The securities market plays a role akin to the nervous system and arteries for the economy, facilitating price discovery in securities and allocating funds to companies that seem most promising. To ensure that this mechanism is not disturbed by information asymmetries favouring the issuer or its insiders, and to ensure liquidity and stability during and immediately following an issue of securities, a merchant banker is engaged to ‘manage’ the issue of securities. A merchant banker essentially oversees critical aspects such as undertaking due diligence of the issuer, undertaking valuation of the issuer’s securities and preparation of the prospectus, on top of its core job of marketing securities. Further, as an underwriter, a merchant banker may buy securities that have remained unsold at the end of an issue, thus ensuring adequate subscription. On August 28, 2024, SEBI released a consultation paper proposing changes to the Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992.
Many key changes pertain to the eligibility and obligations of merchant bankers. Merchant bankers are proposed to be recategorized into Category-1 (possessing a net worth not less than Rs. 50 crores, and authorized to undertake all permitted activities) and Category-2 (possessing a net worth not less than Rs. 10 crores, and authorized to undertake all permitted activities except Main Board Issues). It is unclear why non-underwriting bankers require a networth.
SEBI further proposes to introduce the concept of liquid net worth, which for Category-1 merchant bankers would be not less than Rs. 12.5 crores and for Category-2 merchant bankers would be Rs. 2.5 crores. The maximum underwriting obligations of merchant bankers, currently at 20 times their net worth, are proposed to be reduced to 20 times the liquid net worth for a merchant banker that has maintained 35% of its net worth as liquid, or otherwise the lesser of 7 times the net worth or 20 times the liquid net worth.
Another key set of changes pertains to the activities merchant bankers may undertake. Merchant bankers have traditionally performed a variety of roles, including providing advisory services for projects and syndication of rupee term loans. Further, upon obtaining appropriate registrations, merchant bankers also act in other regulated roles pertaining to the securities market, such as dealers of government securities or stockbrokers. Additionally, merchant bankers as a class have also been specifically recognized as providers of valuation services, both by SEBI for the purposes of acquisitions and share-based employee benefits and sweat equity, and by other authorities, particularly in respect of fair market value of unquoted securities for income tax purposes and pricing of non-debt instruments under foreign exchange rules.
SEBI has now proposed to specifically define the permitted activities for merchant bankers. These would include only activities related to the securities market that are under the jurisdiction of SEBI, and would not include any activity requiring a separate registration. To this effect, a list of permitted activities is provided, although it is not clear whether list is exhaustive. Apart from managing international offering of securities, which may not necessarily fall under the jurisdiction of SEBI, a perusal of the list of permitted activities indicates an intent to confine the activities of merchant bankers to those that are specifically permitted by SEBI under the relevant regulatory framework. What is truly concerning is that an adequate rationale has not been furnished for such a restrictive approach.
Firstly, prohibiting merchant bankers from carrying on activities regulated by other financial sector authorities is not consonant with SEBI’s own approach elsewhere. For instance, in its consultation paper reviewing the regulatory framework concerning Investment Advisers and Research Analysts, dated August 06, 2024, SEBI had proposed to permit investment advisers to advise on products regulated by other financial sector authorities. Further, where other financial sector authorities, such as the Reserve Bank of India, have found merchant bankers suitable to act as dealers of government securities, it is puzzling why SEBI adopts such a restrictive stance. Particularly in the case of valuation activities, as noted by SEBI, other authorities have recognized the validity of valuation by merchant bankers. SEBI has proposed to retain the permissibility of valuation activities by merchant bankers where specified under its own regulations. It is debatable that SEBI, being at most a co-equal authority, now prohibits merchant bankers from valuation activities that may be administered by other authorities. The idea that such activities may still be undertaken through separate divisions, could have been a better alternative to outright prohibition.
Moreover, no rationale has been furnished for prohibiting merchant bankers from carrying on activities that require separate registration with SEBI, nor does there appear to be international precedent for this. In fact, activities corresponding to merchant banking in India are usually carried on by broker-dealers in the United States, recognized as one of the most mature and well-regulated markets. Therefore, SEBI’s proposals, if brought into effect, would require the merchant banking industry in India to restructure its business in ways dissimilar to both existing practice and the rest of the world, for no perceptible regulatory benefit.
Further, SEBI has proposed to cancel the registration granted to a merchant banker if it fails to earn a minimum revenue from its activities. This too is an extreme step, given that revenue from permitted activities, unlike capital adequacy, does not impact the ability of a merchant banker to carry out its obligations. Moreover, there is no international precedent for such a requirement. Indeed, such a requirement may perversely incentivize merchant bankers to procure business by inappropriate means and would entrench existing players.
Another proposal that ought to be reconsidered is the confinement of underwriting activities of merchant bankers to those specifically permitted by SEBI. This proposal appears directed at least partly at curbing the market practice of underwriting private placements of debt securities by listed entities. Yet, this proposal misses the market reality that private placements of debt securities are often the first step to their introduction on the public market, akin to an initial public offering of equity shares in respect of the usual lack of a pre-existing liquid market in them. Absent underwriting by merchant bankers to make a market in such securities, private placements may often fall through. Therefore, we believe that merchant bankers ought to be allowed to underwrite private placements of debt securities.
It is also proposed that merchant bankers not act for an issuer, if the merchant banker’s directors, key personnel, compliance officer, and their relatives, individually or in aggregate hold, more than 0.1% of the issuer's paid up share capital or nominal value of Rs. 10,00,000, whichever is lower, save through mutual funds. Given that such personnel have significant financial expertise and experience, and are likely to hold large portfolios of investments, such a requirement may unnecessarily disqualify many suitable merchant bankers. Rather, it would be sufficient to require disclosure of such shareholding as conflict of interest.
By and large, it is commendable that SEBI has updated its regulatory framework on merchant bankers in line with the changing realities of the market and the regulatory framework. However, there is much to be reconsidered in order to ensure that unduly onerous restrictions that do not serve the interests of the market are not placed on merchant bankers.
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