A study by the Securities and Exchange Board of India (SEBI), of companies listed on the Indian stock exchanges between 2008 to 2011, revealed that over 60 per cent of the listings were trading below their issue price six months after the initial public offering or IPO. Further, a large proportion of listings (almost 50 per cent) had registered falls in value of greater than 20 per cent.

The regulator felt that the sentiments of investors may be negatively impacted, and that they may lose confidence in the capital markets. Accordingly, in September 2012, SEBI issued a discussion paper for public comment on ‘Mandatory Safety Net Mechanism’. Essentially, a safety net mechanism provides for downside protection (a fall in value of shares) for a specified period of time after the IPO event. If the safety net provisions are triggered, the provider of the safety net (such as the promoter) must buy back the shares at the issue (or specified) price. Broadly, SEBI’s objective in issuing this paper was to instil confidence and encourage participation in the capital markets by retail/ small investors. It should be noted that the concept of safety net arrangements is public issues on a voluntary basis has also been previously addressed by SEBI as per Regulation 44 of ICDR Regulations (2009).

The proposed mandatory SEBI requirements, as per the discussion paper, is that the safety net provisions will trigger only in cases where the prices of the shares being issued fall in value by more than 20 per cent from the issue price. The price is calculated as the volume-weighted average market price of such shares for a period of three months from the date of listing. Further, the triggering of the safety net provisions shall take into context the movement in the market index.

SEBI’s discussion paper provides a series of illustrations highlighting how the safety net provisions work — for example, three months after post the issue — if:

the volume-weighted share price drops by 21 per cent and the market index remains unchanged (0 per cent) — the safety net provisions will trigger since relative fall of 21 per cent (21 per cent minus 0 per cent) is more than the 20 per cent trigger level.

the volume-weighted share price drops by 21 per cent and the market index drops by 10 per cent — the safety net provision will not trigger since the relative fall is only 11 per cent (less than the 20 per cent trigger).

The eligibility of the safety net facility, as per the SEBI proposals, are only for original resident retail individual allottees for up to Rs 50,000 in the issue (that is, not applicable for secondary purchases after the IPO). Further, the regulations propose to cap the total obligation on the safety net provider at 5 per cent of the issue size.

Even though the SEBI safety net requirements are not yet mandatory, after the discussion paper was issued, a number of companies have started including some form of safety nets for retail investors in their prospectuses. For example, Justdial Ltd recently completed its IPO, which contained safety net provisions for retail investors. Previously, Sai Silk (Kalamandir) Ltd’s IPO prospectus also contained safety net provisions, but the company was unsuccessful in raising the requisite capital. It should be noted that the terms of the safety net proposed by both these companies differ from the SEBI discussion paper requirements.

Whilst the intentions of the regulator in introducing such provisions are to be commended, it should be noted that, globally, there is little or no precedent (or empirical data) on whether the objectives will be met. Currently, none of the major stock market regulators have a mandatory requirement for safety net provisions, or are even discussing the said topic. Many in the investor community view such provisions as opposed to the core tenets of equity investing, as informed decision making and, hence, disclosures in the IPO prospectus should drive investor activity. Indeed, such provisions may have the inadvertent consequence of encouraging short-term speculation in the equity markets by retail investors, since there is protection for the first three months, as opposed to a meaningful long-term outlook based on the fundamentals of the company issuing capital.

The author is Director, Financial Reporting Advisory Services, Grant Thornton India LLP

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