The Subject of Private Placements - Term Paper Example

BUSINESS REPORT Table of Contents. Page 1 Executive Summary 2 2 Introduction 2 3 Sources of Private Placements 3 4 Private Placements in USA 6 5 Private Placements in Australia 8 6 Private Placements in India 10 7 The Private Placement Controversy 12 8 Comparative Study 14 9 Conclusion 15 10 References 17 1 Executive Summary The subject of Private Placements has been examined and it has been noticed that it is the predominant method of raising capital by companies. Its popularity with both the companies rests with the fact that it is the quickest and the least expensive route. Due diligence is expected and exercised by large and sophisticated investors as there is no binding on companies to make detailed and full disclosures. Exceptions have been taken care of by regulatory authorities who determine the level of disclosure to maintain a balance of information which can materially effect security valuations. There are restrictions on disposals of securities and sales are on hold for the lock-in periods that differ but are for long periods. Provisions and specific conditions have been examined for US, Australian and Indian markets and a comparative study reveals a common thread running between them base of stable politics, liberal economic outlook and good legal systems. There are some differences but of local nature due to unequal maturity. It has been determined that by and large there is satisfactory mechanism in place that ensures that this system is here to stay and prosper. Business Report 2 Introduction Financial Markets all over the world have been formed to enable companies to raise capital for their needs and to allow investors to invest in companies of their choice. Advanced Financial markets have expanded on this simple premise that has expanded with time and maturity. The concept of an investor today does not mean just the individuals who have wealth that they would like to invest. Indeed the individual investor today stands marginalized with the emergence of Institutional Investors No doubt these Institutions are themselves comprised of a huge number of individual investors, who invest in them by choice (Mutual Funds) or by law (Pension Funds). But the control of their money does not lie in the hands of the individual but in the hands of the few who are chosen as directors. There are two ways how companies raise capital, through public offering and by private placements. 3 Sources of Private Placements Funds for private placements are offered by accredited investors who are described as individuals earning $ 200 thousand per annum, a household whose income exceeds $ 300 thousand per annum or venture funds, banks and other financial institutions like insurance companies, pension funds, stock funds and trusts. (SEC Rule 501, Reg.D)1 In fact currently the Institutions have grown so large that they are the largest investors on any stock market and the individual stakeholders have minor shareholdings. Raising capital now requires a different approach. Earlier the companies had to woo the individuals to attract them to their issues. Now they have to attract the big investors as the amount of capital required is also getting to be huge. The companies want to play it safe by ensuring that a large amount of their capital needs are covered by private placements prior to their going for a public issue. One of the primary roles of the Stock Exchange Authorities is to safeguard the interest of the investing public. Although rules may differ from one country to another, the common feature is that they require a very comprehensive disclosure from the companies on their financial information. They are asked not only to explain their earning but past records and future prospects with reasons. All liabilities and possible hidden liabilities have to be accounted for as well. All this is done keeping in mid that the public at large may suffer for want of knowledge. The US Securities & Exchange Commission (SEC) however accepts the fact that the institutions are capable of finding out this and other information by themselves and that these matters can be left between the company and the institutions. They do not require any disclosure until the companies go public. The Australian (ASIC) resolved this issue by allowing an exemption from the need for a prospectus if the securities taken up in a placement were listed on the ASX on the presumption the ASX continuous disclosure requirements mean the market in those securities was fully informed. (Bryan Frith, The Australian, Australia, March 12, 2002)2 In India the view is different. The Economic Times reports that “The Securities and Exchange Board of India (SEBI) have decided to regulate private placement of corporate debt securities. The SEBI secondary market advisory committee has recommended the creation of a regulatory framework for the issuance and trading of all corporate debt securities, including those issued through the private placement route. Among the key recommendations of the committee are exhaustive disclosure requirements as are usually required under the Companies Act, 1956, SEBI Disclosure and Investor Protection Guidelines and the listing agreement of the stock exchange. The committee has made no distinction between disclosure standards for public and private placements”. (The Economic Times, Bombay, India)3 Of course there are exceptions to this rule and especially when a private placement relates to a buyback of a company’s shares or stock by the company itself or by the directors of the company. Such preferential treatment comes under scrutiny as it is likely to prejudice the ordinary share or stockholder. In such cases the ruling is to disclose the necessary information regarding this move and the legality comes under question. The requirements are the use of a Private Placement Memorandum (Regulation D)4, which, for all practical purposes, complies with the requirements of a Prospectus which is required in public offerings. The contents of such memorandum are: a description of the terms of the offering, the company's business, risk factors, additional terms (i.e., anti-dilution protections, registration rights, control features), expenses of the transaction and summary financial information. The purpose of the summary is to make the offering easy to read and understand. However there is always a restrictive clause when there is a private placement. These stocks, shares or debt cannot be sold in the open market for a restricted period which may last fro one to ten years. The rationale behind this is two fold. The SEC is of the view that the parties to the contract must not be able to take undue advantage of other less informed or unsophisticated investors and must not be allowed to make a profit immediately after acquisition of such placement. SEC specifically prohibits the resale of such securities which are stamped as “restricted” (SEC Rule 144.)5 Under the rules the holding period is one year. It further restricts the sale, after the holding period, to 1% of the outstanding shares of the same class being sold in the market at that time. Again such transactions can attract the normal brokerage and must not be solicited for or by the buyer or seller. Besides for any sale the holder has to obtain permission from SEC and once obtained, sale must take place within 3 months or permission lapses. The stamp of “restricted” also has to be removed with permission. All such restrictions are aimed at discouraging misuse of such private placements as many such placements are either at a discount or at least at discounted prices considering their actual worth in the market at the time of placements, 4 Private Placements in USA By far the largest financial market, the US is the most attractive market for Private Placements. Apart from being the financial hub of the world, NASDAQ and NYSE enjoy the most liquidity and everyone from the world is attracted to it. Money flows from every corner and is eager to invest anywhere it feels secure, Companies from other nations too come here to raise capital and the huge amounts are available at these places for investment. In the US, private placements are exempt from public registration under the Securities Act of 1933. The exemption from registration for a private offering is contained in Regulation D of the Securities Act of 1933. While the procedure for conducting a private placement pursuant to the exemption is less stringent than for that of a public offering, the process requires a careful compliance with the terms and restrictions of Regulation D. Lucchesi, William J. explains that The SEC adopted Rule 144A, which establishes new rules covering the buying and reselling of restricted securities. Restricted securities are exempt from SEC registration requirements and cannot be traded on the public markets. Rule 144A was issued in order to improve the liquidity and efficiency of the private placement market by giving more freedom to institutional investors to trade securities.6 He further clarifies the reason behind this rule that this was introduced to encourage foreign companies to sell their securities in the US markets. As a consequence, this also provides another avenue to the US investors to invest in overseas companies. Historically disclosure norms are very strict in the US hence overseas companies were very reluctant to disclose too much to the investors. The rationale was not to defraud but they felt that their trade secrets would be bared and since they do not have stringent Intellectual Property laws they felt insecure about it. A case in point was the famous case where the brand name of Indian Rice Basmati was patented in US as an American Product and even the Indian government could not help the companies concerned. At the same time because of good returns of such overseas companies, the American investor was keen to participate in their capital offerings. Therefore this rule 144 was devised to overcome the hesitancy by overseas companies and resulted in a flood of companies who were equally eager to get large doses of capital that they could not get elsewhere. Companies from all over the world are now participating in this bonanza and it is a win-win situation all around. SEC feels that the large investors are sophisticated enough and diligent enough to find enough for themselves whatever information is necessary to guide their investment. To protect the ordinary investing public SEC put restriction on resale for long periods to prevent any misuse or fraud. In case of resale of restricted securities there is a set of rules that prevents illegal benefits accruing to holders of such securities. Disclosures, that were ignored earlier, come into play and in general the ordinary uninformed investor is protected. The overseas company stand to benefit enormously from private placement in the following ways. These are advantages that come with listing on an American Bourse. Access Capital for growth and development Offers opportunity of Mergers and Acquisitions Enhancement of Corporate Image and Brand Equity Creates ability to attract quality employees Provide easy Liquidity Make Corporate borrowing easier Company valuations made easier Create wealth by using hidden unutilised potential Essentially these are the main attractions for an overseas company to get enlisted in the US and Private Placement makes all this possible without the pain and cost of a Public issue. 5 Private Placements in Australia AUSTRALIAN middle market companies were turning to the US for hundreds of millions of dollars in private debt placements as local investors dried up. JP Morgan analyst Jason Lee said the number of companies going to the US private placement market trebled last year, from four in 2001 to 12 in 2002. (Jane Williams, The Courier Mail)7 The trend continues unabated. The investment opportunities are getting fewer in the US and therefore large investors, with huge funds at their disposal look overseas for investment opportunities. Returns are low back home therefore they look at every opportunity in the growing markets. For this reason even the middle size companies in Australia appear attractive to them as their earning potential is quite great. The competition for these funds is also lesser in the overseas markets hence this becomes an attractive proposition for investing companies. Liquidity is also a factor. The Australian Stock Exchange is the 9th largest in the world while NASDAQ is the 8th. Language is no barrier so communication is no problem. The legal system is also based on common law hence is a great asset. With positive experience growing by the year the confidence is up and so are investments which are lead by Private Placements. Westpac's head of public markets, Peter Bloomfield, said the market was driven by American insurance companies, which must place a proportion of their funds in long-term assets. They have been the biggest arranger for Australian borrowers, in partnership with Banc of America Securities, accounting for $US1.1 billion of the issues last year. ''There is still very strong demand there. The liquidity in the system has been one of the strong drivers behind it,'' said Mr. Bloomfield. (The Australian, February 23, 2004)8 Author: David Uren * Economics correspondent; MATP. Australian companies who had issue placed in US were very satisfied with the generous response of the investors who oversubscribed most issues and for long maturing periods. Origin Energy's chief financial officer Frank Calabria said the utility went to the US private placement market last month and closed five times oversubscribed. Mr. Calabria said Origin was hoping to raise $US175 million ($A287 million) over a range of maturities but came away with $US250 million. ''We had bids up to $US900 million,'' Mr. Calabria told Business Sunday (The Gold Coast Bulletin)9 The Private Placement laws and regulations laid down by ASX are quite the same as proclaimed by SEC in the US. Like the US, Australia also enjoys great political stability. This translates into liberal economic system with sustained growth factored in it. The Australian economy is greatly dependant on its agriculture and great mineral wealth. Lately industry and technology are receiving grater attention and all this is attractive to the investors. Culturally too, Australia and the US are similar and that makes for special bonding between the two nations on both group and individual level. With such affinity business and business opportunity can only but grow. This boosts the investor morale and confidence. 6 Private Placements in India India is a relatively new entrant and as an emerging market has already fired the imagination of investors all over the world. With a stable democracy, a liberal economic programme, its undisputed contribution in the technological field, its great English educated population and its enterprising entrepreneurial skills it has got a place of pride amongst the nations of the world. In a short span of three decades it has risen to be an economic engine that cannot be ignored. Although still behind China, its attractive legal system and open economic policy has made the investors come in hordes to invest in industry as well as in agriculture. The counterpart of SEC and the ASIC is the Securities Exchange Board of India (SEBI) which regulates all the stock exchanges of the country. The stock markets are booming here and of late the trend is not to buckle under undue overseas influence as they can hold on their own. The industry is also resilient and determined to change along with world class requirements. Indeed the world’s largest Polymer Plant is located here and so are some of the other larger companies. There are quite a few fortune 500 companies too and growing in stature and number by the year. Like their other counterparts elsewhere in the world Indian companies too are on an expansion mode. Private Placements are outstripping IPO’s and Public issues but the Private Placement Market in India has two sides to it. One is India centric meaning companies looking for Private Placements within the country, and the other comprises of companies wanting to list overseas, especially in the US. It is interesting to note that quite a few companies take both the routes to enhance their capital from both countries. SEBI has devised its own rules for both Indian Placements and overseas placements. The overseas placement is guided by the fact that only those companies are allowed that have done well in India and have a proven record. SEBI therefore insist on certain disclosures. In order to make Indian markets more competitive and efficient, it has been decided to introduce an additional mode for listed companies to raise funds from domestic market in the form of “Qualified Institutions Placement”. (QIP). The amendments made vide this circular shall come into force with immediate effect. (SEBI)10 For Indian Placements SEBI asks for more disclosures as it is more protective of the Indian investors. Being an emerging market, Indian stock exchanges have witnessed many unscrupulous operators and quite a few “scams” have come to light in the last two decades to warrant this. Insider trading and cornering was rampant and has been brought down to a great extent since then due to stiff disclosure requirements. Avery illuminative narrative is quoted below to elaborate the issues. 7 The private placements controversy Securities issuance in India is now dominated by private placements. Every now and then, we hear about the "impending scam" in the private placements market. (Ajay Shah 2001)10 Central to regulated finance in India are two main issues. One is contract enforcement and the other is investor protection. The first ensures that SEBI is able to interact between the investor and the company on the contractual agreement they agreed to in the Private Placement process. Thus SEBI gets a say in the matter about how contracts should be made. This means that SEBI can and does insist on material disclosures to ensure that contracts do not become a reason of dispute later on. In the second case on the face of it full and proper disclosure is mandatory. It is for the protection of the small investor. SEBI reasons that even in case of large investors like Mutual Funds and Insurance companies the stakeholder is finally the small investor. Therefore any non-disclosure on the part of the company will eventually hurt the small investor and will erode his capital... SEBI’s role in case of contracts is understandable but its stand to protect the small investor has become a matter of argument. One side argues that if two giants agree to certain terms and conditions and engage in a contract, they should be considered capable to cover their requirements and take care of themselves. So the state interference, meaning SEBI, is unnecessary and uncalled for. SEBI should permit them to proceed as is the practice in US. They should not be made to follow normal regulations of disclosure. The crux of the matter is that such impositions may be welcome where the investor invests in small amounts. But there should be a cut-off figure that for people or household investing above a certain sum should be considered what is termed in US as “sophisticated” investors. In such events it is unnecessary to burden the companies involved in lengthy process of disclosures to and permissions from SEBI for carrying out the transactions. The very purpose of Private Placement, lower cost and speedy transactions becomes self-defeating and fructuous in such cases. There is another danger. If the burden of regulations becomes too much, these giants or their economic agents will choose another path that is unregulated. This is a distinct possibility in India given its “alternative” economy, the unaccounted one, at work. . In view of the above clarification let us examine the controversy and its fallout. There is a deep concern that there is lack of transparency and the public at large is ignorant of actual facts about companies. There is also concern that usually contracts of Private Placements are poorly drafted hence we have so many disputes. Absence of regulations makes frauds a reality of life. There are actual concerns and cases where such Private Placements have lead to situations where investors are left with large non-performing assets (NPA). And with little recourse. . Under the circumstances a case for having some regulations seems strong and it makes sense to have greater public information even when a placement is private. It appears that having transparency is the answer to this vexed issue. It would be advisable to have some regulation on transparency even in case of Private Placements. They should be made to make more disclosures where material facts can alter the value of the stake. The long term answer is to strengthen the Indian finance system by introducing better company law regulations as well as compliance rules. . 9 Comparative Study A number of similarities have been observed in the case of US and Australian Private Placement policies and regulations. This is more due to cultural and political affinity. Both have a strong industrial and consumer base that tends to promote companies and brings forth investors. In the case of India and US too there are many similarities as both have strong domestic and overseas Private Placement openings. Both are huge countries with large investing ad working populations. Here the US outnumbers in terms of “sophisticated” investors but India can boast of a very large base of uninformed investing public. SEC encourages overseas companies to US funds and the SEBI encourages Indian Funds to invest locally. But both encourage Private Placements keeping in mind the needs of the different investments climate in each country Between India and Australia there is little common except that companies in both countries look up to US to provide an ideal Private Placement potential, especially for madcap companies. They both have growing industrial base that needs fresh and constant capital and their own resources are limited. One thing that runs common to all three is that they all covet and promote Private Placements and investors are prepared to wait long periods to obtain results. The all also have fairly reasonable legal systems for protection of the investors, both large and small. The all have stable governance and trade policies are not restrictive. It may vary in degree but the economic need is the binding force. Global approaches and International trade has had a very positive effect. Mergers, associations and partnerships of all kinds have formed and as a result there is great demand for capital everywhere for expansions. 10 Conclusion There are great benefits of private placement which attract both the companies and the investors to this route. There is great flexibility and amounts are not fixed. The investment can be in any form of capital or debt. The investors, unlike venture capitalist are prepared to wait for longer periods and are content with reasonable returns. They can also wait for longer maturities of 10 to 15 years. The cost of raising funds is lower than a public offering which involves huge publicity outlays. Finally it is a quicker method of raising capital as there is relatively less waiting time and little or no permissions are required to go ahead. With the world transforming into a global village, geographies no longer matter. Hence it is now seen that while the company may be located in India or Australia, it will easily find interested investors in the US. This bodes very well for international commerce. True that there are hiccups now and then and some unscrupulous individuals and companies try to defraud others. That is reason of having regulatory bodies which are constantly on their toes devising ways and means to regulate the affairs of the wayward. It can therefore be safely concluded that Private Placements will continue to be a favored practice for securing quick capital from diverse sources. Word count 3608 (excluding Executive Summary) References 1 SEC Rule 501, Regulation D. 2 Author: Bryan Frith, The Australian, (Australia) March 12, 2002 Edition: 1 Section: Finance Page: 020 Copyright, 2002, Nationwide News Pty Limited Record Number: AUS-20020312-1-020-4153666V7]   3 Economic Times, The (Bombay, India) Provided By: Financial Times Information Limited - Asia Africa Intelligence Wire Company Name: Securities & Exchange Board of India Copyright 2003. All Rights Reserved. Record Number: A2003050398-18D6-AIW,0,XML,AIW   4 Available at: http://vcexperts.com/vce/library/encyclopedia/documents_view.asp?document_id=89 5 Available at: http://www.sec.gov/investor/pubs/rule144.htm 6 Lucchesi, William J. The CPA Journal Online, Jan 1991.Available at http://www.nysscpa.org/cpajournal/old/09387210.htm 7 Author: Jane Williams, The Courier Mail, And (Brisbane, Australia) April 21, 2003 Edition: 1 - Section: Finance Page: 019 Copyright, 2003, Nationwide News Pty Limited Record Number: CML_T-20030421-1-019-362097 8 Author: David Uren * Economics correspondent; MATP The Australian, February 23, 2004, 9 The Gold Coast Bulletin, (Australia) April 21, 2003 8 Section: Finance Page: 041 Copyright, 2003, Nationwide News Pty Limited Record Number: GCB_T-20030421-1-041-068626   10 Sec 2.2.2B (v) of SEBI (DIP) Guidelines 2000, "Qualified Institutional Buyer" 19th May 2006 Available at: http http://www.sebi.gov.in/circulars/2006/dipcir0506.html 11 Ajay Shah, Business Standard, Kolkata, 31 October 2001 Read More