Friday, July 31, 2009

Issue of Banning Share Warrants to Promoters – SEBI order

I had written earlier on February 26, 2009 here on an issue titled “Is it time to sentence Share Warrants to Dishonorable Discharge?”. Essentially, I had argued that Share Warrants were heavily being misused by Promoters. They allotted, almost exclusively to themselves, Share Warrants at a price and terms that appeared to be absurdly below their fair value. The Companies would almost never have, had an really independent Board be deciding the issue in each case, allotted Share Warrants to an outsider on such sweet terms. Issuing Share Warrants to Promoters in this manner causes serious loss to the Company and its non-Promoter, i.e., public, shareholders.

Of course, while this issue was a concern for many years, the above post was in connection with the amendment by SEBI of its DIP Guidelines in February 2009 whereby the upfront non-refundable amount payable on Share Warrants was increased from 10% to 25% of the Conversion Price.

It did not help that Promoters of numerous companies gladly allowed their Share Warrants to lapse considering that the market price had fallen far below the Conversion Price of the Share Warrants and thus forfeited their 10% deposit. Many of them actually issued fresh Share Warrants paying the higher 25% deposit but on a Conversion Price that was far lower.

A public interest litigation was filed by Rajkot Saher/Jilla Grahak Suraksha Mandal in the Bombay High Court and the Hon’ble Court had directed vide order dated June 18th 2009 SEBI to hear the petitioner and pass appropriate orders within 6 weeks of the order. SEBI has passed an order dated July 30, 2009 on the matter.

SEBI has now passed an order dated July 30, 2009. In this 23 page order, SEBI has essentially concluded that there is nothing wrong in the current law and safeguards and there is also nothing wrong if Promoters have allowed their Share Warrants and deposits to lapse and even if they acquired fresh warrants paying higher upfront deposits.

Readers may go through this 23 page order for more detailed reasoning but I offer some quick comments.

SEBI, justifying the low 10% deposit amount on Share Warrants, says “I also note that in other jurisdictions, the option premium is generally in the range of 10% to 15% for trading of long dated options.”. I find this justification difficult to accept in the Indian context. The basic important elements of the Black-Scholes option valuation formula (who, I believe, got the Noble Prize for this) are interest rates and volatility. Is it plausible that interest, in India, is only 10% for a total period of 18 months? It is even less plausible – in fact consistently found untrue in every option valuation I have come across – to believe that the volatility is 10% over a 18 month period. And mind you, option value is at least the total of the interest and volatility (and a few other factors).

Then, SEBI says that, from just 8 companies listed, a sum of Rs. 1515 crores received as deposits from Promoters have been forfeited when they did not exercise the Share Warrants. SEBI seems to imply that far from the Company and the public losing, the Company has actually gained by such a huge amount – it says – “it may be incorrect to argue that the promoters stand to gain at the cost of the company and its shareholders.” But is not the reality exactly the opposite? In fact, this shows that the companies granted options to exercise Rs. 15150 crores since the deposit amount is just 10%.

Further, of these Rs. 1515 crores, effectively a significant portion goes back to the Promoters to the extent of their holding in the Company. If the average holding is, say, 50%, then Rs. 758 crores goes back effectively to the Promoters!

SEBI then goes on to say,

“It is also noted that of the 4934 listed companies, there had been 1108 preferential allotments since April 2007, of which only 360 were preferential allotment of warrants. Out of the said 360 cases, there were only 100 companies where promoters did not fully exercise the option on the warrants issued to them. Considering the total number of listed companies and number of preferential allotments made during the above period, it is seen that the instances of reissue of warrants to the promoters have not been significant or frequent.”

Again, I find it disturbing that as many as 360 companies allotted Share Warrants apparently to Promoters since April 2007. Further, in as many as 100 companies, the Promoters allowed their deposits and Share Warrants to lapse. While the 8 companies referred to earlier may be the larger of these companies, note that in just 8 companies, the amount lapsed was totally Rs.1515 crores!

On the request of the petitioner that issue of further securities should be only against full payment, SEBI says, “the same would discourage the companies to raise funds through the allotment of warrants and also indirectly restrict the issue of capital to only shares of the company. Considering the nature of the said instruments (warrants) and the fact that only few instances (as brought out in Para 10 above) were noticed where the warrants issued to the promoters had not been exercised, it would be a retrograde step to disable a product which is accepted universally as a fund raising tool. Such a restriction on issuance of warrants may also deprive the operational and capital structuring flexibility for Indian companies.”

I find it difficult to believe that there would be anything wrong in prohibiting issue of Share Warrants at a mere 10/25% deposit exclusively to Promoters – I find it even more difficult to believe it would be a retrograde step and would “deprive the operational and capital structuring flexibility for Indian companies”. What is wrong with a demand that if Share Warrants are to be issued, issue them to all shareholders – let each shareholder decide whether he wants to subscribe or not? Why are Promoters being preferred and given an exclusive deal and why banning such exclusive sweet deals will be a retrograde step?

In the end, SEBI does not find the circumstances warrant any immediate ban and has instead stated that it “initiate a consultative process….to suggest policy changes, if required..”.

All in all, while I personally feel SEBI has missed an opportunity to carry out a complete rehaul, it is also true that SEBI on its own cannot prevent every misuse. The misuse of such instruments is by the Promoters and as SEBI would close one route, another would be invented. It would be the Promoters who themselves would suffer in the long run if they lose their credibility and thus eventually the capital market as a whole. Having said that, isn’t retaining and restoring the credibility of the capital market the function of SEBI? Has it failed in this, at least as far as the question of issue of Share Warrants to Promoters is concerned?

- Jayant Thakur

Note:- I am really grateful to Mr. V. Umakanth for promptly drawing my attention to this SEBI order and sending me a copy for a quick post.

Lock-in for Real Estate FDI Clarified

According to Press Note 2 of 2005 issued by the Department of Industrial Policy and Promotion, there are certain conditions for foreign investment in the real estate sector. The relevant conditions are as follows:

i. Minimum capitalization of US$10 million for wholly owned subsidiaries and US$ 5 million for joint ventures with Indian partners. The funds would have to be brought in within six months of commencement of business of the Company.

ii. Original investment cannot be repatriated before a period of three years from completion of minimum capitalization. However, the investor may be permitted to exit earlier with prior approval of the Government through the FIPS.

The lock-in of 3 years, specified in condition (ii) above, has purportedly been introduced to ensure that only investors with a long-term horizon invest in the real estate/ construction sector. There was some doubt as to the meaning of the expression “original investment” as the lock-in applies to that. While it appears that the Government had initially clarified that the lock-in of 3 years would apply to the initial investment only, it has now adopted the position that the lock-in applies to all foreign investment (and not just the initial investment).

The Mint carries a report that explains the position:

The department of industrial policy and promotion (DIPP) has made it clear that the lock-in period of three years applicable on foreign investments in realty projects—under Press Note 2 of 2005 series—is for the entire investment, against a previous understanding that it applied only for the initial investment.

“We do not know what was the interpretation previously. But the press note meant the lock-in period is applicable for the entire investment. We have already clarified that and we stand by that,” said a DIPP official who spoke on condition of anonymity.

The DIPP had clarified on its bulletin board on 15 July that “original investment means the entire investment brought in as FDI (foreign direct investment) for the purpose of taking up PN 2 (2005) compliant construction development projects which would then remain locked in for three years.” Responding to a further query, the department on Thursday clarified on its bulletin board that “the clarification posted recently (on 15 July) is the correct policy position”.

While this interpretation is beneficial to the investee companies, it may curtail exit options that may be contractually available to foreign investors.

Director and Officer Liability for Dishonour of Cheques

(The following post has been contributed by Avirup Bose. Avirup is an Indian lawyer, who has graduated from NUJS Kolkata and has an LL.M from the Harvard Law School)

On July 6, a Division Bench of the Supreme Court passed a judgment in K.K. Ahuja v. V.K. Vora (MANU/SC/1111/2009, per R.V. Raveendran, J.) (“K.K. Ahuja”), where it considered the particular question as to who can be said to be persons “in-charge of, and was responsible to the company for the business of the company” under Section 141 of the Negotiable Instruments Act, 1881 (“NI Act”). Section 141 of the NI Act provides that when a company’s cheque is dishonoured under Section 138 of the NI Act, then those who were in-charge of the conduct of the business of the company, at the time the offence was committed, would be constructively liable.

K.K. Ahuja, the appellant, had filed two criminal complaints, under Section 138 of the NI Act, against M/S Motorol Speciality Oils Ltd. (the “Company”), and eight of its officers (Chairman, four Directors, VP Finance, General Manager and Deputy General Manager (“DGM”) respectively), in the Court of the Metropolitan Magistrate, Delhi, averring that at the time of the commission of the offence, all the eight officers were in-charge of and responsible for the conduct of the day-to-day business of the Company and thus deemed to be guilty under Section 138, read with, Section 141 of the NI Act. Next, the accused DGM moved to quash the proceedings against him on the ground that as DGM of the Company he was not in-charge of the conduct of the day-to-day business of the Company. This petition was allowed by the Delhi High Court, which was then challenged before the Supreme Court in K.K. Ahuja.

The Supreme Court ruled in dicta that, “[]…. to be vicariously liable under Sub-section (1) of Section 141, a person should fulfill the 'legal requirement' of being a person in law (under the statute governing companies) responsible to the company for the conduct of the business of the company and also fulfill the 'factual requirement' of being a person in charge of the business of the company.” In other words, any corporate officer accused under Section 141(1) of the NI Act has to: (1) be a person responsible to the company for the conduct of the business of the company under the provisions of the Companies Act, 1956 and (2) be in-fact also a person in-charge of the business of the company.

Requirements to satisfy the First Prong:

The Court, relying on Sections 5 and 291 read with clauses (24), (26), (30), (31) and (45) of Section 2 of the Companies Act, 1956, lists the categories of persons who under the Companies Act can be considered as persons who are responsible to the company for the conduct of the business of the company. They are:

(a) the managing director/s;

(b) the whole-time director/s;

(c) the manager;

(d) the secretary;

(e) any person in accordance with whose directions or instructions the Board of directors of the company is accustomed to act;

(f) any person charged by the Board with the responsibility of complying with that provision (and who has given his consent in that behalf to the Board); and

(g) where any company does not have any of the officers specified in clauses (a) to (c), any director or directors who may be specified by the Board in this behalf or where no director is so specified, all the directors.

The above list is exhaustive since the Supreme Court held that other employees of the company cannot be said to be persons who are responsible to the company for the conduct of the business of the company.

Requirements to Satisfy the Second Prong:

The Supreme Court, relying on past precedents, held that the words “person in charge of the business of the company” refer to a person, who is in overall control of the day-to-day business of the company. The Supreme Court further held that, since the question as to who is in “overall control” is a fact specific one, specific averment in the complaint is required. This the Court felt necessary since a person may be a Director and thus belong to the group of officers who are involved in policy-making for the company, yet he may not be in-charge of the business of the company.

Consequently, the Supreme Court provides a two-pronged test—the first prong is a legal, statute-based test, where to prove that a person is responsible to the company for the conduct of the business of the company, one needs to merely check if the accused person falls in any one of the listed categories. The second prong is a fact-based test, where through specific averments the complainant has to allege that the particular accused was in-fact in overall control of the day-to-day business of the company. Both the prongs need to be complied with. Hence, if a person does not satisfy the first prong, i.e., if he is not one of the above-mentioned officers as listed by the Supreme Court, then he is neither required to meet the second prong nor can he be held liable under Section 141(1).

However, if the accused falls under one of the categories listed by the Supreme Court, i.e., he is under statute, the Companies Act 1956, a person responsible to the company for the conduct of the business of the company, then the judgment provides for a sliding scale of averment that needs to be made in the complaint, depending upon the particular category of the officer. These are as tabularized:


Degree of Averment


Managing Director or Joint Managing Director

No need to make an averment that he is in-charge of and responsible to the company, for the conduct of the business of the company. It is sufficient if an averment is made that the accused was the Managing Director or Joint Managing Director at the relevant time.

Because the prefix ‘Managing’ to the word ‘Director’ makes it clear that he was in charge of and was responsible to the company, for the conduct of the business of the company.

A director or an officer of the company who signed the cheque on behalf of the company

No need to make a specific averment that he was in charge of and was responsible to the company, for the conduct of the business of the company or make any specific allegation about consent, connivance or negligence.

Because the very fact that the dishonoured cheque was signed by him on behalf of the company, would give rise to responsibility under Sub-section (2) of Section 141.

Director, Secretary or Manager or a person referred to in clauses (e) and (f) of Section 5 of

Companies Act

An averment in the complaint that he was in charge of, and was responsible to the company, for the conduct of the business of the company is necessary. (Such officers can also be made liable under Section 141(2) by making necessary averments relating to consent and connivance or negligence).

The Supreme Court also held that other officers of the company, apart from those tabularized above, cannot be made liable under Section 141(1) of the NI Act. Such officers can however be made liable under Section 141(2), which provides for liability to corporate directors/officers who may not be in-charge of the conduct of the business of the company, but nevertheless the offence under Section 138 of the NI Act (dishonour of cheque) was committed with their consent or connivance or due to their negligence. However, in such circumstances, specific averments must be made in the complaint as to how and in what manner the accused was guilty of consent and connivance or negligence.

This brings us to an interesting issue, albeit beyond the scope of the present case-- say a non-executive director who is a financial expert and a past banker sits on the Board of a company, which has issued certain cheques, which have been dishonored and returned by the respective banks unpaid. By merely being a non-executive director he is most likely not one of the officers responsible for the conduct of the business of the company, nor is he in-charge of the business of the company. Hence, in the absence of special circumstances, as per KK Ahuja, such a non-executive director will probably not be held liable under Section 141(1). However, the scope of Section 141(2) is wide open. In case such a director votes in favor of a resolution, which provides for payment of a certain sum of money, from one of the several bank accounts of the company, to a supplier/contractor and that cheque bounces—is the director liable? Can his consent be construed from his “yes” vote? I would argue that the case then depends upon how the executive director went about doing his job. Did he ask relevant questions, did he try to inquire if the company had sufficient funds in that particular account, especially if he had reason to believe otherwise? Does the fact that he is a financial expert make him more readily liable under Section 141(2) of the NI Act than the other directors? In fact, in U.S. the Delaware chancery court in re Emerging Communications, Inc. Shareholders Litig., 2004 WL 130 5745 (Del.Ch. June 4, 2004)) found that a particular director who was a former investment banker with relevant experience in the particular industry be held to a higher standard of inquiry than non-expert directors when he failed to apply his “specialized financial expertise”, when evaluating a going-private transaction. The case was uniformly held to have taught directors, especially the non-executive and independent ones, not to simply rely on information either given by the management or outside professionals, especially when they were themselves experts in the relevant field.

One might wonder why the complainant needs to specifically aver in a complaint under Section 138 and 141 of the NI Act, that at the time when the offence was committed, the person accused was in-charge of, and responsible for the conduct of the business, since in the absence of such an averment, as held by the Supreme Court in the three judge decision of S.M.S. Pharmaceuticals Ltd. v. Neeta Bhalla and Anr (“S.M.S. Pharma”(MANU/SC/0622/2005)), Section 141 of the NI Act cannot be invoked. The Supreme Court’s logic in requiring such specific averments before any corporate director/officer can be held liable, as held in a series of decisions [See generally: OP Faizi & Ashish Aggarwal, Khergamvala on The Negotiable Instruments Act 514 – 525(2008)], is that the liability under Section 141(1) is raised by legal fiction, such that even though a person is not personally liable, he will be held liable vicariously and hence a clear case connecting the accused with the commission of the crime, as required under Section 141(1) has to be spelled out in the complaint through specific factual averments. However, the obvious disadvantage the complainant suffers when he has to specifically aver that a certain director or officer was in-charge is that, being an outsider, he might not know exactly how the internal business of the accused company is organized i.e., who are its principal executive officer bearers and who are only involved in business policy making. This is easy when dealing with the Managing Director and the signatories of the cheque, but beyond that the picture becomes fuzzy.

As per S.M.S. Pharma (which the Supreme Court heavily relied upon in KK Ahuja):

“The liability arises from being in charge of and responsible for conduct of business of the company at the relevant time when the offence was committed and not on the basis of merely holding a designation or office in a company. Conversely, a person not holding any office or designation in a Company may be liable if he satisfies the main requirement of being in charge of and responsible for conduct of business of a Company at the relevant time. Liability depends on the role one plays in the affairs of a Company and not on designation or status.” (Emphasis Added)

Imagine a family based company having a majority shareholder holding more than 50% of the stock. The company is nevertheless, run by a team of non-familial professional managers. Can such a majority shareholder be held liable if, the managers of the company, which he controls, issue a cheque, which, is dishonoured by the banks. In KK Ahuja one of the people listed by the Supreme Court in paragraph 14 as persons responsible to the company for the conduct of the business of the company is:

“(e) any person in accordance with whose directions or instructions the Board of directors of the company is accustomed to act;”

A controlling shareholder can very well be someone who regularly instructs the Board and the senior management. Yet, when the complaint would want to include such a controlling shareholder in his complaint, under Section 141(1), he will need to make specific factual averments, showing how in-fact such controlling shareholder was regularly consulted by the Board or otherwise in-charge of the business of the company. The complainant might not have access to such materials if they are not in the public domain. It is not enough for the courts if the complainant merely states that the accused is a “controlling shareholder.” The decision in KK Ahuja fails to take into account such practical business scenarios. The Court could have provided some more guidance, like examples of factual averments that will be required, when a complainant wants to hold corporate officers, who are not managing directors or signatories of the bounced cheques, liable under Section 141(1) of the NI Act. The standard of averment that the Court in KK Ahuja suggests, in paragraph 9, (quoting Saroj Kumar Poddar v. State (NCT of Delhi) MANU/SC/0711/2007): “the complaint should contain averments as to how and in what manner the accused was responsible for the conduct of the business of the company, or otherwise responsible for its functioning”, is general and vague, especially in scenarios described above.

Why cannot the complainant sue the entire Board and the senior management under Section 141 and then such officers can prove that they were not in-fact in-charge of the company’s business at the time of the commission of the crime? It would be much easier for the directors to deny responsibility than for an outsider to aver responsibility on part of internal corporate officers at the trial stage. This view although a minority one, found voice in a two judge bench decision of the Supreme Court in N. Rangachari v. Bharat Sanchar Nigam Ltd (2007) II CCR 191 (SC), which held the following in obiter:

“[]…a person in the commercial world having a transaction with a company is entitled to presume that the directors of the company are incharge of the affairs of the company. If any restrictions on their powers are placed by the memorandum or articles of the company, it is for the directors to establish it at the trial. It is in that context that Section 141 of the Negotiable Instruments Act provides that when the offender is a company, every person, who at the time when the offence was committed was incharge of and was responsible to the company for the conduct of the business of the company, shall also be deemed to be guilty of the offence along with the company. It appears to us that an allegation in the complaint that the named accused are directors of the company itself would usher in the element of their acting for and on behalf of the company and of their being incharge of the company…..

A person normally having business or commercial dealings with a company, would satisfy himself about its creditworthiness and reliability by looking at its promoters and Board of Directors and the nature and extent of its business and its Memorandum or Articles of Association. Other than that, he may not be aware of the arrangements within the company in regard to its management, daily routine, etc. Therefore, when a cheque issued to him by the company is dishonoured, he is expected only to be aware generally of who are incharge of the affairs of the company. It is not reasonable to expect him to know whether the person who signed the cheque was instructed to do so or whether he has been deprived of his authority to do so when he actually signed the cheque. Those are matters peculiarly within the knowledge of the company and those in charge of it. So, all that a payee of a cheque that is dishonoured can be expected to allege is that the persons named in the complaint are in charge of its affairs. The Directors are prima facie in that position.”

To conclude, the Supreme Court in K.K. Ahuja fine-tuned the principles relating to director and officer liability for dishonour of cheques and built upon the policy laid down in the previous case of S.M.S. Pharma. However, there continue to be some open issues as discussed above, and the Court has left complainants with a somewhat insurmountable burden of averment as outsiders to the company.

- Avirup Bose

Thursday, July 30, 2009

SEC Issues Permanent Ban on Abusive Short Sales

In the aftermath of the financial crisis, the US Securities and Exchange Commission (SEC) had issued a temporary ban on the practice of “naked” short sales. By way of a recent press release, SEC has now made the ban permanent. The Press Release defines a “naked” short sale as one where “the investor sells shares "short" without first having borrowed them”.

While the Indian securities regulations permitted short sales only early last year, SEBI’s approach has been guarded to begin with. As discussed in a previous post, “naked” short sales have always been banned in India and only short sales through borrowing of securities have been permitted. That post also discusses the benefits and risks of the practice of short sales in securities generally.

Saturday, July 25, 2009

SEBI clarifies on Insider Trading Regulations amendments of November 2008

SEBI had amended the Insider Trading Regulations 1992 vide a Notification dated November 19, 2008 which I had discussed it here and here. SEBI has now released a set of "Clarifications" on 24th July 2009 on certain issues arising out of the amendments made. I had opined on some of these issues in my earlier posts referred to above and hence me update on what are the clarifications so given.

Curiously, the "clarifications" have no formal standing or reference. It is neither a circular, nor a notification, nor even a press release. It is neither signed nor dated. But it seeks to "clarify" and giving meaning to the Regulations that have legal standing and where such "meaning" is quite contrary - as we will see - to the plain reading of the text. Having said that, the "clarifications" mostly relaxes the requirements and hence, being gift horses, one should not examine them in the mouth too closely!

Let us see the clarifications given.

Recollect that specified persons were banned from carrying out opposite transactions "(banned transactions") for six months of original buy/sale ("original transactions"). The question was whether acquisition of shares under ESOPs scheme and sale of such shares would be considered as transactions that trigger off such ban and whether these themselves are banned.

It is clarified that exercise of ESOPs will neither be deemed to be "original transaction" nor "banned transaction". Thus, by acquiring shares under ESOPs, you don't trigger a ban and if you are banned for six months, you can still exercise ESOPs. The reasoning given is that the ban is only on transactions in secondary market.(Incidentally, I had felt that "However, taking all things into account, perhaps the intention is not to cover shares acquired under ESOPs Schemes. ").

But sale of shares acquired through ESOPs is covered but it will only be deemed to be a "original transaction" and not a "banned transaction". In other words, even if you are under a ban, you can still sell shares acquired under ESOPs but once you sell such shares, you have triggered a ban of six months. On this aspect, I do not understand the basis of clarifying that the sale of shares acquired under ESOPs scheme will not be an "original transaction" - the logic of covering secondary market transactions should apply here also.

Then, it is clarified that every later transaction triggers a fresh six month ban. A purchase on 1st February results in ban till 1st August. However, if there is a fresh purchase on 15th March, there is a ban now till 15th September. Effectively, this means that the ban period is from 2nd Febuary till 15th September.

What about transactions before this amendment - will the amendment create ban in respect of them too - this is an academic issue now at least as the six month period is now complete. It is clarified though that the transactions before the amendment are not to be considered. On a similar note, unwinding of positions in derivatives held on the date of this amendment is possible.

A crucial clarification is that the ban on "sale" of shares for personal emergencies is permisible by waiver by the Compliance Officer. This is not evident from a plain reading of the provision and I had opined that "This bar on such transactions is total. There are no circumstances whether of urgent need or otherwise under which the bar can be lifted. There is also no provision under which even SEBI could grant exemption.". But SEBI thinks it is so evident and hence let us accept this gift without creating legal niceties! Note that this clarification applies only to sales and there can be no purchases within these six month ban period - obviously there cannot be any personal emergency to purchase shares!

It is also clarified that the ban on derivatives does not apply to NIFTY/SENSEX futures.

- Jayant Thakur

Friday, July 24, 2009

The Efficacy of Conventional Corporate Governance Instruments

Each time there is a corporate governance scandal (whether in India or elsewhere), the response has been to use a set of instruments (implemented through regulation or best practices) to avoid a repetition of such occurrences. It appears that these instruments have not always been successful as they come with certain innate limitations, but they are often applied in situations that are different from the context in which these instruments were designed in the first place.

In Uses and Limits of Conventional Corporate Governance Instruments: Analysis and Guidance for Reform, Simon C.Y. Wong reconsiders the efficacy of the conventional corporate governance instruments and provides some suggestions for reform. Here is the abstract of the article:

The global financial crisis is forcing policymakers to again consider the most appropriate governance arrangements for publicly listed companies. As a way to contribute to the current debate on corporate governance reforms, this article examines the uses and limits of five commonly employed corporate governance instruments - transparency, independent monitoring by the board of directors, economic alignment, shareholder rights, and financial liability.

This article discusses how the individual instruments have worked in practice, including instances when they have failed to achieve their intended objectives and, in some cases, worsened the governance ailments that they were designed to cure. For example, the rapid growth of executive compensation persisted - and in some countries, accelerated - after the introduction of individual executive pay disclosure. In the financial sector, the shift toward a board dominated by independent directors ultimately proved to be its Achilles' heel as weak industry knowledge meant that non-executive directors were unable to pick up on warning signs of imprudent risk taking by management.

Following this analysis, suggestions are put forward on improving application of these instruments. Topics explored include 1) the extent to which the board of directors can be relied upon to monitor management, 2) how executive compensation arrangements can be restructured to better align management and shareholder interests, 3) under what circumstances would additional rights for shareholders - such as director nomination rights and an advisory vote on executive pay - be appropriate, and 4) the factors that should be considered when transplanting corporate governance practices across countries.

The article concludes with a discussion of how policymakers should approach corporate governance reform generally.

In addition to the general discussion of various corporate governance systems, the article offers some perspective on the issue of governance in emerging economies (into which category India would fall) where there is generally a concentrated ownership of companies:

When transplanting board models across countries, special attention must be paid to the surrounding context. In markets where controlling shareholders are the norm, the board’s oversight role will likely be substantially constrained because the [non-executive directors] are often elected by the same owner-manager that they are responsible for overseeing. Yet, policymakers in many of these countries continue to strive to replicate the board model in Anglo-Saxon countries, where the shareholder base is typically highly dispersed.

In many markets, ownership structure exerts a non-trivial influence on the character of shareholder rights. To illustrate, given the prevalence of controlling owners in Italy and Mexico, the corporate governance regimes in those countries reserve space on the board for minority shareholders. In other markets where concentrated ownership is the norm, tools such as cumulative voting are often employed to provide a counterweight to the controlling shareholder’s influence. These mechanisms are largely alien to the UK and US, where ownership is generally much more dispersed and, hence, special rights for minority shareholders are not perceived to be necessary.

Among the various contextual factors to consider, ownership structure is perhaps the most important. With dispersed ownership as the norm, the key issues in Anglo-Saxon countries are incumbent management pursuing personal interests at the expense of shareholders and the ongoing challenges in inducing atomized shareholders to actively monitor management. In these markets, the primary tools employed have been independent boards and performance-based remuneration arrangements, including disclosure thereof.

In countries where controlling shareholders are a common feature, the main governance issue is the risk of abuse by dominant owners, particularly through related-party transactions and denial of participation rights. Moreover, as discussed above, there are limits to which the board of directors in firms with concentrated ownership can serve as an effective oversight body. Nonetheless, policymakers in some markets continue to focus on replicating the Anglo-Saxon board model.

Wednesday, July 22, 2009

The Tale of the Resigning Director

In the aftermath of events that occurred at Satyam and Nagarjuna Finance, there has been a mass exodus of independent non-executive directors from boards of Indian listed companies. More often that not, there is no apparent reason offered for resignation by such directors. As we had discussed in an earlier post, the SGX in Singapore has specified a template for notice of resignation of directors so that the investors and the marketplace have detailed information regarding the reasons for resignation.

Recently, there has been an interesting study of director resignations in Singapore by the Corporate Governance and Financial Reporting Centre at the National University of Singapore. The study looked at resignations of independent directors in Singapore over a nearly two-year period:

In a study of announcements from Oct 1, 2007 to May 31, 2009, we found 163 cases of resignation of independent directors. Eighty-five companies had one resignation, while another 24 companies had two, three companies had three, four companies had four, and one had five resignations. Reasons for these 163 resignations can be categorised into personal-related, corporate governance-related, and others. Personal-related reasons made up 112 out of the 163 cases, or 69 per cent.

The three most common personal-related reasons were 'other commitments' (43 cases), 'personal reasons' (15 cases) and 'personal interests' (11 cases). Examples of other personal-related reasons include age, health and business interests. In a few rare cases, very specific reasons were given.

Using this information, the authors explore some possibilities as to the real reasons for resignation:

Are personal-related reasons usually really personal in the sense of having to do with the personal circumstances of the independent director? One way to assess this is to examine whether the director also resigns as independent director from other boards he sits on.

Similarly, one could also examine whether the retiring director (with personal reasons) is joining other boards at or about the same time. The study then details the quantitative data analysed from resignations in Singapore. The authors, however, also caution against imputing too much into independent director resignations:

Of course, if an independent director resigns from one board and not from others, it does not necessarily reflect negatively on the company or on the director himself. For example, he could be resigning from boards because he wants to be able to commit enough time to his directorships. However, in such cases, we would expect the company to say so rather than use bland reasons like 'other commitments' or 'personal interests'.

The study concludes by noting that while the availability of a mandatory resignation template prescribed by SGX has improved transparency on this count in Singapore, the use of “boilerplate disclosures” continues to be common.

Staying on this topic, a column published in Malaysia pushes matters a few steps further and seeks to involve the regulator through an exit-interview of sorts:

Regulators need to start focusing on [independent non-executive director’s (INEDs’)] resignations. We suggest the following:

● Regulators should engage privately with the INED on the reasons for the resignation; and

● Regulators should be quick to question the company (in writing) why the INED has resigned.

The role of all investors is to find out why the INED has resigned. While a company (or a departing INED) will generally be reluctant to make a public statement, investors should seek and get some explanation in private conversations and then draw their own conclusions/take appropriate actions.

It is not entirely clear whether subjecting a resigning director to such an interview or investigation process in India is at all desirable, but there is certainly a case to introduce some level of transparency in independent director resignation process. This applies not only when directors in fact resign in the midst of their tenure, but even when they retire and opt not to offer themselves for re-election.

SEBI prohibits issue of shares with "superior" rights

SEBI has issued a circular dated July 21, 2009, to make amendments to prohibit issue of shares with superior voting rights by listed companies. This is pursuant to SEBI announcement discussed by Mr. Umakanth earlier in this blog here and that post makes an interesting analysis of the term "superior voting rights", particularly in comparison with the existing term "differential voting rights".

Incidentally, the actual amendment covers all superior rights as to voting as well as dividends. The original decision as per the Press Release read that "No listed company can issue shares with superior voting rights.".

The amendment is by way of insertion of a new clause 28A to the Listing Agreement. The amendment is to come into immediate effect though because of the peculiar status of Listing Agreement, one will also have to wait for amendment of the Listing Agreement by respective stock exchanges.

The new clause is brief and is reproduced for ready reference:-

"28A. The company agrees that it shall not issue shares in any manner which may confer on any person, superior rights as to voting or dividend vis-à-vis the rights on equity shares that are already listed."

Quick comments:-
- the prohibition is on issue of shares with "superior" rights and not on "inferior" rights.
- corollary from the earlier point, if a company issues shares with "inferior" rights, those shares will then become the new benchmark. If one takes this further logically, then, thereafter, even "normal" equity shares cannot be issued since these normal shares would have "superior" rights as compared to the existing shares with "inferior rights" assuming such latter shares are also listed!
- Can the amendment affect issue of preference shares which have priority of dividends and at times even rights of sharing further dividends? Or can one say that the intention is to cover issue of equity shares only since the comparison is made to existing equity shares?
- To bring the change into effect, the Listing Agreement is amended. This is curious. One would have thought the SEBI DIP Guidelines could have been a better place.
- Would special rights given to certain investors/promoters under the Article of Association such as veto rights, special rights, etc. be deemed to be "superior rights as to voting"? Can it be said that the ban applies only where the superior rights are given to the "shares" and not to the "persons" holding such shares?

- Jayant Thakur

Tuesday, July 21, 2009

Venture Capital - Foreign and Domestic: Some Comparisons

Consistent with the expansion of the venture capital industry in India, the regulatory regime has been formulated with a view to foster such growth. While the domestic venture capital industry is governed by the SEBI (Venture Capital Funds) Regulations, 1996, the foreign venture capital industry (investing into Indian companies) is governed by the SEBI (Foreign Venture Capital Investors) Regulations, 2000. On the face of it, the regimes appear similar to both types of venture capital investors. Both have been bestowed several exemptions and concessions from other applicable regulations, be it from the lock-in period in an IPO of an investee company or from the obligation to make a mandatory takeover offer when they sell shares to promoters of the investee company. Moreover, foreign venture capital investors (FVCIs) are not subject to pricing guidelines applicable to other foreign investors.

However, while there are similarities between domestic and foreign venture capital investors that emerge from the text of the regulations, there is striking disparity when it comes to the implementation of these regulations. That is also owing to the regulators that govern the two types of venture capital. While SEBI is the sole regulatory authority over domestic venture capital investors, both SEBI and RBI have roles to play when it comes to FVCI. Due to the foreign exchange concerns involved with FVCIs, a more cautious approach has been adopted with reference to FVCIs as compared to domestic venture capitalists. This has invited a significant amount of criticism in the manner in which FVCI applications have been handled by the regulators in the recent past, particularly by the RBI.

As Pranay Bhatia and Rachana Kapadia argue in FVCI Licensing and Pitfalls, RBI’s concern appears to stem from the fact that the FVCI route should not be used to circumvent restrictions under the general foreign direct investment (FDI) route, more so in sensitive sectors such as real estate. Further, they also note that RBI seems to have adopted the view that FVCI investments should be allowed only in nine sectors listed in Section 10(23B) of the Income Tax Act, 1961. Also, as we saw earlier this month, there was uncertainty as to the financial commitment or capitalization of FVCIs before they could submit their applications for registration, which has since been clarified. Such ambiguity in the stance of the regulator has resulted in significant delay in approval of dozens of FVCI application, as a report in The Mint indicates:

At least 43 foreign venture capital investors have been unable to begin investing in Indian start-ups because the requisite permissions from the Reserve Bank of India (RBI) have been delayed. Ten applications have been pending since 2005 and 11 more since 2006.

Capital markets regulator Securities and Exchange Board of India (Sebi) is the regulator for venture capital investors but it typically routes applications from foreign funds through RBI and clears them only after the central bank gives its nod. RBI gets involved because capital flows across national borders are involved.

As the Mint report notes, there is a need for greater transparency on the part of RBI in handling such applications. When there is already a detailed set of regulations, there ought to be very little scope for interpretation or for discretion to authorities to decide on individual applications. Moreover, there is no room for ambivalence in policy stances. The policy ought to be clearly stated in no uncertain terms so that market players are reasonably certain as to the outcome of their applications.