CHAPTER 2 - Primary Markets and Secondary Markets for Securities

Primary Markets and Primary Market Issues

Primary market is where securities are issued by businesses to investors. Once the public issue is completed, allotted and listed, it is ripe for trading in the secondary markets. The stock market is also called the secondary market, because investors purchase and sell securities without engaging with the issuer.

Types of Primary Market Issues

You need to remember that not all primary market issues are necessarily public issues. Primary market issues can be broadly classified under 4 categories.

1. Public issue: Securities are issued to the members of the public, and anyone eligible to invest can participate in the issue. Shares are issued to individuals and institutions.
2. Private placement: Here, securities are issued to a limited set of institutional investors, HNIs, family offices and other qualified investors who can bid and purchase the securities on offer, privately without going through a public issue.
3. Preferential issue: is made to a special set of investors on preferential terms. Such investors typically include promoters, strategic investors, employees etc.
4. Rights and bonus: These are issued to existing investors as on a specific cut-off date, called the record date. While bonus capitalizes reserves and issues additional shares, rights are normally offered to existing shareholders at a discount.

Quite often, more than one of the above categories is bunched together. You must also understand these new equity issues as distinct from new issues by mutual funds. They are referred to as NFOs and are used by fresh fund raising by AMCs or by closed end funds.

Basic Regulatory Requirements for Making a Public Issue

Public issues are regulated by SEBI and the provisions of the Companies Act 2013. Debt issues are regulated by the Government Securities Act 2006 and the Government Securities Regulations 2007.

Let Us Look At Some Key Regulator Features Pertaining To Issuers

• Businesses seeking capital cannot be a sole proprietorship, partnership or AOP. It has to structure itself as a limited company. This requires registration with the Ministry of Corporate Affairs and compliance with requirements of the Indian Companies Act, 2013.
• Banks, financial institutions and NBFCs raising money from the public via deposits have to obtain approval from the RBI and be eligible to borrow in the securities markets. Even governments and municipalities have to abide by the relevant statutes.
• Mutual funds intending to raise money through NFOs have to be registered with SEBI to be able to raise unit capital from the public.

Eligibility for Making a Public Offer

An issuer may make an initial public offer if it satisfies the following conditions.

• The company has net tangible assets of at least Rs. 3 crores in each of the preceding three years of which not more than fifty percent are held in monetary assets and net worth of at least Rs.1 crore in each of the preceding three years.
• Minimum average pre-tax operating profits of Rs. 15 crores calculated on a restated and consolidated basis, during the three most profitable years out of last five.
• Aggregate of proposed issue and all previous issues made during the financial year does not exceed five times its pre-issue net worth.
• If the company has changed its name in the last one year, minimum 50% of the revenue for the preceding year must be from activity indicated in the name.
• An issuer not satisfying above conditions can make an IPO only if the issue is made through the book-building process and the issuer undertakes to allot, at least 75 percent of the net offer to public and to QIBs.
• In any equity IPO, promoter’s contribution should be minimum 20% of the post-issue capital. In case of a further issue of capital, the contribution shall be either 20% of the proposed issue or 20% of the post-issue capital and subjected to 3-year lock-in.
• The net offer to the public of must be at least 25% of each class or kind of equity shares or debenture convertible into equity shares issued by the company.
• A public issue will be kept open for minimum 3 working days and maximum 10 working days for fixed price issues. For book built issues, the offer will be open for a period of 3 to 7 days and extendable by 3 days.
• Any public issue should receive subscription of at least of 90% of the net offer to the public failing which the company has to refund the entire subscription amount received.
• The company making a public issue of shares must enter into an agreement with all the depositories to dematerialize its shares.

Participants in Public Issues

The following are the various categories of investors who buy securities in the primary markets:

• Qualified Institutional Buyers: this category includes the FPIs, Mutual Funds, Insurance Companies, Sovereign Funds, global endowments etc. Allotments to this category are based on discretionary allotment.
• Retail investors are those who invest up to Rs.2 lakhs in a public issue and include individuals and Hindu Undivided Family (HUF).
• The third category is Non-Institutional Buyers (NIBs) who invest more than Rs. 2 lakhs in a single issue. This includes corporates, HNIs and those that do not fit in the above two.

Various Types of Public Issues

There are types of public issues viz. IPOs and FPOs. These IPOs are further classified into two categories viz. Fresh issue of shares and Offer for Sale (OFS). Let us look at that they mean.

IPOs represent the first public offer of shares made by a company. An IPO can be a fresh issue or an offer for sale. In a fresh Issue of Shares new shares are issued by the company to public investors leading to expansion of capital and new investors coming. In an offer for sale (OFS) existing shareholders such as promoters or anchor investors offer a part of their holding to the public investors. There are new investors coming but share capital remains the same as shares only change hands.

FPOs represent a follow-on public offer made by an issuer after it has already made an IPO in the past. This FPO is meant to raise additional funds from existing shareholders to enhance funds for the business.

Pricing Of Different Types of Public Issues

The method of pricing of public issues will depend on whether it is a fixed price issue or a Book Building issue. SEBI regulations allow an issuer to decide the price at which the shares will be allotted to investors in a public issue in both the cases.

Pricing of a fixed price issue

In a fixed price issue, the company in consultation with the lead manager decides on the price at which the shares will be issued depending on fundamentals of the company and the retail and institutional appetite. Pricing methodology is disclosed in the prospectus.

Book Building Issue

Book building IPOs account for more than 90% of the IPOs in the present market and this is based on the process of price discovery by building the demand book. The company and issue managers only specify either a floor price or a price band. Investors have to bid the price and the number of shares and must be above the floor price. In case the investor is not sure at what price to bid, they can just bid at “Cut Off” and it will be considered to have been bid at the discovered price. The entire process is online and automated.

Understanding the Public Issue Process

The following are some of the key steps in making a public issue.

• The company (issuer) passes a board resolution and shareholders resolution for issue of shares and then appoints the lead manager to manage the complete issue.
• The lead manager appoints the Registrar & Transfer Agent, bankers to the issue, brokers to the issue, syndicate members and underwriters to the issue. In-principle approval of the stock exchange is obtained.
• Once the issuer and the lead manager enter into agreements with depositories for the admission of securities in both depositories, the draft prospectus is filed with SEBI.
• Subsequently, changes to the prospectus as suggested by SEBI are made and the prospectus is filed with the Registrar of Companies (ROC). Then the lead manager signs off the due diligence that all the regulatory requirements are complied with.
• The next step is market the issue. This includes advertisements, analyst meets, and road shows for institutional investors and broker meets to gauge investor appetite. Social media is also used aggressively to market the public issue.
• After the regulatory announcement is made in the gazette, the printing and dispatch of prospectus and application forms and other issue material is arranged. Every application form is accompanied by an abridged prospectus.
• Once issue opens, the collection banks and R&T agents reconcile the forms received on a daily basis and give a final collection certificate. In case of book-built issues the bids are collated and the cut-off price is determined.
• Subsequently, the basis of allotment is finalised in consultation with stock exchanges and then the allotted shares are directly credited to the DP accounts of the successful allottees. In case of non-allotment, refund orders are also simultaneously issued.
• The last step is the listing of the shares on the stock exchange with their ISIN code and trading commences in the shares. Now the new issue is available in secondary market.

In the entire IPO process, the most important document is the Prospectus. It is a document that outlines all the information relevant to an investor to make an investment. The content and format of the prospectus is prescribed by SEBI and the Companies Act and shall include, inter alia, items like details of the issuer, promoter details, board members list, key employees, business overview, objects of the issue, terms of public offer etc. In short the prospectus is the legal document to enable you to make critical investment decisions.

While fixed priced issues are based on Prospectus, the book built issues are based on a Red Herring Prospectus, which specifies the band and contains all relevant information as outlined above including the financial statements, projections, legal cases, contingent liabilities etc.

How to apply for a public issue and get allotment?

Your application for a public issue begins with reading the fine print of the prospectus and then taking a decision whether to apply for the IPO or not. Here is the process to apply for an IPO.

• Public issues are open for a limited period as notified in the application form. Investors have to apply during this period and submit to the broker for uploading (online / offline).
• NSE and BSE provide online bidding system for booking built IPOs. It is a screen based system wherein investors can enter bids through the broker trading terminals between 10 am and 5 pm on all issue open dates.
• Price band is announced minimum 5 days before the issue opens so it enables investors to evaluate the issue and decide the price that they are willing to bid for. If you are confused, you can always apply at the cut-off price.
• It is essential to know that Investors who bid a price can revise/modify their bid at any time (before the issue closing) using the revision form attached to the application form. They can also use the online modification facility.
• Payment must be made through a local cheque, DD or by using the ASBA (application supported by blocked amount) facility. ASBA holds funds in your account and only the allotted shares amount is debited on the date of allotment.
• Post the issue closing, the cut-off price is determined based for book built issues based on bids received. Investors who bid at cut-off price or higher are successful bidders and receive allotment at the cut-off price. Lower bids are rejected and monies refunded.
• In case of oversubscription, proportionate allotment is done. For retail investors, the basis of allotment favours small investors. For non-institutional, it is on a proportionate basis and for institutions, the allotment is discretionary.
• On the subject of subscription, certain issues have a greenshoe option where the issue is authorized to retain more than the originally issued sum. This is more common in debt issues. Once the allotment is made, the shares are listed and you are free to sell the shares from your demat account.

Understanding Public Issue of Debt Securities

A company can also make a public issue of debt securities such as debentures or bonds by making an offer through a prospectus. The issue of debt securities is regulated by the provisions of the Companies Act as well as SEBI’s Issue of Debt Securities Regulations, 2008. Even for a debt issue, it is essential to appoint a lead manager who will ensure compliance with all regulatory requirements. Here are some facets of a debt public issue.

Eligibility: Public issue of debt securities can be made by any company registered as a public limited company. It could either be listed or even unlisted. In any public issue of debt securities, the base issue size shall be a minimum of Rs.100 crore.

Offer Document: A company making an issue of debt securities has to file a draft offer document with the stock exchange where the issue is proposed to be listed. The offer document contains all the material information necessary for the investors to evaluate

Listing of Securities: The debentures issued under a public offer have to mandatorily be listed on a stock exchange. An application has to be made to a stock exchange to list the debentures.

Credit rating: Credit rating has to be obtained from at least one credit rating agency and the rating has to be disclosed in the offer document. If the rating has been obtained from more than one rating agency, all the ratings have to be disclosed.

Minimum Subscription: The minimum subscription in a public issue of debt securities is specified at 75% of the base issue size failing which the amount has to be refunded within a period of 12 days from the closure of the issue.

Dematerialization: The issuer of debt securities has to enter into an agreement with a depository for dematerialization of the securities proposed to be issued.

Debenture Trustees: Debenture trustees have to be appointed to oversee the interests of the investors. In case of secured debentures trustees ensure that the pledged security is adequate to meet the obligations to debenture holders.

Debenture Redemption Reserve: For the redemption of the debt securities issued by a company, the issuer has to create a debenture redemption reserve and transfer a portion of profits into it each year till the redemption.

Unsecured Debentures: The issue of unsecured debentures will be treated as public deposits collected by the company and will require adherence to the Companies (Acceptance of Deposits) Rules.

Functions of Secondary Markets

The secondary market is where securities once issued are bought and sold between buyers and sellers depending on their view of the stock. The instruments traded in secondary markets include securities issued in the primary market as well as those that were not issued in the primary market, such as privately placed debt or equity securities and derivatives of such securities created through the creation of futures and options trades. Here are some of the major functions provided by the secondary markets.

Platform for Liquidity

Secondary markets provide liquidity and marketability to existing securities. If an investor wants to sell off equity shares or debentures purchased earlier, it can be done in the secondary market. Investors can exit or enter any listed security via secondary markets. Investors can sell their securities at a low cost and in a short span of time, if there is a liquid secondary market for the securities that they hold. The sellers transfer ownership to buyers who are willing to buy the security at the price prevailing in the secondary market. The liquidity in the market actually reduces the risk for the participants.

Scientific Price Discovery

How do you decide what a stock is worth? Stock values are normally a matter of opinion Secondary markets enable price discovery of traded securities. Each buy or sell transaction reflects the assessment of investors about the worth of the security or the underlying company. Markets reflect the collective opinions of various investors on a real time basis. If an issuing company is performing well or has good future prospects, investors will try to buy shares. As demand rises, the market price of the share will tend to go up. The rising price is a signal of expected good performance in the future. If an issuing company is performing poorly or is likely to face some operating distress in the future, it is likely to see more sellers than buyers of its shares. This will push down its market price.

Barometer of market valuation

This is slightly different from price discovery although it is related. While price discovery is more for secondary market traders and investors, market valuation benefits issuers when they have to raise further capital from the market. A better price discovery allows raising of capital at a more favorable price. For example, consider a company with equity shares of face value of Rs. 10, which are being traded for around Rs. 900 in the market. If the company wants to raise additional capital by issuing fresh equity shares, it could issue them at a price close to Rs. 100, and this premium or valuation benefit helps them to spruce up their free reserves. That comfort is provided by valuations.

Information signalling mechanism

Market prices provide instant information about issuing companies to all market participants. This information comes from various sources. It comes from corporate announcements, results announcements, news flows, statutory filings, earnings estimates, analyst reports, chart formations etc. This information-signalling function of prices works like a continuous monitor of issuing companies, and forces issuers to improve profitability and performance. In matured markets, the price reflects all available information about the security. A large number of players trying to buy and sell based on information about the listed security tend to create a noisy and chaotic movement in prices, but also efficiently incorporate all relevant information into the price. As new information becomes available, prices change to reflect it. The reason markets make the price discovery efficient is through the process of information signalling. Today, there is a surfeit of information for all the leading companies and that enables intelligent and informed decision making.

Facilitates shifts in Corporate Control

Stock markets function as markets for efficient governance by facilitating changes in corporate control. If management is inefficient, a company could end up performing below its potential. Market forces will push down share prices of under-performing companies, leading to their undervaluation. In such cases, the board has a clear barometer to evaluate the current management and making appropriate changes if required.

It could also open the door for management change by acquisitions. Such companies with weak financials can become takeover targets. Potential acquirers could acquire a significant portion of the target firm’s shares in the market, take over its board of directors, and improve its market value through a better value proposition. An actual takeover need not happen; even the possibility of a takeover can be an effective mechanism.

Secondary Market Broker and Their Responsibilities

A broker is a member of a recognised stock exchange who is registered with SEBI and permitted to trade on the screen based trading system of stock exchanges. Trades have to be routed only through the trading terminals of registered brokers of an exchange, to be accepted and executed by the system. Brokers can trade on their own account too, using their own funds. Such transactions are called proprietary trades.

SEBI registration to a broker is granted based on broker’s eligibility to be a member of a stock exchange; availability of adequate office space, equipment and manpower to effectively carry out his activities; past experience in securities trading. SEBI ensures the capital adequacy of brokers by requiring them to deposit a base minimum capital with the stock exchange; and limiting their gross exposures to a multiple of their base capital.

Brokers charge commission for their services. The responsibilities of a broker include:

• Maintain record of client transactions and operate separate trading account for clients and for proprietary trades. They must maintain client funds in a separate account.
• Issue of contract note to clients within 24 hours of the execution of the order and collection of funds or securities from client prior to the pay-in.
• Make delivery or payment to the client within 24 hrs of pay-out from the stock exchange. Brokers must also appoint a full-time compliance officer to oversee.
• Brokers must diligently comply with KYC norms and check all supporting documents. A Unique Client Code (UCC) has to be generated by the broker for each client. The UCC code has to be submitted while placing orders on the exchange platform.