On February 22, 2023, the Securities and Exchange Board of India (“SEBI”) released a consultation paper on, among other things, amendments to the underwriting framework applicable to public offerings under the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“SEBI ICDR Regulations”). On March 29, 2023, changes were approved by the SEBI Board and such amendments became effective on May 23, 2023, pursuant to the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) (Second Amendment) Regulations, 2023 (the “ICDR Amendment”).
The ICDR Amendment mandates, among other things, that if an issuer making a public offering through the book-built route[1] desires to have the offering underwritten to cover any under-subscription, it is required to enter into the underwriting agreement with the underwriters, upfront and prior to filing the red herring prospectus (“RHP”),[2] and disclose in the RHP the maximum number of securities which the underwriters will subscribe either themselves or by procuring subscriptions. The key amendments to the underwriting framework applicable to public offerings through the book-built process have been discussed in greater detail below.
Background
What is “underwriting” and who are “underwriters”
In a securities offering, the term “underwriting” typically means an obligation to subscribe to, or procure subscription for, the offered securities of a company. Underwriters are entities (typically investment banks or stock brokers) that are registered with the SEBI and undertake the underwriting of an issue of securities of a company.
Forms of underwriting in India
As noted in the SEBI’s consultation paper, underwriting in India has primarily taken two forms, namely, ‘soft’ underwriting and ‘hard’ underwriting. Prior to the ICDR Amendment, this distinction was not specifically made in the SEBI regulations; however, these have evolved over time as a matter of practice and are briefly discussed below:
‘Soft’ underwriting
In soft underwriting arrangements, an underwriter enters into the underwriting agreement before the final prospectus is filed but after the book-building is completed and pricing agreed with the issuer. The underwriter agrees to step in to procure subscribers for, or subscribe to, only those offered securities for which valid bids were procured by it and where there is a shortfall of funds against such bids due to rejection of bids. Therefore, the underwriter takes on the ‘payment risk’ associated with bids it has procured and provides the issuer assurance against such payment risk.
Soft underwriting is the prevalent form of underwriting in Indian public offerings, including initial public offerings through the book-built process.
‘Hard’ underwriting
A risk inherent in any public offering is that there may be a shortfall between the quantum of securities offered to investors on the one hand, and the bids for such securities by investors on the other. This shortfall may arise as a result of insufficient demand by investors for the offered securities (referred to as “under-subscription”).
Hard underwriting is an assurance provided by underwriters to the issuer that, if such a gap exists, the underwriters will step in, either by subscribing to the offered securities themselves or by procuring additional subscribers. Therefore, unlike a soft underwriting arrangement, in a hard underwriting the underwriter upfront takes on the ‘subscription risk’ associated with the offering and provides the issuer assurance against such subscription risk.
Historically, in India, hard underwriting arrangements have been more prevalent in fixed price offerings and a few rights issues. The SEBI has introduced changes to the regulations governing hard underwriting, which the issuer may invoke on a voluntary basis.
ICDR Amendment: Key Changes to the Underwriting Framework
The following are the key changes to the underwriting framework in book-built issues:
- the SEBI ICDR Regulations now expressly recognize two distinct types of underwriting: (i) underwriting covering demand shortfall and (ii) underwriting covering risk of technical rejections after the book-building offer period has been completed; also, the issuer has the choice to determine the type of underwriting arrangement;
- in case of underwriting covering demand shortfall, the underwriting agreement is required to be executed prior to the filing of the RHP; for underwriting covering the risk of technical rejections, the underwriting agreement will continue to be executed after pricing and prior to the filing of the final prospectus;
- the SEBI ICDR Regulations clarify that the underwriter need not subscribe to the securities itself and may enter into arrangements to procure subscription for offered securities to fulfil its underwriting obligation – earlier, fulfilment of underwriting obligation through procurement of subscribers was only captured under the Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992 and the Securities and Exchange Board of India (Stock Brokers) Regulations, 1992, and not under the SEBI ICDR Regulations; and
- the SEBI ICDR Regulations clarify that the pre-determined price at which the underwriters will subscribe to, or procure subscribers for, the offered securities will not be less than the issue price.
Implications
Assurance for the issuer
A hard underwriting arrangement gives upfront assurance to the issuer (i.e., prior to launching the offering) against the risk of failure to raise the required capital due to lack of investor demand. While underwriters typically retain the right to terminate their underwriting obligations under certain circumstances such as the occurrence of force majeure events, as a matter of practice, such events are not commonly triggered.
Increased comfort to investors
The requirement to execute the underwriting agreement prior to the filing of the RHP and disclosure of underwriters’ commitment in the RHP allows investors to factor in such information in their investment decision. Further, given the additional risk involved, there may be implications on pricing of the offering to make it more attractive for investors and increase demand.
Underwriters assume greater risk
Given the timing of execution of the hard underwriting agreement, the risk profile for underwriters would increase as at the RHP stage, the quantum of their underwriting devolvement would be uncertain. In contrast, in soft underwriting, an underwriter agrees to underwrite the issue after the issue closes and the shares are priced, by which time the underwriters have a fair assessment of the extent of their underwriting obligation, if any. Also, the period of underwriting risk is shorter in soft underwriting than in hard underwriting. Consequently, hard underwriting arrangements entail greater risk to be borne by, and financial commitment from, the underwriters when compared to soft underwriting arrangements, which risk may get priced into the fees charged by the underwriters.
Conclusion
So far, hard underwriting in Indian book-built public offerings has been the exception rather than the norm. The new framework gives the issuer the option to choose hard underwriting, which may help in tepid market conditions. However, this increases the risk for underwriters and may raise transactional costs for the issuer. Accordingly, it remains to be seen whether this form of underwriting will be invoked more frequently in the future in Indian book-built public offerings.
Footnotes:
[1] Book-built route refers to the process of collection of bids from bidders within the price band, and where pricing is determined on closure of the issue and is based on demand received at various price points within the price band.
[2] RHP, which contains all the details except for information in relation to the issue price and the issue size, is filed with the relevant registrar of companies at least three working days before the issue opens and is used for the purposes of marketing the issue.