Accounting for Derivatives Exposure

A recent announcement by the Institute of Chartered Accounts of India (ICAI) has added to the imbroglio over derivatives. Accounting Standard 30 (AS30) that deals with accounting for derivatives was to become mandatory with effect from April 1, 2011. However, the ICAI in an emergent decision has called for an early adoption of AS30 for financial statements as on March 31, 2008. Corporates not following AS30 are required to measure unrealised losses on financial instruments using principles of prudence explained in AS1. The Business Line has a report on the implications.

This appears to be a knee-jerk reaction to recent events and is likely to cause a stir among corporates in their year-end reporting. Business Standard has an editorial today that touches upon some of the issues:

“… The problem of course is that the directive has come on a week-end, with one working day left for the financial year to close for most companies. Saddling companies with a serious accounting change at the very end of the year has given them an unpleasant shock, and many of them will be scrambling to deal with this last-minute situation. This is not the way in which matters should be dealt with.

The new accounting directive should mean that all the facts will be known when the March accounts are reported, but shareholders may remain in the dark about the true dimensions of the potential problem. If some companies are tempted to take the view that many foreign exchange derivative contracts have maturity dates that are still in the future, and therefore they can legitimately take the view that until the stipulated date comes round, there are no losses to report. Since some of the affected companies have gone to court against the banks that sold them the derivative contracts, they will be taking legal advice on whether they have a strong case, and whether that gives them protection from “marking-to-market”.

Companies will be eager to look for such escape routes as the immediate disclosure of large exposures could endanger their relationships with other bankers and suppliers, with the attendant risk of credit drying up and affecting the running of the business. However, the accounting norms that have been introduced do not leave any room for such creative thinking. There is also the possibility that banks and companies will work out arrangements whereby existing derivative contracts are unwound, and replaced by new contracts that have an even longer maturity period. But even this will not prevent full disclosure to shareholders. In any case, such “ever-greening” of loans also runs the risk of increased exposure, and a bigger problem being bought for the future.”

Improving Stock Sales Practices of Intermediaries

Stock intermediaries around the world, such as brokers and sub-brokers, who recommend and sell securities to clients, are regulated by the securities regulatory agencies of the countries where they operate as well as the stock exchanges of which they are members. However, the stock intermediation industry has been facing several problems over the years on account of inappropriate business practices. These include acquisition of clients without following proper know-your-client (KYC) norms and peddling complex financial products (such as derivatives) to clients, particularly individuals, who do not possess sufficient sophistication to bear the high risk involved in such products.

Further, the stock analysts within these broking entities have been found to have conflicts of interest that impinge on their independence of analysis while providing recommendations to “buy” or “sell” a particular stock. In fact, a few years ago, the (now infamous) Eliot Spitzer, then Attorney General of New York State, prosecuted analysts for issuing rosy recommendations on Internet stocks that they themselves knew were not valuable, and forced settlements that ran into hundreds of millions of dollars. The problems associated with the action arose from the fact that many of these analysts that issued recommendations on companies were affiliated to investment banking arms that were taking those very companies to the public markets through IPO during the Internet boom, and that clearly constituted a conflict of interest.

Regulations regarding sales practices by brokers and analyst conflicts of interest have not been very stringent in India, as compared to more developed markets. However, that is likely to change with SEBI’s Proposed Policy for Improvement in Sales Practice by the Members of the Stock Exchanges that was issued yesterday. The policy document is available here.

Key measures proposed include strengthening KYC norms, sales practices, fair dealing with customers regarding derivatives or new financial products, tackling conflicts of interest and improving recordkeeping.

Comments are due on the proposal before April 15, 2008.

Inadequacies of the FII Regime

One of our guest contributors, Somasekhar Sundaresan, has a well-argued column in the Business Standard in which he calls for an overhaul of the regulations that govern foreign institutional investors (FIIs) in India. Here it is:

The regulatory regime for foreign institutional investors (FIIs) is the Indian capital market’s window to the outside world which often gives the first impression of how ugly or beautiful the house to which it belongs is.

This regulatory regime is in a shambles. Too much is cloaked in undeclared policy, and the administration of law can be unpredictable. Efforts to codify and streamline it have been initiated a few times, but the lack of attention to detail and general apathy to the needs of the market hurts this segment of capital market regulation.

The Indian rupee is not convertible on the capital account and India is still subject to exchange controls which are administered by the Government and the Reserve Bank of India. Not all persons resident outside India are freely permitted to trade in shares on the Indian stock market.

FIIs, as a class, are specially permitted to purchase and sell shares in India and move funds into and outside India at will. They are subjected to individual caps of 10 per cent ownership in any Indian company, and the aggregate FII holding in a company too is capped — in most sectors, it is linked to the level of the overall foreign holding permitted in the respective sectors.

The Securities and Exchange Board of India (SEBI) has been designated as the authority to register and regulate FIIs. The SEBI (Foreign Institutional Investors) Regulations, 1995 (FII Regulations), came to be notified by SEBI only in 1995, years after FIIs had set up shop.

The FII Regulations have hardly undergone any significant amendment to keep pace with developments. Amendments, too, have tended to merely take on board market realities and developments in the system — for example, several years after offshore derivatives instruments and participatory notes (ODIs) became well known, the FII Regulations provided a framework to regulate issuance of such instruments.

Over time, a range of internal policy developed within SEBI, often sporadically. For instance, SEBI took a position that stock broking firms would not be registered as FIIs. Also, it long held a view that any investor describing itself as a “hedge fund” would not be granted FII registration. However, the regulations did not provide for such preferences or ineligibilities. Therefore, the world does not entirely know what the position was. More recently, an unstated aversion to letting foreign companies register as FIIs has gained ground, but has not been codified into law. The FII Regulations even allow foreign individuals to get registered as FIIs. But SEBI does not even register individuals!

Last year, the policy around ODIs was revised and the board of directors of SEBI resolved to make several amendments to the law. This included imposing supply-side constraints on the ability of FIIs to issue such instruments by linking the aggregate size of such instruments to the size of investments of the respective FIIs in India.

The backlash to a consultative paper circulated by SEBI resulted in it taking notice of the slackness in the policy and announcing several measures to ease the registration process. However, nearly 6 months later, the FII Regulations remain untouched.

For instance, the policy decision taken last year was to state that an applicant for FII registration could have any individual investor to beneficially own up to 49 per cent of the fund. The FII Regulations continue to cap at 10 per cent, the maximum ownership that any individual investor could have in a fund, in order to qualify as a broad-based fund.

SEBI had wanted an FII to readily have information about the ultimate beneficial ownership of counterparties to its ODIs. Till date, this area has not been clarified.

Last month, this column spoke about the unsustainable ambiguity against non-resident Indians (NRIs) being occasioned by bad administration of FII Regulations. A provision that makes NRIs ineligible to be registered as FIIs is being cited internally to deny FII registration to funds managed by NRIs.

An amendment to the regulations to remove this prohibition is under consideration. Such an amendment is unnecessary — one does not need to amend the law to correct wrong administration of the law. SEBI has historically never asked FIIs to declare that its funds managers are not NRIs, and indeed, there are many registered FIIs that have NRI fund managers.

Another ambiguity is about whether a fund which is registered as an FII may raise funds from NRI investors. So long as the fund is broad-based, it should matter little who the money is raised from, with the exception of resident Indians. However, SEBI has singularly refrained from putting pen to paper and confirming this position.

The FII Regulations are the broken window of the Indian capital markets that projects a bad image of India to the international community. It is time to fix it.”

The list of problems with the FII regime goes on, and I suppose it is only the word-limit of the column that imposed constraints on Somasekhar.

The most important takeaway from this discussion is the need for precision in regulatory thinking and blemishless communication of the same through drafting. In the context of the FII regulations, their state of apathy due to flawed drafting was best described by Prof. J. R. Varma who commented: “The FII regulations are quite ambiguous. You could read it one way and think hedge funds are allowed, and read it another way and think they are not.” Financial market regulation cannot afford to carry such ambiguity.

At an overall level, it seems that with economic liberalisation in the early 1990s, two broad routes of foreign investment were envisaged, one being foreign direct investment (FDI) and the other foreign institutional investment (FII). The FDI route was tightly regulated and subject to stringent approval requirements, while FII investment under the portfolio route was allowed more freely. FIIs were also eligible to favourable tax treatment on capital gains compared to FDI investment. However, over the years, FDI has undergone sea change. FDI investment is now permissible in most sectors without prior approvals, and such investors can also exit through the stock market at prevailing prices. FDI taxation on taxation has also progressive reduced now making it on par with FII taxation. While the FDI route has been streamlined over time, the FII regulations have been left untouched, thereby largely obliterating the several advantages that were earlier available to FIIs. As Somasekhar has rightly argued, it is time that the FII regulations are also overhauled so as to deal with the dynamic financial environment affecting capital markets.

Tata-JLR Acquisition: The Legal Team

Legal Week has a news report on the law firms that advised on the transaction. They are Hogan & Hartson (for Ford), Herbert Smith (for Tatas) and Allen & Overy (for the consortium of banks). The report, however, does not mention about the involvement of any law firms on the Indian side.

(In case you are unable to access the hyperlink above, please try copying the following and pasting on your browser: http://www.legalweek.com/Articles/1109477/Hogan+and+Herbies+handle+Ford's+1bn+Jaguar+sale.html)