SEBI’s Recent Securities Markets Announcements

Last week, SEBI took certain decisionsin the form of minor reforms to the securities markets, both primary and secondary.

As part of a process that began nearly 3 years ago, SEBI has further liberalized the process for dilution of promoter shareholding in listed companies, since a deadline of June 2013 has been set to ensure minimum level of public shareholding in listed companies. This time, some measures have been adopted to make the “offer for sale through stock exchange mechanism” more efficient. While such measures may make such options more attractive, it is not clear if SEBI’s objective can be achieved within the timeframe given that several companies are yet to comply with the minimum public shareholding norms. It looks likely that SEBI’s enforcement mechanism and its determination in ensuring compliance will be put to rigorous test in a few months.

Some changes have also been suggested to SEBI’s Takeover Regulations that were promulgated in 2011. Several of them are clarificatory in nature or intended to address discrepancies or the lack of clarity that was experienced ever since the new regulations came into effect. However, one of the long standing critiques of the Takeover Regulations pertaining to their lack of appropriate fit with the delisting process has not been addressed in this round despite assurances from SEBI to relook at this issue.

Another announcementthat came last week relates to the implementation of the curbs imposed on acquisition of shares by employee trusts in the secondary markets. SEBI’s decision and rationale were analyzed previously (here). Therefore, now any form of employee stock option or share purchase scheme must necessarily involve the issue of new shares from the company.

Proposed modifications to buyback provisions

SEBI has just placed a discussion paper on its website entitled “Proposed modifications to the existing framework for buy back through open market purchase” for public comments. Comments on the discussion paper have been solicited on or before January 31, 2013.

Upon a review of the current regulations and studying the market dynamics, the key recommendations of the discussion paper are set out below:

1. The merchant bankers should be advised to ensure that a minimum of 50% of the maximum buy-back proposed/disclosed to be bought back.
2. It is proposed that companies complete the buy back in 3 months. To ensure that only serious companies launch the buyback program, it is further proposed that these companies be mandated to put 25% of the maximum amount proposed for buyback in an escrow account.
3. It is proposed that listed companies coming out with buyback programs may not be allowed to raise further capital for a period of two years.
4. In order to ensure that the companies do not launch buyback programs for stabilizing the share price, it is proposed that companies who are not able to buy back 100% of the proposed amount (or the proposed maximum number of shares) may not be allowed to come with another buyback for a period of at least one year irrespective of the mode of approval for buy back.
5. It is also proposed that buy-back of 15% or more of (paid up capital + free reserves) must be only by way of a tender offer method.
6. It is proposed that the issuance of shares pursuant to obligations arising out of Employee Stock Option schemes may be allowed during the buy-back period subject to the following: (a) the shares are not allotted to directors and key managerial personnel of the company; (b) there is no acceleration in the vesting period.
7. It is proposed that the companies shall extinguish/ destroy shares bought back during the month, on or before fifteenth day of the succeeding month subject to the companies destroying the bought back shares in the last month within seven days of the completion of the offer.
8. The current regulations prohibit the promoters of the company in dealing in the securities of the company during the period when buy back is open. It is proposed to extend this restriction to dealing in the securities of the company off–market as well.

SEBI penalises front-running again, does not follow SAT’s order

There is yet another Order of SEBI on front running and SEBI holds that transactions in the nature of front running are violative of the PFUTP Regulations. This is close after SAT’s recent ruling (“the Patel Order”) holding that front running cannot be punished, as discussed by me here, and another later ruling by SAT (“the Karkera Order”) as discussed by Mr. V. Umakanth here. By an Order dated 19^thDecember 2012, the Adjudicating Officer levied penalty of Rs. 25 lakhs on the persons who allegedly made profit of Rs. 7.16 lakhs from transactions that fit the description of what are popularly known as front running transactions.

The facts of the present case, being substantially similar as in earlier cases, need not concern us here to avoid repetition. What is interesting is that, despite the parties drawing attention to the ruling of SAT holding that front running does not amount to violations of the PFUTP Regulations, SEBI has held that it is still punishable under the said Regulations.

It may be remembered that SAT quite clearly held that transactions in nature of front running are punishable under the PFUTP Regulations only if committed by an intermediary and not by others. More specifically, it held that, in absence of any specific provision of law in securities laws, such transactions by non-intermediaries are not punishable at all. To quote the Hon’ble SAT from the Patel Order:-

“In the absence of any specific provision in the Act, rules or regulations prohibiting front running by a person other than an intermediary, we are of the view that the appellants cannot be held guilty of the charges levelled against them.”.

This ruling was followed explicitly in the later SAT ruling in the Karkera Order.

The parties accused in this case did cite the Patel Order before SEBI. However, interestingly, SEBI did not accept this ruling to give relief to the accused on the following ground:-

“The Noticees have even produced the judgment of the Hon'ble Securities Appellate Tribunal in Dipak Patel Vs. The Adjudicating Officer (SAT Appeal No. 216 of 2012 decided on 09/11/2012) in which Regulation 4(2)(q) of PFUTP Regulations, 2003 has been interpreted by the Tribunal. However, the present case does not deal with the violation of the said Regulation but Regulation 3 (a), (b), (c) & (d) and 4(1) of PFUTP Regulations, 2003. The CBI deals in shares on its own account and on behalf of its customers. CBI is a publically listed company and any loss incurred on its investments adversely would affect the interests of its own shareholders and customers. Therefore, the fraudulent and manipulative activities of the Noticees fall upon the CBI and its customers and ultimately on the investors of the securities market. In other words, the undue profits earned by the Noticees are nothing but the losses to them.”

Though not specifically made clear, it does appear that Central Bank of India (the employer of one of the noticees) is not an intermediary. If this is the case, then the SAT rulings would directly apply. The statement of SEBI that “the present case does not deal with the violation of the said Regulation” (i.e., 4(2)(q)) is not valid, in context of the SAT rulings as a whole, particularly the words reproduced earlier.

Moreover, the Patel Order did cite and discuss the provisions of Regulation 3(1) (a) to (d) of the PFUTP Regulations.

The point of SEBI that CBI is a publically listed company and so loss incurred by it would be borne by its shareholders may sound valid but this may imply that if there were no such public shareholders, front running would not be a violation. Same concern can be raised for the point that such transactions affect the interests of its customers. Also, to reiterate, this still does not deal with SAT’s ruling that in absence of specific provisions for non-intermediaries, front running cannot be punished.

An opportunity was thus lost to discuss and analyse the provisions individually and in detail relating to fraud and unfair trade practice in the PFUTP Regulations and apply the same to such cases. Instead, as in earlier case, several provisions were merely cited together and the noticees held to have violated them.

This decision also raises again a long standing concern about the non-binding nature in law of SAT decisions as precedents on SEBI. This concern particularly arises because the next appeal after SAT is straight to the Supreme Court.

The ruling of SAT in the Patel Order (and, so, the Karkera Order too) is of course dissatisfactory, and the concerns it raises have already discussed earlier here. One hopes that this issue is resolved soon by appeal to the Supreme Court and/or amendment to the law. For such Orders as the present one are satisfactory neither as practice, nor as precedents for other cases in other contexts.

Another SAT Order on Front Running

Last month, Mr. Jayant Thakur had discussedan order of the Securities Appellate Tribunal (SAT) in the case of Dipak Patel where SAT interpreted the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003 (the “PFUTP Regulations”) to mean that front running is not a crime unless it is committed by an “intermediary”. Mr. Thakur’s post points to the difficulties in interpreting the PFUTP Regulations. There has been a significant discussion of this decision, and examples include Yash Bansal & Sandeep Parekh, Professor J.R. Varma and Mobis Philipose.

Earlier this week, the SAT has followed an identical approach in another case pertaining to Sujit Karkera, Shilpa Kotak and Purushottam Karkera. The facts are that parties traded in 3 scrips through B P Equities Pvt Ltd in advance of trades by Citigroup Global Markets in those scrips. Evidence suggests that the parties had prior knowledge of the Citigroup trades that was obtained from a trader of Citigroup, Suresh Menon. The facts clearly suggest a case of front running, and SAT is unequivocal regarding the factual circumstances:

5. … The facts on record establish that there was constant flow of information to the appellants from Mr. Suresh Menon and the telephonic conversation related specifically to the order, place, time and quantity of the scrips transacted. On a consideration of the facts on record and the material relied on by the adjudicating officer we have no hesitation in holding that the alleged transactions of the appellant are in the nature of “front running”.

However, SAT was hamstrung by the technicalities of its previous decision in Dipak Patel, and quashed SEBI’s imposition of fine because the parties involved were not “intermediaries” under the PFUTP Regulations. SAT simply followed its own precedent.

Despite the critique of this approach, it appears that SAT would be constrained from making any departures considering that this technicality is well entrenched in its reasoning given these precedents. Hence, any departure to a wider interpretation could only come by way of an appeal by SEBI to the Supreme Court, or alternatively an amendment by SEBI to the PFUTPRegulations to clarify the position.

Short Sellers, Short-Termism and Corporate Governance

I have been following a corporate battle that erupted last month in Singapore. Muddy Waters, a financial research firm based in the US, released a 133-page report on Olam International, a Singapore-based company, alleging several accounting flaws in the company’s financial statements that did not represent the true state of its financial health. Upon this announcement, the price of Olam’s shares fell. It was found that Muddy Waters also simultaneously entered into short sales of Olam shares.[1]

Olam swiftly responded to the allegations in a number of ways. First, it issued a counter-statement responding to Muddy Waters’ allegations. Second, it filed a defamation suit against Muddy Waters before the courts in Singapore. Third, it announced a rights offering of securities. A rights offering is considered to be a defensive tactic employed against such short sale attacks on companies because the lenders of securities to the short sellers will then call back their securities so that they are able to participate in the rights offering. This battle is still ongoing, and it is too early to predict the possible outcomes.

While the above episode is specific to Singapore, Muddy Waters has initiated similar efforts on other companies by questioning their financial statements. For example, one of their targets, Sino-Forest, a Canadian-listed Chinese timber company had to file for bankruptcy following such a battle.

Such occurrences are not altogether alien to India. They have begun to take place here as well. The year 2012 has witnessed several analysts publishing reports regarding various Indian leading companies on matters that range from accounting practices to governance standards to the role of controlling shareholders. By highlighting issues regarding governance of companies, which extends beyond the traditional confines of financial analysis, these intermediaries are imposing considerable pressure on managements and controlling shareholders to reexamine their own governance standards and practices.

However, this phenomenon is very recent, and its impact on overall governance standards is yet unknown. In any event, certain recent reports issued by analysts have been surrounded by their own share of controversies. Not only have these reports been strongly refuted by companies and their managements, in one case a criminal complaint was even filed by the company concerned against the analyst firm and the individuals who authored the report.

The impact of these efforts is likely to be mixed. On the one hand, they will lend themselves to greater transparency on the part of the companies, as the availability of more information and deeper analysis will enable investors to take a more informed view of their investments. In other words, it creates a market-based approach that will likely enhance overall corporate governance standards, transparency and accountability on the part of managers and promoters of listed companies.

However, there is also another side to the story. There is no clarity whether these efforts by analysts and short-sellers will necessary inure to the benefit of the minority and long-term investors. Analysts with short positions are inherently conflicted as it is only their short term interests that motivate their actions. That might not be in the long-term interests of the company and its investors. Hence, it is likely that these efforts may benefit a short group of investors to the detriment of the larger investing community.

Currently, various scenarios are being played out through market forces via steps taken by the analysts followed by responses by the companies. If matters were to go out of hand (and there is not enough to suggest that yet), then it would be interesting to see whether the regulators would step in to moderate these contests.

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[1] Short selling involves the selling of a security that an investor or a trader does not have in possession when placing the sale order in the system. A short seller borrows the security and then sells it in the market with an expectation that it can buy back the same security at a later date for a lower price than it was sold for. The difference in the selling price and the buying price would be the profit earned on short selling.

Settlement of Charges Between Indian Brokerages and the US SEC

Earlier this week, four Indian brokerage houses entered into settlements with the US Securities and Exchange Commission (SEC) for charges of carrying on brokerages services to institutional investors in the United States (US) without registration under the US Securities Exchange Act of 1934 (the Exchange Act). The SEC’s press release and the orders pertaining to the four brokerages are available here.

SEC’s charge arose on the ground that the brokerages were carrying out activities in the US that required registration under the Exchange Act, unless they were able to avail of exemptions. However, none of this was obtained by the brokerages. As the SEC notes, “Section 15(a) of the Exchange Act generally prohibits a broker or dealer from making use of the mails or any instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of any security without being registered with the [SEC] as a broker-dealer”. SEC charged the brokerages for violation of this provision and the relevant rules.

It is important to consider the type of activities that were carried out by the brokerages, which were said to contravene US securities laws. These include:

-       Travel to the US to meet with US investors;

-       Contact with US investors through email and telephone calls;

-       Transmission of research reports on Indian companies to US investors;

-       Purchase and sale of shares on Indian stock exchanges on behalf of US investors;

-       Entering into commission sharing agreements with US registered broker-dealers, and soliciting and providing brokerage services through them;

-       Organizing and sponsoring investor conferences in the US;

-       Participation as a broker in offerings of Indian companies, including initial public offerings, follow-on public offerings and qualified institutional placements (QIPs), which were carried predominantly in India but with some shares being marketed and sold to US investors.

Although the charges were settled by the brokerages without accepting or denying the findings of the SEC, the above discussion provides some guidance as to the type of activities by Indian brokerages that could be called into question by US securities laws.

Of course, the most viable option from a regulatory standpoint would be for brokerages carrying out such activities to register themselves with the SEC. This is particularly relevant given the effects of globalization and the cross-border nature of the securities markets. Several domestic Indian offerings of securities are extensively marketed to overseas investors. Hence, compliance with securities laws in those jurisdictions becomes important from a regulatory perspective. Given that both the substantive laws and enforcement in the US are quite strong, we find instances such as the present charges/settlements, but the same would apply in other leading capital market jurisdictions as well.

Should Government Companies Be Exempt From the Takeover Regulations?

Today’s Business Standard carries a reportindicating that SEBI is in the process of considering a general exemption to the Government from making a mandatory open offer under SEBI’s Takeover Regulations 2011. This comes in the wake of two specific exemptions granted by SEBI this year in the case of IDBI Bank and IFCIwhereby the Government was given special dispensation from making an open offer when it increased its stake in the companies due to conversion of securities into equity shares.

Currently, under the 2011 Regulations, SEBI has the power to grant exemptions on a case-by-case basis, which it has exercised in the two cases mentioned above. But, any grant of blanket exemptions to the Government would be a retrograde step. There is no compelling reason for the Government to be treated on a special footing compared to private acquirers because the Regulations are in the end analysis concerned with the protection of minority shareholders in a listed company. By creating such an exemption, SEBI would be discriminating against shareholders of government companies, as they would lack an exit opportunity through an open offer that is available to shareholders in non-government companies.

Moreover, the grant of such dispensation to the Government does not augur well in terms of ensuring compliance with securities regulation in the interest of investors. The Government ought to be setting an example by undertaking the obligations under securities regulation such as the Takeover Regulations and paving the way for ensuring compliance by private acquirers, thereby protecting the interests of minority shareholders in public listed companies. This method of carving out special provisions for government companies, that began with the lower minimum shareholding of 10% rather than the larger 25% limit for other companies, stands no reason when judged against the purpose of the Takeover Regulations, which is to provide an equal exit opportunity to minority shareholders when there is a change in control of the company.

Such moves could give rise to governance implications in a broader sense. For example, there is already a dispute over the governance matters in Coal India Limited between the Government, which is the controlling shareholder, and a minority shareholder, which has also resulted in litigation that is pending before the Indian courts. Such matters could also be significant in the context of the government disinvestment programme where the limitation of protection to minority shareholders in listed companies substantially owned by the Government could impact the success (or otherwise) of such programme.

It would therefore be preferable for SEBI to exercise the power of exemption on a case-by-case basis as per the current practice. That would not only provide the flexibility to deal with specific circumstances such as those that arose in the IFCI and IDBI Bank cases, but at the same time it would require SEBI to apply its mind to individual cases rather than to deal with them on an overall basis as proposed.