What's red herring prospectus?

What is the difference between an offer document, RHP, a prospectus and an abridged prospectus? What does it mean when someone says "draft offer doc"? "Offer document" means Prospectus in the case of a public issue or offer for sale and Letter of Offer in the case of a rights issue which is filed with Registrar of Companies (RoC) and Stock Exchanges. An offer document covers all the relevant information to help an investor to make his/her investment decision. "Draft Offer document" means the offer document in draft stage. The draft offer documents are filed with SEBI, at least 21 days prior to the filing of the Offer Document with the RoC/ SEs. SEBI may specify changes, if any, in the draft Offer Document and the issuer or the lead merchant banker shall carry out such changes in the draft offer document before filing the Offer Document with the RoC/ SEs. The Draft Offer document is available on the SEBI Web site for public comments for a period of 21 days from the filing of the Draft Offer Document with SEBI. "Red Herring Prospectus" is a prospectus which does not have details of either price or number of shares being offered or the amount of issue. This means that in case the price is not disclosed, the number of shares and the upper and lower price bands are disclosed. On the other hand, an issuer can state the issue size and the number of shares are determined later. An RHP for and FPO can be filed with the RoC without the price band and the issuer, in such a case will notify the floor price or a price band by way of an advertisement one day prior to the opening of the issue. In the case of book-built issues, it is a process of price discovery and the price cannot be determined until the bidding process is completed. Hence, such details are not shown in the Red Herring prospectus filed with the RoC in terms of the provisions of the Companies Act. Only on completion of the bidding process, the details of the final price are included in the offer document. The offer document filed thereafter with ROC is called a prospectus. "Abridged Prospectus" means contains all the salient features of a prospectus. It accompanies the application form of public issues. What does one mean by `Lock-in'? "Lock-in" indicates a freeze on the shares. SEBI Guidelines have stipulated lock-in requirements on shares of promoters mainly to ensure that the promoters or main persons who are controlling the company, shall continue to hold some minimum percentage in the company after the public issue. The requirements are detailed in Chapter IV of DIP guidelines. How the word `Promoter' has been defined?

The promoter has been defined as a person or persons who are in over-all control of the company, who are instrumental in the formulation of a plan or programme pursuant to which the securities are offered to the public and those named in the prospectus as promoters(s). It may be noted that a director / officer of the issuer company or person, if they are acting as such merely in their professional capacity are not be included in the definition of a promoter. `Promoter Group' includes the promoter, an immediate relative of the promoter (i.e. spouse of that person, or any parent, brother, sister or child of the person or of the spouse). In case promoter is a company, a subsidiary or holding company of that company; any company in which the promoter holds 10 per cent or more of the equity capital or which holds 10 per cent or more of the equity capital of the promoter; any company in which a group of individuals or companies or combinations thereof who holds 20 per cent or more of the equity capital in that company also holds 20 per cent or more of the equity capital of the issuer company. source: www.sebi.gov.in BOOK BUILDING PROCESS

Public issue of common shares is essentially carried out in two ways:

Fixed price method, and Book-building method.

Fixed price issues are issues in which the issuer is allowed to price the shares as he wishes. The basis for the price is explained in an offer document through qualitative and quantitative statements. This offer document is filed with the stock exchanges and the registrar of companies. Book-building is a process of price discovery used in public offers. The issuer sets a base price and a band within which the investor is allowed to bid for shares. Take the recent, Yes Bank , the floor price was Rs 38 and the band was from Rs 38 to Rs 45. The investor had to bid for a quantity of shares he wished to subscribe to within this band. The upper price of the band can be a maximum of 1.2 times the floor price. Every public offer through the book-building process has a book running lead manager (BRLM), a merchant banker, who manages the issue. Further, an order book, in which the investors can state the quantity of the stock they are willing to buy, at a price within the band, is built. Thus the term 'book-building.' An issue through the book-building route remains open for a period of 3 to 7 days and can be extended by another three days if the issuer decides to revise the floor price and the band.

Cut-off price Once the issue period is over and the book has been built, the BRLM along with the issuer arrives at a cut-off price. The cut-off price is the price discovered by the market. It is the price at which the shares are issued to the investors. Investors bidding at a price below the cut-off price are ignored. So those investors who apply at a price higher than the cut-off price have a higher chance of getting the stock. So the question that arises is: How is the cut-off price fixed? The cut-off price is arrived at by the method of Dutch auction. In a Dutch auction the price of an item is lowered, until it gets its first bid and then the item is sold at that price. Let's say a company wants to issue one million shares. The floor price for one share of face value, Rs 10, is Rs 48 and the band is between Rs 48 and Rs 55. At Rs 55, on the basis of the bids received, the investors are ready to buy 200,000 shares. So the cut-off price cannot be set at Rs 55 as only 200,000 shares will be sold. So as a next step, the price is lowered to Rs 54. At Rs 54, investors are ready to buy 400,000 shares. So if the cut-off price is set at Rs 54, 600,000 shares will be sold. This still leaves 400,000 shares to be sold. The price is now lowered to Rs 53. At Rs53, investors are ready to buy 400,000 shares. Now if the cut-off price is set at Rs 53, all one million shares will be sold. Investors who had applied for shares at Rs 55 and Rs 54 will also be issued shares at Rs 53. The extra money paid by these investors while applying will be returned to them. Types of investors There are three kinds of investors in a book-building issue. The retail individual investor (RII), the non-institutional investor (NII) and the Qualified Institutional Buyers (QIBs). RII is an investor who applies for stocks for a value of not more than Rs 100,000. Any bid exceeding this amount is considered in the NII category. NIIs are commonly referred to as high net-worth individuals. On the other hand QIBs are institutional investors who posses the expertise and the financial muscle to invest in the securities market. Mutual funds, financial institutions, scheduled commercial banks, insurance companies, provident funds, state industrial development corporations, et cetera fall under the definition of being a QIB. Each of these categories is allocated a certain percentage of the total issue. The total allotment to the RII category has to be at least 35% of the total issue. RIIs also have an option of applying at the cut-off price. This option is not available to other classes of investors. NIIs are to be given at least 15% of the total issue.

And the QIBs are to be issued not more than 50% of the total issue. Allotment to RIIs and NIIs is made through a proportionate allotment system. The allotment to the QIBs is at the discretion of the BRLM. Lately there have been some complaints by the QIBs of BRLMs resorting to favouritism while allocating shares. The Securities and Exchange Board of India (Sebi) is in the process of reviewing this mechanism. Let's suppose, A Ltd, makes an offer for 200,000 shares. The issue is oversubscribed -i.e. there is demand for more shares than the issuer plans to issue. Further, a minimum allotment of 100 shares is to be made for every investor. The cut-off price has been decided and now the allotments are to be made. In the RII category, 1,500 applicants have applied for 100 shares each, i.e. there is a demand for 150,000 shares. A Ltd plans to issue 35% of the total issue to this category, i.e. 70,000 shares. In the NII category, 200 applicants have applied for 500 shares each, i.e. 100,000 shares. A Ltd plans to issue 15% of the total issue to this category, i.e. 30,000 shares. The cut-off price has already been decided, so adjusting the quantity remains the only way of reaching the equilibrium. Applying the proportionate allotment system each investor in the RII category will get 46.67 shares [(70,000/ 150,000) x 100)]. But the minimum allotment has to be 100 shares. So through a lottery, 700 investors are chosen and allotted 100 shares each, making a total of 70,000 shares. In the NII category every investor will get 150 shares [(30,000/100,000) x 500)]. And that is how equilibrium is reached. Dealing with illiquid SharesThe growing problem of illiquidity of stocks needs an urgent solution in the larger interest of investors. Following a directive of the Securities and Exchange Board of India (SEBI), the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), on the basis of the criteria agreed upon between the two bourses and SEBI, have classified 1,585 shares constituting 59 per cent of the traded stocks on BSE and 304 shares accounting for 22 per cent of the stocks traded on NSE as illiquid securities during the month of June 2008. In 2007-08, of the 7,681 shares listed on the BSE, only 2,709 (or 35.3 per cent) were traded, while on the NSE, the securities of 1,244 companies i.e. 90.1 per cent of 1,381 listed companies were traded. The rest were not traded even on a single day in the year. Both on the BSE and the NSE, 85-90 per cent of the traded shares were traded for more than 100 days in a total of 251 trading days. These shares cannot strictly be called liquid. Liquid stocks are those one can buy or sell at around the ruling market price. Except the top 100 shares, the impact cost in terms of

spreads between bids and offers in respect of the remaining shares are quite wide exceeding 2-3 per cent. Even assuming that the securities traded for more than 100 days are liquid, the rest can be categorised as thinly or marginally traded securities, while all other securities not traded even for a day in a year are illiquid securities. Listed securities can thus be categorised under three heads highly traded, thinly or marginally traded, and illiquid. Reasons for lack of liquidity There are three major reasons for lack of liquidity. First, the equity base of the listed stocks of a large number of companies is quite low. There are several companies with equity capital of less than Rs 3 crore due to historical reasons, such as low base of capital, public holding, etc. Second, the floating stock of listed securities, particularly those held by the public, is quite low. As per a discussion paper issued by the Ministry of Finance in June 2007, only about 42 per cent of the shares listed on the NSE constituted the floating stock, of which the public held a meagre 13.35 per cent. The share of retail individual investors (RIIs) was hardly 5 to 6 per cent. Third, there are no market-makers or specialists, as in almost all the developed markets. How to improve liquidity A multi-pronged approach is needed to improve liquidity in stocks. First, both the initial public offer and continuous holding thereafter should be raised to at least 25 per cent of the issued equity capital of a listed company, as proposed in the discussion paper of the Finance Ministry. After tinkering with the minimum percentage of a public offer a number of times, SEBI, with effect from May 1, 2006, said the minimum public offer to be eligible for listing should be at least 25 per cent of each class or kind of securities to be listed. However, a company making a public offer of at least Rs 100 crore with a minimum of 20 lakh shares being offered to the public and the issue being made through bookbuilding, with 60 per cent of the offer being taken by qualified institutional buyers (QIBs), is also eligible for listing. As regards continuous listing requirement, the Listing Agreement provides that a listed company shall maintain public shareholding of a minimum of 25 per cent. In the discussion paper, the proposal is to peg the minimum level of public shareholding, both initially and continuously thereafter, at a minimum level of 25 per cent. This proposal should be implemented forthwith.

Equally important is that the share of retail investors in the public offer needs to be raised from 30 per cent to 40 per cent, and the share of QIBs pruned from 60 per cent to 45 per cent while the share of non-institutional investors be raised from 10 per cent to 15 per cent. Second, in respect of all thinly or marginally traded scrips, either specialists for each scrip, on the lines of the system in vogue in the New York Stock Exchange (all orders for sale and purchase of a scrip are matched by a single specialist) or at least two marketmakers for each scrip need to be appointed by the issuer. Specialists / market-makers must be supplied with shares equivalent to at least one to two per cent of the public offer at the offer price in the case of shares to be listed and, in the case of shares already listed, at the average of the high and low of the weekly prices recorded in the preceding six months. Besides, specialists and market makers need to be offered proper facilities for borrowing funds, preferably at a concessional rate applicable to borrowers in the priority sector. They may also be granted other financial assistance, such as waiver of transaction levy on market-making operations, and fiscal incentives in respect of profits and losses incurred in market-making transactions by way of treating profits / losses on short term as long term, as in the United States. Third, specialists and market makers may not be able to generate adequate liquidity in all the traded securities. In such cases, a call auction system is needed, wherein all buy and sell orders that flow in a day or even a week can be matched at the closing of the period, with the bids and offers being continuously displayed. A similar system is in vogue in a few developed markets. Companies whose shares are not traded even for a day and whose issued capital is less than Rs 3 crore should be directed to enhance their capital to at least Rs 3 crore and the public shareholding to at least 25 per cent of the expanded equity capital, in addition to appointment of market-makers / specialists. A period of one year may be given to the companies. If they fail to comply with these requirements, shares of such companies should be de-listed after the shareholders concerned are given the option to exit, as per the SEBI guidelines relating to delisting of shares. Green shoe option In case the issue has been oversubscribed, as was the case with A Ltd, the company has to exercise a green shoe option to stabilize the post-listing price. When a particular issue is oversubscribed the appetite of investors for the stock has not been satisfied and once it gets listed they tend to pick up the stock from the secondary market. Since the demand is greater than supply the prices tend to rise way beyond what the fundamentals of the stock would justify. So in order to stabilise the post-issue price of the stock, the issuer has to issue more shares in case of oversubscription.

These shares are taken from the pre-issue shareholders or promoters and are issued to the investors who have come in through the public offer on a prorata basis. The green shoe option can be a maximum of 15% of the public offer.