KS Arartik and Paras Tripathi
(Students, Dr. RML National Law University)
In a significant regulatory development, SEBI, at their 208th Board Meeting (BM) held on December 18, 2024, approved the complete overhaul of the Merchant Bankers Regulations, 1992 (MB Regulations). These changes have come in response to the evolution of securities markets and increased compliance requirements. Currently, there are 221 merchant bankers (As of July 31, 2024) that come under the ambit of the MB Regulations. The primary aim of the regulations was to lay down a regulatory framework for the MBs outlining their eligibility, responsibility and continuance in the securities market.
Notified in 1992 by SEBI to address the evolving needs of the securities markets at the time, the MB regulations have never undergone any major change. Accordingly, the changes to MB regulations were long overdue to keep up with the evolving market dynamics. Before amending the MB regulations, SEBI released a consultation paper on August 28, 2024, housing several key recommendations, including reconsidering the ambit of permissible activities, introducing shareholding limits and capital adequacy requirements and reconsidering valuation activities. The consultation paper also talked about stricter compliance standards and enhanced due diligence requirements.
Key Changes
Restricting the Scope of Permitted Activities
Previously, merchant bankers (MB), excluding banks and public financial institutions, were allowed to engage in both securities market-related activities and a broader range of financial services, including dealership of government securities, stockbroking, project advisory services, portfolio management, and syndication of rupee term loans. However, now, as per point 3.1.2, notified by the BM, MBs, other than banks, public financial institutions, and their subsidiaries, will be restricted to undertaking only the activities explicitly permitted by SEBI like IPO management, underwriting, or mergers and acquisitions. They must ‘hive off’ all other regulated activities to a separate legal entity with a separate brand name within two years. This new entity can share resources with the MB on an arms-length basis, but the MB will not bear legal liability for the activities of the separated entity. Additionally, both the MB and the separate entity will be required to adhere to a SEBI-prescribed code of conduct, even if the latter does not carry out SEBI-regulated activities. This comes in light of recent SEBI orders targeted at MBs not carrying out merchant banking activities.
The utility of this change is a bit confusing, as it creates a separate legal reality for activities that are still economically tied together, creating a hyper-specific framework devoid of the greater regulatory context. The extant provisions allowed MBs to undertake certain other activities as per their respective regulations, but now MBs must abide by a SEBI-prescribed Code of Conduct for non-SEBI regulated business. This is clearly an instance of regulatory overreach. SEBI’s insistence on creating two separate entities—often involving the same group of people—to carry out different activities is impractical. Furthermore, taking into account that other regulators have deemed MBs suitable to engage in activities such as dealing in government securities, SEBI’s decision to restrict them might raise some eyebrows.
Capital Adequacy Requirements
The extant framework for MBs mandated a minimum net-worth not less than INR 5 crores at all times as specified under regulation 7 of the MB Regulations. This minimum threshold was established almost 3 decades ago, and for all intents and purposes, such a threshold was no longer tenable, as was noted by industry players themselves. Indian capital markets have seen an influx of activity in the last decade, and there is a need to reflect that in the minimum requirements for MBs. Intermediaries need to be mature enterprises to shoulder the brunt of volume in today’s markets, and such a threshold is necessary to gatekeep intermediation for those who can meet the needs both in capability and capital adequacy. For the regulator, this also meant linking capital adequacy to the scope of permitted activities so as to avoid a one-size-fits-all approach from harming smaller MBs that cater to Small and Medium Enterprises (SMEs).
Therefore, the BM notification now prescribes 2 categories of MBs. Category 1 MBs shall have a net worth no less than INR 50 crores at all times, with their revenue over the last 3 financial years no less than INR 25 crores, and shall be permitted to undertake all permitted activities. The net worth requirement for Category 2 MBs shall be 10 crores, with the revenue requirement set at INR 10 crores over the last 3 financial years. Category 2 MBs shall not be allowed to participate in Main Board issues. All MBs are also required to maintain a liquid net worth of 25% of the minimum requirement prescribed. Existing registered MBs shall be given a time of 2 years to meet these new thresholds. Importantly, the underwriting limit for MBs shall be 20 times of their liquid net worth. MBs engaged only in debt/hybrid issues have been exempted from revenue requirements.
The existing framework prescribed no minimums in terms of liquid net worth and revenue. The BM notification claims to relax revenue requirements in certain situations – it is imperative that prevailing market conditions are considered here on a case-to-case before trigger-happy consequences such as certificate cancellations for MBs failing these criteria. Due to the nature of such requirements, there is often an uptick in misrepresentation and other undesirable activities in the market to meet thresholds. With the recent Trafiksol debacle, it is clear that capital markets are still not immune to undesirable means to meet listing requirements absent adequate oversight from the regulator.
Shareholding Limits
In a major change, if an MB’s directors, key personnel, or compliance officers (or their relatives) hold more than 0.1% of, or INR 10 lakhs in, the issuer’s paid-up capital, the MB is ineligible to manage an issue by the company concerned. This has been done in lieu of concerns regarding conflict-of-interest for MBs, often a leading reason for sub-standard due diligence upon issues.
Such a requirement is quite unprecedented and is in pursuit of ends that could be met with less restrictive means – disclosure requirements in this regard, for example, could serve to alleviate such concerns and would be more in line with the current market environment where the pool of investors is still small. Including relatives in this ambit makes compliance particularly restrictive for issuers, significantly limiting the pool of MBs they can work with and vice versa. MBs were particularly aggrieved with this proposal, yet SEBI has moved forward with this anyway. Eventually, the regulator should relax the threshold limits to more realistic figures.
Valuation Activities
Valuation Activities were never regulated by SEBI, but MBs were permitted to carry out valuation activities under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (SAST Regulations) and SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 (SBEB and SE Regulations). This position has now changed as per point 3.2, notified by the BM, MBs are now no longer permitted to undertake fresh valuation activities, and only existing valuation activities may be completed, and if an MB wishes to take up fresh valuation activities, then they must obtain registration from concerned regulator or authority within nine months. SEBI has given the rationale for the same under point 9.2 of the consultation paper, where SEBI has justified restricting MBs from carrying out valuation activities by citing regulatory requirements and frameworks already established. SEBI has explained that section 247 of the Companies Act 2013 mandates that such valuations be conducted by qualified and experienced professionals registered as valuers, subject to the Companies (Registered Valuers and Valuation) Rules, 2017. SEBI has also emphasized that it has already amended various regulations, such as those governing IPOs, delisting, and buybacks, and now requires valuations to be exclusively conducted by registered valuers. This rationale of SEBI lays stress on that valuation activities carried out by MBs are indecorous as they fall under a distinct regulatory framework managed by IBBI.
This is a significant point of contention as SEBI’s restrictions have now extended to even uncomplicated activities such as valuation, excluding them from the scope of MBs. This restriction is particularly unsolicited when the Central Government and the RBI are of the opinion that MBs can carry out valuation activities for the purposes of foreign exchange laws or taxation. This can be seen as an overreach, with SEBI effectively trying to redraw the entire merchant banking ecosystem by dictating which activities MBs can engage in, irrespective of their financial capability or compliance with net worth and underwriting requirements.
Conclusion – The Bigger Picture
SEBI continues to keep busy with measures designed to enhance investor protection in the country, substantially rehauling public issuances (specifically SMEs) in Indian markets vide its latest Board Meeting. The issue arises when you consider how central SMEs are to the India story, and the sum of these measures necessarily stifles this growth at a time when access to credit to stir activity for small players is still low. Measures in lieu of investor protection can take multiple other paths – a more robust disclosure-based regime, or simply more liability for issue managers by tying them to issuers for longer. Inspiration can be taken from Singapore in this regard, considering how issue managers there face looser thresholds for independence.
No one can reasonably deny that there have been a few spurious SME IPOs of late, but should the reaction be so far-reaching that it hinders the ecosystem altogether? Merchant Bankers will continue to play an important role in facilitating access to credit lines for the country at large, and facilitating their survival is in SEBI’s best interests. As ease of doing business becomes more and more central to India’s financial landscape, it should uniformly benefit players irrespective of their size.
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