Scope of Due Diligence in SEBI (Framework for Rejection of Draft Offer Documents) Order, 2012
SEBI (Framework for Rejection of Draft Offer Documents) Order, 2012 provides various criteria that could lead to rejection of draft offer documents by SEBI, which has to be mandatorily filled by the issuer before raising money from the public under regulation 25 of SEBI (ICDR) Regulation 2018.
The framework has mentioned various rejection criteria such as ultimate promoters being unidentifiable, the purpose of utilizing the proceeds is vague, the existence of circular transactions, major non-compliance by the issuer, etc.
Regulation 24 of SEBI(ICDR) Regulations,2018 mandate that lead manager shall exercise due diligence and satisfy themselves about all aspects of the issue including the veracity and adequacy of disclosure in the draft offer document and the offer document which means merchant banker shall ensure that the framework provided by the SEBI shall be complied with and implemented in draft offer documents. The following steps may be followed for conducting the due diligence
Check whether the issuer has clear business objectives and made internal Plans and procedures for utilizing the proceeds. It will involve liaising with internal management, analyzing business prospects, and ensuring that funds would go into the business mentioned in the offer document.
If the proceeds are raised to set up a plant then liaising with local authorities should be made to know whether required crucial clearances/licenses/permissions/approvals have been received. It would include visiting the local authority office and verifying whether the issuer has received the required clearances.
If the proceeds would be utilized for creating some intangible asset, then analyze financial statements of the issuer, liaison with the management, and ensure a reasonable explanation is provided by the management explaining how the particular investment would benefit the issuer
If the proceeds would be utilized for repayment of some previous loan then the loan agreement should be thoroughly analyzed and a meeting should be conducted with the management of the bank which has issued the loan to understand and verify the explanation given the issuer relating to the utilization of the loan amount in the offer document
List of some of the documents that the merchant banker should ask the issuer to present for due diligence of object of the issue
1. Copies of commercial agreements signed by the issuer such as Purchase agreement to buy the machinery which would facilitate the implementation of the business project, Lease/Rent agreement, etc, and verifying them with other parties.
2. Copies of loan agreement if any, and verify the contents with the bank.
3. Copies of financial statements and progress reports of the issuer such as Sales report, profit analysis report of the issuer. Assistance from some analytics firms may be taken if the information is not complete or too complex to understand the impact of assets on the business on which issue proceeds will be invested.
4. Copies of the crucial clearances/licenses/permissions/approvals that the issuer has received.
Checking the financial statement of the past 5 years of the issuer and checking if there are any sudden spurt in profit or losses which are not consistent with the profit/loss trend.
Checking the audit report and analyzing qualifications made by the auditor in the report. This would also include liaison with the issuer and its related entities auditor.
If any change is there in accounting policies, then it is in the best interest of the issuer.
Analyze business transactions made by the issuer in the past 5 years and if there are made with the related party then it is done at arm length basis. If there are any buying selling of securities between issuer and group entity then the agreement governing them should be analyzed to find any circular transaction.
List of some of the documents that the merchant banker should ask the issuer to present for due diligence of Financial statement
1. Copies of Financial statements for the past 5 years.
2. Copies of the Audit report of the issuer
3. Copies of form MBP-1, MBP-4, etc to understand related party transactions.
4. Statement of reason provided by the issuer if any change has been made in accounting policy.
It would involve liaising with the legal consultant of the issuer and analyzing the impact of some ongoing litigation or regulatory action issuer. Factors such as the amount involved, whether any key managerial person of the issuer would be criminally liable etc. should be taken while considering its impact.
Scope of legal due diligence
Following areas should be checked while conducting legal due diligence
Not every litigation would lead to the offer document getting rejected. The following factor should be considered by the merchant banker relating to materiality.
In general, the issuer should disclose pending litigation to the merchant banker. However, the merchant banker must not only verify the information provided by the issuer but also find if any litigation is concealed by the merchant banker. The following steps may be taken while conducting due diligence-
It would involve liaising with the management and ensure that the business model is not Exaggerated, complex, or misleading and the investors may not be able to assess the risks associated with such business models and it is explained in the offer document in such a way that investors would know where their money will be going.
While conducting Due diligence merchant should ensure that the following information should be provided by the issuer in the draft offer document to disclose its business model-
Check the master data of the issuer to verify the details of the promoter provided by the issuer. If the promoter is a physical person then the identity proofs of the promoters can be asked to verify their information.
Check whether the issuer is involved in any circular transaction in past years by analyzing the share price of it and its related entities.
Duties of the merchant banker change from facts and circumstances. This framework gives a general idea of what offer documents should have and what merchant bankers should do so that offer documents do not get rejected.
List of some of the documents that the merchant banker should ask the issuer to present for due diligence of capital structure of the issuer
The following steps may be taken by the merchant banker while conducting due diligence of the capital structure of the issuer-
Consequences of rejection and one recent example
If the offer document is rejected the issuer shall not access the capital market for one year from the date of such rejection.
Due to the one-year ban after the rejection of the offer document, SEBI generally allows the issuer the option to withdraw its draft offer document and fill a fresh one. One of the classic examples where this regulation was applied by the SEBI was the IPO of Barbeque Nation.
The company had filed draft papers with Sebi in August, seeking approval to float its initial public offer (IPO). The proposed IPO of the firm, which operates Barbeque Nation restaurants, comprises a fresh issue of shares worth up to Rs 200 crore, besides an offer for sale of up to 61.79 lakh shares by promoters. According to merchant banking sources, the public issue was expected to mobilize Rs 700 crore. The Bengaluru-based firm proposed to use the proceeds of the IPO towards the expansion of Barbeque Nation restaurants in the country and repayment of loans. However, SEBI kept processing of Barbeque Nation Hospitality’s proposed IPO in abeyance “pending regulatory action for past violations”.The Securities and Exchange Board of India (Sebi) did not even clarify whether violations have been committed by the company or related entities. When the company finally got the approval for the issue in January 2018, the market conditions turned averse and it could not launch the issue within the one year period. Ultimately the issuer got clearance from Sebi in July 2020. This case showed how important as well as complex due diligence is. Even the involvement of reputed merchant bankers such as IFL Holdings, Edelweiss Financial Services, Jefferies India, and SBI Capital Markets lead could not approve the document. It is a wise saying that in the stock market “Time is money” and the document which could have been approved in 2017 finally got approval in 2020. If Effective Due diligence were conducted by the merchant bankers, the issuer could have paid off his debts and expanded its business