Promoters are once again gifting themselves preferential shares at the expense of retail investors, using a perfectly legitimate loophole. This column first appeared in the Divvya Bhaskar of Gujarat.
Preferential allotments for promoters rear up again
By Sucheta Dalal
Every bull market in recent times has seen industrialists allotting preferential shares to themselves in companies that they control, despite attempts by the capital market regulators to end this pernicious profit making opportunity.
What they do is perfectly legitimate. Section 81 (1A) of the Companies Act allows select groups of persons, such as promoters or collaborators to be allotted preferential shares in order to help the company raise resources.
But the rules are contrary to the concept of shareholder democracy by allowing only the promoters to benefit.
In the early 1990s, when the greed of Indian promoters was at its worst, promoters allotted themselves shares at a steep discount to the market price while selling their existing holding at a huge profit. Sometimes they gave themselves ‘warrants’ that could be converted into shares at a predetermined price, but allowed them to time the conversion to their best advantage.
Promoters are estimated to have pocketed a cool Rs5000 crore in that phase at the cost of the small investor. It provoked Investor protection groups such as the Consumer Education and Research Centre (CERC) to file public interest litigation demanding disgorgement of such unjust enrichment, but the case remains lost in the maze of delayed litigation.
The Securities and Exchange Board of India (SEBI) also reacted by tightening preferential allotment rules in 1994 through several important measures. It mandated that preferential allotment could only be cleared through a special resolution passed at the general body meeting. The price was based on a formula (a six month average high-low price) and fixed to a date one month prior to the shareholders meeting. It also limited such preferential allotment to 20 per cent of the capital and imposed a three-year lock of the newly allotted shares.
The bull run of 2001 however showed that ingenious promoters had still found a way around the rules and made a killing.The companies that exploited preferential allotments to make quick money included TV 18 and Aurobindo Pharma.
Now cut to 2003, when another massive big bull run has created another profit opportunity over the last few months. Again, we have several industrialists swapping existing holdings for preferentially allotted shares to make a fast buck. The promoters of TV 18, for instance, sold a million shares at Rs 168.35 on November 7 to a mutual fund. Then on November 14, they immediately approved a preferential issue for themselves at Rs 152 per share. The price was based on the SEBI formula but still worked to their advantage.
Similarly, Mr.Ramaprasad and Mr.Reddy together sold over four lakh shares of Aurobindo Pharma at the end of August this year. Subsequently, in September, they decided to acquire over 8.5 lakh shares through a preferential issue at Rs 226 a share. The scrip is now ruling at Rs 500 giving them a huge profit opportunity.
A third example is Pantaloon, whose promoters sold 1.9 million shares from their holding to a bunch of mutual funds at Rs 95 each.They then allotted themselves 2.8 million shares at Rs 112 (which is higher than the sale price) to the mutual funds. The price keep moving up and the promoters subsequently offloaded another 4.6 per cent of their equity in the open market at Rs 275 a share and made money.
Although these deals are all completely legal, they are still unfair to a large group of investors who are otherwise called co-owners of the company. It also means that if promoters continue to have a profit opportunity in every bull run, then the preferential allotment rules are not tight enough to plug the loophole.
SEBI itself is looking for answers and a way to end the mischief that is legitimised by its own rules. Hopefully, it will consider the simplest way to end promoter enrichment – which is, to stop the management from voting at the special resolution to clear a preferential allotment to themselves. This is a fair and practical solution. After all, the management is an interested party in such a decision and cannot vote to its advantage. But if shareholders consciously want to reward management by granting them preferential shares, they would still have the freedom to do so.
However, such a decision is not in the jurisdiction of the capital market regulator. It requires changes in the Companies Act, which is a long drawn process.
An interim measure could be to bar preferential allotments to promoters if they have off-loaded their core holding within a one-year period prior to deciding on a preferential allotment to themselves.
When combined with the three-year post allotment lock-in, this would hopefully tighten existing regulations and prevent promoters from taking advantage of sustained bull phases.