Preferential Allotment

Every firm needs capital for investment. They need capital to meet expenditure like expansion, diversification, modernization, M&A etc. from time to time.
When a listed company doesn’t want to go for further public issue and the objective is to raise huge capital by issuing bulk of shares to selected group of people, preferential allotment is a good option.
A private placement is an issue of shares or of convertible securities by a company to a select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a public issue. This is a faster way for a company to raise equity capital.
A private placement of shares or of convertible securities by a listed company is generally known by name of preferential allotment. A listed company going for preferential allotment has to comply with the requirements contained in Chapter XIII of SEBI (DIP) Guidelines, in addition to the requirements specified in the Companies Act. In short preferential issue means allotment of equity to some selected people by a company which has its share already listed.

Example:

On April 20 this year ACC has entered into a Share Subscription Agreement with Shiva Cement Limited (SCL), Rourkela, Orissa by which ACC would be inducted as a shareholder of this company. According to this Agreement ACC will subscribe Preferential Allotment of 1,45,00,000 Equity Shares of Shiva Cement Limited with a face value of Rs. 2/- and a premium of Rs. 9/- per Equity Share in all, aggregating to Rs. 15.95 crore and further Subscribing to Preferential Allotment of 2,27,00,000 warrants of Shiva Cement Limited which has an option to convert into corresponding number of Equity Shares at a face value of Rs. 2/- and a premium of Rs. 9/- per Equity Share within 18 months from the date of allotment.
This is a strategic move by ACC as they have supply agreement with SCL which operates a mini cement plant with a clinkering capacity. It has the scope of being expanded further. ACC is hopeful that after this they can increase there production capacity in Orissa.

Advantages:

One advantage of raising money via a preferential issue is that it helps save costs and time involved in a public issue. More important, if the concerned company is not doing too well at that point in time but requires capital, then retail investors may not want to participate in an issue.

At the same time, there could be some institutions which view the company's troubles as being temporary and feel that some injection of capital could help it out of the trough.

In fact, promoters need such investors in times when the market sentiment is weak and a public issue could fail. Moreover, if promoter is being allotted preferential issue and they acquire more shares in the company, it is a good sign because it shows that the corporate ship is not sinking and they have abiding interest in the company.

There is no requirement of filing any offer document / notice to SEBI in case of the preferential allotment and even no eligibility norm for the company for the preferential allotment.

Apart from this in the preferential allotment the shares are issued in bulk and hence when huge fund requirement is there without incurring much cost and without investing much time.

In current scenario where there is lots of takeover, in preferential issues the shares are issued to friendly investors like promoters to ward-off the risk of take over. If share are issued to public there is a chance that later they can sell it to a firm which has an intension of take over.

Pitfalls:

The preferential allotment is often misused by the promoters as they could secure it because of majority holding by them and they consolidate their hold on the company without paying a fair price for it. As per section 81 (1A) of the companies act, it is merely a formality though special resolution need to be passed but only members present in person and through proxy are counted.

There is a possibility of insider trading. It was a case with Hindustan Lever (HLL)'s purchase of eight lakh shares in Brooke Bond Lipton India Ltd (BBLIL) before the public announcement of the merger between HLL and BBLIL in 1998. Because of the fact that HLL as a subsidiary of Unilever knew about merger they had information and they acquired shares at considerably lower price before announcement of merger.

There have been views of it being anti-democratic as only a few players are offered to buy the share that too at a much cheaper price.

But the main problem which has raised eyebrow of SEBI is more serious. Apparently, promoters takes advantage of bull run by offloading shares at ruling market prices (which used to be higher) and going in for preferential allotment at minimum price as per the formula given in SEBI (DIP) Guidelines (which are lower than current market prices). As such, promoters are profiteering from the bull-run and are also in a position to maintain their stake through preferential allotments to themselves.

Regulations for preferential allotment as per {Chapter XIII OF SEBI DIP (Disclosure and Investor Protection) Guidelines, 2000}

1. No preferential allotment should me made along with the rights issue.
2. A special resolution needs to be passed but if just an ordinary resolution is passed, preferential issue of shares may be done provided sanction of the Central Government is obtained.
3. Pricing

The price at which the preferential shares are to be offered are governed by the SEBI guidelines in case of listed companies. Such shares cannot be issued at a price which is less than the higher of the following :-

The average of the weekly highs and lows of the closing prices of the shares on the stock exchange during 130 trading days preceding the relevant date; or

The average of the weekly highs and lows of the closing prices of the shares on the stock exchange during 10 trading days preceding the relevant date

Relevant date means the date 30 days prior to the date on which general meeting of the shareholders is held.

1. Instruments issued on preferential basis to the promoters are subject to a lock-in of 3 years from the date of allotment, and for other groups, lock-in is 1 year.

2. In case, promoter(s) of a company sells his shares during last six months from the relevant date, he will not be eligible to acquire shares through preferential allotment.

3. In case, the company is making a preferential allotment of shares to promoters, the entire shareholding of the promoter(s) shall necessarily be in demat mode.

Current trends in India:

Preferential allotments are currently used in India in variety of ways. Mutual fund, venture capital firms, FIs etc due to there bargaining power is big buyer of these issues. Reason is that they get it at discount and enjoy capital appreciation in short period. In 2005 Centurion Bank of Punjab raised Rs 384 crore through a preferential issue of equity to funds managed by GW Capital, ChrysCapital and Citigroup Venture Capital International Growth Partnership Mauritius.

In India, large numbers of companies are planning to issue shares to promoters through preferential allotment and some of them have already done so in past.

For example; Promoters of TV 18 sold ten lakh shares @ Rs.168.35 on November 07,2003 to a mutual fund and after one week approved a preferential issue @ Rs.152/- per share. A net profit/difference of Rs.1.4 crore, between the two prices. The market price of the scrip on December 5, 2003 was Rs.195. Promoters got discount of about 22% of the prevailing market price.

And, this is not the only case, there are lots of such instances, where promoters sold there stake in the market just before the preferential allotment and earning unscrupulous profits despite of all the regulations. Due to these cases of misuse of preferential allotment by promoters, SEBI has made many amendment to DIP guidelines.

References:

WWW.sebi.gov.in
WWW.vccircle.com
WWW.investofriend.com
WWW.blonnet.com
WWW.indian-express.com
WWW.acclimited.com

SEBI (DIP) GUIDELINES 2000, Chapter XIII
REVIEW OF SEBI (DIP) GUIDELINES 2000- PROPOSALS - SERIES VI
The Hindu Business Line

Compiled By:
Renu Aggarwal
Naval K Pratihast
Saurabh Raja
Arun Prasath