Among the many ways by which companies can raise capital is preferential issue -- an issue of fresh shares or convertible debentures allotted to a select set of people, whether promoters, their relatives, or institutional investors.

One could call it a wholesale equity market since the retail investors or shareholders are not invited to participate. The issue is currently governed by section 81(1A) of the Companies Act and is similar to the issues made by companies in the US under Rule 144A of the US Securities Act.

Promoters have used preferential allotments as a means for raising their stake in their companies -- whether through shares or equity warrants, which can be converted at a later date.

Unfortunately, however, allegations abound that the system has been misused by unscrupulous promoters, who initially sell their existing holdings at a higher price in the secondary market, and then build up their stakes through such issues at a lower price.

In some instances, promoters are believed to have colluded with investors. Essentially, a group of people has enriched themselves in an unfair manner, to the detriment of the company and smaller shareholders.

Which is why the regulators are now attempting to tighten the guidelines.

Until now, preference shares of promoters or promoter groups have been subject to a lock-in for three years. But this applies only to a maximum of 20 per cent of the paid-up capital and includes capital brought in by way of a preferential issue.

This means that if there are preferential shares in excess of 20 per cent, the promoter is free to sell them at any time. What is now being suggested is that the entire lot of shares allotted to promoters should not be transferable for a period of three years.

Thus, the 20 per cent rule, which was creating anomalous situations, will not apply and all shares issued will be subject to a lock-in for three years.

In addition, a promoter or a promoter group cannot sell any portion of their existing shareholding for six months before the preferential issue.

That would ensure that promoters do not sell shares at a higher price and then issue fresh shares to themselves at a lower price. And furthermore, they cannot also sell existing shares for one year post-allotment.

Since the promoter needs to demonstrate commitment, making the lock-in guidelines more stringent is a step in the right direction. That should ensure that only promoters serious about their businesses are allowed to access the markets.

For investors, the lock-in period is one year and it is being suggested the lock-in should remain. The ostensible reason for institutional investors being subject to a lock-in is that they are privileged, having received a block of shares and, therefore, must pay a price for it.

It is true that institutional investors do benefit by getting a big lot -- if they had to pick up the same number of shares in the market, the cost would be higher, especially in an illiquid counter. Investors, however, are reluctant to lock in their shares claiming that in the event of any adverse news flow, they become sitting ducks.

That is not without justification. Even if there is no negative news relating to the company per se, the market as a whole could fall, for extraneous reasons, and investors would not be able to sell.

This is one reason for investors, including some private equity investors, staying away from preferential issues and preferring instead to pick up a lot from the market as and when it is available.

That, however, defeats the purpose of capital raising since the funds merely move from one investor to another and do not flow into the company. Neither does the free float go up; so if it is a small company, the liquidity does not improve.

On the face of it, there appears to be no reason why a lock-in should be enforced for investors, especially since the minority shareholders approve the issue at a shareholder's meeting.

Moreover, issued are priced in line with a formula stipulated by the regulators. If the share price moves up, retail investors also stand to gain.

In fact, stocks often get re-rated when reputed institutions pick up big holdings, which again is to the benefit of the small shareholder. However, the concern is that being a big investor, a fund might get hold of sensitive information before other investors, and sell ahead of the rest.

So, while there is little to worry about when things are going right and the share price is moving up, a situation should not arise where big investors are privy to sensitive information and dump shares in the market.

Of course, this could happen even with institutional investors who have not bought shares in a preferential issue but in the secondary market. Managements tipping off fund managers ahead of formal announcements are not unheard of.

On the whole, therefore, it would be a pity if investors are kept away from companies that genuinely need capital because not all companies can afford to mop up money through American depository receipts or foreign currency convertible bonds, which need to be of a minimum size to justify the expenses.

Larger companies will always manage to raise resources but mid-sized firms need access to capital.

One advantage of raising money via a preferential issue is that it helps save costs and time involved in a public issue. More important, if the concerned company is not doing too well at that point in time but requires capital, then retail investors may not want to participate in an issue.

At the same time, there could be some institutions who view the company's troubles as being temporary and feel that some injection of capital could help it out of the trough.

In fact, promoters need such investors in times when the market sentiment is weak and a public issue could fail. But such investors, who are willing to take a call on the management's abilities to turn around the company, nonetheless need an exit if things don't work out.

With not too many preferential allotments having taken place, the capital market has also lost out since there is less liquidity in the concerned stock and, consequently, less depth in the market.

Though firms prefer an overseas issue even if they are already listed abroad, because shares fetch a better premium, an overseas issue is costlier and calls for greater compliance.

Thus, if they felt they could price shares at a reasonably good premium in the domestic market and were confident of a good response, they might as well issue preferential shares.

And investors for their part should not mind buying through a preferential issue if there is no lock-in because the premium would be lower and liquidity in the domestic market is better than that in the ADR or global depository receipts markets.

The other issue relating to preferential issues currently being debated is how these issues should be priced. Currently, the price for a preferential issue is the higher of the average of the weekly high and low of the closing prices in past six months, or the average for two weeks.

This formula, it is being suggested, should be changed slightly and the average of the daily weighted average of 130 trading sessions or the last 10 trading sessions, whichever is higher, should be the issue price.

The new formula is better simply because it takes into account a daily weighted average and not closing prices that can, to some extent, be manipulated in infrequently traded counters.

To sum up, preferential issues are good for the capital market and provide companies with an avenue to raise resources. Investors should, therefore, be encouraged to invest in these placements.

If proper checks and balances are put in place there can be no incentive to misuse the system.