Regulatory Reforms in the Capital Markets

SEBI has taken steps in the last few weeks to bring about reforms in the capital markets, particularly in the primary market segment.

The first set of reforms essentially gives effect to decisions taken at SEBI’s board meeting on August 16, 2012. These include matters relating to both the equity markets, where the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 have been amended, and to the debt markets, where the SEBI (Issue and Listing of Debt Securities) Regulations, 2008 have been amended.

The more contentious set of reforms relates to additional protection that SEBI has sought to offer investors in initial public offerings (IPOs). This is by way of two measures,

(i) a proposal for a mandatory safety net mechanism by way of a discussion paper; and

(ii) the issue of the SEBI (Framework for Rejection of Draft Offer Documents) Order, 2012 that deals with specific circumstances where SEBI is entitled to reject an offer document.

These reforms have generated a substantial discussion, principally on the ground that a safety net mechanism takes away the equity risk of an investor, and that the guidelines on rejection of offer documents effectively introduces merit-based regulation of capital markets that was done away with the abolition of the Controller of Capital Issues (CCI) following the liberalised economic policies introduced in 1991.

A detailed discussion and analysis of these proposals are available at the following sources:

- Somasekhar Sundaresan in Business Standard;

- Reportin the Economic Times; 
- Discussion in the Financial Express; and

- Discussionon The Firm – Corporate Law in India.

Relaxations on IDR Redemption

Last year, SEBI issued a circular that imposed some curbs on redemption by holders of Indian depository receipts (IDRs). Under that circular, redemption was permitted only if the IDRs are infrequently traded on the stock exchanges in India. This was a method of limiting exit options to investor exclusively to the Indian markets, except where they are illiquid (in which case conversion into underlying shares and sale on foreign markets will be permissible). This was considered to be highly restrictive to IDRs as an investment opportunity. In any event, the instrument does not appear to have met with any success given that there is only one company that has thus far listed its IDRs on the Indian exchanges.

SEBI has now issued another circulardated August 28, 2012 that permits partial fungibility of IDRs. The objective is “to improve the attractiveness of IDRs as an instrument thereby ensuring long term sustainability of IDRs ...” Under the revised regime, redemption/ conversion of IDRs into underlying equity shares is permissible up to the extent of 25% in each financial year.

While this provides some headroom for fungibility, it is unlikely to result in any significant expansion of the market for IDRs. In that sense, it is only a limited step.

Update: The Reserve Bank of India has also issued a circular giving effect to limited two-way fungibility of IDRs.

The Changing Nature of Public Listed Companies

During the week that the Facebook IPO has captured the attention of market observers, the Economist has carried a couple of pieces (here and here) that raise questions regarding the interest and viability of public listed companies with diffused shareholding (epitomized by the Berle and Means corporation). The statistics shown by the Economist are quite stark:

The number of public companies has dropped dramatically in the Anglo-Saxon world—by 38% since 1997 in America and by 48% in Britain’s main markets. The number of initial public offerings (IPOs) in America dropped from an average of 311 a year in 1980-2000 to just 81 in 2011 (chart 2).

Going public no longer has the glamour it once had. Entrepreneurs have to wait longer—an average of ten years for companies backed by venture capital, compared with four in 1985—and must jump through more hoops. Lawyers and accountants are increasingly specialised and expensive; bankers are less willing to take them public; qualified directors are harder to find, since even “non-execs” can go to prison if they sign false accounts.

However, it appears that modified forms of the public listed corporation, of the varieties prevalent in economies in Asia, remain unaffected. Examples include the state owned enterprises (SOEs) in China and family enterprises in India. As the Economist report notes:

The rise of new economic powers has further changed corporate organisation. In the 1990s it seemed that emerging-market companies would take the Western public company as their model. In fact they have embraced two slightly different corporate forms: SOEs and family conglomerates. These companies list on the stockmarket but do little to constrain the power of the state or of family shareholders.

...

... Family businesses account for about half of listed companies in the Asia-Pacific region and two-thirds in India. Families exercise tight control of their empires—and limit the power of other shareholders—through a variety of mechanisms such as family-controlled trusts (which have more power than boards), appointing family members to managerial positions and attaching different voting rights to different classes of stock. Diversified family firms are good at taking a long-term view, diverting money from cash cows to new industries that might take a long time to produce results. They are also good at dealing with the government failures that plague emerging markets. It is remarkable how fast even India’s lumbering government can move if a Tata or an Ambani calls.

The report further discusses the merits and disadvantages of public listing of corporate securities. Overall, an interesting analysis.

India’s Contribution to the Global IPO Activity

Since economic liberalization in 1991 and following SEBI’s efforts in spearheading the primary capital markets, IPO activity of Indian companies has witnessed significant growth. A recent study that compares global IPO activity with the US domestic markets provides key comparative data that help assess India’s performance. In a paper titled “The U.S. left behind: The rise of IPO activity around the world”, Craig Dodge, Andrew Karolyi and Rene M. Stultz find, from a “comprehensive sample of 29,361 IPOs from 89 countries constituting almost $2.6 trillion (constant 2007 U.S. dollars) of capital raised over 1990 to 2007”, that there has been a steady growth of IPOs around the world in comparison with a decline in IPO activity in the U.S.

A few key findings from the paper are extracted below:

Some of the decrease in the importance of U.S. IPO activity compared to worldwide IPO activity is due to lower IPO activity by U.S. firms, but much of it is explained by the considerable growth of IPOs in other countries that occurs throughout the sample period. To a large extent, this growth is fueled by the emergence of global IPOs, which include both IPOs in which some of the shares are sold outside the home country of the firm going public, and foreign IPOs in which of all the shares are sold outside the home country. … U.S. firms have never been active participants in the global IPO marketplace. This newer global IPO phenomenon is an important tool linked to the globalization of capital markets.

…

This paper documents dramatic changes in the IPO landscape around the world. U.S. IPOs and IPOs from other common law countries have become less important, whether one looks at counts or at proceeds. In fact, U.S. IPO activity has generally not kept pace with the economic importance of the U.S.

Global IPOs have played a critical role in increasing the importance of IPOs by non-U.S. firms. Though firms in countries with weaker institutions are less likely to go public with a domestic IPO, they are more likely to go public in a global IPO. That is, global IPOs enable firms to overcome poor institutions in their country of origin. Perhaps as a result, the laws and institutions of a firm’s country of origin have become significantly less important in affecting the rate and pace of IPO activity in a country.

There are important global drivers in domestic IPO activity. Higher levels of worldwide IPO activity outside a country are strongly and positively related to the level of IPO activity in that country. However, IPO activity is also related to domestic market conditions. Firms are more likely to choose to go public at home when valuations are higher in the home market.

The data analyzed in the paper provides some interesting insights into IPOs by Indian companies. In terms of number of IPOs, India stands in 2^nd place (behind the U.S.) with 4,867 IPOs during the period of study, of which 4,777 are domestic IPOs and 90 are global IPOs. This signifies not only a high number of IPOs in absolute terms, but also demonstrates the overwhelming contribution made by domestic IPOs where securities are listed on Indian stock exchanges. Global IPOs (which presumably, in the Indian context, refer to ADR/GDR offerings listed on foreign exchanges) pale in number. The data indicate the strong attraction of domestic markets in luring Indian companies to list rather than to look overseas. This may also be explained by the fact that even when Indian companies embark on domestic IPOs and list on Indian exchanges, a substantial portion of the capital nevertheless comes from foreign investors. In that sense, foreign investors find comfort in investing in domestic Indian IPOs without requiring issuer companies to activity scout for overseas listings.

The analysis of proceeds raised in IPOs, however, presents a different picture. On that count, India stands in 18^th place with total a capital-raising of $32.2 billion, of which $17.8 billion is from domestic IPOs and $14.4 billion from global IPOs. The leading countries on this parameter are the U.S. ($647.7 billion) followed by China $254.6 billion). At first blush, this may suggest lack of depth in the Indian capital markets in the overall scheme of things. But, the correlation between the number of IPOs and the proceeds raised is also an indicator of one important factor. That is, there appear to be a large number of Indian IPOs with relatively small amounts of capital raised. This could be read to mean that a larger proportion of India’s companies have access to the public capital markets even while raising small amounts of capital. This makes the capital markets regime beneficial not just for large companies, but also for small and medium sized companies.

Of course, several other factors have a role to play in assessing the contribution of IPO markets as the paper suggests, including the quality of the country’s institutions such as corporate governance norms and the availability of sophisticated intermediaries and advisors such as investment bankers, lawyers and accountants.

Supreme Court on Tainted Securities

In Varghese Joseph v The Custodian, the Supreme Court was called on to clarify the approach to be adopted in relation to tainted securities under the Special Court (Trial of Offences relating to Transactions in Securities) Act, 1992. Although there is not much by way of company law principles of even statutory interpretation to be gleaned from the decision, it is of importance due to the investor friendly approach the Court appears to have adopted.

The appellant was a small investor who had purchased 100 equity shares of Reliance Industries Ltd through a broker. He was living abroad, and despite repeated inquiries, was not told of the status of his shares by his broker. When he made a demand with Reliance for dividend and other consequential benefits like issue of rights and bonus on shares, he was informed that his shares were tainted, and hence he was not eligible for those benefits. When he made further inquiries, he was informed by the share broker that a notice had been sent to him for applying for the certification of the shares, which were tainted by virtue of being in the name of a company which subsequently had become the subject matter of attachment as per the order of the Government of India since it was found to be involved in some scam. As a result, the shares issued by this company required certification by the Custodian. The appellant contended that he had not received this letter. When he attempted to procure the necessary certification from the Special Court, he was informed that the last date for the application had expired, and no certification was now permissible. He challenged this on the ground that he was not aware of this cut-off date, but his challenge was rejected as being without merit. Reversing the decision of the lower Courts, the Supreme held upheld the shareholder’s plea. It observes that the Act should be interpreted in a way “that an honest and bonafide investor is not duped of his hard earned money which he invests by purchasing the equity shares of a company”.

Further,

It was obligatory on the part of the Special Court and the Custodian to notice an important fact that when the shares purchased by the appellant were reported to be tainted which was issued through Respondent No.5-M/s. Fair Growth Company by the share broker companies i.e. Respondent No. 4 and 5 and the same was ordered to be attached by the Custodian in view of the Government of India Regulation it was clearly nefarious and dubious activity on the part of the Respondent No.5-M/s. Fair Growth Financial Service Ltd. due to which the unnecessary hassle of certification of the shares issued in the name of M/s. Fair Growth Company became essential. The investors like the appellant herein had absolutely no role in such activity and hence even if the cut off date was fixed by the Special Court for certification of such shares, the same could not have been enforced oblivious of its repercussion on those investors who could not approach the Special Court for certification for reasons beyond their control.

The delay here was of a mere two months and “the Court should have certainly considered the circumstance whether a bonafide purchaser of shares could be denied his due merely on the ground of violation of a cut off date which clearly did not have its existence in the statute and hence had no statutory force”.

Changes to Capital Markets Regulations

On October 25, 2010, SEBI announced a number of changes to regulations governing capital markets.

1. Public offerings.

A new regime is being established for IPOs by insurance companies. Rather than issue a new set of guidelines for that industry, SEBI has decided to apply the ICDR Regulations, 2009 along with additional industry-specific disclosures such as specific risk factors, overview of the insurance industry and a glossary of terms. Other changes in public offering norms include enhancement of a maximum application size for retail individual investors to Rs. 2 lakhs across all issues, the introduction of mandatory pro forma financial statements for issuer companies that have undergone a merger or restructuring after the last disclosed financial statements and the removal of a requirement for minimum promoters’ contribution in a further public offering (FPO).

In progressively addressing issues of gun-jumping, SEBI now requires investment banks to submit a compliance certificate “as to whether the contents of the news reports that appear after the filing of the [draft offer document] are supported by disclosures in offer document or not”. An item which is noteworthy is the reference to news reports appearing in media where the issuer has a private treaty with such media group. This will ensure that the securities are sold pursuant to the offer document, which constitutes the single source of information for marketing purpose as also for legal consequences (such as liability of misrepresentation).

2. Preferential Issues

In a measure that tightens restrictions on issue of securities to promoters, SEBI has provided that promoters (or promoter group) are ineligible to receive equity shares, convertible securities or warrants for a period of one year if they have failed to exercise previously issued warrants. This will operate as a disincentive against issue of warrants to promoters and promoter group, and further curb the misuse of warrants. For a previous discussion on regulation of such warrants, see here and here).

3. Rights Issue for IDRs

SEBI has proposed a new framework for rights issues for foreign companies that have outstanding Indian depository receipts (IDRs). Issuers are required to circulate a wrap document that contains information specific to IDR holders. The level disclosures will be similar to that expected in a rights issue by an Indian company. On a related note, the IDR holders of Standard Chartered were faced with certain legal and regulatory issues regarding their ability to participate in the bank’s recent rights offering, and it is hoped that the new regulatory framework will iron out those issues.

Unlawful Distribution of Capital: The Question of Intent

Five judges of the United Kingdom Supreme Court are scheduled to hear an exceedingly interesting case on October 5 and 6, 2010, on what the Court of Appeal describes in the impugned judgment as a “short, but quite basic company law point”. The judgment of the Court of Appeal in the case - Progress Property v. Moorgarth Group, [2009] EWCA Civ 629 - is available here, and the point of company law that arises is the extent to which the knowledge or intent/motive of a director is relevant in judging whether the sale of an asset amounts to an unlawful distribution of capital. The prohibition on such distribution is codified under the Indian Companies Act, 1956, as well, and is of some importance today, considering the increasingly popular device of intra-group asset transfers.

As background, it is appropriate to recall that the House of Lords held in 1887 (Trevor v. Whitworth) that a corporation cannot return any part of its capital, for it is to the capital of a company that creditors look in the event of liquidation, and are entitled to assume that capital is lost only in the normal course of business. The effect of the rule was to prevent the return by a company of assets to its majority shareholder, the payment of dividend except out of distributable profit, buy-back of shares etc. It was recognised that this is necessary in some circumstances – such as an unexpected loss in assets – and statutory intervention in England through the 1980 and 1985 Companies Act specified these exceptions. The common law doctrine continued to have force outside of the statutory exceptions. The Indian Companies Act, 1956, functions on the same premise, providing in s. 205(1) that dividend may be paid only out of “profits of the company for that year”, and creating specific exceptions for buy-back of shares, reduction of capital etc.

Attempts were made to evade the rule in Trevor v. Whitworth by resorting to more ingenious methods of returning capital – payment of dividend on unrealized profit, payment without accounting unrealized losses and so on. These methods were declared illegal, either by case law or by statute, and could not be ratified by the shareholders, as it was ultra vires the company. The most prominent device to avoid the rule then came to be the sale of assets at an undervalue. This has the effect of returning capital – for example, a company that sells assets worth Rs. 1 crore at Rs. 10 lakh to its majority shareholder does no more than return capital to him. However, it is easy to disagree about valuation, and consequently harder to conclude in these circumstances that the transaction is in fact a disguised return of capital. The locus classicus on this subject is a decision of Hoffman J. in Aveling Barford v. Perion Ltd., [1989] 5 BCC 677. Faced with the sale of a valuable company asset to a company that was controlled by the majority shareholder of the vendor, Hoffman J. held that courts look at “the substance rather than the outward appearance”, and further found that “it was the fact that it was known and intended to be a sale at an undervalue which made it an unlawful distribution [emphasis mine].” The words “known and intended” suggest that the company selling an asset must do so for the purpose of selling at undervalue or returning capital, and it is this question of intent that is set to be heard by the Supreme Court in Progress Property.

The facts of Progress Property are similar to Aveling Barford, with one crucial difference. In 2003, Progress Property Co. Ltd. [“PPC”] and Moorgarth Group Ltd. [“Moorgarth”] were both controlled by Tradegro (UK) Ltd. [“Tradegro”]. PPC held shares in its subsidiary, known as YMS Properties (No. 1) Ltd. [“YMS1”]. Tradegro entered into an agreement with a minority shareholder in PPC to transfer its majority shareholding in that company to him, and as part of this agreement, was required to transfer PPC’s shares in YMS1 to Moorgarth, before completion. In short, the minority shareholder acquiring PPC required Tradegro to divest PPC of its shareholding in YMS1 prior to acquisition. In pursuance of this agreement, PPC sold its stake in YMS1 to Moorgarth in October 2003, for a price of around £ 64,000. This figure was arrived at after making a deduction of £ 4 million for an indemnity which could be enforced against PPC. It later transpired that there was no such indemnity liability, but it was accepted by all parties that this mistake was a genuine one, and that the parties were under the impression that the shares had been sold at market value.

After the takeover was completed, PPC brought an action to declare the sale to Moorgarth invalid and ultra vires, and relied heavily on Aveling Barford for the proposition that a sale at less than full value is ultra vires regardless of whether the sale was effected in ignorance of the true value. The Court of Appeal was quick to reject this “optimistic submission”, pointing out that it is the sale of an asset for the purpose of paying less than full value that makes it ultra vires, and not the mere fact of sale. An important reason for this rule is that it otherwise puts directors at the peril of having every sale questioned, if it subsequently turns out the property had been wrongly valued, even if the directors acted reasonably and in the best interests of the company. PPC also argued that the director “ought” to have known of the valuation error, but the Court of Appeal held that this is of no relevance in determining whether the transaction is ultra vires – for, courts invalidate a return of capital that is “disguised” as a transfer by assigning it an unnaturally low sale price, and not a sale that coincidentally has such a price, whether through the ignorance of the vendor or otherwise.

Interestingly, the rule in Aveling Barford, based on s. 263 of the 1985 English Companies Act, was thought to greatly inconvenience intra-group transfers of assets, or restructuring assets for legitimate business reasons. S. 845 of the 2006 English Companies Act partially modifies the strict rule in Aveling Barford, and an excellent discussion of the reasons for the move is available in the Explanatory Note to the Act (¶¶1151-5). Although these statutory developments predate the events in Progress Property, it is expected that the Supreme Court will affirm the Court of Appeal’s decision, for knowledge and intention are significant factors in assessing the genuineness of a transaction for return of capital purposes.

DEMAT Account for Religious Deities

An interesting issue recently fell for the consideration of the Bombay High Court- whether DEMAT accounts could be held in the name of deities. The Court answered this question in the negative, relying on largely practical and partially moralistic reasons in coming to its conclusions.

The decision was pronounced by a Division Bench of the Bombay High Court in Ganpati Panchayatan Sansthan Trust v. Union of India, on a writ petition filed against an order of the National Securities Depository Ltd. [“NSDL”], refusing to grant permission for the opening of a DEMAT account in the name of some deities. The petitioner was a private unregistered trust, of which the deities were shareholders. The primary contention of the petitioner was that the deities were artificial legal persons, and were recognised as such under Indian law and the Income tax Act. The Senior Counsel appearing for NSDL, Mr. Dwarkadas, contended that only natural persons could hold a DEMAT account, and that there was no provision which allowed an account to be opened in the name of a deity.

However, disappointingly for those interested in the legal rationale adopted by the Court, the contentions of the respondent, and the decision of the Court accepting these contentions make little mention of any legal provision disallowing accounts in the name of artificial persons. Neither do they point out that a natural reading of the provision allowing for DEMAT accounts can extend it only to natural persons.^* The rationale adopted by the Court for holding the refusal by NSDL to be valid, and dismissing the writ petition rested primarily on three bases- (a) a DEMAT account requires regular monitoring, and “personal skill, judgment and supervision”, which cannot be done by an artificial entity; (b) since the petitioner is an unregistered private trust, in the case of an irregularity, neither the deity nor the trust will be held accountable; and (c) that the petition essentially amounted to “bringing the Gods/Goddesses into share transaction business”, which the Court frowned upon. Of these, the first two are clearly pragmatic considerations, while the third is one which reflects the Court’s reluctance to allow the entry of religious deities into commercial transactions. However, by basing its decisions on these grounds, the Court leaves open the larger question of DEMAT accounts for non-religious entities, for which there may be better accountability mechanisms. Thus, while arguably reaching the appropriate conclusion on the facts of the case before it, the judgment does fall short in providing a legal framework for subsequent issues which may arise in similar fact scenarios.

^*(The only mention made is that of a SEBI Circular (¶ 8), the relevant provisions of which have not been reproduced in the decision. Any comments from readers as to which circular is being referred to, or its relevant provisions, are most welcome).

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:

“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.

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.”

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.

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.”

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:

“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.

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:

“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.

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.”

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:

“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.

Short Selling is Here

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

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

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

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

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

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

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

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

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

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

Direct Market Access to Institutional Investors

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

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

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

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

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

FCEB Taxation

In an earlier post on this blog, we analysed foreign currency convertible bonds (FCEBs). Although there was nothing on this count in the Finance Minister’s budget speech, the Finance Bill contains provisions clarifying the taxation position on FCEBs and the shares that arise out of conversion.

Today’s Hindu Business Line carries an article describing the Finance Bill provisions on FCEBs.

Budget Impact

This year’s budget, termed by the media as a populist one, has received mixed reactions from the corporate sector. At the same time, it has not gone well with the stock markets, which fell following the budget announcements.

The entire set of budget materials is available here. Now, we look at some of the key implications of the budget on the corporate sector as well as financial markets:

Corporate Sector

1. Corporate tax rates have been left untouched, although there were some predictions of a possible reduction in rates. Further, there has been no change in the rate of surcharge either.

2. Dividend distribution tax has been streamlined to benefit holding company structures. Hitherto, dividend distribution tax (DDT) was payable by a company that distributes dividend to its shareholders. Where a holding company or parent receives the dividend income from the subsidiary, and then distributes dividend to its shareholders from its profits, it has to pay DDT, which would include as a component the amount distributed that represents the dividend income it received from the subsidiary (that has already been taxed in the hands of the subsidiary). This caused multiple levels of taxation on the same income.

However, the budget seeks to remove this anomaly by allowing the parent to set off the dividend received from a subsidiary so long as the subsidiary has paid DDT, and the parent company is not a subsidiary of another company. In other words, set-off is available only to the ultimate holding company, and not to the intermediates ones in a multiple holding company structure.

Although at first blush this appears to be a beneficial provision, it does have its set of limitations. For instance, in a multilayered holding structure (which is quite typical in infrastructure, real estate, and other companies), the DDT set-off is available only to the ultimate holding company and not intermediate holding companies. Hence, the same income is subject to multiple levels of taxation at intermediate levels, thereby not failing to fully eliminate the double taxation problem. While the proposal encourages holding company structures, it limits tax benefits to single holding companies and not multilayered structures (which would still be tax inefficient).

Further, set off is available only to a “holding company”, implying that such company should either hold shares in excess of 50% in the subsidiary (from which it receives dividends) or should control the board of the subsidiary. If the recipient of the dividend is not a holding company (e.g. if it holds 49% shares), then the set-off is not available. Hence, this benefit would not be available in cases of joint venture and other strategic arrangements where parties may not establish a holding-company relationship.

3. Short term capital gains on sale of shares is increased from 10% to 15%, in an apparent move to encourage investors to stay invested in the longer term.

Financial Markets

1. Market for Corporate Bonds has witnessed further measures for expansion in this Budget. Exchange-traded currency and interest rate futures will be launched. A transparent credit derivatives market with appropriate safeguards will be introduced. Additional measures include the option in domestic convertible bonds of separating the embedded equity option from the bond and possibility of separate trading of the two instruments, and development of a market-based system for classifying financial instruments based on their complexity and implicit risks.

These efforts would make the Indian financial markets more robust and liquid. At the same time, since derivatives trading is inherently risky, the nature of the safeguards that will be put in place assume great importance.

On this point, Ajay Shah has an article in the Business Standard.

2. Permanent Account Number will be the sole identification for all participants in the securities markets, subject to appropriate thresholds.

3. Pan Indian Market for Securities is to be created with cooperation from states. This is essential because stamp duty (for issuance of shares and for transfer of debentures) falls within the domain of the state legislatures in accordance with the Constitution. As states enact differing rates of stamp duty on such transactions, it causes significant difficulty in easily executing stock and bond transactions where investors are located across the nation. Uniformity in stamp duty rates on securities markets is a welcome step as it would dispense would ambiguities in costs of such financial transactions. Further, it would also benefit state governments by doing away with the need for companies to resort to “location shopping” by executing transactions in stamp-duty friendly states.

4. Securities Transaction Tax will be allowed as a deductible expenditure against business income rather than only as a rebate against tax liability (which benefit was restrictive in nature). Further, securities transaction tax (STT) on options have been streamlined to deal with two situations, i.e. where the option is exercised, and where it is not.

5. Commodities Transaction Tax will be introduced on transactions in commodity futures on the same lines as STT on options and futures.

6. Tax Deduction at Source (TDS) will not apply to listed corporate bonds issued in demat form—another measure to boost the bond market.

Other Aspects

Certain additional services have been brought under the service tax net. These include, services provided by stock/commodity exchanges and clearing houses, and customized software, to bring it on par with packaged software and other IT services.

The Budget has been disappointing to the corporate sector on a few counts:

(a) REITs did not receive any attention in the Budget. This leaves taxation of REITs in doubt. As we have discussed earlier on this blog (here and here), the market for REITs is unlikely to receive any impetus unless there is clarification on aspects of their taxation.

(b) Software Technology Parks (STPs) that are entitled to tax holidays until March 31, 2009 have failed to obtain an extension of the holiday to subsequent years. This is despite strong please from the IT industry. Although tax holidays under the SEZ policy are available for future periods, it is difficult for most small and medium IT sector players that were beneficiaries of the STP scheme, to establish SEZs for all their projects and hence the IT sector is likely to be at a disadvantage due to this.

Finally, the Finance Minister has indicated the need to manage foreign capital flows more actively. He stated that the “Government will, in consultation with the RBI, continue to monitor the situation closely and take such temporary measures as may be necessary to moderate the capital flows consistent with the objective of monetary and financial stability.” This implies that the Government will maintain a keen eye on aspects like foreign direct investments (FDI), foreign institutional investors (FIIs), external commercial borrowings (ECBs), foreign currency convertible bonds (FCCBs) and similar schemes, and announcements may be expected from time to time on policies governing these aspects depending on the foreign exchange position as monitored by the Government and the RBI.

Overall, the Budget has not witnessed significant benefits being conferred on the corporate sector or financial markets, though there have been some areas of stimulus for growth. That perhaps explains the mixed reaction from corporates and the markets.

Taxation Issues in Short Selling

An earlier post on this blog had discussed the introduction of short selling in the Indian market and its implications on the market. Today’s Hindu Business Line has an article that refers to lack of clarify in the taxation regime with respect to short sales. Obviously, there seem to be several loose ends to tie, and the authors hope that the forthcoming Budget and the Central Bureau of Direct Taxes (CBDT) would provide necessary clarification on these aspects.

However, a couple of the issues have already received clarification from the CBDT in a circular issued on February 22, 2008.