This article is written by Dhawal Srivastava, a student currently pursuing B.A. LL.B (Hons.) from the Rajiv Gandhi National University of Law, Punjab. In this comprehensive piece, the author has explained the concept of rights issue in raising capital and the legal provisions governing the same in India.
A rights issue is a framework by which listed companies can raise extra, supplementary capital by means of providing discounted rates of the shares to the existing shareholders rather than calling for newer investments in public. The new shares would be in addition to the already held shares by these holders. These rights, provided by the companies to their shareholders, are securities and are not obligatory in nature. Usually, companies in need of liquidity or having a lack of sufficient funds or capital tend to pursue rights issues.
How does the rights issue work?
The system of a rights issue can be explained with the help of an example. For instance, a company ‘A’, running out of adequate capital, has decided to go for issuing rights to the existing shareholders for purchasing additional shares at a discounted price. In normal conditions, the price of a share is 5 rupees, and ‘X’, an existing shareholder, already has 100 shares in A. After the announcement of rights offering to its shareholders, A fixes the price of a share at 2 rupees, provided the existing shareholders purchase 5 for every 10 shares. In other words, this is a five-to-ten or 5:10 rights issue. In this case, X can avail the discounted rate of 60% provided he buys 50 extra shares in addition to the 100 shares owned by him in A.
However, it is not a compulsion for X to pursue this offer. As a matter of fact, there are two more alternatives available to him in such a situation:
- Ignore the rights
- Sell off his rights to some other interested party
There are implications attached to both of the aforementioned options available at the disposal of the shareholder. These are succinctly discussed below:
Expiry of or ignoring the rights
Since it is merely an offer and not an obligation on the part of the shareholder, he or she can even let go of the invitation to invest in newer shares by the company. This can happen because of several reasons, most commonly due to financial constraints on the shareholder or lack of adequate awareness with respect to the long term effects of the shares. However, this alternative is not much recommended as due to the additional shares that would be issued by the company, the shareholding of such a shareholder would be diluted or reduced.
Selling off rights to other interested investors
This alternative is not always made available by the companies. In such cases, these rights are categorised as ‘non-renounceable rights’. However, in some cases, the option of selling off these rights to some other interested investors or underwriters is made available to the shareholders by the companies and these rights are called ‘renounceable’ rights. Post their transference, the nomenclature of these rights changes and are then addressed as ‘nil-paid rights’.
Why do companies pursue a rights issue?
Corporates generally do not prefer rights issues for raising additional capital. However, cash-strapped companies resort to this mechanism in circumstances warranting the same for the purpose of corporate enhancement or some giant mergers or takeover deals. Essentially, companies resort to the rights issue in order to survive and maintain their existence in the market, or when they require liquidity for meeting various objectives.
Rights issue also provides the companies with a wider equity or ownership base and thus facilitate adjustable opportunities for them. Since it also leads to a reduction in the debts to equity ratio of the company, it gets various opportunities in future to seek raising debts. Understanding these long-term effects of the rights issue, companies and corporates go for it.
Advantages and disadvantages of the rights issue
The issue of rights has got both advantages and disadvantages associated with it. These have been discussed below under different headings.
Advantages of a rights issue
The pros of raising capital by rights issue are as follows:
- The equitable distribution of shares amongst the existing shareholders is maintained by the issue of rights shares, causing no disruption in the equilibrium of the shareholdings or equity base of the company. Thus, control of the company is retained in the hands of the old shareholders.
- The company is saved from expanding on additional costs that are incurred in announcing newer invitations of investing in shares such as advertising costs, underwriting fees and others.
- There is always a possibility of future enhancement in the company’s reputation and image in the market if the shareholders are kept satisfied. Rights issues do the same provided they are structured in a profitable manner.
- It is one of the speediest methods of raising additional capital vis-a-vis others as it is counted as an internal matter of the concerned company and is kept free from a lot many stringent guidelines and rules of regulators like Securities and Exchange Board of India and stock exchanges.
- Rights issues also provide the company with a safer alternative of raising capital as it does not have to go for any further debts in order to expand its business.
- It does not leave much space for the directors of the company to misuse the shares by offering discounted rates to their contacts or known acquaintances as the principle essentially binds them to invite investments from existing shareholders only.
- There is no dilution in the incumbent value of the shares as with the newer issues, the prices tend to fall automatically which are compensated by the additional shares purchased by the shareholders. If a public offering of shares is made, then there is a definite possibility of dilution.
- Another pro for the company is a greater certainty of getting shares from the shareholders since these are offered at prices lower than the market costs.
Disadvantages of the rights issue
The cons of raising rights issue have been enlisted below. These are as follows :
- It can amount to a great loss for the inviting company if there is no enthusiasm prevailing on the part of its shareholders to invest in newer shares. This will lead to a subsequent failure in achieving their target and raising the required capital.
- It hinders the company from raising amounts through IPOs or Initial Public Offering. The regulators and stock exchanges usually put a bar on the capital amount which can be raised by any company. This restriction is usually equivalent to the then existing value of equity of that company. Provided a company has grossly reduced or low valued stocks, it gets difficult for it to ameliorate its condition.
- Another perspective associated with the rights issue with regards to the reputation and public image of the firm is not a very positive one. It is also believed that if a reputed company issues rights shares, a negative sentiment runs in the market and future prospective shareholders form an opinion about the company being financially unstable and not reliable for their money.
- Many companies also end up using the additional capital raised from shares purchased in an inappropriate manner, specifically as a means of correcting their balance sheets and causing a negative impact on the shareholders and share prices of the company.
- There is no guarantee whether any profits would be incurred by the shareholders or not.
- The value of shares may also get diluted as there is a proliferation in the number of shares due to the discounted pricing by the company.
The legal framework governing the rights issue
Defined as an issue of capital under section 62 of the Companies Act of 2013, rights issue does have a legal backing within the corporate law regime of India. Besides these, SEBI (ICDR) Regulations of 2009, recently amended in 2020, also govern the functioning of this capital increment mechanism that is adopted by several listed as well as non-listed companies.
In order to understand the related nuances of the law, it becomes contingent to know about Record Date and Letter of Offer:
- Record Date: It is a cut-off date stipulated by the company in order to assess which all shareholders or contributors are eligible for getting the rights since equity base is a variable asset and keeps fluctuating based on several factors, especially in cases of actively trading stock.
- Letter of Offer: Letter of Offer is issued at the time when the companies call for investments from their existing shareholders by means of the rights issue. It contains all the essential and relevant details pertaining to risks and benefits associated provided an investment is made by the prospective shareholder. It is filed with the Registrar of Companies (ROC) and a designated stock exchange. Section III of the guidelines enlist the contents that are supposed to be incorporated in the letter.
The procedure of the Rights Issue in India
Not counting the time taken by SEBI for reviewing, due diligence and drafting of Letter of Offer, it ideally takes 55 to 58 days for the completion of the process. The following procedural steps are involved in the same:
- For the application of the rights issue, a minimum of fifteen days is required.
- A compulsory partaking by certain investors only through the ASBA (Application Supported by Blocked Amount) process (as per the new amendments to the guidelines). Initially, the only non-ASBA mechanism was permissible.
- An intimation before the stipulated record date is required to be made prior to full seven working days.
SEBI Guidelines governing the rights issue
- For the applicability of these guidelines, it is necessary that the equity capitals of the company are listed. The minimum amount of issue for which these are applicable is 50 lakh rupees.
- If there is a withdrawal of the rights issue before the record date, the company shall, for one year, be deemed ineligible for further listing by the regulator (SEBI).
- The underwriting of the rights issue is not mandatory and is optional.
- It is mandatory to appoint Registrars of the Issue.
- It shall also be mandatory for the company to appoint a Category-1 Merchant Banker who holds a SEBI-issued certificate of registration.
- No shares should be left either half or partly paid. In cases of such shares, they should either be completely forfeited or be fully paid.
- The company shall, in agreement with the depository, execute the dematerialisation of the already issued and proposed securities. It should be left at the discretion of the shareholders to have the shares in a dematerialised manner or by way of certificates.
- The closure of the rights issue must happen solely after a minimum period of one month (thirty days) and a maximum period of sixty days.
- SEBI has also provisioned for a minimum level of subscription that is required to be explicitly mentioned in the letter of offer.
- It is not permitted to include reservations in the rights issues. Moreover, the necessity of promotor’s contribution is not required.
- The rights of the holders of fully convertible debentures (FCDs) and partly convertible debentures are also incorporated in the guidelines.
- The regulations also stipulate restrictions on the issue of newer rights issues for capital raising before the expiration of the ongoing one. Moreover, over-subscription shall never be retained.
- Except for cases where the total issue size cross rupees 500 crores, issues shall be made fully paid up within a year’s time.
- From the date of filing the offer document with SEBI, the other documents shall be publicised for a period of 21 days. This shall be done by the Lead Merchant banker.
- Twenty-one days post the date of publication of the draft offer, the Lead Merchant Banker is supposed to file a statement with SEBI, mentioning complaints (if any) and amendments or proposed changes to the offer.
- The banker will also ensure the delivery of letters to the shareholders at least a week before the release of the rights issue.
- The banker shall also ensure the joint as well as the individual satisfaction of minimum subscription.
- Detailed guidelines are also incorporated for the underwriters in the regulations.
- The advertisement for the rights issue shall be ensured and supervised by the Lead Merchant Banker.
- The company shall be expected to notify the regional stock exchange with regards to its utilisation of the funds collected under the rights issue. A minimum of ninety per cent of these funds is supposed to be utilised.
- Post the issue, the banker shall file two kinds of compliance reports: a three-day post-issue monitoring report and a fifty-day post-issue monitoring report.
Notwithstanding its advantages, disadvantages and procedural methodology, it can be concluded that the rights issue is one of the simplest and safest measures for raising capital and expanding corporate structure in the market. Provided that the prospective investors weigh in and understand diligently all the requisite pros and cons of engaging in the issue and take legal consultation from experts, the rights issue is actually a good-to-go option for business enhancement in the competitive market.
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