COMPANY LAW PROJECT

MERCHANT BANKING:
Genesis, Evolution & the Current
Plight in India

Submitted by:
SHARIKA.R

973

Vth Semester

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 INDEX

TOPIC PAGE

Introduction 3

Origin of Merchant Banking 4

Merchant Banking in UK 5

Merchant Banking in India 7

Analysis of Merchant Bankers Regulations 9

Loopholes in the Regulation 10

Recent Developments & Challenges Ahead 12

Conclusion 12

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 1. AN INTRODUCTION TO MERCHANT BANKING

Merchant banking is one of the oldest and specialized financial intermediaries in the primary
market and is popularly called “Accepting and issuing houses”. The term merchant banking is
rather abstract in terms of its definition. However an attempt to define the same can be made by
understanding the services and activities coming within its purview. Very commonly, the
merchant banking has been defined as to what a merchant banker does.1

Sir Edward Reid has stated that, the term merchant bank is sometimes applied to banks who are
not merchants, sometimes to merchants who are not banks, and sometimes to houses who are
neither merchants nor banks.2 Hans-Peter Bauer has put forth eleven characteristics that a
merchant bank should contain: high portion of decision-makers as a percentage of total staff,
quick decision process, high density of information, intense contact with the environment, loose
organizational structure, concentration of short and medium –term engagements, emphasis on fee
and commission income, innovative instead of repetitive operation, sophistical services on
national and international level, low rate of profit distribution and high liquidity ratio.3

In the view of John Dick the meaning and definition of merchant banking has been constantly
evolving due to the dynamic nature of functions of merchant banks, “of its very nature as
merchant banking is always evolving the definitions supplied today would perhaps not be the
same as they were three or four years ago.4 A focused analysis tells us that a merchant bank can
generally be described as a financial services company with a private equity investment arm
offering investment banking and ancillary services as well.

In the Indian context, merchant bank has been defined by V. Gangadhar and M. Sunder as a
service activity. Accordingly, banking departments rendering non-fund based services of
arranging funds rather than providing them to the needing industrial concerns is called merchant
banking.5

1
Harbert J. A.P, Money and Capital Market in UK and Europe (Administration Staff College, UK 1980)
2
Sir Edward Reid, The Role of Merchant Banks Today (Institute of Bankers, London 1963)
3
Hans- Peter Bauer, What is a Merchant Bank
4
John Dick, Why do You Need a Merchant Bank (Institute of Banking & Finance 1976)
5
Gangadhar V., Sunder M., Merchant Banking in India- A Changing Scenario

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 2. ORIGIN OF MERCHANT BANKING
The origin of merchant banking can be traced to the developments of foreign trade and finance
which first occurred during the 13th century. During this period, a few firms engaged in coastal
trade and finance spread throughout the European continent. They were engaged both in
commercial activities and banking activities and also acted as the bankers to the Kings of the
European States. These firms bore exchange risk and security risk in financing the Kings,
Monarchs and Governments who were engaged in continental wars. The main centre for world
trade and finance at that time was Amsterdam, where the Dutch traders relied upon the expertise
of merchant bankers, then known as commission agents, for financing of trade.

Italian grain merchants also started merchant banking activities in late medieval times in Italy
and France during the 17th and 18th centuries. Thus, the Italian merchant bankers introduced
England not only to the world of bill of exchange but also all the institutions and techniques
connected with an organised money market. Initially, merchant banking consisted of merchants
who helped in financing the transactions of other merchants in addition to their own trade. In
France, during this period, a merchant banker was not merely a trader but was regarded as an
entrepreneur par excellence. He was one who invested his accumulated profits in all kinds of
promising activities. He later added banking business to his merchant activities, becoming a
merchant banker.6

Money Changer and Exchanger

In the late medieval to early modern times, there existed a distinction in the banking systems
between money changer and exchanger. Money changers concentrated on the manual change of
different currencies and in due course of time, evolved into public or deposit banks. Exchangers
who operated internationally, engaged in bill-broking, raising foreign exchange and provision of
long-term capital for public borrowers. The exchangers were remitters and merchant bankers.
Thus, the modern merchant banking started from London where the merchants started to finance
the foreign trade through the acceptance of bill of exchange.7

6
Valentine V. Craig, Merchant Banking
7
H.R. Machiraju, Merchant Banking, Principles and Practice (New Age International Publishers, 4th ed.)

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 3. MERCHANT BANKS IN THE UNITED KINGDOM
In the United Kingdom, the advent of merchant banking was in the late 18th century and early
19th century. After the Industrial Revolution, England emerged as a powerful trading nation.
Rich merchant houses that made their fortunes in colonial trade then diversified into banking.
Their principal activity was the acceptance of commercial bills pertaining to domestic as well as
international trade. With the acceptance of the trade bills and their discounting, acceptance
houses, discount houses and issue houses soon came into the picture.8

A merchant banker was primarily a merchant rather than a banker but he was entrusted with
funds by his customers. The oldest recorded merchant bank in London was Baring Brothers.
Merchant banks in the United Kingdom undertake multifarious activities such as: (a) financing
foreign trade, (b) issuing capital, (c) managing individual funds, (d) undertaking foreign security
business and (e) foreign loan business. Many major merchant banking activities which include
money-market lending, corporate finance and investment management are also performed by
money market dealers, commercial banks and finance companies, share brokers and investment
consultants, and unit trust managers.9

Merchant banks also financed the sovereign governments and aided them through the grant of
long term loans. The British government was financed by merchant bankers to purchase shares
of the Suez Canal. They even helped America in the purchase of the State of Louisiana from
Napoleon by raising loans from money market in London. Also the Government of India was
granted a loan by the Lazard Brothers granted loan to for Durgapur Steel Plant.10

Since the end of the Second World War, commercial banks in Western Europe have been
offering multiple services. These services include merchant banking services to their individual
and as well as corporate clients. British banks have also set up divisions or subsidiaries with the
intention of making merchant banking services easily accessible to their customers. In the
present scenario, a merchant banker is one who has the ability to merchandise i.e. to create or
expand a need and fulfill capital requirements. Amidst all the swift changes sweeping the
financial world, merchant banking has emerged as an indispensable financial advisory package.

8
Meir Kohn, Merchant Banking <http://www.dartmouth.edu/~mkohn/Papers/99-05.pdf>
9
Michael T. Skully, Merchant Banking, (The Bankers’ Magazine of Australasia 1977)
10
Anand Bathiya, Investment Banking Origin <http://www.bathiya.com/files/docs/presentations/hib.pdf>

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 4. MERCHANT BANKING- INDIAN SCENARIO

Merchant banking activities started in India from the year 1967. Prior to the enactment of Indian
Companies Act 1956, managing agents acted as issue houses for securities, evaluated project
reports, planned capital structure and to some extent provided venture capital for new firms and
few share broking firms also functioned as merchant bankers. But with the rapid growth in the
number and size of the issues made in the Indian primary market, the need for specialized
merchant banking services was felt.11

Merchant banking activity was formally initiated into the Indian capital markets when Grindlays
Bank received the license from the Reserve Bank in 1967. Grindlays which started with
management of capital issues recognised the needs of emerging class of entrepreneurs for diverse
financial services ranging from production planning and systems design to market research.
Apart from focusing on the needs of small scale units, it provided management consultancy
services to large and medium size companies.12 Following Grindlays Bank, Citi Bank set-up its
Merchant Banking division in 1970. The division took up the task of assisting new entrepreneur
and existing units in the evaluation of new projects and raising funds through borrowing and
issue of equity.

The Banking Commission in its 1972 report emphasised the necessity of merchant banking
service with regard to the wide industrial base of the Indian economy.13 The Commission was in
favour of a separate institutions, as distinct from commercial banks and term lending institutions,
to render merchant banking services. It thus recommended the setting up of merchant banking
institutions. These were to offer investment management and advisory services especially to the
medium and small savers. They should also be in a position to manage provident funds, pension
funds and various types of trusts. This marked the beginning of specialized merchant banking in
India. The State Bank of India was the first to set up a Merchant Banking division in 1972. SBI’s
objective in the initial years was to render corporate advice and assistance to small and medium
entrepreneurs. The commercial banks that followed SBI in setting up merchant banking units in

11
Kapil Baheti, Analysis of merchant banking in India
12
cf Machiraju (n7)
13
Reserve Bank of India, Banking Commission Report 1972
<https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=73>

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1977 were Central Bank of India, Bank of India and Syndicate Bank; in 1978 Bank of Baroda,
Standard Chartered Bank and Mercantile Bank; later the United Bank of India, United
Commercial Bank, Punjab National Bank, Canara Bank and Indian Overseas Bank in late
seventies and early eighties. Among the development banks, ICICI started merchant banking
activities in 1973 which was followed by IFCI in 1986 and then in 1991 IDBI. The merchant
banking gained prominence during 1983-84 due to boom in the new issue.

The economic reforms initiated since 1991 by the Government in the fields of industry, trade and
financial sector have paved the way for fast paced development of the economy. According to
Goldsmith, there is a well proven link between economic growth and financial technology.14
Several projects have been conceived of and several large projects have been set-up in the
infrastructure sector envisaging investment of thousands of crores. This has increased the
demand for a complete range of merchant banking services resulting in a sharp growth in the
Merchant Banking business.15

5. ANALYSIS OF SEBI (MERCHANT BANKERS) REGULATIONS

In exercise of the powers conferred under §30 of the SEBI Act 1992, the Board has made
different regulations for almost all aspects of capital market. Similarly SEBI (Merchant Bankers)
Regulations, 1992 was enacted with the intention of regulating the activities of merchant
bankers. Registration with SEBI is mandatory to carry out the business of merchant banking in
India. No person s allowed carrying out any activity as a Merchant Banker unless he or she holds
a certificate grated by SEBI.

Currently the total number of merchant bankers in India is approximately 1450 with more than
930 registered with SEBI. The objectives of the merchant banking regulations has been stated by
H.R. Machiraju16 as follows: “The merchant bankers regulations which seek to regulate the
raising of funds in the primary market would assure for the issuer a market for raising resources
at low cost, effectively and easily, ensure a high degree of protection of the interest of the
investors and provide for the merchant bankers dynamic and competitive market with high

14
Goldsmith R., Financial Structure and Development (Yale University 1969)
15
Merchant Banking- Nature and Scope <http://www.newagepublishers.com/samplechapter/000490.pdf>
16
cf Machiraju (n7)

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standard of professional competence, honesty, integrity and solvency. The regulations would
promote a primary market which is fair, efficient, flexible and inspire confidence.”

Under the Regulations, merchant bankers were recognized as primary intermediaries in the role
of ‘issue manager’ in the capital market. These regulations provided for the compulsory
registration, capital adequacy requirements, general obligations and responsibilities and code of
conduct for the merchant bankers as also the procedure for inspection of books of accounts,
records and documents of merchant bankers. Merchant banker has been defined as “any person
who is engaged in the business of issue management either by making arrangements regarding
selling, buying or subscribing to securities or acting as manager, consultant, adviser or
rendering corporate advisory service in relation to such issue management.”17

CATEGORIES OF MERCHANT BANKERS

The SEBI has classified merchant bankers under four categories for the purpose of registration.18

Category-I can act as issue manager, advisor, consultant, underwriter and portfolio manager.

Category-II can act as advisor, consultant, underwriter and portfolio manager.

Category-III can act as underwriter, advisor and consultant only.

Category-IV can act as consultant or advisor to the issue of capital.

Since December 9, 1997 only Category I exists. Different categories of merchant bankers were
abolished and only Category-I merchant bankers are registered by the SEBI.

CONSIDERATION OF APPLICATION

The consideration for application for grant of certificate takes into account:19

(a) That the applicant is a body corporate

(b) Employment of two persons who have the experience to conduct the business of merchant
bankers

17
Rule 2(cb) SEBI (Merchant Bankers) Regulations, 1992
18
Rule 3(2) SEBI (Merchant Bankers) Regulations, 1992
19
Rule 6 SEBI (Merchant Bankers) Regulations, 1992

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(c) A person directly or indirectly connected with the applicant has not been granted registration

(d) Capital adequacy and whether involved in litigation relating to securities market

(e) Whether convicted or found guilty of economic offense

(f) Infrastructure like adequate office space, equipment and manpower

(g) Applicant is a fit person and professional qualification in finance, law or business
management

(h) Grant of certificate is in the interests of investors.

GENERAL OBLIGATIONS AND RESPONSIBILITIES

Code of Conduct: The code of conduct stipulates that in the performance of duties, merchant
banker should act in an ethical manner. He is obliged to comply with the code of conduct, render
high standard of service and exercise due diligence, not to indulge in unfair practices, not to
make misrepresentations, give best advice, not to divulge confidential information about the
clients, endeavour to ensure that true and adequate information is provided to investors.
Merchant bankers also have to deal adequately with complaints from investors. They should not
be a party in respect of issue of securities, creation of false market, price rigging or manipulation
or pass price sensitive information. They have a duty to abide by all rules, regulations, guidelines
and resolutions issued by the Government of India and SEBI from time to time.20

Maintenance of Books of Accounts, Records and Documents: Merchant bankers have to keep
and maintain a copy of the balance sheet, a copy of the profit and loss statement, a copy of the
auditor’s report and a statement of financial position. Merchant bankers have to intimate SEBI
where the accounts, records and documents are maintained. They have to furnish annually to the
Board copies of balance sheet, profit and loss account and such other documents for any other
preceding five accounting years as required.21

20
Schedule III, Regulation 13, SEBI (Merchant Bankers) Regulations, 1992
21
Rule 14 SEBI (Merchant Bankers) Regulations, 1992

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 6. LOOPHOLES IN THE REGULATION & 1997 AMENDMENT
CRB Capital Market, which was registered with SEBI as category-I merchant banker and had
also obtained licence to act as non- banking financial company from RBI. It collapsed in May
1997 due to bouncing of cheques which were issued by the company in favour of its fixed
deposit investors. With this came the end of the CRB group and this issue brought to light the
various irregularities on the part of RBI and loopholes in the existing regulatory frame work as
regards merchant bankers functioning as a non- banking financial institutions also.22

In case of non- banking financial company the performance of fund based activities such as
leasing, hire-purchase etc. are controlled by RBI and their fee based activities like merchant
banking activities and underwriting are regulated by SEBI. This resulted in a lack of co-
ordination between RBI and SEBI. The Merchant Bankers Amendment Regulations, 1997 was
enacted under which only body corporate was allowed to function as merchant bankers and
multiple categories of merchant bankers were abolished. They were allowed to undertake only
those activities which were related to securities market and were prohibited from carrying on
fund based activities other than those related exclusively to the capital market. The amendment
ushered in more transparency in disclosure requirements in offer documents and also introduced
mandatory underwriting by lead managers.

EXEMPTION FROM RBI REGULATIONS: In 1997 SEBI had made companies ineligible
for registration as merchant bankers if they are carrying on any of the financial activities
mentioned in the RBI Act. SEBI has suggested to RBI certain exemptions for these merchant
banking companies from the provisions of RBI Act and NBFC Directions. Accordingly RBI
exempted merchant banking companies from compulsory registration23, maintenance of liquid
assets24, creation of reserve fund25 etc. But the eligibility for the same is subject to compliance
with the following conditions: (i) such companies are registered with SEBI as a merchant banker
and are carrying on the business in accordance with rules framed by SEBI; (ii) they acquire
securities only as part of their merchant banking business; (iii) they do not carry on any other
financial activities; and (iv) they do not accept/hold public deposits.
22
cf Kapil (n8)
23
§45 IA, RBI Act 1934
24
§ 45 IB, RBI Act 1934
25
§ 45 IC, RBI Act 1934

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 7. RECENT DEVELOPMENTS IN MERCHANT BANKING &
THE CHALLENGES AHEAD
RECENT TRENDS

The Merchant Banking was regarded to be at its best between the periods of 1985-1992 when
there were many new issues. The coming years are expected to be a party time for merchant
banks. The prediction is that the merchant banking business is going to flourish as many new
issues are coming up.26 The foreign investors are now increasingly venturing into the Indian
economy, both in the form of portfolio investment and foreign direct investments. It is enlarging
the scope of merchant bankers in many ways. Greater disinvestment in the government sector is
giving a big scope to the merchant banks to function as consultants in the country. Time and
again new financial instruments are introduced in the market that provides the merchant bankers
with more opportunities.

The mergers and corporate restructuring along with Memorandum of Understanding (MOU) and
Memorandum of Association (MOA) are giving immense opportunity to the merchant bankers
for consultancy jobs. The Finance Ministry has excluded services provided by merchant banks
and other agencies in a merger and acquisition (M&A) transaction from the scope of taxable
services provided by a `management consultant.' The rationale behind such a decision is that the
role of such agencies is limited to compliance of any statute or regulation, such as takeover
regulations of the Securities and Exchange Board of India (SEBI), and not governed by any
contractual relationship with the advisee company.

CHALLENGES FACED

Firstly, SEBI guideline has restricted the operations of the merchant bankers to Issue
Management and Portfolio Management to some extent. This has limited the scope of their work.
These guidelines have necessitated merchant bankers to rethink their course of conduct, either
restrict their activities or think of separating these activities from the present one and float new
subsidiary and enlarge the scope of its activities. Secondly, poor condition of the new issues
market in India is drying up the business of the merchant bankers.

26
Shreyas B.S, Merchant Banking Past and Present: Indian Scenario, The International Journal Of Business &
Management

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Another problem which confronts the merchant bankers is non-cooperation on the part of the
issuing companies in timely allotment of securities and refund of application money. The
guidelines have put the responsibility on the merchant bankers. They have to seek the co-
operation of the issuing company to shoulder the responsibility. Again, SEBI guidelines stipulate
a minimum net worth of Rs.1 crore for authorization of merchant bankers. Thus the small
merchant bankers who do not have a net worth of Rs.1 crore are put to a great disadvantage may
have to close down their business despite being professional and specialized. This prevents the
entry of young, specialized professionals into the merchant banking business. Very often the
consequences of the inefficiencies of the clients are blamed on to the merchant banks, leaving
them to face the trouble without any fault of their own. These fallacies in the regulations need to
be addressed.

SEBI guidelines have made management by a lead merchant banker and certification mandatory
for rights issues. Though this particular SEBI guideline was, undoubtedly, intended to generate
more information about the quality of the rights offerings, it is likely to have resulted in less
information being available to the investors at large to help them in their investment decisions. In
order to correct this problem, the regulation in question needs to be amended should and
management and certification by a lead merchant banker should not be made compulsory for
rights issues.27

8. CONCLUSION

Thus the Merchant banking Industry in India has witnessed and experienced significant changes.
The motive for which these firms commence their services should be carefully looked into and
the merchant bankers should mold their policy decision and activities to be in tune with the main
objectives of Investor’s protection thus aiming at creating a healthy environment in capital
markets. There is no doubt that merchant banking firms are subject to a host of control measures,
regulations and rules framed and guided by SEBI. Frequent amendments to the policies, though
needed for smooth working of the securities industry, prove to be detrimental to the very
existence of the Merchant Banking system in the country to some extent.

27
Sankar De Sushil Khanna, Merchant Banking under SEBI Guidelines, Economic & Political Weekly, vol.29

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 BIBLIOGRAPHY

 Merchant Banking- Principles And Practice, H.R Machiraju

 Verma V., Merchant Banking

 Taxmann’s SEBI & Corporate Laws

 Bhat V.V., Main Bank system and India

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