By Sandeep Parekh

The securities market plays a role akin to the nervous system for the economy, facilitating price discovery in securities and allocating funds to the most promising companies. To ensure this mechanism is not disturbed by information asymmetries favouring the issuer or insiders, and to ensure liquidity and stability during and immediately after an issue of securities, a merchant banker is engaged to “manage” the issue. A merchant banker essentially oversees critical aspects such as due diligence of the issuer, valuation of the issuer’s securities, and preparing the prospectus, on top of the core job of marketing securities. Further, as an underwriter, a merchant banker may buy securities that have remained unsold at the end of an issue, thus ensuring adequate subscription. On August 28, the Securities and Exchange Board of India (SEBI) released a consultation paper proposing changes to the SEBI (Merchant Bankers) Regulations, 1992.

Many key changes pertain to the eligibility and obligations of merchant bankers. Merchant bankers are proposed to be recategorised into category1 (possessing a net worth not less than Rs 50 crore, and authorised to undertake all permitted activities) and category 2 (net worth not less than Rs 10 crore, and authorised to undertake all permitted activities except main board issues). It is unclear why non-underwriting bankers require a net worth.

SEBI further proposes to introduce the concept of liquid net worth, which for category 1 merchant bankers would be worth not less than Rs 12.5 crore and Rs 2.5 crore for category 2 ones. The maximum underwriting obligations of merchant bankers, currently at 20 times their net worth, are proposed to be reduced to 20 times the liquid net worth for one that has maintained 35% of its net worth as liquid.

Another key set of changes pertains to activities of merchant bankers. They have traditionally performed many roles, including advisory services for projects and syndication of rupee term loans. Further, upon obtaining appropriate registrations, they play other regulated roles in the securities market, such as dealers of government securities or stockbrokers. Merchant bankers, as a class, have also been specifically recognised as providers of valuation services, both by SEBI for the purpose of acquisitions and share-based employee benefits and sweat equity, and by other authorities, particularly in respect of fair market value of unquoted securities for income tax purposes and pricing of non-debt instruments under foreign exchange rules.

SEBI has now proposed to specifically define the permitted activities of merchant bankers. These would include only activities related to the securities market and under the jurisdiction of SEBI, excluding any activity requiring a separate registration. To this effect, it has provided a list — it isn’t clear if it is exhaustive — of permitted activities. Apart from managing international offering of securities, the list indicates an intent to confine the activities of merchant bankers to those specifically permitted by the regulator under the relevant framework. What is truly concerning is that an adequate rationale has not been furnished for such a restrictive approach.

First, prohibiting merchant bankers from activities regulated by other financial sector authorities is not consonant with SEBI’s own approach elsewhere. For instance, in its consultation paper reviewing the regulatory framework for investment advisers and research analysts, dated August 6, SEBI proposed to permit investment advisers to advise on products regulated by other financial sector authorities. Further, while other financial sector authorities such as the Reserve Bank of India have found merchant bankers suitable to act as dealers of government securities, it is puzzling why SEBI adopts a restrictive stance. It is debatable that SEBI, being at most a co-equal authority, now prohibits merchant bankers from valuation activities that may be administered by other authorities. Permitting such activities through separate divisions could have been a better alternative.

Moreover, no rationale has been offered for barring merchant bankers from activities that require separate registration with SEBI, nor does there appear to be any international precedent for this. In fact, activities corresponding to merchant banking in India are usually carried out by broker-dealers in the US. Thus, SEBI’s proposals, if implemented, would require the merchant banking industry to restructure its business in ways dissimilar to both existing practice and the rest of the world for no perceptible regulatory benefit.

Further, SEBI has proposed to cancel the registration granted to a merchant banker if it fails to earn a minimum revenue from its activities. This too is an extreme step, given that revenue from permitted activities, unlike capital adequacy, does not impact the ability of a merchant banker to carry out its obligations. Moreover, there is no international precedent for such a requirement.

Another proposal that should be reconsidered is the limiting of merchant bankers’ underwriting activities to those specifically permitted by SEBI. It appears to be directed, at least partly, at curbing the market practice of underwriting private placements of debt securities by listed entities. Yet, this proposal misses the market reality that private placements of debt securities are often the first step to their introduction in the public market, akin to an initial public offering of equity shares in respect of the usual lack of a pre-existing liquid market. Without underwriting by merchant bankers to make a market in such securities, private placements may often fall through.

It is also proposed that a merchant banker should not act for an issuer if the former’s directors, key personnel, compliance officer, and relatives, individually or in aggregate, hold more than 0.1% of the issuer’s paid-up share capital or nominal value of Rs 10 lakh, whichever is lower, save through mutual funds. Given that such personnel have significant financial expertise and are likely to hold large investment portfolios, such a requirement may needlessly disqualify many merchant bankers. Rather, it would suffice to require disclosure of such shareholding as conflict of interest.

By and large, it is commendable that SEBI has updated its regulatory framework on merchant bankers in line with the changing realities of the market. However, there is much to be reconsidered to ensure that restrictions that do not serve the interests of the market are not placed on merchant bankers.

Co-authored with Aniket Charan and Rishabh Jain, associates, Finsec Law Advisors.

The author is the managing partner, Finsec Law Advisors.

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