[Tirth Purani and Aditi Srivastava are 4th year BALLB (Hons) students at Institute of Law, Nirma University]
Small and medium enterprises (“SMEs”) constitute the backbone of the Indian economy, contributing significantly to employment generation, innovation and growth. When the question of their survival and growth emerges, capital often becomes a roadblock. An initial public offering (“IPO”) is the route often opted for business expansion and growth. To address this, the Bombay Stock Exchange and National Stock Exchange launched a specialised SME Exchange platform in 2010, facilitating public listings with relatively relaxed compliance norms.
Over the years, SME IPOs have raised significant amounts of capital and garnered substantial investor interest from all over the country. However, the Securities and Exchange Board of India (“SEBI”) has flagged several inconsistencies and cases of manipulation in these IPOs. After identifying these underlying issues, SEBI rolled out a Consultation Paper proposing necessary amendments to the provisions governing SME IPOs. In its Board Meeting on 18 December 2024, SEBI approved certain proposals with amendments to enhance transparency, accountability and investor protection in this segment.
This post critically examines issues such as market manipulation, promoter influence, and the high suspension rate of SMEs while raising capital. Further, it analyses the amendments and considers the impact on entities and concludes that the new regulatory framework ensures stability in the market for the SME segment and strengthens investor protection.
Cracks in the SME Framework: Regulatory and Market Vulnerabilities
In 2024, the SMEs raised the highest capital, amounting to Rs 8,288 crores, through 196 IPOs in total, reflecting a surge in retail investor participation. Due to such a high level of interest in such IPOs, retail investors are entering the fray with a view to obtaining short-term and quick gains without fully understanding the background of the entities and long-term risks. Notably, while IPOs undertaken by SMEs account for 78% of the total IPOs, they have contributed only up to 6% of the total capital raised, thereby indicating a disproportionate scale and raising alarms about potential market manipulation. Due to their size, SMEs often raise moderate amounts of capital compared to other entities, offering fewer shares to the public. This creates the possibility of price manipulation by a small group of investors holding larger amounts of the issued shares.
As reported by Reuters, SEBI has expressed its concern that certain small-scale enterprises misrepresent their operations post-IPO, misuse public funds and exploit the SME listing platform contrary to its intended purpose. A pertinent instance is an SME providing software services which was barred by SEBI for misappropriating its IPO proceeds and manipulating the financial statements.
Unlike large-scale entities, most SMEs are predominantly controlled by promoters, such as business families, where the majority shareholding lies in the hands of a few individuals having minimum institutional oversight. As the involvement of private equity investors or institutional investors is limited, this concentration of control enables promoters to exert significant influence over decision-making for their percentage, thereby putting investors’ money in jeopardy.
As noted in SEBI’s consultation paper, as of 15 October 2024 no trade was executed in 35 out of 328 SMEs listed on the Bombay Stock Exchange (BSE) due to their suspension. Therefore, mathematically, 10% of the listed SMEs are not trading due to their suspension and other regulatory reasons reflecting a crucial issue. The suspension rate of 10% is still very high considering the number of listed SMEs, raising questions on regulatory compliance and due diligence conducted by stock exchanges and regulatory authorities. Further, non-trading of shares may also lead to price manipulation, as even minimal trading activity can trigger significant price rises, thereby generating volatility in the market. Given the limited operating bandwidth and constrained operational scale, SMEs listed on stock exchanges often fail to inspire the same degree of investor confidence as larger, more established entities, with such investments in SMEs thereby carrying a liquidity risk. This leaves the investors unable to exit their positions, as the suspension of SME-listed entities coupled with limited trading volumes amplifies liquidity risks.
It has been noted that one out of two listed SMEs have undertaken related party transactions (“RPTs”) exceed Rs. 10 crores. These RPTs are often structured to divert IPO proceeds towards related parties and shell companies controlled by promoters. In order to portray inflated financial health in the books, promoters are constantly undertaking circular transactions without any substantive business activity through related parties and shell companies, thereby painting an “unrealistic picture” of their entity’s financial health. Therefore, the need of the hour calls for rigorous oversight by SEBI into the deployment of IPO funds and the legitimacy of RPTs.
Analysis of the Key Amendments and their impact on SMEs
To mitigate the aforementioned issues and bolster investor protection in the SMEs, the SEBI Board approvedamendments to the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR”) and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR”). Any SME intending to launch an IPO must now demonstrate an operating profit of Rs. 1 crore in any of the two of the preceding three financial years at the time of filing of the Draft Red Herring Prospectus. There have been several instances where SME issuers have raised capital despite having poor financial strength risking investors’ money. This criterion of mandating minimum profitability ensures that solely financially viable companies would be able to access public markets, thereby safeguarding investor interests. A minimum threshold will instil confidence in those investors intending to inject their money into the market.
Prior to the amendment, there was no restriction with respect to offer for sale (“OFS”) in the SME IPO, allowing promoters to significantly dilute their holdings. However, now OFS by selling shareholders in the IPO cannot exceed 20% of the total issue size and selling shareholders are barred from selling more than 50% of their pre-issue shareholding. IPOs are used as a financial ladder for their growth; however, the promoters of the SMEs have been using OFS as a tool to exit from the company by taking advantage of the listing gains. The OFS route provides finances directly to the shareholders rather than to the SME for its expansion. The cap was necessary for upholding the objective of the SMEs, especially for the ones where the majority of the shareholding lies in the hands a of few promoters.
The ICDR Regulations mandate minimum promoter contribution (“MPC”) up to 20% of the post-issue capital of the SME. The MPC was subjected to a lock-in period of three years and the amount exceeding the MPC was subjected to a lock-in period of one year. After the amendment, the amount held in excess of MPC has to be released in a phased manner i.e. lock-in for an initial 50% of the excess amount has to be released after one year and the remaining 50% amount has to be released after two years. As SMEs are usually operated by promoters, this phased lock-in is vital as it ensures the involvement of promoters in the operation of a company. Promoters’ contribution and involvement are crucial for a company’s sustenance and stability. Promoters getting rid of the entire excess amount in one go after the lock-in threatens the company’s growth and only benefits the promoters where a company only remains as a bunch of coaches without an engine.
As earlier highlighted, a significant number of SME-listed entities have engaged in RPTs, often utilized to divert IPO proceeds indirectly to promoters and to manipulate revenue growth through circular transactions to attract investors. Regulation 23 of SEBI’s LODR regulations governing RPTs does not apply uniformly to the RPTs undertaken by SMEs to other entities, absolving them from mandatory shareholder and audit committee approvals.
To curb them from engaging in such transactions, SEBI has extended the applicability of the RPT regulationsapplicable to entities listed on the main board to also apply to SMEs. However, considering their smaller size, an RPT shall be considered material if it is above 10% of annual consolidated turnover or Rs. 50 crores, whichever is lower. Such an amendment ensures a level playing field across listed entities by subjecting SMEs to similar regulatory scrutiny by SEBI. This would curb the diversion of IPO proceeds under the guise of RPTs as well as lead to an increase in corporate governance.
Way Forward and Conclusion
SEBI’s recent amendments attempt to dismantle the SME IPO façade and further strengthen its regulatory ecosystem. By ensuring financial viability, controlling promoter exits through OFS restrictions, tightening lock-in requirements, and aligning RPT regulations with the main board IPO rules, SEBI aims to promote transparency and restore investor confidence. Going forward, continuous monitoring of transactions, stricter enforcement, and robust due diligence by stock exchanges and merchant bankers will be critical for ensuring effective implementation. By leveraging advanced data analytics and fostering collaboration with stock exchanges, SEBI can swiftly identify and curb fraud, ensuring market integrity of the SME sector. To harness the full economic potential of SMEs, it is imperative to establish a framework that facilitates their growth vis-à-vis uphold investor safeguards.
– Tirth Purani & Aditi Srivastava
