A stock swap is a transaction where an acquirer acquires shares of another company and, instead of paying cash for such acquisition, discharges consideration by issuance of its own shares. Business World has surveyed experts on the question as to whether a stock swap amounts to a “sale”. The response is as follows:
Yes : 33%
No : 10%
Maybe : 57%
A summary of the reasons for each answer has been set out in the survey (link provided above).
It appears that the answer "maybe" is probably more appropriate, as a lot would depend on the exact features of the transaction as well as the real intention between the parties. There can be no generalisation as to these matters, especially in a legal sense, as expressions such as "stocks swap", “reverse merger”, etc. are not statutorily defined, but are rather terms that emanate from market practice.
Competition Commission & Global Mergers
There has been a coordinated and consistent move by industry to ensure that merger regulations that have been proposed by the Competition Commission do not cover global mergers whose implications in India are not substantial. We have discussed this issue in the past on this blog (here, here and here). In fact, the draft regulations do contain some de minimis exceptions that seemingly placate industry concerns.
However, adopting a somewhat contrarian approach, in an article in the Economic & Political Weekly titled Are Merger Regulations Diluting Parliamentary Intent?, the authors Manish Agarwal and Aditya Bhattacharjea argue that such exceptions brought in through the draft regulations dilute the intention of the legislature in enacting the Competition Act (and the amendments in 2007). The authors state:
However, adopting a somewhat contrarian approach, in an article in the Economic & Political Weekly titled Are Merger Regulations Diluting Parliamentary Intent?, the authors Manish Agarwal and Aditya Bhattacharjea argue that such exceptions brought in through the draft regulations dilute the intention of the legislature in enacting the Competition Act (and the amendments in 2007). The authors state:
“These merger regulation provisions, in particular, the mandatory notification requirement and the lack of a “domestic nexus” criterion for foreign mergers have been sore points for the domestic as well as international business communities. It has been argued that the mandatory notification system will require notification of foreign mergers with little or no nexus to India and add to the cost of doing business as well as strain the resources of the CCI. The amendment Act has sought to address this concern by providing for a domestic nexus test. Accrodingly, the thresholds for worldwide turnover or assets have been amended, so that only those combinations where at least Rs. 500 crore of the combined worldwide assets or at least Rs. 1,500 crore of combined worldwide turnover of the merging parties is in India, would come under the purview of the Act. However, this amendmednt has not been well received in business and legal circles.The authors subject this modified two-firm domestic nexus test to an economic analysis and advance arguments that there could be scenarios where mergers could fall below the thresholds stipulated above, but would still raise significant competition concerns. Such arguments are certain to be met with stiff resistance from industry circles.
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In order to address this and other procedural objections and to outline its approach towards merger review, the CCI published draft combinations regulations in January 2008, which list certain categories of transactions that will be treated by the CCI as not likely to cause an appreciable adverse effect on competition in India. They include a modified two-firm domestic nexus test according to which combinations in which at least two parties do not each have a minimum of Rs. 200 crore of assets or Rs. 600 crore of turnover in India will be considered benign. …”
Vodafone Income Tax Case
The acquisition of shares in Hutch Essar by Vodafone from Hutchison in a multi-billion dollar M&A deal last year has resulted in a dispute on the taxability of capital gains on the transaction. This dispute is currently pending before the Bombay High Court, with a decision being awaited. The court’s verdict is expected to have serious implications on costs involved in implementing M&A transactions in Indian companies, especially when the buyer and seller are overseas entities.
In this behalf, CNBC-TV18 has an interesting discussion about the possible arguments in the case, and also the impact of the decision on future M&A deals. The background is described in the opening part of the discussion as follows:
In this behalf, CNBC-TV18 has an interesting discussion about the possible arguments in the case, and also the impact of the decision on future M&A deals. The background is described in the opening part of the discussion as follows:
“It is a landmark case that will severely impact the Mergers & Acquisitions (M&A) landscape in India. No matter which way it goes, the Vodafone versus IT department tax case will have an indelible impact on the M&A landscape of India. Last year British Telecom giant Vodafone paid Hong Kong based Hutchison International over USD 11 billion to buy Hutchison’s 67% stake in Indian telecom company Hutchison Essar. The transaction was done through the sale and purchase of shares of CGP, a Mauritius based company that owned that 67% stake in Hutch Essar.See also a previous news report about the case in the Business Standard.
Since the deal was offshore, neither party thought it was taxable in India. But the tax department disagreed. It claimed that capital gains tax most people paid on the transaction and that tax should have been deducted by Vodafone whilst paying Hutch. The matter went to court and was heard over the last two weeks.
Vodafone argued that the deal was not taxable in India as the funds were paid outside India for the purchase of shares in an offshore company that the tax liability should be borne by Hutch; that Vodafone was not liable to withhold tax as the withholding rule in India applied only to Indian residence that the recent amendment to the IT act of imposing a retrospective interest penalty for withholding lapses was unconstitutional.
Now the taxman’s argument was focused on proving that even though the Vodafone-Hutch deal was offshore, it was taxable as the underlying asset was in India and so it pointed out that the capital asset; that is the Hutch-Essar or now Vodafone-Essar joint venture is situated here and was central to the valuation of the offshore shares; that through the sale of offshore shares, Hutch had sold Vodafone valuable rights - in that the Indian asset including tag along rights, management rights and the right to do business in India and that the offshore transaction had resulted in Vodafone having operational control over that Indian asset. The Department also argued that the withholding tax liability always existed and the amendment was just a clarification.”
Security for External Commercial Borrowings: Liberalised Regime
The Reserve Bank of India (RBI) has announced a series of measures to liberalise the regime for Indian borrowers to create security in favour of lenders in case of external commercial borrowings (ECBs). Now, borrowers are only required to obtain the ‘no-objection’ from the authorized dealers (AD) rather than to obtain the prior approval of the RBI for certain types of security (as was the practice until now).
The relevant Circular issued by the RBI yesterday notes:
The relevant Circular issued by the RBI yesterday notes:
“3. As a measure of rationalization of the existing procedures, it has been decided to allow AD Category – I banks to convey ‘no objection’ under the Foreign Exchange Management Act (FEMA), 1999 for creation of charge on immovable assets, financial securities and issue of corporate or personal guarantees in favour of overseas lender / security trustee, to secure the ECB to be raised by the borrower.
4. Before according ‘no objection’ under FEMA, 1999, AD Category – I banks may ensure and satisfy themselves that (i) the underlying ECB is strictly in compliance with the extant ECB guidelines, (ii) there exists a security clause in the Loan Agreement requiring the borrower to create charge on immovable assets / financial securities / furnish corporate or personal guarantee, (iii) the loan agreement has been signed by both the lender and the borrowers, and (iv) the borrower has obtained Loan Registratoin Number (LRN) from the Reserve Bank.”
Management Buyouts (MBOs): Possibilities and Challenges
Earlier this week, The Hindu Business Line carried a detailed column on various business and financial aspects of management buyouts (MBOs), particularly as such deals are being witnessed (albeit infrequently) in India. Simply stated, management buyouts involve the acquisition of a division of a company or the shares in a company, in each case by the managers who have been handling the affairs of such division or company. Such acquisitions take place when owners desire to sell off a division or a company or even close or liquidate it, while the managers on the hand envision future growth potential and are willing to place their bets on improving the performance of the division or company by acquiring it. Since managers may not possess adequate resources to effect such an acquisition, they are often compelled to seek financing or even a strategic partnership for this purpose.Structuring the Deal
At a general level, there are two broad structures that are followed in giving effect to an MBO transaction:
1. Partnership with Private Equity (PE) Players
In this structure, since managers are not able to self-fund an MBO transaction, they only acquire a small stake in the target, with the remaining major stake being taken up by private equity players who may partner with the managers. Managers are usually required to take as much stake in the business as they can afford to, so that their future is tied into that of the business as a method of properly incentivising these managers who are responsible for running the business. Providing additional stake in the form of ‘earn-outs’ may be another method of incentivising the managers.
So far, such types of MBO transactions have been more popular in the Indian context, at least where acquisitions of shares are involved (for reasons we shall see later). The Hindu Business Line column observes:
“Traditionally, Management Buy Outs (MBOs) involved the management wanting to purchase a controlling interest in the company and working along with financial advisors to fund the change of control.This type of MBO transaction is akin to a standard private equity deal involving execution of appropriate investment or shareholders’ agreements between the promoters (here the erstwhile managers) and the private equity investors. These agreements define the rights and obligations of the parties going forward in relation to the target, including in relation to transfer of shares (and restrictions on those) as well as to management and governance of the target (such as board composition, affirmative voting rights and the like).
Today, MBO activities involve promoters divesting their stake in a firm by selling out to PE players willing to finance the asking price. The PE players are flexible enough to enter into a partnering relationship with the existing management. This sort of arrangement is basically just a stake buyout and not a classical MBO.
It is common in scenarios where owners want to hive off entities with poor results and the management lacks funds to hold on to the entity (and their jobs) and are, in turn, bailed out by the PE firm.”
2. Classic Leveraged Structure
In the international context, the MBO structure followed more commonly is the classic leverage structure that is also popular in the case of leveraged buyouts (LBOs) (where the acquirer may not necessarily belong to the existing management, but could be a third party acquirer of the target company or business).
(a) Share acquisitions
Investopedia defines an LBO as follows:
“The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.”In this structure, the acquirers (being the managers) will acquire the entire stake of the target (or at least a large portion of it), for which they will obtain debt financing from lenders or financiers. Managers may also have to commit some capital, but that is relatively minor compared to the large finance obtained through leverage. Here, unlike in the case of private equity type transactions, the managers do not have to cede shareholding to an outside entity such as the private equity players. However, as security for the repayment of the financing obtained by the managers, they would offer as security the assets of the target company.
To illustrate this transaction, manager M may acquire the entire shares of target company T. To finance this, M obtains a loan from bank B. As security for repayment of the loan borrowed by M, company T will create a security over all its assets in favour of bank B.
This classic leveraged structure for MBOs for acquisition of shares in a target company faces almost insurmountable challenges in India. Section 77(2) of the Companies Act, 1956 provides:
“No public company, and no private company which is a subsidiary of a public company, shall give, whether directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares in the company or its holding company …”By virtue of this provision, the target company cannot provide security (which is construed to be ‘financial assistance’) to the lenders so as to provide finance to the managers to acquire shares in the target company. Any contravention of this provision could not only lead to the security being considered void, but would also expose the target company to punishment in the form of fine. Although the amount of the fine is only a minimal amount of Rs. 10,000, any violation could expose companies to reputation risk.
Section 77(2) is a strict provision with no exceptions (in the context of MBOs and LBOs). The only possible exception that may facilitate such leveraged transactions relates to those involving private limited companies (that are not subsidiaries of public limited companies) as such companies are not within the purview of the prohibition on financial assistance.
In this context, it is relevant to note that the Indian position on ‘financial assistance’ is fairly stringent compared to that in other common law countries. In other common law jurisdictions, there is either no prohibition on ‘financial assistance’ (e.g. most U.S. states, including Delaware) or there are processes to overcome the prohibition through what is referred to as the ‘whitewash procedure’ that is practiced, for instance, in the U.K. and Australia.
The stringency of the ‘financial assistance’ law is the principal reason why leveraged buyouts (whether by management or otherwise) have not acquired popularity in the Indian markets. On the other hand, Indian acquirers have utilised leverage while acquiring companies overseas, especially in the U.K., with prominent examples of such acquisitions being those undertaken by the Tata Group in Tetley, Corus and JLR.
If leveraged transactions are to pick up steam in India, there is a dire need to amend the laws relating to ‘financial assistance’ under the Indian Companies Act. While most other jurisdictions have been progressively liberalising their laws to permit leveraged transactions (with checks and balances being imposed in parallel), the Indian law has remained constant over the years without any indication of change in the near future. It is an appropriate time now to revisit this position.
(b) Business Acquisitions
Although share acquisitions would fall within the purview of the prohibition on ‘financial assistance’, leveraged structures can be utilised for purpose of business acquisitions. This would involve an acquisition by a manager, not of shares in a company, but of the business of the company.
In this structure, manager M will set up a special purpose company M Co. This new company M Co will acquire the business undertaking of company T, for which purpose M Co. will obtain financing from bank B. As security for repayment of the loan, M Co. will secure the assets of the business it acquired from T, which after the acquisition now belongs to M Co. itself. There is no prohibition in respect of such transactions as there is no ‘financial assistance’ for the purpose of acquisition of ‘shares’. What is involved is transfer of a business undertaking and not a transfer of shares.
Leveraging in such business transfers are permissible in the Indian context, but transfers of businesses may not provide as much flexibility as share transfers do, and further may be fraught with several risks and additional costs such as stamp duties, taxes, etc.
Other Issues
Apart from certain fundamental structuring issues discussed above, MBOs give rise to two complexities, viz. (i) information asymmetry, and (ii) conflict of interest. These issues are often required to be handled very carefully in MBO transactions.
As regards information asymmetry, it is clear that managers who are running businesses or companies (they propose to acquire) have greater information about the affairs of the businesses or companies than possibly the owners who may be selling them. Hence, it is necessary to ensure that the acquirers do not have any informational advantage while effecting such transactions, and that all relevant information has been disclosed to the sellers.
These transactions also give rise to a conflict of interest, as managers are on the acquiring side as well as the selling side. Care must be taken to ensure that the interests of the minority shareholders or owners in the selling company are protected and that the sale transaction itself is carried out on arm’s length basis.
Overall, MBO transactions do provide interesting possibilities for buyouts, but there are existing challenges under Indian law which need to be overcome before leveraged structures can be used to give effect to these transactions.
Corporate Governance in Banks
With the recent credit crisis weakening the financial position of several banks world-over, the question that is being repeatedly posed is whether the boards of directors of these banks could have foreseen the oncoming crisis or whether they should have taken steps to forestall a slide in their financial position. Fingers are being pointed not only at the executive management of these banks, but also at other independent board members.
In a recent column in the Economic Times, TT Ram Mohan laments the lack of adequate financial expertise among directors of banks that may have possibly led to their downfall. He notes:
In an Indian context, the issue of expertise on bank boards has already been addressed by law. Section 10A of the Banking Regulation Act, 1949 requires that no less than 51% of the directors of every banking company should possess expertise in the area of accountancy, economics, banking, finance, law and such other areas. Indian banks’ boards are to be predominantly comprised of persons with financial or banking background. Further, when it comes to corporate governance, the banking sector is subject to greater regulation compared to other companies. For instance, the Reserve Bank of India (RBI) applies further checks and balance by ensuring a maximum term of 8 years for a bank director and also by possessing powers to reconstitute the board of directors and to approve the appointment and removal of directors in certain situations.
All these point towards the fact that corporate governance in banks (being in the financial sector) has very different implications compared to companies in other sectors. In India, banks are subject to the governance requirements prescribed by clause 49 of the listing agreement as well as those prescribed by the RBI. Other countries follow a slightly modified approach – e.g. Singapore has two sets of codes for corporate governance, one for banks and financial institutions and another for other companies. This approach takes into account the different governance requirements for different types of companies.
Lastly, as to independent directors, there conceptually seems to be a misplaced over-reliance by regulators, commentators and the media on this institution as if it is a panacea to all ills. That is perhaps not to be. Independent directors are only board members (and are not involved in the day-to-day management) who can provide strategic direction and oversight of the company’s affairs. There is still considerable debate over the effectiveness of independent directors in corporate governance, although conventional wisdom suggests that independence in the decision-making process on board will make it objective, impartial and diligent. What is required is to apply substance over form while examining the role of board members, whether independent or otherwise. A Note in the Harvard Law Review published a couple of years ago (119 Harv. L. Rev. 1553 (2006)) aptly sums up this point:
In a recent column in the Economic Times, TT Ram Mohan laments the lack of adequate financial expertise among directors of banks that may have possibly led to their downfall. He notes:
“UBS, one of the world’s largest banks and among the biggest losers in the subprime crisis, is replacing four of its directors. The bank’s objective, according to its new chairman, is to strengthen the board with independent members with top-class financial or audit experience. The departing members include three outsiders with experience respectively in rail equipment, chemicals and information technology.He also questions the effectiveness of independent directors, even if they do possess the requisite expertise:
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Lehman’s audit committee and risk committee has a theatre impresario as member. Citi has a former head of the CIA in the same roles — no doubt, the bank believes that experience in surveillance gained at the CIA has broader applications. Northern Rock’s chairman at the time of its collapse was a zoologist — presumably, this was meant to guard against wild bets on the part of management.”
"One of the big improvements in corporate governance in recent years is said to be the institution of independent director. Boards are expected to have independent directors who will act as a check on management. But the idea that management, in its wisdom, would assemble the required expertise has taken some hard knocks. Many banks, it turns out, have big names aplenty. Banking expertise is sadly wanting.Such concerns about the ineffectiveness of independent directors on such bank boards have also been raised elsewhere in the past. Two posts on the Finlay on Governance Blog are noteworthy. These are Did Bear Stearns Really Have a Board? and Cayne and Greenberg: Two Peas in a Very Dysfunctional Bear Stearns Boardroom Pod.
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To be sure, board expertise does not ensure that tough questions will be asked. Board members may have expertise but they may be unwilling to challenge and confront management. Anybody who has sat on boards knows that any attempt to probe or criticise can inject a jarring note into the proceedings. The superannuated souls who grace many a board prefer the quiet life."
In an Indian context, the issue of expertise on bank boards has already been addressed by law. Section 10A of the Banking Regulation Act, 1949 requires that no less than 51% of the directors of every banking company should possess expertise in the area of accountancy, economics, banking, finance, law and such other areas. Indian banks’ boards are to be predominantly comprised of persons with financial or banking background. Further, when it comes to corporate governance, the banking sector is subject to greater regulation compared to other companies. For instance, the Reserve Bank of India (RBI) applies further checks and balance by ensuring a maximum term of 8 years for a bank director and also by possessing powers to reconstitute the board of directors and to approve the appointment and removal of directors in certain situations.
All these point towards the fact that corporate governance in banks (being in the financial sector) has very different implications compared to companies in other sectors. In India, banks are subject to the governance requirements prescribed by clause 49 of the listing agreement as well as those prescribed by the RBI. Other countries follow a slightly modified approach – e.g. Singapore has two sets of codes for corporate governance, one for banks and financial institutions and another for other companies. This approach takes into account the different governance requirements for different types of companies.
Lastly, as to independent directors, there conceptually seems to be a misplaced over-reliance by regulators, commentators and the media on this institution as if it is a panacea to all ills. That is perhaps not to be. Independent directors are only board members (and are not involved in the day-to-day management) who can provide strategic direction and oversight of the company’s affairs. There is still considerable debate over the effectiveness of independent directors in corporate governance, although conventional wisdom suggests that independence in the decision-making process on board will make it objective, impartial and diligent. What is required is to apply substance over form while examining the role of board members, whether independent or otherwise. A Note in the Harvard Law Review published a couple of years ago (119 Harv. L. Rev. 1553 (2006)) aptly sums up this point:
“Clearly, there is room for improvement. This Note rests on the premise that reliance on independence standards, if properly linked to the core functions implicated by those standards, can lead to practicable structural reforms that promote more effective corporate governance. The key is to reenvision independence as an institutional norm applicable to every director, rather than as an individual norm applicable only to formally independent directors. As such, the goal is to craft a functional conception of director independence that balances the normative goals of independence-based reforms against the behavioral constraints faced by modern boards. …
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This Note’s conceit is that, by recasting independence as an institutional norm that prizes function over form, greater clarity can be brought to bear on the persistent problems of corporate governance. Assuming Adam Smith remains correct in his estimation of what managers are likely to do with “other people’s money”, this approach offers one method of enhancing the board’s ability to limit the damage caused by the separation of ownership from control. For when independence becomes the touchstone of the entire board—rather than the lonely province of the “independent” outsider – monitors, mediators and managers alike can shoulder its burdens and share in its promise. And whatever else regulators, courts, or commentators may say on the subject, it remains the independent board that stands the best chance, and bears the heaviest responsibility, of assuring investor confidence in the corporation.”
Bulk Deals and Order Matching
The availability of income tax exemptions (on long term capital gains) for share transactions that are executed through stock exchanges have caused otherwise negotiated share sale and purchase deals to be implemented through the stock exchange mechanism. This would require parties to bear only the securities transaction tax (STT) at rates which are negligible compared to the erstwhile capital gains tax that would have applied to such deals.
In his blog, Professor J R Varma has an interesting post that deals with some practical issues that arise while putting a negotiated bulk deal through the stock exchange mechanism. Specifically, there is the likelihood of a leakage of some shares owing to orders that are placed at the same time by other purchasers in the market. Professor Varma notes:
In his blog, Professor J R Varma has an interesting post that deals with some practical issues that arise while putting a negotiated bulk deal through the stock exchange mechanism. Specifically, there is the likelihood of a leakage of some shares owing to orders that are placed at the same time by other purchasers in the market. Professor Varma notes:
“It is quite clear that it is possible to do a large trade on the exchange at any price if one is willing to burn through the whole order book and thus share part of the “control premium” with these orders. For example, suppose the current market price is 100 and there are sell orders at prices ranging from 100-110 for a total of say 500,000 shares. The promoter puts in a limit sell order for 100 million shares at a price of 127 and the acquirer immedately thereafter puts in a market buy order for 100 million shares. The market order would first burn through the entire pre-existing order book of 0.5 million shares and then execute the remaining 99.5 million shares against the sell order of the promoters at 127. The only problem is that 0.5 million shares would have been bought at prices above the market price of 100 and this is a small price to pay in relation to the tax that is saved.”The other problem identified relates to fraudulent and unfair trade practices under the SEBI Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003. This would arise if the market places sell orders at high prices in anticipation of acquirers executing bulk deals on stock exchanges. Professor Varma notes here:
“The first problem is that if the whole world can see that this is what is going to happen, it makes sense for anybody who holds Ranbaxy stock to put in limit sale orders at a price of 125 or 126 to take advantage of the bulk deal whenever it happens.While there may be a possible exposure to the regulations that prohibit fraudulent and unfair trade practices, it is often extremely difficult for regulators to succeed in an action under these regulations, for the element of ‘mens rea’ is a necessary ingredient of an offence under those regulations, and proving ‘means rea’ especially in secondary market transactions is an onerous task.
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I am not sure how regulators would look at this issue, because on the one hand, the trade of 100 million shares is a genuine and legitimate trade. On the other hand, it does create a false market and does artificially inflate the price for a short period of time. To this extent, it does appear manipulative.”
Website on Takeover Code
Acquisitions of shares or control of a publicly listed Indian company are governed by the provisions of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (a.k.a. the Takeover Code). Although this piece of regulation is only about a decade old, it has been tested several times in transactions and before SEBI, the appellate tribunal and courts owing to its intricate set of legal provisions.
In an attempt to break down these complexities and to aid readers of the Code in an easy-to-use manner, a new website (http://www.takeovercode.com/) has been launched. This is essentially for the benefit of companies, investment banks as well as regulators. Business Standard has a report highlighting some of the key features:
In an attempt to break down these complexities and to aid readers of the Code in an easy-to-use manner, a new website (http://www.takeovercode.com/) has been launched. This is essentially for the benefit of companies, investment banks as well as regulators. Business Standard has a report highlighting some of the key features:
“The portal, dubbed as a one-stop online solution for intricacies of Indian takeover laws, through its research-led content, aims to inform investors and stakeholders about the complexities of takeover laws in India and make the process of acquisition compliances-efficient and transparent by harnessing the power of the Internet.
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Sebi's takeover code is considered as one of the most complicated in Indian legal jurisprudence.
Consequently, many corporates fail to comply with such complexities leading to imposition of penalties and interpretative disputes and litigations, Vijay said.
Takeovercode.Com intends to simplify the complexities involved with its elaborative compliance reporting, innovative and useful calculators to perform a plethora of functions and advanced search engines to provide up-to-minute information on takeovers, he added.”
The Impending FCCB Conundrum
Foreign currency convertible bonds (FCCBs) have been issued by Indian companies, whereby investors have the option to convert these debt instruments into equity. Such conversion would normally occur when the market price of equity shares at the time of conversion is higher than the conversion price. But, with the markets now moving in the wrong direction, it is unlikely that the FCCB holders will exercise their conversion options. That means they will likely redeem the FCCBs, which partake the nature of repayment of debt. An event less expected by Indian borrowers, this would not only impose huge financial burden on Indian borrowers (who have to raise the cash to meet their obligations), but could also result in various accounting and other related issues.
These aspects have been covered in detail in this column by Rajrishi Singhal in the Economic Times.
(For more on FCCBs, and how they are different from Foreign Currency Exchangeable Bonds (FCEBs), please see this earlier post)
These aspects have been covered in detail in this column by Rajrishi Singhal in the Economic Times.
(For more on FCCBs, and how they are different from Foreign Currency Exchangeable Bonds (FCEBs), please see this earlier post)
Update – July 10, 2008: See also this column in the Hindu Business Line
Differential Voting Rights: Some Further References
In earlier posts (here and here), this Blog had covered the issue of differential voting rights by Indian companies.
A recent column by Srikanth Srinivas in the Business World examines the business rationale for the issuance of shares with differential voting rights and also the pros and cons of such instruments. The key objectives that companies seek to achieve through shares with differential voting rights are to guard against shareholder activism (e.g. the kind initiated by hedge funds in U.S. and U.K. companies) and against hostile takeovers (so as to protect the interests of the promoters and incumbents in management). However, the column also advocates the exercise of caution on this front:
What is peculiar with differential voting rights is the timing of its emergence in the Indian markets. While differential voting rights have been existent in other economies such as the U.S. and Europe for some time, there is now a conscious move in some of those economies (particularly in continental Europe) to shift away from differential voting rights and towards a “one-share one-vote” rule citing corporate governance and control concerns that arise in shares with differential voting rights. The trend appears to be exactly in the opposite direction as far as India is concerned; only time and experience will tell whether differential voting rights will benefit the investors in such shares or impose further risk to their capital.
A recent column by Srikanth Srinivas in the Business World examines the business rationale for the issuance of shares with differential voting rights and also the pros and cons of such instruments. The key objectives that companies seek to achieve through shares with differential voting rights are to guard against shareholder activism (e.g. the kind initiated by hedge funds in U.S. and U.K. companies) and against hostile takeovers (so as to protect the interests of the promoters and incumbents in management). However, the column also advocates the exercise of caution on this front:
“How worried should investors be about differential voting rights? Making voting power proportional to economic ownership serves several goals. First, economic ownership gives shareholders an incentive to exercise voting power well. Second, the coupling of votes and shares strengthens the framework for corporate governance. Third, the power of economic owners to elect directors is a basis for legitimacy of managerial authority.Similar issues have also been identified in an investing column in the Business Standard.
The evidence on corporate governance generally supports the importance of linking votes to economic interest. Voting rights are like property rights to cash flows of the company: decoupling economic and voting rights may benefit a controlling minority structure whose objectives may not quite coincide with that of the rest of the shareholders.
The issue also goes beyond just controlling minority structures. The derivatives revolution and other capital markets developments now allow both outside investors and insiders to decouple economic ownership of shares from voting rights. This decoupling — also called the new vote buying — is a worldwide issue. So before you endorse the idea of differential voting rights, think again.”
What is peculiar with differential voting rights is the timing of its emergence in the Indian markets. While differential voting rights have been existent in other economies such as the U.S. and Europe for some time, there is now a conscious move in some of those economies (particularly in continental Europe) to shift away from differential voting rights and towards a “one-share one-vote” rule citing corporate governance and control concerns that arise in shares with differential voting rights. The trend appears to be exactly in the opposite direction as far as India is concerned; only time and experience will tell whether differential voting rights will benefit the investors in such shares or impose further risk to their capital.
Research Paper: Achieving India’s Growth Potential
Just as the Indian economy reels from its double-digit inflation to the tune of approximately 11%, Goldman Sachs, the leading investment bank, has issued its latest research paper titled Ten Things for India to Achieve its 2050 Potential. This is part of a series of papers published over the last few years by Goldman Sachs covering the BRIC economies of Brazil, Russia, India and China.
The paper builds on Goldman Sachs’ Growth Environment Scores (GES), in which India scores below the other three nations. Further, it ranks 110 out of 181 countries, and for 7 of the 13 components India scores below the developing country average. The current report contains some prescriptions for India to achieve its potential by 2050, noting that “[h]aving the potential and actually achieving it are two different things”. This effectively boils down the lack of proper implementation of reforms that slow down economic progress.
The following are the key recommendations extracted from the paper:
More fundamental is the approach towards some of the solutions to the problems. Here, one finds that most prescriptions turn towards market-based models of economic policy and liberalisation—for instance the recommendations for removal of capital controls, for liberalisation of the financial markets and so on. It is important to note, however, that all of those solutions may not directly apply in the Indian scenario. There is a need to contextualise the prescriptions for reforms so that they appropriately fit into the Indian macroeconomic framework as well as with its past experience. Some of the ideas (and materials) that support this thinking are as follows:
The paper builds on Goldman Sachs’ Growth Environment Scores (GES), in which India scores below the other three nations. Further, it ranks 110 out of 181 countries, and for 7 of the 13 components India scores below the developing country average. The current report contains some prescriptions for India to achieve its potential by 2050, noting that “[h]aving the potential and actually achieving it are two different things”. This effectively boils down the lack of proper implementation of reforms that slow down economic progress.
The following are the key recommendations extracted from the paper:
“We highlight ten key areas where reform is needed. In all likelihood, they areWhile the research paper does well to identify key concerns relating to growth and the areas to be addressed, it does pose some fundamental issues at a macro level. One of the criticisms that may be levelled against the paper is that it does not present any new findings or prescriptions, and all of those contained in the report are well-known and debated (with perhaps little concrete action being taken). But, this critique is more to do with the form and less with the substance of the matters covered.
not the only ten, but we consider them to be the most crucial:
1. Improve governance. Without better governance, delivery systems and effective implementation, India will find it difficult to educate its citizens, build its infrastructure, increase agricultural productivity and ensure that the fruits of economic growth are well established.
2. Raise educational achievement. Among more micro factors, raising India’s educational achievement is a major requirement to help achieve the nation’s potential. According to our basic indicators, a vast number of India’s young people receive no (or only the most basic) education. A major effort to boost basic education is needed. A number of initiatives, such as a continued expansion of Pratham and the introduction of Teach First, for example, should be pursued.
3. Increase quality and quantity of universities. At the other end of the spectrum, India should also have a more defined plan to raise the number and the quality of top universities.
4. Control inflation. Although India has not suffered particularly from dramatic inflation, it is currently experiencing a rise in inflation similar to that seen in a number of emerging economies. We think a formal adoption of Inflation Targeting would be a very sensible move to help India persuade its huge population of the (permanent) benefits of price stability.
5. Introduce a credible fiscal policy. We also believe that India should introduce a more credible medium-term plan for fiscal policy. Targeting low and stable inflation is not easy if fiscal policy is poorly maintained. We think it would be helpful to develop some ‘rules’ for spending over cycles.
6. Liberalise financial markets. To improve further the macro variables within the GES framework, we believe further liberalisation of Indian financial markets is necessary.
7. Increase trade with neighbours. In terms of international trade, India continues to be much less ‘open’ than many of its other large emerging nation colleagues, especially China. Given the significant number of nations with large populations on its borders, we would recommend that India target a major increase in trade with China, Pakistan and Bangladesh.
8. Increase agricultural productivity. Agriculture, especially in these times of rising prices, should be a great opportunity for India. Better specific and defined plans for increasing productivity in agriculture are essential, and could allow India to benefit from the BRIC-related global thirst for better quality food.
9. Improve infrastructure. Focus on infrastructure in India is legendary, and tales of woe abound. Improvements are taking place, as any foreign business visitor will be aware, but the need for more is paramount. Without such improvement, development will be limited.
10. Improve Environmental Quality. The final area where greater reforms are needed is the environment. Achieving greater energy efficiencies and boosting the cleanliness of energy and water usage would increase the likelihood of a sustainable stronger growth path for India.
Perhaps not all these ‘action areas’ can be addressed at the same time, but we believe that, in coming years, progress will have to be made in all of them if India is to achieve its very exciting growth potential."
More fundamental is the approach towards some of the solutions to the problems. Here, one finds that most prescriptions turn towards market-based models of economic policy and liberalisation—for instance the recommendations for removal of capital controls, for liberalisation of the financial markets and so on. It is important to note, however, that all of those solutions may not directly apply in the Indian scenario. There is a need to contextualise the prescriptions for reforms so that they appropriately fit into the Indian macroeconomic framework as well as with its past experience. Some of the ideas (and materials) that support this thinking are as follows:
(a) Commentators have argued that some level of restrictions and governmental regulation on economic and financial activity may be necessary in the context of developing economies. Joseph Stiglitz is a leading proponent of this view, as he strenuously makes his arguments in his book “Globalization and Its Discontents”.
(b) Similarly, as far as India is concerned, arguments have been made that it is India’s partially restrictive policies that have helped weather the recent global credit crisis or even the Asian financial crisis that swept the region over a decade ago (see an earlier post on this blog).
(c) It is also useful in this context to review Dr. Shankar Acharya’s critique of the Draft Report of the High Level Committee on Financial Sector Reforms headed by Dr. Raghuram Rajan, where the point has been made about the need for taking into accounting the realities in India while examining the nature of reforms.
Creating Debt and Securitisation Markets in India
One of the constant criticisms of the Indian financial markets has been the lack of a liquid and vibrant market for debt securities on the one hand and that for securitised instruments on the other. In separate moves announced on the same day (June 19, 2008), SEBI has sought to alleviate both these concerns.
Debt Securities
The SEBI (Issue and Listing of Debt Securities) Regulations, 2008 sets up the regime for issuance of debt securities by companies, public sector undertakings as well as statutory corporations, both by way of a public issue as well as on a private placement basis. Unlike in the case of equity securities, there is no requirement to file an offer document with SEBI for debt securities. Appropriate disclosures are to be filed with the stock exchanges, and they shall be displayed on the websites of the stock exchanges. Although the disclosure requirements have been seemingly simplified, they still have to comply with requirements of Schedule II of the Companies Act, 1956 (since SEBI does not have the requisite powers to alter the requirements of the Companies Act).
Securitised Instruments
The SEBI (Public Offer and Listing of Securitised Debt Instruments), Regulations 2008 provides for public issue and listing of instruments that are issued by a special purpose vehicle (SPV) that purchases receives through securitisation. Although securitisation transactions have witnessed a fair level of size and regularity in the Indian markets, these were confined in the past to private transactions. Securitised debt was incapable of being listed on stock exchanges as there was some doubt as to whether it was a “security” as defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA). But, that doubt was put to rest last year when the SCRA was amended to include an additional element in the definition of a ‘security’ in Section ((h)(ie) as follows:
There is considerable detail in the regulations pertaining to securitized debt, which may even warrant a separate detailed post in due course.
Debt Securities
The SEBI (Issue and Listing of Debt Securities) Regulations, 2008 sets up the regime for issuance of debt securities by companies, public sector undertakings as well as statutory corporations, both by way of a public issue as well as on a private placement basis. Unlike in the case of equity securities, there is no requirement to file an offer document with SEBI for debt securities. Appropriate disclosures are to be filed with the stock exchanges, and they shall be displayed on the websites of the stock exchanges. Although the disclosure requirements have been seemingly simplified, they still have to comply with requirements of Schedule II of the Companies Act, 1956 (since SEBI does not have the requisite powers to alter the requirements of the Companies Act).
Securitised Instruments
The SEBI (Public Offer and Listing of Securitised Debt Instruments), Regulations 2008 provides for public issue and listing of instruments that are issued by a special purpose vehicle (SPV) that purchases receives through securitisation. Although securitisation transactions have witnessed a fair level of size and regularity in the Indian markets, these were confined in the past to private transactions. Securitised debt was incapable of being listed on stock exchanges as there was some doubt as to whether it was a “security” as defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA). But, that doubt was put to rest last year when the SCRA was amended to include an additional element in the definition of a ‘security’ in Section ((h)(ie) as follows:
“any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging the beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be;”Since the SCRA paved the way for creating a market for securitized debt, the recent regulations represent a step towards implementation of this regulatory intent. The Regulations set out the details of the SPV, the manner in which it can acquire receivables as well as the form of instruments it can issue. Unlike the regulations on debt securities which are more focused towards disclosures, the regulations relating to securitized debt are overarching and even govern several substantive issues pertaining to the transactions. This is perhaps explainable by the fact that the past experience of regulators the world over with securitisation markets has not entirely been positive. Securitisation, by its very nature, enables risk-holders to spread that risk over a wide array of investors (especially in the case of public offering of securitised debt), and this can result in a rapid spread of that risk among a larger group of people. This is precisely what occurred during the sub-prime crisis whereby sub-prime mortgage debt that originated in the U.S. was spread using securitisation and CDO (collateralised debt obligation) instruments.
There is considerable detail in the regulations pertaining to securitized debt, which may even warrant a separate detailed post in due course.
CSX/TCI Judgment – Some Thoughts on the SEBI Takeover Regulations
In a closely followed case, the U.S. District Court for the Southern District of New York issued its decision regarding the reporting requirements of a hedge fund (TCI) that had entered into “total return equity swaps” with counterparties in respect of the shares of CSX. Although TCI only entered into cash-settled swaps (without any obligations to obtain delivery of CSX’s shares), the counterparties to the swap in turn hedged their risks by acquiring shares of CSX. On the specific facts of the case, the court held that TCI should be treated as beneficially owning the shares under its cash-settled equity swaps under the anti-avoidance provisions of Rule 13d-3(b) of the Securities Exchange Act of 1934 and hence should have filed the requisite disclosures, which it failed to do so.
A memo by Gibson, Dunn & Crutcher LLP describes the gist of the transaction and the decision as follows:
This decision could have some bearing on the interpretation of the relevant provisions of the SEBI Takeover Regulations (specifically Regulation 7 that provides for disclosures upon acquisition of shares or voting rights that exceed defined percentages). This applies to any person who is an acquirer (that is defined to include a ‘person acting in concert’). In an Indian situation, the primary question will relate to whether the hedge fund or other investor that enters into an equity swap arrangement (even if cash-settled) is said to be acting in concert with the counterparty who may acquire shares to hedge its own position under the swap. If they are indeed persons acting in concert, then the hedge fund or other investor’s shareholding (if any) will be aggregated with the shareholding of the counterparty thereby triggering disclosure requirements if the total shareholding exceeds the prescribed thresholds (e.g. 5%, 10%, 14%, 54% or 74%).
However, there are some key differences between the SEBI Takeover Regulations and the relevant provisions of the Securities Exchange Act Rules cited above. While the definition of ‘person acting in concert’ in Regulation 2(1)(e)(1) of the SEBI Takeover Regulations contains provisions on the same lines as Rule 13d-3(a), there is no anti-abuse provision (like Rule 13d-3(b)) in the SEBI Takeover Regulations. In Indian circumstances, in the absence of such an anti-abuse provision, for any such action to succeed under Indian circumstances, it would be necessary to show that the hedge fund and the counterparty had a ‘common objective or purpose of substantial acquisition or voting rights’, which may be a difficult proposition in a purely cash-settled option. Further, the Indian reporting requirements arise only when a person such as the hedge fund “acquires” shares or voting rights, while the anti-abuse provision imposes the obligation on a person who does not necessarily acquire shares or voting rights, but where such person has an ‘arrangement’ with any other person who has acquired shares (to evade the reporting requirements).
It is likely that the TCI/CSX case will go on appeal. But, it does provide some lessons on the manner in which similar situations are to be dealt with under the SEBI Takeover Regulation. At least, at a basic level, it provokes the debate on whether it is now time to include an anti-abuse provision (such as Rule 13d-3(b)) in the SEBI Takeover Regulations.
A memo by Gibson, Dunn & Crutcher LLP describes the gist of the transaction and the decision as follows:
“One of the main issues raised by the CSX case is whether, in calculating their beneficial ownership, investors are required to count shares in which they have an economic interest through swap or hedging transactions. In the CSX case, TCI held cash-settled “total return equity swaps” under which it obtained the economic risk of stock ownership, but no contractual rights in the underlying shares. While not contractually required under the swaps, the counterparty typically acquires some percentage or the full number of shares that are notionally covered by the swap.The relevant provisions of the Securities and Exchange Act Rules that the court relied on are as follows (as extracted from the Gibson Dunn memo):
The CSX ruling states that decisions by a person to enter into this type of swap arrangement or to terminate the swap can result in the counterparty buying or selling the shares that are notionally covered by the swap. The Court also stated that the counterparty may be likely to vote shares as its client would want in order to maintain a positive business relationship and to bolster the likelihood of obtaining business from the client in the future. …”
Rule 13d-3(a):While Rule 13d-3(a) deals with the question of beneficial ownership in securities for the purpose of disclosure, Rule 13d-3(b) is an anti-abuse provision that prevents the use of arrangements that avoid disclosure requirements. In this case, the court’s decision is largely based on an application of Rule 13d-3(b) to the facts of the case, whereby the court held that TCI shared voting or investment power over shares that its swap counterparties had purchased, on the theory that under the fact TCI had the ability to influence the counterparties’ actions. On this basis, it held that there was a failure by TCI to make appropriate disclosure of its shareholdings.
For the purposes of sections 13(d) and 13(g) of the Act a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) Voting power which includes the power to vote, or to direct the voting of, such security; and/or, (2) Investment power which includes the power to dispose, or to direct the disposition of, such security.
Rule 13d-3(b)
Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose of [sic] effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.
This decision could have some bearing on the interpretation of the relevant provisions of the SEBI Takeover Regulations (specifically Regulation 7 that provides for disclosures upon acquisition of shares or voting rights that exceed defined percentages). This applies to any person who is an acquirer (that is defined to include a ‘person acting in concert’). In an Indian situation, the primary question will relate to whether the hedge fund or other investor that enters into an equity swap arrangement (even if cash-settled) is said to be acting in concert with the counterparty who may acquire shares to hedge its own position under the swap. If they are indeed persons acting in concert, then the hedge fund or other investor’s shareholding (if any) will be aggregated with the shareholding of the counterparty thereby triggering disclosure requirements if the total shareholding exceeds the prescribed thresholds (e.g. 5%, 10%, 14%, 54% or 74%).
However, there are some key differences between the SEBI Takeover Regulations and the relevant provisions of the Securities Exchange Act Rules cited above. While the definition of ‘person acting in concert’ in Regulation 2(1)(e)(1) of the SEBI Takeover Regulations contains provisions on the same lines as Rule 13d-3(a), there is no anti-abuse provision (like Rule 13d-3(b)) in the SEBI Takeover Regulations. In Indian circumstances, in the absence of such an anti-abuse provision, for any such action to succeed under Indian circumstances, it would be necessary to show that the hedge fund and the counterparty had a ‘common objective or purpose of substantial acquisition or voting rights’, which may be a difficult proposition in a purely cash-settled option. Further, the Indian reporting requirements arise only when a person such as the hedge fund “acquires” shares or voting rights, while the anti-abuse provision imposes the obligation on a person who does not necessarily acquire shares or voting rights, but where such person has an ‘arrangement’ with any other person who has acquired shares (to evade the reporting requirements).
It is likely that the TCI/CSX case will go on appeal. But, it does provide some lessons on the manner in which similar situations are to be dealt with under the SEBI Takeover Regulation. At least, at a basic level, it provokes the debate on whether it is now time to include an anti-abuse provision (such as Rule 13d-3(b)) in the SEBI Takeover Regulations.
Daiichi Sankyo - Ranbaxy
June 13 edition of Mint carried my column on how Daiichi Sankyo - Ranbaxy deal vindicates Indian IPR regime. Check the following link:
http://www.livemint.com/2008/06/13001424/Daiichi-Sankyo-vindicates-Indi.html
http://www.livemint.com/2008/06/13001424/Daiichi-Sankyo-vindicates-Indi.html
Top Law Schools
Today's Mint ranks top law schools. Check the following link:
http://www.livemint.com/2008/06/12001201/India8217s-Best-Colleges.html?d=1
http://www.livemint.com/2008/06/12001201/India8217s-Best-Colleges.html?d=1
Oil Price Rise: Shareholders vs. Consumers
The spike in the price of oil has created a peculiar situation for the Indian oil companies that are in the public sector. These public sector undertakings (PSUs) are predominantly owned by the Government, with a portion of the shares (usually a minority) held by public shareholders. The shares of these entities are listed on stock exchanges, which subject them to norms of corporate governance prescribed by SEBI.
However, despite the global spurt in prices, the Government has contained the prices of oil in India, which has resulted in considerable losses to oil PSUs (that extend to hundreds of millions of dollars on a daily basis.). Hence, while consumers (irrespective of their ability to pay) are benefiting from this move, the minority shareholders in these companies are suffering a massive blow. Does this strategy adopted augur well in the light of existing corporate governance norms? That is the key question. PSUs are in any case have never been at the forefront of taking on board corporate governance norms prescribed in Clause 49 of the listing agreement – for example, several PSUs are still yet to restructure their boards to maintain the minimum number of independent directors.
In this background, the Economic Times carries a column by U R Bhat that analyses this dichotomy and proffers some solutions:
However, despite the global spurt in prices, the Government has contained the prices of oil in India, which has resulted in considerable losses to oil PSUs (that extend to hundreds of millions of dollars on a daily basis.). Hence, while consumers (irrespective of their ability to pay) are benefiting from this move, the minority shareholders in these companies are suffering a massive blow. Does this strategy adopted augur well in the light of existing corporate governance norms? That is the key question. PSUs are in any case have never been at the forefront of taking on board corporate governance norms prescribed in Clause 49 of the listing agreement – for example, several PSUs are still yet to restructure their boards to maintain the minimum number of independent directors.
In this background, the Economic Times carries a column by U R Bhat that analyses this dichotomy and proffers some solutions:
“This is particularly galling in the light of the fact that the oil companies that are made to bleed are not wholly-owned by the government but are listed entities with a significant minority shareholding by the public. It is indeed possible for free market principles to co-exist with the just concerns for the welfare of the vulnerable sections of society. The role of a government that is concerned with the welfare of its citizens needs to be segregated from its role as the majority owner of listed commercial enterprises.This situation presents a classic conflict between the interests of consumers and the shareholders of a company – the type we have been considering earlier in the context of Dodge v. Ford Motor Company.
As a majority shareholder, the government needs to ensure that the listed companies function on sound commercial principles while it has to meet its social objectives by direct subsidies to the needy or by indirect subsidies through the oil marketing companies. However, they need to be used only as distributors of the subsidies and not as the providers of subsidies. We now have a situation where even the affluent sections of society get the same subsidy on petroleum products as the poor, even as the majority shareholder is severely compromising the tenets of good corporate governance by forcing the oil companies to run commercially-unviable businesses.
The government’s lack of concern to the basic principles of corporate governance that have been laid out through the listing agreement is not restricted to just the oil companies. Mandatory adherence to Clause 49 of the listing agreement, especially in relation to appointment of independent directors continues to be violated by the listed majority government-owned companies.
From a capital market viewpoint, the appropriate course of action for the government if it indeed wants to continue this way is to transparently make an open offer to the minority shareholders and proceed to delist these companies through the reverse book-building methodology.
Though this would amount to backdoor nationalisation — making a mockery of the gains achieved in the course of more than a decade-and-a-half of economic reforms — it is possibly a better option than destroying the trust of minority shareholders. It is about time the government takes the lead in setting high standards of corporate governance for India Inc., to follow.”
The Proper Purpose of a Corporation
One of the themes that we often explore on this Blog relates to the determination of the proper purpose of a corporation – i.e. whether a corporation exists solely to carry on business for the benefit of its owners (i.e. shareholders), or whether it has a larger responsibility towards other stakeholders and generally the society.
The Harvard Corporate Governance Blog has a post referring to essays by two leading U.S. corporate law professors who join the debate:
The Harvard Corporate Governance Blog has a post referring to essays by two leading U.S. corporate law professors who join the debate:
“In the latest issue of the Virginia Law & Business Review, we debate whether the classic case of Dodge v. Ford, and its claim that maximizing shareholder wealth is the proper purpose of a business corporation, deserves a place in the modern legal canon. Lynn argues that Dodge v. Ford is bad law, at least when cited for the principle that corporate directors should maximize shareholder wealth. As a positive matter, Lynn suggests, no modern jurisdiction follows this rule, and as a normative matter, advances in economic theory suggest that the goal of shareholder wealth maximization is at best inefficient and at worst incoherent. Jon argues that shareholder wealth maximization is both conceptually coherent and consistent with economic theory, and that Dodge v. Ford can be used to illustrate the fact that shareholder wealth maximization is both a valid goal for corporate law and an ethical requirement, even in contexts in which enforceability is practically impossible.Regarding the subject-matter of the debate, i.e. the Dodge v. Ford case, please see a previous post on this Blog pointing to Wikipedia.
The debate can be found here.”
FDI: Reporting Under Automatic Route
Whenever foreign investors subscribe to an issue of shares by an Indian company, there are certain reporting requirements that need to be complied with. In terms of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000, the reporting obligations arise at two stages: (i) within 30 days of receipt by the amount of consideration by the Indian company; and (ii) within 30 days of issue and allotment of the shares. The latter reporting requirement is satisfied through the filing of Form FC-GPR to the Regional Office of the Reserve Bank of India (RBI).
By way of a circular issued on May 30, 2008, the RBI has issued a revised format for the Form FC-GPR that incorporates substantial know-your-customer (KYC) norms. Companies are now required to follow this new format while filing Form FC-GPR with the RBI.
The Economic Times has this report that explains the possible rationale for the recent changes imposed by the RBI.
By way of a circular issued on May 30, 2008, the RBI has issued a revised format for the Form FC-GPR that incorporates substantial know-your-customer (KYC) norms. Companies are now required to follow this new format while filing Form FC-GPR with the RBI.
The Economic Times has this report that explains the possible rationale for the recent changes imposed by the RBI.
Differential Voting Rights: A Markets Perspective
Economic Times carries the views and recommendations of various market participants about the feasibility and economics of issue of differential voting rights by Indian companies.
One interviewee notes:
One interviewee notes:
“Differential voting rights can work every where in the world, and so also in India. These are ideally good instruments for passive investors, typically small investors, who seek higher dividend, and are not necessarily interested in taking a voting position. It is clear that no investor would agree to a sacrifice, which differential voting rights lead to, unless they are suitably compensated, and compensated in financial terms.
Since institutions are active investors, at least they are supposed to be so as per their charters, I do not think there would be any significant demand from them for such shares. Significantly, they invest primarily for capital gains, and not for dividends. There is one operational issue.
The law provides for issue of shares with differential voting rights. This means that a company may issue shares carrying voting rights with different weights, for example with weights of 100 and say 75 and say 50 and say 0. This, however, can lead to huge confusion.”
India Today: Law School Rankings
Spicy IP points to India Today magazine’s latest survey ranking law schools in India. This year’s results reveal the following order at the top in the overall ranking:
1. National Academy of Legal Studies & Research University (NALSAR), Hyderabad;
2. National Law School of India University (NLSIU), Bangalore;
3. Campus Law Centre, University of Delhi, Delhi;
4. National Law Institute University, Bhopal;
5. The W.B. National University of Juridical Sciences, Kolkata.
This year’s highlight is NALSAR’s emergence to the top spot for the first time, edging out NLSIU (that has been maintaining the honours for all but one year that India Today has been conducting the survey).
India Today’s rankings have been carried out based on a set of perceptual scores and a set of factual scores, all determined through identified parameters. The parameters are reputation of college, quality of academic input, student care, infrastructure, and job prospects. This table indicates that while NALSAR consistently ranked 2 on most counts (including perceptual) and ranked 1 on factual scores, NLSIU ranked 1 on most counts but ranked only a mere 13 on factual scores which appears to have cost it the top position. The survey explains this finding:
1. National Academy of Legal Studies & Research University (NALSAR), Hyderabad;
2. National Law School of India University (NLSIU), Bangalore;
3. Campus Law Centre, University of Delhi, Delhi;
4. National Law Institute University, Bhopal;
5. The W.B. National University of Juridical Sciences, Kolkata.
This year’s highlight is NALSAR’s emergence to the top spot for the first time, edging out NLSIU (that has been maintaining the honours for all but one year that India Today has been conducting the survey).
India Today’s rankings have been carried out based on a set of perceptual scores and a set of factual scores, all determined through identified parameters. The parameters are reputation of college, quality of academic input, student care, infrastructure, and job prospects. This table indicates that while NALSAR consistently ranked 2 on most counts (including perceptual) and ranked 1 on factual scores, NLSIU ranked 1 on most counts but ranked only a mere 13 on factual scores which appears to have cost it the top position. The survey explains this finding:
“Finally there is the National Academy of Legal Studies and Research (NALSAR), Hyderabad, which pulled off the impossible by toppling National Law School of India University (NLSIU), Bangalore, from the number one slot in the law stream.Rankings aside, observations in the survey clearly imply that legal education in India has a come a long way and has caught up with other streams of education.
NALSAR is a relative newcomer compared to its venerable Bangalore counterpart. Part of the reason for its triumph this year is its emphasis on providing world class infrastructure facilities that include virtual universal classrooms combined with outstanding faculty and consistency in training.
Perceptually, NLSIU may have scored top markets but it compared poorly with NALSAR in its factual ratings. So after years we have a new winner in the law category.”
Some Lessons from Bear Stearns
The New York Times DealProfessor has a column Burying Bear Stearns that highlights the takeaways from the Bear Stearns saga, which incidentally are matters we often endeavour to stress on this blog. They are:
- Moral hazard
- Systemic risk
- Corporate governance
- Moral hazard
- Systemic risk
- Corporate governance
SWFs as FIIs; Other Amendments to FII Regulations
SEBI has announced a fairly detailed set of amendments to the SEBI (Foreign Institutional Investors) Regulations, 1995.
One of the key amendments relates to the recognition of sovereign wealth funds (SWFs) as a category of investors eligible to invest into the Indian markets as FIIs. This marks a significant move because it makes clear the Indian regulators’ policy approach towards SWFs in the Indian markets. It is also remarkable in a sense because several other countries are yet undecided as to their precise policy of regulating SWFs. The registration of SWFs with SEBI as FIIs would introduce transparency as they would be required to submit the requisite information to SEBI regarding their organisation and operations both at the time of registration and thereafter on a continuing basis. This would help overcome one of the key criticisms of SWFs that they are relatively opaque to the outside world. Further, limitations on FII investments in Indian companies such as the fact that they cannot invest more than 10% in a single company would operate as checks and balances against assertion of excessive influence by SWFs in the Indian marketplace.
However, the current policy pronouncement also leaves some matters open for interpretation. For instance, there seems to be nothing that requires SWFs to invest only through the FII route as a mandatory matter. This is only an option available to SWFs and they may possibly continue to invest under the foreign direct investment (FDI) route otherwise available to foreign investors, in which case they may not be subject to the 10% cap on investment in single companies and other transparency requirements. This dual regime available to SWF (i.e. both the FII route as well as the FDI route) may still leave room for ambiguity and interpretation, and hence a clarification on these matters would be most desirable.
Apart from enabling SWFs to invest as FIIs, the new amendments bring about some further changes to the FII Regulations, which are as follows (quoted from the SEBI circular):
* The policy measures on Offshore Derivative Instruments (Participatory Notes) and changes to the registration criteria specified in SEBI Press Release dated October 25, 2007 have been incorporated in the regulations.
* In order to streamline the process of registration, the Application Forms for grant of registration as a FII and Sub Account have been modified.
* An asset management company, investment manager or advisor or an institutional portfolio manager set up and/ or owned by non resident Indians (NRIs) shall be eligible to be registered as FII subject to the condition that they shall not invest their proprietary funds. This has been enabled by suitable modification to Explanation II under Regulation 13 of the said regulations.
* The type of securities in which FIIs are permitted to invest has been widened to include schemes floated by a Collective Investment Scheme.
Some press reports are available here: The Economic Times, IndianExpress.com.
One of the key amendments relates to the recognition of sovereign wealth funds (SWFs) as a category of investors eligible to invest into the Indian markets as FIIs. This marks a significant move because it makes clear the Indian regulators’ policy approach towards SWFs in the Indian markets. It is also remarkable in a sense because several other countries are yet undecided as to their precise policy of regulating SWFs. The registration of SWFs with SEBI as FIIs would introduce transparency as they would be required to submit the requisite information to SEBI regarding their organisation and operations both at the time of registration and thereafter on a continuing basis. This would help overcome one of the key criticisms of SWFs that they are relatively opaque to the outside world. Further, limitations on FII investments in Indian companies such as the fact that they cannot invest more than 10% in a single company would operate as checks and balances against assertion of excessive influence by SWFs in the Indian marketplace.
However, the current policy pronouncement also leaves some matters open for interpretation. For instance, there seems to be nothing that requires SWFs to invest only through the FII route as a mandatory matter. This is only an option available to SWFs and they may possibly continue to invest under the foreign direct investment (FDI) route otherwise available to foreign investors, in which case they may not be subject to the 10% cap on investment in single companies and other transparency requirements. This dual regime available to SWF (i.e. both the FII route as well as the FDI route) may still leave room for ambiguity and interpretation, and hence a clarification on these matters would be most desirable.
Apart from enabling SWFs to invest as FIIs, the new amendments bring about some further changes to the FII Regulations, which are as follows (quoted from the SEBI circular):
* The policy measures on Offshore Derivative Instruments (Participatory Notes) and changes to the registration criteria specified in SEBI Press Release dated October 25, 2007 have been incorporated in the regulations.
* In order to streamline the process of registration, the Application Forms for grant of registration as a FII and Sub Account have been modified.
* An asset management company, investment manager or advisor or an institutional portfolio manager set up and/ or owned by non resident Indians (NRIs) shall be eligible to be registered as FII subject to the condition that they shall not invest their proprietary funds. This has been enabled by suitable modification to Explanation II under Regulation 13 of the said regulations.
* The type of securities in which FIIs are permitted to invest has been widened to include schemes floated by a Collective Investment Scheme.
Some press reports are available here: The Economic Times, IndianExpress.com.
External Commercial Borrowings Liberalised
In August 2007, the Government tightened its policies on external commercial borrowings (ECBs). However, subsequently, in view of the changed economic scenario in the country, it has decided to liberalise its policies on ECBs. In a circular issued yesterday, the Reserve Bank of India (RBI) now allows borrowers in the infrastructure sector to borrow up to US$ 100 million for permissible end uses under the approval route. In case of other borrowers, the existing limit of US$ 20 million for permissible end uses under the approval route has been enhanced to US$ 50 million. The allowable interest rates have also been increased.
This move would allow better scope Indian corporate to raise foreign currency borrowings as ECBs were largely curtailed since August 2007 until now. Livemint has a brief report on the possible effects of this liberalization.
Update – June 3, 2008: By way of another notification issued on June 2, 2008, the RBI has allowed borrowers in the services sector, viz. hotels, hospitals and software companies to avail of ECBs up to US$ 100 million, per financial year, for the purposes of import of capital goods under the automatic route.
This move would allow better scope Indian corporate to raise foreign currency borrowings as ECBs were largely curtailed since August 2007 until now. Livemint has a brief report on the possible effects of this liberalization.
Update – June 3, 2008: By way of another notification issued on June 2, 2008, the RBI has allowed borrowers in the services sector, viz. hotels, hospitals and software companies to avail of ECBs up to US$ 100 million, per financial year, for the purposes of import of capital goods under the automatic route.
A Progress Report on SEBI's Recent Initiatives
LiveMint carries a report analyzing SEBI’s progress under its new chairman, Mr. C. B. Bhave, who completes 100 days in office. While several initiatives have been taken in the primary and secondary markets, there seems to be a lot to be done as far as legal and investigation matters are concerned. The report states that “[t]he need to strengthen Sebi’s investigation and legal wings arises because instances of the appellate body, the Securities Appellate Tribunal or SAT, setting aside Sebi orders have been on the rise.”
Incidentally, SEBI has announced a few weeks ago that it invites applications for the Post of Executive Director (Legal) on contract or on deputation basis.
Incidentally, SEBI has announced a few weeks ago that it invites applications for the Post of Executive Director (Legal) on contract or on deputation basis.
Enabling SMEs Access the Capital Markets
Although the small and medium enterprises (SMEs) constitute a significant portion of India’s economy, they face several hurdles in accessing capital in a cost-effective manner. As far the capital markets are concerned, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 provide several eligibility criteria for companies to qualify for being able to initiate public offerings. These include a past track record, minimum net worth requirements and the like that maintain the bar at a high level for SMEs to clear, and hence they are effectively kept out of the capital markets.
In order to overcome this present disposition, SEBI has recently issued a discussion paper that not only relaxes some of these eligibility criteria for public offerings of securities by SMEs, but even provides for a separate stock exchange on which SMEs can list their securities. The consultation paper details the need for a separate securities listing and trading route for SMEs. It also lists out parallels from other countries such as the Alternative Investment Market (AIM) in London, the Growth Enterprises Market (GEM) in Hong Kong and MOTHERS in Japan. All these provide separate avenues for listing of SMEs shares in the respective economies.
Since the eligibility criteria for listing have been relaxed, investor protection measures are sought to be introduced through different means. And that is by limiting investment opportunities in the SME listed segment only to large investors (investing and trading a minimum of Rs. 500,000). This is similar to the US concept of accredited investors, with the logic being that large investors (both institutional and individual) are either sophisticated enough to appreciate risks involved in investments or are able to obtain suitable investment advice; in any case, large investors are better able to absorb the risks involved in any such investments.
The minimum Rs. 500,000 investment requirement will continue in the secondary market as well. This will be ensured by way of imposing minimum trading lots of that amount, so that large investors do not purchase SME securities in public offerings and then down-sell them in smaller lots in the secondary markets. The continuous listing as well as financial reporting requirements for SMEs would be less stringent compared to their larger counterparts.
Overall, this is a welcome move as it could potentially create financing avenues for SMEs and also a separate market for investors keen to target that segment of the economy. This is also in tune with the international trend as we have seen earlier. However, it also calls for some caution and pessimism, particularly in view of past attempts which have failed. The prime attempt relates to the establishment of the OTC Exchange of India (OTCEI), which has not garnered the attention of the SME segment as it was expected to. Recent reports and commentaries have pointed to the need to ensure that this is not repeated with the current attempt (see, LiveMint and Mostly Economics blog).
From a legal and regulatory standpoint, it is likely to be more difficult to control the activities of SMEs as they may not have adequate infrastructure to meet with the required audit, reporting and compliance procedures as compared to the larger more established corporates. The reputation incentives of SMEs to comply with listing requirements and corporate governance may not be as high as their larger counterparts. One way to overcome this problem would be to have the SMEs piggyback on the reputation of a third party intermediary (also commonly referred to as “gatekeepers”). For instance, several jurisdictions still follow the requirement of having an intermediary such as an investment bank act as a sponsor in respect of an SME entity.
The role of the sponsor is to ensure compliance of norms by the SMEs failing which the regulator would hold the sponsor responsible. The mechanism is designed to provide enough reputation incentives to the sponsor to ensure that the SMEs do not fail, and therefore indirectly protect the interest of the investors. This “sponsor-supervised” model is being followed in the recently established Catalist, which is Singapore’s market segment for growth companies. The Catalist website describes its regulatory structure as follows:
Comments are due on SEBI’s discussion paper by June 6, 2008 (which does not leave much time though).
In order to overcome this present disposition, SEBI has recently issued a discussion paper that not only relaxes some of these eligibility criteria for public offerings of securities by SMEs, but even provides for a separate stock exchange on which SMEs can list their securities. The consultation paper details the need for a separate securities listing and trading route for SMEs. It also lists out parallels from other countries such as the Alternative Investment Market (AIM) in London, the Growth Enterprises Market (GEM) in Hong Kong and MOTHERS in Japan. All these provide separate avenues for listing of SMEs shares in the respective economies.
Since the eligibility criteria for listing have been relaxed, investor protection measures are sought to be introduced through different means. And that is by limiting investment opportunities in the SME listed segment only to large investors (investing and trading a minimum of Rs. 500,000). This is similar to the US concept of accredited investors, with the logic being that large investors (both institutional and individual) are either sophisticated enough to appreciate risks involved in investments or are able to obtain suitable investment advice; in any case, large investors are better able to absorb the risks involved in any such investments.
The minimum Rs. 500,000 investment requirement will continue in the secondary market as well. This will be ensured by way of imposing minimum trading lots of that amount, so that large investors do not purchase SME securities in public offerings and then down-sell them in smaller lots in the secondary markets. The continuous listing as well as financial reporting requirements for SMEs would be less stringent compared to their larger counterparts.
Overall, this is a welcome move as it could potentially create financing avenues for SMEs and also a separate market for investors keen to target that segment of the economy. This is also in tune with the international trend as we have seen earlier. However, it also calls for some caution and pessimism, particularly in view of past attempts which have failed. The prime attempt relates to the establishment of the OTC Exchange of India (OTCEI), which has not garnered the attention of the SME segment as it was expected to. Recent reports and commentaries have pointed to the need to ensure that this is not repeated with the current attempt (see, LiveMint and Mostly Economics blog).
From a legal and regulatory standpoint, it is likely to be more difficult to control the activities of SMEs as they may not have adequate infrastructure to meet with the required audit, reporting and compliance procedures as compared to the larger more established corporates. The reputation incentives of SMEs to comply with listing requirements and corporate governance may not be as high as their larger counterparts. One way to overcome this problem would be to have the SMEs piggyback on the reputation of a third party intermediary (also commonly referred to as “gatekeepers”). For instance, several jurisdictions still follow the requirement of having an intermediary such as an investment bank act as a sponsor in respect of an SME entity.
The role of the sponsor is to ensure compliance of norms by the SMEs failing which the regulator would hold the sponsor responsible. The mechanism is designed to provide enough reputation incentives to the sponsor to ensure that the SMEs do not fail, and therefore indirectly protect the interest of the investors. This “sponsor-supervised” model is being followed in the recently established Catalist, which is Singapore’s market segment for growth companies. The Catalist website describes its regulatory structure as follows:
“In a Sponsor-supervised market, SGX [Singapore’s stock exchange] continues to regulate companies through its admission and continuing obligation rules. It also retains the power to discipline them when there is a rule breach. However, approved "Sponsors" undertake the direct supervision of the companies.There are indeed benefits in this sponsor-supervised model, and it may help for SEBI to explore this option in the Indian context as well.
Sponsors are qualified professional companies experienced in corporate finance and compliance advisory work. They are authorized and regulated by SGX through strict admission and continuing obligation rules.
…
The Sponsor's main role at IPO is to assess the company's suitability to list and to prepare it for listing. After IPO, Sponsors are to advise and supervise listed companies on responsibilities in a public market. Sponsors are expected to whistleblow to SGX when there is an affirmed or suspected rules breach.”
Comments are due on SEBI’s discussion paper by June 6, 2008 (which does not leave much time though).
Participatory Notes and Disclosure Requirements
In an earlier post, we had discussed the decision of the Securities Appellate Tribunal (SAT) setting aside a SEBI order that imposed a penalty of Rs. 1 crore on an FII for giving a false declaration regarding its issuance of participatory notes. Our guest contributor, Somasekhar Sundaresan, has written a column in The Business Standard analysing this decision. Of particular relevance are the implications of the decision on participatory notes in general. He states:
“The latest decision from the SAT is yet another pointer to the pervasive ambiguity that the legal framework governing P-Notes is riddled with. Numerous fundamental concepts have remained undefined, and several prohibitions and policy positions have been developed within Sebi files, without the law actually containing requisite provisions (See Without Contempt – editions dated March 31, 2008, October 22, 2007).
An earlier bench of the SAT had set aside an order passed by Sebi charging an FII with failure to comply with "know your client" because the FII had been unable to confirm that no NRIs or persons of Indian origin were beneficially interested in any manner in any upward layer of shareholding in the P-Note counterparty entity. The FII Regulations had not required recording of such detailed data at such level. SEBI's position had been that the plain English meaning of the term "know your client" took care of this requirement.
Funnily, the very term "P-Note" or "offshore derivative instrument" remains undefined. Therefore, the very applicability of the regulatory edifice created by Sebi can be ambiguous depending on the nature of the instrument. For instance, an FII could well issue a P-Note without holding the underlying securities, if it does not care to hedge its exposure. Till date, there is no provision making it mandatory to issue P-Notes only against an underlying holding of Indian securities in the hands of the FII. It is completely unclear if the P-Note policy restrictions would affect such unhedged P-Notes.
While issuance of P-Notes against underlying holding in exchange-traded options and futures was banned by Sebi last year, there can obviously be no legitimate ban on a foreign person issuing P-Notes against holdings in Nifty futures ((Nifty is the National Stock Exchange's flagship index) that are traded on the Singapore Exchange. It would be foolhardy to believe that movements in the Nifty futures in Singapore would be insulated from impacting price movements in Indian securities. Therefore, the ban on derivatives-based P-Notes can become quite meaningless.
It is time to take an intense and hard look at the regulatory framework for P-Notes and ask some existential questions.”
Financial Disclosures by Companies
A column by Rahul Roy in The Business Standard deals with the proposed revision and simplification of Schedule VI to the Companies Act. This schedule prescribes the presentation and disclosure requirements for financial statements. The column strenuously argues that the current version of Schedule VI is severely outdated and as to how it should be brought in tune with developments in the financial world. However, questions are raised about whether amendment to Schedule VI is the right way to proceed:
“Globally, professional bodies of accounting standard setters prescribe accounting formats. The advantages are obvious. This is a specialised area which requires professional input; and has to be updated frequently to keep pace with changes in the economic and commercial environment. A schedule to a law, which has to be debated and amended only by Parliament obviously does not offer the flexibility required. Also given the scheme of things, an accounting legislation may not be the highest priority of our Parliamentarians.In addition, the Rahul Roy points to the multiplicity of prescriptions that operates in relation to disclosure of financial statements, and the compounding confusion that it brings about:
Today, the prescriptions of Schedule-VI are far removed from the reality of what financial statements mean. It is only a legal figment that accounts in India comply with Schedule-VI. For starters, Schedule-VI does not even have any prescribed format for a Profit & Loss Account; it does not require a cash flow statement; it does not require disclosure of accounting policies; it does not require disclosure for leases; it does not warrant disclosure of deferred taxes or disclosure regarding impairment losses or intangibles. Further, the Schedule VI was conceived in an era when nobody had even heard of derivatives and so remains blissfully unaware of derivatives and disclosure of potential losses therein.
On the other hand, the Schedule-VI requires detailed disclosure of inventories, capacity, production and turnover for every significant item produced or traded. This is not required under any global framework and is potentially disadvantageous for the Indian industry vis-à-vis its global competitors as it forces companies operating in India to disclose their confidential operating data. These disclosures were conceived in a "Licence Raj" era and serve no useful purpose today when alternate Segment Reporting data is already available.”
“While on one hand the MCA is trying to reinvent the Schedule-VI, on the other hand multiplicity and confusion in the standard setting process in the country is increasing. ICAI's Accounting Standards Board is setting Standards; the National Advisory Committee of Accounting Standards (NACAS) is considering and notifying Standards; the MCA is notifying Rules (Accounting Standards Rules, 2000) that directly contradict Schedule-VI thereby creating a legislative conflict by specifying that a Rule will override an Act !!; the RBI is issuing provisioning & income recognition guidelines; SEBI is mandating presentation and disclosure formats of interim and annual results; and the ICAI is busy issuing ‘announcements', impacting accounting but without either the due diligent process of formulating Standards or investing these announcements with the authority of a mandatory pronouncement.”
Foreign Currency Borrowings: FCEBs and ECB
In an earlier post, we had analysed the notification of the Government of India permitting the issuance of Foreign Currency Exchangeable Bonds (FCEBs). The Reserve Bank of India (RBI) was expected to prescribe detailed guidelines on the mechanism for the issuance of FCEBs. It is now reported in LiveMint that the detailed guidelies would be issued by the RBI within a month.
Separately, we can expect to see some developments on the external commercial borrowings (ECBs) front. In view of increasing capital flows into India and a strenghtening rupee, the RBI had imposed tight restrictions on ECBs in August 2007, thereby making it difficult for Indian corporates to raise ECBs. But, now that the capital flows have stabilised, it may be time for a review of the policy. The Economic Times has an editorial that argues:
Separately, we can expect to see some developments on the external commercial borrowings (ECBs) front. In view of increasing capital flows into India and a strenghtening rupee, the RBI had imposed tight restrictions on ECBs in August 2007, thereby making it difficult for Indian corporates to raise ECBs. But, now that the capital flows have stabilised, it may be time for a review of the policy. The Economic Times has an editorial that argues:
“The government may ease restrictions on overseas corporate borrowing when it, together with the RBI, reviews the external commercial borrowing (ECB) policy later this month. This is timely given the apparent drop in industrial activity and the recent sharp depreciation of the rupee against the dollar. Last year, the government had imposed restrictions on debt funds the corporates could bring into the country following a sharp increase in foreign inflows.
…
The government could, therefore, think of selectively relaxing ECB norms to make funds available to those sectors or industries that are finding it difficult to raise resources locally. The RBI should allow smaller corporates, the backbone of the economy, to access funds overseas for meeting rupee expenditure. The quantum of flows is unlikely to be of an order that would worry the central bank.”
Bharti-MTN: Structural Problems
The proposed deal between Bharti and MTN to combine their businesses fell through over the weekend. Although the principal reason for the fallout appears to be disagreement over who would control the combined entity, that was aided by problems with structuring the deal from a regulatory perspective. As The Economic Times reports:
“In addition, there are other factors that may have contributed to the collapse of the talks. According to industry sources, a Bharti-MTN merger would have faced major regulatory hurdles on the FDI front. “The merger would have meant that foreign holding in Bharti Airtel would have reached around 85%. While Bharti executives had told MTN that they would be able to get the FDI sectoral cap waived, the feedback that MTN directors were independently receiving was that it would be difficult for the sectoral cap to be relaxed,” said an industry source.”This clearly indicates the difficulties that Indian companies would face in using their own shares as currency for foreign acquisitions when they are operating in sectors that have a cap on the level of foreign shareholding, with telecom being a prime example. This is particularly so in case of Indian acquirers that already have a large foreign shareholding, thereby limiting the structuring options for overseas acquisitions largely to cash transactions or to the establishment of overseas subsidiaries that carry out such acquisitions.
A Possible IDR Debut in the Indian Markets
A few months ago, we had lamented about the lack of even a single issuance of IDRs by foreign companies in the Indian markets; this, despite the relaxation of rules in 2007 to facilitate IDR listings. We had said:
Further, dual listings would also bring about their own sets of issues for companies to deal with. For example, Indian companies listed in the US not only have to comply with Indian corporate governance requirements, but in addition also have to follow the Sarbanes Oxley Act of 2002 as well as the rules of the exchange on which their securities are listed in the US (i.e. either NYSE or NASDAQ). Similarly, in the case of companies issuing IDRs, not only do they have to comply with listing requirements in other jurisdictions (where their securities are listed) but also with the listing agreement with the relevant Indian stock exchange. Of particular relevance is clause 49 of the listing agreement in India which deals with issues involving corporate governance (specifically board and committee structures, audit, disclosure and transparency norms and the like). This would add to compliance requirements on such companies, to the extent the Indian corporate governance requirements vary from those in other jurisdictions where they are listed. An example is cited in the Economic Times report as follows:
“Indian Depository Receipts (IDRs) are instruments that enable foreign companies to access the Indian capital markets. It also provides avenues for Indian investors to make investments in foreign companies. In order to facilitate this process, the Companies (Issue of Indian Depository Receipts) Rules, 2004 were promulgated. Even after three years had elapsed, no single foreign company had availed on this route to access the Indian capital markets. Upon finding that the conditions for an IDR offering were too stringent, the Rules were amended in July 2007 to relax some of the conditions. However, status quo continues with no takers yet.”This situation may possibly change with a report in The Economic Times that Standard Chartered Bank is looking to list its securities on Indian stock exchanges in the form of IDRs. VC Cirle also has a brief analysis. Such a listing would be a path breaker as far as Indian listings of foreign companies are concerned, and would open up avenues for other similar companies too. Being the first deal of its kind, it would certainly necessitate close discussions with regulators such as SEBI (being the securities regulator) and the RBI (being the regulator for banks having Indian operations as well as on the foreign exchange front).
Further, dual listings would also bring about their own sets of issues for companies to deal with. For example, Indian companies listed in the US not only have to comply with Indian corporate governance requirements, but in addition also have to follow the Sarbanes Oxley Act of 2002 as well as the rules of the exchange on which their securities are listed in the US (i.e. either NYSE or NASDAQ). Similarly, in the case of companies issuing IDRs, not only do they have to comply with listing requirements in other jurisdictions (where their securities are listed) but also with the listing agreement with the relevant Indian stock exchange. Of particular relevance is clause 49 of the listing agreement in India which deals with issues involving corporate governance (specifically board and committee structures, audit, disclosure and transparency norms and the like). This would add to compliance requirements on such companies, to the extent the Indian corporate governance requirements vary from those in other jurisdictions where they are listed. An example is cited in the Economic Times report as follows:
“However, StanChart has to think through certain local regulatory needs before pursuing IDRs. For instance, the bank announces its financial results every six months in markets like the UK, as against listed entities in India that must do so every quarter. Also, laws will have to be changed to allow capital gain tax benefits as IDRs have not been included in the definition of ‘securities’. Besides, the bank should have the flexibility to repatriate the money raised through listing.”Notwithstanding such issues (that require to be addressed), it is hoped that the first IDR deal takes place in the near future as that will clearly pave the way for such future listings by foreign companies on Indian stock exchanges.
Role of Rating Agencies
Credit rating agencies have come under fire on account of their role in the recent global financial crisis arising out of the repackaging of subprime mortgage debts. This has resulted in a call for tighter regulation of rating agencies. But, this revelation in Financial Times is startling:
“Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models, a Financial Times investigation has discovered.
Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.
News of the coding error comes as ratings agencies are under pressure from regulators and governments, who see failings in the rating of complex structured debt as an integral part of the financial crisis. While coding errors do occur there is no record of one being so significant.
Moody’s said it was “conducting a thorough review” of the rating of the constant proportion debt obligations – derivative instruments conceived at the height of the credit bubble that appeared to promise investors very high returns with little risk. Moody’s is also reviewing what disclosure of the error was made.”
Taxation on Sale of Shares in a Foreign Holding Company
Often, divestments by foreign owners of Indian companies are effected through a sale of the stake outside India. More specifically, where foreign companies hold shares in Indian companies through intermediate offshore investment companies, they can effect a divestment by merely selling off shares of the offshore holding companies. This does not in any way result in a transfer of shares of the Indian company giving rise to taxation of capital gains in India. But, the question still remains as to whether such indirect sales that achieve the same end result should also be taxed in India. This issue is discussed in a column by Mukesh Butani in The Business Standard.
Legal Hurdles to Private Equity Investment
Although the flow of foreign private equity into India has been quite steady, there continue to be several ambiguities in the legal regime relating to private equity investment. Through interviews with experts, CNBC -TV18 identifies some of the issues. These include the following:
1. Governance rights: When private equity investors acquire rights in listed companies (such as veto rights on key decisions), there is a possibility that they may acquire “control” over the company thereby triggering public offer requirements under the SEBI Takeover Regulations. This primarily arises because of an expansive interpretation of the term “control” that has been adopted by SEBI.
2. Lack of flexibility on convertible instruments: A popular instrument used for private equity in the past was convertible preference shares. However, since May 2007, preference shares with a conversion option have been treated as external commercial borrowings (ECB) necessitating onerous approvals for investment.
3. Minimum pricing norms: This prevents private equity investors from taking a stake at a discount to market price, a matter we had posted on earlier.
4. Other issues identified in the discussion are the lack of the ability of private equity funds to carry out due diligence (except in limited circumstances), which is owing to insider trading regulations prescribed by SEBI, and also the inability of private equity (or other) investors to carry out leveraged transactions (which involve leveraging the assets of the target company) in India.
Many of these issues ultimately boil down to a single structural problem – the lack of a special regime governing private equity investors. Private equity is treated as any other form of investment and hence is subject to the same regulations that are applicable to other foreign investors (whether financial or strategic), which bring along with it associated regulatory difficulties and ambiguities. A somewhat elegant solution to this problem would be to treat private equity separately and to take into account the special features of private equity investment and to provide a separate window to such investors. Although such a separate regulatory regime for private equity funds has been contemplated in the past, no concrete steps have been taken in that direction yet. Perhaps it is time that these issues are revisited because private equity is a predominant source of funding for Indian companies seeking expansion, especially when market conditions are not necessarily opportune for capital raising from the public through IPOs.
Public Shareholding: Listed companies are required to maintain a minimum level of public shareholding in order to ensure continued listing. However, there is some ambiguity on whether such ‘public’ shareholding would cover only retail investors or whether that would include large investors such as mutual funds, foreign institutional investors, banks, high net worth individuals and similar such investors. CNBC-TV18 has a related report on this topic.
1. Governance rights: When private equity investors acquire rights in listed companies (such as veto rights on key decisions), there is a possibility that they may acquire “control” over the company thereby triggering public offer requirements under the SEBI Takeover Regulations. This primarily arises because of an expansive interpretation of the term “control” that has been adopted by SEBI.
2. Lack of flexibility on convertible instruments: A popular instrument used for private equity in the past was convertible preference shares. However, since May 2007, preference shares with a conversion option have been treated as external commercial borrowings (ECB) necessitating onerous approvals for investment.
3. Minimum pricing norms: This prevents private equity investors from taking a stake at a discount to market price, a matter we had posted on earlier.
4. Other issues identified in the discussion are the lack of the ability of private equity funds to carry out due diligence (except in limited circumstances), which is owing to insider trading regulations prescribed by SEBI, and also the inability of private equity (or other) investors to carry out leveraged transactions (which involve leveraging the assets of the target company) in India.
Many of these issues ultimately boil down to a single structural problem – the lack of a special regime governing private equity investors. Private equity is treated as any other form of investment and hence is subject to the same regulations that are applicable to other foreign investors (whether financial or strategic), which bring along with it associated regulatory difficulties and ambiguities. A somewhat elegant solution to this problem would be to treat private equity separately and to take into account the special features of private equity investment and to provide a separate window to such investors. Although such a separate regulatory regime for private equity funds has been contemplated in the past, no concrete steps have been taken in that direction yet. Perhaps it is time that these issues are revisited because private equity is a predominant source of funding for Indian companies seeking expansion, especially when market conditions are not necessarily opportune for capital raising from the public through IPOs.
Public Shareholding: Listed companies are required to maintain a minimum level of public shareholding in order to ensure continued listing. However, there is some ambiguity on whether such ‘public’ shareholding would cover only retail investors or whether that would include large investors such as mutual funds, foreign institutional investors, banks, high net worth individuals and similar such investors. CNBC-TV18 has a related report on this topic.
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