Process of IPO and Due Diligence

READING MATERIAL
Advanced Securities Law

UNIT 2
Public Issues: Initial Public Offering-‐II

ADVANCED SECURITIES LAW | 2

| In the previous Unit we began our study of Now that we are familiar with the conditions that an
initial public offers (“IPOs”). We looked at issuing company is required to comply with in order to
what constitutes an IPO and understood the undertake an IPO, let us delve into the process to be
eligibility criteria to be fulfilled by an issuing
followed by such a company. Before moving forward,
company.
please note that the ICDR Regulations clearly lay out the
In this Unit, we will look at the process process to be followed in case of a book-‐building issue in
followed by an issuing company in the run up Part A of Schedule XI. You can access a copy of the ICDR
to an IPO. As we go through the process, we Regulations at
will refer to the requirements laid down in the
http://www.sebi.gov.in/cms/sebi_data/commondocs/icd
relevant provisions of the Companies Act, 2013
(“Companies Act”) and the Securities and june26_p.pdf.
Exchange Board of India (Issue of Capital and
Disclosure Requirements) Regulations, 2009
(“ICDR Regulations”). | Appointment of Merchant Bankers and Other
Intermediaries
One of the key participants in an IPO is the merchant
bank or ‘lead manger’ or, in the case of a book-‐building
issue, a ‘book-‐runner’.1 To broadly understand the key
participants involved in an IPO, please do refer to our

Programme on Introduction to Securities Law on
myLaw.net.
© Rainmaker Learning Resources Private Limited, 2013. Any unauthorised use, distribution, display, or reproduction of this material shall attract all applicable civil and criminal law
remedies.

Merchant bankers or lead managers are intermediaries If the IPO is a book-‐building issue, the company is also
that specialise in the marketing, selling, and research of required to appoint syndicate members and bankers to
securities. The ICDR Regulations mandate that an IPO the issue.4 The company must also appoint a registrar to
must have at least one merchant banker,2 though usually the issue, who cannot be the lead merchant banker.
multiple merchant bankers are appointed in an IPO. The Investors can contact the registrar to the issue in case of
number usually depends on the size of the IPO and the any pre-‐issue or post-‐issue related problems such as
ability of the merchant bankers to market it. non-‐receipt of letters of allotment, credit of allotted
shares in respective beneficiary accounts, and refund
In order to appoint the intermediaries, the company
orders.5 Importantly, the company must only appoint
enters into an agreement with the merchant bankers,
intermediaries who are registered with the Securities
commonly known as the ‘Issue Agreement’.3 This
and Exchange Board of India (“SEBI”). The allocation of
agreement in the context of the IPO, amongst other
responsibilities between the intermediaries is discussed
things, sets out the role of the lead managers, the term
in detail in Schedule I to the ICDR Regulations.
of their engagement, the terms of the issue, the
responsibility of the company to provide information and
documents to the lead managers, and the duties of the
lead managers to appoint intermediaries. A format of The Offer Document: Draft Red Herring
this agreement is provided in Schedule II to the ICDR Prospectus to Final Prospectus
Regulations. We know that the primary document based on which an
issuing company undertakes an IPO is the offer
remedies.

document or the prospectus. In this section, we will The issue of a prospectus is mandatory except:
delve into the nature, process of drafting, key
• In the case of a rights issue;
components, filing, and registration of a prospectus.
• When the issue relates to shares which are in all
respects uniform with shares previously issued and for
the time being quoted on a stock exchange; or
What is a prospectus?
• Where shares are not offered to the public, for
A prospectus is the final document released by an issuing instance when shares are placed privately to less than
company to the public. Investors in the public rely on this fifty persons. Please note that we will discuss rights
document to determine whether to invest in the issuing issues and private placement in later Units.
company and to what extent. The Companies Act defines
a prospectus in Section 2(70) as any document that is Illustration: StartMeUp Private Limited is a new private
issued or described as a prospectus. It covers any red company launched by its promoter Mr. KV who holds
herring prospectus, shelf prospectus, notice, circular, 100 shares in the company. Mr. KV has started this
advertisement, or any other document that invites offers company with the aim of changing the social media
from the public for subscription to or purchase of any sector. He decides to bring in certain other stakeholders
securities of a company. who have technical expertise in that field – Mr. AG and
Mr. DP. He offers them a stake in the company. The
company issues fifty shares each to Mr. AG and Mr. DP.
In such a scenario, the shares are being placed privately
and no prospectus needs to be issued.
remedies.

Components of a prospectus protect itself against liability. If the issuer discloses all
material information in the prospectus, then it is
The prospectus must comply with both Section 26 of the
protected from any fraud or misrepresentation claims by
Companies Act, which prescribes the broad contents of
investors. Hence, it is in the interest of the issuer to
the prospectus and Chapter III of the ICDR Regulations,
ensure complete disclosure. Interestingly, under Indian
which contains a more detailed description of every item
law, in the case of a specific issuance by an Indian
that a prospectus contains.
company to sophisticated investors the disclosure
Broadly, the Companies Act requires the disclosure of requirements and the requirement of a detailed
information regarding the issuing company, for instance prospectus are not present, as in the eyes of the
its management, the projects that the company regulator the risk involved here is lower since the issue is
proposes to undertake, if any, and the financial not proposed to be made to the general public.
statements of the company along with major risks that
Now let us look at the factors that affect the drafting of
the company faces.
the prospectus.
Essentially, every prospectus is required to ensure that
the issuing company is disclosing all the relevant details

(including risks) about itself and its business. Thus, the Due diligence
general public has the required information to assess
Before proceeding to the finer aspects of a due diligence,
whether they would like to invest in the IPO and assume
it will be useful to understand a lawyers’ role in an IPO.
the risk that the company and its business carry. Further,
The lawyers work together with the issuing company and
the prospectus is also a document for the issuer to
remedies.

merchant bankers throughout the IPO process. Typically, to the issuing company and the IPO. Some of the
the main role of lawyers and merchant bankers is to common issues that arise:
ensure that the offer document is drafted in accordance § Consent required from third parties such as
with regulatory requirements, the information in the lenders;
offer document is true and correct, and all material § Breach of material agreements;
information for prospective investors have been included § Potential issues in material agreements such as
in the offer document.6 A well-‐prepared and transparent unilateral right of termination by other parties;
offer document serves as an insurance policy for the § Important litigation that could prove, has proved,
issuer against allegations from investors with respect to or could have proved to be harmful to the
the IPO. company;
§ Necessary licenses or approvals not in place; and
Due diligence forms the very basis for drafting a
§ Breach of any law/regulations in the past, which
transparent offer document, which is true and correct. A
have not been addressed or detected so far.
due diligence process serves the following purposes:
• Verifying the statements made in the offer document: Please note that while the lawyers carry out a legal due
As far as possible the statements made in the offer diligence, the lead managers carry out a commercial due
document should be independently verified from the diligence. This diligence addresses the financial
documents available with the issuing company. performance and prospects of the issuing company.
• Identifying issues with regard to the IPO: The diligence

is meant to raise all potential legal issues with respect
remedies.

As mentioned before, the offer document acts as the company.7 While projections are prohibited by the
‘liability insurance’ for the company and the lead regulations, forward-‐looking statements are generally
managers. This is mainly because any investor should frowned upon unless backed up by documents.

invest in the shares only after reading the full offer
Illustration: The company cannot state that it “is
document. Therefore, it is deemed that any risk or
planning to acquire Five hundred acres of land in
potential future liability that is highlighted in the
Mumbai” without back up documents such as a letter
document is read and understood by the investor. The
of intent or a memorandum of understanding. The
lead managers also run the risk of being sued by an
only flexibility in this regard is provided in the
investor and being imposed with sanctions by the SEBI
‘strategy’ section of the offer document, as part of the
for non-‐fulfilment of its duty of due diligence as a lead
chapter where the company discusses its business
manager.
operations, where the broad strategies to be followed
A lawyer in charge of drafting the document should, by the company, including strategies in the future, are
therefore, be extremely careful in ensuring the accuracy provided.
of the offer document. Some of the key rules for drafting • No superlatives should be used unless backed up by a
an offer document are as follows: third party independent source. Adjectives, which are
superlative in nature, should be avoided.
• No projections, forward-‐looking statements: A lawyer
drafts the document based on the diligence done on

remedies.

Illustration: The issuing company cannot state that the further. While this Unit does not cover the details of all
product they are manufacturing is “the best in the the disclosures required to be made in the offer
country” unless they can cite an independent source document, it is necessary to know the following
as having made that determination or assertion. important mandatory disclosures, which require an

exercise of judgment on the part of the issuer, the lead
• All issues identified in the diligence that can be a
managers and the lawyers:
potential threat to an investment in the company
should typically be highlighted in the offer document. • Risk Factors: This is one of the most important
chapters in the offer document. It highlights all

present and potential material risks in the company.
Disclosure requirements The risk factors are usually of the following kinds:
There are mainly two types of disclosures in the offer § Risks pertaining to the company: These are the risks
document: that have come out of the legal, financial, and
business diligence. The financial and business due
• Mandated by law, that is, the ICDR Regulations; and diligence are typically the same as a commercial
• Disclosures driven by good practices of highlighting diligence. These include risks with respect to the
key issues. business model of the company and current or
Part A of Schedule VIII of the ICDR Regulations deals, in potential litigation risks.
detail, with the disclosures to be made. We recommend § Risks associated with the industry: These include
that you go through Schedule VIII before proceeding general risks that every company in that industry
remedies.

faces, which may affect the investors’ decision to • Identification of the Promoter, Promoter Group, and
invest in that industry. Group Companies: This is one of the key aspects of an

IPO, as the public needs to know who the promoter
Illustration: A company engaged in the passenger
behind the issuing company is.
airlines sector would be affected by fluctuating fuel
In addition, the ICDR Regulations require the
prices, as it would result in airfares increasing
disclosure of other promoter group entities, which
leading to a decline in travel and revenues for the
also hold shares in the company, as well as group
company.
companies. To better understand the manner in which
§ External risks: These are more general risks that are the promoter, promoter group, and group companies
applicable to all companies, such as strikes, can be identified, please refer to Annexure 1 of the
terrorist attacks, war, and other similar scenarios. Supplementary Material for this Unit.
§ Risks relating to investing in equity securities: This
• Financial Statements: While the lawyers have very

section highlights the generic risks of investing in
little role to play in the financial statements, it is
volatile securities such as equity shares.
important to know the following key aspects of
• Objects of the Issue: The offer document must clearly financial information to given in the offer document:8
detail the use of the proceeds of the IPO. Typically, a § The financial statements must be audited;
company shows that the funds would be used for § The financial statements of last five years must be
capital expenditure, setting up of projects, or similar provided;
activities. A third party agency is usually appointed to § The latest financial statements cannot be more
oversee the use of proceeds.
remedies.

than six months old. Therefore, often audited not limited to earnings per share, price earning
financials of a quarter or half yearly financials are ratio, average return on net worth, net asset value
also included depending on the timing of the filing per share, and comparison of such data with that
of the offer document; of the peer group of the issuer company.
§ Financial statements must be ‘restated’, that is, § Statement of Tax Benefits: Description of any
brought in compliance with the applicable special tax benefits for the issuer and its
accounting guidelines. Importantly, financial shareholders.
statements must be capable of comparison across § Issuer’s business: A description of the business
different years and quarters; and undertaken by the issuing company.
§ The ICDR Regulations mandate certain specific § Industry: A description of the industry in which the
schedules such as borrowing details, which must be issuing company operates along with an update on
included. the recent relevant developments in that industry,

if any.
• Other disclosures: Some of the other chapters that are
§ Issuer’s management: A description of the board
contained in the offer document include:
of directors, the board committees of the issuer
§ Capital Structure: Disclosure in relation to the
company, and the key management personnel at a
allotments made by the company and the current
level below the board.
shareholding of the promoters;
§ Basis of Issue Price: Disclosure of the basis for the
identified price band and issue price, including but

remedies.

§ Regulations and policies in India: An overview of significant items of income and expenditure.
the regulations and policies applicable to the § Outstanding litigation and material developments:
issuer company on account of the business Description of the litigation initiated by and
conducted by the issuer company. against the issuer company, its subsidiaries and
§ History and certain corporate matters: A consolidated entities, its directors, promoters, and
description of the history of the issuing company group companies.
and its incorporation.
In order to add credibility to the representations and
§ Issuer’s subsidiaries and other consolidated
disclosures made in the offer document, the issuing
entities: A descriptive list of the subsidiaries of the
company often includes statements from experts in the
issuing company and any other entities the results
relevant fields for the purposes of the disclosure. Please
of whom are consolidated into the accounts of the
refer to Annexure 2 in the Supplementary Material to
issuing company.
this Unit to better understand the conditions stipulated
§ Management’s discussion and analysis of financial
in the Companies Act in relation to such expert
condition and results of operations: Analysis on the
statements.
results of operations, the factors that may effect
the results of operations, comparisons of the most
recent financial year with the previous financial Filing of the offer document
years (at least last three financial years) on the
major heads of the profit and loss statement Once a draft of the offer document is prepared, it is
including an analysis of reasons for the changes in referred to as the draft red herring prospectus (“DRHP”).
remedies.

A DRHP must be filed, along with specified fees, at the • The date of receipt of satisfactory reply from the lead
stock exchanges where the securities are to be listed. merchant bankers, where the SEBI has sought any
The DRHP must also be filed with the SEBI at least thirty clarification or additional information from them; or
days prior to filing of the red herring prospectus or • The date of receipt of clarification or information from
prospectus with the relevant Registrar of Companies any regulator or agency, where the SEBI has sought
(“RoC”). any clarification or information from such regulator or
agency; or
Illustration: If the DRHP is filed on June 30, 2011, then
the red herring prospectus can be filed only after July 30, • The date of receipt of a copy of the in-‐principle
2011. On a practical note, however, this should never be approval letter issued by the recognised stock
a problem as the process of receipt of observations on exchanges9.
the DRHP, responding to them, and finalising the The issuer then amends the DRHP to the satisfaction of
document necessarily takes longer than thirty days. the SEBI. In the case of a book-‐building issue, this revised
On receiving the DRHP, the SEBI may issue its document is a red herring prospectus, which is almost
observations and suggest changes to the DRHP, within final, except for the number of shares and the price of
thirty days from the later of the following dates: the shares. This red herring prospectus is filed with the
SEBI, along with a letter explaining the manner in which
• The date of receipt of the DRHP; or the SEBI’s observations have been incorporated.10 After
the bidding process and fixing the price, the final
prospectus is issued.
remedies.

In the case of a fixed price issue, the revised DRHP these provisions have been discussed in the
becomes the prospectus straight away. Supplementary Material to this Unit. Further the
prospectus must be accompanied by the requisite

consent in writing of the person, if any, named in the
Registration of a Prospectus prospectus as the auditor, legal advisor, attorney,
The final prospectus must be filed with the SEBI, the solicitor, banker, or broker of the company. In addition
stock exchange on which the securities are to be listed, to this, a prospectus must be issued within ninety days of
and registered with the RoC. its registration with the RoC or a fresh registration would
be required.11
According to Section 26(4) of the Companies Act, a copy
of the prospectus signed by every person named as a The offer documents filed with SEBI are available at
director or a proposed director or his or her duly http://www.sebi.gov.in/sebiweb/home/HomeAction.do?
authorised attorney must be registered with the RoC doListDept=yes&deptId=1 and you may find them
before the prospectus is issued to the public. The interesting and also helpful in understanding this area of
prospectus must be accompanied, amongst other practice.
documents, by the experts’ consent and all material With this we conclude our study of the process to be
documents enlisted in the prospectus. followed by an issuing company while preparing an offer
Section 26(7) further states that the RoC cannot register document. In the next Unit we will continue to look at
a prospectus unless the requirements of Section 26 of public issues and some other key aspects that must be
the Companies Act have been complied with. Note that borne in mind for IPOs and public issues in general. |
remedies.

Suggested Reading
Articles
• Manendra Singh, “Liability for Misstatement in
Prospectus: Where to Stop”, Legal India, accessed at
http://www.legalindia.in/liability-‐for-‐misstatement-‐in-‐
prospectus-‐where-‐to-‐stop.

• “Court directs SEBI to probe DLF’s ‘misstatement’ in
RHP”, Economic Times, April 11, 2010 accessed at
http://articles.economictimes.indiatimes.com/2010-‐
04-‐11/news/27621830_1_red-‐herring-‐prospectus-‐
dlfs-‐sebi.

Statutes and Regulations
• Chapter III, Companies Act, 2013.
• Securities and Exchange Board of India, ICDR
Regulations accessed at
http://www.sebi.gov.in/guide/sebiidcrreg.pdf.
remedies.

Web pages

• Securities and Exchange Board of India, How to Read
Offer Document and Invest in IPO page, accessed at

http://www.sebi.gov.in/sebiweb/home/list/4/37/32/0

/How-‐to-‐Read-‐Offer-‐Document-‐and-‐Invest-‐in-‐Initial-‐

Public-‐Offers-‐IPO-‐.

1 Regulation 2(1)(g), ICDR Regulations.
2 Regulation 5(1), ICDR Regulations.

6 Regulation 64, ICDR Regulations.
7 Clause 1(e), Part A, Schedule VII, ICDR Regulations.

9 As required by Regulation 7, ICDR Regulations.

11 Section 26(8), Companies Act.
remedies.

Process of IPO and Due Diligence

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Process of IPO and Due Diligence

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READING MATERIAL

Advanced Securities Law

drafts the document based on the diligence done on

• Financial Statements: While the lawyers have very

9 As required by Regulation 7, ICDR Regulations.

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