With IPO bandwagon running in full stream, many companies are planning to board the same. Planning for an IPO is a long and meticulous process and which amongst many things involves re-aligning companies’ long terms goals , overhauling systems and process, financial restructuring, compliance management and due diligence. In respect to due diligence process, secretarial compliances form the backbone of the entire process. In this article, we will discuss some key aspects related to due diligence of secretarial compliances and key areas, which require specific attention.

Due diligence: Scope and boundary

As part of the IPO preparation, a due diligence of secretarial compliances is undertaken to assess the status. In terms of the ICDR Regulations, the merchant bankers have to assess the risk related to compliances for the look back period of three years. Therefore, companies shall ensure that all the secretarial compliances are in order for the said period. While overall compliances are reviewed for the said period only, the compliances related to capital evolution, are examined since incorporation.

Capital Evolution

As discussed, secretarial compliances in connection with capital evolution need to be examined since incorporation. Since IPO generally include offer for sale or fresh issue of shares or both, it is necessary to ensure that the entire chain of capital evolution is rigorously sensitized to ensure that all requisite compliances are there. One needs to ensure that all compliances including documentation in connection with increase of authorized capital, allotment and transfer of shares, members, have been duly undertaken.

This, at times, becomes a problem for companies which are in existence for more than 20-30 years, as record keeping for such a long period throws away many challenges. In this context, generally, it is seen that there are issues in connection with retrieving old filings with the registrar of companies, as the same used to happen physically. Moreover, records related to old entries in the register of members at times are also not available. A general mitigation measure in such cases is to provide necessary disclosures under risk factors in the offer document.

Filings with the Registrar of Companies

A company is required to undertake many filings under the Companies Act, 2013 with the Registrar of Companies. At times, these filings are done beyond the prescribed period on payment of prescribed additional fees. While generally these delayed filings don’t call for any penal action but details of such filling forms part of risk factors in the offer document, which will certainly put compliance culture within the organization in a bad light. So, please ensure your company regularly undertake its filings within prescribed timelines.

Loans from/to Directors and relatives

Closely held companies often tend to lend to, or borrow funds from, directors and their relatives, to meet regular need of funds of either of the parties. Such borrowing and lending become a critical point as part of the diligence, as, at times, relevant compliances are missed.

First of all, lending to directors and their relatives is strictly prohibited under Section 185 of the Act, unless your company is exempted from the provisions. Further, for lending to companies in which directors are interested, specific approval of shareholders by way of special resolution is required coupled with restrictions on end usage of funds. So, ensure that necessary controls are built around lending to directors, relatives and companies in which they are interested. Compliance lapses in such areas will require companies to file for the adjudication of penalties.

Similarly, while borrowing from directors and relatives, companies also tend to forget to disclose the same in their board’s report and financial statements. Further also ensure that the necessary declaration that funds being lent are not borrowed has been obtained.

It is advisable to sensitize the finance team as to the eligible persons from whom and to whom funds can be, borrowed or lent. Wherever possible, also ensure that all borrowings and lending are backed by necessary agreements.

Related Party Transactions (RPTs)

Related Party Transactions (RPTs) can often be a red flag during due diligence. Such transactions, when conducted transparently and in compliance with Section 188 of the Companies Act, 2013, can avoid potential conflicts of interest.

Companies preparing for an IPO must:

• Establish systems to ensure that all related parties are duly identified.
• Ensure that all RPTs are conducted at arm’s length and are in the ordinary course of business. Company should have necessary documents to back arm’s length claim.
• Ensure necessary approval from the Board of Directors or Shareholders have been obtained.
• Ensure about the adequate disclosures regarding these transactions in the financial statements and Board’s Report.

It is important to note that during the IPO process, an Independent Chartered Accountant is generally appointed to review all related party transactions. Therefore, it becomes much more important to ensure due compliance in this process.

Corporate Social Responsibility (CSR)

Compliance with CSR obligations, as required by Section 135 of the Companies Act, 2013 is another essential component which needs scrutiny during the due-diligence process. CSR compliance is not just a legal requirement but also a reflection of the company’s commitment to societal development.

Every company having net worth of Rs. 500 crore or more, or turnover of Rs. 1,000 crore or more or a net profit of Rs. 5 crore or more during the immediately preceding financial year shall constitute a CSR Committee and spend at least 2% of the average net profits of the company made during the three immediately preceding financial year in the activities specified in Schedule VII of the Companies Act, 2013.

Some of the gaps, which are generally identified in compliance of CSR provisions are as follows

• Failure to disclose the reasons for not spending the required CSR expenditure in the Board report
• Failure to transfer the amount in unspent CSR Account
• Failure to transfer the amount to specified funds within six months of the end of the financial year.

Companies should put in place a robust mechanism to ensure that the provisions of Section 135 are duly complied.

Disclosures in Board’s Report and Annual Return

The Board’s Report and Annual Return serve as a repository of important disclosures that affect the company’s corporate governance and financial performance. These documents are scrutinized heavily during IPO due diligence. Common violations which are observed in the board’s report include disclosure reporting incorrect details of board meeting, exempted deposited borrowed from directors, reasons for failure to spend CSR expenditure, details of related party transactions etc. Similarly in Annual Return, incorrect reporting of board meetings or transfer of shares-related details. It is important to note that these violations are not easily rectifiable as times Registrar of Companies do direct the companies to obtain approval of National Company Law Tribunal for revising the Board’s report.

While preparing a board report, companies shall be diligent to ensure that all required financial and other disclosures are duly made.

Appointment as Whole-Time Director (WTD)

Private companies tend to appoint Directors with monthly remuneration as employees without either appointing or designating them as Whole-time Directors of the Company. As per sub-clause (94) of Section 2, a “whole-time director” includes a director in the whole-time employment of the company. Therefore, where companies are paying remuneration to their directors as an employee, they will be treated as whole-time Directors. Generally, in such cases, companies either fail to file requisite forms in connection with the appointment or fix their tenure or report the same in the Annual Return. Companies must ensure to designate their whole-time directors and undertake necessary filings or disclosure in the said respect.

Declaration in Respect of Significant Beneficial Ownership (Section 90)

Section 89 and Section 90 of the Companies Act, 2013, require companies to maintain and disclose accurate records of beneficial ownership. This is critical in ensuring transparency in ownership and control, particularly when preparing for an IPO. Companies must:

• Ensure that all shareholders have filed declarations under Section 89 for beneficial ownership, if required.
• Review compliance with Section 90, which mandates disclosure of significant beneficial owners (SBOs) who hold more than 10% of the company’s shares.

Considering the recent adjudication orders passed by the Registrar of Companies, compliance of the provisions of Section 90 becomes much more relevant from an IPO perspective.

Mitigating Actions

Whereas a result of secretarial due diligence, instances of non-compliances under the Companies Act, 2013 are found, then the following mitigating actions are available:

• File a compounding application under Section 441 with National Company Law Tribunal or Regional Director for regularizing the default. Such application can be filed where the default is punishable either by fine or fine or imprisonment or both; or
• File an adjudication application under Section 454 with the Registrar of Companies for regularizing defaults, which are punishable with penalty; or
• Where neither of the aforementioned options are available, consider reporting them under risk factors in the offer document depending upon the materiality of default.

CONCLUSION

Closely held companies generally tend to undermine the importance of secretarial compliances until they plan to go for an IPO. IPO readiness requires a comprehensive approach to secretarial compliance and disclosures. By ensuring strict adherence to the regulations outlined above, companies can mitigate risks, build investor trust, and facilitate a smooth IPO process.