FIIs and Offshore Instruments: Another SEBI Order Set Aside

Readers may recollect that the Securities Appellate Tribunal (SAT) in 2005 overturned the order of SEBI prohibiting UBS, its affiliates and agents from issuing offshore derivative instruments (ODIs) with underlying Indian securities for a period of one year (on account of UBS’ failure to provide infromation about investors to whom it had issued such ODIs). The SAT found that the SEBI (Foreign Institutional Investors) Regulations, 1995 were unclear as to the information required to be provided by foreign institutional investors (FIIs) in relation to the ODIs. It held that such information lacks precise definition, and in any event there was no requirement to provide information regarding directors and shareholders of entities (such as hedge funds) that held the ODIs.

In yet another order passed yesterday, SAT set aside an order of SEBI’s adjudicating officer who imposed a penalty of Rs. 1 crore (rupees ten million) on Goldman Sachs Investment (Mauritius) Limited in connection with its issuance of ODIs. SEBI’s allegation was that Goldman Sachs, through an FII entity, had invested in underlying shares of Himachal Futuristic Communications Ltd. and in turn issued ODIs on a back to back basis to Magnus Capital Corporation Limited, which is an overseas corporate body (OCB). SEBI alleged that Goldman Sachs had filed false declarations in its reporting to SEBI on ODIs (as regards their issuance to OCBs) and hence was liable for the penalty.

SAT set aside the order of SEBI primarily on two grounds:

1. Since there was no bar on the FIIs and their sub-accounts to issue/ subscribe/ purchase any derivative instrument to/ from Indian residents or OCBs, it would be reasonable to presume that many of them may have dealt with such persons in the course of their business activities. Consequently, they cannot be asked to furnish an undertaking in the absence of any bar to deal with such persons.

2. The adjudication officer’s show cause notice is confusing and does not spell out clearly the allegations against Goldman Sachs. This, in effect, represents a failure of natural justice.

In an unusual move, SAT also awarded costs to Goldman Sachs to the extent of Rs. 100,000.

This order is important for two reasons. First, it highlights several inadequacies in the existing FII Regulations prescribed by SEBI. There is lack of clarity in the reporting requirements by FII, due to which SEBI has been unable to succeed on two high profile actions it had initiated (being the UBS and Goldman Sachs cases). Perhaps it is necessary to specify the disclosures more clearly and to remove vagueness and ambiguity so as to avoid similar situations in the future. I have dealt with some of these issues in the paper on hedge funds which is abstracted in an earlier post on this blog.

Second, it highlights deficiencies in the adjudication process adopted, particularly with reference to compliance with principles of natural justice. This, as we have previously discussed, is a repetitive factor in numerous SEBI orders that have been set aside by SAT.

Regulating Hedge Funds

I have uploaded an abstract of a working paper titled Analysing India's Approach to Hedge Fund Regulation on SSRN, which is reproduced below:

“Hedge funds tend to employ aggressive investment strategies, and they highly leverage their funds. While hedge funds infuse liquidity into the financial markets and enhance market efficiency, they also engage in complex financial transactions that leave open the possibility of systemic losses that are often borne by the financial markets they invest in.

In this context, the role of regulation of hedge funds in host-countries that receive their investment assumes importance. Regulation needs to balance healthy development of financial markets and the prevention of 'systemic loss' due to risky investment strategies. While a worldwide debate lingers on the need for governmental regulation to rein in hedge funds (as opposed to leaving it to market forces to determine their own regulation through market discipline), the Indian securities regulator, the Securities and Exchange Board of India (SEBI) has experienced a checkered history of regulating hedge funds while always adopting a somewhat cautious approach. It has employed different regulatory strategies to deal with hedge fund investments. These include the prohibition strategy, disclosure strategy, restriction strategy and the registration strategy.

This paper analyses SEBI's strategies for regulating offshore hedge funds investing into India. It finds that each time a regulatory strategy has been employed by SEBI, the hedge fund industry has reacted by displaying considerable malleability in being able to dilute the force of regulation. One such instance relates to the manner in which hedge funds reacted to the prohibition strategy by investing through offshore derivative instruments such as participatory notes so as to stay outside the purview of the Indian regulatory regime (although this route too has been significantly curtailed more recently). Using the example of SEBI's measures in the Indian context, the paper examines the dynamics involved in regulating the offshore hedge fund industry. Although this study is primarily focused on India, the results would apply at a conceptual level to other emerging economies that receive investments from offshore hedge funds.”

Miscellaneous: Commodities futures, FDI, Exchange-traded funds

The following are some key developments in the corporate sector over the last couple of days that are worth noting:

1. Commodities Futures

We had earlier discussed on this blog the preliminary findings of the Expert Committee under the chairmanship of Dr. Abhijit Sen, which failed to find a clear causation between commodity futures and the price rise in agricultural commodities. However, the Government seems to have overruled the findings in a sense when it banned futures trading in 4 commodities, being chana, soya complex, rubber and potato. This decision is not altogether uncontroversial, considering that there have been calls for a consistent futures policy. Further, the Dr. Sen committee has itself expressed its concern over the decision. The move is also likely to largely affect the trading on the commodities exchanges.

On a separate note, S. Gurumurthy presents a critical view about commodities futures and the Sen Committee findings.

2. FDI in Retail

The Hindu Business Line reports that there is unlikely to be a Government decision on the permissibility of foreign direct investment in retail trade in the near future.

3. Exchange Traded Funds

The Hindu Business Line has a column that explains this concept, which is slowly gaining popularity.

4. US-India Investment Norms

The Economic Times reports:

The US is putting pressure on India for a level-playing field for American companies investing in the country. Washington is pressing for a national treatment to US companies in the bilateral investment treaty (BIT) currently being negotiated.

A national treatment would place US investors on par with Indian investors and they may not have to adhere to the stringent guidelines laid down by the Foreign Investment Promotion Board (FIPB).

The US also wants India to agree to subjecting investment disputes between the two countries to international arbitration. While India has been resisting the proposals, the US is keen that the two become an integral part of the treaty.

An Examination for Directors

A few weeks ago, we carried a post by Pramod Rao discussing the implications of recent changes to Clause 49 of the listing agreement, the key ones being strengthening the role of the independent directors on boards of Indian listed companies. Although relegated only to a non-mandatory provision, one of the changes states that a “company may ensure that the person who is being appointed as an independent director has the requisite qualifications and experience which would be of use to the company and which, in the opinion of the company, would enable him to contribute effectively to the company in his capacity as an independent director.”

Although corporate governance norms are being tightened to provide for stricter definitions of “independence” and to enhance the role of independent directors, there are likely to be implementation problems on a continuing basis when viewed from a practical standpoint. Independent directors are either busy professionals who do not have sufficient time to devote to board roles on companies, or they are sometimes persons without the requisite qualifications to make effective contributions to boards in an increasingly complex business, financial and regulatory environment.

In order to overcome some of these problems, two US law professors, Ronald Gilson and Reinier Kraakman (in their article “Reinventing the Outside Director: An Agenda for Institutional Investors”) had suggested way back in 1990-91 that there should be a cadre of professional directors created to serve on corporate boards. These professional directors, as they envisaged, will be independent of management and shareholders (and thereby satisfy our current definition of independence) with requisite qualifications in business, finance and so on, and their only occupation will be that of acting as independent directors on say 6 boards in all. This way, these directors will be able to apply their expertise in monitoring corporate managements as independent directors on a full-time basis without being distracted by other vocations. However, that idea has not yet found favour in the corporate world, neither in India nor in any of the other recognised jurisdictions.

However, a concept that comes close to the idea of a professional director is one of a qualifying examination for directors. The Financial Times carries a report Directors face tough tests that describes the Chartered Director test prescribed by the Institute of Directors in London:

Businesses – even modestly sized ones – face increasing levels of complexity as far as compliance and risk management are concerned. Where should an aspiring director turn for an up-to-date, robust preparation for the role he or she is hoping to perform?

One place you might not expect to find cutting-edge advice on the issue is the august, Grade 1-listed John Nash building that is home to the UK’s Institute of Directors, a venerable employers organisation.

The outward appearance may not suggest modernity. But the IoD has gone further than any other institution to codify the director’s role, and offers a meaningful and relevant qualification – that of the Chartered Director (C Dir) – that should help both executives and non-executives prepare for the demands of the job.

Launched at the start of the decade, the C Dir is not a pseudo-label that can be acquired by sitting through a few lectures and sending off a couple of vouchers in the post. An aspiring C Dir has to clear several high hurdles before being awarded the qualification. To date, 660 have achieved the title, fewer than 100 a year since its inception.

“Getting my PhD was a doddle compared with this,” says Suzy Walton (left), an occupational psychologist, non-executive director of several organisations, former member of Tony Blair’s delivery unit in the UK cabinet office – and a newly minted C Dir. “These were the toughest set of exams I have ever done. I practically had to move into the IoD while I was preparing for them. I know all the best places to sit and work there.”

Such measures would ensure that independent directors not only satisfy the technical requirements of independence, but are also independent in state of mind and have the necessary capabilities and resrouces to truly challenge management on key business and corporate decisions. It is well worth thinking on the lines of mandatory qualification and training for independent directors even in the Indian context so as to make their roles and contributions more meaningful, not just in compliance with the letter of law, but also in the true spirit of corporate governance.