transfers between the acquirer and persons acting in concert after a period of three years from the closure of the open offer subject to other conditions. The acquisition of shares in the ordinary course of business by stock brokers, market makers, financial institutions and banks, merchant banker or promoter, pursuant to a safety net arrangement in a public offer and by specified international financial institutions. Allotments made by acquirer in exchange for shares received in an open offer.

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Transmission of shares by law.

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Transfers by financial institutions and venture capital funds to promoters.

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Rehabilitation schemes under the SICA or any other law.

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In addition to the general exemptions as above, SEBI can accord case-bycase exemptions based on the facts of each case.

The operational aspects of the Code relating to conduct of the public offers and other procedural requirements thereof are discussed separately in Chapter 9 relating to ‘Exit Offers’.

15.7.4 Deal Process for Acquisitions and Takeovers An acquisition and/or takeover of shares can happen under three routes: �

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Open Market Purchase: Under this route, the acquirer purchases shares of a listed company from the secondary market and consolidates these holdings. If the acquirer so wishes, the trigger points specified in the Takeover Code can be breached thereby making it mandatory for the open offer to be made to the public. Once the public offer is successful, the acquirer ends up as a substantial stakeholder. Thereafter it is up to the acquirer to takeover the company or not depending upon the strategic objectives behind the acquisition. Hostile acquisitions are most often started through this route whereby the identity of the acquirer can be kept confidential till the disclosure requirements under the Takeover Code are triggered off. Negotiated Acquisition: The acquirer strikes a deal to acquire a stake in the target company from one or more existing shareholders so as to make a substantial acquisition. The sellers could be the promoters themselves or other non-promoter shareholders. In cases involving strategic disinvestments by the promoters, this route is generally adopted. In a negotiated acquisition, the sellers are paid the sale consideration by the acquirers and therefore, the company does not get any benefit of the consideration. In a strategic disinvestment, the acquirer provides an exit route for the existing promoters. If the acquirer triggers off a strategic disinvestment by buying out the existing promoters with an attractive exit price, it becomes a ‘friendly takeover’. The expression friendly takeover has two dimensions:(a) it is friendly because the promoters ultimately sell their stakes willingly and

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(b) it is a takeover since the existing promoters never contemplated an exit on their own. �

Preferential Allotment: When an acquisition is intended for the benefit of the company, it is customary to build the stake of the acquirer through issue of fresh equity so that the company receives the sale consideration. Induction of strategic partners into a company is generally through this route.

In the open market purchase route, the acquirer does not come in contact with the promoters or management of the target company until after the disclosure requirements are met. If the acquirer wishes to go for the open offer, the public announcement has to be made upon reaching the trigger point of 15% mentioned above. Thereafter the public offer is made and if the existing promoters wish to contest they could make a counter-offer. The Takeover Code provides enough leeway for a corporate battle of control in such cases within its framework. The operational requirements thereof are also furnished in Chapter 9. Finally, whether the acquisition leads to a takeover or not would depend upon the turn of events in the public offer. The negotiated acquisition route calls for deal making between the seller and the acquirer that would require the services of expert investment bankers. The investment banker structures the deal, helps in negotiations and finalising the term sheet. Thereafter, the share purchase agreement is drawn up and executed to close the deal. The share purchase agreement stipulates the roadmap for the transfer of the shares to the acquirer and the settlement of the purchase consideration to the seller. Usually negotiated deals involve valuation and due diligence which would require third party investment bankers or other professionals to be involved. Thereafter, depending upon whether the open offer is triggered or not, the rest of the acquisition process takes place. The preferential allotment route is only another mode of concluding a strategic deal except that in such cases, there is no seller and a buyer. The acquirer enters into a subscription agreement with the company for subscribing to the preferential offer. Preferential offers are no longer exempt under the takeover code. Therefore, if pursuant to such allotment, the open offer requirement is triggered off, it needs to be complied with by the acquirer. The rest of the process is similar to that of a negotiated acquisition described above.

15.7.5 Strategic Issues in Acquisitions and Takeovers While acquisitions may sometimes add value to a company and are therefore desirable, takeovers have to be viewed with much more skepticism, especially if

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the acquirer has no track record of building companies but is more of a takeover artiste who is interested in looking at the acquired companies as stock-in-trade. Some of the important strategic issues in the context of an acquisition or a takeover are the following: �

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In an acquisition through the negotiated or preferential route, the main considerations for the company relate to the valuation being offered, fund requirement of the company and qualitative value addition from the acquirer. The promoters need to think of the dilution in their stakes and the postplacement shareholding pattern. If the open offer requirement is being triggered off, its implications on the shareholding pattern also need to be examined. From the acquirer’s point of view, the total investment including the public offer needs to be assessed at the specified valuation. If the acquirer has no intentions of a takeover and is comfortable to remain in a strategic position, the option to trigger off the open offer may not be exercised. In strategic exits made by existing promoters through negotiated sell-offs, the acquirer obviously pays a control or strategic premium to the sellers. In such cases, it may be beneficial for the public to encash such premium in the open offer made in connection with such acquisition. The public investors should also weigh the quality of the future management in taking the decision to exit the company. In a case wherein a negotiated acquisition could lead to a de-listing of the company, the acquirer has to consider the flip side of taking the company private as that could impact future fund raising and valuation. The contrary may also be true that as a result of de-listing, the company may be able to raise private equity at higher valuations if it is presently being under-valued in the market. There had been frivolous acquisitions in the past by raiders who had no intentions of entering the target company. They made such acquisitions with the sole intention of selling their holdings back to the promoters of the target company at a hefty profit. Such acquisitions by promoters of stock in their own companies at hefty premium is called ‘green mail’. Green mail acquisitions can prove to be expensive propositions for promoters to protect their interests. A better way would be to consolidate their stakes from time to time through open market purchases and open offers. In the past decade, there have been several cases of consolidation of promoter stakes by various groups; a process that was also partly fuelled by the depressed secondary market. For instance, Tata Sons, the holding company of the Tata group,

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consolidated its holdings in group companies in a major revamp made in the nineties. The primary objective of the strategy was to increase the stake of Tata Sons in core group companies to around 26%. Tata Sons issued nonconvertible debentures to the tune of Rs.108 crore which was subscribed to by the group companies. Using these and other funds, Tata Sons increased its stake in TISCO to 15% from the earlier 7.5%. After the revamp, Tata Sons held around 15% in Tata Electric, Tata Power and Tata Hydro, around 11 to 12% in ACC and TELCO, and 32% and 45% respectively in Tata Chemicals and Indian Hotels. Other groups like RPG and UB had followed this route to consolidate their businesses and be insulated from hostile takeovers from competitors and other acquirers. Some others such as the Sheths of Great Eastern Shipping sought the help of white squires to ward off takeover attempts. In the case of GE Shipping, it was the Mahindra Group that came to their rescue. Some others create what are known as ‘poison pills’, i.e. special exercise rights on shares that would make it more difficult and expensive for an acquirer to takeover the target company against the will of its board of directors. Other defence strategies include hiving-off attractive assets or production facilities into closely-held group companies or 100% subsidiaries and offering partner status to white knights with deep pockets so that they can ward off predators. Both these options have to be weighed carefully after assessing all the implications. For e.g. India Cements was the white knight for Raasi Cements in the wake of a takeover threat, but the same white knight became the predator at a later date. Similarly, hiveoffs from blue-chip companies just to ward off takeover attempts could have other implications on the future growth, market capitalization and fund raising capability of such companies. �

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In takeover tussles, the mechanism of open offer, counter-offer, revisions and withdrawals are permitted under the Takeover Code. During such battle of wits, there is a need to evaluate the cost-benefit ratio at each stage and take decisions since their financial and strategic implications can be profound. Both the acquirer and the promoters need to be advised by their respective investment bankers so that a clear winner could emerge. In the battle for Indian Aluminium between Sterlite and Alcan, there were several twists in the tale before Alcan could successfully defend its company. JM Morgan Stanley had advised Alcan. The India Cements take over of Raasi Cements and Vishnu Cements is another case in point. An important dimension in this context is about the valuation and deal price for an acquistion or a takeover. There is a fundamental difference between

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a strategic acquisition or takeover and a hostile takeover in this respect. In a strategic deal for either an acquisition or a takeover, the acquirer would have the benefit of a lot of information flow from the management since the deal is being made from both sides. There would even be a due diligence done prior to the actual investment by the acquirer. However, in a hostile acquisition, the main benchmark for the acquirer could only be the market capitalization of the target company. A full-fledged valuation and due diligence may not be possible due to lack of sufficient information and co-operation from the target company. Therefore, the acquirer needs to be astute and play the cards well to be able to successfully clinch the deal. The deal price must be attractive enough to elicit a favourable deal closure but at the same time, the acquirer cannot afford to overpay the strategic premium. The criticality of the advice to be given by the investment banker is felt in this area as well. �

Last but not least is the issue of financing acquisitions and takeovers. While structured leveraged buy-outs are not in vogue in India, the climate has distinctly turned favourable for raising takeover finance with some financial institutions, investment banks and private equity funds emerging as lenders/investors in such deals for the acquirers. Some structured financing deals involving Indian companies, such as the buy-out of Tetley by Tata Tea have also been seen. Acquirers have to plan their financing strategies well so as not to over-leverage their existing companies for the purpose of acquisitions. India Cements went into a debt trap by borrowing from financial institutions for its massive takeovers. There have also been examples of the other side to the story as well, such as Wipro, which waited with a cash pile for a good takeover or acquisition opportunity until it bought over Spectramind.

15.8 Role of Investment Banker in Corporate Re-organizations As may be appreciated from the various discussions on corporate re-organization in this Chapter so far, the importance of the role played by the investment banker cannot be over-emphasized. It has already been indicated that this area forms a key segment in their business portfolio. In all corporate re-organizations, the investment banker performs the pivotal role of transaction service, acting as a catalyst for the entire deal. In a corporate restructuring involving a split-up or a divestiture by a

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company or a disinvesment by the promoters, the investment banker prepares the entire feasibility plan, deal structure, prepares the necessary deal specific literature, identifies the buyers or the sellers as the case may be, conducts the valuation and due diligence ( as a third party) and negotiations for arriving at the term sheet. The investment banker also works closely with other professionals such as accountants and legal advisors in order to look at the legal, accounting and tax issues involving such corporate re-organizations. Based on the deal structure arrived at, the scheme is prepared by the lawyers to be presented to the shareholders and the High Court under Sections 391–394 of the Companies Act. With the powers of the High Court now being shifted to the Tribunal, this function may also be performed by other professionals. In transactions involving mergers and acquisitions, the task is even more onerous. In a merger, the key function of an investment banker is the search and identification of the other party to the deal. Thereafter, there are critical functions relating to preparation and circulation of information memoranda, deal structuring and negotiations apart from ancillary functions of valuation and due diligence that could be done by third party investment bankers. Since a merger involves statutory compliance and petitioning the Court (now Tribunal), it involves teamwork with other professionals such as accountants, lawyers or company secretaries. It is worthwhile to note that it is only after the deal structure is firmed up that the scheme of the merger is drawn up to draft it in a legal language. Therefore, the deal structure is critical as it has financial and strategic implications for both parties. From this point of view, the investment banker’s function has utmost significance. As has been illustrated in the discussion on accounting for amalgamations, the structure of the post-merger balance sheet is critical since it impacts the distributable reserves, the fund raising capability and book value of the share. This could have market repercussions as well. The investment banker has to have a clear view of these implications and advise the client suitably in arriving at the optimum strategy for the merger and post-merger balance sheet. Discussions with accounting professionals working on the balance sheet would help in this respect to come out with creative ideas. Similarly the tax implications also determine the right strategy, especially in split-ups. As may be appreciated, a group restructuring could be quite a complicated assignment that could involve a combination of a split-up, merger and an acquisition. The investment banker should work closely with accounting, legal and tax experts in such cases to bring out a holistic solution. In acquisitions and takeovers involving open offers, the investment banker plays the dual role of an investment bank as well as a merchant bank. The merchant

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banking role is in managing the public offer and ensuring compliance with the SEBI Takeover Code. The Takeover Code places onerous responsibility on the merchant banker for the purpose of the open offer in terms of the public announcement and disclosures in the offer letters. The other critical functions are in valuation and deal advisory based on the strategic and financial issues. Some of these issues have been discussed in Section 15.7.5 above. In transactions related to M&A, the investment banker has to represent a client either from the buy side or the sell side. This would mean that in each such deal, there would at least be two investment bankers representing either party to the transaction. Usually, an acquisition leads to spin-off transactions, which provide additional work for the investment banker such as raising finance for the takeover through debt or equity offerings.

15.9 Conclusion In time, M&A will grow, to be of more significance to the Indian industry. Investment banks will find such advisory to become a more significant business area than it is today. The relative growth in the number of deals shows this trend. As the number of deals and average deal sizes grow, the skill-sets of Indian investment banks in providing high quality advice would also be tested. There are several boutique investment banks that have started to specialize in M&A advisory for the SME segment while the big players concentrate on the top rung corporates. Reverse cross-border deals are also growing in number with more Indian companies looking for overseas acquisitions. All these trends augur well for Indian industry in general and investment banks in particular. What needs to be done is for investment banks to position themselves appropriately and look for new competencies, especially in advising on cross-border deals so that there is a wider canvas to operate on. The future definitely holds a lot of potential in this service area for Indian investment banks.

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Notes 1. Source: Bloomberg. Data is for the first half of CY 03. Includes mergers, acquisitions, divestitures and self-tenders. Does not include open market purchases. 2. Source: Bloomberg. Data is for the first half of CY 03. Includes mergers, acquisitions, divestitures and self-tenders. Does not include open market purchases.

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3. As reported in The Economic Times dated 5th December 2003. 4. According to CMIE data.

� Select References 1. News Reports and articles in The Economic Times. 2. News Reports and articles in the Business Standard. 3. Articles in various issues of ‘Analyst’ published by the ICFAI Press.

� Self-Test Questions 1. What are corporate re-organizations? Why do they happen? What are the types of corporate re-organizations? 2. What are the methods for splitting up a company? What are the strategic and other considerations that go to decide the method adopted in a given situation? 3. How is the process of a corporate split-up different from that of a merger? 4. What is the definitive role of an investment banker in transactions involving corporate union and corporate split-up? 5. What are the triggers for the Takeover Code? What are its main requirements? 6. Are hostile takeovers possible under the Takeover Code? How does one ensure success in a hostile takeover within the framework of law? 7. What are the strategic issues in M&A that investment bankers can advise upon? What is the transaction support that they provide?

� Annexure I

� CASES IN CORPORATE RESTRUCTURING I. Mahindra & Mahindra Mahindra and Mahindra (M&M) undertook a financial restructuring by amalgamating three of its subsidiaries and writing off deferred revenue expenses up to a maximum of Rs. 500 crore against the share premium account. The balance in the share premium account (SPA) stood at Rs. 819 crore at that time that would have come down to Rs. 319 crore after the write off. The write-off is on account of product development, VRS schemes and minor software expenditure, to the extent of Rs. 374 crore as on September 30, 2001. The remaining was the likely expenditure to be incurred on account of product development, and VRS schemes up to March 2002. As a result of the amalgamation of group companies, M&M wrote off the value of investments of its shares in these subsidiaries. This write-off, which was about Rs. 500 crore, was in addition to the write-off mentioned earlier. The company’s net worth stood at Rs. 2069 crore as on March 31st, 2001. The company was expected to earn a profit on revaluation of the shares of M-BT (Mahindra-British Telecom) in which one of its merging subsidiaries had a 31.9% stake.

II. Godrej & Boyce Godrej & Boyce Manufacturing, the closely held flagship of the Adi Godrej group, revamped its operations in 2001 by merging some of its divisions which were operating as separate SBUs. This also involved relocating some of its divisions out of Mumbai to cheaper locations such as Chennai, Goa and Pune in a bid to trim operating costs.

III. TVS Group The TVS Group made a restructuring of its subsidiary, Lakshmi Auto Components (LAC) ahead of its merger with the parent at a later date. LAC acquired Sundaram

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Auto Components (SAC) with an intention to move its own plastic and rubber components business to the latter. Since LAC was mainly a contract manufacturer for TVS Motor Company, the flagship of the group, its other business was also being moved to SAC.

IV. Aditya Birla Group The Aditya Birla Group decided to transfer Indo Gulf Corporation’s investments and cross-holdings in group firms to Hindalco Industries. This was aimed at rationalising cross-holdings in the manufacturing companies of the group. Indo Gulf held 3% in Indian Rayon, 0.6% in Grasim, 1.26% in MRPL and some shares in Idea Cellular, the mobile telephony JV with the Tatas and AT&T. Hindalco held a lot many shares in group companies. With the recasting of shareholdings, the holdings in the manufacturing companies remained mainly with Hindalco and Grasim, while Indian Rayon was to spearhead the new businesses such as insurance (Birla Sunlife) and IT (PSI Data Systems) — (Business Standard 23/07/2002).

V. Bharti Group The FIPB rejected in early 2002, the proposal of Bharti Global, a holding company which held shares in Bharti Telecom and Bharti Healthcare, to transfer its entire shareholding in these two companies to its Mauritius based wholly owned subsidiary, Indian Continental Investments. The ground for the rejection was that it did not fit into the guidelines though the question of ‘round tripping’ was not raised. Bharti Televentures re-organised its group structure under four linear subsidiaries for its four business segments— cellular, basic, long distance and broadband. Bharti Cellular would be the subsidiary for all the cellular operations, which would own 100% of the two companies Bharti Mobile and Bharti Mobinet, which operate cellular networks in AP & Karnataka and Chennai respectively.

VI. UB Group The United Breweries Group hived off off its beer division into a separate SPV, which inducted Scottish & Newcastle (S&N) as a strategic partner. The UB Group holds 40%, S&N holds 40% and the balance is held by private persons in the SPV. S&N invested Rs. 250 crore into the SPV for a 40% stake apart from

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investing another Rs. 175 crore into other UB group companies. The investment was used to wipe off UB group’s debt burden of Rs. 350 crore. The investment in the SPV of Rs. 250 crore came in the form of Rs. 200 crore of redeemable optionally convertible preference shares and Rs. 50 crore of debt funds. UB intends to convert the entire funds into equity within two to five years at an appropriate valua-tion. The understanding is to cap S&N’s shareholding at 26% at the time of such conversion.

VII. Jindal Group Jindal Strips Ltd ( JSL) put forward a plan to hive off its investments in group companies, Jindal Steel and Alloys, Jindal Holdings and the US firm Massilon into a separate company. The move for de-subsidiarization is to create a capital structure that will help JSL in its future plans. JSL has a total debt of Rs. 750 crore and the efforts are to bring down the cost of capital to below 10% from 13.7%. The company’s earlier plan of selling off its subsidiary Jindal Steel and Alloys to its group company Jindal Iron and Steel did not meet the favour of the lenders. (Economic Times 9th January 2003). Jindal Strips also announced a restructuring whereby its stainless steel business will be demerged into a new company Jindal Stainless while Jindal Strips will be made a holding company to manage the company’s businesses and investments. Jindal Stainless would make a bonus issue to help its shareholders to regain their previous level of holdings.

VIII. RPG Group The Gramophone Company of India Ltd. (now Saregama) amalgamated its subsidiaries with itself to create a bigger company with consolidated business interests. The RPG group embarked on a restructuring of its tyre and rubber business in late 2002. The rubber business would be consolidated in Ceat Ltd, which would merge the rubber division of group company Harrison Malayalam with itself. The objective was to strengthen the business of Ceat by providing it with backward integration for sourcing rubber for its tyre manufacturing as also to provide synergistic effect. In order to focus on its core business, Ceat would de-merge its Rs. 180 crore investment portfolio to its subsidiary company Meteoric Industrial Finance Company following which, it would cease to be a subsidiary. Besides, Harrison Malayalam, the second largest tea producer in south India would merge its wholly owned subsidiaries with itself and concentrate on its core business of tea.

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IX. Jumbo Group The Jumbo group of Manu Chhabria restructured its equity holdings in Indian group companies. The company decided to transfer its holding in Gordon Woodroffe from its domestic holding companies to Jumbo’s non-resident holding company, Jumbo World Holdings. Earlier, the Jumbo group tried to do the same thing with its other two major companies in India, Shaw Wallace and Falcon Tyres, but was turned down by the Government. The Government gave the approval for the transfer of holdings after FIPB verified whether Jumbo World Holdings was under the status of an OCB or not. This was necessary since Gordon Woodroffe was engaged in property development and management services.

X. Lucky Goldstar (LG) LG Korea, restructured its business in India by merging its two 100% subsidiaries, LG Electronics India (electrical goods and appliances) and LG Electronic Systems (telecom equipments). Post-amalgamation, there would be one 100% subsidiary LG Electronics India, but its paid-up capital would increase. This required government approval for modifications to the original collaboration approval.

XI. IL&FS De-Subsidiarization IL&FS de-subsidiarized its trusteeship services company IL&FS Trust Company. This was achieved by a preferential allotment made by the trust company at a price of Rs. 500 per share to other subsidiaries and affiliates of IL&FS. Post restructuring, IL&FS held 40% while 25% was held by Investsmart India and IL&FS Venture Corporation. The balance 10% was held by IL&FS Merchant Banking Services Ltd. The de-subsidiarization was done to leverage the synergies between the other companies and the trust company. Investsmart was subsequently merged with IL&FS (Economic Times 17th August 2001).

� Annexure II

� CASE STUDY IN CORPORATE SPLIT-UP THE LARSEN & TOUBRO AFFAIR The Aditya Birla group through Grasim Ltd. acquired the stake of Reliance Industries Ltd in Larsen & Toubro Ltd. (L&T) in 2001 amounting to 10.05%. Subsequently it adopted the creeping acquisition route and since the stake of Grasim in L&T was nearing the trigger point of 15%, as per the Takeover Code, Grasim made an open offer in late 2002 to acquire 20% of L&T at an offer price of Rs. 190 per share. The management of L&T on the other hand, felt that the valuation was too low against a fair value of around Rs. 300. Therefore, they approached the Financial Institutions to oppose the Grasim open offer. The FIs had in the past thwarted the attempt by Reliance to enter L&T. The strategy of Grasim on the other hand appeared to be to get over with the open offer and then go for the creeping acquisition route to get controlling stake in L&T. This was the strategy adopted by Reliance in BSES. Though Grasim had been maintaining that L&T was a strategic investment and that it did not seek to control day-to-day operations, the open offer was a move to pre-empt L&T from de-merging its cement division and inviting a strategic MNC partner therein. The SEBI issued a direction to the merchant banker JM Morgan Stanley to hold Grasim’s open offer till its investigation in Gujarat Ambuja ACC case was completed. In that case, Gujarat Ambuja Cements bought over ACC from the Tatas acquiring in the bargain, 14.4% of ACC in two stages. It maintained that its investment was strategic and not to seek operational control. However SEBI had been investigating whether Gujarat Ambuja had management control on ACC and therefore, if it had violated the Takeover Code by not making an open offer. In its order to Grasim, SEBI wanted to investigate the same aspect in the L&T case as well. It also indicated that it would look into the pricing aspect, which the other shareholders felt was low. Grasim had paid Rs. 306 per share to Reliance. The financial institutions (FIs), which were holding 36% in L&T, were the single largest shareholder group. Grasim immediately filed an appeal on the SEBI order with the Securities Appellate Tribunal (SAT). Grasim’s contention was that they had followed the rule

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book in making the open offer. As far as the price was concerned, Grasim felt that it was a fair price considering that it had paid an entry premium to Reliance. Any upward revision would have affected the interests of the shareholders of Grasim in which incidentally, the FIs held 24%. The open offer was only optional to L&T shareholders and therefore they did not have the necessity to opt for the indicated pricing.

The stand-off between Grasim and L&T Management The L&T management had been striving to restructure L&T by hiving off the cement division (which is now the largest in India) and inducting a strategic partner. Initially, three global cement majors Lafarge, Cemex and Holcim evinced interest in it. In the meantime, the Reliance shareholding changed hands and Grasim came in with two Board seats. This gave an indication to the market that the cement demerger would never happen. In the meantime the foreign suitors lost momentum due to the emergence of Grasim in the picture. Under the circumstances, there were no other serious contenders to bid for L&T as a whole. The L&T management felt that eventually Grasim wanted all its cement business under one company and would therefore work towards the interests of Grasim, to the detriment of the shareholders of L&T. This issue of ‘conflict of interest’ had surfaced and the management put up stiff resistance to Grasim at the board level. The suggestion by Grasim to have cross-manufacturing arrangement between the two companies would have benefitted Grasim at the cost of L&T, since the latter had better brands. The management felt protecting L&T’s interests in future and still remaining in control would be tough for them. The management therefore resisted the open offer and sought institutional support. As far as the Birlas were concerned, they needed majority control eventually to steer their investments in L&T to safety and derive value.

The Demerger Proposal by L&T and the Counter Demerger Proposal by Grasim Since the proposed open offer by Grasim was stalled by SEBI, in the intervening period, the L&T management sought to revive its demerger plan and seek support for it from the FIs. Looking at the turn of events, Grasim came up with an

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alternative demerger plan and made its case with the FIs. Before either of the plans could go forward, SEBI in the interim gave a green signal for the original open offer of Grasim at Rs. 190 per share. This offer opened for the public in May 2003. Grasim had said in March that in the event of the FIs agreeing to its version of the demerger plan, it would go ahead with the open offer at the first stage and then go for the demerger and acquire a majority stake in the cement company by offering a value of $75 a tonne, which was the value a strategic investor was willing to give. However, if the FIs were to decline the demerger, Grasim intended to increase its open offer price by 20% to the range of around Rs. 225–240 per share. The outcome was dependent upon the decision of the FIs and the success of the open offer.

The Valuation of L&T based on Sum of Parts Rs. crore Engineering division valued at 5 times EBITDA

2347

Cement division valued at $80 per tonne

6600

Electrical division valued at one time revenue

705

Diversified businesses valued at one time revenue

425

Software division valued at 10 times net profit

420

Total gross valuation

10497

Less total debt

–3543

Value of equity

6954

Outstanding equity shares (no. in crore)

24.86

Value per share (Rs.)

280

Source : Business Standard (Smart Investor) dated 18th November 2002.

L&T’s Structured Demerger Proposal The L&T management’s plan was as follows: The L&T management through this route wanted to maintain the say for L&T in the cement company thereby preventing the Aditya Birla group from exercising control. The dilution to strategic investor could happen either through fresh issue of

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Larsen & Toubro Ltd. Grasim —14.5% LIC and UTI —27% Other Institutional Investors —18% Public and others —60.5%

L&T Cement Ltd. Demerger

(Structured Demerger) L&T Ltd — 70% Shareholders of L&T—30% (In the ratio of their L&T holdings)

Strategic sale

L&T Cement Ltd L&T Ltd—70% Shareholders of L&T—24% Strategic Investor—6%.

shares (in which case the original 70:30 ratio between L&T and its shareholders inter se would have remained static after the strategic sale) with the funds being received by the company or through disinvestment by the shareholders of L&T or a combination of both. The strategic partner was CDC Partners, a private equity investor. The management felt that its proposal would result in greater gains for the shareholders of L&T. This was because the strategic investor would pay a higher price than the Birlas for a stake in the cement business. Secondly, by keeping 70% with itself, L&T could offload a part of it at a future date to strategic investors at higher valuations, looking at the good long term prospects of the cement industry. CDC agreed to pick up 6.8% in L&T Cement but put in a lot of restrictive conditions such as: �

Right to nominate a board seat.

�

Fully convertible FCDs which can be converted before December 2004.

�

If not converted, the debentures would be redeemed in three tranches between 2004 and 2007.

�

Can exit the company, full exit possible after 2007.

�

Conditions on operational issues.

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�

� �

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Drag along right to insist on L&T to sell 51% in all including its 6.8% in case it planned to exit the company. This was to get a better valuation from a strategic investor. Veto power on declaration of dividends, sale of assets and appointment of key executives. The alternative suggested by the L&T management was to allow exercise put option if it disagreed on major issues without being able to block decisions. Price offered translated to $76 per tonne. Co-sale — if L&T makes secondary market sales between 2004 and 2007, CDC has the right to sell alongside.

As an alternative to the CDC proposal, the L&T management suggested a competitive bidding route whereby a strategic partner would be selected out of several bidders. Under this plan, L&T would have 75% stake in the demerged company and the balance would be with L&T shareholders. At a later date it would offer a strategic stake to an investor out of the 75%. It was open to the idea of having Grasim as a strategic partner to offload a stake of 47.5% at a valuation of $100 per tonne. Through this route, Grasim would get 47.5% from L&T in addition to the 3.5% it would be holding as part of the 25% with the L&T shareholders, thus making it a cumulative holding of 51%. In addition, it would then make an open offer for an additional 20% as per the Takeover Code. The L&T management held that this plan would result in the best deal for the L&T shareholders. The valuation of $100 per tonne was justified by maintaining that it was in line with other valuations in the industry. Vishnu Cements was acquired for $82 per tonne by Zuari Cements. As compared to it L&T had multi-locational plants, larger capacity of over 16 million tonnes, captive power facilities, premium brand and a jetty for the export of clinker. Therefore the expectation of $100–105 per tonne was justified.

Grasim’s Vertical Demerger Proposal I The Grasim management’s plan was as follows: Larsen & Toubro Ltd Grasim —14.5% LIC and UTI —27% Other institutional investors —18% Public and others — 60.5%

L&T Cement Ltd. (listed Co.) Demerger

(Vertical Demerger) Grasim—14.5% LIC and UTI —27% Other institutional investors—18% Public and others— 60.5%

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Under the vertical split structure as above, L&T Ltd. as a company would not hold anything in L&T Cement. This structure, according to the Birlas, favoured the shareholders than the company itself. This also meant that Grasim at a later date could look at an open offer in L&T Cement thereby gaining control. Grasim opposed the competitive bidding route suggested by the L&T management on the ground that L&T Cement already had a candidate for the same in Grasim which had agreed to pay Rs. 130 per share ($65 per tonne) after the vertical demerger for its additional stake in the demerged company. The L&T management analysed that under the vertical split, since Grasim would hold 14.5% of the cement company, it would need to acquire an additional 36% through an open offer to gain majority control. At the price offered by Grasim, this was much lower an investment than what was envisaged by the L&T management under its structured demerger plan.

Grasim’s Demerger Proposal II Since the L&T management and the FIs were of the view that the subsidiarisation plan would realize better shareholder value than the vertical split suggested by Grasim, an alternative plan was put forth by Grasim. Larsen & Toubro Ltd. Grasim —14.5% LIC and UTI —27% Other institutional investors —18% Public and others — 60.5%

L&T Cement Ltd. (listed Co.) Demerger

(Structured Demerger) L&T shareholders — 60% L&T Ltd. — 40%

Strategic sale

L&T Cement Ltd. L&T Ltd.—15% Shareholders of L&T—60% Grasim—25%

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Under this plan, the company would at first stage be demerged with L&T Ltd. holding 40% and the rest by the shareholders of L&T in their existing ratio. This would mean that Grasim would hold about 9% out of the 60% held by all shareholders. At the second stage, Grasim would buy a strategic stake of 25% from L&T Ltd. out of its 40% at a price of $76 per tonne matching the price offered by CDC. After the acquisition, Grasim would have around 34%. In addition, it would have had to acquire an additional 20% through an open offer thereby gaining majority control of about 54%. The open offer made by Grasim was eventually allowed by SEBI after clearing charges against Grasim in its earlier buy from Reliance. The open offer made at Rs. 190 a share for L&T evoked poor response from the public and Grasim managed to increase its stake by only 1%. Thereafter, Grasim’s second proposal found favour with ICRA, the rating agency that was appointed by the L&T management to examine both the proposals and make suitable recommendations. ICRA favoured the vertical demerger plan of Grasim stating that it would give the existing shareholders of L&T a representation in the cement business. However, ICRA recommended a higher price of $85 per tonne as the valuation for the cement business. Taking note of ICRA’s recommendations, Grasim hiked the price of its offer for the vertical demerger to $76 per tonne in order to impress upon the financial institutions to part with their 36% stake in L&T. This translated into a price of Rs. 170 per share for the cement business.

L&T’s Viewpoint Overall, the L&T management’s view was to have a structure whereby L&T Ltd. would realize a strategic premium for parting with controlling interest in the cement business. They were opposed to the vertical split for two reasons: (1) with a 15% stake in the cement company to start with, Grasim could go for an open offer for 20% at market price and thereafter adopt the creeping acquisition route to gain majority control without having to pay any strategic premium. This would be to the detriment of L&T shareholders. (2) L&T management did not want Grasim to have the controlling say in the cement business, to safeguard its own interests. So it wanted L&T to have majority control in the demerged company. The management felt that if at all Grasim were to take a controlling interest, it should fork out a strategic premium for it in line with competitive valuation.

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The Deal Closure The final deal that was entered into by Grasim with L&T in June 2003 paved the way for the largest M&A transaction in the country, then valued at Rs. 2200 crore. The deal structure was as follows: �

�

�

�

L&T would hive-off its cement business into a new company, which would be christened Cemco through a structured de-merger. L&T in its corporate capacity would hold 20% and the rest would be in the nature of a de-merger to the existing shareholders of L&T. As a result of the above, Grasim by virtue of its existing 15.7% stake in L&T would get a representation of around 12.6% in Cemco. Grasim would then acquire 8.5% of Cemco from L&T (out of its 20%) at a price of Rs. 171 per share amounting to Rs. 360 crore. Through this process, Grasim’ stake would increase to more than 20% with a corresponding fall in L&T’s stake to 11.5%. Consequently, the Takeover Code would be triggered off. Grasim would then make an open offer for 30% in Cemco, at Rs. 171 per share, with a total open offer size of Rs. 1280 crore. Therefore, the total outflow for Grasim would be Rs. 1640 crore for a stake of 51% in Cemco. Thereby Grasim would get controlling interest in the cement business of L&T, post demerger. Since Grasim’s strategic interest was only in L&T’s cement business and not in its engineering business, it would sell off its 15.7% in the parent company to the employee trusts of L&T.

This final structure brought the curtains down on one of the longest board room manoeuvers for a takeover in corporate India, spanning more than 18 months. It was a personal triumph for the young Kumara Mangalam Birla, the Chairman of the Rs. 300 billion Aditya Birla group.

The Final Take The L&T deal catapulted Grasim into the global league with the largest manufacturing capacity for cement in Asia going upto 31 mtpa. Grasim would account for a 42% market share and would also save on costs. The company estimated a future cost saving of Rs. 100 crore per annum. The markets cheered the deal and Grasim’ shares went upto a 52 week high of Rs. 414 on its announcement. L&T scrip also

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rose to Rs. 239. L&T was to get a cash generation of Rs. 360 crore from the deal immediately. In addition, more than 50% of its outstanding debt of Rs. 3000 crore was to be transferred to Cemco upon the demerger, thereby cutting down its interest cost and debt–equity ratio. However, in the final deal structure, Cemco was not going to get the benefit of certain assets, which were included in the initial demerger proposal. These were the L&T brand name, its ready mixed concrete plants, a power gas plant in Andhra Pradesh and some buildings. These were to remain with L&T. Therefore, in the final take, it was a win-win situation both for Grasim and L&T. The whole deal was finally completed as follows: �

�

�

The acquisition of 8.5% stake from L&T in Cemco ( it was narmal Ultra Tech Cemco. ltd) was made for a consideration of Rs. 362 crore. The open offer by Grasim in Ultra Tech Cemco ltd was made at Rs. 342 per share for a 30% stake which was oversubscribed by more than 2 times. The total payout for the AV Birla Group on the entire acquisition amounted to Rs. 2668 crore translating into a cost of $80 per tonne which makes it one of the best valuations in the domestic cement industry.

� Annexure III

� CASES IN MERGERS AND AMALGAMATIONS The ICICI—ICICI Bank Amalgamation In 2002, ICICI Ltd. (ICICI), one of India’s foremost financial institutions and two of its group companies, ICICI Capital Services Ltd and ICICI Personal Financial Services Ltd amalgamated with ICICI Bank Ltd, a banking company in which ICICI held 46% at the time of the amalgamation. ICICI, which was established in 1955 as a development financial institution at the instance of the World Bank, the Government of India and the Indian industry was designed for project financing in India. Over the years, especially after liberalization in 1991, ICICI entered other financial products and services and set up independent subsidiaries and affiliates in venture capital, asset management, investment banking, commercial banking, broking and marketing, personal finance, Internet stock trading, home finance and insurance. It also merged the SCICI, a group company originally formed to finance the shipping industry with itself. The merger of ICICI with its own bank was the culmination of a process of transformation of ICICI from a development financial institution into a universal bank. As per the explanatory statement furnished to the members on the amalgamation, the proposal was explained and justified as a forward-looking step. Relevant extracts from the statement are given below:

The issue of universal banking, which in the Indian context means conversion of long-term development financial institutions into commercial banks, has been discussed at length over the past few years. The Reserve Bank of India in its Mid-Term Review of Monetary and Credit Policy for fiscal 2000 and its circular on Approach to Universal Banking issued on April 28, 2001, announced that it would consider proposals from development financial institutions (like ICICI) wishing to transform themselves into banks on a case-by-case basis. In its MidTerm Review of Monetary and Credit Policy for fiscal 2002, the Reserve Bank of India encouraged financial institutions to submit proposals for their transformation into banks.

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As a bank, ICICI would have the ability to accept low-cost demand deposits and offer a wider range of products and services, and greater opportunities for earning non-fund based income in the form of banking fees and commissions. In view of the benefits of transformation into a bank and the Reserve Bank of India’s pronouncements on universal banking, ICICI explored various corporate structuring alternatives for its transformation into a universal bank. ICICI also held discussions with the Reserve Bank of India on an appropriate transition path and compliance with regulatory requirements. ICICI Bank also considered various strategic alternatives, in the context of the emerging competitive scenario in the Indian banking industry, and the move towards universal banking. ICICI Bank identified a large capital base and size and scale of operations as key success factors in the Indian banking industry. The strategic alternatives examined by ICICI and ICICI Bank included an amalgamation of the two entities, in view of ICICI’s significant shareholding in ICICI Bank, and the existing strong business synergies between the two entities. ICICI also considered the reorganization of its subsidiary companies. The amalgamation is expected to be beneficial to both ICICI and ICICI Bank shareholders. The management and the Board of Directors of ICICI believe that the amalgamation would enhance value for ICICI shareholders through the merged entity’s access to low-cost deposits, greater opportunities for earning fee-based income and the ability to participate in the payments system and provide transaction-banking services. The management and the Board of Directors of ICICI Bank believe that the amalgamation would enhance value for ICICI Bank shareholders through a large capital base and scale of operations, seamless access to ICICI’s strong corporate relationships built up over five decades, entry into new business segments, higher market share in various business segments, particularly fee-based services, and access to the vast talent pool of ICICI and its subsidiaries. The merged entity would be the second largest among all banks in India, ranked on the basis of their total assets. The merged entity would leverage on its capital base, comprehensive suite of products and services, extensive corporate and retail customer relationships, technologyenabled distribution architecture, strong brand franchise and vast talent pool. The merged entity would have improved capability to offer a

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wide range of products and services, ranging from project finance to retail finance, with a diversified resource base, improved portfolio risk management capability and deeper client relationships.

The RIL–RPL Merger The merger of the two group companies of the Reliance group, Reliance Industries Ltd (RIL) and Reliance Petroleum Ltd (RPL) created history of sorts. RIL is India’s biggest petrochemicals manufacturer and RPL has the largest single location refinery in the world. The merged company at that time, ranked second in India after Hindustan Lever Ltd. in terms of market capitalization and second to Indian Oil Ltd in terms of revenue. The merged company became India’s own fully integrated energy company with operations in oil and gas exploration and production, refining and marketing, petrochemicals, and textiles. The merger was concluded at a swap ratio of 1X11 (one share of RIL for every 11 shares in RPL). It was a case of absorption of RPL by RIL whereby the merged company was retained as RIL. The Ambani family owned 34 percent of the merged RIL. The merger also took RIL into the big league of Fortune 500 companies. Another landmark was that the combined entity could have the largest shareholder population in the world of about 3.5 million. The merger was justified in terms of positioning the combined entity better for achieving scale, size, integration and enhanced financial strength and flexibility to pursue future growth opportunities,, in an increasingly globally competitive environment. This was true given the fact that though the combined RIL was big in the Indian context, it was still small compared to the global oil majors. The merger was also strategically positioned to meet the increased investments required in the oil retailing business and the other new business initiatives of the group, notably Reliance Infocomm Ltd. RPL’s huge cash kitty of about Rs. 5000 crore would provide support to RIL, while RIL’s tax shelters would shield such incomes to some extent. The combined entity would also save considerably on sales tax in inter-company sales.

� Annexure IV

� CASES IN ACQUISITIONS AND TAKEOVERS I. Acquisitions through Open Market Purchases Bombay Dyeing Mr. Arun Bajoria, the jute baron from Kolkata, made a takeover bid for Bombay Dyeing Co. Ltd in late 2000. The offer was to buy out Mr. Nusli Wadia’s stake in the company so as to gain management control. Simultaneously he also went on record with an offer to sell out his entire holding to Reliance Industries at a price even lower than the price of Rs. 200 asked of Bombay Dyeing. Mr. Bajoria had by then used the open market purchase route to acquire about 14% of the company. At that time the ruling market price of the company’s share was around Rs. 105. On a representation from Bombay Dyeing, the Company Law Board restrained Mr. Bajoria from exercising his voting rights. During that period SEBI investigated whether Mr. Bajoria had informed Bombay Dyeing once his holding crossed 5% as per the provisions of the Takeover Code. Attempts were also on at Bombay Dyeing to prevent a hostile takeover of the company. However, it was apparent that Mr. Bajoria did not wish to go for an open offer under the Takeover Code to attain majority stake. He was however interested in taking up the 15% held by LIC at that time. His acquisition through the market purchase route had included shares held by UTI. A controversy arose on the violation of the disclosure requirements under the Takeover Code due to the manner in which the market purchases were made. The shares were acquired using the route of financing a loan against pledge of the shares of the company, which were subsequently appropriated towards default by the borrower in repaying such loan. Using this mechanism, a potential acquirer can use a third party as a conduit for the acquisition by providing finance as a loan. The borrower would purchase the shares of the target company and pledge them as

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security. The loan would be intentionally defaulted so that the shares become those of the acquirer by default. Since this does not amount to a direct acquisition, Mr. Bajoria claimed that the disclosure requirement did not arise.

BSES (now Reliance Energy) One of the major acquisitions through market purchase route was made during 2002–03 by Reliance Power Ventures Ltd., a subsidiary of Reliance Industries Ltd., which acquired 91.70 lakh shares in BSES in three tranches accounting for 6.6% of the paid up capital of BSES taking its own shareholding to 28.3% in BSES.

Chambal Fertilisers The KK Birla group made creeping acquisition in Chambal Fertilisers through market route, investing about Rs. 5 crore to acquire about 1.08% of that company’s paid up capital (Business Standard 10th October 2002).

Astra Zeneca Two firms of Anglo-Swedish drug maker Astra Zeneca Plc. offered to buy out the remaining 12.79% stake in the Indian unit from public shareholders. The acquisition cost Rs. 24 crore at Rs. 375 per share in Astra Zeneca Pharma. With this offer, Astra Zeneca Pharma, became a wholly owned subsidiary of the parent company.

II. Open Offer Acquisitions BSL (Formerly Bhilwara Synthetics Ltd.) The promoters of BSL decided not to react using a counter offer put up by Mr. Sarda, the acquirer, for a 30% stake in BSL. The financial institutions held 8.6% of the stake and the promoters had not even contacted them or chalked out any other strategy to thwart the takeover bid. The holding of the promoters was 36.78% and they were banking on the idea that the open offer would not elicit a favorable response from the minority holders. This belief was backed by the fact that the Sarda open offer at Rs. 80 was a conditional offer, which meant that the acquirer would

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return all subscriptions to the open offer if it were below the 30% level. In the meantime, the promoters reportedly made market purchases to consolidate their stake.

Philips India Philips India de-listed after it decided to buy back 17.1% of its stake at Rs. 105 per share. The offer price was at a premium of 35% over the closing price on November 20, 2001 and 48% over the SEBI mandated price. The buyback was to increase the parent’s stake from the then existing 82.9% (which was as a result of an earlier buy back offer made in November 2000 which raised their holding from the then 55%). The buy back in 2001 was to make Philips India a wholly owned subsidiary of the Royal Philips Electronics Company, Netherlands. The buy back offer was successful and the parent company’s holding went up to 92% post buy back. The company bought back the shares of the rest of the shareholders and de-listed from the stock exchanges. Using the buy back route for de-listing was permitted at that time, a route that was later on plugged by SEBI. For more discussion on this issue, please refer to Chapter 9.

TSSL TISCO acquired more than 90% of the equity in its special steel subsudairy—Tata SSL (TSSL) after a second open offer. TISCO requested TSSL to initiate proceedings to de-list itself from the BSE. TSSL makes steel wires, narrow cold sheets and coils, and profiles. The offer made was aimed at acquiring the entire shareholding of TSSL at Rs. 27 a share for the fully paid up share and at Rs. 2 per share for the partly paid up share. The entire offer involved an outflow of Rs. 14.03 crore for TISCO. The first offer enabled TISCO to hike its stake in TSSL from 44.83% to 83.15%. The primary reason for TISCO’s move is to gain from the synergy between the businesses of the two companies. With the creeping acquisition being increased to 10 percent there was no room for the Tata group to increase its stake further. The group had increased its stake in TISCO from 24.24% to 26.22% in 2001.

INDAL This was the largest ever all-cash buy-out takeover in corporate India. Hindalco, part of the Aditya Birla Group, acquired downstream aluminium major, Indian Aluminium (Indal). The acquisition deal, which was announced in March 2000, involved a staggering price of Rs. 1008 crore for a 74.62 percent stake in Indal. The

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deal was structured in two parts consisting of a buy-out and an open offer. The first part of the deal, which involved the buy-out of Alcan (the Canadian parent company) in Indal through the transfer of 54.62 percent stake of Alcan to Hindalco, was completed immediately. The second part, for the rest of the 20 percent stake, for which an open offer was announced, had to be completed by the end of June 2000. The entire acquisition was funded from the company's own internal accruals, investments and liquid funds. The company had liquid funds and investments aggregating Rs. 1200 crore as against the aggregate cost of Rs.1008 crore required for financing the acquisition. Even after such a huge drain on cash, the residual debt-equity ratio of Hindalco was 0.2, which was well below the industry average. The company had made it clear that it did not propose to raise any debt or issue fresh equity for this purpose. The takeover by Hindalco came close on the heels of an earlier unsuccessful bid by Sterlite Industries to acquire Indal during which time, Alcan defended its 34% stake in Indal successfully. This was subsequently consolidated to 54%. However, a subsequent refocus in strategy globally by Alcan in favour of upstream products led to the sellout of Indal to Hindalco. For Hindalco, it made perfect business sense because while it was India's largest integrated aluminum company, Indal was a market leader in alumina and downstream products. The deal was struck by DSP Merrill Lynch representing the AV Birla group and JM Morgan Stanley representing Alcan.

Raasi Cement It was a takeover that started on a helpful note, with India Cements (IC) acquiring shares of Raasi from the open market route, at the instance of the promoters of Raasi in the wake of an imminent takeover threat. In the process, IC acquired more than 18% of Raasi and made an open offer for 20% under the Takeover Code. IC had gained experience in takeover battles before by successfully snatching Visakha Cement from the jaws of Gujarat Ambuja Cements Ltd. The battle for Raasi stretched over several months and witnessed an intense fight between IC and the promoters of Raasi (the B.V. Raju family). The Raasi promoters fought an unsuccessful battle to fend off the takeover, with several interesting weapons including the poison pill. The drama ended with IC paying a consideration of Rs. 445 crore for Raasi and another Rs. 115 crore for Vishnu Cements, a group company of Raasi. IC was keen on the

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acquisition so as to get access to the large cement market in Andhra Pradesh and to consolidate its position as the leading cement manufacturer in South India. In addition, IC got access to limestone reserves, a major raw material for cement. The acquisition also meant improvement in logistics and saving on operational costs for IC.

Tata Tetley The Tata Tea buy-out of Tetley UK, had many firsts to its credit. It was a structured acquisition through the creation of an off-shore Special Purpose Entity (SPE) by Tata Tea to provide bankruptcy remoteness and not leverage its own balance sheet. It was also India’s first leveraged buyout transaction. It was again India’s largest overseas corporate acquisition until then. The deal size of 305 million pounds (GBP) was structured by Mr. Rana Kapoor of Rabo Bank. The deal positioned Tata Tea among the global leaders in second position. The SPE created for this purpose called Tata Tea Great Britain, was capitalised with an initial sum of GBP 70 million out of which Tata Tea contributed GBP 60 million. Tata Tea’s US subsidiary, Tata Tea Inc., contributed the balance of GBP 10 million. The SPE then leveraged its capital at a debt–equity ratio of 3.36 to raise a debt of GBP 235 million to complete the total financing for the deal. The entire debt amount of GBP 235 million was broken up into four tranches with varying tenors from 7 to 9.5 years, with a floating coupon rate of around LIBOR + 400 basis points. Rabobank was the lead financing agency with an exposure of GBP 215 million while venture capital funds contributed the balance of GBP 20 million. The entire debt was structured as non-recourse to Tata by securing it against Tetley's brands and physical assets. Tetley’s valuation for the purpose of arriving at the purchase consideration was done on the basis of discounted future cash flow method, taking into account Tetley’s own cash accruals and Tata Tea’s own strengths. The entire deal size of GBP 305 million consisted of the purchase consideration of GBP 271 million, legal, banking and advisory costs and future financing requirements. The SPE acquired all the assets of Tetley in an all-cash buy out.

Failed M&A Deals During the heights of the technology boom of 2000, Indian software companies announced a slew of acquisitions both at home and abroad. Many of them eventually

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did not materialize. While some of them failed on account of high valuations in the wake of the subsequent meltdown, others failed on due diligence. An example is Film Roman, a prime time television animation company in which Pentamedia Graphics was to pick-up a 51% stake for $15 million in cash as per the agreement. After Film Roman was de-listed, Pentamedia renegotiated to acquire a 60% stake instead of 51% for the same amount. However, Pentamedia did not make the payment by the due date and proposed an alternative to acquire a 49.9% stake for $10 million. Film Roman rejected this proposal and the transaction was called off. Many other deals failed on account of high valuations, lack of proper due diligence and unfulfilled parameters such as easy client transferability and geographical spread. On similar lines, the acquisition of San Vision Technology, initiated by DSQ software in July 2000, remained hanging over the purchase consideration. At the time of the initial agreement, DSQ had agreed to pay $30 million in an all-stock deal. But due to the crash in stock market valuations, San Vision called off the deal. On the domestic acquisition scene, in March 2001, Mascon Global had announced a merger with Maars Software. It was called off later in July citing poor market conditions. Earlier that year the boards of the two companies had met and announced equity swap of 9X1. In yet another case, Polaris Software Labs was to acquire a New Jersey based company Data Inc. for a value of 21 million. The deal was co-ordinated by UBS Warburg and was subject to due diligence by KPMG. After the acquisition process reached an advanced stage, Polaris called it off citing objections made by its audit committee. The incident even led to a lawsuit by Data Inc. in the US on the ground that Polaris had gone back on the terms and conditions in the original agreement.

Open Offer Exemptions The Securities and Exchange Board of India granted exemption to the Ahmedabad based ice-cream maker Vadilal from making a public offer under the Takeover Code. Vadilal Dairy had sought exemption under the Code as it issued shares to the promoters in lieu of warrants already allotted to them. The conversion would have led to the holdings of some promoters increasing by five percent or more. As per the provisions of the Code at that time, promoters were allowed to increase their holdings by up to two percent in a financial year beyond which a public offer was mandatory. The SEBI panel on the Takeover Code had earlier rejected the exemption but reconsidered its view after Vadilal made additional representations in its support. SEBI agreed with the views of the panel and granted the necessary exemption.

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SEBI had earlier granted exemption to Sun Pharmaceuticals under the Takeover Code for acquiring an additional stake in MJ Pharma, where it already held 20%. Sun Pharmaceuticals Ltd had put in an application for acquiring an additional stake in MJ Pharma. The original acquisition was completed in 1996 and Sun complied with the open offer requirements at that time. However since the intention was to acquire additional equity they had sought to be excused from making another open offer. SEBI granted the exemption to Sun since it had already completed a public offer and was only acquiring an additional stake. Other examples of open offer exemptions granted by the SEBI include the cases of SPIC and the German group Mannesmann. The SEBI panel granted exemption to these groups on the grounds that it was only a inter-se sale of holdings from one promoter group to another. Mannesmann had acquired a 40% stake of Mahindra & Mahindra in International Instruments and since the German group was already a collaborator in the company, the panel granted exemption. SPIC acquired an 8% stake in SPIC Organics and was granted exemption on the same grounds.

Chapter

16 Government Advisory

B

eing an advisor to the Government is a matter of great privilege and immense responsibility as well. Investment bankers are fortunate to be among Topics to comprehend the privileged few who are cut out for the task. Providing strategic financial advice to the � Scope of Government Government is a recent phenomenon in India necessiadvisory services and disinvestment mandates. tated as a fall out of the liberalized policies and economic compulsions facing the public sector enter- � Disinvestments — rationprises (PSEs). The Government presently looks at ale, institutional framework, process overview, being more of a catalyst and a regulator in a marketkey considerations. oriented economy that finds its own equilibrium. Therefore, the present day agenda of the Government � Key responsibilities of a financial advisor in a disinis to identify new sectors for economic development vestment assignment. and create a conducive policy and regulatory environment. In parallel, the Government also looks for exit � Other government advisory services. from loss making PSEs and disinvesting its stake in profit-making PSEs at substantial gains. All these initiatives require expert financial advice and the

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Government therefore looks for advisors to provide this service. There have been several disinvestments and advisory assignments that have been handled by reputed investment banks in recent years. However, investment banks also face stiff competition from pure advisory firms in this segment. This chapter examines the scope of services rendered in Government advisory work, especially with regard to disinvestments and also outlines the procedural aspects thereof.

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16.1 Introduction In the nationalization era of the 1960s and 1970s, several sectors of industry were brought under State control by takeover of private sector units. The nationalization of airlines, railways, banks and insurance are some cases in point. This was in line with the socialist nature of the Constitution. Besides, the Industries (Development and Regulation) Act specified industries that had to be under compulsory licence. Private investment was prohibited in many sectors and were the exclusive domain of the public sector such as petroleum, nuclear energy, power, railways, etc., which were considered strategic for the economy. With the advent of liberalization, all these policies have been abandoned and private initiative is welcome in almost every sector. Besides, the Central Government has brought in policy initiatives to identify and develop new sectors that would spur growth and development. The radical changes that are happening at policy level which redefine economic realities are so profound that the Government finds it necessary to appoint external advisors to assist in the formulation of such policies and examine the possible repercussions. Similarly, the Government is also looking to maximize the utilization of its assets for economic gain. This would reduce its dependence on borrowings that balloon the fiscal deficit. Under this scenario, there are a lot of steps that need to be taken on several fronts such as: �

Identification of growth areas for the economy and formulation of suitable policies thereof. In recent years, there have been several policy documents drawn up in sectors such as infrastructure, telecom, information technology, agriculture, housing, etc.

�

Harnessing the assets belonging to the Government in several sectors and public sector companies.

�

Roping in private investment and partnership in projects that are initiated by the Government or public sector corporations.

�

Identification of strategies for Government’s exit plan from loss-making and profit-making PSEs.

Most of the policy work in the above areas could be entrusted to the think tanks in the Government itself or to special committees set up for this purpose. For example, in the case of infrastructure, the Rakesh Mohan Committee was set up to examine the requirements and recommend policy initiatives. External advisors are generally roped in at the next level of implementation of such plans through various projects. In the case of disinvestments, each proposal requires in-depth examination

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and formulation of strategy, keeping in view the state of the capital markets and other economic parameters. Therefore, for these kinds of projects and disinvestments assignments, the Government calls for the services of advisors of repute through a bidding process. Investment banks are the prime candidates for such assignments due to their vast experience in capital markets, project finance and international finance. More importantly, such large transactions require expert skills in valuation and due diligence work. Valuation is perhaps the most critical part of Government related transactions in order to fix the ‘reserve price’ and to advise on the price evaluation of various bids received from private parties. Due to these reasons, investment bankers are the most preferred advisors in Government transactions. As in the case of other service areas, in Government advisory too, the investment banker has to work in close co-ordination with other professionals. In addition, rapport has to be built up with the concerned ministries and government officials that would enable the work to proceed smoothly, especially in examining policy and regulatory issues and bringing them to the notice of the Government. There would also be several complex legal and tax issues to be addressed which could require clearance from the Law Ministry or other appropriate authorities.

16.2 Service Areas and Role of the Financial Advisor Investment bankers are associated in government advisory work in the following broad areas: �

In policy work for feasibility studies, policy recommendations or assisting in preparation of policy documents.

�

In project advisory work for projects floated with the Government initiative or through public sector corporations.

�

In disinvestments of Government’s stake in PSEs, including the management of public offers or other such transactions arising from such initiatives.

Most of the work related to preparation of feasibility plans that investment banks do for the Government is similar to what is required to be done for a private sector client. These aspects have already been dealt with in Chapter 12. As far as assistance in policy formulation is concerned, it involves macro level studies in particular industry sectors and laying down a road map for the development of the sector.

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Some of the specific requirements of such studies could be as follows: �

Examining the current situation of an industry or an economic sector and identifying the problem areas and bottlenecks for growth.

�

Studying the potential for growth, its economic importance either in the domestic or export sectors and the key drivers for such growth.

�

Identifying the type and extent of investments required and the ideal model for Government and private partnership.

�

Key policy framework required in the sector, gap analysis with respect to the existing policy and regulatory changes that need to back up the policy initiative.

As far as project advisory work for the Government or any statutory or local authority is concerned, this would relate to examining the feasibility of the project, formulate the project structure, viability analysis, envisaging the role and structure for private participation, assisting the Government in the process of inviting expression of interest from private parties, and identification and selection of the right party. Usually, the advisor would be selected by inviting expression of interest through a Request for Proposal (RFP) or other similar document issued by the Government that spells out the terms of reference for the advisor. Sometimes, the assignment would be for an integrated techno-financial advisory service, which would require the investment bank to form a consortium with technical consultancy firms to qualify for the bid. An illustrative scope of work for a Government project is furnished in the Annexure to this chapter. The other important area where advisors are being sought is in the area of disinvestment of Government holdings in public sector companies and corporations. Since these are transactions that consist of sale of equity holdings, they are intricately woven with the capital market, valuation of shares, and proper exit strategies. The Government needs expert advice in these areas. Therefore, disinvestments advisory has become the most sought after service area for investments banks that specialize in Government advisory. The various facets of this very important service area are discussed in the following paragraphs of this chapter.

16.3 Introduction to Disinvestment Disinvestment, which in common parlance is used synonymously with ‘privatisation’ essentially means the selling of shares held by the Government in Public Sector

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Undertakings (PSUs) or PSEs to persons (other than the Government) through various methods. Privatisation on the other hand refers to a disinvestment wherein the stake of the Government in a particular PSU is brought down to a minority level. Therefore all disinvestments transactions may not amount to privatisation. Disinvestment may also be distinguished from the word ‘divestiture’ so as to mean only a dilution of government stake in such companies and not a complete exit through a sell-off. In most companies that are disinvested, the Government continues to hold significant stakes due to policy considerations. However, there are however some examples of complete exit by the Government. Though such cases are essentially divestitures, for the purpose of convenience, these are included under the term ‘disinvestment’ by the Government. Countries the world over have been privatising their public enterprises over the past thirty years. Great Britain has been the frontrunner in this process and the rest of the world has been encouraged by the success of disinvestment in Britain.

16.3.1 Rationale for Disinvestment The public sector has played a vital role in the development of our economy. The primary objective of setting up public enterprises was to build infrastructure for economic development, create employment opportunities, promote balanced regional development, and generate investible resources for development. The Industrial Policy Resolution of 1956 has been the guiding force for the evolution of the public sector in the country. The critical sectors of the economy continue to be controlled by public enterprises, while the private sector has flourished in the areas earmarked for them. However, over a period of fifty years, the public sector has been plagued by several systemic problems, with the result that many PSUs today have accumulated huge losses and the Government is unable to sustain them much longer. Low productivity, lack of technological upgradation, poor management and huge manpower costs resulted in poor performance. This has resulted in their inability to keep pace with the fast changing world and face competition. The result has been that many large PSUs have become unviable and a burden on the exchequer. Any commercial entity needs efficient management, quick decision-making, ability to withstand competition, and infusion of funds to survive and grow. Therefore the time for greater private participation in economic development seems to have come. The need for reducing the government participation in business is therefore more important now than ever before. While the Government is expected to continue playing an important role in critical areas such as health, education, and social security, more and more areas that were earlier the monopoly of the state are being thrown open for privatisation.

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The government’s approach to PSUs has been to revive the potentially viable enterprises, close down the unviable ones and bring down the Government equity in non-strategic PSUs to 26% or lower. Protecting the interests of the workers through attractive VRS and other measures has also been of prime importance. The primary objective for disinvestment is that it would help in releasing huge amount of scarce public resources locked up in non-strategic PSEs for deployment in areas much higher on social priority, such as public health, family welfare, education and infrastructure. It would also help in stemming further outflow of these scarce public resources for sustaining the unviable non-strategic PSEs. The money from disinvestment would help in reducing public debt. A large pool of tangible and intangible assets and human resources currently locked up in managing the PSEs would be released for redeployment in areas that are much higher on social priority but are short of such resources. Some other benefits of disinvestment are: �

It would expose the privatized companies to market discipline, thereby forcing them to become more efficient and survive or cease on their own financial and economic strength.

�

Wider distribution of wealth, through offering of shares of privatized companies to small investors and employees.

�

Boost the capital market; the increase in floating stock would give the market more depth and liquidity and give investors easier exit options.

�

Opening up the erstwhile public sector areas to private investors would increase economic activity and have an overall beneficial effect on the economy, employment and tax revenues in the medium to long term.

�

In some areas like the telecom sector, the end of the public sector monopoly would bring relief to consumers by way of more choices and cheaper and better quality of products and services.

16.3.2 Historical Approach to Disinvestment In India disinvestment began in 1990–91 when minority shares were auctioned by the Government in 47 companies. While the policy on disinvestment evolved over a period of time, it was mostly dictated by the objectives of the ruling party in power. The first positive step came in 1996 when the United Front Government

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set up the Disinvestment Commission to advise the Government on the disinvestment process. It was only in 1999 that the Department of Disinvestment was set up to establish a systematic policy approach to disinvestment and to give a fresh impetus to the programme that would emphasize increasingly on strategic sale of identified PSUs. The end objective was to use the entire receipts from disinvestment for meeting expenditure in social sectors, restructuring of PSUs and retiring public debt. In the period between 1992 to 2000, minority shares in 62 PSUs were sold by different methods. However, with the setting up of the Department of Disinvestment (DoD), the last three years have witnessed the strategic sale of several big companies, giving a major thrust to the entire process.

Year

No. of Cos. Actual in which receipts (in equity was Rs. Crores) sold

Method of Disinvestment

1991–92

47

3038

Minority shares sold by auction method in bundles of ‘very good’, ‘good’ and ‘average companies’.

1992–93

35

1913

Bundling of shares abandoned. Shares sold separately for each company by auction method.

1993–94

—

—

Equity of 7 companies sold by open auction but proceeds received in 94-95.

1994–95

13

4843

Sale through auction method,in which NRIs and other persons legally permitted to buy, hold or sell equity, allowed to participate.

1995–96

5

362

Equities of four companies auctioned and Government piggy backed in the IDBI fixed price offering for the fifth company.

1996–97

1

380

GDR (VSNL) in international market.

1997–98

1

902

GDR (MTNL) in international market.

1998–99

5

5371

GDR (VSNL)/Domestic offerings with the participation of FIIs (CONCOR, GAIL). Cross purchase by 3 oil sector companies ie, GAIL,ONGC and IOC.

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(Contd.) 1999–00

2

1829

GDR (GAIL) in international market, MFIL’s strategic sale and some other disinvestments.

2000–01

4

1868

Strategic sale of BALCO, LJMC; Takeover-KRL (CRL), CPCL (MRL), BRPL.

2001–02

10

5632

Strategic sale of CMC (51%), HTL (74%), VSNL (25%), IBP (33.58%), PPL (74%), and sale by other modes (ITDC and HCI); surplus reserves: STC and MMTC.

2002–03

6

3342

Strategic sale of Jessop (72%), HZL (26%), MFIL (26%), IPCL (25%) and other modes (HCI, Maruti)

�

Table 16.1 Central Government’s Score Card in Disinvestments1

The table above shows the actual disinvestment that has been made from 1991–92 to 2002–03, the method adopted and the extent of disinvestment in different PSUs.

16.4 Disinvestment Methodologies Different countries have followed diverse methods of privatization, with variations in procedures mainly depending on the sectors in which the privatized companies operated. While no statutory guidelines or rigid rules were made to determine the mode, most Governments chose the method on the basis of their policy priorities— such as to maximize the value of proceeds, improve efficiency, bring in new technology and management or to develop the capital markets. In addition, the financial performance of the company, the state of capital markets and the strength of the regulatory mechanism decided the method used to privatise companies. The common methods of privatisation world over have been the following.

16.4.1 Public Offering of Shares Developed countries with vibrant capital markets have followed the Initial Public Offer (IPO) route to a greater extent than small countries with weak markets and

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institutions. During the 1990s, public offerings on an average accounted for close to two thirds of all privatisation proceeds, although they are more expensive and take longer time to implement. Great Britain has depended on the public offering route for privatising most of the companies. Table 16.2 illustrates:

Year

Company

Type of Sale

1977

British Petroleum

IPO

1981

British Aerospace

IPO

1981

Cable & Wireless

IPO

1982

Britoil

IPO

1984

British Telecom

IPO

1985–1989

British Shipbuilders

1986

British Gas

1986–1988

National Bus Co.

1987

British Airports Authority

IPO

1987

British Steel

IPO

1989

10 Water and Sewerage Cos.

IPO

1990–1991

12 Electricity Distributors

IPO

1991–1992

Electricity Generating Cos.

IPO

1992–1997

Trust Ports

Pvt. Sales and MBOs

1994–1995

London Buses

Pvt. Sales and MBOs

1996

Railtrack

IPO

1996

Her Majesty's Stationery Office

Pvt. Sales

Pvt Sales and MBOs IPO Pvt.. Sales and MBOs

� Table 16.2 Disinvestment methodologies in Great Britain2 Other countries like France, Germany and Italy have also followed the Public Offering route for privatization. Most nations have allowed foreign ownership of privatized companies. However, since the beginning of 2000, poor market conditions along with the type of assets on offer have led to significant decline in the share of public offerings relative to other key methods of sale.

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16.4.2 Strategic Sale This method involves a direct sale or a trade sale by means of an auction or negotiation and does not involve the public. A strategic sale along with management control has been the preferred route for privatisation in countries where the capital markets are shallow and determining the correct share price of a company not yet listed in the markets is very difficult. This method is more flexible in accommodating transaction specific conditions. In India, direct sales of minority stakes by way of auction was the preferred method in the early ’90s. However post ’99-00, there has been a greater stress on strategic sale involving an effective transfer of control and management to private entities. It was felt that the government would get a better price from the private investor if it cedes actual control. Most of the recent cases of disinvestment in companies such as Modern Foods, BALCO, CMC, VSNL, IBP, ITDC Hotels, Maruti and HZL have been through the strategic sale route. However there has been a controversy on the method of sale to be adopted, especially for the big oil companies, with some factions feeling that IPO should be the preferred route for all profit-making companies. The IPO route would involve issue of fresh shares resulting in cash generation for the company against the strategic sale that would basically mean dilution in the government’s stake and receipts therein going to the government. The total market capitalization of 32 PSU stocks jumped by 73% between 8th January 2002 and 16 May 2002 against a 14% rise in capitalization of the total BSE Sensex. Also, share prices of companies like CMC and Modern Foods shot up after privatization. The disinvestment ministry’s logic is that as more companies are sold through the strategic sale route and the market capitalization of the PSU stocks goes up, there is no reason why some shares (10% to 20%) of various companies cannot be sold even while management control is retained by the government. Determining the correct price of some companies whose shares are not yet listed on the stock exchanges is one problem, while some companies, especially the oil and power companies have been valued at very high levels, raising doubts on whether investors can afford to buy such highly priced shares. This continues to be a vexed issue for the Disinvestment Ministry.

16.4.3 Combination Method In several OECD countries, a combined approach has been used to maximize the benefits associated with each method of sale and to achieve multiple objectives.

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Initially, a direct sale with controlling interest is made to a strategic buyer to provide the company with strong management. Subsequently, smaller stakes are sold through a public offering to retail and institutional investors as a means of developing the equity market. Alternatively, a share in the company is sold on the stock markets and once its market price is determined, a controlling stake is sold to a strategic partner. In most of such cases, a portion of the shares is allocated for sale to employees in order to ensure their participation and gain their support. Some of the large companies were privatized through a step-by-step process in France, Germany and Latin American countries especially Chile and Mexico. Other examples are privatisation of ENI, Italy and TPSA, the Polish telecom major. A more recent development is the use of convertible bond issues as a means of privatizing state owned enterprises. For example, Greece privatized OTE, a telecom major and Korea privatized Korea Telecom. There have been a couple of reversals too in privatization, leading to re-nationalization. The foremost in such cases is UK’s Railtrack, a rail infrastructure company that was privatized in 1996, which had to be taken over by the government again after financial difficulties and concerns over rail safety. Air New Zealand, the airline company that was privatized had to be bailed out by the government, which once again owns 80% of the airline. Table 16.3 illustrates the methods followed for disinvestment by different countries:

16.5 Valuation Approaches in Disinvestment Valuation of the enterprise being disinvested often assumes the most critical task in the disinvestment process. It is also the most challenging and debatable issue in the process and is highly subjective. The method of valuation to be adopted varies from case to case and is mostly determined by the nature of the transaction, the health of the company being valued, the nature of the industry and the company’s intrinsic strength. Valuation assumes importance where the shares of the company being disinvested are not listed or where the capital markets do not fully reflect the intrinsic worth of the shares being disinvested. The Disinvestment Commission has laid down guidelines for valuation and has recommended several methods of valuation. In reality however, more than one method of valuation is often adopted and the best value determined thereof.

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Country

Direct Sales

Vouchers

MBO

Russia

Secondary

Primary

NA

Bulgaria

Primary

Secondary

NA

Czech Republic

Secondary

Primary

NA

Hungary

Primary

NA

Secondary

Poland

Primary

NA

Secondary

Romania

Secondary

NA

Primary

Armenia

NA

Primary

Secondary

Azerbaijan

Secondary

Primary

NA

Ukraine

Secondary

NA

Primary

Primary and Secondary refer to the relative importance of the particular mode followed in each country. NA means ‘not applicable’.

� Table 16.3 Disinvestment methods in various countries3 Where the Government continues to hold more than 51% shares in the divested firm, valuation refers to the valuation of shares. However, if the disinvestment is for more than 51% stake, then valuation means the value of assets of the company being disinvested. The valuation exercise, whether of shares or the assets is normally done by the global advisors to the disinvestment process. However to avoid a conflict of interest, the global advisors are not involved in the fixation of the reserve price, which is done by the evaluation committee of the Inter-Ministerial Group overseeing the disinvestment. The following methods of valuation have been recommended to the Government of India by the Disinvestment Commission.

16.5.1 Discounted Cash Flow Method (DCF) This method is the most popular way of arriving at the value of an enterprise. The DCF method is used to determine the present value of a business on a going concern basis by measuring the future cash flows, discounted to the present time at an appropriate discount rate. The value is divided into two parts: (a) Value of the

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forecasted cash flows during the explicit period and (b) terminal value of the firm. The present value of these figures is arrived at by using the weighted average cost of capital. The sum of the present values is said to be the value of the firm. Free cash flow is derived by deducting the total of annual tax outflow, inclusive of tax shield enjoyed on account of debt service, incremental amount invested in working capital and capital expenditure from the respective year’s profit before depreciation, interest and tax for the explicit period. Terminal value reflects the average business conditions of the company that are expected to prevail over the long term in perpetuity i.e., beyond the explicit period. The DCF method assumes that by the terminal date, the business will have achieved a steady state and will be growing at a constant rate. The discount rate that is applied to estimate the present value of the free cash flows is the Weighted Average Cost of Capital (WACC). The main components of WACC are the cost of equity, post-tax cost of debt and the target capital structure of the company. The DCF method has already been discussed in Chapter 3. The DCF is considered the best method of valuation the world over because it takes into account all the factors that are relevant for valuation. It is most appropriate where the business is being acquired on a going concern basis and where the business has substantial intangibles like brand, goodwill, marketing network etc. It is not suitable where the business has large undisclosed assets. Hence where there are substantial non-core assets, they have to be valued separately and added to the DCF valuation. The accuracy of this method is largely dependant on the ability to forecast the cash flows. For profit making companies with stable cash flows, this method is ideal. However, where there is a high degree of uncertainty, this method may not give the correct valuation.

16.5.2 Balance Sheet Method In this method, the value of a business is arrived at on the basis of the net value of assets or the capital employed as per the financial statements rather than the future cash flows. Hence the investment made in the business is given greater importance than the potential earnings. This method is useful where the value of intangibles is not high or where the business is relatively new. However this method is not useful where the financial statements do not reflect the true value of the assets or where the value of intangibles is high. Also, it is ineffective where due to changes in the industry, market or the business environment, the assets have become redundant. Normally, this method is used to arrive at the reserve price or threshold price, which is the minimum acceptable price for the seller and is used as one of the methods of valuation of an enterprise.

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16.5.3 Transaction Multiple Method This method of valuation uses the transaction value or the traded value of comparable companies to arrive at the multiple at which the company should be valued. These can be the earnings multiple, sales multiple or the book value multiple. However the most common multiple that is recommended by the Disinvestment Commission is the earnings multiple which means the earnings before interest, tax, depreciation and amortization and the sales multiple. This method is used when there are comparable companies in the industry and the business is fairly stable. While this method captures most value elements in the business, it is based on the past or current transactions or traded values and does not take into account the possible changes in the future cash flows of the business or the time value of money. However, since it reflects the current market view it is a useful tool to check the accuracy of the valuations arrived at from other methods.

16.5.4 Asset Valuation Method In this method, the replacement value or the current market value of the assets of the company are used as basis of valuation. In other words it arrives at the investment that would be required to set up a new company in similar business. The future earnings capacity of the company have no relevance in this method. It is a good indicator of the entry barriers that exist in the business. The asset valuation method can be useful in case of liquidation or closure of the business. There are several PSUs owning huge, non-operational assets that have high market value but are presently lying unutilized or underutilized with the company. The actual value of the company may get distorted due to under-valuation of these assets as represented in the balance sheet. Hence in a strategic sale, it is of prime importance to value these assets separately before arriving at the value of the company as a whole.

16.6 Contemporary Concerns in Disinvestment The disinvestment process in India has been going on for several years now and while the initial steps were largely dictated by the policy of the ruling government, the real thrust to the process began with the setting up of the Department of Disinvestment. The intial disinvestments in companies like Modern Foods, BALCO, HZL and CMC, while being successful, have also been eye openers in the sense that several critical issues have come to light in each of these disinvestments.

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The lessons learnt from each of these disinvestments have been in valuable for the subsequent efforts. While some issues have been specific to the company being disinvested, there are some other critical issues that assume tremendous importance in any disinvestment deal. The most important of these are the labour issues, legal hurdles, and environmental protection.

16.6.1 Labour and Social Security Public sector companies in India as elsewhere have large resources of manpower locked in, resulting in huge burden of labour costs, and more often than not, low productivity. When PSUs are disinvested, the issue of labour restructuring assumes enormous importance and is a critical factor that decides the fate of the disinvestment process itself. Selling a PSU with the labour force intact is quite risky and often results in low levels of interest being shown in the transaction and often lowers the price offers. Alternatively, leaving the task of large-scale retrenchment to the new investor could cause social problems and have political implications. Hence, the Government has an important role to play in the process of labour restructuring. In India, the issue of labour management in the disinvestment process is extremely important since the total workforce in PSUs is about 2 million with strong labour unions in most sectors. The Government is therefore faced with the task of preparing and funding special programmes to deal with labour unrest and unemployment. The World Bank, since 1990, has been supporting labour adjustment in disinvestments around the world. The support mainly consists of technical assistance to Governments to help develop retirement and severance packages, design employee share ownership schemes, redeploy workers through active labour market programmes, etc. The World Bank has also provided direct financing for severance payments, provided it results in improved productivity of the enterprise and special mitigation efforts are put in place. For some underdeveloped countries, the Bank has also helped in poverty alleviation programmes to provide compensatory assistance, advice, training, and placement services. The most common method of downsizing labour is the Voluntary Retirement Scheme (VRS). The size of the benefits varies from enterprise to enterprise and is dictated by the legal and contractual obligations. In most cases, a well designed VRS scheme helps not only to buy the support of the workforce for the disinvestment but also results in redeployment of the redundant workers in productive activities elsewhere in the economy. However care has to be taken in designing the package so that it does not result in heavy financial burden for the government. In

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India, most PSUs with large workforces have implemented VRS as part of the overall restructuring programmes being undertaken and have downsized the workforce considerably. Retraining and redeployment support to the retired workers is one of the objectives that Government is committed to but has not been very successful in implementing. In most cases, the demand for retraining is very low and most surplus workers would have left their jobs even before the retraining schemes become operational. However in some countries like Argentina and Guinea privatized companies have been successful in helping retired workers to set up co-operatives and enter into service contracts, thereby providing employment for the workers. Employee Share Option Scheme, popularly known as ESOPs, is one of the ways of building labour support and has been quite successful in India. The Government has set aside some percentage of shares for employees during the various stages of disinvestment in most big disinvestments so far and employees have made substantial financial gains due to rapid share appreciation after takeover by the new management. However, financing the ESOP schemes has been a concern in most developing countries. One example of handling this is in Chile where the workers were allowed to use their retirement benefits to invest in the shares, with the guarantee that the value of the shares would not fall below their entitled benefits at the time of retirement. Due to this, more than 80% of the workers participated in the programme. In any labour restructuring exercise, it is very important that the workers are kept informed of the developments and their involvement is ensured to reduce the fear and insecurity that often results as soon as the decision to disinvest is made. Most workers understand that reforms are inevitable, but lack of information gives scope for gossip and wrong information making the rounds and resulting in obstacles to the process. An early communication to the workers and the unions about the method of disinvestment, the safety net being put in place, the regulatory arrangements being developed to protect consumer welfare, and the actual schemes of severance being designed would ensure better understanding and support from the workers and the general public.

16.6.2 Legal Issues Any announcement of disinvestment is preceded by a long and detailed evaluation of the company in question by the Ministry of Disinvestment and the other concerned

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departments. The timing of the disinvestments, the preparatory work for making the deal a saleable one, the resultant restructuring of the unit, and other such issues are normally completed before the actual disinvestment takes place. However, at times, hurdles in the form of legal issues not envisaged at the beginning could delay or endanger the process itself. The most recent example of this is in the case of disinvestment of HPCL and BPCL, the two large oil companies. Despite opposition from many quarters including the Petroleum Ministry, the Government went ahead and announced the disinvestment of HPCL and BPCL but was stopped in its tracks when the Supreme Court stayed the process due to litigation. Two public interest litigation4 writ petitions were filed questioning the decision of the Government to sell majority of shares in HPCL and BPCL. The petitioners contended that in the Preamble to the Acts under which these companies were nationalized, it is provided that oil distribution business be vested in the State so that the distribution serves the common good. It is also stated that the assets and the oil distribution business must vest in the State or in Government companies only. Hence the disinvestment in these two companies could be achieved only if the impugned Acts were repealed or amended appropriately. In addition, the petitioners challenged the objective of the Government in losing control over the assets and oil distribution business of these companies, which were against their very enactments. The Government defended its action by submitting that the decision to disinvest was purely an administrative decision relating to the economic policy of the State and no prior approval of the Parliament was therefore required in the present case. They also stated that the said companies were registered under the Companies Act 1956 and the sale of shares do not require Parliamentary approval, nor do the Memorandum and Articles of Association of the companies contain any such restrictions of transfer of shares. Examples of two earlier disinvestments viz., IBP Co. Ltd. and Maruti Udyog Ltd. were cited where Parliamentary approval was not obtained. It was also stated that after dismantling the Administered Price Mechanism, the Government’s main responsibility in the petroleum sector was laying down the broad policy framework, with the objectives of ensuring oil security in the country and protecting the interests of the consumers. Hence disinvestment by the Government of its shareholding in State owned enterprises was an instrument of economic policy and accepted globally. The Supreme Court, in its examination of the petition observed, ‘Setting up a new public sector company is defined as a new instrument of service for which approval of Parliament is required, for expenditure from the Consolidated Fund of

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India. If this is the background in which a new company is set up, can such a company be dismantled without some kind of parliamentary mandate?’. The Supreme Court has further noted ‘legislation must allow adequate flexibility, in the choice of the privatization technique best suited to each, while providing basic safeguards guaranteeing the integrity and efficiency of the process. Success of the programme hinges on, among other things, a basic consensus among Parliament, Government, and head of State on the scope and broad lines of the programme; a clear mandate given to the executing agencies along with the power necessary for fulfilling that mandate; and unambiguous, flexible, and competitive privatisation procedures applied in a transparent manner by officials accountable for their actions’. Setting aside the earlier cases which had no parliamentary approval, the Supreme Court in its ruling restrained the Central Government from proceeding with the disinvestments in HPCL and BPCL without appropriately amending the statutes concerned. Hence the entire process has come to a standstill, affecting the Government’s disinvestment programme in a big way. Legal or statutory hurdles can therefore have far reaching implications on the disinvesment process. These need to be addressed appropriately.

16.6.1 Environment Protection The World Bank, which plays an important role in privatisation of state-owned corporations the world over, has taken up the issue of environment protection as a priority in such cases. They have issued directives to Governments going in for privatisation to ensure that environmental issues are given prime importance at the time of disinvestment. They have recommended that the global advisors to the government on disinvestment should take the responsibility of conducting an environmental due diligence on the company before sell-off. These due diligence findings have to be made a part of the CIM so that the potential buyers are kept informed of the their own environmental responsibilities after taking over the company. The global advisors have to conduct the environmental due diligence either by themselves, if they are competent to do so, or appoint environmental consultants to conduct the same.

16.6.4 Utilization of Disinvestment Proceeds The proceeds from disinvestment are normally used to bridge the fiscal deficit in most countries. However there are several contrary views on this subject. Many

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experts feel that that the best way to utilise the proceeds is to retire public debt rather than spending the money in meeting current revenue expenditure. Most countries have utilized the proceeds for either of the above two purposes. Reduction in public debt will not only ease the fiscal deficit but will also release money into the financial market and further bring down interest rates. Some countries have however earmarked the proceeds for specific programmes that are outside the State budget. India too has over the past years spent most of the proceeds on meeting Government expenditure. However, the real big proceeds from disinvestment are yet to come and probably the Government will utilize them for retiring public debt, social spending and on infrastructure projects.

16.7 Contractual Issues and Documentation in Strategic Disinvestments Disinvestment through the strategic sale route has become the most acceptable and popular method of privatisation. When the Government decides to divest its stake in a company it has to choose a private sector partner carefully so that it gets the best value for the shares being sold, while at the same time the value of the business that is sold enhances subsequent to the sale. Strategic sale is a method wherein the private sector partner not only gets a substantial stake in the company but is also vested with the management control of the company, for which the buyer is willing to pay a control premium. In the past, disinvestments of shares through the open market route did not fetch good prices since the management control remained with the Government, denying the private sector a significant role in the company. The transfer of management control from the Government to the strategic partner need not necessarily be taken to mean a transfer of 51% or more of the total equity share capital. As per the Companies Act 1956, a Government company is one where the Government holds more than 51% of the equity capital. Once the Government’s share is reduced to less than 51%, it ceases to be a government company and requires suitable changes in the Articles of Association. In many cases, though the government holds more equity that the strategic partner, management control can be vested with the strategic partner. In strategic sale of PSUs, the Government typically has affirmative rights on several issues, which are much wider in scope that what is provided under the Companies Act for special resolutions.

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The stakeholders in a disinvestment transaction apart from the PSU itself, would typically involve: �

The Government

�

The strategic partner

�

Other shareholders

�

Employees.

The documentation for a strategic sale would therefore revolve around the above stakeholders and would have to be structured in such a way that the concerns of all the stakeholders are adequately addressed. A strategic sale has two components:(a) transfer of shares and (b) transfer of management control. Hence the most important documents that are involved in a strategic sale are: �

The Share Holders Agreement (SHA)

�

The Share Purchase Agreement (SPA).

The SHA governs the transfer of shares and the SPA governs the transfer of management. If the bidder were to take over the company through a Special Purpose Vehicle (SPV), then a Parent Guarantee Agreement would also come into force. We can now examine and discuss the structure of these documents and the significance of some important clauses that go a long way in ensuring a smooth disinvestment process.

16.7.1 The Share Holders’ Agreement (SHA) The Share Holders Agreement defines the relationship between the strategic partner and the shareholders (the Government) once the company is transferred to the strategic partner. The SHA normally has a recital that is not legally binding but is a broad statement of the intent. It states that the agreement should ensure an assurance by the strategic partner: �

To continue with the existing employees with service conditions not inferior to what they currently enjoy and in case of retrenchment, offer of at least a Voluntary Retirement Scheme

�

To make best endeavour to protect the interest of the Scheduled Caste/ Scheduled Tribe/Handicapped employees

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�

Not to resort to asset stripping

�

To continue the line of business following best business practices.

Affirmative Rights In a strategic sale, the management control is passed on to the strategic partner along with the transfer of shares. But the Government would like to ensure that the strategic partner is following the agreement in the right spirit. Some issues which are of prime importance to the Government like asset stripping, employee issues, disposal of assets, etc., need to be safeguarded at all times irrespective of the change in the stakes of the shareholders. To ensure this the Government normally provides for veto rights in certain important matters. These are called ‘affirmative rights’ and would cover some issues such as: �

Asset stripping, i.e. restricting the strategic partner from selling or otherwise disposing of assets beyond a certain limit.

�

Business line cannot be changed

�

Decision to retrench employees or change their service contracts

�

Opening new businesses

�

Winding up the company

�

Reduction of share capital.

The Government would have to earmark special issues in each case, but at the same time not make it so restrictive that the strategic partner would be frustrated for lack of freedom. Similarly affirmative rights of the Government on these issues should survive even if the Government’s holding goes below 26% . There are several issues on which a special resolution is required and the Government, as a 26% stake holder can block a proposal in the general meeting. Hence, an item which is not included in the list of items requiring affirmative vote of the Government, but is an item requiring a special resolution, it can be passed in the board if the strategic partner has majority but can subsequently be blocked by the Government in the general meeting.

Asset Stripping One of the biggest concerns on the Government’s part in any strategic sale of a PSU is that of asset stripping. Most PSUs have large assets in the form of land, buildings,

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plant and machinery, etc. The strategic partner may dispose off the valuable assets and leave the company to become sick, thereby defeating the very purpose of sale. To avoid this, a clause on affirmative rights of Government in case of sale of assets after takeover is normally incorporated in the agreement, as explained above. Also, the presence of a Government nominee for quorum of meetings to consider asset sale is a must. While it is not desirable to have a complete ban on sale of assets without Government vote, since many of the old assets may need to be replaced with new ones, a threshold limit can be stipulated in the agreement to avoid later disputes.

Exit Mechanism In any SHA, it is very crucial to define the exit mechanism upfront. Normally in a strategic sale, a lock-in period is stipulated for the strategic partner. Similarly in case of the bidder coming in through a SPV, a minimum lock-in period for holding shares in the SPV is to be stipulated to avoid unexpected exits later. The right of first refusal should be given to the other party in case one party has decided to exit. This is normally given on a reciprocal basis. The Agreement would also provide for tag along rights to the parties in case they do not exercise their right of first refusal. This basically means that if the strategic partner is selling its shares to a third party, the Government can require that its holding be also sold along with the strategic partner’s share at the same price. This also brings us to the question of what happens to the remainder of the Government’s shareholding in the company after the disinvestment. A lock-in period can be stipulated for the Government’s stake as well, if the strategic partner so desires. Otherwise, a ‘call and put’ option can be included, wherein the Government can exercise the put option after a minimum holding period or the strategic partner may exercise the call option to buy out the Government’s stake after a minimum lock-in period. The basic idea behind such clauses is to ensure that the strategic partner is there to stay and allow the Government to exit after some time, depending upon how the company is shaping up. The strategic partner should have the freedom to continue alone after some time, since the ultimate objective is for the Government to exit from the commercial entity.

Raising of Capital Raising capital after the strategic sale is a tricky issue since it could mean a change in the stakes of the shareholders. In most cases, it becomes necessary to inject funds into the company soon after the sale, either to meet some urgent revenue expenditure or

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important capital expenditure. The agreement can provide for such funds to be brought in by the strategic partner at the time of takeover itself. However, the strategic partner may like to initially take over the management and then raise the capital at the second stage. Normally further capital is raised either in in the form of debt or through equity in the by way of a rights issue, a public offer or a preferential allotment. Whenever the strategic partner raises capital by way of equity, it would mean a reduction in the Government’s holding in the company. To safeguard the Government from losing its right to vote, the affirmative rights should remain during the life of the agreement. Even if the agreement itself is terminated due to some reason, the Government’s affirmative right on important issues should continue as long as it has even one share. Similarly, the agreement should also stipulate the restrictions for raising equity or loans from third parties through preferential allotment or through renunciation of rights.

Board Representation and Quorum Normally representation on the board of directors is pro-rata to the shareholding percentage. However the SHA can stipulate the minimum percentage of shareholding below which the Government cannot have a Board representation. Similarly, the disinvested company may no longer require the existing functional directors who have been appointed by the Government. Hence the agreement should provide adequate provisions to compensate them for their balance tenure either through an appropriate VRS or some other mode. Procedure for the meetings can also be stipulated if necessary, although in the absence of it, the normal provisions of the Companies Act would apply. However, the Government should ensure that a nominee should be counted for the quorum and every meeting should report the status of the company and major events happening therein.

Termination Termination of the agreement would take place either by mutual agreement or the company becoming bankrupt or either party holding less than the outstanding and issued voting equity share or vice versa. In some extreme cases, the Government may insist on continuing the agreement even if it holds one share. Normally all representations and warranties terminate with the termination of the Agreement.

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However, some covenants such as confidentiality and indemnity may survive the termination. Similarly, if the Government wants protection for employees even after termination, it should be provided in the agreement.

16.7.2 The Share Purchase Agreement (SPA) The SPA governs the transfer of shares or the purchase of shares by the strategic partner. It clearly states the number of shares being transferred by the Government to the strategic partner, the price per share and total consideration. The closing of the SPA happens once all the ‘Conditions Precedent’ i.e. all approvals, all representations and warranties, all obligations, covenants and agreements are performed. Hence the date on which the SPA is signed and executed is called the Closing Date and the SHA then comes into effect. The closing of the agreement can be done in one or two ways depending upon whether the sale consideration is received in full or in part. Also in case of a listed company, transfer of management control cannot take place until the public offer announcement in terms of the Takeover Code of SEBI is completed within four days of signing the SPA. All post closing adjustments in the purchase price due to losses incurred, due to breach by the other party of any of the covenants, agreements or obligations have to be made within the stipulated period.

16.8 Disinvestment in State PSEs Apart from the central PSEs coming under the purview of the Central Government, there are a large number of State level Public Enterprises (SLPEs) under the purview of the respective State Governments. The total investment in these SLPEs has been estimated at close to Rs. 220,000 crore in March 2001 compared to the over Rs. 274,000 crore in Central PSEs. As in the case of the Central PSEs, the SLPEs are mostly in poor financial health with large accumulated losses. Of the total 1003 SLPEs, about 378 have been identified for disinvestments, winding up or restructuring. The process has been initiated in 294 of these SLPEs and on date 36 have been privatized and about 84 have been closed down. However the progress in disinvestments in the states has not been uniform all over. While some states like Andhra Pradesh have taken the lead, states such as Tamil Nadu and West Bengal have been slow. Andhra Pradesh has already privatised 13 SLPEs. Its Public Enterprises Reform Programme is a component of the AP Economic

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Restructuring Project, supported by the World Bank in the form of a partial contribution towards the voluntary retirement scheme. The state has also set up an implementation secretariat for the programme. Orissa has also privatized 9 SLPEs and closed down 11 SLPEs. Gujarat and Karnataka are two other states which have taken up disinvestment as a serious matter and have initiated the process in several SLPEs. Table 16.4 shows the progress of reforms in SLPEs No. of SLPEs

Andhra Pradesh

SLPEs identified for disinvestments/ winding up/ restructuring

Process initiated

SLPEs privatized

SLPEs closed down

128

87

79

13

12

Assam

49

NA

NA

—

—

Bihar

54

6

6

Delhi

NA

NA

—

—

—

Gujarat

54

24

24

3

6

Haryana

45

8

6

1

4

HimachalPradesh

21

15

8

3

2

Jammu & Kashmir

20

7

2

—

—

Karnataka

85

39

20

2

11

Kerala

111

55

40

—

10

Madhya Pradesh

26

14

14

1

—

Maharashtra

65

11

4

—

—

Manipur

14

10

NA

—

—

Orissa

72

33

10

9

11

Punjab

53

5

5

1

6

Rajasthan

24

10

6

1

1

TamilNadu

59

29

29

—

7

Uttar Pradesh

41

25

25

1

14

West Bengal

82

15

15

—

—

1003

378

294

36

84

TOTAL

� Table 16.4 Details of disinvestments in SLPEs5

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16.9 International Experience in Disinvestment Privatization of government owned enterprises has been accepted as an economic necessity all over the world. It is a universally recognized fact that the instrument of public ownership widely used in the post war reconstruction period is no longer the most desirable instrument for development. Further, the fact that unless the national industries survive the pressure of international competition, they would perish, has made governments all over the world take up the process of disinvestment as a top priority. Moreover, the Government’s inability to raise taxes and reduce expenditure, in most countries, and the use of taxpayer’s money in running industries has come under serious criticism. Such pressures have led to large scale privatisation the world over.

16.9.1 United Kingdom The earliest instances of disinvestment can be seen in Britain where public sector enterprises accounted for 25%of the GDP and 30% of all employment. PSU losses and borrowing amounted to nearly 3 billion pounds per year and their record of investment, productivity, industrial relations and service to the public was very poor. Not only was the financial cost substantial, but since the nationalised industries dominated 16 key sectors including transport, energy and communications, their effect on the entire economy made Britain what its neighbours called ‘The Sick Man of Europe’. Under Prime Minister Margaret Thatcher’s rule, privatisation was given top priority and around 60 large public sector companies including railways, aerospace, oil, telecommunications, mining, and bus services representing 10% of the GDP were sold off. More than 1.2 million government-owned housing units were sold and by 1997, receipts from privatisation exceeded 67 billion pounds. Regulation and competition were effectively used while privatizing services and infrastructure. Although it was initially resisted both by consumers and employees, consumers were benefited from lower prices, greater choice and better services. Simultaneously productivity in such units improved. Employees too benefited in the medium term due to increase in economic activity. Since privatisation of British Telecom in 1984, their main line prices have dropped by 50% while the number of phones grew by 30%. Similarly in the power sector, domestic prices have fallen by 25% since privatisation of electric companies and British Gas has cut costs by 30% to consumers and 40% to industry after privatization. Privatisation also offered a

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liberal opportunity to invest in divested shares, with the number of British shareowners increasing from 5% in 1979 to more than 25% in1990. Several European countries embraced privatisation in the 1980s. Prominent among them are the following.

16.9.2 France In France, eight large groups and three medium sized banks privatized in 1986–87. Later on, 21 companies were privatized including two of the largest banks and three largest insurance companies.

16.9.3 Germany Germany made a few early disinvestments including Preusag in 1959, Volkswagen (partly) in 1960 and Veba (partly) in 1965. During 1983-90, shares in five companies were disinvested through public offerings. Post 1990, following the reunification with East Germany, several more companies were privatised and large tracts of agricultural and forest land were sold off.

16.9.4 Italy In Italy, during early 1990s, public sector companies were converted into joint stock companies. In the late 1990s, IRI, the holding company, ENEL, the state electricity company and IMI, the state-owned bank were all privatized. In the Far East, China has been one of earliest countries to have followed disinvestment as one of the ways of restructuring the state-owned enterprises. The Chinese market reforms started in 1978 with corporatisation and listing of shares of efficient state-owned companies on domestic and foreign stock exchanges. In 1978, over 75% of industrial output was produced by the state sector. This fell to 34% by 1995.A gradual process of reforming the state-owned enterprises was conceptualised with a plan to privatise roughly half of the government’s stake of 60–70% in Shanghai’s 900 listed stocks. However many restrictions were imposed on the actual sale and in most listed state-owned enterprises, only one-third of the stock was to be owned by individuals with the remaining two-thirds being owned by the

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state and domestic institutions. In terms of foreign investors, no listed Chinese company had a majority of its shares in foreign hands until 1997. Several Latin American countries such as Chile, Brazil and Mexico, apart from other countries such as Australia, Korea and Thailand are also some of other countries that have privatised government-owned companies through different methods.

16.10 Process Flow and Role of Investment Banker in Disinvestments The process of disinvestment is a long and complex affair that involves the participation of several parties apart from the Government. The role of an investment banker in this process is a very critical one and often assumes great importance in complex transactions. An investment banker is normally appointed as advisor to the Government to assist it in carrying out the disinvestment process. It would be relevant to understand the process of appointment of advisor to the process at this stage before we discuss the actual scope of work. In keeping with the objective of maintaining the highest degree of transparency in the process, the Government makes the appointment of ‘Global Advisor’ a part of the bidding procedure. Announcements are made in the media about the concerned disinvestments and competent parties are called to make bids for being appointed as ‘Advisor to the Government’ in the disinvestment process. While in most cases, the method of disinvestments would have already been decided based on the recommendations of the Disinvestment Commission or the Cabinet Committee on Disinvestment, the advisors or consultants would be asked to submit their bids in two parts, one being the ‘technical bid’ and the second being the ‘financial bid’. The technical part of the bid would essentially involve giving credentials of the firm including the background, prior experience in handling such assignments, manpower resources available, qualification and experience of the people handling such work etc. More importantly, the consultants would have to make a critical assessment of the company being disinvested and furnish their suggestions for a successful disinvestment. It is here that the skill of the consultant is judged for giving the mandate. Hence, it is very important for the consultant to make a detailed study of the case and come up with a road map for a successful completion of the transaction. The financial bid is normally the quote for the fees, which is generally quoted as a percentage of the gross sale consideration received by the Government.

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The scope of work for the advisor would cover the following: �

Examine the financial affairs of the concerned PSU in detail and suggest suitable measures to restructure/reorganize the affairs of company prior to disinvestment.

�

Advise the Government on the best method of disinvestment after having evaluated all the alternatives. .

�

Preparation and issue of Advertisement in leading newspapers inviting Expression of Interest (EOI) from interested parties.

�

Shortlist the prospective bidders based on pre-determined objective, screening criteria/requirements.

�

Preparation of the Confidential Information Memorandum.

�

Preparation of draft Share Purchase Agreement and Share Holders Agreement.

�

Assist the company in the preparation of Data room and facilitate due diligence of the company.

�

Undertake valuation of the PSU and arrive at the Reserve price.

�

Invite the final bids.

�

Evaluation of final bids, help in negotiation and finalize the terms of sale.

It is clear from above that an investment banker, as advisor to the Government plays a very crucial role and requires skills in different disciplines to be able to effectively guide the Government. The Advisor is also expected to co-ordinate the efforts of all the parties involved in the process such as legal advisors, assets valuers, officials of the company and the officials from the concerned Ministry and all the parties interested in the bidding process. At the same time, in order to maintain transparency, the advisor would have to take suitable precautions at each stage of the process to avoid complications at a later stage.

16.10.1 Steps in the Transaction The sequence and the steps involved in a disinvestment transaction and the role of the advisor therein are discussed below.

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Appointment of Advisor Government of India is carrying out the disinvestment process in accordance with the prescribed procedure to ensure complete transparency. Proposal for disinvestment of any PSU, based on the recommendations of the Disinvestment Commission or in accordance with the declared disinvestment policy of the Government, are placed for consideration of the Cabinet Committeee on Disinvestment (CCD). After the CCD clears the proposal, selection of advisors is made through competitive bidding. As explained earlier, the Government normally issues an advertisement inviting bids from interested parties for appointing advisors to each disinvestment. Selection of an Advisor is made on the basis of the experience of the advisor in handling such transactions, the resources that the advisor can deploy for the process and the fees that the advisor is expected to charge for the process. The short-listed parties are called to make a presentation to the Government officials usually representing the DoD, the concerned ministry and officials of the company being disinvested. The selected advisor is then issued a Letter of Intent describing in detail the scope of work and terms of appointment. In cases where the transaction is very large and complex, more than one advisor is appointed and the scope of work for each advisor is determined separately. A confidentiality agreement would be signed with the advisor to maintain high standards of integrity in the process.

Commencement of Work As mentioned earlier, the work of an advisor could involve various tasks to be performed much before the actual disinvestment process begins. This is often the case where the company to be disinvested needs some restructuring or reorganizing to be done so that it is well prepared for being disinvested. The advisor normally undertakes a due diligence of the company and examines in detail the various issues that need to be addressed before commencing the disinvestment process. A typical example of this could be in case of disinvestment of a company that has several subsidiaries in different businesses and at multiple locations. In such cases, the advisor would have to study each of the subsidiaries in detail to examine the problems and issues that have to be tackled, the impact on the holding company by disinvesting the subsidiary and the inter-relationships between the subsidiaries. Normally, financial restructuring would be required for each of the subsidiaries with or without business restructuring. Issues such as sharing of assets, inter company loans and advances and inter-dependence on business activities need to be resolved to make

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the disinvestment an attractive proposition. Also, the sequence in which the companies could be disinvested is an important decision that needs to be taken after the above assessment is made. Another case in point could be a company which has substantial surplus assets or large reserves which could distort the actual value of the company. For example, VSNL had huge reserves of Rs. 5918 crore, out of which Government took away Rs. 3918 crores by way of a 750% dividend and 10% dividend tax prior to disinvesting its stake. The surplus land owned by the company was demerged into a separate company before calling for bids. Such large scale restructuring involves several complexities and proves to be a challenge for the advisor.

Inviting Expression of Interest (EoI) Once the company is ready for disinvestment, the advisor, in consultation with government, prepares and issues an advertisement in leading newspapers calling for expression of interest (EoI) from interested parties. The advertisement contains basic details of the company and highlights of the transaction. Prior to the issue of advertisement, the eligibility criteria or requirements for short-listing would be finalised in consultation with the Government to be sure of the resourcefulness of the prospective bidders and a certain minimum standard of quality in the interest shown by the parties. Normally the eligibility criteria would be specified in terms of the net worth of the interested party or turnover of the company or both. This would be highlighted in the advertisement and a specific time and date would be stipulated for receiving the EoI. The advisor has to interact with the parties wanting to respond to the advertisement and answer any queries that they might have. It is very important to note here that the advisors have to keep their paper work updated and maintain proper records for future reference. Since confidentiality is fundamental to the process, it is of utmost importance to maintain a high degree of secrecy wherever required and be accountable at all times.

Short-listing of Prospective Bidders Once the EoIs are received, the prospective bidders are short-listed, based on predetermined objective screening criteria/requirements. They are also provided with a Preliminary Information Memorandum giving the highlights of the company’s operations and financial performance. The shortlisted candidates are also required to enter into a Confidentiality Agreement with the company before proceeding further.

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Confidential Information Memorandum One of the most critical roles played by an advisor in the disinvestment process is in conducting the due diligence on the PSE being disinvested and in preparation of the Confidential Information Memorandum (CIM). The advisor acts as an important link between the company being disinvested and the various interested parties in the disinvestment process and hence plays a key role in it. The advisor has to perform a detailed due diligence on the company by interacting with the top management and officials of the company. A scrutiny of all statutory and legal books, contracts, agreements and other important documents maintained by the company has to be made. Visits to the manufacturing locations of the company are very essential as part of this exercise. Information that needs to be given in the CIM will have to be gathered during this time. The CIM will contain details of the company’s operations, financial performance, operational statistics, infrastructure, market information, pending legal issues, environment reports, and other essential information required to help the bidders prepare their bids. Drafts of the Bid Document will also be given at this stage.

Draft Shareholders Agreement The draft SPA and SHA have to be prepared with the help of legal advisors. These are critical documents that need to be prepared with a lot of care and all the critical clauses are examined and discussed in detail before finalizing them. Important clauses of these documents are also discussed with the prospective bidders for their reactions.

Due Diligence For the prospective bidders, performing a due diligence on the company being disinvested is a critical task and is given prime importance. The advisors along with the help of the company will first prepare a ‘Data Room’ where all important books and documents that need to be examined are kept ready. Prospective bidders are allotted specific time schedules when they are permitted access to the Data Room. Discussions are then held with the officials of the company, representatives of the Government and advisors for clarifications. The prospective bidders are also allowed to visit the factory premises and other important locations of the company. The bidders can conduct the technical and financial due diligence themselves or

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employ outside specialists like investment banks or consulting firms to do the job. The completion of due diligence is an important step in the disinvestment process, making way for the preparation of final bids.

Valuation The task of valuation of the company is taken up concurrently by the advisor during this time. Valuation is normally undertaken according to standard national and international practices. Usually more than one method of valuation is done and results evaluated to determine the ‘Reserve Price’. Where asset valuation has to be done separately, specialist valuers are employed to do the valuation. The final valuation figures are discussed in detail by the representatives of the Government and the top management of the company to arrive at a mutually acceptable reserve price.

Bidding Procedure To ensure absolute transparency and avoid tampering, the Ministry of Disinvestment has evolved a bidding procedure, which has been strictly followed in all the disinvestments made till now. The reserve price is not fixed by the Government before the bidders submit their financial bids so that there is no chance of the bidders knowing the reserve price. Alternatively, the Government should also have no knowledge of the financial bids that have come in so as not to be influenced by them. Importantly, the advisors are not allowed to finalise the reserve price since there could be a conflict of interest for them by trying to keep the reserve price low. Bids are normally received in two separate sealed envelopes, one containing the price bid and the second containing the other statutory documents stipulated in the CIM. The advisors open the second envelope and along with the Legal advisors scrutinize the documents to ensure that they are in order. The financial bids are put in a separate envelope and sealed for further action. The global advisors then have to submit their valuation reports in sealed envelopes to the Evaluation Committee of the Inter Ministerial Group (IMG). The advisors make a presentation to the Evaluation Committee about the business valuation and asset valuation and their recommendation of what should be the reserve price. Thereafter they withdraw from the meeting and the Evaluation Committee then deliberates and recommends a reserve price. A final meeting of the IMG is then conducted to finalize the reserve price recommended by the Evaluation Committee and the financial bids are

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opened. While the bidders are allowed to be present at the time of opening the bids, they have to withdraw along with the advisors after the bids are opened to enable the IMG to discuss and make their recommendations of whether to accept the highest bid or not. The final recommendations of the IMG are then placed before the CCD for final approval.

Documentation Based on the reactions received from prospective bidders, the Share Purchase Agreement and Share Holders Agreement are finalized. These are then vetted by the Ministry of Law and approved by the Government. Thereafter, these are sent to prospective bidders for inviting the final binding bids—both technical and financial. The bids received are examined, analyzed and evaluated by the IMG and the recommendations of the IMG are placed before the CCD for final approval of the bids, the strategic partner, SPA, SHA and other ancillary issues. The IMG comprises of officers from the Ministry of Finance, Department of Public Enterprises, the administrative ministry/department controlling the PSU apart from the officials of the Department of Disinvestment. The advisors have to assist the IMG and DoD in the entire discussion process. After the transaction is complete, all papers and documents relating to the disinvestment are handed over to the Comptroller and Auditor General of India (CAG) to enable the CAG to undertake evaluation of the disinvestment and place the matter in the Parliament, after which it is released to the public.

16.10.2 Critical Issues in the Role of an Advisor The disinvestment process explained above highlights the role that an advisor has to play in the process. The advisor acts as a facilitator and is responsible for co-ordinating the activities to ensure a smooth flow of work. However, the responsibility that is vested in an advisor as a deal maker and strategist has a fiduciary dimension and is far greater than the role of a facilitator. Some key issues are critical in discharging these functions. These are discussed below.

Maintaining Transparency and Confidentiality The advisors are bound by the confidentiality agreement that they sign at the beginning of the transaction. However in reality, maintaining transparency and at the same time confidentiality is a tricky issue that has to be handled with extreme care

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and caution. The stakeholders in a disinvestments process are many. Apart from the Government and the strategic partner, there are other stakeholders like the PSU itself, other shareholders and employees. The law and regulatory authorities are another set of people the advisor has to deal with. In such an environment, it is a difficult job to be transparent and at the same time maintain secrecy. Confidentiality can very often be misunderstood as not being transparent. Within their own firm, the advisors have to take care to ensure that there is no leakage of confidential information or conflict of interest with other clients that they may be dealing with.

Valuation The task of valuing the enterprise being disinvested is the job of the advisor. While the methodologies for valuation are standardized, the very issue of doing the valuation could give rise to a conflict of interest. The advisor is not involved in finalizing the Reserve Price. However, the Reserve Price is fixed based on the valuation done by the advisor thereby giving scope for a conflict of interest. Any distortion in the valuation could have its effect in the finalization of the Reserve Price. A solution to this could be in appointing an external valuer (other than the advisor) to do the valuation or to get more than one valuation done (like in the Maruti Udyog case) to get an unbiased opinion about the correct value of the enterprise. Hence, it is very important for the advisor to be unbiased and extremely ethical in doing the valuation.

Due Diligence The short listed parties conduct a due diligence on the PSU being disinvested. The Advisor plays an important role in this exercise and is responsible to keep the Data Room ready for the purpose. The Data Room contains all the important documents that the parties need to check before arriving at their final bids. Any concealment of information or misrepresentation of facts can lead to serious consequences. Hence the advisor has a tremendous responsibility to ensure that the entire process of due diligence is transparent and all queries are answered fully and satisfactorily.

16.11 Role of Investment Banker in Bid Advisory The discussion so far has been centred around the investment banker being an advisor to the Government for its disinvestments in PSEs. However, as may be

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appreciated from the above, there is a need for investment bankers to advise the private bidders as well. It would therefore be relevant to learn about the role of an advisor to the private party making a bid in disinvestments. Also known as ‘Bid Advisory’, this is the role of an advisor to the company that is making a bid in a strategic sale. While this role is similar to the role of an advisor in any project, acquisition or takeover deal, bid advisory in disinvestments has special significance since it involves dealing with the Government itself on the other side. Being appointed as advisor to a company /group that is planning to bid for a strategic stake in a PSE is usually dependent on the relationship that the investment banker has with the company and its competence in handling such assignments. The scope of work of an advisor in a disinvestment bid is discussed below.

16.11.1 Submission of the Expression of Interest An announcement of a disinvestment is normally followed by an advertisement calling for Expression of Interest (EoI) from the interested parties. This becomes the starting point for the work of an advisor. A company wanting to put in an EoI has to satisfy itself that the company it wants to acquire fits into its overall long-term corporate strategy and that it has the required approval from the board/shareholders to go ahead. Having confirmed that, the management would then appoint an advisor to help it go through the various steps of the transaction. In order to submit the EoI, the company/group/consortium has to satisfy the eligibility criteria that is stipulated in the advertisement. The first task of the advisor is to go through the required documents and be satisfied that the eligibility criteria have been met. Having achieved this, the formal EoI can be submitted in the prescribed format to the concerned authority.

16.11.2 Evaluation of the Information Memorandum The parties who satisfy the eligibility criteria are given a Preliminary Information Memorandum or the Confidential Information Memoradum (CIM) that gives in detail, all information pertaining to the company being disinvested. An advisor would have to study the CIM in detail and any queries or clarifications required can be sought from the company or its advisors. This is the first major task that the advisor has to perform in the process of preparing the ‘Bid Document’. The CIM not only gives information about the company but also provides the format of the bid document and the procedure for bidding.

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16.11.3 Due Diligence Armed with information about the company and its operations, the shortlisted candidates are then allowed to visit the Data Room prepared for the purpose of due diligence. An advisor has a critical role to play in the performance of due diligence. It is at this stage that the bidding company gets an opportunity to see the various documents and books of the company being disinvested and also visit the manufacturing facilities of the company. Information that is gathered at this stage is critical in the preparation of the bid document. Since due diligence has to be performed within the given time, sufficient preparation and care has to be taken to ensure that all information that is required is obtained and that there are no information gaps or lack of understanding on any issue subsisting thereafter. Among the documents, special mention has to be made about the draft SPA and the SHA that would be provided to the bidders at this stage. These are two important documents that need to be examined in detail. Legal advice is normally sought for this purpose. Special attention has to be paid to important clauses that deal with employees, affirmative rights of the Government on certain issues, exit mechanism, board representation and indemnity. Since these documents become the center point for all future negotiations, it is of utmost importance that these are examined and understood well before submitting the final bids.

16.11.4 Valuation and Preparation of the Final Bid The last stage in the bidding process would be to actually prepare the final bid document. As has been discussed earlier, bids are normally required to be submitted in two parts i.e. the financial bid and the technical bid. The bid documents have to be filled in without any errors or misrepresentation. The financial bid is the price that the company/group/consortium is willing to pay to acquire a strategic stake in the company being disinvested. Hence to arrive at this price, a detailed valuation has to be made by the advisor based on the information furnished in the CIM and discussions with the global advisors to the Government or the officials of the PSU. The advisor has to use all the skills and prior experience required for this purpose, along with a lot of market intelligence in arriving at the appropriate financial bid. The recommendations on the valuation have to be discussed with the management to arrive at the final price. The technical bid would normally contain information about the bidder’s track record, financial performance, reasons for bidding, detailed plan of action for the company being acquired and required documentary evidence. Usual documents that are

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required are: �

Bank Guarantee

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Board Authorization

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Application under Section 108A of the Companies Act, if required

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FIPB/SIA application, if required

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Copy of the Share holders agreement/Share Purchase agreement authenticated by the bidder based on which the bid has been made

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Other documents if any.

Bidders are allowed to be present at the time of opening the bids. Thereafter, the highest bidder is called for negotiation and conclusion of the deal. The advisor plays a very important role at this stage and has to demonstrate the necessary skills in concluding the transaction in the best interest of the client.

16.12 Case Studies in Disinvestment I. Maruti Udyog Limited (MUL) Background Maruti Udyog Limited (MUL), India’s dominant automobile manufacturer, is a joint venture of Government of India (GOI) and Suzuki Motor Corporation (Suzuki), Japan. MUL has to its credit the distinction of being the most popular car manufacturer in India, especially in the small segment, and the Maruti brand as the common man’s car is well established in the market. As at the year ended March 31, 2001, MUL had an equity capital of Rs. 132.30 crore and a net worth of Rs. 2,642 crore. MUL enjoyed the status of being the market leader for several years. However with the advent of competition, especially from the international car manufacturers, MUL’s profitability has been under pressure. According to the joint venture agreement, GOI and Suzuki had joint control over the management of MUL. Each party appointed the Chairman and Managing Director of the company by turns. In addition, the joint venture agreement also restrained the GOI from selling the shares of MUL to a third party without the consent of Suzuki.

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Preparation for Disinvestment In February 2001 the Government decided on disinvestment in MUL. This was strategized to be made through a rights issue to existing shareholders with a renunciation option. In order to negotiate the deal with Suzuki on behalf of the Government, a negotiating team was constituted comprising of the Secretary of the Ministry of Disinvestment, Secretary of the Department of Heavy Industry and Mr. K.V. Kamath, Managing Director and CEO, ICICI Bank Ltd. The Committee was asked to negotiate and finalize the modalities of disinvestment with Suzuki. After a series of meetings, the negotiating team and Suzuki arrived at a consensus. Both sides agreed that the disinvestment of GOI shares in MUL would be done in two phases. In the first phase, a rights issue would be made and after the completion of the rights issue, an offer for sale of existing GOI shares would be made in the primary market. It was acknowledged that this method would help in infusing capital into MUL for its expansion and growth and at the same time lead to increase in the value of MUL and its share price in a transparent manner. More importantly, this would help to determine the benchmark for further disinvestment. The value of the rights issue agreed upon was Rs. 400 crore, which was arrived at primarily on the basis of the estimates of capital expenditure requirements in MUL. With regard to valuation of Maruti shares, it was agreed that GOI and Suzuki would jointly identify and appoint three reputed valuers to determine the value of shares and the average of the three values accepted. KPMG, Ernst & Young and S.B. Billimoria were appointed as valuers and they submitted their valuation reports in January 2002, copies of which were also made available to Suzuki. The fair value per share recommended by the three valuers was Rs. 3,200 by KPMG, Rs. 3,142.18 by Ernst & Young and Rs. 3,500 by S.B. Billimoria. The average of the valuations made by three different valuers worked out to Rs.3,280. After valuation reports were received, the second round of meetings were held between the negotiating teams of the GOI and Suzuki to finalize the issues such as the price at which the rights issue would be made, the portion of the GOI’s rights share to be subscribed by Suzuki, the renunciation premium and the control premium and modalities for the sale of existing shares held by GOI, etc. A revised joint venture agreement was also discussed and finalized. Kotak Mahindra Capital Company (KMCC) acted as the financial advisor to GOI. Dua & Associates were the legal advisors to Government.

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The Disinvestment Process The GOI approved the disinvestment in MUL on 14th May 2002 through the twostage process as follows: (i) Rights issue by MUL in the first phase of Rs. 400 crore with GOI renouncing its rights shares to Suzuki. Suzuki would gain majority control and pay an additional Rs. 1000 crore to GOI as control premium. (ii) Sale of GOI’s existing shares through an offer for sale in the second phase; the issue to be underwritten by Suzuki. In order to appreciate the above process, it would be relevant to know the various issues that were discussed and agreed to by both the parties. The highlights of the agreement reached between the negotiating teams of GOI and Suzuki are as follows: 1. The total value of the rights issue would be Rs. 400 crore. The rights issue price would be Rs. 3,280/- per share. Hence the rights issue would be for a total of 12,19,512 shares of Rs. 100/- each. 2. The average of the 3 values as calculated by the three valuers appointed for the purpose i.e. Rs. 3,280/- per share was agreed as the fair value for the purpose of working out the renunciation premium. 3. GOI would renounce all its rights shares of 6,06,585 shares and Suzuki would subscribe to all the rights shares so renounced by GOI at the fair market value. 4. Suzuki would pay a control premium of Rs. 1,000 crore to GOI without GOI parting with even a single share in MUL. 5. Suzuki and GOI agreed to enter into a revised joint venture agreement that would supersede any other prior agreements or understandings between the parties. 6. Suitable amendments in the memorandum and articles of association of MUL would be carried out to bring them in line with the decisions recorded above and also to enable the listing of MUL shares on the stock exchange. 7. The revised JVA envisages that GOI would sell its existing shares in the domestic market with participation of Indian and global investors, as permitted by law, after the completion of the rights issue transaction.

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8. Suzuki agreed to underwrite the first offer for sale of approximately 36 lakh shares held by GOI at a price of Rs. 2,300/- per share. The balance of 29 lakh shares, were underwritten upto 30th April 2004 either at the current book value (Rs. 2,000/- per share) or the prevailing book value at the time of sale, whichever was higher. In addition, under the revised terms, GOI has a ‘put’ option after the listing of the share, at a discount of 15% and/or 10% of the average market price. 9. Since the rights issue will be of a size of 12,19,512 shares, the relative shareholding of Suzuki and GOI after completion of the rights issue would be 54.20% and 45.54% respectively.

Analysis of the Transaction The MUL disinvestment is unique in nature compared to the other strategic sale transactions such as VSNL, BALCO, HZL, CMC, etc. Since the disinvestment was made in phases with two different modes, it makes an interesting case study.

GOI’s status The fair value of MUL’s shares was arrived at by three independent valuers since MUL was not a listed company. This average value worked out to Rs. 3,280/- per share. Based on this value per share: Value of GOI’s existing 65,80,181 shares at Rs. 3,280/per share

Rs. 2,158 crore

Control premium received from Suzuki

Rs. 1,000 crore

Value of approx. 36 lakh shares at public issue price of Rs. 2,300/- per share

Rs. 844 crore

Value of balance approx. 29 lakh shares at Rs. 2,000 per share

Rs. 580 crore

TOTAL

Rs. 2,424 crore

It should be noted here that if the existing shares were to be sold at more than the present book value, GOI’s gross receipts would further go up.

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GOI has been receiving dividend on its shareholding in MUL and in the past several years it has received about Rs.13–20 crore per annum. In the year 2000–01, MUL did not declare any dividend. After the first phase of the disinvestment was completed, GOI received Rs.1,000 crore upfront from Suzuki as control premium, which yields interest of Rs.60 crore per annum at the conservative rate of 6%. In addition to this, it would receive dividend on the existing shares if it does not sell those shares. If it sells the shares then GOI would receive a minimum of Rs. 85 crore per annum (at the rate of 6%) on the balance receipts of Rs.1,424 crore as indicated above. Thus, the minimum annual yield to GOI would be Rs. 145 crore against the present dividend level of Rs. 13–20 crore per annum.

Suzuki’s Status As per the original JV agreement, Suzuki had 50% shares in MUL and management rights, which by itself was more than the legitimate equal rights. This was because of their status of being technology suppliers, apart from being JV partners. The control premium that Suzuki had to offer to GOI has to be viewed in this background since in other cases of disinvestment, the strategic partner does not have any control before acquiring GOI shares but acquires control only after the strategic sale. The revised JVA stipulates certain value enhancements to be made by Suzuki. The revised JV words them as follows: ‘Suzuki will �

endeavour to make MUL the source for some of its models globally,

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assist MUL to access new export markets,

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give discount on certain components as previously agreed to by it,

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set up a task force to explore the possibilities of further reduction in costs at MUL,

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promote MUL and its products in the global market.

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aggressively strengthen MUL’s manufacturing and technical capabilities so as to make MUL’s products internationally competitive in terms of quality and cost.”

In the eventuality of GOI withdrawing and Suzuki undertaking the above activities, the beneficiary would be not only Suzuki but also the Indian automobile sector in India. According to the Disinvestment Ministry’s estimates, MUL today contributes

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nearly Rs. 2,500 crore to the national exchequer annually. In addition the higher growth and earnings of MUL would result in higher receipts to GOI through taxes from MUL. Further, all the above measures by Suzuki would enhance the value of MUL and hence ensure the possibility of much higher receipts than the minimum estimated above.

Price/Multiple Ratio Analysis A simple calculation of the P/E ratio for the transaction would show that for 49.74% share at a value of Rs. 2,424 crores, the value of the company would be Rs. 4,873 crore. The profit earned by MUL in the year 2001–02 was Rs. 55 crore. This gives a P/E ratio of about 89 which compares well with the P/E ratios of some other disinvestments like 37 (HTL), 63 (IBP), 11(VSNL), 19 (Balco), 12 (CMC) and 26 (HZL). Based on the overall valuation of the company at Rs. 4,873 crore as indicated above, the per share value of MUL works out to about Rs. 3,684, which is far above the Book Value of about Rs. 2,000 per share, resulting in price to book value ratio of 1.8. It is also higher than the valuation made by the three valuers at Rs. 3,280.

II. Bharat Aluminium Company Ltd. (BALCO) Background BALCO is a fully integrated aluminium producing company, having its own captive mines, an alumina refinery, an aluminium smelter, a captive power plant, and downstream fabrication facilities and was set up in 1965. Its manufacturing facilities are situated in Korba (Chhattisgarh) and it has a fabrication unit in Bidhanbag (West Bengal). The refining capacity of BALCO is 2 lakh tonnes per year and its smelting capacity is one lakh tonnes per year. Its employee strength was 6,436 as on 2nd March 2001. It had an equity share capital of Rs. 489 crore and free reserves of Rs. 424 crore.

Disinvestment Process BALCO though a profit making PSU, was facing dwindling fortunes due to declining profitability. It was using outdated technology and required a huge infusion of funds to modernise the plant. Since the Government was unable to infuse funds and

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considered BALCO as a non-core investment, it was referred to the Disinvesment Commission. In accordance with their recommendations, the Government decided to disinvest 51% stake in BALCO to a strategic investor. Jardine Fleming, a reputed investment banking (now part of the J.P. Morgan Chase group) was appointed as advisor to the GOI in the transaction. Simultaneously, in view of its large equity base and huge reserves, the Ministry of Mines suggested that BALCO's equity be reduced by 50% prior to disinvestment, using its substantial cash surplus. This proposal was accepted and the Government received Rs. 244 crore from the capital restructuring of BALCO, and another Rs. 31 crore as tax on this amount, prior to disinvestment. Although the strategic sale process for BALCO started in late 1997 after the initial decision of the Government, it finally came to an end on 2nd March 2001. After the bidding process, it was decided to sell GOI’s 51% stake to Sterlite Industries, the highest bidder for a price of Rs. 551.50 crores. This was higher than the values indicated by the various methods of valuation used and the reserve price of Rs.400 crores. The Government thus recovered a total amount of Rs. 826.50 crore from this privatisation. Financially, the sale was beneficial to the Government because assuming a 6% rate of interest on its funds, the Government gains about Rs. 50 crore against approximately Rs. 5.69 crore as dividend it used to get for the 51% shares, in earlier years. The BALCO disinvestment was the first major deal that was completed by the Government. But post-disinvestment, a number of issues were raised especially with regard to transparency, valuation and protection of employees’ interests. In fact, the employees and the State Government even went to court contesting the disinvestments but could not succeed. Employees concerns received special attention, with specific clauses in the SHA being inserted, which offer adequate protection to all levels of employees with regard to their job safety and severance packages. The strategic partner had to agree not to retrench any employee at least for one year. Any retrenchment subsequent to that would have to be done at terms, which were not less beneficial to the employees than under VRS schemes of the government in force at that time. The government on their part agreed to provide insurance for losses due to litigation, arising out of equipment failure at the plant. This was criticised for being against accepted commercial practices and for setting an unhealthy trend for future disinvestments. The BALCO disinvestment is also popular for the landmark judgement that the Supreme Court delivered when the workers went on a 67-day strike and filed three writ petitions—two in the Delhi High Court and one in the Chhatisgarh High Court, against disinvestment in BALCO, in February 2001. The Supreme Court in its

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unanimous judgement delivered on 10th December 2001 validated the disinvestment by the Government in BALCO. The landmark judgement also defined, amongst others, the parameters of judicial review in Government’s economic policy matters. The Supreme Court, while validating the BALCO disinvestment and dismissing the petitions, remarked, ‘Thus, apart from the fact that the policy of disinvestment cannot be questioned as such, the facts herein show that fair, just and equitable procedure has been followed in carrying out this disinvestment.’ This judgement facilitated the path of other successful privatisations.

Post Disinvestment Scenario The matter of carrying out the second phase of disinvestments by making a public issue for the balance 49% equity is still pending. The new management introduced VRS and a total of 956 applications were accepted. Long-term wage agreement for a period of 5 years was entered into on 7th October 2001. New practices such as job rotation and appraisal system for employees have been introduced. The new management is also proposing an investment of Rs. 6,000 crore which will increase production by 400%.

16.13 Conclusion Government advisory is a vast practice area for investment banks in three main segments—policy advisory, project advisory and disinvestment advisory. In India, these areas, especially disinvestment advisory are bound to grow in future, keeping in view the economic compulsions. An acceptable model is yet to evolve on loss making PSEs and exit policy therein. State disinvestments are still in a very nascent stage and would pick up in future as more and more state governments find it difficult to sustain loss-making state PSUs. Sale of surplus assets, hive-offs and restructuring, public offers and strategic sale in PSU companies could keep investment bankers busy for a long time to come.

� Notes 1. Source: Ministry of Disinvestment, Government of India. 2. Source: Pricewaterhouse Coopers data as reported in the ET Disinvestment Survey, The Economic Times dated 21st March 2003.

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3. Data from the European Bank for Reconstruction and Development as reported in the ET Disinvestment Survey, The Economic Times dated 21st March 2003. 4. For the complete version, please refer to the Judgement of the Supreme Court in Writ Petition (Civil) No. 171 and 286 of 2003. 5. Source: Ministry of Disinvestment, Government of India.

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Select References 1. ET Disinvestment Survey, The Economic Times dated 21st March 2003. 2. ‘How UK was turned around’ by S.J. Masty, Senior policy advisor with London’s Adam Smith Institute, The Economic Times, 14th April, 2003. 3. Official website of the Ministry of Disinvestment, Government of India. 4. ‘Labour Redundancies and Privatisation’ by Sunita Kikeri in Viewpoint, Note No. 174, January 1999, published by the World Bank.

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Self-Test Questions 1. How are disinvestments justified from an economic point of view? What are the contemporary concerns? 2. What are the methodologies adopted for disinvestments of PSEs? How do they compare? 3. What are the valuation approaches used in valuation of PSEs for disinvestments? What is the role of the advisor in determining the reserve price? 4. Explain the process involved in a disinvestment programme with special reference to the role of the financial advisor. 5. What are the government advisory areas for investment banks apart from disinvestments?

� Annexure I No. 6/4/2001-DD-II Government of India Department of Disinvestment Dated 13th July 2001 OFFICE MEMORANDUM Subject: Guidelines for qualification of Advisors for disinvestment process Government has examined the issue of framing comprehensive and transparent guidelines defining the criteria for selection of Advisors, so that the parties selected through competitive bidding inspire public confidence. Earlier, a set of criteria like sector experience, knowledge, commitment, etc. used to be prescribed. Based on experience and in consultation with concerned departments, Government has decided to prescribe the following additional criteria for the qualification/disqualification of the parties to act as advisors to the Government for the disinvestment transactions: (a) Any conviction by a Court of Law or indictment/adverse order by a regulatory authority for a grave offence against the Advising concern or its sister concern would constitute a disqualification. Grave offence would be defined to be of such a nature that it outrages the moral sense of the community. The decision in regard to the nature of offence would be taken on a case to case basis after considering the facts of the case and relevant legal principles by the Government. Similarly, the decision in regard to the relationship between the sister concerns would be taken, based on relevant facts and after examining whether the two concerns are substantially controlled by the same person/persons. (b) In case such a disqualification takes place, after the entity has already been appointed as Advisor, the party would be under an obligation to withdraw

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voluntarily from the disinvestment process, failing which the Government would have the liberty to terminate the appointment/contract. (c) Disqualification shall continue for a period that Government deems appropriate. (d) Any entity, which is disqualified from participating in the disinvestment process, would not be allowed to remain associated with it or get associated merely because it has preferred an appeal against the order based on which it has been disqualified. The mere pendency of appeal will have no effect on the disqualification. (e) The disqualification criteria would come into effect immediately and would apply to all the advisors already appointed by the Government for various disinvestment transactions, which have not yet been completed. (f) Before disqualifying a concern, a Show Cause Notice why it should not disqualified would be issued to it and it would be given an opportunity to explain its position. (g) Henceforth, these criteria will be prescribed in the advertisements seeking Expressions of Interest (EOI) from the interested parties to act as Advisor. Further, the interested parties shall be required to provide with their EOI an undertaking to the effect that no investigation by a regulatory authority is pending against them. In case any investigation is pending against the concern or its sister concern or against the CEO or any of its Directors/ Managers/Employees, full details of such investigation including the name of the investigating agency, the charge/offence for which the investigation has been launched, name and designation of persons against whom the investigation has been launched and other relevant information should be disclosed, to the satisfaction of the Government. For other criteria also, similar undertaking will be obtained along with EOI. They would also have to give an undertaking that if they are disqualified as per the prescribed criteria, at any time before the transaction is completed, they would be required to inform the Government of the same and voluntarily withdraw from the assignment. (h) The interested parties would also be required to give an undertaking that there exists no conflict of interest as on the date of their appointment as advisors in handling of the transaction and that, in future, if such a conflict of interest arises, the Advisor would immediately intimate the Government of the same. For disinvestment proposes, ‘conflict of interest’ is defined to

878

Investment Banking

include engaging in any activity or business by the Advisor in association with any third Party, during the engagement, which would or may be reasonably expected to, directly or indirectly, materially adversely affect the interest of Government of India or the Company (being disinvested) in relation to the transaction, and in respect of which the Advisor has or may obtain any proprietary or confidential information during the engagement, that, if known to any other client of the Advisor, could be used in any manner by such client to the material disadvantage of Government of India or the Company (being disinvested) in the transaction. The conflict of interest would be deemed to have arisen if any Advisor firm/concern, has any professional or commercial relationship with any bidding firm/concern for the same disinvestment transaction during the pendency of such transaction. In this context, both Advisor firm and bidding firm would mean the distinct and separate legal entities and would not include their sister concern, group concern or affiliates, etc. The professional or commercial relationship is defined to include acting on behalf of the bidder or undertaking any assignment for the bidder of any nature, whether or not directly related to disinvestment transaction. (i) On receiving information on conflict of interest, the Government would give the option to the Advisor to either eliminate the conflict of interest within a stipulated time or withdraw from the transaction and the Advisor would be required to act accordingly, failing which Government would have the liberty to terminate the appointment/contract.

(A.K. Tewari) Under Secretary to the Government of India

� Annexure II

� ILLUSTRATIVE SCOPE OF WORK IN PROJECTS INITIATED BY THE GOVERNMENT OR STATUTORY AUTHORITIES (Extracts from the Request for Proposal Document issued by AAI)

The Project : Modernisation of Non-Metro Airports Initiated by : Airport Authority of India Scope of Work for the Indian Financial Consultant (IFC) Brief purpose of this assignment is to: (a) Assess the value of city side assets comprising of terminal buildings, associated infrastructure and existing other facilities on the city side of airports. (b) Evaluate the economic potential and financial viability of targeted airports for private joint venture participation in the development of city side of airports. (A Special Purpose vehicle (SPV) may be constituted with AAI, Joint Venture partner ( JVP), State Govt, Financial Institutions etc for operation and management of city side of each targeted airport). (c) Identify and help attract a list of ‘serious’ potential investors (both International and Indian) and (i) Evaluate the bids of the prospective investors (ii) Draft Lease/concession agreement (iii) Draft Joint Venture agreement (iv) Assist AAI in negotiating the transfer of the development sites at the selected airports to the successful bidders, and (v) Assist AAI in closing the transaction.

880

Investment Banking

The IFC shall identify the target airports jointly with Global Technical Advisor (GTA). The IFC will make use of inputs from GTA on the cost of construction on modification or expansion of terminal building or construction of new building with associated infrastructure including Cargo and other relevant inputs form time to time to work out the feasibility report in the financial viability of the airports for private joint venture participation. Due to any reason, if inputs from GTA or delay in mutually evolved joint action plan between IFC and GTA to meet the proposed time table for various activities as listed in Terms of reference (TOR— Annexure I) results in time and cost over runs, the AAI will not be liable to pay any cost compensation on this account and will have right to take further action as considered appropriate in this regard. Further, the IFC shall formulate appropriate/suitable Business and Financial plan for the targeted AAI’s Non-metro airports to be considered by AAI for inviting private sector participation. In all, the IFC shall develop strategy for inducing private investment for the development o f city side of such targeted airports. For the purpose, the scope of work of IFC will be in 03 phases: Phase I—Due Diligence and Valuation Phase II—Sale Memorandum and Marketing Plan and Phase III—Selection Process and Transfer of Assets. The proposed scope of the work should serve as the minimum requirement to fulfill the AAI’s objective. If additional areas are deemed necessary, these should be highlighted in the IFC’s technical proposal

(a) Phase I—Due Diligence and Valuation During this phase, the IFC will be required to undertake the necessary diagnostic preparations that would determine the airports financial, operational, commercial and services performed, indicative strategic and investment plans and assess the alternative structures undertake valuations of assets and liabilities and identify areas for inducting private sector participation. The IFC will be required to undertake the following tasks but not limited to: (I) Conduct a detailed Due Diligence, of the data supplied by AAI the feasibility studies, development proposals including the traffic forecasts as proposed by the GTA and based on the same prepare a business and Financial

Government Advisory

881

plan for the identified and viable non-metro airports. The detailed due diligence should cover the following areas: (i) Review all environmental policies and compliance standards (ii) Review of labour laws and contractual obligations with subcontractors (iii) Review all existing long term leases, concessions, commercial contracts (e.g.. Duty-fee, parking, retail shops, fuel etc.) and other related obligations as also existing policies with regards to all these contracts in force and suggest changes that may be required for transferring these to the prospective Joints Venture Company ( JVC) (while reviewing, the IFC would consider the covenants made by AAI to foreign Institutions to maintain the present legal entity without any material changes) (iv) Review Real estate holdings and ownership arrangements (v) Review Relationship and obligations of the airports with other Central and State government agencies (e.g.. Customer, Immigration, Police Security, Air Traffic Control etc) and suggest appropriate instructional interface between these agencies and the JVC (vi) Suggest the institutional interface between AAI’s new structure and the prospective JVC consequent to the private sector participation viable airports (vii) Suggest the institutional interface between transport agencies (e.g.. Tourism, Inter-Model transport etc.) (viii) Assess the economic potential and financial status of the AAI’s nonmetro airports (ix) Assess the value of AAI’s city side assets for consideration as AAI’s equity and formulate proposal to utilize excess assets not included in equity. In this regard the modifications suggested by GTA including the proposed construction of new facilities are also to be taken in account. (x) Work out modalities to make such airports /investments in such airports as viable economic units, which shall include necessary advise in the commercial exploitation of the selected airports (xi) Review and develop appropriate mechanisms for the smooth operational and financial management during the transition period. They

882

Investment Banking

should cover management of all capital expenditure programmes (on going and likely to be taken up) during the transition period. (xii) Consider all the implications on the employees of AAI likely to arise as a consequence of private sector participation and suggest appropriate steps/measures for the amicable resolution of the same: (xiii) Any other matter as may be required for conducting the due diligence exercise. II. Based on the above due diligence, identify viable Airports for Private Sector participation and specific areas of development at each of the identified Airports and prepare a long-term Business and Financial Plan for each of the specified Airports for activities related to Air Traffic, Passenger, Cargo and flight movements as also covering the areas for commercial exploitation of the available land III. any other work as may be considered necessary by AAI After completing the “Due diligence and Valuation” phase, the IFC shall submit a feasibility report incorporating the above items for the consideration and approval of AAI. The airports, which are viable and specific area of development Airport for private sector participation with all other relevant details, will be indicated.

(b) Phase II—sale Memorandum and Marketing plan After the completion of the Phase—I, the AAI will resolve key issues as identified or projected by the IFC in the Phase—I report and decide on the next phase. Subject to acceptance of report or clearance from AAI of phase—I, the IFC will undertake the 2nd Phase. In this phase the IFC will, jointly with the GTA, prepare all reports and documentation on the assets and liabilities to be transferred to potential JVC and formulate, jointly with the GTA, a marketing plan relating to the private sector participation through JVC of the city side of variable Airports. This would involve the following tasks: (i) Identify a potential list of targeted firms who have demonstrated prior experience in these sectors with regards to the specifications for the call of bids (ii) Prepare a marketing plan and other relevant information such as the “Project Information Memorandum” that will be used in the promotion of this process

Government Advisory

883

(iii) On behalf of AAI organize, jointly with the GTA “road shows” at various national/international strategic locations and other public relation efforts to promote business opportunity for investment in the Indian aviation infrastructure and airports services sectors (iv) Establish a “Data room” that will make available all the necessary documentation (e.g.. Corporate articles, financial, legal, regulatory, indicative investment requirements, commercial and sectoral, descriptions etc) required by the prospective investors to undertake their own due diligence in preparing their individual offers (v) Develop, jointly with the GTA, the pre-qualification criteria for selecting the successful bidding groups and prepare, jointly with the GTA, the Request for Expression of interest (RFEOI) documents (vi) Suggest any action (including policy modification) that in the judgment of the IFC would improve the success of private sector participation, (vii) Any other work as may be considered necessary by AAI After completing the Sale Memorandum and Marketing Plan phase, the IFC shall submit a report incorporating the above items for the consideration and approval of AAI. This feasibility report will, inter-alia, indicate viable commercial activities, investments, Financial structure, profitability and strategy for private sector participation for the city of each of the targeted Non Metro Airports.

(c) Phase III—Selection Process and Transfer of Assets On completion and acceptance of the second phase report, the AAI will decide on the third phase. During the third phase, the IFC will be required to assist the AAI in refining/modifying the investor profile and the terms and conditions of the transfer contract and finalizing the legal documents. This would involve the following tasks: (i) Provide advice on the financial, legal and commercial aspects to be taken into consideration in the specifications of the bid call to ensure transparency of the business and to improve the interest and participation of potential bidders: (ii) Establish benchmark and performance criteria for each of the potential Airports in order to measure the on-going performance and eventual success of private sector participation

884

Investment Banking

(iii) Develop a detailed action plan for setting up of a Joint venture company ( JVC) and draft the all the requisite documents for the successful Registration and incorporation of JVC’s. (iv) Assist in issue of advertisement for call of bids, prepare bidding documents, undertake security, processing and evaluation of bids (v) To finalize RFP documents after obtaining the requisite inputs from the GTA (vi) Jointly, with the GTA, evaluate the Technical and Cost Proposals received from the prospective Joint venture partners ( JVP’s) and recommend to AAI, the short-listing and final selection of JVPs, assist AAI in conducting of final negotiations and execution of the various agreements such as the joint Venture Agreements, Lease/concessions Agreements etc. (vii) Advise and assist in the eventual transfer of the specific areas of activity at each of the airports to JVCs (viii) Signing of the contracts, finalization of financial plan and financial closure will be the responsibility of IFC and (ix) Any other work as may be considered necessary by AAI The terms “participation”, “collaborate”, “assist”, “assess”, “coordinate”, “develop” and similar other words mean the active participation of the IFC. However, it should be noted that all decision-making would be the sole responsibility of the AAI.

Part IV Appendix 1 Capital Market Statistics Appendix 2 Abstracts of a Public Issue Prospectus Appendix 3 Abstracts of a Letter of Offer for Rights Issue Appendix 4 Abstracts of a Letter of Offer for Buy-back Under Tender Route Appendix 5 Abstracts of a Letter of Offer for Buy-back Under Open Market Purchase Route Appendix 6 Abstracts of a Scheme of Merger Appendix 7 Abstracts of a Scheme of Hive-off Appendix 8 Abstracts of a Letter of Offer Under an Open Offer Appendix 9 Fundamental Financial Concepts

Appendix 1 CAPITAL MARKET STATISTICS As percent of GDP at Current Market Prices 1998–99

1999–00

2000–01 (Provisional)

2001–02 (Estimates)

Gross Domestic Savings

21.5

24.1

23.4

24

Household savings

18.8

20.8

21.6

In Financial Assets

10.5

10.8

11

In Physical Assets

8.4

9.6

9.9

Private corporate saving

3.7

3.7

4.2

22.5 Not available Not available Not available

22.6

25.2

24

Gross Domestic Investment

23.7

Source: Economic Survey, GOI 2002–03, RBI Annual Report 2001–02. Excerpted from SEBI Annual Report 2002–2003.

Table APP 1.1 Savings and Investment trends in Indian economy

�

1998–99

1999–00

2000–01

2001–02 (Estimates)

2,07,390

2,39,058

2,56,734

2,91,405

26,773

35,275

32,229

40,451

1,80,617

2,03,783

2,24,505

2,50,954

Currency

21,822

20,845

17,686

28,192

Deposits

80,250

89,598

1,05,078

1,12,517

Government schemes

28,220

28,985

39,008

49,923

Shares, debentures and mutual fund schemes

6,992

17,045

6,135

6,946

Contractual savings (Life insurance, PF and pension schemes)

69,836

82,585

88,828

93,827

(Rs. Crore) Gross savings in Financial Assets Less Financial liabilities Net savings

Source: Economic Survey, GOI 2002–03, RBI Annual Report 2001–02, Excerpted from SEBI Annual Report 2002–2003.

�

Table APP 1.2 Savings in Financial Assets by the household sector

888

Investment Banking

1946

1961

1971

1975

7

7

8

8

1125

1203

1599

1506

2111

Issued Capital of Listed Companies in Rs. crore

270

Market capitalisation in Rs. crore on BSE (BSE+NSE for 2000 and 2002)

971

As on 31st December Recognised Stock Exchanges Companies Listed

Public Offers

1980

1985

1991

1995

2000

2002

9

14

20

22

23

23

1552

2265

4344

6229

8593

9871

9644

2838

3230

3697

6174

8967

11784

11784

11784

753

1812

2614

3973

9723

32041

59583

NC*

NC*

1292

2675

3273

6750

25302

110279

478121

1933268

1249085

Source: The Official Directory of the BSE, Official website of SEBI. *Not comipled

�

Table APP 1.3 Growth of Indian Capital Market

889

Appendix 1

(Rs.. Crore) Ahmedabad BSE Bangalore Bhubaneshwar Calcutta Cochin Coimbatore Delhi Gauhati

2001–02

2002–03

14,843.54

15,458.64

3,07,392.30

3,14,073.20

70.20

0.00

0.00

0.00

27,074.70

6,539.90

26.60

0.00

0.00

0.00

5,828.00

11.10

0.00

0.05

Hyderabad

41.20

4.60

ICSE

55.30

64.80

Jaipur Ludhiana Madras

0.00

0.00

856.60

0.00

24.10

0.00

Magadh

0.00

0.51

Mangalore

0.00

0.00

Madhya Pradesh NSE OTCEI Pune Saurashtra Kutch UP Vadodara Total

15.90

0.00

5,13,166.90

6,17,988.60

3.70

0.10

1,171.00

1.81

0.00

0.00

25,237.30

14,763.40

10.10

2.59

8,95,817.40

9,68,907.60

Source: Stock Exchange data as excerpted from SEBI Annual Report 2002–2003.

�

Table APP 1.4 Turnover on Indian Stock Echanges

890

Investment Banking

Type of institution

Number as on 31st March 2002

Stock Exchanges with equity segment

23

Stock Exchanges with debt segment

2

Stock Exchanges with derivative segment

2

Total Stock brokers (out of which corporate brokers)

9,687 (3,862)

Sub-brokers

12,208

Portfolio managers (in March 2003)

47 (54)

Custodians

12

Primary dealers

18

Debenture Trustees (in March 2003)

40 (35)

Source: NSE's Indian Securities Market Review 2002, SEBI Annual Report 2002–2003

Table APP 1.5 Capital Market Intermediaries/service providers

�

% of total Merrill Lynch

9.0

Goldman Sachs

7.5

Credit Suisse First Boston

7.2

Salomon Smith Barney ( Citigroup)

6.7

Morgan Stanley

6.3

J.P. Morgan

5.5

UBS Warburg

4.6

Lehman Brothers

3.6

Deutsche Bank

3.5

Bank of America

2.4

�

Table APP 2.1 Market shares of Global Investment Banks

891

Appendix 1

Citigroup (US)

CSFB (Swiss)

Deutsche (German)

J.P.Morgan (US)

UBSWarburg (Swiss)

Citibank

CSFB

Deutsche Bank

J.P.Morgan Chase

UBS Warburg

Donaldson, Lufkin & Jenrette

Morgan Grenfell

Chemical Bank (merged)

Dillon Read

Pershing

Alex Brown

Beacon Group

Paine Webber

Bankers Trust

Robert Fleming

Philips & Drew

Hambrecht & Quist

Swiss Bank (merged)

Salomon Smith Barney (Investment Bank) Schroders

�

Table APP 2.2 Universal Banks and their investment banking affiliates

Year

Resources raised by Resources raised by non-government mutual funds companies

1992–93

19,803

13,021

1993–94

19,330

11,243

1994–95

26,417

11,275

1995–96

16,075

–5,833

1996–97

10,410

–2,037

1997–98

3138

4,064

1998–99

5,013

3,611

1999–00

5,153

19,953

2000–01

4,949

11,135

2001–02

5,692

8,024

Source: Excerpted from the Indian Stock market Review 2002 published by the NSE, page 15.

�

Table APP 3.2 Primary Market fund mobilisation

892

Investment Banking

2001–02 (Rs. Crore)

Year

2002–03 (Rs. Crore)

Public Issues IPOs (6)

1031.82

1038.68

Secondary Offers (0)

0.00

0.00

Rights (8 in 2001–02 and 11 in 2002–03

193.61

418.18

Total (14 in 2001–02 and 17 in 2002–03

1225.43

1456.86

Source : SEBI Annual Report 2002–2003

Table APP 3.3 Primary Market Equity Issues

�

Issuer

Type

Year

Size of Offers Rs. crore

Issue pricing Rs. per share

Canara Bank

Public

Nov-02

385

35

Allahabad Bank

Public

Oct-02

100

10

Union Bank of India

Public

Aug-02

288

16

I-flex Solutions Ltd.

Offer for sale /Public

Jun-02

210

530

Bharti Tele-ventures Ltd.

Public

Jan -02

649

35

Andhra Bank

Public

Feb -01

150

10

Vijaya Bank

Public

Nov-00

100

10

Indian Overseas Bank

Public

Sept -00

111

10

PNB Gilts Ltd.

Public

Jul-00

105

30

Syndicate Bank

Public

Oct-99

125

10

ICICI Banking Corporation Ltd.

Public

Aug-97

144

35

Source : www.mutualfundsindia.com

�

Table APP 3.4 Large Equity Issues in recent years

893

Appendix 1

Issuer

Type

Year

Issue pricing Rs. per share

D-Link (India) Ltd.

Public

Mar-01

300

Adlabs Films Ltd.

Public

Dec-00

120

Balaji Telefilms Ltd.

Public

Oct-00

130

Public

Sept -00

155

Pritish Nandy Communications Ltd. Tips Industries Ltd.

Public

Oct-00

325

Padmalaya Telefilms Ltd.

Public

May-00

100

Mascot Systems Ltd.

Public

May-00

480

Ajanta Pharma Ltd.

Public

Mar-00

225

Cadila Healthcare Ltd.

Public

Feb -00

250

Feb -00

300

Jan -00

120

Geometric Software Solutions Co. Ltd.

Public Offer for sale/Public Offer for sale/Public

Jan -00

300

Television Eighteen India Ltd.

Public

Dec-99

180

Glenmark Pharmaceuticals Ltd.

Public

Dec-99

200

HCL Technologies Ltd.

Public

Nov-99

580

Hughes Software Systems Ltd. Vintage Cards and Creations Ltd.

Public

Oct-99

630

Public

Sept -99

225

Offer for Sale Public Offer for Sale/Public

Sept -99

750

Sept -99

120

Aug-99

210

Cinevista Communications Ltd. Shree Rama Multi-Tech Ltd.

Videsh Sanchar Nigam Ltd. Kale Consultants Ltd. Polaris Software Ltd. Source : www.mutualfundsindia.com

�

Table APP 3.5 High-priced Equity Issues in recent years

894

Investment Banking

Year

2000–01 (Rs. Crore)

2001–02 (Rs. Crore)

Government Securities

128483

152508

Private placements (mostly debt securities)

67836

64950

206879

226911

94.90%

95.83%

Total capital raised from the primary market Percentage of government securities and private placements to total capital mobilized

Source: Excerpted from the Indian Stock market Review 2002 published by the NSE

�

Table APP 4.4 Capital raised in Primary Market

Year 1995–96 1996–97 1997–98 1998–99 1999–2000 2000–01 2001–02

Equity (%) 72.39 55.99 41.17 15.34 58.41 52.79 16.88

Debt % 27.61 44.01 58.83 84.66 41.59 47.21 83.12

Source : SEBI. Excerpted from the Indian Stock market Review 2002 published by the NSE

� Table APP 4.5 Debt and Equity Capital raised in Public Issues

895

Appendix 1

�

Period

Issuer Company

May 92 Nov 92 July 93 Sept 93 Oct 93 Nov 93 Nov 93

Reliance Industries Grasim Industries Hindalco SPIC ITC Mahindra& Mahindra Bombay Dyeing

Dec 93 Jan 94 Jan 94 Jan 94 Jan 94 Feb 94 Feb 94 Feb 94 Feb 94 Feb 94 Feb 94 Feb 94 Mar 94 April 94

Gujarat Ambu a Cement Videocon ArvindMills Indo GulfFertilisers Indian Rayon Jain Irrigation G. E. Shipping United Phosphorus Wockhardt Tata Power Reliance Industries IndianAluminium Garden Silk CESC

GDR Issue Price US$ 16.35 12.98 16.10 11.15 15.30 7.44 9.20 11.90 8.10 9.78 4.51 22.51 11.12 15.94 41.00 28.69 710.00 24.10 10.15 26.28 53.34

Table APP 8.1 Select Euro Issues of GDRs/Eurobonds in early nineties Company

Listed On

Period

Dr. Reddy's Laboratories Ltd.

NYSE

Apr-01

HDFC Bank Ltd.

NYSE

Jul-01

ICICI Bank Ltd.

NYSE

Mar-00

Mahanagar Telephone Nigam Ltd.

NYSE

Sep -01

Satyam Computer Services Ltd.

NYSE

May-01

Silverline Technologies Ltd.

NYSE

Jun-00

Videsh Sanchar Nigam Ltd.

NYSE

Aug-00

Infosys Technologies Ltd.

NASDAQ

Mar-99

Satyam Infoway Ltd.

NASDAQ

Oct-99

Rediff.com India Ltd.

NASDAQ

Jun-00

�

Table APP 8.2 Public Offers of ADR/ADS by Indian Companies

896

Investment Banking

Company Aptech

Traded on PORTAL (NASDAQOTC MARKET)

Period Jul-00

Ashok Leyland

PORTAL

Mar-95

Bajaj Auto

PORTAL

Nov-94

BSES (GDR)

PORTAL

Mar-96

CromptonGreaves (GDR)

PORTAL

Jul-96

EID Parr

PORTAL

Jul-94

East India Hotels

PORTAL

Oct-94

Finolex Cables (GDR)

PORTAL

Jul-94

IPCL

PORTAL

Dec-94

Indian Hotels

PORTAL

May-95

JK Corp (GDR)

PORTAL

Oct-94

Larsen & Toubro

PORTAL

Nov-94

State Bank of India

PORTAL

Oct-96

Steel Authorit of India (GDR)

PORTAL

Mar-96

Tata Tea

PORTAL

Mar-00

Team Asia Semiconductors

PORTAL

Nov-01

�

Table APP 8.3 Select 144A Private Placements of GDRs/Eurobonds by Indian Companies

� Appendix 2

DRAFT RED HERRING PROSPECTUS Please read Section 60B of the Companies Act, 1956 Dated [·] (Will become Prospectus on the date of filing with the RoC) (Draft Red Herring Prospectus will be updated upon RoC filing) 100% Book Building Issue

Maruti Udyog Limited (Incorporated on February 24, 1981 under the Companies Act, 1956) Registered Office: 11th Floor, Jeevan Prakash Building, 25, Kasturba Gandhi Marg, New Delhi—110 001 Tel. no.: +91-11-2331-6831; Fax no.: +91-11-2371-3575/2331-8754; E-Mail: [email protected]; Website: www.marutiudyog.com Factory: Palam–Gurgaon Road, Gurgaon—122 015, Haryana Tel no.: +91-124-234-6721; Fax no.: +91-124-501-5701

OFFER FOR SALE OF 72,243,300 EQUITY SHARES OF RS. 5/- EACH AT A PRICE OF RS. • FOR CASH AGGREGATING RS. • MILLION (HEREINAFTER REFERRED TO AS THE “OFFER”). THE OFFER WOULD CONSTITUTE 25% OF THE FULLY DILUTED POST OFFER PAID-UP CAPITAL OF THE COMPANY. THE SIZE OF THE OFFER MAY BE ENHANCED TO THE EXTENT OF UPTO 10% OF THE OFFER I.E. BY UPTO 7,224,300 EQUITY SHARES OF RS. 5/- EACH IN CASE THE SELLING SHAREHOLDER DECIDES TO RETAIN ANY OVERSUBSCRIPTION. IN SUCH A CASE, THE SIZE OF THE OFFER MAY INCREASE UPTO 79,467,600 EQUITY SHARES OF RS. 5/- EACH FLOOR PRICE RS. _____ PER EQUITY SHARE OF FACE VALUE RS. 5/The Offer is being made through the 100% Book Building Process wherein a maximum of 60% of the Offer shall be offered on a discretionary basis to Qualified Institutional Buyers. Further, not less than 15% of the Offer shall be available for allocation on a proportionate basis to Wholesale Bidders and not less than 25% of the Offer shall be available for allocation

898

Investment Banking

on a proportionate basis to Retail Bidders, subject to valid bids being received at or above the Offer Price. RISK IN RELATION TO FIRST OFFER This being the first Offer of equity shares of Maruti Udyog Limited (our “Company”), there has been no formal market for the equity shares of the Company. The Offer Price (as determined by the Selling Shareholders in consultation with our Company, the Book Running Lead Manager and Co-Book Running Lead Managers, on the basis of assessment of market demand for the equity shares by way of book building) should not be taken to be indicative of the market price of the equity shares after the equity shares are listed. No assurance can be given regarding an active and/or sustained trading in the equity shares of the Company nor regarding the price at which the equity shares will be traded after listing. GENERAL RISKS Investments in equity and equity-related securities involve a degree of risk and investors should not invest any funds in this Offer unless they can afford to take the risk of losing their investment. Investors are advised to read the risk factors carefully before taking an investment decision in this offering. For taking an investment decision, investors must rely on their own examination of the Company and the Offer including the risks involved. The equity shares offered in the Offer have not been recommended or approved by the Securities and Exchange Board of India (SEBI), nor does SEBI guarantee the accuracy or adequacy of this Draft Red Herring Prospectus. Specific attention of the investors is invited to the summarized and detailed statements in Risk Factors beginning on page no. i. COMPANY’S ABSOLUTE RESPONSIBILITY Maruti Udyog Limited, having made all reasonable inquiries, accepts responsibility for and confirms that this Draft Red Herring Prospectus contains all information with regard to Maruti Udyog Limited and the Offer, which is material in the context of the Offer, that the information contained in this Draft Red Herring Prospectus is true and correct in all material aspects and is not misleading in any material respect, that the opinions and intentions expressed herein are honestly held and that there are no other facts, the omission of which makes this Draft Red Herring Prospectus as a whole or any of such information or the expression of any such opinions or intentions misleading in any material respect. LISTING The equity shares offered through this Draft Red Herring Prospectus are proposed to be listed on the Delhi Stock Exchange Association Ltd. (the Regional Stock Exchange), the National Stock Exchange of India Limited and The Stock Exchange, Mumbai. We have received in-principle approval from these Stock Exchanges for the listing of our equity shares pursuant to letters dated _________, _________ and ___________respectively.

899

Appendix 2

BOOK RUNNING LEAD MANAGER

Kotak Mahindra Capital Company Ltd. 3rd Floor,Bakhtawar 229, NarimanPoint Mumbai–400021 Tel no.: 91-22-5634 1100:Fax no.: 91-22-2284 0492 Email: .

REGISTRAR TO THE OFFER

MCS Limited Sri Venkatesh Bhavan 212-A, Shahpurjat New Delhi –110 049 Tel no.: 91-11-2649 4830; Email: [email protected]

CO-BOOK RUNNING LEAD MANAGER

ICICI Securities Ltd. 41/ 44,MinooDesaiMarg, Colaba Mumbai–400005 Tel no.: 91-22-2288 2460 Fax no.: 91-22-2283 7045 Email:[email protected]

CO-BOOK RUNNING LEAD MANAGER

JM Morgan Stanley Pvt. Ltd. 141, Maker Chambers III 229, NarimanPoint Mumbai–400021 Tel no.: 91-22-5630 3030 Fax no.: 91-22-2202 8227 Email:marutiipo@jmmor ganstanley.com

CO-BOOK RUNNING LEAD MANAGER

HSBC Securities and Capital Markets (India) Pvt. Ltd. 52/ 60, Mahatma Gandhi Road, Fort, Mumbai – 400001 Tel no.: 91-22-2267 4921 Fax no.: 91-22-2263 1984 Email:[email protected]

OFFER PROGRAM BID/OFFER OPENS ON

BID/OFFER CLOSES ON

Forward-Looking Statements This draft red herring prospectus contains certain “forward-looking statements”. These forward looking statements generally can be identified by words or phrases such as we “believe”, “expect”, “estimate”, “anticipate”, “intend”, “plan” or other words or phrases of similar import. Similarly, statements that describe our objectives, plans or goals also are forward-looking statements. All forward looking statements are subject to risks, uncertainties and assumptions about us that could cause actual results to differ materially from those contemplated by the relevant forwardlooking statement. Important factors that could cause actual results to differ materially from our expectations include, among others: � �

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General economic and business conditions in India; Our ability to successfully implement our strategy, our growth and expansion plans and technological changes; Changes in the value of the Indian rupee and other currency changes; Changes in the Indian and international interest rates; Changes in laws and regulations that apply to the Indian automobile industry; Increasing competition in and the conditions of the Indian automobile industry; Changes in political conditions in India; Changes in the foreign exchange control regulations in India.

900

Investment Banking

For further discussion of factors that could cause our actual results to differ, see “Risk Factors” beginning on page (i) of this Draft Red Herring Prospectus. By their nature, certain market risk disclosures are only estimates and could be materially different from what actually occurs in the future. As a result, actual future gains or losses could materially differ from those that have been estimated. Neither our Company nor the members of the Syndicate, nor any of their respective affiliates have any obligation to update or otherwise revise any statements reflecting circumstances arising after the date hereof or to reflect the occurrence of underlying events, even if the underlying assumptions do not come to fruition. In accordance with SEBI requirements, our Company, the BRLM and the Co-BRLMs will ensure that investors in India are informed of material developments until such time as the grant of listing and trading permission by the Stock Exchanges. RISK FACTORS An investment in equity shares involves a high degree of risk. You should carefully consider all of the information in this Draft Red Herring Prospectus, including the risks and uncertainties described below, before making an investment in our equity shares. If any of the following risks actually occur, our business, financial condition and results of operations could suffer, the trading price of our equity shares could decline, and you may lose all or part of your investment. Unless stated otherwise, the financial data in this section are derived from ou unconsolidated financial statements prepared in accordance with Indian GAAP, included elsewhere in this Draft Red Herring Prospectus. Unless otherwise indicated, all financial and statistical data relating to the automobile industry in the following discussion are derived from the CRIS INFAC Annual Review of 2001 or 2002. These data have been reclassified in certain respects for purposes of presentation. The sales volumes for Maruti included in the following discussion refer to sales by Maruti to dealers, while computations of Maruti’s market share are based on sales to the customer set forth in the CRIS INFAC Annual Review of 2001 or 2002. For more information, see “Certain Conventions; Use of Market Data” of this Draft Red Herring Prospectus.

Internal Risk Factors We operate in a highly competitive environment and competitive pressure on our business is likely to continue. Since the delicensing of the passenger car industry by the GoI in 1993, a number of international and domestic automobile manufacturers have begun manufacturing passenger cars in India and have entered the Indian passenger car market. As a result, the Indian passenger car market has become highly competitive. In a growing market, our overall market share in terms of number of passenger cars sold in the Indian market had declined from 83.1% in fiscal 1998 to 57.6% in fiscal 2001 and increased in fiscal 2002 to 58.6%. We are primarily focused on the A and B segments (priced below Rs. 500,000) which are particularly price-sensitive and together constituted more than 86% of sales volumes in the Indian passenger car market in fiscal 2002. Our market share for passenger cars in the B segment (priced between Rs. 300,000 and Rs. 500,000), declined to 36.9% in fiscal 2001 from 67.3% in fiscal 1998. In fiscal 2002, our market share in the

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B segment was 40.3%. Our sales volumes in the combined A and B segments comprised 95.4% of our domestic sales volumes in fiscal 2002. We are currently the only manufacturer that sells passenger cars in the A segment. In segment B, we compete primarily with three other manufacturers. In the future, we may also face competition from other domestic and international manufacturers that enter the A and B segments, including international manufacturers that have been successful in foreign markets for cars of a similar size but are yet to enter these segments in India. Some of the international manufacturers that have entered the Indian market in recent years have significantly greater financial resources than us, which may enhance their ability to compete with us. The C segment (priced between Rs. 500,000 and Rs. 1,000,000), which comprised 4.2% of our domestic sales volumes in fiscal 2002, is significantly more fragmented than the A and B segments and we face competition from several manufacturers in this segment. We exported passenger cars comprising 3.9%, 3.1%, 2.6% and 6.9%, of our total sales in fiscal 2000, 2001, 2002, and the nine months ended December 31, 2002, respectively, to many countries including countries in Western Europe. We expect to continue to face competition in the export markets, which may reduce demand for our products in those markets. Since most of our cars run on petrol, we also compete with manufacturers of cars with diesel engines. We may also face competition from public transportation systems in India as they improve. We compete primarily based on price, product performance, brand image, new model launches, distribution network and the availability of value-added after sales services and after sales support. If we are unable to compete effectively based on these factors, competition may reduce our market share in individual segments of the passenger car market as well as our overall market share in the future. We expect competitive pressure on our business to continue. Our net profits have fluctuated during the last three fiscal years, including a net loss in fiscal 2001. While we achieved profitable operations in fiscal 2002, we may face a decline in our profits or a reduction in sales volumes in the future due to intense competition. We are substantially dependent on the Maruti 800, which comprised 42.5% of our domestic sales volumes in fiscal 2002. At present, we are the only manufacturer in India to produce passenger cars in the A segment (priced below Rs. 300,000), which contributed approximately 60% of our domestic sales volumes in fiscal 2002. A substantial portion of our sales volumes is derived from the sales of the Maruti 800 model, which is an A segment car. In fiscal 2002, Maruti 800 accounted for 42.5% of our domestic sales volumes. We anticipate that the Maruti 800 will continue to dominate the small car segment and account for a substantial portion of our sales. Consequently, our future success will, to a large extent, depend on continued demand for and market acceptance of the Maruti 800, our ability to enhance and develop the Maruti 800 to meet the evolving needs of the customers, and our ability, following the end of the product life cycle of the Maruti 800, to find another model that will generate similar sales volumes in a similar price range. A change in

902

Investment Banking

consumer preferences, technological change or other factors could reduce demand for the Maruti 800, which could lead to a material adverse affect on our business and results of operations. In addition, a competitor could start manufacturing cars in the A segment to compete with the Maruti 800. We could face competition from imports of new or pre-owned cars of various categories, and from cars manufactured or assembled in India using imported components. In April 2001, all quantitative restrictions on the import of automobiles into India were removed. The GoI has, since March 2002, allowed automatic approvals for foreign equity ownership of up to 100% in entities manufacturing automobiles and components in India. There remain relatively high tariffs on imports of automobiles and components and other restrictions such as quantity restrictions. We expect that tariffs on the import of components, CKDs or CBUs will be reduced in the near future in order to comply with India’s obligations under the World Trade Organisation agreement. If tariffs on the import of new or pre-owned cars or components are reduced, or other restrictions on such imports are removed, we could face increased competition from automobile manufacturers that import new or pre-owned passenger cars to India or manufacture passenger cars in India using imported components. Our ability to reduce our cost of production and thereby increase our operational efficiency is an essential part of our business strategy and we cannot assure you that our cost reduction measures will continue to achieve the operational efficiencies they have done in the past. Reducing our cost of production is essential to our business strategy in a highly competitive market environment. We have significantly reduced costs through a combination of measures such as increasing the use of locally manufactured components for our products, reducing the cost of manufacturing and increasing productivity. In the past, these measures have allowed us greater flexibility in reducing the prices of our products in an increasingly competitive market environment. Our measures to increase our operational efficiency may not yield similar results in the future, which may adversely affect our sales volumes or profit margins. Suzuki has the ability to exercise significant control over us and its interests may conflict with your interests as a shareholder. Suzuki owns 54.2% of our outstanding equity shares and is our controlling shareholder. As a result, Suzuki has the ability to exercise significant control over most matters requiring approval by shareholders, including the election and removal of directors and other significant corporate transactions. In addition, Suzuki could, by exercising its powers of control, delay or defer a change in control of our Company or a change in our Company’s capital structure, delay or defer a merger, consolidation, takeover or other business combinations involving our Company, or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of our Company. Following Suzuki’s acquisition of a controlling interest in us, the success of our business also depends on our continued ability to integrate Suzuki personnel into our management structure.

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903

Suzuki is a major manufacturer and exporter of passenger cars and motorcycles. Approximately 20% of Suzuki’s outstanding equity shares are owned by General Motors of Canada Ltd., which is part of the General Motors group. The General Motors group also has an Indian venture competing with us in segment C of the automobile industry. We have entered into several non-exclusive agreements with Suzuki and its affiliates for the supply of technical know-how, assistance and information related to our products and after-sales service, and for the supply of raw materials, components, and other inputs. These agreements place restrictions on our ability to export and to manufacture and sell products that compete with the products covered by the agreements. Suzuki’s global interests and our interests as a company may not always be aligned in the future. Suzuki has the ability to change our business strategy. In addition, if there is a change of control of Suzuki, Suzuki’s relationship with us and our business strategy may change in the future. For details of the terms governing our relationship with Suzuki and restrictions imposed on us by our agreements with Suzuki and details of the nature of our transactions with its affiliates, please see “Related Party Transactions” of this Draft Red Herring Prospectus and “Our Promoter” of this Draft Red Herring Prospectus. We are substantially dependent on Suzuki. Suzuki, which became our controlling shareholder in 2002, has several license agreements with us under which it has, since our inception: �

provided us with technical know-how, assistance and information for the manufacture, sale and after-sales service of our products and parts;

�

supplied components for our passenger cars; deputed technical personnel; helped us develop manufacturing processes and integrate certain Japanese management practices such as kaizen, which is Japanese for continuous improvement, in our plants; trained our personnel; and

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helped us develop and manage the supply chain for our products.

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Suzuki has agreed to no longer charge royalty for the Maruti 800, Omni, Gypsy, Esteem and Zen models, which arrangement is subject to revision in the event of the introduction of new technology or upgradation in specifications due to changes in market conditions or requirements of new laws or norms. In addition, Suzuki will provide a 10% discount on knocked down components imported by us, except those imported for the Alto model built for exports, for the period April 2003 to March 2005. Suzuki is entitled to terminate any of its existing licence agreements with us by giving notice six months before the end of the original term and each renewal period. In addition, we have commercial relationships with some of Suzuki’s affiliates relating to the supply of materials, services, spares and accessories, vendor assistance, including guarantees and co-lease arrangements, and the purchase of dies and moulds and capital

904

Investment Banking

equipment. If Suzuki terminates any license agreement or any of its affiliates terminate their agreements with us, we may be unable to obtain necessary inputs, information or services for our business from alternative sources or at a reasonable cost. Since we are substantially dependent on Suzuki and Suzuki’s technical personnel, if a material adverse change occurs in Suzuki’s business, or if Suzuki ceases to provide technical know-how and assistance, components, training and other aid, our business may be adversely affected. We are dependent on a limited number of vendors for the supply of critical components, consumables and raw materials used in the manufacture of our products. We depend on external suppliers, whom we refer to as vendors, for the supply of raw materials, components and spare parts for our products. As of March 31, 2003, we had an aggregate of 299 vendors of components in India. We had strategic equity interests through joint venture agreements in 13 of these vendors. We collaborate closely with many of our vendors in order to secure a reliable supply of components that meet our requirements and to generate economies of scale. As a result of this approach, for several inputs in our manufacturing process such as glass, seats and axles, we rely on a sole vendor or only a limited number of vendors. The failure by a vendor to adhere to our technical specifications, quality requirements and production and delivery schedules could disrupt our manufacturing process. If a vendor fails to meet quality standards, it could be exposed to warranty and other product liability costs, and expose us to the risk of product liability claims. In addition, a vendor on whom we are dependent may raise its prices or a dispute may arise between us and the vendor. If we are dependent on a sole vendor or a limited number of vendors for a critical input, we may find it difficult to replace a vendor on a timely basis and at reasonable cost, and our business and results of operations may be adversely affected. For example, labour unrest in February 2003 at one of our vendor’s facilities disrupted the supply of engine cylinder blocks to us, which had an adverse impact on our production volumes in March 2003. Further, the unauthorised market for our spares and accessories will become stronger should vendors decide to supply such spares and accessories directly to the market. Disputes between our major shareholders may have an adverse impact on our business. After this offering, Suzuki and the GoI will hold 54.2% and approximately 20.8%, respectively, of our outstanding equity shares. Subject to certain restrictions in the RJVA between Suzuki and the GoI, Suzuki has the right to nominate a majority of the directors on our Board and the right to nominate our chairman and our managing director. However, after this offering, the GoI will retain certain rights under the RJVA, including the right to nominate one of our directors so long as it owns in excess of 10% of our outstanding equity shares. In addition, until the earlier of December 31, 2003 or the termination of the RJVA, we are not permitted to sell, transfer, lease or dispose our fixed assets in excess of 10% in any fiscal year, other than in the ordinary course of business, increase our paid up capital, commence winding up proceedings or enter into any arrangements with creditors, without the affirmative vote of the director nominated by the GoI. The RJVA will terminate if the GoI ceases to own more than 10% of our outstanding equity shares. In the past, our shareholders had disputes relating to the management of our Company

Appendix 2

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that resulted in delays in the investment decisions, upgradation and launch of new models of cars, and this adversely affected our business and results of operations. If a dispute arises between Suzuki and the GoI with respect to their respective rights under the RJVA or otherwise in connection with us, or a dispute arises among any other major shareholders in the future in connection with us, our business could be adversely affected. We are subject to risks of assuming product warranty, recall and product liability costs due to defects in our products or related after-sales services, which could generate adverse publicity and adversely affect our business, results of operations and financial condition. Defects, if any, in our products could require us to publicly undertake service actions or recall campaigns. Such actions could require us to expend considerable resources in correcting these problems and could adversely affect demand for our products. Defects in our products that arise from defective components or spare parts supplied by our vendors may be covered under warranties provided by our vendors. We are not covered by insurance for product warranty claims for cars sold in India. Our product warranty insurance only covers claims that are asserted during the third and fourth year in the life of a car and are covered by extended warranties purchased by customers. An unusual number or amount of warranty claims against a vendor could affect us adversely because we depend on a limited number of vendors for the supply of raw materials and components. Repeated warranty claims may result in a rise in our insurance premium. In addition, such claims could have an impact on our consolidated results of operations and financial condition as some of our vendors are our affiliates and for some of our vendors we are guarantors on outstanding loans or lease payment obligations. Further, any defect in our products or after-sales services provided by authorized dealers or third parties could also result in customer claims for damages. In defending such a claim, we could incur substantial costs and receive adverse publicity. Management resources could be diverted away from our business towards defending such claim. As a result, our business, results of operations and financial condition could suffer. We cannot assure you that the limitations of liability set forth in our contracts with vendors will be enforceable in all instances or will otherwise protect us from liability for damages. Further, we are not fully insured against all potential hazards incidental to our business. For example, our insurance does not cover replacement cost of plant and machinery, product liability costs for cars sold in India and losses related to recall of cars for design defects or replacement of components or spare parts. Potential delays in the launch of new models in the market and lower-than-anticipated market acceptance of new or existing models can cause us to lose market share and adversely affect our results of operations. In a highly competitive environment where the passenger car industry has excess capacity, competitors can gain a significant advantage by bringing a new model to market in a particular segment before we do. For example, a delay in the launch of one of our models has, in the past allowed a competitor’s model to precede it in the market and develop a competitive advantage.

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Investment Banking

In addition, the launch of a new model usually requires substantial capital investment and costs of production of new models are higher since, at least initially, new models have high import content. The capital investments in plant and machinery associated with the launch of a new model may result in higher levels of depreciation. Our loss in fiscal 2001 was partially attributable to these factors. Similar investments by us in the future may have an adverse impact on our profitability. Therefore, if market acceptance of any of our new models is lower than anticipated, we may be unable to gain the intended economic benefits of our investments and higher cost of production, and our results of operations may be adversely affected. We had negative cash flows in fiscal 2001 and issued an aggregate amount of Rs. 3,000 million secured non-convertible redeemable debentures to help fund our capital expenditure requirements. As of December 31, 2002, we had cash and bank balances and current investments amounting to Rs. 9,992 million. If we are unable to fund our working capital or capital expenditure required for the launch of new models and other purposes using cash from our operations, we may need to incur indebtedness. In addition, our major capital projects may not be completed, completed in the timeframe or at the cost levels originally anticipated. Our employees are represented by a trade union and any labour unrest at our manufacturing facility or our vendors’ facilities could adversely affect our operations and profitability. On March 31, 2003, we had 4,590 employees, of which 2,999 are represented by a trade union. Our manufacturing operations were affected by a strike from October 12, 2000 to January 8, 2001 arising from a dispute between the management and the union regarding the specifics of a new incentive scheme proposed by the management. The strike was resolved with the signing of a good conduct agreement between the workers and the management. While our production volumes were not significantly affected during the strike, future labour unrest at our facility or at the facilities of our vendors could adversely affect our manufacturing operations and our operating results. We are involved in negotiations with the union for the renewal of a wage settlement agreement, which expired in March 2000, the terms of which may adversely affect our results of operations and financial condition. At March 31, 2003, 2,999 of our employees were represented by the Maruti Udyog Kamgar Union, or the MUKU. We are involved in negotiations with the MUKU for the renewal of a wage settlement agreement, which expired in March 2000. In the previous wage settlement agreement, entered into in February 1998, we had agreed to provide retrospective wages from April 1996 until the date of the agreement for certain categories of employees, and other benefits such as transport subsidies and increases in the amounts of permissible advances. We had also agreed to set up a pension scheme with more favourable terms for employees than the statutorily required employee provident fund. Breakdowns in our information technology based communication systems may disrupt our operations. We rely on an information technology based communications infrastructure which links our offices, vendors, dealers and Suzuki, and is essential to the management of our supply chain,

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inventory, manufacturing and new businesses. It also forms an integral part of our internal communications and management information systems. In the case of a breakdown, the ordering and follow-up system with vendors and dealers will be affected, which could lead to production stoppages, significant increases in levels of inventory and lead times. It may also disrupt our internal decision-making process by causing loss of data and making it difficult for members of our management team to communicate with each other in a timely manner. We have launched several new businesses and we cannot assure you that we will remain successful in these businesses or that they will yield the intended economic benefit. To complement our core business of manufacture and sale of passenger cars, we have recently entered into alliances with third parties for the sale of pre-owned Maruti passenger cars, providing financing for purchases of our products, providing automobile insurance for our products, and providing leasing and fleet management services in relation to our products, in each case using the “Maruti” brand name. These businesses form an integral part of our business strategy to offer a “one-stop shop” for the needs of the Indian consumer in order to foster brand loyalty and benefit from our extensive dealership network for distribution of the services. We have launched these businesses during and after fiscal 2002, and they are in their early stages. Some of the business models we are using are relatively new to the Indian passenger car industry and we cannot assure you that these business models will gain widespread acceptance. Governmental regulation may also have an adverse impact on the economic viability of these business models. We have limited experience in these businesses and are substantially dependent on our alliance partners in the case of each of our new businesses. We cannot assure you that we will succeed in developing the management skills required to be successful in these businesses. In addition, since our brand is associated with these businesses, their failure may weaken our brand. Although we have limited our liability towards our alliance partners and their customers, we anticipate that customers will require us to fulfil expectations related to the services provided by our alliance partners since our brand is associated with these businesses. On January 14, 2002, we incorporated three wholly owned subsidiaries and made capital investments of Rs. 0.5 million in each of these companies: True Value Solutions Limited, or TVSL, to facilitate the business of selling pre-owned Maruti passenger cars through our dealership network, and Maruti Insurance Distribution Services Limited, or MIDSL, and Maruti Insurance Brokers Limited, or MIBL, as insurance intermediaries to facilitate the distribution of automobile insurance in alliance with certain insurance companies. In the nine months ended December 31, 2002, TVSL, MIDSL and MIBL generated a profit after tax of Rs. 596,000, Rs. 184,000 and Rs. 1,597,000, respectively. We conduct our automobile finance business in alliance with finance companies, and our leasing and fleet management business in alliance with providers of automobile financing and insurance, dealers and car rental agencies. These investments may not yield the intended economic benefits. We have several group companies, some of which have yielded low returns on investment. Some of these group companies are also loss making, which may adversely affect our result of operations.

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Investment Banking

We have equity stakes in 19 group companies. Some of these have yielded low returns on investment or incurred losses in the last three years, as set out in the table below: Profit/(Loss) in Rs. million for financial year ended March 31: Joi nt V enture N ame

MUL S harehol ding

2002

2001

2000

J. J. Impex (Delhi) Pvt Limited

49.0%

5.05

1.76

(1.82)

Mark Auto Industries Limited

33.9%

3.02

(25.11)

6.90

Maruti Countrywide Auto Financial Services Limited

26.0%

(44.67)

(4.73)

24.52

These investments may continue to adversely affect our consolidated results of operations and financial condition. Our strategic investments in, and capital commitments for the benefit of, vendors may adversely affect our consolidated results of operations and financial condition. Close collaboration with vendors is an important part of our business strategy. We have made strategic equity investments in 13 vendors that supply critical raw materials and components for the manufacture of our products, some of which have yielded low or negative returns on investment or have been generating losses in the course of the last three fiscal years. In the case of some of our vendors, we have made capital commitments as their guarantors for their obligations under leases or loan agreements. The future performance of these vendors may therefore adversely affect our results of operations and financial condition. For more information on the recent financial performance of vendors in whom we have strategic investments, see “Our Group Companies—Our Joint Ventures” of this Draft Red Herring Prospectus. Our contingent liabilities as per Indian Accounting Standards are as follows: As of December 31, 2002, our contingent liabilities not accounted for were as follows: �

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Claims against us not acknowledged as debts in the aggregate amount of Rs. 12,692 million due to sales tax, excise, customs, income tax and disputed claims us. Guarantees given by us to HDFC in the aggregate amount of Rs. 350 million against a term loan of Rs. 350 million given by HDFC Limited to Maruti Employees Co-operative House Building Society Limited, Bhondsi. The aggregate amount outstanding under the loan as of December 31, 2002 was Rs. 190 million. Guarantees given to finance companies in the aggregate amount of Rs. 497 million for term loans and lease finance provided to various vendors for the purchase of dies and moulds of certain models. Leasing commitments in the aggregate amount of Rs. 2,645 million as co-lessee under certain agreements between various vendors, as lessees, and finance companies or banks, as lessors, for the leasing of dies and moulds for certain models.

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To the extent that any of these contingent liabilities become actual liabilities, they will adversely affect our results of operations and financial condition in the future. We are dependent on our dealership network for the sales and distribution of our products. We believe that our extensive network of 178 authorised dealers as of March 31, 2003 is one of our most important competitive advantages in the passenger car industry. We maintain close contact with our dealers and monitor their performance, but we do not have control over them. Since the dealers have direct contact with the retail customers at the time they purchase the product and during after-sales services and support, their conduct has a significant impact on the consumer’s perception of our products and our brand. We are therefore subject to the risk that dealers fail to adhere to the quality standards we set for them in respect of providing sales and after-sales service and support, and thereby negatively affect market perception of our products. In addition, in the recent past, intense competition among our dealers or with dealers of competitors’ products and other factors beyond our control have negatively affected the financial condition of some of our dealers. If this happens on a large scale, a significant portion of our dealers’ businesses would be affected and therefore they may be unable to provide after-sales service and support to customers. Further, our dealers could engage in other businesses that could hinder them from providing quality services. Finally, we bear the risk of dealer default to customers and consequent customer recourse to Maruti. Although we are not contractually liable to the customer in these instances, we have to expend considerable resources defending such claims and ensuring that defaulting dealerships are terminated. In addition, sales and distribution of our vehicles may be affected if we are unable to deliver them to dealers in a timely manner due to disruptions in railway or road transportation networks due to weather related events, labour strikes or otherwise. For example, in April 2003, a nation-wide strike by truck drivers in India adversely affected our distribution channels. All these factors could erode one of our major competitive advantages and could adversely affect our business and results of operations. We are dependent on our key management personnel and our ability to attract and retain talented professionals. We rely on the expertise and services of key members of our senior management such as our Managing Director and our Marketing Director. If we lose any of these key personnel, we may find it difficult to find replacements with similar knowledge and experience, especially in relation to our business and our Company, and integrate them into our organization. As a result, our business, results of operations and financial condition could be adversely affected. In addition, we compete with other companies in and outside our industry to recruit and retain highly skilled professionals trained in automobile engineering, product development and marketing. If we are unable to attract highly skilled professionals, fail to integrate them into our organization, or fail to retain them after we have invested resources in their training, our ability to compete and our results of operations may be adversely affected. In addition, we do not have any non-competition agreements with any of our senior management or other members of our management team.

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Investment Banking

We are yet to receive certain statutory approvals required in the ordinary course of business. We are yet to receive the following renewals and approval: �

�

The Haryana State Pollution Control Board (HSPCB) consent relating to the discharge of effluents by us, was valid till March 31, 2003. We filed an application for the extension of this consent for FY2004 and FY2005 on December 20, 2002. The HSPCB consent setting permissible emission levels was valid till March 31, 2003. We filed an application for the extension of this consent for FY2004 and FY2005 on December 20, 2002.

Failure to obtain these renewals, which have been regularly obtained in the past, would adversely affect our business. In addition, we have not received building completion certificates and approvals under the Punjab Schedule and Controlled Areas (Restriction of Unregulated Developments) Act, 1963 for any of our buildings in our manufacturing facility. We have applied for the approval of the building plans and submitted the required plans, drawings and other relevant documents. We are defendants in a number of legal proceedings that if determined against us, could have a material adverse impact on our results of operations and financial condition. We are defendants in a number of legal proceedings incidental to our business and operations. We were also subject to claims against us arising from excise, sales tax, customs, income tax, consumer disputes and other disputed demands for an aggregate amount of Rs. 12,692 million as of December 31, 2002. We are currently disputing claims made against us by the excise department, including one claim of Rs. 2,003.58 million pending before the Commissioner of Excise arising from the MODVAT credit on capital goods. Also, there are a number of civil and criminal cases filed against us and our directors. Based on legal advice, we believe that we have strong defenses to these claims and have not, therefore, established any reserves in our financial statements for the amounts of potential liability. Should any new developments arise, such as a change in Indian law or a ruling against us by appellate courts or tribunals, we may need to establish reserves in our financial statements, which could increase our expenses and our current liabilities. Furthermore, if a claim is determined against us and we are required to pay all or a portion of the disputed amount, it could have a material adverse affect on our results of operations. All of the above legal proceedings are pending at different levels of adjudication before various courts, tribunals, enquiry officers, and appellate tribunals. For more information regarding

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litigation, see “Outstanding Litigation and Material Developments” of this Draft Red Herring Prospectus. Any future equity offerings by us or our existing shareholders, or the issue of options under an employee stock option plan, may lead to dilution of your shareholding in us or affect the market price of our equity shares. As a purchaser of equity shares in this offering, you may experience dilution to your shareholding to the extent that we make future equity offerings or issue stock options under any employee stock option plan. In addition, under the RJVA, the GoI has an option to offer its remaining stake of 2,968,009 equity shares of Rs. 100 each that is 59,360,180 equity shares of Rs. 5 each, representing 20.8% of the equity share capital of Maruti, either by way of additional offers to the public or by exercising an option to put the equity shares to Suzuki. For additional details on the rights of the GoI under the RJVA, see “Our Promoter” of this Draft Red Herring Prospectus.

External Risk Factors Our performance is linked to the performance of the Indian economy and the passenger car industry in India. Demand for passenger cars can be adversely affected by factors such as an increase in fuel prices, macro-economic performance, and competition from alternative modes of transport. In fiscal 2001 and fiscal 2002, demand for passenger cars in India has been depressed, the industry has experienced excess capacity, and competition has intensified as a result. We are dependent on the Indian passenger car market as exports contributed only 3.9%, 3.1%, 2.6% and 6.9%, of our total sales in fiscal 2000, 2001, 2002, and the nine months ended December 31, 2002, respectively. We have therefore been subject to increasing competitive pricing pressure. Excess capacity in the industry is likely to further intensify competitive pricing pressure in the event of continued economic downturn, which may have a material adverse impact on our results of operations. Should consumer demand soften or interest rates increase, our profitability may be affected. In addition, these conditions may have an adverse impact on the performance of the financial markets in India and may cause the market price of our equity shares on the Indian stock exchanges to decline in the future. After this offering, the price of our equity shares may be highly volatile, or an active trading market for our equity shares may not develop. The prices of our equity shares on the Indian stock exchanges may fluctuate after this offering as a result of several factors, including: � � �

volatility in the Indian and global securities market; our results of operations and performance, in terms of market share; performance of our competitors, the Indian passenger car industry and the perception in the market about investments in the automobile sector;

912 �

� �

�

Investment Banking media reports about the GoI’s process of selling its stake in us and other companies in which the GoI has an equity participation; changes in the estimates of our performance or recommendations by financial analysts; significant developments in India’s economic liberalization and deregulation policies; and significant developments in India’s fiscal and environmental regulations.

There has been no public market for our equity shares and the prices of our equity shares may fluctuate after this offering. There can be no assurance that an active trading market for our equity shares will develop or be sustained after this offering or that the prices at which our equity shares are initially traded will correspond to the prices at which our equity shares will trade in the market subsequent to this offering. Increases in the cost of raw materials and automobile components may have a material adverse impact on our results of operations. In fiscal 2002, consumption of raw materials and components formed 73% of our total expenditure net of excise duty. We enter into contracts with suppliers of these inputs in order to fix our input costs over a defined period. We also have joint venture agreements with 13 vendors that supply these inputs. If costs of raw materials and components rise, our results of operations will be adversely affected. If the supply of power or the fuel needed to generate power is interrupted, it could disrupt our production process or subject us to additional costs. The state of Haryana, where we are located, has a power shortage and is unable to meet our needs for power for our operations. We have a captive power plant for the production of 60 MW of power. Any interruption in the supply of power from our captive power plant would disrupt our manufacturing operations. Due to a decision of the Supreme Court of India applicable to the industrial use of natural gas, we are no longer able to use natural gas as fuel for generating power in our captive power plant. Instead, we have been using naphtha as fuel since July 2002. Naphtha is a more expensive fuel than natural gas. In addition, in case of a shortage in our supply of naphtha or other fuels we rely on in the future, we may have to resort to generating power from other more expensive sources of fuel to ensure that our production is not affected. We continue to look for less expensive sources of fuel. Compliance with increasingly stringent safety or emissions standards relating to our products or our manufacturing facility, or other environmental regulation, may adversely affect our business and results of operations. In the last few years, the GoI has introduced several regulations regarding emission levels, fuel efficiency, noise and safety of cars, as well as levels of pollutants generated by the plants that produce cars. These regulations are likely to become more stringent and the cost of complying with these regulations may be significant. We are committed to improving and maintaining our environmental and safety standards with respect to our products and our

Appendix 2

913

manufacturing facility, and have received the ISO 14001 certification for environmental management. In fiscal 2001, we incurred substantial additional costs to upgrade our vehicles to comply with Bharat Stage II emission norms. To comply with the requirements of environmental regulation, we may have to incur substantial capital expenditure and research and development costs to upgrade our products and our manufacturing facility, which may increase our cost of production and thereby adversely affect our results of operations. If we are unable to comply with these standards within the timeframe provided to us, our production and sales may be adversely affected. For details on the environmental regulation to which we are currently subject, see “Regulations and Policies” of this Draft Red Herring Prospectus. Taxes and other levies imposed by the GoI on the acquisition and ownership of passenger cars, or GoI regulation relating to us may have a material adverse effect on demand for our products. Taxes and other levies imposed by the central or state governments in India that affect our industry include: �

customs duties on imports of raw materials and components;

�

excise duty on the manufacture of cars;

�

central and state sales tax;

�

value added tax;

�

road and registration tax; and

�

income disclosure requirements applicable to customers who want to purchase cars.

These taxes and levies affect the cost of production and prices of our products and therefore the demand for our products. In addition, restrictions or levies imposed by the government on the use of vehicles, such as a congestion charge or other traffic control measures, could affect the demand for our cars in the future. An increase in any of these taxes or levies, or the imposition of new taxes or levies in the future, may have a material adverse impact on our business, results of operations and financial condition. For details on the taxes and levies relating to our industry, see “Regulations and Policies” of this Draft Red Herring Prospectus. Our failure to anticipate, or adapt our business to, consumer preferences in the automobile industry may adversely affect our business and our leadership position in the small car segment. Evolving industry standards, changing consumer preferences, technological changes and new product introductions characterize the automobile industry. Our success depends on our ability to keep pace with these changes and introduce products with contemporary features. We may not be successful in addressing these developments on a timely basis or if we address these developments, our new products may not be successful in the marketplace. In addition, products developed by others may make our products less competitive.

914

Investment Banking

Although we produce some cars that run on diesel, liquefied petroleum gas and compressed natural gas, most of the cars we produce run on petrol. If the price of diesel falls significantly below that of petrol, demand for cars running on diesel is likely to rise at the expense of demand for our products. In addition, with petroleum being a limited natural resource, several companies are in the process of developing cars running on alternative sources of fuel. Cars using energy sources other than petrol or diesel, such as electricity, may become more popular in the future. We may not be able to introduce successful and popular cars that use such alternative sources of energy. While we expect to continue to manufacture products in most segments of the Indian passenger car market, our business strategy is to focus primarily on producing a wide range of models in the A and B segments, which together comprised over 86% of the sales volumes in the Indian passenger car market in fiscal 2002. As consumer income levels rise in India, our lack of concentration on, and competitiveness in, the segments for cars priced above Rs. 500,000 (the C, D and E segments) has promoted, and may continue to promote, attrition of our customers upgrading from the A and B segments towards our competitors. We are subject to risks arising from exchange rate fluctuations. We import a substantial amount of our imported components, especially for newer models, from Suzuki. Since the cost of these components is denominated in Yen, any adverse fluctuations with respect to the exchange rate of Yen for Indian Rupees is likely to affect our input costs. We continue to bear this risk despite the increasing use of locally manufactured components in each of our models over time. In addition, we are subject to exchange rate fluctuations in relation to the export of our products. We enter into foreign exchange forward and derivative contracts to hedge these risks, but these contracts may not protect us fully from losses due to fluctuations in foreign exchange rates. Our manufacturing operations and substantially all of our assets and those of most of our vendor affiliates are located in or in close proximity to one high volume facility in Gurgaon, Haryana, which exposes us to the risk of significant disruptions in production should a catastrophe occur at or in the vicinity of such facility. Our operations are dependent on our ability to protect our infrastructure including plant and machinery against damage from fire, earthquakes, floods, power losses and similar events. The occurrence of a natural disaster or other unanticipated problems at our facility or the facilities of our vendors could cause interruptions in our operations. This risk is particularly relevant because our manufacturing operations are located in one facility, many of our vendors are located within 100 kilometres of that facility and some of our vendors are located in the facility. Conversely, some of our vendors are not located in close proximity to our facility and are therefore heavily reliant on transportation networks that connect their facilities to ours. If they are unable to deliver raw materials or components to us in a timely manner due to disruptions in railway or road transportation networks due to weather-related events, labour strikes or otherwise, we may be forced to stop production. For example, the nation-wide strike by truck drivers in India in April 2003 adversely affected our production volumes. Any damage or failure that causes interruptions in our operations could have a material adverse effect on our business, financial condition and results of operations.

Appendix 2

915

Terrorist attacks and other acts of violence or war involving India, the United States, and other countries could adversely affect the financial markets, result in loss of customer confidence, and adversely affect our business, results of operations and financial condition. Terrorist attacks, such as the ones that occurred in New York and Washington, D.C. on September 11, 2001 and New Delhi on December 13, 2001 and Bali on October 12, 2002, and other acts of violence or war, including those involving India, the United States or other countries, may adversely affect Indian and worldwide financial markets. These acts may also result in a loss of business confidence and have other consequences that could adversely affect our business, results of operations and financial condition. More generally, any of these events could adversely affect fuel prices, cause consumer spending to decrease, cause increased volatility in the financial markets and have an adverse impact on the economies of India and other countries, including economic recession.

Notes to Risk Factors 1. The average cost of acquisition of equity shares of Rs. 5 each held by the Selling Shareholder is Rs. 4.980. 2. The average cost of acquisition of equity shares of Rs. 5 each held by Suzuki is Rs. 32.08. 3. The Company had made a rights issue of 1,219,512 equity shares of Rs.100/- each amounting to about Rs. 4,000 million on May 30, 2002 at a price per share of Rs. 3280/-. In addition, Suzuki paid a control premium of Rs. 10 billion to GoI. 4. The book value per equity share of Rs. 5 each as on December 31, 2002 is Rs. 106. 5. The net worth of our Company as on December 31, 2002 is Rs. 30,018 million. 6. The present offer is an Offer of sale of 72,243,300 equity shares of Rs. 5/- each at a price of Rs. • for cash aggregating Rs. • million. 7. The size of the Offer will be enhanced to the extent of upto 10% of the Offer i.e. upto 7,224,300 equity shares of Rs. 5/- each in case the Selling Shareholder decides to retain any over-subscription. In such a case, the size of the Offer may increase upto 79,467,600 equity shares of Rs. 5/- each. 8. For related party transactions refer to the section entitled “Related Party Transactions” of this Draft Red Herring Prospectus. 9. Investors may note that in case of over-subscription in the Offer, allotment to wholesale bidders and retail bidders shall be on proportionate basis. For more information, see “Basis of Allotment” on page of this Draft Red Herring Prospectus. 10. Investors are free to contact the BRLM or the Co-BRLMs for any clarification or information on the Offer who will be obliged to provide the same.

916

Investment Banking

11. The investors may contact the BRLM or the Co-BRLMs for any complaints pertaining to the Offer. 12. Investors are advised to refer to the paragraph entitled “Basis for Issue Price” of this Draft Red Herring Prospectus.

THE OFFER

Equity shares off ered : Offer for sale by selling shareholder

72,243,300* equity shares of Rs. 5/- each

O f w hich : Qualified institutional buyers portion

43,345,900 equity shares of Rs. 5/- each (Allocation on a discretionary basis)

Wholesale portion

10,836,500 equity shares of Rs. 5/- each (Allocation on a proportionate basis) 18,060,900 equity shares of Rs. 5/- each (Allocation on a proportionate basis)

Retail portion

Equity shares ou tstanding prior to the O ff er

288,910,060 equity shares of Rs. 5/- each

Equity shares ou tstanding after the O ff er**

288,910,060 equity shares of Rs. 5/- each

U se of proceeds

Our Company will not receive any proceeds from the Offer For more information, see Objects of the Offer of this Draft Red Herring Prospectus for additional information

* SEBI, vide its letter RM/21334/2003 dated October 29, 2002, has granted its approval fo retention of over-subscription over and above the limit of 10% allowed for the purposes of rounding off only, under clause 6.4.2(f) of SEBI Guidelines. **As this is an offer for sale, there will be no change in the number of equity shares outstanding subsequent to the Offer.

SUMMARY We should read the following summary together with the risk factors and the more detailed information about us, and our financial data included elsewhere in this Draft Red Herring Prospectus. Unless otherwise indicated, all financial and statistical data relating to the automobile industry in the following discussion are derived from the CRIS INFAC Annual Review of 2001 or 2002. These data have been reclassified in certain respects for purposes of presentation. The sales volumes for Maruti included in

Appendix 2

917

the following discussion refer to sales by Maruti to dealers, while computations of Maruti’s market share are based on sales to the customer set forth in the CRIS INFAC Annual Review of 2001 or 2002. For more information, see “Certain Conventions; Use of Market Data” of this Draft Red Herring Prospectus.

Our business We are the largest passenger car manufacturer in India. We sold 339,964 cars in India in fiscal 2002 with an overall market share of 58.6% in fiscal 2002. Our product range includes ten basic models with more than 50 variants. We are the leading manufacturer of cars in the A and B segments, which together constituted over 86% of sales in the Indian passenger car market in fiscal 2002. In fiscal 2002, we had a combined market share in the A and B segments of 64.9%. We also export certain models to various countries, which contributed 3.9%, 3.1%, 2.6% and 6.9%, respectively, of our total sales in fiscal 2000, 2001 and 2002 and the nine months ended December 31, 2002. We are a subsidiary of Suzuki Motor Corporation, the largest manufacturer of mini passenger vehicles in Japan since fiscal 1974, in terms of sales volumes, with a market share of 31.6% in 2002, according to the Japan Mini Vehicles Association. Suzuki was also the eleventh largest vehicle manufacturer in the world and the fourth largest manufacturer in Japan in terms of worldwide sales volumes in 2000, according to Automotive Intelligence.

Our competitive strengths We believe we are well positioned to maintain and enhance our leadership position in the small car segment in India, while continuing to offer products in most segments of the Indian market, on account of our competitive strengths, which include the following: �

Expertise in small car technology

�

Skilled labour and experienced management

�

Integrated manufacturing facility

�

Extensive product portfolio

�

Brand strength

�

Extensive sales and service network

�

Strong vendor base and higher rates of localisation

�

Quality products

�

Capital resources.

918

Investment Banking

Our Principal Objectives As the leading player in the small car segment of the Indian market, we have the following principal objectives: �

�

�

To continue to expand the size of the Indian market for small cars by strengthening and expanding our dealer network and making automobile financing available at competitive rates; To strengthen our leadership position in the small car segment of the Indian market; and To continue to benchmark ourselves against improving global manufacturing, marketing and other practices and standards, strive to increase customer satisfaction through quality products and new initiatives, and promote the financial strength of our sale network.

Our Business Strategy We intend to continue to focus on the small car segment, while offering products in most segments of the Indian passenger car market. We aim to achieve our principal objectives by pursuing the following business strategies: Maintain and enhance our product range. We intend to utilize Suzuki’s expertise in small car technology to produce new variants of our existing models and to upgrade our products with contemporary technology and features. Increase reach and penetration. We plan to continue to utilize our extensive sales and service network to increase the reach, in terms of geographical spread, and penetration, in terms of sales volumes, of our products across India. Increased availability of automobile finance. We continue to seek opportunities to expand the size of the Indian passenger car market, especially in the small car segment, through facilitating easy availability of automobile finance. To that end, we have recently entered into an agreement with the State Bank of India. Secure repeat purchases by offering a “360 degree customer experience”. On the basis of our belief that securing repeat purchases from an existing customer requires less expenditure than acquiring a new customer, we aim to provide customers with a “one-stop shop” for automobiles and automobile-related products and services. Continue to benchmark our manufacturing capabilities. We plan to continue to benchmark our manufacturing capabilities with the most efficient car manufacturing facilities of Suzuki and its subsidiaries.

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919

Continue to reduce costs to offer more competitive products. Cost competitiveness has been, and continues to be, central to our strategy as the leading manufacturer in the small car segment to expand the size of the market by offering competitively priced, high quality products. The components of this strategy are: �

Higher levels of localisation

�

Vendor participation in cost reduction

�

Cost reduction on warranties

�

Reduction in initial investment cost

�

Reduction in number of vehicle platforms

�

Achieve further cost reduction through higher productivity.

Lower cost of ownership. Through our business strategies, we seek to reduce the consumer’s cost of ownership of our cars, which comprises the cost of purchase, the cost of fuel and maintenance, including spare parts and repairs, during the life of the vehicle, insurance, and resale value. SUMMARY UNCONSOLIDATED FINANCIAL DATA You should read the following summary unconsolidated data, which have been prepared in accordance with Indian GAAP, in conjunction with our audited unconsolidated financial statements for each of fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002, including the notes thereto and the reports thereon, which appear elsewhere in this Red Herring Prospectus and “Management’s Discussion and analysis of financial condition and results of operations”. These financial statements are prepared in accordance with Indian GAAP, which differs in certain significant respects from US GAAP. For more information on these differences, see “Summary of Significant Differences Between Indian GAAP, IAS and US GAAP” included elsewhere in this prospectus. Our audited consolidated financial statements consolidating (1) the results of operations and financial condition of our subsidiaries for the fiscal year ended March 31, 2002 and the nine months ended December 31, 2002, and (2) the results of operations and financial condition of our subsidiaries, our joint ventures and our associates for the nine months ended December 31, 2002, are included elsewhere in this prospectus under “Consolidated Financial Statements as per AS 21” and “Consolidated Financial Statements as per AS 21, AS 23 and AS 27”, respectively.

920

Investment Banking SUMMARY OF FINANCIAL DATA

Summary of Profit and Loss Account, as Restated

(Rs . in millions ) For the period A pril 1, 2002 to D ecemb er 31, 2002

Fin ancial Year ended M arch 31, 2002

Fin ancial Year ended M arch 31, 2001

Fin ancial Year ended M arch 31, 2000

Fin ancial Year ended M arch 31, 1999

Fin ancial Year ended M arch 31, 1998 *

63,667

90,809

89,287

93,151

77,814

82,066

Other Income/Revenue

2,543

3,294

3,246

3,574

3,992

2,714

Total Income /Reve nue

66,210

94,103

92,533

96,725

81,806

84,780

Total Expenditu re

64,568

92,917

95,196

92,875

73,963

75,095

Prof it /(Loss ) before tax

1,627

1,183

(2,692)

3,851

7,841

9,773

Net Profit/(Loss) after tax as per audited statement of accounts (A)

929

1,045

(2,694)

3,301

5,230

6,519

Total A djustme nts (B)

(324)

(160)

1,121

(864)

216

1,029

Adjusted Profit/(Loss) (A+B)

605

885

(1,573)

2,437

5,446

7,548

Total sales

Summary of Assets and Liabilities, as Restated D ecemb er 31, 2002

M arch 31, 2002

M arch 31, 2001

M arch 31, 2000

M arch 31, 1999

(Rs. in millions) M arch 31, 1998

A.

Total Fixed A sse ts

23,389

25,025

26,155

24,099

14,123

10,290

B.

Inve stme nts :

10,632

968

955

3,974

4,845

9,695

C.

Current A sse ts , Loan s & A dvan ce : 5,344

6,811

8,655

9,902

5,784

5,758

Inventories

921

Appendix 2 Sundry Debtors

5,960

8,393

6,755

4,663

2,766

2,614

Cash & Bank balances

229

719

876

317

8,169

1,335

Other Current Assets

605

479

716

1,039

1,079

994

Loans & Advances

3,544

4,604

5,508

4,225

5,364

5,146

Total

15,682

21,006

22,510

20,146

23,162

15,847

D.

Total Liab ilitie s and provision s

19,685

21,824

24,328

21,288

16,972

15,623

E.

N et Worth (A + B + C – D)

30,018

25,175

25,292

26,931

25,158

20,209

F.

S hare Capital

1,445

1,323

1,323

1,323

1,323

1,323

G. Total rese rve s and su rplu s

29,517

25,044

24,556

26,131

24,098

19,092

H. M isc ellan eou s Expenditu re to the extent not w ritte n off I. N et Worth (F + G – H)

944

1,192

587

523

263

206

30,018

25,175

25,292

26,931

25,158

20,209

GENERAL INFORMATION

Authority for the Offer In terms of the RJVA, the Selling Shareholder has the option to sell approximately 72,243,380 equity shares of Rs. 5/- each (approximately 3,612,169 equity shares of Rs. 100/- each) or more, by way of an initial public offer. For details on the RJVA, please see the section titled “Our Promoters” of this Draft Red Herring Prospectus. As per the letter no. 2[16]/2000-PE-VI, dated February 7, 2003, from the Ministry of Heavy Industries and Public Enterprises, Department of Heavy Industry, GoI, the Cabinet Committee of Disinvestment has approved the disinvestment in Maruti by GoI by way of Offer for sale of its shareholding in the domestic market. Pursuant to the decision taken by the Cabinet Committee, the Ministry of Heavy Industry and Public Enterprises, acting for and on behalf of the President of India, has been authorized to offer 72,243,380 equity shares of Rs. 5/- each (3,612,169 equity shares of Rs. 100/- each as per the said letter) and such additional number of equity shares as may be permitted to be offered for allotment towards over-subscription. SEBI vide its letter RM/21334/2003 dated October 29, 2002 has granted its approval for retention of over-subscription over and above the limit of 10% allowed for the purposes of rounding off under clause 6.4.2(f) of SEBI Guidelines. Our Company has also consented to the Offer through their Board Resolution dated March 25, 2003.

922

Investment Banking

Prohibition by SEBI Our Company, our Directors/Promoters and persons in control, its subsidiaries, its associates, its directors, its promoters, other companies/entities promoted by Suzuki and companies/entities with which our Company’s directors are associated as directors have not been prohibited from accessing/operating in the capital markets or restrained from buying/selling/dealing in securities under any order or direction passed by SEBI.

Eligibility for the Offer Our Company is eligible for the Offer as per Clause 2.2.1 of the SEBI Guidelines as explained under: �

�

�

A track record of distributable profits as per Section 205 of Companies Act, for at least three out of immediately preceding five years; A pre-issue net worth of not less than Rs. 10 million in three out of preceding five years, with the minimum net worth met during the immediately preceding two years; and The proposed Offer size is not expected to exceed five times the pre-Offer net worth.

The net profit, dividend and net worth from the Auditor’s Report included under the head “Unconsolidated Financial Statements”, for the last 5 years and the nine-month period ending December 31, 2002, is reproduced below: (Rs . million ) 9 mon th period ending D ecember 31, 2002

FY2002

FY2001

FY2000

FY1999

FY1998

2,437

5,446

7,548

331

397

397

26,931

25,158

20,209

Adjusted profit/(loss)

605

885

(1,573)

Dividend

–

397

–

Net Worth

30,018

25,175

25,292

Disclaimer Clause AS REQUIRED, A COPY OF THE DRAFT RED HERRING PROSPECTUS HAS BEEN SUBMITTED TO SEBI. IT IS TO BE DISTINCTLY UNDERSTOOD THAT SUBMISSION OF THE DRAFT RED HERRING PROSPECTUS TO SEBI SHOULD NOT, IN ANY WAY, BE DEEMED OR CONSTRUED TO MEAN THAT THE SAME HAS BEEN CLEARED OR APPROVED BY SEBI. SEBI DOES NOT TAKE ANY RESPONSIBILITY EITHER FOR THE FINANCIAL SOUNDNESS OF ANY SCHEME OR THE PROJECT FOR WHICH THE OFFER IS PROPOSED TO BE MADE OR FOR THE CORRECTNESS OF THE STATEMENTS MADE OR OPINIONS EXPRESSED IN THE DRAFT RED HERRING PROSPECTUS. THE

Appendix 2

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BOOK RUNNING LEAD MANAGER, KOTAK MAHINDRA CAPITAL COMPANY LIMITED AND THE CO-BOOK RUNNING LEAD MANAGERS, ICICI SECURITIES LIMITED AND J M MORGAN STANLEY PRIVATE LIMITED AND HSBC SECURITIES AND CAPITAL MARKETS (INDIA) PRIVATE LIMITED HAVE CERTIFIED THAT THE DISCLOSURES MADE IN THE DRAFT RED HERRING PROSPECTUS ARE GENERALLY ADEQUATE AND ARE IN CONFORMITY WITH SEBI GUIDELINES FOR DISCLOSURES AND INVESTOR PROTECTION AS FOR THE TIME BEING IN FORCE. THIS REQUIREMENT IS TO FACILITATE INVESTORS TO TAKE AN INFORMED DECISION FOR MAKING AN INVESTMENT IN THE PROPOSED OFFER. IT SHOULD ALSO BE CLEARLY UNDERSTOOD THAT WHILE THE COMPANY IS PRIMARILY RESPONSIBLE FOR THE CORRECTNESS, ADEQUACY AND DISCLOSURE OF ALL RELEVANT INFORMATION IN THE DRAFT RED HERRING PROSPECTUS, THE BOOK RUNNING LEAD MANAGER AND CO-BOOK RUNNING LEAD MANAGERS ARE EXPECTED TO EXERCISE DUE DILIGENCE TO ENSURE THAT THE COMPANY DISCHARGES ITS RESPONSIBILITY ADEQUATELY IN THIS BEHALF AND TOWARDS THIS PURPOSE, THE BOOK RUNNING LEAD MANAGER, KOTAK MAHINDRA CAPIAL COMPANY LIMITED AND THE CO-BOOK RUNNING LEAD MANAGERS, ICICI SECURITIES LIMITED, AND J M MORGAN STANLEY PRIVATE LIMITED AND HSBC SECURITIES AND CAPITAL MARKETS (INDIA) PRIVATE LIMITED HAVE FURNISHED TO SEBI, A DUE DILIGENCE CERTIFICATE DATED APRIL 25, 2003 IN ACCORDANCE WITH THE SEBI GUIDELINES WHICH READS AS FOLLOWS: “WE HAVE EXAMINED VARIOUS DOCUMENTS INCLUDING THOSE RELATING TO LITIGATION LIKE COMMERCIAL DISPUTES, PATENT DISPUTES, DISPUTES WITH COLLABORATORS, ETC. AND OTHER MATERIALS IN CONNECTION WITH THE FINALISATION OF THE DRAFT RED HERRING PROSPECTUS PERTAINING TO THE SAID OFFER. ON THE BASIS OF SUCH EXAMINATION AND THE DISCUSSIONS WITH THE COMPANY, ITS DIRECTORS AND OTHER OFFICERS, OTHER AGENCIES, INDEPENDENT VERIFICATION OF THE STATEMENTS CONCERNING THE OBJECTS OF THE OFFER, PROJECTED PROFITABILITY, PRICE JUSTIFICATION AND THE CONTENTS OF THE DOCUMENTS MENTIONED IN THE ANNEXURE AND OTHER PAPERS FURNISHED BY THE COMPANY, WE CONFIRM THAT: �

THE DRAFT RED HERRING PROSPECTUS FORWARDED TO SEBI IS IN CONFORMITY WITH THE DOCUMENTS, MATERIALS AND PAPERS RELEVANT TO THE OFFER;

�

ALL THE LEGAL REQUIREMENTS CONNECTED WITH THE SAID OFFER AS ALSO THE GUIDE-LINES, INSTRUCTIONS, ETC. ISSUED BY SEBI, THE GOVERNMENT AND ANY OTHER COMPETENT AUTHORITY IN THIS BEHALF HAVE BEEN DULY COMPLIED WITH; AND

�

THE DISCLOSURES MADE IN THE DRAFT RED HERRING PROSPECTUS ARE TRUE, FAIR AND ADEQUATE TO ENABLE THE INVESTORS TO MAKE A WELL-INFORMED DECISION AS TO THE INVESTMENT IN THE PROPOSED OFFER.

WE CONFIRM THAT BESIDES OURSELVES, ALL THE INTERMEDIARIES NAMED IN THE DRAFT RED HERRING PROSPECTUS ARE REGISTERED WITH SEBI AND THAT TILL DATE SUCH REGISTRATIONS ARE VALID. WHEN UNDERWRITTEN, WE SHALL SATISFY OURSELVES ABOUT THE NET WORTH OF THE UNDERWRITERS TO FULFIL THEIR UNDERWRITING COMMITMENTS.” ALL LEGAL REQUIREMENTS PERTAINING TO THE OFFER WILL BE COMPLIED WITH AT THE TIME OF FILING OF THE DRAFT RED HERRING PROSPECTUS WITH THE ROC IN TERMS OF SEC-

924

Investment Banking

TION 60B OF THE ACT. ALL LEGAL REQUIREMENTS PERTAINING TO THE OFFER WILL BE COMPLIED WITH AT THE TIME OF REGISTRATION OF THE PROSPECTUS WITH THE ROC IN TERMS OF SECTION 56, SECTION 60 AND SECTION 60B OF THE COMPANIES ACT. THE FILING OF THE DRAFT RED HERRING PROSPECTUS DOES NOT, HOWEVER, ABSOLVE THE COMPANY AND SELLING SHAREHOLDER FROM ANY LIABILITIES UNDER SECTION 63 AND SECTION 68 OF THE ACT OR FROM THE REQUIREMENT OF OBTAINING SUCH STATUTORY AND OTHER CLEARANCES AS MAY BE REQUIRED FOR THE PURPOSE OF THE PROPOSED OFFER. SEBI FURTHER RESERVES THE RIGHT TO TAKE UP AT ANY POINT OF TIME, WITH THE BOOK RUNNING LEAD MANAGER AND THE CO-BOOK RUNNING LEAD MANAGERS, ANY IRREGULARITIES OR LAPSES IN THE DRAFT RED HERRING PROSPECTUS.

Caution The Selling Shareholder, our Company, the BRLM and the Co-BRLMs accept no responsibility for statements made otherwise than in the Draft Red Herring Prospectus or in the advertisements or any other material issued by or at our instance and anyone placing reliance on any other source of information would be doing so at his or her own risk. The BRLM and Co-BRLMs accept no responsibility, save to the limited extent as provided in the Underwriting Agreement to be entered into between the Underwriters and us and the Memorandum of Understanding. All information shall be made available by the Selling Shareholder, our Company, the BRLM and the Co-BRLMs to the public and investors at large and no selective or additional information would be available for a section of the investors in any manner whatsoever including at road show presentations, in research or sales reports or at bidding centres, etc.

Disclaimer in Respect of Jurisdiction This Offer is being made in India to persons resident in India including Indian nationals resident in India who are majors, HUFs, companies, corporate bodies and societies registered under the applicable laws in India and authorized to invest in shares, Indian mutual funds registered with SEBI, Indian financial institutions, commercial banks, regional rural banks, co-operative banks (subject to RBI permission), Trusts registered under the Societies Registration Act, 1860, as amended from time to time, or any other Trust law and who are authorized under their constitution to hold and invest in shares) and to non-residents including NRIs and FIIs. This Draft Red Herring Prospectus does not, however, constitute an offer to sell or an invitation to subscribe to shares offered hereby in any other jurisdiction to any person to whom it is unlawful to make an offer or invitation in such jurisdiction. Any person into whose possession this Draft Red Herring Prospectus comes is required to inform himself or herself about, and to observe, any such restrictions. Any dispute arising out of this Offer will be subject to the jurisdiction of appropriate court(s) in New Delhi only. No action has been or will be taken to permit a public offering in any jurisdiction where action would be required for that purpose, except that this Draft Red Herring Prospectus has been sub-

Appendix 2

925

mitted to the SEBI. Accordingly, the equity shares represented thereby may not be offered or sold, directly or indirectly, and this Draft Red Herring Prospectus may not be distributed, in any jurisdiction, except in accordance with the legal requirements applicable in such jurisdiction. Neither the delivery of this Draft Red Herring Prospectus nor any sale hereunder shall, under any circumstances, create any implication that there has been no change in the affairs of Maruti since the date hereof or that the information contained herein is correct as of any time subsequent to this date.

Disclaimer Clause of the DSE As required, a copy of this Draft Red Herring Prospectus has been submitted to DSE. DSE has given vide its letter dated _________, permission to the Company to use the DSE’s name in this Draft Red Herring Prospectus as one of the stock exchanges on which this Company’s securities are proposed to be listed subject to the Company fulfilling the various criteria for listing including the one related to paid up capital and market capitalisation (i.e. the paid up capital shall not be less than Rs. 100 million and market capitalisation shall not be less that Rs. 250 million at the time of listing). The DSE has scrutinized this Draft Red Herring Prospectus for its limited internal purpose of deciding on the matter of granting the aforesaid permission to this Company. It is to be distinctly understood that the aforesaid permission given by DSE should not in any way be deemed or construed to mean that this Draft Red Herring Prospectus has been cleared or approved by DSE; nor does it in any manner warrant, certify or endorse the correctness or completeness of any of the contents of this Draft Red Herring Prospectus; nor does it warrant that this Company’s securities will be listed or will continue to be listed on the DSE; nor does it take any responsibility for the financial or other soundness of this Company, its promoters, its management or any scheme or project of this Company. Every person who desires to apply for or otherwise acquires any securities of the Company may do so pursuant to independent inquiry, investigation and analysis and shall not have any claim against the DSE whatsoever by reason of any loss which may be suffered by such person consequent to or in connection with such subscription/acquisition whether by reason of anything stated or omitted to be stated herein or any other reason whatsoever.

Disclaimer Clause of the NSE As required, a copy of this Draft Red Herring Prospectus has been submitted to NSE. NSE has given vide its letter dated ______, permission to the Company to use the NSE’s name in this Draft Red Herring Prospectus as one of the stock exchanges on which this Company’s securities are proposed to be listed subject to the Company fulfilling the various criteria for listing including the one related to paid up capital and market capitalisation (i.e. the paid up capital shall not be less than Rs. 100 million and market capitalisation shall not be less that Rs. 250 million at the time of listing). The NSE has scrutinized this Draft Red Herring Prospectus for its limited internal purpose of deciding on the matter of granting the aforesaid permission to this Company. It is to be distinctly understood that the aforesaid permission given by NSE should not in any way

926

Investment Banking

be deemed or construed to mean that the Draft Red Herring Prospectus has been cleared or approved by NSE; nor does it in any manner warrant, certify or endorse the correctness or completeness of any of the contents of this Draft Red Herring Prospectus; nor does it warrant that this Company’s securities will be listed or will continue to be listed on the NSE; nor does it take any responsibility for the financial or other soundness of this Company, its promoters, its management or any scheme or project of this Company. Every person who desires to apply for or otherwise acquires any securities of the Company may do so pursuant to independent inquiry, investigation and analysis and shall not have any claim against the NSE whatsoever by reason of any loss which may be suffered by such person consequent to or in connection with such subscription/acquisition whether by reason of anything stated or omitted to be stated herein or any other reason whatsoever.

Disclaimer Clause of BSE As required, a copy of this Draft Red Herring Prospectus has been submitted to BSE. The BSE has given vide its letter dated ________, permission to this Company to use the BSE’s name in this Draft Red Herring Prospectus as one of the stock exchanges on which this Company’s securities are proposed to be listed. The BSE has scrutinised this Draft Red Herring Prospectus for its limited internal purpose of deciding on the matter of granting the aforesaid permission to this Company. The BSE does not in any manner: �

�

�

�

warrant, certify or endorse the correctness or completeness of any of the contents of this Draft Red Herring Prospectus; or warrant that this Company’s securities will be listed or will continue to be listed on the BSE; or take any responsibility for the financial or other soundness of this Company, its promoters, its management or any scheme or project of this Company; and it should not for any reason be deemed or construed to mean that this Draft Red Herring Prospectus has been cleared or approved by the BSE. Every person who desires to apply for or otherwise acquires any securities of this Company may do so pursuant to independent inquiry, investigation and analysis and shall not have any claim against the BSE whatsoever by reason of any loss which may be suffered by such person consequent to or in connection with such subscription/acquisition whether by reason of anything stated or omitted to be stated herein or for any other reason whatsoever.

Filing A copy of the Draft Red Herring Prospectus, along with the documents required to be filed under 60B of the Companies Act, would be delivered for registration to the RoC and a copy of

Appendix 2

927

the Prospectus to be filed under Section 60 of the Companies Act would be delivered for registration with RoC. A copy of the Draft Red Herring Prospectus has been filed with SEBI at Ground Floor, Mittal Court, “A” Wing, Nariman Point, Mumbai 400 021.

Listing Applications have been made to the DSE (Regional Stock Exchange), the NSE and the BSE for permission to deal in and for an official quotation of our equity shares. If the permissions to deal in and for an official quotation of our equity shares are not granted by any of the Stock Exchanges mentioned above, the Selling Shareholder will forthwith repay, without interest, all moneys received from the applicants in pursuance of this Draft Red Herring Prospectus. If such money is not repaid within eight days after the Selling Shareholder becomes liable to repay it (i.e. from the date of refusal or within 70 days from the date of Offer Closing Date, whichever is earlier), then the Selling Shareholder shall, on and from expiry of eight days, be liable to repay the money, with interest at the rate of 15% per annum on application money, as prescribed under Section 73 of the Companies Act. Our Company shall ensure that all steps for the completion of the necessary formalities for listing and commencement of trading at all the Stock Exchanges mentioned above are taken within seven working days of finalisation and adoption of the basis of allotment for the Offer.

Minimum Subscription This being an offer for sale, the requirement of minimum subscription is not a pre-condition for completion of the Offer and obtaining listing permissions.

Impersonation Attention of the applicants is specifically drawn to the provisions of sub-section (1) of Section 68A of the Companies Act, which is reproduced below: “Any person who: (a) makes in a fictitious name, an application to a company for acquiring or subscribing for, any shares therein, or (b) otherwise induces a company to allot, or register any transfer of shares therein to him, or any other person in a fictitious name, shall be punishable with imprisonment for a term which may extend to five years.”

928

Investment Banking

Withdrawal of the Offer The Selling Shareholder, in consultation with our Company, the BRLM and the Co-BRLMs, reserves the right not to proceed with the Offer anytime after the Bid/Offer Closing Date without assigning any reason thereof.

Letters of Allotment or Refund Orders The Selling Shareholder and our Company shall give credit to the Beneficiary Account with Depository Participants within two working days of finalisation of the basis of transfer of equity shares. The Selling Shareholder and we shall ensure dispatch refund orders, if any, of value up to Rs. 1,500, by “Under Certificate of Posting”, and will dispatch refund orders above Rs. 1,500, if any, by registered post or speed post at the sole or first bidder's sole risk, within 15 days of the Offer Closing Date. In accordance with the Companies Act, the requirements of the Stock Exchanges and SEBI Guidelines, the Selling Shareholder and we further undertake that: �

�

�

Allocation and transfer of equity shares will be made only in dematerialized form within 15 days from the Offer Closing Date; Dispatch of refund orders/ cancelled Stockinvests will be done within 15 days from the Offer Closing Date; and The Selling Shareholder shall pay interest at 15% per annum (for any delay beyond the 15 day time period as mentioned above), if transfer is not made, refund orders/cancelled Stockinvests are not dispatched and/or demat credits are not made to investors within the 15 day time prescribed above.

The Selling Shareholder will provide adequate funds required for dispatch of refund orders or allotment advice to the Registrar to the Offer. Refunds will be made by cheques, pay-orders or demand drafts drawn on a bank appointed by us and the Selling Shareholder, as a refund banker and payable at par at places where bids are received. Bank charges, if any, for encashing such cheques, pay orders or demand drafts at other centers will be payable by the bidders.

Offer Program BID/OFFER CLOSES ON

:

BID/OFFER CLOSES ON

:

Appendix 2

929

Bids and any revision in bids shall be accepted only between 10 a.m. and 3 p.m. (India Time) during the Bidding Period as mentioned above at the bidding centres mentioned on the Bid cum Application Form except that on the Bid Closing Date, the Bids shall be accepted only between 10 a.m. and 1 p.m. (Indian Standard Time) or uploaded till such time as may be permitted by the BSE and NSE on the Offer Closing Date. Book Running Lead Manager Kotak Mahindra Capital Company Ltd. Bakhtawar, 3rd Floor 229 Nariman Point Mumbai 400 021 Tel no.: +91-22-5634 1100 Fax no.: +91-22-2284 0492 e-mail: [email protected] Co-Book Running Lead Manager ICICI Securities Ltd. 41/ 44 Minoo Desai Marg, Colaba Mumbai, India 400 005 Tel no.: +91-22-2288 2460 Fax no.: +91-22-2283 7045 e-mail: [email protected]

Co-Book Running Lead Manager JM Morgan Stanley Pvt. Ltd. 141, Maker Chambers III 229, Nariman Point Mumbai 400 021 Tel no.: 91-22-5630 3030 Fax no.: 91-22-5630 1694 e-mail: [email protected]

Co-Book Running Lead Manager HSBC Securities and Capital Markets (India) Pvt. Ltd. 52/ 60, Mahatma Gandhi Road, Fort Mumbai 400 001 Tel no.: 91-22-2267 4921 Fax no.: 91-22-2263 1984 e-mail: [email protected]

930

Investment Banking

Syndicate Members Statement of Inter-Se Allocation of Responsibilities

Sl. N o.

A ctivities

1.

Capital structuring with the relative components and formalities such as type of instruments etc.

2.

Due diligence of our Company's operations/management/business plans/legal etc. Drafting and Design of Red Herring Prospectus and of statutory advertisement including memorandum containing salient features of the Prospectus. The BRLM shall ensure compliance with stipulated requirements and completion of prescribed formalities with the Stock Exchanges, RoC and SEBI.

Responsibility Co -ordinator KMCC I-Sec JMMS HSBC KMCC I Sec JMMS HSBC

KMCC

KMCC

3.

Drafting and approval of all publicity material other than statutory advertisement as mentioned in (2) above including corporate advertisement, brochure, etc.

KMCC I-Sec JMMS HSBC

I-Sec

4.

Appointment of other intermediaries viz. Registrar, Printers, Advertising Agency and Bankers to the Offer.

KMCC I-Sec JMMS HSBC

KMCC

KMCC I-Sec JMMS HSBC

I-Sec

5.

Marketing of the Offer, which will cover inter alia • Formulating marketing strategies, preparation of publicity budget • Finalise Media & PR strategy • Finalise centers for holding conferences for brokers etc. • Finalise collection centers • Follow-up on distribution of publicity and issue material including form, prospectus and deciding on the quantum of the Offer material.

6.

Finalize the list and division of investors for one to one meetings, deciding pricing and institutional allocation in consultation with the Selling Shareholders/Company, finalization of Prospectus and RoC filing.

KMCC I-Sec JMMS HSBC

KMCC

7.

The post bidding activities including management of escrow accounts, coordinate non institutional allocation, intimation of allocation and dispatch of refunds to bidders etc.

KMCC I-Sec JMMS HSBC

I-Sec

931

Appendix 2

8.

The post issue activities for the issue will involve essential follow up steps, which include the finalisation of listing of instruments and dispatch of certificates and demat delivery of shares, with the various agencies connected with the work such as the Registrar to the Offer and Bankers to the Offer and the bank handling refund business. The merchant banker shall be responsible for ensuring that these agencies fulfill their functions and enable it to discharge this responsibility through suitable agreements with our Company.

KMCC I-Sec JMMS HSBC

I-Sec

The responsibilities and co-ordination for various activities in this Offer have been distributed between the BRLM and the Co-BRLMs as under: The selection of various agencies like the Registrar to the Offer, Bankers to the Offer, Escrow Collection Bank(s), Syndicate Members, Legal Advisors to the Offer, Brokers, Advertising Agencies, Public Relations agencies etc. will be finalised by the Selling Shareholder.

Credit Rating As this is an Offer for equity shares there is no credit rating for this Offer. The credit ratings for the various borrowing programs by our Company in the last three years have been listed below:

Borrow ing Prog ram

Rating A ge ncy

Rating

D ate of letter from the rating age ncy

Rs. 2,000 million non-convertible debenture

ICRA

LAAA (reaffirmation)

March 5, 2002

Rs. 1,000 million commercial paper

ICRA

A1+

March 5, 2002

Rs. 2,000 million non-convertible debenture

ICRA

LAAA

July 7, 2000

Rs . 1,000 million commercial paper

ICRA

A1+

July 7, 2000

Trustees As the Offer is of equity shares, the appointment of trustees is not required.

932

Investment Banking

Book Building Process Book building refers to the collection of Bids from investors, which is based on the Floor Price, the Offer Price being fixed after the Bid Closing Date. The principal parties involved in the Book Building Process are: 1. The Company; Suzuki; GoI 2. Book Running Lead Manager; 3. Co-Book Running Lead Managers; and 4. Syndicate Members who are intermediaries registered with SEBI and eligible to act as underwriters. The BRLM/Co-BRLMS appoints syndicate Members. SEBI, through its guidelines, has permitted an offer of securities to the public through the 100% Book Building Process, wherein not more than 60% of the Offer shall be allocated on a discretionary basis to QIBs. Further, not less than 15% of the Offer shall be available for allocation on a proportionate basis to Wholesale Bidders and not less than 25% of the Offer shall be available for allocation on a proportionate basis to Retail Bidders, subject to valid Bids being received at or above the Offer Price. We will comply with these guidelines for this Offer. In this regard, we have appointed the Book Running Lead Manager and the Co-Book Running Lead Managers to procure subscription to the Offer. The process of book building, under SEBI guidelines, is relatively new and the investors are advised to make their own judgement about investment through this process prior to making a Bid in the Offer. Steps to be taken by the Bidders for bidding: �

Check whether he/she is eligible for bidding;

�

Bidder necessarily needs to have a demat account; and

�

Ensure that the Bid cum Application Form is duly completed as per instructions given in this Draft Red Herring Prospectus and in the Bid cum Application Form.

Underwriting Agreement After the determination of the Offer Price and prior to filing of the Prospectus with RoC, the Selling Shareholder and our Company will enter into an Underwriting Agreement with the Underwriters for the equity shares proposed to be offered through the Offer. It is proposed that pursuant to the terms of the Underwriting Agreement, the BRLM and the Co-BRLMs shall be responsible for bringing in the amount devolved in the event that the Syndicate Members do not fulfill their underwriting obligations.

933

Appendix 2

CAPITAL STRUCTURE (Rs . million )

S hare Capital as on SEBI filing date A gg regate nominal val ue

A gg regate val ue at off er price

A. A uthorised Capital1 310,000,000

Equity shares of Rs.. 5/- each2

1,550.00

B. Issued , S ubscribed A nd Paid-U p Capital 288,910,060

Equity shares of Rs. 5/each

1,444.55

C. Present net of fer to the public in terms of this D raft RHP 3 Offer for Sale 72,243,300 4

Equity shares of Rs . 5/each

361.22

[• ]

D . Equity Capital after the O ffer 288,910,060

Equity shares of Rs . 5/each

1,444.55

E. S hare Premium A ccou nt Before the Offer

4,240.59

After the Offer

4,240.59

1

The authorized share capital of our Company was increased from Rs. 1,350 million divided into 13.5 million equity shares of Rs. 100 each to Rs. 1,550 million divided into 15.5 million equity shares of Rs. 100 each through special resolution passed at its extra ordinary general meeting held on May 15, 2002. 2

Subsequently, a stock split was approved at an extraordinary general meeting of our shareholders held on March 25, 2003, resulting in each equity share of Rs. 100 being sub-divided into 20 equity shares of Rs. 5 each and consequently the equity shares were sub-divided with effect from March 25, 2003. 3

The net Offer to the public is by an offer for sale by the GoI of 72,243,300 equity shares of Rs. 5/- each.

934

Investment Banking

4

SEBI vide its letter RM/21334/2003 dated October 29, 2002 has granted its approval for retention of over-subscription over and above the limit of 10% allowed for the purposes of rounding off only, under clause 6.4.2(f) of SEBI Guidelines. Hence the size of the Offer may be enhanced to the extent of upto 10% of the Offer i.e. by upto 7,224,300 equity shares of Rs. 5/- each, in case the selling shareholder decides to retain any over-subscription. In such a case, the size of the Offer may increase upto 79,467,600 equity shares of Rs. 5/- each. NOTES TO THE CAPITAL STRUCTURE

1. Share Capital History of our Company:

Date of Allotment

Number of Equity Shares

Face Value (Rs.)

Issue Price (Rs.)

February 24, 1981

3

100

December 24, 1981

50,000

September 23, 1982 January 1983

Cumulative Share Premium (Rs. million)

Consideration

Reasons for Allotment

100

Cash

Subscription to equity shares on signing of Memorandum

Nil

100

100

Cash

Nil

442,000

100

100

Other than cash

Memorandum President of India Allotment to the President of India for vesting assets under the Acquisition Act

173,000

100

100

Cash

Allotment to Suzuki

Nil

1,776,000

100

100

Cash

Allotment to the President of India

Nil

March 1, 1984

392,000

100

100

Cash

Allotment to Suzuki

Nil

March 29, 1985

320,870

100

100

Cash

Allotment to Suzuki

Nil

June 3, 1985

346,127

100

100

Cash

Allotment to the President of India

Nil

July 31, 1985

51,987

100

100

Cash

Allotment to Suzuki

Nil Nil

October 25, 1983

Nil

July 31, 1985

55,451

100

100

Cash

Allotment to the President of India

February 18, 1986

503,000

100

100

Cash

Allotment to Suzuki

Nil

February 18, 1986

1,563,000

100

100

Cash

Allotment to the President of India

Nil

May 19, 1986

47,000

100

100

Cash

Allotment to Suzuki

Nil

May 19, 1986

500,000

100

100

Cash

Allotment to the President of India

Nil

935

Appendix 2

September 30, 1986

243,000

100

100

Cash

Allotment to Suzuki

Nil

September 30, 1986

200,000

100

100

Cash

Allotment to the President of India

Nil

December 22, 1986

300,000

100

100

Cash

Allotment to the President of India

Nil

March 3, 1987

243,000

100

100

Cash

Allotment to Suzuki

Nil

March 3, 1987

200,000

100

100

Cash

Nil

June 26, 1987

180,000

100

100

Cash

Allotment to the President of India Allotment to the President of India

December 21, 1987

244,000

100

100

Cash

Allotment to Suzuki

Nil

December 21, 1987

700,000

100

100

Cash

Allotment to the President of India

Nil

March 1, 1988

302,000

100

100

Cash

Allotment to the President of India

Nil

May 20, 1988

106,200

100

100

Cash

Allotment to Suzuki

Nil

January 10, 1989

2,085,664

100

100

Cash

Allotment to Suzuki

Nil

June 20, 1992

2,204,860

100

269

Cash

Allotment to Suzuki

373

May 30, 2002

1,216,341

100

3,280

Cash

Rights issue

Total

14,445,503

Total

288,910,060

5

Nil

4,241

Rs.100/- paid-up equity shares sub-divided into 20 equity shares

4,241

2. Promoters Contribution and Lock-in: Suzuki has locked in 57,782,012 equity shares of Rs. 5/- each towards promoter’s contribution for a period of 3 years from the date of Transfer of equity shares in this Offer. The details of the equity shares locked in by Suzuki have been tabulated below: D ate of A llotment

Equivalent N umber of number of equity equity shares (of shares (of face face value of value of Rs . 5 Rs . 100 each ) each )

Issue Price for con sideration as cash for equity shares of face value Rs . 100/- each (Rs .)

Percentage of pre-O ffer and pos t-O ffe r paid -up capital (%)

Lock - in period

June 20, 1992

1,672,764

33,455,272

269

11.58

3 years

May 30, 2002

1,216,337

24,326,740

3,280

8.42

3 years

Total

2,889,101

57,782,012

20.00

936

Investment Banking

Subsequent to this Offer, GoI, under the RJVA has the right to exercise its put option and sell its portion of our equity shares to Suzuki. Such put option will commence from four months after the date of listing of our equity shares and expire twenty-four months after the date of listing of our equity shares. Other than the above and the equity shares being offered for sale in this Offer, the entire pre-Offer share capital of our Company shall be locked in for the period of 1 year from the date of transfer in this Offer. The Promoters may pledge their equity shares with banks or financial institutions as additional security for loans whenever availed by them from banks/ financial institutions. 3. Shareholding pattern of our Company before and after the Offer:

Pre -split S harehol ders

Pre -O ffe r

Post -O ffe r

N umber of equity shares

Percentage

Suzuki

7,830,918

54.2

7,830,918

54.2

President of India*

6,614,579

45.8

3,002,414

20.8

Promoter grou p

6

0.0

6

0.0

Public

0

0.0

3,612,165

25.0

14,445,503

100.0

14,445,503

100.0

N umber of equity shares

Percentage

Promote r

Total

*Acting through the Ministry of Heavy Industries and Public Enterprise, GoI.

Post -split S harehol ders

Pre -Issue

Post -Issue

N umber of equity shares

Percentage

N umber of equity shares

Suzuki

156,618,360

54.2

156,618,360

54.2

President of India*

132,291,580

45.8

60,048,280

20.8

120

0.0

120

0.0

0

0.0

72,243,300

25.0

100.0

288,910,060

100.0

Percentage

Promote r

Promoter grou p

Public Total

288,910,060

*Acting through the Ministry of Heavy Industries and Public Enterprise, GoI.

937

Appendix 2

Besides the Promoters, none of the promoter group companies have any shareholding in us. 4. The list of top 10 shareholders of our Company and the number of equity shares held by them is as under: Top ten shareholders on the date of filing the Draft Red Herring Prospectus with SEBI are as follows: S erial N umber

N ame of S harehol ders

Number of equity shares Rs . 5/- each

1

Suzuki

156,618,360

2

President of India*

132,291,580

3

Mr. Sunil Kumar Chaturvedi (Nominee of President of India)

20

4

Mr. M. R. Bali (Nominee of President of India)

20

5

Mr. Shinzo Nakanishi (Chairman)(nominee of Suzuki)

20

6

Mr. Kinji Saito (Director) (nominee of Suzuki)

20

7

Mr. Shinichi Takeuchi (Director) (nominee of Suzuki)

20

8

Mr. Motohiro Atsumi (Director) (nominee of Suzuki)

20

Total

288,910,060

* Acting through the Ministry of Heavy Industries and public Enterprises, GoI.

Top ten shareholders ten days prior to the date of filing Draft Red Herring Prospectus with SEBI are as follows: S erial N umbe r

N ame of S hareholders

N umbe r of equity sha res of Rs . 5/- each

1

Suzuki

156,618,360

2

President of India*

131,603,580

3

MUL-EMBF

4

Mr. Sunil Kumar Chaturvedi (Nominee of President of India)

20

5

Mr. M. R. Bali (Nominee of President of India)

20

6

Mr. Shinzo Nakanishi (Chairman) (nominee of Suzuki)

20

7

Mr. Kinji Saito (Director) (nominee of Suzuki)

20

8

Mr. Shinichi Takeuchi (Director) (nominee of Suzuki)

20

9

Mr. Motohiro Atsumi (Director) (nominee of Suzuki)

20

Total *Acting through the Ministry of Heavy Industries and Public Enterprise, GoI.

688,000

288,910,060

938

Investment Banking

Top ten shareholders two years prior to the date of filing the Draft Red Herring Prospectus with SEBI are as follows: S erial N umbe r

N umbe r of equity sha res of Rs . 100/- each

N ame of S hareholders

1

Suzuki

6,614,581

2

President of India*

6,580,179

3

MUL-EMBF

4

Mr. Pradeep Kumar (Nominee of President of India)

1

5

Mr. B. S. Negi (Nominee of President of India)

1

34,400

13,229,162

Total *Acting through the Ministry of Heavy Industries and Public Enterprise, GoI.

5. There are no outstanding warrants, options or rights to convert debentures, loans or other instruments into our equity shares, as on date. 6. None of our Promoters, members of the promoter group or directors of Suzuki have purchased or sold any equity shares during a period of six months preceding the date on which the Draft Red Herring Prospectus is filed with SEBI except as stated below: a. As per the terms of the trust deed for the MUL–EMBF, the equity shares held by the MUL–EMBF could only be transferred to GoI. GoI and the Trustees of the MUL–EMBF have vide letter dated April 16, 2003 agreed to the terms of the acquisition and transfer of the 688,000 equity shares of Rs. 5 each held by the MUL–EMBF to GoI. The transfer of the shares in favor of GoI was completed on April 17, 2003. GoI has agreed to pay the MUL–EMBF, consideration in two tranches. The first tranche is payable no later than May 31, 2003, at a price per share of Rs. 115. The second tranche is to be paid within a reasonable period of the completion of the listing of the equity shares of MUL. The second tranche payment is the difference between the Offer Price and Rs. 115. b. As per the circular resolution dated February 12, 2003, under Section 289 of The Act, 4 equity shares of Rs.100/- each were transferred from Suzuki in favour of following individual nominees to be held in trust for Suzuki: S erial N umbe r

N ame of D irector

N umber of eq uity shares of Rs . 100/- each 1

N umber of eq uity shares of Rs . 5/- each

1

Mr. Shinzo Nakanishi (Chairman)

20

2

Mr. Kinji Saito

1

20

3

Mr. Shinichi Takeuchi

1

20

4

Mr. Motohiro Atsumi

1

20

Appendix 2

939

7. The Selling Shareholder, our Company, our Directors, BRLM or Co-BRLMs have not entered into any buy-back and/or standby arrangements for purchase of equity shares of our Company from any person except as stated in the RJVA and disclosed in the section “Terms of the Offer”. 8. There are no outstanding employee stock option plans or employee share purchase schemes outstanding. 9. We have received approval from GoI, Ministry of Finance and Company Affairs (Department of Economic Affairs) pursuant to its letter no. FC.II: 74(1982)-Comp dated April 16, 2003 for the transfer of equity shares in this Offer to eligible non-resident investors, NRIs and FIIs. In terms of the approval of GoI, OCBs have not been permitted to participate in the Offer. Our Company has received approval from the RBI for (a) transfer of equity shares in the Offer for Sale to NRIs and FIIs pursuant to its letter No. ________________ dated ________________; and (B) participation of FIIs in this Offer pursuant to its letter No. _____________________ dated ___________. 10. In this Offer, in case of over-subscription in all categories, not more than 60% of the Offer shall be available for allocation on a discretionary basis to Qualified Institutional Buyers, a minimum of 15% of the Offer shall be available for allocation on a proportionate basis to Wholesale Bidders and a minimum of 25% of the Offer shall be available for allocation on a proportionate basis to Retail Bidders, subject to valid bids being received at or above the Offer Price. Under-subscription, if any, in any category would be met with spill over from other categories at the sole discretion of the Selling Shareholder, the BRLM and the Co-BRLMs. 11. A Bidder cannot make a Bid for more than the number of equity shares offered through the Offer, subject to the maximum limit of investment prescribed under relevant laws applicable to each category of investor. 12. The size of the Offer may be increased to the extent of upto 10% of the Offer i.e. upto 7,224,300 equity shares of Rs. 5/- each, in case the Selling Shareholder decides to retain any over-subscription. In such a case, the size of the Offer may increase upto 79,467,600 equity shares of Rs. 5/- each. 13. An over-subscription to the extent of 10% of the Offer can be retained for the purposes of rounding off to the nearest multiple of ____ equity shares while finalizing the basis of allotment. 14. There would be no further issue of capital whether by way of issue of bonus shares, preferential allotment, rights issue or in any other manner during the period commencing from submission of the Draft Red Herring Prospectus with SEBI until the equity shares offered have been listed. 15. We presently do not intend or propose to alter our capital structure for a period of six months from the date of opening of the Offer, by way of split or consolidation of the denomination of equity shares or further issue of equity shares (including issue of securities

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convertible into exchangeable, directly or indirectly for equity shares) whether preferential or otherwise, except that we may issue options to our employees pursuant to an employee stock option plan or, if we enter into acquisitions or joint ventures, we may consider raising additional capital to fund such activity or use equity shares as currency for acquisition or participation in such joint ventures. 16. We have not issued any equity shares out of revaluation reserves or for consideration other than cash, except for equity shares issued to President of India under the Acquisition Act. For details please refer to note no.1 given above and the section entitled “Our History”. 17. At any given point of time, there shall be only one denomination for the equity shares of our Company and we shall comply with such disclosure and accounting norms specified by SEBI from time to time. 18. We have 8 shareholders as on date. 19. We have entered into agreements with GoI and Suzuki. These agreements are agreements for licenses, agreements relating to the management of our Company and the rights and obligations of GoI, Suzuki and our Company and the put options between the GoI and Suzuki. For details of the various agreements referred to above, please refer to the section entitled “Our Promoter”. OBJECTS OF THE OFFER This being an Offer for Sale, the objects of the Offer are to list the equity shares of our Company and carry out the sale of 72,243,300 equity shares of Rs. 5/- each by the Selling Shareholder.

Our Business Unless otherwise indicated, all financial and statistical data relating to the automobile industry in the following discussion are derived from the CRIS INFAC Annual Review of 2001 or 2002. These data have been reclassified in certain respects for purposes of presentation. The references to prices of our products in this section are to the ex-showroom price in Delhi. The sales volumes for Maruti included in the following discussion are in respect of sales by Maruti to dealers, while computations of Maruti’s market share are based on retail sales volumes of Maruti vehicles set forth in the CRIS INFAC Annual Review of 2001 or 2002. For more information, see “Certain Conventions; Use of Market Data” of this Draft Red Herring Prospectus.

Overview We are a subsidiary of Suzuki Motor Corporation, the largest manufacturer of mini passenger vehicles in Japan since fiscal 1974, in terms of sales volumes, with a market share of 31.6% in 2002,

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according to the Japan Mini Vehicles Association. Suzuki was also the eleventh largest vehicle manufacturer in the world and the fourth largest manufacturer in Japan in terms of worldwide sales volumes in 2000, according to Automotive Intelligence. In 2002, Suzuki had a 22% share of the market in Asia for vehicles exported from Japan, according to the Japan Automobile Manufacturers Association. Maruti was ranked twentieth by Automotive Intelligence in terms of worldwide sales volumes amongst vehicle manufacturers. We have been the largest passenger car manufacturer in India since 1986. In the Indian passenger car market in fiscal 2002, we had the highest sales volumes of 339,964 cars and a market share of 58.6%. The remaining market share was divided among approximately nine other manufacturers. Our market share was more than three times the share of the manufacturer ranked second in terms of sales volumes for fiscal 2002, and exceeded the combined market share of other manufacturers by more than 40%. We have a diverse product range that includes ten basic models with over 50 variants, of which nine models are manufactured by us and one is imported from Suzuki, with prices ranging from approximately Rs. 200,000 to approximately Rs. 1.8 million. Our wide product range is supported by an extensive sales and service network in India. We manufacture cars for most segments of the Indian passenger car market, and are the leading manufacturer of cars priced below Rs. 500,000 comprising segments A and B, to which we refer as the small car segment. The small car segment constituted more than 86% of the Indian passenger car market in fiscal 2002. In fiscal 2002, we had sales volumes of 324,371 cars in the small car segment, which resulted in a market share in that segment of 64.9%. We intend to continue to focus on the small car segment, which we expect will continue to be the largest segment in the Indian passenger car market in the foreseeable future.

Our Principal Objectives As the leading manufacturer in the small car segment of the Indian market, we have the following principal objectives: � �

�

To strengthen our leadership position in the small car segment of the Indian market; To continue to expand the size of the Indian market for small cars by strengthening and expanding our dealer network and making automobile financing available at competitive rates; and To continue to benchmark ourselves against improving global manufacturing, marketing and other practices and standards, strive to increase customer satisfaction through quality products and new initiatives, and promote the financial strength of our dealer network.

Our History Prior to our incorporation, GoI had under the Acquisition Act, acquired the entire undertaking of Maruti Limited. We were incorporated on February 24, 1981 with the main object of acquir-

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ing and taking over from GoI the undertakings of Maruti Limited. All the land and property of Maruti Ltd’s factory had been acquired by the Central Government under the Maruti Ltd (Acquisition and Transfer of Undertakings) Act, 1980 (The Acquisition Act). Under “The Acquisition Act”, the Central Government has directed vide notification date April 24, 1981, that the undertakings of Maruti Ltd and the right, title and interest shall vest in the company known as Maruti Udyog Ltd. on and from April 23, 1981. Our main objects as set forth in our Memorandum of Association are: �

�

�

�

To acquire and take over from GoI the right, title, and interest in relation to the undertakings of Maruti Ltd. as provided for in the appropriate enactment of GoI together with the liabilities of GoI so far as they are related to the Undertakings of the said Company. To carry on the business of manufacturers of, and dealers in, automobiles, motorcars, lorries, buses, vans, motorcycles, cycle-cars, motor, scooters, carriages, amphibious vehicles, and vehicles suitable for propulsion on land, sea, or in the air or in any combination thereof and vehicles of all descriptions (all hereinafter comprised in the term “motor and other things”), whether propelled or assisted by means of petrol, diesel, spirit, steam, gas, electrical, animal, or other power, and of internal combustion and other engines, chassis-bodies and other components, parts and accessories and all machinery, implements, utensils, appliances, apparatus, lubricants, cements, solutions enamels and all things capable of being used for, in, or in connection with manufacture, maintenance, and working of motors and other things or in the construction of any track or surface adapted for the use thereof. To carry on the business of garage keepers and suppliers of and dealers in petrol, electricity and other motive power for motors and other things. To carry on in the business of iron founders, mechanical engineers, and manufacturers of machinery, tool makers, brass founders, metal workers, boiler makers, mill rights, machinists, iron and steel converters, smiths, wood workers, builders, electroplaters, chromium platers, lacquerers, enamellers, painters, metallurgists, electrical engineers, and printers and to carry on any branch of manufacturing and engineering business.

Our activities are carried out and in the past have been carried out in accordance with the objects as specified in our Memorandum of Association.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion of our financial condition and results of operations together with our audited unconsolidated financial statements for each of the fiscal years ended March 31, 1998, 1999, 2000, 2001 and 2002, and the nine months ended December 31, 2002, including the notes thereto and the reports thereon, which appear elsewhere in this Draft Red Herring Prospectus. These financial statements are prepared in accordance with Indian GAAP, which differs in certain significant respects from US GAAP.

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For more information on these differences, see “Summary of Significant Differences Between Indian GAAP and US GAAP” of this Draft Red Herring Prospectus. The following discussion is based on our audited unconsolidated financial statements for fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002, which have been prepared in accordance with Indian GAAP, and on information available from other sources. Our fiscal year ends on March 31 of each year, so all references to a particular fiscal year are to the twelve-month period ended March 31 of that year. Unless otherwise indicated, all financial and statistical data relating to the automobile industry in the following discussion are derived from the CRIS INFAC Annual Review of 2001 or 2002. These data have been reclassified in certain respects for purposes of presentation. The sales volumes for Maruti included in the following discussion refer to sales by Maruti to dealers, while computations of Maruti’s market share are based on sales to the customer set forth in the CRIS INFAC Annual Review of 2001 or 2002. For more information, see “Certain Conventions; Use of Market Data” of this Draft Red Herring Prospectus.

Overview We are the largest passenger car manufacturer in India. We sold 339,964 cars in India in fiscal 2002 with an overall market share of 58.6% in fiscal 2002. Our product range includes ten basic models with more than 50 variants. We are the leading manufacturer of cars in the A and B segments, which together constituted over 86% of sales in the Indian passenger car market in fiscal 2002. In fiscal 2002, we had a combined market share in the A and B segments of 64.9%. We also export certain models to various countries, which contributed 3.9%, 3.1%, 2.6% and 6.9%, respectively, of our total sales in fiscal 2000, 2001 and 2002 and the nine months ended December 31, 2002.

Evaluation of Factors Affecting our Operations Several factors have affected our results of operations in the past and may continue to do so in the future, including: Competition As the number of international and domestic automobile manufacturers in the Indian passenger car market has increased in recent years with several new entrants, competition has been intense in the Indian passenger car market. While our product range includes products in each of segments A, B and C, we focus primarily on the A and B segments of the passenger car market in India, which together constituted more than 86% of sales volumes in the Indian passenger car market in fiscal 2002. The sales of the Maruti 800 and Omni, our A segment models, contribute a substantial portion of our revenue. In fiscal 2000, 2001 and 2002, sales of the Maruti 800 comprised 49.1%, 45.3% and 42.5%, respectively, of our domestic sales volumes. We are currently the only manufacturer that sells passenger cars in the A segment. In segment B, we compete primarily with Hyundai, Telco and Fiat. Sales of the Zen, Alto and WagonR, our models in the B

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segment, comprised 38.1% of our domestic sales volumes in the nine months ended December 31, 2002. Our market share in segment B was 31.3%, 36.9% and 40.3% in fiscal 2000, 2001 and 2002, respectively. Our sales volumes in the combined A and B segments comprised 95.4% of our domestic sales volumes in fiscal 2002. The segments for cars priced above Rs. 500,000, which together constituted approximately 14% of the Indian passenger car market in fiscal 2002, are significantly more fragmented than the small car segment, with several players competing for what has been a relatively small share of the passenger car market in terms of sales volumes. Sales of the Esteem, Versa and Baleno, our models in the C segment, comprised 4.2% of our domestic sales volumes in the nine months ended December 31, 2002. Other players in segment C include Hyundai, Ford, Honda, General Motors, Hindustan Motors and Fiat. Our market share in segment C was 29.3%, 18.9% and 19.6% in fiscal 2000, 2001 and 2002, respectively. In the future, we may also face competition from other domestic and international manufacturers that enter into the A and B segments, including international manufacturers that have been successful in foreign markets for cars of a similar size but are yet to enter these segments in India. Substantial investments are required in order to set up manufacturing facilities with the scale required to compete effectively in the Indian passenger car market, especially in the small car segment. We believe that this has contributed to the concentration of relatively few players in the small car segment in comparison with greater fragmentation in the C and D segments. Our manufacturing facility has an installed capacity of 350,000 vehicles per year. We have, in each of the five fiscal years ended March 31, 2002, produced in excess of our installed capacity. We believe that, with minimal capital expenditure, we would be able to produce more than 500,000 vehicles per year. While we had a capacity utilization of approximately 102% in fiscal 2002, the average capacity utilization among the major players in the Indian passenger car industry was approximately 58%. We believe that our ability to expand our production volumes without significant additional capital expenditure and our relatively high levels of capacity utilization generate significant economies of scale and are a significant competitive strength in the small car segment. In addition, our access to Suzuki technology, the range of models and variants in our product portfolio, our brand image and our extensive sales and service network are competitive strengths in the A and B segments of the Indian passenger car market. While our market share may fluctuate from year to year, we expect to maintain our leadership position in the small car segment in India. In order to compete effectively, we have incurred, and expect to continue to periodically incur, expenditure either in the development of new models or their variants, or in the upgradation of existing models and their variants. In addition, the cost of producing new models is initially high compared to existing models and generally declines over the life of the model. We expect that these factors will continue to affect our results of operations in the foreseeable future. Although we produce some cars that run on diesel, liquefied petroleum gas and compressed natural gas, most of the cars we produce run on petrol. Some of our competitors sell cars that run on

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diesel, which is currently less expensive than petrol in India, although the price differential between petrol and diesel in India has declined over time. The success of diesel-run cars in the Indian market will depend on a number of factors, including the suitability of diesel engines for cars in the small car segment, the costs incurred by manufacturers in developing the capability to produce cars that run on diesel, the differential between diesel prices in relation to the price of petrol in India, and the ability of diesel engine technology in India to comply with emission norms. We will continue to evaluate our strategy in respect of diesel-run cars. In addition, we face competition in our export markets. We do not expect that our export sales will grow significantly as a percentage of our total sales in the near future. New model introductions In the highly competitive environment of the Indian passenger car industry, it is important to periodically introduce new models that address customer demand in terms of their price, features and performance. Following the settlement in June 1998 of the dispute between our shareholders, we launched the WagonR (segment B) and Baleno (segment C) in December 1999, the Alto (segment B) in September 2000 and the Versa (segment C) in October 2001. Thus, in the short span of 22 months from December 1999, we launched four new models, in addition to certain variants. We expanded our installed capacity to 350,000 with our third plant becoming operational in March 1999. The expansion of our capacity and the launch of these models required substantial capital investment over a relatively short period, resulting in relatively high depreciation. In addition, the cost of components was relatively high due to low levels of localisation early in the life of the models. Further, the delay in the launch of our segment B models allowed competitors to launch and gain market share for their own models prior to the launch of our models. These factors adversely affected our profitability and contributed to our loss before tax in fiscal 2001. The launch of a new model tends to affect our results of operations in the following ways: �

�

Depreciation. Preparation for the launch of a new model usually requires substantial capital investment, which results in depreciation charges over the life of the model. Capitalization of plant and machinery acquired in connection with new model launches and capacity expansion led to relatively high depreciation of Rs. 2,631 million, Rs. 3,223 million and Rs. 3,429 million in fiscal 2000, 2001 and 2002, respectively. Depreciation as a percentage of net sales was 3.8%, 4.8%, 4.8% and 4.8% in fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002. We expect depreciation as a percentage of net sales to decline in fiscal 2003 and fiscal 2004. Cost of Components. Our new models typically use a higher proportion of imported components, and therefore have lower levels of localisation, than our existing models. We generally increase the level of localisation over time by working with vendors to increase the proportion of locally sourced components. Generally, the cost of locally sourced components is less than the cost of imported components. The high cost of components in the initial period of production of the WagonR, Alto and Baleno was one of the factors in the increase in consumption as a percentage of net sales from 74.7% in fiscal 1999 to 80.2% in fiscal 2000 and 88.6% in fiscal 2001. Subsequently,

946

�

�

�

Investment Banking consumption as a percentage of net sales declined to 80.7% and 79.9% for fiscal 2002 and the nine months ended December 31, 2002, respectively. Primarily through collaborative efforts with vendors in India, we expect to increase the initial levels of localization in our new models. Economies of Scale. Our new models typically take time to generate the sales volumes necessary to achieve significant economies of scale. As a result, early in the life of the model, the increases in sales may not be sufficient to offset the effect of relatively high levels of depreciation and cost of components on our results of operations. Market acceptance. The ability of our new models to achieve anticipated sales volumes in order for us to recover our initial investment and achieve economies of scale will depend on their market acceptance and other market conditions. Changing Product Mix. Our product mix changed in fiscal 2002 primarily due to a 12% increase in the domestic sales of the Zen, WagonR and Alto. The average selling price, inclusive of excise duty and freight, for our vehicles during fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002, was Rs. 218,490, Rs. 241,188, Rs. 240,852 and Rs. 242,379, respectively. The increase in the average selling price between fiscal 2000 and fiscal 2001 was primarily due to a change in our product mix due to the launch of the WagonR and Baleno models in December 1999, in the B and C segments, respectively.

Cost reduction measures Steel and automobile components comprised 94% of our consumption of raw materials and components in fiscal 2002. We enter into contracts with suppliers of these inputs in order to fix our input costs over a defined period. Fluctuations in input costs for steel and automobile components affect our cost of raw materials and components and therefore our results of operations. An essential component of our strategy to remain profitable in a competitive environment is to reduce our costs and increase our operational efficiency. We have been able to reduce our costs significantly since fiscal 2001 by: �

�

�

�

reducing the costs of our components primarily through increasing our levels of localisation; increasing productivity in our manufacturing facility and at vendors’ facilities, and enhanced focus on quality in relation to our products and those of our vendors to reduce warranty costs; measures to reduce costs of producing a component without changing its functional utility, which we refer to as value analysis and value engineering; and better inventory management.

The resulting cost reduction was a primary factor in our ability to generate a profit before tax of Rs.1,183 million in fiscal 2002 after incurring a loss before tax of Rs. 2,692 million in fiscal 2001. In addition, we have recently entered into a joint venture with Suzuki to establish an aluminium foundry. The foundry will manufacture components such as cylinder heads, cylinder blocks for

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aluminum engines and transmission cases. We believe that this venture will help us to increase our localisation levels and reduce costs. We intend to continue these cost reduction measures in the foreseeable future. We expect that our ability to reduce costs in the next two fiscal years will be enhanced by the following commitments by Suzuki: �

�

For fiscal 2004 and fiscal 2005, Suzuki will provide a 10% discount on knocked down components imported by us, except for components imported for the Alto built for export. Thereafter, the discounts will be determined subject to market conditions in India. With respect to the Alto which is built for exports, discounts are already applicable from February 2003 until January 2004. The value of our purchases of components from Suzuki in fiscal 2002 and the nine months ended December 31, 2002 is Rs. 7,804 million and Rs. 5,851 million, respectively. Suzuki will no longer charge royalty for the Maruti 800, Omni, Gypsy, Esteem and Zen models. This arrangement is subject to revision in the event of the introduction of new technology or upgradation in specifications due to changes in market conditions or requirements of new laws or norms. The total royalty expenses on these models paid to Suzuki in fiscal 2002 were Rs. 779.5 million.

Due to a decision of the Supreme Court of India applicable to the industrial usage of natural gas, we are no longer able to use natural gas as fuel for generating power in our captive power plant. Instead, we are currently using naphtha as fuel. Naphtha is more expensive than natural gas. We expect that our power and fuel expenses will be higher in fiscal 2003 as compared to fiscal 2002. We continue to look for less expensive sources of fuel.

Environmental and fiscal regulation Environmental regulation. To comply with current and future environmental regulation, we may have to incur substantial capital expenditure and research and development costs to upgrade our products and our manufacturing facility, which may increase our cost of production. For example, in fiscal 2001 we incurred substantial additional costs to upgrade our vehicles to comply with Bharat Stage II emission norms. The more stringent Bharat Stage III emission norms may become applicable in the future, and will entail additional costs for automobile manufacturers in the industry, including us, and may also result in an increase in the price to the customer of our products. Fiscal regulation. Changes in excise duties, sales tax and customs duties, and other fiscal levies affect the costs of manufacturers including ourselves, are reflected in the price to the customer, and therefore can stimulate or adversely affect demand for cars in the country. For example, in May 2000, in response to the introduction of the uniform sales tax in that month, we reduced the prices of several models in order to keep the price to the customer unchanged, which resulted in a decline in the rupee value of our total sales and profitability for fiscal 2001. The rate of excise duty on passenger cars has declined in recent years, beginning with a reduction from 40% to 32% in March 2001. The GoI’s union budget of March 2003 further reduced the rate of excise

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duty to 24% and levied a National Calamity Contingency duty at the rate of 1%. Excise duty is recovered at actual cost and included in the selling price of our cars. Reduction in the rate of excise duty therefore reduces the price to the customer and thereby tends to stimulate demand for passenger cars, especially in the price-sensitive A and B segments. We also benefit from a duty drawback on exports, which enables us to recover import duties levied on imports used to manufacture products for export. We expect that changes in taxes or levies, the imposition of new taxes or levies in the future, or the loss of tax or other benefits we currently enjoy, will continue to be factors affecting our business, results of operations and financial condition. Foreign exchange rate fluctuations We import a substantial proportion of our components, especially for newer models, from Suzuki in Japan. Since the cost of these components is denominated in Yen, fluctuations with respect to the exchange rate of Yen for Indian Rupees can increase or reduce our input costs. In addition, we are subject to exchange rate fluctuations in relation to the export of our products. We enter into foreign exchange forward and derivative contracts to hedge these risks, but these contracts may not protect us fully from losses due to fluctuations in foreign exchange rates. Macroeconomic environment Income levels of consumers are key determinants of demand in the passenger car market. In addition, interest rates tend to have an impact on our sales as availability and cost of car finance is one of the key drivers of demand in India. Demand for passenger cars can also be affected by factors such as a change in fuel prices, the performance of the Indian economy and competition from alternative modes of transport. Such changes are likely to continue to have an impact on the business of passenger car manufacturers in India, including us. Consolidated reporting Our audited consolidated financial statements consolidating (1) the results of operations and financial condition of our subsidiaries for the fiscal year ended March 31, 2002 and the nine months ended December 31, 2002, and (2) the results of operations and financial condition of our subsidiaries, our joint ventures and our associates for the nine months ended December 31, 2002, are included elsewhere in this prospectus under “Consolidated Financial Statements as per AS 21” and “Consolidated Financial Statements as per AS 21, AS 23 and AS 27”, respectively. Following this offering, we expect to report on a periodic basis our consolidated results of operations for fiscal 2003 onwards, consolidating the results of our subsidiaries, our joint ventures and our associates, in addition to our unconsolidated results of operations. Revenue Our revenue has two components: total sales and other revenue. Our total sales comprise sales of products manufactured by us and sales of products manufactured for our vehicles by vendors and sold by us.

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Sales of products manufactured by us The sales of products manufactured by us comprise: � � �

domestic sales of vehicles; exports of vehicles; and sales of spares, dies and moulds.

We recognize domestic sales upon dispatch of goods from the factory. We recognize sales from exports upon dispatch of goods from the port of embarkation. Sales of products manufactured by us includes excise duty and freight, which are also included in our expenditure. Domestic sales of vehicles. Domestic sales of vehicles contributed 90.3%, 90.5%, 90.2% and 87.8% to total sales in fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002, respectively. We sold 384,850, 335,133, 339,964 and 230,618 vehicles in the domestic market during fiscal 2000, 2001 and 2002 and the nine months ended December 31, 2002, respectively. We revise our selling prices periodically depending on market conditions, modifications in product features and changes in government regulation. Our major revisions in selling prices during the three years and nine months ended December 31, 2002 occurred in May 2000 for several models in response to an increase in sales tax resulting from the introduction of the uniform sales tax in that month, and in July 2002, for the Maruti 800 model. Exports of vehicles. We export our Alto and Maruti 800 models to various countries including the Netherlands, Italy, Germany, United Kingdom, France, Bangladesh, Nepal, Sri Lanka, Chile and Egypt. Our cars are exported mainly under the Suzuki brand. Export sales of vehicles contributed 3.9%, 3.1%, 2.6% and 6.9%, respectively, to our total sales in fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002. We exported 21,450, 15,300, 12,233 and 21,172 vehicles, respectively, during fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002. Sales of manufactured spares, dies and moulds. We manufacture spares, dies and moulds for our vehicles. The spares that are manufactured are primarily body and engine parts. Our sales of manufactured spares constituted 17.2% of our total sales of spares and accessories in the nine months ended December 31, 2002. Sales of manufactured spares, dies and moulds constituted 0.8%, 0.9%, 1% and 1%, respectively, of our total sales in fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002. Sales of products traded by us We import or purchase locally spares and accessories and sell them to dealers and wholesale traders in spare parts, whom we refer to as stockists. Sales of traded spares and accessories contributed 3.3%, 4.1%, 4.7% and 4.3%, respectively, of total sales in fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002.

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We purchase dies and moulds used in the manufacture of various components for the launch of new models or modifications of existing models and sell the same to vendors at actual cost for use in the manufacture of components for us. Sales from traded dies and moulds contributed 1.8%, 1.4%, 1.6% and 0.02%, respectively, of total sales in fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002. Other revenue Other revenue consists primarily of the sale of scrap, interest on investments and receivables, net gains from sale of investments, sale of power, sales tax incentives granted under the Haryana Sales Tax law for a period of 14 years beginning August 2001, and revenue from our new business initiatives. Sale of power was discontinued in April 2002 after natural gas became unavailable as a fuel for generating power in our captive power plant. Revenue from new business initiatives comprises revenue from services provided by us in connection with automobile finance, leasing and fleet management and sale of pre-owned cars. We generated Rs. 44 million of net revenue in the nine months ended December 31, 2002 from the new business initiatives. Other revenue contributed approximately 3.7%, 3.5%, 3.5% and 3.8% of the total revenue in fiscal 2000, 2001 and 2002 and the nine months ended December 31, 2002 respectively.

Expenditure Consumption Consumption includes: �

consumption of raw materials and components, which includes consumption of imported and indigenous components, steel and other consumables such as paints;

�

cost of spares/dies and moulds sold;

�

consumption of stores;

�

�

(accretion)/decretion to work-in-progress and finished goods, which includes the value of goods that are works-in-progress and finished goods that were not sold; and vehicles for own use.

The consumption of raw materials and components constituted 90% of consumption in the nine months ended December 31, 2002. We record imported components at landed cost. Raw materials and components sourced from within India contributed 68%, 67%, 72% and 73%, respectively, of our total consumption of raw materials and components in fiscal 2000, 2001, 2002 and the nine months ended December 31, 2002.

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Excise duty Excise duty expense includes excise duty on manufactured vehicles, manufactured spares, manufactured dies and moulds and scrap generated. Excise duty is recovered at actual cost and included in our selling prices. Manufacturing/administrative and other expenses Our manufacturing/administrative and other expenses consist primarily of running royalty paid under our licence agreements with Suzuki and power and fuel expenses for the production of power by our captive power plant. We pay a lump sum and running royalty to Suzuki in accordance with the terms of licence agreements for the transfer of various technologies. We pay a fixed amount as lump sum royalty in connection with the launch of each model. Running royalty is calculated every six months as a fixed percentage of the free on board, or FOB value of the components not imported from Suzuki, for any given model. In fiscal 2002, the running royalty was Rs. 1,160 million, of which Rs. 779.5 million was paid in respect of the Maruti 800, Omni, Zen, Gypsy and Esteem models. Power and fuel expenses constituted 11.4%, 16%, 14.5% and 22.9%, respectively, of our manufacturing/administrative and other expenses in fiscal 2000, 2001, 2002 and the nine months ended December 31, 2002. Selling and distribution expenses Selling and distribution expenses consist primarily of advertisement, publicity and sales promotion expenses and commissions and incentives to dealers. Freight expenses, which are also a major constituent of selling and distribution expenses, are, in the case of domestic sales, recovered at actual cost and included in total sales. Adjusted Profit/(Loss) after Tax The adjusted profit/(loss) after tax consists of the net profit/(loss) after tax as per the audited statement of accounts, adjusted on account of (1) changes in accounting policies and (2) the impact of material adjustments and prior period items. Our critical accounting policies Preparation of financial statements in accordance with generally accepted accounting principles in India, the applicable accounting standards issued by the Institute of Chartered Accountants of India and the relevant provisions of the Companies Act, 1956, require our management to make judgements, estimates and assumptions regarding uncertainties that affect the reported amounts of our assets and liabilities, disclosures of contingent liabilities and the reported amounts of revenues and expenses. These judgements, assumptions and estimates are reflected in our accounting policies, which are more fully described in the auditor's report appearing elsewhere in this prospectus.

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Investment Banking

Certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant assumptions and estimates of our management. We refer to these accounting policies as our “critical accounting policies”. Our management uses its historical experience and analyses the terms of existing contracts, historical cost convention, industry trends, information provided by our dealers and information available from other outside sources, as appropriate, when forming its assumptions and estimates. However, this task is inexact because our management is making assumptions and providing estimates on matters that are inherently uncertain. While we believe that all aspects of our financial statements should be studied and understood in assessing our current and expected financial condition and results, we believe that the following critical accounting policies warrant additional attention: Fixed assets We carry fixed assets (except freehold land) at cost of acquisition or construction or at manufacturing cost (in case of own manufactured assets) in the year of capitalization less accumulated depreciation. In respect of the various project related activities, which are carried on concurrently with production, expenses on administration and supervision incurred, the bifurcation of which between production and construction activities is not ascertainable, are charged to revenue. Depreciation Fixed assets except for leasehold land are depreciated on straight-line method on a pro-rata basis from the month in which the asset is put to use. For assets capitalized before April 2, 1987, depreciation has been provided at the rates computed in terms of Section 205(2)(b) of the Companies Act, 1956, in terms of Circular No. 1/86 dated 21.05.86 of the GoI. For assets capitalized on or after April 2, 1987, depreciation has been provided at the rates prescribed in Schedule XIV to the Companies Act, 1956 except for certain fixed assets where based on our management's estimate of the useful life of the assets, higher depreciation has been provided at the following rates: Plant and Machinery: Single Shift Double Shift Triple Shift Dies and Jigs:

7.31% 11.88% 15.83% 19.00%

We amortize leasehold land over the period of lease. We depreciate at the rate of 100%, plant and machinery, the written down value of which at the beginning of the year is Rs. 5,000

Appendix 2

953

or less and other assets the written down value of which at the beginning of the year is Rs.1,000 or less. We provide the depreciation on revised unamortised depreciable amount prospectively, over the residual useful life of the asset, in case of assets where the historical cost has undergone a change due to increase or decrease in long-term liability on account of foreign exchange fluctuation, change in duties, etc. Estimates of useful life are subject to changes in economic environment and different assumptions and conditions. Factors such as changes in planned uses of buildings, machinery or equipment could result in shortened useful lives or impairment. Inventories We value inventories at lower of cost, determined on weighted average basis, and net realizable value. We estimate the net realizable value based upon the prevailing market prices subsequent to the end of the fiscal year. We write off tools over a period of three years except for tools valuing Rs. 5,000 or less individually which are charged off to revenue in the year of purchase. We charge off machinery spares, other than those supplied along with main plant and machinery, which are capitalized and depreciated accordingly, to revenue on consumption except those valuing Rs. 5,000 or less individually, which are charged off to revenue in the year of purchase and those whose value are not individually ascertainable are written off over a period of three years. Investments We value our current investments at lower of cost and fair value. We value our long-term investments at cost except in case of permanent diminution in their value, wherein necessary provision is made. Deferred Revenue Expenditure We write off deferred revenue expenditure over the period of its benefit. Estimates of period of its benefits are subject to changes in economic environment and different assumptions and conditions. Deferred Tax The tax expense for the year or period, as applicable, comprising current tax and deferred tax, is included in determining the net profit/(loss) for such year or period. However, in fiscal 2003, the year during which liability provision must be created, the accumulated deferred tax liability at the beginning of the year has been recognized with a corresponding charge to the general reserve in accordance with Accounting Standard 22 issued by the Institute of Chartered Accountants of India.

954

Investment Banking

We recognize deferred tax assets for all deductible timing differences and carry forward to the extent it is probable that future taxable profit will be available against which such deferred tax assets can be realized. We review our deferred tax assets at each balance sheet date and writedown/write-up to reflect the amount that is reasonably/ virtually certain (as the case may be) to be realized. We may reduce from time to time the amount of our deferred tax assets considered realizable if our estimates of future taxable income are reduced or there is a change in the governing taxation laws. Deferred tax assets and liabilities are measured at the tax rates that have been enacted or substantively enacted at the balance sheet date. Contingent liabilities Contingent liabilities are accounted as per Accounting Standard 4 on “Contingencies and Event Occurring After Balance Sheet Date” issued by the Institute of Chartered Accountants of India. Contingent loss arising from tax disputes and other claims are provided for when it is probable that: a liability has been incurred as at the balance sheet date; and � an amount can be reasonably estimated. This requires significant management judgements which may be based on opinions of legal experts, wherever necessary. �

Disclosure by way of “notes to the accounts” is made when either of the above conditions is not met and possibility of loss is not remote.

Liquidity and Capital Resources Liquidity Our primary liquidity needs have been historically to finance our working capital needs and our capital expenditures. To fund these costs, we have relied on cash flows from operations and short-term and long-term borrowings. Cash Flows The table below summarizes our cash flows for the years ended March 31, 2002 and March 31, 2001 and the nine months ended December 31, 2002. (Rs . in millions )

Cash Flow Net Cash Flow from (used in) operating activities Net Cash Used in investing activities

D ecember 31, 2002

M arch 31, 2002

M arch 31, 2001

7,640

6,539

(2,448)

(9,463)

(1,281)

(1,935)

955

Appendix 2 Net Cash flow from (used in) financing activities Net Increase/(Decrease) in Cash and Cash Equivalents

1,333

(5,415)

4,942

(490)

(157)

559

Figures in brackets represent cash outflow.

Our cash flows from operations are influenced primarily by capital expenditure, working capital requirements and cash from operations and incurrence and repayment of debt. Our net cash flow provided by operating activities was a negative Rs. 2,448 million in fiscal 2001, primarily due to our increased working capital requirements and our loss before tax in fiscal 2001. Our cash flow from operating activities before working capital changes in fiscal 2001 was Rs. 440 million. Our net cash flow from operating activities was Rs. 6,539 million in fiscal 2002, primarily due to our reduced working capital requirements and profit before tax in fiscal 2002. Our net cash flow from operating activities for the nine months ended December 31, 2002 was Rs. 7,640 million. Net cash used in investing activities was a negative Rs. 1,935 million and a negative Rs. 1,281 million during fiscal 2001 and 2002 respectively and a negative Rs. 9,463 million for the nine months ended December 31, 2002. Our net cash used in investing activities for fiscal 2001 related primarily to purchase of fixed assets for the launch of new models and capacity expansion, partially offset by proceeds received from the sale of our investments in certain mutual funds and bonds. Our net cash used in investing activities for fiscal 2002 related primarily to the purchase of fixed assets for the launch of the Versa model in November 2001. Our net cash used in investing activities for the nine months ended December 31, 2002 related primarily to investment of surplus funds in mutual funds. Our net cash flow from financing activities was Rs. 4,942 million in fiscal 2001, primarily due to an issuance of non-convertible debentures to help fund our capital expenditure requirements, and a negative Rs. 5,415 in fiscal 2002, primarily due to repayment of short-term borrowings. Our net cash from financing activities increased to Rs. 1,333 million in the nine months ended December 31, 2002, primarily due to proceeds we received from our rights issue to Suzuki in the amount of Rs. 3,990 million in May 2002, partially offset by repayment of short-term borrowings.

Indebtedness Key terms of our outstanding indebtedness as of December 31, 2002 were as follows: 11.20% secured non-convertible redeemable debentures. We had an aggregate principal amount of Rs. 2,000 million of our 11.20% secured non-convertible redeemable debentures (Series I) outstanding at December 31, 2002. These debentures are redeemable at par on July 24, 2007 with

956

Investment Banking

a put or call option on July 24, 2005. These debentures bear interest at a rate of 11.2% per annum and are secured by mortgages on specific buildings and plant and machinery. 12.00% secured non-convertible redeemable debentures. We had an aggregate principal amount of Rs. 1,000 million of our 12.00% secured redeemable non-convertible debentures (Series II) outstanding at December 31, 2002. Of this aggregate principal amount, 30% is payable on December 4, 2005, 30% on December 4, 2006 and the remaining 40% on December 4, 2007. These debentures bear interest at the rate of 12% per annum and are secured by mortgages on specific buildings and plant and machinery. Long-term foreign currency loan. We had an aggregate principal amount of US$30 million outstanding under long term foreign currency external commercial borrowing from Bank of Tokyo—Mitsubishi at December 31, 2002. The first tranche of US$10 million of the outstanding principal amount is repayable on February 16, 2004, and the second tranche of US$20 million is repayable on February 27, 2004. The interest rate applicable to the long-term foreign currency loan is 0.60% per annum over six months floating London Interbank Offered Rate, or LIBOR, the LIBOR rate being reset every six months. The loan is secured by a negative lien on specific fixed assets of our company. Working capital facility. We had an aggregate principal amount of Rs. 115 million outstanding under a secured working capital facility from HDFC Bank at December 31, 2002. The interest rate applicable to the loan is 0.75% per annum over the Mumbai Interbank Offered Rate, or MIBOR, compounded on a daily basis. The loan is secured by a pari passu first charge on our stock, book debts and other current assets. Off-balance sheet arrangements Vendors of certain components need specific dies and moulds to manufacture those components for us. These dies and moulds are customized for specific models. Substantial investment is required for the purchase of these dies and moulds. To make these dies and moulds available to vendors, we have entered, as co-lessee, into various agreements between various vendors, as lessees, and finance companies or banks, as lessors, for the leasing of dies and moulds for certain models. The aggregate amounts of our obligations under such agreements were Rs. 1,639 million at March 31, 2000, Rs. 3,545 million at March 31, 2001, Rs. 3,384 million at March 31, 2002, and Rs. 2,645 million at December 31, 2002. We have also provided guarantees to finance companies for term loans and for lease finance given to various vendors, for purchase of dies and moulds for certain models. At December 31, 2002, we were guarantors to certain finance companies for term loans in the aggregate principal amount of Rs. 60 million and for lease financing of Rs. 437 million, to facilitate the purchase by various vendors of dies and moulds of certain models. We have also provided a guarantee to HDFC Limited for a term loan of Rs. 350 million to Maruti Employees Co-operative House Building Society Limited and the amount outstanding under the loan at December 31, 2002 was Rs. 190 million.

Appendix 2

957

Historical and planned capital expenditures In fiscal 2001, we had purchased fixed assets amounting to Rs. 6,036 million, primarily for the launch of new models and capacity expansion. Our total borrowings in fiscal 2001 increased by Rs. 5,617 million. In fiscal 2002, we had purchased fixed assets amounting to Rs. 2,229 million, primarily for the launch of the Versa model in November 2001. Our total borrowings in fiscal 2002 decreased by Rs. 4,626 million. We have received the necessary authorizations and expect to spend an aggregate amount of approximately Rs. 3,580 million in fiscal 2004 on the following projects: �

automation and research and development;

�

minor modifications to existing models and workshops;

�

normal annual capital maintenance; and

�

construction of a new corporate office and marketing plaza.

We may adjust the amount of our capital expenditure upward or downward based on our cash flow from operations and market conditions. Principal sources of liquidity At December 31, 2002, cash and bank balances and current investments amounted to Rs. 9,992 million. We believe that our anticipated cash flows from operations, together with our existing cash and issuance of short-term and long-term debt, will be sufficient to meet our working capital and capital expenditure requirements for fiscal 2004. Our anticipated cash flows from operations however depend on a number of factors beyond our control, such as demand for passenger cars, prevailing economic conditions in the market, the competition in the automobile industry and the cost of our inputs. We may therefore need to incur additional indebtedness.

Transactions with Related Parties We have entered into several transactions for transfer of technology, purchase of components and training of personnel with Suzuki. We believe that the prices paid for the purchase of components from Suzuki are not comparable with prevalent market prices, as the components are of a specialised nature. We enter into contracts for exports of vehicles to some of Suzuki’s subsidiaries in other countries. We have also entered into certain transactions with many of our joint ventures and subsidiaries. In the ordinary course of business, certain loans and advances are given to many of our vendors on commercially reasonable terms having regard to market conditions. Some of our joint ventures and associates avail of the same policy. For more information, see “Related Party Transactions” of this Draft Red Herring Prospectus.

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Investment Banking

In addition, our board of directors has approved long-term and short-term loans to be granted from time to time of a maximum aggregate amount of Rs. 950 million to Suzuki Metals Private Limited, or SMPIL, our joint venture with Suzuki, set up to establish an aluminium foundry. As of December 31, 2002, an aggregate amount of Rs. 60 million in loans was outstanding. The interest rate charged by Maruti to SMPIL was benchmarked against interest rates offered by financial institutions. As of March 31, 2003, we had no loans outstanding to directors and an aggregate amount of Rs.953,051 outstanding in loans to key management personnel. All employees, including directors and key management personnel, are entitled to various categories of loans in accordance with our policy.

Quantitative and Qualitative Disclosures about Market Risk Our exposure to market risk is a function of our manufacturing and selling activities. We are exposed to market risk from changes in both foreign exchange rates and interest rates. Exchange rate risk We face exchange rate risk to the extent that our receivables and payables are denominated in currencies other than Indian rupees. We import raw materials and components and make royalty payments for technology licenced from Suzuki. All these costs are denominated in foreign currencies, with substantially all imports of components denominated in Yen, imports of raw materials denominated in US dollars and royalty payments denominated in Yen. Our aggregate cost of imported raw materials and components was Rs. 17,924 million and Rs. 15,003 million in fiscal 2001 and 2002, respectively. Our aggregate cost for running royalty payments to Suzuki was in the amount of Rs. 872 million in the nine months ended December 2002 and Rs. 1,160 million in fiscal 2002, respectively. Exports of vehicles contributed 3.9%, 3.1%, 2.6% and 6.9%, respectively, of our total sales in fiscal 2000, 2001 and 2002, and the nine months ended December 31, 2002. These sales were denominated primarily in US dollars. In addition, we have US$30 million outstanding under a long-term foreign currency loan repayable in February 2004. Appreciation or depreciation of the Indian rupee relative to the currency of our payables and receivables can increase our payment obligations or reduce our export sales. We enter into foreign exchange forward and derivative contracts to hedge these risks, but these contracts may not protect us fully from losses due to fluctuations in foreign exchange rates. Interest rate risk Our interest rate risk results from changes in interest rates, which may affect our financial expenses. We bear interest rate risk with respect to the following indebtedness:

Appendix 2

959

The rate of interest applicable to the US$30 million outstanding at December 31, 2002 under our long-term foreign currency loan is 0.60% per annum over six months floating LIBOR, the LIBOR rate being reset every six months. This loan is repayable in full in February 2004. The rate of interest applicable to the Rs. 115 million outstanding at a spread of 0.75% per annum over the Mumbai Interbank Offered Rate, or MIBOR, compounded on a daily basis. On November 13, 2001, we entered into a rupee-interest rate swap with a nominal value of Rs. 1,000 million to be amortised in line with the repayment schedule for our 12.00% secured redeemable non-convertible debentures (Series II) with Citibank N.A. Under the swap agreement, effective November 15, 2001, we swapped our fixed interest rate liability of 12% per annum on our debentures Series II of Rs. 1,000 million until maturity on December 4, 2007, into a floating rate of interest at a spread of 3.18% over the “Average five year GoI Securities”, computed as the simple average of the daily five year annualized yield for GoI securities for ten business days preceding and including the interest payment date. The first setting of five year GoI securities rate was done in advance at the time of entering into the swap at 7.46% per annum to be valid till December 3, 2002. The subsequent resets will be done annually in arrears. We are entitled under the swap agreement to receive a fixed rate of interest on the aggregate principal amount of Rs. 1,000 million at the fixed rate of 12% per annum. A rise in interest rates may increase our interest payment obligations under the instruments described above. We do not bear interest rate risk in relation to our other indebtedness, all of which requires interest payments at fixed rates of interest.

Effect of Inflation During fiscal 2000, 2001 and 2002, the All India Consumer Price Index increased by 3.5%, 3.8% and 4.2%, respectively. Since we set the price for our products sold in India based on various factors, including inflation, inflation has not had a significant effect on the result of our operations to date. We do not expect that inflation rates in India will have a significant impact on our results of operations for the foreseeable future.

Unusual and Infrequent Events or Transactions There have been no events, to our knowledge, other than as described in this prospectus, which may be called “unusual” or “infrequent”.

Significant Accounting and Regulatory Changes Accounting Standard 22 on deferred taxes became mandatory with effect from April 1, 2002, resulting in significant increase in amount of income tax provision.

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Investment Banking

New products or Business Segments We are in the business of manufacturing cars. As part of our continuing operations, we have introduced and will continuing to introduce various new models or variants of existing models depending on varying market conditions and customer preferences. We have recently entered into certain new businesses. For more information on these businesses, see “Our Business — New Business Initiatives” of this Draft Red Herring Prospectus.

CORPORATE GOVERNANCE The guidelines in respect of corporate governance will be applicable to us immediately upon the listing of our equity shares on the Stock Exchanges. We undertake to adopt the Corporate Governance Code as per clause 49 of the listing agreement of the Stock Exchanges prior to entering into the listing agreement. We intend to comply with SEBI guidelines in respect to corporate governance, especially with respect to the appointment of independent directors to our board and constituting our board committees: the Shareholding/Investor Grievance Committee; and the Audit Committee; and the Compensation Committee.

REVISED JOINT VENTURE AGREEMENT Suzuki entered into a license agreement (the “License Agreement”) with us on October 2, 1982. In order for us to implement the License Agreement, we invited Suzuki to become a shareholder in our Company and entered into a Joint Venture Agreement with GoI and Suzuki on October 2, 1982. Pursuant to the Joint Venture Agreement, Suzuki subscribed to 26% of the paid up and issued equity share capital of our Company, which was later increased to 40% in 1988. Suzuki, GoI and we entered into an agreement concerning major policy decisions dated October 2, 1982. This agreement listed the decisions for which the concurrence of Suzuki was required. Suzuki, GoI and we also entered into a Subscription and Amendment Agreement dated June 2, 1992 (“Amendment Agreement”) whereby Suzuki increased its shareholding in our company to 50%. As part of its ongoing disinvestment program GoI decided to transfer management control to Suzuki by renouncing its share in the rights issue of our Company to Suzuki and entered into the RJVA on May 15, 2002. Suzuki paid Rs. 10,000 million as control premium to the GoI and in addition to its own, it also subscribed to GoI’s share of the our rights issue. Suzuki agreed to subscribe and pay for 1,216,341 equity shares at the subscription price of Rs. 3,280 per equity share (Rs. 100 being the face value and Rupees Three Thousand One Hundred and Eighty (Rs. 3,180) being the premium). Suzuki became our majority shareholder and now owns 54.2% of our equity shares. The RJVA substituted and replaced, in its entirety, the Joint Venture Agreement as amended subsequently by the Subscription and Amendment Agreement and the Major Policy Decisions Agreement between GoI and the Suzuki.

Appendix 2

961

The RJVA and Suzuki’s subsequent letter dated February 19, 2003 provide that GoI shall divest all of its shareholding or at least 25% of our paid up share capital in a public offer through price discovery by way of a book building process by July 31, 2003 in one tranche. GoI has the option to extend the time for completing the offer upto December 31, 2003. The RJVA also provides that the minimum floor price for a bid for our equity shares of face value Rs. 100/- shall be Rs. 2,300. Suzuki has agreed that if the Offer Price for this Offer were fixed at the Floor Price, Suzuki would bid for any shortfall in the demand for the Offer. Please see “Terms of the Offer” of this Draft Red Herring Prospectus. After the completion of this Offer, GoI has the right: (i) to sell the remainder of its shareholding in our Company on any Indian stock exchange within twenty four (24) months commencing from the date of the listing; or, (ii) GoI by exercising their put option under the RJVA can cause Suzuki to purchase its unsold equity shares. GoI may exercise this put option at any time after four (4) months from the date of listing of our equity shares upto the expiry of twenty four (24) months after the date of listing of our equity shares. The RJVA additionally provides that no equity share held by GoI can be transferred by or on behalf of GoI without the written consent of Suzuki. The RJVA provides that GoI is entitled to divest its equity shares in the Indian market subject to the restriction that no person shall hold more than 5% of the total paid up equity shares except for Indian public financial institutions, multilateral and bilateral development financial institutions, scheduled commercial banks, mutual funds, foreign institutional investors, foreign venture capital investors and venture capital funds registered with SEBI may hold 10% of the equity shares. By entering into the RJVA, subject to certain restrictions in the RJVA, Suzuki has among other rights, the right to nominate a majority of the directors on our Board. The chairman of our Board has a casting vote in a board meeting. The RJVA also provides that our managing director will be our chief executive officer and is vested with substantial operational management powers, subject to the overall superintendence, direction and control of our Board and exercise of such powers by the Board. As per the RJVA, prior to December 31, 2003 and so long as GoI holds 25% of our equity shares, GoI has the right to nominate for appointment two directors on our Board. After GoI’s right to appoint two directors ceases, so long as GoI holds upto 10% of our equity shares, or until the end of the period of 12 months after the expiry of the last put option under the RJVA (whichever is earlier), GoI has the right to appoint one (1) director on our Board. In addition as per the RJVA, the affirmative rights of GoI will decline with time and these rights will cease after December 31, 2003. z The RJVA will terminate automatically and all rights of GoI would cease once the GoI shareholding reduces to less than 10%.

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Investment Banking

OUTSTANDING LITIGATION AND MATERIAL DEVELOPMENTS There are no contingent liabilities not provided for, outstanding litigation, disputes, non payment of statutory dues, overdues to banks/financial institutions, defaults against banks/ financial institutions, defaults in dues towards instrument holders like debenture holders, fixed deposits, and arrears on cumulative preference shares issued by the Company, defaults in creation of full security as per terms of issue/other liabilities, proceedings initiated for economic/civil/any other offences (including past cases where penalties may or may not have been awarded and irrespective of whether they are specified under paragraph (i) of part 1 of Schedule XIII of the Companies Act, 1956) against our Company except the following:

AGAINST OUR COMPANY

Criminal Cases There are 17 cases filed by customers against the Company and its dealers u/s 420 of the Indian Penal Code, 1860 alleging that the Company and its dealers have failed to perform their obligations either under the contract of sale of vehicle or the obligation under warranty. Of these cases fifteen (15) cases relate to sale wherein the complainant has filed the criminal complaint relating to sales. Two relate to non-performance of warranty obligation after the sale of vehicle. In sixteen (16) of these cases the Managing Director has been made a party to the case or the case has been filed against the company through the Managing Director.

Civil Cases A. Money Recovery 1. We have a total of 45 money recovery suits pending against us in various courts in India. The total amount claimed from us is Rs. 173,190,686. A few material cases are disclosed below: �

�

Classic Motors Ltd was a dealer appointed by us and had collected booking amounts for vehicles from various parties. Ashok Leyland Limited has initiated legal proceedings against Classic Motors and our Company alleging a total amount of Rs. 42,700,000. Tata Finance Limited has also initiated legal proceedings against Classic Motors and our Company. Tata Finance Limited has alleged that they had booked 40 Maruti vehicles through Classic Motors Limited. Tata Finance Limited has claimed a refund of Rs. 3,100,000 from our Company and Classic Motors Ltd. Escorts Finance Ltd has also initiated proceedings against Classic Motors Ltd. We have been named as a party in the suit but Escorts Finance Ltd has not sought any relief against us. All the above suits are pending before the High Court at New Delhi. ICICI Bank Ltd has filed a case against our Company and Ganga Automobiles, a dealer of our Company. ICICI Bank had paid Ganga Automobiles for the booking of

Appendix 2

963

60 cars. The total amount being claimed by ICICI Bank is Rs. 17,845,000. The case is pending before the City Civil Court at Ahmedabad. �

�

�

�

�

�

DCL Finance Limited (“DCL”) had filed three (3) suits against Mahalaxmi Motors, RKS Motors and our Company in the Court of the III Additional Chief Judge, City Civil Court of Hyderabad. The City Civil Court of Hyderabad has decreed the suits in favour of DCL. As on the date of the decree, the consolidated amount of all 3 decrees, inclusive of interest and costs, is Rs. 9,240,473. Our Company has filed 3 appeals in the High Court of Andhra Pradesh against the decrees of the City Civil Court. The appeals are pending before the High Court of Andhra Pradesh. The High Court of Andhra Pradesh has passed a stay order in all three cases and directed us to deposit half of the decretal amount plus cost and interest. We have deposited half of the decretal amount and the interest plus the costs. There has been no objection raised by DCL vis-à-vis the amount deposited. Pennar Paterson Securities Limited has filed a suit against our Company and Mahalaxmi Motors, an erstwhile dealer of our Company. The suit is filed before the Court of the III Additional Chief Judge, City Civil Court at Hyderabad. Pennar Paterson has alleged that demand drafts had been made in favour of our Company for the booking of 20 cars. The claim is for a refund of a sum of Rs. 9,240,473. Gujarat Lease Financing has initiated legal proceedings against Competent Automobiles (a dealer appointed by our Company) and our Company in the High Court of Delhi. Gujarat Lease Financing has alleged that it intended to lease certain vehicles manufactured by our Company from Competent Automobiles. Gujarat Lease Financing has claimed that booking amounts were advanced to Competent Automobiles but no specifications as to vehicles were stated at that time. It is alleged that 1431 cars were booked but not delivered. Gujarat Lease Financing has claimed a refund of Rs. 16,655,643.28. ICICI Bank Ltd has initiated legal proceedings against Rama Automobiles (an erstwhile of our Company) and our Company before the Debt Recovery Tribunal, Ahmedabad. ICICI Bank is seeking relief against Rama Automobiles in terms of an agreement entered into between Rama Automobiles and ICICI Bank. The Company is not a party to this agreement. The total refund claimed is Rs. 75,603,000. A substantial portion of the amounts involved in the above cases is regarding the nondelivery of cars by dealers appointed by MUL after accepting payments from customers. As per the terms of the dealership agreement entered into between MUL and the dealers our dealers are appointed on a principal-to-principal basis. The terms of the sale to the customers do not create a privity of contract between MUL and the customer. The sale by MUL to the dealer and the sale from the dealer to the customer are on a principal to principal basis. MUL’s responsibility is to provide the dealer with the vehicles booked by the dealer. A claim for recovery of Rs. 20 million has been filed by one, Mr. Pradeep Arora against us and Allied Motors (Pvt.) Ltd., an erstwhile dealer Hyundai Motor India Limited has initiated proceedings against Varun Motors (our dealer) and our Company. Hyundai Motors has alleged that Varun Motors tampered

964

Investment Banking with a car (manufactured by Hyundai) and used that car for a test drive offer to potential buyers. It is alleged that customers were asked to compare the Hyundai car with a Maruti vehicle. It is alleged that the Hyundai car used was tampered and had been made defective thus resulting in below par performance. The Hyundai Motor India Ltd has claimed compensation of Rs. 10,000,000. The matter is at the trial stage in the City Civil Court in Hyderabad.

B. Other Civil Cases In addition to the above there are 24 other cases relating to various aspects, such as dealership disputes, claim for damages and directions, which are pending before various courts. BASIS OF ISSUE PRICE 1. Adjusted Earning Per Share (EPS) (As per unconsolidated Indian Accounting Standards). Pre-Split Rupees

Post-Split

Weight

Rupees

Weight

1

Year ended March 31,2000

184.22

1

9.21

1

2

Year ended March 31,2001

(118.91)

2

(5.95)

2

3

Year ended March 31,2002

66.92

3

3.35

3

4

Nine month ended December 31, 2002 (Annualised)

56.64

4

2.83

4

Weighted Average

37.37

1.87

Note 1: The shareholders in the Extra-Ordinary General Meeting held on March 25, 2003 have approved the sub-division of equity shares of face value of Rs. 100 each into twenty equity shares of face value of Rs. 5 each. Subsequent to this sub-division, the authorised equity share capital of Rs. 1,550,000,000 has been divided into 310,000,000 equity shares of Rs. 5 each and the issued, subscribed and paid up capital of Rs. 1,444,550,300 has been divided into 288,910,060 equity shares of Rs. 5 each. Accordingly, the ratios have been computed on the basis of number of equity shares, both pre-split and post-split. Note 2: A. The Earning Per Share has been computed on the basis of adjusted profits & losses for the respective year/period drawn after considering the Impact of accounting policy changes and prior period adjustments/regroupings pertaining to earlier years.

965

Appendix 2

B. The denominator considered for the purpose of calculating Earning Per Share is the weighted average number of equity shares outstanding during the period. 2. Price/Earning (P/E) ratio in relation to Issue Price of Rs. [*] a. Based on nine months ended Dec 2002 EPS (annualized) of Rs. 56.64 (pre –split) and Rs. 2.83 (post-split)— [*] b. Industry P/E (i) Highest

-

(ii) Lowest

-

(iii) Industry Composite Source: Capital Market Volume. Category: January 20–February 2, 2003. 3. Average Return on Net Worth %

Weight

1

Year ended March 31,2000

9.05

1

2

Year ended March 31,2001

(6.22)

2

3

Year ended March 31,2002

3.52

3

4

Nine month ended December 31, 2002 (Annualised)

2.69

4

Weigh ted A ve rage

1.79

Note: A. The Average Return on Net Worth has been computed on the basis of adjusted profits & losses for the respective year/period drawn after considering the Impact of accounting policy changes and prior period adjustments/ regroupings pertaining to earlier years. 4. Minimum Return on Increased Net Worth required to maintain pre-issue EPS. There is no change in net worth due to offer for sale. 5. Net Asset Value per Share, as on December 31, 2002 Pre-Split

— Rs. 2,118.

Post-Split

— Rs. 106.

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Investment Banking

Net Asset Value Per Share represents Shareholders’ equity less miscellaneous expenses as Divided by Weighted Average Number of Shares. 6. Net Asset Value per Share after issue. There is no change in net worth due to offer for sale. Issue Price Per Share: Rs. [*] * Issue Price Per Share will be determined on conclusion of book building process.

OTHER REGULATORY DISCLOSURES

Stock Market Data for our Equity Shares This being an initial public offering of our Company, the equity shares of our Company are not listed on any stock exchange.

Particulars Regarding Public Issues during the Last Five Years We have not made any public issue during the last five years.

Companies Under the Same Management There are no companies under the same management within the meaning of erstwhile Section 370(1B) of the Companies Act 1956, other than the subsidiaries and group Companies, details of which are provided in the section entitled “Group Companies” of this Draft Red Herring Prospectus.

Mechanism for Redressal of Investor Grievances The agreement between the Registrar to the Offer, MCS Ltd. and us, will provide for retention of records with the Registrar to the Offer for a period of at least one year from the last date of dispatch of letters of allotment, demat credit, refund orders to enable the investors to approach the Registrar to the Offer for redressal of their grievances. All grievances relating to the Offer may be addressed to the Registrar to the Offer, giving full details such as name, address of the applicant, number of shares applied for, amount paid on application and the bank branch or collection center where the application was submitted.

967

Appendix 2

Disposal of Investor Grievances We estimate that the average time required by us or the Registrar to the Offer for the redressal of routine investor grievances shall be seven working days from the date of receipt of the complaint. In case of non-routine complaints and complaints where external agencies are involved, we will seek to redress these complaints as expeditiously as possible. We have appointed Mr. S Ravi Aiyar as the Compliance Officer and he may be contacted in case of any pre-Issue or post-Issue-related problems. He can be contacted at: Maruti Udyog Limited; 11th floor, Jeevan Prakash Building, 25 Kasturba Gandhi Marg, New Delhi 110 001; Tel: +91-11-2331 6831; Fax no.: +91-11-2371 3575, 23318754; e-mail: [email protected] UNCONSOLIDATED FINANCIAL STATEMENTS FOR

FIVE YEARS AND NINE MONTHS ENDING

DECEMBER 31, 2002

Auditor’s Report To The Board of Directors Maruti Udyog Limited Dear Sirs, A. We have examined the books and accounts of Maruti Udyog Ltd. (MUL) for the five financial years ended March 31, 2002 being the last date to which the accounts of the company have been made up and audited by us for presentation to the members. We have also examined and found correct the accounts of MUL for the period from April 1, 2002 to December 31, 2002 prepared and approved by the Board of Directors of the company. We have accepted the relevant accounts and statements in respect of Maruti Insurance Brokers Limited, Maruti Insurance Distribution Services Limited and True Value Solutions Limited, the three subsidiaries of the Company for the three months period ended March 31, 2002 audited and reported by M/s V. Sankar Aiyar & Co., the auditors of the subsidiaries. We have also accepted the accounts of these companies for the period April 1, 2002 to December 31, 2002 prepared and approved by Board of Directors of the respective companies and audited by the respective auditors. In accordance with the requirements of: (a) Paragraph B(1) of Part II of Schedule II to the Companies Act, 1956. (b) The Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines 2000 issued by SEBI on January 19, 2000 in pursuance of Section 11 of SEBI Act, 1992, “the SEBI Guidelines”. (c) Instructions dated March 5, 2003 received from the company, requesting us to carry out work relating to the offer document being issued by the company in connection with

968

Investment Banking the offer of sale by the GoI of certain equity shares in the company (referred to as the issue).

We report that the profits of the company for the above years are as set out below. These profits (expressed in millions of rupees) have been arrived at after charging all expenses of management, including depreciation and after making such adjustments (and regroupings) as in our opinion are appropriate and are subject to the notes given below. Adjustments may be necessary to make the accounts for the period from April 1, 2002 to December 31, 2002, to comply with the requirements of the law relating to accounts to be laid before the company in general meeting, but at the date of signing this report, we are not aware of any material adjustments which would affect the results of the accounts. In accordance with para 6.18.3(ii) of the SEBI Guidelines, also attached are restated summary financial statements of subsidiaries Maruti Insurance Brokers Limited, Maruti Insurance Distribution Services Limited and True Value Solutions Limited of the Company for the period ended December 31, 2002 and period ended March 31, 2002. We have accepted the relevant restated summary financial statements in respect of the above subsidiaries for the above periods, which were audited by other auditors as mentioned therein. In respect of the relevant summary financial statements for the period ended December 31, 2002, the respective auditors have reported that the said financial statements are true and correct and the said restated financial statements have been prepared in accordance with Part II of Schedule II of the Act and the SEBI Guidelines. The financial statements of the Company’s subsidiaries have not been consolidated into the attached summary statements of the Company and are enclosed as Annexures—E, F and G to this report. In all the subsidiaries the beneficial ownership entirely vests with the Company, the assets and liabilities and profit or loss as applicable, of such subsidiaries in the aforementioned financial statements entirely concern the members of the Company. B. OTHER FINANCIAL INFORMATION We have examined the following financial information relating to Maruti Udyog Limited proposed to be included in the Offer Document, as approved by you and annexed to this report. i. Summary of accounting ratios based on the adjusted profits relating to earnings per share, net asset value and return on net worth is enclosed as Annexure A. ii. Capitalisation statement as at 31st December 2002 of the Company is enclosed as Annexure B. iii. Statement of taxation is enclosed as Annexure C. iv. Details of items of other income are enclosed as Annexure D. In our opinion the financial information of the Company as stated to this report as mentioned in paragraph (A) & (B) above read with respective significant accounting policies, after making groupings and adjustments and subject to non adjustment of certain matters as stated in notes to accounts, have been prepared in accordance with Part II of Schedule II of the Act and the SEBI Guidelines.

969

Appendix 2

This report is intended solely for your information and for inclusion in the Offer Document in connection with the Offer for Sale of the Company and is not to be used, referred to or distributed for any other purpose without our prior written consent. Yours faithfully, Sd/S. Berera Partner For and on behalf of Price Waterhouse Chartered Accountants New Delhi Date: 25/3/03 OTHER FINANCIAL INFORMATION Summary of Accounting Ratios Annexure A Key ratios

Earning Per Share (Rs.)

For the pe riod Financial A pril 1, 2002 Year ended to D ecembe r M arch 31, 31, 2002 2002 42.68 66.92

Net Asset Value per Share (Rs.) Return on Net worth (%) Weighted Average Numbers of Equity Share Outstanding during the period/year

Financial Financial Year ended Year ended M arch 31, M arch 31, 2000 2001

Financial Year ended M arch 31, 1999

Financial Year ended M arch 31, 1998

(118.91)

184.22

411.68

570.56

2,118

1,903

1,912

2,036

1,902

1,528

2.02

3.52

(6.22)

9.05

21.65

37.35

14,175,205

13,229,162

13,229,162

13,229,162

13,229,162

13,229,162

Formula: Earnings Per Share (Rs.)

=

Net Profit after tax and before extraordinary items Weighted Average Numbers of Equity Shares Outstanding During the period/year

970

Investment Banking

Net Asset Value Per Share (Rs.)

=

Net worth excluding revaluation reserve Weighted Average Numbers of Equity Shares Outstanding During the period/year

Return on Net Worth (%)

=

Net profit before extraordinary items but after adjusted tax Net worth excluding revaluation reserve

Notes: 1. Earnings per share and Return on net worth for the period ended 31st December, 2002 are for a period of nine month and therefore are not comparable with previous year figures. 2. Above ratios are computed on the basis of stand-alone (unconsolidated) restated financials of Maruti Udyog Limited. 3. Ratios have been computed on the basis of the adjusted profits/ losses for the respective years/ period. Summary of Accounting Ratios (Post-Split) The shareholders in the Extra-Ordinary General Meeting held on March 25, 2003 have approved the sub-division of equity shares of face value of Rs. 100 each into twenty equity shares of face value of Rs. 5 each. Subsequent to this sub-division, the authorised equity share capital of Rs. 1,550, 000,000 has been divided into 310,000,000 equity shares of Rs. 5 each and the issued, subscribed and paid up capital of Rs. 1,444,550,300 has been divided into 288,910,060 equity shares of Rs. 5 each. Accordingly, the ratios have been computed on the basis of number of equity shares post-split. Post split Key ratios

For the Financial period April Year ended 1, 2002 to March 31, December 31, 2002 31, 2002

Financial Year ended March 31, 2002

Financial Year ended March 31, 2002

Financial Financial Year ended Year ended March 31, March 31, 2002 2002

Earning Per Share (Rs.)

2.13

3.35

(5.95)

9.21

20.58

28.53

Net Asset Value per Share (Rs.)

106

95

96

102

95

76

Return on Net worth (%)

2.02

3.52

(6.22)

9.05

21.65

37.35

264,583,240

264,583,240

Weighted Average Numbers of Equity Share Outstanding during the period/year

283,504,100

264,583,240

264,583,240

264,583,240

971

Appendix 2 Formula: Earnings Per Share (Rs.)

=

Net Profit after tax and before extraordinary items Weighted Average Numbers of Equity Shares (post-split) outstanding During the period/year

Net Asset Value Per Share (Rs.)

=

Net worth excluding revaluation reserve Weighted Average Numbers of Equity Shares (post-split) Outstanding During the period/year

Return on Net Worth (%)

=

Net profit before extraordinary items but after adjusted tax Net worth excluding revaluation reserve

Notes: 1. Earnings per share and Return on net worth for the period ended 31st December, 2002 are for a period of nine month and therefore are not comparable with previous year figures. 2. Above ratios are computed on the basis of stand-alone (unconsolidated) restated financials of Maruti Udyog Limited. 3. Ratios have been computed on the basis of the adjusted profits/ losses for the respective years/ period. CAPITALIZATION STATEMENT (POST-I SSUE)

Particula rs

Annexure-B (Rs. in millions) A s at D ecembe r 31, 2002*

Short Term Debt

115

Long Term Debt (A)

4,440

Total Debt

4,555

Share Holders Fund Share Capital

1,445

Reserves after adjustments of miscellaneous expenditure, to the extent not written off.#

28,573

Total Shareholders Fund (B)

30,018

Long Term Debt/Total Shareholders Fund (A/B)

* The GoI is selling part of its stake in the Company and accordingly no money is received by the Company from this offer. Therefore, there is no change in capitalisation statement, pre and post issue. # The above has been calculated after considering the adjustments.

0.15

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Investment Banking

STATEMENT OF TAX SHELTERS

Particula rs

Profit/(Loss ) bef ore tax but after Extraordinary items as per books (A)

Financial Year en ded M arch 31, 2002

Financial Year en ded M arch 31, 2001

Financial Year en ded M arch 31, 2000

Financial Year en ded M arch 31, 1999

Financial Year en ded M arch 31, 1998

1,183

(2,692)

3,851

7,841

9,773

422

(1,065)

1,483

2,744

3,421

Interest on tax free securities

(26)

(49)

(176)

(192)

(163)

Dividend exempt u/s 10(33)

(39)

(37)

(451)

(75)

(45)

Penalties

–

–

–

–

–

Donations

–

4

6

–

–

Deduction u/s 80G

–

–

(6)

–

–

Deduction u/s 80IA

–

–

(74)

(441)

(940)

Deduction u/s 80HHC

–

–

(113)

(445)

(814)

(5)

(186)

(106)

(72)

(221)

(70)

(268)

(920)

(1,225)

(2,183)

(1,603)

(1,773)

(1,140)

(302)

88

35

122

310

33

173

Deduction u/s 35

(169)

(194)

(98)

(172)

(45)

Borrowing cost capitalised in the books claimed as revenue expense in Income Tax

(136)

(143)

(8)

–

–

Deferred Revenue Expenditure net of claimed in Income Tax

20

(64)

(260)

(57)

(21)

Tax on actual rate on profits A djustments Permanent D ifferences (B)

Indexation difference on Long term Capital Gain/Loss

Total Permanent D ifferences (B) Timing D ifferences (C) Difference between tax depreciation and book depreciation Capital Expenditure debited to profit and loss account in books

973

Appendix 2

Statutory duties claimed on paid basis net of reversal of duties claimed in Income Tax in earlier years

1,224

(287)

(796)

(36)

(421)

Diff between interest accrued and investment as per Income Tax

–

(212)

22

(59)

18

Diff between interest accrued and interest received

–

11

25

66

1

(36)

–

–

–

–

(10)

–

–

50

–

Disallowance u/s 40A(7)

13

–

–

–

–

Disallowance u/s 35AB

–

–

–

(17)

(24)

Disallowance u/s 43B

(120)

(87)

(169)

851

(2)

Provisions for doubtful current assets and Contingent liabilities debited to P&L Account net of w/back

(349)

309

409

(315)

2,409

Prior Period Expenses (net of claimed in Income Tax Act)

1

31

(35)

16

19

Total Timing D ifferences (C)

(1,130)

(2,287)

(1,740)

58

2,195

N et A djustments (B+C)

(1,200)

(2,555)

(2,660)

(1,167)

12

(428)

(1,011)

(1,024)

(409)

4

(17)

(5,247)

1,191

6,674

9,785

–

–

–

–

–

Taxable Income /(Loss ) (D +E)

(17)

(5,247)

1,191

6,674

9,785

Taxable Income as per MAT

1,325

–

–

–

–

101

–

463

2,336

3,425

–

–

–

2

13

Total Tax as per return

101

–

463

2,338

3,438

Carried Forward Business Loss

(40)

(40)

–

–

–

(5,009)

(4,998)

–

–

–

Voluntary Retirement Scheme Provision in diminution in value of investment accounted for in the books

Tax S aving thereo n Profit/(Loss ) as per Income Tax Returns (D )= (A+B+C) Brought Forw ard Losses adjusted (E)

Tax as per Income tax as returned Interest u/s 234

Carried Forward Depreciation Loss

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Investment Banking

Carried Forward Capital Loss

Total Carried Forw ard Loss as per Return

(227)

(221)

(12)

–

–

(5,276)

(5,259)

(12)

–

–

CONSOLIDATED FINANCIAL STATEMENTS AS PER AS 21, AS 23 AND AS 27 Report of the auditors’ to the Board of Directors of Maruti Udyog Limited. 1. We have audited the attached summary restated consolidated balance sheet of Maruti Udyog Limited (the Company), its subsidiary companies, joint ventures and associates (the Group) as at 31st December 2002 and the relative summary restated consolidated profit and loss account for the nine months ended on that date annexed thereto both of which we have signed under reference to this report. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audit. 2. We conducted our audit in accordance with generally accepted auditing standards in India. Those standards require that we plan and perform the audit to obtain reasonable assurance whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework and are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit and the reports of other auditors provide a reasonable basis for our opinion. 3. (a) We did not audit the financial statements of the subsidiary companies, True Value Solutions Limited, Maruti Insurance Brokers Limited and Maruti Insurance Distribution Services Limited as at 31st December 2002. These financial statements of subsidiary companies have been audited by another audit firm whose reports have been forwarded to us, and in our opinion, in so far as it relates to the amounts included in respect of the subsidiary companies, is based solely on the reports of the other auditors. (b) The financial statements of joint venture and associate companies used for preparation of the summary restated consolidated financial statements are not restated and are unaudited. Accordingly, we have relied on the financial statements as submitted by the joint ventures and associates to the company. (c) The financial statements of subsidiary companies and joint ventures reflect net assets of Rs. 4 million and Rs. 90 million respectively, as at 31st December, 2002 and Net Profit after tax of Rs. 2 million and Rs. 5 million respectively, for the nine months period ended 31st December, 2002. The financial statements of associates reflect a Net Profit after tax of Rs. 4 million for the nine months period ended 31st December 2002.

Appendix 2

975

4. We report that the summary restated consolidated financial statements have been prepared by the company in accordance with the requirements of Accounting Standard (AS) 21 ‘Consolidated Financial Statements’, AS 23 ‘Accounting for Investments in Associates in Consolidated Financial Statements’ and AS 27 ‘Financial Reporting of Interest in Joint Venture’ issued by the Institute of Chartered Accountants of India, on the basis of the separate audited financial statements of the Company and its subsidiary companies and unaudited financial statements of the joint ventures and associates included in the summary restated consolidated financial statements. 5. The financial statements of the associate companies have not been prepared on a consolidated basis as per AS 21 and AS 23 where applicable. The impact that such consolidation may have on the financial statements of such associate companies is not ascertainable. 6. In our opinion, and on the basis of the information and explanations given to us and on consideration of the separate audit reports on individual audited financial statements of the Company and its aforesaid subsidiary companies and the unaudited financial statements of the joint venture and associate companies, the summary restated consolidated financial statements together with the notes thereon and attached thereto, subject to paras 3b) and 5 above, give a true and fair view in conformity with the accounting principles generally accepted in India: (a). In the case of the summary restated consolidated balance sheet, of the consolidated state of affairs of Maruti Udyog Limited and its Group as at 31st December 2002; and (b). In the case of the summary restated consolidated profit and loss account, of the consolidated result of operations for the nine months period ended 31st December 2002. 7. This report is intended solely for your information and for inclusion in the offer document being issued by the Company in connection with the offer for sale by the GoI of certain equity shares in the Company and is not to be used, referred to or distributed for any other purpose without our prior written consent. Sd/S. Berera Partner For and on behalf of Price Waterhouse Chartered Accountants Place: New Delhi Date: March 25, 2003 TERMS OF THE OFFER The equity shares being offered are subject to the provisions of the Companies Act, our Memorandum and Articles, conditions of the FIPB and RBI approvals, the terms of this Draft

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Red Herring Prospectus, Bid cum Application Form, the Revision Form, the CAN and other terms and conditions as may be incorporated in the Share Certificates/Letters of Allotment and other documents/certificates that may be executed in respect of the Offer. The equity shares shall also be subject to laws as applicable, guidelines, notifications and regulations relating to the issue of capital and listing of securities issued from time to time by SEBI, GoI, Stock Exchanges, RBI, RoC and/or other authorities, as in force on the date of the Offer and to the extent applicable. The equity shares being offered are also subject to the conditions in the RJVA.

Authority for the Offer In terms of the RJVA, the Selling Shareholder has the option to sell approximately 72,243,380 equity shares of Rs. 5/- each (approximately 3,612,169 equity shares of Rs. 100/- each as per the RJVA) or more by way of an initial public offer. For details on the RJVA, please see the section titled “Our Promoters”. As per the letter no. 2[16]/2000–PE-VI, dated February 7, 2003, from the Ministry of Heavy Industries and Public Enterprises, Department of Heavy Industry, GoI, the Cabinet Committee of Disinvestment has approved the disinvestment in Maruti by GoI by way of Offer for sale of its shareholding in the domestic market. Pursuant to the decision taken by the Cabinet Committee, the Ministry of Heavy Industry and Public Enterprises, acting for and on behalf of the President of India, has been authorized to offer upto 72,243,380 equity shares of Rs. 5/- each (3,612,169 equity shares of Rs. 100/- each as per the said letter) and such additional number of equity shares as may be permitted to be offered for allotment against oversubscription. SEBI vide its letter RM/21334/2003 dated October 29, 2002 has granted its approval for retention of over-subscription over and above the limit of 10% allowed for the purposes of rounding off only, under clause 6.4.2(f) of SEBI Guidelines. Our Company has also consented to the Offer through Board Resolution dated March 25, 2003. RANKING OF EQUITY SHARES The equity shares being offered shall be subject to the provisions of our Memorandum and Articles and shall rank pari-passu with the existing equity shares of our Company, including rights in respect of dividends. FACE VALUE AND OFFER PRICE The equity shares with a face value of Rs. 5/- each are being offered in the Offer at a total price of Rs. ___ per share. At any given point of time there shall be only one denomination for the equity shares.

Appendix 2

977

RIGHTS OF THE EQUITY SHAREHOLDER Subject to applicable laws, the equity shareholders shall have the following rights: �

Right to receive dividend, if declared;

�

Right to attend general meetings and exercise voting powers, unless prohibited by law;

�

Right to vote on a poll either in person or by proxy;

�

Right to receive offers for rights shares and be allotted bonus shares, if announced;

�

Right to receive surplus on liquidation;

�

The right of free transferability; and

�

Such other rights, as may be available to a shareholder of a listed public company under the Companies Act and Memorandum and Articles.

For a detailed description of the main provisions of our Articles dealing with voting rights, dividend, forfeiture and lien, restrictions on transfer and transmission and/or consolidation/ splitting, refer to the section on “Main Provisions of Articles of Association of the Company” on page in this Draft Red Herring Prospectus.

MARKET LOT In terms of Section 68B of the Companies Act, the equity shares in this Offer shall be transferred only in dematerialized form. In terms of existing SEBI Guidelines, the trading of our equity shares shall only be in dematerialized form. Since trading of our equity shares is in dematerialized form, the tradable lot is one equity share. Transfer of the equity shares upon allocation will be done only in electronic form in lots of [•] equity shares.

JURISDICTION Exclusive jurisdiction for the purpose of this Offer is with competent courts/ authorities in New Delhi, India.

APPLICATION BY NON RESIDENTS/NRIS/FIIS Our Company has received approval from GoI, Ministry of Finance and Company Affairs (Department of Economic Affairs) pursuant to its letter no. FC.II: 74(1982)-Comp dated April 16, 2003 for the transfer of equity shares in this Offer to eligible non-resident investors, NRIs and FIIs. In terms of the approval of GoI, OCBs have not been permitted to participate in the

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Offer. Our Company has received approval from the RBI for (a) transfer of equity shares in the Offer for Sale to Non Residents, NRIs and FIIs pursuant to its letter no. ________________ dated ________________. Subject to obtaining such approvals, it will not be necessary for the investors to seek separate permission from the FIPB/RBI for this specific purpose. However it is to be distinctly understood that there is no reservation for Non Residents, NRIs and FIIs and all Non Residents, NRI and FII applicants will be treated on the same basis with other categories for the purpose of allocation. The Transfer of equity shares to Non Residents shall be subject to the conditions as may be prescribed by GoI or RBI while granting such approvals.

OFFER STRUCTURE The present Offer, for cash at a premium of Rs. [•] per equity share of Rs. 5/- aggregating total consideration of Rs. [•] million is being made through a 100% book building process.

QIBs

Wholesale Bidders

Retail

Number of equity shares

Up to 43,345,900 equity shares or Offer size less allocation to Wholesale Bidders and Retail Bidders

Minimum of 10,836,500 equity shares or Offer size less allocation to QIBs and Retail Portion

Minimum of 18,060,900 equity shares or Offer Size less allocation to QIBs and Wholesale Portion

Percentage of Offer Size available for allocation

Up to 60% or Offer size less allocation to Non – Institutional Portion and Retail Portion

Minimum 15% or Offer size less allocation to QIBs and Retail Portion

Minimum 25% or Offer Size less allocation to QIBs and Wholesale Portion

Basis of Allocation or Allotment if respective category is oversubscribed

Discretionary

Proportionate

Proportionate

Minimum Bid

____ equity shares and thereafter in multiples of ___equity shares

___equity shares and thereafter in multiples of ___equity shares

___equity shares and thereafter in multiples of ___equity shares

Maximum Bid

Not exceeding the size of the Offer

Not exceeding the size of the Offer

1,000 equity shares

Allotment Mode

Compulsory in Dematerialised form

Compulsory in Dematerialised form

Compulsory in Dematerialised form

Trading Lot

One

One

One

Market lot

–

–

–

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Appendix 2

Who can Apply

Public financial institutions, as specified in section 4A of the Companies Act, scheduled commercial banks, mutual funds, foreign institutional investors registered with SEBI, multi-lateral and bi-lateral development financial institutions, venture capital funds registered with SEBI, foreign venture capital investors registered with SEBI and state industrial development corporations

Resident Indian individuals, HUF (in the name of Karta), companies, corporate bodies, NRIs, societies and trusts

Individuals (including NRIs and HUFs) applying for up to 1,000 equity shares

Terms of Payment

Full Bid Amount on Bidding unless waived by the members of the Syndicate

Margin Amount at the time of submission of Bid cum Application Form to the members of the Syndicate

Margin Amount at the time of submission of Bid cum Application Form to the members of the Syndicate

Subject to valid bids being received at or above the Offer Price. Undersubscription, if any, in any of the categories, would be allowed to be met with spill over from any of the other categories, at the discretion of the Selling Shareholder, BRLM and the Co-BRLMs.

SUZUKI’S STAND-BY SUPPORT (a) As per clause 6.1(b) of the RJVA dated May 15, 2002, “Suzuki agrees that in the event the book building exercise is undertaken and the offer process initiated, Suzuki shall bridge any shortfall between the Shares offered for sale and the bids received. For this purpose it is agreed that where the floor price, in the public offer, is Rs. 2,300 and there is a shortfall in the demand through the bids received, Suzuki shall, and Suzuki undertakes to, as of no later than the date and time of the closure of the issue, submit a bid to the extent of the said shortfall at the said price of Rs. 2,300 per Share, in accordance with all relevant approvals”. Further, as per SEBI letter dated April 16, 2003 addressed to the Secretary, Ministry of Disinvestment, GoI: (a) the shares acquired by Suzuki in the offer, in accordance with the stand by support, would not attract the lock-in provisions of SEBI Guidelines. (b) In case the public holding in the company falls below 25%, on account of Suzuki meeting the shortfall in the issue, the company would be required to provide an undertaking to the stock exchange(s), at the time of finalizing the basis of allotment, stating that

980

Investment Banking the company would increase the percentage of public holding to the required minimum threshold level with the specified time.

RETENTION OF OVERSUBRCRIPTION SEBI vide its letter RM/21334/2003 dated October 29, 2002 has granted its approval for retention of over-subscription over and above the limit of 10% allowed for the purposes of rounding off only, under clause 6.4.2 (f) of SEBI Guidelines. Hence the size of the Offer may be enhanced to the extent of upto 10% of the Offer i.e. by upto 7,224,300 equity shares of Rs. 5/- each, in case the selling shareholder decides to retain any over-subscription. In such a case, the size of the Offer may increase upto 79,467,600 equity shares of Rs. 5/- each.

OFFER PROCEDURE

Book Building Procedure The Offer is being made through the 100% book building scheme wherein up to 60% of the Offer shall be available for allocation on a discretionary basis to Qualified Institutional Buyers. Further, not less than 15% of the Offer shall be available for allocation on a proportionate basis to Wholesale Bidders and the not less than 25% of the Offer shall be available for allocation on a proportionate basis to Retail Bidders, subject to valid bids being received at or above the Offer Price. Bidders are required to submit their Bids through the members of the Syndicate. The Selling Shareholder and our Company in consultation with the BRLM and Co-BRLMs reserves the right to reject any Bid procured by any or all members of the Syndicate without assigning any reason therefore in case of QIBs. In case of Wholesale Bidders and Retail Bidders, the Selling Shareholder and our Company would have a right to reject the Bids only on technical grounds. Investors should note that equity shares would be transferred to all successful allottees only in dematerialised form.

Bid cum Application Form Bidders shall only use the specified Bid cum Application Form bearing the stamp of a member of the Syndicate for the purpose of making a Bid in terms of this Draft Red Herring Prospectus. The Bidder shall have the option to make a maximum of three Bids in the Bid cum Application Form and such options shall not be considered as multiple bids. Upon the allocation of equity shares, dispatch of the CAN and filing of the Prospectus with the RoC, the Bid cum Application Form shall be considered as the Application Form. Upon completing and submitting the Bid cum Application Form to a member of the Syndicate, the Bidder is deemed to have authorised our Company to make the necessary changes in this Draft Red Herring Prospectus and the Bid cum Application Form as would be required for filing the Prospectus with the RoC and as would be required by the RoC after such filing, without prior or subsequent notice of such changes to the Bidder.

981

Appendix 2

The prescribed colour of the Bid cum Application Form for various categories, is as follows:

Category

Colour of Bid cum Application Form

Indian Public or NRIs applying on a nonrepatriation basis Non-residents including NRIs or FIIs applying on a repatriation basis

White Blue

Who can Bid �

�

�

� �

Indian nationals resident in India who are majors, in single or joint names (not more than three); Hindu undivided families or HUFs, in the individual name of the Karta. The Bidder should specify that the Bid is being made in the name of the HUF in the Bid cum Application Form as follows: “Name of Sole or First bidder: XYZ Hindu Undivided Family applying through XYZ, where XYZ is the name of the Karta”. Bids by HUFs would be considered at par with those from individuals; Companies, corporate bodies and societies registered under the applicable laws in India and authorised to invest in equity shares; Indian mutual funds registered with SEBI; Indian financial institutions, commercial banks, regional rural banks, co-operative banks (subject to RBI permission, as applicable);

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Venture capital funds registered with SEBI;

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Foreign venture capital investors registered with SEBI;

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State Industrial Development Corporations;

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Trusts registered under the Societies Registration Act, 1860, as amended, or under any other law relating to Trusts and who are authorised under their constitution to hold and invest in equity shares; Non-residents including NRIs and FIIs on a repatriation basis or a non-repatriation basis subject to applicable laws; and Scientific and/or industrial research organisations authorised to invest in equity shares.

Note: The BRLM, Co-BRLMs, Syndicate Members and any associate of the BRLM, Co-BRLMs, and Syndicate Members (except asset management companies on behalf of mutual funds, Indian financial institutions and public sector banks) cannot participate in that portion of the Offer where allocation is discretionary. Further, the BRLM or Co-BRLMs shall not be entitled to subscribe to this Offer in any manner except towards fulfilling underwriting obligation. Additionally, in accordance with the RJVA, no single bidder will be allocated equity shares that would result in their holding exceeding 5% of the total equity share capital of our Company.

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Investment Banking

Bidders are advised to ensure that any single Bid from them does not exceed the investment limits or maximum number of equity shares that can be held by them under the relevant regulations or statutory guidelines. As per the current regulations, the following restrictions are applicable for investments by mutual funds: No mutual fund scheme shall invest more than 10% of its net asset value in the equity shares or equity related instruments of any company provided that the limit of 10% shall not be applicable for investments in index funds or sector or industry specific funds. No mutual fund under all its schemes should own more than 10% of any company’s paid-up capital carrying voting rights. The offer of equity shares to a single FII should not exceed 10% of the post-offer paid-up capital of the company (i.e 10% of 288,910,060 equity shares of Rs. 5/- each). In respect of an FII investing in our equity shares on behalf of its sub-accounts, the investment on behalf of each subaccount shall not exceed 10% of our total issued capital or 5% of our total issued capital in case such sub-account is a foreign corporate or an individual. As of now, the aggregate FII holding in the Company cannot exceed 24% of our total issued capital. The above information is given for the benefit of the Bidders. Our Company, the BRLM and the Co-BRLMs are not liable for any amendments or modification or changes in applicable laws or regulations, which may happen after the date of this Draft Red Herring Prospectus. Bidders are advised to make their independent investigations and ensure that their number of equity shares bid for do not exceed the applicable limits under laws or regulations.

Maximum and Minimum Bid Size (a) For Retail Bidders: The Bid must be for a minimum of ___ equity shares and in multiples of ___ equity shares thereafter up to a maximum of 1,000 equity shares. In case the Bid is for more than 1,000 equity shares, the same would be considered for allocation under the Wholesale Bidders category. (b) For other (Wholesale Bidders and QIBs) Bidders: The Bid must be for a minimum of ___ equity shares and in multiples of ___ equity shares thereafter. A Bid cannot be submitted for more than the size of the Offer. However, the maximum Bid by a QIB investor should not exceed the investment limits prescribed for them by the regulatory or statutory authorities governing them.

Bidding Process 1. Our Company has filed the Red Herring Prospectus with the RoC. 2. The members of the Syndicate will circulate copies of the Draft Red Herring Prospectus along with the Bid cum Application Form to potential investors. 3. Any investor who would like to obtain the Draft Red Herring Prospectus along with the Bid cum Application Form can obtain the same from our corporate office or from any of the BRLM or Co-BRLMs or Syndicate Members.

Appendix 2

983

4. Our Company, the BRLM and the Co-BRLMs shall declare the Bid/Offer Opening Date, Bid/Offer Closing Date and Floor Price and publish the same in two widely circulated newspapers (one each in English and Hindi). This advertisement shall contain the salient features of the Draft Red Herring Prospectus as specified under Form 2A of the Companies Act, the method and process of bidding and the names and addresses of the BRLM, Co-BRLMs and Syndicate Members. The BRLM, Co-BRLMs and Syndicate Members shall start accepting Bids from the Bidders from the Bid/Offer Opening Date. 5. Investors who are interested in subscribing for our Company’s equity shares should approach any of the BRLM or Co-BRLMs or Syndicate Members or their authorised agent(s) to register their Bid. 6. The Bids should be submitted on the prescribed Bid cum Application Form only. Bid cum Application Forms should bear the stamp of the BRLM or Co-BRLMs or Syndicate Members. Bid cum Application Forms which do not bear the stamp of the BRLM or Co-BRLMs or Syndicate Members will be rejected.

Bidding 1. Each Bid cum Application Form will give the Bidder the choice to bid for up to three optional prices (for details refer to the paragraph entitled “Bids at Different Price Levels” on page of this Draft Red Herring Prospectus below) and specify the demand (i.e. the number of equity shares bid for). The price and demand options submitted by the Bidder in the Bid cum Application Form will be treated as optional demands from the Bidder and will not be cumulated. After determination of the Offer Price, the maximum number of equity shares bid for by a Bidder at or above the Offer Price will be considered for allocation and the rest of the Bid(s), irrespective of the bid price, will become automatically invalid. 2. The Bidder cannot bid on another Bid cum Application Form after Bids on one Bid cum Application Form have been submitted to any member of the Syndicate. Submission of a second Bid cum Application Form to either the same or to another member of the Syndicate will be treated as multiple bidding and is liable to be rejected either before entering the Bid into the electronic bidding system, or at any point of time prior to the transfer of equity shares in this Offer. 3. The BRLM, Co-BRLMs and Syndicate Members will enter each option into the electronic bidding system as a separate Bid and generate a Transaction Registration Slip (TRS), for each price and demand option and give the same to the Bidder. Therefore, a Bidder can receive up to three TRSs for each Bid cum Application Form. 4. Along with the Bid cum Application Form, all Bidders will make payment in the manner described under the paragraph “Terms of Payment” on page of the draft Red Herring Prospectus.

Bids at Different Price Levels The Floor Price has been fixed at Rs. ___ per Equity Share of Rs. 5/- each for reference purposes of the Bidders. The Floor Price is only indicative. The Selling Shareholder in consultation with

984

Investment Banking

our Company, the BRLM and Co-BRLMs can finalise the Offer Price at or above the Floor Price in accordance with this clause without the prior approval of, or intimation, to the Bidders. The Bidder can bid at any price at or above the Floor Price. The Bidder has to bid for the desired number of equity shares at a specific price. Bidding at “Cut-off Price” is prohibited for QIB or Wholesale Bidders and such Bids from QIBs or Wholesale Bidders shall be rejected. Retail Bidders may bid at “Cut-off Price”. The Bidder can bid at any price in multiples of Re. 1 only, at or above the Floor Price.

Escrow Mechanism The Selling Shareholder, our Company and the members of the Syndicate shall open Escrow Accounts with one or more Escrow Collection Banks in whose favour the Bidders shall make out the cheque or demand draft in respect of the Bid and/or revision. Cheques or demand drafts received from Bidders in a certain category would be deposited in the Escrow Account for the Offer. The Escrow Collection Banks will act in terms of this Draft Red Herring Prospectus and the Escrow Agreement. The monies in the Escrow Account for the Offer shall be maintained by the Escrow Collection Bank(s) for and on behalf of the Bidders. The Escrow Collection Bank(s) shall not exercise any lien whatsoever over the monies deposited therein and shall hold the monies therein in trust for the Bidders. On the Designated Date, the Escrow Collection Banks shall transfer the monies from the Escrow Account to the Public Offer Account with the Bankers to the Offer. Payments of refund to the Bidders shall also be made from the Escrow Collection Banks, as per the terms of the Escrow Agreement and this draft Red Herring Prospectus. The Bidders should note that the escrow mechanism is not prescribed by SEBI and has been established as an arrangement between the Selling Shareholder, our Company, the members of the Syndicate, the Escrow Collection Bank(s) and the Registrar to the Offer to facilitate collections from the Bidders.

Terms of Payment and Payment into the Escrow Collection Account Each Bidder shall, with the submission of the Bid cum Application Form draw a cheque, demand draft or Stockinvest for the maximum amount of the Bid in favour of the Escrow Account of the Escrow Collection Bank (for details refer to the paragraph “Payment Instructions”) and submit the same to the member of the Syndicate with whom the Bid is being deposited. Bid cum Application Forms accompanied by cash shall not be accepted. The maximum bid price has to be paid at the time of submission of the Bid cum Application Form based on the highest bidding option of the Bidder. The members of the Syndicate shall deposit the cheque, demand draft or Stockinvest with the Escrow Collection Bank. The Escrow Collection Bank will hold all monies collected for the benefit of the Bidders till such time as the Designated Date. On the Designated Date, the Escrow Collection Bank shall transfer the funds in respect of those Bidders whose Bids have been

Appendix 2

985

accepted from the Escrow Account for the Offer, as per the terms of the Escrow Agreement, into the Public Offer Account with the Bankers to the Offer. The balance amounts after the transfer to the Public Offer Account, lying credited with the Escrow Collection Banks shall be held for the benefit of the Bidders who are entitled to refunds. On the Designated Date and no later than 15 days from the Bid/Offer Closing Date, the Escrow Collection Bank shall also refund all amounts payable to unsuccessful Bidders and also the excess amount paid on bidding, if any, after adjustment for allocation, to the Bidders. The members of the Syndicate may, at their discretion, waive requirement of payment by Wholesale Bidders or QIB Bidders, at the time of the submission of the Bid cum Application Form. Where such payment at the time of submission of the Bid cum Application Form is waived at the discretion of the members of the Syndicate, the Offer Price shall be payable for the allocated equity shares no later than the date specified in the CAN, which shall be a minimum period of two days from date of communication of the allocation list to the members of the Syndicate by the BRLM and Co-BRLMs. If the payment is not made favouring the Escrow Account within the time stipulated above, the Bid of the Bidder is liable to be cancelled. However, if the members of the Syndicate do not waive such payment, the full amount of payment has to be made at the time of submission of the Bid Form. Where the Bidder has been allocated lesser number of equity shares than they had bid for, the excess amount paid on bidding, if any, after adjustment for allocation, will be refunded to such Bidder within 15 days from the Bid/Offer Closing Date.

Electronic Registration of Bids 1. The members of the Syndicate will register the Bids using the on-line facilities of NSE and BSE. There will be at least one on-line connectivity with each city where a Stock Exchange Centre is located in India, where the Bids are accepted. 2. NSE and BSE will offer a screen-based facility for registering Bids for the Offer. This facility will be available on the terminals of the members of the Syndicate and their authorised agents during the Bidding Period. Members of the Syndicate can also set up facilities for off-line electronic registration of Bids subject to the condition that they will subsequently download the off-line data file into the on-line facilities for book building on an hourly basis. On the Bid Closing Date, we will upload the bids till such time as permitted by the Stock Exchanges. 3. The aggregate demand and price for bids registered on each of the electronic facilities of NSE and BSE will be downloaded on an hourly basis and consolidated. A graphical representation of consolidated demand and price would be made available at the bidding centres during the bidding period. 4. At the time of registering each Bid, the members of the Syndicate shall enter the following details of the investor in the on-line system: Õ Name of the investor Õ Investor Category—Individual, Corporate, NRI, FII, or Mutual Funds etc.

986

Investment Banking Õ Numbers of equity shares bid for Õ Bid price Õ Bid cum Application Form number Õ Whether payment is made upon submission of Bid cum Application Form Õ Depository Participant Identification no. and Client Identification no. of the demat account of the Bidder.

5. A system generated TRS will be given to the Bidder as a proof of the registration of each of the bidding options. It is the Bidder’s responsibility to obtain the TRS from the members of the Syndicate. The registration of the Bid by the member of the Syndicate does not guarantee that the equity shares shall be allocated either by the Selling Shareholder or the members of the Syndicate or us. Such TRS will be non-negotiable and by itself will not create any obligation of any kind. 6. It is to be distinctly understood that the permission given by NSE to use their network and software of the online IPO system should not in any way be deemed or construed that the compliance with various statutory and other requirements by the Selling Shareholder, our Company, BRLM or Co-BRLMs are cleared or approved by NSE; nor does it in any manner warrant, certify or endorse the correctness or completeness of any of the compliance with the statutory and other requirements nor does it take any responsibility for the financial or other soundness of our Company, promoters, management or any scheme or our project. 7. It is also to be distinctly understood that the approval given by NSE should not in any way be deemed or construed that the Draft Red Herring Prospectus has been cleared or approved by NSE; nor does it in any manner warrant, certify or endorse the correctness or completeness of any of the contents of this Draft Red Herring Prospectus; nor does it warrant that the equity shares will be listed or will continue to be listed on the NSE.

Build Up of the Book and Revision of Bids 1. Bids registered by various Bidders through the members of the Syndicate shall be electronically transmitted to the NSE or BSE mainframe on an on-line basis. Data would be uploaded on an hourly basis. 2. The book gets built up at various price levels. This information will be available with the BRLM and Co-BRLMs on an regular basis. 3. During the Bidding Period, any Bidder who has registered an interest in the equity shares at a particular price level is free to revise the Bid to a higher price level (upward revision) as well as to lower price level subject to the Floor Price (downward revision) using the printed Revision Form which is a part of the Bid cum Application Form. 4. Revisions can be made in both the desired number of equity shares and the bid price by using the Revision Form. The Bidder must complete the details of all the options in

Appendix 2

987

the Bid cum Application Form or earlier Revision Form and revisions for all the options as per the Bid cum Application Form or earlier Revision Form. For example, if a Bidder has bid for three options in the Bid cum Application Form or the earlier Revision Form and is changing only one of the options in the Revision Form, the Bidder must still fill the details of the other two options, that are not being revised, in the Revision Form unchanged. Incomplete or inaccurate Revision Forms will not be accepted by the members of the Syndicate. 5. The Bidder can make this revision any number of times during the Bidding Period. However, for any revision(s) in the earlier Bid, the Bidders will have to use the services of the same member of the Syndicate through whom the original Bid was placed. Bidders are advised to retain copies of the blank Revision Form. 6. Any revision of the Bid shall be accompanied by payment in the form of cheque or demand draft or Stockinvest for the incremental amount, if any, to be paid on account of the upward revision of the Bid. The excess amount, if any, resulting from downward revision of the Bid would be returned to the Bidder at the time of refund in accordance with the terms of this Draft Red Herring Prospectus. In case of QIBs, the members of the Syndicate may at their sole discretion waive the payment requirement at the time of one or more revisions by the Bidders. 7. When a Bidder revises a Bid, the Bidder shall surrender the earlier TRS and get a revised TRS from the members of the Syndicate. It is the responsibility of the Bidder to request for and obtain the revised TRS, which will act as proof of having revised the Bid. 8. In case of discrepancy of data between the electronic book and the physical book, the decision of the BRLM and Co-BRLMs based on the physical records of the Bid cum Application Form shall be final and binding on all concerned.

Price Discovery and Allocation 1. After the Bid/Offer Closing Date, the BRLM and Co-BRLMs shall analyse the demand generated at various price levels and discuss pricing strategy with the Selling Shareholder and our Company. 2. The Selling Shareholder will in consultation with our Company, the BRLM and CoBRLMs, finalise the “Offer Price”. The Selling Shareholder and our Company will in consultation with the BRLM and Co-BRLMs finalize the number of equity shares to be transferred and the allocation to successful QIB Bidders. The allocation will be decided based on the quality of the Bidder determined broadly by the size, price and date of the Bid. 3. The allocation for QIBs of 60% of the Offer Size would be discretionary. The allocation to Wholesale Bidders and Retail Bidders of not less than 15% and not less than 25% of the Offer Size respectively would be on proportionate basis, in consultation with the regional Stock Exchange, subject to valid Bids being received at or above the Offer Price. 4. Undersubscription, if any, in any category, would be allowed to be met with spill over from any of the other categories, at the sole discretion of the Selling Shareholder, BRLM and Co-BRLM(s).

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Investment Banking

5. Allocation to Non Residents, NRIs or FIIs applying on repatriation basis will be subject to the terms and conditions stipulated by the FIPB and RBI while granting permission for Offer of equity shares to them. 6. The BRLM and Co-BRLMs, in consultation with the Selling Shareholder and our Company, shall notify the Syndicate Members of the Offer Price and allocations to their respective Bidders where the full Bid Amount has not been collected from the Bidders. 7. The Selling Shareholder, in consultation with our Company, reserve the right to cancel the Offer any time after the Bid/Offer Opening Date.

Signing of Underwriting Agreement and RoC Filing 1. The Selling Shareholder, our Company, the BRLM, the Co-BRLMs and the Syndicate Members shall enter into an Underwriting Agreement on reaching agreement upon the Offer Price and allocation(s) to the Bidders. 2. After the Underwriting Agreement is signed between the Selling Shareholder, our Company, the BRLM, the Co-BRLMs and the Syndicate Members, we will file the Red Herring Prospectus with RoC, which then would be termed ‘Prospectus’. The Prospectus would have details of the Offer Price, size of the Offer, underwriting arrangements and would be complete in all material respects.

Advertisement regarding Offer Price and Prospectus A statutory advertisement will be issued by us after the filing of the Prospectus with the RoC. This advertisement, in addition to the information that has to be set out in the statutory advertisement, shall indicate the Offer Price along with a table showing the number of equity shares and the amount payable by an investor. Any material updates between the Draft Red Herring Prospectus and the Prospectus will be included in such statutory advertisement.

Issuance of Confirmation of Allocation Note 1. The BRLM or Co-BRLMs or Registrar to the Offer shall send to the members of the Syndicate a list of their Bidders who have been allocated equity shares in the Offer. 2. The BRLM, Co-BRLMs or Syndicate Members would then send the CAN to their Bidders who have been allocated equity shares in the Offer. The despatch of a CAN shall be deemed a valid, binding and irrevocable contract for the Bidder to pay the entire Offer Price for all the equity shares allocated to such Bidder. Those Bidders who have not paid into the Escrow Account for the Offer at the time of bidding shall pay in full the amount payable into the Escrow Account for the Offer by the Pay-in Date specified in the CAN. 3. Bidders who have been allocated equity shares and who have already paid into the Escrow Account for the Offer at the time of bidding shall directly receive the CAN from the Registrar to the Offer subject, however, to realisation of their cheque or demand draft paid into the Escrow Account for the Offer. The despatch of a CAN shall be a deemed a valid, binding and irrevocable contract for the Bidder to pay the entire Offer Price for all the equity shares transferred to such Bidder.

Appendix 2

989

Designated Date and Transfer in the Offer After the funds are transferred from the Escrow Account for the Offer to the Public Offer Account on the Designated Date, the Selling Shareholder and our Company would ensure the transfer of equity shares to the allottees within two days of the allotment. All allottees will receive credit for the equity shares directly in their depository account. Equity shares will be transferred only in the dematerialised form to the allottees. Allottees will have the option to re-materialise the equity shares so transferred, if they so desire, as per the provisions of the Companies Act and the Depositories Act. The Selling Shareholder and we will ensure the transfer of equity shares within 15 days of closure of the bidding and also ensure that credit is given to the allottees’ depository accounts within two working days from the date of allotment.

Submission of Bid cum Application Form All Bid cum Application Forms or Revision Forms duly completed and accompanied by account payee cheques or drafts or Stockinvest shall be submitted to the members of the Syndicate at the time of submission of the Bid cum Application Form unless waived by a member of the Syndicate at its sole discretion. The collection center of the BRLM, Co-BRLMs or Syndicate Members will acknowledge the receipt of the Bid cum Application Forms or Revision Forms by stamping and returning to the Bidder the acknowledgement slip. This acknowledgement slip will serve as the duplicate of the Bid cum Application Form for the records of the Bidder. No separate receipts shall be issued for the money paid on the submission of Bid cum Application Form or Revision Form.

Our Right to Reject Bids The Selling Shareholder, we and the members of the Syndicate reserve the right to reject any Bid without assigning any reason therefore in case of QIBs. In case of Wholesale Bidders and Retail Bidders, the Selling Shareholder and we would have the right to reject bids based on technical grounds. Consequent refunds shall be made by cheque or pay order or draft and will be sent to the bidder’s address at the Bidder’s risk.

Equity Shares in Dematerialised Form with NSDL or CDSL In terms of Section 68B of the Companies Act, the equity shares in this Offer shall be transferred only in dematerialized form, (i.e. not in the form of physical certificates but be fungible and be represented by the statement issued through electronic mode).

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Investment Banking

In this context, two tripartite agreement have been signed between the Registrar, the Depositories and us: �

An agreement dated [ ] between NSDL, us and [ ]; and

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An agreement dated [ ] between CDSL, us and [ ].

Bids from any investor without the following details of his or her depository account are liable to be rejected. 1. A Bidder applying for equity shares must have at least one beneficiary account with either of the Depository Participants of NSDL or CDSL prior to making the Bid. 2. The Bidder must necessarily fill in the details (including the beneficiary account number and Depository Participant’s Identification number) appearing in the Bid cum Application Form or Revision Form. 3. Equity shares transferred to a Bidder will be credited in electronic form directly to the beneficiary account (with the Depository Participant) of the Bidder 4. Names in the Bid cum Application Form or Revision Form should be identical to those appearing in the account details in the Depository. In case of joint holders, the names should necessarily be in the same sequence as they appear in the depository account of the Bidder(s) . 5. If incomplete or incorrect details are given under the heading ‘Bidders Depository Account Details’ in the Bid cum Application Form or Revision Form, it is liable to be rejected. 6. The Bidder is responsible for the correctness of his or her demographic details given in the Bid cum Application Form vis-à-vis those with his or her Depository Participant. 7. It may be noted that equity shares in electronic form can be traded only on the stock exchanges having electronic connectivity with NSDL or CDSL. All the stock exchanges where our equity shares are proposed to be listed are connected to NSDL and CDSL. 8. The trading of our equity shares would be in dematerialised form only for all investors. COMMUNICATIONS All future communications in connection with Bids made in the Offer should be addressed to the Registrar to the Offer quoting the full name of the sole or First Bidder, Bid cum Application Form number, number of equity shares applied for, date of Bid form, name and address of the member of the Syndicate where the Bid was submitted and cheque, draft or Stockinvest number and issuing bank thereof.

UTILIZATION OF OFFER PROCEEDS The Selling Shareholder certifies that all monies received out of the Offer shall be transferred to a separate Bank account other than the bank account referred to in sub-section (3) of Section 73 of the Companies Act.

Appendix 2

991

The Selling Shareholder shall not have recourse to the Offer proceeds until approval for trading of equity shares from all the stock exchanges where listing is sought is received.

PROCEDURE AND TIME SCHEDULE FOR TRANSFER OF EQUITY SHARES The Selling Shareholder and we reserve at our absolute and uncontrolled discretion and without assigning any reason thereof, the right to accept or reject any Bid in whole or in part. In case a Bid is rejected in full, the whole of the Bid Amount will be refunded to the Bidder within 15 days of the Bid/Offer Closing Date. In case a Bid is rejected in part, the excess Bid Amount will be refunded to the Bidder within 15 days of the Bid/Offer Closing Date. The Selling Shareholder and we will ensure the transfer of the equity shares within 15 days from the Bid/Offer Closing Date. The Selling Shareholder shall pay interest at the rate of 15% per annum (for any delay beyond the periods as mentioned above), if transfer is not made, refund orders, cancelled Stockinvests are not dispatched and/or demat credits are not made to investors within two working days from the date of allotment.

DISPOSAL OF APPLICATIONS AND APPLICATION MONEY The Selling Shareholder and we shall ensure dispatch of allotment advice, refund orders or cancelled Stockinvests and giving of benefit to the Beneficiary Account with Depository Participants and submission of the transfer and listing documents to the Stock Exchanges within two working days of finalisation of the basis of allotment of equity shares. The Selling Shareholder and we shall ensure the dispatch of refund orders, if any, of value up to Rs. 1,500, “Under Certificate of Posting”, and dispatch of refund orders above Rs. 1,500, if any, by Registered Post or Speed Post at the sole or First Bidder's sole risk. We shall use best efforts to ensure that all steps for completion of the necessary formalities for listing and commencement of trading at all the Stock Exchanges where the equity shares are proposed to be listed, are taken within seven working days of finalisation of the basis of allotment. In accordance with the Companies Act, the requirements of the stock exchanges and SEBI Guidelines, the Selling Shareholder and we, further undertake that: �

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Transfer of equity shares shall be made only in dematerialised form within 15 days of the Bid/Offer Closing Date; The Selling Shareholder and we would ensure despatch of refund orders and cancelled Stockinvests within 15 days of the Bid/Offer Closing Date; and The Selling Shareholder shall pay interest at 15% per annum (for any delay beyond the 15 day time period as mentioned above), if transfer is not made, refund orders and cancelled Stockinvests are not dispatched and/or demat credits are not made to investors within the 15 day time prescribed above.

992

Investment Banking

The Selling Shareholder will provide adequate funds required for dispatch of refund orders or allotment advice to the Registrar to the Offer. Refunds will be made by cheques, pay orders or demand drafts drawn on a bank appointed by us as a refund banker and payable at par at places where Bids are received. Bank charges, if any, for cashing such cheques, pay orders or demand drafts at other centres will be payable by the Bidders.

Interest on Refund of excess Bid Amount The Selling Shareholder shall pay interest at the rate of 15% per annum on the excess Bid Amount received by us if refund orders are not dispatched within 15 days from the Bid/Offer Closing Date as per the Guidelines issued by the GoI, Ministry of Finance pursuant to their letter no. F-8/6/SE/79 dated July 21, 1983, as amended by their letter no. F/14/SE/85 dated September 27, 1985, addressed to the stock exchanges, and as further modified by SEBI's Clarification XXI dated October 27, 1997, with respect to the SEBI Guidelines.

Disposal of Applications made by Stockinvest The procedure for disposal of applications made by cash, cheque, pay order or demand draft described above will apply mutatis-mutandis to applications accompanied by Stockinvests, except for the following: In case of non-allotment, the Registrar to the Offer will return the Stockinvest directly to the Bidder with the stamp “CANCELLED” and/or “NOT ALLOCATED” across the face of the instrument within 15 days from the Bid/Offer Closing Date. On allotment or partial allotment, the Registrar to the Offer shall fill in the amount (which will be less than or equal to the amount filled in by the investor) before presenting the Stockinvest to the respective issuing banker for payment to the extent of allotment. The bank issuing the Stockinvest will lift the lien on the balance amount, if any, of the deposit.

STATUTORY AND OTHER INFORMATION

Consents Consents in writing of: (a) the Directors, the Company Secretary, the Auditors, Legal Advisors, Bankers to the Company and Bankers to the Offer; and (b) Book Running Lead Manager to the Offer, Co-Book Running Lead Managers to the Offer, Escrow Collection Bankers, Registrar to the Offer and Legal Advisors to the Underwriters, to act in their respective capacities, have been obtained and filed along with a copy of the Prospectus with the Registrar of Companies, NCT of Delhi and Haryana located at New Delhi, as required under Section 60 and 60B of the Companies Act and such consents have not been withdrawn up to the time of delivery of the offer document for registration.

Appendix 2

993

Price Waterhouse, Chartered Accountants and our statutory auditors have given their written consent to the inclusion of their report in the form and context in which it appears in the Draft Red Herring Prospectus and such consent and report has not been withdrawn up to the time of delivery of the Draft Red Herring Prospectus for registration to the RoC. Price Waterhouse, Chartered Accountants have given their written consent to the tax benefits accruing to our Company and its members in the form and context in which it appears in the Draft Red Herring Prospectus and has not withdrawn the same up to the time of delivery of the Draft Red Herring Prospectus for registration to the RoC.

Minimum Subscription This being an offer for sale, the requirement of minimum subscription is not a pre-condition for completion of the Offer and obtaining listing permissions.

Expert Opinion Save as stated elsewhere in the Draft Red Herring Prospectus, we have not obtained any expert opinions.

Changes in Auditors during the last three years There have been no changes of the auditors in the last three years

Basis of Allotment or Allocation 1. For Retail Bidders �

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Bids received from the Retail Bidders at or above the Offer Price shall be grouped together to determine the total demand under this category. The allocation to all the successful Retail Bidders will be made at the Offer Price. The Offer size less allocation to Non-Institutional Bidders and QIBs shall be available for allocation to Retail Bidders who have bid in the Offer at a price, which is equal to or greater than the Offer Price. If the aggregate demand in this category is less than or equal to 18,060,900 equity shares at or above the Offer Price, full allocation shall be made to the Retail Bidders to the extent of their demand. If the aggregate demand in this category is greater than 18,060,900 equity shares at or above the Offer Price, the allocation shall be made on a proportionate basis up to a minimum of ___ equity shares. For the method of proportionate basis of allotment, refer below.

994

Investment Banking

2. For Wholesale Bidders �

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�

�

Bids received from Wholesale Bidders at or above the Offer Price shall be grouped together to determine the total demand under this category. The allocation to all successful Wholesale Bidders will be made at the Offer Price. The Offer size less allocation to QIBs and Retail Portion shall be available for allocation to Wholesale Bidders who have bid in the Offer at a price, which is equal to or greater than the Offer Price. If the aggregate demand in this category is less than or equal to _____ equity shares at or above the Offer Price, full allocation shall be made to Wholesale Bidders to the extent of their demand. In case the aggregate demand in this category is greater than ____ equity shares at or above the Offer Price, allocation shall be made on a proportionate basis up to a minimum of ____ equity shares. For the method of proportionate basis of allotment refer below.

The aggregate allocation to A and B shall not exceed ____ equity shares. 3. For QIBs �

�

�

Bids received from the QIBs at or above the Offer Price shall be grouped together to determine the total demand under this category. The allocation to all the QIBs will be made at the Offer Price. The Offer size less allocation to Non-Institutional Portion and Retail Portion shall be available for allocation to QIBs who have bid in the Offer at a price, which is equal to or greater than the Offer Price. The allocation would be broadly decided based on the quality of the Bidder determined by the size, price and date of the Bid.

The Selling Shareholder and our Company, in consultation with the BRLMs and Co-BRLMs would have the discretion for any allocation to QIBs.

Method of Prop]ortionate Basis of Allotment In the event the Offer is over-subscribed, the basis of allotment to Retail and Wholesale Bidders shall be finalised by us in consultation with the DSE (the Regional Stock Exchange). The Executive Director or Managing Director of the DSE along with the BRLM/Co-BRLMs and the Registrar to the Offer shall be responsible for ensuring that the basis of allotment is finalised in a fair and proper manner. The transfer shall be made in marketable lot, on a proportionate basis as explained below: (a). Bidders will be categorised according to the number of equity shares applied for

Appendix 2

995

(b). The total number of equity shares to be transferred to each category as a whole shall be arrived at on a proportionate basis, which is the total number of equity shares, applied for in that category (number of bidders in the category multiplied by the number of shares applied for) multiplied by the inverse of the over-subscription ratio. (c). Number of equity shares to be transferred to the successful Bidders will be arrived at on a proportionate basis, which is total number of equity shares, applied for by each Bidder in that category multiplied by the inverse of the over-subscription ratio. (d). In all Bids where the proportionate allotment is less than ___ equity shares per Bidder, the transfer shall be made as follows: � �

Each successful Bidder shall be transferred a minimum of ___ equity shares; and The successful Bidders out of the total Bidders for a category shall be determined by draw of lots in a manner such that the total number of equity shares transferred in that category is equal to the number of equity shares calculated in accordance with (b) above.

(e). If the proportionate allotment to an Bidder works out to a number that is more than ___ but is not a multiple of ___ (which is the marketable lot), the number in excess of the multiple of ___ would be rounded off to the higher multiple of ___ if that number is ___ or higher. If that number is lower than ___, it would be rounded off to the lower multiple of __. All Bidders in such categories would be transferred equity shares arrived at after such rounding off. (f). If the equity shares allocated on a proportionate basis to any category are more than the equity shares transferred to the Bidders in that category, the remaining equity shares available for transfer shall be first adjusted against any other category, where the allotted shares are not sufficient for proportionate allotment to the successful bidders in that category. The balance equity shares, if any, remaining after such adjustment will be added to the category comprising Bidders applying for minimum number of equity shares.

Expenses of the Offer The expenses of the Offer payable by the Selling Shareholder inclusive of brokerage, fees payable to the BRLM, Co-BRLM, Syndicate Members, other advisors to the Offer, fees of Legal Advisors to the Offer and Auditors, stamp duty, printing, publication, advertising and distribution expenses, bank charges, fees payable to the Registrar to the Offer and other miscellaneous expenses is estimated to be approximately ___% of the Offer size, and will be met out of the proceeds of the Offer. The listing fees will be paid for by us.

Fees Payable to the BRLM The total fees payable to the Book Running Lead Manager will be as per the Letter of Appointment dated May 17, 2002 issued by GoI, a copy of which is available for inspection at our Corporate Office.

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Investment Banking

Fees Payable to the Co-BRLMs The total fees payable to the Co-BRLMs will be as per the Letters of Appointment dated November 8, 2002 and December 26, 2002 issued by GoI, a copy of which is available for inspection at our Corporate Office.

Fees Payable to the Registrar to the Offer The fees payable to the Registrar to the Offer will be as per the the Letter of Appointment dated March 17, 2003, a copy of which is available for inspection at our Corporate Office. Adequate funds will be provided to the Registrar to the Offer to enable them to send refund orders or allotment advice by registered post.

Commission and Brokerage on Previous Issues Except as stated elsewhere in the Draft Red Herring Prospectus, no sum has been paid or is payable as commission or brokerage for subscribing to or procuring or agreeing to procure subscription for any of our equity shares since our inception.

Previous Rights and Public Issues We have made a rights issue of 1,219,512 equity shares of Rs. 100 each at a price of Rs. 3,280 per equity share, under which 1,216,341 equity shares were allotted on May 30, 2002 to the shareholders who subscribed to the rights issue, while the remaining 3,171 equity shares were not issued on account of non-subscription. Other than such rights issue, we have not made any rights or public issue since its inception.

Outstanding Debentures or Bond Issues As of December 31, 2002, we have Rs. 3,000 million of non-convertible debentures , which have been issued in 2000.

Outstanding Preference Shares As of December 31, 2002, we did not have any outstanding preference shares.

Capitalisation of Reserves or Profits We have not capitalised our reserves or profits at any time.

Issues otherwise than for Cash Except as stated above and in the section entitled “Capital Structure” on page in the Draft Red Herring Prospectus, we have not issued any equity shares for consideration otherwise than for cash.

Appendix 2

997

Option to Subscribe Equity shares being offered through this draft Red Herring Prospectus can be applied for in the dematerialized form only.

Purchase of Property There is no property which we have purchased or acquired or proposes to purchase or acquire which is to be paid for wholly or partly out of the proceeds of the present Offer or the purchase or acquisition of which has not been completed on the date of this Draft Red Herring Prospectus, other than property in respect of which: �

The contracts for the purchase or acquisition were entered into in the ordinary course of the business, and the contracts were not entered into in contemplation of the Offer nor is the Offer contemplated in consequence of the contracts;

�

or the amount of the purchase money is not material;

�

or the relevant disclosures in the Draft Red Herring Prospectus

Except as elsewhere stated in this Draft Red Herring Prospectus, we have not purchased any property in which any of its promoters and/or Directors, have any direct or indirect interest in any payment made thereof.

Interest of Promoters and Directors Except as stated in “Related Party Transactions” on page of the Draft Red Herring Prospectus, the promoters, the promoter group companies and other related parties do not have any interest in our business except to the extent of investments made by them in our Company and earning returns thereon. Except as stated otherwise in this Draft Red Herring Prospectus, we have not entered into any contract, agreements or arrangement during the preceding two years from the date of the Draft Red Herring Prospectus in which the directors are interested directly or indirectly and no payments have been made to them in respect of these contracts, agreements or arrangements or are proposed to be made to them.

Revaluation of Assets We have not revalued any of its assets since its inception.

Classes of Shares Our authorised capital is Rs. 1,550 million, which is divided into 310 million equity shares of Rs. 5/- each.

998

Investment Banking

MAIN PROVISIONS OF ARTICLES OF ASSOCIATION OF MARUTI UDYOG LIMITED (Not reproduced herein ) MATERIAL CONTRACTS AND DOCUMENTS FOR INSPECTIONS The following Contracts (not being contracts entered into in the ordinary course of business carried on by our Company or entered into more than two years before the date of this Draft Red Herring Prospectus) which are or may be deemed material have been entered or to be entered into by our Company. These Contracts, copies of which have been attached to the copy of this Draft Red Herring Prospectus, delivered to the Registrar of Companies, National Capital Territory of Delhi and Haryana located at New Delhi for registration and also the documents for inspection referred to hereunder, may be inspected at the Corporate Office of our Company situated at 11th Floor, Jeevan Prakash Building, 25, Kasturba Gandhi Marg, New Delhi 110 001 from 10.00 a.m. to 4.00 p.m. from the date of this Draft Red Herring Prospectus until the date of Issue Closing Date. MATERIAL CONTRACTS 1. Letter of appointment to Kotak Mahindra Capital Company Ltd from GoI dated May 17, 2002 appointing them as BRLM. 2. Letter of appointment to ICICI Securities Ltd from GoI dated November 8, 2002 appointing them as Co-BRLM. 3. Letter of appointment to JM Morgan Stanley Pvt. Ltd. and HSBC Securities and Capital Markets (India) Pvt. Ltd. from GoI dated December 12, 2002 appointing them as Co-BRLM. 4. Memorandum of Understanding amongst GoI, the Company, BRLM and CoBRLMs. 5. Letter from GoI appointing MCS Ltd. 6. Letter from GoI appointing _____ [Syndicate members]. 7. Underwriting agreement. 8. Syndicate agreement. 9. Escrow agreement. MATERIAL DOCUMENTS 10. 11. 12. 13.

Revised Joint Venture Agreement dated May 15, 2002. Letter from Suzuki dated February 19, 2003. Our Memorandum and Articles of Association as amended from time to time. Our certificate of incorporation dated February 24, 1981.

14. Resolution of the Board of Directors of the Company, passed at its Meeting held on ____.

Appendix 2

999

15. Letters dated February 7, 2003, from Ministry of Heavy Industries and Public Enterprises, Department of Heavy Industry, authorizing the issue. 16. The Report of the Auditors, M/s Price Waterhouse, Chartered Accountants as set out herein dated March 25, 2003 and March 31, 2003. 17. Copies of the Annual Report for the year ended March 31, 1998, 1999, 2000, 2001 and 2002 of the Company on which Report of the Auditors of the Company, M/s Price Waterhouse, and Chartered Accountants is based. 18. A copy of the tax benefit report dated ______ from our Auditors, M/s Price Waterhouse, Chartered Accountants. 19. Consent dated __, from our Auditors for inclusion of their report on Accounts in the form and context in which they appear in the Draft Red Herring Prospectus. 20. Consents of: (a)Auditors, Bankers to the Company and (b) Book Running Lead Manager, Co-Book Running Lead Managers, Advocate & Solicitor, Legal Advisors, Registrar and Bankers to the Offer as referred to in their respective capacities. 21. General Power of Attorney executed by Directors of the Company in favour of person(s) for signing and making necessary changes in the Draft Red Herring Prospectus. 22. Resolution of the Meeting of the Board of Directors held on _____, authorising the Registrar to the Offer to sign the Stockinvests on our behalf for realising the proceeds of the Stockinvests. 23. Resolution of our Members passed at the Extra Ordinary General Meeting held on ____appointing M/s Price Waterhouse, Chartered Accountants as Auditors for the year 2001–2002. 24. Due Diligence Certificate dated April 25, 2003 to SEBI from, Kotak Mahindra Capital Company Limited, ICICI Securities Limited, JM Morgan Stanley Private Limited and HSBC Securities and Capital Markets (India) Pvt. Ltd. 25. SEBI As per the letter no. 2[16]/2000–PE-VI, dated February 7, 2003, from the Ministry of Heavy Industries and Public Enterprises, Department of Heavy Industry, GoI, the Cabinet Committee of Disinvestment has approved the disinvestment in Maruti by GoI by way of Offer for sale of its shareholding in the domestic market. 26. SEBI letter RM/21334/2003 dated October 29, 2002 granting approval for retention of over-subscription over and above the limit of 10% allowed for the purposes of rounding off under clause 6.4.2(f) of SEBI Guidelines. 27. SEBI observation letters no. ______ dated ______ , ______ and fresh due-diligence certificate dated ______. 28. In-principle listing approval dated ________ , _______and _________ from DSE, NSE and BSE. Initial listing application dated _______, ___________ and ______, for listing the equity shares at DSE, NSE and BSE, respectively. 29. Approval from the RBI for (a) transfer of equity shares in the Offer for Sale to NRIs and FIIs pursuant to its letter no. __________dated __________; (b) transfer of equity shares by the existing non-resident shareholders to residents pursuant to the Offer for

1000

Investment Banking Sale pursuant to its letter No. __________dated __________; and (c) participation of FIIs in the Fresh Issue pursuant to its letter No. ______ dated _____ .

30. Tripartite Agreement between the NSDL, us and _____ dated _____ . 31. Tripartite Agreement between the CDSL, us and ____ dated _____. 32. Annual Report of the group companies. 33. Approval from GoI, Ministry of Finance and Company Affairs (Department of Economic Affairs) pursuant to its letter no. FC.II: 74(1982)-Comp dated April 16, 2003 for the transfer of equity shares in this Offer to eligible non-resident investors, NRIs and FIIs. In terms of the approval of GoI, OCBs have not been permitted to participate in the Offer.

DECLARATION All the relevant provisions of the Companies Act, 1956, and the guidelines issued by the GoI or the guidelines issued by the Securities and Exchange Board of India, as the case may be, have been complied with and no statement made in this Draft Red Herring Prospectus is contrary to the provisions of the Companies Act, 1956, the Securities and Exchange Board of India Act, 1992 or rules made thereunder or guidelines issued, as the case may be.

SIGNED BY THE DIRECTORS Mr. (Through their constituted attorney Mr.______________) SIGNED BY THE SELLING SHAREHOLDER Mr _________(As authorised vide _______) Date: Place:

� Appendix 3

Private and Confidential LETTER OF OFFER For Equity Shareholders of the Company Only

THE DHAMPUR SUGAR MILLS LIMITED Incorporated under the Indian Companies Act VII of 1913 On 22nd May 1933 at Lucknow Registered Office: Dhampur, District—Bijnore, U.P. 246 761 Corporate Office: 221,Okhla Industrial Estate, Phase-III, New Delhi 110 020 Phone: 51612456, 55602448, Fax: 011-26910507, 28612459 Email: [email protected], Website : dhampur.com Issue of 8098663 Equity Shares of Rs. 10/- each for cash at par aggregating to Rs. 809.87 lakhs on rights basis to the existing Equity Shareholders of the Company in the ratio of Four Equity Shares for every Thirteen Equity Shares (4 : 13) held on 20th October 2003 (Here after referred to as the “Record Date”)

GENERAL RISKS Investments in Equity and Equity related securities involve a degree of risk and investors should not invest any funds in this Issue unless they can afford to take the risk of losing their investment. Investors are advised to read the Risk Factors carefully before taking an investment decision in this Issue. For taking an investment decision, investors must rely on their own examination of the Issuer and the Issue including the risks involved. The securities have not been recommended or approved by the Securities and Exchange Board of India (SEBI) nor does SEBI guarantee the accuracy or adequacy of this document. Investors are advised to refer to “Risk Factors” on page (i ) to (x) carefully before making an investment in this Issue.

ISSUER'S ABSOLUTE RESPONSIBILITY The Issuer having made all reasonable inquiries, accepts responsibility for and confirms that this Letter of Offer contains all information with regard to the Issuer and the Issue, which is

1002

Investment Banking

material in the context of this Issue, that the information contained in this Letter of Offer is true and correct in all material aspects and is not misleading in any material respect, that the opinions and intentions expressed herein are honestly held and that there are no other facts, the omission of which makes this Letter of Offer as a whole or any such information or the expression of any such opinions or intentions misleading in any material respect.

Listing The existing equity shares of the Company are listed on The National Stock Exchange of India Ltd., The Stock Exchange, Mumbai, The Stock Exchange-Ahmedabad and The Delhi Stock Exchange association Ltd. The Company is seeking delisting of its securities from Ahmedabad, Delhi and Delhi Stock Exchange(s) under the Securities and Exchange board of India (Delisting of Securities) Guidelines, 2003. On request of the Company its shares have been delisted from The U.P. Stock Exchange Association Ltd. vide their letter no UPSE/LC/2003-2004 dt. 26-0-2003. The equity shares to be issued through this Rights Issue would be listed on The National Stock Exchange of India Ltd and The Stock Exchange, Mumbai. In-principle approval for listing has been obtained from The National Stock Exchange of India Ltd on July 29, 2003 vide their letter no. NSE/LIST/48945, The Stock Exchange, Mumbai on 25th July 2003 vide their letter no. List/rkk/aal/03. The Company has paid the annual listing fees upto March, 2004 to the above stock exchanges.

Credit Rating This being an issue of equity shares, no credit rating is required.

Issue Programme

Issue Opens on

Last date for receiving requests For Split forms

10th November 2003

25th November 2003

Issue Closes on

9th December 2003

1003

Appendix 3

MANAGER TO THE OFFER

Indbank Merchant Banking Services Ltd. (Subsidiary of Indian Bank) 6A, Atma Ram House, 1 Tolstoy Marg New Delhi–110 001 Ph. No.: 011 23353264, 23731148 -49 Fax No.: 011 23353264 Email: [email protected] SEBI Registration Number : INM 00000 1394

REGISTRAR TO THE OFFER

Alankit Assignments Limited 205-Anarkali Market, Jhandewalan Extension New Delhi 110 055 Ph. No.: 011–51540060-63 Fax No.: 011-51540064 E mail :[email protected] SEBI Registration Number: INR 000002532

Risk Factors and Management Perceptions Thereof The investors should consider the following risk factors together with all other information included in this Letter of Offer carefully, in evaluating the Company and its business before making any investment decision. Any projections, forecasts and estimates contained herein are forward looking statements that involve risks and uncertainties. Such statements use forward looking terminology like “may”, “believes”, “will”, “expect”, “anticipate”, “estimate”, “plan” or other similar words. The Company’s actual results could differ from those anticipated in these forward-looking statements as a result of certain factors including those, which are set forth in the “Risk factors”. The Letter of Offer also includes statistical data regarding the Sugar Industry. This data has been obtained from industry publications, reports and other sources that the Company and the Lead Manager believe to be reliable. Neither the Company nor the Lead Manager has independently verified such data.

INTERNAL RISK FACTORS

Risk Factor 1 Accumulated losses in Company The Company is incurring losses for the last five years and its net worth has decreased from Rs. 15844.99 Lakhs as on 30th September, 1998 to Rs. 3866.37 Lakhs as on 30th September, 2002. The losses of the company for the last five years are as under

1004

Investment Banking (Rs. in lakhs)

Year/Period Ended

As on 30.09.1998

As on 30.09.1999

As on 30.09.2000

As on 30.09.2001

As on 30.09.2002

Sales

33536.33

32362.52

29783.79

45318.67

41011.56

103.34

101.52

51

0.7

—

708.4

453.89

175.7

348.2

236.54

Increase (Decrease) in Stocks

–2640.33

–768.46

6106.11

–7630.21

3801.46

PBDIT Depreciation Interest Loss before Tax & Extraordinary items.

3107.56 1291.55 3489.53 (1676.52)

2341.08 1451.3 4363.9 (3474.12)

2979.68 1503.38 4851.07 (3374.77)

5129.47 1539.15 5074.1 (1483.78)

2650.71 1550.9 3803.64 (2703.83)

–1.21

15.87

0.95

–469.05

–482.59

–1677.73

– 3458.25

–3373.82

–1952.83

–3186.42

Other Income from operation Other Income

Extraordinary Item Net (Loss) before Tax Provision for Taxation Net (Loss) after Tax

–1

—

—

–3.04

–1678.73

–3458.25

–3373.82

–1955.87

— –3186.42

The total Secured Loans outstanding as on 30.09.2002 is Rs. 300.04 Crores and Interest due thereon is Rs. 24.09 Crores. The company has accumulated losses of Rs. 5850.22 lakhs as on 30.09.2002. The Losses to the company are higher after incorporating the extra ordinary items.

Management Perception The losses are mainly due to poor industry and economic scenario, high level of inventory and high debt profile & its cost to Company. The interest rate on working capital and term loan have now been reduced by the lenders as per the restructuring Scheme approved by the CDR Cell, vide their approval letter no. CDR/729 dated 10 April, 2003. The cane price from sugar season 2002-2003 is being paid as per Statutory Minimum Price fixed by Central Govt. ranging form Rs. 80/- to Rs. 85/per quintal as against proposed Advised Price of State Govt. of Rs. 100/- per quintal.

Risk Factor 2 Loss making Subsidiaries

1005

Appendix 3

The company has investments of Rs. 4985.91 Lakhs in the shares of subsidiary companies and a partnership firm, and debts aggregating Rs. 3013.93 Lakhs are also outstanding from subsidiary companies as at 30th September 2002. The company has also an exposure of Rs. 4518.65 Lakhs in respect of guarantee given to financial institutions and banks for repayment of finance facilities provided by them to these subsidiary companies. The fall in the value of these investments is considered temporary by the management. M/s DSM Agro Products Ltd. a Subsidiary of The Dhampur Sugar Mills Ltd. has been refereed to BIFR. The net profit/(Loss) of these subsidiaries is as under: (Rs. lakhs) Name of Subsidiary

1998–2000

2000–2001

2001–2002

DSM Agro Products Limited (DSMAPL)

(1076.08)

(2641.13)

(671.68)

Mansurpur Sugar Mills Limited (MSML)

(696.92)

29.62

42.21

(.042)

(.401)

DSM Hitech Products Limited

Management Perception DSM Agro Products Ltd. made substantial losses on account of the losses incurred in Kraft paper unit and the company has closed operations of its paper unit and later on sold the same in February 2002. Management has now concentrated mainly on sugar production. The rehabilitation proposal of DSM Agro Products Ltd. is under consideration of BIFR and the recovery of loan can be planned only after approval of rehabilitation proposal by BIFR. Mansurpur Sugar Mills Ltd. is a profit making subsidiary since past two years and is under modernisation and Expansion. DSM Hitech Products Ltd. has discontinued its business and has repaid its debts to the company

Risk Factor 3 The two Investment companies in the group have incurred losses in the last 2 years. The Loss after tax of these companies for the last two years are as under Rs. lakhs 31.03.2001 a. Saraswati Properties Ltd. b. Goel Investment Ltd.

31.03.2002

60.78

9.74

0.63

1.55

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Investment Banking

Management Perception The companies belong to the promoter family and their losses do not have any impact on the financial position of the issuer company.

Risk Factor 4 Short Fall in Achievement of Projections Made in the Last Rights Issue The performance of the company was below the projections mentioned in the letter of offer in earlier Rights Issue made in 1995. The key heads in which the projection could not be achieved by the company are as below: Particulars

Projections for 3.9.96

Results as on 30.9.96

Projections for 30.9.97

Results as on 30.9.97

Projection for 30.9.98

Results as on 30.9.98

Sales

30175.60

31722.17

34715.76

33079.76

35773.95

33030.78

PAT

2973.00

585.16

3397.93

1040.08

3469.50

(436.12)

21191.12

16560.64

24134.64

16586.35

26998.30

15294.99

Networth

Management Perception The projections could not be achieved due to subdued performance of its sugar units and the high term debt level. The companies performance is also adversely affected due to the continued downturn in the sugar industry.

Risk Factor 5 High Debt Profile of the Company The total secured loan of the company as on 30.09.2002 were Rs. 32413.80 Lakhs as against the Networth of Rs. 3866.37 Lakhs.

Management Perception Out of total secured loan of Rs. 32413.80 lakhs Rs. 11860.01 lakhs being Bank Borrowings is secured against stocks of the company and rest term loans are secured against fixed assets of the

Appendix 3

1007

company. The high cost of debt profile of the company has an adverse effect on the financial position of the company which had necessitated the re-structuring of debts of the company by CDR Cell of Financial Institutions and Banks which inter-alia provides reduced rate of interest

Risk Factor 6 Default in Principal and Interest There has been default in paying interest of Rs. 2409.28 lakhs and principal repayment of Rs. 758 lakhs as on 30th September, 2002 to the Financial Institutions & Banks. Management Perception The Financial Institutions and Banks under CDR Mechanism have funded entire outstanding interest and principal repayment has been deferred till April, 2005, except UTI, the matter of UTI is subjudice.

Risk Factor 7 There has been default in payment of Cumulative preference dividend. The arrears of dividend as on 30.09.2002 stood at Rs. 378.37 lakhs on Redeemable preference shares issued to Corporate and Financial institutions.

Management Pereception The dividend could not be paid due to inadequacy of profits in terms of company law. The payment of redeemable preference shares have now been restructured for future period starting from 2013 to 2015 in 3 equal instalment, by CDR as per their restructuring scheme.

Risk Factor 8 Grant of Rs. 284 Lakhs received from IDBI out of US AID grant resources for Co-Generation project is subject to certain terms & condition and in event of non fulfillment of these terms & condition, the grant shall be repaid with interest at the maximum lending rate of rupees loan and till that time the grant is secured by hypothecation of all movable assets of Co-generation plant at Rouzagaon

Management Perception The Terms and conditions are being complied within the permissible norms.

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Investment Banking

Risk Factor 9 There was default in interest/Principal on unsecured Non-Convertible Debentures of Rs 354.00 Lakhs. as on 30.09.2001 to the subscriber Bajaj Auto Ltd.

Management Perception As per the settlement made by the company, the above NCD are redeemable in monthly instalments commencing from 21.01.2002 to 21.11.2003 without payment of any interest after 28.04.2001. As on 17.09.2003 the dues is Rs. 46.17 Lakhs Approximately

Risk Factor 10 Dues From Uttar Pradesh Power Corporation Ltd. The company is supplying surplus power to Uttar Pradesh Power Corporation Ltd. and the payment is abnormally delayed by Uttar Pradesh Power Corporation Ltd.

Management Perception The company regularly follows up the matter with UP Power Corporation Ltd. for recovery of its dues.

Risk Factor 11 Interest on debts and advances to companies and investment in partnership firm aggregating Rs. 3252.68 lakhs given/invested by the company has not been accounted for in view of their financial position .

Management Perception The Income has not been accounted for in accordance with the prudent accounting policies.

Risk Factor 12 The company has not declared and paid any dividend on equity shares for last five years after financial year 1996–1997.

Appendix 3

1009

Management Perception The company did not declare and paid any dividend after 1996-1997 due to losses and inadequacy of profits of the company.

Risk Factor 13 There has been no transaction recorded in the securities of the company for the last three years at The Stock Exchange-Ahmedabad, The Delhi Stock Exchange Association Ltd. and The UP Stock Exchange Association Ltd. (Regional) and the company is seeking delisting of its securities from these stock exchanges.

Management Perception The equity shares of the company are listed and traded at NSE & BSE. These stock exchanges provide screen based trading which is widely accessible from different location of INDIA.

Risk Factor 14 Mr. Vijay kumar Goel, the promoter of The Dhampur Sugar Mills Ltd. is a director of VLS Finance Ltd. against whom SEBI has conducted enquiries. SEBI had issued order against another Director of The Dhampur Sugar Mills Ltd., namely Shri M P Mehrotra who is also a promoter director of VLS Finance. The order was set aside by SAT and SEBI has filed an appeal before Hon’ble Supreme Court of India.

Management Perception As on date the matter is set aside and is subjudice before the Hon’ble Supreme Court.

Risk Factor 15 The shares of the company has been suspended for trading on 25.06.2001 on The National Stock Exchange of India Ltd. due to shortcoming in compliance of certain clause of listing agreement.

Management Perception The suspension was revoked on 5.11.2001 by The National Stock Exchange of India Ltd., upon submission of reply by the company to the satisfaction of the Exchange and no penalty has been imposed on company.

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Investment Banking

Risk Factor 16 The contingent liabilities have not been provided for, as these contingent liabilities have not been crystalised. Further there would have been an impact on the issuer companies financial statements if the Contingent liabilities of the subsidiary company is crystaliysed. (A) CONTINGENT LIABILITIES OF THE ISSUER COMPANY (THE DHAMPUR SUGAR MILLS LIMITED) As on 30th September 2002, the Company had the following contingent liabilities: (a). Claims against the company not acknowledged as debts in respect of some pending cases of employees under Labour Laws—amount not ascertainable. (b). Disputed Excise Duty penalty demands—Rs. 29.87 lakhs. (c). Disputed Excise Duty demands—Rs. 128.55 lakhs (d). Disputed CENVAT credit on inputs & capital items Rs. 223.45 Lakhs against which Rs.14.26 lakhs has been paid by the company. (e). Disputed Purchase Tax penalty demand—Rs. 41.14 lakhs. (f). Disputed demand for interest on excise duty realised against levy sugar —Rs. 7.65 lakhs. (g). Disputed demand against cane price for year 1978–79 (covered by bank guarantee)— Rs. 21.20 lakhs. (h). Disputed demand for Electricity Dues of Rs. 10.30 lakhs against which Rs. 10.30 lakhs has been deposited under protest. (i). Disputed Liability for demand drafts aggregating Rs. 58.06 lakhs debited by banks. (j). Disputed Liability for stamp duty Rs. 68.24 lakhs, against which a sum of Rs. 6.52 lakhs has been deposited under protest and a bank guarantee for Rs. 20.48 lakhs has been submitted. (k). Counter guarantee given by the company in favour of Punjab National Bank aggregating to Rs. 5 lakhs against the guarantee furnished by the bank on behalf of the company in favour of UP Pollution Control Board. (l). Additional and disputed trade tax liability on sale of Molasses, Chemicals, Particle Board and Paper and Card Board for the assessment year 1990–91 to December 1999 assessments in respect of which either not completed or pending in appeals amounting to Rs. 1083.07 lakhs, against which the department has realised a sum aggregating Rs. 91.38 lakhs. Liability for trade tax on sale of molasses is disputed by the company before the Hon’ble High Court of Judicature at Allahabad and as such no liability in respect thereof is being accounted for. (m). Disputed Trade Tax and penalty demand raised by the Department pending Adjudication of Appellate Authorities Rs. 1355.50 lakhs, out of this Rs. 117.34 lakhs have been deposited under protest. (n). Demand raised against the company by the Directorate of Sugar, against the excess amount paid on account of revision of levy sugar price consequent upon the judgement

Appendix 3

1011

of the Hon’ble Supreme Court in the case of Malprabha amounting to Rs. 193.36 lakhs for the sugar seasons 1974–1975 to 1979–1980, being disputed and not accepted by the company. o. Arrears of dividend on cumulative preference shares for the year 1999–2000, 2000–2001, 2001–2002 amounting to Rs. 378.31 lakhs subject to deduction of tax at source, if applicable, at the time of such declaration/payment. p. Levy of entry tax on sugar has been challenged by the company before the Hon’ble High Court of Judicature at Allahabad and as such no liability in respect thereof is being provided in the accounts for the period upto 31.8.2002, the amount of which is not ascertained. However the company is depositing such entry tax under protest w.e.f. 1.9.2002 out of its own resources.

Management Perception The items listed above are in the normal course of business and may not crystalised in view of legal recourse taken by the company. (B) CONTINENT LIABILITIES OF DSM AGRO PRODUCTS LTD (Rs. in lakhs) Particulars

As on 30.09.2002

1.

Claims not acknowledged as debts.

(i)

Disputed Sales Tax/duty demand.

(ii)

Disputed Demand for Interest against Sugar Cane Purchase Tax Arrears.

4.72

(iii)

Disputed Demand for Interest on Excise Duty realised against levy sugar

7.65

(iv)

Disputed Demand against Cane price for the Year1978–79 (covered by Bank Gurantee)

676.64

21.20

(v)

Disputed Excise duty demand.

(vi)

Disputed Demand for Electricity dues in the name of Fine Straw Board (A unit of LH Sugar Factory Ltd. erstwhile owner of Sugar Unit) raised on DSM Sugar Kashipur (Amount deposited under protest Rs. 5.09 lakhs)

5.09

Disputed Demand for Electric dues raised by Electricity Department (Amount deposited under protest Rs. 5.21 Lakhs)

5.21

Estimated amount of Contract remaining to be executed on capital account not provided for

Nil

(vii)

2. 3.

Future lease obligations in respect of assets on finance lease.

106.84

99.76

1012

Investment Banking

(C) CONTINGENT LIABILITIES OF MANSURPUR SUGAR MILLS LTD. 1. Claims against Company not acknowledged as debts:— i. Disputed MODVAT claim and other demand raised by excise Department and paid by the Company, pending adjudication of appellate authorities—Rs. 14.26 Lakhs (Previous year Rs. 14.26 lakhs). ii. Disputed trade tax and penalty demand raised by the Department pending adjudication of appellate authorities Rs. 678.86 lakhs (previous year Rs. 458.88 lakhs), out of this Rs. 117.34 lakhs (previous year Rs. 117.34 lakhs) has been deposited under protest. iii. Disputed stamp duty demand Rs. 25.00 Lakhs (Previous year NIL). iv. Claims of ex employees—Amount not ascertainable.

2. Contingent liability not provided for in respect of:— i. Corporate guarantee given by the Company in favor of a Bank on behalf of The Dhampur Sugar Mills Ltd., the holding Company, aggregating to Rs. 17,200 lakhs against loan taken by them, actual loans outstanding as on 30th June, 2002 aggregating Rs. 15,441.34. Lakhs. ii. Disputed trade tax liability on sale of molasses for the periods, which are pending for assessment—Amount not ascertained. iii. Disputed entry tax liability Rs. 72.70 lakhs.

Management Perception The items listed above are in the normal course of the business. There could only be impact on the issuer company’s financial statement to the extent it is holding company, if the contingent liabilities of the subsidiary companies are crystallized.

Risk Factor 17 Litigations of the Dhampur Sugar Mills Ltd. The following is a list of litigations concerning the Company (Exclusive of those mentioned in risk factors and contingent liabilities mentioned above):— (A) Pertaining to Securities Laws:— Nil

1013

Appendix 3 (B) Pertaining to Labour Laws:— 42 cases. None of the cases is for pecuniary value of Rs. 1 lakh or more. (C) Pertaining to Statutory Authorities:— 79 Cases. None of the cases is for pecuniary value of Rs. 1 lakh or more.

(D) Pertaining to other matters ( with pecuniary value of Rs. 1 lakh and above on principal amount):—

Sl. No. 1

Name of the Party

Description of the matter

Adjudicating Authority

DSM vs Revenue Board Allahabad, DM Bijnore

Civil Suit under Indian Stamp Act

High Court, Allahabad

2

Magnetic Consultant Services, Recovery of Interest outstanding LKO vs DSM PF Trust

3

DSM vs State Bank of India & Others

4

Case No. 6194/03

SDJ, Bijnore

Amount Rs. 32,00,000 Rs. 1,35,329 + 12.5% interest

Suit for wrong debit by Bank

Civil Judge, Barabanki

482/98

Rs. 58,06,080

N M Engineers vs DSM

Supplier Dispute

Civil Judge, Lucknow

82/2001

Rs. 1,38,107

5

Leader Valves Ltd. vs DSM

Supplier Dispute

Civil Judge, Jalandhar

100/2001

Rs. 1,48,755

6

Shankar Bux Singh, Vinod Kumar Singh vs DSM & Others

Misc. Cane Dispute

District Forum, Barabanki

90/99

Rs. 3,30,750

7

Sandeep Sharma vs State

Civil Suit under Indian Stamp Act

CCRA, Allahabad

153/98

Rs. 1,16,764/50

8

DSM vs State

Civil Suit under Indian Stamp Act

CCRA, Allahabad

471/98

Rs.2,54,250

9

DSM vs State & Others

Civil Suit under Indian Stamp Act

High Court, Lucknow Bench

2077/97

Rs. 37,83,197/50

10

DSM vs State & Others

Civil Suit under Indian Stamp Act

High Court, Lucknow Bench

388/99

Rs. 5,40,459

11

H MDoyal& Co. vs DSM

Supplier Dispute

ADJ, Tis Hazari, Delhi

12

Chemical Centre vs DSM Sugar, Asmoli

Supplier Dispute

UTI vs Dhampur Sugar Mills Ltd.

Writ Petition for injunction against sale of Property Charged

13

14

Administrator of specific undertakings of UTI, Mumbai vs The Dhampur Sugar Mills Ltd. and others

TOTAL

Recovery suit filed for recovery of dues with DRT, Lucknow

Rs. 2,60,000 Rs. 1,34,740/80

High Court Mumabi Debt Recovery Tribunal, Lucknow

9 of 2003

Approx. Rs. 125 lakhs

76 of 2003

Approx. Rs. 250 lakhs

Rs. 5,23,48,431/- Approx.

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Investment Banking

Litigations of Subsidiariary Companies The following is a list of litigations concerning the subsidiary Companies (Exclusive of those mentioned in risk factors and contingent liabilities mentioned above):— 1. MANSURPUR SUGAR MILLS LTD. (A) Pertaining to Securities Laws:— Nil Pertaining to Labour Laws:— 51 cases. None of the cases is for pecuniary value of Rs. 1 Lakh or more. (B) Pertaining to Statutory Authorities:— 15 Cases. None of the cases is for pecuniary value of Rs. 1 Lakh or more. Others:— 8 Cases. None of the cases is for pecuniary value of Rs. 1 Lakh or more. 2. DSM AGRO PRODUCTS LTD. (A) Pertaining to Securities Laws:— Nil Pertaining to Labour Laws:— 8 Cases. None of the case is for pecuniary value of Rs. 1 Lakhs or more. Pertaining to Statutory Authorities:Nil Others:— 6 Cases. None of the case is for pecuniary value of Rs. 1 Lakhs or more

External Risk Factors 1. Controlled industry 1. Being a controlled industry, the performance of the company in Sugar is dependent on Government policy.

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1015

2. Availability of Raw Material Availability of sugar cane—The major raw material is dependent on monsoon conditions. Bad monsoonic conditions may deteriote the cane crop resulting in poor production and recovery. Heavy rains may cause water logging in certain cane areas thus damaging the sugar cane crop. 3. Risk of political instability The performance of the Company may be affected by a number of factors beyond its control including political and economic developments both in India and worldwide. 4. Risk of Regulatory uncertainty The business of the Company is subject to the regulations of Government of India. Changes in the fiscal policies adopted by the Government could have an adverse impact on the profitability of the Company. A significant change in the Government’s economic liberalization and deregulation policies could affect business and economic conditions in India and the business of the Company, in particular, changes in other regulations the environmental norms may affect the operations of the Company. 5. Risk of economic slowdown The overall demand for the products manufactured by the company are closely linked to increase in population and overall growth of the economy and other related matters. The slowdown in India’s economic growth may have an adverse impact on the demand for products manufactured by the Company.

Management Perception These external risk factors are beyond the control of Management.

EXTERNAL RISK FACTOR 6 Free Sugar Pricing The sale price of free sugar is governed by market forces and demand/supply equation which may react to external factors.

Management Perception The company is selling its product at a price in parity with the overall market price. The free sugar price in the market are governed by demand/supply equation which is the ordinary course of the business.

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Investment Banking

EXTERNAL RISK FACTOR 7 Sugar Cane Pricing The price of major raw material i.e. sugar cane is decided by Government.

Management Perception During season 2002–2003 sugar industry has strongly opposed abnormal increase in cane price by State Government and obtained stay of the same from Hon’ble High Court. The matter is presently pending with the Hon’ble Supreme Court, Meanwhile, the government has proposed to grant Rs. 600 Crores towards cane dues to be paid to farmers being difference in Statutory Minimum Price and State Advice Price which has reduced the burden on the sugar industry. The company is hopeful that a formula for fixation of sugar cane price shall be worked out shortly by Central Government. EXTERNAL RISK FACTOR 8 Huge Stock Levels The industry is saddled with huge stocks and the sugar season 2001–2002 commenced with opening stock of 11 million tons putting burden on Working Capital , Storage and Causing deterioration in quality.

Management Perception The sugar release is controlled by the Government. It is evident from past year that sugar consumption in India is increasing. Source: “ISMA—Hand book of sugar statistics—June 2002 edition”. EXTERNAL RISK FACTOR 9 The financial position of the company was adversely affected due to substantial fall in prices of sugar and rise in price of raw material sugar cane by the state government.

Management Perception The payment of sugar cane is being paid by the company as per the Statutory Minimum Price declared by the Central Government. The cane price as per SMP for the sugar units of the company for sugar season 2002-2003 range from Rs. 80 to Rs. 85 per quintal as against proposed SAP of Rs.100/- per quintal. The average sugar price at the end of last financial year in September 2002 were Rs.1240/- per Bag, which has now gradually increased to Rs. 1275/- per bag in September 2003. However the sugar prices may fluctuate in accordance with market forces.

Appendix 3

1017

EXTERNAL RISK FACTOR 10 The low international sugar price does not make export a commercially viable proposition.

Management Perception The company sells its main product i.e sugar in domestic market only. Note: 1. The company does not depend for the supply/purchase of the product/raw material on a particular market segment i.e on particular Wholesaler, Retailer or Consumer. 2. The company has taken adequate insurance for its assets. 3. The company has not defaulted in repayment of Public Deposits. 4. The object of this Rights issue is to finance the working capital requirement of the company and that the issue is brought out to fulfill the conditions of the restructuring package prescribed by FIs and Banks. 5. The Networth of the company as on 30.09.2002 was Rs. 3866.37 Lakhs and the issue size is Rs. 809.87 Lakhs. 6. The Average cost of holding of promoters in the equity shares of the company is Rs. 20.88 per shares. The Book Value as on 30.09.2002 is Rs. 14.69 per share. 7. There is no interest of promoters/Directors/Key Managerial personnel other than reimbursement of Expenses incurred or normal remuneration or benefits. For details of Remuneration paid to Executive/Whole time directors, please refer “Notes to the accounts” of Financial Statements of the company as given in the Letter of Offer. 8. There is no venture of promoters having business interest/Other interest in the issuer company except group/ subsidiaries of the issuer company. 9. The company has transacted with Group/Subsidiary company during the last financial year and value of the same is disclosed under the head “Related party transactions” of the issuer company financial statements “NOTES”. 10. The disclosure of all loans and advances made to person(s)/Companies in which directors are interested as on 30.09.2002 is given under heading “Amount due to/From related party” on page no. 33. 11. The company has adequate manpower. 12. The Directors, their associates and relatives have made no transactions of sale/purchase of Shares of the Company during the last six months from 08.07.2003 to 16.09.2003 except 7000 shares @ 19.76 sold on 06.08.2003, 616 shares @ 20.22 on 7.08.2003 and 500 shares @ 20.10 on 08.08.2003 by Mrs. Asha Kumari Swarup a relative of a director.

(1) General Information Name of the Company and Address of the Registered Office and Corporate Office

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Investment Banking

Registered Office The Dhampur Sugar Mills Limited Dhampur, Dist : Bijnore (U.P.) 246 761 Phone : 01344-220006, 220662 E-mail : [email protected]

Corporate Office The Dhampur Sugar Mills Limited 221, OkhlaIndustrial Estate, Phase - III, New Delhi 110 020 Phone: 51612456, 55602448, Fax: 011-26910507, 28612459 Email: [email protected]

i. Eligibility For The Issue: The Company is an existing company under the Act, whose equity shares are listed on The National Stock Exchange of India Limited, The Stock Exchange, Mumbai, The Stock Exchange -Ahemdabad , The Delhi Stock Exchange Association Ltd.. It is eligible to offer this Rights Issue in terms of Clause 2.4(iv) of the SEBI (Disclosure and Investor Protection) Guidelines, 2000 and amendments thereto (“SEBI Guidelines”). The Company, its promoter(s), its directors or any of the Company’s associate or group companies and companies in which the directors of the Company are associated as director(s) or promoter(s) have not been prohibited from accessing the capital market under any order or direction passed by SEBI or any other regulatory authority.

ii. Government And Other Approvals The Company can undertake the activities and no further approvals from any Government Authorities/FIPB/RBI are required by the Company. No new activities are proposed by the company. The lenders of the Company do not have any clause in their agreement that restricts this Rights Issue. The Lenders while approving Corporate Debt Restructuring scheme have stipulated to increase the paid up equity share capital of the company. (2 ) DISCLAIMER CLAUSE AS REQUIRED, A COPY OF THIS LETTER OF OFFER HAS BEEN SUBMITTED TO SEBI. IT IS TO BE DISTINCTLY UNDERSTOOD THAT SUBMISSION OF DRAFT LETTER OF OFFER TO SECURITIES AND EXCHANGE BOARD OF INDIA (‘SEBI’) SHOULD NOT IN ANY WAY BE DEEMED OR CONSTRUED THAT THE SAME HAS BEEN CLEARED OR APPROVED BY SEBI. SEBI DOES NOT TAKE ANY RESPONSIBILITY EITHER FOR THE FINANCIAL SOUNDNESS OF ANY SCHEME OR THE PROJECT FOR WHICH THE ISSUE IS PROPOSED TO BE MADE OR FOR THE CORRECTNESS OF THE STATEMENTS MADE OR OPINIONS EXPRESSED IN THE LETTER OF OFFER. THE LEAD MANAGER TO THE ISSUE, INDBANK MERCHANT BANKING SERVICES LIMITED HAS CERTIFIED

Appendix 3

1019

THAT THE DISCLOSURES MADE IN THE LETTER OF OFFER ARE GENERALLY ADEQUATE AND ARE IN CONFORMITY WITH THE SEBI (DISCLOSURE AND INVESTOR PROTECTION) GUIDELINES IN FORCE FOR THE TIME BEING. THIS REQUIREMENT IS TO FACILITATE INVESTORS TO TAKE AN INFORMED DECISION FOR MAKING INVESTMENT IN THE PROPOSED ISSUE. IT SHOULD ALSO BE CLEARLY UNDERSTOOD THAT WHILE THE ISSUER COMPANY IS PRIMARILY RESPONSIBLE FOR THE CORRECTNESS, ADEQUACY AND DISCLOSURE OF ALL RELEVANT INFORMATION IN THE LETTER OF OFFER, THE LEAD MANAGER IS EXPECTED TO EXERCISE DUE DILIGENCE TO ENSURE THAT THE COMPANY DISCHARGES ITS RESPONSIBILITY ADEQUATELY IN THIS BEHALF AND TOWARDS THIS PURPOSE, THE LEAD MANAGER, INDBANK MERCHANT BANKING SERVICES LIMITED HAS FURNISHED TO SEBI A DUE DILIGENCE CERTIFICATE DATED 08.07.2003 IN ACCORDANCE WITH SEBI (MERCHANT BANKERS) REGULATIONS 1992 WHICH READS AS FOLLOWS: 1. WE HAVE EXAMINED VARIOUS DOCUMENTS INCLUDING THOSE RELATING TO LITIGATION LIKE COMMERCIAL DISPUTES, PATENT DISPUTES, DISPUTES WITH COLLABORATORS ETC. AND OTHER MATERIALS IN CONNECTION WITH THE FINALISATION OF THE LETTER OF OFFER PERTAINING TO THE SAID ISSUE. 2. ON THE BASIS OF SUCH EXAMINATION AND DISCUSSIONS WITH THE COMPANY, ITS DIRECTORS AND OTHER OFFICERS, OTHER AGENCIES, INDEPENDENT VERIFICATION OF STATEMENT CONCERNING THE OBJECTS OF THE ISSUE, PROJECTED PROFITABILITY, PRICE JUSTIFICATION AND THE CONTENTS OF THE DOCUMENTS MENTIONED IN THE ANNEXURE AND OTHER PAPERS FURNISHED BY THE COMPANY. WE CONFIRM THAT: (a) THE LETTER OF OFFER FORWARDED TO SEBI IS IN CONFORMITY WITH THE DOCUMENTS, MATERIALS AND PAPERS RELEVANT TO THE ISSUE; (b) ALL THE LEGAL REQUIREMENTS CONNECTED WITH THE SAID ISSUE, AS ALSO THE GUIDELINES, INSTRUCTIONS ETC. ISSUED BY SEBI, THE GOVERNMENT AND ANY OTHER COMPETENT AUTHORITY IN THIS BEHALF HAVE BEEN DULY COMPLIED WITH; AND (c) THE DISCLOSURES MADE IN THE LETTER OF OFFER ARE TRUE, FAIR AND ADEQUATE TO ENABLE THE INVESTORS TO MAKE A WELL INFORMED DECISION AS TO THE INVESTMENT IN THE PROPOSED ISSUE AND (d) WE CONFIRM THAT BESIDE OURSELVES, ALL THE INTERMEDIARIES NAMED IN THE LETTER OF OFFER ARE REGISTERED WITH SEBI AND THAT TILL DATE SUCH REGISTRATION IS VALID.”

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Investment Banking

The filing of Letter of Offer does not, however, absolve the Company from any liabilities under Section 63 of the Act or from the requirement of obtaining such statutory and other clearances as may be required for the purpose of the proposed Issue. SEBI further reserves the right to take up, at any point of time, with the Lead Manager any irregularities or lapses in the Letter of Offer. (i) DISCLAIMER FROM THE ISSUER COMPANY The Company accepts no responsibility for statements made otherwise than in the Letter of Offer or in the advertisements or any other material issued by or at the instance of the Company and that anyone placing reliance on any other source of information would be doing so at his/her/their own risk. All information shall be made available by the Issuer to the shareholders and no selective or additional information would be made available for a section of the shareholders or investors in any manner whatsoever including at presentations, research or sales reports etc after filing the Letter of Offer with SEBI. (ii) DISCLAIMER IN RESPECT OF JURISDICTION This Letter of Offer has been prepared under the provisions of Indian Laws and the applicable rules and regulations thereunder. Any disputes arising out of this issue would be subject to the jurisdiction of appropriate court(s) in Uttar Pradesh, India only. The draft offer document has been filed with SEBI for its obsevations and SEBI has given its observations vide their letter no. 5/1400/03-NRO/17450 dated September 05, 2003 and that the final offer document has been filed with Stock exchange(s), (iii) DISCLAIMER OF THE NATIONAL STOCK EXCHANGE OF INDIA LTD. “As required, a copy of this Letter of Offer has been submitted to The National Stock Exchange of India Ltd (here after referred to as NSE). NSE has given vide its letter dated July 29, 2003 permission to the issuer to use the Exchange’s name in this Letter of Offer as one of the stock exchange on which this issuers securities are proposed to be listed. The Exchange has scrutinized this Letter of Offer for its limited internal purpose of deciding on the matter of granting the aforesaid permission to the issuer. It is to be distinctly understood that the aforesaid permission given by NSE should not in any way be deemed or construed that the Letter of Offer has been cleared or approved by NSE; nor does it in any manner warrant, certify or endorse the correctness or completeness of any of the content of this Letter of Offer; nor does it warrant that this issuers securities will be listed or will continue to be listed on the Exchanges nor does it take any responsibility for the financial or other soundness of this issuer, its promoters, its management or any scheme or project of this issuer. Every person who desires to apply for or otherwise acquire any security of this issuer may do so pursuant to independent inquiry, investigation and analysis and shall not have any claim against

Appendix 3

1021

the Exchange whatsoever be reason of any loss which may be suffered by such person consequent to or in connection with such subscription/acquisition whether by reason of anything stated or ommited to be stated herein or any other reason whatsoever.” (iv) DISCLAIMER OF THE STOCK EXCHANGE—AHMEDABAD “As required, a copy of this Letter of Offer has been submitted to The Stock Exchange— AHMEDABAD (herein after referred to as ASE). ASE has given vide its letter dated July 21,2003 permission to the issuer to use the Exchange’s name in this Letter of Offer as one of the stock exchange on which this issuers securities are proposed to be listed. The Exchange has scrutinized this Letter of Offer for its limited internal purpose of deciding on the matter of granting the aforesaid permission to the issuer. It is to be distinctly understood that the aforesaid permission given by ASE should not in any way be deemed or construed that the Letter of Offer has been cleared or approved by ASE; nor does it in any manner warrant, certify or endorse the correctness or completeness of any of the content of this Letter of Offer; nor does it warrant that this issuers securities will be listed or will continue to be listed on the Exchanges nor does it take any responsibility for the financial or other soundness of this issuer, its promoters, its management or any scheme or project of this issuer. Every person who desires to apply for or otherwise acquire any security of this issuer may do so pursuant to independent inquiry, investigation and analysis and shall not have any claim against the Exchange whatsoever be reason of any loss which may be suffered by such person consequent to or in connection with such subscription/acquisition whether by reason of anything stated or ommited to be stated herein or any other reason whatsoever.”

(v) DISCLAIMER OF OTHER STOCK EXCHANGE(S) The other Stock Exchange(s) do not in any manner:— (i). Warrant, certify or endrose the correctness or completeness of any of the contents of this offer document, or (ii). Warrant that the company’s securities will be listed or will continue to be listed on the Exchange, or (iii). Take any responsibility for the financial or other soundness of this Company, its promoters , its manangement or any scheme or project of the Company. It should not for any reason be deemed or construed that this LOF has been cleared or approved by the Stock Exchanges. Every person who would like to apply for or otherwise acquire any equity shares of the Company may do so pursuant to independent inquiry, investigation and analysis and shall not have any claim against Stock Exchanges whatsoever by reason of any loss which may be suffered by such person consequent to or in connection with such subscription or acquisition whether by reason of anything stated or omitted to be stated herein or any other reason whatsoever.

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(3) Impersonation As a matter of abundant caution, attention of the applicants is specifically drawn to the provisions of sub-section (1) of Section 68A of the Act, which is reproduced below: “Any person who (a) makes in a fictitious name, an application to a company for acquiring or Subscribing for, any shares therein, or (b) otherwise induces a company to allot, or register any transfer of shares therein to him, or any other person in a fictitious name, shall be punishable with imprisonment for a term which may extend to five years.”

(4) Filing The Letter of Offer was submitted to Securities & Exchange Board of India Northern Region, Block No.32, Rajendra Bhavan, Rajendra Place, District Centre, New Delhi 110 008. SEBI has given its observations. The Letter of Offer was also filed with The National Stock Exchange of India Ltd., The Stock Exchange, Mumbai, The Stock Exchange—Ahmedabad, The Delhi Stock Exchange Association Ltd. and The UP Stock Exchange Association Ltd.(Regional).

(5) Listing The existing equity shares of the Company are listed on The National Stock Exchange of India Ltd., The Stock Exchange, Mumbai, The Stock Exchange-Ahmedabad and The Delhi Stock Exchange Association Ltd. The Company has paid the current annual listing fees to each of the stock exchanges where its equity shares are listed. The equity shares to be issued through this rights issue would be listed on The National Stock Exchange of India Ltd. and The Stock Exchange, Mumbai. In principal approval for listing has been obtained from The National Stock Exchange of India Ltd. vide their letter No. NSE/LIST/48945 dated July 29, 2003 and the The Stock Exchange, Mumbai vide their letter No. List/rkk/aak/03 dated 25th July 2003. The Company proposes to delist its shares from The Stock Exchange -Ahemedabad and The Delhi Stock Exchange Association Ltd. On request of the Company its shares have been delisted from The U P Stock Exchange Association Ltd. vide their letter no. UPSE/LC/2003-3004 dated 260-2003. The Company will make application for listing the above securities on the stock exchanges mentioned above upon the closure of the Rights issue.

(6) Utilisation of Issue Proceeds The Board of Directors declares that: The funds received against this issue will be transferred to a separate Bank Account other than the Bank Account referred to sub-section (3) of Section 73 of the Act.

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1023

The funds received against this Rights Issue will be kept in a separate Bank Account and the Company will not have any access to such funds unless it satisfies the UP Stock Exchange (Regional) or NSE or BSE as the case may be with suitable documentary evidence that the minimum subscription of 90% of the Issue has been received by the Company.

(7) Minimum Subscription If the Company does not receive the minimum subscription of 90% of the Issue, the entire subscription shall be refunded to the applicants within 42 days from the date of closure of the Issue. If there is a delay in the refund of subscription by more than 8 days after the Company becomes liable to pay the subscription amount (i.e. 42 days after closure of the Issue) the Company will pay interest for the delayed period at prescribed rates in sub-sections (2) and (2A) of Section 73 of the Act. The Issue will become undersubscribed after considering the number of shares applied for only after the close of the Issue. The promoters or any other person can subscribe to such undersubscribed portion as per the relevant provisions of the Law. If any person presently in control of the Company desires to subscribe to such undersubscribed portion and if disclosure is made pursuant to SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 such allotment of the undersubscribed protion will be governed by the provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997

(8) Allotment Letters and Refund Orders The Company will complete allotment of Equity Shares and issue and credit the allotted Equity Shares to the respective beneficiary account and/or despatch the letter of allotment/ Equity Share certificates and/or letter of regret, alongwith the refund order, if any, within a period of six weeks from the date of closure of the Issue. If such monies are not repaid within eight days from the day the Company becomes liable to pay it (i.e. six weeks after closure of the Issue), the Company shall, pay such monies with interest rate as prescribed under sub-sections (2) and (2A) of Section 73 of the Act. The letter of allotment/equity share certificates/refund order exceeding Rs. 1500/- would be sent by registered post/speed post to the sole/first applicant’s registered address. Refund orders up to the value of Rs.1500/- would be sent under Certificate of Posting. Such refund orders would be payable at par at all places where the applications were originally accepted. The same would be marked account payee only and would be drawn in favour of the sole/first applicant. Adequate funds would be made available to the Registrars to the Issue for this purpose. In case the Company issues letters of allotment, the corresponding share certificates will be issued within three months from the date of allotment thereof or such extended time as may be approved by the Company Law Board under Section 113 of the Act or other applicable provisions, if any. Allottees are requested to preserve such letters of allotment that would be exchanged later for the share certificates.

1024

Investment Banking

(9) Issue Schedule Issue Opening Date

10th November 2003

Last Date for receiving requests for split forms

25th November 2003

Issue Closing Date

9th December 2003

(10) Issue Management Team Lead Manager to the Issue Indbank Merchant Banking Services Ltd. 6A, Atma Ram House, 1 Tolstoy Marg, New Delhi 110 001 Ph. : 011 23353264,23731148-49, Fax : 011 23353264 E-mail: [email protected] SEBI Registration Number : INM 00000 1394 Auditors of the Company 1. M/s Mittal Gupta & Company, Chartered Accountants 14-Ratan Mahal, 15/197-Civil Lines Kanpur 208 001. Ph.: 2305829, 2305748 Fax: 0512-2303235 E-mail: [email protected] 2. M/s S. Vaish & Company Chartered Accountants G-1, Akash Ganga, 15/96-Civil Lines Kanpur-208 001 Company Secretary Mr. Arhant Jain The Dhampur Sugar Mills Limited Dhampur, Distt : Bijnore (U.P.) – 246 761 Ph.: 01344-220884 Fax : 01344-220006 E-mail: [email protected]

Bankers to the Issue Punjab National Bank NSIC Building Okhla Industrial Estate New Delhi 110 020

Registrar to the Issue Alankit Assignments Limited 205-Anarkali Market, Jhandewalan Extension New Delhi-110 055 Ph. : 011–51540060-63 Fax : 011-51540064 E-mail: [email protected] SEBI Registration Number: INR 000002532 Legal Advisor to the Issue Mr. Saket Sharma, B.Com, LL.B, FCS 14-Ratan Mahal, 15/197-Civil Lines Kanpur-208 001. Ph.: 2305829, 2305748 Fax: 0512-2303235 Email: [email protected]

Compliance Officer Mr. Atul K Kulshreshtha The Dhampur Sugar Mills Ltd 221-Okhla Industrial Estate Phase- III, New Delhi 110 020. Phone: 011 – 55602448 Fax: 011-26910507 E-mail: [email protected]

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Appendix 3

The Investor’s attention is invited to contact the compliance officer in case of any pre issue/post issue related problems such as non-receipt of letter of allotment/share certificates/refund orders/cancelled stock invests etc.

(11) Credit Rating This being an issue of Equity Shares, no credit rating is required.

(12) Compulsory Dematerialised Dealing The equity shares of the Company have been under compulsory dematerialized trading for the investors with effect from October 2000. The Company has an agreement with National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL) and its equity shares bear the ISIN No. INE 041A01016.

(13) Underwriting/Standby Arrangements The present issue is not underwritten. The Company has not entered into any standby arrangements. Important (a). The Issuer and the Lead Managers are obliged to update the Letter of Offer and keep the public informed of any material changes till the commencement of trading. (b). All information shall be made available by the Lead Managers and the Issuer to the public and investors at large and no selective or additional information would be available for a section of the investors in any manner whatsoever including at road shows, presentations, in research or sales reports, etc.

(14). Capital Structure Amount (Rs.)

Authorised Share Capital

3,50,00,000

Equity Shares of Rs. 10/- each

35,00,00,000/-

40,00,000

Redeemable Preference Shares of Rs. 100/- each

40,00,00,000/-

Contd.

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Investment Banking

Issued, Subscribed and Paid-Up Capital1

Amount (Rs.)

2,63,20,653 3,25,496

Equity Shares of Rs.10/- each : 26,32,06,530/Add: shares forfeited 6,52,470/-

26,38,59,000/-

*14,13,940

10% Redeemable Preference Shares of Rs. 100/each

14,13,94,000/-

Present issue being offered to the Equity Shareholders throught this letter of Offer

80,98,663

Equity Shares of Rs. 10/- each at par

8,09,86,630

Paid up - Equity Capital after the Issue (Assuming Equity Shareholders opt for all the Equity Shares offered) 3,47,44,812

Equity Shares of Rs. 10/- each at par

34,48,45,630/-

* Details of holders of 14,13,940 10 % Redeemable Preference shares of Rs. 100/- each are as under:

Name of Share holder

No. of Preference Shares held

IFCI Ltd.

4,13,940

ICICI Ltd.

10,00,000

Total

14,13,940

Notes to the Capital Structure (i) Build up of Equity Capital Date of Issue

No. of Face Equity Shares Value (Rs.)

Issue Price (Rs.)

Consideration

Incorporation to 1986 –1987

155,900

10/-

10/-

Cash

Contribution by promoters and famil members

1987–1988

122,960

10/-

10/-

Cash

Conversion of Preference Shares into equit shares

1988 –1989

321,140

10/-

10/-

Cash

First Public issue of equity shares

1989 –1990

600,000

10/-

N.A.

N.A.

Bonus in the ratio of 1:1

1991–1992

1,200,000

10/-

N.A.

N.A.

Bonus in the ratio of 1:1

Remarks

1027

Appendix 3

Public/Right issue of FCDs @ Rs. 180/- each converted into 2 equity shares

1991–1992

2,044,400

10/-

90/-

Cash

1993 –1994

2,222,200

10/-

N.A.

N.A.

Bonus in the ratio of 1:2

1993–1994

1,200,000

10/-

345/-

Cash

Private placement

1994–1995

3,493,594

10/-

48/-

Cash

Conversion of Warrants attached with Deep Discount Bonds

1994–1995

209,775

10/-

110/-

Cash

Conversion of one CPN into one equity share

2000–2001

3,472,550

10/-

17/-

Cash

Conversion of loan of ICICI/IFCI into equity shares

2000–2001

1,603,630

10/-

17/-

Cash

Conversion of loan of ICICI into equity shares

2001–2002

10,000,000

10/-

10/-

Cash

issue of shares on Preferential basis

Total

26,646,149

(ii) Current Shareholding pattern of the Company (as on 19.09.2003) *Post-issue shares from the Rights Issue

Sl. No.

Shareholders

No. of Equity Shares held

% age of Pre - Issue Capital

1.

Promoters & persons acting in Concert. Mr. V K GoelMr. A K Goel Mr Gautam Goel Mr Gaurav Goel Mrs Vinita Goel Mrs. Sarla Goel Mrs Deepa Goel Goel Investments Ltd. Saraswati Properties Ltd.

5,366,376

20.39

7,017,569

20.39

2.

Banks/Financial Institutions/ Mutual Funds A Banks B Mutual Funds C Financial Institutions

1,374,735 24,650 1,541,051

5.22 0.09 5.85

1,797,730 32,235 2,015,221

5.22 0.09 5.85

3.

Non Resident Indians/OCBs/FIIs

2,974,646

11.30

3889922

11.30

4.

Others – Corporate – Public

8,931,394 6,107,801

33.93 23.22

11,679,515 7,987,124

33.93 23.22

Total

26,320,653

100.00

34,419,316

100

% age post-issue capital

1028

Investment Banking

(iii) Promoters Contribution and lock-in Sl. No.

Date of Allotment

Mode of acquisition / Consideration

No. of Shares

Face Value

Issue Price

% age PostIssue Paid up Capital

*Lock in period

75.84%

Finished

1

As on 1.04.1992

Promoters Group held

1820364

10/-

2

28.09.1992

Conversion of FCDs

500286

10/-

90/-

52.22%

Finished

3

27.10.1993

Bonus (1: 2)

998225

10/-

N.A.

49.78%

N.A.

4

25.04.1995

Conversion of warrants

1500000

10/-

48/-

42.41%

Finished

5.

Since 1.04.1992

Net Purchase/Sale

Total

547501

20.39%

**5366376

*Note: Since the lock-in-period has finished the same is stated as FINISHED. ** The following shares of promoters are pledged with Banks/Instutions/other lenders: 39,29,486 equity shares are pledged with ICICI Bank Ltd., 6,41,525 equity shares are pledged with Bajaj Auto Ltd., and 4,29,785 shares are pledged with Tata Finance Ltd. as security for their respective facilities sanctioned to the Company.

(iv) Top 10 Shareholders as on Date of the Letter of Offer Sl. No.

Shareholders

No. of Shares

Percentage

1

M/s Goel Investment Ltd

4293635

16.313

2

M/s Sonitron Ltd.

3705716

14.071

3

M/s Shudh Edible Products Pvt. Ltd.

3629860

13.801

4

ICICI Bank Ltd.

1373160

5.221

5

IFCI Ltd.

1511525

5.743

1029

Appendix 3 6

Bual Management Incorporated

1497932

5.691

7

Mrs. Asha Kumari Swarup

1470789

5.619

8

M/s Saraswati Properties Ltd.

489840

1.862

9

Mr. Vijay Kumar

318466

1.211

Mr. Ashok Kumar Goel

202000

0.768

10

(v) Top 10 Shareholders as on 10 Days before the Date of Letter of Offer Sl. No.

Shareholders

No. of Shares

Percentage

1

M/s Goel Investment Ltd

4293635

16.313

2

M/s Sonitron Ltd.

3705716

14.071

3

M/s Shudh Edible Products Pvt. Ltd.

3629860

13.801

4

ICICI Bank Ltd.

1470789

5.591

5

IFCI Ltd.

1511525

5.743

6

Bual Management Incorporated

1497932

5.691

7

Mrs. Asha Kumari Swarup

1470789

5.59

8

M/s Saraswati Properties Ltd.

489840

1.862

9

Mr. Vijay Kumar

318466

1.211

10

Mr. Ashok Kumar Goel

(vi) Top 10 Shareholders as on Two Years before the Date of Letter of Offer Sl. No.

Shareholders

No. of Shares

Percentage

1

Goel Investments Ltd.

2681770

18.222

2

ICICI Ltd.

1961025

13.324

3

Saraswati Properties Ltd.

1626973

11.054

4

IFCI Ltd.

1511525

10.270

5

Vijay Kumar Goel

589235

4.009

6

Bajaj Auto Ltd.

426030

2.895

7

Ashok Kumar Goel

243410

1.654

8

Sonitron Ltd.

195400

1.327

9

Shery Gupta

131140

1.166

45500

0.309

10

GIC Ltd.

1030

Investment Banking

(vii). Details of Shareholding of the Promoters, Promoter Group and Directors of the Company Shareholders

No of Equity % of pre-Issue Post-issue Share % of postShares Held Capital Holding from Issue Capital the *Righs Issue

Mr. V K Goel

318466

1.21%

416456

1.21%

Mr. A K Goel

202000

0.77%

264154

0.77%

Mr. Gautam Goel

18805

0.07%

24591

0.07%

Mr. Gaurav Goel

16850

0.06%

22035

0.06%

Mrs. Vinita Goel

16850

0.06%

22035

0.06%

Mrs. Salra Geol

3280

0.01%

4289

0.01%

Mrs. Deepa Geol

6650

0.03%

8696

0.03%

4293635

16.31%

5614753

16.31%

489840

1.86%

640560

1.86%

5366376

20.39%

7017569

20.39%

Goel Investments Ltd. Saraswati Properties Ltd. TOTAL

* Assuming all the applicants exercise their rights in full.

(a) The Promoters have confirmed that they will subscribe to their Rights entitlement in full. The Promoters also intend to apply for additional Equity Shares in addition to their entitlement. (b) The acquisition of additional securities or subscription to the shortfall shall be exempt in terms of proviso to Regulation 3(1)(b)(ii) of the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997. Further this acquisition will not result in change of control of the management of the Company. (c) The Directors, their associates and relatives have made no transactions of sale/purchase of Shares of the Company during the last six months from 08.07.2003 to 16.09.2003 except 7000 shares sold on 06.08.2003, 616 shares sold on 7.08.2003 and 500 shares on 08.08.2003 by Mrs. Asha Kumari Swarup, relative of a Director. (d) The present issue being a right issue, as per extant SEBI Guidelines, the requirement of promoters’ contribution is not applicable. (e) The Company has not availed of “bridge loans” to be repaid from the proceeds of the Issue. (f) The Promoters, Directors and Lead Merchant bankers of the Issue have not entered into any buy-back, standby or similar arrangements for any of the securities being issued through this Letter of Offer.

Appendix 3

1031

(g). The terms of issue to Non-Resident Equity Shareholders/Applicants have been presented under the “Terms of the Issue” section of this document. (h). The Company has complied with all applicable SEBI Guidelines for preferential allotment during past allotments of shares on a preferential basis, certified by Mittal Gupta & Company, Chartered Accountants. (i). At any given time, there shall be only one denomination of the equity shares of the Company. (j). There are no outstanding warrants, option or any debenture, bonds which would entitle holder thereof to acquire further shares in the Company. (k). As per FEMA Regulations 2000, a general permission has been given to (a) Indian Companies to issue Rights shares to Non Residents and to send such shares out of India and (b) Non Residents to acquire such shares, subject to stipulated conditions. Hence the company does not need any in-principle permission from RBI for issue of shares to Non Residents upto their entitlement and the Non Resident shareholders need not apply to RBI for any such approval. (l). No further issue of capital by way of issue of bonus shares, preferential allotment, rights issue or public issue or in any other manner which will affect the Equity Capital of the Company, shall be made during the period commencing from the filing of the Letter of Offer with SEBI and the date on which the Equity Shares issued under this Letter of Offer are listed or application amounts are refunded on account of the failure of the Issue. (m). The Company presently does not have any intention or proposal to alter its capital structure within a period of six months from the date of opening of the Issue, by way of split/consolidation of the denominations of shares or further issue of shares whether preferential or otherwise. (n). No penalties is imposed by SEBI/other regulatory body in India and abroad to the issuer company. (o). No. of members/Shareholders as on 19.09.2003 is 24,489. (p). The Company has not issued shares for consideration other than cash or out of revaluation reserve at any point of time. (q). The Promoters/Directors of the company do not have any other interest in the other Company other than reimbursement of expenses incurred or normal remuneration or benefit.

(15) Terms of the Issue (i) AUTHORITY FOR THE PRESENT ISSUE The present Rights Issue has been authorised by the resolution passed by the Board on 30th June 2003. (ii) BASIS OF THE ISSUE The shareholders whose names appear as beneficial owners in respect of the shares held in the

1032

Investment Banking

electronic form and on the Register of Members of the Company in respect of the shares held in physical form on the Record Date shall be entitled to the Equity Shares offered on rights basis in the ratio of Four Equity Share for cash at par for every Thirteen Equity Share (4:13) held by them on the Record Date. (iii) RIGHTS ENTITLEMENT As your name appears as beneficial owner in respect of the shares held in the electronic form or appears in the Register of Members of the Company in respect of the Shares held in physical form as an Equity Shareholder of the Company on the record date you are entitled to the number of Equity Shares shown in Block I of Part “A” of the enclosed CAF. (iv) PRINCIPAL TERMS OF THE ISSUE The Equity Shares now being offered are subject to the provisions of the Act and the terms and conditions of this LOF, the CAF, the Memorandum and Articles of Association of the Company (“Memorandum” and “Articles”), the Foreign Exchange Management Act 1999 (“FEMA”) and the Letters of Allotment/Share Certificates to be issued. Over and above such terms and conditions, the shares shall also be subject to applicable laws, guidelines, notifications and regulations relating to issue of capital and listing of securities issued from time to time by SEBI, the Government of India, RBI and or other authorities. (v) ISSUE PRICE Each Equity Share is of the face value of Rs. 10/- and is being offered at par. (vi) TERMS OF PAYMENT The amount per Equity Share shall be payable as under: On application: Rs. 5/- per share on call: Rs. 5/- per share The shares will be initially listed as partly paid up shares. The shares offered through this right issue shall be made fully paid up on payment of call money. The call will be made to make the shares fully paid up within 12 months from the date of allotment of shares. In case, the call money is not paid within 12 months the subscription money already paid will be forfeited. (vii) RANKING OF EQUITY SHARES The Equity Shares allotted pursuant to this LOF shall rank pari-passu in all respects with the existing Equity Shares of the Company including in respect of dividend, if any, declared by the Company, for the financial year, in which these Equity Shares are allotted. (viii) FRACTIONAL ENTITLEMENT If the shareholding of any of the equity shareholders is less than 13 or not in the multiples of 13, then the fractional entitlement of such holders shall be rounded upto the next higher integer. The additional equity shares so issued will be adjusted from the promoters entitlement.

Appendix 3

1033

(ix) MARKET LOT The Market Lot for equity shares held in dematerialsed form is one. In case of physical certificates the company would issue one certificate for the equity shares allotted to one person (Consolidated Certificate). In respect of the consolidated certificate, the company will only upon receipt of a request from the equity shareholders, split such consolidated certificate into smaller denomination within 3 days from the date of the request from the equity shareholders. No fee would be charged by the company for splitting the consolidated certificate, but stamp duty payable if any will be borne by the equity shareholders. (x) ACCEPTANCE OF OFFER You may accept and apply for the Equity Shares offered hereby to you wholly or in part by filling in Part “A” of the enclosed CAF and submit the same along with the payment of application money to any of the specified branches of Punjab National Bank authorised in this behalf or to the collection center specified on the reverse of the CAF on or before the close of banking hours on 9th December 2003. (xi) ADDITIONAL EQUITY SHARES You are eligible to apply for additional Equity Shares over and above the number of Equity Shares you are entitled to, provided you apply for all the Equity Shares to which you are entitled without renouncing them, in whole or in part, in favour of any other person(s). The Board of Directors reserves the sole and absolute right to reject any such application for additional equity shares without assigning any reasons thereof. If you desire to apply for additional Equity Shares, please indicate your requirement in Block IV of Part “A” of the CAF. (xii) RENUNCIATION This Issue shall be deemed to include a right exercisable by you to renounce the Equity Shares offered to you either in full or in part in favour of one or more persons subject to the approval of the Board of Directors. Such renounce(s) can only be Indian Nationals (including minor through their natural/legal guardian)/limited companies incorporated under and governed by the Act, Statutory corporations/institutions, Trusts (registered under the Indian Trust Act), Societies (registered under the Societies Registration Act, 1860 or any other applicable laws) provided that such Trust/Society is authorised under its constitution/bye laws to hold equity shares in a company and cannot be a partnership firm, foreign nationals or nominees of any of them or to any person situated or having jurisdiction where the offering in terms of this LOF could be illegal or require compliance with securities laws of such jurisdiction or any other persons not approved by the Board. Any renunciation from Resident Indian Shareholder(s) to Non-Resident Indian(s) or from NonResident Indian Shareholder(s) to other Non-Resident Indian(s) or from Non-Resident Indian Shareholder(s) to Resident Indian(s) is subject to the renouncer(s)/renouncee(s) obtaining the approval, if required, of the FIPB and/or necessary permissiof of the RBI under the Foreign Exchange Management Act, 1999 (FEMA) and other applicable laws and such permissions should be attached to the CAF. Applications not accompanied by the aforesaid approval are liable to be rejected.

1034

Investment Banking

The Board of Directors reserves the right to reject the request for allotment to renouncees in its sole and absolute discretion without assigning any reasons thereof. Part A of the CAF must not be used by any person(s) other than those in whose favour this offer has been made. Submission of the enclosed CAF to the Banker to the Issue/collection centre specified on the reverse of the CAF with the Form of Renunciation (Part B of the CAF) duly filled in shall be conclusive evidence for the Company of the person(s) applying for Equity Shares in Part “C” to receive allotment of such Equity Shares. Renouncee(s) will have the right to apply for additional Equity Shares. Renouncee(s) will have no right to renounce any Equity Shares in favour of any other person. (xiii) PROCEDURE FOR RENUNCIATION (a) To renounce the whole Offer: If you wish to renounce this offer in whole, please complete Part B of the CAF. In case of joint holders, all joint holders must sign this part of the CAF. The person in whose favour renunciation has been made should complete and sign Part C of the CAF. In case of joint renouncees, all joint renouncees must sign this part of the CAF. (b) To renounce in part: If you wish to either accept this Offer in part and renounce the balance or renounce the entire offer in favour of two or more renouncees, apply to the Registrar to the Issue, who must first split the CAF. Please indicate your requirement for Split Forms in the space provided for this purpose in Part D of the CAF and return the entire CAF to the Registrar to the Issue so as to reach them latest by the close of business hours on 25th November 2003. On receipt of the required number of split forms from the Registrar, the procedure as mentioned in para (a) above should have to be followed. (c) Change and/or introduction of additional holders: If you wish to apply for Equity Shares jointly with any other person or persons, not more than 3, who is/are not already joint holders with you, it shall amount to renunciation and the procedure as stated above for renunciation shall have to be followed. Even a change in the sequence of the joint holders shall amount to renunciation and the procedure, as stated above shall have to be followed. However, any right of renunciation is subject to the express condition that the Board of Directors of the Company or a committee thereof shall be entitled in its absolute discretion to reject the request for allotment from the renouncees without assigning any reasons thereof. (xiv) SPLITTING OF COMPOSITE APPLICATION FORMS Request for Split Forms should be sent to the Registrar to the Issue namely Alankit Assignments Ltd. 205-Anarkali Market, Jhandewalan Extension, New Delhi110 055 before the closure of business hours on or before 25th November 2003 by filling in Part “D” of the CAF along with

Appendix 3

1035

entire CAF. Split Forms cannot be re-split. The renouncee(s) shall not be entitled to Split Form(s). Request for Split Form should be made in multiples of 100 Equity Shares only. Requests for split forms will be entertained only once. (xv) ARRANGEMENT FOR ODD LOT EQUITY SHARES: The Company has not made any arrangements for disposal of odd lot equity shares arising out of this issue. The Company will issue certificates of denomination equal to the number of shares being allotted to the equity shareholder, in the form of 1-5-10-50 shares.

(16) How to Apply for Equity Shares You may exercise any of the following options with regard to the Equity Shares offered to you, using the enclosed CAF. OPTIONS AVAILABLE AND ACTION REQUIRED OPTION AVAILABLE

ACTION REQUIRED

A. Accept your entitlement to all the Equity Shares offered to you

Fill in and sign "Part A" of the CAF

B. Accept your entitlement to all the Equity shares offered to you and apply For additional Shares

Fill in and sign "Part A" of the CAF after indicating in Block IV the number of additional Equity Shares applied for

C. Accept only a part of your entitlement of the Equity Shares offered to you (without renouncing the balance) D. Renounce your full entitlement of the Equity Shares offered to you to any other person (Renouncee) (Joint Renouncees not exceeding three are considered as one Renouncee)

Fill and sign "Part A" of the CAF

E. Accept a part of your entitlement of the Equity Shares offered to you and Then renounce the balance to one Renouncee

Fill in and sign "Part D" of the CAF for Split Forms after indicating the required number of Split Application Forms and take action as indicated below: (i) For the Equity Shares, if any, which you want to accept, fill in and sign "Part A" of one Split Composite Application Form (ii) For the Equity Shares you want to renounce, fill in and sign "Part B" in the required number of Split Composite Application Forms indicating the number of Equity Shares renounced to each renouncee. (iii) Each of the renouncees should then fill in and sign "Part C"of the respective Split Composite Application Form for the Equity Shares accepted by the renouncee. Follow the procedures stated in (E) above for obtaining the required number of Split Composite Application Forms and on receipt of Split Composite Application Forms follow the procedure as stated in (E) (ii) and (iii) above.

F. Renounce your entitlement of the Equity Shares offered to you, to more than one renouncee.

Fill in and sign Part "B" of the CAF indicating the number of Equity Shares renounced. The renouncee must fill and sign Part "C" of the CAF

1036

Investment Banking

Applications for Equity Shares should be made only on the CAF, which are provided by the Company. The CAF should be completed in all respects as explained under the head “INSTRUCTIONS” indicated on the reverse of the CAF before submission to the Banker to the Issue at their collection Centres mentioned on the reverse of the CAF on or before the closure of the subscription list. Non Resident Shareholders/Renouncees should forward their applications to Bankers to the Issue as mentioned in the CAF for Non Resident Equity Shareholders. No part of the CAF should be detached under any circumstances. For applicants residing at places other than designated Bank Collection Centres. Applicants residing at places other than the cities where the bank collection centers have been opened should send their completed CAF by registered post to Alankit Assignments Ltd., 205-Anarkali Market, Jhandewalan Extension, New Delhi 110 055 alongwith bank drafts (net of bank charges and registered post charges) payable at New Delhi in favour of “DSML—Rights Issue” and crossed “A/c Payee only” or Stockinvest in favour of “The Dhampur Sugar Mills Limited” and crossed “A/c Payee only” so that the same are received on or before Closure of the Issue (i.e. 9th December 2003). The Company will not be liable for any postal delays and applications received through mail after the closure of the Issue are liable to be rejected and returned to the applicants. Applications by mail should not be sent in any other manner except as mentioned above. The CAF alongwith application money must not be sent to the Company or the Lead Managers to the Issue except as mentioned above. The applicants are requested to strictly adhere to these instructions. In case the CAF is misplaced by the applicant, the applicants may request the Registrar to the Issue, for issue of a duplicate CAF, by furnishing the registered folio number, DP ID Number, Client ID Number and their full name and address. In case the original and duplicate CAFs are lodged for subscription, allotment will be made on the basis of the duplicate CAF and the original CAF will be ignored.

Application on Plain Paper Shareholders who have neither received the original CAF(s) nor are in a position to obtain the duplicate CAF(s) may make an application to subscribe to the Rights Issue on plain paper, along with an Account Payee Cheque/demand draft payable at New Delhi to be drawn in favour of “DSML—Rights Issue” and marked “A/c Payee” or through a Stock invest to be drawn in the name of the Company i.e. “The Dhampur Sugar Mills Limited” and crossed “A/c Payee only” and send the same by Registered Post directly to the Registrar to the Issue, so as to reach them on or before the closure of the Issue. The envelope should be superscribed “DSMLRights”.

Appendix 3

1037

(17) Basis of Allotment The basis of allotment shall be finalised by the Board of Directors of the Company in consultation with Lead Manager, The National Stock Exchange of India Ltd. or The Stock Exchange— Mumbai or The UP Stock Exchange Association Limited (Regional), as the case may be. The Board will proceed to allot the Equity Shares in the following order of priority: 1. Full allotment to the Equity Shareholders who have applied for their Rights Entitlement either in full or in part and also to the renouncees who have applied in full or in part for the Equity Shares renounced in their favour. 2. To the Equity Shareholders who having applied for their full Rights Entitlement of Equity Shares, have applied for additional Equity Shares, provided there is surplus after making full allotment under (1) above. The allotment of such additional Equity Shares shall be made as far as possible on equitable basis with reference to number of Equity Shares held on, 20th October 2003 i.e. Record Date, within the overall size of Rights Issue at the sole and absolute discretion of the Board of Directors in consultation as aforesaid. 3. Allotment to renouncees (must be the existing Shareholders) who having applied for all the Equity Shares renounced in their favour and have applied for additional shares, will be made, provided there is a surplus remaining after 1 and 2 above. 4. Equity Shares remaining unsubscribed after making full allotments under (1), (2) and (3) above, shall be disposed of by the Board to the Promoters or other existing shareholders only and the decision of the Board in this regard shall be final and binding. After taking into account the full allotment under (1), (2) and (3) above, if there is any unsubscribed portion, the Rights Issue, shall be deemed to be “unsubscribed” for the purpose of regulation 3(1)(b) of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeover) Regulations, 1997. In that event, allotment shall be made in terms of (4) above. The Company expects to complete the allotment of Equity Share within a period of 42 days from the date of closure of the Issue in accordance with the listing agreement with the Stock Exchanges. No oversubscription shall be retained by the Issuer Company Allotment to promoters of any unsubscribed portion over and above their entitlement will be done in compliance with Clause 40A of the listing agreement.

(18) Disposal of Application and Application Money The Board reserves the right to reject applications in case the application is not made in terms of this LOF. In case an application is rejected in full, the whole of the application money received will be refunded to the first named applicant and where an application is rejected in part, the excess application money will be refunded to the first named applicant within 6 weeks from the date of closure of the subscription list in accordance with Section 73 of the Act. If there

1038

Investment Banking

is delay of refund of application money by more than 8 days after the Company becomes liable to pay (i.e. forty two days after the closure of Issue), the Company will pay interest for the delayed period at the rate prescribed under sub-section (2) and (2A) of Section 73 of the Act. The subscription monies received in respect of this Issue will be kept in a separate bank account and the Company will not have access to nor appropriate the funds until it has satisfied the concerned authority with suitable documentary evidence that minimum subscription of 90% of the application money for the Issue has been received.

(19) Declaration hy the Issuer Company The Company undertakes that: (a) The complaints received with respect to the Issue shall be attended to by the Company expeditiously and satisfactorily; (b) All steps for completion of the necessary formalities for listing and commencement of trading at all stock exchanges where the securities are to be listed will be taken within 7 working days of finalisation of basis of allotment; (c) Funds required for despatch of refund orders/allotment letters/certificates by registered post shall be made available to the Registrar to the Issue by the Company; (d) Certificates of the securities/refund orders to the Non-Resident Indians shall be despatched within the specified time subject to receipt of approval from RBI, if any; (e) All amount received out of the Issue of shares to the investors shall be transferred to a separate bank account other than the bank account referred to in sub-section (3) of Section 73 of the Act; (f) No further Issue of shares shall be made till the shares offered through this LOF are listed or till the application amounts are refunded on account of non-listing, under subscription, etc. IMPORTANT 1. Please read this Letter of Offer carefully before taking any action. The instructions contained in the accompanying Composite Application Form (CAF) are an integral part of the conditions of this Letter of Offer and must be carefully followed; otherwise the application is liable to be rejected. 2. All inquiries in connection with this Letter of Offer or accompanying CAF and requests for split application forms must be addressed (quoting the Registered Folio Number/DP and Client ID Number, the CAF number and the name of the first equity shareholder as mentioned on the CAF and superscribed “The Dhampur Sugar Mills Limited—Rights Issue” on the envelope) to the Registrar to the Issue. 3. The rights issue will not be kept open for more than 30 days unless extended in which case it will be kept open for a maximum of 60 days.

1039

Appendix 3

(20) Particulars of the Issue (i) OBJECTS OF THE ISSUE The objects of this Issue are as follows: 1. To improve and strengthen the working capital base of the Company and to enable the Company to improve its net worth and 2. To meet the expenses of the Issue. The object clause of the Memorandum enables the Company to undertake its existing activities and the activities for which the funds are being raised by this Issue.

(ii) FUNDS REQUIREMENT & MEANS OF FINANCE Total requirement of funds to be raised through this rights issue and the deployment is given below: Funds Requirement

Amount (Rs. in lakhs)

Additional working capital for 1st year

400 lakhs

Additional working capital for 2nd year

400 lakhs

Means of Finance Rights issue of Equity Shares of Rs. 10/- each for cash at par. Rs. 5/- to be paid on application and balance Rs. 5/- on call

800 lakhs

(iii) RATIONALE/NECESSITY OF THE ISSUE DSML is in the business of manufacturing Sugar, Chemicals and co-generation of power. Over the past few years the performance of the Company has been strained due to subdued performance of its sugar units and high term debt level. The Company’s financial performance has been adversely affected due to the continuing downturn in the sugar industry. To take out of the critical financial crunch, the Corporate Debt Restructuring Cell of Financial Institutions and Bankers have devised the scheme of Corporate Debt Restructuring. They have stipulated to bring in Rs. 800 lakhs in the form of equity for meeting the additional working capital requirement. The requirement of additional working capital of Rs. 8 crores is as per following cost of scheme and means of finance as envisaged in the corporate debt restructuring scheme:

1040

Investment Banking

(Rs. in crores)

Cost of Scheme

I year

II year

Capital Expenditure

—

—

Upfront payment to FIs/banks

—

—

Repayment of FIs/banks' dues

—

—

4.00

4.00

Additional margin money for working capital Others-Payment of cane arrears Total Means of Finance Promoters contribution Equity Unsecured Loan Sale of surplus assets/investment Fresh Term Loans

30.00

—

34.00

4.00

—

—

4.00

4.00

—

—

30.00

Fresh W.C. borrowings

—

—

Internal accruals

—

—

Others (please specify)

—

—

34.00

4.00

Total

The fresh term loan of Rs. 30 crores as above have been sanctioned by Punjab National Bank vide their letter dt. 20th June 2003 for Rs. 24 crores and Bank of Baroda vide their letter number BR/21/NGN/676 dt 30th July 2003 for Rs. 6.00 Crores. The Company has obtained No objection Certificate from the lead Institution (ICICI Bank Ltd.) vide their letter dated 29th September, 2003 and the lead Bank( Punjab National Bank), which is also acting as Bankers to the issue has given its acceptance and hence has no objection in respect of this right issue. Outstanding of FIs and Banks as on 31.07.2003

Name of the Institution/Bank/Companies

(Rs. in lakhs) Amount

IFCI

2476.28

ICICI

5685.56

IDBI

2269.85

Bank

20109.8

1041

Appendix 3

HDFC

89.50

TIFAC-Sug. Tech. Mission

87.50

Zero coupon Term loan-FI -

1416.18

NCD -FI/Companies

1189.96

Zero coupon loan-NCD

1178.37

CPN/Deep Dis. Bond

724.17

PICUP

82.50

Total

35309.67

Working Capital Term Loans from Banks Particulars

Punjab National Bank

(Rs. in lakhs)

Sanctioned Amount Fund Based Non-Fund Based 129.10

64.75

Bank of Baroda

29.75

9.00

District Co-Operative Banks

16.48

—

175.33

73.75

Total

The Salient Features of the Corporate Debt Restructuring Scheme approved vide Reference no. CDR/729 dated April 10, 2003 are as under: Term Loan (a). Terms Loans to carry interest rate at ICICI PLR +0.5% p.a. payable quarterly or equivalent monthly (b). Simple interest due on the cutoff date (September 30, 2002) and accruing from Oct 1, 2002 to March 31, 2004 to be funded into a Zero Coupon Term Loan 2. (c). Waiver of CI (“Compound Interest”) and LD (“ liquidated damage”) as on the cut-off date. (d). Existing Zero Coupon Loan 1 to be repaid in 36 equal monthly installments from Oct 2007 to September 2010. (e). PNB and BOB to provide fresh working capital term loans of Rs. 30 Crores. The Fresh and existing WCTL to carry interest rate at PLR of the respective banks. The Fresh

1042

Investment Banking Working Capital Term Loan shall be repaid in 28 quarterly installments commencing from December 2005 to September 2012 .

(f). Payments due to IDBI and other institutions who had not sanctioned the earlier restructuring schemes shall be paid during 3 years from Fy. 2004 to Fy. 2006 after recomputing their dues as per the earlier and present restructuring.

Bank Borrowings 1. Interest rate on working capital borrowings to be charged at PLR of the respective banks from the cut off date. 2. Working capital bankers shall provide working capital facilities based on its drawing power. Others Liabilities (including lessors) The existing terms and conditions (including rate of interest and repayment schedule) will be renegotiated to the satisfaction of ICICI Bank under the present scheme of restructuring.

Preference Shares Cumulative Redeemable Preference Shares to be redeemed in three equal annual instalments from December 2013 to December 2015.

Others a. The pledge of the promoters shareholding in The Dhampur Sugars Mills Limited and the personal guarantees of the promoters shall continue till the repayment of the entire loans outstanding and the preference share holding of the institutions. b. *The company shall take steps for sale of one of the operating units ( including that of subsidiaries). To facilitate this, the Company shall also appoint an advisor to carry out the transactions in a form and manner satisfactory to lead bank. As Asset Sale Committee would be formed comprising of one representative from the Company and two each from the lead institutions and lead bank. The net proceeds received by the Company from the sale of any operating unit shall be utilised in a form and manner satisfactory to the lenders. c. The promoters/company shall raise/arrange subscription to equity of atleast Rs.8 Crore (Rs.4 Crores before September 30, 2003 and Rs.4 Crores by February 29,2004 ) on terms satisfactory to the lenders. The equity subscribed to by the promoters shall be pledged with ICICI Bank on behalf of all the lenders. *Note: The Asset Sale Committee is yet to be formed and there is no time period stipulated in the CDR Restructuring Scheme.

1043

Appendix 3

UNSECURED LOANS OF THE DHAMPUR SUGAR MILLS LTD. AS ON 30.09.2002 (Rs. in lakhs) Particulars

Amount

Fixed Deposit

832.10

* Debenture 354000 14.50% NCD of Rs. 100 each

215.48

Short Term Loans from Limited Company

106.15

TOTAL

1153.73

*In accordance with the settlement made by the Company the above noted NCDs are redeemable in Monthly instalments commencing from 21.01.2002 to 21.11.2003 without payment of any interest after 28.04.2001.

AGE WISE ANALYSIS OF SUNDRY DEBTORS OF THE DHAMPUR SUGAR MILLS LTD. AS ON 30.09.2002 (Rs. in lakhs) Particulars Debts outstanding for a period Exceeding Six Months consider good

Amount 513.08

Other Debts-Consider good

1673.01

TOTAL

2186.09

AGGREGATED BOOK VALUE OF QUOTED INVESTMENT OF THE DHAMPUR SUGAR MILLS LTD. AS ON 30.09.2002 (Rs. in lakhs) Particulars

Amount

Aggregate amount of Investment in Quoted shares (net of Provisions)

1106.43

Aggregate Market value of Quoted Shares

405.0

1044

Investment Banking

(21) Financial Performance of the Company AUDITORS’ REPORT The Board of Directors, The Dhampur Sugar Mills Limited Dhampur, Distt Bijnore (UP) 246 761 We have examined the accompanying statement of Adjusted Profits and Losses as per Annexure “A” of The Dhampur Sugar Mills Limited having their Registered Office at Dhampur , Distt Bijnore (UP) 246 761 (here after referred to as the Company) for each of the year ended 30th September 1998, 30th September 1999, 30th September 2000, 30th September 2001 and 30th September, 2002 and the accompanying statement of Adjusted Assets and Liabilities of the Company as per Annexure “B” as on those dates being the last date upto which the accounts of the Company have been made up and furnished to us by the Board of Directors of the Company. These statements reflect the Profits/Losses for each of the relevant year and Assets and Liabilities as on 30th September 1998, 30th September 1999, 30th September 2000, 30th September 2001 and 30th September 2002, as extracted from the Profit and Loss Account for those years and Balance Sheets as at those dates after making therein the disclosures and adjustments required to be made in accordance with the provisions of paragraph 6.18 of the Securities and Exchange Board of India (Disclosures and Investor Protection) Guidelines, 2000 and read together with enclosed significant Accounting polices as per Annexure “C” and material notes to the statement as per Annexure “D” and our audit observations on the matters in respect of manufacturing and other companies (Auditors Report) order, 1988 issued by the Company law Board in terms of Section 227 (4A) of the Companies Act, 1956 as per Annexure “E” and some of the Auditors qualification for which no adjustments could be carried out as set out in Annexure “F”. We had audited the Profit and Loss Account of the Company for the half year ended 31st March 2003. We further report that the Accounts of the Company as on 30th September, 2002 have been prepared by the management on the principles applicable to a “Going Concern”. We have also examined the accompanying statement of rates of dividend as per Annexure “G” wherein no dividends have been paid in respect of any class of shares by the Company in respect of each of the year ended 30th September 1998, 30th September 1999, 30th September 2000, 30th September 2001 and 30th September 2002. We have also examined the accompanying statement of accounting ratios of the Company as per Annexure “H” for each of the year ended 30th September 1998, 30th September 1999, 30th September 2000, 30th September 2001 and 30th September 2002.and report that, in our opinion, they have been correctly computed from the figures as stated in the statements of Adjusted Profits and Losses and Adjusted Assets and Liabilities of the Company referred to in paragraph 1 above.

1045

Appendix 3 NAME OF THE AUDITORS OF SUBSIDIARY COMPANIES – DSM Agro Products Limited—M/s Mittal Gupta & Company – Mansurpur Sugar Mills Ltd.—M/s. Mittal Gupta & Company.

This report is intended solely for your information and for inclusion in the Letter of Offer document in connection with the proposed Rights Issue of the Company and is not to be used, referred to or distributed for any other purposes without our prior written consent. For Mittal Gupta & Company for: S. Vaish & Company CHARTERED ACCOUNTANTS CHARTERED ACCOUNTANTS Sd/- Sd/(AKSHAY K. GUPTA) (S. P. AGRAWAL) Partner Partner Dated : 31st July 2003 Memorandum of adjustments in Profit & Loss Account in accordance with the Provisions of para 6.18 of SEBI (Disclosure of Investor Protection) Guidelines, 2000. (Rs. in lakhs) Particulars

Net loss before tax & extraordinary items as per audited accounts (i) Effect of change in method of valuation of closing stock in accordance with AS-2 of ICAI in the year 1998-99 and earlier year (Refer note no 10 for the year ended 30.09.1999 as per Annexure "D" (ii) Adjustment of material amounts of income/expenses for earlier years to which they relate : (a) Manufacturing,operational, administrative & other expenses (b) Other Income (c) Interest Adjusted Net loss before tax & extraordinary items

1997–98

1998–99

1999–2000

2000–01

2001–02

(–) 435.12

(–)4342.93

(–)3306.84

(–)1596.03

(–)2703.83

(–) 969.83

(+)969.83

—

—

—

(–) 37.52

(–) 77.66

(+) 8.82

(+)112.25

—

(–)204.83 (–)29.22

— (–)23.36

(–)68.88 (–)7.87

— —

— —

(–)1676.52

(–)3474.12

(–)3374.77

(–)1483.78

(–)2703.83

1046

Investment Banking

Annexure B SCHEDULE OF ADJUSTED ASSETS AND LIABILITIES Year/ Period Ended A.

As on 30.09.1998

As on 30.09.1999

(Rupees in lakhs)

As on 30.09.2000

As on 30.09.2001

As on 30.09.2002

Fixed Assets Gross Block

28710.71

33197.14

33221.96

33440.73

34492.11

8427.2

9634.26

10596.89

11737.33

13193.02

20283.51

23562.88

22625.07

21703.4

21299.09

—

—

—

20283.51

23562.88

22625.07

21703.4

21299.09

4088.83

353.08

476.55

386.34

850.02

24372.34

23915.96

23101.62

22089.74

22149.11

5216.12

5681.68

5950.4

5967.08

5313.78

Inventories

11950.5

8971.31

15393.58

7668.38

11564.55

Sundry Debtors

2642.83

2102.27

2464.54

2401.52

2186.09

650.88

472.48

625.51

1237.57

602.83

8684.96

7226.67

7114.52

6509.65

4531.32

29496.99

31493.58

37718.58

31424.55

32413.8

Unsecured Loan

3548.00

935.07

1118.51

1297.73

1153.73

Deferred Liabilities

1174.42

1218.41

1517.2

1822.71

159.72

Current Liabilities & Provisions

3455.53

4313.76

6646.56

5294.97

8754.06

15842.69

10409.55

7649.32

6033.98

3866.37

1680.97

1680.97

2669.91

3052.53

4052.53

14161.72

8728.58

5575.09

5645.25

5664.06

595.68

2663.8

5850.22

7649.32

6033.98

3866.37

Less: Depreciation Net Block Less : Revaluation Reserve Net Block after adjustment for Revaluation Reserve Capital Work-in-progress including advances against Machinery if any Total B.

Investments

C.

CurrentAssets, Loans & Advances

Cash & Bank Balances Loans and Advances D.

—

—

Liabilities & Provisions Secured Loan

NetWorth (A+B+C-D) Represented By 1. Share Capital 2. Reserves& Surplus Less : Revaluation Reserve 3. Less Profit & Loss Account Net Worth (1+2-3)

— 15842.69

— 10409.55

1047

Appendix 3

ANNEXURE H Accounting Ratio (Rs. in lakhs) Financial Year Ended

As on 30.09.1998

As on 30.09.1999

As on 30.09.2000

As on 30.09.2001

As on 30.09.2002

–1676.52

–3474.12

–3374.77

–1483.78

–2703.83

No of Equity Shares

112.45

112.45

112.45

134.45

215.27

Earning per share(Basic & Diluted) (Rs)

–14.91

–30.89

–30.01

–11.04

–12.56

15842.69

10409.55

7649.32

6033.98

3866.37

Return on Net Worth

–10.58

–33.37

–44.12

–24.59

–69.93

NAV per share ( Rs.)

140.91

92.57

68.02

36.97

14.69

Profit after tax (Excluding extraordinary items & Dividend on preference shares)

Net Worth

Notes : (a). Earning Per Share = Adjusted Profit after Tax but before extraordinary items (net of taxes)/weighted no. of shares. (b). Cash Earning Per Share (After extraordinary item) = Adjusted Profit after extra ordinary items but before depreciation and weighted no. of shares. (c). Return on Net Worth (%) = Adjusted Profit after Tax but before extraordinary items/ adjusted net worth. (d). Net Asset Value per Share = (Adjusted Net Worth less preference Share Capital)/no. of equity shares outstanding at the year end. (e). Net Worth = Share Capital + Reserves and Surplus excluding Revaluation Reserve – Profit & Loss Accounts. (f). Weighted average No. of Shares = No. of Shares at the beginning of the year + (no. of shares issued during the year * no. of days during the year for which shares were outstanding/ total no. of days during the year).

ANNEXURE I TAX SHELTER There are substantial losses to the Company in the years September 1998 to September 2002. In view thereof and considering brought forward taxable losses, there is no effect of any tax shelter on the losses of the company.

1048

Investment Banking

CAPITALISATION STATEMENT (Rs. in Lakhs) Pre-issue as on 30.09.2002

As adjusted for the issue

Short-Term Debt Long-Term Debt

16832.68 16734.85

16832.68 16734.85

Total Debt

33567.53

33567.53

Shareholders Fund Share Capital Reserves & Surplus Profit & Loss Account Total Shareholders Fund Total Long Term Debt/Equity Ratio

4052.53 5664.06 (5850.22) 3866.37 4.33:1

4862.40 5664.06 (5850.22) 4676.24 3.58:1

Auditors Report Ends. Indbank Merchant Banking Services Limited confirms that all notes on accounts with significant accounting policies and auditors qualification are incorporated.

(22) Management Discussion and Analysis

Year Ended

As on 30.09.2000 Audited

As on 30.09.2001 Audited

As on 30.09.2002 Audited

As on 31.03.2003 Audited 6 months

As on 30.06.2003 Unaudited 9 months

Sales (inclusive of excise duty) a) of products manufactured by the Co. b) of products Traded by the Company c) Income from operation

29171.30 612.49 51.00

44835.64 483.03 0.70

40688.00 323.56 --

19428.02 included above

32557.94 included above

Total

29834.79

45319.37

41011.56

19428.02

32557.94

175.70 6106.11

348.20 (7630.21)

236.54 3801.46

444.96 9989.56

582.03 9878.71

36116.60

38037.36

45049.56

29862.54

43018.68

Other Income Increase (Decrease) in Stocks Total

1049

Appendix 3

Expenditure Raw Material Consumption

22838.71

21931.17

29813.63

21130.79

29666.51

Purchase of goods traded in

579.99

455.20

334.79

Included above

Included above

Staff Costs

2315.84

2359.27

2582.29

1323.38

1971.57

Other Manufacturing Expenses

3604.13

4035.70

4125.22

3291.27

4623.72

Administration Selling & Dist. Exp.

1346.40

1611.89

2195.15

Included above

Included above

Excise Duty

2451.85

2514.66

3347.77

2443.23

3490.12

Interest and Financial Cost (Net)

4851.07

5074.10

3803.64

1586.05

2556.85

Depreciation

1503.38

1539.15

1550.90

778.21

1193.41

Total

39491.37

39521.14

47753.39

30552.93

43502.18

Net (Loss) before Tax & Extraordinary Items

(3374.77)

(1483.78)

(2703.83)

(690.33)

(383.50)

0.95

(469.05)

(482.59)

0.00

0.00

(3373.82)

(1952.83)

(3186.42)

(690.33)

(383.50)

—

(3.04)

—

200.00 (deferred)

100.00 (deferred )

(3373.82)

(1955.87)

(3186.42)

(490.33)

(283.50)

Extraordinary Item Net (Loss) before Tax Provision for Taxation

Net (Loss) after Tax

The Company mainly manufactures Sugar, chemicals and co-generation of power. The year wise discussion on the aforesaid financial data is as follows: For the Year ended on 30th September 2000 The Company enhanced cane crushing by 18% to 23.99 lakh tonnes. The total production of sugar of the Company is enhanced by 21% to 2.25 lakh tonnes against 1.86 lakh tonnes in previous year. The sugar industry in saddled with highest ever sugar stocks. The closing stocks of sugar in the Company also enhanced by 76%. Interest burden has also increased due to enhanced drawing of working capital limits and also due to increase in rate of interest by banks. The Govt. has taken some positive steps i.e. levy entitlement is reduced from 40% to 30% w.e.f. 1.1.2000 and sugar import duty is increased to 60% in February 2000. The Govt. has also

1050

Investment Banking

permitted export of 10 lakh tonnes of sugar but the export prices are still depressed. Still a lot more needs to be done for the long term interest of the sugar industry. The net production chemicals (Acetic Anhydride, Ethyl Acetate, Acetaldehyde, Acetic Acid, and CO2) during the year marginally declined due to unfavourable market conditions. The company has supplied 23185 MW of surplus power to State Electricity Board. Payment of electricity bills is abnormally delayed by UPSEB. For the Year ended on 30th September, 2001 The total production of sugar of the company is 2.13 lakh tonnes as against 2.25 lakh tonnes in the previous year. The marginal decline in cane crushing resulting in lower production is mainly due to lower availability of sugar cane in sugar unit, Dhampur, where a part of area witnessed water logging due to heavy rains, damaging the sugar cane crop. The company has launched sulpher less sugar in 1 kg pack branded as “Dhampure” which will improve price realization in future. The Govt. has taken some positive steps i.e. levy entitlement is reduced from 30% to 15% . The Govt. has also allowed the industry to freely export the sugar from 26th April, 2001 in view of the increased sugar production and availability in the country. But the export prices are still depressed. Forward and future trading in sugar has also been allowed by the Govt. Although efforts made by Govt. are appreciable, but still a lot more needs to be done for the long term interest of the sugar industry. The production of chemicals (Acetic Anhydride, Ethyl Acetate, Acetaldehyde, Acetic Acid and CO2) has increased substantially by 64% to 12003 MT. The production of Oxalic Acid plant also increased by 30%. The company has supplied 20303 MW (23185 MW) of surplus power to State Electricity Board. Payment of electricity bills is abnormally delayed by UPSEB. The Company has booked a loss on sale of Particle Board of Rs. 469.05 Lakhs. For the Year ended on 30th September 2002 The financial position of the Company is adversely affected due to substantial fall in prices of sugar and rise in price of raw material sugar cane by State Govt. The production of chemicals (Acetic Anhydride, Ethyl Acetate, Acetaldehyde, Acetic Acid and CO2) has increased substantially by 31% to 14964 MT. The production of Oxalic Acid plant also increased to 1635 MT. The company has supplied 23329MW (20303 MW) of surplus power to State Electricity Board. Payment of electricity bills is abnormally delayed by UPSEB. The sugar is amongst the largest agro processing industries in India. By way of sugar cane price about Rs. 16000 crores are disbursed amongst farmers directly. Besides, its annual contribution to the central and state exchequers by way of taxes is around Rs. 1800 crores. The industry does not depend on fossil fuel but generates its own renewable sources of energy. Not only that it generates surplus power through cogeneration for use by consumers in interior rural areas. It has

Appendix 3

1051

the potential to generate 5000 MW surplus power and reduce import bill of petroleum products by 5% by manufacture of ethanol. The Govt. has made mandatory w.e.f. 1st January, 2003 the blending of Ethanol with petrol to produce ‘Gasohol’ to the extent of 5% in nine states and four union territories. The Govt. has also removed restrictions w.e.f. 17th March, 2002 on buying, selling, storage, transportation, distribution, disposal and usage of sugar by relaxing provisions of Essential Commodities Act, 1955. No licence is required from any authority for dealing in sugar. For the Period Ended on June 30, 2003 (9 Months) The losses are reduced over previous year, mainly on account of payment of cane price on statutory minimum price fixed by Central Govt. instead of State Advised Price in earlier years which was higher.

(23) Stock Market Data LISTING & STOCK MARKET DATA The Company’s shares are listed on The National Stock Exchange of India Ltd, The Stock Exchange, Mumbai, The Delhi Stock Exchange Association Ltd., and The Stock Exchange, Ahmedabad, The Company is seeking delisting from The Delhi Stock Exchange Association Ltd., and The Stock Exchange, Ahmedabad. On the request of the company its shares have been delisted from the UP stock Exchange Association Ltd. vide their letter no. UPSE/LC/2003-2004 dt. 26-09-2003 High, low and average market prices for last three years and monthly high, low and average market prices for the six months preceding this announcement and their corresponding volumes on (a). The UP Stock Exchange Association Ltd. (Regional): There is no transaction recorded for the last three years in The UP Stock Exchange Association Ltd. (Source: The UP Stock Exchange Association Ltd.) (b). The Delhi Stock Exchange Association Ltd: There is no transaction recorded for last three years in The Delhi stock Exchange Association Ltd. ( Source: The Delhi Stock Exchange Association Ltd.) (c). The Stock Exchange Ahmedabad : There is no transaction recorded for the last three years in The Stock Exchange Ahmedabad. (Source: The Stock Exchange- Ahmedabad) (d). The Stock Exchange, Mumbai.

1052 Period

2001–2002 2002 – 2003 2003 – 2004 (2) Monthly March 2003 April 2003 May 2003 June 2003 July 2003 August 2003 Sept 2003

Investment Banking

High (Rs.)

Date of High & No. of Shares traded on that date

Low (Rs.)

Date of Low & No. of Shares traded on that date

Average Price*

Total volume traded in period

8.75 28.00 29.40

31.12.01, 200 08.07.02, 56101 27.08.2003,355585

5.80 8.10 8.55

02.11.01, 50 22.01.02, 400 26.03.03, 2568

7.28 18.05 18.90

250 56501 358153

11.30 11.20 14.70 18.20 23.25 29.40 27.65

13.03.03,9781 02.04.03, 3202 30.05.03, 13927 06.06.03, 849 08.07.2003,140175 27.08.2003,355585 01.09.2003,208667

8.55 9.05 9.40 13.65 14.55 16.10 19.10

26.03.03, 2568 01.04.03, 758 05.05.03, 1563 03.06.03,6404 01.07.2003,6308 01.08.2003,121402 01.09.2003,60292

9.93 10.13 12.05 15.93 18.90 22.75 23.37

12349 3960 15490 7253 146483 476987 268959

(24) Basis for Issue Price The Issue is being made at par i.e. Rs. 10/- per share on rights basis to the existing shareholders. Quantitative Factors Adjusted Earnings Per Shares (EPS): Year 1999–2000 2000–2001 2001–2002 Weighted Average 1. Price/Earning Ratio ( P/E) The closing market price of the equity shares of the company on the NSE on the day after the Board approved the issue i.e 30.06.03 was Rs.15.45. The EPS of the company is negative thus PE can not be calculated. Source : (http://www.nseindia.com/) P/E Based on the weighted average—N/A *Industry P/E: Highest Lowest Industry Average *Since the Company P/E is negative comparison could not be done.

EPS (Rs.)

–29.33 –11.77 –11.97

Weight

1 2 3 –14.79

— — —

1053

Appendix 3

2. Return on Networth : Year1999–2000 2000–2001 2001–2002 Weighted Average

–44.11% –24.59% –69.93%

3. Minimum Return on Increased Net worth required to maintain pre issue EPS : Pre Issue WEIGHTED Average EPS (Rs.) Present Networth as on 30/09/2002 (Rs. in Lakhs) Increased Net Worth (Rs. in Lakhs) Minimum return required

–14.79

1 2 3 –50.51%

–14.79 3866.37 4676.24 NA

4. Net Asset Value ( NAV) As on 30/09/2002 (Rs.)

14.69

5. Net Asset Value after issue Post Issue Asset Value (Rupees in Lakhs) Post Issue no. of Shares Net Asset Value after issue (Rs.) Issue Price ( Rs.)

4676.24 34744812 11.10 10

(25) Promise vs Performance in the Last Issue The last Issue of the Company was made in 1995 for the Rights issue of 37,86,732 Convertible Premium Notes (CPNs) of Rs.110/- each for cash at par. The details financial projections for the three years as given in the Letter of Offer for the CPN issue and the targets achieved are as under: (Rs. in lakhs) Particulars

Sales

Projections for 30.9.96

Results as on 30.9.96

Projections for 30.9.97

Results as on 30.9.97

Projections for 30.9.98

Results as on 30.9.98

30175.60

31722.17

34715.76

33079.76

35773.95

33030.78

Other Income

859.00

1223.18

859.00

595.97

859.00

882.18

Total Income

31034.60

32945.35

35574.76

33675.73

36632.95

33912.96

1054

Investment Banking

Gross Profit (PBDIT)

7516.77

4245.10

9076.02

5397.72

8934.93

4319.74

Interest & Lease Rentals

3086.27

2647.61

3308.60

3129.92

3077.93

3460.31

Depreciation

1457.50

1012.33

1520.00

1215.92

1520.00

1294.55

Profit before Tax

2973.00

585.16

4247.71

1105.08

4336.99

(435.12)

849.48

65.00

867.40

1.00

Tax

Profit after Tax

—

—

2973.00

585.16

3397.93

1040.08

3469.50

(436.12)

EPS (Rs)

19.63

5.05

22.43

9.19

22.91

N.A.

Cash EPS

29.25

13.81

32.47

19.94

32.94

7.63

139.90

143.13

159.34

146.65

178.24

136.02

1514.69

1130.97

1514.69

1124.50

1514.69

1124.50

Reserves

19676.43

15429.67

22619.95

15455.38

25483.67

14164.02

Networth

21191.12

16560.64

24134.64

16586.35

26998.30

15294.99

Book Value (Rs) Equity

(26) Declaration No Statements made in this Letter of Offer shall contravene any of the provisions of the Companies Act, 1956, and the Rules made thereunder. All the legal requirements connected with the said issue as also the guidelines, instructions, etc., issued by SEBI, Government and any other competent authority in this behalf have been complied with. Yours faithfully, By order of the Board of Directors of The Dhampur Sugar Mills Limited Sd/Place: New Delhi Date: 16.09.2003

Appendix 4 DRAFT LETTER OF OFFER

S.R.P. TOOLS LIMITED Registered Office: 108, Thambu Chetty Street, Chennai 600 001

This Document is Important and Requires your Immediate Attention This Letter of Offer is being sent to you as a shareholder of the Company on the Specified Date ( January 18, 2003). For any clarification/help on the subject, investors are advised to contact the Manager to the Offer namely Meghraj Financial Services (India) Pvt. Ltd. or the Compliance Officer. Offer to buy back upto 9,90,000 fully paid equity shares of face value Rs. 10 each representing 25% of the issued, subscribed and paid-up equity share capital of S.R.P. Tools Limited at Rs. 35 per share through a Tender Offer in accordance with the Companies Act, 1956 as amended and the Securities & Exchange Board of India (Buy-back of Securities) Regulations, 1998

The Procedure for Tender/Offer is set out on page No. -- of this Letter of Offer. A Tender/Offer Form is enclosed with this Letter of Offer. The Form with relevant enclosures should be despatched/delivered so as to reach before the close of business hours at the Registered Office of the Company on or before March 5, 2003.

Manager to the Buy–Back Offer Meghraj Financial Services (India) Private Limited. 3rd Floor, Khanna Construction House 44, Dr. R.G. Thadani Marg,Worli Mumbai 400 018 Tel: 022-24931764 Fax: 022-24931765 E-mail: [email protected]

Compliance Officer Mr. J. Sridhar Vice-President (Finance) & Secretary

S.R.P. Tools Limited 108, Thambu Chetty Street Chennai 600 001 Phone: 044-5234429/5234430 Fax: 044-5268373 E-mail: [email protected]

Offer opens on:

February 5, 2003

Offer closes on:

March 5, 2003

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Collection Centre 1. Registered shareholders and shareholders who have obtained delivery after the Specified Date (“unregistered shareholders”) who wish to tender their shares should submit their response by Courier/Registered Post/Hand Delivery to the Registered Office of the Company at the address given below between 10.00 a.m. and 5.30 p.m. on all working days.

Address S.R.P. Tools Ltd. 108, Thambu Chetty Street Chennai 600 001

Phone/Fax No.

Contact Person

Phone:044-5234430 Mr. R. Parthasarathy Fax:044-5268373

RESPONSES SHOULD NOT BE SENT to the Manager to the Buy-back Offer

Offer Time Table Activity

Date

Extra-Ordinary General Meeting

December 7, 2002

Public Announcement

December 9, 2002

Specified Date

January 18, 2003

Opening of the Buy-Back Offer

February 5, 2003

Closure of the Buy-Back Offer

March 5, 2003

Finalise basis of allocation Despatch of consideration warrant/share certificate Extinguishment of shares

March 15, 2003 March 22, 2003 March 22, 2003

The Company has adhered/will adhere to the SEBI stipulated time limits.

Disclaimer Clause As required, a copy of this Letter of Offer and Public Announcement has been submitted to Securities and Exchange Board of India. It is to be distinctly understood that submission of Letter of Offer and Public Announcement to SEBI should not in

Appendix 4

1057

any way be deemed or construed that the same has been cleared or approved by SEBI. SEBI does not take any responsibility either for the correctness of the statements made or opinions expressed in the Letter of Offer and Public Announcement. The Manager to the Buy-back Offer, Meghraj Financial Services (India) Pvt. Ltd, has certified that the disclosures made in the Letter of Offer are generally adequate and are in conformity with SEBI (Buy-back of Securities) Regulations, 1998. This requirement is to facilitate investors to take an informed decision as to the acceptance of the Offer. It should also be clearly understood that while the Company is primarily responsible for the correctness, adequacy and disclosure of all relevant information in the Letter of Offer and Public Announcement, the Manager to the Buy-back offer is expected to exercise Due Diligence to ensure that the Company discharges its responsibility adequately and in this behalf and towards this purpose, the Manager to the Buy-back offer, Meghraj Financial Services (India) Pvt. Ltd has furnished to SEBI a Due Diligence Certificate dated December 12, 2002 in accordance with SEBI (Buy-back of Securities) Regulations, 1998 which reads as follows: We have examined the various documents and material papers relevant to the buyback as part of the due-diligence carried out by us in connection with the finalisation of the Public Announcement and Letter Of Offer. On the basis of such examination and the discussions with the Company, we hereby state that: �

�

�

�

The Public Announcement and the Letter Of Offer is in conformity with the documents, materials and papers relevant to the buyback; All the legal requirements connected with the said offer including SEBI (Buyback of Securities) Regulations, 1998, have been duly complied with; The disclosures in the Public Announcement and the Letter Of Offer are, to the best of our knowledge, true, fair and adequate in all material respects for the shareholders of the Company to make a well informed decision in respect of the buyback; Funds borrowed from banks and Financial Institutions will not be used for the buyback.

The filing of the Draft Letter of Offer does not, however absolve the Company from any liabilities under Section 77A, Section 77AA and 77B of the Companies (Amendment) Act, 2001 or from the requirement of obtaining such statutory or other clearances as may be required for the purpose of the proposed issue. SEBI, further reserves the right to take up, at any point of time, with the Manager to the Buy-back Offer any irregularities or lapses in Letter of Offer. Promoters/Directors declare and confirm that no information/material likely to have a bearing on the decision of shareholders has been suppressed/withheld and/or incorporated in the manner that would amount to mis-statement/mis-representation and in the event of it transpiring at any point of time that any information/material has been suppressed/withheld and/or amounts to a mis-statement/mis-representation, the

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Promoters/Directors and the Company shall be liable for penalty in terms of the provisions of the Companies Act, 1956 and the SEBI (Buy-back of Securities) Regulations, 1998.

I. Details of the Offer 1. S.R.P. Tools Limited hereby announces its intention to buy back upto 9,90,000 fully paid equity shares of face value Rs. 10 each, representing 25% of the paid-up equity share capital, through Tender Offer from the shareholders of the Company at a price of Rs. 35 per share, payable in cash. The Buy-back Offer is being made in accordance with the Act, the Regulations and other applicable laws. Shareholders have the option of tendering their shares in response to the Buy-back Offer. 2. The Company will adopt the Tender Offer route for the Buy-back and will restrict the Buy-back to a maximum of 9,90,000 fully paid equity shares representing 25% of the paid-up equity share capital of the Company on proportionate basis. 3. The total amount to be expended towards Buy-back by the Company, assuming 100% response to the Offer, aggregates to Rs. 346.50 lakhs, which is 24.06% of the paid-up share capital and free reserves of the Company as on March 31, 2002. 4. The Promoters currently (as on December 7, 2002) hold 2,214,701 equity shares, representing 55.92% of the paid-up equity share capital of the Company. Some of the promoters, holding an aggregate of 54,800 shares, retain the option to tender their shares in the proposed Buy-back Offer. The non-promoter Directors and the employees of the Company are eligible to offer their shares in the buy-back. Assuming 100% response to the Offer and if all the shares tendered in response to the Offer are accepted in full, the Promoters will hold a maximum 74.56% and a minimum 72.72% of the issued, subscribed and paid-up equity share capital of the Company after the Buy-back Offer. 5. The shares will be acquired free from all liens, charges and encumbrances. 6. The Company will ensure compliance with Sections 77(A) and 77(B) of the Companies Act, 1956. 7. The Company shall abide by the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, if applicable. 8. The non-promoter holding after completion of the buy-back offer will not fall below the level of 25%.

II. Details of Public Announcement of the Buy-Back Offer As per Regulation 8(1) of the Regulations, the Company has made a Public Announcement in the following newspapers on December 9, 2002. Newspaper

Language

Business Line

English

Makkal Kural

Tamil

Navbharat

Hindi

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1059

III. Authority for the Buy-Back Offer & Statutory Approvals Pursuant to Section 77A and the applicable provisions of the Act and the Regulations, the present offer for Buy-back of shares of the Company from the shareholders has been duly authorized by: 1. Article 49A of the Articles of Association of the Company. 2. A Resolution passed by the Board of Directors of the Company (“Board”) at its meeting held on October 31, 2002. 3. A Special Resolution passed by the shareholders of the Company by means of a Postal Ballot, the result of which was declared at the Extraordinary General Meeting on December 7, 2002. 4. A Resolution passed by the Board at its meeting held on December 7, 2002. 5. The Offer is subject to approvals, if any, required under the provisions of the Act, the Regulations and/or such other Acts in force for the time being.

IV. Necessity for Buy-Back 1. The shares of the Company are listed on the Madras Stock Exchange, Chennai (MSE) only. The rationale behind listing is to provide liquidity to the Shareholders by enabling them to buy/sell the shares on the Stock Exchange. Such liquidity is presently not available to the Shareholders of the Company due to limited trading in the shares. Through this Buy-back offer, the Company intends to provide liquidity to the existing Shareholders, as also provide an exit route.

V. Basis of Offer Price 1. The offer price has been based on the market price of the shares of the Company on the Stock Exchange and the Book Value of the Shares. 2. The last traded price of the shares of the Company on the MSE on October 24, 2002 was Rs. 18/- (Rupees Eighteen only) per share. The Buy-back price of Rs. 35/- (Rupees Thirty five only) per share is at a premium of 94.44% over the aforesaid price. 3. The Book Value of the share, excluding revaluation reserves, based on the audited financials as on March 31, 2002 was Rs.36.36 per share. The Buy-back price is at a multiple of 0.96 to Book Value.

VI. Sources of Funds for Buy-Back & Cost Thereof 1. The Company proposes to buy back a maximum of 990,000 fully paid equity shares at a price of Rs. 35 per share. The total amount of funds required for the Buy-back is a maximum of Rs. 346.50 lakhs, assuming 100% response to the Buy-Back Offer.

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Investment Banking

2. The Company proposes to meet the funds required for the Buy-back Offer from free reserves/internally generated funds. The cost of financing the buy-back could therefore be the notional loss of income that the funds would have earned had they been deployed in the ordinary course of company’s business.

VII. Details of Escrow Account The Company has opened an Escrow Account, with the Global Trust Bank, Chennai in accordance with Regulation 10(2) of the Regulations and will transfer to it a cash deposit of Rs. 86,62,500 (Rupees Eighty six lakhs sixty two thousand five hundred only) being 25% of the total consideration payable before the opening of the buyback offer. The Company has issued directions to the bank to act as per the instructions of the Manager to the Buy-back Offer, Meghraj Financial Services (India) Pvt. Ltd.

VIII. Capital Structure & Shareholding Pattern 1. Present Capital Structure & Shareholding (i). The present issued, subscribed and paid-up equity share capital of the Company consists of 39,60,000 fully paid equity shares of face value Rs. 10 each aggregating Rs. 3,96,00,000. (ii). There are no partly paid shares. Further, there are no other outstanding securities to be converted into equity shares. (iii). There are no locked-in or non-transferable equity shares. (iv). The present shareholding pattern (as on December 7, 2002) is as below: Shareholder category Promoters Banks/Institutions

No. of shares held 22,14,701

% Shareholding 55.92

3,93,860

9.95

Others

13,51,439

34.13

Total

39,60,000

100.00

2. Post Buy-Back Capital Structure & Shareholding (i) After the completion of the Buy-Back Offer, assuming 100% response to the Offer, the issued, subscribed and paid-up equity share capital of the Company would consist of 29,70,000 equity shares of Rs. 10/- each aggregating Rs. 2,97,00,000 comprising of a maximum 22,14,701 shares and minimum 21,59,901 shares held by the promoters and a maximum 8,10,099 shares and minimum 7,55,299 held by non-promoters.

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1061

(ii) Assuming 100% response to the Buy-Back Offer from Public, the Promoters holding will increase to a maximum 74.56% and minimum 72.72% of the paid up capital. (iii) The pre-and post-offer debt equity ratio is 0.13 and 0.17, respectively.

IX. Information About the Shareholding of the Promoters 1. The aggregate shareholding of the promoters on the date of the Public Announcement (December 7, 2002) is 22,14,701 shares of Rs.10 each constituting 55.92% of the issued, subscribed and paid-up equity share capital of the Company. 2. The promoters purchased in aggregate 1,08,485 shares of the Company during the period of twelve months preceding the date of the Public Announcement. The maximum and minimum price at which the shares were purchased was Rs. 18/- per share on various dates, the latest date was October 24, 2002. There was inter-se transfer of 2400 shares between the promoters at Rs. 18/- per share during the said period. 3. Some of the promoters , holding an aggregate of 54,800 shares retain the option of participating in the Buy-back offer. Assuming 100% response to the offer, the promoters will hold maximum 74.56% and minimum 72.72% of the post Buy-back capital of the Company.

X. Management Discussion and Analysis on Likely Impact of Buy-Back on the Company 1. The buy-back is not likely to cause any material impact on the profits of the Company except the notional loss of income, if any, on the cash to be utilized for the buy-back. 2. The buy-back program is expected to contribute to the overall enhancement of shareholder value. 3. In the manner indicated in Para IX(3) above, the shareholding of the promoters will increase to maximum 74.56% and minimum 72.72% of the post Buy-back share capital of the Company and the public shareholding will decrease correspondingly to minimum 25.44% and maximum 27.28%. 4. There will be no change in the management structure of the Company consequent to the buy-back. 5. The post buy-back debt equity ratio is on the assumption of 100% response to the buyback offer. 6. Based on audited results for the year ended March 31, 2002, consequent to the Buyback Offer, salient financial parameters of the Company would be:

1062 Parameter

Net-worth (Rs. lakhs )

Investment Banking

Value (pre-Buy-Back) on Value (post-Buy-Back) on audited results for the year audited results for the year ended March 31, 2002 ended March 31, 2002 1440.13

1093.63

Return on Net worth (%)

0.29

0.39

Earnings per Share (Rs.)

0.11

0.14

36.36

36.82

318.18

250

0.13

0.17

Book Value per Share (Rs.) P/E (Based on Buy-back Price of Rs. 35 per share) Debt Equity Ratio

XI. Note on Taxation 1. In respect of Shareholder The extract of Income Tax Act 1961 as amended by Finance Act 1999, relating to treatment in case of buyback of shares is given below: ‘Section 2(22) Dividend’ includes—(a)___ to___ (e) but ‘dividend’ does not include ___ (iv) Any payment made by a Company on purchase of its own shares from a shareholder in accordance with the provisions of section 77A of the Companies Act, 1956 (1 of 1956)”

Section 46A “Where a shareholder or a holder of other specified securities receives any consideration from any company for purchase of its own shares or other specified securities held by such shareholder or holder of other specified securities, then, subject to the provisions of Section 48, the difference between the cost of acquisition and the value of consideration received by the shareholder or the holder of other specified securities, as the case may be, shall be deemed to be the capital gains arising to such shareholder or the holder of other specified securities, as the case may be, in the year in which such shares or other specified securities were purchased by the Company. Explanation—For the purposes of this section, “specified securities” shall have the meaning assigned to it in Explanation to Section 77A of the Companies Act, 1956 (1 of 1956)”.

Appendix 4

1063

As per Section 46 A of the Income Tax Act, 1961 the difference between the cost of acquisition and the value of Buy-back consideration received by shareholders shall be chargeable to tax as “capital gains”. Investors are advised to consult their tax consultants for treatment that may be given by the respective assessing officer in their case. Company or Manager to the Buy-back Offer do not accept any responsibility for the accuracy or otherwise of this advice.

2. In respect of the Company There are no specific tax benefits to the Company on account of Buy-back.

XII. Documents for Inspection Copies of the following documents will be available for inspection at the Registered Office of the Company between 9.30 a.m. and 4.30 p.m. on all working days (Monday to Friday) during the Offer period: 1. Memorandum & Articles of Association of the Company. 2. Annual Reports for the years 1999–2000, 2000–2001, 2001–2002 and Limited Review results for the 6 months period ended September 30, 2002. 3. A resolution passed by the Board of Directors (“Board”) at its meeting held on October 31,2002 recommending buy-back and convening the Extraordinary General Meeting. 4. Copy of the Notice to shareholders and postal ballot form for the Extraordinary General Meeting on December 7, 2002 and the explanatory statement thereof. 5. Special Resolution authorizing buy-back of shares by the Company passed by the shareholders at the Extraordinary General Meeting (through postal ballot) of the Company held on December 7, 2002. 6. Scrutiniser’s report dated December 5, 2002 of the results of the postal ballot with respect to the buy-back of shares. 7. A Resolution passed by the Board at its meeting held on December 7, 2002 forming a sub-committee for buy back. 8. Auditor’s Certificate dated October 31, 2002 as prescribed in Schedule I clause (xi) under Regulation 5(1) of the Regulations. 9. Auditors’ Certificate dated December 7, 2002 as prescribed under Schedule III clause 24 under Regulation 8(4) of the Regulations. 10. Declaration of Solvency and an affidavit verifying the same as per Form 4A of the Companies (Central Government’s) General Rules and Forms, 1956.

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Investment Banking

11. Copy of Public Announcement dated December 7, 2002 made by the Company as per Regulation 8(1) of the Regulations. 12. Observation letter Ref.___ dated ___ issued by SEBI. 13. Escrow confirmation letter dated December 9, 2002 from Global Trust Bank, Mylapore Branch, and Chennai. 14. Memorandum of Understanding signed by the Company with the Manager to the Offer, namely, Meghraj Financial Services (India) Pvt. Ltd.

XIII. Procedure for Tender/Offer and Settlement 1. General Instructions (i). The Offer is open to all shareholders of the Company. The Letter of Offer and Tender/ Offer Form will be mailed to all the shareholders of the Company whose names appear on the Register of Members of the Company as on January 18, 2003. (ii). The Company will not accept any shares for Buy-back, in case of court restraints on transfer/sale of shares. (iii). The Company will consider all the shares tendered for Buy-back by shareholders, for acceptance under the Buy-back Offer, irrespective of whether the shareholder is registered with the Company as on the Specified Date or has obtained delivery after the Specified Date or he holds the shares in street name. In case the tenderer is an unregistered shareholder, he should submit the transfer deed complete in all respects, along with the share certificates. Where the Tender/Offer forms are signed under Power of Attorney or by Authorised Signatory (ies) on behalf of a Company or a body corporate, the Power of Attorney/signing authority must be previously registered with the Company, as also the specimen signatures of the authorized signatory. Where the relevant document is not so registered, a copy of the same duly certified by a Notary Public/Gazetted Officer should be enclosed with the Tender/Offer form. (iv). The Company does not have any shares subject to lock-in provisions or which are non-transferable. Hence the question of the Company not buying back such shares as per Regulation 19(5) does not arise. (v). No single offeror can tender shares more than the shares proposed to be bought back and any Tender/Offer Form wherein the number of shares offered by a shareholder exceeds the total number of shares to be bought back will be rejected. (vi). The Company will not accept equity shares offered for buy-back where loss of share certificates has not been notified to the Company before the specified date. (vii). Shareholders may offer for buy-back their full holding or any part of their holding of equity shares of the company, as they desire. (viii). In the event of the aggregate number of shares offered by the shareholders are more

Appendix 4

1065

than the total number of shares to be bought back by the Company, the acceptances per shareholder shall be made as under: (a) Entire shares tendered by a shareholder being less than the minimum market lot shall be accepted in full and (b) Thereafter the acceptances will be on proportionate basis in a manner to ensure that the acceptance is in market lot. In the event of oversubscription drawl of lots shall be done. ix. Nothing contained herein shall confer any right on the part of any shareholder to offer, or any obligation on the part of the Company or the Board of Directors of the Company to buy-back any equity shares and/or impair any power of the Company or the Board of Directors of the Company to terminate the process in relation to the buyback, if so permissible by law. x. An unregistered transferee will have to submit duly executed transfer deed(s) for transfer of equity shares in his/her name along with the original broker note (or certified copy thereof), share certificates, tender/offer form. In case the equity share transfer form has been sent to the Company for transfer then the proof of posting along with the copy of the transfer deed, copy of equity share certificate(s) needs to be attached with the Tender/Offer Form.

Specific Instructions (i). Shareholders to whom this Offer is made are free to tender/offer their shareholding to the Company in whole or in part. (ii). Shareholders should tender one form irrespective of the number of folios held. Multiple Applications by a shareholder will be rejected. (iii). Shareholders of the Company who wish to tender/offer their shares in response to this Buy-back Offer should deliver the following documents: (a) The relevant Tender/Offer Form duly signed (by all shareholders in case the shares are in joint names) in the same order in which they hold the shares. (b) Original share certificates. (iv). Unregistered shareholders who wish to tender/offer their shares in response to the Buy-back Offer should send the application in plain paper signed by all shareholders, stating folio number, name, address, number of shares held, share certificate number, distinctive numbers, number of shares tendered for Buy-back, bank account details together with the original share certificates & duly executed transfer deed (complete in all respects) and other relevant documents (as mentioned in v below). (v). Shareholders should also provide all relevant documents in addition to the above documents. Such may include (but not limited to):

1066

Investment Banking (a) Duly attested Power of Attorney if any person other than the shareholder has signed the relevant Tender/Offer Form. (b) Duly attested death certificate/succession certificate in case any shareholder has expired. (c) Necessary corporate authorisations, such as Board Resolutions, etc., in case of companies.

(vi). Collection Centre: All responses to this Buy-back offer should be sent to the Registered Office of the Company by courier/registered post/hand delivery at 108, Thambu Chetty Street, Chennai 600 001 so as to reach before 5.30 p.m. on or before March 5, 2003. Consideration will be paid by crossed account payee demand draft/pay order/warrant to those shareholders whose offer has been accepted by the Company. The demand draft/pay order/ warrant will be drawn in the name of the first named person in case of joint shareholders. The intimation regarding acceptance or non-acceptance of the shares and the corresponding payment for the accepted shares and/or share certificates for the rejected shares will be despatched to shareholders by Registered Post by March 22, 2003. (vii). It is mandatory for shareholders to indicate the bank account details to which the consideration would be payable at the appropriate place in the Tender/Offer Form. (viii). Non-receipt of this Letter of Offer by, or accidental omission to despatch the Letter of Offer to any person who is eligible to receive this Offer, shall not invalidate the Offer in any way. In case of non-receipt of this Letter of Offer, shareholders may send their application in plain paper signed by all shareholders, stating folio number, name, address, number of shares held, share certificate number, distinctive numbers, number of shares tendered for Buy-back, bank account details together with the original share certificates and other relevant documents (as mentioned in iii & v above) to the Registered Office of the Company before 5.30 p.m. on or before March 5, 2003. (ix). All documents/remittances sent by or to shareholders will be at their own risk. Shareholders of the Company are advised to adequately safeguard their interests in this regard.

XIV. Extract of the Explanatory Statement Annexed to the Notice Sent to the Shareholders for Passing the Buy-Back Resolution by Postal Ballot 1. The Board of Directors of the Company at their meeting held on October 31, 2002 considered and approved the proposal for buy back of its shares by the Company, as authorized by Article 49 A of the Articles of Association of the Company. 2. The maximum price at which the buy back of the shares shall be made is at Rs.35/- per share.

Appendix 4

1067

3. The shares of the Company is listed on the Madras Stock Exchange (MSE), Chennai. At present there is limited trading of the shares on the Stock Exchange. The rationale behind listing is to provide liquidity to the shareholders by enabling them to buy/sell the shares on the Stock Exchanges. Such liquidity is not available to the shareholders due to limited trading in the shares. The Company intends to provide liquidity to the existing shareholders, through this buy back offer, to provide them an exit route. 4. The Company will adopt the “Tender Offer method” to buy back the shares of the Company on a proportionate basis from the existing shareholders. 5. A maximum amount of Rs. 346.50 lakhs is required to finance the buy back of the shares of the Company and the same is proposed to be financed from internally generated funds. This amount does not exceed 25% of the paid-up share capital and free reserves of the Company as per the audited results as on March 31, 2002. 6. The buy back is expected to be completed in 12 months’ time as permitted under the Companies Act, 1956 although the Company will endeavor to complete the process at an early date. 7. The basis of arriving at the maximum buy back price is the last quoted market price of equity shares of the Company. The last quoted price of the share on MSE was Rs. 18/- per share on October 24, 2002. The maximum buy back price of Rs.35/- is at a premium of 94.4% over the aforesaid price. 8. The Company intends to acquire a maximum of 9,90,000 equity shares of Rs.10/- each constituting 25% of the fully paid up equity share capital of the Company, at a price not exceeding Rs.35/- per share involving a maximum outlay of Rs. 346.50 lakhs (which does not exceed 25% of the paid up share capital and free reserves of the company as on March 31, 2002), from the shareholders other than the promoters. 9. (a) The aggregate shareholding of the promoters/persons in control of the company as on the date of the notice is 22,14,701 equity shares of Rs. 10/- each constituting about 55.92 % of the issued, subscribed and paid up equity share capital of the company. (b) The promoters have purchased 1,02,685 equity shares during the period of six months preceding the date of the Board Meeting at which the Buy-back was approved and from the date of the Board Meeting till the date of Notice convening the Extra-ordinary General Meeting. The maximum and minimum price at which the shares were purchased was Rs. 18/- per share on various dates, the latest date was October 24, 2002. The promoters have not sold any equity shares during the said period. 10. The promoters and/or persons in control of the company would not be participating in this buy back, excepting for some relatives of the promoters, holding an aggregate of 54,800 equity shares, who retain the option of participating in the buyback. 11. The Board of Directors confirm that there are no defaults subsisting in repayment of deposits, redemption of debentures or preference shares or repayment of term loans to any financial institutions or banks.

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Investment Banking

12. The Board of Directors confirm that based on a full enquiry conducted into the affairs and prospects of the company and taking into account all the liabilities including prospective and contingent liabilities payable as if the company were being wound up under the Companies Act, 1956, the Board of Directors have formed an opinion that: (a) Immediately following the date on which the Extra-ordinary General Meeting of the company is held, there are no grounds on which the company could be found unable to pay its debts. (b) As regards its prospects for the year immediately following the date of the Extraordinary General Meeting having regard to their intentions with respect to the management of the company’s business during the said year and to the amount and character of the financial resources which will be available to the company during the said year, the company will be able to meet its liabilities as and when they fall due and will not be rendered insolvent within a period of one year from that date.

AUDITORS REPORT October 31, 2002 The Board of Directors S.R.P. Tools Limited 108, Thambu Chetty Street Chennai 600 001 Sirs , Sub: BUY BACK OF EQUITY SHARES This is to certify that (i) We have inquired into the Company’s state of affairs. (ii) The amount of the permissible capital payment for the securities in question is in our view properly determined as on March 31, 2002 are as follows: Rs. (lakhs) Paid up Capital Free Reserves Total of the above 25% of the above (Permissible limit)

396.00 1044.13 1440.13 360.03

Appendix 4

1069

Further, we certify that the proposed buyback of 9,90,000 equity shares at Rs.35/- per share aggregating to Rs. 346.50 lakhs is within the above permissible limit. (i) The Board of Directors have formed the opinion on October 31, 2002, as specified in their confirmation in the Explanatory Statement attached to Notice convening Extraordinary General Meeting pursuant to Sec.173(2), on reasonable grounds and that the company having regard to its state of affairs will not be rendered insolvent within a period of one year from December 7, 2002 being the date of Extra-ordinary General Meeting. Yours faithfully, For M.C. Ranganathan & Co. Chartered Accountants

XV. Declaration by The Board of Directors As required under Clause 23 of Schedule III to the Securities and Exchange Board of India (Buy-back of Securities) Regulations, 1998, we hereby declare that: (i). The Board of Directors confirm that there are no defaults subsisting in repayment of deposits, redemption of debentures or preference shares or repayment of term loans to any financial institutions or banks. (ii). The Board of Directors confirm that based on a full enquiry conducted into the affairs and prospects of the Company and taking into account all the liabilities including prospective and contingent liabilities payable as if the Company were being wound up under the Companies Act, 1956, the Board of Directors have formed an opinion that (a). Immediately following the date of the Letter of Offer, there are no grounds on which the Company could be found unable to pay its debts. (b). As regards its prospects for the year immediately following the date of the Letter of Offer that, having regard to their intentions with respect to the management of the Company’s business during the said year and to the amount and character of the financial resources which will be available to the Company during the said year, the Company will be able to meet its liabilities as and when they fall due and will not be rendered insolvent within a period of one year from that date. This declaration is made and issued under the authority of the Board of Directors in terms of the resolution passed at the meeting held on December 7, 2002. Date: December 7, 2002 Place: Chennai

For and on behalf of the Board of Directors of S.R.P. Tools Limited S. Rm. Pl. Subramanian (Chairman & Managing Director), S.Ramanathan (Managing Director)

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XVI. Compliance Officer & Investor Service Centre i. Compliance Officer Mr. J. Sridhar Vice President (Finance) & Secretary S.R.P. Tools Limited 108, Thambu Chetty Street Chennai 600 001 Phone: 044-5234429/4430; Fax: 0484-5268373 E-mail: [email protected] ii. Investor service centre Registered Office: 108, Thambu Chetty Street Chennai 600 001 Phone: 044-5234430; Fax: 044-5268373 Contact Person: Mr. R. Parthasarathy The Compliance Officer/ Investor Service Centers can be contacted between 9.30 a.m. and 5.30 p.m. on all working days (Monday to Saturday).

XVII. Remedies Available to The Investors 1. If the Company makes any default in complying with the provisions of Section 77A of the Act or any rules made hereunder, or any regulation made under clause (f) of subsection (2) of Section 77A, the Company or any officer of the Company who is in default shall be punishable with imprisonment for a term which may extend to two years or with a fine which may extend to Rs. 50,000 or both. 2. The address of the concerned office of the Registrar of Companies is Shastri Bhavan, Haddows Road, Chennai 600 006. As per Regulation 19(1)(a) of the Regulations, the Directors of the Company accept full responsibility for the information contained in the Letter of Offer. This Letter of Offer is issued under the authority of the Board of Directors in terms of the resolution passed by the Board on December 7, 2002.

Place: Chennai Date:

For and on behalf of S.R.P. Tools Limited S. Rm. Pl. Subramanian (Chairman & Managing Director) S. Ramanathan (Managing Director)

Appendix 5

BRITANNIA INDUSTRIES LIMITED REGD. OFFICE: 5/1A Hungerford Street, Kolkata, West Bengal 700 017 PUBLIC ANNOUNCEMENT FOR THE ATTENTION OF THE SHAREHOLDERS/BENEFICIAL OWNERS OF EQUITY SHARES OF THE COMPANY

[This public announcement is in compliance with the Securities and Exchange Board of India (Buyback of Securities) Regulations, 1998] Offer for Buy-back of Equity Shares from Open Market through Stock Exchanges

The Offer Britannia Industries Limited (“Britannia” or “the Company”) hereby announces the Buy-Back (the “Buy-Back”) of its fully paid up equity shares of the face value Rs. 10/- each (“Shares”) from the existing owners/beneficial owners of the Shares of the Company from the open market through stock exchange using the electronic trading facilities of The Stock Exchange, Mumbai (“BSE”) and the National Stock Exchange of India Limited (“NSE”) (together as “Stock Exchanges”) in accordance with Section 77A and 77B of the Companies Act, 1956 (the “Act”) and the Securities and Exchange Board of India (Buyback of Securities) Regulations, 1998 (the “Buyback Regulations”) for a maximum of up to 25,00,000 Shares at a price not exceeding Rs. 650/- per equity share (“Maximum Buyback Price”) payable in cash for an aggregate amount not exceeding Rs. 920 mn (Rupees Nine Hundred and Twenty million only) (“Buy-Back Size”). The Buyback Size represents 24.97% of the aggregate of the Company's paid up equity capital and free reserves as on March 31, 2002. The maximum number of Shares to be bought back i.e. 25,00,000 Shares, represent 9.31% of the paid up equity capital of the Company. The number of Shares finally bought back would depend on the average price paid for the Shares bought back and the amount deployed in the Buyback. However, the maximum number

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Investment Banking

of Shares to be bought back is limited to 25,00,000 Shares and the amount to be deployed in the Buyback is limited to Rs. 920 mn. As an illustration, at the Maximum Buyback Price and for an aggregate amount Rs. 920 mn deployed, the number of Shares bought back would be 14,15,384 which would amount to approximately 5.27% of the pre-buyback paid up equity share capital of the Company. Should the average price be lower than Rs. 650/- per Share, the number of Shares bought back would be more, assuming the deployment of an aggregate amount of Rs. 920 mn. Hence there is no specific minimum number of Shares that the Company proposes to buy back.

Authority for the Buyback Pursuant to Section 77A and 77B and other applicable provisions of the Act, the Buyback Regulations, and the relevant provisions in the Articles of Association of the Company, the present Buyback from the open market through Stock Exchanges has been duly authorised by: (a). A resolution passed by the Board of Directors of the Company (the “Board”) at their meeting held on June 4, 2002. (b). A special resolution passed by Shareholders of the Company through postal ballot, the result of which was declared at the Annual General Meeting of the Company held on August 06, 2002. (c). A resolution passed by the Board of Directors of the Company at their meeting held on August 06, 2002.

Brief Information about the Company a. Brief History Britannia Biscuit Company Limited (BBCo), a company manufacturing and selling biscuits, was incorporated on March 21, 1918, though the company was operating under the name of V.S. Brothers since 1897. The brand “Britannia” was used to sell these biscuits. Hence the brand “Britannia” is now over 83 years old. The Peak Frean Co. (UK) acquired a controlling stake in BBCo in 1924. BBCo got its major push by supplying high protein biscuits to the defence forces in World War II and this provided a boost to the company’s growth. The Company, over time, has established its own manufacturing plants in the four metros and at present is one of the large Bakery companies in India. In 1978 BBCo went public and changed its name to Britannia Industries Limited in 1979. In 1982, Nabisco Brands Inc., USA become a major foreign shareholder. Since 1993, the controlling interest in the Company is held jointly between the Wadia Group of India and Groupe Danone of France.

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1997 saw the diversification of the Company into Dairy products. This was along with the launch of the new corporate logo “Eat Healthy Think Better”. Consequent to this, the Company was positioned as a comprehensive Food and Beverage Company with sales crossing Rs. 14.5 billion for FY2002. In March 2002, the Company transferred the Dairy business to Britannia New Zealand Foods Private Limited, a joint venture with Fonterra Co-operative Group of New Zealand. The Company also concluded a Buyback of its shares during FY2002. b. Present Operations Britannia Industries Limited currently operates in the Bakery industry. Whereas the Registered Office of the Company has always been located at Kolkata, the Corporate Office has been in Bangalore since 1989. Britannia is one of the large players in the biscuit market in the country with a sales of over 2,28,000 tonnes of biscuits in FY2002. Some of the brands of the Company are “Tiger” “Good Day”, “Mariegold”, “Little Hearts”, “Maska Chaska” and many more. The Company also makes Bread and Cakes as part of its Bakery business. In addition to its domestic sales, the Company is also concentrating on exports of its Bakery products—which are exported to a number of our neighbouring countries and even, in a small way, to Western markets. c. Brief Financial Information of the Company The audited financial information on the company for the last three financial years and unaudited figures for the three months ended June 30, 2002, is given below: (Rs. million) For the Year/Period ended on

30/06/2002 (3 months)*

31/03/2002

31/03/2001

31/03/2000

Sales

3265.8

14509.8

13325.2

11698.4

Total Income

3275.9

14754.0

13486.4

11857.5

369.5

2975.1

1429.2

1015.9

28.2

144.0

100.9

73.2

PBDIT Interest Expenses Depreciation

63.0

240.1

188.9

171.8

PBT

278.3

2591.0

1139.4

770.9

PAT

187.0

2031.7

705.4

510.2

Paid up Equity Share Capital

—

268.5

278.5

278.5

Reserves and Surplus

—

3429.8

2122.7

1586.1

Networth

—

3481.3

2238.3

1742.9

Total Debt

—

1846.7

1762.6

1098.3

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Investment Banking

Book Value per share (Rs.)

—

129.7

80.4

62.6

EPS (Rs.)

—

75.7

25.3

18.3

Debt Equity Ratio

—

0.53

0.79

0.63

Return on Networth (%)

—

58.4

31.5

29.3

*Unaudited figures.

Definitions Networth = Equity Share Capital + Reserves and Surplus (excluding revaluation reserves) – Miscellaneous Expenditure (to the extent not written off) Book Value per Share = (Networth)/(No. of Shares outstanding at the year end) EPS (Earnings per Share) = (Profit after Tax)/(No. of Shares outstanding at the year end) Debt Equity Ratio = (Total Debt)/(Networth) Return on Networth = (Profit after Tax)/(Networth) Listing Details and Stock Market Data (a). The Company's shares are listed on Calcutta Stock Exchange Association Limited (regional stock exchange), BSE, NSE, the Bangalore Stock Exchange Limited and Cochin Stock Exchange Limited. (b). High, low and average market prices for last three years and monthly high, low and average market prices for seven months preceding the announcement of the offer and their corresponding volumes on BSE and NSE, where the Shares of the Company are more frequently traded, are as follows: The Stock Exchange, Mumbai Year/Period

High Price (Rs .)

1999 01/01/1999 to 26/09/1999 27/09/1999 to 31/12/1999 2000

Date and the no. Low Price of shares traded (Rs .) on the day of High Price

Date and the no. Average Price of shares traded (Rs .) on the day of Low Price

Volume (number of equity shares traded)

(Ex-Bonus trading from 27/09/1999) 1710.40 1086.00 911.10

2001

820.00

January, 2002

616.75

February, 2002

600.00

23/09/1999 26748 27/09/1999 5220 10/01/2000 37624 14/02/2001 108298 10/01/2002 487 28/02/2002 7096

868.00 695.00 468.00 485.55 573.00 548.00

11/01/1999 38871 30/12/1999 11965 07/03/2000 36788 17/09/2001 1446 25/01/2002 6018 21/02/2002 83116

1289.2* 890.5*

4655484

675.96

3641928

730.09

1106514

589.51

112054

565.82

413378

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Appendix 5 March, 2002

570.00

April, 2002

552.00

May, 2002

550.00

June, 2002

558.00

July, 2002

531.95

01/03/2002 23967 02/04/2002 12569 03/05/2002 1538 05/06/2002 2849 12/07/2002 36647

525.00 522.00 505.00 505.05 505.00

20/03/2002 7783 11/04/2002 27808 20/05/2002 4004 27/06/2002 30684 31/07/2002 712

538.27

236325

537.55

158317

538.07

133341

518.16

113405

519.09

145573

Source: BSE, www.bseindia.com *arithmetic average of high and low price.

The National Stock Exchange Year/Period

High Price (Rs.)

1999

Date and the no. of shares traded on the day of High Price

Low Price (Rs.)

Date and the no. Average Price of shares traded (Rs.) on the day of Low Price

Volume (number of equity shares traded)

(Ex-Bonus trading from 22/09/1999)

01/01/1999 to 21/09/1999

1650.00

21/04/1999 33400

867.00

05/01/1999 8000

1310.71

2286943

22/09/1999 to 31/12/1999

1264.00

24/09/1999 24446

692.00

30/12/1999 6318

860.00

802434

2000

920.00

11/01/2000 20635

705.00

03/01/2000 7512

842.90

250309

2001

824.00

01/01/2001 6141

460.00

24/09/2001 3298

273.64*

2197556

January, 2002

614.00

01/01/2002 2238

568.00

31/01/2002 16398

591.00*

124144

February, 2002

598.00

01/02/2002 15484

536.05

04/02/2002 2284

581.50*

124144

March, 2002

583.90

04/03/2002 4611

521.00

28/03/2002 3414

552.45*

159888

April, 2002

555.00

02/04/2002 2653

522.75

11/04/2002 16125

538.88*

74374

May, 2002

576.00

28/05/2002 6387

510.90

24/05/2002 2856

543.45*

79728

June, 2002

555.00

06/06/2002 7419

502.55

27/06/2002 2494

528.78*

124654

July, 2002

558.00

19/07/2002 3515

482.00

31/07/2002 3608

520.00*

112085

Source: NSE, www.nseindia.com *arithmetic average of high and low price.

(c). Notice of the Board Meeting convened to consider the proposal to buy-back a part of the Shares of the Company was given to the Stock Exchanges on May 20, 2002. The price of the Company's equity share on May 20, 2002 on BSE and NSE was Rs. 528.50 and Rs. 525.15, respectively. The Board at its meeting held on June 4, 2002 approved

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Investment Banking the proposal for buy-back up to 25,00,000 Shares at a price not exceeding Rs. 650/per Share for an aggregate amount not exceeding Rs. 920 mn. The closing market price as on June 5, 2002 i.e. immediately after the date of the Board resolution approving the buy-back on BSE and NSE was Rs. 538.35 and Rs. 539.85 respectively.

(d). In 1999, the Company issued bonus shares in the proportion of one bonus share for every two equity shares held. Ex-bonus trading commenced on the BSE from September 27, 1999 and on the NSE from September 22, 1999. The equity share price for the year 1999, is accordingly, split into two period segments: cum bonus and exbonus. The bonus shares were allotted on October 27, 1999.

Capital structure and Shareholding pattern (a). Issued and subscribed Equity Share capital of the Company comprises 2,68,50,450 equity shares of Rs.10 each fully paid-up. (b). The shareholding pattern of the Company as on August 6, 2002 is as under: Particulars of the Shareholders

Current Shareholdings No. of shares

Promoters and/or persons who are in control and/or acting in concert FIIs

Post Buy-Back Shareholdings*

% of the share capital

1,21,73,969

45.34

5,64,613

2.10

Indian Financial Institution (Banks, FIs)

48,81,420

18.18

Indian Mutual Funds

26,81,604

9.99

1,81,064

0.67

63,67,780

23.72

2,68,50,450

100.00

NRIs and OCBs Public and others Total

No. of shares

% of the share capital

1,21,73,969

47.86

1,32,61,097

52.14

2,54,35,066

100.00

(c). *Assumed that at a proposed maximum price of Rs. 650/- per Share and for an aggregate amount of Rs. 920 mn deployed, 14,15,384 Shares would be bought back. (d). There are no partly paid-up shares or outstanding convertible instruments. (e). There are no locked-in or non-transferable shares. (f). The Promoter group and the persons in control of the company hold a total of 1,21,73,969 Shares as on August 6, 2002. (g). Neither the Promoter group nor the persons in control of the Company have purchased or sold Shares of the Company during the 12 months preceding the date of this Public Announcement. (h). The promoters of the Company do not intend to tender shares in the Buyback.

Appendix 5

1077

Necessity for Buy-Back The Company currently has substantial reserves that are deployed in financial assets that yield returns below the desired rate of return for shareholders. The Company believes that it would keep generating enough cashflows to meet the requirements of the present business. In view of this, the Company intends to return surplus cash to its shareholders through the buyback process. This offers a reasonably fair exit opportunity to those shareholders who so desire, in a manner that does not substantially impact the market price of the Company’s Shares to the detriment of the continuing shareholders. Further, the Buyback is also expected to enhance the earnings per share of the company in future and create long term shareholder value. Maximum amount to be invested and sources of funds for Buy-Back. The shareholders of the Company have approved, through a postal ballot, the result of which was declared at the Annual General Meeting on August 06, 2002, the Buyback of a maximum of 25,00,000 Shares at a maximum price of Rs. 650/- per Share and maximum amount of Rs. 920 mn to be deployed for the purpose of Buyback. The funds for the buyback operation would be available from the cash surplus, current accruals and liquidation of financial assets of the Company. The Company does not intend to raise any debt for the purpose of financing the buyback and hence no cost of finance is involved.

Management Discussion on likely impact of the Buy-Back on the Company (a). Consequent upon buy-back of equity shares as proposed, the Company does not anticipate any significant change in the earnings from its business except to the extent of loss of investment income on the amount utilised for funding the Buyback. (b). The Buy-Back is expected to contribute to further improvement in the financial ratios and an overall enhancement of the shareholder value. (c). Post Buy-Back, the Debt Equity Ratio, assuming a deployment of Rs. 920 mn, will be within 2–1 as prescribed under section 77A of the Act. (d). The Promoter group and the people in control of the Company have informed the Company that they do not intend to participate in the Buyback. Consequent to the Buyback, and subject to the final response to the Buyback, the percentage holding of Promoter group would increase beyond 45.34%. The Buyback will not affect the present management structure of the Company. (e). The percentage holdings of the Non-Resident shareholders, Indian Financial Institutions, Banks, FIIs and Indian Public shareholders would undergo a change consequent to Buyback and based on the number of shares offered by/bought back from these shareholders.

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Statutory Approvals (a). The Company has obtained the permission from the Shareholders of the Company by a Special Resolution passed through a postal ballot, the result of which was declared at the Annual General Meeting held on August 6, 2002. (b). Buyback from Non-Resident shareholders will be subject to approval, if any, of the appropriate authority including the Reserve Bank of India, as applicable. Extract from the Explanatory Statement to the notice sent to the Shareholders convening the Annual General Meeting held on August 06, 2002 As required under the provisions of Section 77A(3) of the Companies Act, 1956 (“the Act”) and Regulation 5(1) of the Securities & Exchange Board of India (Buy-back of Securities) Regulations, 1998 read with Schedule I annexed thereto (“Buy-Back Regulations”), the following Explanatory Statement sets out the various details required to be disclosed. 1. The Board of Directors of the Company (“the Board”) at its Meeting held on 4th June, 2002 considered and approved the proposal for buy-back of up to a maximum of 25,00,000 equity shares (Two and a Half Million Equity Shares) of face value of Rs. 10 /- and outflow not exceeding Rs. 920 Million (Rupees Nine Hundred and Twenty Million) up to a price not exceeding Rs. 650 (Rupees Six Hundred and Fifty) per equity share (hereinafter referred to as “the buy-Back”) in accordance with the provisions contained in Article 57A of the Company’s Articles of Association and Section 77A and 77B and all other applicable provisions of the Act and the Regulations. 2. The Buy-Back proposal is being mooted in keeping with the Company’s desire to maximise returns to investors and enhance overall shareholder value by returning surplus cash to shareholders in an investor friendly manner. Also the buy-back is an efficient mechanism for providing an exit opportunity to those shareholders who so desire, in a manner that does not substantially impact the market price of the Company’s shares to the detriment of the continuing shareholders. Further, the buy-back is also expected to enhance the earnings per share of the Company in future and create long term shareholder value. 3. The Buy-Back is proposed to be implemented by the Company by the methodology of open market purchases through the Stock Exchanges in such manner as may be prescribed by the Act and under the Regulations, and on such terms and conditions as may be determined by the Board at a later date. The Company shall not Buy-Back its shares from any persons through negotiated deal whether on or off the Stock Exchanges or through spot transactions or through any private arrangements in the implementation of the Buy-Back. As an enabling provision, approval of the members is sought to empower the Board to resort to other permitted methodologies of implementing Buy-Back including tender route, subject to the Company fulfilling applicable statutory regulations. 4. The equity shares of the Company are proposed to be bought back at a maximum price not exceeding Rs. 650 (Rupees Six Hundred and Fifty) per equity share in terms of the above Resolution. This price has been arrived at after taking into consideration factors

Appendix 5

1079

such as the book value, the market value of the shares on the Stock Exchanges and the possible impact of the buy-back on the Company’s earnings per share. The market price as proposed above, while providing an option to the shareholders to sell their shares at a premium over the current market price, will ensure that the growth of the Company is not impaired in any way and that the value of the shares after the buy-back for the continuing shareholders is preserved. 5. The aggregate paid-up capital and free reserves of the Company as at 31st March, 2002 is Rs. 3684.54 Million and in accordance with the provisions of the Act, the maximum amount allowed to be utilised for implementing the buy-back is Rs. 921.13 Million representing 25% of the paid-up capital and free reserves of the Company. Further, as per the provisions of the Act, the maximum number of equity shares permitted to be bought back shall be 67,12,613 representing 25% of the total paid-up capital of the Company i.e. 2,68,50,450 equity shares of Rs. 10/- each aggregating to Rs. 268.5 million. The above resolution seeks the consent of the shareholders for the Board (including a Committee thereof) to determine the price and the number of equity shares to be bought back by the Company within the aforesaid limits. The funds required for the buy-back will be met out of the free reserves of the Company. The debt equity ratio of the Company after the buy-back will be well within the limit of 2:1 as prescribed under the Act. 6. (a) The aggregate shareholding of the Promoters and of the Directors of the Promoters where the Promoter is a Company and of the persons who are in the control of the Company (hereinafter collectively referred to as “the Promoters”) as on the date of this Notice is 1,21,73,969 equity shares constituting 45.34% of the issued share capital of the Company. (b) No shares were either purchased or sold by the Promoters during the period of six months preceding June 04, 2002, i.e. the date of the Board Meeting at which the buy-back was approved and the date hereof. 7. The Company shall not purchase shares under the Buy-back from the Promoters or persons in control of the Company. 8. As per the provisions of the Act, the Special Resolution passed by the shareholders approving the buy-back shall be valid for a maximum period of 12 months from the date of passing of the said Resolution. The Board shall determine the time frame for completion of the buy-back within this validity period. 9. In accordance with the regulatory provisions, the shares bought back by the Company will compulsorily be cancelled and will not be held for re-issue at a later date. 10. In terms of the provisions of Section 77A(8) of the Act, the Company will not be entitled to make a fresh issue of equity shares for a period of six months from the date of completion of the Buy-back envisaged under this Resolution except in cases/circumstances mentioned in the said Section.

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11. The Company confirms that there are no defaults subsisting in the repayment of deposits, redemption of debentures or preference shares or repayment of term loans to any financial institutions or banks. 12. The Board confirms: (i). that it has made the necessary and full enquiry into the affairs and prospects of the Company and has formed the opinion: (a). that immediately following the date on which the general meeting is convened, there will be no grounds on which the Company could be found unable to pay its debts; and (b). as regards its prospects for the year immediately following the date of the general meeting, that having regard to its intentions with respect to the management of the Company’s business during that year and to the amount and character of the financial resources which will, in the view of the Board be available to the Company during that year, the Company will be able to meet its liabilities as and when they fall due and will not be rendered insolvent within a period of one year from the date of the general meeting; and (ii). in forming its opinion for the above purposes, the Board has taken into account the liabilities as if the Company were being wound up under the provisions of the Companies Act, 1956 (including prospective and contingent liabilities). 13. The text of the Report dated June 04, 2002 received from Messrs. Lovelock & Lewes, the Statutory Auditors of the Company, addressed to the Board of Directors is reproduced below: “In connection with the proposed buy-back of Equity Shares approved by the Board of Directors of Britannia Industries Limited (‘the Company’) at its meeting held on 4th June 2002, in pursuance of the provisions of the Companies Act, 1956 and the Securities and Exchange Board of India (Buy-back of Securities) Regulations, 1998 and based on the information and explanations given to us, we report that: (i). We have enquired into the state of affairs of the Company in relation to its audited accounts for the year ended 31st March 2002, which were taken on record by the Board of Directors at their meeting held on 4th June 2002. (ii). The capital payment (including premium) of an amount not exceeding Rs. 920 Million towards the buy-back of equity shares has been properly determined in accordance with Section 77A(2)(c) and is within the permissible amount of 25% of the paid up equity capital and the free reserves of the Company, as computed below:

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Appendix 5

As on 31st March 2002 (Rs. in million) Share Capital Free Reserves: General Reserve Balance in Profit & Loss Account Capital Redemption Reserve

268.505 2906.038 500.000 10.000 3416.038 3684.543

Maximum amount permissible for buy-back i.e. 25% of the total paid up capital and free reserves

921.136

(iii). The Board of Directors in their meeting held on 4th June 2002 have formed their opinion, as specified in clause (X) of Schedule I of the Securities Exchange Board of India (Buyback of Securities) Regulations, 1998 on reasonable grounds and that the Company will not, having regard to its state of affairs, be rendered insolvent within a period of one year from the date of the Annual General Meeting of the Members of the Company proposed to be held on 6th August 2002.” 14. All the material documents referred to in the Explanatory Statement such as the Memorandum and Articles of Association, relevant Board Resolutions for the Buyback and the Auditors’ Report on their enquiry into the state of affairs of the Company are available for inspection by the shareholders at the Registered Office of the Company on any working day (except Saturdays, Sundays and Public Holidays) between 11.00 a.m. and 1.00 p.m. up to July 30, 2002. 15. As the proposed buy-back will be in the interest of the Company, the Directors recommend the passing of the resolution as set out herein above. 16. None of the Directors are in any way concerned or interested either directly or indirectly in this Resolution except to the extent that in like manner as for all other shareholders, their percentage holding in the post buy-back equity share capital of the Company shall proportionately stand enhanced consequent upon the buy-back.

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Proposed Time Table

Milestone

Time Frame

Date of opening of the buyback

Not earlier than September 05, 2002

Acceptance of Shares

Within 15 days of the relevant pay out dates of the Stock Exchanges

Extinguishment of Shares

Within 7 days of acceptance as above

Last date for the Buyback

August 05, 2003 or earlier as may be decided by the Board of Directors of the Company

Process and Methodology to be adopted for Buy-Back: (a). The Buy-Back is open to all shareholders/beneficial owners of the Shares except promoters and persons in control of the Company. (b). The Company proposes to affect the Buyback from the open market through the stock exchanges with electronic trading facility. The Company proposes to Buyback Shares on: NSE BSE (c). For the aforesaid Buyback, the Company has appointed the following brokers (“Brokers”) through whom the purchases and settlement on account of the Buyback would be made � �

�

�

�

Investsmart India Limited (8th Floor, The IL&FS Financial Centre, Plot C22, G Block, Bandra Kurla Complex, Bandra (East), Mumbai 400 051. Tel: 0226533333). Kotak Securities Limited (Bakhtawar, 1st Floor, 249 Nariman Point, Mumbai 400 021. Tel: 022-2341100, 2324747). SBI Capital Markets Limited (202 Maker Tower E, Cuffe Parade, Mumbai 400 005. Tel: 022-2189166, 2165247).

(d). The Buyback of shares will be made only through the order matching mechanism except “all or none” order matching system. (e). The Company from time to time, but not earlier than September 05, 2002, place “buy” orders on the BSE and/or NSE to Buyback Shares through Brokers, in such quantities and at such prices, not exceeding Rs. 650/- per Share, as it may deem fit, depending upon the prevailing quotations of the Shares in the secondary market. Intimation about the Company's presence in BSE and/or NSE to buyback its Shares will be made available to the respective Stock Exchanges.

Appendix 5

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(f). Shareholders/beneficial owners, who desire to sell their shares under the Buyback, would have to do so through a stock broker, who is a member of BSE and/or NSE, whenever the company has placed a buy order for buyback of shares by indicating to their broker the details of the shares they intend to sell. The trade will be executed at the price at which the order matches and that price will be the price for that seller. It may be noted that all the Shares bought back by the Company may not be at a uniform price and that there shall be no obligation on the Company to place a “buy” order either on a daily basis or in both the odd lot as well as the normal trading segment of both the Stock Exchanges or otherwise. (g). The Shares of the Company are traded in the compulsory demat mode. Shareholders holding physical Shares can sell their Shares in the odd lot trading segment of the Stock Exchanges, if and when the Company places an order in that segment. (h). Nothing contained herein shall confer any right on the part of any shareholder to the offer, or any obligation on the part of the Company or the Board to buy back any Shares and/or impair any power of the Company or the Board to terminate any process related to the Buyback, if so permissible by law. Method of Settlement (a). The Company will pay the buyback consideration to the Brokers on every settlement date as applicable in respect of the Shares bought back. (b). The shareholders/beneficial owners holding shares in the demat form would be required to transfer the number of Shares sold by tendering the delivery instruction to their respective Depository Participant (“DP”) for debiting their beneficiary account maintained with the DP and crediting the same to the pool account of the broker through whom the trade was executed. Shareholders/beneficial owners holding the share in physical form may present their Share certificates along with valid transfer deeds to their respective brokers through whom the trade was executed. (c). The Company has opened a Depository Account styled “Britannia Industries Ltd— Buy-Back of Equity Shares” with Infrastructure Leasing and Financial Services Limited. The Shares bought back in the demat form would be transferred into the aforesaid account by the Brokers on receipt of the shares after the clearing and settlement mechanism of BSE and NSE. (d). The Shares lying in credit in the aforesaid account will be periodically extinguished, within 7 days from the date of acceptance of the shares, in the manner specified in the Buyback Regulations. In respect of the Shares bought in the physical form, the shares would be extinguished and the share certificates physically destroyed within 7 days of the acceptance of the Offer in the manner specified in the Buyback Regulations. The details of the Shares extinguished would be notified to the stock exchanges on which the Shares are listed and traded and to the Securities and Exchange Board of India as per the provisions of the Buy-Back Regulations.

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Investment Banking

Compliance Officer and remedies for investor protection Mr. Ravi Mannath Company Secretary Britannia Industries Limited Britannia Gardens, Airport Road, Vimanapura, Bangalore 560 017 Tel: 91-80-5278585 Fax: 91-80-5266063 E-mail: [email protected] Investor may contact the compliance officer for any clarification or address their grievances, if any, during the office hours i.e. 10.00 a.m. and 5.00 p.m. on all working days except holidays.

Investors Service Centres Britannia Industries Limited 5/1 A, Hungerford Street Kolkata 700 017 Tel: 033-2472439/2057 Fax: 033-2472501 Britannia Industries Limited Britannia Gardens, Airport Road, Vimanapura Bangalore 560 017 Tel: 080-5278585 Fax: 080-5263265 Manager to the Offer The Company has appointed Investsmart India Limited as Manager to the Offer. Their contact details are: Investsmart India Limited 8th Floor, The IL&FS Financial Centre Plot C-22, G-Block, Bandra Kurla Complex Bandra (E), Mumbai 400 051 Tel: 022-6533333 Fax: 022-6533093 E-mail: [email protected]

1085

Appendix 5 Directors’ Responsibility

As per the Regulations 19(1)(a) of the SEBI (Buyback of Securities) Regulations, 1998, the Directors of the Company accept full and final responsibility for the information contained in this Public Announcement. For and on Behalf of the Board of Directors of Britannia Industries Limited Director

Managing Director

Appendix 6

SCHEME OF AMALGAMATION Of ICICI LIMITED ICICI CAPITAL SERVICES LIMITED ICICI PERSONAL FINANCIAL SERVICES LIMITED Collectively the Transferor Companies With ICICI BANK LIMITED………………….. THE TRANSFEREE COMPANY

PART I GENERAL 1. This Scheme of Amalgamation (hereinafter refereed to as the “Scheme”) provides for the amalgamation of ICICI Lim9ited, ICICI Capital Services Limited and ICICI Personal Financial Services Limited (both ICICI Capital Sevices Limited and ICICI Personal Financial Services Limited, are wholly-owned subsidiaries of ICICI limited) with ICICI Bank Limited pursuant to Sections 391 to 394 and other relevant provisions of the Act. 2. In this Scheme, unless repugnant to the meaning or context thereof, the following expressions shall have the following meanings: “Act” means the Companies Act, 1956 or any amendment or re-enactment thereof. “ADRs” means American depositary receipts issued pursuant to the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanisam) Scheme, 1993 together with any modifications thereto and other applicable laws and where relevant shall include the underlying equity shares relating thereto. “Appointed Date” means the later of (i) March 30,2002 and (ii) the date on which the approval of the Reserve Bank of India for the Scheme becomes effective.

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Investment Banking

“Assets” or “Undertaking” means all the undertakings, the entire businesses, all the properties (whether movable or immovable, tangible or intangible), assets deposits, investments of all kinds (including shares, scripts, stocks, bonds, debentures, debenture stock, units or pass through certificates), all cash balances with the Reserve Banks of India and other banks, money ar call and short notice, loans , advances, contingent rights or benefits, lease and hire purchase contracts and assets, securitised assets, receivables, benefit of assets or properties or other interest held in trust, benefit of any security arrangements, authorities, allotments, approvals, reversions, buildings structures, office, residential and other premises, tenancies, leases, licenses, fixed and other assets, powers, consents, authorities, registrations, agreements, contracts, engagements, arrangements of all kinds, rights, titles, interests, benefits and advantages of whatsoever nature and wheresoever situate belonging to or in the ownership, power or possession or in the control of or vested in or granted in favour of or held for the benefit of or enjoyed by the Transferor Companies or to which the Transferor Companies may be entitled and include but without being limited to trade and service names and marks and other intellectual property rights of any nature whatsoever, permits, approvals, authorizations, rights to use and avail of telephones, telexes, fasmile, email, internet, leased line connections and installations, utilities, electricity and other servies, reserves, provisions, funds, benefits of all agreements, all records, files, papers, computer programmes, manuals, data, catalogues, sales and advertising materials, lists and other details of present and former customers and suppliers, customers credit information, customer and supplier pricing information and other records in connection with or relating to the Tranferor Companies and all other interest of whatsoever nature belonging to or in the ownership, power, possession or in the control of or vested in or granted in favour of or held for the benefit of or enjoyed by the Transferor Companies, whether in India or abroad. “Deposit Agreement” shall have the meaning ascribed to it in Clause 17(a). “Depositary” shall have the meaning ascribed to it in Clause 17(a). “Effective Date” means the last of dates on which all conditions, matters and filings referred to in Clause 26 hereof have been fulfilled and necessary orders, approvals and consents referred to therein have been obtained. References in this Scheme to the date of “coming into effect of this Scheme” or “effectiveness of this Scheme” shall mean the Effective Date. “ICICI” means ICICI Limited, a company incorporated under the Indian Companies Act, 1914 and having its registered office at ICICI Towers, Bandra-Kurla Complex, Mumbai 400 051,Maharashtra. “ICICI Bank”or the “Transeree Company” means ICICI Bank Limited, a company incorporated under the Companies Act,1956 and licenses by the Reserve Bank of India under the Banking Regulation Act, 1949 and having its registered office at Landmark, Race Course Circle, Vadodara 390 007, Gujarat. “ICICI Bank Shares” shall have the meaning ascribed to it in Clause 8.

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1089

“ICICI Capital” means ICICI Capital Services Limited, a Company incorporated under the Companies Act, 1956, and having its registered office at ICICI Towers, Bandra-Kurla Complex, Mumbai 400 051, Maharashtra. “ICICI PFS” means ICICI Personal Financial Services Limited, a Company incorporated under the Companies Act, 1956, and having its registered office at ICICI Towers, Bandra-Kurla Complex, Mumbai 400 051, Maharashtra. “ICICI Stock Options” shall have the meaning ascribed to it in Clause 9(b)(i). “Joint Committee” shall the meaning ascribed to in Clause 72 (a). “Members” shall have the meaning ascribed to it in Clause 13(a). “Liabilities” shall have the meaning ascribed to it in Clause 5(a). “Pleged Documents” shall have the meaning ascribed to it in Clause 4(e). “Prefernce Shares” shall have the meaning ascribed to it in Clause 13(e) “Record Date” shall have the meaning ascribed to it in Clause 13(a) “Securities Act” shall have the meaning ascribed to it in Clause 17(b) “Security Trustee” shall have the meaning ascribed to it in Clause 4(e). “Share Exchange Ratio” shall have the meaning ascribed to it in Clause 13(a) “Transferor Companies” means collectively ICICI,ICICI Capital and ICICI PFS and “Transferor Companies”, means individually each of them. “Transferor Companies’ Securities” shall have the meaning ascribed to it in Clause 5(d). “Trust” shall have the meaning ascribed to it in Clause 8. “Trust Deed” shall the meaning ascribed to it in Clause 8. “Trustees” shall have the meaning ascribed to it in Clause 8.

PART II SHARE CAPITAL 3. (a) The share capital of ICICI as of September 30, 2001 is as under:

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Investment Banking

AUTHORISED

(IN RUPEES)

1,600,000,000 Equity Shares of Rs.10/- each

1600,00,00,000

5,000,000,000 Preference Shares of Rs.10/- each

5000,00,00,000

350 Preference Shares of Rs.10,000,000/- each

350,00,00,000 6950,00,00,000

ISSUED, SUBSCRIBED AND PAID-UP 785,345,448 Equity Shares of Rs.10/- each fully paid-up Less: Calls in arrears

785,34,54,480

48,29,648,19 784,86,24,831.81

3500.001% Preference Shares of Rs.1,00,00,000/- each fully paid-up redeemable at par on April 20, 2018

350,00,00,000

Of the Above (i) 6,750,000 Equity Shares are allotted as fully paid up by way of bonus shares by capitalization of General Reserve. (ii) 222,534,943 Equity Shares are allotted as fully paid up by conversion of Debentures/Loans into Equity shares (including 9,798,327 Equity Shares on conversion of loans of erstwhile SCICI Ltd.). (iii) 69,184,024 Equity Shares are allotted as fully paid up towards consideration for amalgamation of erstwhile SCICI Ltd with ICICI. (iv) 2,395,205 Equity Shares are allotted as fully paid up towards consideration for amalgamation of erstwhile ITC Classic Finance Limited with ICICI.

1091

Appendix 6

(v) 1,657,061 Equity Shares are allotted as fully paid up towards consideration for amalgamation of erstwhile Anagram Finance Limited with ICICI. (vi) 256,414,285 (including 96,700,000 Equity Shares represented by Global Depositary Receipts which were converted into American Depositary Shares) Equity Shares are allotted as fully paid up represented by American Depositary Shares through an international offering in US Dollars.

(b) The Share capital of ICICI Capital as of September 30, 2001 is as under: AUTHORISED 5,000,000 Equity Shares of Rs.10/- each

(IN RUPEES) 5,00,00,000

ISSUED, SUBSCRIBED AND PAID UP 5,000,000 Equity Shares of Rs. 10/- each fully paid up

5,00,00,000

(c) The Share capital of ICICI PFS as of September 30, 2001 is as under: AUTHORISED

(IN RUPEES)

150,000,000 Equity Shares of Rs. 10/- each

150,00,00,000

ISSUED, SUBSCRIBED AND PAID UP 5,000,000 Equity Shares of Rs. 10/- each fully paid up

5,00,00,000

(d) The Share capital of the Transferee Company as of September 30, 2001 is as under: AUTHORISED

(IN RUPEES)

3000,000,000 Equity Shares of Rs. 10/- each

3000,00,00,000

ISSUED, SUBSCRIBED AND PAID UP 220,358,680 Equity Shares of Rs. 10/- each fully paid up

220,35,86,800

Of the above 23,539,800 Equity Shares are allotted as fully paid up towards consideration for amalgamation of erstwhile Bank of Madura Limited with the ICICI Bank.

1092

Investment Banking PART III TRANSFER AND VESTING

4. Upon the coming into effect of this Scheme and with effect from the Appointed Date and subject to the provisions of this Scheme: (a) The Undertaking of the Transferor Companies shall, pursuant to the provisions of Section 394(2) of the Act, without any further act, instrument or deed, be and stand transferred to and vested in or be deemed to have been transferred to and vested in the Transferee Company as a going concern so as to become as and from the Appointed Date, the estate, assets, rights, title, interest and authorities of the Transferee Company. (b) Without prejudice to sub clause (a) above, in respect of such of the assets of the Undertaking as are movable in nature or are otherwise capable of transfer by manual delivery or by endorsement and/or delivery, the same may be so transferred by the Transferor Companies, and shall, upon such transfer, become the property, estate, assets, rights, titile, interest and authorities of the Transferee Company. (c) All the Licenses, permits , quotas, approvals, incentives, subsidies, rights, claims, leases, tenancy rights, liberties, rehabilitation schemes, special status and other benefits or privilages enjoyed or conferred upon or held or availed of by and all rights and benefits that have accrued to the Transferor shall, pursuant to th provisions of Section 394(2) of the Act, without any further act, instrument or deed, be and stand transferred to and vest in or be deemed to be transferred to and vested in and be available to the Transfereee Company so as to become as and from the Appointed Date the estates, assets, rights, title, interets and authorities of the Transferee Company and shall remain valid, effective and enforceable on the same terms and conditions to the extent permissible under law. (d) All assets, estate, rights, title, interest, licenses and authorities acquired by or quotas, approvals, incentives, subsidies, rights, claims, leases, tenancy rights, liberties, rehabilitation schemes, special status and other benefits or privileges enjoyed or conferred upon or held or availed of by and/or all rights and benefits that have accrued to the Transferor Companies after the Appointed Date and prior to the Effective Date in connection or in relation to the operation of the Undertaking shall, pursuant to the provisions of Section 394(2) of the Act, without any further act, instrument or deed, be and stand transferred to and vested or deemed to be transferred to and vested in the Transferee Company. (e) Such of the shares which have been pledged in favour of one or more of Transeferor Companies (the “Pledged Shares”), whether in their own name or as an agent or trustee, by third parties by way of security under the terms of the relevant agreements, documents and/or arrangements (collectively the “Pledge Documents”), shall, without any further act, instrument or deed be and stand transferred to ICICI Trusteeship Services Limited, a company incorporated under the Companies Act, 1956 and having its registered office at ICICI Towers, Bandra-Kurla Complex, Mumbai 400 051, Maharashtra who shall hold the Pledged Shares on trust as a trustee exclusively for the

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benefit of the persons for whose benefit the pledge has been creatd (ICICI Trusteeship Services Limited, hereinafter referred to as the “Security Trustee”), and all the rights, benefits and obligations of such Transferor Company as pledgee, agent or trustee under the Pledge Documents shall be and stand transferred to and vested in the Security Trustee, and the Pledge Documents shall continue to be in full force and effect and may be enforced as fully and effectually as if, instead of such Transferor Company, the Security Trustee had been a party thereto. The Security Trustee shall hold the Pledged Shares in trust for the benefit of the persons for whose benefit the pledge has been created and exercise all powers, trusts, authorities, duties and discretions as are specifically vested in the Security Trustee under the pledge Documents and such other rights, powers and discretions as are reasonable incidental thereto, on and subject to the instructions and directions issued by the person for whose benefit the pledge has been created, from time to time.

5. Upon the coming into effect of this Scheme and with effect from the Appointed Date: (a) All debts, including rupee and foreign currency loans, term deposits, time and demand liabilities, borrowings, bills payable, interest accrued and all other duties, liabilities, undertakings and obligations of the Transferor Companies (the “Liabilities”) shall, pursuant to the provisions of Section 394(2) of the Act, without any further act, instrument or deed be and stand transferred to and vested in or be deemed to stand transferred to and vested in, the Transferee Company so as to become the Liabilities of the Transfereee Company, and further that it shall not be necessary to obtain the consent of any person who is a party any contract or arrangement by virtue of which such Liabilities have arisen in order to give effect to the provisions of the Clause. (b) In case of such of the Liabilities or the documents governing such of the Liabilities where there is an obligation on one or more of the Transferor Companies to maintain any privilage or status specifically conferred by any statute or regulation, such obligation and related consequences thereof shall cease to be operative against the Transferee Company, and the relevant terms of the documents governing such Liabilities shall, without any urther act, instrument or deed, stand modified accordingly. (c) All public deposits, debentures or bonds of the Transferor Companies shall be kept distinctly identified in the record of the Transferee Company for all intents and purposes including taxation and accounting and shall not be combined with any exiting outstanding deposit scheme or series of debentures or bonds of the Transferee Company. (d) (i) All Debentures, bonds, notes or other securities of the Transferor companies, whether convertible into equity or otherwise, (the “Transferor companies’ Securities”), shall, pursuant to the provisions of Section 394(2) of the Act,without any further act, instrument or deed become securities of the Transferee Company and all rights, powers, duties and obligations in relation thereto shall be and stand transferred to and vested in or deemed to be transferred to and vested in and shall be exercised

1094

Investment Banking by or against the Transferee Company as if it were the Transferor Company in respect of the Transferor Companies’ Securities so transferred. If the Transferor Companies’ Securities are listed on any stock exchange, the same shall, subject to applicable regulations, be listed and/or admitted to trading on the relevant stock exchange/s whether in India or abroad,where the Transferor Companies’ Securities were listed and/or admitted to trading on the same terms and conditions unless otherwise modified in accordance with the provisions hereof.

(ii) Loans and other obligations (including any guarantees, letters of credit, letters of comfort or any other instrument or arrangement which may give rise to a contingent liability in whatever form), if any, due or which may at any time in future become due between or amongst the Transferor Companies and the Transferee Company shall stand discharged and there shall be no liability in that behalf on either party. Provided however, security over any moveable and/or immoveable properties and security in any other form (both present and future), if any, created by any person in favour of any one or more of the Transferor Companies for securing the obligation of the persons for and on whose behalf a guarantee, letter of credit, letter of comfort or other similar instrument has been executed or arrangements entered into by the Transferor Companies in favour of the Transferee Company shall, pursuant to the provisions of Section 394(2) of the Act, without any further act, instrument or deed stand vested in and be deemed to be in favour of the Transferee Company and the benefit of such security shall be available to the Transferee Company as if such security was ab initio created in favour of the Transferee Company. (iii) Any securities, debentures or notes, if any, issued by any one or more of the Transferor Companies, and held by the Transferee Company, and vice versa shall, unless sold or transferred by such Transferor Company or the Transferee Company, as the case may be, at any time prior to the Appointed Date or the Effective Date (whichever is later), stand cancelled as on the Effective Date, and shall be of no effect and such Transferor Company or the Transferee Company, as the case may be, shall have no further obligation outstanding in that behalf. (iv) Without prejudice to the provisions of clause (d)(ii) above, the guarantees, letters of credit, letters of comfort and other similar arrangements, if any, given or executed or made by ICICI in favour of, for the benefit of and on behalf of, ICICI Capital and/or ICICI PFS in favour of any person shall stand discharged.

(e) If the Effective Date occurs after the Appointed Date, the following provisions shall apply: (i) where any of the liabilities and obligations of the Transferor Companies as on the Appointed Date transferred to the Transferee Company have been discharged by the Transferor Companies after the Appointed Date and prior to the Effective Date, such discharge shall be deemed to have been for and on account of the Transferee Company; (ii) all loans raised and utilized and all debts, duties, undertakings, liabilities and obligations incurred or undertaken by the Transferor Companies in relation to or in

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connection with the Undertaking after the Appointed Date and prior to the Effective Date shall be deemed to have been raised, used, incurred or undertaken for and on behalf of the Transferee Company and to the extent they are outstanding on the Effective Date, shall, pursuant to the provisions of Section 394(2) of the Act, without any further act, instrument or deed be and stand transferred to or vested in or be deemed to be transferred to and vested in the Transferee Company and shall become the liabilities and obligations of the Transferee Company which shall meet, discharge and satisfy the same; and (iii) all estates, assets, rights, title, interests and authorities accrued to and/or acquired by the Transferor Companies in relation to or in connection with the Undertaking after the Appointed Date and prior to the Effective Date shall have been deemed to have been accrued to and/or acquired for and on behalf of the Transferee Company and shall, pursuant to the provisions of Section 394(2) of the Act, without any further act, instrument or deed be and stand transferred to or vested in or be deemed to be transferred to or vested in the Transferee Company to that extent and shall become the estates, assets, right, title, interests and authorities of the Transferee Company. 6. If the Effective Date occurs after the Appointed Date: (a) Each of the Transferor Companies with effect from the Appointed Date and upto and including the Effective Date: (i) shall carry on and shall be deemed to have carried on all the business and activities as hitherto and shall hold and stand possessed of and shall be deemed to have held and stood possessed of the Undertaking on account of, and in trust for, the Transferee Company; and (ii) all the profits or incomes accruing or arising to the Transferor Companies, or expenditure or losses arising or incurred (including the effect of taxes, if any, thereon) by the Transferor Companies shall, for all purposes, be treated and be deemed to be and accrue as the profits or incomes or expenditure or losses or taxes of the Transferee Company, as the case may be. (b) Each of the Transferor Companies with effect from the Appointed Date and upto and including the Effective Date shall carry on its business and activities with reasonable diligence and business prudence and shall not undertake financial commitments either for itself or on behalf of its subsidiaries or group companies or any third party, or sell, transfer, alienate, charge, mortgage or encumber the Undertaking or any part thereof, save and except in each case in the following circumstances: (i) if the same is in its ordinary course of business as carried on by it as on the date of filing of this Scheme with the High Court of Judicature at Bombay and the High Court of Gujarat at Ahmedabad; or (ii) if the same is expressly permitted by this Scheme; or (iii) if prior written consent of the Transferee Company has been obtained.

1096

Investment Banking

(c) The Transferee Company with effect from the Appointed Date and upto and including the Effective Date shall carry on its business and activities with reasonable diligence and business prudence and shall not undertake financial commitments either for itself or on behalf of its subsidiaries or group companies or any third party, or sell, transfer, alienate, charge, mortgage or encumber its undertaking or any part thereof, save and except in each case in the following circumstances: (i) if the same is in its ordinary course of business as carried on by it as on the date of filing this Scheme with the High Court of Judicature at Bombay and the High Court of Gujarat at Ahmedabad; or (ii) if the same is expressly permitted by this Scheme; or (iii) if prior written consent of each of the Transferor Companies has been obtained. 7. (a) The Board of Directors of ICICI and the Transferee Company have jointly constituted a committee in the manner described in sub-clause (i) below (the "Joint Committee") to perform the functions specified in sub-clause (ii) below from the date of filing of this Scheme with the High Court of Judicature at Bombay and the High Court of Gujarat at Ahmedabad until the Effective Date. (b) The constitution of the Joint Committee shall be as mentioned herein below: (i) Shri K. V. Kamath (Managing Director and Chief Executive Officer, ICICI), as the Chairman of the Joint Committee; (ii) Shri H. N. Sinor (Managing Director and Chief Executive Officer, ICICI Bank), as a member of the Joint Committee; (iii) Shri K. V. Kamath shall have the power and authority to appoint such additional members of the Joint Committee, as may be necessary, from amongst the whole time Directors and/or employees of ICIGI; (iv) Shri H. N. Sinor shall have the power and authority to appoint such additional members of the Joint Committee, as may be necessary, from amongst the whole time Directors and/or employees of ICICI Bank. (c) From the date of filing of this Scheme with the High Court of Judicature at Bombay and the High Court of Gujarat at Ahmedabad and until the Effective Date, the Joint Committee shall perform the following functions: (i) in case of any ambiguity or any question as to whether any matter is within or outside the ordinary course of the business of the Transferor Companies and/or the Transferee Company, it shall determine the same on the basis of evidence that it may deem relevant for the purpose (including the books and records of the Transferor Companies and/or the Transferee Company); (ii) to consider for approval the matters pertaining to the share capital of the Transferor Companies and/or the Transferee Company as specified in Clause 9 below;

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(iii) to deal with the matters, if any, in relation to change in the employees' compensation structure of the Transferor Companies and the Transferee Company and matters incidental or consequential or related thereto; and (iv) to perform such other functions specifically provided elsewhere in this Scheme or as may be specifically conferred on it by the Boards of Directors of ICICI and the Transferee Company respectively. (d) Unless otherwise agreed to between Shri K. V. Kamath and Shri H. N. Sinor, the quorum for meetings of the Joint Committee shall be two (2). The Joint Committee shall meet at such times and places, and shall observe and follow such rules and procedure formulated by the Joint Committee, from time to time, in regard to the transaction of business at its meetings. The Chairman of the Joint Committee or, if for any reason, the Chairman is unable to attend a meeting of the Joint Committee, any other member elected by the members present from amongst themselves at the meeting shall preside at such meeting. All matters shall be decided by the Joint Committee by a majority vote of the members present and voting at the meeting, and in the event of an equality of votes, the Chairman or in his absence, the person presiding, shall have the second or casting vote. If, however, without convening a meeting of the members of the Joint Committee any matter is decided by the Joint Committee wherein the consent or approval of the majority of the members of the Joint Committee is obtained by letter or letters or any instrument signed by such members of the Joint Committee then such letter or letters or instrument shall constitute a resolution passed or decision taken at the meeting of the Joint Committee duly convened and held and shall have the effect accordingly. All decisions of the Joint Committee determined as aforesaid shall be binding on the Transferor Companies and the Transferee Company. 8. ICICI may, on the Appointed Date, transfer all the shares of the Transferee Company held by it on such date (the “ICICI Bank Shares”) to an individual trustee or a Board of trustees (including the survivors or survivor of any of the trustees comprising such Board of trustees) or a corporate trustee (hereinafter referred to as the “Trustees”), to have and to hold the ICICI Bank Shares in trust together with all additions or accretions thereto upon trust exclusively for the benefit of ICICI and its successor subject to the powers, provisions, discretions, rights and agreements contained in the instrument (the “Trust Deed”) establishing the aforesaid trust (the “Trust”). The Trustees shall not exercise any voting rights with respect to ICICI Bank Shares. It is proposed that the Trustee shall, within a period of 24 months from the Effective Date subject however to the prevailing market conditions (in which case, the said period may be suitably extended in the discretion of the Trustees), sell, transfer or dispose of the ICICI Bank Shares at such time or times and in such manner as may be proper in accordance with provisions of the Trust Deed and shall remit the proceeds thereof to ICICI or its successor and consequent thereto all obligations of the Trustees under the Trust Deed shall stand discharged and the trust shall stand terminated. 9. (a) From the date of filing of this Scheme with the High Court of Judicature at Bombay and the High Court of Gujarat at Ahmedabad and upto and including the Effective Date, none of the Transferor Companies and/or the Transferee Company shall make any change in its capital structure in any manner either by any increase (including by way of issue of equity and/or preference shares on a rights basis or by way of a public issue, bonus shares

1098

Investment Banking

and/or convertible debentures or otherwise), decrease, reduction, reclassification, subdivision, consolidation, re-organisation, or in any other manner which may, in any way, affect the Share Exchange Ratio (as defined in Clause 13 below), except with the prior approval of the Joint Committee ided that nothing contained in this sub-clause shall be deemed to affect any pre-existing obligations of any of the Transferor Companies and/or the Transferee Company, including in respect of the Issue of further employees' stock options, vesting of stock options or exercise of vested options under any existing scheme or conversion of any loan or convertible security into equity shares in accordance with the terms of any loan obtained or convertible security issued by any of the Transferor Companies and/or the Transferee Company. (b) (i) With in respect to the stock options granted by ICICI under the employees’ stock options scheme to its directors and employees and employees of ICICI Capital or ICICI PFS or any other subsidiary or associate company of ICICI which have not yet been exercised and are outstanding (“ICICI Stock Options”), the said directors and employees shall, in lieu of the options held by them in ICICI, receive such number of options in the Transferee Company determined in accordance with the Share Exchange Ratio (as defined in Clause 13 below). The exercise price of the options received by the aforesaid directors and employees in lieu of the ICICI Stock Options shall be twice the price payable by the said directors and employees for the exercise of the ICICI Stock Options. All other terms and conditions in relation to the options aforesaid shall be similar to those contained in the employees stock option scheme of the Transferee Company. (ii) Upon the coming into effect of this Scheme, Section IV Part I of the employees' stock options scheme of the Transferee Company shall stand amended in the following manner: “The maximum number of Options granted to any Eligible Employee in a financial year shall not exceed 0.05% of the issued equity shares of the Bank at the time of grant of the Options and the aggregate of all such Options granted to the Eligible Employees shall not exceed five percent of the aggregate number of the issued equity shares of the Bank after coming into effect of the amalgamation of ICICI Limited, ICICI Capital Services Limited and ICICI Personal Financial Services Limited with the Bank and the issuance of equity shares by the Bank pursuant to the aforesaid amalgamation of ICICI Limited, ICICI Capital Services Limited and ICICI Personal Financial Services Limited with the Bank.” 10. Upon the coming into effect of this Scheme: (a) all suits, actions and legal and other proceedings by or against the Transferor Companies pending and/or arising on or before the Appointed Date or the Effective Date (whichever is later) shall be transferred in the name of the Transferee Company and shall be continued and be enforced by or against the Transferee Company as effectually and in the same manner and to the same extent as if the same had been pending and/or arisen by or against the Transferee Company (b) the Transferee Company shall be notified as the “designated person” under the provisions of Section 16 read with Section 2(d) of the Shipping Development Fund Committee (Abolition) Act, 1986 and all suits, actions and legal and other proceedings

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by or against ICICI in its capacity as such “designated person” pending and/or arising on or before the Appointed Date or the Effective Date (whichever is later) shall be transferred in the name of the Transferee Company and shall be continued and be enforced by or against the Transferee Company as effectually and in the same manner and to the same extent as if the Transferee Company had originally been notified as the “designated person” in that behalf and as if the same had been pending and/or arisen by or against the Transferee Company. 11. (a) Upon the coming into effect of this Scheme, and subject to the provisions of this Scheme, all contracts, deeds, bonds, agreements, arrangements and other instruments (including all tenancies, leases, licenses and other assurances in favour of any of the Transferor Companies or powers or authorities granted by or to any of them) of whatsoever nature to which any of the Transferor Companies is a party or to the benefit of which any of the Transferor Companies may be eligible, and which are subsisting or having effect immediately before the Appointed Date or the Effective Date (whichever is later), shall, without any further act, instrument or deed, be in full force and effect in favour of or against the Transferee Company, as the case may be, and may be enforced as fully and effectually as if, instead of such Transferor Company, the Transferee Company had been a party or beneficiary or obligee thereto. (b) The Transferee Company may, at any time after the coming into effect of this Scheme in accordance with the provisions hereof, if so required, under any law or otherwise, execute deeds of confirmation in favour of any party to any contract or arrangement to which any of the Transferor Companies is a party or any writings as may be necessary to be executed in order to give formal effect to the above provisions. The Transferee Company shall be deemed to be authorized to execute any such writings on behalf of the Transferor Companies and to carry out or perform all formalities or compliances required for the purposes referred to above on the part of the Transferor Companies.

12. Upon the coming into effect of this Scheme: (a) The employees of the Transferor Companies who are in service on the Appointed Date or the Effective Date (whichever is later), shall become the employees solely of the Transferee Company on such date without any break or interruption in service and on terms and conditions as to remuneration not less favourable than those subsisting with reference to the respective Transferor Companies on the said date. (b) The existing provident fund, gratuity fund, and pension and/or superannuation fund or trusts created by the Transferor Companies or any other special funds created or existing for the benefit of the employees of the Transferor Companies shall be transferred to the relevant funds of the Transferee Company. In the event that the Transferee Company does not have its own fund with respect to any such matters, the Transferee Company shall create its own funds to which the contributions pertaining to the employees of Transferor Companies shall be transferred.

1100

Investment Banking PART IV REORGANIZATION OF CAPITAL

13. (a) Upon the coming into effect of this Scheme, and in consideration of the transfer of and vesting of the Undertaking and the Liabilities of the Transteror Companies in the Transferee Company in terms of this Scheme, the Transferee Company shall without any further application, act, instrument or deed, issue and allot to the equity shareholders of ICICI whose names are recorded in the Register of Members of ICICI (the "Members"), on a date (hereinafter referred to as the "Record Date") to be fixed by the Board of Directors of the Transferee Company or a committee of such Board of Directors, equity shares of Rs. 10/- (Rupees ten only) each, credited as fully paid up, in the ratio of l (one) equity share of the face value of Rs. 10/- (Rupees ten only) each in the Transferee Company for every 2 (two) equity shares of the face value of Rs. 10/(Rupees ten only) each held in ICICI . (the above ratio in which the shares of the Transferee Company are to be allotted to the shareholders of ICICI by the Transferee Company is hereinafter referred to as the "Share Exchange Ratio"). (b) The share certificates in relation to the shares held by the said Members in ICICI (and the ADRs that have been issued representing the underlying shares in ICICI) shall be deemed to have been automatically cancelled and be of no effect on and from such Record Date, without any further act, instrument or deed. In so far as the issue of shares pursuant to sub-clause (a) above is concerned, each of the said Members of ICICI, shall have the option, exercisable by notice in writing by the said Members to the Transferee Company on or before such date as may be determined by the Board of Directors of the Transferee Company or a committee of such Board of Directors, to receive either in certificate form or in dematerialised form, the shares of the Transferee Company in lieu thereof and in terms hereof. In the event that such notice has not been received by the Transferee Company in respect of any of the said Members, the shares of the Transferee Company shall be issued to such Members in certificate form. Those of the said Members exercising the option to receive the shares in dematerialised form shall be required to have an account with a depository participant and shall provide details thereof and such other confirmations as may be required. It is only thereupon that the Transferee Company shall issue and directly credit the demat/dematerialised securities account of such Member with the shares of the Transferee Company. (c) No shares shall be issued by the Transferee Company pursuant to the amalgamation of ICICI Capital and ICICI PFS, both of which are wholly owned subsidiaries of ICICI. (d) In respect of equity shares of ICICI where calls are in arrears, without prejudice to any remedies that ICICI or the Transferee Company, as the case may be, shall have in this behalf, the Transferee Company shall not be bound to issue any shares of the Transferee Company (whether partly paid or otherwise) nor to confirm any entitlement to such holder until such time as the calis-in-arrears are paid. (e) Upon the coming into effect of this Scheme, the Transferee Company shall issue to the holders of 0.001% preference shares of Rs. 1,00,00,000/- each fully paid-up (the

Appendix 6

1101

“Preference Shares”) of ICICI one 0.001% preference share of Rs. 1,00,00,000/- fully paid in lieu of every Preference Share on the same terms and conditions subject to the approval of the Reserve Bank of India and issue of notification and/or grant of permission for issuance of such preference shares, and/or amendment of the Banking Regulation Act, 1949. Provided however, in case such approval and/or grant of permission and/or amendment is not forthcoming ICICI will make alternate arrangements for accounting for the Preference Shares. The Preference Shares of ICICI shall stand cancelled upon the issuance of the preference shares by the Transferee Company as aforesaid. Nothing contained in this Clause shall affect the redemption on maturity of any of the Preference Shares of ICICI prior to the Effective Date. 14. No fractional certificates shall be issued by the Transferee Company with respect to fractional entitlements, if any, to any Member. The Board of Directors of the Transferee Company shall, instead consolidate all such fractional entitlements and thereupon issue and allot equity shares in lieu thereof to the Trust or a director or an officer of the Transferee Company or such other person as the Transferee Company shall appoint in this behalf who shall hold the shares in trust on behalf of the Members entitled to fractional entitlements with the express understanding that such Trust, director(s) or officer(s) or person shall sell the same in the market at such time or times and at such price or prices in the market and to such person or persons, as it/he/they deem fit, and pay to the Transferee Company, the net sale proceeds thereof, whereupon the Transferee Company shall distribute such net sale proceeds to the Members of ICICI in proportion to their respective fractional entitlements. 15. Equity shares issued and allotted by the Transferee Company in terms of Clause 13 shall be subject to the provisions of the Articles of Association of the Transferee Company and shall rank pari passu in all respects with the then existing equity shares of the Transferee Company, including in respect of dividends, if any, that may be declared by the Transferee Company, on or after the Appointed Date. 16. Equity shares of the Transferee Company issued in terms of Clause 13 above, shall, subject to applicable regulations, be listed or admitted to trading on the relevant stock exchangers, whether in India or abroad, where the equity shares of the Transferee Company are presently listed or admitted to trading. 17. (a) Upon the coming into effect of this Scheme and the issue of shares in the Share Exchange Ratio, pursuant to Clause 13 above, the Transferee Company shall instruct its depositary (the "Depositary") to issue ADRs of the Transferee Company to the existing investors in ADRs of ICICI in an appropriate manner in accordance with the terms of the Deposit Agreement entered into amongst the Transferee Company, Bankers Trust Company and all registered holders and beneficial owners from time to time of the ADRs of the Transferee Company (the "Deposit Agreement"). The Transferee Company and the Depositary shall enter into such further documents as may be necessary and appropriate in this behalf. (b) The Transferee Company shall take necessary steps for the issue of ADRs pursuant to Clause 17(a) above and for listing the ADRs on the New York Stock Exchange, including without limitation the filing of a supplemental listing application with the New

1102

Investment Banking

York Stock Exchange and any required amendment of the Form F-6 under the Securities Act of 1933, as amended, of the United States of America (the "Securities Act"). (c) The ADRs issued to the existing investors in the ADRs of ICICI pursuant to Clause 17(a) above shall be similar in all material respects with the then existing ADRs of the Transferee Company. (d) The equity shares underlying the ADRs issued to the existing investors in the ADRs of ICICI shall not be registered under Securities Act in reliance upon the exemption from registration contained in Section 3(a)(10) of the Securities Act, and upon a no-action letter issued by the staff of the US Securities and Exchange Commission. To obtain this exemption, the Transferee Company will rely on the approval of the Scheme by the High Court of Judicature at Bombay and the High Court of Gujarat at Ahmedabad following the hearing by each court. (e) If, on account of the Share Exchange Ratio, fractional ADRs of the Transferee Company have to be issued, then, in accordance with Section 4.03 of the Deposit Agreement, in lieu of delivering receipts for fractional ADRs the Depository may, in its discretion, sell the shares represented by the aggregate of such fractions, at public or private sale, at such place or places and at such price or prices as it may deem proper, and distribute the net proceeds of any such sale in accordance with the terms of the Deposit Agreement. PART V GENERAL TERMS AND CONDITIONS 18. (a) The Transferor Companies and the Transferee Company shall be entitled to declare and pay dividends, whether interim or final, to their respective equity shareholders with respect to the accounting period prior to the Appointed Date. Provided that any such declaration after the Appointed Date and prior to the Effective Date shall be made with the prior approval of the Board of Directors of the Transferor Companies and the Transferee Company. (b) Until the coming into effect of this Scheme, the holder of equity shares of the Transferor Companies and the Transferee Company shall, save as expressly provided otherwise in this Scheme, continue to enjoy their existing rights under their respective articles of association including the right to receive dividends. (c) It is clarified that the aforesaid provisions in respect of declaration of dividends, whether interim or final, are enabling provisions only and shall not be deemed to confer any right on any member of any of the Transferor Companies and/or the Transferee Company to demand or claim any dividends which, subject to the provisions of the Act, shall be entirely at the discretion of the respective Boards of Directors of the Transferor Companies and the Transferee Company and subject, wherever necessary, to the approval of the shareholders of the Transferor Companies and the Transferee Company, respectively. 19. (a) Upon the coming into effect of this Scheme and with effect from the Appointed Date, for the purpose of accounting for and dealing with the value of the assets and liabilities of ICICI in the books of the Transferee Company, the fair value of the assets (after deducting such provisions as are outstanding in the books of ICICI on the date

Appendix 6

1103

immediately preceding the Appointed Date in respect of any asset or class of assets) and liabilities shall be determined on the Appointed Date to the satisfaction of the Transferee Company. (b) Upon the coming into effect of the Scheme and with effect from the Appointed Date: (i) If the fair value of any class of assets of ICICI determined in accordance with subclause (a) above is less than the value of such class of assets appearing in the books of ICICI immediately prior to the Appointed Date, the assets shall be accounted for and dealt with in the books of the Transferee Company at the value appearing in the books of ICICI on the date immediately preceding the Appointed Date and a provision equal to the difference between the value appearing in the books of ICICI and the fair value determined in accordance with sub-clause (a) above shall be made in the books of the Transferee Company. (ii) If the fair value of any class of assets of ICICI determined in accordance with subclause (a) above is greater than the value of such class of assets appearing in the books of ICICI immediately prior to the Appointed Date, the assets shall be accounted for and dealt with in the books of the Transferee Company at the fair value.| (iii) Provisions outstanding in the books of ICICI on the date immediately preceding the Appointed Date with respect to any asset or class of assets shall be accounted for and dealt with in the books of the Transferee Company as provisions against the assets or class of assets against which such provisions were held in the books of ICICI on the date immediately preceding the Appointed Date. (iv) The liabilities of ICICI shall be accounted for and dealt with in the books of the Transferee Company at the fair value determined in accordance with sub-clause (a) above. (c) The excess of the fair value of the net assets of ICICI over the paid-up value of the shares to be issued and allotted pursuant to the terms of Clause 13, shall be accounted for and dealt with in the books of the Transferee Company as follows: (i) The balance in “Special Reserve Account” of ICICI shall continue to be designated as Special Reserve Account in the books of the Transferee Company; (ii) The balance in “Debenture Redemption Reserve Account” of ICICI shall continue to be designated as a Debenture Redemption Reserve Account in the books of the Transferee Company; (iii) The aggregate balance in “Capital Reserve Account” Capital Redemption Reserve Account” Share Premium Account” General Reserve Account” Profit and Loss Account” and any other account included in reserves and surplus of ICICI on the date immediately preceding the Appointed Date shall be reduced by the provisions created in accordance with sub-clause (b)(i) above and such further adjustments as may be deemed necessary including such adjustments as may be required to ensure the uniform application of accounting standards and policies adopted by the Transferee

1104

Investment Banking Company and the net balance thereof shall be credited by the Transferee Company to its General Reserve Account.

(d) (i) Upon the coming into effect of the Scheme and with effect from the Appointed Date, the assets and liabilities of ICICI Capital and ICICI PFS shall be accounted for and dealt with in the books of the Transferee Company at their fair values to be determined on the Appointed Date to the satisfaction of the Transferee Company. (ii) In determining the fair value of the assets and liabilities of ICICI Capital and ICICI PFS and making the necessary adjustments, the provisions of sub-clauses (a) to (c) above shall be applied mutatis mutandis to ICICI Capital and ICICI PFS. (iii) An amount equal to the net assets of ICICI Capital and ICICI PFS shall be credited by the Transferee Company to its General Reserve Account. 20. Upon the coming into effect of this Scheme: (a) Clauses V of the Memorandum of Association of the Transferee Company shall, without any further act, instrument or deed, be and stand altered, modified and amended pursuant to Sections 94 and 394 and other applicable provisions of the Act in the manner set forth in Schedule I hereto. (b) The Articles of Association of the Transferee Company shall, without any further act, instrument or deed, be and stand altered, modified and amended pursuant to Sections 31 and 394 and other applicable provisions of the Act in the manner set forth in Schedule 11 hereto. 21. Upon the coming into effect of this Scheme, the Board of Directors of the Transferee Company shall be reconstituted in accordance with the provisions of the Act and the Banking Regulation Act, 1949. Provided that, subject to the approval of the Reserve Bank of India, the maximum number of Directors on the Board of Directors shall be increased to 21 (exclusive of the nominee director appointed by the Government of India and the director as may be nominated pursuant to the trust documents in relation to the issue of debentures or bonds of the Transferee Company and/or the Transferor Companies). 22. Upon the coming into effect of this Scheme, the borrowing limits of the Transferee Company in terms of Section 293(1)(d) of the said Act, shall without further act, instrument or deed stand enhanced by an amount aggregating to Rs.100,550 crore being the aggregate borrowing limits of the Transferor Companies, such limits being incremental to the existing limits of the Transferee Company. 23. The Transferor Companies shall with all reasonable despatch, make applications/petitions under Sections 391 and 394 and other applicable provisions of the Act to the High Court of Judicature at Bombay for sanctioning of this Scheme and for dissolution of the Transferor Companies without winding up under the provisions of law, and obtain all approvals as may be required under law. Upon coming into effect of this Scheme, the Transferor Companies shall, without any further act, deed, or instrument, be dissolved without winding-up.

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24. The Transferee Company shall also with all reasonable despatch, make applications/petitions under Sections 391 and 394 and other applicable provisions of the Act to the High Court of Gujarat at Ahmedabad for sanctioning of this Scheme under the provisions of law, and obtain all approvals as may be required under law. 25. (a) The Transferor Companies and the Transferee Company may assent from time to time on behalf of all persons concerned to any modifications or amendments or additions to this Scheme or to any conditions or limitations which either the Boards of Directors of any of the Transferor Companies and the Transferee Company deem fit, or which the High Court of Judicature at Bombay and/or the High Court of Gujarat at Ahmedabad and/or any other authorities (including the Reserve Bank of India) under law may deem fit to approve of or impose and which the Transferor Companies and the Transferee Company may in their discretion deem fit and to resolve all doubts or difficulties that may arise in carrying out and implementing this Scheme and to do, authorise and execute all acts, instruments, deeds, matters and things necessary, or to review the position relating to the satisfaction of the conditions to this Scheme and if necessary, to waive any of those (to the extent permissible under law) for bringing this Scheme into effect. In the event of any of the conditions that may be imposed by the Courts or other authorities (including the Reserve Bank of India) which the Transferor Companies or the Transferee Company may find unacceptable for any reason, then the Transferor Companies and the Transferee Company are at liberty to withdraw the Scheme. The aforesaid powers of the Transferor Companies and the Transferee Company may be exercised by their respective Boards of Directors, a committee or committees of the concerned Board of Directors or any director authorised in that behalf by the concerned Board of Directors (hereinafter referred to as the “delegates”). (b) For the purpose of giving effect to this Scheme or to any modifications or amendments thereof or additions thereto, the delegate of the Transferor Companies and Transferee Company may give and are authorised to determine and give all such directions as are necessary including directions for settling or removing any question of doubt or difficulty that may arise and such determination or directions, as the case may be, shall be binding on all parties, in the same manner as if the same were specifically incorporated in this Scheme. (c) In the event of there being any pending share transfers, whether lodged or outstanding, of any shareholder of ICICI, the Board of Directors or any committee thereof of ICICI shall be empowered in appropriate cases, even subsequent to the Record Date to effectuate such a transfer in ICICI as if such changes in registered holder were operative as on the Record Date, in order to remove any difficulties arising to the transferor or the transferee of the share in the Transferee Company and in relation to the new shares after the Scheme becomes effective. 26. This Scheme is conditional upon and subject to: (a) the Scheme being agreed to by the requisite majorities of the members of the Transferor Companies and the Transferee Company as required under the Act and the requisite orders of the High Court of Judicature at Bombay and the High Court of Gujarat at Ahmedabad referred to in Clauses 23 and 24 above being obtained;

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Investment Banking

(b) the approval of the Reserve Bank of India being obtained; (c) such other sanctions and approvals including from any governmental authority or contracting party, if any, as may be required by law or contract in respect of the Scheme being obtained; and (d) the certified copies of the court orders referred to in this Scheme being filed with the Registrar of Companies, Maharashtra, and the Registrar of Companies, Gujarat. 27. In the event of this Scheme not becoming effective by June 30, 2002 or by such later date as may be agreed to by the respective Boards of Directors of the Transferor Companies and the Transferee Company, this Scheme shall become null and void and in that event no rights and liabilities whatsoever shall accrue to or be incurred inter se by the parties or their shareholders or creditors or employees or any other person. In such case each Company shall bear its own costs or as may be mutually agreed amongst themselves. 28. All costs, charges and expenses, including any taxes and duties of the Transferor Companies and Transferee Company respectively in relation to or in connection with this Scheme and incidental to the completion of the amalgamation of the Transferor Companies in pursuance of this Scheme shall be borne an aid by ICICI.

Appendix 7

SCHEME OF ARRANGEMENT BETWEEN INDIAN RAYON AND INDUSTRIES LIMITED

Transferor Company

VIKRAM INSULATORS PRIVATE LIMITED

Transferee Company

AND THEIR RESPECTIVE SHAREHOLDERS AND CREDITORS

PART I—GENERAL This Scheme of Arrangement (hereinafter referred to as the “Scheme”) provides for the reconstruction of the Transferor Company consequential upon the transfer of the Transferred Business (as defined hereinafter) of the Transferor Company to the Transferee Company and consequent issue of shares and debentures by the Transferee Company to the Transferor Company pursuant to the relevant provisions of the Act. 1. Definitions In this Scheme, unless repugnant to the meaning or context thereof, the following expressions shall have the following meaning: (A) “Act7” means the Companies Act, 1956 or any statutory modification or re-enactment thereof for the time being in force; (B) “Appointed Date” means 1st day of August 2002; (C) “Effective Date” means the date on which all the conditions and matters referred to in Clause 24 hereof have been fulfilled and approvals and consents referred to therein have been obtained. References in this Scheme to the date of “coming into effect of this Scheme” or “effectiveness of this Scheme” shall mean the Effective Date; (D) “Employees” mean the staff, workmen and employees of the Transferred Business; (E) “Jaya Shree Insulator Division” or “JSI” means the division of the Transferor Company comprising of:

1108

Investment Banking

(i) Insulator plant of 20,000 tonnes per annum (“tpa”) installed capacity located at Halol in the State of Gujarat; (ii) Insulator plant of 14,000 tonnes per annum (“tpa”) installed capacity located at Rishra in the State of West Bengal; (iii) lightning arrestor manufacturing plant of 25,000 Nos. capacity located at Halol in the State of Gujarat, and (iv) allied business of dealing in insulator hardware fittings. (F) “Remaining Business” means all the businesses and the divisions of the Transferor Company other than the Transferred Business; (G) “Scheme” or “this Scheme” means this Scheme of Arrangement in its present form or with any modification(s) made under Clause 23 of this Scheme; (H) “Transferee Company” or “VIPL” means Vikram Insulators Private Limited, a company incorporated under the Act and having its registered office at P.O. Meghasar, Taluka Halol, District Panchmahal, Gujarat 389 330. (I) “Transferor Company” or “IRIL” means Indian Rayon And Industries Limited, a company incorporated under the Act and having its registered office at JunagadhVeraval Road, Veraval 362 266, Gujarat. ( J) “Transferred Business” means all the business, undertakings, properties and liabilities, of whatsoever nature and kind and wheresoever situate, as on 1st August, 2002 of the Transferor Company pertaining to its Jaya Shree Insulator Division, on a going concern basis, together with all their assets and liabilities and shall mean and include (without limitation): (i) all assets, moveable and immoveable, real or personal, in possession or reversion, corporeal or incorporeal, tangible or intangible of whatsoever nature, wheresoever situate including buildings, sheds, godowns, warehouses, offices, plant and machineries, electric plants, electrical insulators, vehicles, equipment, furniture, sundry debtors, inventories, cash and bank balances, bills of exchange, deposits, loans and advances together with all present and future liabilities (including contingent liabilities pertaining to the Transferred Business) as appearing in the books of the Jaya Shree Insulator Division of the Transferor Company as on 31st July, 2002 a summary of which is annexed hereto as Schedule 1; (ii) all permits, quotas, rights, entitlements, industrial and other licences, approvals, consents, tenancies, offices, trade marks, patents, copyrights, all other intellectual property rights, bank accounts, privileges, all other rights, benefits and entitlements including sales tax deferrals and other benefits, lease rights (including the benefit of any applications made therefor), licences, powers and facilities of every kind, nature and description whatsoever, rights to use and avail of telephones, telexes, facsimile connections, e-mail connections, communication facilities and installations, utilities, electricity and other services, provisions, funds, benefits of

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all agreements, contracts and arrangements and all other interests in connection with or relating to the Transferred Business; (iii) all earnest moneys and/or security deposits paid by the Transferor Company in connection with or relating to the Transferred Business; (iv) all Employees of the Transferor Company engaged in or in relation to the Transferred Business as on the Effective Date; (v) all debts, liabilities, duties, responsibilities and obligations of the Transferor Company relating to the Transferred Business as appearing in the certified Balance Sheet of Jaya Shree Insulator Division as on 31st July, 2002; and (vi) all necessary records, files, papers, engineering and process information, computer programmes, manuals, data, catalogues, quotations, sales and advertising materials, list of present and former customers and suppliers, customer credit information, customer pricing information and other records in connection with or relating to the Transferred Business;

2. Share Capital: (a) The share capital structure of the Transferor Company as on 31st July, 2002 is as follows: Rs. in crores Authorised 8,50,00,000 Equity Shares of Rs. 10 each 15,00,000 Redeemable Preference Shares of Rs.100 each

85.00 15.00 100.00

Issued, Subscribed and Paid-up 5,98,76,742 Equity Shares of Rs. 10 each fully paid-up*

59.88 59.88

Includes 35,08,952 equity shares represented by Global Depositary Receipts (GDRs). Note: Issue of 38,181 equity shares and the bonus shares thereon is held in abeyance pursuant to the provisions of Section 206A of the Act. (b) The share capital structure of the Transferee Company as on 31st July, 2002 is as follows: Rs. in crores Authorised 20,000 Equity Shares of Rs. 10 each

0.02 0.02

1110

Investment Banking Issued Subscribed and Paid-up 10,000 Equity Shares of Rs. 10 each fully paid-up

0.01 0.01

PART II—TRANSFERRED BUSINESS 3. (a) With effect from the Appointed Date, all the estates, assets, properties, liabilities, obligations, rights, title and interest of the Transferred Business shall, pursuant to Section 394 of the Act and without any further act or deed, be transferred to and vested in or be deemed to have been transferred to and vested in the Transferee Company so as to become as and from the Appointed Date, the estates, assets, properties, liabilities, obligations, rights, title and interest of the Transferee Company. The entire Transferred Business shall be managed by the Transferee Company as a joint venture of the Transferor Company with NGK Insulators Ltd., Japan (NGK). NGK will infuse further capital and provide the technical know-how to the Transferee Company. (b) With respect to such of the assets of the Transferred Business as are movable in nature or are otherwise capable of transfer by delivery or by endorsement and delivery, the same shall pursuant to the provisions of Section 394 of the Act stand transferred without requiring any further deed or instrument of conveyance for transfer of the same, and shall become the property of the Transferee Company as an integral part of the Business/undertakings hereby transferred. (c) With respect to such of the assets of the Transferred Business other than those referred to in sub-clause (b) above, the same shall, as more particularly provided in sub-clause (a) above, without any further act, instrument or deed, be transferred to and vested in and/or be deemed to be transferred to and vested in the Transferee Company on the Appointed Date pursuant to the provisions of Section 394 of the Act. (d) Any statutory licences, permissions, approvals or consents to carry on the operations of the Transferred Business shall stand vested in or transferred to the Transferee Company without any further act or deed and shall be appropriately mutated by the Statutory Authorities concerned in favour of the Transferee Company upon the vesting and transfer of the Transferred Business pursuant to this Scheme. The benefit of all statutory and regulatory permissions, factory licenses, environmental approvals and consents, sales tax registrations or other licenses and consents shall vest in and become available to the Transferee Company pursuant to this Scheme. 4. (a) Upon coming into the effect of the Scheme, the debts, liabilities and obligations of the Transferor Company relating to its Transferred Business shall without any further act or deed be and stand transferred to the Transferee Company and shall thereupon become the debts, liabilities and obligations of the Transferee Company which it undertakes to meet, discharge and satisfy to the exclusion of the Transferor Company and to keep the Transferor Company indemnified at all times from and against all such debts, liabilities, duties and obligations and from and against all actions, demands and proceedings in

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respect thereto. It shall not be necessary to obtain the consent of any third party or other person who is a party to any contract or arrangement by virtue of which such debts, liabilities, duties and obligations have arisen in order to give effect to the provisions of this sub-clause. (b) All loans raised and used and all liabilities and obligations incurred by the Transferor Company after the Appointed Date and prior to the Effective Date for operations of the Transferred Business shall also stand transferred to and vested in the Transferee Company upon the coming into effect of the Scheme. (c) All liabilities and obligations arising out of guarantees executed by the Transferor Company, relating to the Transferred Business in favour of third party shall become liability/obligation of the Transferee Company which it undertakes to meet, discharge and satisfy. (d) The assets of the Transferred Business shall be transferred free from all encumbrances (other than for securing the debts, liabilities, facilities, if any, being part of the Transferred Business as may be decided by the Boards of Directors of the Transferor Company and the Transferee Company) and defects in title and the Transferor Company shall take the necessary procedural steps so as to effectuate the transfer free from all encumbrances and to rectify the defects in title, if any, within twelve months from the Effective Date to the extent permissible under the law. (e) Provided however that: (i) in the event that there are any liabilities relating to the Transferred Business as on 31.07.2002 which are not in the knowledge of the Transferor Company and accordingly have not been disclosed by the Transferor Company in the Balance Sheet as on 31.07.2002 of Jaya Shree Insulator Division and which existed prior to the Effective Date; or (ii) if any liability relating to the Transferred Business arises as a consequence of acts of the Transferor Company prior to the Effective Date; or (iii) if any Contingent Liability(ies) of the Transferred Business, for which no provision has been made in the Balance Sheet as on 31.07.2002 of the Jaya Shree Insulators Division results in an actual liability, [hereinafter collectively referred to as the “Undisclosed Liability(ies)”] and each such individual Undisclosed Liability is in excess of Rs. 5 lakh or the cumulative amount of such Undisclosed Liabilities exceed Rs. 15 lakhs in any Financial Year, the Transferee Company shall not be responsible for any such Liabilities and all such Liabilities shall be entirely that of the Transferor Company. If any such Undisclosed Liability materializes at any time into an actual liability, the Transferor Company shall pay to the Transferee Company, the amount representing the said Liability within 15 days of the Transferee Company intimating the liability to the Transferor Company. However, if any Contingent Liability relating to the Transferred Business for which provision has been made in the books of accounts as on 31.07.2002 of the Jaya Shree Insulator Division and

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which does not finally materialize into an actual liability, as and when it is so finally determined, the Transferor Company shall be entitled to adjustment of such amount against any payment required to be made by the Transferor Company to the Transferee Company for a Contingent Liability for which no provision was made. 5. (a) Upon the coming into effect of this Scheme and subject to the provisions of this Scheme, all contracts, deeds, bonds, agreements, schemes, arrangements and other instruments of whatsoever nature in relation to the Transferred Business to which the Transferor Company is a party or to the benefit of which the Transferor Company is or may be eligible, and which are subsisting or having effect immediately before the Effective Date, shall be in full force and effect on or against or in favour, as the case may be, of the Transferee Company and may be enforced as fully and effectually as if, instead of the Transferor Company, the Transferee Company had been a party or beneficiary or obligee thereto. (b) The Transferee Company may, at any time after the coming into effect of this Scheme in accordance with the provisions hereof, if so required, under any law or otherwise, execute deeds, confirmations or other writings or tripartite arrangements with any party to any contract or arrangement to which the Transferor Company is a party or any writings as may be necessary to be executed in order to give formal effect to the above provisions. The Transferor Company will, if necessary, also be a party to the above. 6. (a) Upon the coming into effect of the Scheme, all legal or other proceedings by or against the Transferor Company under any statute, whether pending on the Appointed Date or which may be instituted in future (whether before or after the Effective Date) with respect to any matter arising before or after the Effective Date and relating to the Transferred Business shall be continued and be enforced by or against the Transferee Company after the Effective Date. In the event of any difference or difficulty on whether any specific legal or other proceeding relates to the Transferred Business or not, a certificate jointly issued by the Transferor Company and the Transferee Company as to whether such proceeding relates to the Transferred Business or not, shall be conclusive evidence of the matter. (b) Upon the Scheme being effective, the Transferee Company undertakes to have all legal or other proceedings initiated by or against the Transferor Company referred to in subclause (a) above transferred into its name and to have the same continued, prosecuted and enforced by or against the Transferee Company to the exclusion of the Transferor Company. The Transferee Company also undertakes to pay all amounts including interest, penalties, damages, etc. which the Transferor Company may be called upon to pay or secure with respect to any liability or obligations relating to the Transferred Business of the Transferor Company for the period upto the Effective Date and any reasonable costs incurred by the Transferor Company with respect to the proceedings started by or against it relatable to the period up to the Effective Date upon submission of the necessary evidence by the Transferor Company to the Transferee Company for making such payment. (c) If any proceedings are pending against the Transferor Company as on the Appointed Date or are taken against it in respect of the matters arising before/after the Appointed Date and before the Effective Date, it shall defend the same upto the Effective Date, in

Appendix 7

1113

accordance with the advice of the Transferee Company and at the cost of the Transferee Company, and the lafter shall reimburse and indemnify the Transferor Company against all liabilities and obligations incurred by the Transferor Company in respect thereof. 7. With effect from the Appointed Date and up to and including the Effective Date, (a) the Transferor Company shall be deemed to have been carrying on and to be carrying on all business and activities relating to the Transferred Business and stand possessed of all the assets, properties, liabilities, obligations, rights, title and interest of the Transferred Business for and on account of, and in trust for, the Transferee Company; and b) all profits accruing to the Transferor Company, or losses arising or incurred by it (including the effect of taxes if any thereon), relating to the Transferred Business shall for all purposes, be treated as the profits, taxes or losses, as the case may be, of the Transferee Company. 8. (a) The Transferor Company hereby undertakes that it will from the Appointed Date up to and including the Effective Date preserve and carry on the Transferred Business with diligence and prudence and agrees that it will not, without the prior written consent of the Transferee Company, alienate, charge or otherwise deal with or dispose of the Transferred Business or any part thereof or recruit new employees (in each case except in the ordinary course of business) or conclude settlements with union or employees without the concurrence of the Transferee Company or undertake substantial expansion of the Transferred Business. (b) The Transferor Company has agreed that it shall run the business in such a manner that the net book value of the Transferred Business i.e. the book value of the assets of the Transferred Business less the book value of the liabilities thereof on Effective Date shall not fall below US Dollar equivalent of Rs.103.95 Crores (Rupees one hundred and three crores ninety five lakhs only) without taking into account any value for goodwill (the Agreed Amount). In case the net book value is lower than the Agreed Amount, the Transferor Company shall remit to the Transferee Company, the difference between the Agreed Amount and the net book value of the Transferred Business on the Effective Date. 9. (a) The Transferee Company undertakes to engage, on and from the Effective Date, all Employees of the Transferor Company engaged in the Transferred Business and who are in the employment of the Transferor Company as on the Effective Date with the benefit of continuity of service, on the same terms and conditions on which they are engaged by the Transferor Company, being not unfavourable to the terms and conditions applicable to the Employees of the Transferred Business, without any interruption of service as a result of the transfer. In the event of any difference or difficulty on whether any Employee was engaged in the Transferred Business or not, a certificate jointly issued by the Transferor Company and the Transferee Company as to whether such Employee is engaged in the Transferred Business or not, shall be conclusive evidence of the matter. The Transferee Company undertakes to continue to abide by any agreement settlement entered into by the Transferor Company in respect of the Transferred Business with any union/Employee of the Transferor Company in relation to

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the Transferred Business. The Transferee Company agrees that for the purpose of payment of any compensation, gratuity and other terminal benefits, the past services of such Employees with the Transferor Company shall also be taken into account, and agrees and undertakes to pay the same as and when payable. (b) In regard to provident fund trusts, gratuity fund and pension and/or superannuation fund or any other fund created or existing for the benefit of the Employees of the Transferred Business of the Transferor company, upon the Scheme becoming effective, the Transferee Company shall stand substituted for the Transferor Company, for all purposes whatsoever, including relating to the obligation to make contributions to the said funds in accordance with the provisions of such scheme, funds, bye laws, etc. in respect of the Employees of the Transferred Business. In so far as the existing provident fund trusts, gratuity fund and pension and/ or superannuation fund trusts created by the Transferor Company for its staff, workmen and employees (including Employees of the Transferred Business) are concerned, the part of the funds referable to the Employees who are being transferred shall be continued to be held by the Transferor Company for the benefit of the Employees who are being transferred to the Transferee Company pursuant to this Scheme in the manner provided hereinafter. In the event that the Transferee Company has its own funds in respect of any of the funds referred to above, the amounts in such funds in respect of contributions pertaining to the Employees of the Transferred Business shall, subject to the necessary approvals and permissions, be transferred to the relevant funds of the Transferee Company. In the event that the Transferee Company does not have its own fund in respect of any of the aforesaid matters, the Transferee Company shall, subject to necessary approvals and permissions, continue to contribute in respect of the Employees engaged in the Transferred Business to the relevant funds of the Transferor Company, until such time that the Transferee Company creates its own fund, at which time the contributions pertaining to the employees of the Transferred Business shall be transferred to the funds created by the Transferee Company. 10. The transfer and vesting of the assets, liabilities and obligations of the Transferred Business under Clauses 3 and 4 and the continuance of the proceedings by or against the Transferee Company under Clause 6 hereof shall not affect any transaction or proceedings already completed by the Transferor Company on and after the Appointed Date to the end and intent that, subject to Clause 8, the Transferee Company accepts all acts, deeds and things done and executed by the Transferor Company as acts, deeds and things done and executed by and/or on behalf of the Transferee Company.

PART—III REMAINING BUSINESS 11. With effect from the Appointed Date and upto and including the Effective Date, (a) the Transferor Company shall be deemed to have been carrying on and to be carrying on all business and activities relating to the Remaining Business for and on its own behalf; (b) all profits accruing to the Transferor Company thereon or losses arising or incurred by it (including the effect of taxes, if any, thereon) relating to the Remaining Business

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1115

shall, for all purposes, be treated as the profits, taxes or losses, as the case may be, of the Transferor Company. The Remaining Business and all the assets, liabilities and obligations pertaining thereto shall continue to belong to and remain vested in and be managed by the Transferor Company. 12. (a) In so far as the existing security in respect of the loans of the Transferor Company and other liabilities relating to the Remaining Business are concerned, such security shall, without any further act, instrument or deed be continued with the Transferor Company on the assets remaining with the Transferor Company. (b) In so far as the assets remaining with the Transferor Company are concerned, the same shall, without any further act, instrument or deed be released from any charge thereon in respect of liabilities that are being transferred to the Transferee Company pursuant to the Scheme. (c) In so far as the assets pertaining to the Transferred Business which are being transferred to the Transferee Company pursuant to this Scheme is concerned, the same shall, without any further act, instrument or deed be released from any charge thereon in respect of the financial assistance, loans and/or debentures that are remaining with the Transferor Company. The provisions of this Clause shall operate, not withstanding anything to the contrary contained in any deed or writing or terms of sanction or issue or any security documents all of which instruments shall stand modified and/or superseded by this Clause. 13. All legal or other proceedings by or against the Transferor Company under any statute, whether pending on the Appointed Date or which may be instituted in future, whether or not in respect of any matter arising before the Effective Date and relating to the Remaining Business (including those relating to any property, right, power, liability, obligation or duties of the Transferor Company in respect of the Remaining Business) shall be continued and enforced by or against the Transferor Company. PART—IV CONSIDERATION 14. In consideration for the Transferred Business, the Transferee Company shall allot to the Transferor Company: (a) 1,24,90,000 equity shares of the face value of Rs. 10/- each at par; and (b) Debentures of an amount being the rupee equivalent of U.S. Dollars 2,50,00,000, being the amount received by the Transferee Company in Rupees on subscription to the shares of the Transferee Company by NGK, on such terms and conditions and in such form, as may be acceptable to the Transferor Company. However, the Transferor Company shall not transfer these Debentures and the Debentures will be redeemed by the Transferee Company as decided by its Board of Directors and agreed to by the Transferor Company.

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15. There shall be no reduction of share capital of the Transferor Company under this Scheme.

PART—V GENERAL TERMS & CONDITIONS 16. (a) The Transferor Company and the Transferee Company shall be entitled to declare and pay dividends, whether interim or final, to their respective shareholders in respect of the accounting period prior to the Effective Date. (b) The equity shares of the Transferee Company to be issued and allotted to the Transferor Company as provided in Clause 14 hereof shall be proportionately entitled to dividends from the Effective Date and the equity shares of the Transferee Company to be issued and allotted to NGK shall be proportionately entitled to dividends from the date of allotment. The Transferor Company and the Transferee Company shall, save as expressly provided otherwise in this Scheme, continue to enjoy their existing rights under their respective Articles of Association including the right to declare dividends. (c) It is clarified that the aforesaid provisions in respect of declaration of dividends are enabling provisions only and shall not be deemed to confer any right on any member of the Transferor Company and/or the Transferee Company to demand or claim any dividends which, subject to the provisions of the said Act, shall be entirely at the discretion of the respective Boards of Directors of the Transferor Company and the Transferee Company and subject to the approval of the shareholders of the Transferor Company and the Transferee Company, respectively. 17. Within 30 days of the Scheme becoming effective, the name of the Transferee Company will be changed to “BIRLA NGK Private Limited”, or if such name is unavailable, any other name as the Transferee Company may decide. 18. Accounting Treatment in the Books of the Transferor Company and the Transferee Company (i) In case of the Transferor Company, the book values of the assets and liabilities of the Transferred Business as on the Appointed Date shall be reduced from its respective assets and liabilities. The Investments made in the Share Capital and Debentures of the Transferee Company will be debited to Investments in Shares and Debentures respectively in the books of the Transferor Company at its face value. The excess of the face value of equity shares and debentures to be allotted under the Scheme over the difference between the value of the assets and liabilities of the Transferred Business shall be credited to the Profit & Loss Account of the Transferor Company. (ii) The accounting treatment in the Transferee Company's books shall be in accordance with generally accepted accounting principles. 19. All taxes paid or payable by the Transferor Company in respect of the operations and/or the profits of the Transferred Business whether before or after the Effective Date, shall be on

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account of the Transferee Company and, in so far it relates to the tax payment (whether by way of deduction at source, advance tax or otherwise howsoever) by the Tansferor Company in respect of the profits of the Transferred Business from and after the Appointed Date, the same shall be deemed to be the tax paid by the Transferee Company, and, shall, in all proceedings, be dealt with accordingly. 20. Upon this Scheme coming into effect, the Authorised Share Capital of the Transferee Company shall, without any further act or deed, be automatically increased from Rs. 2,00,000 (Two lakhs) to Rs.25,00,00,000 (Twenty Five crores). Consequently, Clause V of the Memorandum of Association of the Transferee Company (relating to the authorised share capital) shall, without any further act, instrument or deed, be and stand altered, modified and amended pursuant to Sections 16, 94 and 394 and other applicable provisions of the Act, as the case may be, in the manner set out below and be replaced by the following clause: “The authorised share capital of the Company is Rs. 25,00,00,000 (Rupees Twenty Five Crores only) consisting of 2,50,00,000 (Two crore Fifty lakh) equity shares of Rs. 10/- (Rupees Ten only) each, with powers to increase or reduce the share capital and consolidate or sub divide the shares and issue shares of higher or lower denomination 21. Upon the Scheme becoming effective, the Transferor Company and the Transferee Company shall file the necessary particulars and/or modification(s) of charge, with the Registrar of Companies, Gujarat to give effect to the above provisions. 22. The Transferor Company and the Transferee Company shall make necessary applications before the High Court of Gujarat at Ahmedabad for the sanction of this Scheme of Arrangement under Sections 391 and 394 of the Act. 23. (a) The Transferor Company (by its Board of Directors) and the Transferee Company (by its Board of Directors), either by themselves or through a committee appointed by them in this behalf, may, in their full and absolute discretion, assent to any alteration or modification to this Scheme which the Court and/or any other Authority may deem fit to approve or impose. In the event any of the conditions that may be imposed by the Court and/or Authority which the Transferor Company and the Transferee Company may find unacceptable for any reason, then they are at liberty to withdraw from the Scheme. (b) The Transferor Company (by its Board of Directors) and the Transferee Company (by its Board of Directors), either by themselves or through a committee appointed by them in this behalf, may give such directions as they may consider necessary to settle any question or difficulty arising under the Scheme or in regard to and of the meaning or interpretation of the Scheme or implementation thereof or in any matter whatsoever connected therewith (including any question or difficulty arising in connection with any deceased or insolvent shareholders, depositors or debenture holders of the respective companies), or to review the position relating to the satisfaction of various conditions to the scheme and if necessary, to waive any of those (to the extent permissible under law).

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(c) Upto the Effective Date, any Issue as to whether any asset or liability pertains to the Transferred Business or not shall be decided by the Boards of Directors of the Transferor Company and the Transferee Company, either by themselves or through a committee appointed by them in this behalf, on the basis of evidence that they may deem relevant for the purpose (including the books and records of the Transferor Company). 24. The Scheme is conditional upon and subject to: (a) the Scheme being agreed to by the respective requisite majorities of the various classes of members and creditors (where applicable) of the Transferor Company and the Transferee Company as required under the Act and the requisite orders of the High Court of Gujarat at Ahmedabad being obtained; (b) the approval of the Ministry of Finance and/or Reserve Bank of India under the Foreign Exchange Management Act, 1999 if required, being obtained in relation to various matters referred to in terms of this Scheme for which such approval(s) is/are necessary; (c) such other sanctions and approvals including sanction of any Governmental Authority, creditor or contracting party being obtained as may be required by law or contract in respect of the Scheme; and (d) the certified copies of the court orders referred to in this Scheme being filed with the Registrar of Companies, Gujarat. 25. In the event of this Scheme failing to take effect finally by 31st March, 2003 or by such later date as may be agreed by the respective Boards of Directors of the Transferor Company and the Transferee Company, this Scheme shall become null and void and in that event no rights and liabilities whatsoever shall accrue to or be incurred inter se by the parties or their shareholders or creditors or employees or any other person. In such case each Company shall bear its own costs or as may be mutually agreed. 26. In the event of non-fulfillment of any or all obligations under the Scheme by any Company towards the other Company, inter-se or to third parties and non-performance of which will put the other Company under any obligation, then such Company will indemnity all costs/ interest, etc. to the other Company. 27. If any part of this Scheme is found to be unworkable for any reason whatsoever, the same shall not, subject to the decision of the Transferor Company and the Transferee Company, affect the validity or implementation of the other parts and/or provisions of this Scheme. 28. All taxes, costs, charges, levies and expenses which are statutorily the liability of the Transferee Company including stamp duty for the transfer shall be borne by the Transferee Company. All other taxes, costs, charges, levies and expenses in relation to or in connection with or incidental to this Scheme or the implementation thereof shall be borne and paid for by the Transferor Company.

Appendix 8

This Document is important and requires your immediate attention. This Letter of Offer is sent to you as a Shareholder(s) of

LOTUS CHOCOLATE COMPANY LIMITED If you require any clarifications about the action to be taken, you may consult your Stock Broker or investment consultant or Manager to the Offer. In case you have recently sold your Shares in the Company, please hand over this Letter of Offer and the accompanying Form of Acceptance cum acknowledgement and transfer deed to the Member of Stock Exchange through whom the said sale was effected.

Cash Offer at a Price of Rs. 1.00/- (Rupee One Only) Per Fully Paid Equity Share The Offer is made only for fully paid up shares and no partly paid up share will be acquired [Pursuant to Regulation 10 & 12 of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 and subsequent amendments thereof]

TO ACQUIRE from existing equity shareholders upto 25,68,210 fully paid equity shares of Rs. 10/- each forming 20% of the subscribed and paid-up equity share capital, 20.01 of voting capital, of the company at a price of Rs. 1.00/- per share of

LOTUS CHOCOLATE COMPANY LIMITED having its registered office at #403, 4th Floor, Diamond House, Punjagutta, Hyderabad 500 082. Tel: (040) 2340 1966/4967 Fax: (040) 2340 1312

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Shri Alapati Ramakrishna S/o Shri Jaya Deo residing at H. No. 8-3-214/29, 2nd Floor, 242 Sreenivasa Colony (West), Ameerpet, Hyderabad 500 038. Tel: (040) 23743109 Fax: (040) 23755289 And Shri Devabhuktuni Durga Prasad S/o Shri Rama Koteswara Rao residing at 307, Pancom Business Centre, Ameerpet “x” Roads, Hyderabad-500 073. Tel (040) 23750433 Fax:(040) 23740753 1. Mode of payment is in Cash. 2. Partly Paid Shareholders are not eligible to participate in the Offer. 3. This is not a Competitive Bid. 4. This Offer is not conditional as to any minimum level of acceptance. 5. The Offer is subject to approval of Reserve Bank of India under the Foreign Exchange Management Act, 1999, for transferring 54,18,838 equity shares of Rs.10/- each fully paid and 73,96,600 Preference Shares of Rs. 10/- each fully paid, by Network Foods International Limited to the Acquirers. 6. The Offer is subject to the approval of the Reserve Bank of India (“RBI”) under the Foreign Exchange Management Act, 1999 for acquiring shares tendered by non-resident shareholders including NRIs/FIIs and OCBs. In case of acceptances from NRI/OCB/FIIs shareholders, the Acquirer would after closure of the offer, make the requisite applications to RBI to obtain its approval for transfer of such shares of LCC to the Acquirer. There are no other statutory approvals required to acquire shares that are tendered pursuant to this offer. 7. Shareholders who have accepted the Offer by tendering the requisite documents, in terms of the Public Announcement/Letter of Offer, can withdraw the same up to three working days prior (i.e. on or before 10-11-2003) to the date of the closure of the Offer. 8. Acquirer has the option to revise the Offer Price upward any time up to seven working days prior to the date of the closure of the Offer (i.e. on or before 05-11-2003). 9. The upward revision/withdrawal if any, of the offer would also be informed by way of Public Announcement in respect of such changes in all the newspapers in which the original Public Announcement was made and the Acquirer shall pay the same price for all shares tendered anytime during the Offer. 10. If there is Competitive Bid: (i) The Public offers under all the subsisting bids shall close on the same date. (ii) As the offer price cannot be revised during 7 working days prior to the closing

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date of the offers/bids, it would, therefore, be in the interest of the shareholders to wait till the commencement of that period to know the final offer price of each bid and tender their acceptance accordingly. 11. Shareholders may obtain a copy of Public Announcement, Revised Public Announcement and Letter of Offer [including Form of Acceptance cum Acknowledgement and Form of Withdrawal] on SEBI’s website at www.sebi.gov.in

MANAGER TO THE OFFER CIL SECURITIES LIMITED SEBI Regn No. INM 000009694 #214, Raghava Ratna Towers, Chirag Ali Lane, Abids, Hyderabad 500 001. Tel. Nos. (040) 2320 2465/3155. Fax No. (040) 2320 3028. Contact Person: Shri B. M. Maheshwari E-Mail: [email protected] The Schedule of activities is as follows: Activity

Day and Date

Public Announcement (PA) date

Wednesday, 27th August 2003

Specified date

Saturday, 20th September 2003

Date by which Letter Of Offer to be posted to shareholders

Monday, 6th October 2003

Date of opening of the Offer

Wednesday, 15th October 2003

Date of closing of the Offer

Thursday, 13th November 2003

Last date for a competitive bid

Wednesday, 17th September 2003

Last date for revising the offer price/number of shares

Wednesday, 5th November 2003

Last date for withdrawal of acceptance by shareholders

Monday, 10th November 2003

Date of communicating rejection/acceptance and payment of consideration for applications accepted

Friday, 12th December 2003

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Index Sl. No.

Subject

Page No.

1

Disclaimer clause

3

2

Details of the Offer

3

3

Background of Acquirers

5

4

Disclosure in terms of Regulation 21(3)

6

5

Background of the Target Company

7

6

Offer Price

10

7

Financial Arrangements

11

8

Terms and Conditions of the Offer

11

9

Procedure for acceptance and settlement of the Offer

12

10

Documents for inspection

15

11

Declaration by the Acquirer

15

12

Form of Acceptance -cum-Acknowledgement, Form of Withdrawal

Annexed

DEFINITIONS/ABBREVIATIONS Acquirers

Shri Alapati Ramakrishna and Shri Devabhuktuni Durga Prasad

BSE

The Stock Exchange, Mumbai

CDSL

Central Depository Services (India) Limited

DP

Depository Participant

EPS

Earning per equity share

HSE

The Hyderabad Stock Exchange Limited, Hyderabad

Letter of offer/LOO

This Letter of Offer dated 01-10-2003

Offer

Cash offer being made by the Acquirers to the Shareholders of the Target Company

RBI

Reserve Bank of India

Public Announcement/PA

Public Announcement for the open offer issued on behalf of the Acquirers on August 27, 2003 and on 4th October, 2003

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Manager to the Offer

CIL Securities Limited

Shares

Equity Shares

Target Company/LCC

Lotus Chocolate Company Limited

The Regulations/SEBI (SAST) Regulations 1997

Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 and subsequent amendments thereof

Specified Date

Saturday, September 20, 2003

SEBI

Securities and Exchange Board of India

1. DISCLAIMER CLAUSE IT IS TO BE DISTINCTLY UNDERSTOOD THAT FILING OF DRAFT LETTER OF OFFER WITH SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) SHOULD NOT IN ANY WAY BE DEEMED OR CONSTRUED THAT THE SAME HAS BEEN CLEARED, VETTED OR APPROVED BY SEBI. THE DRAFT LETTER OF OFFER HAS BEEN SUBMITTED TO SEBI FOR A LIMITED PURPOSE OF OVERSEEING WHETHER THE DISCLOSURES CONTAINED THEREIN ARE GENERALLY ADEQUATE AND ARE IN CONFORMITY WITH THE REGULATIONS. THIS REQUIREMENT IS TO FACILITATE THE SHAREHOLDERS OF LOTUS CHOCOLATE COMPANY LIMITED (LCC), THE TARGET COMPANY, TO TAKE AN INFORMED DECISION WITH REGARD TO THE OFFER. SEBI DOES NOT TAKE ANY RESPONSIBILITY EITHER FOR FINANCIAL SOUNDNESS OF THE ACQUIRERS, OR THE COMPANY WHOSE SHARES/CONTROL IS PROPOSED TO BE ACQUIRED OR FOR THE CORRECTNESS OF THE STATEMENTS MADE OR OPINIONS EXPRESSED IN THE LETTER OF OFFER. IT SHOULD ALSO BE CLEARLY UNDERSTOOD THAT WHILE ACQUIRERS ARE PRIMARILY RESPONSIBLE FOR THE CORRECTNESS, ADEQUACY AND DISCLOSURE OF ALL RELEVANT INFORMATION IN THIS LETTER OF OFFER, THE MERCHANT BANKER IS EXPECTED TO EXERCISE DUE DILIGENCE TO ENSURE THAT ACQUIRERS DULY DISCHARGE THEIR RESPONSIBILITY ADEQUATELY. IN THIS BEHALF, AND TOWARDS THIS PURPOSE, THE MANAGER TO THE OFFER M/S. CIL SECURITIES LIMITED HAS SUBMITTED A DUE DILIGENCE CERTIFICATE DATED 06-09-2003 TO SEBI IN ACCORDANCE WITH THE SEBI (SUBSTANTIAL ACQUISITION OF SHARES AND TAKEOVERS) REGULATIONS, 1997 AND SUBSEQUENT AMENDMENT (S) THEREOF. THE FILING OF THE LETTER OF OFFER DOES NOT, HOWEVER, ABSOLVE THE ACQUIRERS FROM THE REQUIREMENT OF OBTAINING SUCH STATUTORY CLEARANCES AS MAY BE REQUIRED FOR THE PURPOSE OF THE OFFER.

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ANY INFORMATION OR REPRESENTATIONS WITH RESPECT TO SUCH MATTERS NOT CONTAINED IN THE LETTER OF OFFER OR IN THE DOCUMENTS INCORPORATED BY REFERENCE IN THE LETTER OF OFFER MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORISED BY ACQUIRER. ANYONE PLACING RELIANCE ON ANY OTHER SOURCE OF INFORMATION WOULD BE DOING SO AT HIS/HER/THEIR OWN RISK.

2. Details of the Offer 2.1 Background of the Offer a. This Offer is made for Substantial acquisition of Shares, in accordance with Regulation 10 and change in control, in accordance with Regulation 12 of SEBI (Substantial Acquisition of Shares & Takeovers) Regulations, 1997 and subsequent amendments thereto. b. The acquirers have entered into a Sale and Purchase Agreement dated 22.08.2003, with Network Foods International Limited (NFIL), having its registered office at 5 Shenton Way #29-00 UIC Building, Singapore phone No.: (0065) 67577678, Fax No.:(0065) 67577671 to purchase in aggregate 54,18,838 Equity Shares of the Target Company representing 42.21% of the total paid up Equity Capital of the Target Company at a price of Rs. 0.234/- per fully paid Equity Share and 73,96,600 Preference Shares representing 100% of the Preference Share Capital of the Target Company at a price of Rs. 0.234/- per Preference Share payable in cash. NFIL is the holding Company of the Target Company. The said acquisition of shares requires the approval of RBI under FEMA Regulations. The application to RBI will be made in due course. c. Some of the main features of the Agreement are mentioned below: I. The Seller has agreed to sell, transfer and assign the said 54,18,838 Equity Shares of Rs. 10/- each of the Target Company representing 42.21% of the total paid up Equity Capital of the Target Company at a price of Rs. 0.234/- per fully paid Equity Share and 73,96,600 Preference Shares of Rs. 10/- each of the Target Company representing 100% of the Preference Share Capital of the Target Company at a price of Rs. 0.234/per Preference Share payable in cash, to the Acquirer and the Acquirer agreed to purchase the said shares from the Seller, for a total consideration amount of Rs. 30,00,000/- (Rupees Thirty Lakhs only). II. The Seller and Acquirers have appointed M/s Kesar Dass B. & Associates, Advocates & Solicitors, having their office at D-228-229, Lajpat Nagar, Part 1, New Delhi 110 024 as Escrow Agent who acts on behalf both Seller and Acquirers. III. The Acquirers paid total amount of Rs. 30,00,000/- [Rupees Thirty Lakhs only] to M/s Kesar Dass B & Associates, New Delhi on signing of this agreement (i.e., 22-082003).

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1125

IV. The Seller has deposited the said shares along with duly executed Transfer Deeds with the Escrow Agent M/s Kesar Dass B & Associates, New Delhi on the same day (i.e., 22-08-2003). V. The Seller has absolute right and complete authority to enter into the present transaction and the Seller is not in any way prevented. VI. This Agreement is subject to the compliance of the provisions of the SEBI (SAST) Regulations and the Sale Purchase Agreement shall not be acted upon by the parties in case of non-compliance of any provisions of the SEBI (SAST) Regulations. VII. On Completion of formalities or as soon as possible NFIL shall obtain the resignation of Mr Chan Chong Lum and Sushil Premchand from the Board of the Target Company and induct both the Acquirers i.e., Shri Alapati Ramakrishna and Shri Devabhuktuni Durga Prasad as Directors of the Target Company. d. The proposed change in control is consequent to the Agreement whose salient features are described in 2.1(c) above. e. Shri Alapati Ramakrishna and Shri Devabhuktuni Durga Prasad (‘the Acquirers’), are making an open Offer to the public Shareholders of Lotus Chocolate Company Limited (‘ LCC’, ‘ the Target Company’) to acquire 25,68,210 Equity Shares of Rs. 10/- each, representing 20% of the subscribed Capital, 20.01% of the voting capital and 20% of the paid up equity capital of the Target Company, at a price of Rs. 1.00/- (Rupee One only) per each fully paid up Equity Share. (‘the Offer Price’), payable in cash (‘The Offer’) subject to the terms and conditions mentioned hereinafter. f. The information as obtained from BSE & HSE the Stock Exchanges, where Equity Shares of LCC are listed, the Shares of LCC are infrequently traded as per the SEBI (SAST) Regulations , during the 6 calendar months preceding the month in which the PA was made. g. The Acquirers, Seller or the Target Company have not been prohibited by SEBI from dealing in securities, in terms of direction issued u/s 11B of SEBI Act or under any of the Regulations made under the SEBI Act. h. Securities & Exchange Board of India (SEBI) has not initiated any enquiries, or awarded any penalties against the Acquirers, other ventures of the Acquirers / Group / associate Companies or Companies in which the Acquirers are interested. No such action is also taken against the Target Company. i. The Offer is subject to approval of Reserve Bank of India under the Foreign Exchange Management Act, 1999, for transferring 54,18,838 equity shares of Rs.10/- each fully paid and 73,96,600 Preference Shares of Rs. 10/- each fully paid, by Network Foods International Limited to the Acquirers.

1126

Investment Banking

j. Mr. Chan Chong Lum and Mr. Sushil Premchand will resign from the Board of Directors of the Target Company and both the Acquirers i.e., Shri Alapati Ramakrishna and Shri Devabhuktuni Durga Prasad will be inducted as Directors of the Target Company 2.2 Details of the proposed Offer a. A Public Announcement, as per Regulation 15 (1) of the Regulations, was made in the following Newspapers, announcing the intention of the Acquirers to acquire 25,68,210 Equity Shares representing 20.00 % of the subscribed Capital (20.01% of the voting Capital & 20.00 % of the paid up capital) of LCC through an Open Offer.

Newspaper Language

Editions

Date of PA

Business Standard

English

All Editions

Wednesday, 27th August 2003

Andhra Bhoomi

Telugu

All Editions

Wednesday, 27th August 2003

Hindi

Hyderabad

Wednesday, 27th August 2003

Daily Hindi Milap

The above Public Announcement and Revised Public Announcement were issued in all the editions of Business Standard, Andhra Bhoomi and Hyderabad Edition of Daily Hindi Milap. The Public Announcement made on 27th August 2003 and Revised Public Announcement made on 4th September 2003 is also available on the SEBI website at www.sebi.gov.in b. The Acquirers proposes to acquire the Fully paid Equity Shares, at a price of Rs. 1.00/(Rupee One only). The Offer is made only for fully paid up shares and no partly paid up share will be acquired. c. The consideration will be paid in Cash. d. This is not a competitive bid. e. This Offer is not conditional as to any minimum level of acceptance. f. The Acquirers do not hold any Equity Shares in the Target Company as on date of the Public announcement, i.e. Wednesday, 27th August 2003. g. The Acquirers have not acquired any Shares since the date of PA.

Appendix 8

1127

h. The Acquirers have not been allotted any Equity Share of LCC by way of allotment in a public or rights or preferential issue during the twenty six week period prior to the date of Public Announcement. The Acquirers have also not acquired any Share of LCC, in any manner during the preceding 12 months from the date of this Public Announcement. 2.3. The Specified Date a. The Specified date for determining the eligibility of Shareholders for participating in this Offer is Saturday, September 20, 2003. b. The Specified date is only for the purpose of determining the names of the Shareholders as on such date, to whom the Letter of Offer would be sent and all owners (registered or unregistered) of Shares of Lotus Chocolate Company Limited anytime before the closure of the Offer, are eligible to participate in the Offer.

3. Background of The Acquirers 3.1 Information about Acquirers a. Shri Alapati Ramakrishna is an Engineering Graduate. He worked as a Plant Engineer with Kesoram Cement Ltd., for about 4 years, worked as Mechanical Engineer with Gulf Cement Company, UAE, which was managed by Ube Industries, Japan for about 13 years. He also worked as General Manager with National Council for Cement & Building Material for about 2 years. He promoted a Niharika Polymers Pvt. Ltd., which is manufacturing, dealing etc of packing materials of all types of Jars, bottles, bags, boxes, etc. Accordingly he worked as an Engineer in various positions in Japan, Dubai and Saudi Arabia for 14 years and has been in manufacturing field since 1999 in India. The Networth of Shri Alapati Ramakrishna as on 25-08-2003 is Rs. 2,02,81,862/(Rupees Two Crore Two Lakh Eighty One Thousand Eight Hundred and Sixty Two only) as certified by A.P.P. Kasipathi Partner of M/s. Yaji Associates, Chartered Accountants, 10-3-281/1/301, 3rd Floor, K.H.R. Buildings, Humayun Nagar, Mehedipatnam, Hyderabad 500 028, Ph No. (040) 2353 2597/8 (Membership No. 19442). b. Shri Devabhuktuni Durga Prasad is a Chartered Accountant. He worked as Accounts Officer and Systems Analyst with Associate Cements Company Limited for about 4 years and also worked as Finance Manager for Fujairah Cement Industries, Fujairah, UAE, which is one of the largest cement manufacturers in UAE. He has an overall experience of 25 years in the field of Finance, Investments, Accountancy and Stock Broking both in India and Abroad. He is a partner of M/s Durga Prasad & Co, member of the National Stock Exchange of India Limited since 29-02-1996. The Networth of Shri Devabhuktuni Durga Prasad as on 24-08-2003 is Rs. 2,63,11,849/- ( Rupees Two Crore Sixty Three Lakh Eleven Thousand Eight Hundred and Forty Nine only/-) as certified by G. Jagadeswara Rao, Partner of M/s. S.R.Mohan & Co., Chartered Accountants, III

1128

Investment Banking Floor, North Block, Raghava Ratna Towers, Chirag Ali Lane, Hyderabad 500 001, Ph No. (040) 23201123/1223, Fax No. (040) 23205535, (Membership No. 21361)

c. Brief information on the Acquirers is given hereunder:

Name & Residential Address

Relationship , if any, with other Acquirer

Net Worth , as Certified by Chartered Accountant

NIL

Rs. 2,02,81,862/(25-08-2003)

NIL

Rs. 2,63,11,849/(24-08-2003)

Shri Alapati Ramakrishna S/o Shri Jaya Deo residing at H. No. 8 -3 -214/29 2nd Floor, 242 Sreenivasa Colony (West), Ameerpet, Hyderabad 500 038 Shri Devabhuktuni Durga Prasad S/o Shri Rama Koteswara Rao residing at 307, Pancom Business Centre, Ameerpet "x" Roads, Hyderabad 500 073

Companies in which is a full time Director. Neeharika Polymers Private Limited (Managing Director)

Durga Prasad Securities Private Limited—Director

d. Since the acquirers are not having any shares in LCC, the disclosures under Chapter II of Regulations are not applicable. e. There is no formal agreement entered into between the acquirers with regard to the offer/ acquisition of shares. f. (i) Shri Devabhuktuni Durga Prasad has promoted M/s Durga Prasad Securities Private Limited. M/s Durga Prasad Securities Private Limited was incorporated on February 16, 2000 and the Company is yet to commence its operations. As certified by G. Jagadeswara Rao, Partner of M/s. S.R. Mohan & Co., Chartered Accountants, III Floor, North Block, Raghava Ratna Towers, Chirag Ali Lane, Hyderabad 500 001, (Membership No. 21361), the Auditors of the Company, the first Balance Sheet of M/s Durga Prasad Securities Private Limited, was prepared as on 31/03/2002. The financial details of M/s Durga Prasad Securities Private Limited as taken from the said certificate, are as under:

Particulars Equity capital

(Rs. in lakhs) 31.03.2002

31.03.2003 0.25

0.25

Reserves (excluding revaluation reserves)

0

0

Total Income

0

0

1129

Appendix 8 Profit After Tax (PAT)

0

(0.05)

Earnings Per Shares (EPS)

0

0

Net Asset Value

8

8

(ii) M/s Durga Prasad & Co., a partnership firm, wherein Shri Devabhuktuni Durga Prasad is a partner, is a member of the National Stock Exchange of India Limited, which has been dealing as a stock broker since 29-02-1996. The financial details of M/s Durga Prasad & Co., as taken from the financial statements as filed with the Income Tax Department, are as under: (Rs. in lakhs) Particulars

31.03.2003 (Provisional)

31.03.2002

31.03.2001

31.03.2000

Equity capital (Partners Capital)

124.69

119.53

127.98

114.60

Reserves (excluding revaluation reserves)

0

0

0

0

94.30

104.31

149.83

157.73

Profit After Tax (PAT)

5.22

(1.67)

19.30

9.67

Earnings Per Shares (EPS)

NA

NA

NA

NA

Net Asset Value

NA

NA

NA

NA

Total Income

(iii) Shri Alapati Ramakrishna has promted M/s Neeharika Polymers Private Limited. M/s Neeharika Polymers Private Limited was incorporated on 18.09.1997 and it is mainly engaged in manufacturing, dealing etc of packing materials of all types of Jars, bottles, bags, boxes etc. The financial details as taken from the Audited Balance Sheets, of M/s Neeharika Polymers Private Limited are as under: (Rs. in lakhs) Particulars Equity capital

Reserves (excluding revaluation reserves)

31.03.2002

31.03.2001

31.03.2000

325

325

325

0

0

0.01

1130

Investment Banking

Total Income

236.88

179.70

0.43

Profit After Tax (PAT)

(86.35)

(111.27)

0.01

Negative

Negative

Negligible

17.15

18.58

21.22

Earnings Per Shares (EPS Net Asset Value

The above companies/firm are not sick industrial companies. 3.2. Object and Purpose of Acquisition and Future Plans: a. The Offer to the Shareholders of LCC is for substantial acquisition of Shares by the Acquirers accompanied with change in Management of the Target Company. b. The acquirers do not have any specific future major expansion plan as on the date of Public Announcement. c. As on the date of Public Announcement, the acquirers do not have any intention to make any major change to the existing line of business of the Target Company, or to dispose off or otherwise encumbrance of any assets of Target Company in succeeding two years except in ordinary course of business of the target company. They undertake that they shall not sell, dispose of or otherwise encumber any substantial assets of the Target Company except with the prior approval of the shareholders. 3.3 Past Actions by Sebi/Stock Exchanges Against the Acquirers or Other Ventures of Acquirers a. Securities & Exchange Board of India (SEBI)/The Stock Exchanges have not initiated any enquiries, or awarded any penalties against the Acquirers, other ventures of the Acquirers/Group/associate Companies or Companies in which the Acquirers are interested. No such action is also taken against the Target Company. b. M/s Durga Prasad & Co., a partnership firm, wherein Shri Devabhuktuni Durga Prasad is a partner, is a member of the National Stock Exchange of India Limited, which has been dealing as a stock broker since 29-02-1996. Except the said firm no other Company/venture promoted by the Acquirers or belonging to the Group is registered with SEBI as a market intermediary. c. Securities & Exchange Board of India (SEBI)/The Stock Exchanges have not initiated any enquiries, or not taken any action against M/s Durga Prasad & Co. The said firm, in the normal course of trade has paid necessary penalties to the National Stock Exchange of India Limited (NSEIL) for non-compliance of its Rules, Regulations and By-laws.

Appendix 8

1131

3.4 Option Under Regulation 21(3) If pursuant to this Offer and/or acquisition of shares from the open market or through negotiation or otherwise, the public shareholding falls to 10% or less of the voting capital of the Target Company, then in accordance with Regulations, the Acquirers undertake to disinvest through an offer for sale or by a fresh issue of capital to the public, which shall open within a period of 6 months from the date of closure of public offer, such number of shares so as to satisfy the listing requirements.

4. Background of the Target Company 4.1 Brief History and Main Area of Operations: a. LCC was incorporated as a Public Limited Company on 3rd October, 1988, at Hyderabad under the Companies Act, 1956. b. The Registered Office of LCC is situated at #403, 4th Floor, Diamond House, Punjagutta, Hyderabad 500 082. c. LCC was originally promoted by Sri Vijayaraghavan Nambiar, an engineer with post graduation in industrial management and past experience in manufacturing cocoa products and chocolates, Smt. T. Sarada, a renowned actress of Indian Cinema and APIDC, an AP state owned corporation for promoting industries. In September, 1993 the company offered its controlling stake to the tune of 30.77 lakhs equity shares to Sunshine Allied Investments Limited (SAIL), Singapore. In May 1994 SAIL brought in an additional Rs. 206.13 Laks for 17.2 Lacs equity shares at a premium of Rs. 2/- towards equity capital, thereby the holding became 51%. There upon LCC became subsidiary of SAIL. On 12-8-1995 the SAIL has changed its name from Sunshine Allied Investments Limited to Pengkalen Investments Limited. On 05-09-1997 Pengkalen Investments Limited changed its name to Network Foods International Limited. The promoter group presently holds 67,02,858 Equity Shares of Rs. 10/- each in LCC, constituting approximately 52.20% of the issued and paid up Equity Capital and 73,96,600 Preference Shares of Rs. 10/- each constituting 100.00% of the preference Capital. d. The Authorized Capital of LCC as on date is Rs. 2200 Lacs comprising of Rs. 1400 Lakhs Equity Share Capital divided into 140 Lacs Equity Shares of Rs. 10/- each and of Rs. 800 Lakhs Preference Share Capital divided into 80 Lacs Preference Shares of Rs 10/- each. The Issued & Subscribed Capital is 1,28,41,049 Equity Shares of Rs. 10/- each aggregating to Rs. 1284.10 Lacs and 73,96,600 Preference Shares of Rs. 10/- each aggregating to Rs. 739.66 Lakhs. The Paid up Capital of LCC as on 31st December 2002 is Rs. 2023.46 Lakhs since there are calls in arrears to the tune of Rs. 0.30 Lakhs on 6000 Equity Shares. e. LCC has, as its main objects, business of manufacturing, buying, selling, import and export of all kinds of chocolate products, chocolate confectionary, derivatives of cocoa and beverages, etc.

1132

Investment Banking

f. LCC is engaged in manufacture of Chocolates/Cocoa Products. g. No action has been taken by the Stock Exchanges or SEBI against the Acquirers, LCC. 4.2 Share capital structure of the target company. As per Article 87 ‘ No member shall be entitled to vote either personally or by proxy for another Member at any General Meeting or a class of shareholders either upon a show of hands or upon a poll in respect of any shares registered in his name on which any class or other sums presently payable by him have been paid or in regard to which the Company has exercised, any right of lien.’ Paid up Equity Shares of Target company Fully paid up equity shares

Partly paid up equity shares

No .of Shares/ voting rights 1,28,35,049/1,28,35,049

6,000/NIL

% of shares/voting rights 99.95%/100%

0.05%/NIL

Total paid up equity shares

1,28,41,049/1,28,35,049

100%/100%

Total voting rights in Target company

1,28,41,049/1,28,35,049

100%/100%

4.3 There are no outstanding instruments in the nature of warrants/fully convertible debentures/partly convertible debentures, etc., which are convertible into equity at any later date. 4.4 The Seller, Promoters and other major shareholders have complied with the applicable provisions of Chapter-II of SEBI (SAST) Regulations. However the Company has defaulted in filing declarations under Regulations 6 & 8 of SEBI (SAST) Regulations. The Company has filed all pending declarations under Regulations 6 & 8 under the SEBI (Regularization Scheme) 2002. 4.5. LCC has been complying with the listing requirements of the Stock Exchanges without default except the following: i. The intimation for Book Closure for the year 2000 and 2001 was given for a period less than 30 days. The company received a Show cause notice from BSE in this respect. The Company has given necessary replies and no punitive action in this regard has been taken by BSE. ii. The Listing Fee for the year 2003–2004, of BSE and HSE, has not yet been paid. No punitive action in this regard has been taken by the respective Stock Exchange.

1133

Appendix 8

4.6. As on the date of Public Announcement i.e 27/08/2003, composition of Board of Directors of LCC is Shri. R. Badrinarayanan (Managing Director), Shri. Sushil Premchand, Shri. Chan Chong Lum, Dr. Easo John, Ms. T. Sarada, and Shri J. Harinarayan, IAS. As informed by the Company vide its letter dated 06/09/2003, Mr Badrinarayan has tendered his resignation on 03/09/2003, from the position of Managing Director, and Dr. Easo John has tendered his resignation on 01/09/2003 from the directorship. There are no directors representing the acquirers on the Board of Directors of LCC. 4.7. No merger/demerger, spin off have taken place during the last 3 years and also no change of name was made since the incorporation of LCC.

4.8 Financial Information: Brief Audited financial details of LCC for the last 3 years are furnished as under: (Amount Rs. in lakhs) Profit & Loss Statement Income from operations

31.12.2000 (Audited)

31.12.2001 (Audited)

31.12.2002 (Audited)

30.06.2003 (Provisional)

1315.46

1010.12

511.56

98.49

Other Income

37.60

47.04

218.87

99.68

Total Income

1353.06

1057.16

730.43

198.17

Total Expenditure.

1357.37

1527.83

726.49

222.71

Profit/(Loss) Before Depreciation Interest and Tax

(4.31)

(470.67)

3.94

(24.54)

Depreciation

92.35

99.70

105.12

52.39

Interest

70.53

62.87

50.56

19.46

Profit Before Tax

(167.19)

(633.24)

(151.74)

(96.39)

Provision for Tax

0

0

0

0

(167.19)

(633.24)

(151.74)

(96.39)

Profit After Tax

1134 Balance Sheet Statement

Investment Banking

31.12.2000 (Audited)

31.12.2001 (Audited)

31.12.2002 (Audited)

30.06.2003 (Provisional)

Sources of funds : Paid up share capital

2023.46

2023.46

2023.46

2023.46

394.68

394.68

394.68

394.68

Networth*

582.13

250.04

81.46

(14.94)

Secured loans

626.38

531.97

531.27

506.81

Unsecured loans

231.06

248.48

249.41

248.81

3275.58

3198.60

3198.83

3173.76

927.71

859.22

759.28

707.45

0.25

0.26

0.16

0.16

511.60

171.02

102.70

33.07

Total miscellaneous expenditure not written off

1836.02

2168.09

2336.69

2433.08

Total

3275.58

3198.60

3198.83

3173.76

Reserves and Surplus (excluding revaluation reserves)

Total Uses of funds : Net fixed assets Investments Net current assets

*Networth = Equity Capital + Preference Capital + Free Reserves (excluding Revaluation Reserves) – Miscellaneous Expenditure not written off (including Profit & Loss A/c debit balance) Note: 1. The Company has 10% redeemable cumulative preference capital of Rs. 739.66 Lakhs. While calculating Networth of LCC, if the Preference Capital is not considered, the Networth is Rs. (157.53) Lakhs, Rs. (489.62) Lakhs, Rs. (658.2) Lakhs, Rs. (754.6) Lakhs as on 31.12.2000, 31.12.2001, 31.12.2002, 30.06.2003 respectively. 2. The company has the accrued liability of Rs. 73.96 Lakhs of preference dividend for each financial year. As per the audited accounts the contingent liability ascertained for financial year ending 31.12.2000, 31.12.2001 & 31.12.2002 is of Rs. 176.91 Lakhs, 250.87 Lakhs & 324.83 Lakhs respectively. If the accrued unpaid preference dividend is considered while calculating the networth, the networth of LCC is Rs. (334.44) Lakhs, Rs. (740.49) Lakhs & Rs. (983.03) Lakhs, as on 31.12.2000, 31.12.2001 & 31.12.2002 respectively.

1135

Appendix 8

Other Financial Data

31.12.2000 (Audited)

Dividend (%)

31.12.2001 (Audited)

31.12.2002 (Audited)

30.06.2003 (Provisional)

0

0

0

0

(1.30)

(4.93)

(1.18)

(0.75)

Return on Networth (%)

(28)

(253)

(186)

(645)

Book Value Per Share$

2.88

1.23

0.40

(0.07)

Earning Per Share (Rs.)

$= For calculating book value of Share if contingent liability for accrued unpaid preference dividend as detailed above is reduced, the networth for financial year ending 31.12.2000, 31.12.2001 & 31.12.2002 would be Rs. 405.22 Lakhs, Rs. (0.83) Lakhs & Rs. (243.37) Lakhs respectively. Accordingly the Book Value per Share would be Rs. 2.00, Rs. (0.004) & Rs. (1.20), respectively. During the year ended 31st December 2001 preliminary expenses and Share issues expenses of Rs. 15.67 lakhs and deferred revenue expenditure of Rs. 366.67 lakhs was written-off as per the advise made by NFIL ( holding Company) in line with the International accounting guidelines (SAS-34) in Singapore. This has resulted in loss for the said year being increased by Rs. 275.64 Lakhs. The above information is based on the Annual Audited Accounts for the year ended 31st Decemeber 2000, 31st December 2001, 31st December 2002. The unaudited (provisional) finanancial statements for the half year ended 30.06.2003 was certified by the management of LCC and auditors of LCC, M/s K. Vijayaraghavan & Associates.

4.9 The equity shareholding pattern of the Target Company before and after the Offer (assuming full acceptance of the Offer) is given in the Table below. Shareholders'category

Shareholding & voting rights prior to the agreement/acquisition and offer

Shares/voting rights agreed to be acquired which triggered off the Regulations

(A)

No.

Shares/voting rights Share holding/voting to be acquired in open rights after the acquisition offer (Assuming full and offer. i.e. acceptances)

(B)

(C)

(A)+(B)+(C)=(D)

%

No.

%

No.

%

No.

%

67,02,858

52.20

0

0

0

0

12,84,020

9.99

0

0

0

0

0

0

0

0

52.20

0

0

0

0

12,84,020

9.99

0 0 0

27,09,419 27,09,419 0

21.10 21.11 0

10.00 10.00 0

39,93,524 39,93,524 0

31.10 31.11 0

(1) Promoters.

(a) Parties to agreement, if any (b) Promoters other than (a) above

Total 1(a+b)

(2) Acquirers (a) Main Acquirer** (i) Shri D. Durga Prasad (ii) Shri A. RamaKrishna (b) PACs **

67,02,858

0 0 0

12,84,105 12,84,105 0

1136

Investment Banking

Total 2(a+b)

0

0

54,18,838

42.21

(3) Parties to agreement other than (1) (a) & (2)

0

0

0

(4) Public (other than parties to agreement, acquirers & PACs)

61,38,191

47.80

0

a) FIs/MFs/FIIs/Banks, SFIs (indicate names) (i) Canara Bank (Trustees: Canbank Mutual Fund) (ii) Andhara Pradesh Industrial Dev Corp. Ltd. (iii) Bank of India (iv) State Bank of India b) Others (Indicate the total number of shareholders in "Public category")

GRAND TOTAL (1+2+3+4)

2,800 5,90,000

0.02 4.59

600 100

0.00 0.00 43.18

55,44,691

25,68,210

20.00

79,87,048

62.21

0

0

0

0

35,69,981

27.80

0 0

0 0

0 0

0 0

0 0

0 0

0 0

0 0

0

0

61,38,191

47.80

0

0

1,28,41,049

100

54,18,838

42.21

0

25,68,210

20.00

0

35,69,981

27.80

1,28,41,049

100

The number of Shareholders in the “Public Category” as on Record Date (i.e. 20-09-2003) is 17,207.

5. Offer Price and Financial Arrangements 5.1. Justification of Offer price (a). The Equity Shares of LCC are listed at BSE and HSE. The Equity Shares are not admitted as permitted security in any other Stock Exchange. (b). The annualized trading turnover of Equity Shares of LCC, during the preceding 6 calendar months prior to the month in which Public Announcement was made. i.e. during February 2003 to July 2003 (both inclusive) is 1,95,659 Equity Shares ,at BSE and there is no trading on HSE . The Shares are thus infrequently traded at BSE and HSE in terms of Regulation 20(5). (c). The trading data is as under: Name of stock exchange(s)

Total No. of Shares traded during the 6 calendar months prior to the month in which PA was made

Total No. of listed Shares

Annualized Trading turnover (in terms of % to total listed shares)

The Stock Exchange, Mumbai

1,95,659

1,28,41,049

3.05

NIL

1,28,41,049

NIL

The Hyderabad Stock Exchange Limited

1137

Appendix 8

The trading volume data of BSE has been taken from the Stock Exchange's official website www.bseindia.com. d. Since the Equity Shares of LCC are infrequently traded as per explanation (i) under Regulation 20(5) at the BSE during the 6 calendar months preceding the month in which the Public Announcement is made, the Offer price has been justified, taking into account, the following parameters, as set out under Regulations 20(5). Sl No.

Particulars

31-12-2002

30-06-2003

(a)

The negotiated price under the agreements under Reg. 14(1)

Rs.0.234 per share

Rs.0.234 per share

(b)

The highest price paid by the acquirers or persons acting in concert with them for any acquisitions, including by way of allotment in a public/rights/preferential issue, if any, during the 26-week period, prior to the date of Public Announcement

Not Applicable

Not Applicable

(c)

Other parameters (as on December 31, 2002) Return on Net Worth (%)

(186)

(645)

Book value per share (Rs.)

0.40

(0.07)

(1.18)

(0.75)

Price to Earnings Multiple based on the Offer Price

0.00

0.00

Industry P/E Ratio (Source: Vol. XVIII No. 5 Date March, 2, 2003 Dalal Street Investment Journal)

24.7

Earning per share (Rs.)

Thus the offer price of Re 1.00/- (Rupee One only) is justified in terms of Regulation 20(5) of the Regulations. LCC has 6,000 shares with calls in arrears of Rs. 5/- each aggregating to Rs. 30,000/-. The Offer is only for fully paid up shares and no partly paid up share will be acquired. Note: While calculating the above parameters the accumulated unpaid preference dividend is not considered. If it is considered, the Return on Networth, Book Value per share, Earning Per Share would be negative. e. There is no non-compete agreement for payment to any person. f. The Offer price is justified in terms of Regulation 20(11) of the Regulations. g. This is not a competitive bid. h. In the event of any further Acquisition by the Acquirers after the Public Announcement and any time till Wednesday, 5th November, 2003 and in the event of such acquisition

1138

Investment Banking price being higher than the price offered under this Offer, the Offer price will be revised upwardly to ensure that the price offered under this Offer is not less than the highest price paid for any such acquisitions. Any such upward revision will be notified through an announcement in all dailies where the original Public Announcement was made.

(i). The last date for any upward revision is Wednesday, 5th November 2003. 5.2. Financial Arrangements: (a). Assuming full acceptance, the total funds requirements to meet this Offer is Rs. 25,68,210/- (Rupees Twenty Five Lacs Sixty Eight Thousand Two Hundred and Ten only). (b). In accordance with Regulation 28 of the SEBI (SAST) Regulations, the Acquirers have created an Escrow Account in the form of Cash for Rs.3,60,150 (Rupees Three Lacs Sixty Thousand One Hundred and Fifty only), on August 26, 2003, being more than 25% of the total consideration payable under the Offer, with The State Bank of India, Secunderabad Branch, Hyderabad- 500 003 and a lien has been marked on the said account in favor of CIL Securities Ltd., Manager to the Offer. Pursuant to the increase in Offer Price, the Acquirers have deposited the additional sum of Rs. 2,82,000/- in the said escrow account, on September 15, 2003, thereby total amount in the said account increased to Rs. 6,42,150 (Rupees Six Lacs Forty Two Thousand One Hundred and Fifty only) and a lien has been marked on the said account in favor of CIL Securities Ltd., Manager to the Offer. (c). The Acquirers have authorized CIL Securities Ltd., Managers to the Offer to realize the value of the Escrow Account in terms of the Regulations. (d). The Acquirers shall arrange to pay the consideration on or before Friday, 12th December 2003. Payment will be made to the person named by the acceptors in the relevant box in the Acceptance Form by “Account Payee” crossed Cheque/Pay Orders/Demand Drafts as indicated in the form of acceptance. If no such details are filled in by the acceptor(s), then the same will be sent by registered post/certificate of posting to the Sole/First holder at their registered address at the Equity Share holder’s own risk. (e). CIL Securities Limited, Managers to the Offer states that they have satisfied themselves that the Acquirers have adequate financial resources to fulfill the obligations under the open offer. The consideration shall be paid by the Acquirers from own sources. No borrowing from Banks/Financial Institutions is being envisaged for the purpose. All the funds shall be domestic and no foreign funds shall be utilized. (f). As per Certificate dated 25/08/2003, issued A.P.P. Kasipathi Partner of M/s. Yaji Associates, Chartered Accountants, 10-3-281/1/301, 3rd Floor, K.H.R.Buildings, Humayun Nagar, Mehedipatnam 89, Hyderabad 500 028, Ph No. (040) 2353 2597/8

Appendix 8

1139

(Membership No. 19442) the Net Worth of Shri Alapati Ramakrishna as on 25.07.2003 is Rs. 2,02,81,862/- (Rupees Two Crore Two Lac Eighty One Thousand Eight Hundred and Sixty Two only). (g). As per Certificate dated 25/08/2003, issued G. Jagadeswara Rao, Partner of M/s. S. R. Mohan & Co., Chartered Accountants, III Floor, North Block, Raghava Ratna Towers, Chirag Ali Lane, Hyderabad 500 001, Ph No. (040) 23201123/1223, Fax No. (040) 23205535, (Membership No. 21361) the Net Worth of Shri Devabhuktuni Durga Prasad as on 24-08-2003 is Rs. 2,63,11,849/- ( Rupees Two Crore Sixty Three Lac Eleven Thousand Eight Hundred and Forty Nine only/-). (h). G. Jagadeswara Rao, Partner of M/s. S. R. Mohan & Co., Chartered Accountants, III Floor, North Block, Raghava Ratna Towers, Chirag Ali Lane, Hyderabad 500 001, Ph No. (040) 23201123/1223, Fax No. (040) 23205535, (Membership No. 21361) , vide their Certificate dated 01/09/2003, have certified that Shri Durga Prasad Devabhaktuni (one of the acquirers) have adequate liquid resources to implement the Offer, including the expenses thereof. (i). A.P.P. Kasipathi Partner of M/s. Yaji Associates, Chartered Accountants, 10-3-281/1/301, 3rd Floor, K.H.R.Buildings, Humayun Nagar, Mehedipatnam, Hyderabad-500 028, Ph No. (040) 2353 2597/8, (Membership No.19442), vide their Certificate dated 01/09/2003, have certified that Shri Alapati Ramakrishna (one of the acquirers) have adequate liquid resources to implement the Offer, including the expenses thereof. (j). CIL Securities Limited, Manager to the Offer states that they have satisfied themselves about the ability of the Acquirers to implement this Offer in accordance with the regulations. (k). The payment of consideration/dispatch of unaccepted shares/ crediting of unaccepted shares in dematerialized form to the Beneficiary account shall be made on or before Friday, 12th December 2003.

6. Terms and Conditions of The Offer (a). This Offer will open on Wednesday, 15th October, 2003 and will close on Thursday, 13th November, 2003. The Equity Shares offered under this Offer should be free from all liens, charges, equitable interests, encumbrances and are to be offered together with, if any, of all rights of dividends, bonuses or rights from now on and hereafter. (b). Specified date is only for the purpose of determining the names of the Shareholders as on such date, to whom the Letter of Offer would be sent and all owners (registered or unregistered) of Shares of LCC anytime before the closure of the Offer, are eligible to participate in the Offer. (c). This Offer is made to all Shareholders of LCC (except the Acquirers and parties to the agreement) whose name appear in the Register of members of the Company on Saturday, September, 20, 2003, the Specified Date. This Offer is also open to persons (except the Acquirers and parties to the agreement) who own Equity Shares in LCC any

1140

Investment Banking time prior to the closure of the Offer but are not registered Shareholders as on the “Specified date”. Those Shareholders of LCC who have sold or otherwise disposed off their holding in full or part and receiving this Offer are requested to hand over this Letter of Offer or a copy thereof to the broker or purchaser of the Shares to enable them to participate in the Offer. Such unregistered Shareholders who have acquired Equity Shares of LCC till date of closure of the Offer can participate in the Offer. Shareholders who have sent their Shares for transfer and have not received them back may send in their application alongwith valid transfer deeds indicating the Distinctive Numbers, Folio number of transferee, number of Shares etc. and the date on which the Shares were sent for transfer.

(d). Accidental omission to despatch this Letter of Offer to any person to whom this Offer has been made to or non-receipt of this Letter of Offer by any such person shall not invalidate this Offer in anyway. In case of non-receipt of this Letter of Offer, the eligible person may approach the Manager to the Offer mentioned in this Letter of Offer and obtain copies of this Letter of Offer and Acceptance Form. In case the eligible member is located at place(s) other than where the office of the Manager to the Offer is situated, he/she/they may make an application on a plain paper stating his/her/their name, address, number of Equity Shares held , Distinctive numbers and Folio number etc. The executed documents should reach the Managers latest by 5.00 p.m. on Thursday, 13th November 2003, being the date of closure of the Offer. (e). Those Shareholders who have not received the Letter of Offer may apply on plain paper as detailed above enclosing the Share Certificates and valid transfer forms. The Shareholders shall also have the facility of downloading the Letter of Offer and Acceptance Form from SEBI website (www.sebi.gov.in.) and the downloaded Application Forms can be used. (f). Unregistered Shareholders/those applying on plain paper/downloaded forms/whose Shares are pending transfer will not be required to provide any Indemnity Bond/Letter. (g). There are no Locked In Shares. (h). The Offer is subject to approval of Reserve Bank of India under the Foreign Exchange Management Act, 1999, for transferring 54,18,838 equity shares of Rs. 10/- each fully paid and 73,96,600 Preference Shares of Rs.10/- each fully paid, by Network Foods International Limited to the Acquirers. (i). The Offer is subject to the approval of the Reserve Bank of India (“RBI”) under the Foreign Exchange Management Act, 1999 for acquiring shares tendered by non-resident shareholders including NRIs/FIIs and OCBs. In case of acceptances from NRI/OCB/FIIs shareholders, the Acquirer would after closure of the offer, make the requisite applications to RBI to obtain its approval for transfer of such shares of LCC to the Acquirer. There are no other statutory approvals required to acquire shares that are tendered pursuant to this offer. (j). Partly Paid Shareholders are not eligible to participate in the Offer.

1141

Appendix 8

7. Procedure for Acceptance and Settlement 7.1 Acceptance of the Offer A. Mode of Acceptance

Name and Address of the persons (Managers to the Offer) to whom the Shares should be sent including name of the contact person, telephone no., fax no., etc.

Working days and timings

Mode of delivery

CIL SECURITIES LIMITED #214, Raghava Ratna Towers, Chirag Ali Lane, Abids, Hyderabad 500 001. Tel. Nos. (040) 2320 2465/3155 Fax No. (040) 2320 3028 Contact Person : Shri B.M. Maheshwari E Mail: [email protected]

Monday to Saturday (Except on Holidays) 11:00 A.M to 5:00 PM

By Post/ Courier/ Hand Delivery

(b). The Equity shareholders holding shares in physical form/ beneficial owners holding shares in dematerialized form, may please note that the Form of Acceptance, Share Certificates/ copy of the delivery instructions and other documents shall be sent only to the Managers to the Offer and not to the Acquirers, Target Company and Sellers. (c). If the number of Equity Shares Offered by the Shareholders is more than the Offer size, then the acquisition from each Shareholder will be as per Regulation 21 (6) of the SEBI (SAST) Regulations, on proportionate basis. The Acquirers accept all valid fully paid up Shares tendered and no partly paid up share will be accepted. In case, the number of valid fully paid Shares are more than the number of Shares proposed to be acquired, then, the fully paid Shares will be acquired on a proportionate basis, in such a way that acquisition from a Shareholder shall not be less than marketable lot or the entire holding, if it is less than the marketable lot. In case, the number of valid fully paid Shares are less than the number of Shares proposed to be acquired, then the Acquirers will acquire the fully paid Shares on firm basis. The market lot for LCC's Shares is 100 for Shares in physical form and 1 for Shares held in dematerialized form. (d). The acceptance will be made in consultation with the Manager to the Offer. For Shareholders holding Shares in physical form (a). Shareholders holding Shares in physical form and wishing to tender their Equity Shares will be required to send their form of acceptance, original Share certificates and transfer deeds to the Managers to the Offer: Cil Securities Ltd., at their Regd Office at #214,

1142

Investment Banking Raghava Ratna Towers, Chirag Ali Lane, Abids, Hyderabad 500 001. Telephone Nos. (040) 2320 2465/3155. Fax No. (040) 2320 3028 (Contact Person: Shri B.M. Maheshwari), either by hand delivery on weekdays or by Registered Post, on or before the closure of the Offer i.e. Thursday, 13th November 2003, in accordance with the instructions specified in the Letter of Offer and in the Form of Acceptance.

(b). In case of non-receipt of the letter of Offer, the eligible person may send his consent on plain paper stating the name, address, number of Shares held, distinctive numbers, certificate numbers and the number of Equity Shares Offered along with the Share certificates, duly signed transfer forms and other required documents to the Managers to the Offer before the closure of the Offer. (c). In case the Share certificate(s) and the transfer deeds are lodged with LCC/its transfer agents for transfer and have not been received back, then the acceptance shall be accompanied by (i) the Share Transfer deed(s) and (ii) the acknowledgement of the lodgment with, or receipt issued by LCC/its transfer agents for the Share certificate(s) so lodged. Where the transfer deed(s) are signed by a Constituted Attorney, a certified copy of the Power of Attorney shall also be lodged. In the case of bodies corporate/Limited Companies, certified copies of Memorandum & Articles of Association and a copy of the Board Resolution authorizing the signatory shall also be sent alongwith. (d). Persons who hold the Equity Shares of LCC on the Specified Date, but who are not registered as Shareholders on the Specified Date are also eligible to participate in the Offer. All such persons should send their applications in writing to the Managers to the Offer along with necessary proof of ownership and other documents as specified above. (A) Registered Share Holders should enclose: (a). The enclosed Acceptance Form duly completed and signed in accordance with the instructions contained therein and signed by the Equity Shareholders of LCC in the same order in which they hold Equity Shares and shall be sent to the Managers to the Offer. This order cannot be changed or altered nor can any new name be added for the purpose of accepting the Acquirers’ Open Offer. (b). Original Equity Share Certificate(s) valid transfer deed (s) duly filled in and signed (by all the Equity Shareholders in case the Equity Shares are held jointly ) as per the specimen signatures lodged with LCC and duly witnessed. (B) Unregistered owners should enclose: (a). Form of Acceptance-cum-acknowledgement duly completed and signed in accordance with instructions contained therein, signed by the unregistered Shareholder(s). (b). Original Share certificates. (c). Original broker contract note of a registered broker of a recognized Stock Exchange.

Appendix 8

1143

(d). Valid Share transfer deed as received from the market. The details of the buyer should be left blank. If the details of buyer are filled in, the tender will not be valid under the Offer. All other requirements for valid transfer will be pre-conditions for valid acceptance. Please do not fill any other details in the transfer deed. For Beneficial Owners holding Shares in dematerialized Form (a). Beneficial owners (holders of shares in Dematerialized Form) who wish to tender their shares will be required to send their Form of Acceptance-cum-acknowledgement along with a photocopy of the delivery instructions in “Off-market” mode or counterfoil of the delivery instruction in “Off-market” mode, duly acknowledged by the Depository Participant (DP) in favour of a special depository account opened by the Manager to the Offer, in accordance with instruction specified in the Letter of Offer and in the Form of Acceptance-cum-acknowledgement. The details of the special depository account is given below: DP Name

CIL Securities Limited

DP ID

13500

Client Name

Cil Sec Ltd Escrow A/c —LCC Open Offer

Client Id

1201350000016670

(b). All beneficiary owners maintaining account with NSDL are required to fill in an additional inter-depository slip maintained with the DP while giving instructions to their respective DP. (c). In case of non receipt of the Letter of Offer, beneficial owners may send their applications in writing to the Managers to the Offer, on a plain paper stating the name, address, number of shares held, number of shares offered, DP name, DP ID, beneficiary account number and photocopy of the delivery instruction in “Off-market”, or counterfoil of the delivery instruction in Off-market” mode, duly acknowledged by the DP, in favour of the special depository account, so as to reach the Managers to the Offer on or before the closure of the Offer. (d). The Form of acceptance and other documents required to be submitted, herewith, will be accepted by Cil Securities Limited, Managers to the offer at their Regd Office at #214, Raghava Ratna Towers, Chirag Ali Lane, Abids, Hyderabad 500 001. Telephone Nos. (040) 2320 2465/3155. Fax No. (040) 2320 3028 (Contact Person: Ms. Shri B.M. Maheshwari), between 11 A.M. to 5 P.M. on working days, during the period, the Offer is open. 7.2 Settlement (a). In case of acceptance on proportionate basis, the unaccepted Share Certificates, Transfer deeds and other documents, if any, will be returned by Registered Post at the

1144

Investment Banking Share holder’s/unregistered holder’s sole risk as per the details furnished in the form of acceptance-cum-acknowledgement. Shares held in demat form to the extent not accepted will be returned to the beneficial owner to the credit of the beneficial owner’s DP Account with the respective DP as per the details furnished by the beneficial owner in the form of acceptance cum acknowledgement.

(b). The Acquirers shall arrange to pay the consideration on or before Friday, 12th December 2003. Payment will be made to the person named by the acceptors in the relevant box in the Acceptance Form by “Account Payee” crossed Cheque/Pay Order/Demand Draft, as indicated in the form of acceptance. If no such details are filled in by the acceptor(s), then the same will be sent by registered post to the Sole/First holder at their registered address at the Equity Share holder’s own risk. (c). In terms of Regulation 22(12) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997, in the case of non receipt of statutory approvals, SEBI has the power to grant extension of time for the purpose of making payment subject to, the Acquirers agreeing to pay interest to the Shareholders for delay beyond 30 days from date of closure of the Offer. (d). The Equity Shares Certificate(s) and the transfer deed(s) or Shares transferred to the Special Depository Account together with the Acceptance Form submitted by the acceptors of the Offer, will be held by the Managers in trust for the acceptors of the Offer until the Acquirers complete the offer obligations in terms of regulations.

7.3 Withdrawal from the Offer (a). The Shareholders, who are desirous of withdrawing their acceptances tendered in the Offer, can do so upto 3 Working days, prior to the date of closure of the Offer in terms of Regulation 22(5A) of SEBI (SAST) Regulations. (b). The Withdrawal option can be exercised by submitting the Form of Withdrawal attached to the Letter of Offer duly filled in, with relevant particulars, so as to reach the Manager to the Offer on or before Monday, November 10, 2003. In case of nonreceipt of Form of Withdrawal, the Withdrawal option can be exercised by making an application on plain paper alongwith the following details: In the case of Shares held in physical Form: Name, Address, Distinctive numbers, Folio nos., No. of Shares tendered/withdrawn, In the case of Shares held in Demat Form: Name, Address, Photocopy of Delivery instruction duly acknowledged by the DP, No. of Shares tendered/withdrawn, (c). The Share Certificates in respect of Shares withdrawn by Shareholders will be returned by Registered Post/Credited back to the same beneficiary account from where the Shares were delivered “OFF MARKET”.

Appendix 8

1145

7.4 Other Relevant Information (a). The instructions, authorizations and provisions contained in the Acceptance Form constitute part of the terms of the Offer. (b). Barring unforeseen circumstances, the Acquirers would endeavor to obtain all the approvals before the last date indicated for communicating rejection/acceptance and payment of consideration for applications accepted i.e. Friday, 12th December 2003. (c). The Manager to the Offer shall submit a final report to SEBI within 45 days of closure of the Offer in accordance with Regulation 24(7) of the Regulations. (d). The acceptance of this Offer is entirely at the discretion of the Equity Shareholders of LCC. (e). The Acquirers or Manager to the Offer accept no responsibility for any loss of Equity Share Certificates, Offer Acceptance Forms etc. during transit and the Equity Shareholders of LCC are advised to adequately safeguard their interest in this regard. (f). This is not a conditional Offer and there is no stipulation as to the minimum level of acceptance. (g). The Public Announcement, Letter of Offer and the Form of Acceptance and Withdrawal will also be available on the SEBI website: www.sebi.gov.in. In case of non-receipt of the Letter of Offer, all Shareholders including unregistered Shareholders, if they so desire, may download the Letter of Offer and the Form of Acceptance from the SEBI website for applying in the Offer. (h). The acceptance of this Offer by the Shareholders of LCC must be absolute and unqualified. Any acceptance of this Offer which is conditional or incomplete in any respect will be rejected without assigning any reason whatsoever. (i). The Share Certificates in respect of Shares unaccepted will be returned by Registered Post/Credited back to the same beneficiary account from where the Shares were delivered “OFF MARKET”.

8. Documents for Inspection Copies of the following documents will be available for inspection at Registered Office of Managers to the offer at 214, Raghava Ratna Towers, Chirag Ali Lane, Abids, Hyderabad 500 001, during normal business hours (11.00 A.M. to 5.00 P.M.) on all working days during the period from the date of this Letter of Offer till date of closure of the Offer. (a). Copy of agreement dated 22.08.2003 entered between NFIL and Acquirers. (b). Copy of MOU dated August 25, 2003, between the Acquirers and Manager to the Offer. (c). Copy of the Agreement dated September 05, 2003 for opening of Special Depository Account.

1146

Investment Banking

(d). Audited Annual Reports of LCC for the last three years, 2000, 2001, 2002 & Limitedly reviewed Accounts for the half year ended 30.06.2003. (e). Copies of Certificates dated 25/08/2003, issued by A.P.P.Kasipathi Partner of M/s. Yaji Associates, Chartered Accountants, 10-3-281/1/301, 3rd Floor, K.H.R. Buildings, Humayun Nagar, Mehedipatnam, Hyderabad 500 028, Ph No. (040) 2353 2597/8, (Membership No. 9442), certifying the Net Worth of Shri. Alapati Ramakrishna. (f). Copies of Certificates dated 25/08/2003, issued by G. Jagadeswara Rao, Partner of M/s. S.R. Mohan & Co., Chartered Accountants, III Floor, North Block, Raghava Ratna Towers, Chirag Ali Lane, Hyderabad 500 001, Ph No. (040) 23201123/1223, Fax No. (040) 23205535 (Membership No. 21361) certifying the Net Worth of Shri Devabhuktuni Durga Prasad. (g). Copy of Certificate dated 01/09/2003, issued by Mr. G. Jagadeswara Rao, Partner of M/s. S.R.Mohan & Co., Chartered Accountants, III Floor, North Block, Raghava Ratna Towers, Chirag Ali Lane, Hyderabad 500 001, Ph No. (040) 23201123/1223, Fax No. (040) 23205535, ( Membership No.21361) , certifying that Shri Durga Prasad Devabhaktuni (one of the acquirers) have adequate liquid resources to implement the Offer, including the expenses thereof. (h). Copy of Certificate dated 01/09/2003, issued by Mr. A.P.P. Kasipathi Partner of M/s. Yaji Associates, Chartered Accountants, 10-3-281/1/301, 3rd Floor, K.H.R. Buildings, Humayun Nagar, Mehedipatnam, Hyderabad-500 028, Ph No. (040) 2353 2597/8, (Membership No. 19442), certifying that Shri Alapati Ramakrishna (one of the acquirers) have adequate liquid resources to implement the Offer, including the expenses thereof. (i). Copy of letter dated September 15, 2003, from State Bank of India, Secunderabad Branch, Hyderabad 500 003 confirming the opening of Escrow Account and certifying that lien has been noted in favor of CIL Securities Limited, Manager to the Offer. (j). Copy of Letter addressed by Shri Alapati Ramakrishna and Shri. Devabhuktuni Durga Prasad, giving unqualified authority to Manager to the Offer to dispose off funds held in Escrow Account and copy of letter addressed to State Bank of India, Secunderabad Branch, Hyderabad 500 003 in this regard. (k). Copies of the Public Announcements made in newspapers on August 27, 2003. (l). Due Diligence letter dated 06.09.2003 submitted to SEBI by CIL Securities Ltd., Manager to the Offer. (m). SEBI Observation letter No. DCR/MM/03/18488 dated 29th September 2003.

9. Declaration The Acquirers accepts full responsibility for the information contained in this Letter of Offer and Form of Acceptance. All information contained in this document is as on the date of the Public Announcement, unless stated otherwise.

Appendix 8

1147

The Acquirers shall be jointly and severally responsible for ensuring compliance of the Regulations. Signed by the Acquirers

Sd/- Sd/Shri Devabhuktuni Durga Prasad Shri Alapati Ramakrishna Place: Hyderabad Date: 01/10/2003 Encl.: 1. Form of Acceptance cum Acknowledgement. 2. Form of Withdrawal.

Appendix 9

THE TIME VALUE OF MONEY Money has time value. A rupee today is more valuable than a rupee a year hence. Why? There are several reasons: � �

�

Individuals, in general, prefer current consumption to future consumption. Capital can be employed productively to generate positive returns. An investment of one rupee today would grow to (1 + r) a year hence (r is the rate of return earned on the investment). In an inflationary period, a rupee today represents a greater real purchasing power than a rupee a year hence.

Many financial problems involve cash flows occurring at different points of time. For evaluating such cash flows, an explicit consideration of time value of money is required. This chapter discusses the method for dealing with time value of money and its applications to security valuation. It is divided into six sections which are as follows: �

Future value of a single amount

�

Future value of an annuity

�

Present value of a single amount

�

Present value of an annuity

�

Bond valuation

�

Equity valuation

1. Future Value of a Single Amount Suppose you have Rs. 1,000 today and you deposit it with a financial institution which pays 10 percent interest compounded annually, for a period of 3 years. The deposit would grow as follows:

1150

Investment Banking Rs.

First year:

Principal at the beginning

1,000

Interest for the year (Rs.1,000 Ò 0.10)

Second year:

100

Principal at the end

1,100

Principal at the beginning

1,100

Interest for the year (Rs.1,100 Ò 0.10)

Third year:

110

Principal at the end

1,210

Principal at the beginning

1,210

Interest for the year (Rs.1,210 Ò 0.10)

121

Principal at the end

1,331

Formula The general formula for the future value of a single amount is: Future Value = Present Value (1 + r)n where r is the interest rate per year and n is the number of years over which compounding is done. The factor (1 + r)n is called the future value factor, FVr,n. It is very tedious to calculate this factor unless you have a calculator. To reduce the tedium, tables are available. Exhibit 10.1 gives the value of this factor for several combinations of r and n. A comprehensive table is given in Appendix A at the end of this book.

Exhibit 10.1 Value of FVr,n for Various Combinations of r and n n/r

6%

8%

10%

12%

14%

2

1.124

1.166

1.210

1.254

1.300

1151

Appendix 9

4

1.162

1.366

1.464

1.574

1.689

6

1.419

1.587

1.772

1.974

2.195

8

1.594

1.851

2.144

3.106

3.707

10

2.012

2.518

3.138

3.896

4.817

Example If you deposit Rs. 1,000 today in a bank which pays 10 percent interest, compounded annually, how much will the deposit grow to after 8 years and 12 years? The future value, 8 years hence will be: Rs.1,000 (1.10)8 = Rs. 1,000(2.144) = Rs. 2,144

The future value, 12 years hence will be: Rs. 1,000(1.10)12 = Rs. 1,000(3.138) = Rs. 3,138 Doubling Period Investors commonly ask the question: How long would it take to double the amount at a given rate of interest? To answer this question, we may look at the future value interest factor table. Looking at Exhibit 10.1, we find that when the interest rate is 12 percent, it takes about 6 years to double the amount; when the interest rate is 6 percent it takes about 12 years to double the amount, so on and so forth. Is there a thumb rule which dispenses with the use of the future value interest factor table? Yes, there is one and it is called the Rule of 72. According to this thumb rule, the doubling period is obtained by dividing 72 by the interest rate. For example, if the interest rate is 8 percent, the doubling period is about 9 years (72/8). Likewise, if the interest rate is 4 percent, the doubling period is about 18 years (72/4). Though somewhat crude, it is a handy and useful thumb rule. Shorter Compounding Periods So far we have assumed that compounding is done annually. Now, consider the case where compounding is done more frequently. Suppose you deposit Rs. 1,000 with a finance company, which advertises that it pays 12 percent interest semi-annually this means that the interest is paid every six months. Your deposit (if interest is not withdrawn) grows as follows:

1152

Investment Banking

First Six Months:

Principle at the beginning

Rs. 1,000.0

Interest for 6 months

Rs.

60.0

Rs. 1,000 Ò .12/2

Second Six Months:

Principle at the end

Rs. 1,060.0

Principle at the beginning

Rs. 1,060.0

Interest for months

Rs.

63.6

Rs. 1,060 Ò .12/2 Principle at the end

Rs. 1,123.6

Note that if the compounding is done annually, the principal at the end of one year would be Rs. 1,000(1.12) = Rs. 1,120.0. The difference of Rs. 3.6 (between Rs. 1,123.6 under semi-annual compounding and Rs. 1,120.0 under annual compounding) represents interest on interest for the second 6 months. The general formula for the future value of a single cash amount when compounding is done more frequently than annually is: Future Value = Present Value(1 + r / m )m Ò

n

where, r is the nominal annual interest rate, m is the number of times compounding is done in a year, and n is the number of years over which compounding is done. Example How much does a deposit of Rs. 5,000 grow to at the end of 6 years, if the nominal rate of interest is 12 percent and the frequency of compounding is 4 times a year? The amount after 6 years will be Rs. 5,000(1 + 0.12/4)4Ò6 = Rs. 5,000(1.03)24 = Rs. 5,000 Ò 2.0328 = Rs. 10,164

Effective versus Nominal Rate We have seen above that, Rs. 1,000 grows to Rs. 1,123.6 at the end of the year if the nominal rate of interest is 12 percent and compounding is done semi-annually. This means that Rs. 1,000 grows at the rate of 12.36 percent per annum. The figure of 12.36 percent is called the effective rate of interest—the rate of interest under annual compounding, which produces the same results as that produced by an interest rate of 12 percent under semi-annual compounding.

1153

Appendix 9

The general relationship between the effective rate of interest and the nominal rate of interest is as follows: r = (1 + k/n)m – 1 where, r is the effective rate of interest, k is the nominal rate of interest, m is the frequency of compounding per year and n is the number of years or time periods. Example A bank offers 8 percent nominal rate of interest with quarterly compounding. What is the effective rate of interest? The effective rate of interest is: (1 + 0.08/4)4 – 1 = 0.0824 = 8.24 percent Exhibit 10.2 gives the relationship between the nominal and effective rates of interest for different compounding periods. In general, the effect of increasing the frequency of compounding is not as dramatic as some would believe it to be—the additional gains dwindle as the frequency of compounding increases. Exhibit 10.2 Nominal and Effective Rates of Interest Nominal Rate %

Effective Rate % Annual Compounding

Semi-annual Compounding

Quarterly Compounding

Monthly Compounding

8

8.00

8.16

8.24

8.30

12

12.00

12.36

12.55

12.68

10.2 Future Value of an Annuity An annuity is a series of periodic cash flows (payments and receipts) of equal amounts. The premium payments of a life insurance policy, for example, are an annuity. When the cash flows occur at the end of each period, the annuity is called a regular annuity or a deferred annuity. When the cash flows occur at the beginning of each period, the annuity is called an annuity due. Our discussion here will focus on a regular annuity—the formulae of course can be applied, with some modifications, to an annuity due.

1154

Investment Banking

Suppose you deposit Rs. 1,000 annually in a bank for 5 years and your deposits earn a compound interest rate of 10 percent. What will be the value of this series of deposits (an annuity) at the end of 5 years? Assuming that each deposit occurs at the end of the year, the future value of this annuity will be: Rs. 1,000(1.10)4 + Rs. 1,000(1.10)3 + Rs. 1,000(1.10)2 + Rs. 1,000(1.10) + Rs. 1,000 = Rs. 1, 000(1.464) + Rs. 1,000(1.331) + Rs. 1,000(1.21) + Rs. 1,000(1.10) + Rs. 1,000 = Rs. 6,105. The time line of this annuity is shown in Exhibit 10.3.

Exhibit 10.3 Time Line for an Annuity

1

2

3

1,000

1,000

1,000

4 1,000

5 1,000 + 1,100 + 1,210 + 1,331 + 1,464 Rs.6,105

Formula In general terms, the future value of an annuity is given by the formula: Future value of an annuity = Constant Periodic flow

(1+r)n – 1 r

1155

Appendix 9

where, r is the interest rate per period and n, the duration of the annuity. The expression in the bracket is the future value annuity factor, FVAr, n. Exhibit 10.4 shows the value of this factor for several combinations of r and n. A comprehensive table is given in Appendix A at the end of this book.

Exhibit 10.4 Value of FVAr,n for Various combinations of r and n n/r

6%

8%

10%

12%

14%

2

2.060

2.080

2.100

2.120

2.140

4

4.375

4.507

4.641

4.779

4.921

6

6.975

7.336

7.716

8.115

8.536

8

9.897

10.636

11.436

12.299

13.232

10

13.181

18.977

15.937

17.548

19.337

12

16.869

18.977

21.384

24.133

27.270

Example Four equal annual payments of Rs. 2,000 are made into a deposit account that pays 8 percent interest per year. What is the future value of this annuity at the end of 4 years? Rs. 2,000(FVIFA 8%, 4 yrs) = Rs. 2,000 (4.507) = Rs. 9,014 10.3 Present Value of a Single Amount Suppose someone promises to give you Rs. 1,000 three year hence. What is the present value of this amount if the interest rate is 10 percent? The present value can be calculated by discounting Rs. 1,000 to the present point of time, as follows: Value three years hence

= Rs. 1,000

Value two years hence

= Rs. 1,000(1/1.10)

Value one year hence

= Rs.1,000(1/1.10) Ò (1/1.10)

Value now (present value)

= Rs. 1,000(1/1.10) Ò (1/1.10) Ò (1/1.10)

1156

Investment Banking

Formula The process of discounting, used for calculating the present value, is simply the inverse of compounding. The present value formula can be readily obtained by manipulating the compounding formula. Future Value = Present Value (1 + r)n Dividing both the sides of the above equation by (1 + r)n, we get, Present value = Future value Ò

1 (1+r)n

The factor 1/(1+r)n in the above equation is called the present value factor, PVr,n. Exhibit 10.5 gives the value of this factor for several combinations of r and n. A comprehensive table is given in Appendix A, at the end of the book. Example Find the present value of Rs. 1,000 receivable 6 years hence, if the rate of discount is 10 percent. The present value is: Rs. 1,000(PV10%, 6) = Rs. 1,000(0.564) = Rs. 565

Exhibit 10.5 Value of Pv r,n for various combinations of r and n n/r

6%

8%

10%

12%

14%

2

0.890

0.857

0.826

0.797

0.770

4

0.792

0.735

0.683

0.636

0.592

6

0.705

0.630

0.565

0.507

0.456

8

0.626

0.540

0.467

0.404

0.351

10

0.558

0.463

0.386

0.322

0.270

12

0.497

0.397

0.319

0.257

0.208

10.4 Present Value of an Annuity Suppose you expect to receive Rs. 1,000 annually for 3 years, each receipt occurring at the end of the year. What is the present value of this stream of benefits if the discount rate is 10 percent? The present value of this annuity is simply the sum of the present values of all the inflows of this annuity:

1157

Appendix 9 Rs. 1,000 (1/1.10) + Rs. 1,000(1/1.10)2 + Rs. 1,000(1/1.10)3 Rs. 1,000 Ò 0.909 + Rs. 1,000 Ò 0.826 + Rs. 1,000 Ò 0.751 Rs. 2,478.8 The time line for this problem is shown in Exhibit 10.6.

Formula In general terms, the present value of an annuity is given by the formula: Present value of an annuity = Constant Periodic flow Ò

1–

1 (1+r)n – 1 r

where r is the interest rate per period and n, the duration of the annuity. The expression in the bracket is the present value annuity factor, PVAr,n. Exhibit 10.7 shows the value of this factor for several combinations of r and n. A more comprehensive table is given in Appendix A, at the end of this book.

Exhibit 10.6 Time line of an Annuity

0

1

2

3

1,000

1,000

1,000

90.1 826.4 751.3 Rs. 2,478.8 Present value

1158

Investment Banking

Exhibit 10.7 Value of PVAr,n for Various Combinations of r and n n/r

6%

8%

10%

12%

14%

2

1.833

1.783

1.737

1.690

1.647

4

3.465

2.312

3.170

3.037

2.914

6

4.917

4.623

4.355

4.111

3.889

8

6.210

5.747

5.335

4.968

4.639

10

7.360

6.710

6.145

5.650

5.216

12

8.384

7.536

6.814

6.194

5.660

Example What is the present value of a 4- year annuity of Rs. 10,000 discounted at 10 percent? The PVA10% ,4 is Rs. 3,170. Hence, the present value of the annuity is Rs. 10,000(3.170) = Rs. 31,700

Loan Amortisation Schedule Most loans are repaid in equal periodic instalments (monthly, quarterly, or annually), which cover interest as well as principal repayment. Such loans are referred to as amortised loans. For an amortised loan we would like to know, (a) the periodic instalment payment and (b) the loan amortisation schedule showing the break up of the periodic instalment payments between the interest component and the principal repayment component. To illustrate how these are calculated, let us look an example. Suppose a firm borrows Rs. 1,000,000 at an interest rate of 15 percent and the loan is to be repaid in 5 equal instalments payable at the end of each of the next 5 years. The annual instalment payment A is obtained by solving the following equation.

Loan amount

= A Ò PVAn=5, r=15%

1,000,000

= A Ò 3.3522

Hence A

= 298,312

1159

Appendix 9

The amortisation schedule is shown in Exhibit 10.8. The interest component is the largest for year 1 and progressively declines as the outstanding loan amount decreases. Exhibit 10.8 Loan Amortisation Schedule

Year

1 2 3 4 5

Beginning Amount (1)

Annual Instalment (2)

Interest a

1,000,000 851,688 681,129 484,986 259,422

298,312 298,312 298,312 298,312 298,312

150,000 127,753 102,169 727,482 38,913

(3)

Principal Remaining Repayment b Balance (2)–(3) = (4) (1)–(4) = (5) 148,312 170,559 196,143 225,564 259,399

851,688 681,129 484,986 259,422 23*

a. Interest is calculated by multiplying the beginning loan balance by the interest rate. b. Principal repayment is equal to annual instalment minus interest. *Due to rounding off error, a small balance is shown.

Equated Monthly Instalment In the previous illustration we considered equated annual instalments. In many cases, such as housing loans or car loans, however, the borrower has to repay the loan with interest in equated monthly instalments (EMIs). The calculation of the EMI is analagous to the calculation of the equated annual instalment, except that the unit period is one month not one year. The calculation of EMI may be illustrated with an example. Example Shyam takes a housing loan of Rs. 1,000,000 carrying an interest of 1 percent per month. The loan is to be repaid over 180 months. What is the EMI? The EMI is obtained by solving the following equation: 1,000,000 = A Ò PVAn = 180, r = 1.00%

1– 1,000,000 = A Ò

1 (1+r)n r

1160

Investment Banking

1– 1,000,000 = A Ò

1 (1.01)180 .01

1,000,000 = A Ò 83.3217 A =

1,000,000 83.3217

Rs. 12,002

Present value of a Perpetuity A perpetuity is an annuity of infinite duration. In general terms: Present value of a perpetuity = Constant periodic flow

1 r

where, r is the discount rate. The expression in the bracket is the present value perpetuity factor. Put in words, it means that the present value perpetuity factor is simply 1 divided by the interest rate expressed in decimal form. Hence, the present value of a perpetuity is simply equal to the constant annual payment divided by the interest rate. For example, the present value of a perpetuity of Rs. 10,000, when the interest rate is 10 percent is equal to: Rs. 10,000/0.10 = Rs. 100,000. Intuitively, this is quite convincing because an initial sum of Rs. 100,000 would, if invested at the interest rate of 10 percent, provide a constant annual income of Rs. 10,000 forever, without any impairment of the capital value.

10.5 Bond Valuation Terminology A bond or debenture (hereafter, referred to as only bond), akin to a promissory note, is an instrument of debt issued by a business or governmental unit. In order to understand the valuation of bonds, we need to be familiar with certain bond-related terms. Par Value This is the value stated on the face of the bond. It represents the amount the firm borrows and promises to repay at the time of maturity. Usually, the par or face value of bonds issued by the business firms is Rs.100. Sometimes it is Rs. 1,000.

Appendix 9

1161

Coupon Rate and Interest A bond carries a specific interest rate which is called the coupon rate. The interest payable to the bond holder is simply: par value of the bond Ò coupon rate. For example, the annual interest payable on a bond which has a par value of Rs. 1000 and a coupon rate of 10 percent is Rs. 10 (Rs. 100 Ò 10 percent).

Maturity Period Typically, corporate bonds have a maturity period of 3 to 10 years, whereas government bonds have maturity periods extending upto 20 years. At the time of maturity, the par (face) value plus perhaps a nominal premium is payable to the bondholder. Basic Bond Valuation Model As noted above, the bond holder receives a fixed annual interest payment for a certain number of years and a fixed principal repayment (equal to par value) at the time of maturity. Hence, the value of a bond is: Value = I (PVAr, n) + F (PVr, n) where, I is the annual interest payable on the bond, F is the principal amount (par value) of the bond, r is the required return on the bond, and n is the maturity period. Example A Rs. 100 par value bond, bearing a coupon rate of 12 percent will mature after 8 years. The required rate of return on this bond is 14 percent. What is the value of this bond? Since the annual interest payment will be Rs. 12 for 8 years, and the principal repayment will be Rs. 100 at the end of 8 years, the value of the bond will be: V = Rs. 12 (PVA14% , 8 yrs) + Rs. 100(PV14%, 8 yrs) = Rs. 12(4.639) + Rs. 100(0.351) = Rs. 90.77 Example A Rs. 1,000 par value bond, bearing a coupon rate of 14 percent, will mature after 5 years. The required rate of return on this bond is 13 percent. What is the value of this bond? Since the annual interest payment will be Rs. 140 for 5 years and the principal repayment will be Rs. 1,000 at the end of 5 years, the value of the bond will be: V = Rs. 140(PVA13% , 5 yrs) + Rs. 1,000(PV13%, 5 yrs) = Rs. 140(3.517) + Rs. 1,000(0.543) = Rs. 1,035.4

1162

Investment Banking

Bond Valuation with Semi-annual interest Most of the bonds pay interest semi-annually. To value such bonds, we have to work with a unit period of six months, and not one year. This means that the bond valuation equation has to be modified along the following lines: �

The annual interest payment I, must be divided by two to obtain the semi-annual interest payment.

�

The number of years to maturity must be multiplied by two to get the number of halfyearly periods.

�

The discount rate has to be divided by two to get the discount rate applicable to halfyearly periods. Value = I/2(PVAr/2, 2n) + F(PVr/2, 2n)

Example A Rs.100 par value bond carried a coupon rate of 12 percent and a maturity period of 8 years. Interest is payable semi-annually. Compute the value of the bond if the required rate of return is 14 percent. The value of the bond = 6 (PVA7 %, 16 yrs) + 100 (PV7 %, 16 yrs) = Rs. 6(9.447) + Rs. 100(0.388) = Rs. 95.5

Yield to Maturity The yield to maturity (YTM) of a bond is the interest rate that makes the present value of the cash flows receivable from owning the bond equal to the price of the bond. Mathematically, it is the interest rate (r) which satisfies the equation: C P = (1+r)

C + + õõõ + (1+r)2

C

M + (1+r)n (1+r)n

where P is the price of the bond, C is the annual interest, M is the maturity value, and n is the number of years left to maturity. The computation of YTM requires a trial and error procedure. To illustrate this, consider a Rs.1,000 par value bond, carrying a coupon rate of 9 percent, maturing after 8 years. The bond is currently selling for Rs.800. What is the YTM on this bond? The YTM is the value of r in the following equation:

1163

Appendix 9

n 800 =

q

90 1000 + (1+r) (1+r)

t=1

= 90(PVIFAr, 8yrs) + 1,000(PVIFr, 8yrs) Let us begin with a discount rate of 12 percent. Putting a value of 12 percent for r we find that the right-hand side of the above expression is Rs. 90(PVIFA12%, 8yrs) + Rs. 1,000(PVIF12%, 8yrs) = Rs. 90(4.968) + Rs. 1,000(0.404) = Rs. 851.0 Since this value is greater than Rs. 800, we may have to try a higher value for r. Let us try r = 14 percent. This makes the right-hand side equal to: Rs. 90 (PVIFA14%, 8yrs) + Rs. 1,000(PVIF14%, 8yrs) = Rs. 90(4.639) + Rs. 1,000(0.351) = Rs. 768.1

Since this value is less than Rs. 800, we try a lower value for r. Let us try r = 13 percent. This makes the right-hand side equal to : Rs. 90(PVIFA13%, 8yrs) + Rs. 1,000(PVIF13%, 8yrs) = Rs. 90(4.800) + Rs. 1,000(0.376) = Rs. 808 Thus r lies between 13 percent and 14 percent. Using a linear interpolation in the range 13 percent to 14 percent, we find that r is equal to 13.2 percent. 808 – 800 13% + (14% – 13%) Ò

= 13.2% 808 – 768.1

An Approximation If you are not inclined to follow the trial-and-error approach described above, you can employ the following formula to find the approximate YTM on a bond:

1164 Balance Sheet Statement

Investment Banking

31.12.2000 (Audited)

31.12.2001 (Audited)

31.12.2002 (Audited)

30.06.2003 (Provisional)

Sources of funds : Paid up share capital

2023.46

2023.46

2023.46

2023.46

394.68

394.68

394.68

394.68

Networth*

582.13

250.04

81.46

(14.94)

Secured loans

626.38

531.97

531.27

506.81

Unsecured loans

231.06

248.48

249.41

248.81

3275.58

3198.60

3198.83

3173.76

927.71

859.22

759.28

707.45

0.25

0.26

0.16

0.16

511.60

171.02

102.70

33.07

Total miscellaneous expenditure not written off

1836.02

2168.09

2336.69

2433.08

Total

3275.58

3198.60

3198.83

3173.76

Reserves and Surplus (excluding revaluation reserves)

Total Uses of funds : Net fixed assets Investments Net current assets

*Networth = Equity Capital + Preference Capital + Free Reserves (excluding Revaluation Reserves) – Miscellaneous Expenditure not written off (including Profit & Loss A/c debit balance) Note: 1. The Company has 10% redeemable cumulative preference capital of Rs. 739.66 Lakhs. While calculating Networth of LCC, if the Preference Capital is not considered, the Networth is Rs. (157.53) Lakhs, Rs. (489.62) Lakhs, Rs. (658.2) Lakhs, Rs. (754.6) Lakhs as on 31.12.2000, 31.12.2001, 31.12.2002, 30.06.2003 respectively. 2. The company has the accrued liability of Rs. 73.96 Lakhs of preference dividend for each financial year. As per the audited accounts the contingent liability ascertained for financial year ending 31.12.2000, 31.12.2001 & 31.12.2002 is of Rs. 176.91 Lakhs, 250.87 Lakhs & 324.83 Lakhs respectively. If the accrued unpaid preference dividend is considered while calculating the networth, the networth of LCC is Rs. (334.44) Lakhs, Rs. (740.49) Lakhs & Rs. (983.03) Lakhs, as on 31.12.2000, 31.12.2001 & 31.12.2002 respectively.

1165

Appendix 9 C + (M – P)/n YTM = 0.4M + 0.6P

where, YTM is the yield to maturity, C is the annual interest payment, M is the maturity value, P is the present price of bond, and n is the years to maturity. To illustrate the use of this formula, let us consider the bond discussed above. The approximate YTM of the bond works out to: 90 + (1000 – 800)/8 YTM =

= 13.1% 0.4 Ò 1000 + 0.6 Ò 800

Thus, we find that this formula gives a value which is very close to the true value. Hence it is very useful. The YTM calculation considers the current coupon income as well as the capital gain or loss the investor will realise by holding the bond to maturity. In addition, it takes into account the timing of the cash flows.

10.6 Equity Valuation As an equity shareholder, you expect to receive a stream of dividends from it, which extends indefinitely into the future. So the intrinsic value of an equity share may be expressed as follows: D1 Value

=

D2 +

(1+r)

(1+r)2

Dn +õõõ+

(1+r)n

+-õõõ

where, D1, D2, õõõ are the dividends receivable at the end of the year 1, year 2, and so on, and r is the rate of return required from the equity share. The above equation is general enough to permit any pattern of dividends—constant, rising, declining, or randomly fluctuating. Two patterns are commonly employed in practice: constant dividends and constant growth of dividends. If we assume that the dividends per share remains constant year after year, at a value of D, the dividend stream is a perpetuity. Hence, the value of the equity share will be: D Value = r

1166

Investment Banking

Dividends, however, tend to grow over time. If we assume that the dividend per share grows at a constant rate, denoted by the symbol g (growth rate), the value of the equity share is:

Value

=

D1(1+g)2

D2(1+g)

D1 + (1+r)

(1+r)2

+õõõ+

(1+r)n

+õõõ

Note that, the dividend per share for year 2 is simply the dividend per share for year 1 multiplied by the growth factor (1 + g), and so on. If the above expression looks menacing, you can derive consolation from the fact that it simplifies to: D1 Value = r–g Example Ramesh Engineering Company is expected to grow at a rate of 8 percent per annum. The dividend expected on Ramesh’s equity share a year hence is Rs. 2.00 What is the value of the share, if investors require a return of 18 percent on this share? 2.00 Value =

=

Rs. 20.00

0.18 – 0.08

SUMMARY �

Money has time value. A rupee today is more valuable than a rupee a year hence.

�

The general formula for the future value of a single amount is : Future value = Present value(1+r)n

�

�

�

The value of the compounding factor, (1+r)n, depends on the interest rate (r) and the life of the investment (n). According to the rule of 72, the doubling period is obtained by dividing 72 by the interest rate. The general formula for the future value of a single cash amount when compounding is done more frequently than annually is: Future value = Present value [1+r/m]m*n

Appendix 9 �

1167

An annuity is a series of periodic cash flows (payments and receipts) of equal amounts. The future value of an annuity is: Future value of an annuity = Constant periodic flow [(1+r)n – 1)/r]

�

The process of discounting, used for calculating the present value, is simply the inverse of compounding. The present value of a single amount is: Present value = Future value Ò 1/(1+r)n

�

The present value of an annuity is: Present value of an annuity = Constant periodic flow [1 – 1/ (1+r)n] /r

�

A perpetuity is an annuity of infinite duration. In general terms: Present value of a perpetuity = Constant periodic flow [1/r]

�

The holder of a bond receives a fixed annual interest payment for a certain number of years and a certain principal repayment at the time of maturity. Hence, the value of a bond is: Value = Interest [Present value of an annuity factor] + Principal [Present value factor]

�

�

The yield to maturity (YTM) on a bond is the rate of return the investor earns when he buys the bond and holds it till maturity. The intrinsic value of an equity share is: Intrinsic value = Present value of the future stream of dividends

�

If the dividend per share grows at a constant rate, the intrinsic value of the equity share is: Dividend1 Value = Discount rate — Growth rate

List of Terms/Acronyms used in this Book

ABS

Asset Backed Security

ACC

Associated Cement Companies Ltd.

ADB

Asian Development Bank

ADR

American Depository Receipt

AFI

All India Financial Institution

AMBI

The Association of Merchant Bankers of India

AMFI

Association of Mutual Funds of India

AOA

Articles of Association

ARC

Asset Reconstruction Company

BO

Build-Operate

BOD

Bought out Deal

BOLT

Bombay Online Trading

BOLT

Build-Own-Lease-Transfer

1170

List of Terms/Acronyms used in this book

BOO

Build-Own-Operate

BOOT

Build-Own-Operate-Transfer

BOT

Build-Operate-Transfer

BSE

The Stock Exchange, Mumbai, (formerly known as the Bombay Stock Exchange)

CCFI

Cabinet Committee for Foreign Investment

CCI

The Controller of Capital Issues

CDC

Commonwealth Development Corporation

CDR

Corporate Debt Restructuring

CDSL

Central Depository Services Ltd.

CIM

Confidential Information Memorandum

CLA

Central Listing Authority

CMP

Current Market Price

COMPANIES ACT

The Companies Act, 1956

COMPETITION ACT

The Competition Act, 2002

CRISIL

CRISIL Ltd. (formerly Credit Rating and Information Services of India Ltd.)

DCA

Department of Company Affairs, MoF

DCF

Discounted Cash Flow

DDB

Deep Discount Bond

List of Terms/Acronyms used in this book

1171

DEA

Department of Economic Affairs, MoF

DE-LISTING GUIDELINES

Securities and Exchange Board of India (De-listing of Securities) Guidelines 2003

DFHI

Discount and Finance House of India Ltd.

DIP GUIDELINES SEBI

(Disclosure and Investor Protection) Guidelines, 2000

DOT

Department of Telecommunications, GoI.

DP

Depository Participant

DRR

Debenture Redemption Reserve

DTAA

Double Taxation Avoidance Agreement

E&Y

Ernst & Young

EBIT

Earnings Before Interest and Tax

EBITDA

Earnings Before Interest, Tax, Depreciation and Amortisations

ECB

External Commercial Borrowing

EOI

Expression of Interest

EPC

Equipment Procurement and Construction

EPS

Earnings Per Share

ESOP

Employee Stock Option Plan

ESPS

Employee Share Purchase Scheme

EVA

Economic Value Added

1172

List of Terms/Acronyms used in this book

F&O

Futures and Options

FASB

Financial Accounting Standards Board

FCD

Fully Convertible Debenture

FDI

Foreign Direct Investment

FEMA

The Foreign Exchange Management Act, 1999

FII

Foreign Institutional Investor

FIMMDA

Fixed Income Money Market Dealers’ Association

FIPB

Foreign Investment Promotion Board

FRN

Floating Rate Note

FTO

Free to Operate

FVCI

Foreign Venture Capital Investor

GAIL

Gas Authority of India Ltd.

GDP

Gross Domestic Product

GDR

Global Depository Receipt

GIC

General Insurance Corporation of India

GoI

The Government of India

GTB

Global Trust Bank Ltd.

GUIDELINES

‘Guidelines for Preferential Issues’.

HDFC

Housing Development Finance Corporation Ltd.

List of Terms/Acronyms used in this book

1173

HMT

HMT Ltd. (formerly Hindustan Machine Tools Ltd.)

HNI

High Networth Investor

I (D&R) Act

The Industries (Development Regulation) Act, 1951

IBRD

International Bank for Reconstruction and Development (World Bank)

ICA

Inter-Creditor Agreement

ICAI

The Institute of Chartered Accountants of India

ICICI

ICICI Bank Ltd., (formerly The Industrial Credit and Investment Corporation of India Ltd.)

ICSI

The Institute of Company Secretaries of India

IDBI

The Industrial Development Bank of India

IDFC

Infrastructure Development Finance Company Ltd.

IFC

International Finance Corporation

IFCI

IFCI Ltd. (formerly The Industrial Finance Corporation of India)

IIBI

Industrial Investment Bank of India

IL & FS

Infrastructure Leasing & Financial Services Ltd.

IOC

Indian Oil Corporation Ltd.

and

1174

List of Terms/Acronyms used in this book

IPCL

IPCL Ltd, (formerly Indian Petrochemicals Corporation Ltd.)

IPO

Initial Public Offer

IPR

Intellectual Property Right

ISE

The Inter-connected Stock Exchange of India Ltd.

IT Act

The Income Tax Act, 1961

JV

Joint Venture

JVA

Joint Venture Agreement

L of O

Letter of Offer

LBO

Leveraged Buyout

LIC

Life Insurance Corporation of India

LICHF

LIC Housing Finance Ltd.

LM

Lead Manager

LSE

London Stock Exchange

M&A

Mergers and Acquisitions

MBS

Mortgage backed Security

MDA

Management Discussion and Analysis

MIBOR

Mumbai Inter-bank Offered Rate

MOA

Memorandum of Association

MoF

The Ministry of Finance, Government of India

List of Terms/Acronyms used in this book

1175

MRPL

Mangalore Refineries and Petroleum Ltd.

MVA

Market Value Added

NASDAQ

The National Association for Securities Dealers Automated Quotation System, The NASDAQ Stock Market, USA

NAV

Net Asset Value

NBFC

Non-banking Financial Company

NCD

Non-convertible Debenture

NCLT

National Company Law Tribunal

NHB

National Housing Bank

NRI

Non-resident Indian

NS

Negotiated Settlement

NSDL

National Securities Depository Ltd.

NSE

The National Stock Exchange

NTPC

National Thermal Power Corporation Ltd.

NYSE

New York Stock Exchange

O&M

Operations and Maintenance

OBC

Oriental Bank of Commerce

OCB

Overseas Corporate Body

ODI

Overseas Direct Investment

OECD

Organization for Economic Co-operation and Development

1176

List of Terms/Acronyms used in this book

OFCD

Optionally Fully Convertible Debenture

ONGC

Oil and Natural Gas Corporation Ltd.

OTC

Over the Counter

OTCEI

The OTC Exchange of India Ltd.

OTS

One Time Settlement

P/E RATIO

Price to Earnings Ratio

PAT

Profit After Tax

PBT

Profit Before Tax

PCD

Partly Convertible Debenture

PIO

Person of Indian Origin

PREFERENTIAL OFFER

Chapter XIII of the DIP Guidelines on

GUIDELINES

‘Guidelines for Preferential Issues’.

PSE

Public Sector Enterprise

PSU

Public Sector Undertaking

PTC

Pass Through Certificate

PWC

Price Waterhouse Coopers

QIB

Qualified Institutional Buyer

RBI

The Reserve Bank of India

RFP

Request For Proposal

ROC

Registrar of Companies

RONW

Return on Networth

SBI

The State Bank of India

List of Terms/Acronyms used in this book

1177

SCR RULES

Securities Contracts (Regulation) Rules, 1957

SCRA

The Securities Contracts (Regulation) Act, 1956

SEBI

The Securities and Exchange Board

SEBI Act

The Securities and Exchange Board Act, 1992

SEC

Securities and Exchange Commission, USA

SECURITISATION ACT

Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002

SFI

State Financial Institution

SHA

Shareholders’ Agreement

SHCI

Stock Holding Corporation of India Ltd.

SIA

Secretariat for Industrial Assistance

SICA

Sick Industrial Companies (Special Provisions) Act, 1985

SIDBI

The Small Industries Development Bank of India

SIDC

State Industrial Development Corporation

SLR

Statutory Liquidity Ratio

SME SEGMENT

Small and Medium Enterprise Segment

SPA

Share Purchase Agreement

SPN

Secured Premium Note

1178

List of Terms/Acronyms used in this book

SPV

Special Purpose Vehicle

SSI

Small Scale Industry

STA

Share Transfer Agent

TAKEOVER CODE

Securities Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 1997

TELCO

Tata Motors Ltd (formerly Tate Electric and Locomotive Company Ltd.)

TISCO

Tata Iron and Steel Company Ltd.

USA

United States of America

UTI

Unit Trust of India

VC

Venture Capital

VCF

Venture Capital Fund

VCU

Venture Capital Undertaking

VRS

Voluntary Retirement Scheme

WACC

Weighted Average Cost of Capital

WDM

Wholesale Debt Market

ZCB

Zero Interest Convertible Bond

Subject Index

A Accounting Standard 57, 66 Acquisitions and takeovers 87 Affirmative rights 848, 850 American investment banks 72, 73, 82 Approval of technical collaboration 592 Approval of techno-financial collaboration 595 Asset stripping 850

C Capital market 7, 5, 6 Capital market reforms 55 Capital reduction 708, 730 CCI guidelines 141, 142 CDR scheme 716, 717 Company with unlimited liability 571 Composite issue 287, 318 Compulsory de-listing 415, 417

B Bankers to issue 91, 36, 165 Basis of allotment 264, 270 Bid advisory 650, 653 Bonus issue 120, 65 Book building 56, 152 Book running 83, 248 Bought out deal 245, 255 Brokers to issue 162, 166 BSE 15, 16, 17 Business advisory services 552, 555 Business portfolio of Indian investment banks 86, 87 Business portfolio of investment banks 71, 77

Conflict of interest issue 102, 106 Consolidated reporting and disclosure requirements 574 Conventional venture capitalist method 506 Convertible instruments 124, 332 Corporate advisory services 551, 553 Corporate re-organisation 759, 762 Corporate restructuring 757, 762 Corporate structuring 551, 557 Counter-offer and revision 443 Coupon rate 178, 179 Credit rating agencies 35, 36 Creeping acquisition 296, 297 Custodial services 48, 53

1180

Subject Index

D Dabhol Power Company 668 DCF 136, 138 Debenture redemption reserve 324, 331 Debenture trustees 36, 42 Debt restructuring 700, 701 Debt securities 173, 174 Deep discount bond 186, 190 De-listing offer 413, 414 Demerger 768, 769 Depositories and participants 36, 44 Depository receipts 347, 348 Dilution management 294, 295 Disinvestment 830, 831 Dividend payout 128, 129 Dividend yield 128, 129 DRT 720, 746 DTAA 569, 570 Due diligence 369, 379

E Eligibility for IPO 230 EPS 124, 127 Equity dilution 290, 292 Equity restructuring 697, 700 Equity warrants 125, 127 ESOP 132, 134 ESPS 465, 468 Euro bond 339 European investment banks 75 EVA 128, 129 Evolution of Indian capital market 16 Expression of interest 883 External Commercial Borrowings 631, 644

F Fair practices code for lenders 692 FCCB issue 363, 371 FCD 184, 185 FDI investors 151, 152 Financial closure 639, 640 Financial markets 5, 7 Financial restructuring 697, 698 Firm allotments and reservations 232, 233 First Chicago method 507 Floating rate bond 187 Foreign collaboration 643 Foreign institutional investors 222, 233 Foreign investment 641, 653 Foreign venture capital investors 151, 157 Franchise agreement 596 Full recourse and limited recourse structures 633 Fungibility of depository receipts 352, 353

G Global stock market 15 Government advisory 830, 831 Green shoe option 253, 254 Gross domestic product 4

H Historical evolution of capital market 12 Hive-off 768, 769 Holding company 564, 565

1181

Subject Index

I IDR issue 369, 370 Information memorandum 491, 494 Institutional intermediation in capital flows 5 Institutional investor 116, 148 Intellectual property 466, 467 Inter-creditor agreement 716, 752 International bond market 339, 341 Investment banking and merchant banking 72, 74, 86, 89, 153 IPO 211, 212 Issue advertisements 261 Issue managers 162, 169 Issue marketing 246, 259 Issue pricing 220, 223 Issue structuring 227, 273

J Joint venture 551, 555 Joint venture agreement 579, 615

L Letter of offer 298, 302 Listed and unlisted shares 120 Lock-in 222, 226

M Management Discussion and Analysis 243, 244 Market capitalization 215, 239 Market intermediaries 11, 14 Medium term notes 347

Mergers and amalgamations 757, 759 Money market 4, 6 MVA 128, 129

N NAV 136 NCD 180 Negotiated acquisition 793 Negotiated settlement 710,713 NSE 22

O Offer document 211, 222 Offer for sale 215, 221 One time settlement 715, 717 On-line IPO 254, 265 Open market purchase 424, 428 Open offer 414, 418 OTC issue 255 Overseas direct investment 612

P P/E ratio 127, 128 PCD 183, 198 Portfolio managers 35, 36 Preference shares 116, 118 Preferential allotment 222, 233 Premium value and par value 118 Pre-money valuation 504, 505 Pricing a buyback 429 Primary and secondary Market 21, 22 Private equity 463, 492 Private placement 222, 256

1182

Subject Index

Project advisory services 627, 631 Project consortium 626, 627 Project finance 625, 626 Project financing 625, 626 Project structuring 639, 641 Promoter holding 564, 565 Promoters’ contribution 226 PSU bonds 530, 532 PTCs 193, 195 Public announcement 419, 427 Public issue 217, 219 Public offer of debt instruments 325, 330

Q QIB 222, 229

R Registrars to issue 164, 169 Regulatory authorities for capital market 33 Restructuring through Split-up 766, 773 Retail investor 116, 119 Return on capitalization 504 Reverse book building 420, 421 Rights issue 116, 127 Rights renunciation 295 RONW 124, 127

Shareholders’ agreement 642, 664 Sponsored ADR/GDR issue 354, 357 SPV 193, 194 Step-up in value 504, 508 Stock swap 368 Strategic sale 215, 219 Subsidiarisation 560, 561 Sweat equity 132, 133 Sweeteners 175, 187

T Take-out financing 630, 687 Takeover Code 760, 771 Technical collaboration 589, 592 Technology transfer 588, 591 Term sheet 510, 511 Types of shares 115, 117

U Underwriting 73, 74 Universal banks 76, 77

V Valuation methodologies 134 Venture capital 145, 149 Voluntary de-listing 415, 417

S SEBI 18, 30 Secondary offer 146 Securitisation 191, 192 Securitisation Act 720 Share buyback 418, 423 Share premium 119, 120 Share transfer agents 19, 35

Y Yield 179, 180

Z Zero coupon bond 184, 191