PSUs and Corporate Governance

In a continuation of the debate between SEBI and the public sector undertakings (PSUs) over whether the latter should comply with the provisions of Clause 49 of the listing agreement regarding corporate governance, the SEBI Chairman, Mr. Damodaran has categorically stated that there will be no relaxation for PSUs from the applicability of the corporate governance norms (see reports in the Economic Times, Business Standard and Hindu Business Line). The SEBI Chairman has insisted on a level playing field for private corporates and PSUs when it comes to corporate governance. I find SEBI’s position to be quite reasonable. There are several reasons why PSUs ought to comply with the corporate governance requirements.

First, PSUs (whose shares are listed on stock exchange and who are therefore required to comply with Clause 49) do access capital markets from time to time like any other private issuer company. Several of the large public offerings are in fact carried out by PSUs.

Second, PSUs do have significant public shareholding where their shares are held either by institutional investors or retail individual investors. Corporate governance regulations (as contained in Clause 49) are intended to protect the interests of these investors through disclosure norms and other checks and balances (such as an independent board, audit committee, etc.).

Third, India has been moving up the rankings for its corporate governance measures, and this is indeed one of the key factors for attracting significant investment and thereby boosting its capital markets. Any relaxations that dilute corporate governance requirements will not augur well.

There is therefore a dire need for PSUs to ensure compliance with corporate governance requirements just like their peers in the private sectors, as both types of entities are required to act in the interests of their public shareholders and other stakeholders.

Now, Kidnapping Insurance

Today’s Business Times, Singapore (page requires subscription) carries an interesting story that companies in India are taking out kidnapping insurance for their top employees located in high-growth hubs such as Hyderabad, Bangalore and Delhi suburbs Gurgaon and Noida. As for the nature of the policies taken, the newspaper reports:

“The kidnapping-terror policies cover ransom, hiring charges of negotiators and trauma counselling. The insured amounts can range from US$1 million to US$5 million, with premiums typically 1-3 per cent. In the US, such premiums gross over US$300 million.”

This comes in the wake of several kidnappings (high-profile or otherwise) in the recent past that have targeted top-level corporate executives and their families.

Participatory Notes: Regulating Complex Financial Instruments

Today’s Mint carries a column by Niranjan Rajadhyaksha that deals with the issues relating to regulation of complex financial instruments such as participatory notes that are held by investors like hedge funds. Referring to the classic debate between public regulation and market regulation, he states:

“Regulators have two options: to demand more clarity on what is going on or to clamp down on financial innovation. The former is quite clearly the more sensible option. Bans never help, although there are the inevitable calls for them whenever there are problems in the financial markets. Usually, crises in the real economy bring with them calls for further deregulation while crises in the financial economy come with calls for tighter regulation: That’s a big paradox in the annals of contemporary policy debate.

All this is of relevance to India. The domestic financial markets are still repressed. Local investors have access to a limited range of securities to buy and sell. But the same cannot be said of offshore investors who are taking positions on the Indian economy—either directly or indirectly. Many of them are hedge funds who use a range of trading strategies. They buy into the India story through participatory notes (PNs), which are offshore instruments backed by Indian equities and derivatives and whose proliferation has kept troubling the Reserve Bank of India and the Securities And Exchange Board of India (Sebi).”

He also cites an IMF Working Paper by Manmohan Singh that traces the use of participatory notes in the Indian financial markets, and concludes with the impact of the regulatory pronouncements issued by SEBI in October 2007. The abstract of the paper runs as follows:

“This paper focuses on the use of participatory notes (PNs) by foreign investors, as a conduit for portfolio flows into Indian equity markets for more than a decade. The broadening of India's foreign investor base, in recent years, has a bias towards hedge funds/unregistered foreign investors who invest primarily via PNs. While tax arbitrage via capital gains tax has almost disappeared since July 2004, it is intriguing to note that since then the demand for PNs has actually increased. The paper suggests some reasons for the continuation of a buoyant market in PNs, and explains the possible impact from the recent regulatory changes.”

SEBI’s October 2007 pronouncements can be found here and here. Essentially, they bar foreign institutional investors (FIIs) from issuing PNs on derivatives and require them to wind-down their existing positions within 18 months. As far as PNs for cash are concerned, they are permitted up to a maximum of 40% of the assets under custody (AUC) of the FIIs.

Manmohan Singh concludes as follows:

“SEBI’s ban on the issuance of PNs on derivatives will reshuffle the investor base on portfolio inflows. Its proposal may increase the inflows onshore by the apparent interest from real money accounts to register onshore (including pension, endowments, charitable trusts etc); however, inflows from margin accounts (i.e., from investors who use PNs on derivatives) are likely to disappear along with some investors from the PN cash market. Inflows from PNs on derivatives will not be replaced since this route allowed transactions that cannot be mimicked onshore. The near-term impact depends on how staggered the unwinding is likely to be. Once the reshuffling of the investor base in favor of the real money account takes place over the next 18 months, capital flows are likely to be more stable.”

Although SEBI’s pronouncements are likely to cause churn in FII investments during the 18-month period and possibly disrupt investment flows, the regulator’s action is a unique step toward investor regulation and enhanced transparency. While economies like the US are still grappling with the issue of whether to regulate hedge funds and other similar investors, India has taken the step of imposing stringent regulations by requiring hedge funds and other PN holders to register directly with SEBI rather than use conduits such as PNs to avoid registration requirements.

Insider Trading and Short Swing Profits

SEBI yesterday issued a Consultative Paper on introduction of ‘Short Swing Profit’ regulations in India. Under this proposal, any insider would be compelled to surrender profits to the company that are derived from a transaction involving the purchase and sale of securities by the insider within a period of six months.

The consultative paper sets out the objective of the proposed regulation:

“Such a Regulation will check insiders, who have greater access to price sensitive company information, from taking advantage of information for the purpose of making short-term profits (short swing profits). It is assumed that insiders have a long term investment in the company and are not expected to make rapid buy/sell transactions, which are assumedly based on at least some level of superior access to information, whether material or not. Additionally, as mentioned above, it will align the long term objectives of company insiders with the company shareholders.”

An important aspect of the proposed regulation is that the mere facts of a person being an insider and that of conducting the buy and sell trades within a six-month window are sufficient to invoke the surrender requirement. Mens rea or the element of state of mind is not a pre-requisite. The consultative paper elaborates:

“Liability will be imposed without any necessity for guilt or wrongfulness and conversely a direction to surrender profits made in a short swing transaction shall not necessarily imply any form of guilt. The surrender of profits made in such short swing transactions shall be automatically imposed as a part of good corporate governance requirement. The short swing rule will get automatically attracted as soon as two things are established. First is the fact of being an insider or a “designated insider” (which is elaborated below). And second, the fact that the same securities were bought and sold within six months of each other. In such a regulation, the intent of the person shall be immaterial. Merely the fact of the trade will be sufficient to take action i.e. direction to make over such profits to the company.”

It, however, remains to be seen whether judicial authorities will follow the letter of the law, or impute the requirement of mental element while interpreting the provisions of the law. For example, while interpreting the provisions of the SEBI (Insider Trading) Regulations, 1992, the Securities Appellate Tribunal has in the past held that if a person who had indulged in insider trading had no intention of gaining any unfair advantage, then the charge of insider trading cannot be sustained (Rakesh Agrawal v. Securities and Exchange Board of India, [2004] 49 SCL 351).

Under the present proposal, certain transactions would be exempt from this stipulation: transactions approved by a regulatory authority, employment benefit plans, bona fide gifts and inheritances, mergers and acquisitions, etc.

The consultative paper is open for comment until January 21, 2008.