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Red herring prospectus under Company Law

April 25, 2024

This article has been written by Suryanshi Bothra. It discusses in depth all aspects of a red herring prospectus including its components, legal requirements, importance, objectives, benefits and disadvantages.

Introduction

The dynamic nature of financial markets makes the issuance of securities by the company a pivotal moment in determining its future and growth. Investors are eagerly waiting to invest in promising companies seeking to raise capital. This results in a realm where opportunities and risks dance in tandem. Companies amidst fulfilling regulatory requirements and marketing their IPOs release a plethora of documents. These documents are used by the investors to make a qualitative and quantitative analysis of the company. One of the documents that help investors do so is the red herring prospectus. This document preludes the final prospectus and the initial public offer and offers the investors a sneak peek into the financials and potential pitfalls of a company.

Despite its intriguing name, this kind of prospectus proves to be a huge asset for both the investors and the companies. As the financial market evolves, it becomes essential for every investor to understand the nuances of the red herring prospectus. This article aims to unravel each aspect of the red herring prospectus from its history and evolution to the relevant case law regarding the same. In the process, we will also be demystifying the legal jargon and understanding all key aspects of the prospectus.

Prospectus and its importance

Section 2(70) of The Companies Act 2013 talks about a prospectus. It refers to an informational booklet or offer document that provides investors with all the necessary information about the company. The definition of a prospectus provided in the Companies Act clarifies that any notice, circular, advertisement or any other document inviting offers from the public for the subscription or purchase of securities shall be included under a prospectus. According to the SEBI guidelines, it’s mandatory for all companies launching an IPO to issue a prospectus. It must be issued by all companies trying to raise funds from the general public. However, in cases of public companies, if the directors are certain that they can raise the required amount of funding from private sources instead of the public, there is no need for a prospectus.

What is a red herring prospectus

A red herring prospectus contains information about the company’s operations, functions, future prospects and plans. It is a preliminary prospectus, or the first prospectus which has to be filed with SEBI. However, it does not include quantum details of the issue such as its price and the number of shares offered. The name ‘Red Herring’ derives from a disclosure that is made in red letters on the prospectus. It states that the company will not attempt to sell the securities before approval and that the information provided may be incomplete and subject to changes. A red herring prospectus does not include the complete information of the quantum or value of the securities. It consists of a list of particulars relating to the company’s functions and operations. It ultimately enables the potential investors to acquire the information required to assess the goals and health of the company.

Why are there no price details

The red herring prospectus includes only preliminary details. It is issued so that potential investors can assess the company. It allows companies to make a preliminary offering while also providing flexibility in finalising the size of the public offering and its share price. Based on the public’s reaction to the red herring prospectus the company can make these decisions efficiently. Since the details of the price and size of the offering are decided closer to the final offering date, it is convenient for the companies to file a red herring prospectus as mandated by SEBI. After they have finalised the quantum aspects of the IPO they can publish it in the final prospectus.

Why are there no quantum details

By not mentioning the quantum aspects, that is, the exact number of shares offered in the red herring prospectus, issuers and underwriters can navigate the IPO process more effectively. The issue of red herring prospectus helps the company get an idea of the demand for the company’s shares. It helps the company fix the offering price competitively and make sure that it accurately reflects market demand. The regulatory authorities like SEBI often require companies to file amendments to the prospectus. It is done in case there are significant changes to the offering size or terms before the release of the IPO. Therefore, delaying the disclosure of the exact number of shares reduces the need for frequent updates to the prospectus and streamlines the regulatory process.

What is a draft red herring prospectus

Draft red herring prospectus is an initial document. It is a preliminary version which is filed with regulatory bodies like SEBI. It contains all essential aspects of the business’s operations, financials, future prospects, etc. It provides no information that would be required to make investment decisions. It does not mention the offer price or the number of shares. It plays an important role in the release of a red herring prospectus and the launch of an IPO. It helps in garnering information regarding the potential investors. While the final red herring prospectus provides complete and accurate information. The draft red herring prospectus provides a brief idea of the company’s affairs. It allows potential investors to scrutinize the company. It is helpful for risk calculation and understanding growth prospects. According to the guidelines of the Securities Exchange Board of India, it is mandatory for companies to file a draft red herring prospectus. It is filed with regulatory requirements, investor protection guidelines and disclosure forms. The red herring prospectus is an invitation to the offer and the draft red herring prospectus is a prelude to the invitation. The draft red herring prospectus has to be refiled with SEBI in case there is a substantial difference between the draft red herring prospectus and red herring prospectus. SEBI treats the draft red herring prospectus as more than just a prelude to the red herring prospectus.

Laws governing red herring prospectus in India

Companies Act 2013 and SEBI guidelines provide all the laws regarding red herring prospectus in India. According to Section 32, a company may issue a red herring prospectus before the issue of a prospectus when proposing to make an offer of securities. A red herring prospectus has to be filled before the registrar 3 days prior to the list of subscriptions or offers. Moreover, it carries the same obligations as other prospectuses.

Historical evolution of red herring prospectus

The red herring prospectus has a historical evolution which aligned with the growth of India’s capital markets:

In the pre-liberalisation era, before 1991 India had a controlled economy with limited private participation. Hence the concept of a red herring prospectus was not prevalent.
After liberalisation, the SEBI guidelines of 1996 were introduced. In these guidelines, a red herring prospectus emerged as a document filed during the IPO process.
With the advancement of technology, like everything, this document too became easily available to the public. Increased accessibility led to increased transparency.
SEBI’s new initiatives to streamline the IPO process led to the red herring prospectus becoming a crucial document. Periodic amendments enhanced the disclosure requirements to provide a more accurate representation of the fair. Increasing globalisation has led to an increasing significance of red herring prospectus as they help attract foreign investment.

Matter to be set out in red herring prospectus

All essential information about the company must be included in an effective red herring prospectus. Some of these are listed below.

Name, Address and the company structure
The purpose for which the funds were raised through the IPO and how they will be utilised. It should contain a complete breakdown of how the funds will be allocated. For example in expansion or debt repayment or it would be used as working capital.
Financial statements from previous years, including balance sheets, income statements, and cash flow statements must be included. Additionally, management discussion and analysis (MD&A) of financial conditions and results of operations are often a part of a red herring prospectus.
A comprehensive list of risk factors associated with the business, industry, market conditions, potential challenges and uncertainties.
The competitive landscape of the industry in which the company operates and the market trends are mentioned in the red herring prospectus.
Outstanding legal disputes and significant recent material developments need to be disclosed.
The credit rating assigned to the company and an overview of its debt instruments are mentioned wherever applicable.
Details of the agreement with underwriters handling the IPO and escrow arrangements.
Details about the company’s ongoing research and development initiatives as well as future plans are a part of the red herring prospectus.
In case the company holds patents, copyrights, trademarks and other intellectual property rights, it is usually beneficial for the company to disclose such information.
Supply chain details and information on any tax benefits available to investors in the company’s securities.
Information on employee relations and labour unions as well as details of any existing or proposed employee stock option plans are crucial.
An overview of the company’s corporate social responsibility initiatives, including details on social and environmental contributions can be provided.
A company’s involvement in joint ventures, collaborations, or partnerships.

Objectives of issuing red herring prospectus

The primary objective of issuing a red herring prospectus is to inform potential investors about the company, its promoter, financials, business model, growth prospects, and the risks of investing. The company’s objectives for raising funds are also mentioned in the prospectus. Companies try to gauge the interest of potential investors and generate preliminary attention before the formal launch of the IPO.

Additionally, the red herring prospectus is seen as a marketing tool by the companies. It creates anticipation and excitement in the market. It is also issued in compliance with regulatory requirements, as companies are obligated to file it with the Registrar at least three days before opening the subscription list. This first prospectus streamlines the IPO process and helps in securing regulatory approvals.

Procedure for issuing red herring prospectus

Issuing a red herring prospectus is a long process involving multiple discussions, drafts and approvals. The complete process is listed below.

The company appoints intermediaries such as promoters, lead managers, underwriters, solicitors, and other professionals to issue securities.
A thorough due diligence is conducted on the company’s operations, financials, and prospects to ensure an accurate and comprehensive prospectus.
A draft red herring prospectus which is a preliminary document contains detailed information about the company, excluding specific details like the issue price and quantity of securities.
The Board of Directors approves the draft red herring prospectus
The red herring prospectus is then submitted to the Securities and Exchange Board of India (SEBI) for approval and is filed with the Registrar of Companies (RoC) and stock exchanges where the company is seeking to list its securities.
SEBI reviews the red herring prospectus and seeks clarifications or sometimes provides observations. These need to be adequately addressed by the companies.
Once the observations are addressed, the red herring prospectus, along with SEBI’s observations, is made public for investor awareness.
A public notice is published, and the red herring prospectus is made available to the public through various channels, including the company’s website.

SEBI (Issue of Capital and Disclosure Requirement) Regulations, 2009

The red herring prospectus must adhere to the disclosure requirements outlined in Schedule II of the Companies Act, 1956. It must also adhere to the additional disclosures in Part A of Schedule VIII, considering the provisions of Parts B and C. Also, if a company plans to issue capital to the public through the book-building process, the red herring prospectus must fulfil disclosure requirements as per Regulation 57(2)(a).

Common issues in a red herring prospectus

According to the Companies Act as well as SEBI guidelines it is necessary to ensure that the red herring prospectus portrays a true and fair picture of the the company. Providing false information and nondisclosure in the prospectus can have serious consequences. Listed below are the issues, relevant case laws and defences.

Misstatements in red herring prospectus

The Company’s Act 2013 does not clearly describe the term ‘Misstatement’. However, Section 447’s explanation of the Act defines deceit as any act of omission, concealment of facts, abuse of position by a person or in connivance with a person to gain undue advantage from deceiving any party related to the company including shareholders and creditors. The Companies Act places equal criminal liability to both fraud and misrepresentation.

Criminal liability

Section 34 of the Companies Act states that if any prospectus that includes a false statement whether through inclusion or omission is issued and distributed, the person with the authority to issue such prospectus will be held liable. Section 447 of the Companies Act provides the punishment for such misrepresentation to be a minimum of six months and a maximum of 10 years with fines ranging from the amount involved in the fraud to three times the amount. If the suppression of facts in the preliminary public offer violates public interest then the minimum punishment would be 3 years. Section 441 stresses the seriousness of the offence of any misstatement in the prospectus by stating that it shall not be compoundable. A defence for the person held criminally liable for misstatements is provided in the proviso to Section 34 of the Act. This applies in cases where the accused can prove that the misstatement or omission was not significant or that there was some rational ground to the statement at the time of issue of the prospectus.

Civil liability

Directors, promoters, and experts involved in the process of issuing the prospectus can be held liable to pay compensation to any and all persons who have suffered losses acting on misleading statements in the prospectus. If the misstatement is issued to defraud the public or for any unlawful purpose then every person involved in the issue of such prospectus could be held personally liable without any limitation to losses or damages. A director or any person with the authority to issue a prospectus is not held liable if upon learning of the illegal statements in the prospectus withdraws consent to the red herring prospectus. It is essential that he/she issues a reasonable public notice highlighting that the prospectus was issued without their consent.

Non-disclosure of material information in red herring prospectus

Failure to disclose material information undermines the integrity of the securities market and leads to a non-transparent system. Non-disclosure of material information in a red herring prospectus is a serious issue that can have regulatory implications including fines, penalties, or restrictions on the company or its directors. Additionally, investors who suffer losses due to non-disclosure have a right to file lawsuits against the company for misrepresentation or fraud. In cases where non-disclosure is identified, regulatory authorities ask the companies to take corrective actions such as amending the prospectus, providing additional information, or addressing the concerns raised by the regulatory body.

The DLF Limited and Ors v. SEBI(2012) case is one prominent case law where the Tribunal upheld that there was an abuse of the Disclosure and Investor Protection (DIP) guidelines. There was a dispute that arose from discrepancies in DLF’s red herring prospectus. The red herring prospectus stated that Sudipti Estates Pvt. Ltd. (SEPL) was a collaborative venture while the final prospectus contradicted the claim and stated that it wasn’t a co-venture. DLF argued that the non-disclosure of the relationship would not have influenced investor decisions. They contended that there was no evidence suggesting profits by the use of unfair means from the alliance with subsidiaries. Therefore, SEBI’s prohibition order should be set aside but it also claimed that a report of a holding-subsidiary arrangement between the entities would constitute essential material which would have to be contained in the prospectus.

Advantages of issuing a red herring prospectus

A red herring prospectus provides potential investors with an opportunity to familiarise themselves with the company’s operations and prospects. It helps generate an early market interest and spread awareness about the upcoming IPO.
Issuing a red herring prospectus allows the company to test investor interest and assess market demand for its shares. This can help the company make informed decisions about the pricing and allocation of its shares before finalising the offer price.
It helps companies comply with regulatory requirements by providing detailed information about the proposed IPO. This transparency can help build trust among investors and regulatory authorities.

Disadvantages of issuing a red herring prospectus

red herring prospectus es lack some essential information like the offer price and number of issued shares. This compromises the investor’s ability to make an informed decision and hence can act as a deterrent.
The company might experience some market volatility in the period between the issue of the red herring prospectus and the finalisation of the offer price. The market conditions may become unfavourable.
Any discrepancies or variations between the red herring prospectus and the final prospectus need to be carefully addressed or it might lead to regulatory scrutiny and legal issues.

Differences between red herring prospectus for acquisition of a private company and for IPO

Basis	Red Herring Prospectus for Acquisition of a Private Company	Red Herring Prospectus for an IPO
Nature of the company	Private Company	Private company in the process of going public
Purpose	As part of the disclosure process, a company may issue a red herring process when it is in the process of acquiring another private company.	It acts as a preliminary prospectus for a company that intends to go public. This document contains essential information about the company’s business, financial performance, risk factors, management, and other relevant details.
Regulatory requirement	The regulatory requirements are less stringent.	The regulatory requirements are stringent and exclusive disclosure of financials is required.
Investor base	It provides information to the existing shareholders about the upcoming acquisition and what it entails.	It is open to public investors and is used to attract larger scale public investment.,

Relevant case laws on red herring prospectus

Some of the prominent case laws on red herring prospectus have been mentioned below.

Indowind Energy Limited v. Wescare (India) Ltd. & Ors. Subuthi Pvt. Ltd.(2010)

In the case of Indowind Energy Limited v. Wescare (India) Ltd. & Ors. Subuthi Pvt. Ltd.(2010), Subhuti entered into an agreement with Wescare. The agreement included an arbitration clause contingent upon approval from all three companies including Indowind. Indowind did not approve the agreement but the other two parties proceeded to fulfil their obligations. The respondent amid the dispute initiated arbitration proceedings and sought interim relief to prevent Indowind’s IPO.

The case has significant authority in questions regarding the liability of underwriters. Underwriters play a key role in the IPO process by helping to structure the offering, price the securities, and distribute them to investors. If the underwriters have certain significant information which is not present in the red herring prospectus or if they failed to conduct adequate due diligence, they could be held accountable for their actions. The judgment underscores the importance of clarity and precision in red-herring prospectuses. It is especially important in cases concerning agreements entered into by the company.

The judgement held that while companies can refer to agreements in the prospectus, the enforceability of those must be established. Transparency and comprehensive disclosure in red-herring prospectuses is essential to ensure that investors make informed decisions. The court held ambiguities or omissions in the prospectus could undermine investor confidence and potentially lead to legal challenges.

Kimsuk Krishna Sinha v. SEBI (2010)

The Kimsuk Krishna Sinha v. SEBI (2010) case sheds light on SEBI’s responsibilities if there is a misrepresentation in the draft red herring prospectus. The court in its decision acknowledged SEBI’s authority to examine the red herring prospectus thoroughly and to ensure the disclosure of all necessary information truthfully. The court emphasises that even if the public issue has been closed, SEBI’s duty to inquire about the veracity of information continues.

The ruling also clarified that SEBI has the authority to take appropriate enforcement actions. It can be against issuers of the DRHP or even other parties that were involved in the preparation and dissemination of a misleading red herring prospectus. The process of enforcement may include imposing penalties, issuing warnings, etc. It may also go to the extent of barring entities from participating in the securities market.

Conclusion

The significance of a red herring prospectus goes beyond being a mere informational document. The functions of a red herring prospectus range from fulfilling regulatory mandates to Marketing the upcoming IPO through strategically giving information about the company’s goals and objectives. The document provides information to the investors regarding the company and helps the company estimate the reaction of the public after the release of its IPO. It is therefore beneficial for both parties.

The red herring prospectus serves as a legal instrument that has the ability to bind companies to the statements made within the document. Misstatements and non-disclosures in the said document could lead to civil and criminal action. The SEBI regulatory guidelines and the precedents set in landmark cases make transparency and accuracy paramount. Therefore, companies must navigate this legal terrain with precision. On the other hand, the investors must ensure that they exercise due diligence in interpreting the information presented in a red herring prospectus and make an informed decision.

The role played by red herring prospectus in fostering a relationship between companies and their potential investors is becoming quite significant. If used smartly and judicially the red herring prospectus can become a powerful tool that can help shape the narrative of a company’s public offering. It can notably influence the course of a company’s financial future.

Frequently Asked Questions (FAQs)

What role does red herring prospectus play in empowering investors?

The red herring prospectus empowers investors by providing important information about a company before the initial public offer is made. This gives investors an insight into the company’s structure, objectives and plans for expansion. Moreover, it allows the investors to conduct in-depth research into the company’s finances. This allows investors to make well-informed decisions. Investors’ ability to assess risks, and understand the business before the release of a final prospectus fosters transparency in financial markets.

What information is not included in the red herring prospectus?

According to Schedule XI of para 7 of the above ICDR Regulations, the companies don’t have to disclose the price of the shares in a red herring prospectus. In places where the size of the issue is mentioned, it might not include the price and quantity of securities. These details are finalised only after capturing the investor’s attention during the IPO’s book-building process. It ensures flexibility and adaptability to market conditions. This document is released with a warning and is considered an incomplete document. After these details are determined, this document gets amended. A final prospectus is then issued to the investors.

Is the red herring prospectus the final prospectus?

No, a red herring prospectus is not a final prospectus. It is issued before the final prospectus as an initial document. It provides potential investors with key information and ignites an interest in the market. The final prospectus is issued after the offer price, number of shares, closing date and other specifics are determined. However, even though this is just an initial document it holds significant weightage and legal standing.

What is the difference between a red herring prospectus and a shelf prospectus?

A red herring prospectus is issued for a specific public offering. On the other hand, a shelf prospectus is filed for multiple offerings spanning over a duration of time according to the validity. A shelf prospectus provides more flexibility than the red herring prospectus for subsequent issuances of securities.

What is a red herring in law?

In law, the primary meaning of a red herring is a legal factual issue that is irrelevant and used to divert attention away from the main issue. It can also be referred to as a misleading clue or distraction. Additionally, it can also be used to refer to the first step in procedures that require government approval, especially in cases of apartment conversion.

Who prepares a red herring prospectus?

The red herring prospectus is prepared by the company’s management, directors, underwriters, and other professionals such as legal and financial experts. The document was prepared after a series of discussions and requires the approval of the board. It undergoes regulatory scrutiny by SEBI before being made available to potential investors. All the issues flagged by the regulatory board need to be addressed.

What are the different types of prospectuses?

There are majorly 4 types of prospectuses mentioned in the Companies Act 2013, they are-

Shelf Prospectus,
Abridged Prospectus,
Deemed Prospectus and
Red Herring Prospectus.

What is a shelf prospectus?

Explanation to Section 31 refers to Shelf Prospectus as a “prospectus in respect of which the securities or class of securities included therein are issued for subscription in one or more issues over a certain period without the issue of a further prospectus.” It is a single prospectus for multiple public offerings issued during the period of validity.

What is an abridged prospectus?

An abridged prospectus is a summary of the prospectus of a company. According to Section 2(1) of the Act, an abridged prospectus is a memorandum containing such salient features of a prospectus as may be specified by the Securities and Exchange Board by making regulations on this behalf. Also, Section 33 of the Act mandates that no form of application for the purchase of any of the securities of a company shall be issued unless such form is accompanied by an abridged prospectus.

What is deemed a prospectus?

A deemed prospectus can be filed for allotting shares or securities through an intermediary, a merchant bank or a stockbroker. It is released by an intermediary on behalf of the issuing company. It can be considered a legal document for an offer for sale if the offer to the public by the intermediary was made within six months of the allotment of shares to the intermediary or if the company that allotted its shares to the intermediary has not received any consideration for the shares till the date the offer was made by the intermediary.