SEBI proposes to regulate private debt platforms

Proposals include stock broker registration, 6 months lock-in after allotment by an issuer

– finserv@vinodkothari.com

Background

Growth of investor interest in fixed income investment options is a sign of maturity of a market. Indian investors have traditionally been looking at securities markets for equity-type returns and use mutual funds, bank deposits etc. for fixed returns. However, in recent years, the avenues for fixed income investing in corporate bonds, P2P lending platforms, various types of collective investment schemes such as property shares^[1], etc. have flourished. Hence, as investors become active and aware, they no longer limit themselves to mutual funds. Investors are now moving to debt trading platforms, which is the subject matter of SEBI’s Consultation Paper on Online Bond Trading Platforms^[2] (‘Paper’). Due to stringent requirements for debt listing, the number of issuances, the number of listed debt issuances to the public is relatively low. Considering the growing investor interest, the lack of volumes of public issuances and limitations of trading of bonds through electronic bond platforms, several platforms started offering listed and unlisted debt securities to investors. This is what we are referring to as “debt trading platforms” here.

Such platforms have been able to bring the much-needed liquidity to the debt market, and they deal with the public at large; hence, may pose several risks to the investors and the capital markets. Recognising this development and the need to regulate such platforms, for public comments.

While the paper was intended to address certain issues in the manner that these platforms are currently operating and promote such debt platforms, some of the proposals seem to be going against the very genesis of such models. Read further to see why and how.

Debt issuance platforms vs debt trading platforms

First of all, it must be noted that while there may be debt trading platforms, it is not possible to think of a “debt issuance” platform. This is because of the essential corporate law rule that lays the distinction between a public offer and a private placement. A public offer, that is, inviting one and all, to invest in the securities of a company has to result in listing, and can only be made subject to compliance with the Companies Act and ICDR regulations on public offers. On the other hand, a private placement, by definition, is a selective invitation to pre-identified investors, not exceeding 200 in a year, to invest in securities. Therefore, if a platform is being used by an issuer to offer securities to investors in general, and therefore, effectively puts the securities for subscription by unidentified investors, or identified investors adding to more than 200, it is breaching the essential rule about public offers. For this purpose, it doesn’t matter how many people actually subscribe to the offer – if the offer is made “generally”, that is, except to specific and pre-identified investors, it will deviate from the definition of “private placement” and will be regarded as a public offer.

However, if an investor has acquired certain debt securities, and wants to sell the same, he may make an offer for sale to investors, such as those registered on the debt trading platform. It is an arguable question as to why this will not be regarded as “public offer”, as the definition of “public offer” in Explanation below sec. 23 (2) of the Companies Act includes an offer for sale as well. If we duck this question, then, if the issuance of securities is made by a company with a view to these securities being offered to the public, then section 25 comes and requires the offer for sale to be done exactly as a public offer.^[3]

If the trading of debt securities in the so-called debt trading platforms is merely a device to bring a broad range of investors, the platform may actually have been used as a device to get rid of the restrictions on private placements. Hence, the Consultation Paper talks about the platforms being used to escape “deemed public issue” (DPI) rule. Broadly, this is how the so-called DPI would have happened – A company intending to issue debentures to more than 200 investors is restrained due to compliance with listing guidelines. Taking a leeway, the Company privately places the debentures to a single investor, who then sells it to several other investors, of course, more than 200 in number. Effectively, all the investors (more than 200) have been able to invest in the debentures and the Company did not have to go through the listing process.

To avoid this regulatory arbitrage, the Paper proposes a lock-in period for debt securities that are offered for sale on bond platforms for a period of six months from the date of allotment of such debt securities by the issuer. The language suggests:

• The lock-in shall be on debt securities offered for sale on the platform- one may transfer the same outside the platform;
• The lock-in shall be from the date of allotment of the debt securities – and not on each subsequent transfer;

One may understand from the above that debt securities may be offered on the platforms only when a period of at least 6 months lapses from the date of allotment. Since the idea is to prevent the investors from subscribing to debentures for further sale, this lock-in should not be relevant for inter-se transfer between existing investors.

With a lock-in period as high as this, liquidity of the debt securities is impacted, which is quite opposite of the regulator’s well-known intention. It is imperative to prevent such DPIs while maintaining liquidity, hence, a balanced approach may be taken.

Our recommendations:

• The lock-in period may be reduced;
• The limitation may be connected to the volume of issuance;

Concerns (intended) to be Addressed

Since the platforms providing services of trading in debt securities have mushroomed recently, they are not regulated by any regulator. The broad objective is to bring about regulatory oversight, common standard practices, and investor protection.

The Paper has been issued with the intention to address the following issues:

• No standard practices for KYC;
• No customer grievance redressal or investor protection measures;
• The practices are violative of private placement guidelines and may actually be deemed public issuance;
• Possibility of mis-representing information to lure investors;
• No reporting of trades;
• Platforms virtually performing the role of clearing corporations.

Understanding the Proposed Framework

The Paper proposes the broad contours of the framework for regulating such platforms, which are discussed below:

Registration as a stock broker

Being facilitators for trading in debt securities, these platforms are proposed to be regulated as an intermediary, more specifically, as a stock broker. Hence, these platforms will be regulated as a stock broker, which includes the following major compliance requirements:

Major provisions under stock broker regulations –

1. Registration and obtaining licence with SEBI as a stock broker [para 3(1) of Stock Broker Regulations]
2. Membership with any stock exchange [para 10 of Stock Broker Regulations]
3. Abiding by the rules, regulations and  bye-laws of  the  stock  exchange  which  are applicable to him [para 9(b) of Stock Broker Regulations]
4. Maintenance of minimum net worth as per Stock Broker Regulations
5.  Appointment of compliance officer [para 18A]

Only eligible securities to be traded

Here, eligible securities means listed debt securities only. The intention seems to limit the trading of debt securities to listed ones only. Listed securities already have a market i.e. stock exchanges; it is the unlisted securities which lack liquidity. The very purpose of having such platforms is to render liquidity to the debt market, which will be defeated if the said restriction is imposed.

Further, unlisted bonds can be lawfully issued and traded. Having a platform which makes buyers meet the sellers is only facilitating the trading in debt securities, which is definitely not barred, and hence, having platforms providing services for trading in debt securities should not be a concern.

As one may also see from the analysis of existing platforms (provided above in this article), the most common offering of such platforms is enabling trading in unlisted debt securities. This restriction may result in wiping off the existence of such platforms.

Routing of transactions through the Stock Exchanges

In order to avoid settlement risks, the Paper proposes that the transactions in debt securities are routed through the debt segment or Request for Quote platform of the stock exchanges. Involvement of exchange does away with the innovation brought in by the platforms. The whole idea of the platform is to act as a second-tier exchange to facilitate transactions other than through exchanges.

The platforms provide efficiency in settlement and trading transactions, which will not be possible if an exchange is involved. This may completely finish the market for trading in unlisted debt securities.

Conclusion

While the intention of the Paper is quite positive, the framework may limit or completely wipe off the transactions in unlisted debt securities. For the debt market to grow, trading in unlisted debt securities must continue. These platforms should be regulated, but not in a way the same limits the market. SEBI may relook the proposed provisions and consider relaxing the same.

---

^[1] We are not commenting on the legality of some of these schemes. We have expressed our views on this issue in our article – https://vinodkothari.com/2021/01/law-relating-to-collective-investment-schemes-on-shared-ownership-of-real-assets/

^[2] https://www.sebi.gov.in/reports-and-statistics/reports/jul-2022/consultation-paper-on-online-bond-trading-platforms-proposed-regulatory-framework_61087.html

^[3] The meaning of “private placement” has always been a subject matter of controversy, as also considerable avenues for legal sophistry creating gaps in the regulatory framework, as was quite evident from the massive misuse of the provisions by Sahara group of companies.