SEBI Consultation paper on Review of SME segment framework under SEBI (ICDR) Regulations, 2018, and applicability of corporate governance provisions under SEBI (LODR) Regulations, 2015 on SME companies to strengthen pre-listing and post-listing SME provisions - MMJC

Introduction

SEBI has proposed 26 reforms to improve the framework governing SMEs under the SEBI (ICDR) Regulations, 2018, and the SEBI (LODR) Regulations, 2015. These reforms aim to enhance transparency, governance, and investor protection while encouraging growth in the SME sector.

Detailed Key Proposals

PART I: SME provisions under ICDR

A.SME IPO Process:

I. Increase in Minimum Application Size

• Proposal: To Increase the minimum application size for SME IPOs from ₹1 lakh to ₹2 lakh (or ₹4 lakh as an alternative).
• Rationale: Smaller investors often face significant risks in SME IPOs due to market volatility and limited liquidity. An increase in the minimum application size ensures only well-informed investors with greater financial capacity participate.
• Regulation Reference: Regulation 267(2) of ICDR.

II. Revised NII Allotment Structure

1. Proposal: Divide the NII category based on application size into:

Sub-Category I: Up to ₹10 lakh (1/3 allocation).

Sub-Category II: Above ₹10 lakh (2/3 allocation).

2. Rationale: This willalign SME IPO allotment rules with Main Board practices of allocation methodology for NII category.Earlier Proportionate allotment tends to encourage over-leveraging, over statement of interest and thus at times encourage mispricing.

III. Allotment process and basis of allotment

Proposal: Raise the minimum number of allottees required for an SME IPO from 50 to 200.

Rationale: The investor base in India has grown a lot since 2010. Increasing the minimum number of allottees in SME IPOs will ensure only companies with genuine investor interest get listed. It will also improve post-listing liquidity by having more investors involved. With the new “draw of lots” method for SME allotments, smaller investors in the NII category will also have a fair chance of receiving shares.

Regulation Reference: Regulation 268(1) of ICDR.

IV. Restrictions on Offer for Sale (OFS)

1. Proposal: To Limit OFS to 20% of the total issue size and cap selling shareholders’ sales to 20% of their pre-issue holdings.
2. Rationale: The SME Exchange was created to help small and medium enterprises raise funds for growth, not for promoters to dilute their stakes. Data shows many SME IPOs include a significant Offer for Sale (OFS) component, with some exceeding 20% of the issue size. Since OFS proceeds don’t benefit the company directly, it is suggested to limit OFS to ensure funds are used for business growth.
3. Regulation Reference: Regulation 238 of ICDR

V. Mandatory Monitoring of Issue Proceeds

1. Proposal:

• To Require monitoring agencies for issues above ₹20 crore.
• To Mandate monitoring for objectives like acquisitions or subsidiary funding, irrespective of issue size.
• To ensure proper use of IPO funds, a statutory auditor’s certificate should be required if no monitoring agency is appointed. This certificate should be submitted with half-yearly financial statements to the exchange and reviewed by the company’s Audit Committee and Board until the funds are fully utilized.

2. Rationale:

• A monitoring agency, like a SEBI-registered Credit Rating Agency, ensures IPO funds are used as disclosed, reducing misuse. It provides transparency for investors and accountability for issuers by submitting regular six-month reports, which are reviewed by the company’s Audit Committee and Board.

3. Regulation Reference: Regulation 262 of ICDR

VI. Lock-in of specified securities held by the promoters

1. Proposal:

• Extend lock-in for Minimum Promoter Contribution (MPC) to 5 years (from 3yr).
• Release promoter holdings in excess of MPC in two phases: 50% after one year and the rest 50% after two years.

2.Rationale:

• Prevents promoters from completely exiting shortly after IPO, ensuring long-term commitment, as it is observed that Promoter holding drops immediately after one year of listing excluding the mandatory MPC of 20% which is locked-in for longer period.

3.Regulation reference: No such regulation currently.

VII. General Corporate Purpose (GCP) portion of issue size

1.Proposal:

• Restrict GCP allocation to 10% of the issue size or ₹10 crore, whichever is lower.
• Eliminate provisions 230(3) of ICDR allowing funds for unidentified acquisitions.

2.Rationale:Prevents misuse of funds under ambiguous headings like GCP.

3.Regulation Reference: Regulation 2(r), 230(2), 230(3) of ICDR

B. Eligibility criteria for an SME IPO (Regulation 228 and Regulation 229):

I. Entities not eligible to make an IPO

Restriction w.r.t. Promoter Group for Eligibility:

• Proposal:
  To include the Promoter Group in Regulation 228 (b), (c), and (d), which currently applies to the issuer’s promoters or directors. This means if the promoters or directors are involved in companies that are debarred from the capital market or are wilful defaulters, fraudulent borrowers, or fugitives, the issuer should also be ineligible for an SME IPO.
• Rationale:
  Many SMEs are closely held by the promoter and their group, and the actions of the promoter group can significantly affect the company. Including the promoter group ensures that the company does not get listed if the group has a history of serious financial misconduct.
• Regulation Reference: Regulation 228 (b), (c), and (d) of the ICDR Regulations.

II. Eligibility requirements for an initial public offer

1. Proposal:

• Proposed that, for companies converted from Limited Liability Partnerships (LLPs) or partnerships, the company should exist for at least two full financial years before filing for an SME IPO. The restated financial statements after conversion should comply with Schedule III of the Companies Act, 2013.
• Proposed that, if there is a change in promoters or new promoters acquire 50% or more shareholding within two years before filing the draft offer document, a 2-year cooling-off period should be required before going for an SME IPO.

2. Rationale:

• Converted companies need time to establish a clear financial history, as financial statements for LLPs/partnerships differ from those of a company.
• A cooling-off period ensures new promoters have time to demonstrate their ability to manage the company before it goes public.

3.Regulation Reference: Regulation 229 of ICDR, Schedule III of the Companies Act, 2013.

VIII. Additional eligibility requirements for an initial public offer

1.Mandatory More that ₹10 Crore Issue Size

• Proposal: Allow IPOs only for companies with issue sizes above ₹10 crore.
• Rationale: Smaller issues can access alternate funding sources, ensuring only growth-ready companies enter the public market.

2.Operating Profit Threshold

• Proposal: It is proposed that an issuer should be eligible to make an initial public offer only if the issuer have operating profit (earnings before interest, depreciation and tax) of Rs. 3 crores from operations for at least any 2 out of 3 financial years preceding the application.
• Rationale: A minimum operating profit threshold indicates that the company has achieved certain level of profitability and is financially viable.

3.Standardize Face Value of Shares

• Proposal: It is proposed to mandate SME issuers to have shares having face value of Rs. 10/- for its issued capital and for proposed new shares to be issued and listed through IPO. This proposal shall be prospective and applicable only for the new companies coming for listing through SME IPO
• Rationale: – In order to increase readability of financials and ensure comparability between issuer companies, it is suggested that all issuers have same face value

C.Migration of SME Companies to Main Board

I. Requirement of compulsory migration linked with fund raising post listing:

1.Proposal

• To allow companies with a post-issue paid-up capital exceeding ₹25 crore to continue raising funds on the SME platform without migrating to the Main Board, as long as they meet corporate governance and disclosure requirements under the SEBI (LODR) regulations, including quarterly results.
• Companies should only migrate to the Main Board once they meet the exchange’s eligibility criteria for migration.

2.Rationale:

• The current rule forces companies with capital beyond ₹25 crore to migrate to the Main Board, which restricts their ability to raise further funds. The proposal allows these companies to continue raising funds while adhering to Main Board standards, thus promoting growth without forcing premature migration. It also prevents misuse of the SME platform as a stepping stone for Main Board listing by ensuring compliance with stricter governance and disclosure norms.

3.Regulation Reference: Regulation 280(2) of ICDR, SEBI (LODR) Regulations.

D. Objects of the Issue and additional disclosure requirements under Schedule VI

1.Object of the issue is repayment of loan of promoter / promoter group

• Proposal: It is proposed that for SME issues, where objects of the issue consist of Repayment of Loan of Promoter, Promoter Group or any related party, from the issue proceeds, whether directly or indirectly, may not be permitted
• Rationale: Ensures funds are directed toward business expansion rather than promoter interests.

2.Object of the issue is to fund working capital

• Proposal: To Mandate statutory auditor certificates for working capital allocations exceeding ₹5 crore on half yearly basis.
• Rationale: It’s been observed that requirement of GCP rises substantially when company goes to IPO without any strong rationale as compared to last 3 years. An additional requirement of statutory auditor certificate specifically for proceeds utilized for working capital should be provided herein which shall be duly endorsed by the audit committee and board of the company

3.Disclosure of firm arrangement of finance up to seventy- five % of issue proceeds

• Proposal: To Disclose bank appraisal reports for projects partially funded by banks.
• Rationale: Ensures additional diligence and transparency for investors.

4.Additional disclosure specific to the company (ICDR Schedule VI)

Proposal:

• To disclose details of senior management (e.g., department heads) along with their experience.
• To Include disclosures in material document for inspection in offer document on EPF/ESIC compliance and Merchant Banker site visits.

Rationale:

• Above disclosure shall provide investors with more information including employee strength of the company leading to better disclosure by the company

5.Disclosure of fees of Merchant Banker

• Proposal: Fees of Merchant Bankers in any form / name / purpose may be disclosed in the RHP
• Rationale: Many a times it is noted that fees of Merchant Banker exceed 30-40% of the issue size. Thus, it defeats the purpose of providing an alternative fund-raising mechanism for SMEs

E. Other Proposals:

1.Offer document to be made available to public

• Proposal:
  Make the Draft Red Herring Prospectus (DRHP) of SME IPOs available to the public for comments for at least 21 days after filing with the stock exchanges. It should be hosted on the stock exchanges’ and lead managers’ websites and announced in newspapers (in English, Hindi, and a regional language) inviting public comments
• Rationale:
  This will allow the public to review the DRHP and provide feedback before the IPO opens, increasing transparency and reducing complaints that typically arise only after the IPO opens
• Regulation Reference:Regulation 247 of ICDR for SME, Regulation 26(1) and 26(2) for Main Board IPOs.

2.Converting outstanding convertible securities before IPO

• Proposal: To Mandate the conversion of all outstanding convertible securities before SME IPOs.
• Rationale: Provides clarity on the company’s capital structure.
• Regulation Reference: Regulation 5(2)

3.Due-diligence certificate by Merchant Banker

• Proposal: It shall be mandated for Merchant Banker to submit due-diligence certificate to Stock Exchanges at the time of filing of draft offer document.
• Rationale: Since, in SME IPOs DRHP is not filed with SEBI, due-diligence certificate at the time of DRHP can be submitted to Stock Exchanges.
• Regulation Reference: Regulation 246 of ICDR as per form A of Schedule V and Form G of Schedule V

4.Non-uniformity in nomenclature

• Proposal: Standardize the term “post-issue paid-up capital” across all SME regulations.
• Rationale: Eliminates ambiguities in regulatory language
• Regulation Reference: Chapter IX – IPO by SME, of ICDR, Regulation 229 (2) of ICDR

5.Addition of new Regulation in line with regulation 59 of SEBI ICDR Regulation

• Proposal: Post-listing exit opportunity for dissenting shareholders may be provided in SME chapter in line with main board provisions
• Rationale: This will help in protecting the interest of the investors.
• Regulation Reference: regulation 59 of SEBI ICDR

6.Clarification w.r.t. Securities ineligible for minimum promoters’ contribution (MPC)

• Proposal: It is proposed that an explanation may be provided that Price per share for determining securities ineligible for MPC, shall be adjusted for corporate actions e.g. split, bonus etc. done by the Issuer Company
• Rationale: A clarification is needed that the price for determining eligibility should be adjusted for corporate actions like stock splits or bonus issues. For example, if shares were bought at ₹100 and a 1:1 split occurs, the acquisition price should be adjusted to ₹50. This adjusted price should then be used to compare with the issue price when determining eligibility for Minimum Promoter Contribution (MPC)

• Regulation Reference: Regulation 237(1)(b) of ICDR

PART II: Streamlining applicability of corporate governance provisions under SEBI (LODR) Regulations, 2015

a.To align SME and Main Board listed entities and protect investor interests, it is proposed to extend LODR Regulations to SME listed entities.

I. Applicability of provisions pertaining to related party transactions (RPTs):

• Proposal:
  Extend the Related Party Transaction (RPT) provisions under Regulation 23 of LODR to SME listed entities, except those with paid-up capital under ₹10 crore and net worth below ₹25 crore. The materiality threshold for shareholder approval should be set at 10% of annual turnover, instead of ₹1000 crore, to reflect the size of SME transactions.
• Rationale:
  LODR’s RPT rules are stricter than the Companies Act and applying them to SMEs will help prevent fund misuse through related parties. This change ensures uniform RPT norms for both SME and Main Board entities, while accounting for the smaller size of SME transactions.
• Regulation Reference: Regulation 23 of LODR

II. Disclosure of composition and meetings of the board of directors and its committees:

• Proposal:
  SME listed entities should disclose the composition of their Board of Directors and committee meetings, including details like attendance and meeting dates, on a quarterly basis. This requirement will apply to SMEs with a paid-up capital above ₹10 crore and net worth above ₹25 crore.
• Rationale:
  Board composition and frequent meetings are crucial for effective governance. Extending this disclosure requirement to SMEs will increase transparency and allow better monitoring by stock exchanges, analysts, and investors.
• Regulation Reference: Regulation 27 of LODR.

III. Periodic filings:

• Proposal:
  SME listed entities should submit their shareholding pattern, statement of deviations or variations, and financial results on a quarterly basis, instead of the current half-yearly requirement, to align with Main Board listed entities.
• Rationale:
  These filings are crucial for understanding a company’s financial health and fund utilization. Quarterly submissions will provide more timely information and improve transparency for SME listed entities.
• Regulation Reference: Regulation 27 of LODR.

Conclusion:

SEBI’s 26 proposals aim to strike a balance between investor protection and SME growth, fostering a transparent and robust listing ecosystem. Public feedback is invited by December 4, 2024, through this link.