Is it time to sentence Share Warrants to Dishonorable Discharge?

(SEBI DIP Guidelines amendments – Part 2)

Several amendments have been made to the SEBI DIP Guidelines as briefly highlighted here. I am sharing a few more thoughts on two areas, but in separate posts.

This post focuses on the increase of minimum deposit on Share Warrants from 10% to 25% of issue price. This amendment was the least unexpected, even too late. Too late because it has already been heavily misused and abused and also made at a time when Promoters are least likely to subscribe to Share Warrants.

In fact, there appears to be literally a flood of cases of Promoters allowing the 10% deposit on existing Share Warrants to be forfeited. I have even heard that advisors are straining their legal creativity in finding ways in which even this 10% could be returned to the Promoters! True, most I have heard of till now sound bird-brained but, considering the stakes involved, further efforts are on.

Coming back, let us quickly highlight some aspects of Share Warrants to place the recent amendment in context. Share Warrants are instruments that give a right and option to the holder to acquire shares within a specified time and at a specified price. They are thus similar to ESOPs and also to options traded in markets, though the latter represent private contracts where the listed company is not involved.

Share Warrants thus have several advantages. You don’t need to pay the full share price upfront. You can exercise the Share Warrants anytime. You even have the option to back out and let the deposit be forfeited. And so on.

For the Company, they were often useful as, for example, acting as sweeteners to otherwise unattractive Unsecured, Non-Convertible Bonds. They also had the weak justification, in the early years of globalization, of allowing Promoters to increase their stake to prevent hostile takeovers. However, they quickly degenerated to being used almost exclusively to enrich Promoters, at the cost of the Company and other shareholders.

Consider, from the point of view of the Promoters, the free lunch of Share Warrants.

You get the Share Warrants (earlier for free) by paying just 10% deposit. Even if this deposit is forfeited, you still get to share it to the extent of your holding (e.g., a Promoter holding 50% of the Company thus shares 50% of the forfeited deposit).

Even this deposit of 10% was an absurdly low amount – it barely covered the interest on the balance 90% for 18 months. But interest is obviously not the only factor. Often the bigger advantage is of the option. Having done and reviewed several valuations of options in context of ESOPs, I have found that in numerous cases, particularly in times of higher volatility, even the increased 25% deposit may be found to be too low.

Further, in case of market-traded options, the option premium is an additional cost and not part-payment of the purchase price. Thus, even if you decide to actually purchase the shares, you pay the full purchase price in addition to this premium. In case of Share Warrants, the deposit paid is adjusted against the issue price.

Till a recent prohibition, Share Warrants also represented simple arbitrage. Sell today and buy Share Warrants by paying 10% deposit. This also meant that the surplus cash could be used to acquire higher shares and raise the balance amount later.

It was also quickly realized by Promoters that Share Warrants could help avoid the creeping acquisition limits. Well planned, the Promoters could increase their holding by 15% over 18 months without violating the 5% creeping acquisition limits. All this by paying just 10% today and that too at today’s prices! Needless to say, this technique was widely used.

How sound was the deal from the point of view of the Company? Almost certainly a loss making one since if the same deal was offered to a third party, he would have paid a far higher amount. The public shareholders obviously also lost.

SEBI of course has been chipping away slowly at the anomalies. The early amendments included reducing the conversion to period to the current 18 months and the 10% deposit, increased to 25% now. There is a ban on preferential allotment to those who have sold in last six months. The lock-in has been effectively increased, as discussed separately here.  And so on.

Consider, though, from a different perspective, these very amendments over time which appear mainly intended to protect Share Warrants from misuse by Promoters. What was the result on Share Warrant itself as an instrument? How sound a financial proposition they appear to third party, non-Promoter investors? How attractive would Share Warrants sound, if one has to pay 25% upfront, if one has to convert them within 18 months, if one has to suffer double lockin, if the conversion price has to be a minimum one related to recent prices, and so on?

The latest amendment comes not only too late but also at a time when Promoters are least in the mood to acquire Share Warrants simply because the six monthly average prices are typically higher than the current market price.

What then is the justification for continuing to allow issuance of an instrument that is a win-win proposition for the Promoters and a lose-lose one for the Company and the public shareholders? Is it not time for, instead of making marginal improvements, simply sentencing Share Warrants to a dishonorable discharge, having led, far more often than not, a disgraceful existence?!

Alternatively, major changes are required if they are to be continued. Linking pricing and deposit for Share Warrants to past average prices is absurd. Share Warrants are equivalent to options and should be valued as such. Even a rudimentary version of the Black-Scholes formula would give a fairer price. Remember, this technique is already being used, albeit as an alternative, for valuing and accounting for ESOPs.

And, at the very least, it is this price that should be paid. The amount should be paid as a premium for being granted the Share Warrants and not as a deposit that is adjustable towards the issue price!

Also, at the risk of sounding petty, I would even suggest that if this amount paid by Promoters is to be forfeited, it should be distributed as a special dividend/bonus to non-Promoter shareholders! (as I said, sharp minds are hard at work, so I keep hearing, to find ways to return the forfeitable deposits to the Promoters on existing Share Warrants suddenly found to be out of the money).

There should also be a commercial justification for issuance of Share Warrants, especially from the point of view of the Company. The Company puts itself in a peculiar position when it issues Share Warrants. Other Potential investors are wary of the potential dilution and thus the Company becomes slightly unattractive to them. The Company may or may not receive the balance amount for the shares. And it may receive this balance price at any time the Promoters deem fit. Is it a commercially sound proposition for the Company to issue Share Warrants on such terms and where monies come in such uncertain manner and timing? Only if the answer is a clear yes, that the Share Warrants should be issued.

Another alternative is to ban issuance of Share Warrants to Promoters altogether, just as ESOPs are so banned.

–       Jayant Thakur