Tuesday, June 24, 2008

The Impending FCCB Conundrum

Foreign currency convertible bonds (FCCBs) have been issued by Indian companies, whereby investors have the option to convert these debt instruments into equity. Such conversion would normally occur when the market price of equity shares at the time of conversion is higher than the conversion price. But, with the markets now moving in the wrong direction, it is unlikely that the FCCB holders will exercise their conversion options. That means they will likely redeem the FCCBs, which partake the nature of repayment of debt. An event less expected by Indian borrowers, this would not only impose huge financial burden on Indian borrowers (who have to raise the cash to meet their obligations), but could also result in various accounting and other related issues.

These aspects have been covered in detail in this column by Rajrishi Singhal in the Economic Times.

(For more on FCCBs, and how they are different from Foreign Currency Exchangeable Bonds (FCEBs), please see this earlier post)

Update – July 10, 2008: See also this column in the Hindu Business Line

Monday, June 23, 2008

Differential Voting Rights: Some Further References

In earlier posts (here and here), this Blog had covered the issue of differential voting rights by Indian companies.

A recent column by Srikanth Srinivas in the Business World examines the business rationale for the issuance of shares with differential voting rights and also the pros and cons of such instruments. The key objectives that companies seek to achieve through shares with differential voting rights are to guard against shareholder activism (e.g. the kind initiated by hedge funds in U.S. and U.K. companies) and against hostile takeovers (so as to protect the interests of the promoters and incumbents in management). However, the column also advocates the exercise of caution on this front:

“How worried should investors be about differential voting rights? Making voting power proportional to economic ownership serves several goals. First, economic ownership gives shareholders an incentive to exercise voting power well. Second, the coupling of votes and shares strengthens the framework for corporate governance. Third, the power of economic owners to elect directors is a basis for legitimacy of managerial authority.

The evidence on corporate governance generally supports the importance of linking votes to economic interest. Voting rights are like property rights to cash flows of the company: decoupling economic and voting rights may benefit a controlling minority structure whose objectives may not quite coincide with that of the rest of the shareholders.

The issue also goes beyond just controlling minority structures. The derivatives revolution and other capital markets developments now allow both outside investors and insiders to decouple economic ownership of shares from voting rights. This decoupling — also called the new vote buying — is a worldwide issue. So before you endorse the idea of differential voting rights, think again.”
Similar issues have also been identified in an investing column in the Business Standard.

What is peculiar with differential voting rights is the timing of its emergence in the Indian markets. While differential voting rights have been existent in other economies such as the U.S. and Europe for some time, there is now a conscious move in some of those economies (particularly in continental Europe) to shift away from differential voting rights and towards a “one-share one-vote” rule citing corporate governance and control concerns that arise in shares with differential voting rights. The trend appears to be exactly in the opposite direction as far as India is concerned; only time and experience will tell whether differential voting rights will benefit the investors in such shares or impose further risk to their capital.

Sunday, June 22, 2008

Research Paper: Achieving India’s Growth Potential

Just as the Indian economy reels from its double-digit inflation to the tune of approximately 11%, Goldman Sachs, the leading investment bank, has issued its latest research paper titled Ten Things for India to Achieve its 2050 Potential. This is part of a series of papers published over the last few years by Goldman Sachs covering the BRIC economies of Brazil, Russia, India and China.

The paper builds on Goldman Sachs’ Growth Environment Scores (GES), in which India scores below the other three nations. Further, it ranks 110 out of 181 countries, and for 7 of the 13 components India scores below the developing country average. The current report contains some prescriptions for India to achieve its potential by 2050, noting that “[h]aving the potential and actually achieving it are two different things”. This effectively boils down the lack of proper implementation of reforms that slow down economic progress.

The following are the key recommendations extracted from the paper:

“We highlight ten key areas where reform is needed. In all likelihood, they are
not the only ten, but we consider them to be the most crucial:

1. Improve governance. Without better governance, delivery systems and effective implementation, India will find it difficult to educate its citizens, build its infrastructure, increase agricultural productivity and ensure that the fruits of economic growth are well established.

2. Raise educational achievement. Among more micro factors, raising India’s educational achievement is a major requirement to help achieve the nation’s potential. According to our basic indicators, a vast number of India’s young people receive no (or only the most basic) education. A major effort to boost basic education is needed. A number of initiatives, such as a continued expansion of Pratham and the introduction of Teach First, for example, should be pursued.

3. Increase quality and quantity of universities. At the other end of the spectrum, India should also have a more defined plan to raise the number and the quality of top universities.

4. Control inflation. Although India has not suffered particularly from dramatic inflation, it is currently experiencing a rise in inflation similar to that seen in a number of emerging economies. We think a formal adoption of Inflation Targeting would be a very sensible move to help India persuade its huge population of the (permanent) benefits of price stability.

5. Introduce a credible fiscal policy. We also believe that India should introduce a more credible medium-term plan for fiscal policy. Targeting low and stable inflation is not easy if fiscal policy is poorly maintained. We think it would be helpful to develop some ‘rules’ for spending over cycles.

6. Liberalise financial markets. To improve further the macro variables within the GES framework, we believe further liberalisation of Indian financial markets is necessary.

7. Increase trade with neighbours. In terms of international trade, India continues to be much less ‘open’ than many of its other large emerging nation colleagues, especially China. Given the significant number of nations with large populations on its borders, we would recommend that India target a major increase in trade with China, Pakistan and Bangladesh.

8. Increase agricultural productivity. Agriculture, especially in these times of rising prices, should be a great opportunity for India. Better specific and defined plans for increasing productivity in agriculture are essential, and could allow India to benefit from the BRIC-related global thirst for better quality food.

9. Improve infrastructure. Focus on infrastructure in India is legendary, and tales of woe abound. Improvements are taking place, as any foreign business visitor will be aware, but the need for more is paramount. Without such improvement, development will be limited.

10. Improve Environmental Quality. The final area where greater reforms are needed is the environment. Achieving greater energy efficiencies and boosting the cleanliness of energy and water usage would increase the likelihood of a sustainable stronger growth path for India.

Perhaps not all these ‘action areas’ can be addressed at the same time, but we believe that, in coming years, progress will have to be made in all of them if India is to achieve its very exciting growth potential."
While the research paper does well to identify key concerns relating to growth and the areas to be addressed, it does pose some fundamental issues at a macro level. One of the criticisms that may be levelled against the paper is that it does not present any new findings or prescriptions, and all of those contained in the report are well-known and debated (with perhaps little concrete action being taken). But, this critique is more to do with the form and less with the substance of the matters covered.

More fundamental is the approach towards some of the solutions to the problems. Here, one finds that most prescriptions turn towards market-based models of economic policy and liberalisation—for instance the recommendations for removal of capital controls, for liberalisation of the financial markets and so on. It is important to note, however, that all of those solutions may not directly apply in the Indian scenario. There is a need to contextualise the prescriptions for reforms so that they appropriately fit into the Indian macroeconomic framework as well as with its past experience. Some of the ideas (and materials) that support this thinking are as follows:

(a) Commentators have argued that some level of restrictions and governmental regulation on economic and financial activity may be necessary in the context of developing economies. Joseph Stiglitz is a leading proponent of this view, as he strenuously makes his arguments in his book “Globalization and Its Discontents”.

(b) Similarly, as far as India is concerned, arguments have been made that it is India’s partially restrictive policies that have helped weather the recent global credit crisis or even the Asian financial crisis that swept the region over a decade ago (see an earlier post on this blog).

(c) It is also useful in this context to review Dr. Shankar Acharya’s critique of the Draft Report of the High Level Committee on Financial Sector Reforms headed by Dr. Raghuram Rajan, where the point has been made about the need for taking into accounting the realities in India while examining the nature of reforms.

Saturday, June 21, 2008

Creating Debt and Securitisation Markets in India

One of the constant criticisms of the Indian financial markets has been the lack of a liquid and vibrant market for debt securities on the one hand and that for securitised instruments on the other. In separate moves announced on the same day (June 19, 2008), SEBI has sought to alleviate both these concerns.

Debt Securities

The SEBI (Issue and Listing of Debt Securities) Regulations, 2008 sets up the regime for issuance of debt securities by companies, public sector undertakings as well as statutory corporations, both by way of a public issue as well as on a private placement basis. Unlike in the case of equity securities, there is no requirement to file an offer document with SEBI for debt securities. Appropriate disclosures are to be filed with the stock exchanges, and they shall be displayed on the websites of the stock exchanges. Although the disclosure requirements have been seemingly simplified, they still have to comply with requirements of Schedule II of the Companies Act, 1956 (since SEBI does not have the requisite powers to alter the requirements of the Companies Act).

Securitised Instruments

The SEBI (Public Offer and Listing of Securitised Debt Instruments), Regulations 2008 provides for public issue and listing of instruments that are issued by a special purpose vehicle (SPV) that purchases receives through securitisation. Although securitisation transactions have witnessed a fair level of size and regularity in the Indian markets, these were confined in the past to private transactions. Securitised debt was incapable of being listed on stock exchanges as there was some doubt as to whether it was a “security” as defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956 (SCRA). But, that doubt was put to rest last year when the SCRA was amended to include an additional element in the definition of a ‘security’ in Section ((h)(ie) as follows:
“any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging the beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be;”
Since the SCRA paved the way for creating a market for securitized debt, the recent regulations represent a step towards implementation of this regulatory intent. The Regulations set out the details of the SPV, the manner in which it can acquire receivables as well as the form of instruments it can issue. Unlike the regulations on debt securities which are more focused towards disclosures, the regulations relating to securitized debt are overarching and even govern several substantive issues pertaining to the transactions. This is perhaps explainable by the fact that the past experience of regulators the world over with securitisation markets has not entirely been positive. Securitisation, by its very nature, enables risk-holders to spread that risk over a wide array of investors (especially in the case of public offering of securitised debt), and this can result in a rapid spread of that risk among a larger group of people. This is precisely what occurred during the sub-prime crisis whereby sub-prime mortgage debt that originated in the U.S. was spread using securitisation and CDO (collateralised debt obligation) instruments.

There is considerable detail in the regulations pertaining to securitized debt, which may even warrant a separate detailed post in due course.

Tuesday, June 17, 2008

CSX/TCI Judgment – Some Thoughts on the SEBI Takeover Regulations

In a closely followed case, the U.S. District Court for the Southern District of New York issued its decision regarding the reporting requirements of a hedge fund (TCI) that had entered into “total return equity swaps” with counterparties in respect of the shares of CSX. Although TCI only entered into cash-settled swaps (without any obligations to obtain delivery of CSX’s shares), the counterparties to the swap in turn hedged their risks by acquiring shares of CSX. On the specific facts of the case, the court held that TCI should be treated as beneficially owning the shares under its cash-settled equity swaps under the anti-avoidance provisions of Rule 13d-3(b) of the Securities Exchange Act of 1934 and hence should have filed the requisite disclosures, which it failed to do so.

A memo by Gibson, Dunn & Crutcher LLP describes the gist of the transaction and the decision as follows:

“One of the main issues raised by the CSX case is whether, in calculating their beneficial ownership, investors are required to count shares in which they have an economic interest through swap or hedging transactions. In the CSX case, TCI held cash-settled “total return equity swaps” under which it obtained the economic risk of stock ownership, but no contractual rights in the underlying shares. While not contractually required under the swaps, the counterparty typically acquires some percentage or the full number of shares that are notionally covered by the swap.

The CSX ruling states that decisions by a person to enter into this type of swap arrangement or to terminate the swap can result in the counterparty buying or selling the shares that are notionally covered by the swap. The Court also stated that the counterparty may be likely to vote shares as its client would want in order to maintain a positive business relationship and to bolster the likelihood of obtaining business from the client in the future. …”
The relevant provisions of the Securities and Exchange Act Rules that the court relied on are as follows (as extracted from the Gibson Dunn memo):

Rule 13d-3(a):

For the purposes of sections 13(d) and 13(g) of the Act a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) Voting power which includes the power to vote, or to direct the voting of, such security; and/or, (2) Investment power which includes the power to dispose, or to direct the disposition of, such security.

Rule 13d-3(b)

Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose of [sic] effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.
While Rule 13d-3(a) deals with the question of beneficial ownership in securities for the purpose of disclosure, Rule 13d-3(b) is an anti-abuse provision that prevents the use of arrangements that avoid disclosure requirements. In this case, the court’s decision is largely based on an application of Rule 13d-3(b) to the facts of the case, whereby the court held that TCI shared voting or investment power over shares that its swap counterparties had purchased, on the theory that under the fact TCI had the ability to influence the counterparties’ actions. On this basis, it held that there was a failure by TCI to make appropriate disclosure of its shareholdings.

This decision could have some bearing on the interpretation of the relevant provisions of the SEBI Takeover Regulations (specifically Regulation 7 that provides for disclosures upon acquisition of shares or voting rights that exceed defined percentages). This applies to any person who is an acquirer (that is defined to include a ‘person acting in concert’). In an Indian situation, the primary question will relate to whether the hedge fund or other investor that enters into an equity swap arrangement (even if cash-settled) is said to be acting in concert with the counterparty who may acquire shares to hedge its own position under the swap. If they are indeed persons acting in concert, then the hedge fund or other investor’s shareholding (if any) will be aggregated with the shareholding of the counterparty thereby triggering disclosure requirements if the total shareholding exceeds the prescribed thresholds (e.g. 5%, 10%, 14%, 54% or 74%).

However, there are some key differences between the SEBI Takeover Regulations and the relevant provisions of the Securities Exchange Act Rules cited above. While the definition of ‘person acting in concert’ in Regulation 2(1)(e)(1) of the SEBI Takeover Regulations contains provisions on the same lines as Rule 13d-3(a), there is no anti-abuse provision (like Rule 13d-3(b)) in the SEBI Takeover Regulations. In Indian circumstances, in the absence of such an anti-abuse provision, for any such action to succeed under Indian circumstances, it would be necessary to show that the hedge fund and the counterparty had a ‘common objective or purpose of substantial acquisition or voting rights’, which may be a difficult proposition in a purely cash-settled option. Further, the Indian reporting requirements arise only when a person such as the hedge fund “acquires” shares or voting rights, while the anti-abuse provision imposes the obligation on a person who does not necessarily acquire shares or voting rights, but where such person has an ‘arrangement’ with any other person who has acquired shares (to evade the reporting requirements).

It is likely that the TCI/CSX case will go on appeal. But, it does provide some lessons on the manner in which similar situations are to be dealt with under the SEBI Takeover Regulation. At least, at a basic level, it provokes the debate on whether it is now time to include an anti-abuse provision (such as Rule 13d-3(b)) in the SEBI Takeover Regulations.

Sunday, June 15, 2008

Daiichi Sankyo - Ranbaxy

June 13 edition of Mint carried my column on how Daiichi Sankyo - Ranbaxy deal vindicates Indian IPR regime. Check the following link:

Thursday, June 12, 2008

Tuesday, June 10, 2008

Oil Price Rise: Shareholders vs. Consumers

The spike in the price of oil has created a peculiar situation for the Indian oil companies that are in the public sector. These public sector undertakings (PSUs) are predominantly owned by the Government, with a portion of the shares (usually a minority) held by public shareholders. The shares of these entities are listed on stock exchanges, which subject them to norms of corporate governance prescribed by SEBI.

However, despite the global spurt in prices, the Government has contained the prices of oil in India, which has resulted in considerable losses to oil PSUs (that extend to hundreds of millions of dollars on a daily basis.). Hence, while consumers (irrespective of their ability to pay) are benefiting from this move, the minority shareholders in these companies are suffering a massive blow. Does this strategy adopted augur well in the light of existing corporate governance norms? That is the key question. PSUs are in any case have never been at the forefront of taking on board corporate governance norms prescribed in Clause 49 of the listing agreement – for example, several PSUs are still yet to restructure their boards to maintain the minimum number of independent directors.

In this background, the Economic Times carries a column by U R Bhat that analyses this dichotomy and proffers some solutions:

“This is particularly galling in the light of the fact that the oil companies that are made to bleed are not wholly-owned by the government but are listed entities with a significant minority shareholding by the public. It is indeed possible for free market principles to co-exist with the just concerns for the welfare of the vulnerable sections of society. The role of a government that is concerned with the welfare of its citizens needs to be segregated from its role as the majority owner of listed commercial enterprises.

As a majority shareholder, the government needs to ensure that the listed companies function on sound commercial principles while it has to meet its social objectives by direct subsidies to the needy or by indirect subsidies through the oil marketing companies. However, they need to be used only as distributors of the subsidies and not as the providers of subsidies. We now have a situation where even the affluent sections of society get the same subsidy on petroleum products as the poor, even as the majority shareholder is severely compromising the tenets of good corporate governance by forcing the oil companies to run commercially-unviable businesses.

The government’s lack of concern to the basic principles of corporate governance that have been laid out through the listing agreement is not restricted to just the oil companies. Mandatory adherence to Clause 49 of the listing agreement, especially in relation to appointment of independent directors continues to be violated by the listed majority government-owned companies.

From a capital market viewpoint, the appropriate course of action for the government if it indeed wants to continue this way is to transparently make an open offer to the minority shareholders and proceed to delist these companies through the reverse book-building methodology.

Though this would amount to backdoor nationalisation — making a mockery of the gains achieved in the course of more than a decade-and-a-half of economic reforms — it is possibly a better option than destroying the trust of minority shareholders. It is about time the government takes the lead in setting high standards of corporate governance for India Inc., to follow.”
This situation presents a classic conflict between the interests of consumers and the shareholders of a company – the type we have been considering earlier in the context of Dodge v. Ford Motor Company.

Wednesday, June 4, 2008

The Proper Purpose of a Corporation

One of the themes that we often explore on this Blog relates to the determination of the proper purpose of a corporation – i.e. whether a corporation exists solely to carry on business for the benefit of its owners (i.e. shareholders), or whether it has a larger responsibility towards other stakeholders and generally the society.

The Harvard Corporate Governance Blog has a post referring to essays by two leading U.S. corporate law professors who join the debate:

“In the latest issue of the Virginia Law & Business Review, we debate whether the classic case of Dodge v. Ford, and its claim that maximizing shareholder wealth is the proper purpose of a business corporation, deserves a place in the modern legal canon. Lynn argues that Dodge v. Ford is bad law, at least when cited for the principle that corporate directors should maximize shareholder wealth. As a positive matter, Lynn suggests, no modern jurisdiction follows this rule, and as a normative matter, advances in economic theory suggest that the goal of shareholder wealth maximization is at best inefficient and at worst incoherent. Jon argues that shareholder wealth maximization is both conceptually coherent and consistent with economic theory, and that Dodge v. Ford can be used to illustrate the fact that shareholder wealth maximization is both a valid goal for corporate law and an ethical requirement, even in contexts in which enforceability is practically impossible.

The debate can be found here.”
Regarding the subject-matter of the debate, i.e. the Dodge v. Ford case, please see a previous post on this Blog pointing to Wikipedia.

Monday, June 2, 2008

FDI: Reporting Under Automatic Route

Whenever foreign investors subscribe to an issue of shares by an Indian company, there are certain reporting requirements that need to be complied with. In terms of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000, the reporting obligations arise at two stages: (i) within 30 days of receipt by the amount of consideration by the Indian company; and (ii) within 30 days of issue and allotment of the shares. The latter reporting requirement is satisfied through the filing of Form FC-GPR to the Regional Office of the Reserve Bank of India (RBI).

By way of a circular issued on May 30, 2008, the RBI has issued a revised format for the Form FC-GPR that incorporates substantial know-your-customer (KYC) norms. Companies are now required to follow this new format while filing Form FC-GPR with the RBI.

The Economic Times has this report that explains the possible rationale for the recent changes imposed by the RBI.

Sunday, June 1, 2008

Differential Voting Rights: A Markets Perspective

Economic Times carries the views and recommendations of various market participants about the feasibility and economics of issue of differential voting rights by Indian companies.

One interviewee notes:

“Differential voting rights can work every where in the world, and so also in India. These are ideally good instruments for passive investors, typically small investors, who seek higher dividend, and are not necessarily interested in taking a voting position. It is clear that no investor would agree to a sacrifice, which differential voting rights lead to, unless they are suitably compensated, and compensated in financial terms.

Since institutions are active investors, at least they are supposed to be so as per their charters, I do not think there would be any significant demand from them for such shares. Significantly, they invest primarily for capital gains, and not for dividends. There is one operational issue.

The law provides for issue of shares with differential voting rights. This means that a company may issue shares carrying voting rights with different weights, for example with weights of 100 and say 75 and say 50 and say 0. This, however, can lead to huge confusion.”

India Today: Law School Rankings

Spicy IP points to India Today magazine’s latest survey ranking law schools in India. This year’s results reveal the following order at the top in the overall ranking:

1. National Academy of Legal Studies & Research University (NALSAR), Hyderabad;
2. National Law School of India University (NLSIU), Bangalore;
3. Campus Law Centre, University of Delhi, Delhi;
4. National Law Institute University, Bhopal;
5. The W.B. National University of Juridical Sciences, Kolkata.

This year’s highlight is NALSAR’s emergence to the top spot for the first time, edging out NLSIU (that has been maintaining the honours for all but one year that India Today has been conducting the survey).

India Today’s rankings have been carried out based on a set of perceptual scores and a set of factual scores, all determined through identified parameters. The parameters are reputation of college, quality of academic input, student care, infrastructure, and job prospects. This table indicates that while NALSAR consistently ranked 2 on most counts (including perceptual) and ranked 1 on factual scores, NLSIU ranked 1 on most counts but ranked only a mere 13 on factual scores which appears to have cost it the top position. The survey explains this finding:

“Finally there is the National Academy of Legal Studies and Research (NALSAR), Hyderabad, which pulled off the impossible by toppling National Law School of India University (NLSIU), Bangalore, from the number one slot in the law stream.

NALSAR is a relative newcomer compared to its venerable Bangalore counterpart. Part of the reason for its triumph this year is its emphasis on providing world class infrastructure facilities that include virtual universal classrooms combined with outstanding faculty and consistency in training.

Perceptually, NLSIU may have scored top markets but it compared poorly with NALSAR in its factual ratings. So after years we have a new winner in the law category.”
Rankings aside, observations in the survey clearly imply that legal education in India has a come a long way and has caught up with other streams of education.