On May 24 2011, the Ministry of Corporate Affairs (MCA) issued draft rules for preferential allotment by unlisted public companies (draft rules). Preferential allotment refers to offer of shares and so on other than a rateable offer to the current shareholders in proportion to their current shareholding. The draft rules will be applicable to preferential issue of equity shares and any other financial instrument which would be convertible into or exchanged with equity shares.
Such preferential issues are covered by the Unlisted Public Companies (Preferential Allotment and Private Placement) Rules 2003. Under these rules, the notice of the shareholders meeting approving the preferential allotment is required to be accompanied with an explanatory statement containing the pricing and objects of the issue as well as the issue's impact on the promoters' shareholding. A compliance certificate by a company secretary or statutory auditors of the company is also required. The pricing of the conversion of the convertible instruments to equity shares is required to be decided upfront.
One of the most, if not the most, disconcerting proposal of the draft rules is that private placement of any convertible instruments in a cumulative amount of Rs50 million ($1.12 million) or more requires the company to seek prior approval from the MCA. The draft rules stipulate that there should be a minimum gap of 60 days between two offerings.
The draft rules have also proposed that in addition to the passing of a special resolution by shareholders, an unlisted public company will have to make certain mandatory disclosures in an offer document for any such preferential allotment of equity shares and convertible instruments and such offer document will have to be approved in the shareholders meeting. A copy of the offer document, the special resolution by shareholders authorising the issue and a compliance certificate from a Chartered Accountant, Company Secretary or Cost Accountant will have to be filed with the Registrar of Companies. The draft rules also mandate that the gap between the opening and closing of the offer should not be more than 30 days.
While the intent of the proposed changes is not clear, it has been suggested that this move is in furtherance of MCA's bid to protect minority shareholders. Whatever the intent may be, the requirement of seeking permission from the MCA before a private placement of convertible instruments is onerous and likely to cause delay in bona fide private equity deals which involve issue of convertibles. Another distressing requirement is the gap of 60 days to be maintained between two issues; this may prove troublesome in cases where the investment is to be done in tranches.
The stricter compliance requirements and prior approval in cases of issue of convertible instruments that meet the Rs50 million threshold is regressive to say the least. If the proposed changes in the draft rules are accepted, there will be a definite adverse impact on the investment environment in the country. The MCA is still awaiting public comments on the draft rules. It is hoped that better sense prevails and the restrictive requirements are dropped off in the finalised rules.