Enabling SMEs Access the Capital Markets

Although the small and medium enterprises (SMEs) constitute a significant portion of India’s economy, they face several hurdles in accessing capital in a cost-effective manner. As far the capital markets are concerned, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 provide several eligibility criteria for companies to qualify for being able to initiate public offerings. These include a past track record, minimum net worth requirements and the like that maintain the bar at a high level for SMEs to clear, and hence they are effectively kept out of the capital markets.

In order to overcome this present disposition, SEBI has recently issued a discussion paper that not only relaxes some of these eligibility criteria for public offerings of securities by SMEs, but even provides for a separate stock exchange on which SMEs can list their securities. The consultation paper details the need for a separate securities listing and trading route for SMEs. It also lists out parallels from other countries such as the Alternative Investment Market (AIM) in London, the Growth Enterprises Market (GEM) in Hong Kong and MOTHERS in Japan. All these provide separate avenues for listing of SMEs shares in the respective economies.

Since the eligibility criteria for listing have been relaxed, investor protection measures are sought to be introduced through different means. And that is by limiting investment opportunities in the SME listed segment only to large investors (investing and trading a minimum of Rs. 500,000). This is similar to the US concept of accredited investors, with the logic being that large investors (both institutional and individual) are either sophisticated enough to appreciate risks involved in investments or are able to obtain suitable investment advice; in any case, large investors are better able to absorb the risks involved in any such investments.

The minimum Rs. 500,000 investment requirement will continue in the secondary market as well. This will be ensured by way of imposing minimum trading lots of that amount, so that large investors do not purchase SME securities in public offerings and then down-sell them in smaller lots in the secondary markets. The continuous listing as well as financial reporting requirements for SMEs would be less stringent compared to their larger counterparts.

Overall, this is a welcome move as it could potentially create financing avenues for SMEs and also a separate market for investors keen to target that segment of the economy. This is also in tune with the international trend as we have seen earlier. However, it also calls for some caution and pessimism, particularly in view of past attempts which have failed. The prime attempt relates to the establishment of the OTC Exchange of India (OTCEI), which has not garnered the attention of the SME segment as it was expected to. Recent reports and commentaries have pointed to the need to ensure that this is not repeated with the current attempt (see, LiveMint and Mostly Economics blog).

From a legal and regulatory standpoint, it is likely to be more difficult to control the activities of SMEs as they may not have adequate infrastructure to meet with the required audit, reporting and compliance procedures as compared to the larger more established corporates. The reputation incentives of SMEs to comply with listing requirements and corporate governance may not be as high as their larger counterparts. One way to overcome this problem would be to have the SMEs piggyback on the reputation of a third party intermediary (also commonly referred to as “gatekeepers”). For instance, several jurisdictions still follow the requirement of having an intermediary such as an investment bank act as a sponsor in respect of an SME entity.
The role of the sponsor is to ensure compliance of norms by the SMEs failing which the regulator would hold the sponsor responsible. The mechanism is designed to provide enough reputation incentives to the sponsor to ensure that the SMEs do not fail, and therefore indirectly protect the interest of the investors. This “sponsor-supervised” model is being followed in the recently established Catalist, which is Singapore’s market segment for growth companies. The Catalist website describes its regulatory structure as follows:

“In a Sponsor-supervised market, SGX [Singapore’s stock exchange] continues to regulate companies through its admission and continuing obligation rules. It also retains the power to discipline them when there is a rule breach. However, approved "Sponsors" undertake the direct supervision of the companies.

Sponsors are qualified professional companies experienced in corporate finance and compliance advisory work. They are authorized and regulated by SGX through strict admission and continuing obligation rules.
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The Sponsor's main role at IPO is to assess the company's suitability to list and to prepare it for listing. After IPO, Sponsors are to advise and supervise listed companies on responsibilities in a public market. Sponsors are expected to whistleblow to SGX when there is an affirmed or suspected rules breach.”

There are indeed benefits in this sponsor-supervised model, and it may help for SEBI to explore this option in the Indian context as well.

Comments are due on SEBI’s discussion paper by June 6, 2008 (which does not leave much time though).

Participatory Notes and Disclosure Requirements

In an earlier post, we had discussed the decision of the Securities Appellate Tribunal (SAT) setting aside a SEBI order that imposed a penalty of Rs. 1 crore on an FII for giving a false declaration regarding its issuance of participatory notes. Our guest contributor, Somasekhar Sundaresan, has written a column in The Business Standard analysing this decision. Of particular relevance are the implications of the decision on participatory notes in general. He states:

“The latest decision from the SAT is yet another pointer to the pervasive ambiguity that the legal framework governing P-Notes is riddled with. Numerous fundamental concepts have remained undefined, and several prohibitions and policy positions have been developed within Sebi files, without the law actually containing requisite provisions (See Without Contempt – editions dated March 31, 2008, October 22, 2007).

An earlier bench of the SAT had set aside an order passed by Sebi charging an FII with failure to comply with "know your client" because the FII had been unable to confirm that no NRIs or persons of Indian origin were beneficially interested in any manner in any upward layer of shareholding in the P-Note counterparty entity. The FII Regulations had not required recording of such detailed data at such level. SEBI's position had been that the plain English meaning of the term "know your client" took care of this requirement.

Funnily, the very term "P-Note" or "offshore derivative instrument" remains undefined. Therefore, the very applicability of the regulatory edifice created by Sebi can be ambiguous depending on the nature of the instrument. For instance, an FII could well issue a P-Note without holding the underlying securities, if it does not care to hedge its exposure. Till date, there is no provision making it mandatory to issue P-Notes only against an underlying holding of Indian securities in the hands of the FII. It is completely unclear if the P-Note policy restrictions would affect such unhedged P-Notes.

While issuance of P-Notes against underlying holding in exchange-traded options and futures was banned by Sebi last year, there can obviously be no legitimate ban on a foreign person issuing P-Notes against holdings in Nifty futures ((Nifty is the National Stock Exchange's flagship index) that are traded on the Singapore Exchange. It would be foolhardy to believe that movements in the Nifty futures in Singapore would be insulated from impacting price movements in Indian securities. Therefore, the ban on derivatives-based P-Notes can become quite meaningless.

It is time to take an intense and hard look at the regulatory framework for P-Notes and ask some existential questions.”

Financial Disclosures by Companies

A column by Rahul Roy in The Business Standard deals with the proposed revision and simplification of Schedule VI to the Companies Act. This schedule prescribes the presentation and disclosure requirements for financial statements. The column strenuously argues that the current version of Schedule VI is severely outdated and as to how it should be brought in tune with developments in the financial world. However, questions are raised about whether amendment to Schedule VI is the right way to proceed:

“Globally, professional bodies of accounting standard setters prescribe accounting formats. The advantages are obvious. This is a specialised area which requires professional input; and has to be updated frequently to keep pace with changes in the economic and commercial environment. A schedule to a law, which has to be debated and amended only by Parliament obviously does not offer the flexibility required. Also given the scheme of things, an accounting legislation may not be the highest priority of our Parliamentarians.

Today, the prescriptions of Schedule-VI are far removed from the reality of what financial statements mean. It is only a legal figment that accounts in India comply with Schedule-VI. For starters, Schedule-VI does not even have any prescribed format for a Profit & Loss Account; it does not require a cash flow statement; it does not require disclosure of accounting policies; it does not require disclosure for leases; it does not warrant disclosure of deferred taxes or disclosure regarding impairment losses or intangibles. Further, the Schedule VI was conceived in an era when nobody had even heard of derivatives and so remains blissfully unaware of derivatives and disclosure of potential losses therein.

On the other hand, the Schedule-VI requires detailed disclosure of inventories, capacity, production and turnover for every significant item produced or traded. This is not required under any global framework and is potentially disadvantageous for the Indian industry vis-à-vis its global competitors as it forces companies operating in India to disclose their confidential operating data. These disclosures were conceived in a "Licence Raj" era and serve no useful purpose today when alternate Segment Reporting data is already available.”

In addition, the Rahul Roy points to the multiplicity of prescriptions that operates in relation to disclosure of financial statements, and the compounding confusion that it brings about:

“While on one hand the MCA is trying to reinvent the Schedule-VI, on the other hand multiplicity and confusion in the standard setting process in the country is increasing. ICAI's Accounting Standards Board is setting Standards; the National Advisory Committee of Accounting Standards (NACAS) is considering and notifying Standards; the MCA is notifying Rules (Accounting Standards Rules, 2000) that directly contradict Schedule-VI thereby creating a legislative conflict by specifying that a Rule will override an Act !!; the RBI is issuing provisioning & income recognition guidelines; SEBI is mandating presentation and disclosure formats of interim and annual results; and the ICAI is busy issuing ‘announcements', impacting accounting but without either the due diligent process of formulating Standards or investing these announcements with the authority of a mandatory pronouncement.”

Foreign Currency Borrowings: FCEBs and ECB

In an earlier post, we had analysed the notification of the Government of India permitting the issuance of Foreign Currency Exchangeable Bonds (FCEBs). The Reserve Bank of India (RBI) was expected to prescribe detailed guidelines on the mechanism for the issuance of FCEBs. It is now reported in LiveMint that the detailed guidelies would be issued by the RBI within a month.

Separately, we can expect to see some developments on the external commercial borrowings (ECBs) front. In view of increasing capital flows into India and a strenghtening rupee, the RBI had imposed tight restrictions on ECBs in August 2007, thereby making it difficult for Indian corporates to raise ECBs. But, now that the capital flows have stabilised, it may be time for a review of the policy. The Economic Times has an editorial that argues:

“The government may ease restrictions on overseas corporate borrowing when it, together with the RBI, reviews the external commercial borrowing (ECB) policy later this month. This is timely given the apparent drop in industrial activity and the recent sharp depreciation of the rupee against the dollar. Last year, the government had imposed restrictions on debt funds the corporates could bring into the country following a sharp increase in foreign inflows.
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The government could, therefore, think of selectively relaxing ECB norms to make funds available to those sectors or industries that are finding it difficult to raise resources locally. The RBI should allow smaller corporates, the backbone of the economy, to access funds overseas for meeting rupee expenditure. The quantum of flows is unlikely to be of an order that would worry the central bank.”