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Capital Raising under Securities Board of India Guidelines:An Economic Examination of Capital Market Reforms in an Emerging Market

by

Sankar De

Haas School of Business, University of California, Berkeley

and

Center for Professional Development in Finance (CPDF), Berkeley

Present version: July, 2001

Abstract

The economic policy of liberalization introduced by the Indian government in 1992

requires for its success smooth and uninterrupted flow of private capital into Indian

industry and commerce. In this context, the present study examines the economic and

financial implications of some of the regulations introduced by the new Securities and

Exchange Board of India (SEBI) through the guidelines it has periodically issued. The

regulations in question apply to investment or merchant banking services required for

corporate issues of long-term securities in India. We find that some implications of the

guidelines may be in conflict with the professed objective of the current economic policy

of the Indian government to induce the corporate sector to raise external funds from

private investors. More seriously, we find that the guidelines may be self-defeating in the

sense that they may result in less , rather than more, information for the investing public.

*This study was initiated when I was at the Indian Institute of Management, Calcutta. I thank the Centrefor Management and Development Studies (CMDS) at the Institute for financial support for the study.During the course of the study I benefited from discussions with many representatives of financialinstitutions and regulatory authorities. I am especially grateful to A. Chowdhury (ANZ Grindlays Bank),K. A. Chaukar (ICICI), G. R. Ramakrishna (SEBI), R. Ravimohan (OTC), and R. Vishwanathan (SBICapital Markets Ltd) for their detailed input. I also thank the seminar participants at the Center for Economic Research, Tilburg University, Holland, Indian Statistical Institute (New Delhi), Delhi School of Economics, National Institute of Public Finance and Policy (New Delhi), Indian Institute of Management(Calcutta), the World Bank, the Econometric Society annual meetings, UC-Berkeley, and UC-Santa Cruzfor their comments on earlier versions of this paper. None of them are responsible for any of the viewsexpressed in this paper.


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Capital Raising under Securities Board of India Guidelines:

An Economic Examination of Capital Market Reforms in an Emerging Market

I. Introduction The Securities and Exchange Board of India (SEBI), established as an

administrative body in April, 1988, became a statutory body in January, 1992. The

transformation was formalized by an act of the Indian parliament in April, 1992. The act

charged the SEBI, the first national regulatory body in India with comprehensive

statutory powers over practically all aspects of capital market operations "to protect the

interests of the investors and to promote the development of, and to regulate, the

securities markets by such measures as it thinks fit" 1.

To see the significance of the above charges, one has to take note of two major

developments in Indian capital markets in recent years, one on the side of supply and the

other on the side of demand. The last decade has witnessed a tremendous growth in the

markets, aided in more recent years by the new economic policy of liberalization

introduced by the Indian government. On the other hand, the same economic policy,

incorporating gradual introduction of free market principles, has created an

unprecedented demand for private risk capital in industry and commerce. Traditionally,

the Indian corporate sector has relied excessively on certain special financial institutions

owned and/or controlled by the government for its long-term capital needs. While the

institutions, which include Industrial Development Bank of India (IDBI), Industrial

Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of

India (ICICI), and a number of other national and state-level agencies, often providedfunds to the private sector corporations on concessional terms, in their turn the

institutions themselves received considerable concessional finance from the central bank

1 The Securities and Exchange Board of India Act, 1992, Chapter IV.


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in the country, the Reserve Bank of India 2. To break this circle of subsidized financing,

the new economic policy encourages the corporations to raise resources increasingly

from private investors 3. In this context, the promotion and development of the capital

markets as well as facilitation of public participation in those markets by ensuring orderlydisclosure of information about the borrowing corporations and other forms of investor

protection were naturally recognized as two very important goals for the national

regulatory body.

In this study, we examine the economic and financial implications of some of

the regulations introduced by the SEBI, through the guidelines it has periodically issued,

in execution of its responsibilities. The regulations in question apply to investment or

merchant banking services required for corporate issues of long-term securities in India.

It has been suggested in the financial press that the SEBI guidelines are in the process of

making the current investment banking scenario in India fundamentally different from the

past. In our analysis, we are concerned with determining whether the changes being

effected by the regulations are consistent with the twin goals of capital market

development and investor protection. We also consider the further question whether

alternative measures, which would achieve the same objectives in an economically more

efficient way, could be recommended (given, of course, a precise notion of economic

efficiency appropriate for the present case).

We proceed as follows. In section II of this paper, we place the subject of the

present study in its context and discuss certain institutional features of merchant banking

relating to issues of long-term corporate securities. In the process, we draw attention to

2 The annual survey of capital markets in India, undertaken by the Reserve Bank of India and published inits annual report, provides aggregative data on the subject.

3 A very recent articulation of this goal is found in the Pre-budget Economic Survey, presented to theIndian parliament in February, 1993, by the Ministry of Finance of the Indian government, whichrecommends, among other things that "the corporate sector will have to be encouraged to raise resourcesincreasingly from the market".


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some merchant banking practices which differ between the USA and India. In section

III, we present a model of the choice of merchant banking services by issuing

corporations. The model recognizes the fact that the new issues markets are typically

prone, perhaps more so in developing capital markets such as in India, to problems of asymmetric information between the issuing corporations and the investing public. As a

result, the process of certification of prospective issues by merchant bankers, an aspect of

merchant banking which in actual practice is very important for the regulatory

authorities, plays a central role in the model. We postulate, realistically, a generally

efficient but imperfect certification process. In this process, a high quality issue may not

always secure a positive evaluation or, for that matter, a low quality issue may not always

obtain a negative evaluation; however, the evaluation of a high quality issue is more

likely to be positive than the evaluation of a low quality issue. As a model of quality

certification, the model may be of independent interest to economists, and is related to

the works of De and Nabar (1991a; 1992). In section IV, we examine the implications of

the SEBI guidelines in question in terms of the results of the model. We find that some

possible implications of the guidelines may be in conflict with the professed objective of

the current economic policy of the Indian government to induce the corporate sector to

raise external funds from private investors. More seriously, we find that the guidelines

may be self-defeating in the sense that they may result in less , rather than more,

information for the investing public about the typically unobservable quality of a new

issue. In section V, we present our recommendations and conclusions.

Our analysis indicates that certain SEBI regulations, such as mandatory

certification for rights issues and mandatory full underwriting for public issues, are either dysfunctional or superfluous and should be repealed. In their place, we recommend

reliance on certain specific market mechanisms. We must state that our recommendations

do not stem from the position that government interventions are in general inferior to

market forces in achieving most economic objectives but because, in the present case, the


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SEBI's objective of improving disclosure of private information and investor protection

can be achieved in a more economically efficient way through the suggested market

mechanisms. Our rationale is pure economic efficiency. To make our case, it has not been

necessary for us to appeal to any of the well-known economic and extra-economicarguments which may be invoked against government interventions in general 4.

However, our reasoning as well as our conclusions may very well extend to similar cases

of government intervention in India and elsewhere.

Several aspects of the study merit attention. The efficacy of government

interventions has been studied extensively, in general terms as well as in the specific

context of the historical experience of various countries, in certain other spheres, most

notably in foreign trade but, to the best of our knowledge, not in capital markets under

asymmetric information. It is hoped that in this respect the present study will add useful

insights to the ongoing debate between government interventionists and proponents of

market forces. We hope, further, that the study has useful observations to offer on the

development and promotion of capital markets in India and in other countries similarly

situated. In particular, we make the observation that promotion of capital market

efficiency and enhancement of investor protection are often, fortunately for us,

compatible and not conflicting goals. This is surely the case when capital market

efficiency consists in reduction of asymmetric information between the issuing

corporations and the investing public. Usually, the latter are better protected as they are

more informed. This insight plays a major role in our recommendations.

The regulations under study, themselves new, are part of a package which is

currently evolving in India. We hope that the present analysis of their probableimplications will be of some value to the regulatory authorities in India in determining

the future direction of their reform agenda. We hope, further, that, in a broader context,

4 Krueger (1990) provides a lucid survey of the major arguments.


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the study will be of interest to scholars studying economics of regulations in developing

markets.

II. Merchant banking services and different offering methods

In raising capital with long-term securities, public corporations have the choice of

broadly three methods of offering them for sale : public issues, rights issues, and private

placements. In the first method, which has been by far the most important mode of

raising long-term capital in the USA and more important than the other two methods also

in India until very recently 5, the management of the issuing corporation offer the new

issue to the investing public in general. The process involved is usually elaborate and

often complex. As a result, the issuing corporation hires one or more merchant banking

companies to manage the issue process, including origination, marketing, and distribution

of the issue.

A very important part of the issue origination process is the investigation and

certification of the new issue provided by the merchant banker (usually by the lead

merchant banker in case more than one banker are involved in the issue ). Typically, the

merchant banker is required to verify the content of the issue prospectus released by the

issuing corporation and to exercise 'due diligence' in the process. In US courts of law,

due diligence has been interpreted as the kind of diligence which a reasonable person will

bring to bear on his personal financial matters. Normally, the regulatory authorities

require the merchant banker to furnish a due diligence certificate before they grant their

approval to the issue. In India, provision of this certificate in a prescribed format by lead

5 82% of all equity offerings by existing companies in the USA during the period 1963-81 were publicissues, the other 18% being rights issues (Eckbo and Masulis, 1989). Further, fully two-thirds of the rightsissues had a "stand-by" underwriting arrangement whereby they could be sold to the public at large if theywere not taken up by the existing shareholders. Corresponding data for India is available only for morerecent years; see section IV below.


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merchant bankers for an issue is mandatory under the new guidelines for merchant

banking activities 6.

Even when no explicit certificate is either required or furnished, the certification

implicit in an offering managed by an investment banker may be important. The qualityof the new issue, which is often not evident to the investing public, may appear to be

certified or vetted by the merchant banker concerned who is perceived to back it with his

reputation. The quality certification aspect of the investment banking process has been

noted in general terms as well as in the context of US capital markets (see Baron, 1982;

Beatty and Ritter, 1986; Booth and Smith, 1986; De and Nabar, 1991b and 1992; Hansen,

1986; and Rock, 1986).

In trying to market the new issue, the merchant banker performs a number of

different functions, including selection of advertisements, bankers, collection centers, and

brokers. None of them, however, compares in importance with the task of securing

underwriting arrangements for the issue. Under a typical underwriting arrangement in

India, the underwriter (or a consortium of underwriters if the issue is sizable, which may

include, in addition to the merchant bankers themselves 7, public financial institutions and

approved commercial banks, insurance companies, and stockbrokers) undertakes to

accept a specified number of shares in the event the public do not subscribe to them. The

number of shares, thus underwritten, constitutes his accepted devolvement 8 .

6 See section 4(g) of the Guidelines for Merchant Bankers, dated April 9, 1990, issued by the Ministry of Finance and subsequent notifications on the subject by the SEBI. See also our discussion in section IV

below.7 To ensure a direct stake in the issue under their management, the lead merchant bankers are requiredunder the new guidelines to accept a minimum of 5% underwriting obligation in the issue (see theGuidelines for Merchant Bankers, section 4(h), dated April 1, 1990, issued by the Ministry of Finance),subject to a ceiling. The SEBI has subsequently decreed (vide notification no. F8/III/MB/92-SEBI, dated 2.1. 92) that the outstanding commitments of any individual merchant banker should not exceed five timeshis net worth at any point in time.8 This mode of underwriting is comparable to what is known in the USA as "stand-by underwriting", inthe sense that the underwriter stands by to see if the public will subscribe to the shares in the first place. Interms of the underwriter's liability, this particular arrangement stands somewhere between a "firmcommitment underwriting" arrangement and a "best efforts" arrangement. As its name implies, under afirm commitment underwriting arrangement the underwriter provides an explicit guarantee, a firmcommitment, that the issue will be marketed. The underwriter actually purchases the new issue from theissuing corporation at an agreed upon price and then offers it for sale to the investing public on his own


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Typically, the responsibilities of the merchant banker extend to the distribution of

the new issue. In India, the distribution-related responsibilities of the merchant banker,

including allotment of securities to the investors and timely refunds, have been

formalized and incorporated in the new guidelines for merchant bankers. The guidelinesclearly state that "the involvement of merchant bankers in an issue should continue at

least until the completion of the essential steps' 9. In all, the responsibilities of merchant

bankers under the new guidelines in force in India extend all the way from verification of

material facts disclosed in the prospectus for the new issue under their management to

the completion of all issue formalities, including timely dispatch of securities and

refunds.

Under the second method of issuing long-term securities, namely a rights issue,

the corporation offers the new common stock directly to its current shareholders. To start

with, each shareholders is given a "right" to subscribe to a pro rata amount of the new

offering at a fixed subscription price over a specified, usually short, subscription period.

The shareholder has the option to exercise his subscription rights himself or sell the

rights to others 10.

account. The spread between the price paid to the corporation and the offering price to the publicconstitutes the bulk of his compensation. On the other hand, under a 'best efforts' arrangement, aninvestment bank, without guaranteeing any results, undertakes to sell as many of the new shares as possibleat an agreed-upon price. It should be noted that neither of the above two underwriting arrangements are

prevalent in India By contrast, however, firm commitment underwriting is by far the most popular mode of public issues in the USA, accounting for as much as 82% of all public issues and 88% of all underwrittenissues. Best efforts arrangements are, on the other hand, used exclusively to market initial public offeringsof small companies.

9 See sections 4(i) and 4(j) of the Guidelines for Merchant Bankers, dated April 9, 1990, issued by theMinistry of Finance of the Indian government.

10 As its name implies, a rights issue with a stand-by underwriting arrangement, is a cross between the twomethods. Like the rights method, this method offers privileged subscription rights to the currentshareholders. However, under this arrangement an underwriting syndicate is hired to "stand by" during thesubscription period and to "take up" all unsubscribed shares at the end of this period at the subscription

price. Typically, the compensation of the syndicate consists of two distinct elements : an initial stand-byfee and a take-up fee proportional to the number of shares taken up and resold.


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How do the two methods, public issue and rights issue, compare with each other ?

The two relevant criteria in this connection are, as in any subject of this nature, relative

benefits and costs of the two methods. On the side of benefits, a public issue carries with

it the merchant banker's certification. On the other hand, a rights issue, being solddirectly to the existing shareholders of the corporation, does not require management by a

merchant banker, in which case it is not screened for quality either (though in India the

SEBI has made management by a lead merchant banker mandatory for a rights issue

exceeding a certain size; more on this point in section IV of this article below). However,

there are costs to merchant banking services, and they can be significant. In India, the

existing government regulations permit total merchant banking fees for an issue to go up

to 0.5% of the first Rupees (Rs.) 250 million of the issue proceeds and to 0.2% of any

additional amount.

A significant benefit to be considered in this connection is the degree of

effectiveness with which either method ensures that the issue is successful in raising the

target amount of capital. A public issue with full underwriting, of course, carries a

guarantee of total success. This guarantee is absolute unless the underwriters for the

issue default on their accepted commitments. However, the underwriters provide this

guarantee for a usually substantial commission. In India, under the current government

regulations the ceiling rate for underwriting commission is 2.5% of the underwriter's

commitments. This amount, comparable to an insurance premium, is payable regardless

of the number of shares eventually taken up by the underwriter. In addition, brokers to

the issue selected by the lead merchant banker can charge up to 1.5% of the value of the

equity sold through them. However, since some shares of the new issue may be directlysold by the issuing corporation, the total brokerage costs of the issue may be less than

1.5% of the issue proceeds.

By contrast, however, the rights method can be equally reliable and, at the same

time, would not normally require any underwriting or brokerage costs. To see this point,


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let us note that the benefit to the current shareholders of the issuing company from

holding the rights is the differential between the ex-rights price, that is the market price

per share after the rights are issued, and the subscription price of each new share. This

benefit is positive as long as the ex-rights price exceeds the subscription price. Therefore, by setting the subscription price sufficiently low, this benefit can be made virtually

certain, inducing the current shareholders to exercise their rights and take up the new

issue. Equivalently, if a shareholder does not exercise his rights, or does not sell his

rights to another shareholder who will exercise the rights, his wealth is reduced by the

market value of the rights. By making this cost appropriately high through a sufficiently

low subscription price, the probability of the failure of a rights issue can be made

arbitrarily small . Though there are a larger number of shares outstanding after the

issue, for any shareholder who exercises the rights the pro-rata ownership of the

corporation remains the same as before. There is no economic basis to suppose that the

stock-split effect of a rights offering by itself can cause valuation losses and no empirical

evidence to indicate that investors generally consider stock splits as bad news. Further, if

the entire new issue, for whatever reason, is not subscribed, a stand-by underwriter can

be contracted to take up the remaining shares at the end of the subscription period.

Though this will require some cost, the resulting cost will be considerably less than the

underwriting cost for the full issue.

A new issue involves a number of other, usually smaller, expenses required for

advertising, printing and mailing of issue prospectuses and share application forms,

registration of shares, listing of the issue with an exchange, and printing and mailing of

share certificates and refund orders. Normally, these expenses are also considerablyhigher for a public issue than for a rights issue. According to the informal estimates

supplied by the ICICI, one of the leading merchant banking houses in India, the other

expenses may add up to 3.5% of the issue proceeds for a public issue of equity of Rs. 500


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million and above. The corresponding figure for a rights issue of the same size is less

definite but appears to be around 1.5% 11 .

On balance, if a corporation has the choice of raising a certain amount of long-

term capital through either a public issue or a rights issue of long-term securities, the public issue method will have the advantage of certification but, at the same time, entail

appreciably higher costs. Since the 'self-insurance' of the success of a rights issue is

virtually costless, the difference in issue costs of a rights offering and a public offering

of the same size and same certainty of issue success can be substantial. For example, for

a Rs. 500 million offering of new equity in India, the cost differential can be as high as

6.6% of the issue proceeds if the rights offering is not managed by a merchant banker

(as they are not elsewhere), 0.6% going toward merchant banking fees, 2.5% toward

underwriting commission, 1.5% toward brokerage fees, and around 2% being accounted

for by the other expenses. Documented evidence indicates that this differential is

substantial, though somewhat lower, also in the US capital markets 12.

Conceivably, the differential between the actual total costs of the two issue

methods is even larger. There are implicit or indirect costs associated with each method

which are, by their very nature, less amenable to precise quantification. Even so, it

would appear that they are, like direct costs, appreciably higher in the case of public

issues. Although no systematic study on the subject has been undertaken in India, the

existing studies in the USA have identified principally two types of indirect costs

associated with offerings of long-term securities : underpricing and negative reaction in

the secondary market. Underpricing occurs when the offer price for the new issue is set

11 We are grateful to Mr. M. K. Jajoo of the ICICI, Calcutta, for sharing this information with us.

12 In the most comprehensive empirical study on the subject, Eckbo and Masulis (1989) found that theratio of total direct costs to gross proceeds was 6.8% in the case of underwritten public offerings, 4.27%in the case of rights offerings with stand-by underwriting based on the observed average take-up of 5% of the issue by the underwriter, and 1.68% in the case of pure rights offerings. For public utilities, the ratioswere 4.36%, 2.51%, and 0.6% respectively. Other studies have also noted significantly higher direct costsin underwritten offerings.


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below its true price or the price the market can bear. No matter why underpricing takes

place 13, underpricing cost adds to the direct floatation costs noted above. Measuring the

extent of underpricing by the level of the offer price relative to the closing price on the

day immediately following the offering, various studies have found that, on an average,underwritten issues of industrial corporations in the USA are underpriced and that the

magnitude of underpricing is statistically significant (Eckbo and Masulis, 1989; Smith

1977). Underpricing, however, is not an issue in the case of rights offerings as long as

the rights are exercised, there being no change in the pro-rata ownership of the

corporation for the current shareholders. In fact, as we have discussed above, for a

rights issue to be successful the offer or subscription price must be set lower than the ex-

rights price.

The other component of indirect costs, namely observed decline in the price of a

corporation's outstanding stock in the secondary market consequent to the announcement

of a new offering, can be very sizable. The studies on the subject in the USA have found

that negative secondary market reaction to offerings of new equity by existing

corporations is pervasive regardless of the offering method employed 14. However, the

negative market reaction has been found to be considerably more pronounced in the case

of public offerings (Asquith and Mullins, 1986; Masulis and Korwar, 1986; Eckbo and

Masulis, 1989). Since the price decline is spread over all existing shares, the cost

implications of an adverse market reaction can be huge. A 3% percent decline

attributable to the announcement of the new offering, which is the observed average

decline for underwritten offerings by industrial corporations, translates into a loss to the

existing shareholders to the extent of 30% of the gross proceeds if the size of the newissue is about a tenth the size of the outstanding equity .

13 Among other reasons, it has been suggested in the literature that the underwriting syndicate resorts tounderpricing in order to favor preferred customers and to be able to market the issue with certainty.

14 Smith (1986) surveys the hypotheses advanced to explain the observed negative market reaction.


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Although no systematic empirical study on the magnitude of either of the two

types of indirect costs of new issues in India exists, there have been enough reports in

the financial press, and many expressions of concern by the regulatory authorities, to

suggest that underpricing is a persistent phenomenon. In fact, prior to the SEBI regime,the prescribed system of determining the price of new issues of equity was designed to

make it significantly downward biased relative to actual market value 15. The SEBI

guidelines currently in force permit, within certain restrictions applicable largely to first

public issues of new or existing private and closely held companies, "free pricing"

whereby the issuing company is empowered to decide on the issue price in consultation

with the lead merchant banker 16. The extent of underpricing under the new policy will

probably go down and gravitate towards the level observed in other countries.

III. A model of choice of offering methods when only public offerings are certified

In this section we present a general model of the choice of offering methods faced

by the issuing corporation. The model is built on the premise that a public issue is

managed by a merchant banker. It is, therefore, subjected to the certification process of

the merchant banker and backed by underwriting. A rights issue, on the other hand, has

neither of the two features. As we have stated above, this corresponds to the typical

scenario in most capital markets.

The model recognizes that markets for new issues are likely to have serious

Akerlovian information asymmetry problems. It is in the nature of these markets that the

issuers will know more about the quality of their issues than the outside investors. If

15 Under this system, the Controller of Capital Issues used to arrive at the "fair value" of a new issue of equity on the basis of "net asset value" (NAV), "price earnings capitalization value" (PECV), and marketvalue of the issue. If the average of NAV and PECV, capitalized at a specified rate, fell short of marketvalue by less than 20%, the average was regarded as a fair value. In other words, as much as 20%undervaluation was considered acceptable. Since revaluation of fixed assets was not ordinarily permittedfor NAV computation, the average was usually an underestimate of the true value.

16 See SEBI guidelines for disclosure and investor protection vide GL/IP No. 1/SEBI/PMD 92-93, dated11. 6. 92, and the subsequent clarifications issued by the SEBI.


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anything, this problem is likely to be appreciably more acute in developing capital

markets, such as in India, than in their counterparts in the USA and other western

economies. It makes sense to argue that in such markets the issuers will choose the

offering method, out of the several available, which will be the best for them given their private information.

1. Basic structure

We consider an economy with n firms. Each firm in this economy has a new project.

Project identification and selection by firms is extraneous to the subject of this paper. The

projects require an investment of K dollars each but differ from each other in terms of the

expected value, E, of their cash flows. Since project cost, K, is the same for all projects, E

unambiguously determines their quality level. For the sake of simplicity, let us assume that there

are only two quality levels associated with the projects, indexed by t (for type), t {1,2} = T,

where 1 indicates the better of the two types. Therefore, E 1 > E 2. It is common knowledge that

even a type 2 project has a non-negative NPV; E 1 > E 2 K. Since no project should have a

market value lower than E 2 in spite of uncertainty about project quality, any project is financially

viable in the absence of issue costs. 17

All firms have some assets in place. The present value of the cash flows from these

assets in place, a, is the same for all firms and is, moreover, common knowledge. The sole

purpose of this restriction is to focus on the financing of the new projects. 18 We can now,

without ambiguity, characterize a firm as a type t firm if it undertakes a new project of type t.

2. Insiders and outsiders

All decisions in a firm are taken by its manager (insiders). We consider a scenario in

which the managers of all firms in the economy have decided on equity financing for their

projects. They, however, need to decide on the method of equity financing. A crucial factor in

17 This restriction is imposed in order to determine the conditions under which public offerings, which are costlier, aremade in preference to rights offerings even though rights offerings, if made, would be accepted with certainty.

18 As long as a is common knowledge, all results in this paper hold even if the value of a differs across firms. Wemake this assumption to simplify algebraic exposition.


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this decision process is the manager's inside knowledge of the project. Specifically, the manager

knows the true type of his project. In other words, he knows E t. All other agents in the economy,

including the current shareholders and outside investors, know only that proportion of the firms

(or, equivalently, projects) are of type 1 and (1- ) proportion are of type 2.

The manager's decision to opt for rights (R) issue or public (P) issue sends a message

denoted by m, m {P,R} = M, to the other agents in the economy. It could be supposed that the

manager has another choice too, namely not to proceed with the project. However, as we shall

see below, it is never optimal for the manager to exercise this option.

On the other side of the market, in the event of a rights issue the current shareholders

respond to the firm's message by either exercising (E) their rights or not exercising (NE). They,

therefore, draw their response, r, from the set r R = {E, NE}. In the case of a public offering, the

response of the market participants, possibly consisting of current shareholders as well as other

investors, is either Z, the fraction of the firm's total equity that they would need in exchange for K

dollars, or NA, implying non-acceptance of the proposal. Therefore, the market's response, r, in

the case of a public issue is drawn from the set r P = {Z, NA; 0 Z 1}. Note that, though (E t - k)

is hypothesized to be non-negative, it does not follow that, net of issue costs, it is still non-

negative. As a result, NA is a feasible market response to public offerings. In the event of a

rights issue (m = R) if the current shareholders respond with r = NE, or in the event of a public

issue (m = P) if the market responds with r = NA, the issue fails and the project is dropped. In

either event, the market value of the firm remains a.

We shall verify later that no firm in our setting will find it optimal to revise its message

after the initial announcement, ensuring subgame-perfection.

3. Merchant banker's roleIn the manner described in section II above, the merchant banker conducts research to

evaluate each project submitted to him. For a given project, the findings, f, are either high (H) or

low (L). Thus, f {H, L} = F. The probability of high findings differs according to project type

in the following manner :


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Prob [H|t=1] = q 1; Prob [ H|t=2] = q 2.

To capture realistically the efficiency of the merchant banker in project evaluation, we

make the following assumption :

A1: 1 q1 > q2 0 (but not q 1 = 1 and q 2 = 0)

The assumption implies that the evaluation process is generally efficient in that the

banker is more likely to come up with high findings if the firm is type 1 rather than type 2.

However, the process is not perfect. As a result, a type 1 firm may not always obtain a high

classification or a type 2 firm may not always obtain a low classification. This assumption

precludes the two extreme cases: q 1 = 1 and q 2 = 0 (perfect efficiency) and q 1 = q 2 (total ineffi-

ciency). Note that if q 1 were less than q 2, and if this fact were known to the market participants,

they would simply treat L as a favorable finding and H as an unfavorable finding. We assume

that they are aware of the information processing efficiency of the merchant banker including, in

particular, values of q 1 and q 2.

For the purpose of this paper, we shall, without ambiguity, let K represent the

differential between the costs of public method and rights method of issuing K dollars of new

equity, where 0 <


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vL = v(P, r P, L). Let V denote the market value of a project of type t at the start of the game.

Then, if the firm opts for a public issue, V = V(t, P, r P) = q tvH + (1-q t)vL, indicating that it can

draw an H finding with probability q t and an L finding with probability (1-q t). On the other

hand, if it opts for a rights offering, V = V(R,r R ), representing the expected value of the project

based on market posteriors upon observing the rights offering.

The manager's compensation, W, in this model consists of fixed wages, a 0, plus a

fraction, a 1, of the outstanding equity of the firm. Without loss of generality we take a 0 = 0.

Then,

a1[qt(1-Z H)(vH -k) + (1-q t)(1-Z L)(vL- K) + a] if m = P, r P = Z

W = a 1[V(R, r R ) + a - K] if m = R, r R = E (2)

a1a otherwise

Recall that K represents the differential between the flotation costs of the two methods and Z f is

the fraction of the total equity of the firm that the outside investors demand in exchange for K

dollars, given the banker's finding f {H, L} 19.

The manager will choose m so as to maximize (2). However, note that

a1[V(R,r R ) + a - K] a1a. In other words, the third option in equation (2) above, namely not to

accept the new project, is always dominated by the second. This is because, even in the event the

project is accorded the least favorable valuation by the market, V(R,r R ) +a - K = E 2 + a - K a,

since E 2 K. As a result, the manager will be effectively concerned with the choice between P

and R only.

The current shareholders' payoff, S, is as follows:

(1-a 1)[qt(1 - Z H)(vH - K)+(1-q t)(1- Z L)(vL - K) + a] if m = P, r P= ZS = (3)

(1-a 1)[V(R, r R ) +a - K] if m = R, r R = E

19 At the beginning of the game, the value of the firm as seen by the manger will be different from the value investorswill be willing to pay. Institutional restrictions on insider trading, however, will prevent the manager from utilizing hisinformational advantage for securing personal gains.


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Since the manager receives a 1 fraction of the existing equity, the current shareholders

receive (1-a 1) fraction. Note that the current shareholders' payoff is proportional to the manager's

payoff. This feature enables us to abstract from possible shareholder-manager conflicts and

related costs which may result in the rejection of a rights offering, and to determine the conditions

under which costlier public offerings are made in preference to rights offerings.

The payoff to the investors other than the current shareholders, Y, is:

Zf [vf - K] if m = P, r P = Z, f {H, L}Y = (4)

0 otherwise

Note that the other investors do not participate in rights offerings. Also, since their response is

conditional on the banker's findings, their payoff depends on f.

If capital markets are competitive, the outside investors require that

Zf [vf - K] = K. 20 (5)

Using condition (5) and the definition of V(t, P, r P) from above, for expositional

convenience equations (2) and (3) above can be rewritten as equations (2') and (3') below: 21

20 An alternative formulation of equation (5) would be: Zf [v

f ] = K + K, implying that firms raise not only the project

cost, K, but also the public issue costs, K, from outside investors. Note that, as a result, this formulation wouldrequire deletion of K from equations (2), (3), and (4). However, as long as the outsiders recover their investments,this reformulation leaves the payoff to the current shareholders and the manager, and consequently all our results,unaffected. We prefer the present formulation because, in our view, certification costs, which are included in publicissue costs, are comparable to signaling costs and should, therefore, come from the insiders.21 The expected value of a firm is the expected value of its new project plus the value of its current operations. For afirm that decides to finance its project with a public offering, its expected market value at the point in time it decideson the offering and before the merchant banker's findings are obtained is V(t,P,r P)+a-K = q tvH+(1-q t)vL+ a-K.Since the outside shareholders break even, they receive K dollars. The share of the current shareholders plus themanager is, therefore, q tvH+(1-q t)vL+a-K-K = V(t,P,r P)+a-K-K. As a handy reference, for a firm with a project of

type t if it opts for P, the following will hold:

(1) (2) (3)expected value of projectnet of public issue costs

expected value of firm expected payoff to newshareholders

qtvH + (1-q t)vL- K q tvH + (1-q t)vL+ a - K K

(4) (5) (6)expected payoff to the

manager plus the currentshareholders

expected payoff to themanager

expected payoff to thecurrent shareholders

qtvH+(1-q t)vL+a-K-K a 1[qtvH+(1-q t)vL+a- K -K] (1-a 1)[qtvH+(1-q t)vL+a- K -K]


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a1[V(t,P, r P) + a - K - K] if m = P, r P = ZW = a 1[V(R,r R ) + a - K] if m = R, r R = E

(1-a1

)[V(t,P,r P

) + a - K - K] if m = P, r P

= ZS = (3')

(1-a 1)[V(R,r R ) + a - K] if m = R, r R = E

Though the foregoing discussion has been in terms of pure strategies, P or R, sub-

sequent analysis of the game allows for mixed strategies as well. We denote by t the probability

with which firms of type t send the message m = P. Though a formal definition of a mixed

strategy can be given, intuitively t can be seen as the proportion of type t firms that choose

public offerings and (1- t) as the proportion that choose rights offerings.

5. Nash sequential equilibrium

A Nash sequential equilibrium (NSE), due to Kreps and Wilson [1982], in the game described

above is an ordered triple ( t, r *,) satisfying the following conditions:

C1: t argmax {W[V(t, t,r)]}, t [0,1], t T

C2(a): r * argmax {Y[Z f ]}, r r P if m = P

subject to: Z f [vf - K] = K, f {H,L}

(b): r * argmax {S[V(m,r)]}, r r R if m = R

C3: If P is an equilibrium action market posterior belief, (t|f; 1,2), conditioned on the

equilibrium strategies 1 and 2as well as on the merchant banker's findings f , or if

R is an equilibrium action market posterior belief, (t|1,2), conditioned on 1 and

2, are determined by Bayes rule. If, on the other hand, P or R is an off-equilibrium

action, then (t|U), (t|R) [0,1].

6. Equilibrium results when only public offerings are certified

If firms of each type, 1 or 2, can choose either P or R or randomize between the two strategies,

there are nine type-strategy combinations that are candidates for an equilibrium outcome. In


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Table 1 below, our findings for each type-strategy combination are summarized in the cor-

responding cell. In each case, the results are obtained in the context of the scenario described

above where public issues are screened for quality , but the rights issues are not.

Table 1

Equilibrium results when public offerings are certified but rights offerings are not

Strategies Type 1 chooses P : 1 = 1 Type 1 chooses R : 1 = 0 Type 1 chooses a mixedstrategy : 1 < 1 < 1

Type 2 chooses P :2 = 1

(1)

NSE exists for 'low' cost

differential K only

(4)

No NSE

(7)

No NSE

Type 2 chooses R :2 = 0

(2)

No NSE

(5)

NSE given certain off -

equilibrium beliefs but not

robust to Divinity criterion

(8)

No NSE

Type 2 chooses amixed strategy :0 < 2 < 1

(3)

NSE exists for 'higher'cost differential K

(6)

No NSE

(9)

No NSE

We discuss the intuition underlying the results and present the proof of the main equilibrium

results below. The formal proofs of the other results are omitted.

The main findings of this study are that in equilibrium 1= 1 and 0 < 2 1, representing

boxes 1 and 3 in Table 1 above. Since the probability of H findings are higher for a type 1 firm than

for a type 2 firm, given q 1 > q2, a type 1 firm at the beginning of the capital raising game expects a

higher outcome from public offering than a type 2 firm. Both firms, on the other hand, expect the

same outcome from rights offering since this offering method does not involve any screening. If,


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therefore, type 2 firms expect the same outcome from the two offering methods, inducing them to

randomize between the two strategies, type 1 firms will strictly prefer the public method with its

higher expected outcome. Of course, if type 2 firms prefer public offering to rights offering, it

follows that type 1 firms will prefer it even more so. This explains the preference of a type 1 firm for

public issues. As for a type 2 firm, since the screening process associated with public offering is

noisy, it would like to opt for this method with a view to benefiting from the noise and possible mis-

classification. However, as more and more type 2 firms choose public issues, the expected outcome

for any type 2 firm from this method will be diluted. If the cost differential between the two methods

is sufficiently low, its expected outcome from public offering with noisy certification may still exceed

its expected outcome from rights offering, which in this case is E 2 or the true value of its project

(since type 1 firms do not make rights offerings, any firm making a rights offering is viewed as a type

2 firm and its issue valued accordingly). This results in the equilibrium strategy combination ( 1=

2= 1).

If the cost differential is higher, the expected outcome for a type 2 firm from underwriting

may be no higher than E 2, making it indifferent, and consequently randomize, between the two

strategies at the margin. This results in the equilibrium strategy combination ( 1= 1, 0< 2


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unfounded outcome where no firm opts for a public offering. If this possibility is excluded, the two

possible equilibrium outcomes in our model, given 1 q1 > q 2 0 (but not q 1=1, q 2= 0) , are (1) a

differentiated pooling (DP) equilibrium where all firms opt for public offering if the cost differential is

below a certain level; and (2) a differentiated semi-separating (DSS) equilibrium, if the differential is

above that level but not too high. In the two equilibria, the public offering-pool is differentiated in the

sense that a type 1 firm, at the start of the game, has a higher expected outcome from public offering

than a type 2 firm, since q 1 > q2.

In the second equilibrium both actions, P and R, are observed. The first equilibrium is robust

to the strong Universal Divinity 22 refinement due to Banks and Sobel (1987) and, therefore, survives

weaker refinements such as Cho-Kreps Intuitive criterion.

In order to demonstrate the equilibrium results formally, the definitions and observations

discussed below are necessary.

In sub-section 4 above, v H and v L are defined as the market value of the project of the firm

conditional on the firm drawing H and L findings respectively. When 1 proportion of type 1 firms

and 2 proportion of type 2 firms opt for public offering, define v H(1,2) and v L(1,2) as the

corresponding project values. Risk-neutrality on the part of the capital market participants implies that

vH(1,2) = E 1( 1|H; 1,2) + E 2( 2|H; 1,2) and v L(1,2) =E 1( 1|L ; 1 ,2) + E 2( 2|L; 1,2).

Note that E 1 > vH(1,2) and v L(1,2) > E 2.

Observation 1 . For a given ( 1,2) pair except ( 1, 0) and (0, 2),

(i) v H(1,2) > v L(1,2), and

(ii) q 1vH(1,2) + (1-q 1)vL(1,2) > q 2vH (1,2) + (1 -q 2)vL(1,2) .

For ( 1,

0) and (0, 2

), the inequality signs in (i) and (ii) above are replaced with equality.

The observation follows from the fact that E 1 > E 2, q1 > q 2, and (1|H; 1,2) > (1|L; 1,2)

whereas (2|H; 1,2) < (2|L; 1,2) . 23 It implies that a given issue, regardless of type, will have a

22 Note that our model is somewhat different from the pure signaling game in Banks and Sobel (1987). The difference isthat there is a move by nature (findings being H or L) between message transmission by the informed party and the response

by the uninformed parties. However, we have ascertained that the Divinity refinement in Banks and Sobel extends to our analysis.


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higher expected value if the findings are high rather than low. Further, since a type 1 issue is more

likely to generate high findings than a type 2 issue, the type 1 issue will have a higher expected value

if both types are screened by the merchant banker. However, if only one type is screened , this of

course does not apply. Note that, since E 1 > v H and v L > E 2 from above, it follows that E 1 > v H> q 1vH+ (1-q 1)vL>

q2vH + (1-q 2)vL > v L > E 2 for a given ( 1, 2) pair.

Observation 2: For any type t,

(i) q tvH(1,2) + (1-q t)vL(1,2) < q tvH(1,2') + (1-q t)vL(1,2') where 2' < 2, and

(ii) q tvH(1,2) + (1-q t)vL(1,2) > q tvH(1',2) + (1-q t)vL(1',2) where 1' E 2,this observation is based on the fact that,when 2' < 2,

(1|H; 1,2) < (1|H; 1, 2')and (1|L; 1,2) < (1|L; 1,2')) . When 1' < 1, the inequalities

are reversed. 24 The intuition behind this observation is straightforward. If a type 2 issue leaves the

pool of public issues, then the expected value of both types of issues left in the pool increases because

the average quality in the pool increases. Exactly the opposite happens when a type 1 issue leaves.

Proposition I. If public offerings are certified but rights offerings are not, then

(1) for 0 , where q 2vH(1= 2= 1) + (1-q 2)vL(1= 2= 1) - E 2 = K, the DP equilibrium

(1*= 2*= 1) is an NSE and Universally Divine; and

(2) for > > , where E 1 - E2 = K, the DSS equilibrium ( 1= 1, 0 < 2< 1) is viable.

Proof (1) In the case of the DP equilibrium, R is an off-equilibrium strategy. Suppose (2|R) = 1.

Then, since q 1vH(1,2) + (1-q 1)vL(1,2) >> E 2 and q 2vH(1,2) + (1-q 2)vL(1,2) > >E 2 for any

(1,2) pair, (which follows from part (i) of observation 1 above that v H(1,2) > v L(1,2) > E 2),

there exists such that, for all 0 , q 1vH(1,2) + (1-q 1)vL(1,2) - K > E 2 and q 2vH(1,2)

+ (1-q 2)vL(1,2) - K > E 2. Then, for 0 , both types prefer P, making DP an NSE, where

23 To verify this, use q 1 > q 2 in the posterior probability functions.24 This is easily verified from posterior probability functions.


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is implicitly given by q 2vH(1=2=1) + (1-q 2)vL(1=2=1) - K = E 2. Furthermore, since

q1vH(1=2=1) + (1-q 1)vL(1=2=1) > q 2vH(1=2=1) + (1-q 2)vL(1=2=1) from observation 1,

there is a larger set of market responses which make defection from this equilibrium more attractive to

type 2 than to type 1 firms. 25 Hence, (2|R) = 1 is a reasonable belief by Universal Divinity criterion.

(2) Since q 1vH(1=2=1) + (1-q 1)vL(1=2=1) - K > q 2vH(1=2=1) + (1-q 2)vL(1=2=1) - K

= E 2, these exists > such that q 1vH(1=1, 2


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firm will have an incentive to deviate from the equilibrium strategy after observing the merchant

banker's evaluation, thus ensuring subgame-perfection.

7. Some characteristics of equilibrium results

In both equilibrium outcomes, type 1 and type 2 firms in the public issue pool expect

differentiatial outcomes which are related to their respective quality levels. Given q 1 > q 2, which is

what we should expect if the certification process associated with a public issue is efficient, type 1

firms expect more from a public issue than type 2 firms, as indicated by

q1vH(1,2) + (1-q 1)vL(1,2) > q 2vH(1,2) + (1 -q 2)vL(1,2) in observation 1 above. In this

sense, certification performs a valuable economic function though, if there is noise in the information

generated by the certification process, the resulting separation between different types of issues is not

perfect.

In this connection it is to be noted that the DSS equilibrium is informationally more efficient

than the DP equilibrium. In the DSS equilibrium type 2 firms are partially separated from type 1

firms in that any firm making a rights offering is correctly identified as a type 2 firm, while both types

of firms may make public offerings. By contrast, in the DP equilibrium there is no separation between

firm types at all; all firms make public offerings.

The DSS equilibrium is also more consistent with empirical evidence than the DP equilibrium.

The DSS equilibrium allows for the existence of both methods in equilibrium. In practice both

methods are employed to market new issues. In terms of our analysis in the preceding sub-section, it

would thus appear that, empirically, values are appropriate for the DSS equilibrium to obtain :

> > . Further, empirical evidence indicates that, instead of resorting to one equity offering

method all the time, some firms appear to alternate between rights and public offerings. This evidenceis consistent with randomizing behavior of type 2 firms implied by the DSS equilibrium.


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8. Other equilibrium candidates

It is easy to see that the two separating equilibrium candidates ( 1=1, 2=0) and ( 1=0, 2=1)

do not satisfy NSE conditions. The cost differential is fixed, and there are no other dissipative costs,

type-related or otherwise, in this model. Thus, non-mimicry, an essential prerequisite for separation,

cannot be guaranteed, ruling out boxes 2 and 4 in Table 1 above. The R-pooling equilibrium

(1=2=0) satisfies NSE conditions given certain off-equilibrium market beliefs. Those beliefs,

however, do not survive the Divinity criterion. Intuitively, a type 1 project has a higher probability

than a type 2 project of being classified as a high quality project through screening associated with the

public issue process. Therefore, as long as the expected outcome for a type 1 firm, net of the cost

differential, is greater from public than from rights offering, it will have a stronger incentive to defect

from the pool than a type 2 firm. If, as a result, the outsiders associate the off-equilibrium message (P)

with a type 1 firm, the equilibrium breaks down, ruling out box 5 in Table 1 above.

It can be shown that, regardless of the strategy employed by a type 2 firm, that is whether

(i) 2=1, or (ii) 2=0, or (iii) 0< 2


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IV. Implications of SEBI guidelines

We now consider the implications of certain SEBI guidelines for the two

offering methods in the light of our results above.

In terms of the guidelines for merchant bankers issued by the Government of India, Ministry of Finance, in 1990 26, all issues should be managed by at least one

authorized merchant banker functioning as a sole manager or the lead manager.

Subsequently, the SEBI has clarified that the guidelines cover public as well as rights

issues 27, though in the case of rights issues of smaller size, implying Rs. 5 million or less,

the issuing company will have the option to manage the issue itself or by a merchant

banker 28. Accordingly, for all public issues and for rights issues exceeding Rs. 5

million, management by an authorized merchant banker is mandatory. It may be noted

that the guidelines in effect cover all issues, since rights issues of smaller than Rs. 5

million are extremely rare. In fact, in the month of November 1992 , the last month for

which this information is available, the smallest rights issue was exactly Rs. 5 million,

while the average issue size was as large as Rs. 294.2 million 29.

Further, the SEBI has advised that in the case of rights issues managed by

merchant bankers, the lead banker should submit a due diligence certificate to the SEBI.

Combined, the two guidelines have made merchant banker certification mandatory for

effectively all rights issues in India. This is a marked departure from the regulations in

other countries where rights issues typically do not require such certification.

Undoubtedly, the SEBI guidelines in this respect are well-intentioned and were

introduced to enhance investor protection. However, on a closer inspection, they are

26 vide circular no F-1 (44) SE/86 Pt.III, dated 9. 4. 1990, section 4(e)

27 vide SEBI press release dated September 17, 1990.

28 vide SEBI press release no. F8 (101) MB/91, dated July 25, 1991.

29 Source : PRIME, a newsletter published by Praxis Consulting and Information Services PVT. LTD, New Delhi 110019.


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susceptible to problems of design as well as enforcement. In the usual setup where more

expensive public issues, managed by investment bankers, are certified for quality and the

less expensive rights issues are not, the issuing company, by its deliberate act of opting

for one or the other method, conveys valuable private information to the rest of themarket. As outlined in section III above, given all other things the same, a corporation

with a high quality issue will be more inclined to seek certification than a low quality

issue. However, since both public and rights issues require certification by merchant

bankers under the new SEBI guidelines, the only remaining difference of consequence

between the two offering methods is the fact that public issues need costly underwriting

for issue success while rights issues can virtually costlessly guarantee it. Separately, as

part of its guidelines for disclosure and investor protection, the SEBI has made full

underwriting mandatory for a public issue 30. Hence, between a public issue with full

underwriting and a rights issue of the same size, the differential in total issue costs will

include the cost of full underwriting as well as the other costs which, as we have seen in

section II above, are also appreciably higher for a public offering. Given all other things

the same, this is likely to result in a shift of corporate preference from more expensive

public issues to less expensive rights issues. One can think of two undesirable

consequences of this development.

First, while in a public offering the issuing corporation seeks to approach the

entire investing community, in a rights offering it focuses only on its current

shareholders. A shift from the former method to the latter will be a regressive step in

view of an important goal of the current financial sector reforms in India, namely to have

the corporate sector raise external funds increasingly from private investors and, in the process, achieve wider public participation in capital market activities. This goal, which

has been articulated many times by various government sources, is intended to reduce the

30 vide circular no. GL/IP No. 1/SEBI/PPMD 92-93, dated 11.6.1992.


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traditional dependence of the corporate sector in India on special financial institutions

owned and/or controlled by the government, including the IFCI, ICICI, IDBI, and other

national and state-level institutions, for the bulk of its long-term capital needs, often on

concessional terms. As we have noted in section I above, in the process the financialinstitutions have come to acquire considerable equity stakes in major Indian corporations.

A recent survey of institutional holdings in the financial press indicates that the special

financial institutions own between 35% and 66% of the equity in each of the twenty-five

largest private corporations in India 31. Under the circumstances, a rights offering by an

Indian corporation involves, in a large measure, going back to the same financial

institutions, and through them to the government, for more capital participation.

Another, and a potentially more serious, problem with this set of SEBI guidelines

is that there is a very real possibility that they will result in making the capital markets in

India informationally less , rather than more, efficient. In other words, their effect will be

precisely the opposite of what the regulatory authorities have clearly intended to

accomplish by mandating third-party certification of all offerings. In terms of our

framework which is premised on a generally efficient but imperfect certification process,

mandatory certification of all offerings implies that an issuing corporation of type t will

expect q tVH + (1-q t)VL - K from a public issue and q tVH + (1-q t)VL from a rights

issue. Clearly, any issuing firm will opt for the rights issue. A minor modification of

Proposition I in section III above indicates that the resulting equilibrium will be a DP

equilibrium where the differentiated pool will consist of all rights offerings 32. However,

as we have noted in section III above, a DP equilibrium is less informative than a DSS

equilibrium where both types of offerings are made. While the latter equilibrium allows

31 See "Corporate Dossier" in the Economic Times, June 19, 1992.

32 Following the logic in Proposition I above, it is easily shown that any firm deviating from thisequilibrium and making a public issue will be viewed as a type 2 firm. Since q tVH + (1-q t)VL strictlyexceeds E 2, no firm will opt for a public offering either as a pure strategy or in a mixed strategy.


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for partial separation between different types of issues in terms of quality, the former

equilibrium permits no differentiation at all. In this sense, the new situation is

informationally less favorable for the investors than the normal scenario where only

public offerings require certification, a feature which, coupled with a sufficiently highcost differential, results in a DSS equilibrium (see section III above).

The essence of the above observation can be restated as follows. Intuitively, a

rights offering with certification offers as much as a public offering with full

underwriting, but at a lower cost. As a result, the issuing corporations which would

previously opt for a public offering now decide in favor of a rights issue. To that extent,

there is no net change either in the total volume of certified offerings or in the

information generated for the investing public. However, the low quality issues which

previously would not go through the process of certification, the cost being too high in

relation to the possible gains from misclassification, and would be recognized as low

quality issues as a result, have now access to certification through a low-cost rights

offering. The certification process being imperfect, some of them will secure a higher

classification than they merit (note that, for them, there is no corresponding risk of an

erroneously lower classification than they deserve). To that extent, information available

to the potential investors will be vitiated.

We have argued above that the SEBI guidelines on merchant banking are

designed to induce a shift in corporate preference from public offering, which has

traditionally been the major method of raising long-term capital in India, to rights

offering and noted some undesirable implications of this development. There are

indications that, in a good measure, the shift has already taken place. Table 2 below presents evidence in support of this observation. In 1991-92, there was a sharp increase

in the share of rights offerings in the total volume of new capital issues, from a little over

a half to almost two-thirds. It may be noted that 1991-92 was the first financial year

following the SEBI directive, issued in September 1990, which explicitly made


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management and certification by a lead merchant banker mandatory for all rights

offerings. Preliminary evidence indicates that the share of rights offerings has gone up

even higher in 1992-93. This increase is especially significant in view of the fact that the

total volume of new capital issues has itself increased considerably in each of these twoyears. In its last annual survey of Indian capital markets, the central bank of India has

highlighted this development, but has not attempted an analysis of the underlying

reasons 33.

Table 2

New Capital Issues by Non-government Public Limited Companies in India

April, 1989- March,

1990*

April, 1990 - March,

1991*

April, 1991 - March,

1992*

March. 1992 -

February, 1993**

No. Volume %

(Rs. billion)

No. Volume %

(Rs. billion)

No. Volume %

(Rs. billion)

No. Volume %

(Rs. billion)

Public Issues 190 31.40 48.5 152 20.45 48.4 210 19.04 33.1 527 54.04 31.2

Rights Issues 218 33.33 51.5 211 21.85 51.6 306 38.47 66.9 447 119.26 68.8

Total 408 64.73 100 363 42.30 100 516 57.51 100 974 173.30 100

* Source : Reserve Bank of India Annual Review, 1991-92, Appendix Table V.4

**Source : Praxis Consulting and Information Services LTD, New Delhi 110019.

V. Recommendations and conclusions

33 "A marked feature of the new issue market during 1991-92 was the substantial rise in rights issues"(Reserve Bank of India Annual Report, 1991-92, page 64).


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The priorities of a national regulatory agency like the SEBI may appear

occasionally to conflict with each other. Investor protection and smooth and efficient

functioning of capital markets are two examples of such priorities. In a genuine conflict

one could find enough justification for the SEBI to emphasize investor protection at theexpense of capital market efficiency. However, at a deeper level of understanding and

analysis, a conflict of this nature is often more illusory than real. In fact, in many cases

what promotes capital market efficiency is also what ultimately enhances investor

protection. This certainly is the case when market efficiency consists in reduction of

asymmetric information between the management of the issuing corporations who

typically have private information about the quality of their issues and the rest of the

market participants who usually are not privy to it. Usually, the latter are better protected

as they are more informed. This observation has two implications for regulatory action.

First, a regulatory control on normal market mechanisms initiated in the mistaken notion

of offering better protection to investors may be counterproductive and, if so, should be

avoided. Second, on a more positive note, it is important to promote market mechanisms

which improve capital market efficiency by mitigating asymmetric information problems,

because it ultimately results in sounder investor protection.

In our recommendations, we have been guided by these two considerations. A

prime candidate for the application of the first principle is the SEBI guideline which has

made management by a lead merchant banker and certification mandatory for rights

issues. Though this particular SEBI guideline was, undoubtedly, intended to generate

more information about the quality of the rights offerings, as we have discussed in

section IV above it is likely to have resulted in less information being available to theinvestors at large to help them in their investment decisions. To correct this problem, the

regulation in question should be repealed. In other words, management and certification

by a lead merchant banker should not be required for rights issues in India, much in the

same manner as they are not in the USA and elsewhere.


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The second consideration, namely to suggest measures which would reduce

asymmetric information in capital markets and thereby enhance investor protection, has

prompted us to look at a related SEBI guideline. This is the guideline, referred to above

(see footnote 30), which has made full underwriting mandatory for a public issue. Thesame guideline also lays down a minimum 90% subscription rule. If an issuing company

does not receive 90% of the issue from public subscriptions plus accepted commitments

from the underwriters within 120 days of the opening of the issue, the company is

required to refund the subscribed amount. This part of the guideline is apparently based

on the logic that, unless a firm is able to raise a substantial part of the capital required for

a project, it will not have sufficient funds to undertake the project, in which case it should

refund the money which was contributed in the belief that the project will be undertaken.

However, given mandatory full underwriting, this part of the guideline will be triggered

only if one or more underwriters renege on their accepted commitments. In this case the

issuing company itself merits protection, not punishment.

In its present form, this guideline is unquestionably difficult to justify. The

simultaneous imposition of mandatory full underwriting and 90% subscription rule is not

only unnecessary for investor protection, it also imposes significant avoidable costs on

the issuing corporations and perhaps also on the regulatory authorities. However, suitably

modified, the guideline could be used to improve capital market efficiency, reduce

offering costs for the issuing corporations and, at the same time, enhance investor

protection by generating more reliable information about the quality of the issues. The

following modification could be proposed. Continue the 90% subscription rule, but make

it stronger and have the issuing corporations refund the subscriptions with a penalty, theamount of the penalty in each case being proportional to the extent of the shortfall from

90%. Given this provision, underwriting could be made optional for the corporations.

Their choice of the level of underwriting - low, high, or full as the case may be - would

then signal their private information about the quality of their issues, a low level


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indicating a high quality. The corporations that are confident of a favorable market

response to their offerings would benefit from this provision and save considerable issue

costs now eaten up by underwriting fees. It may be recalled from our discussion in

section II above that the underwriting fees in India are based on the amount of the newoffering being underwritten, and not on the amount, if any, being eventually picked up by

the underwriters. A corporation which chooses underwriting for 10% of its issue will

have its underwriting costs reduced to 0.25% of its issue proceeds from the present level

of 2.5%. Further, regulatory supervision would be necessary to ensure compliance with

one requirement rather than the two under the current guidelines. This, too, would

presumably result in cost savings for the corporations as well as the regulatory

authorities. Finally, the provision of refund of subscriptions with a penalty based on the

extent of the shortfall will constitute a check on the possible tendency of the issuing

corporations to signal falsely, because the potential cost would be higher for low quality

issues than for high quality issues 34.

It appears that the present capital market conditions in India are propitious for

introduction of this scheme. With the new policy of economic liberalization initiated by

the government, the capital markets in general, and the new issues markets in particular,

have become remarkably buoyant. A very large proportion of the public issues are over-

subscribed, indicating that the proposed scheme will cause relatively little disruption in

the new issues markets while substantially lowering underwriting costs in many

deserving cases. According to the data annually published by the Reserve Bank of India

on new issues markets 35, in each of the four financial years from 1988-89 to 1991-92

34 It may be noted that the scheme we are proposing here is essentially similar to the much discussed modelof insurance contracts under asymmetric information where healthier insurees opt for a contract with ahigher deductible and a lower premium than the others (see Rothschild and Stiglitz, 1976; Riley, 1979;Wilson, 1980). Purchasing underwriting services is , after all, purchasing insurance against a possible lack of public response. Given a suitable equilibrium concept (Riley, 1979), this scheme may be shown toseparate different quality types successfully.

35 See the Reserve Bank of India Annual Report, 1988-89, 1989-90, 1990-91, and 1991-92.


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(1991-92 being the last year for which this information is available), 87% or more of the

new issues were over-subscribed. In fact, in 1989-90 this proportion was as high as 95%.

Further, in 1991-92, the number of issues which were subscribed to more than ten times

accounted for 50.5% of the total issues for which data are available. At 21.9%, this proportion was significant in the previous year also 36.

Summing up, we make the following recommendations :

1) The regulation requiring all issues to be managed and certified by a merchant

banker should be relaxed in the case of rights offerings. Public offering being costlier,

the proposed change will make it uneconomical for some low quality issues to seek

certification in the hope of benefiting from imperfection of the certification process.

Thus, separation in terms of quality between different types of issues will be more

complete in equilibrium. Generally, the set of issues which are placed through a public

offering will include all high quality and some low quality issues. On the other hand,

only low quality issues will be placed through a rights offering.

2) For the set of issues which are placed through a public offering, further

screening can be achieved by making underwriting optional. In that case, the issuing

corporation's choice of the level of underwriting will signal the quality of its issue, a low

level indicating a high quality. The proposed change should also result in lower average

issue costs for the set. However, it is not likely to make public offering a more attractive

option for low quality issues, because cost reduction will not be uniform across all issues

within this set. Generally, in the case of high quality issues which can expect a positive

public response, it will be possible to take advantage of this option and achieve cost

reduction.

36 The issues, except for some in 1991-92, were authorized under the previous regime of the Controller of Capital Issues. As we have noted in section II above, the pricing scheme then in force allowed for significant underpricing, a fact which may have partly accounted for the widespread over-subscription.However, again as we have noted before, the present free pricing policy is also likely to result in someunderpricing, as it has in the USA and elsewhere.


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3) For the screening mechanism in the preceding recommendation to be effective,

the current 90% subscription rule should be strengthened. In the case of a shortfall, the

issuing corporations should be required to refund the subscriptions as well as pay a

penalty proportional to the extent of the shortfall.A distinguishing feature of the above recommendations is that they substitute, for

the most part, market mechanisms for government regulations such as mandatory

certification for rights issues and mandatory full underwriting for public issues. It may

be noticed that we have recommended the substitutions, not because we take the position

that government interventions are in general inferior to market forces in achieving most

economic objectives but because, in the present case, the SEBI's objective of improving

disclosure of private information and investor protection can be achieved in a more

economically efficient way through the market mechanisms suggested above. Our

rationale is pure economic efficiency. To make our case, it has not been necessary for us

to appeal to any of the well-known economic and extra-economic arguments which may

be invoked against government interventions in general. Having said that, we must

mention that at least one of them is very relevant to the present case. As Krueger (1984)

has pointed out, a regulation, once introduced as a response to a real or perceived crisis,

induces the regulated parties to attempt to circumvent it, which in turn motivates the

regulatory authorities to intensify the regulation or introduce additional interventions.

Since the regulations in the present case may fall short of their goals, it may very well

result in escalation of controls and regulations. The experience with regulations in other

sectors of the Indian economy provides little assurance that it will not happen.

References


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Asquith, P. and D. Mullins, Equity Issues and Stock Price Dilution, Journal of

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Banks, J. and J. Sobel, "Equilibrium Selection in Signaling Games",

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Baron, D., "A Model of the Demand for Investment Banking Advising andDistribution Services for New Issues", Journal of Finance , 1982, 37, 955-976.

Beatty, R. and J. Ritter, "Investment Banking, Reputation, and the Underpricing

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Offerings", Journal of Financial Economics , 1977, 5, 273-307.Smith, C., "Investment Banking and the Capital Acquisition Process", Journal of

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