Red Herring Prospectus And Related Judicial Stance

I.  Introduction

The process by which a company or a corporation makes its Initial Public Offering (IPO) is threaded with various other formalities and ancillary procedures which it must undertake in order to satisfy the Guidelines and Requirements issued by SEBI, which is the regulator for security markets in India. These guidelines are to be adhered to by the offering company after it decides to issue its debentures and shares by making an offer to the public, in order to safeguard the interest of the investors who choose may want to subscribe to the company’s shares. One such guideline prescribes that the offering company disclose all the relevant information about its business operations and financials so as to enable accountable decision making on the part of the investors. This is to be achieved by issuing a document, which is called the Red Herring Prospectus (RHP). The Companies Act of 2013 (Hereinafter, the Act), which regulates the responsibilities of a company mandates the issuance of a RHP by a company before it makes a public offering of securities. This paper, after briefly discussions the legislative provisions for a RHP, will reflect upon the judicial stance on this in its latter part.

II. Research Question

  1. What is the purpose of issuing a Red Herring Prospectus?
  2. What are the consequences of failing to adhere with the object of such a document?
  3. What is the liability incurred by a company in case of misdemeanor?

III. Scope and Hypothesis

This paper seeks to discuss the judicial stance on a Red Herring Prospectus after only briefly looking at the legislations pertaining to it. It particularly will discuss three instances of deviation from the process of issuing a RHP as prescribed under the respective legislations by discussing various cases that have relied on the landmark judgment of Sahara India Real Estate Corporations Ltd. And Others v. SEBI, but excluding an analysis of this particular judgment.

A Red Herring Prospectus is a document issued to potential investors but excludes information on the price and quantum of securities that is to be offered. By an analysis of case laws based on issuance of a RHP, it is contended that the members of a company as well as the company itself must suffer criminal liability for gross non compliance with the guidelines pertaining to Red Herring Prospectus to the extent to which investors may place reliance and suffer losses.

IV. Analysis of Red Herring Prospectus

To understand the concept of a Red Herring Prospectus we first need to first look at the statutory position and purpose of a RHP. Section 32 of the Act, which corresponds to Section 60B[1] of the Companies Act, 1956 explains the purpose and process of a Red Herring Prospectus (RHP). It is issued prior to the issuing of the Prospectus (which must contain names and addresses of the Registered Office, capital structure of the company, the dates of opening and closing of issues and other necessary details as stipulated in section 26 of the 2013 Act), when a company proposes to make an offer of securities and the explanation to Section 32 defines a RHP as “a prospectus which does not include complete particulars of the quantum or price of the securities included therein”.[2] A Red Herring Prospectus is an important instrument by which the price of a security offered to the public can be discovered by using the method of ‘book-building’[3] Merchant bankers who handle the public offerings of debentures or shares of companies use a RHP to test the demand and price for the securities proposed to be offered and thereby use it to determine the final size and prize for the public offer.[4]

By a compound reading of all the four sub-sections of Section 32 of the Act we can surmise that all the implications that come with concealment, mis-statement and inaccuracies as well as all the requirements to exercise due care and diligence while drafting a prospectus are also required to be followed and borne in mind while drafting a RHP as well.[5]

After having looked at the Statutory provisions on RHP we must take our attention towards the Judicial Stance on issues related to Red Herring Prospectus. There can be inconsistencies in between the RHP and the final prospectus that is issued by a company or corporation and it can give rise a number of irregularities. In this section we shall deal with the three instances of deviation in the procedure there is for issuance of RHPs.

One of the three instances is when Public issue of shares is claimed as private distribution by the companies. It has been observed that in numerous cases, the companies avoid filing of a prospectus by collecting funds or issuing funds in the name of private placement. The court dealt with a similar issue in Re: Gitanjali Udyog Ltd and Others[6] wherein the company issued offers for Non-convertible Debentures (NCDs) to a few allottees and claimed that it was done by way of private placement. On-going through the prospectus and offer documents, SEBI found out that the offer was made to ‘Financial Institution, Mutual Funds, HUFs and Cooperate Bodies’. Consequently, it held that such a category of persons cannot be regarded as investors for private placements.  Since, the offer of NCDs was in the nature of public offer, before making such an offer the company was required to register its prospectus with the ROC. Furthermore, the company had not complied with the directions given under S. 40(2) of the Companies Act, 2013 which requires that the prospectus should state the names of the stock exchanges.[7] As a result, the company was made liable for illegal and unauthorised mobilizing of public funds.

In Re. Shah Group Builder[8], the issue was whether the equity shares issued by a company constitutes a public offer. The court made use of S. 67 of the Companies Act, 1956while holding the builders liable.[9]The court also relied on the judgment given in Sahara India Real Estate Corporations Ltd. And Others v. SEBI[10] where it was opined that if an offer or invitation is given to 50 or more persons, a public issue is carried out even if it is shown that the shares or debentures are not available for subscription or purchase by persons other than those receiving the offer or invitation. Thus, these cases provide a clear stand on the issue.

The second kind of irregularity may occur because of Non-disclosure of material information in the prospectus. SEBI (Disclosure and Investor Protection Guidelines) Regulations, 2000 were replaced by SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 yet the former are applied in most cases before the courts as the DIP guidelines have been borrowed from the corresponding provisions of the ICDR regulations and a show cause issued under the latter will be deemed the same as under the former. In the case of DLF Limited and Ors v. SEBI[11] before the Securities Appellate Tribunal of Mumbai bench, DLF had filed a draft RHP before SEBI stating that a certain Sudipti Estates Pvt. Ltd. (SEPL) was a joint venture of DLF but this stance was subsequently altered when a new prospectus was issued by them after withdrawing the previous one. SEBI in an order against DLF prohibited six of its directors from trading in the securities market for three years on the basis of a compliant which claimed that contrary to disclosure by DLF in its prospectus, two of its wholly-owned subsidiaries were the only two shareholders in SELP. One of the arguments from DLF’s side was that since non-disclosure of the relation between DLF and those subsidiaries would have had no significance in the investors’ decision and that there was nothing to suggest that DLF was unjustly benefitting from its association with the subsidiaries, the prohibitory order by SEBI must be set aside. The Tribunal in Mumbai accepted that there was a violation of the DIP guidelines by DLF because of non-disclosure of information relating to the subsidiary companies but discredited the prohibitory order by SEBI saying that DLF had not placed reliance on any documents which would’ve misled the investors and also that prohibiting DLF from trading in securities for a cumbersome period of three years would affect the interest of investors as well. There are arguments supporting the contention that the three companies were not “acting in concert” as just a holding-subsidiary relation is not all to determine that.[12] However, the very point of issuing a draft prospectus is to make sure that any information in relation to any business practice or financials to which the resultant proceeds of the securities may either directly or indirectly apply must be mentioned in the prospectus.[13] Therefore it is contended that non-disclosure of a holding-subsidiary relation between the companies would constitute important information that would need to be stated in the prospectus.

Another issue is the misstatement or false representations in a prospectus. In India, both civil and criminal liability arises out of such misstatement.[14]As the transactions are commercial in nature and only monetary harm is suffered, compensation has to be paid in case of civil liability.[15] But, the liability attracted, in cases where an Initial Public Offer (IPO) is filed for an offer of securities to the public, is minimum punishment of three years along with fine. Misrepresentation has not been defined in the Companies Act, 2013. But under explanation given in S. 447 of the 2013 Act an inclusive definition of fraud has been given. It states that

fraud in relation to affairs of a company or any body corporate, includes any act, omission, concealment of any fact or abuse of position committed by any person or any other person with the connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss.”[16]

Under the 2013 Act, criminal liability for fraud is same as that for misinterpretation.[17] Questions have been raised regarding the need of having both criminal as well as civil liability for the same irregularity of misstatement or misrepresentation. This issue was taken up in the case of R. v. Kylsant.[18] In this case the court was of the view that by doing so the company was jeopardizing the interests of the investors. Hence, the company was made liable. In addition to this, this case also highlighted the fact that in criminal proceedings, as opposed to civil proceedings, even true statements made in the prospectus can be inferred as false if there is a suspicion of prejudice.[19] In Ajay Jain v. Registrar of Companies,[20] the company issued a prospectus for inviting investors wherein it stated that it would undertake leasing activities. It also represented that the company was incurring profits. However, the true intention of the directors of the company was to gather funds from the public. Thus, it was prima facie evident that the directors had knowledge that the statement made in the prospectus was false.  Therefore, the petition of the director under S. 482 of Criminal Procedure Code was quashed by the court.

From the above discussion and analysis of various judicial precedents related to RHPs we have been able to determine its significance in the securities market and ascertain the judiciary’s stance on it. Therefore we would be justified in saying that the directors of a company need to observe utmost precaution while drafting a RHP and ensure that there is nothing misleading in the document which can affect the decision of an investor in an adversarial manner.

V. Conclusion

On perusing through the statutes and judicial precedents on RHP it can be surmised that there hasn’t been a substantial change in the guidelines set for issuance of a RHP except for inclusion of provisos and stricter punishments. The primary motive behind having such a document is ensuring welfare of investors and misappropriation of funds raised by companies through sale of securities.

 

[1] S. 60B, The Companies Act, 1956

[2] S. 32, The Companies Act, 2013 .

[3] Defined by Clause 2(1)(9) of the Working Draft of the Companies Bill.

[4] A Ramaiya, Guide to the Companies Act, 697 (18th ed .,2015) .

[5] Ibid.

[6]Re: GitanjaliUdyog Ltd and Others,(2015),WTM/SR/SEBI – ERO/119/06/2015,SEBI.

[7] S. 40(2), The Companies Act 2013, states “Where a prospectus states that an application under sub-section (1) has been made, such prospectus shall also state the name or names of the stock exchange in which the securities shall be dealt with.”

[8]Re. Shah Group Builder,(2015),WTM/RKA/CFD/65/2015,SEBI.

[9]This section provided that even if a group of persons were specifically mentioned to be the target investors if their number was 50 or more, it would comprise a public offer.

[10]Sahara India Real Estate Corporations Ltd. And Others v. SEBI, (2013) 1 SCC 1.

[11] DLF Ltd & ors v. SEBI, (2015).

[12] M/S Daiichi Sankyo Company v. Jayaram Chigurupati & Ors,(2010) 7 SCC 449.

[13] S. 26(1)(b)(iv), The Companies Act, 2013.

[14]S. 34 & 35, The Companies Act, 2013.

[15]A Ramaiya, Guide to the companies act(16th ed.,2004).

[16] S. 447, The Companies Act, 2013.

[17]S. 447,The Companies Act,2013.

[18]R. v. Kylsant, 1 K.B. 442(1932,House of Lords).

[19]Ibid.

[20]Ajay Jain v. Registrar of Comp, (2012) 107 CLA 450.

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