Chapter 6: Issue Management - General Obligations of Merchant Bankers and Due Diligence

The SEBI ICDR Regulations establish strict operational obligations governing the conduct of Merchant Bankers during public and rights offerings. These provisions preserve market fairness, prevent manipulative market behavior, and maintain professional independence.

1. Absolute Prohibition of Incentives

Under Regulation 23 of the ICDR Regulations:

• No person connected with an issue—including the issuer, promoters, directors, lead merchant bankers, underwriters, syndicate members, or brokers—may offer any direct or indirect incentive, gift, rebate, commission, or service to any person for submitting an application for allotment of securities.
• This prohibition applies to all forms of commercial consideration, whether in cash, kind, or ancillary services.
• Permitted Exception: Normal statutory fees, brokerage, and underwriting commissions paid to registered intermediaries for professional services rendered in connection with managing the issue are exempt.

2. Restrictions on Personal Trading by Merchant Banking Personnel

• To eliminate conflicts of interest and prevent front-running or trading on Unpublished Price Sensitive Information (UPSI):
  • Neither the merchant banker, its directors, partners, key management personnel, nor employees involved in issue management may deal in the securities of the issuer company.
  • This trading restriction applies from the date of formal appointment of the merchant banker until thirty days following the date of listing and commencement of trading of the securities on recognized stock exchanges.

3. Pre-Issue Agreements and Due Diligence Dossiers

• The lead merchant banker must execute a formal Memorandum of Understanding (MoU) with the issuer prior to undertaking any issue management work.
• The merchant banker must assemble and maintain an exhaustive Due Diligence Working Paper Dossier, containing every verification record, chartered accountant certificate, legal search report, title clearance document, and management representation letter relied upon in drafting the offer document.

Public communications released by an issuer, merchant banker, or connected intermediary during an upcoming public offering are subject to strict regulatory constraints under Schedule IX of the ICDR Regulations.

Core Rules of Public Communications (Schedule IX)

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|                            SCHEDULE IX PUBLICITY COMPLIANCE FRAMEWORK                             |
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|                                                                                                   |
|  1. TRUTH & FAIRNESS       • Communications must be truthful, fair, and non-manipulative.         |
|  2. CONSISTENCY            • Cannot contain any statement, projection, or claim NOT in the DRHP.  |
|  3. PROHIBITION OF SLOGANS • Cannot utilize commercial issue slogans, hyperbole, or taglines.     |
|  4. QUIET PERIOD RULES     • Normal product advertisements permitted; corporate hype prohibited.  |
|  5. RESEARCH RESTRICTIONS  • Syndicate brokers cannot publish subjective research notes.         |
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Analytical Breakdown of Publicity Constraints

• Strict Alignment with Offer Document:
  • Any press release, digital announcement, social media post, corporate presentation, or video interview released by the issuer or lead managers must contain only information consistent with disclosures in the draft offer document or offer document.
  • No forward-looking financial forecasts, unsubstantiated revenue projections, or unverified market share claims may be disseminated.
• Prohibition of Issue Slogans and Promotional Branding:
  • Advertisements must not feature promotional slogans, celebrity endorsements, or marketing catchphrases designed to hype the issue.
  • All public advertisements must prominently display the mandatory Risk Factor Box directing investors to review the risk factors in the offer document before investing.
• Restrictions on Research Reports:
  • Merchant bankers and syndicate brokers are subject to strict restrictions regarding research reports.
  • Any research report prepared by a syndicate entity must be distributed strictly to its own clients without selective leaks and must disclose all underwriting relationships, shareholdings, and commercial interests in the issuer.

Due diligence is the cornerstone of merchant banking practice. It represents the comprehensive, independent investigative process through which lead managers verify the legal, operational, and financial standing of an issuer before inviting public investment.

THE THREE PILLARS OF DUE DILIGENCE

The Three Pillars of Investigation

1. Legal Due Diligence:

   • Verification of constitutional documents (Memorandum and Articles of Association).
   • Title searches on owned real estate, long-term lease deeds, and intellectual property registrations (patents, trademarks, copyrights).
   • Review of material commercial contracts, joint venture agreements, and loan covenants.
   • Litigation searches across District Courts, High Courts, the Supreme Court, NCLT, and regulatory databases to ensure full disclosure of criminal, tax, and civil litigation.

2. Financial Due Diligence:

   • Scrutiny of restated financial statements for the preceding three financial years prepared under Ind AS.
   • Analysis of related-party transactions (RPTs) to ensure arm's-length commercial pricing.
   • Reconciliation of contingent liabilities, off-balance sheet commitments, working capital cycles, and tax disputes.

3. Business and Commercial Due Diligence:

   • Physical site visits to operating factories, mining sites, corporate offices, and warehouses.
   • Background checks on promoters, key management personnel, and directors to verify fit-and-proper standing.
   • Independent customer and supplier referencing to verify sales volumes and operational stability.

Due Diligence Certificates (Schedule V of ICDR)

The Lead Merchant Banker must submit four formal Due Diligence Certificates to SEBI at critical milestones:

• Form A: Submitted along with the DRHP to SEBI, certifying that disclosures are true, fair, and adequate to enable investors to make an informed investment decision.
• Form B: Submitted along with the RHP to the ROC and SEBI, certifying that all SEBI observations have been fully incorporated.
• Form C: Submitted along with the Final Prospectus, confirming final pricing, subscription details, and updated litigation disclosures.
• Form D: Submitted immediately post-issue closure, confirming compliant allotment and unblocking of application funds.

The Offer for Sale through the Stock Exchange Mechanism (OFS-SE) provides a rapid, transparent, and liquid platform enabling promoters and eligible non-promoter shareholders of listed companies to dilute their holdings.

Regulatory Architecture of the OFS Mechanism

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|                                      OFS-SE WORKFLOW DYNAMICS                                     |
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|                                                                                                   |
|  [ INTIMATION TO EXCHANGES ]  -->  [ T-DAY: NON-RETAIL BIDDING ]  -->  [ T+1 DAY: RETAIL BIDDING ]|
|  • Notice filed at least 1         • Institutional / non-retail        • Retail investors bid     |
|    working day before opening        investors submit bids             • 10% reserved for retail  |
|  • Floor price announced (can      • Cut-off price determined          • Retail discount applied  |
|    be in sealed envelope)            for retail allocation               if declared by seller    |
|                                                                                                   |
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• Purpose and Applicability:
  • Primarily used by promoters to comply with the 25% Minimum Public Shareholding (MPS) rule under Rule 19A of SCRR or by large institutional shareholders to divest equity without creating market volatility.
  • Operates through a dedicated electronic order window on recognized stock exchanges during market hours.
• Procedural Milestones:
  1. Advance Intimation: The seller must inform stock exchanges of its intention to conduct an OFS at least one working day prior to the issue opening date.
  2. Floor Price Declaration: The seller declares a Floor Price below which no bids will be accepted (or may submit the floor price in a sealed envelope to the stock exchange).
  3. Two-Day Bidding Window:
     • Day T (Non-Retail Bidding): Institutional and non-retail investors submit limit bids. Allotment is executed on a price-priority basis (Single Clearing Price or Multiple Clearing Prices).
     • Day T+1 (Retail Bidding): Retail investors bid on the following day. At least 10% of the OFS size is reserved exclusively for retail investors (applying for shares worth up to INR 2 Lakhs).
  4. Settlement: Executed on standard stock exchange clearing house rolling settlement cycles, ensuring delivery of shares to buyers and funds to the seller.

Listed corporate enterprises frequently raise targeted equity capital from strategic investors or institutional funds via Preferential Issues or Qualified Institutions Placements.

1. Preferential Issue (Chapter V of ICDR)

An allotment of shares or convertible securities by a listed company to an identified person or group on a private placement basis:

• Statutory Shareholder Approval: Requires passing a Special Resolution at a general meeting. Allotment must be completed within fifteen days from the date of passing the resolution.
• Statutory Pricing Formulas (Regulation 164):
  • For frequently traded shares, the minimum issue price must be not less than the higher of:
    1. The 90 trading days Volume-Weighted Average Price (VWAP) preceding the relevant date.
    2. The 10 trading days VWAP preceding the relevant date.
  • For companies under financial stress or debt restructuring, specialized alternative pricing formulas apply.
• Mandatory Lock-In:
  • Securities allotted to promoters are locked in for 18 months (or 3 years if over specified thresholds).
  • Securities allotted to non-promoter strategic investors are locked in for 6 months from the date of trading approval.

2. Qualified Institutional Placement (QIP - Chapter VI of ICDR)

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|                                  QIP REGULATORY BENCHMARKS                                        |
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|                                                                                                   |
|  • ELIGIBILITY             : Listed issuer whose equity shares have traded for at least 1 year.   |
|  • INVESTOR CLASS          : Qualified Institutional Buyers (QIBs) only.                          |
|  • DOCUMENTATION           : Preliminary Placement Document & Placement Document (No SEBI filing).|
|  • ALLOTTEE DIVERSIFICATION: Minimum 2 allottees for issues <= INR 250 Crores.                    |
|                              Minimum 5 allottees for issues > INR 250 Crores.                     |
|  • SINGLE ALLOTTEE CEILING : No single QIB allottee can receive more than 50% of issue size.      |
|  • STATUTORY PRICING       : Not less than the 2-week VWAP preceding the relevant date.           |
|                              (Issuer can offer maximum 5% discount with shareholder approval).    |
|  • MORATORIUM PERIOD       : Minimum 180 CALENDAR DAYS must elapse between two successive QIPs.   |
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Rights issues and Indian Depository Receipts represent specialized issuance structures enabling listed domestic companies to offer shares to existing owners and foreign corporations to raise Indian Rupee capital.

1. Rights Issue Framework (Chapter III of ICDR)

• Record Date and Renunciation: The issuer determines a Record Date to identify eligible shareholders. Eligible shareholders receive dematerialized Rights Entitlements (REs) credited directly into their demat accounts prior to the issue opening date.
• Trading of Rights Entitlements:
  • Shareholders who do not wish to subscribe can renounce their rights by selling their REs on the secondary market platform of stock exchanges during the renunciation window.
  • Third-party buyers purchasing REs can apply for the underlying shares by submitting ASBA applications at the rights issue price.
• Fast-Track Rights Issue (Regulation 99):
  • Seasoned listed issuers can execute rights offerings on an expedited track without waiting for SEBI observation letters, provided they satisfy compliance, public float, and market capitalization thresholds.

2. Indian Depository Receipts (IDR - Chapter VIII of ICDR)

• An IDR is a financial instrument denominated in Indian Rupees, issued by a domestic Indian depository against underlying equity shares of a foreign issuing company deposited with an Overseas Custodian Bank.
• Eligibility Criteria for Foreign Issuers:
  • The foreign company must be listed in its home country for at least three immediately preceding years.
  • Must have a continuous track record of distributable profits for at least three out of the preceding five years.
  • Must maintain a minimum pre-issue paid-up capital and free reserves of at least USD 50 Million.
• Role of Merchant Banker:
  • Acts as Lead Manager to the IDR offering, coordinating international accounting reconciliations between foreign GAAP/IFRS and Indian Ind AS, managing regulatory filings with SEBI and the RBI, and ensuring domestic investor protection standards are upheld.