Regulatory Updates: SEBI and CCI

SEBI: Stock Exchanges and Clearing Corporations

SEBI has issued the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012 that deal with the recognition, ownership and governance of stock exchanges and clearing corporations.

Certain minimum ownership and net worth requirements have been specified. Maximum shareholding by a single shareholder has been limited to 5% (with some exception). Moreover, a majority of equity shares is required to be held by public shareholders.

Relevant extracts are as follows:

17. (1) Atleast fifty one per cent. of the paid up equity share capital of a recognised stock exchange shall be held by public.

(2) No person resident in India shall at any time, directly or indirectly, either individually or together with persons acting in concert, acquire or hold more than five per cent. of the paid up equity share capital in a recognised stock exchange:

 Provided that,—

(i) a stock exchange;

(ii) a depository; 

(iii) a banking company;

(iv) an insurance company; and 

(v) a public financial institution,

may acquire or hold, either directly or indirectly, either individually or together with persons acting in concert, upto fifteen per cent. of the paid up equity share capital of a recognised stock exchange.

(3) No person resident outside India, directly  or indirectly, either individually or together with persons acting in concert, shall acquire or hold more than five per cent. of the paid up equity share capital in a recognised stock exchange.

Every stock exchange is required to have a minimum net worth of Rs. 100 crores.

In addition to the regulations, SEBI has issued a press release that details additional mechanism for regulating conflicts of interest in market infrastructure institutions such as stock exchanges and clearing corporations.

These regulations arise as a result of the settlement arrived at by SEBI with the MCX Exchange during the pendency of an appeal before the Supreme Court. They are also issued pursuant to decisionstaken by SEBI on April 2, 2012.

CCI: Cement Companies

In a significant order, the Competition Commission of India (CCI) has imposed a hefty penalty on 11 cement manufacturers for anti-competitive practices. CCI’s accompanying press release summarizes the impact:

The Competition Commission of India has found cement manufacturers in violation of the provisions of the Competition Act, 2002 which deals with anticompetitive agreements including Cartels. The order was passed pursuant to investigation carried out by the Director General upon information filed by Builders Association of India. The Commission has imposed penalty on 11 Cement Manufacturers named in the information @0.5 times of their profit for the year 2009-10 and 2010-11. The penalty amount so worked out amounts to more than Six thousand Crores.  The Commission has also imposed penalty on the Cement Manufacturers Association.

[emphasis added]

The order is fairly lengthy (at 258 pages), and we will have the opportunity to analyze it in some detail soon.

Impact of SEBI Order on Governance of Exchanges

The concept of demutualization of stock exchanges has given rise to some questions regarding the governance of demutualized exchanges. That concept requires exchanges to separate ownership and governance from that of its trading members. Some issues pertaining to demutualization have come up before SEBI in its investigation into the affairs of the United Stock Exchange of India Limited (USE). SEBI issued a recent orderwarning USE “to be more cautious and perceptive in the discharge of its function and the regulatory duties”. It also required USE to amend its articles of association (which is the subject matter of discussion in this post).

SEBI found concentration of volumes in trading on the USE through two trading members, with one of them Jaypee Capital Services Limited being a promoter of USE. An analysis of SEBI’s order on the issue of trading concentration can be found in Mobis Philipose’s columnin The Mint; but this post focuses on the observation of SEBI regarding the board rights of the key shareholders of USE. Specifically, it relates to an insertion in the articles of association of a clause that provides for specific quorum, whereby no board meeting shall be constituted unless at least one director representing Jaypee Capital, BSE and Federal Bank (being the key shareholders) are present. SEBI found such a quorum requirement to impinge upon the governance of the stock exchange. The SEBI member observes:

I note that such kind of special arrangements as did by USE is not in the interests of independent functioning of the stock exchange. The Special Articles i.e., Part II of AoA has overriding effect over its General AoA and these rights to certain shareholders appear to be detrimental to the interest of other stakeholders. These are inconsistent, imprudent and contrary to the best corporate governance practices. In my opinion, such special arrangements surely constrain the independent functioning of the Stock Exchange. … I note that these defaults on the part of USE not only reflect bias on the part of the Exchange towards certain shareholders, but also reveals that such provisions in AoA are against the spirit of demutualization of stock exchanges.

This suggests that even a customary provision for quorum in shareholders agreements (that may be incorporated in the articles of association) can be found to go against the independent governance of a stock exchange. In that sense, the impact of SEBI’s order is to impose high standards of governance in an exchange, which may obviate special clauses in favour of particular shareholders that are common in other types of companies.

Moreover, this may be contrasted with cases involving other companies, where such protective provisions in shareholders’ agreements and articles of association in favour of particular shareholders are treated more liberally. For instance, in the controversy involving the definition of “control”, the Securities Appellate Tribunal (SAT) had held that not only such quorum provisions but even affirmative voting rights (or veto) rights would not confer “control” on the shareholder so as to trigger mandatory takeover offer requirements (although that ruling has been somewhat disturbed by a consent order on appeal before the Supreme Court).

The key take away from this order of SEBI is that shareholders’ agreements and articles of association of stock exchanges may be subject to closer scrutiny by regulators who appear averse to special rights in favour of any particular shareholder.

SEBI Regulates Algorithmic Trading

In order to keep up with advances in technology involving securities trading, SEBI has issued to the stock exchanges broad guidelines on algorithmic trading in the securities markets. The concept of algorithmic trading is defined as any “order that is generated using automated execution logic”. Such trading is effected by automated electronic platforms that analyze split-second information and act at speeds not capable of being generated through human intervention.

In order to mitigate any risks from such trading, SEBI’s guidelines require stock exchanges to put in place mechanisms – “arrangements, procedures and system capability” – to deal with the speed and volume of trading. Further, the stock exchanges are to “ensure that all “algorithmic orders are necessarily routed through broker servers located in India”. They also require stock exchanges to ensure that brokers providing the facility of algorithmic trading satisfy certain basic requirements and comply with initial conformance tests.

Bombay HC in the MCX Case: Partial Reprieve to “Options” in Securities

Apart from dealing with specific issues relating to the facts of MCX’s application to commence the business of a stock exchange, the Bombay High Court’s judgment introduces greater clarity regarding the enforceability of options in securities of Indian public unlisted companies.

The court was concerned with two issues pertaining to buyback and option arrangements that were entered into between certain shareholders of MCX. The first pertains to the lack of disclosure of these arrangements to SEBI. The Court found that these arrangements should not have been withheld by the company (and its shareholders) from SEBI, particularly in the context of a stock exchange that also performs a certain regulatory role. The second pertains to the legal validity and enforceability of buyback and option arrangements under law, more specifically the Securities Contracts (Regulation) Act, 1956 (SCRA). This post focuses on the second aspect that relates to substantive aspects of the enforceability of options in securities.

The Court’s ruling on this count may be divided into three parts:

(i) whether options in securities constitute a forward contract that is illegal;

(ii) whether the SCRA applies to unlisted public companies; and

(iii) whether the options violate s. 18A of the SCRA as they are not traded and settled through a stock exchange.

As to the first issue, there appears to be a difference in the characterization of the transaction by SEBI in its order of 23 September 2010 and subsequent submissions to the High Court. Although SEBI’s order proceeds on the basis that the arrangements involved a firm buyback of shares, subsequent determination indicates that these were only “options” and not firm arrangements in the nature of forward contracts. The High Court came to the conclusion that what is proscribed under the SCRA are firm buyback contracts (or forward contracts), and not options. The distinction between the two types of arrangements has been carefully considered by the court as follows:

75. In a buy back agreement of the nature involved in the present case, the promissor who makes an offer to buy back shares cannot compel the exercise of the option by the promisee to sell the shares at a future point in time. If the promisee declines to exercise the option, the promissor cannot compel performance. A concluded contract for the sale and purchase of shares comes into existence only when the promisee upon whom an option is conferred, exercises the option to sell the shares. Hence, an option to purchase or repurchase is regarded as being in the nature of a privilege.

…

77. The distinction between an option to purchase or repurchase and an agreement for sale and purchase simpliciter lies in the fact that the former is by its nature dependent on the discretion of the person who is granted the option whereas the latter is a reciprocal arrangement imposing obligations and benefits on the promissor and the promisee. The performance of an option cannot be compelled by the person who has granted the option. Contrariwise in the case of an agreement, performance can be elicited at the behest of either of the parties. In the case of an option, a concluded contract for purchase or repurchase arises only if the option is exercised and upon the exercise of the option. Under the notification that has been issued under the SCRA, a contract for the sale or purchase of securities has to be a spot delivery contract or a contract for cash or hand delivery or special delivery. In the present case, the contract for sale or purchase of the securities would fructify only upon the exercise of the option … in future. If the option were not to be exercised by them, no contract for sale or purchase of securities would come into existence. Moreover, if the option were to be exercised, there is nothing to indicate that the performance of the contract would be by anything other than by a spot delivery, cash or special delivery. 

In arriving at this conclusion, the court relied on an earlier decision of the Bombay High Court in Jethalal P. Thakkar v. R.N. Kapur, AIR 1956 Bom 74. Although there was a subsequent decision of the single judge to the contrary in Niskalp Investments and Trading Company Ltd. v. Hinduja TMT Ltd. (2008) 143 Comp. Cas. 204 (Bom), that was not considered as it did not “advance the discourse” for it was “rendered on a summons for judgment in a summary suit”.

Certain observations of the court also indicate that where shares are dealt with through the depository system, then that would automatically be treated as “spot delivery” as the definition of that expression permits such treatment. For example, the Court observes:

Where securities are dealt with by a depository, the transfer of securities by a depository from the account of a beneficial owner to another beneficial owner is within the ambit of spot delivery.

While this is helpful in advancing the cause of enforceability of options by ensuring that the shares are held in dematerialized form, it is possible to push the envelope a further to argue that the same principle should even apply to a firm buyback arrangement or forward contract, as it would be treated as a “spot delivery” contract merely by virtue of the securities being held in dematerialized form and transferred through the depository. This aspect has not been considered by the Court expressly, but it might be a plausible argument through logical extension of what has been expressed by the court.

As to the second issue, the Court considered the available case law on whether the SCRA encompasses public unlisted companies as well as listed ones. On this question, the Court has relied upon the Supreme Court’s rulings in Naresh K. Aggarwala v. Canbank Financial Services Ltd. (2010) 6 SCC 178 and Bank of India Finance Ltd. v. The Custodian AIR 1997 SC 1952 to suggest that the SCRA applies even to public unlisted companies. Hence, the scope and applicability of that continues to be quite wide in nature.

The third issue pertains to whether options can be traded only on the stock exchange, or whether they can be entered into privately on a negotiated basis. This is in view of s. 18A of the SCRA which provides that contracts in derivatives are legal only if they are traded on a recognized stock exchange. The Court did not pronounce its opinion on this issue because it was not advanced initially in the show cause notice of SEBI, and was raised only in subsequent submissions.

I have had occasion to consider the enforceability of options in securities in some detail in this paper, which has now been published in the NUJS Law Review, where I argued that (i) “options” are not forward contracts, they are different from buyback arrangements, and hence should be enforceable under the SCRA; (ii) the SCRA should apply only to listed companies and not to public unlisted companies; and (iii) s. 18A should not apply to physically-settled options that are entered into over-the-counter. The Bombay High Court in the MCX case has vindicated the stance on the first issue, rejected the approach on the second issue (primarily due to the existence of Supreme Court’s rulings on the point, which only it can overturn) and refused to decide on the third issue due to procedural considerations.

The Bombay High Court’s judgment represents a step forward in resolving the issue pertaining to the enforceability of options in securities that has continued to vex corporate practitioners for over two decades now. However, it is difficult to assume that the last word has been said on the matter. Certain issues, such as the impact of s. 18A, still remain. While the significance of the legal issues raised in this case may very well command an appeal to the Supreme Court, much of this ambivalence can be ended by appropriate notification or regulation by SEBI under SCRA to induce the necessary clarity rather than to place the onus on the judiciary to resolve them.

Bombay HC in the MCX Case: Summary of the Judgment

The following is a summary of the various issues decided by the court, as extracted from the conclusions in the judgment itself:

(i) Though the MIMPS Regulations in terms apply to a stock exchange in respect of which a Scheme for demutualisation and corporatisation has been approved under Section 4B, the application of those regulations was extended to the Petitioner by SEBI as a condition for the grant of recognition. Though initially SEBI demanded full compliance with the MIMPS Regulations, the requirement which was imposed while extending recognition thereafter, was full compliance with the relevant Regulations. In either view of the matter, there must be a genuine, bona fide and honest attempt to comply with the MIMPS Regulations;

…

(iii) Regulation 8 prescribes the limit for holding of shares in a stock exchange by a person resident in India, individually or with persons acting in concert. The manner in which a dilution of the equity stake of the promoters had to take place in order to ensure compliance with the provisions of the MIMPS Regulations was not confined to the modes specified in Regulation 4. Many of the modalities prescribed in Regulation 4 do not apply to a stock exchange like the Petitioner which has no trading members. So long as there is a genuine divestment of the equity stake of the promoters in excess of the limit prescribed by Regulation 8, that would fulfill the requirement of Regulation 8;

(iv) Stock exchanges are an integral part of the statutory framework which SEBI regulates in relation to the securities market. The relationship between a stock exchange and SEBI is one based on trust and utmost good faith. A stock exchange is duty bound to make a full and honest disclosure of all material and relevant facts which have a bearing on the issue as to whether the requirements of the MIMPS Regulations have been fulfilled. The existence of the buy back agreements was a material circumstance which ought to have been disclosed to SEBI;

(v) The sanctioning of the Scheme of capital reduction by the Company Judge under Sections 391 to 393 read with Sections 100 to 103 of the Companies' Act, 1956, does not preclude SEBI as a statutory regulator from determining as to whether the provisions of the MIMPS Regulations have been complied with. SEBI is independently entitled to ensure compliance with the MIMPS Regulations which have been made a condition for the grant of recognition. The statutory functions conferred upon SEBI under the SCRA and cognate legislation are not diluted;

…

(vii) The buy back agreements cannot be held to be illegal as found in the impugned order of the Whole Time Member of SEBI on the ground that they constitute forward contracts. A buy back confers an option on the promisee and no contract for the purchase and sale of shares is made until the option is exercised. The promissor cannot compel the exercise of the option and if the promisee were not to exercise the option in future, there would be no contract for the sale and purchase of shares. Once a contract is arrived at upon the option being exercised, the contract would be fulfilled by spot delivery and would, therefore, not be unlawful.

(viii) The alternate submission which has been urged on behalf of SEBI at the hearing that the buy back agreements constitute an option in securities and being derivatives violate the provisions of Section 18A of the SCRA is not the basis either of the notice to show cause that was issued to the Petitioner or of the order passed by the Whole Time Member of SEBI. SEBI has in fact, issued a notice to show cause to the Petitioner subsequent to the order asserting that as a ground. In that view of the matter, it will not be appropriate or proper for this Court to render any finding on that aspect, particularly when it did not find a place either in the notice to show cause or in the order passed thereon;

(ix) The definition of the expression "persons acting in concert" is for the purpose of the MIMPS Regulations derived from the Takeover Regulations, by Explanation (IV) to Regulation 8 of the MIMPS Regulations. Regulation 8 after its amendment in 2008, refers only to the holding of shares and not to the acquisition and holding of the shares as earlier. In applying the provisions of Regulation 2(1)(e) of the Takeover Regulations (which defines "persons acting in concert") to the MIMPS Regulations, it would be permissible following well settled principles in that regard to make some alteration in detail to render the regulations meaningful and effective. However, the essential ingredients of the expression "persons acting in concert" in the Takeover Regulations cannot be abrogated. …;

(x) The impugned order passed by the Whole Time Member has failed to apply the principal test enunciated by the judgment of the Supreme Court in Daichi Sankyo (supra) in determining as to whether certain persons may be held to be acting in concert. The mere fact that two persons have come together in promoting a Company does not lead to the inference that they are acting in concert for the purposes of the Takeover Regulations. …;

…

(xii) On the aspect as to whether the Petitioner is a fit and proper person for the grant of recognition, the finding which has been arrived at in the impugned order is inter alia based on a conclusion as to the illegality of the buy back agreements on the ground that they are forward contracts, which is found to be erroneous in the present judgment. The effect of the non- disclosure of the buy back agreements to SEBI should be considered having regard to the fact that a genuine attempt has been made by the promoters by tendering an undertaking to the Court that their shareholding together shall not exceed five per cent of the equity capital, notwithstanding the exercise of the options.

Bombay HC Ruling on the MCX-SEBI Case

The Bombay High Court has pronounced its judgment today in the matter relating to the denial of a stock exchange licence to the MCX Exchange. The Court has set aside SEBI's order of 23 September 2010 (which was discussed here) and directed SEBI to reconsider MCX's application afresh in the light of the Court's observations.

The judgment has significant implications on various aspects, including "persons acting in concert" and the enforceability of buyback arrangements and options in securities. We will have the opportunity to discuss some of these in greater detail.

Regulation of Stock Exchanges: Ownership and Governance

We have previously discussed the Bimal Jalan Committee report on “Review of Ownership and Governance of Market Infrastructure Institutions”. The report has been subject to intense debate, and the overwhelming view emerging is that the recommendations will destroy competition in the sphere. In this post, I attempt to list some of the relevant readings on this issue:

- Views in the Business Standard;

- Surjit Bhalla in the Indian Express;

- Mobis Philipose in The Mint;

- Nitin Potdar in Money Control;

- Jayanth Varma in the Financial Express; and

- Sandeep Parekh in the Financial Express.

Ownership and Governance of Market Infrastructure Institutions

The report of the Bimal Jalan committee on “Review of Ownership and Governance of Market Infrastructure Institutions” is now available on SEBI’s website for public comments (due on December 31, 2010). The report makes a number of key recommendations regarding the ownership structure and corporate governance norms pertaining to three key institutions providing securities market infrastructure, being the stock exchanges, clearing corporations and depositories. Of the three institutions, matters relating to stock exchanges have evoked the greatest amount of debate recently.

On the one hand, stock exchanges are crucial to a country economic infrastructure and they perform a public function by engaging in regulatory supervision over companies that are listed on it. On the other hand, stock exchanges need to evolve their businesses and practices through innovation and competition fuelled by private entrepreneurship and capital investments. The committee report essentially attempts to reconcile these somewhat conflicting objectives. This it does so by: (i) imposing restrictions on maximum ownership of market infrastructure institutions (MIIs), (ii) providing greater means of attracting long-term committed “anchor” financial investors rather than short-term investors or speculators, (iii) prohibiting listing of MIIs, (iv) prescribing stringent corporate governance norms for such institutions, including the appointment of public interest directors.

As we have previously discussed on this Blog, the crucial element of regulation of MIIs, and particularly stock exchanges, is the conflicts of interest they create: “stock exchanges are not only profit-making institutions that are companies in form and substance, but they also carry out a regulatory role in respect of companies that are listed on them.” The committee report is helpful as it discusses (on pages 22 and 23) the various methods by which such conflicts have been addressed:

Strong Exchange SRO Model: A public authority is the primary regulator, it relies on Exchange(s) to perform extensive regulatory functions that extend beyond its market operations, including regulating member’s business conduct. Examples: US (CME), Australia (ASX), Japan (TSE, OSE), Malaysia (Bursa Malaysia).
…

India has adopted the strong exchange SRO model. It is premature to think of the ‘independent SRO model’ [where the exchange performs extensive regulatory functions] in the Indian context given its evolution over a period to is present state; the government model may not be entirely possible in the Indian context considering the size of the market. However, due to the potential conflict of interest in the strong exchange SRO model, the Committee is of the view that SEBI must take a more active role in setting a level playing field with regard to fees, entry, etc. of members of MIIs.

In order to address these conflicts in terms of process, the Committee has recommended that regulatory functions of the exchange (such as risk management, surveillance, listing, enforcement, etc.) should report directly to an independent committee of the board consisting of a majority of public interest directors and also to the CEO (through dual reporting).

The detailed recommendations of the committee have been summarized and analysed here, here and here.

While imposing high barriers to entry into the market infrastructure sector will ensure quality and integrity of players, there exist arguments to the contrary that such a regime will encourage monopolistic behavior and discourage the useful effects of competition.

Depreciation on Intangible Assets

A year ago (almost to the date), we had discussed the decision of the Bombay High Court in CIT v. Techno Shares, observing that it appeared at odds with section 32 of the Income Tax Act. Last week, the Supreme Court overruled the Bombay High Court. However, while the conclusion arrived at by the Court seems appropriate on the facts of the case, it is slightly disappointing that the basis on which the Bombay High Court had arrived at its conclusion has gone unaddressed by the Apex Court.

The issue which fell for the Court’s consideration was whether deprecation could be allowed on the membership card of a member of the Bombay Stock Exchange. The Indian law on depreciation is governed by section 32 of the Income Tax Act, the relevant part of which provides for depreciation ‘know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial right of similar nature’. Thus, the Court was asked whether the membership card could be said to be a ‘license’ or a ‘business or commercial right of a similar nature’.

The Bombay High Court, in deciding this issue had held that the card was neither a license nor a business or commercial right covered by the provision. The rationale adopted by the Court was that, applying the principle of noscitur a sociis and ejusdem generis (broadly meaning words in a statute should take colour from their context), the overriding requirement for allowing depreciation on intangibles under section 32 was that they be related to intellectual property rights [“IPR”]. Since the membership card had no relation to any IPR, the Bombay High Court refused to allow depreciation.

The Supreme Court however, has arrived at a different conclusion. The Court examined in detail the provision and the Rules and Bye-Laws of the Bombay Stock Exchange, to come to the conclusion that it is a business/commercial right, and that its terms make it clear that this right is in the form of a license. The Court observes that membership of the stock exchange enables a person to trade on the floor of the exchange, to participate in trading sessions and to access the market. This “right to participate in the market has an economic and money value. It is an expense incurred by the assessee which satisfies the test of being a ‘licence’ or ‘any other business or commercial right of similar nature’ in terms of Section 32(1)(ii)” (¶ 19).

Thus, the Court concluded that membership granted business/commercial rights in the nature of a license, and hence was clearly covered by the scope of the provision. However, in so doing, the Court does not explicitly express its view the reasoning adopted by the Bombay High Court- in its reading into the provision an IPR requirement, and in its reading ‘license’ narrowly. Obviously, by allowing depreciation on the membership card, the Court has impliedly rejected the argument on an IPR requirement being read into section 32. However, the reading down of ‘license’, which was also an important part of the Bombay High Court’s reasoning, has not got special attention from the Apex Court. In fact, the Court seems to be at pains to emphasise that the decision is not applicable beyond the specific confines of the facts at hand. In the words of the Court,

We hold that the said right of membership is a “business or commercial right” which gives a non-defaulting continuing member a right to access the Exchange and to participate therein and in that sense it is a licence or akin to licence in terms of Section 32(1)(ii) of the 1961 Act. That, such a right vests in the Exchange only on default/demise in terms of the Rules and Bye-laws of BSE, as they stood at the relevant time. Our judgment should not be understood to mean that every business or commercial right would constitute a “licence” or a “franchise” in terms of Section 32(1)(ii) of the 1961 Act. [emphasis supplied]

In sum, the Court has impliedly dismissed the IPR requirement read in by the Bombay High Court, while leaving the field open for further curbs being read into the interpretation of ‘any other business or commercial right of similar nature’.