Disclosures in Complex Transactions

With increasing complexity in transactions entered into by companies, especially in the financial sector, there is the lingering question of how these transactions are to be meaningfully disclosed to shareholders of the companies so as to enable them to take an investment decision (such as to buy, sell, hold, etc.). The trouble here is that institutional investors themselves are unable to appreciate the real nature of these transactions. We have seen some of this in the sub-prime crisis when several such investors bought collateralized debt obligations (CDOs). How then does one expect lay investors to grasp the intricacies involved in these transactions when they happen to be shareholders or other security holders in any of the companies that are parties to such deals?

In Going beyond Greek letters in Livemint, Amol Agrawal flags the issue by giving the example of the UBS annual report that was sent to its shareholders:

“Swiss bank UBS AG has recently released a report where it has tried to explain to shareholders what went wrong in the subprime crisis. UBS is one of the worst affected firms and the decisions of its managers needed explanation. The report is an honest admission of various judgemental errors by the management.

One wonders how many of UBS’ shareholders understood what was written. It sounds Greek all the way. There is a surfeit of jargon and acronyms. One has to continuously flip back the pages to understand the chain of events.”

He then goes on to deal with some of the policy implications that lay behind disclosures and complex financial transactions:

“All this poses numerous problems for the policymakers. They have to not only develop their financial systems, but also make them more crisis-resistant. Take the India example. There have been numerous reports on India’s financial sector. All these committees/reports suggest the same —an efficient financial system with more participation of public and encouraging financial innovation. But then, we can’t really ignore the risks from these fancy financial products. The UBS-type shareholder reports might soon be written by Indian firms (I hope not in times of crisis) and the recent derivatives crisis suggests the time will come sooner than later. How many shareholders will actually understand these derivative positions? If they don’t, then the purpose of bringing more public savings into capital markets needs to be questioned.

The subprime crisis has pointed to the need for financial literacy, but understanding what happens in financial markets requires much more than basic financial literacy. Even the best financial brains can’t figure out the developments. Hedge fund Long Term Capital Management (LTCM) failed miserably despite having Nobel-winning economists on board. The subprime crisis is a collective failure of many such minds.

There is an urgent need to tackle the perverse incentives and complexity in the financial system. The regulators alone can’t do the job and the participants will have to become responsible themselves. But then, we are all interested in our yachts, who cares for the customers/shareholders? Financial deepening without creating financial excesses (as said by Hervé Hannoun of the Bank of International Settlements) is the need of the hour. The focus so far has been on the first part. The sooner we move to second, the better it will be.”

The observations in the article are interesting. Disclosures relating to complex transactions will always result in information asymmetry. However, that just seems to be a fact that one cannot wish away. It is almost impossible to provide these disclosures in simple terms that are comprehensible to a lay investor. If at all that is attempted, there is a sure risk of oversimplification that may alter the meaning, relevance and importance of that information. Therefore, the option of providing simple disclosure that lay investors understand may not be a viable option.

As Steven Schwarcz notes in his article Rethinking the Disclosure Paradigm in a World of Complexity, what we have is a “dilemma that some structured transactions are so complex that disclosure to investors of the company originating the transaction is necessarily imperfect – either oversimplifying the transaction, or providing detail and sophistication beyond the level of even most institutional investors and securities analysts.”

This then means that disclosure is not the proper means to regulate complex financial transactions. Such transactions must either be restricted by law and regulation, or alternatively such complex investment opportunities must be made available only to sophisticated investors (e.g. qualified institutional buyers) and not to those who cannot understand and appreciate the full extent of the risks they may be taking with these investments. This must, of course, be weighed against the need for vibrant financial markets that encourage financial innovation - always a tough balance.

Indian Corporates on an African Trail

Several large as well as medium sized Indian companies have undertaken outbound investments and offshore acquisitions in the last decade. These have primarily been in developed markets such as the United States or in various European countries such as the United Kingdom, Germany and so on.

The year 2008 has witnessed the emergence of a new phenomenon, whereby Indian companies are seen scouting in Africa for potential investments and acquisitions. Indeed, Africa is a continent that is flush with natural resources, although not all of them have been put to optimal use. Apart from that, China has already obtained a head-start by making investments and forging alliances in various African countries, and Indian companies would certainly not like to find themselves in a position of having lost out on opportunities to its key competitor, China. Africa also presents itself as a large market for Indian goods and services, that makes it attractive for Indian companies.

This phenomenon is covered by The Economist in two of its articles. The first, The Indians are coming, examines the general trade and investment scenario between India and various African countries. The second, Eyes on Africa, discusses the specific transaction involving the potential acquisition of a stake by India’s Bharti Airtel in MTN, Africa’s largest mobile-phone operator.

IPO Scam: Another SEBI Order Set Aside

In an order passed on May 2, 2008, the Securities Appellate Tribunal (SAT) set aside the order of SEBI that directed 10 entities (including Karvy Stock Broking Limited) to disgorge a sum of Rs. 115.82 crores. The Hindu Business Line has a background to the case:

“The scam related to certain entities cornering IPO shares (in 2003-05) reserved for the retail category by using fictitious demat accounts. These demat accounts were ultimately transferred to the financiers through key operators. The financiers made their gains on the first day of listing of these shares.

SEBI’s disgorgement order of November 2006 had directed 10 entities including Karvy to jointly and severally pay up Rs 115.82 crore towards disgorgement (paying up money made through illegal or unethical gains).

However, SEBI refused to spell out how much each entity would have to pay, saying that it was a matter to be settled between the accused entities. It was against this order that the appeals to SAT were made.”

As is the case with several appeals before SAT that arise out of SEBI orders, Karvy succeeded mainly on procedural grounds. SAT found that SEBI had failed to follow the principles of natural justice in not calling upon the appellant, Karvy, to show cause why it should not be ordered to disgorge the amount determined in the order. The SAT even went to the extent of expressing its anguish “over the irrational manner in which [SEBI] proceeded to pass the impugned order only against the two depositories and their participants.” The SAT appears to have taken strict note of the fact that the ultimate beneficiaries of the scam, being the various beneficiary account holders, were not issued any directions by SEBI for disgorgement, while SEBI forcefully pursued the depositories and the participants only.

While, the SAT order itself is largely premised on grounds of natural justice, it does contain some useful explanation about the concept of “disgorgement” in relation to securities law:

“Before we deal with the contentions of the parties, it is necessary to understand what disgorgement is. It is a common term in developed markets across the world though it is new to the securities market in India. Black’s Law Dictionary defines disgorgement as “The act of giving up something (such as profits illegally obtained) on demand or by legal compulsion.” In commercial terms, disgorgement is the forced giving up of profits obtained by illegal or unethical acts. It is a repayment of ill-gotten gains that is imposed on wrongdoers by the courts. Disgorgement is a monetary equitable remedy that is designed to prevent a wrongdoer from unjustly enriching himself as a result of his illegal conduct. It is not a punishment nor is it concerned with the damages sustained by the victims of the unlawful conduct. Disgorgement of ill-gotten gains may be ordered against one who has violated the securities laws/regulations but it is not every violator who could be asked to disgorge. Only such wrongdoers who have made gains as a result of their illegal act(s) could be asked to do so. Since the chief purpose of ordering disgorgement is to make sure that the wrongdoers do not profit from their wrongdoing, it would follow that the disgorgement amount should not exceed the total profits realized as the result of the unlawful activity. In a disgorgement action, the burden of showing that the amount sought to be disgorged reasonably approximates the amount of unjust enrichment is on [SEBI].”

Differential Voting Rights as a Takeover Defence

Shares with differential voting rights (DVRs) have been permitted to be issued by Indian companies since 2001 when the Companies (Issue of Share Capital with Differential Voting Rights) Rules were issued. Not only have there been stringent conditions imposed with respect to issuance of shares with DVRs, but the rules themselves have given rise to several issues (particularly with reference to interpretation) due to which not many companies have actually availed of the benefits of DVRs.

DVRs can potentially be an effective tool to defend against hostile takeovers. For instance, promoters of a company may issue shares with DVRs to themselves, whereby they can hold a small number of shares, but still exercise a large number of votes. This will act as a resistance against hostile acquirers.

Today’s Livemint reports that a case pertaining to Jagatjit Industries that is currently pending before the Company Law Board may well clarify some of the existing ambiguities relating to DVRs and help determine their effectiveness as a takeover defence. The report also contains a discussion on several implications of issuance of DVRs, especially under the SEBI Takeover Code.