Thursday, January 31, 2008

The Case for an Indian SWF

Sovereign wealth fund (SWF) is a fund owned by a state composed of financial assets such as stocks, bonds, property or other financial instruments.

Sovereign wealth funds are, broadly defined, entities that can manage the national savings for the purposes of investment.

The accumulated funds may have their origin in, or may represent foreign currency deposits, gold, SDRs and IMF reserve position held by central banks and monetary authorities, along with other national assets such as pension investments, oil funds, or other industrial and financial holdings.

These are assets of the sovereign nations which are typically (but not necessarily) held in domestic and different reserve currencies such as the dollar, euro and yen. The names attributed to the management entities may include central banks, official investment companies, state pension funds, sovereign oil funds and so on.

SWFs are typically created when governments have budgetary surpluses and have little or no international debt. This excess liquidity is not always possible or desirable to hold as money or to channel it into consumption immediately. This is especially the case when a nation depends on raw material exports like oil, copper or diamonds. To reduce the volatility of government revenues, counter the boom-bust cycles' adverse effect on government spending and the national economy or build up savings for future generations, SWFs may be created. One example of such a fund is The Government Pension Fund of Norway.

Other reasons for creating SWFs may be economical, or strategic, such as war chests for uncertain times. For example, the Kuwait Investment Authority during the Gulf war managed excess reserves above the level needed for currency reserves (although many central banks do that now). The Government of Singapore Investment Corporation is partially the expression of a desire to create an international financial center. The Korean Investment Corporation has since been similarly managed.

Case for establishing an Indian SWF
As opposed to forming an SWF from foreign currency reserves or budgetary surpluses, it is instead suggested that the Government of India’s shareholding in various Public Sector Undertakings (PSUs) or government companies should form the corpus of the Indian SWF.

There are three broad categories of PSUs which are owned by a plethora of Government ministries or departments, namely Manufacturing or Extraction based companies, Trading or Services companies, and lastly, Financial services companies (including SBI, public sector banks, LIC, etc.). Many of these are wholly owned or have been partially listed. All of the Government’s holdings can be transferred to the Indian SWF, and which would then constitute the single directly owned government company.

Additionally, enterprises that are hitherto not corporatised, could be corporatised, and then transferred to the Indian SWF. This has been undertaken in the past for creation of Bharat Sanchar Nigam Ltd – BSNL, created out of the Dept of Telecom, and could be considered for Indian Railways, Indian Postal Services, etc. Similarly, in the financial services sector, statutory corporations could be corporatised, and the special statutes repealed – these would include the LIC Act, GIC Act and the two Bank Nationalization Acts, SBI Act & SBI (Subsidiary Banks) Act DICGC Act, etc. As again, this has been undertaken in the past for IDBI and IFCI, whereby the statutes by which IDBI and IFCI were created were repealed, and the two institutions incorporated as companies under Companies Act, 1956.

Objectives in forming an Indian SWF can be: de-linking PSUs / government companies from direct government oversight, support & budgetary allocations, and requiring market orientation & discipline in terms of raising capital or debt resources, corporate governance, creating value for government/taxpayers, unlocking value by part divestment and re-channeling proceeds to national priorities (including national employment guarantee scheme, healthcare & education).

Such an enterprise could also partner Indian or multinational companies in establishing Greenfield projects that create employment, enhance competition & creates consumer demand.

Utilizing & harnessing strategic legal options
Under the Companies Act, 1956, there are two modes through which a company is treated as a subsidiary of another –
(a) By ownership of more than 50% of the equity OR
(b) By ability to appoint majority of the members of the Board of Directors.

If the Indian SWF is constituted as a company, and owns the PSUs/government companies, it can undertake value creation/unlock value at two-levels: it can require changes to the Articles of Association of such PSUs/government companies that give the Indian SWF the right to appoint the majority of the members of the Board of Directors of these PSUs/government companies.

With such an ability, public offering (or follow-on offering, where the PSU/government company is already listed) or private placement to strategic/financial investors of upto 70% of the equity of the PSU/government company can be undertaken without diluting the control over such companies.

At the second level, the Indian SWF can divest upto 49% of its equity in a public offering or by private placement to strategic/financial investors.

Illustrative list of PSUs/government companies in each of the above three categories:
· Manufacturing or Extraction based or Energy companies: Indian Oil, Hindustan Petroleum, Bharat Petroleum, ONGC, Steel Authority of India Ltd, National Thermal Power Corp, Gas Authority of India Ltd, Bharat Heavy Electricals Ltd, Bharat Earth Movers Ltd, Hindustan Aeronautics Ltd, HMT,
· Trading or Services companies: National Aviation Co of India (Air India, Indian Airlines, Air India Express), Bharat Sanchar Nigam Ltd, Mahanagar Telephone Nigam Ltd, Delhi Metro Rail Corporation, Konkan Railway Corporation,
· Financial services companies: State Bank of India group, Punjab National Bank, Bank of Baroda, Canara Bank, Bank of India, Indian Overseas Bank

The Indian SWF would hence come very close to resembling Temasek – itself a creation of the Government of Singapore & which began with originally with a portfolio only comprising of Singapore government owned companies, and today has an internationally diversified portfolio, valued in excess of USD 100 billion.

The Indian SWF can be subject to oversight by Prime Ministers’ Office / Cabinet Committee on Economic Affairs, and it (or the PSUs/government companies owned by it) would not have any other oversight by any other Government ministry or department. It (or the PSUs/government companies) could of course remain subject to regulatory oversight, e.g, RBI or SEBI as applicable.

Relevant News Articles
Sovereign fund may boost India's wealth
31 Jan, 2008, 0002 hrs IST,Deepshikha Sikarwar, TNN

NEW DELHI: While Sovereign Wealth Funds (SWF) owned by big Asian economies invest in assets the world over, Indian policymakers too are looking at whether the country needs to float such a fund. The finance ministry is planning to set up a committee to examine the pros and cons of an Indian sovereign wealth fund.
An SWF essentially helps governments get better returns on the excess foreign exchange reserves they accumulate. Singapore, for instance, earns over 20% annually by deploying its SWFs in diversified assets abroad. India earns less than 5% by investing its forex reserves in US treasury bills. In times of excess capital flows, the return becomes negative as it pays higher than 5% interest rate in sterilising excess dollar flows.
Within the government, at present, there are strong views for and against the country setting up an SWF. The thinking in support of the view has gained momentum after the country’s next-door neighbour China floated a $200-billion SWF, China Investment Corp, in September.
Those arguing against the fund say China is building its corpus from current account surpluses while India remains a current account deficit country. Although setting up an SWF may not be possible immediately, the government wants to begin the groundwork for such a move in future, sources told ET. The committee would also look at what kind of structure would be best for the country if it floats an SWF. It may be pointed that finance minister P Chidambaram recently ruled out any proposal to set up an SWF.
However, the idea of SWF could gain momentum once foreign exchange reserves increase well beyond $300 billion. The country’s foreign exchange reserves stood at $266.55 billion at the end of December.
Those who support the move feel the country could earn better returns if it floats such a fund. However, even as the country debates whether it should have an SWF or not, some SWFs have forayed into the country to reap benefits of its booming economy. Singapore government’s Temasek and Abu Dhabi Investment Agency have been present in the country for some time though the Chinese SWF is yet to make a formal entry into India.
India’s public sector companies emerged as big gainers of the booming stock market during 2007. LiveMint,com December 26, 2007
Save for a few hiccups, such as the resignation of Prahlad K. Basu as chairman of Board for Reconstruction of Public Sector Enterprises (BRPSE), the public sector units, or PSUs, saw a slew of partial sales and listings on bourses.

Even with less than four dozen in number as listed entities, the PSUs account for some 20% share of the overall market capitalization of the more than 4,000 entities at the bourses. In actual terms, led by Oil and Natural Gas Corp. Ltd and NTPC Ltd, total market capitalisation of the listed PSUs was Rs14.5 trillion toward the end of the year. ONGC was the largest contributor with a market cap, nearly 17% of the total PSU market cap. NTPC’s share in the PSU market cap is about 13%.
MMTC Ltd soared and traded as high as Rs56,931 before coming back down to Rs28,143, still well above its 52-week low and, along with NMDC, entered the Rs2 trillion market cap club. The government holds more than 98% stake in the companies.
But this came along with a turf battle among the top listed PSUs—NTPC and Bharat Heavy Electricals Ltd (Bhel), backed by their ministries. NTPC wanted to recreate another Bhel, either on its own or with a partner, to ensure that it gets all the machines and equipment for its upcoming power projects. But Bhel opposed it strongly, saying it had the capability to meet the national demand and there should be no duplication at the cost of national resources. The outcome of this turf war would be known in the future.
Meanwhile, the government gave more powers to the state-owned entities, creating more of the so-called Navratna and Mini-ratna entities, and increasing their decision making powers.
Bharat Electronics Ltd, Hindustan Aeronautics Ltd and Power Finance Corp. were conferred the Navratna status, giving them more financial and administrative powers. With the conferment of the coveted status on these three firms, the Navratna club now has 12 public sector enterprises. The status enabled the three PSUs to forge joint ventures in India and abroad, which can be up to 15% of their net worth or Rs 1,000 crore, whichever is lower, without taking prior permission of the administrative ministry. Besides, the board also has powers to decide on merger and acquisitions.
Heavy Industries minister Santosh Mohan Deb said four PSUs—National Aluminium Co., NMDC, Power Grid Corp. of India Ltd and Rural Electrification Corp. —would be given Navratna status when they appoint independent directors.
The financial autonomy package announced on the basis of the recommendations of the empowered committee, headed by Nitish Sengupta, left very little to desire for the PSUs to acquire competitive age within the country but also hone up skills for global exposure and acquisition.
Steel Authority of India Ltd and Coal India Ltd are globe trotting for mining prospects, while oil giants—ONGC and Indian Oil Corp. Ltd, Bharat Petroleum Corp. Ltd and Hindustan Petroleum Corp. Ltd made new alliances with global players like steel tycoon Lakshmi Mittal or acquire oil equity in Russia or far off Africa.

Beating India Inc in market game, PSUs also fought for turf
NEW DELHI: It is sheer destiny that the public sector emerged as the single largest gainer of the booming stock market during 2007 but the government as the owner also empowered these temples of yesteryears to go global and regain the pristine glory even in a liberalised economy.

Save for a few hiccups, like resignation of Prahlad K Basu as chairman of Board for Reconstruction of Public Sector Enterprises or search for independent directors, the PSUs seem to have overcome their worst with the UPA regime unleashing a programme of part-sale of entities for listing on bourses. Even with less than four dozen in number as listed entities, the PSUs account for over 20 per cent share of the overall market capitalisation of the more than 4,000 entities at the bourses. In actual terms, led by ONGC and NTPC, total market capitalisation of the listed PSUs was over Rs 14,55,000 crore, possibly prompting government to go for more listings.
ONGC was the largest contributor with a market cap of Rs 2,45,082 crore as on November 23. The oil major represented 16.84 per cent of the total PSU market cap. NTPC's share in the PSU market cap is 13.41 per cent at Rs 195,087 crore.
It may be difficult to believe, but an unheard of company in the stock markets - MMTC Ltd - emerged as the most valuable company at the BSE, toppling ONGC, and being quoted at Rs 40,500 along with NMDC Ltd with a share price of about Rs 16,000. The two companies, in which government holds more than 98 per cent stake, entered the coveted Rs two trillion market cap club, becoming most coveted PSUs after ONGC. Shares of NMDC surged three per cent in November to close at Rs 15,834, taking its market cap to Rs 2,09,261 crore, while MMTC gained five per cent to end at Rs 40,460 with a valuation of Rs 2,02,301 crore. But this came along with a turf battle among the top listed PSUs -- NTPC and BHEL, backed by their ministries. NTPC wanted to recreate another BHEL, either on its own or with a partner, to ensure that it gets all the machines and equipment for its upcoming power projects. But the market leader in equipment opposed it tooth and nail, saying it had all the capability to meet the national demand and there should be no duplication at the cost of national resources. The outcome of this turf war would be known in future, but the redeeming feature of the year for the public sector is that the government kept on adding muscle to the state-owned entities. Not only did it create more Navratna and Mini-ratna entities but also increased their decision making powers.
Bharat Electronics Ltd, Hindustan Aeronautics Ltd and Power Finance Corporation were conferred the Navratna status, giving them more financial and administrative powers. With the conferment of the coveted status on these three companies, the Navratna club now has 12 public sector enterprises

Review of FDI Policy

The Union Cabinet has approved changes to the Foreign Direct Investment (FDI) Policy, and increased avenues and limits for foreign investment in certain sectors. These are:

- construction development projects
- civil aviation
- petroleum & natural gas
- commodity exchanges
- credit information companies
- mining
- industrial parks.

For details, see reports in Business Standard and LiveMint.

One sector that is conspicuous by its absence in the recent review is retail trade.

Some Lessons for M&A Deal Documentation

Recent months have witnessed a spate of M&A deals in the US that have turned sour even before they were consummated, and they have quite naturally ended up in court. In pure legal terms, these involve a scenario where disputes arise between the parties between signing of the definitive agreements and closing whereby one of the parties is not willing to perform its obligations under the agreements. This has turned the focus on the deal documentation and its interpretation. There are some lessons for M&A lawyers in other jurisdictions (such as India) too that can be taken away from this.

Most cases have involved the failure of the acquirer to consummate the transaction, and a suit filed by the seller or the target company requiring the seller to complete. Here is a quick summary of the types of principal clauses that have been called into question:

1. Just Say No: Specific Performance versus (Liquidated) Damages

One option for the acquirer to walk away from a transaction by paying damages to the other party (liquidated, in case the damages have been specified in the contract itself). However, it is quite natural for the other party to insist on specific performance of the contract. Which obligation prevails – damages or specific performance?

This scenario was played out in the Cerebrus – United Rentals Inc. Case, which has been discussed in an earlier post on this blog. The Delaware Court of Chancery in that case interpreted the contract as not imposing an obligation on Cerebrus to complete its acquisition of United Rentals Inc.

2. Material Adverse Effect (MAE)

This is sometimes also known as MAC – for material adverse change.

It is not unusual for an MAE clause to give the right to an acquirer not to consummate the acquisition transaction in case MAE occurs between signing and closing. An interpretation of one such clause came up before a Tennessee Chancery Court in the Genesco – Finish Line Case. In this case, Finish Line refused to complete an acquisition of Genesco on the ground that there had been a material adverse change, specifically deterioration in the financial position of Genesco. Consequently, Genesco sued for specific performance.

The MAE clause in the agreement (section 3.1(a)) was worded as follows:

““Company Material Adverse Effect” shall mean any event, circumstance, change or effect that, individually or in the aggregate, is materially adverse to the business, condition (financial or otherwise), assets, liabilities or results of operations of the Company and the Company Subsidiaries, taken as a whole; provided, however, that none of the following shall constitute, or shall be considered in determining whether there has occurred, and no event or circumstance, change or effect resulting from or arising out of any of the following shall constitute, a Company Material Adverse Effect: (A) …; (B) changes in the national or world economy or financial markets as a whole or changes in general economic conditions that affect the industries in which the Company and the Company Subsidiaries conduct their business, so long as such changes or conditions do not adversely affect the Company and the Company Subsidiaries, taken as a whole, in a materially disproportionate manner relative to other similarly situated participants in the industries or markets in which they operate; ….”
In its order, the Tennessee Chancery court interpreted the clause above in the context of the events that led to a deterioration of the financial position of Genesco, and concluded that the decline in Genesco’s performance was to due to the general economic conditions and was not disproportionate to its peers in the industry. Therefore, the transaction fell squarely within the “carve-out” to MAE in sub-section (B) of section 3.1(a), and as there was no MAE, the court ordered specific performance.

The matter is now on appeal.

3. Failure of Conditions Precedent

This scenario involves a position taken by the party unwilling to complete that one or more of the conditions precedent to closing have not been satisfied. For example, where certain regulatory approvals are required, the transaction cannot be consummated unless the approvals have been obtained (without any unduly onerous conditions or requirements).

This very situation is the dispute in the Alliance Data Systems (ADS) – Blackstone Case, where Blackstone (the acquirer) is faced with certain financial and operational requirements imposed by the Office of Comptroller and Currency (OCC) while approving its acquisition of ADS. For a brief analysis of this situation and the possible outcomes, see The Deal Professor.

As this report indicates, the dispute has just ended up in court, and we can expect an outcome on the interpretation of the conditions precedent clause.
(Update – February 5, 2007: For a list of the various clauses in M&A agreements that have been called into question in recent deals, see a post titled Is M&A Dead? on the Deal Professor)

Company Information in India

The Harvard Business School (HBS) Working Knowledge carries an interview of Professor Tarun Khanna of HBS in connection with the release of new book “Billions of Entrepreneurs in India and China”. An excerpt from the book (which compares India and China on a broad range of factors) deals with the availability of company information in India with some references to the nature of the legal system:

“Is it easier to find reliable information about a company in India?

Yes. First, as a result of a legal system derived from the common-law tradition, annual reports provide the rudiments of information that Western observers expect, and familiar rules govern corporate disclosure. Real-time stock market data are readily available on all publicly traded companies, a result of vigorous competition between the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).

Private-sector intermediaries in India use business models that include information synthesized from company disclosures and intelligence that they gather from the ground. The Centre for Monitoring Indian Economy (CMIE), for example, is a privately owned clearinghouse for reliable information on publicly traded firms and some privately held firms in India. Founded in 1976, CMIE is the brainchild of the entrepreneur Narottam Shah. Numerous credit-rating agencies work off the primary information available from companies and from CMIE to provide risk analyses for debt claimants.”
He then goes on to talk about the vibrancy of the press in India. Further, he states:

“Indian companies and financial institutions are not free from fraud and error. On the contrary, India's financial scan of 1992, which I discuss at some length in a subsequent chapter, was at least as egregious as the stock market fever that gripped China in the same year. Both countries have seen their share of financial shenanigans, but their responses to the systemic problems in their financial sectors could not be more different. India celebrated information and embraced competition and market forces, whereas China left intact and arguably strengthened government control of the stock exchanges.”
It is not clear whether these remarks can be taken to reflect the general nature of corporate transparency and availability of information in India, but Professor Khanna’s observations indeed show that India fares better on this count than China on a comparative basis (which is really the substance of his study).

Tuesday, January 29, 2008

SEBI: Proposal on Integrated Disclosures

An aspect of the Indian securities regulations that has always been somewhat puzzling is the stark disparity in the disclosure regimes governing the primary markets and secondary markets. While a strong disclosure regime has been a boon to the primary markets where companies making a public offering are required to issue a prospectus with fairly onerous disclosure requirements accompanied by stiff liability provisions, an equally weak disclosure regime in the secondary markets has been a malaise in the secondary markets which function with far less continuing disclosure obligations on companies that are already listed on the stock exchanges. As an earlier post on this blog had noted:

“In the Indian context, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 that have been strengthened over the years, impose strict disclosure norms on companies issuing capital to investors. However, this is applicable only when companies make public offerings (an initial public offering (IPO) or a follow-on public offering (FPO)) or qualified institutional placements (QIP) of shares to investors; these are typically known as primary market transactions. But, once the shares of the company are already traded on the stock exchange, the obligations of companies to make disclosure are much less severe. Hence, a person who buys shares of a listed company on the stock exchange in a secondary market transaction has far less information compared to a person who purchases shares in a public offering. This causes many retail secondary market investors to acquire shares in overvalued stocks during a boom without having understood the fundamentals of the company and the economy. This disparity between disclosures in primary market transactions and secondary market transactions may require correction by SEBI.”
As to the sources of law governing disclosures, primary market transactions (offerings by companies or selling shareholders) are governed by the SEBI (Disclosure and Investor Protection) Guidelines, 2000, which are fairly detailed, while secondary market disclosures (or continuing disclosures by existing listed companies) are governed by the listing agreement with the stock exchanges (clause 41 and other related provisions) which require far less disclosures on a continuing basis (and these too are mainly related to financial reporting).

As a measure to address this problem, SEBI yesterday announced that the Sub-Committee on Integrated Disclosures has submitted its report for standardizing and streamlining the corporate disclosures by integrating initial disclosures made under an offer document with the continuing disclosure requirements after a company gets listed. The report states:

“The goal of reduction of duplication and a holistic approach to disclosures can come about only when we are able to move from registration of issue of securities to a model where the company itself is registered. Under the proposed structure, there will be a need to strengthen the existing disclosure norms so that information which is sought only at the time of issue of capital becomes generally available not only to investors of new securities but to the existing shareholders as well. As a result, full disclosures would be enjoyed by a larger class of investors and potential investors; at the same time, by avoiding duplication, issue costs would come down. Seasoned companies with a reliable track record would be able to raise capital easily and at a lower cost.”
For those of you who are interested in the modalities for integrated disclosures, these are extracted below from the Report:

"A major benefit of the proposed fungibility between initial disclosures (prospectus) and continuous disclosures (various disclosures like the annual report, quarterly reports, stock exchange notifications etc.) would be the reduced cost of compliance. Thus, if a company goes to the capital market for the first time in an IPO, it would find that because of the fungibility of company information, the cost and effort in continuing disclosures and in creating an annual report would get reduced drastically. Conversely, a seasoned listed company (which is listed for over 1 year and is in compliance with the various relevant enactments) already has the company information out in the public domain and thus could merely copy and paste the information along with any material updates and transaction based information, whenever it is required to prepare an offer document. An even more efficient means of integrating the information would be to incorporate the company information by reference into a prospectus. Such incorporation by reference exists in the US markets. Of course, any updates since the last annual/quarterly reports must be published as material updates in the prospectus along with the transaction based information about the securities on offer. Further, the integration will not dilute the liability of the issuer, directors, merchant bankers and others who must continue to carry out necessary due diligence before raising of capital by the company. Thus integration could reduce the cost of compliance while at the same time improve the disclosures being made to the investors.

Even without incorporation by reference, there will be two benefits of the above exercise. One, the same set of information and the same format will be used for making public company information whether it is the primary market disclosures or the secondary market disclosures. Conversely, even if a company is a first time issuer of equity capital, its continuous disclosures would be cast in the same die as the company information in the prospectus (as described in the previous paragraph) - thus making disclosures transferable and fungible. Second, continuous information will be substantially strengthened, eliminating the bias the current regulatory framework has towards protecting primary market investors over protecting secondary market investors. An efficient means of integrating could be by using a single set of regulations which gives a descriptive line item of company information. For instance there would be line items of: Description of Business, Description of Property, Legal Proceedings, Financial Data, MD&A (company information), Contents of First Page of Prospectus, Types of Securities Offered, Disclosure of Selling Commissions (transaction information). This master set of regulations can then be used with different forms. For instance, to draft a prospectus, one would use Company information and transaction information from the various line items. Similarly for a rights issue a simpler set of line items would be used from the same pool of items. A listed company which is coming to tap further capital thus can incorporate by reference the company information and use only the transaction information in its prospectus. For an annual report, one would tap the same pool and take only the company based information.”
This essentially introduces a master set of disclosure regulations from which companies can adapt and choose specific line items depending on the nature of disclosure required, e.g. for a initial public offering, rights issue, follow-on public offering or even annual or other continuing disclosure. Further, companies have the option of incorporating by reference other information (such as annual report or other financial statements) into offer documents.

This streamlining of disclosures was long overdue and will go a long way in integrating the primary and secondary markets. This is consistent with the U.S. SEC requirements that provide for a master set of disclosures in the form of Regulation S-K (for non-financial information) and Regulation S-X (for financial information) from which companies are required to borrow specific line items depending on the nature of disclosure required to be made. It would also make newer types of issuances (such as shelf-registration and fast-track offerings) more meaningful, for where companies have already made adequate continuing disclosures, this scheme would largely cut down the disclosure to be made at the time of shelf-offerings or fast-track public offerings.

Comments are due on the Report and the draft disclosure requirements by March 15, 2008.

Lessons from the Turmoil

Today’s Business Standard carries an editorial that deals with possible regulatory responses to financial markets crises, a theme also addressed in a recent post on this blog. Here is an excerpt from the editorial:

“The history of financial regulation shows such regulation is rooted in crisis. Significant regulatory change usually takes place in response to the perceived inability of the previous regime to anticipate and prevent a crisis. This is not in and of itself a negative attribute. Any attempt to envisage every possible scenario and build in regulatory safeguards in anticipation can completely stifle innovation. However, it is critical that the right lessons are learned from every crisis. The true test of a regulatory system lies in its ability to avoid the same crisis a second time around.”
The entire editorial is worth reading, and is not very long (only 4 paragraphs!).

Monday, January 28, 2008

Miscellaneous: Stock Exchanges; Online IPO Applications

There are two pieces in the Economic Times today that deal with stock exchange operations and electronic settlement in IPOs.

1. Alternative Trading Systems

The first is an op-ed by C K G Nair and M S Sahoo that explains the metamorphosis that the stock exchanges are undergoing. They write:

"For the past few years SEs have been in the process of shedding their old skins to look young and to remain vibrant. Organisational innovations (corporatisation and demutualisation), institutional innovations (emergence of regulators and self-regulatory organisations - SROs, clearing corporations), market innovations (alternate trading systems — ATSs), outsourcing and technological changes have been making the SE horizon too narrow prompting questions on their very relevance.

Interestingly, some of these have been autonomous changes, willingly adapted and adopted by the SEs.

Electronic communication networks (that facilitates trading of securities among its subscribers), crossing networks (that matches orders for execution without first routing to a SE), negotiated dealing system (which matches orders in government securities) are market innovations that challenge the core functions of the SE.

Similarly, there are electronic systems which display buy-sell quotes of counter-parties to enable the buyers and the sellers in the corporate bond market to strike deals either at the SE or bilaterally. These ATSs, some of which are called ‘dabba trading’ in Indian context, are diverting trades from SEs.

The unbundling bandwagon has made heavy inroads into SE operations. Many specialised service providers have taken up core functions of the SE. Specialised securities settlement systems have come up the world over to handle post-trading activities."

Since stock exchange operations are being fragmented and spread out over several entities, it gives rise to some interesting legal issues:

“Thus trading, clearing, settlement, market regulation, listing and broking are no more the exclusive prerogative of SEs. There is no function which is core or exclusive to a SE. While core functions of a SE are being taken over by/transferred to other agencies, the definition of ‘stock exchange’ in the Securities Contracts (Regulation) Act (SCRA) in India hardly protects the turf of the exchange.

The SE under the law is a body corporate, incorporated under the Companies Act, for the purpose of assisting, regulating or controlling business of buying, selling or dealing in securities. Thus, all corporate intermediaries in securities market, all of whom assist in dealing in securities, are SEs while the negotiated dealing system which provides trading platform for government securities is not.

Are the SEs only to implement the regulations made by statutory regulators? That too, when they have limited enforcement powers and they operate in competition with the less regulated new world of ATSs? Or else, do the ‘traditional’ SEs still perform an essential function in capitalism?

Yes, they do. SEs are legal entities having full statutory backing in all jurisdictions, while ATSs are far from achieving such an overarching statutory backing even in the jurisdictions they are permitted.

Legal vacuum is a major constraint in the growth of markets and organisations such as exchanges that fill up the void become institutions. The cost of regulation of a market with no exchange like central facilitator and with overcrowded, thinly legalised multiple commercial entities, will be too high and impractical.”

This gives food for thought and the need for possible further research, especially under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities Contracts (Regulation) Rules, 1957.

2. Online Investing in IPOs

An editorial suggests that IPOs applications need to be shifted to the electronic mode to speed up the application process for investors from the current 20-day period from application to refund. It states:

“Better process management can shave off a few days at the most, but certainly not compress it to seven days that SEBI is reported to be targeting.

For that to happen retail applications, at least a substantial portion, would have to shift to the electronic mode. This sounds a big task, but is doable because a good part of the information such as address and bank account details going into a physical IPO application is already available with depositories. Suitable software can import all that information on to an online form through the investor’s unique depository number or PAN.

All that the investor would then need to mention is the bid amount and submit the check. This would require greater number of application centres, but post issue closing work would be cut down substantially. In fact, in such a situation even banks and post offices could also collect applications for a fee.”

This raises an important question as to why IPO applications are still required to be made in physical form while several other processes, including filings with the Government (for example the MCA-21 under the Companies Act, 1956) can be made online. Perhaps the time is opportune for a change in the process.

More on the “Decoupling” Theory

The previous two posts (here and here) have argued that the “decoupling” theory, when it comes to emerging markets (like India and China), is a myth. Here is some additional analysis in an article in the Economist:

“INVESTORS were until recently big fans of the “decoupling” theory, the notion that Asian economies can shrug off an American recession. This week's plunge in share prices, at one point taking the MSCI Emerging Asia Index down 25% from its October high, suggests they have changed their minds. But the fact that their stockmarkets are still coupled does not mean that their economies will follow America over a cliff.

Decoupling was always a misnomer if it implied that an American recession would have no impact in the East. Exports and hence profits would certainly be squeezed; some fear Japan may even be tipping back into recession (see article). Instead, the real argument in the rest of Asia was that it would suffer less than in previous American downturns.”
The article also ends with a caution that the argument against decoupling may have been overplayed to an extent:

“Slowing exports will affect domestic spending. But macroeconomic fundamentals are much healthier in East Asia these days. Large foreign-exchange reserves make countries less vulnerable to shocks. Budgets are in surplus or close to balance, providing more scope for fiscal stimulus to support growth.

For all these reasons, even if Asia's exports clearly have not decoupled from America, its economies will be less hurt by a recession there than in the past. Standard Chartered forecasts that emerging Asia will grow by an average of 6.4% in 2008, down from 7.8% in 2007. In 2001 growth dropped by three percentage points, to 4.2%. Financial markets were slow to realise that growth and hence profits in some countries in emerging Asia will be dented by an American downturn. But now they risk exaggerating the potential damage.”

Sunday, January 27, 2008

Stock Market Turmoil and the Role of Regulation

This is a cross-post from the Law and Other Things blog, to which also I contribute.

Riding the downward tide of the global capital markets, Indian stock prices too tumbled 1,408 points on Monday, January 21, 2008 making investors poorer by $155 billion in a single day. The rout continued on Tuesday as well, before the markets partially recovered towards the end of the week. Reports indicate that investors have lost Rs. 18.05 trillion in 7 days; many of them saw their life-savings being wiped-out while some went bankrupt. The Gujarat police despatched a posse of policemen to secure Ahmedabad’s largest lake – yes, there is a connection – due to the fear of suicides by distraught investors and brokers.


Several reasons have been proffered for the Indian stock market crash. First is the fear of a recession in the United States (US) sparked by the subprime crisis, which is expected to have an impact on the global markets. The Economist reports (in the general context of the global crash):
“For some, this merely represents a case of stockmarkets catching up with reality. It is now a year since the subprime crisis first emerged. In that time central banks have cut interest rates, investment banks have announced big write-offs and various rescue packages have been suggested. But the end of the crisis is not yet in sight. Indeed, another leg of the debt crisis may be under way, if problems of monoline debt-insurers (an obscure but important bunch who guarantee the timely repayment of bond principal and interest when the issuer defaults) are not contained. If the American economy is not now in recession, it is close enough not to make a practical difference to sentiment.

For much of past year equity investors knew those salient facts but chose instead to take comfort from three more bullish factors. First was that the Federal Reserve would rescue both the markets and the economy, as it has done so often before. Second, even if the American economy faltered, the rest of the world (particularly Asia) could take up the burden of producing global growth. Third, given the global picture, corporate profits could stay high.

All three assumptions are now coming under question. … An indication of the change in sentiment came when America's administration announced plans for a fiscal stimulus on Friday. In good times, that would have kick-started a market rally; in the current mood, the package was seen as a sign of desperation.”
The second reason attributed to the Indian stock market’s decline is massive divestment of Indian stocks by hedge funds and foreign institutional investors (FIIs) either to cash in on the previous bull run in the Indian markets or as a result of reallocation of their investment portfolios arising out of the battering they may have taken due to the US subprime crisis and the lack of liquidity. The global movement of capital in and out of countries (including India) may have caused stocks to turn volatile.

The third is tight domestic liquidity position caused by investors blocking their money in large IPO applications such as that of Reliance Power and Emaar MGF.

The fourth is several chinks exposed in the financial markets’ infrastructure. Just to list a few (and these may not be the only ones), stock exchanges required brokers to pay additional margin money amid declining markets, but brokers were unable to do so as payments from their clients were still awaited as cheques take at least 2 days to clear for the brokers to obtain money from their clients. It has been argued that there is a mismatch between the financial market system and the banking system in terms of timing. Some have gone even further and argued that the margin system enforced by SEBI and stock exchanges is itself questionable (see this column by Surjit Bhalla in the Business Standard).

Last, but not the least, is the omnipresent spectre that pervades any stock market crash – the idea of “irrational exuberance” (a phrase said to have been coined by the former chairman of the US Federal Reserve, Alan Greenspan) on the part of investors and overvaluation of stocks which results in a correction of the markets at some point in time. Some see this as the correction of the markets bringing them down to their real levels.

The Debate

Speaking for myself, it may still be early days before blame can be pinpointed on any single person or institutions or groups of them for either triggering off the present crisis or failing to take adequate steps to prevent or mitigate such a crisis. This may require an in-depth study of the turn of events. Unlike certain previous stock market crises (which have been termed “scams”, and appropriately so), there yet appear to be no allegations of shenanigans in any of the market players. Readers will recollect that the 1992 scam was largely attributed to the (mis)conduct of the late Harshad Mehta, while the 2001 scam to broker Ketan Parikh. Those scams did propel the Government to set up Joint Parliamentary Committees (JPC) to investigate the actions of various parties involved in stock market transactions. I am yet to come across either any such allegations of deviousness or any calls for such a JPC in this case.

This episode nevertheless has assumed political proportions. The Government, speaking through the Finance Minister has reiterated that the fundamentals of the Indian economy are strong, and that the market fall is attributable to continuing uncertainties in the global economy. Unsurprisingly, the BJP and the CPI have refused to buy the Government’s argument. The BJP has not only demanded intervention by SEBI, but has also blamed the Finance Ministry and SEBI for allowing overvalued IPOs, not restraining over-speculation and not improving the faulty settlement mechanism. Not to be left behind, the CPI alleges ‘malpractices’ in the stock markets that led to the crash (without further substantiation) and has called for an increase in the securities transaction tax.

All this begs the question: would the existence of a better regulatory system governing markets have prevented the turmoil? Should the financial market regulators (the Finance Ministry, SEBI and RBI) have taken measures to prevent the occurrence of such a crisis? Does this episode demonstrate the need for tighter governmental regulation on financial markets?

Role of Regulation

Since events are still unfolding and we do not have intricate details of acts by market players, and further there is no evidence of egregiousness or fraud, this analysis will necessarily have to be limited to the reasons for the crash as set out earlier in the post. The reasons can be categorized into three types: (i) external shocks (US recession, subprime crisis and sell-down by hedge funds and FIIs), (ii) internal system failures (illiquidity due to large IPOs and failure of markets’ infrastructure), and (iii) irrational exuberance of investors (overvaluation of stocks).

1. External Shocks

This seems the most plausible reason for the crash on the Indian markets. Not only does the crash come in the wake of the subprime crisis and fears of a US recession, it correlates directly with the decline in markets all over the world; it is not as if this was a phenomenon isolated to India. To blame Indian regulators for this would not hold water. It is nothing but the result of globalization and free flow of capital across the world. That naturally leads me to my next point. One important lesson that the Indian financial regulators can learn from this, though, is that “decoupling” of emerging economies (like India and China) from those of the developed economies (like the US and Western European nations) is a myth. Events that occur in one part of the world are bound to have a serious impact in other parts of the world. It seems to me that the turmoil of last week takes a further step in silencing the proponents of the “decoupling” theory. It is important that the Indian financial regulators recognize this while tailoring their policies for the financial markets.

Let us look at the menu of options available to the policy makers. A safe option would be to revert to the protectionist policies that were followed before India embarked on its new economic policy in 1991. While that would effectively insulate India from global volatility, this is not something one would advocate because we are not only far ahead down the path of economic liberalisation but any such stance would lead to India’s economic isolation. The other option would be to let the market control events (and correct itself) and hence impose minimal governmental regulation. But, to embrace dogmatic capitalism and a laissez-faire approach would be counterproductive. The path that the Indian regulators have adopted is somewhat of a midway approach of progressive liberalisation and de-regulation.

India still does have several restrictions on foreign investment, both on the strategic side and the portfolio side. On the portfolio side, which is what the stock markets are largely concerned with, SEBI has prescribed regulations for foreign institutional investors (FIIs) that require FIIs to register with SEBI and also imposes various curbs on their conduct. More recently, SEBI has placed severe restrictions on investments by hedge funds and required them to “come through the front door” (a statement attributable to the SEBI Chairman, Mr. M. Damodaran) rather than investing through the opaque participatory note (PN) structure that they hitherto used. Despite resistance from market players as being a harsh move and the consequent mini-market-crash in October 2007, SEBI did not relent under pressure and persisted with the rule, which became final on October 25, 2007. India is one of the few nations that tightly regulate hedge funds, in as much as this move is constantly pounded with criticism from the western media as indirect strengthening of capital controls on the Indian economy. The reader might well ask: why then was there a sell down in last week’s turmoil purportedly by hedge funds and FIIs that SEBI could not prevent? Perhaps the answer lies in the fact that the revised regulations on hedge funds are not only new, but also have inbuilt time periods (e.g. an 18-month period) for parts of it to come into effect.

While regulators or regulations cannot prevent external shocks altogether, measures can be taken to mitigate its impact.

2. Internal System Failures

While the external shocks seem primarily responsible for causing the markets to tumble, the downfall may have exacerbated by internal system failures. These include settlement-related issues, margin requirements, circuit breakers and other technical matters involved in stock trading and stock exchange operations. This does give rise to the need for introspection – perhaps it is this precise area where regulatory reforms will play a significant role to prevent recurrences. SEBI needs to investigate further to identify the systemic failures in the financial markets and make suitable modifications and corrections to the system with the assistance of financial market experts.

3. Irrational Exuberance

Investors pump money into the stock markets in the expectation that the price of their stock will go up and provide (sometimes quick) returns. But, often stocks are overvalued and investors enter the markets during a boom and then suffer losses when there is a subsequent downfall. The criticism is that investors make investment decisions without regard to the underlying fundamentals of either the company in which they invest or the economy itself. What role can regulation play here, and is there always a failure of regulation when markets go on a downward spiral and cause losses to investors?

At the outset, I find it hard to sympathize with the position that the government should be blamed for all the adverse outcomes (and consequent ill-fortunes) of its citizens’ financial choices. Financial markets are risky indeed, and it is not everyone who plays in that market that can absorb or handle the risk involved. Is it right to ask the government to adopt a paternalistic attitude and protect all investors against such risks? If not, to what extent can investors rely on the government for protection?

There are two types of investors. One consists of the institutional investors, such as FIIs, hedge funds, banks, insurance companies and so on, or individual investors such as high-net worth individuals, who possess a certain level of sophistication – their funds are managed by qualified and experienced investment managers. Such sophisticated investors may require less regulatory protection as they are well aware of the risks of the stock market; they are also well funded and capitalized to absorb shocks.

It is the second type of investors, the men and women on the street (referred to as retail investors) that do not possess knowledge and sophistication when it comes to investment matters, who beseech governmental protection. They often invest their life-savings that sometimes turn into dust, as many of them experienced during last week’s meltdown. While law and regulation cannot hand-hold such investors and protect them from their irrationalities, it can certain equip them and provide them with enough information and knowledge that can help them make rational choices. Regulators lay down disclosure norms that require companies to publish all investment risks in their offer documents.

In the Indian context, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 that have been strengthened over the years, impose strict disclosure norms on companies issuing capital to investors. However, this is applicable only when companies make public offerings (an initial public offering (IPO) or a follow-on public offering (FPO)) or qualified institutional placements (QIP) of shares to investors; these are typically known as primary market transactions. But, once the shares of the company are already traded on the stock exchange, the obligations of companies to make disclosure are much less severe. Hence, a person who buys shares of a listed company on the stock exchange in a secondary market transaction has far less information compared to a person who purchases shares in a public offering. This causes many retail secondary market investors to acquire shares in overvalued stocks during a boom without having understood the fundamentals of the company and the economy. This disparity between disclosures in primary market transactions and secondary market transactions may require correction by SEBI.

Another area to protect individual investors is through investor education. Though SEBI and the Ministry of Company Affairs have initiated several programmes to this end (here is SEBI’s Investor Awareness site) they do not appear to have gathered enough steam. This is an area where regulators can play a far greater role in minimizing the damage caused to investors in case of market turmoil.

Suggestions have been made (by the CPI General Secretary, A. P. Bardhan in particular) that the securities transaction tax (STT) must be heavily hiked from its current rate of 0.1%. It is not clear if this is mere rhetoric or how this proposal will help, as it will still be the individual investors (in addition to the other investors of course) who will have to bear the burden of the additional outgo.

In sum, the recent market turmoil has exposed the need for further regulatory action to safeguard investors in the Indian markets as we have seen above, but it is my belief that commentators are overplaying the scenario and taking it too far by attributing the crisis to regulatory failure. The crises would have occurred anyway, but its blow could have been softened with better regulation.

The ShockGen Effect

On a slightly different note, but still remaining within the confines of financial market regulation, a single trader named Jerome Kerviel belonging to Societe Generale (SocGen) was reported last Thursday to have caused the bank a loss of over €5 billion in the largest ever fraud in the investment banking history. He is said to have far exceed his sanctioned trading limits, manipulated computer records and created elaborate fictitious hedging limits to cover up his scheme, and still managed to remain undetected for almost 10 days despite high levels of compliance controls. Query: will any number of regulators or any amount of regulation have prevented this crisis?

Tuesday, January 22, 2008

The Asian Stock Market Meltdown

The oft-repeated adage that goes “when America sneezes, the rest of the world catches a cold” was proven to be true once again when stock markets across Asia crashed, some to record levels. The Indian markets were not to be spared—the Sensex tumbled 1,408 points on Monday, and share prices continued to dive today on opening of the markets when trading had to be halted.

It is indeed intriguing that such devastation did not occur sooner, though the effects of the subprime crisis were largely known by the middle of 2007. The Economist has some answers for this phenomenon:

“For some, this merely represents a case of stockmarkets catching up with reality. It is now a year since the subprime crisis first emerged. In that time central banks have cut interest rates, investment banks have announced big write-offs and various rescue packages have been suggested. But the end of the crisis is not yet in sight. Indeed, another leg of the debt crisis may be under way, if problems of monoline debt-insurers (an obscure but important bunch who guarantee the timely repayment of bond principal and interest when the issuer defaults) are not contained. If the American economy is not now in recession, it is close enough not to make a practical difference to sentiment.

For much of past year equity investors knew those salient facts but chose instead to take comfort from three more bullish factors. First was that the Federal Reserve would rescue both the markets and the economy, as it has done so often before. Second, even if the American economy faltered, the rest of the world (particularly Asia) could take up the burden of producing global growth. Third, given the global picture, corporate profits could stay high.

All three assumptions are now coming under question. … An indication of the change in sentiment came when America's administration announced plans for a fiscal stimulus on Friday. In good times, that would have kick-started a market rally; in the current mood, the package was seen as a sign of desperation.”
The Government has, unsurprisingly, advised investors to stay calm. The Economic Times reports that the Finance Minister Mr. P. Chidambaram has based this advice on the fact that the fundamentals of the Indian economny are strong. The news report further quotes: "The economy will grow this year at close to 9.0 percent and even according to Dr. Rangarajan's committee report it will grow 8.5 percent next year."

However, even to a person like me who is not an economist, it is becoming clear that the decoupling of markets (such as India and China) from the US economy or other major markets is a myth in this increasingly globalizing world, and this episode is one additional piece of evidence pointing towards that direction. Any policies of the government for regulating the markets will have to necessarily take this crucial factor into account.

Sunday, January 20, 2008

Competition Commission: Draft Merger Regulations Now Available

An earlier post on this blog noted the concerns of the industry relating to the merger regulations proposed by the Competition Commission and also certain comments made by the acting chairman of the Competition Commission of India to allay any fears of the industry.

The proposed draft of the Competition Commission of India (Combination) Regulations, 200_ that deal with merger regulation were made available on the website (here) of the Commission a couple of days ago. This development has somehow failed to catch the attention of the mainstream business media as yet.

The draft regulations do address some of the concerns raised by the industry, but several issues still remain open. Upon a quick review of the draft regulations, the following appear to be the key aspects of the regulations:

1. De minimis transactions and other exceptions

The regulations seek to keep certain types of transactions outside the purview of the regulations by deeming these categories as not likely to cause an appreciable adverse effect on competition in India.

First of these relates to acquisition of shares or voting rights by a party solely as an investment or in the ordinary course of business so long as such acquisition does not exceed 26% shares in the target company. These are a fairly common type of transactions in the realm of mergers and acquisitions. However, the transaction should not result in the acquirer obtaining “control” of the enterprise being acquired. This is clearly intended to allow transactions by acquirers that do not seek to take majority stakes in companies. A stake of 26% (that is not likely to cause an appreciable adverse effect on competition) would enable the acquirer to exercise negative rights by blocking special resolutions that require 75% majority in order to be approved.

One area that seems to be ambiguous and needs further clarity pertains to the meaning of “control”. This is important as the exemption from pre-merger notification does not apply to transactions where the acquirer takes control. What are the parameters for defining control? Would the existence of board nomination rights by the acquirer and its other management related provisions amount to control? Do supermajority voting rights given to the acquirer (whereby its approval is required for the company to carry out a set of defined actions) amount to control? These matters are left to interpretation in the present draft of the regulations, and further clarity would be required if disputes are to be avoided. Past experience indicates that despite the existence of a detailed definition of “control” under the SEBI Takeover Regulations, the issue has been a subject-matter repeated discussions and deliberation between corporates, advisors and regulators. In that background, a broad definition of control (as there presently exists in the Competition Act and regulations) would only exacerbate the problem.

Other transactions that do not cause appreciable adverse effect on competition include:

- acquisition of assets not directly related to the business activity of the acquirer or made solely as an investment or in the ordinary course of business, not leading to control of the enterprise;
- acquisition of shares of a subsidiary by a parent company;
- acquisition resulting from gift or intestate or testamentary succession or transfer by a settler to an irrevocable trust;
- acquisition of current assets in the ordinary course of business;
- acquisition by underwriter in the ordinary course of business and in the process of underwriting;
- acquisition under a bonus or rights issue.

2. Timeframe for Approval

A key objection from the industry to merger regulation has been the inordinate delay that the merger regulation and approval process can cause to the implementation of a transaction. The Competition Act, 2002 (as amended in 2007) grants a period of 210 days (or approximately 7 months) for the Competition Commission to revert on a pre-merger notification, until which time the transaction cannot be given effect to. Industry’s argument was buttressed by the fact that other key competition regulators globally (such as the US and EU) had imposed a much shorter period of 30 days for approval.

The draft regulations arrive at some sort of a compromise by introducing the requirement of the Commission’s opinion on prima facie case within 30 days from the date of a pre-merger notification by the parties. Where the Commission forms a prima facie opinion that the combination is not likely to cause an appreciable adverse effect on competition within India, the Commission would convey the same to the parties. Where the opinion is formed the other way, then the transaction would be subject to the detailed investigation process that could potentially last 210 days.

While this compromise evidences the intention of the Commission to act much faster than it is mandated to under the Act, the proof of the matter will lie essentially in its implementation. This would also depend on the staffing of the commission, the speed with which its administrative machinery moves and such other matters that are beyond the letter of the law. What is surprising is that the intention to shorten the time frame for approval is not accompanied with any sanctions. For instance, it is not clear as to what happens if the Commission does not communicate its prima facie opinion within the time frame of 30 days. While there is a fairly strong sanction if the Commission does not act within the 210 day period for approval (where the transaction will be deemed approved by the Commission), no such provision exists for the 30-day prima facie opinion provision. This is a matter that requires fine-tuning by the imposition of incentives (or disincentives, as the case may be) on the Commission to ensure that it acts within the 30-day period, failing which there could be problems relating to the implementation of this shortened time frame.

These are just some observations on the key provisions of the combination regulations, and I will post further if I find any other matters that are noteworthy on this count.

(Update: The Economic Times carried a column on February 1, 2008 that discusses the implications of the merger regulations)

Friday, January 18, 2008

IPOs: Listing Day Price Band

Initial public offerings by companies are beset with the aspect of what is known as ‘underpricing’. This is when companies accessing the capital markets for the first time experience a significant jump in the stock price on the first day of trading. This works to the advantage of investors who have been allocated shares in the IPO, as they benefit from selling the shares on the first day of trading and making a quick profit from the IPO.

In order to curtail such activities, in a proposal announced yesterday, SEBI is considering the imposition of a 25% price band on the issue price on the first day of trading of an IPO stock.
The price band applies only to issuances up to Rs. 250 crores (Rs. 2.5 billion), as studies (by way of back testing) have revealed that first day fluctuations are rampant in such small offerings, and not when it come to large offerings.

SEBI’s proposal is laudable as it introduces a further level of orderliness in the IPO process, including its possible impact on price discovery and allocation to investors. However, questions such as whether this should be limited to offerings of only up to Rs. 250 crores and whether the method of fixing this number (based on evidence from recent IPOs) is appropriate remain open, and these will likely be the subject of comments on the proposal.

Comments are invited by SEBI until January 31, 2008.

(Update – January 21, 2008: Here is an editorial in the Economic Times on SEBI’s proposal)

Thursday, January 17, 2008

Faith-Based Indexes on Dow: For Hinduism and Buddhism

The Prime Newswire reports that Dow Jones Indexes and Dharma Investments, a leading private investment firm pioneering the development of faith-based investment have launched the Dow Jones Dharma Indexes. The new indexes measure the performance of companies selected according to the value systems and principles of Dharmic religions, especially Hinduism and Buddhism.

The report adds:

“To be included in the Dow Jones Dharma Indexes, stocks must pass a set of industry, environmental, corporate governance and qualitative screens for Dharmic compliance.

Industry screens include unacceptable sectors and business practices. Environmental screens take account of a company's impact or policies with respect to emissions, climate change and carbon footprint analysis, oil and chemical spills and waste management and recycling. Corporate Governance screens comprise the handling of labor relations/disputes/discrimination allegations, human rights violations, working conditions/wages.

Excluded from the index are companies from sectors that are deemed unacceptable due to the nature of their business activities and operations. Excluded are also companies that have exposure to unacceptable business practices. Some examples of unacceptable sectors are aerospace and defense, brewers, casinos and gaming, pharmaceuticals, tobacco. Some examples for unacceptable business practices are alcohol, adult entertainment, animal testing and genetic modification of agricultural products.”

That does take the concepts of corporate governance, corporate social responsibility (CSR) and socially responsible investing (SRI) to a new level.

Competition Commission and Merger Regulation

The Competition Commission is working on the draft of the Competition Commission (Combinations) Regulations, which are expected to be announced shortly. Due to concerns from the industry regarding these regulations operating as a serious hurdle to M&A activity in the country, there are indications that the Competition Commission will introduce provisions in the draft regulations that are likely to assuage industry concerns.

One such concern is that the current proposals would attract even transactions that are very small in size, and thereby unnecessary add costs and complexities to the system. However, as the Business Standard reports, the Competition Commission is considering the introduction of de minimis provisions that will let small transactions get by without scrutiny:

“Vinod K Dhall, the acting chairman of the Competition Commission of India (CCI), is putting several provisions in its draft regulations to address industry’s fears that the commission will stall mergers and acquisitions.

The fears have mounted since Parliament cleared the Competition Act, 2002, under which the government set up the commission five years ago.

Acutely aware of the concerns, Dhall is putting in de minimis (of minimum importance) provisions in the commission’s draft regulations so that not all M&As have to come to the commission.

Already, in the case of cross-border mergers, there is no need to notify the commission unless the merged entity has Rs 500 crore in assets or Rs 1,500 crore in turnover in India.

The commission is likely to incorporate a de minimis provision that both the merging entities should have a threshold of assets or turnover in India for the CCI to come into the picture. So if an Indian company overtakes a foreign company, which is very big but has no turnover in India, there will be no need to notify the commission.

Dhall plans to put in another de minimis provision pertaining to the size of the transaction. The thinking in the commission is that a deal should come to it only if at least 15 per cent equity changes hands, which is also the kick-off point for the Securities & Exchange Board of India’s takeover regulations.”
At a more general level, Mr. Vinod Dhall, member and acting chairman of the Competition Commission of India, writes in the Economic Times to assuage concerns of the industry with respect to merger control regulations. He says:

“The MRTP Act and the Competition Act are as different as chalk and cheese. The former, over time, emerged as an arm of the 'command and control regime', while the Competition Act is an essential ingredient of a market based economy, seeking proactively to promote and preserve competition and its benefits in markets. The Competition Commission is also unlike a sector regulator. For the Commission, the market is the best regulator, rewarding the efficient and punishing the inefficient enterprises. The Commission's role is like a referee's, allowing rivals to compete vigorously and stepping in only when a foul is committed, the fouls being only the prohibited acts in the Act.”
The Government’s position with respect to merger regulation will become clear once the draft regulations are issued. The draft regulations are expected anytime now as the website of the Competition Commission indicates that they would be hosted on the site by January 18, 2008.

(Update - January 18, 2008: The draft regulations are now available on the Competition Commission's website hyperlinked above)

Stoneridge: US Supreme Court Limits Scope of Securities Law Suits


A significant decision in the area of securities laws was handed two days ago by the US Supreme Court in the case of Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. In its judgment (available here), the court (by a 5:3 majority) held that private actions for securities fraud (under Section 10(b) of the Securities Exchange Act, 1934) are not allowed against third parties who did not directly mislead the investors, but were business partners of the issuer company involved.

A class-action suit was filed by the investors of Charter Communications, Inc. against two suppliers of Charter, being Scientific-Atlanta, Inc. and Motorola Inc. The investors alleged that in order to enable Charter’s quarterly reports meet Wall Street expectations, the respondents Scientific-Atlanta and Motorola entered into a scheme with Charter so as to artificially inflate Charter’s earnings. The respondents executed contracts that enabled Charter to book higher profits and capitalize certain expenses so as to boost its financial results. The auditors (who incidentally happened to be none other than Arthur Andersen) were misled by these transactions and audited the financial results of Charter on that basis. The question that arose for consideration by the Supreme Court was whether the respondents, who were only suppliers and customers of Charter, were liable for defrauding Charter’s investors.

The Supreme Court ruled against any liability on the part of the respondents, Scientific-Atlanta and Motorola. The court ruled that there was no right of action because Charter’s investors did not rely upon the respondents’ statements or representations, as they had no role in preparing or disseminating Charter’s financial statements. The court held that the plaintiff must prove reliance, as here relevant, reliance upon a material misrepresentation or omission by the respondents.

A rebuttable presumption of such reliance is found in two circumstances. First, if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance. Second, under the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public. Neither presumption applies here: the respondents had no duty to disclose; and their deceptive acts were not communicated to the investing public during the relevant times.

The court also affirmed its previous ruling that the private right of action does not extend to aiders and abettors. Upon a full consideration, the court held that the respondents were not liable to private action by the investors of Charter for any alleged misrepresentation.

As this decision in a sense represents the victory of business and corporations over the investor community, it has naturally generated a heated debate. Blawgosphere is replete with discussions about the outcome of the case and the reasoning of the Supreme Court. Those of you who may be interested in reviewing the case in the light of US securities law and policies may wish to refer to following blawgs for reactions (both positive and negative) on the decision:

- Scotus Blog
- Law & Business Professor Bainbridge
- Ideoblog
- Truth on the Market
- The Race to the Bottom

Some Implications

What, if any, are the implications of the decision for Indian companies? The implications, are I think, both direct as well as oblique. Let us look at each one of them as follows:

  1. Indian companies listed in the US: Perhaps it is this set of companies who will be impacted directly by this decision. Investors in these companies would not have a private action against third parties that are not responsible for misrepresentation. For instance, customers and suppliers of US-listed Indian companies would have no liability under US securities laws.

    An interesting question that this throws open is whether other third parties involved in relation to an issuer company such as investment bankers, accounts and lawyers would also be entitled to take the benefit of the Supreme Court decision in Stoneridge and thereby exonerate themselves from liability. Prudence indicates that that would not be the case because parties such as investment bankers, accountants and lawyers are more closely involved in the investment matters pertaining to issuers than are customers and suppliers and hence they are more proximate to acts of the issuer company in issuing statements of the company that cause misrepresentation among investors. However, this question is yet open and we may have to await a future ruling on this issue before it can be put to rest.

  2. Indian companies looking to list overseas: One of the important considerations for Indian companies that choose to list overseas also pertains to the stringency of regulatory regimes in the jurisdictions that they plan to list. A relevant criterion these days relates to the strict disclosure and internal control measures imposed on US-listed companies by the Sarbanes-Oxley Act of 2002 that significantly increases compliance costs on these companies. Owing to this, one also begins to witness the emergence of regulatory competition with other jurisdictions and stock exchange such as London, Singapore and Hong Kong vying to attract issuers from countries like India to list on their exchanges. Furthermore, the depth and robustness of the Indian capital markets themselves need not be reemphasized more – what with the Reliance Power IPO taking all of one minute to lap up its full offering size of US$ 3 billion.

    It is in this overall context that we consider a policy statement made by the US Supreme Court in the Stoneridge decision:

    Overseas firms with no other exposure to our securities laws could be deterred from doing business here. … This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets

    Clearly, this statement evidences the court’s concern about regulatory competition and flight of capital markets from the US to other countries where issuers play the game of regulatory arbitrage, and therefore that the US securities laws should be interpreted so as to prevent a dilution of domestic markets. In other words, this statement (by implication) is a recognition that not only should US companies be prevented from listing elsewhere but also that the liability regime should be conducive for foreign issuers (such as Indian companies) to be listed in the US markets.

  3. Indian companies doing business with US-listed companies: The policy statement of the court quoted above also seems to take into account other companies that are not listed in the US (or for that matter listed anywhere at all) that may be doing business with US-listed companies either as suppliers or customers or in any other capacity. If third parties were held liable for private actions by investors, then that would result in outside entities that are customers or suppliers having to submit to US securities law. For example, there are thousands of Indian companies that do business with US-listed entities, but are themselves not listed in the US. By its decision, the court avoided a perverse situation where such Indian companies may have had to comply with US securities laws by merely doing business with US-listed entities.

  4. Persuasive value under Indian law: Although the US Supreme Court decision is not binding when it comes to interpretation of Indian securities laws dealing with third party liability, either under the Companies Act, 1956 or the Securities and Exchange Board of India Act, 1992 and the various regulations and guidelines issued thereunder, Indian courts may be persuaded by the reasoning of the US Supreme Court. As issues of securities regulation are fairly at an evolutionary stage, courts and regulatory authorities in India often refer to the jurisprudence developed in the US for assistance. For example, it is not at all unusual for SEBI and the Securities Appellate Tribunal (SAT) to defer to US cases in areas like insider trading and securities fraud, all mainly pertaining to Section 10(b) of the US Securities Exchange Act, 1934.

Sunday, January 13, 2008

Indo-Mauritius Tax Treaty: Benefits to Stay

Indications are that the Double Taxation Avoidance Treaty between India and Mauritius will stay despite pressure from the Indian tax authorities. In fact, the Treaty may be strengthened to withstand repeated scrutiny from the Indian tax authorities.

The Economic Times reports:

“The controversial double tax avoidance treaty between India and Mauritius is likely to survive despite pressure from the income-tax authorities. The pact may be reworked, but not scrapped, thanks to the lobbying by a high-level delegation headed by Mauritius Prime Minister Navinchandra Ramgoolam.

The pact, crucial for foreign institutional investors (FIIs) investing in India, has been facing an uncertain future since the revenue department in the finance ministry is opposed to loopholes that allow exploitation of the pact by intended beneficiaries. Several foreign companies, for example, have invested in India through what is known as the Mauritius route.

It is understood that Mr Ramgoolam discussed the issue with Prime Minister Manmohan Singh and pleaded strongly for status quo. The pact is crucial for Mauritius that is keen to develop itself into a leading financial centre of the world by offering attractively-low tax rates. Due to treaties like the one with India, a number of FIIs and foreign companies register special purpose vehicles (SPVs) in Mauritius for investment in other countries.”
Clearly, on this occasion, the pressure is mounting from the Mauritius side as it strives to ward off increasing competition from countries like Singapore and Cyprus that are providing tax-beneficial routes to foreign investors making investments into India.

Saturday, January 12, 2008

Comparative Corporate Governance (Part II)

Continuing from the previous post on this topic:

4. The Convergence vs. Divergence Debate

The dominance of managers over shareholders in the US, the role of institutions in the UK, that of banks and labour unions in Germany, the existence of complex cross holding structures in East Asia (such as chaebol in Korea and the keiretsu in Japan), state-owned enterprises in China and finally family-owned businesses in India. These are just some of the special features of corporate ownership and management in various countries that are unique to each of them. On the face of this diversity, the question that is being raised is whether there can be a convergence in corporate governance. With globalization and increasing ease in the flight of capital across the world, will there be one single model of corporate governance that would emerge to fit all economies?

This very question has been the subject of a recent article (Is One Global Model of Corporate Governance Likely, or Even Desirable?) in Knowledge@Wharton. The article considers arguments in favour of both convergence and divergence. Convergence towards a single model appears to be driven by two factors, viz. (i) the need of global capital investors to see a common model of internationally accepted governance standards, and (ii) commonality in regulation, principally triggered by the Sarbanes Oxley Act of 2002 enacted in the US which is being adopted in one form or the other by several other countries. The article notes:

“Wharton management professor Michael Useem says companies around the world are increasingly converging on a model developed largely in the United States in response to the growing power of global capital investors. As a result of new technology and liberalization of government controls on capital flows, massive pools of investment can move in and out of countries more freely than ever before. Companies that globalize operations or ownership know that adoption of internationally accepted governance standards would help them compete against other firms, he argues.”

Another force driving convergence is regulation. Following the passage of the Sarbanes-Oxley Act of 2002 in the United States, other countries enacted similar regulatory provisions that also focus on some of the key elements of board structure and overall governance.”
On the other hand, there are several arguments that militate against the concept of convergence in corporate governance. As the article further notes:

“[Wharton management professor Mauro Guillen] stresses that nations and companies will continue to exhibit local characteristics because different countries have followed varying patters of economic development. A complex mix of historic, legal, political and economic factors shapes each nation’s corporate landscape, according to Guillen. As a result, corporate governance and board structures vary around the world. “We continue to see companies in different parts of the world continuing to do things the way they always have,” he notes. “Often there are many cross-national differences.””
Although the debate remains inconclusive, the article points to the fact that some basic aspects of governance are here to stay, with perhaps some variance in different countries. These include independence of the board and transparency.

To me, it appears that we continue to be a long way away from convergence. The country-specific factors that have been spoken about earlier cannot be wished away. Transplantation of legal and business concepts such as corporate governance, an independent board and the like from one legal system (such as the US) to other countries without proper adaptation to the local systems and practices would result in a situation that is not entirely desirable. For instance, the adoption of strict corporate governance systems (that are based on the western models) in countries like India and China have not been trouble-free. There is a tendency for companies to follow a “check-the-box” approach to corporate governance by complying with the procedure, but failing in substance (barring, of course, several companies that have voluntarily adhered to high standards of corporate governance). It is such legal transplantation that has resulted in lack of proper implementation (often even at a mere procedural level) of the new corporate governance standards in the emerging markets. Knowledge@Wharton observes:

“India, too, has taken steps to increase the independence of its board members with a provision known as Clause 49 of the country’s listing agreements. The clause states that half of all directors must be independent. Compliance with the regulation, which took effect January 1, 2006, has been somewhat spotty – with government-owned companies slow to respond.

According to an analysis by the Asian Corporate Governance Association, Indian enforcement of Clause 49 is weak and many companies ignore governance codes. “Most mid- and small-cap companies do not see the value of corporate governance. Most listed companies, including many large ones, take merely a box-ticking approach,” the association states in a review of Indian governance”
The outcome of the convergence debate has enormous implications indeed for India.

5. Empirical Evidence on Indian Corporate Governance

On a more optimistic note, an event study (Can Corporate Governance Reforms Increase Firms' Market Values? Evidence from India) by two US law professors, Bernard Black and Vikramaditya Khanna, shows some correlation between strengthening of corporate governance regulations and improvement in corporate performance. They report that the announcement of the introduction of Clause 49 into the listing agreement in 1999 resulted in an increase in share price of large publicly listed companies over a two-day event window, relative to smaller listed companies; mid-sized firms reported an intermediate reaction.

Here is the abstract of their paper:

“A central problem in conducting an event study of the valuation effects of corporate governance reforms is that most reforms affect all firms in a country. Share price changes may reflect the reforms, but could also reflect other information. We address this identification issue by studying India's adoption of major governance reforms (Clause 49). Clause 49 requires, among other things, audit committees, a minimum number of independent directors, and CEO/CFO certification of financial statements and internal controls. The reforms were sponsored by the Confederation of Indian Industry (an organization of large Indian public firms), applied initially to larger firms, and reached smaller public firms only after a several-year lag. The difference in effective dates offers a natural experiment: Large firms are the treatment group for the reforms. Small firms provide a control group for other news affecting India generally. The May 1999 announcement by Indian securities regulators of plans to adopt what became Clause 49 is accompanied by a 4% increase in the price of large firms over a two-day event window (the announcement date plus the next trading day), relative to smaller public firms; the difference grows to 7% over a five-day event window and 10% over a two-week window. Mid-sized firms had an intermediate reaction.

Faster growing firms gained more than other firms, consistent with firms that need external equity capital benefiting more from governance rules. Cross-listed firms gained more than other firms, suggesting that local regulation can sometimes complement, rather than substitute for, the benefits of cross-listing. The positive reaction of large Indian firms contrasts with the mixed reaction to the Sarbanes-Oxley Act (which is similar to Clause 49 in important respects), suggesting that the value of mandatory governance rules may depend on a country's prior institutional environment.”

This seems to indicate that at least the larger public listed companies and their investors favour strong corporate governance norms.

6. Collaboration Between Key Regulators

Earlier this week, the Securities and Exchange Board of India (SEBI) and the US Securities and Exchange Commission (SEC) announced terms for increased cooperation and collaboration between them. While corporate governance standards and internal controls would be part of the agenda, the collaboration would extend to other matters as well, such as oversight of dually regulated entities, regulatory and compliance issues relating to outsourcing, accounting and auditing standards, areas for continued capacity-building and technical cooperation and cross-border cooperation and information sharing in securities enforcement matters.

Further details are available in this press release issued by the SEC.

That brings us to an end of this two-part series on recent issues in Comparative Corporate Governance. However, there would certainly be more discussion on these issues as and when there are further developments.