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
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.
Taxation on Slump Sales
A ‘slump sale’ is one of the methods available to give effect to a transfer of a division or undertaking of a company to another company. Under this method, all the assets and liabilities of (or relatable to) the undertaking are transferred for a ‘lump sum’ consideration without assigning values to the individual assets and liabilities of that undertaking. Unlike certain other types of merger and acquisition transactions, such as qualifying amalgamations or demergers, that are exempt from capital gains taxation on account of transfer of the undertaking, slump sales give rise to liability for capital gains taxation in the hands of the transferor company. However, the manner of computation of capital gains tax for a slump sale has been specifically laid down in the Income Tax Act, 1961 and is different from the treatment that applies to transfers of other forms of capital assets.
The Hindu Business Line carries an article by H. P. Ranina explaining the capital gains tax implications of a slump sale. The article commences as follows:
The Hindu Business Line carries an article by H. P. Ranina explaining the capital gains tax implications of a slump sale. The article commences as follows:
“Section 50-B of the Income-Tax Act, 1961, is a special provision for computing capital gains chargeable to tax in the case of a slump sale. Such capital gains are deemed to be long term where the undertaking has been owned and held by the assessee for more than three years, irrespective of the period for which each individual asset of the undertaking has been held.The article then goes on to deal with the nuances of computing net worth, especially in a situation where the liabilities of the undertaking are greater than the assets, and particularly on the issue of whether there can ever be a ‘negative’ net worth.
Therefore, Section 50-B would prevail over the general provisions of the law. Sections 48 and 49 have been made applicable, subject to some modification, for computing capital gains in the case of a slump sale.
Defining ‘net worth’
The net worth of the undertaking transferred is deemed to be the cost of acquisition and cost of improvement for calculating the capital gains. The net worth is to be computed in accordance with Explanations 1 and 2 of Section 50-B.
As per Explanation 1, “net worth” has been defined as the aggregate value of total assets of the undertaking as reduced by the value of liabilities of such undertaking as appearing in the books of account.
Explanation 2 provides that the value of depreciable assets shall be taken as the written-down value (WDV) determined under Section 43(6)(c) of the Act, while the value of non-depreciable assets will be taken as per the books. The net worth so computed is to be certified by the report of the accountant as defined in Section 288(2).”
Training Directors
I had earlier posted about the Chartered Director test prescribed by the Institute of Directors in London, which is a qualifying examination for directors on corporate boards. In response, one our readers from Australia, Susie Reece Jones, has been kind enough to provide us with some details about the situation in Australia in this regard.
In Australia, there is almost a de facto pre-requisite that a director seeking board membership should have completed the Company Director’s Education Program with the Australian Institute of Company Directors (AICD). Whilst the program is not mandated, it is considered appropriate that directors have taken and complete the course. Membership of the AICD helps directors as well. The directors’ education course can be undertaken part- or full-time and encompasses a multitude of subjects including, but not limited to, corporate law. The course culminates in an examination for candidates. There are regular and frequent follow up courses (as the AICD website suggests) and these are generally well patronised. The demand for such courses also stands enhanced given increasing liability implications for corporate directors, and the need for awareness of possible risks and mitigating factors (such as directors’ and officers’ liability insurance policies).
On a more general note, Australia also has a strong talent pool of independent company directors. Board seats are indeed hard to obtain, as large public companies undertake a rigorous and transparent recruitment process for independent directors. There is also a focus on recruiting women on corporate boards (although not mandated by law), but this has yet to become the norm on Australian boards.
It is useful to look at such instances in other corporate governance regimes as the Indian corporate fraternity continues to set and improve its own best practices.
In Australia, there is almost a de facto pre-requisite that a director seeking board membership should have completed the Company Director’s Education Program with the Australian Institute of Company Directors (AICD). Whilst the program is not mandated, it is considered appropriate that directors have taken and complete the course. Membership of the AICD helps directors as well. The directors’ education course can be undertaken part- or full-time and encompasses a multitude of subjects including, but not limited to, corporate law. The course culminates in an examination for candidates. There are regular and frequent follow up courses (as the AICD website suggests) and these are generally well patronised. The demand for such courses also stands enhanced given increasing liability implications for corporate directors, and the need for awareness of possible risks and mitigating factors (such as directors’ and officers’ liability insurance policies).
On a more general note, Australia also has a strong talent pool of independent company directors. Board seats are indeed hard to obtain, as large public companies undertake a rigorous and transparent recruitment process for independent directors. There is also a focus on recruiting women on corporate boards (although not mandated by law), but this has yet to become the norm on Australian boards.
It is useful to look at such instances in other corporate governance regimes as the Indian corporate fraternity continues to set and improve its own best practices.
SEBI Eases Payment Norms in Public Offerings
On May 13, 2008, SEBI created a new method of payment or earmarking of funds for subscription to securities in a public offering. The press release states:
“Easing of payment process in public / rights issue:The Hindu Business Line highlights some of the benefits to investors:
The Board approved, in principle, the concept of marking lien on bank account as an alternative mode of payment in public / rights issues. The concept will enable the application money to remain in the bank account of the applicant till such time the allotment is finalized and thus eliminate the refund process. The modalities in this regard would be worked out separately.”
“This would also reduce the burden on registrars and merchant bankers. But bankers to the issue can no longer enjoy the floating interest, said officials associated with the IPO process.
Most important of all, investors would not have to wait for their refund money. It also ensures that a liquidity crisis such as that of January 2008 does not occur again.
At that time, many investors were unable to buy scrips which were at attractive lows, as their money was locked up in the Reliance Power and the Future Capital IPOs. Nor could they meet their margin money requirements.”
FIIs and Offshore Instruments: Another SEBI Order Set Aside
Readers may recollect that the Securities Appellate Tribunal (SAT) in 2005 overturned the order of SEBI prohibiting UBS, its affiliates and agents from issuing offshore derivative instruments (ODIs) with underlying Indian securities for a period of one year (on account of UBS’ failure to provide infromation about investors to whom it had issued such ODIs). The SAT found that the SEBI (Foreign Institutional Investors) Regulations, 1995 were unclear as to the information required to be provided by foreign institutional investors (FIIs) in relation to the ODIs. It held that such information lacks precise definition, and in any event there was no requirement to provide information regarding directors and shareholders of entities (such as hedge funds) that held the ODIs.
In yet another order passed yesterday, SAT set aside an order of SEBI’s adjudicating officer who imposed a penalty of Rs. 1 crore (rupees ten million) on Goldman Sachs Investment (Mauritius) Limited in connection with its issuance of ODIs. SEBI’s allegation was that Goldman Sachs, through an FII entity, had invested in underlying shares of Himachal Futuristic Communications Ltd. and in turn issued ODIs on a back to back basis to Magnus Capital Corporation Limited, which is an overseas corporate body (OCB). SEBI alleged that Goldman Sachs had filed false declarations in its reporting to SEBI on ODIs (as regards their issuance to OCBs) and hence was liable for the penalty.
SAT set aside the order of SEBI primarily on two grounds:
1. Since there was no bar on the FIIs and their sub-accounts to issue/ subscribe/ purchase any derivative instrument to/ from Indian residents or OCBs, it would be reasonable to presume that many of them may have dealt with such persons in the course of their business activities. Consequently, they cannot be asked to furnish an undertaking in the absence of any bar to deal with such persons.
2. The adjudication officer’s show cause notice is confusing and does not spell out clearly the allegations against Goldman Sachs. This, in effect, represents a failure of natural justice.
In an unusual move, SAT also awarded costs to Goldman Sachs to the extent of Rs. 100,000.
This order is important for two reasons. First, it highlights several inadequacies in the existing FII Regulations prescribed by SEBI. There is lack of clarity in the reporting requirements by FII, due to which SEBI has been unable to succeed on two high profile actions it had initiated (being the UBS and Goldman Sachs cases). Perhaps it is necessary to specify the disclosures more clearly and to remove vagueness and ambiguity so as to avoid similar situations in the future. I have dealt with some of these issues in the paper on hedge funds which is abstracted in an earlier post on this blog.
Second, it highlights deficiencies in the adjudication process adopted, particularly with reference to compliance with principles of natural justice. This, as we have previously discussed, is a repetitive factor in numerous SEBI orders that have been set aside by SAT.
In yet another order passed yesterday, SAT set aside an order of SEBI’s adjudicating officer who imposed a penalty of Rs. 1 crore (rupees ten million) on Goldman Sachs Investment (Mauritius) Limited in connection with its issuance of ODIs. SEBI’s allegation was that Goldman Sachs, through an FII entity, had invested in underlying shares of Himachal Futuristic Communications Ltd. and in turn issued ODIs on a back to back basis to Magnus Capital Corporation Limited, which is an overseas corporate body (OCB). SEBI alleged that Goldman Sachs had filed false declarations in its reporting to SEBI on ODIs (as regards their issuance to OCBs) and hence was liable for the penalty.
SAT set aside the order of SEBI primarily on two grounds:
1. Since there was no bar on the FIIs and their sub-accounts to issue/ subscribe/ purchase any derivative instrument to/ from Indian residents or OCBs, it would be reasonable to presume that many of them may have dealt with such persons in the course of their business activities. Consequently, they cannot be asked to furnish an undertaking in the absence of any bar to deal with such persons.
2. The adjudication officer’s show cause notice is confusing and does not spell out clearly the allegations against Goldman Sachs. This, in effect, represents a failure of natural justice.
In an unusual move, SAT also awarded costs to Goldman Sachs to the extent of Rs. 100,000.
This order is important for two reasons. First, it highlights several inadequacies in the existing FII Regulations prescribed by SEBI. There is lack of clarity in the reporting requirements by FII, due to which SEBI has been unable to succeed on two high profile actions it had initiated (being the UBS and Goldman Sachs cases). Perhaps it is necessary to specify the disclosures more clearly and to remove vagueness and ambiguity so as to avoid similar situations in the future. I have dealt with some of these issues in the paper on hedge funds which is abstracted in an earlier post on this blog.
Second, it highlights deficiencies in the adjudication process adopted, particularly with reference to compliance with principles of natural justice. This, as we have previously discussed, is a repetitive factor in numerous SEBI orders that have been set aside by SAT.
Regulating Hedge Funds
I have uploaded an abstract of a working paper titled Analysing India's Approach to Hedge Fund Regulation on SSRN, which is reproduced below:
“Hedge funds tend to employ aggressive investment strategies, and they highly leverage their funds. While hedge funds infuse liquidity into the financial markets and enhance market efficiency, they also engage in complex financial transactions that leave open the possibility of systemic losses that are often borne by the financial markets they invest in.
In this context, the role of regulation of hedge funds in host-countries that receive their investment assumes importance. Regulation needs to balance healthy development of financial markets and the prevention of 'systemic loss' due to risky investment strategies. While a worldwide debate lingers on the need for governmental regulation to rein in hedge funds (as opposed to leaving it to market forces to determine their own regulation through market discipline), the Indian securities regulator, the Securities and Exchange Board of India (SEBI) has experienced a checkered history of regulating hedge funds while always adopting a somewhat cautious approach. It has employed different regulatory strategies to deal with hedge fund investments. These include the prohibition strategy, disclosure strategy, restriction strategy and the registration strategy.
This paper analyses SEBI's strategies for regulating offshore hedge funds investing into India. It finds that each time a regulatory strategy has been employed by SEBI, the hedge fund industry has reacted by displaying considerable malleability in being able to dilute the force of regulation. One such instance relates to the manner in which hedge funds reacted to the prohibition strategy by investing through offshore derivative instruments such as participatory notes so as to stay outside the purview of the Indian regulatory regime (although this route too has been significantly curtailed more recently). Using the example of SEBI's measures in the Indian context, the paper examines the dynamics involved in regulating the offshore hedge fund industry. Although this study is primarily focused on India, the results would apply at a conceptual level to other emerging economies that receive investments from offshore hedge funds.”
Miscellaneous: Commodities futures, FDI, Exchange-traded funds
The following are some key developments in the corporate sector over the last couple of days that are worth noting:
1. Commodities Futures
We had earlier discussed on this blog the preliminary findings of the Expert Committee under the chairmanship of Dr. Abhijit Sen, which failed to find a clear causation between commodity futures and the price rise in agricultural commodities. However, the Government seems to have overruled the findings in a sense when it banned futures trading in 4 commodities, being chana, soya complex, rubber and potato. This decision is not altogether uncontroversial, considering that there have been calls for a consistent futures policy. Further, the Dr. Sen committee has itself expressed its concern over the decision. The move is also likely to largely affect the trading on the commodities exchanges.
On a separate note, S. Gurumurthy presents a critical view about commodities futures and the Sen Committee findings.
2. FDI in Retail
The Hindu Business Line reports that there is unlikely to be a Government decision on the permissibility of foreign direct investment in retail trade in the near future.
3. Exchange Traded Funds
The Hindu Business Line has a column that explains this concept, which is slowly gaining popularity.
4. US-India Investment Norms
The Economic Times reports:
1. Commodities Futures
We had earlier discussed on this blog the preliminary findings of the Expert Committee under the chairmanship of Dr. Abhijit Sen, which failed to find a clear causation between commodity futures and the price rise in agricultural commodities. However, the Government seems to have overruled the findings in a sense when it banned futures trading in 4 commodities, being chana, soya complex, rubber and potato. This decision is not altogether uncontroversial, considering that there have been calls for a consistent futures policy. Further, the Dr. Sen committee has itself expressed its concern over the decision. The move is also likely to largely affect the trading on the commodities exchanges.
On a separate note, S. Gurumurthy presents a critical view about commodities futures and the Sen Committee findings.
2. FDI in Retail
The Hindu Business Line reports that there is unlikely to be a Government decision on the permissibility of foreign direct investment in retail trade in the near future.
3. Exchange Traded Funds
The Hindu Business Line has a column that explains this concept, which is slowly gaining popularity.
4. US-India Investment Norms
The Economic Times reports:
The US is putting pressure on India for a level-playing field for American companies investing in the country. Washington is pressing for a national treatment to US companies in the bilateral investment treaty (BIT) currently being negotiated.
A national treatment would place US investors on par with Indian investors and they may not have to adhere to the stringent guidelines laid down by the Foreign Investment Promotion Board (FIPB).
The US also wants India to agree to subjecting investment disputes between the two countries to international arbitration. While India has been resisting the proposals, the US is keen that the two become an integral part of the treaty.
An Examination for Directors
A few weeks ago, we carried a post by Pramod Rao discussing the implications of recent changes to Clause 49 of the listing agreement, the key ones being strengthening the role of the independent directors on boards of Indian listed companies. Although relegated only to a non-mandatory provision, one of the changes states that a “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.”
Although corporate governance norms are being tightened to provide for stricter definitions of “independence” and to enhance the role of independent directors, there are likely to be implementation problems on a continuing basis when viewed from a practical standpoint. Independent directors are either busy professionals who do not have sufficient time to devote to board roles on companies, or they are sometimes persons without the requisite qualifications to make effective contributions to boards in an increasingly complex business, financial and regulatory environment.
In order to overcome some of these problems, two US law professors, Ronald Gilson and Reinier Kraakman (in their article “Reinventing the Outside Director: An Agenda for Institutional Investors”) had suggested way back in 1990-91 that there should be a cadre of professional directors created to serve on corporate boards. These professional directors, as they envisaged, will be independent of management and shareholders (and thereby satisfy our current definition of independence) with requisite qualifications in business, finance and so on, and their only occupation will be that of acting as independent directors on say 6 boards in all. This way, these directors will be able to apply their expertise in monitoring corporate managements as independent directors on a full-time basis without being distracted by other vocations. However, that idea has not yet found favour in the corporate world, neither in India nor in any of the other recognised jurisdictions.
However, a concept that comes close to the idea of a professional director is one of a qualifying examination for directors. The Financial Times carries a report Directors face tough tests that describes the Chartered Director test prescribed by the Institute of Directors in London:
Although corporate governance norms are being tightened to provide for stricter definitions of “independence” and to enhance the role of independent directors, there are likely to be implementation problems on a continuing basis when viewed from a practical standpoint. Independent directors are either busy professionals who do not have sufficient time to devote to board roles on companies, or they are sometimes persons without the requisite qualifications to make effective contributions to boards in an increasingly complex business, financial and regulatory environment.
In order to overcome some of these problems, two US law professors, Ronald Gilson and Reinier Kraakman (in their article “Reinventing the Outside Director: An Agenda for Institutional Investors”) had suggested way back in 1990-91 that there should be a cadre of professional directors created to serve on corporate boards. These professional directors, as they envisaged, will be independent of management and shareholders (and thereby satisfy our current definition of independence) with requisite qualifications in business, finance and so on, and their only occupation will be that of acting as independent directors on say 6 boards in all. This way, these directors will be able to apply their expertise in monitoring corporate managements as independent directors on a full-time basis without being distracted by other vocations. However, that idea has not yet found favour in the corporate world, neither in India nor in any of the other recognised jurisdictions.
However, a concept that comes close to the idea of a professional director is one of a qualifying examination for directors. The Financial Times carries a report Directors face tough tests that describes the Chartered Director test prescribed by the Institute of Directors in London:
Businesses – even modestly sized ones – face increasing levels of complexity as far as compliance and risk management are concerned. Where should an aspiring director turn for an up-to-date, robust preparation for the role he or she is hoping to perform?Such measures would ensure that independent directors not only satisfy the technical requirements of independence, but are also independent in state of mind and have the necessary capabilities and resrouces to truly challenge management on key business and corporate decisions. It is well worth thinking on the lines of mandatory qualification and training for independent directors even in the Indian context so as to make their roles and contributions more meaningful, not just in compliance with the letter of law, but also in the true spirit of corporate governance.
One place you might not expect to find cutting-edge advice on the issue is the august, Grade 1-listed John Nash building that is home to the UK’s Institute of Directors, a venerable employers organisation.
The outward appearance may not suggest modernity. But the IoD has gone further than any other institution to codify the director’s role, and offers a meaningful and relevant qualification – that of the Chartered Director (C Dir) – that should help both executives and non-executives prepare for the demands of the job.
Launched at the start of the decade, the C Dir is not a pseudo-label that can be acquired by sitting through a few lectures and sending off a couple of vouchers in the post. An aspiring C Dir has to clear several high hurdles before being awarded the qualification. To date, 660 have achieved the title, fewer than 100 a year since its inception.
“Getting my PhD was a doddle compared with this,” says Suzy Walton (left), an occupational psychologist, non-executive director of several organisations, former member of Tony Blair’s delivery unit in the UK cabinet office – and a newly minted C Dir. “These were the toughest set of exams I have ever done. I practically had to move into the IoD while I was preparing for them. I know all the best places to sit and work there.”
Disclosures in Complex Transactions
With increasing complexity in transactions entered into by companies, especially in the financial sector, there is the lingering question of how these transactions are to be meaningfully disclosed to shareholders of the companies so as to enable them to take an investment decision (such as to buy, sell, hold, etc.). The trouble here is that institutional investors themselves are unable to appreciate the real nature of these transactions. We have seen some of this in the sub-prime crisis when several such investors bought collateralized debt obligations (CDOs). How then does one expect lay investors to grasp the intricacies involved in these transactions when they happen to be shareholders or other security holders in any of the companies that are parties to such deals?In Going beyond Greek letters in Livemint, Amol Agrawal flags the issue by giving the example of the UBS annual report that was sent to its shareholders:
“Swiss bank UBS AG has recently released a report where it has tried to explain to shareholders what went wrong in the subprime crisis. UBS is one of the worst affected firms and the decisions of its managers needed explanation. The report is an honest admission of various judgemental errors by the management.He then goes on to deal with some of the policy implications that lay behind disclosures and complex financial transactions:
One wonders how many of UBS’ shareholders understood what was written. It sounds Greek all the way. There is a surfeit of jargon and acronyms. One has to continuously flip back the pages to understand the chain of events.”
“All this poses numerous problems for the policymakers. They have to not only develop their financial systems, but also make them more crisis-resistant. Take the India example. There have been numerous reports on India’s financial sector. All these committees/reports suggest the same —an efficient financial system with more participation of public and encouraging financial innovation. But then, we can’t really ignore the risks from these fancy financial products. The UBS-type shareholder reports might soon be written by Indian firms (I hope not in times of crisis) and the recent derivatives crisis suggests the time will come sooner than later. How many shareholders will actually understand these derivative positions? If they don’t, then the purpose of bringing more public savings into capital markets needs to be questioned.The observations in the article are interesting. Disclosures relating to complex transactions will always result in information asymmetry. However, that just seems to be a fact that one cannot wish away. It is almost impossible to provide these disclosures in simple terms that are comprehensible to a lay investor. If at all that is attempted, there is a sure risk of oversimplification that may alter the meaning, relevance and importance of that information. Therefore, the option of providing simple disclosure that lay investors understand may not be a viable option.
The subprime crisis has pointed to the need for financial literacy, but understanding what happens in financial markets requires much more than basic financial literacy. Even the best financial brains can’t figure out the developments. Hedge fund Long Term Capital Management (LTCM) failed miserably despite having Nobel-winning economists on board. The subprime crisis is a collective failure of many such minds.
There is an urgent need to tackle the perverse incentives and complexity in the financial system. The regulators alone can’t do the job and the participants will have to become responsible themselves. But then, we are all interested in our yachts, who cares for the customers/shareholders? Financial deepening without creating financial excesses (as said by Hervé Hannoun of the Bank of International Settlements) is the need of the hour. The focus so far has been on the first part. The sooner we move to second, the better it will be.”
As Steven Schwarcz notes in his article Rethinking the Disclosure Paradigm in a World of Complexity, what we have is a “dilemma that some structured transactions are so complex that disclosure to investors of the company originating the transaction is necessarily imperfect – either oversimplifying the transaction, or providing detail and sophistication beyond the level of even most institutional investors and securities analysts.”
This then means that disclosure is not the proper means to regulate complex financial transactions. Such transactions must either be restricted by law and regulation, or alternatively such complex investment opportunities must be made available only to sophisticated investors (e.g. qualified institutional buyers) and not to those who cannot understand and appreciate the full extent of the risks they may be taking with these investments. This must, of course, be weighed against the need for vibrant financial markets that encourage financial innovation - always a tough balance.
Indian Corporates on an African Trail
Several large as well as medium sized Indian companies have undertaken outbound investments and offshore acquisitions in the last decade. These have primarily been in developed markets such as the United States or in various European countries such as the United Kingdom, Germany and so on.The year 2008 has witnessed the emergence of a new phenomenon, whereby Indian companies are seen scouting in Africa for potential investments and acquisitions. Indeed, Africa is a continent that is flush with natural resources, although not all of them have been put to optimal use. Apart from that, China has already obtained a head-start by making investments and forging alliances in various African countries, and Indian companies would certainly not like to find themselves in a position of having lost out on opportunities to its key competitor, China. Africa also presents itself as a large market for Indian goods and services, that makes it attractive for Indian companies.
This phenomenon is covered by The Economist in two of its articles. The first, The Indians are coming, examines the general trade and investment scenario between India and various African countries. The second, Eyes on Africa, discusses the specific transaction involving the potential acquisition of a stake by India’s Bharti Airtel in MTN, Africa’s largest mobile-phone operator.
IPO Scam: Another SEBI Order Set Aside
In an order passed on May 2, 2008, the Securities Appellate Tribunal (SAT) set aside the order of SEBI that directed 10 entities (including Karvy Stock Broking Limited) to disgorge a sum of Rs. 115.82 crores. The Hindu Business Line has a background to the case:
While, the SAT order itself is largely premised on grounds of natural justice, it does contain some useful explanation about the concept of “disgorgement” in relation to securities law:
“The scam related to certain entities cornering IPO shares (in 2003-05) reserved for the retail category by using fictitious demat accounts. These demat accounts were ultimately transferred to the financiers through key operators. The financiers made their gains on the first day of listing of these shares.As is the case with several appeals before SAT that arise out of SEBI orders, Karvy succeeded mainly on procedural grounds. SAT found that SEBI had failed to follow the principles of natural justice in not calling upon the appellant, Karvy, to show cause why it should not be ordered to disgorge the amount determined in the order. The SAT even went to the extent of expressing its anguish “over the irrational manner in which [SEBI] proceeded to pass the impugned order only against the two depositories and their participants.” The SAT appears to have taken strict note of the fact that the ultimate beneficiaries of the scam, being the various beneficiary account holders, were not issued any directions by SEBI for disgorgement, while SEBI forcefully pursued the depositories and the participants only.
SEBI’s disgorgement order of November 2006 had directed 10 entities including Karvy to jointly and severally pay up Rs 115.82 crore towards disgorgement (paying up money made through illegal or unethical gains).
However, SEBI refused to spell out how much each entity would have to pay, saying that it was a matter to be settled between the accused entities. It was against this order that the appeals to SAT were made.”
While, the SAT order itself is largely premised on grounds of natural justice, it does contain some useful explanation about the concept of “disgorgement” in relation to securities law:
“Before we deal with the contentions of the parties, it is necessary to understand what disgorgement is. It is a common term in developed markets across the world though it is new to the securities market in India. Black’s Law Dictionary defines disgorgement as “The act of giving up something (such as profits illegally obtained) on demand or by legal compulsion.” In commercial terms, disgorgement is the forced giving up of profits obtained by illegal or unethical acts. It is a repayment of ill-gotten gains that is imposed on wrongdoers by the courts. Disgorgement is a monetary equitable remedy that is designed to prevent a wrongdoer from unjustly enriching himself as a result of his illegal conduct. It is not a punishment nor is it concerned with the damages sustained by the victims of the unlawful conduct. Disgorgement of ill-gotten gains may be ordered against one who has violated the securities laws/regulations but it is not every violator who could be asked to disgorge. Only such wrongdoers who have made gains as a result of their illegal act(s) could be asked to do so. Since the chief purpose of ordering disgorgement is to make sure that the wrongdoers do not profit from their wrongdoing, it would follow that the disgorgement amount should not exceed the total profits realized as the result of the unlawful activity. In a disgorgement action, the burden of showing that the amount sought to be disgorged reasonably approximates the amount of unjust enrichment is on [SEBI].”
Differential Voting Rights as a Takeover Defence
Shares with differential voting rights (DVRs) have been permitted to be issued by Indian companies since 2001 when the Companies (Issue of Share Capital with Differential Voting Rights) Rules were issued. Not only have there been stringent conditions imposed with respect to issuance of shares with DVRs, but the rules themselves have given rise to several issues (particularly with reference to interpretation) due to which not many companies have actually availed of the benefits of DVRs.
DVRs can potentially be an effective tool to defend against hostile takeovers. For instance, promoters of a company may issue shares with DVRs to themselves, whereby they can hold a small number of shares, but still exercise a large number of votes. This will act as a resistance against hostile acquirers.
Today’s Livemint reports that a case pertaining to Jagatjit Industries that is currently pending before the Company Law Board may well clarify some of the existing ambiguities relating to DVRs and help determine their effectiveness as a takeover defence. The report also contains a discussion on several implications of issuance of DVRs, especially under the SEBI Takeover Code.
DVRs can potentially be an effective tool to defend against hostile takeovers. For instance, promoters of a company may issue shares with DVRs to themselves, whereby they can hold a small number of shares, but still exercise a large number of votes. This will act as a resistance against hostile acquirers.
Today’s Livemint reports that a case pertaining to Jagatjit Industries that is currently pending before the Company Law Board may well clarify some of the existing ambiguities relating to DVRs and help determine their effectiveness as a takeover defence. The report also contains a discussion on several implications of issuance of DVRs, especially under the SEBI Takeover Code.
Micro..hoo: A New Twist
This new development on the international M&A front is worth briefly noting on this blog.We had all expected to see a highly-contested battle for control of Yahoo! panning out over the next few months. A hostile bid by Microsoft was keenly on the cards. But, it all ended last weekend turning out to be a damp squib, with CEO Steve Ballmer announcing Microsoft intention of withdrawing from the deal in a letter to Yahoo! CEO Jerry Yang. The main reason cited in the letter is Yahoo’s threat to outsource search to Google, which deterred Microsoft from launching a hostile bid.
There are differing viewpoints held by some about why Microsoft may have adopted such a strategy rather than move ahead aggressively with a hostile bid on Yahoo! Others even argue that this episode hardly denotes the end of the takeover saga – it is only a ploy by Microsoft to beat the share price of Yahoo! down (and also incite indignant shareholders to initiate action against the Yahoo! board) and thereby enhance its negotiating leverage on the deal. Overall, from a legal standpoint, it appears that challenges to Microsoft withdrawal or even to Yahoo’s uncompromising stand (that led to the withdrawal) in courts in the US are not likely to be sustained based on past precedent. Following are links to some of the discussion on this issue.
1. BusinessAssociations Blog discusses the effectiveness of a defense used by Yahoo! to ward off a hostile bid threat by Microsoft. This relates to the use of a strategic partnership (in this case with Google) as a takeover defense – perhaps as some sort of a “poison pill”.
2. The Deal Professor suspects that Microsoft has had to withdraw due to a slow strategy it adopted thus far. He says:
“I’ve always thought that the problem with this strategy Microsoft has adopted thus far — slow and easy — is that it missed a maneuver from Larry Ellison’s tried-and-true playbook. In Larry’s world, you launch your full hostile as soon as possible in order to begin the time-clock running on your required antitrust regulatory clearances. Thus, when the target (Peoplesoft, etc.) finally agrees to negotiate provided you raise your bid, you don’t have to worry about closing risk. By that time, you’ve already obtained the necessary antitrust and other regulatory clearances. You put a few more dollars on the table and close in the next few weeks.3. Ideoblog offers some thoughts including the possibility of success (or otherwise) of any shareholder suits against Yahoo! in connection with the failure of Micorsoft’s takeover attempt, and consequent fall in price of Yahoo! shares. Larry Ribstein, the author of the blog says:
Microsoft has not followed this route. Thus, in any negotiation with Yahoo now, Yahoo has bargaining leverage to demand a “hell or high water” provision which would require Microsoft to make assets dispositions, license technology or other actions to satisfy the demands of antitrust regulators. Remember, Microsoft has never been on the good side of regulators – the Department of Justice would love to have the benefit of this provision.”
“First, would the suit against Yahoo’s “poison pill” work? I doubt it. Time is on Yahoo's side – it was still negotiating to increase shareholder value and had not sold control.4. Finally, this also gives rise to some corporate governance issues. For instance, Yahoo! shareholders may possibly contend that the board did not act in the interest of the shareholders by placing undue resistance to the Microsoft bid that resulted in its failure, and that Yahoo’s actions were driven by sentimental reasons (to preserve the positions of the incumbents, such as the founder). Even here, it may be a difficult case for shareholders challenging the actions as Yahoo! was always ready to complete a deal, but at a higher price.
Second, if Yahoo stock does take a beating and Ballmer does come back, could he and MS be sued for securities fraud – making a deliberately false threat to produce this result? Possibly under 14(e) and 10b-5, but very hard to prove.”
(Update – May 7, 2008: Law.com credits Yahoo’s lawyers with a clever strategy they used to ward off Microsoft’s maneuvers)
Revised Limited Liability Partnership Bill on the Horizon
A revised bill on Limited Liability Partnerships (LLPs) has been approved by the Union Cabinet, reports The Economic Times. The LLP Bill is set to be introduced in Parliament soon. The establishment of LLPs would enable professional services firms, such as those constituted by chartered accountants and lawyers, to carry on their activities without risk of personal liability of partners (beyond their share of capital in the firm). This would bring the Indian legal position on par with other developed jurisdictions where LLPs have been permitted for professional services firms. The new Bill replaces the previous Bill of 2006 as it takes into account suggestions given by the Standing Committee
As with many other laws and regulations that seek to establish new types of entities, the tax position regarding LLPs is yet unclear. However, it is expected that necessary changes will be brought about through amendments to the Income Tax Act to clarify the position regarding taxation of LLPs. A thornier issue relates to the payment of stamp duty when companies (mostly private limited) or other entities convert themselves into LLPs. When such conversion occurs, there is notionally a transfer of property of the erstwhile company or other entity to the LLP thereby resulting in a conveyance that is subject to stamp duty. Conversions to LLPs become prohibitively expensive if the stamp duty implications are severe. This scenario gets further complicated because stamp duty on conveyances fall within the state subject, and the Centre cannot legislate on the same. Hence, it becomes virtually impossible to convince all relevant states to impose less rates of stamp duty on conveyances arising out of conversion to LLPs or even to seek an exemption for such transaction. That could impose a hindrance on cost-effective implementation of conversions to LLPs.
These and other implications can be reviewed further once the Bill is introduced in Parliament and its detailed provisions are known.
As with many other laws and regulations that seek to establish new types of entities, the tax position regarding LLPs is yet unclear. However, it is expected that necessary changes will be brought about through amendments to the Income Tax Act to clarify the position regarding taxation of LLPs. A thornier issue relates to the payment of stamp duty when companies (mostly private limited) or other entities convert themselves into LLPs. When such conversion occurs, there is notionally a transfer of property of the erstwhile company or other entity to the LLP thereby resulting in a conveyance that is subject to stamp duty. Conversions to LLPs become prohibitively expensive if the stamp duty implications are severe. This scenario gets further complicated because stamp duty on conveyances fall within the state subject, and the Centre cannot legislate on the same. Hence, it becomes virtually impossible to convince all relevant states to impose less rates of stamp duty on conveyances arising out of conversion to LLPs or even to seek an exemption for such transaction. That could impose a hindrance on cost-effective implementation of conversions to LLPs.
These and other implications can be reviewed further once the Bill is introduced in Parliament and its detailed provisions are known.
Draft Report on Commodity Futures
One of the reasons ascribed to the recent price rise in India is the introduction and expansion of the commodities futures markets. This has, however, been partly put to rest if one were to go by the observations contained in the draft report of the Expert Committee on Commodity Futures Trading headed by Prof. Abhijit Sen. The Committee, which issued its draft report recently, failed to find a clear causation between commodity futures and the price rise in agricultural commodities. The report states:
Spot markets have also been found to require large-scale reforms. Here are some excerpts:
“The fact that agricultural price inflation accelerated during the post futures period does not, however, necessarily mean that this was caused by futures trading. One reason for the acceleration of price increase in the post futures period was that the immediate pre-futures period had been one of relatively low agricultural prices, reflecting an international downturn in commodity prices. A part of the acceleration in the post futures period may be due to rebound/recovery of the past trend.On the other hand, the Committee is not entirely pleased with the present functioning of the futures markets. For instance, it found that futures and hedging have failed to result in proper price discovery or an effective mechanism of risk management, which have in fact become poorer. The report makes a call to upgrade the quality of regulation both by the Forward Markets Commission and the commodity exchanges in order to prevent manipulation and abuse by speculators and arbitrageurs.
A study of supply fundamentals (production, changes in inventory and international trade) show that changes in these also contributed to higher inflation during the period under consideration. Nonetheless, recent behaviour of food grains prices does not appear to be explained completely by supply shortfalls, and, in particular, contribution of international price movements to domestic price outcomes appears to have increased substantially. Claims that futures trading were a cause of the inflation in sensitive commodities needs to be viewed in this context.”
Spot markets have also been found to require large-scale reforms. Here are some excerpts:
“Reforming spot markets should be given top priority. There is a need to give thrust to encourage all state governments to pass Model APMC Act. In fact, the model APMC Act is going to revolutionize agriculture marketing in the country. Further, in order to promote integrated national markets, the Central Government should take active steps to bring inter-state spot trade under the regulation of a central authority rather than leave it to highly scattered APMCs. Entry 33 in concurrent list of 7th Schedule of the Constitution seems to provide such a jurisdiction. The setting up of National Spot Electronic Exchanges by the National Commodity Exchanges is an attempt to create a national integrated market.”From this, it is possible to glean mixed conclusions. On the one hand, there is no evidence of the commodity futures markets exacerbating the inflation of essential commodity prices. On the other hand, there is still a lot of work to be done in improving the regulations relating to commodity futures and the exchanges on which these futures are traded. Spot markets also require a complete overhaul.
A Weak Start to Short Selling
Although short sales were allowed to commence last week (on April 21, 2008), the response thus far has been lukewarm. Various reasons have been offered for this result. The Hindu Business Line reports that market players attributed the poor response to bad timing, to relatively higher margin requirements for securities lending and borrowing (SLB) as compared to the future and options (F&O) segment of trade, and to the lack of operational readiness on the part of institutions. On the other hand, an The Economic Times report states that foreign institutional investors (FIIs) (who hold the key to the success of short selling) continue to use the participatory notes (PNs) route for shorting on Indian securities rather than to go through the mechanism established by SEBI. From these, it appears that there are several loose ends to be tied before the short selling mechanism can be implemented on a large scale.
In the meanwhile, there are more fundamental questions being raised about the desirability of short selling. Knowledge@Wharton carries an article that notes:
In the meanwhile, there are more fundamental questions being raised about the desirability of short selling. Knowledge@Wharton carries an article that notes:
“When Bear Stearns collapsed in March, some insiders argued it was wrong to blame the firm’s risky bets on mortgaged-backed securities. They had another culprit: malevolent traders working together in the upside-down world of short sales – making money by knocking down Bear’s stock.Apart from this, short selling may also induce a tendency towards price manipulation. For instance, the Securities and Exchange Commission (SEC) recently issued a press release where it charged a Wall Street trader with fraud for spreading false rumours. The release states:
No one openly admits to conducting a “bear raid,” since deliberately manipulating stock prices is illegal. But Wall Street has long believed bear raids can and do take place. There has, however, been little academic research to explain the forces at work. Now two finance experts have shed some light on the process. “We basically describe a theory of how bear raid manipulation works,” says Wharton finance professor Itay Goldstein. He and Alexander Guembel of the Said Business School and Lincoln College at the University of Oxford describe the procedure in their paper titled, “Manipulation and the Allocational Role of Prices.”
Their key finding illuminates the interplay between a firm’s real economic value and its stock price, showing how traders who deliberately drive the share price down can undermine the firm’s health, causing the share price to fall further in a vicious cycle.”
“The U.S. Securities and Exchange Commission today filed a settled civil action in the United States District Court for the Southern District of New York, charging Paul S. Berliner, a Wall Street trader formerly associated with Schottenfeld Group, LLC, with securities fraud and market manipulation for intentionally disseminating a false rumor concerning The Blackstone Group's acquisition of Alliance Data Systems Corp. The Commission's complaint alleges that on November 29, 2007 — approximately six months after Blackstone entered into an agreement to acquire ADS at $81.75 per share — Berliner drafted and disseminated a false rumor that ADS's board of directors was meeting to consider a revised proposal from Blackstone to acquire ADS at a significantly lower price of $70 per share. The Commission alleges that this false rumor caused the price of ADS stock to plummet, and that Berliner profited by short selling ADS stock and covering those sales as the false rumor caused the price of ADS stock to fall.”While short selling has begun in the Indian markets, the regulators ought to be watchful of such situations. Vigilance and monitoring of market activity is crucial. The SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 do contain detailed provisions prohibiting fraudulent and manipulative trading, and these regulations can potentially be used to curb such activity.
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