IPO Funds: Diversion and Commercial Flexibility
Isha Ahlawat**
Initial Public Offerings (IPOs) are often endorsed as stimulants of economic growth, infusing businesses with the capital they require to expand, innovate, and generate jobs. In 2023, India’s surging stock market witnessed 57 new IPOs, raising a combined total of $5.9 billion – the fourth highest annual amount raised in the past decade. However, a closer look at the Securities and Exchange Board of India’s (SEBI) history of encounters with cases of IPO fund misappropriation compels a temperance of optimism. On multiple occasions, it has come to light that the proceeds from IPOs are not used as intended, indicating wanton corporate malfeasance and foreboding a potential loss of public trust in financial markets.
In some instances, companies have diverted IPO funds to inflate executive pay packages or acquire businesses that do not align with the company’s core strategy. In others, IPO funds have been diverted simply for the purposes of committing outright fraud. As recently as May 2024, SEBI banned Varanium Cloud and its promoter after an investigation uncovered that the company did not have any business activity and had directed proceeds obtained from its IPO to investments in a hospitality business called Turmeric Luxury instead of establishing data centres like it had promised in its prospectus. The misuse of IPO funds is not simply an accounting problem. It has broader implications for the economy. When companies misallocate their IPO proceeds, they forego opportunities to invest in research and development, expand into new markets, and create jobs.
However, resolving the issue of IPO fund diversion throws up several unique problems from the perspective of all the parties involved – the regulator, the investors and the promoters. To illustrate this further, let us consider the case of Birla Pacific Medspa Limited. A few years ago, the company found itself entangled in allegations of diversion of IPO funds. In its prospectus, the company had stated that the funds would be utilized to open 55 outlets of Evolve Medspa across different cities. Not only were no new centres inaugurated, but 50% of the funds were used to deploy inter-corporate deposits (“ICDs”) to group companies.
Regulation 57 (1) of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, mandates that the offer document must contain all material disclosures so as to enable applicants to make informed decisions regarding investments. Moreover, per clause (XVI) (B) (2) of Part A of Schedule VIII of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, all signatories to the offer must certify that the disclosures provided in the offer document are correct and true. On 23rd October, 2020, SEBI gave a final order in the matter and held that the noticees had provided misstatements in the prospectus. It was held that the objects of offer provided in the prospectus were incorrect as no centers were opened. It was also found that the diversion of the IPO funds to ICDs was not covered by the disclosure concerning the interim use of funds mentioned in the prospectus.
However, on 26th August, 2021, the Securities Appellate Tribunal (“SAT”) reversed SEBI’s order and stated that SEBI’s finding was perverse and that there were no misstatements in the prospectus of BPML. The SAT held that if IPO funds are not used in the manner indicated in the prospectus, then the actions of the relevant company cannot be interpreted to mean that “there was a misstatement in the prospectus.” Instead, deviation from the objects of the offer would at best be considered a violation of the terms of the prospectus. It was also held that ICDs can be interpreted as liquid instruments and therefore, did not need to be mentioned separately in the prospectus, in the present matter.
This matter raises questions regarding companies’ obligations to adhere to the objects specified in the prospectus, and the scope that companies have for deviating from the objects mentioned in the prospectus. Institutionally, as a financial regulator, SEBI is the guardian of investors, and therefore, has a responsibility to ensure that their interests remain protected. The objects of offer are disclosed in the prospectus so as to enable investors to have insights into the manner in which their investments will be used by the company. It is also important for companies to adhere to the objects of the offer in order to provide security and stability to investors and to comply with the terms based on which applicants make their investment decisions.
SAT’s analysis in the Birla Pacific Medspa case was incomplete for it largely engaged with the procedural and epistemic aspects of what a “misstatement” in the prospectus means, while ignoring the materialities of how it affects the objectives of financial market regulation. The diversion of IPO funds to inter-corporate deposits (ICDs) demanded greater scrutiny since it laid bare the potential conflicts of interest and the prioritization of personal or group interests over the interests of public shareholders.
Recently, in January 2022, in furtherance of upholding its responsibility to protect the interests of investors, SEBI introduced the SEBI (Issue of Capital and Disclosure Requirements) Amendment Regulations, 2022. Through this amendment, SEBI has altered some obligations that IPO bound companies need to comply with. For instance, a company cannot spend more than 35% of its IPO funds for future inorganic growth and general corporate purposes, cumulatively. This amendment has been introduced after certain companies, especially new age tech companies, conducted their IPOs without identifying their specific investment targets or acquisitions. At its core, this amendment is aimed at reducing information asymmetry in the securities market between issuer companies and investors, but it also has the effect of reducing the flexibility that the issuer companies have in determining the manner in which they want to utilize the IPO funds.
Take for instance Section 27 (1) of the Companies Act, 2013, which states that a company is not allowed to vary the objects of the prospectus, unless it gains approval to do so through a special resolution in a general meeting. The restriction on a company’s ability to deviate from the objects stated in the IPO prospectus has been introduced to protect investors who may make investment decisions based on the information and disclosures provided in the prospectus, including the manner of utilization of the IPO funds. Such provisions are essential for mitigating the risks involved in issuer companies earmarking a considerable part of the IPO funds for unidentified investments and acquisitions. However, such a restriction greatly limits the ability of the issuer company to deviate even slightly from the scheme of allocation of its IPO funds that it has provided in the prospectus.
For example, Orient Green Power Company Limited had to get the approval of its shareholders for changing the amount to be spent on the objects mentioned in its prospectus by 0.05% or 0.42 crores. Thus, the requirement established under Section 27 (1) of the Companies Act, 2013, imposes an onerous burden on companies with respect to the application of the IPO funds on an object that varies from the objects specified in the prospectus. This raises questions regarding the efficacy of laws mandating the disclosure of objects of the offer in the offer document. A company becomes restricted from going beyond the scope of the objects of the offer and has to adopt the process mentioned under Section 27 (1) of the Companies Act, 2013, to be able to deviate from the same. It is noteworthy that pursuant to this provision, SEBI recently imposed fines totaling up to Rs. 2.3 crore on 32 entities which have allegedly diverted IPO funds.
Issuer companies must, therefore, adhere to the objects of the offer, as specified by them in the prospectus. However, the obligation to comply with the disclosures made with respect to the objects of the offer must not be interpreted very strictly. So long as the funds are utilized for purposes that may be adjacent to those mentioned in the prospectus and there is no prima facie evidence of fraud, the company must have some room to determine its strategy for utilizing the funds raised through IPOs. Companies and businesses operate in a dynamic environment and are impacted by macroeconomic events. In such a situation, it is important to account for circumstances in which it may become economically unfeasible for issuer companies to adhere to the objects of the offer that they may have disclosed in the prospectus.
Moreover, as SEBI noted in its decision on Varanium Cloud, investors must also exercise caution and conduct due diligence before investing in schemes that might promise seemingly attractive returns. At the same time, SEBI’s monitoring capacity to investigate how a company is utilizing the proceeds of IPOs must be enhanced. So far, this role has fallen within the mandate of the Registrar of Companies which is required to do this in tandem with SEBI. However, the process of coordination is often time taking and riddled with bureaucratic red tape, leaving SEBI to often rely on external inferences such as unusual stock price movement to detect misconduct. Heightening the requirements for reporting how IPO funds are utilized and imposing strict penalties for failure to do so will likely deter companies from reneging on the statements made in the prospectuses, fostering greater market discipline.
** Isha Ahlawat, BCL (Oxon.)
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About the Authors
Shuchi is a recent graduate of B.A. LL.B. (H) from Jindal Global Law School. She will be joining the Corporate Law and Financial Regulation vertical at Vidhi. As a student, she has interned with the corporate law and finance teams of several organizations, including White & Case LLP, IndusLaw and Khaitan & Co. She is also highly interested in photography, cinema and literature.
