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

  • For Object of the issue

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.

  • For Financial statements

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.

  • For the existence of litigation including regulatory action

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

  • Regulatory compliance- It would include compliance with the Companies Act, income tax act, SEBI laws, etc
  • Contractual compliance- It would include compliance under various material contracts by the company.
  • Compliance under intra-corporate Aspects- It would include compliance with AOA, MOA, Policies, code of conduct, etc
  • Financial aspects- It would include reading the balance sheet to identify financial obligations and penalties paid by the issuer.

Materiality Factor

Not every litigation would lead to the offer document getting rejected. The following factor should be considered by the merchant banker relating to materiality.

  • Amount of Fine involved- If the amount of penalty involved would be that much that it adversely affect the solvency of the company should be disclosed
  • Criminal liability- If the suit may lead to imprisonment of Key managerial personnel then it should be disclosed.
  • Financial capability- Whether the issuer is financially capable to bear the burden if the suit is lost.
  • Degree of offense involved- If the offense involved would be relating to serious offenses such as money laundering, insider trading, or offense involving moral turpitude.

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-

  • Verifying the provided information from the High court, Local district courts, and Tribunals websites.
  • Verifying the information provided through liaising with the attorney representing the issuer.
  • Researching Government websites by using Company/Promoter/Related entities name to find out if any litigation is concealed by the issuer
  • Liasoning with Parties to contract to verify if the issuer has made default on its contractual obligation.
  • Checking minutes and copies of resolutions passed by the issuer in the past 5 years to verify if any transaction which is ultra vires to MOA, AOA done by the issuer.
  • The business model of the issue

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-

  • Overview of the issuer business which would include nature of the industry the issuer works in, Information about visions and values in which company believes
  • Information about the products the issuer manufacturer or services the issuer provides
  • Strengths and strategies of the issuer, which should be verified from Financial statements and media outlets
  • Description of the Products of the issuer and what their needs are to the general public
  • Information about the production facility of the issuer which would include production capacity, the place where they are situated, etc.
  • Other relevant information such as pricing policy, inventory management policy, after-sales services provided, etc.
  • Capital Structure

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

  • Financial statements of the company
  • Reports showing the history of equity capital of the company
  • Reports showing shares issued for consideration other than cash
  • Reports of the history of the equity shares held by the promoters
  • Details of promoter contribution and lock in requirement on them, if any
  • Reports showing shareholder pattern of the issuer
  • Details of shares held by the directors or KMP of the company.
  • Bank statements of the issuer and shareholders.

The following steps may be taken by the merchant banker while conducting due diligence of the capital structure of the issuer-

  • Verify debit and credit transactions from issuer and shareholders bank statements
  • Sorting out individual and corporate promoters to identify ultimate promoters
  • Check ITR’s of the shareholders
  • If the promoter of the issuer is corporate entities then check the ultimate promoters behind the corporate layers
  • Check compliance with section 42 of the companies act and other applicable section is thereby making checklists
  • Special attention should be given to the issue of share done within 1 year before the filing of the offer document
  • If Capital structure involves a loan element then liaising should be made with entity which has given the loan
  • Making a timeline of the sale purchase of the shares of issuer and verify each one of them for any susceptible transaction

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

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