Corporate Governance & Enforcement

The corporate governance norms prescribed by SEBI were tightened earlier this month (as discussed here), whereby the requirement of independence of directors has been made more stringent. However, it is disheartening to note that while there is a move by the regulator to enhance mandatory norms on corporate governance at a substantive level, there is a lot still left to be desired when it comes to implementation. We often find that the principal defaulters are the public sector undertakings themselves. See this news report in Telecom Tiger (http://www.telecomtiger.com/fullstory.aspx?storyid=1681):

“The Controller and Auditor General (CAG) of India has hit out strongly against state-run MTNL stating that the PSU is flouting corporate governance norms by not appointing specified number of independent Directors on its board as per Clause 49 of the listing agreement.

According to the CAG report, there is only one independent director on the board of MTNL, which operates telecom services in Delhi and Mumbai, as against the requirement of six independent directors.”

Such stories have been repeated in the Indian corporate sector over the last few years. Although the enforcement of corporate governance norms is crucial to the success of a good governance regime, at present it appears that companies, especially the public sector undertakings, are largely able to escape with impunity in spite of failure to comply with the corporate governance norms. Stricter implementation of corporate governance norms should not only ensure proper appointment of truly independent directors on corporate boards, but also that they discharge their functions effectively and carry out their responsibilities to protect the interests of the public shareholders in a listed company.

While on this topic, it is worth briefly noting some recent developments in Singapore. The Code of Corporate Governance 2005 in Singapore also requires the appointment of independent directors constituting at least one-third of the board. Companies did comply with these requirements of appointment. However, over a period of time, whenever there was a corporate governance failure in a company, it was found that the independent directors simply resigned from their posts, often citing person reasons or other reasons not related to the governance of the company. Hence, regulators have now required companies to explain the reasons for resignation of independent directors, so that shareholders are made aware of the precise background of events that led to independent director resignations.

Most recently, an independent director of China Aviation Oil, Lee Suet Fern, resigned from the board of the company. In her letter of resignation, she said it was becoming increasingly difficult for her to properly discharge her role, as a result of CAO's approach to information flow and the management of decision making, review and oversight. This compelled the company to strengthen its measures to improve corporate governance and also to announce the same to its shareholders. This episode indicates that while resignation by independent directors is not the ideal response to corporate governance problems within companies, they do bring out these concerns into the open and force such companies to act in more transparent manner.

REMFs: The New Indian Real Estate Investment Opportunity

It was back in 2006 that SEBI had cleared the deck for the launch of real estate mutual funds (REMFs) as means to enable retail investors to take advantage of the enhancement in Indian property prices. For almost two years, there were no concrete steps taken to promulgate regulations for the establishment of REMFs. However, on April 25, 2008, SEBI announced amendments to the SEBI (Mutual Funds) Regulations, 1996 that permit the launch of REMFs. The notification amending the Regulations is available here.

The REMF scheme is one which invests directly or indirectly in real estate assets or other permissible assets. Some of the key features of REMFs as allowed by SEBI are as follows:

- Existing mutual funds are eligible to launch REMFs if they have adequate number of experienced key personnel / directors.

- Sponsors seeking to set up new mutual funds, for launching only REMF schemes, shall be carrying on business in real estate for a period not less than five years. They shall also fulfill all other eligibility criteria applicable for sponsoring a mutual fund.
- Every REMF scheme shall be close-ended and its units shall be listed on a recognized stock exchange.

- Net asset value (NAV) of the scheme shall be declared daily.

- At least 35% of the net assets of the scheme shall be invested directly in real estate assets. The balance may be invested in mortgage backed securities, securities of companies engaged in dealing in real estate assets or in undertaking real estate development projects and other securities. Taken together, investments in real estate assets, real estate related securities (including mortgage backed securities) shall not be less than 75% of the net assets of the scheme.

- Each asset shall be valued by two valuers, who are accredited by a credit rating agency, every 90 days from date of purchase. The lower of the two values shall be taken for the computation of NAV

- Caps have been imposed on investments in a single city, single project, securities issued by sponsor/associate companies etc.

- The amended regulations have also specified accounting and valuation norms pertaining to REMF schemes.

The delay in the launch of REMFs is perhaps understandable. There are several complexities involved in the operation of real estate funds that require careful consideration. I had written an op-ed column in businesslawyer.in a few months ago highlighting these complexities:

“The delay in establishment of a legal regime for real estate mutual funds can be ascribed to complexities associated with the Indian real estate sector. To mention a few, the real estate sector is bogged down by problems with title to land owing to the absence of proper maintenance of title records. India does not offer title certification and properties are often the subject-matter of litigation for protracted periods of time. The real estate sector is also burdened with a high incidence of stamp duties – achieving uniformity and reduction in stamp duties is an almost impossible task as stamp duty on conveyance of immovable property is a matter for states to legislate, and not the Centre. Apart from legal problems, there are also commercial issues to grapple with – to name just one, valuation of real estate is highly contentious. Due to the existence of these fundamental issues relating to the real estate sector, investments in this sector tend to be risky.

Regulation of REMFs need to take into account these risks specific to the real estate sector so that while REMFs provide an attractive investment avenue to retail investors, regulation also protects their interests against industry-specific risks. This can be achieved through stringent disclosure norms that are prescribed by the regulators.”

The amended regulations issued by SEBI on REMFs do address some of these concerns, while they are lacking on others. First, on the question of specific disclosure norms governing REMFs, the regulations do not specify the disclosures to be made by REMFs while launching a scheme, and it is left to SEBI to prescribe those. While it may have been prudent for the disclosure norms to have been set out in the regulations themselves, there is still opportunity for SEBI to prescribe the disclosure norms. It would be imperative for SEBI to announce a detailed set of disclosures for REMFs that take into account the risks involved in real estate investments. This ought to be effected promptly, and in any case before REMF schemes are in fact launched by mutual funds. A uniform set of disclosures would also enable investors to compare various REMF investment options.

Second, on the question of valuation, SEBI’s efforts are laudable as it appears to have placed significant emphasis on this aspect, as the amended regulations contain a great level of detail not only in respect of the norms of valuation, but also on the manner in which the valuation process itself is carried out. For example, there are requirements for valuation by two valuers who do not possess any conflict of interest. Further, there is a cooling off period whereby no valuer can continue with valuation of a particular real estate for more than two years and that no such valuer can value that same asset for a period of three years thereafter.

In all, with the returns from the real estate sector looking quite promising, this step of allowing REMFs provides an additional opportunity to retail investors to benefit from property value appreciation, and the Indian markets will certainly witness the launch of several REMF schemes in the near future, now that SEBI has paved the way for them.

What is still unclear though is whether REMFs would be the only avenue available to retail investors, or whether real estate investment trusts (REITs) would also be an option. As we had discussed in an earlier post on this blog, SEBI had announced draft regulations for REITs in December last year. While some of the features of REMFs are similar to those of REITs, their treatment in the respective regulations by SEBI is not quite the same. There have been no further steps taken on the REITs front, and it remains to be seen whether the REMFs presently announced eclipse developments on the REITs front or whether we could possibly witness the emergence of REITs in addition to REMFs.

(Update – May 7, 2008: Here is a column in The Economic Times analysing the new regulations on real estate mutual funds)

Success of Venture Capital Investments in India

One of our readers, Aravind Balajee, brings to our attention this story from VC Circle. It relates to a tremendously successful exit by a venture capital investor, UTI Ventures, from an Indian portfolio company, Excelsoft Technologies Pvt. Ltd. The details are here:

“There is a thing or two to learn from this exit deal of UTI Ventures. One is that the Indian software product companies are not all that bad an investment. Second, early stage investment in India can get you bumper returns (of course, if your investment is right).

The Bangalore-based venture-turned-growth capital private equity firm has made the highest multiple of returns for an Indian fund from Excelsoft Technologies Pvt Ltd, the Mysore-based e-learning company. Global private equity fund DE Shaw has bought out the entire 35.5 per cent stake of UTI Ventures in Excelsoft for $31 million. UTIVF’s original investment in the company was only Rs 2.5 crore (in 2000) or $600,000.

The previous higher exit multiples include about 26-30X in Suzlon Energy by ChrysCapital and Citigroup Venture Capital, 25X in Mphasis by Baring Private Equity and Gaja Capital Partner’s 22X in another e-learning company Educomp Solutions.”

For any venture capital (VC) or private equity (PE) investor, the availability of a smooth exit from the investment is one of the most critical factors that determine the investment’s success. Exit can be achieved through a sale of securities by the VC or PE investor into the stock markets in case of listed securities. Such investors also exit through initial public offerings (IPOs) by the portfolio companies, whereby the securities get listed on one or more stock exchanges. The obligation of the portfolio company to provide a stock market exit (usually by way of an IPO) to the VC or PE investor is detailed in specific terms in the investment agreements entered into between the VC or PE investors on the one hand and the portfolio company or its promoters on the other. Exit can be achieved by way of a private sale to another investor (in case of both listed and unlisted securities).

The liquidity, depth and robustness of the stock markets are important factors that determine the success of a market sale, whereas the availability of a strong community of financial investors (that buy stakes from other investors) determines the success of a private sale.

Examples like the UTI-Excelsoft deal demonstrate that the Indian markets are maturing at a rapid pace to provide better exits to VC and PE investors. This is despite the markets having suffered temporary setbacks owing to financial crises that have been gripping world markets over the last year or so. The trading activity on the two primary Indian stock exchanges (Bombay Stock Exchange and National Stock Exchange) has grown exponentially. Further, the markets have also grown in terms of the number of listed companies. As a paper “Law, Finance, and Politics: The Case of India” (that we had reviewed in an earlier post on this blog) notes:

“… India has an extraordinarily high number of listed companies—second only to the US. However, their average market capitalization is relatively small. Moreover, the ‘depth’ of India’s equity markets—as measured by the ratio of market capitalization to GDP—is higher than that for comparable developing countries such as China, or indeed for many developed countries, including Germany”

This fact indicates that the increasing maturity and liquidity of the Indian markets facilitates easier exit by VC and PE investors through stock market sales.

Similarly, there has also been a rise in the VC and PE investment community in India thereby expanding the market for private sales. With more and more players entering the space, there are increasing numbers of investors that are willing to acquire stakes from VC or PE investors in Indian companies on a private basis through negotiations. This provides an avenue for VC and PE investors to sell in a private market even if the securities of the portfolio company have not been listed in an IPO. The UTI exit from Excelsoft presents a typical illustration of a private sale, where the shares were sold in this instance to DE Shaw, a private equity player.

Apart from ease of exits (and myriad other commercial and business factors), the availability of a facilitative and unambiguous legal regime governing VC and PE investors is also determinative of the success of the industry. As far as the VC industry is concerned, the venture capital norms issued by the Securities and Exchange Board of India (SEBI), separately for the domestic industry (in the form of the SEBI (Venture Capital Funds) Regulations, 1996) and for the offshore industry (in the form of the SEBI (Foreign Venture Capital Investor) Regulations, 2000) have evolved over a period of time creating an increasingly favourable regime for VC investors.

The PE industry, on the other hand, is not directly regulated by any Indian regulatory authority, but is subject to the same regulations for investment that govern other foreign direct investors (FDI) or foreign institutional investors (FIIs). The continuing liberalisation of FDI and FII norms has indirectly benefited the PE industry in bringing about flexibility in their investment norms. Of course, there are, and would continue to be, several operational issues that still require to be addressed, but at an overall level, the legal regime relating to VCs and PEs have come a long way.

Even when it comes to contracting with VC and PE investors, Indian companies and their advisors are increasingly becoming familiar with Silicon-valley style investment agreements for VC investors and international standards on terms and conditions in PE agreements. Such familiarity with international best practices on the part of the Indian industry would aid in the development of a vibrant VC and PE markets in India. In all, the legal and contractual regimes for VC and PE investments facilitate a vibrant market and an increasingly large number of successful deals bear testimony to this fact.

Role of Law and Politics in India’s Economic Growth

There is a recent paper titled “Law, Finance, and Politics: The Case of India” by John Armour and Priya Lele that has been posted on SSRN. The authors join the debate as to whether a country’s legal origins (e.g. common law or civil law) necessarily have an impact on the extent of its financial development, and in doing so, they examine India as a case study. The authors find that in India’s case, political explanations have a greater bearing in explaining India’s growth, and that its legal heritage as a common law country has not played a significant role towards that end.

Here is the abstract:

“The process of liberalization of India's economy since 1991 has brought with it considerable development both of its financial markets and the legal institutions which support these. An influential body of recent economic work asserts that a country's 'legal origin' - as a civilian or common law jurisdiction - plays an important part in determining the development of its investor protection regulations, and consequently its financial development. An alternative theory claims that the determinants of investor protection are political, rather than legal. We use the case of India to test these theories. We find little support for the idea that India's legal heritage as a common law country has been influential in speeding the path of regulatory reforms and financial development. There is a complementarity between (i) India's relative success in services and software, (ii) the relative strength of its financial markets for outside equity, as opposed to outside debt, and (iii) the relative success of stock market regulation, as opposed to reforms of creditor rights. We conclude that political explanations have more traction in explaining the case of India than do theories based on 'legal origins'.”

The paper also contains a useful background discussion about the development of various institutions in India’s business and financial sectors. These include the evolution and the roles of bodies like the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (BSE) as well as other self-regulatory bodies like the stock exchanges. The paper also offers some reasons why the capital markets in India have been growing at a fast pace and acquiring greater depth, while the debt markets (including for bank lending) have not been keeping the same pace.

New Merger Norms for Telcos

The Indian telecommunications industry has witnessed significant consolidation over the last few years, with several large scale investments and mergers having occurred in this space. The Department of Telecommunications (DOT) has now issued Guidelines for intra-circle merger of licencees, which seek to strengthen DOT’s control and oversight of such mergers. While these guidelines incorporate several specific rules regarding intra-circle telco mergers, there continue to be several ambiguities in the guidelines (that may require further clarification from the DOT) and may constrain M&A transactions in the telecom space.

Following are some of the key features of the guidelines, with a discussion on areas that require clarification:

1. Prior approval of DOT

All mergers of intra-circle licencees require the prior approval of the DOT. This is consistent with the overarching control and regulation that DOT exercises over the telecom industry. However, the guidelines are unclear as the principles on which DOT ought to exercise its discretion to approve or reject a merger. In that sense, it appears to confer wide discretion to DOT, thereby possibly leaving parties to a potential merger with uncertainty as to the stance that DOT may take or as to the requirements that DOT would look for while considering such a merger.

Further, as this report in the Economic Times notes, seeking prior approval of the DOT becomes a sensitive issue in the case of mergers involving public listed companies. Such companies owe obligations under disclosure norms whereby they are required to make available material information (such as a potential merger) to shareholders through the stock exchange. Hence, companies would be required to carefully strategise their chronology of events in a merger transaction such that they are able to obtain the approval of the DOT (which would involve sharing of information regarding the merger with the regulator), but at the same time ensuring compliance with reporting requirements under disclosure and corporate governance norms.

2. Level of Dominance

The market share of the merged entity in the relevant market shall not be greater than 40% either in terms of subscriber base separately for wireless as well as wireline subscriber base or in terms of adjusted gross revenue. This is to prevent a monopolistic situation. While this is a notable cause in terms of prevention of competitive practices, the stipulation in these Guidelines and the power conferred on the DOT to grant approval is in addition to regulations relating to competition as set out in the Competition Act and the powers of the Competition Commission (once established). This would potentially create a conflict of authority over competition matters, and would also result in merger participants having to comply with dual anti-competition norms that would make the merger process extremely cumbersome.

Another condition that the Guidelines stipulate is that a merger will not be allowed if it results in the number of relevant service provider in the area being reduced to below four. This again is a competition regulation matter and would create some amount of duality in regulation.

3. Lock-in Period

Permission for mergers can be granted only after completion of 3 years from the effective date of the licences. As the clause stands, it is expected that not only should all the companies involved in the merger have been in operation for 3 years, but the very licences that are the subject matter of the merger should have been in effect for 3 years. Hence, if any of the companies has not been in operation for 3 years, or if the relevant licence has not been in effect for 3 years, then the merger will not be permitted by the DOT. Press reports indicate the Cellular Operators’ Association of India is seeking to clarify some of these issues.

4. Other Conditions

There are several other conditions, including that merger of licences shall be restricted to the same service area, that the entities shall comply with specific spectrum allocation requirement and that the duration of the licence of the merged entity in the respective area will be equal to the remaining duration of the licence of the merging entities whichever is less on the date of merger. As regards acquisitions of shares by one entity holding a licence to an area of shares of another entity licensed in the same area, the existing guidelines shall continue. This means that a licencee cannot acquire more than 10% shares in another licencee entity in the same area.

While these guidelines do lay down specific conditions for intra-circle mergers of telcos, the conditions appear to be onerous and that may tend to make such mergers more complicated than they presently are.

Disclosure Norms for Law Firms

So far, public listings of securities by law firms has not caught on despite the first law firm (Australia’s Slater & Gordon) listing about a year ago. The legal practice regulations in most jurisdictions do not permit law firms to either take a corporate form or to issue its securities to the public. But, if law firms are permitted to go public, and indeed if they do so, they would be subject to the same disclosure regulations as any other publicly listed companies are.

This is likely to result in some interesting situations when it comes to disclosures by law firms as David Lat’s article in The New York Observer points out. The article’s hypothetical press release and disclosure containing the quarterly results of a publicly traded law firm adds a lot of humour to the tale!

SEBI Pricing Norms & Private Equity

When the market prices of companies in India are lower than what they were a few months ago, they would obviously be attractive to private equity funds and similar investors. However, the SEBI minimum pricing norms as set out in Chapter XIII of the SEBI (Disclosure & Investor Protection) Guidelines, 2000 are hampering deals in these market conditions, as this report by INDIA PE suggests.

The minimum pricing norms specify the higher of 26-weeks or 2-weeks average of the weekly high and low closing prices quoted on the specified stock exchange. Any issuance of shares by an Indian listed company cannot be below that price. While the 2-week average may track current market conditions, the 26-week average is likely to be higher than the current price in a falling market. Hence, private equity players will be forced by regulation to pay a price that is at a premium to current market price.

This, however, only applies to listed companies, which involve private investment in public enterprises (PIPE deals). In case of unlisted companies, since the shares do not have a ready market, companies have greater flexibility in pricing share issuances. Where the investor is a domestic person, the minimum price really is the par value of the share, as any price below that will result in issuance of shares at a discount which involves a cumbersome procedure to effect. Where the investor is a foreign person, the minimum price would be that determined by a valuer in accordance with the formula prescribed by the Controller of Capital Issues (CCI), which takes into account the financials of the investee company based on its past performance.

Dispute Resolution under the New Company Law

The establishment of the National Company Law Tribunal (NCLT) has been mired in controversy right from the start. Although the Companies Act was amended as early as 2002 to pave the way for the NCLT, the body is yet to be established (and the relevant provisions of the Amendment Act of 2002 are yet to be notified) as several aspects of its constitution and functioning have been the subject matter of litigation, which is now pending before the Supreme Court of India. The NCLT was expected to take over the role of the High Court (in dealing with company law matters), the Company Law Board (CLB) and the Board of Industrial and Financial Reconstruction (BIFR). However, pending the constitution of the NCLT, all these other dispute resolution bodies continue to perform their roles as originally envisaged.

While that is the present position, the Government seems to be taking steps to introduce some alternate mechanisms in the Companies Bill that is proposed to be introduced in the current session of Parliament. Specifically, the following proposals have been reported in the media:

(a) the jurisdiction of the BIFR will be transferred to the CLB, whereby the CLB will hear matters relating to sick industrial companies (see report in The Hindu Business Line);

(b) the Government will set up special courts to hear cases involving company law breaches and offences relating to the same, so that there is a speedier enforcement mechanism (see report in The Economic Times);

Some of these moves appear to be short-term in nature and pending the judgment of the Supreme Court regarding the validity of NCLT’s establishment. While they may take care of certain immediate needs, it is likely to cause confusion in the long term. What is needed is a comprehensive review and justice delivery system in company law matters through a single legislation (or amendment process), rather than a piecemeal approach. Constant changes in law would cause confusion to companies and investors in structuring their businesses and carrying out their operations.

What is more frustrating is the successful (at least in part) challenges to some of these legislations in the past. For example, the Companies Amendment Act establishing in the NCLT and the Competition Act establishing the Competition Commission, were both passed as early as 2002 and are on the statute books, but are yet incapable of implementation (although the Competition Act has been subsequently amended to address some of the concerns). Such unsuccessful attempts at changing laws and implementing statutory authorities and courts only adds to the confusion. Hence, adequate caution needs to be exercised while introducing any further changes to dispute resolution bodies under company law so as to ensure that such changes will be able to withstand legal and constitutional scrutiny by courts and therefore can be implemented in a time-effective manner without undue delays.

Consolidation in the Indian Financial Sector

The financial services sector in India (both in the banking and non-banking finance industry) has witnessed consolidation over the last few years through various mergers & acquisitions. This trend will perhaps continue in the future as well. A recent speech by V. Leeladhar, Deputy Governor of the Reserve Bank of India contains a good overview of the statutory and regulatory framework that governs consolidation (particularly mergers) in the Indian financial sector. This includes:

- voluntary amalgamation among private banks;
- compulsory amalgamation of private sector banks;
- merger of public sector banks;
- merger between a private sector bank and a non-banking finance company
(NBFC);
- merger of a housing finance subsidiary with the parent public sector bank;
- consolidation of development finance institutions;
- consolidation of regional rural banks.

The speech contains an overview of the regulatory provisions under which such mergers can take place, and also provides examples of mergers that have taken place under each category.

Short Selling is Here

We had carried an earlier post commenting on the proposed introduction of short selling on the Indian stock exchanges and discussing the broad implications of that move.

Short selling is now being implemented with effect from Monday, April 21, 2008, and the Bombay Stock Exchange as well as the National Stock Exchange have installed their securities lending and borrowing (SLB) mechanisms in preparation for this. The Economic Times has a report.

However, as the Business Standard notes, certain key players in the market such as banks and insurance companies may be unable to participate in short sales unless there is a change in law governing them. Here are some details:

“According to sources close to the development, banks are not allowed to short-sell equities.

“According to Section 6 of the Banking Regulation Act and the Securities Contract Regulation Act, banks are not allowed to short-sell. It will require an amendment to the Act if banks were to short-sell and RBI (the Reserve Bank of India) is not in favour of this,” said a source.

Even for lending and borrowing of equities to facilitate delivery-based short-selling, banks will require a separate provision from RBI.

There has to be a cap within the overall exposure to the equity market to restrict banks’ exposure to lending and borrowing of securities.

The Insurance Regulatory and Development Authority (Irda) too is not in favour of insurance companies short-selling equities.

Irda is of the view that insurance companies cannot short-sell in the equity market as it amounts to speculation and the Act does not permit speculation with policyholders’ money.

However, it is in the process of framing guidelines for insurance companies to engage in lending and borrowing of stocks to earn on the idle portfolio.”

Regulating Companies: Whose Role is it Anyway?

In the case of listed companies, when it comes to corporate governance, there is a classic dichotomy in regulation. On the one hand, it is the Ministry of Company Affairs that is largely responsible for the implementation of the Companies Act, 1956, while it is SEBI that is responsible for implementation of the corporate governance norms, which is contained in Clause 49 of the listing agreement. These are not mutually exclusive and there is bound to be overlap. However, a certain amount of confusion does prevail as to the separation of powers between the Ministry of Company Affairs and SEBI.

In a column in today’s Business Standard, Jaimini Bhagwati laments the lack of clarity in this behalf:

“Under the 1956 Companies Act, all Indian companies are covered by the regulatory oversight of the Ministry of Corporate Affairs (MCA) and listed companies are also regulated by SEBI. The ICAI, which was established under the 1949 Chartered Accountants Act, regulates the accounting profession. Clearly, SEBI can take action under Clause 49. However, what is not obvious is whether the principal responsibility for enforcing better corporate governance rests with the MCA or the regulator concerned depending on the nature of the company. Currently, SEBI can prescribe rules under Section 55A of the 1956 Companies Act. It is this type of overlap, despite the coordination committees between the MCA and SEBI, which provides the environment in which regulatory accountability slips between cracks.”

The column also deals with corporate governance failures in relation to the recent derivative transactions that have ended up in courts:

“The ICAI has indicated that the recommendatory and mandatory requirements of AS-30 would kick in from 2009 and 2011, respectively. In the interim, the institute has urged companies to declare their derivatives’ losses. It is surprising that seven years after the Securities and Contracts Regulation Act was amended in 2001 to allow trading in exchange-traded derivatives and the Reserve Bank of India (RBI) had formulated guidelines for over-the-counter currency derivatives even earlier, MTM accounting norms for derivatives have not caught up with international standards.

Is this lack of transparent (to investors) norms for derivatives accounting symptomatic of a wider malaise? That is, in corporate governance terms (e.g. financial reporting, derivatives accounting, appointments of board members, deposit taking, liquidation procedures, etc.), are Indian firms lagging behind internationally acknowledged best practices? Further, is this primarily because there is no statute-based autonomous (from government) regulator for companies? This is not to blame the MCA, SEBI or ICAI for patchy and delayed reporting on MTM accounting for derivatives transactions. All things considered, it seems that the existing framework for regulating companies in India is flawed.

In this context, the MCA’s J.J. Irani “Expert Committee on Company Law” submitted its findings at the end of May 2005. According to the Irani report, “it is important that the basic principles guiding the operation of corporate entities from registration to winding up or liquidation should be available in a single, comprehensive, centrally administered framework” (Chapter II, paragraph 5 of the report). Having recognised the need for a single centre of control, the report goes off on a tangent on this issue. For instance, about the need to demarcate the respective jurisdictions of the MCA and SEBI, the Irani report states that “this perception is misplaced”. More importantly, the report does not recommend which government or regulatory agency should be held principally accountable if there is gross incompetence or worse in the management of companies. Almost three years have passed since the Irani report was finalised and the following are examples of issues on which there is continuing lack of agreement: (a) age limit for directors; (b) number of boards on which the same director can serve; and (c) insolvency law which provides for bankruptcy, trustees to be appointed and liquidation.

The MCA is responsible for administering the 1956 Companies Act for all firms, irrespective of the nature of their activities and whether these are listed or not. However, does the MCA have the appropriate mandate and the required number of adequately trained staff to regulate all companies? It is a ministry and not a regulator. To carry out regulatory functions, as distinct from the role of a ministry, which is accountable to Parliament, it is a pre-requisite that the personnel concerned have the required expertise, both educational and professional, and sufficiently long tenures in the same area of work.

Returning to the issue of independent directors — would such directors be impervious to the machinations of corporate boardrooms? A complementary approach could be to focus on the working of specific board committees which are important. For example, the transparency and efficiency with which an audit committee works is important for better levels of corporate governance. Consequently, attention needs to be paid to ensure that the head of an audit committee is a professional without any connection, past or present, with the company, its promoters or management. It should be obligatory for the head of an audit committee to provide written disclosure to this effect and for the chairman to confirm this in the company’s annual report. To summarise, it is time to assign the responsibility of regulating companies and reviewing current rules to an existing regulator or to set up a separate autonomous regulator as distinct from a ministry.”

Bhagwati’s comments on the demarcation of jurisdiction between the various authorities are important, because failing clarity on this issue, errant companies will be able to take advantage of the prevailing confusion on the regulatory front and escape the regulatory bite with impunity.

Directors’ Duties During Times of Crises

The unexpected market conditions in recent times have rocked corporate boards world over. Healthy companies have begun to declare less satisfactory results, while the unlucky one’s face extinction. Companies are increasingly being exposed to liabilities towards shareholders, creditors and other counterparties, and consequently, directors of such companies are having to face difficult conditions in which to exercise their judgments on such boards.

In this context, the Harvard Law School Corporate Governance Blog carries a memo titled Corporate Governance Update: Advice for Directors in Complicated Times: The Fundamentals Still Apply prepared by Wachtell Lipton, that contains some practical advice and a set of dos and don’ts to directors on corporate boards. While the memo has been prepared in the context of US law (specifically Delaware), it is set in quite general and user-friendly terms and its principles would apply across jurisdictions, including in relation to directors on Indian companies.

Corporate Governance and the Indian Derivatives Saga

While on the issue of corporate governance and the role of boards in financial crises, an article by Govindraj Ethiraj in the Business Standard makes for interesting reading. Specifically, it laments the inadequacy of controls and the failure of corporate governance in companies that entered into complicated derivatives transactions without adequately appreciating the risks involved in those. It further adds:

“How did it happen? I am not sure but a good question to ask is when. My understanding is that companies have been steadily stepping up their exposure to currency swaps and the like for at least four years now. Over time, as the stockmarkets (which bolster sentiment) have held their own and the prospect of any downside risk appeared more and more distant with every passing day, chief financial officers (CFOs) of companies have got braver.

One key driver appears to be the desire to cut down on interest costs. Not surprisingly, banks have played a role here, structuring products that got more exotic by the day. One consultant I spoke to said he challenged most CFOs to make “head or tail” of the complex derivative contracts that they had signed, on behalf of their companies. Maybe shareholders are also at fault for not asking but the fact is that no one paid attention or more likely didn’t care as long as the bottom line was fine.
…

It’s possible many companies did keep their boards informed and made the appropriate references in their balance sheets. Though this does seem unlikely, even if they did, then as I mentioned earlier, no one was watching. It’s also possible that some companies are in violation of law. Either way, shareholders must perhaps shoulder some part of the blame.

To conclude, is this another Enron waiting in the wings? Not quite but it does raise some fundamental questions on what companies do with their shareholders’ funds. It’s also about how when the good times roll, everyone forgets to look at the figures closely. There is something in the original Cadbury committee definition of corporate governance. If I remember correctly it said, “Corporate governance is the system by which companies are directed and controlled.”

SWFs and Capital Flows

The Indian Government’s latest position on sovereign wealth funds (SWFs) can be gathered from a recent speech delivered by the Governor of the Reserve Bank of India, Dr. Y.V. Reddy at a session on ‘The Role of Government-owned Investment Vehicles in Global Capital Flows’ in the International Capital Markets and Emerging Markets Roundtable held at Washington DC on April 14, 2008.

His speech covers flow of capital from SWFs in two directions, (i) investments by foreign SWFs into India, where India is the host country, and (ii) potential investments by an Indian SWF (were one to be created) into other countries, where India will be the home country. Here are some salient features:

1. SWF Fund Flows into India

The Governor’s speech largely states the existing position regarding foreign investments into India, which is that foreign investors can come into the country either through the foreign direct investment (FDI) route or the foreign institutional investment (FII) route. Under the FDI route, most industry sectors are eligible for foreign investment under the automatic route, while the others require prior approval of the Foreign Investment Promotion Board. FDI is also subject to applicable caps on foreign investment in certain sectors. Under the FII route, the investing entities need to be registered with the Securities and Exchange Board of India (SEBI) either as FIIs or sub-account, and here too there are limits up to which FIIs and sub-account can invest in each company.

SWFs can come either under the FDI route or the FII route. In other words, there is no separate policy formulated for investment of foreign SWFs in Indian securities, and they are treated like any other foreign investor. Some SWFs have been investing for years now under this general policy, with Temasek (of Singapore) being the best example.

It is clear from this that the Government is yet to come out with a policy on accepting SWF investments into India. What it seems to be carrying out though is to keep a close watch on developments elsewhere (such as IMF, OECD, etc.) before taking policy measures specific to India.

2. SWF Fund Flows out of India

This would essentially require India to set up its own SWF so as to invest its surpluses in other countries in order to derive returns on those. Although Dr. Reddy’s speech appears to be quite balanced at first blush in pointing out both the advantages and disadvantages of establishing an Indian SWF, the disadvantages appear far in excess of the advantages. This seems to signal the Government’s current thinking, which is to wait and watch and not hurry to set up its own SWF.

Although there were early calls from the financial services industry and commentators for setting up an Indian SWF, those have gradually died down, and the current opinion increasingly seems to be against setting up an Indian SWF. For example, Vinay Nair, a senior fellow with the Wharton Financial Institutions Centre vehemently opposes the idea of an Indian SWF in an article in India Knowledge@Wharton. He says:

“… it is also important to remember that a democratic government has a mandate to play a role in promoting public welfare. Governments have a responsibility to invest in projects that generate public good. It is no secret that India needs massive investment in infrastructure, education and health care projects. It is useful to note that among most sovereign funds that have non-oil-based revenue sources, such domestic investment needs are minimal. Governments in China, Singapore and Australia, for example, have addressed these issues.

In my view, India should come up with a two-pronged approach. First, the country should develop a plan where excess reserves are used to fund infrastructure, education and health care needs in a non-corrupt and efficient manner. This would decrease the government’s reliance on tax revenues and provide an effective tax cut. Second, India should start building the country’s ability to detect high-potential investment opportunities overseas, just as the government of Singapore did. Such a project should start at a small scale and then be developed over time. This dual approach to managing the country’s national savings would serve India much better than rushing to set up a sovereign wealth fund to buy energy assets.”

This also marks a clear change in sentiment over the last few months relating to SWFs. Perhaps, this is owing to the lacklustre performance of SWF investments (primarily in distressed assets) during 2007.

More on the Indian Derivatives Saga

While the legalities of several derivative transactions entered into between banks and corporates are pending consideration of courts, it appears that these matters have ended up in court in the first place because of unexpected market movements over the last few months which defied all prior indications and past market history. Livemint has a detailed analysis by Niranjan Rajadhyaksha who examines the transactions which resulted in disputes between the banks and corporates, and the reasons for such disputes.

He also identifies the principal problem with such derivative transactions, which is the inability to assess any losses. He says:

“Counting the damage

It is now time to count the damages.

How the losses will be totted up will depend on the precise nature of the derivatives that companies and banks have entered into. The easiest ones to deal with are what are called exchange-traded derivatives. These derivatives have a daily market quote, similar to the daily price of a listed share in the stock exchange, so marking them to market is not much of a problem.

The OTC derivatives that have been privately negotiated and are not traded will present more difficulties to accountants. The most popular way to put a value on them is to use the Black Scholes option-pricing model that is used the world over. “Unless options are listed and traded in the market, the Black Scholes model will be used to value what companies and banks hold,” says Gautam Nayak, partner in audit firm Contractor, Nayak and Kishnadwala.

This iconic valuation model was unveiled in 1973 by financial economists Fisher Black and Myron Scholes. Their widely used formula—which Indian accountants are likely to use—takes many factors into account: the price of the underlying asset, the strike price of the option, the risk-free rate of interest, the time in years for the expiration of the option contract and the implied volatility.

Rising interest rates and higher volatility in the financial markets could lead to steeper falls in the notional price of options in the months ahead. The global derivatives market continues to gasp for air—and banks with credit derivatives will have to keep more money aside as provisions.

We have not yet seen the end of the great Indian derivatives mess.”

Of course, some of the damage may come to light sooner as companies begin to declare their March 31 results, since the ICAI has issued guidance on the earlier implementation of AS30 beginning March 31 (see earlier post on this blog).

The article contains some oblique references to the failure of regulation that resulted in the crisis with respect to derivatives. It states:

“The financial sector as a whole has evolved a lot and the banking industry is coming up with newer and newer instruments which are complex. Unfortunately, regulators have not kept pace with the developments happening. The gulf between players introducing ever newer and more complex instruments and the regulators is widening to the disadvantage of the public,” says Rajeev Chandrasekhar, the member of Parliament who asked the parliamentary question that Chidambaram replied to.”

The issue of regulating complex instruments such as derivatives is quite a challenging one, with no clear-cut solutions. It perhaps commands an entire blog post by itself. But it may be worth stating a few salient points (at a high level) here for the moment.

Globally, countries follow two broad patterns of regulation of complex financial instruments. At one end of the spectrum is public regulation, which necessitates the government or regulatory authorities to step in and lay down rules and standards for operation of market players, the failure to comply with which will result in adverse consequences. At the other end of the spectrum lies private market regulation, whereby the players in the market who deal in complex financial instruments, exercise diligent market discipline through self-determined systems of checks and balances so as to avert financial crises, without involving any form of government intervention. The optimal approach to regulation should ensure that markets will function in a systematic manner without suffering from financial crises, systemic losses and other impacts that adversely affect the players and stakeholders, but at the same time the regulation should not be so onerous as to stymie financial innovation and sophistication, which form the lifeblood of financial market activity.

In an economy like India that still lacks a high level of financial sophistication (just to give an instance, several corporates that entered into these derivative transactions claim that they did not know the nature of the obligations they were incurring when they signed on the dotted line), pure market regulation may not be the answer. Some level of public regulation seems inevitable. The policy makers in the Government, however, carry the onerous task of injecting the right of level of public regulation that protects the interests of market players without dampening financial growth and market sentiments.

(Update – April 17, 2008: Today’s Hindu Business Line carries two articles on accounting for derivatives exposure. They are Accounting of Derivative Losses and Shocker of a Standard.)

Measuring the Success of Capitalism

Being back on blawgosphere after a brief hiatus, I noticed this interesting column by Arun Maira in today’s Times of India. By way of background, the recent events in the US and UK have cast a serious doubt on the efficacy of capitalism as a viable economic model. It has been subject to challenge in particular on the ground that it promotes greed, leading businesses to go overboard and that it also causes severe disparity in income and wealth in society. At the same time, a movement that connects business to society is also gaining momentum, as we have seen in some of the previous posts on this blog relating to social business (here and here).

Arun Maira poses some interesting questions and provides some perspectives on these matters. Here are some extracts:

“In his book Supercapitalism: The Transformation of Business, Democracy, and Everyday Life, Robert Reich, a member of former President Bill Clinton's cabinet, observes that the wealth of the two richest Americans - Bill Gates and Warren Buffet - is equal to the combined wealth of 100 million poorer Americans.

He argues that this is a result of the capitalist process. He does not grudge the two their wealth. But he says a system that can result in such huge disparities cannot be completely right. In India, the wealth of the richest Indians now equals the wealth of the richest Americans. One may wonder how many hundreds of millions of poorer Indians' wealth would equal one of these rich Indians' wealth?

Bill Emmott, former editor-in-chief of The Economist, in his book 20:21 Vision: 20th Century Lessons for the 21st Century says, "Capitalism in its present form is unpopular, unstable, unequal, and unclean". These critics of capitalism are not communists. They are capitalists. Yet, they are calling for a better way. Therefore, let us not be stuck in ideologies. Let us face realities. Why is it 'socialist' and wrong to forgive the loans of struggling farmers in India, while it is 'capitalist' and right to help Bear Stearns' rich investment bankers on Wall Street pay off their loans?

When we consider how to transform capitalism to make it more inclusive and more sustainable, we must consider the role of business corporations in society. They are the engines of capitalism. Therefore, business leaders must consider the footprints of their corporation's activities on the human community and on the environment.

We cannot remain stuck with the super capitalist notion that the business of business must be only business, and that corporate leaders are responsible only for creating shareholder value. We need a new framework for business management for the 21st century”

Amendments to Clause 49

SEBI has on April 8, 2008 issued a press release and circular amending certain provisions of Clause 49 relating to corporate governance, and can be viewed here: http://www.sebi.gov.in/Index.jsp?contentDisp=WhatsNewScroll&FilePath=/press/2008/200895.html

The composition of board of directors has been required to be as under:
(a) where chairman is an executive chairman, atleast half the board has to comprise of independent directors
(b) where the chairman is a non-executive chairman, then one-third of the board has to comprise of independent directors

The primary amendment brings item (b) on par with item (a) above in certain specific situations.

A brief analysis is as below:

Mandatory provisions:
1. If the non-executive Chairman is a promoter or is related to promoters or persons occupying management positions at the board level or at one level below the board, at least one-half of the board of the company should consist of independent directors.

Will impact companies
– having a non-executive Chairman who is a promoter or related to promoters &
– Having a non-executive Chairman related to persons occupying management positions at the board level or at one level below the Board.

Such companies will need to ensure that one-half of the board consists of independent directors.
This changeover is from a situation where if a company had a non-executive Chairman, then only one-third of the board needed to consist of independent directors.

Given that a large part of Corporate India comprises business houses / promoter driven enterprises, the impact can be quite a very high magnitude.

2. Disclosure of relationships between directors inter-se shall be made in the Annual Report, notice of appointment of a director, prospectus and letter of offer for issuances and any related filings made to the stock exchanges where the company is listed.

An ambiguity which is created is whether the inter-se relationship amongst directors that needs to be disclosed in specified documents/filings is with reference to:
- ‘reporting relationship’ OR
- relationship of being ‘relatives’

3. The gap between resignation/removal of an independent director and appointment of another independent director in his place shall not exceed 180 days. However, this provision would not apply in case a company fulfils the minimum requirement of independent directors in its Board, i.e., one-third or one-half as the case may be, even without filling the vacancy created by such resignation/removal.

- This is an on-going requirement

– essentially, if an independent director has retired/resigned/been removed, then his replacement should be found within 180 days.
- no impact where minimum requirement of independent directors is satisfied without filing up the vacancy.

4. The minimum age for independent directors shall be 21 years.
Companies will need to ensure incoming directors are of this age.
An ambiguity – what about companies who already have directors below this age OR does the capacity to contract as per Indian Contract Act anyway rules out those below 21 years of age from being a director, and hence this modification was not really required?

Non-mandatory provisions:
- The Board - A non-executive Chairman may be entitled to maintain a Chairman’s office at the company’s expense and also allowed reimbursement of expenses incurred in performance of his duties.

- Independent Directors may have a tenure not exceeding, in the aggregate, a period of nine years, on the Board of a company.
Some ambiguities which arise due to this requirement:
- Does the tenure already served require being reckoned for directors on board a listed company?
- Does the tenure served by a director prior to listing of a company which lists hereafter require being reckoned

Whilst the provision is itself non-mandatory – but in case of non-adoption, a specific disclosure in the annual report needs to be made and companies wanting to ensure good governance will be faced with the above ambiguities whilst complying.

Some segments will be able to ensure immediate compliance. for example in case of banking companies, the Banking Regulation Act already has a mandatory requirement limiting an independent director’s term to 8 years – itself a stricter standard than SEBI’s non-mandatory requirement limiting the term to 9 years.

- The company may ensure that the person who is being appointed as an independent director has the requisite qualifications and experience which would be of use to the company and which, in the opinion of the company, would enable him to contribute effectively to the company in his capacity as an independent director.

As mentioned though these three requirements are non-mandatory, in case of non-adoption, a specific disclosure in the annual report needs to be made.

These modifications to clause 49 reflect a continuing eye being kept by SEBI on Corporate India and prevailing Corporate governance standards - which is quite comforting! Clarifying the ambiguities will pave way for smooth adoption of these changes.

One aspect which may be challenging for Corporate India is the timing of these modifications - with financial years largely ending in March, with adoption of annual accounts within the quarter ending June, followed by circulation of annual report, may mean disclosures having to be made as on the date of the Annual report on the compliance with clause 49, and therefore compel steps to ensure compliance starting very quickly.

Draft Report of the High Level Committee on Financial Sector Reforms

The Draft CFSR report is up on the Planning Commission website for public view and can be accessed from the following link: http://www.planningcommission.gov.in/reports/genrep/report_fr.htm

A commentary which appeared in Business Standard is available at: http://www.business-standard.com/common/news_article.php?autono=319612&leftnm=4&subLeft=0&chkFlg=

More on Social Business

After I wrote an earlier post on Social Business over a month ago, I came across some interesting examples of efforts being made to integrate companies and society. These are not just voluntary efforts by companies to act in societal interest, but matters of policy pronounced by legislatures to be complied with by the corporate sector. These policies make it mandatory on companies to act in the interests of society – in a manner of speaking, these amount to “legislating” on corporate social responsibility.

I am listing those below (with some relevant extracts).

1. Oregon’s Corporate Code

The Conglomerate Blog has a report on recent amendments to the Oregon Corporate Code that requires companies to act in an environmentally and socially responsible manner. It says:

“Oregon recently amended its corporate code to expressly permit corporations to include in their charter a provision authorizing or directing the corporation to conduct its business "in a manner that is environmentally and socially responsible." The legislative history of the amendment notes that courts in other jurisdictions have interpreted corporations' obligation to act in shareholders' interest to mean that corporations must maximize shareholder profit, even if it results in a corporate failure to act environmentally and socially responsible. Apparently the amendment is designed to counteract this kind of interpretation, and encourage corporations to engage in sustainable behavior.”

2. Social Responsibility and Islamic Principles

The Race to the Bottom blog has a report on Saudi Arabian law that imposes a duty on companies to make an annual payment of a percentage of income and capital to a governmental organization for social purposes. It says:

“Companies in the United States are subjected to a legal obligation to act in the best interests of shareholders, something that usually translates into profit maximization. They have no additional legal obligations to their community or employees.

It is, however, different in the Kingdom of Saudi Arabia, where companies are governed by Islamic law. Islam imposes an obligation of Zakat, the duty to give alms. Zakat is one of the five pillars of Islam, which also include prayers and the month of Ramadan fasting among others. Its importance comes from the idea that the rich must provide financial support to the needy.

The duty applies not only to individuals but also to all Saudi and Gulf Cooperation Consul companies. As in the United States, corporations in Saudi Arabia are treated as fictional persons with specific legal obligations. This fictional personality explains the reason for which the payment of Zakat is levied on businesses under the Islamic law principles. It is also a way of paying back to the company's community.

Companies must make an annual payment equal to 2.5% of income and capital (for the capital and income items included in calculating Zakat, gohere). Revenues are collected by theDepartment of Zakat, a governmental organization and distributed to needy and poor people across the country. Zakat payments made of listed companies has to bedisclosed and filed with the Capital Market Authority (the Saudi Version of the SEC).”

3. Corporate Social Responsibility in China

Even the recent Company Law of the People’s Republic of China, enacted in 2005, has a set of obligations on companies that amount to corporate social responsibility. For example, Article 17 states:

“A company shall protect the legal rights and interests of its employees, enter into labor contracts with them according to law, take part in social insurance, improve labor protection and make production safe.

A company shall take various measures to improve the professional eduction and on-the-job training of its employees so as to enhance their quality.”

This provision too deviates from the general principles of company law, which give shareholders the supremacy over all other constitutents (such as employees). That is perhaps also explainable given the socialist origins of the Chinese corporate sector and the particular need to protect labour and employees.

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The developments discussed above are all the more interesting because they mark a serious departure from age-old principles of corporate law where companies were required to be run for the benefit of the shareholders only. A classic depiction of the shareholder-primacy principle can be found in the case of Dodge v. Ford that was decided by the Michigan Supreme Court in 1919 (see a brief description of the case in Wikipedia), where the court held that a business corporation is organized primarily for the profit of the stockholders, as opposed to the community or its employees.

Although the Indian Parliament itself has not made any specific endeavours to include the concept of corporate social responsibility specifically in the Companies Act, there are several openings for courts to interpret certain elements of social responsibility into obligations of Indian companies. For instance, the expression “public interest” is fairly ubiquitous in various sections of the Companies Act, and this may connote responsibilities of companies beyond merely towards their shareholders. The interests of creditors, employees, consumers and the public have also come up before courts at the time of sanction of amalgamations under Section 394 of the Companies Act (which is a provision that uses the expression “public interest”). However, I am not aware of any case that clearly deals with the dichotomy between shareholdres and other interests, and a resolution of this issue may have to await another day. Nevertheless, these types of issues are likely to become more prominent in the near future as the movement towards corporate social responsibility gathers momentum.

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Next week: Blogging from me during the next week (commencing April 7) is likely to be intermittent at best, if at all, and will resume with regularity from the week after that.

Direct Market Access to Institutional Investors

SEBI yesterday issued a circular to the BSE and NSE with a view to granting direct market access to institutional clients through the brokers’ infrastructure. The rationale for the move is described in the circular as follows:

“Direct Market Access (DMA) is a facility which allows brokers to offer clients direct access to the exchange trading system through the broker’s infrastructure without manual intervention by the broker. Some of the advantages offered by DMA are direct control of clients over orders, faster execution of client orders, reduced risk of errors associated with manual order entry, greater transparency, increased liquidity, lower impact costs for large orders, better audit trails and better use of hedging and arbitrage opportunities through the use of decision support tools / algorithms for trading.

While ensuring conformity with the provisions of the Securities Contract (Regulations) Act, 1956 (42 of 1956), Stock Exchanges may facilitate Direct Market Access for Investors …”

This will, of course, be subject to necessary amendments to byelaws and regulations of the stock exchanges.

Further reports on this development are available at The Hindu Business Line and Livemint.

Foreign Investment in the Small Scale Sector

The small scale sector has continued to receive protection from the Government when it comes to foreign investment, despite liberalisation pervading in the economy generally. It is time to alter that position, argues an editorial in today’s Financial Express:

“Foreign direct investment (FDI) in small-scale industry (SSI)? It could be just what the sector needs. In fact, the government’s reported move to liberalise FDI here by shifting the approval regime from the case-by-case approach currently used by the FIPB to the automatic route, and by perhaps even raising the industry-specific caps on foreign equity ownership, could boost India’s prospects in the race to secure global capital for its Economy. Foreign money brings with it new expertise, international discipline in the deployment of funds and sometimes even strategic inputs, from which entire market segments tend to benefit. Ideally, of course, the entire SSI list—there are 35 industries still on it reserved for small players—should be scrapped and 100% FDI invited in all manufacturing sectors, big and small, with only a handful of strategic industries kept out of foreign control. But if the proposed FDI-in-SSI move has the effect of impressing upon our reservationists the value of foreign inputs, then maybe this is a clever way to pry open the sector for bigger and better things to come.”

Perhaps there is merit in reviewing the current approach of the Government.

Derivatives in Commodities: Some Issues

This is a cross-post from the Law and Other Things Blog.

The issue over commodities exchanges and trading of futures and options in respect commodities has been brought to the fore with the Left parties deciding not to support the Forward Contracts (Regulation) Amendment Bill.

By way of background, commodities trading can occur in two ways. One is spot trading, where a buyer and seller of commodities enter into a contract, and settle the same by delivery of the commodities and the corresponding payment within a predefined time period (usually up to 11 days). The second is forward trading, where the delivery and/or payment occurs beyond such pre-defined period. Under the Constitution, spot trading is left to States to legislate, while forward trading is within the domain of the Parliament. It is under the latter powers that the Parliament enacted the Forward Contracts (Regulation) Act, 1952 (FCRA) that governs forward trading in commodities. Under the FCRA, while forward trading was permitted in some commodities and restricted in others, options were prohibited. To explain an option, it is a contract under which one party has the option or right (but not the obligation) to buy or to sell a commodity at a predetermined price. The administrative authority under the FCRA was the Forward Markets Commission (FMC), which was a government body.

With the development of the commodities futures markets over the last few years, the Government proposed an overhaul of the FCRA to take these recent developments into account. The principal changes relate to the allowance of options in commodities (that were earlier prohibited), the reestablishment of the FMC as an independent regulator (on similar lines as SEBI) rather than as an arm of the Government itself, and the organisation of commodities exchanges (to enable commodities futures trading) on corporate lines similar to stock exchanges. While these issues were part of the Forward Contracts (Regulation) Bill, 2006 that was pending in Parliament, the Government accelerated the reform process by ensuring the promulgation of the Forward Contracts (Regulation) Ordinance, 2008. The key features of the Ordinance are set out in a press release issued by the Government.

While there could be some questions as to the way in which the Government secured the changes through an Ordinance just two weeks before the Parliament commenced its session, there is little doubt that these changes were long overdue. Like the stock markets in India, the commodities markets too have been developing in a structured fashion over the last few years. Two large electronic exchanges in the form of the Multi Commodity Exchange of India Limited (MCX) and the National Commodities and Derivatives Exchange Limited (NCDEX) have been established and they now handle a significant portion of futures trading that occurs in commodities in India.

Economically, futures trading provides several benefits; it creates liquidity in the markets, enables price discovery by signaling the best price to the rest of the market participants, and most importantly, it provides traders with an avenue to hedge their risks. But, we must bear in mind that derivatives (such as futures and options) are complex instruments and hence are inherently risky. They are largely based on movements in commodity prices, and wrong bets on market movement can prove to be very costly, sometimes even to sophisticated players.

The Left has largely attacked the Ordinance by attributing the recent surge in commodity prices to extensive futures trading. However, that seems somewhat misdirected, as there is no correlation established between futures trading and increase in prices. Price increases could possibly arise due to myriad other factors.

I find that an important aspect that the Ordinance has failed to tackle is the issue of complexity of derivatives. It is not sufficient if the law merely provides a platform for derivatives trading in commodities. There needs to be a proper mechanism for disclosure, which requires persons that are selling futures and options in commodities to disclose all details (the risks in particular) relating to these products in a manner that the buyers of such products are able to appreciate the risks involved before they decide whether to participate in that market or not. In relation to derivatives in the stock market, the detailed rules issued by SEBI largely serve that purpose. It is also to be noted that the commodities futures market is likely to be patronised primarily by traders (some of them who may be of medium to small-scale) who may not possess sufficient sophistication to comprehend the risks involved in such complex instruments. The experience with derivatives in the financial markets (where the level of sophistication is somewhat higher) has not been good either, what with several companies now filing suits against banks (with whom they entered into derivative transactions) to renege on their commitments, including on the grounds that they did not fully understand what they were entering into. For details, see here and here on the Indian Corporate Law Blog). Therefore, a proper disclosure regime is called for in commodities trading so as to ensure informed trading in commodities derivatives, and thereby a transparent market.

The Left has also opposed foreign direct investment (FDI) in commodities exchanges. Although the press reports (referring to the Left objections) indicate that the FDI has been permitted under the Ordinance, it is not the accurate position. FDI is governed by various policies issued by the Department of Industrial Policy and Promotion (and not the Ordinance). The Press Note 2 of 2008 allows foreign investment of 49% in commodities exchanges (with 26% FDI and 23% FII investment) with the prior approval of the Government. Further, no foreign investor/entity, including persons acting in concert, will hold more than 5% equity in such companies. This appears to me to be a balanced approach towards foreign investment. While it allows major world players in this industry to participate in the Indian market and thereby introduce their expertise and business practices, it guards domestic interests as well. It is fairly restrictive as (i) investment is possible only with prior Government approval, (ii) majority shareholding still remains with domestic owners; and (iii) there is no risk of dominance by a single foreign player (or group) on an exchange as individual investments are capped at 5%.

It is likely that these issues will be the subject of heated debate in the near future, especially as the Bill comes up for discussion in Parliament.

Preposterous policy view from SEBI on QIPs and Public Shareholding

The Securities and Exchange Board of India has issued an informal guidance relating to the Listing Agreement and the SEBI (Disclosure and Investor Protection) Guidelines ("DIP Guidelines") that defies all logic and reason.

Clause 13.A.1.1(b) of the DIP Guidelines, which governs private placements to qualified institutional buyers, provides that a listed company ought to be in compliance with the prescribed minimum public shareholding requirements of the Listing Agreement in order to effect a qualified institutional placement ("QIP").

Clause 40A (vii) and clause 40A(viii) of the Listing Agreement provides that where the public shareholding in a company falls below the minimum level of public shareholding on account of supervening extraordinary events such as the implementation of a scheme of arrangement, public shareholding ought to be restored, in consultation with the stock exchange, to the prescribed minimum level through one of the following methods:

(a) Issuance of shares to public through prospectus;

(b) Offer for sale of shares held by promoters to public through prospectus;

(c) Sale of shares held by promoters through the secondary market; or

(d) Any other method which does not adversely affect the interest of minority shareholders.

A listed company that had undergone a Scheme of Arrangement by merging another company into itself faced a fall in public shareholding and therefore desired to effect a QIP to restore public shareholding to the prescribed level. Since the DIP Guidelines required a company to be compliant with the Listing Agreement in order to be able to transact a QIP, the company sought an informal guidance from SEBI to confirm that it could indeed effect a QIP as a means of increasing public shareholding.

Since the very purpose of the QIP was to restore public shareholding to the minimum level, upon completion of the QIP, the company would be compliant with the Listing Agreement. SEBI has taken an unsustainable technical view. In an informal guidance, SEBI has said that a status of compliance with the Listing Agreement is a condition precedent to the eligibility to effect a QIP. Since the company in question is not compliant before the QIP, it did not matter that the QIP would be the transaction that would ensure compliance with the prescribed level of public shareholding. SEBI has ruled that the company would not be allowed to transact a QIP and has held that the company is ineligible under the DIP Guidelines.

SEBI's view is not just amusing but also clearly violative of the purpose behind the DIP Guidelines. It is settled law that not just "guidelines", but even other forms of securities laws made under the SEBI Act, as indeed regulatory law, have to be purposively construed, and not strictly construed on the lines of fiscal statute. The purpose of the Listing Agreement is to ensure that every company has a minimum public shareholding at a prescribed level. The stock exchanges are empowered to have a dialogue with the company and work out the means of attaining the prescribed level of public shareholding. In this case, the stock exchange and the company had agreed that the public shareholding would be restored, among others, by means such as QIP, which would only increase the shares held by the public.

SEBI's informal guidance is contrary to the spirit of the DIP Guidelines and the Listing Agreement, each of which constitutes regulatory law formulated by SEBI. If a company seeks to comply with the prescribed level of minimum public shareholding, it is rather strange that SEBI should disallow the means of ensuring such compliance. So long as the QIP would push the company towards compliance with the salutary provisions prescribing minimum public shareholding, the purpose behind the law would have been achieved. The purpose behind the DIP Guidelines is to regulate private placements of securities within the parameters of the law. The QIP, in this case, would have promoted and furthered the cause of getting the company to comply with the law. However, SEBI, in its wisdom, has treated an eligibility clause in the Listing Agreement, on the lines of a condition of grant of a tax exemption, and by a narrow interpretation, has promoted the continued non-compliance with the Listing Agreement. This is a travesty.

Such a position would result in similarly-placed companies being forced to go in for public offerings, or sale of shares by promoter-shareholders. There is no reasonable object in the securities laws that would support forcing the adoption of such a mechanism. The right course for SEBI would have been to clarify that so long as the QIP results in the public shareholding level becoming compliant, the eligibility clause in the DIP Guidelines would not come in the way of the QIP.

An opportunity has been lost. It is not too late for SEBI to rectify this position and issue a correction in its view.

- Somasekhar Sundaresan

Post Script:-

Informal guidance letters contain the following disclaimer:-

"This letter does not express a decision of the Board on the question referred."

While this line is to pre-empt such interpretative letters being treated as "orders" that can be challenged before the Securities Appellate Tribunal, it makes a mockery of the Informal Guidance Scheme itself. The question it raises is that if the position taken by SEBI is actually not a decision of SEBI, of what value at all is it? It is a waste of time and energy for all concerned including SEBI?