Preferential allotments of shares in public listed companies tend to receive greater public scrutiny. This is because certain investors receive shares in the company, while the existing shareholders suffer a dilution. Hence, the pricing of preferential allotments assumes great importance, as the level of dilution depends upon the price at which shares are allotted to the investors.
Conventional wisdom has it that the pricing of preferential allotments for companies with frequently-traded shares is based upon the historical price pattern that the company's shares have experienced over a predefined time. A longstanding formula prescribed by the Securities and Exchange Board of India was that the floor price for a preferential allotment is the higher of (a) the average of the weekly high and low of the volume-weighted average price of the shares quoted on the stock exchange for 26 weeks preceding the relevant date, and (b) such an average over two weeks prior to the relevant date. In that sense, the pricing norms for preferential allotments relied entirely on a market-driven mechanism.
Onset Of The Controversy
Such a well-oiled pricing mechanism came under severe strain during the year 2021 in a series of cases, including a proposed preferential allotment of shares by PNB Housing Finance Ltd. to a clutch of investors led by entities affiliated with The Carlyle Group. While the issue price complied with the norms laid down by SEBI as mentioned above, there was a call from proxy advisory firms for an independent valuation to be carried out. Matters were compounded because PNB Housing’s Articles of Association carried a clause that required a valuation by a registered r for preferential allotments. SEBI ordered a halt of the shareholders’ meeting that was to consider the matter.
Against this, the company preferred an appeal to the Securities Appellate Tribunal. In a somewhat curious turn of events, the two members of the SAT returned a split verdict. While the presiding officer concluded that the SEBI regulations, which provide for a market-based pricing, are a complete code and that no independent valuation was required, the other member arrived at a contrary conclusion, largely on the ground that the articles of the company required such a valuation. Such a deadlock could not be broken in the absence of the appointment of a third member of SAT.
In the meanwhile, and due to the lack of an end in sight, PNB Housing and the Carlyle Group decided to call off their proposed transaction, which led to an eventual withdrawal of the appeal before the SAT.
In November 2021, the market regulator released a consultation paper suggesting reforms to the preferential allotment pricing norms. Thereafter, on Dec. 28, 2021, SEBI’s board announced changes to the SEBI regulations on the issue of capital and disclosure requirements. Although the precise wording of the amendments to the regulations is yet to be known, the general tenor of SEBI’s announcements indicates that the reforms in some ways liberalise the pricing norms and make it easy for companies to engage in preferential allotments and, in other ways, they also impose considerable restrictions on pricing with a view to protecting the interests of minority shareholders in the issuer companies.
Continued Relevance Of Market-Based Pricing
At a primary level, SEBI has not jettisoned the historical market price of the company’s shares in computing the floor for the pricing in a preferential allotment. On the contrary, SEBI has liberalised the norms by reducing the previous 26-week requirement to 90 days and the two-week requirement to 10 days. The market had found the previous norms to be too onerous with a lengthy look-back period. This was particularly cumbersome in scenarios of plunging market prices, as faced upon the onset of Covid-19.
The previous norms had the effect of stymying the efforts of companies in undertaking preferential allotments at low prices, even if essential for the company to stay financially afloat.
The current move has generally been well received, as it is in tune with the needs of the times. Of course, companies whose shares are infrequently traded will need to base their preferential allotment pricing on an independent valuation. Clearly, as a measure to iron out the creases that emanated from the PNB Housing transaction, SEBI now stipulates that any stricter provision in the articles of association must be complied with.
Radical Changes For Substantial or Control Transactions
The erstwhile regime did not make a distinction between preferential allotments that confer substantial shareholding or control on the investor, and other transactions that do not, except for the fact that acquisitions of control through preferential allotments would also trigger the SEBI takeover regulations. However, the current reforms instill a dichotomy into the pricing norms by making a clear distinction between non-control transactions (which are purely driven by market-based pricing) and substantial or control transactions (which are subject to more onerous pricing requirements). Where a preferential allotment involves an issue of more than 5% of the post issue fully diluted share capital of the company to an investor or persons acting in concert, or where there is a change in control of the company as a result of such allotment, there is also a requirement for the company to obtain evaluation report from a registered independent r. Such a valuation shall be considered for purpose of determination of the floor price in addition to the market-based formulaic approach.
This clearly indicates SEBI’s intention to introduce an additional layer of protection for minority shareholders where there is a substantial or control transaction. The approach seems to undermine the mere reliance on market-based pricing and highlights the need for an independent valuation.
This has a number of implications.
First, it enables the company to seek a control premium from investors, for which a market-based determination would not be an appropriate yardstick. Such a control premium would be based on the price that the independent r arrives at.
Second, there could be questions as to the independence and fairness in the valuation, for which the guidelines are not entirely clear. For instance, there could be concerns on how independence is to be considered as regards the firm that is undertaking the valuation exercise. Moreover, there could be a great deal of subjectivity in the valuation approach and methodology, although guidance could indeed be obtained from relevant accounting standards as well as other areas, such as taxation, where fairness in valuation assumes importance.
Third, while the market-based determination is quantitative, tangible, and certain, the independent valuation approach tends to be more qualitative, subjective, and uncertain. The benefits of such an approach to minority shareholders will have to be weighed against the costs of enhancing the protective mechanisms in pricing a preferential allotment of shares.
Given that the market-based mechanism was well entrenched in preferential allotments, this new approach could take some time to incorporate itself into the market.
Preferential allotments that result in a change of control are now subject to additional corporate governance mechanisms. For instance, a committee of independent directors of the issuer company is now required to issue a recommendation on all aspects of the preferential allotment, including pricing. This is also accompanied by transparency requirements which require that the voting pattern in such a committee be made public. Evidently, these measures are intended to assuage a concern that preferential allotments could be misused by incumbents and companies to the disadvantage of outside shareholders.
Non-Cash Consideration
Finally, in another restrictive move, SEBI has also clamped down on the practice of issue of shares for consideration other than cash. Although there was no restriction on the types of consideration for the issue of shares, the reforms are now clear that such alternative consideration can only comprise of shares and no other form of goods or property. Such shares too must be subject to an independent valuation. While SEBI has referred to such transactions as “share swaps”, only the fine print will tell whether the consideration must be in the form of shares issued by the investor or whether it can be shares that the investors hold in other companies, whether they are subsidiaries or not.
In all, SEBI has, within a very short span of time, introduced significant reforms to pricing in the preferential allotment of shares, including additional protective mechanisms by deviating from the market-based approach, which has been the mainstay for decades. The reforms have been both liberal at some levels and restrictive at others, thereby constituting a mixed bag.
Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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