A recent advisory by Sebi to merchant bankers has again sparked a debate around special rights that private equity (PE) investors have in portfolio companies going for public listing. Sebi has directed merchant bankers to ensure that private equity investors do not have any special rights in IPO-bound companies. Implicitly, Sebi wants these rights to fall away at the stage when a company files its updated Draft Red Herring Prospectus (DRHP). For PE investors, this SEBI mandate presents an unnecessary complexity and risk, should there be any unforeseen last-minute issue or change in the IPO roll-out.

The changes may seem a bit odd for Sebi to ask companies to now drop these rights at the stage of filing an updated DRHP, when as per existing norms all special rights in any case fall away upon listing of IPO shares on stock exchanges. Effectively, Sebi is intending to advance the timing of terminating special rights, from the date of listing of IPO shares to the date of filing of updated DRHP.

Typically, shares are listed within a month of filing of updated DRHP, unless of course a company itself delays or shelves its IPO. Sebi’s objective arguably is to ensure that no PE investor or for that matter no person or investor or promoter of an IPO-bound company has any special or superior rights over public shareholders. Therefore, all rights must fall away before the company is listed.

Given that filing an updated DRHP is an advanced stage of an IPO, showing the company’s seriousness of raising public funds, Sebi may have felt that it is appropriate for the rights to fall at the time of filing updated DRHP. As said, if these rights survive post the IPO, they will create a superior class of shareholders which is what a listed company cannot have.

Of course, once listed, the shareholders are free to approve these special rights by following due process of law. In that case, any person who is given special rights will be with the blessings of public shareholders of the company. Thus, the only effect of Sebi’s diktat is that special rights which could have been retained until the listing of a company, will now have to be given up much earlier at the stage of submitting updated DRHP. PE investors typically have many special rights which are critical for their investment and governance of portfolio companies. A PE investor gets these rights depending on its commercial agreement with portfolio companies, the shareholding level and size of the investment made. The rights are incorporated in shareholders’ agreement (SHA) and in the company’s articles of association. A few of the common rights are director/observer nomination right, veto right, information right, anti-dilution right, rights of first refusal, tag along right, liquidation preference and exit rights.From PE investors’ perspective, their problem is not the falling away of these special rights or the timing when they will fall but how to restore them, should the IPO not materialise for any reason. Once the rights are removed from SHA and articles of association, it will become difficult to get them back. This situation could happen if a company withdraws its IPO. There are examples of companies aborting IPOs even after Sebi’s clearance. This could be due to unfavourable market conditions, internal management and business decisions, etc. Ideally, to protect PE investors stuck in this situation, Sebi regulations must provide that terminated special rights should automatically restore if an IPO is aborted, since in the first place, the rights had fallen in anticipation of IPO. The possibility of Sebi making any regulations for this looks remote, as these special rights are not statutory rights, but only contractual rights agreed between parties.

For a PE investor to remain invested in a company with no rights is not a feasible option either. So, a contractual arrangement can be made to have the rights back. One option is for parties to have a provision in the SHA and articles of association at the time when investment is made to provide that if IPO fails for any reason, these rights should be automatically reinstated in the SHA and the articles of association. However, articles of association can only be modified with a shareholders’ vote. Any concern that shareholders may not vote in favour can be addressed by PE investors being given voting rights through a power of attorney or a proxy, which it can use to modify the articles.

(The author is a partner with JSA Advocates & Solicitors. Views are personal)

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