This article is written by Yash Mukadam, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from lawsikho.com.

Introduction

A merchant bank is an organization that acts as an intermediary between the issuers and the ultimate purchasers of securities in the primary security market. Merchant banks are often instrumental in driving economic development of a country as they act as a source of funds and information for corporations, facilitating complex transactions. 

The formal beginning of merchant banking can be traced back to 1967 when the Reserve Bank of India provided a license to the Grindlays Bank. Citibank started the merchant banking services in 1970 and the State Bank of India followed the same in 1972. 

Entities that can function as merchant bankers

Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992 define Merchant Banker as – “any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities or acting as manager, consultant, adviser or rendering corporate advisory service in relation to such issue management” while ‘Issue’ is defined as “an offer of sale or purchase of securities by any body corporate, or by any other person or group of persons on its or his or their behalf, as the case may be, to or from the public, or the holders of securities of such body corporate or person or group of persons through a merchant banker”.

Thus, a merchant banker is a person who is engaged in the business of consulting, managing and/or advising in the matters of offer of sale or purchase of securities by companies. Several legislations and regulations require indulging the services of a SEBI registered merchant banker in several transactions. A merchant banker can be registered with SEBI under any of the following categories:

• CATEGORY IV: to only act as an advisor or consultant to an issue;
• CATEGORY III: to act as an underwriter in addition to acting as an advisor or consultant;
• CATEGORY II: to act as portfolio manager/co-manager (also requires a separate certificate of registration under the provisions of the Securities and Exchange Board of India (Portfolio Manager) Regulations, 1993) in addition to acting as an adviser, consultant or underwriter;
• CATEGORY I: to carry on any activity of the issue management such as preparation of prospectus and other information relating to the issue, determining financial structure, tie up of financiers and final allotment and refund of the subscriptions in addition to acting as adviser, consultant, manager, underwriter, portfolio manager. 

Before granting a certificate of registration, SEBI takes into account all matters which are relevant to the activities relating to a merchant banker. An applicant needs to be a body corporate having the necessary infrastructure, such as office space, equipment, manpower etc, as well as having at least 2 people in its employment who have experience in merchant banking activities. An NBFC, as defined under clause (f) of section 45-I of the Reserve Bank of India Act, 1934 cannot, however, function as a SEBI registered merchant bank.  The applicant, his partner, director or principal officer cannot be involved in any litigation connected with the securities market that can possibly have an adverse bearing on the business of the applicant nor can they have been convicted for any offence involving moral turpitude or any economic offence. The applicant also needs to have a net worth (net worth = paid up capital + free reserves) of at least INR 5 crores.  Once satisfied, SEBI will register a merchant banker and grant a certificate in that regard. The certificate is granted on conditions that the merchant banker would acquire prior approval of SEBI before any change in control, it would maintain the capital adequacy requirement of net worth, it would intimate SEBI of any changes that have taken place in the information that was submitted, while seeking registration and that adequate steps would be taken for redressal of grievances within 1 month and SEBI would be kept informed about the number, nature and other particulars of the complaints received.  

In case an application is rejected, the applicant can apply to SEBI within 30 days from date of receipt of the rejection for reconsideration of its decision. 

Section 6(1)(d) of the Banking Regulation Act, 1949 permits banks to indulge in activities like ‘underwriting, participating in, managing and carrying out of any issue, public or private, of State, municipal or other loans or of shares, stock, debentures, or debenture stock of any company, corporation or association’. Section 19(1) allows banks to undertake these activities by establishing subsidiaries albeit certain restrictions such as being able to hold shares only up to 30% of the paid-up share capital of that subsidiary or 30% of its own paid-up share capital and reserves, whichever is less. Additionally, RBI’s Master Circular on para banking activities permits banks to undertake certain merchant banking functions by setting up a branch or a subsidiary. The said circular allows banks and their subsidiaries to undertake underwriting services by being in conformation with the SEBI regulations on merchant banking. Similarly, it also allows undertaking of portfolio management services with prior approval from RBI by being in conformation with the SEBI regulations on portfolio managers. RBI’s master circular on Exemptions from the provisions of RBI Act, 1934 exempts merchant banking departments/subsidiaries from the provisions of section 45-IA (requirement of registration and net owned fund, section 45-IB (maintenance of liquid assets) and section 45-IC (creation of Reserve Fund) of the RBI Act, 1934 provided certain conditions are met.  

Therefore where a bank wishes to pursue merchant banking, it requires a banking license from RBI in addition to SEBI registration referred to above. Some of the major merchant banks operating in India are subsidiaries or departments of banks – SBI capital markets Ltd. & ICICI Securities Ltd.  

Role in an acquisition transaction

Merchant bankers play a varied role in an acquisition ranging from acting as an advisor or consultant to a full-fledged issue manager. Scope of their functions is extremely wide as ‘advising’ and ‘consulting’ can involve so many activities. Oftentimes, merchant bankers identify assets/undertakings that are being offered for sale, they find potential buyers, negotiate prices and oversee the entire transaction. 

In case of takeovers, the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 entrusts certain functions to merchant bankers. Before making a public announcement for an open offer, the acquirer is required to appoint a merchant banker, who is not an associate of the acquirer, as the manager to the open offer. The public announcement as well as a detailed public statement is to be made through this manager. He is also the one who files the letter of offer with SEBI. SEBI approaches the manager in case it requires any clarification/further information. In case the escrow account required to be open under the regulations is to be in the form of bank guarantee, then such guarantee is to be issued in favour of the manager, a similar provision exists when the account is in the form dealing with securities. The manager is empowered to make payments out of the escrow account.  While determining offer price for an open, in case where shares are not frequently traded or in cases where share value is not determinable by any of the parameters laid down in this regard, the valuation of shares is to be done by an independent merchant banker (or an independent chartered accountant) not being a manager to the open offer. In fact, the manager to the open offer (who is essentially a merchant banker) plays a key role in determining the offer price.  Likewise, in cases where listed securities are offered as consideration, one of the parameters for calculating value of those securities involves the determination and certification of the ratio of exchange of shares by a duly certified merchant banker (or an independent chartered accountant) not being a manager to the open offer. In a way, a merchant banker (in the form of a manager) acts as a facilitator representing the acquirer to the SEBI, public shareholders and other stakeholders.    

Conclusion

Rapid urbanization in the 1980s and the LPG reforms of the 90s increased the importance of merchant banks. Now, with increased business activities in all avenues, more and more merchant bankers, with their expertise, are going to be needed to facilitate their transactions. 

However, there are certain limitations that would need to be overcome for the practice area to flourish. Merchant bankers are only allowed to deal with issue related activities which restricts their scope of activities. Their involvement should be widened for them to develop adequate expertise to provide a full range of merchant banking activities. SEBI regulations also stipulate a very high capital adequacy requirement not allowing smaller firms or individuals to undertake merchant baking activities despite having the required level of expertise. A lot of time there is also non-cooperation and default at a client’s end who rarely have to face repercussions of the same while the merchant banker may suffer a blow to his reputation. The merchant banking legislation has undoubtedly brought their services in the mainstream but certain tweaks are needed to keep up with changes in the current business scenario.    

References

“Master Circular – Para-Banking Activities” Reserve Bank of India – Master Circulars, www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=9837.

“Master Circular – Exemptions from the Provisions of RBI Act, 1934” Reserve Bank of India – Master Circulars, www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=9822.

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