Tuesday, December 27, 2016

A Careless Concern for Workmen’s Dues: Insolvency Code of 2016

(The following guest post is contributed by Mridul Godha, a third-year student at the National Law University, Jodhpur)

The Joint Committee on the Insolvency and Bankruptcy Code of the Lok Sabha was much concerned about the welfare of workmen. “Workers are the nerve centre of the company. In the event of any company becoming insolvent or bankrupt, the workmen to get affected adversely and, therefore, priority has to be given to their outstanding dues” [sic]. To protect the interest of workmen, the Committee increased the dues to be preferentially paid to workmen under Clauses 53 and 178 of the Insolvency and Bankruptcy Code, 2016 to a period of twenty-four months instead of the earlier twelve months. Further, they placed the sub-clause on workmen’s dues at number one and put the secured creditor’s clause at number two, despite the pari passu status of the two sub-clauses, as a symbolic gesture of the importance given to workmen.

However, it seems like the Committee’s concern for the workmen’s dues was limited to the proceeds from the sale of the liquidation asset of the company in case of insolvency.

To explain this point, it is important to understand the procedure of liquidation proceedings under the Insolvency and Bankruptcy Code of 2016. Section 52 provides a secured creditor with two options in liquidation proceedings: (a) he may relinquish his security interest and receive proceeds from the sale of assets by the liquidator (which takes him to Section 53); or (b) he may realise the security interest on his own by following the procedure in Section 52 itself.

The procedure in the former case is amply clear. Section 53 provides the order of priority which must be followed while making payments from the proceeds received when the liquidator sells the company’s assets. This order is often called the waterfall. The waterfall under Section 53 places the workmen’s dues pari passu with the debts owed to a secured creditor. This is consistent with the waterfall under Section 529A of the 1956 Act and Section 326 of the 2013 Act.

The issue arises under the latter case, i.e., when the secured creditor opts out of the liquidation proceedings to realise the security interest on his own. The procedure for this option is in Section 52 and gives the secured creditor a great deal of freedom to enforce, realise, settle, compromise or deal with the secured assets to cover the debts due to it. While there is an obligation placed upon the secured creditor to identify the secured assets, get them approved by the liquidator and tender any surplus proceeds to the liquidator, there is no obligation to share a portion of the proceeds with the workmen. This is problematic.

First, it does not fit with the general scheme of the Companies Act of 2013 and 1956 wherein the workmen’s dues were in line with the secured creditor’s dues when the company was wound up due to insolvency. Second, it does not align with the rest of the scheme of the Insolvency Code of 2016 itself which prescribes the pari passu status to workmen’s dues under Sections 53 and 178. Third, it allows the secured creditor to “bypass” the need to share liquidation proceeds with workmen which he would otherwise be required to share under the Section 53 procedure.

The 2016 Code came into force on 5 August 2016 and it is still unclear whether the exclusion of workmen’s dues from the waterfall under Section 52 is an oversight by the drafters or not. While some commentators call this an ambiguity,[1] in my view, the clear exclusion of workmen from Section 52 and their inclusion elsewhere means that their claims are not pari passu with those of the secured creditor if the secured creditor exercises his/her right of enforcement under Section 52. In fact, the Joint Committee has discussed the workmen’s dues only in the context of Section 53 in its Report. My view is further buttressed by the fact that on 15 December 2016, the Government notified the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016 which also omit mentioning that workmen are to get dues alongside a secured creditor. Had the exclusion of workmen been an oversight, these Regulations would have been utilized by the Government as an opportunity to clarify that the pari passu principle covers both the options available with the secured creditor in liquidation proceedings.

Did the Joint Committee really intend to put their concern for workmen into effect in one option and allow the secured creditors to “bypass” this concern by taking the second option? I do not think so.

[1] http://blogs.economictimes.indiatimes.com/et-commentary/how-bankruptcy-code-treats-secured-creditors/

Sunday, December 25, 2016

Appointment and Removal of Independent Directors: Need for Reform?

The removal this week by three Tata group companies of Mr. Nusli Wadia as an independent director from each of them has reinvigorated some of the debate surrounding board independence from a conceptual standpoint. This has provided critics of board independence with more fodder. In the past, there was anecdotal evidence that whenever there were disagreements between managements or promoters on the one hand and independent directors on the other, either the term of the independent director would not be renewed upon expiry or such director simply resigned from the board. To my knowledge, this the first time an independent director has been removed by shareholders on account of a disagreement, in this case with the promoters. Hence, the occasion is somewhat momentous and may require some regulatory soul-searching.

Retaliating to his removal, Mr. Wadia has argues that independent directors carry onerous duties and responsibilities without any protection whatsoever. Moreover, he alleges that the promoters of the respective Tata group companies ought to have abstained from the extraordinary general meetings called for his removal, and that the majority for his removal should have been a higher threshold of 75% rather than a simple majority. Here, the episode reveals some significant chinks the regulatory armour surrounding independent directors.

In an earlier paper in 2011 titled “Evolution and Effectiveness of Independent Directors in Indian Corporate Governance”, I had sought to identify some of the problems relating to board independence, which have now manifested in the Tata group. The first concern is that independent directors are appointed like any other directors. I had noted:

[The law] does not contain any specific procedure for nomination and appointment of independent directors. That process occurs in the same manner as it does for any other director. It therefore requires us to explore the provisions of the Indian Companies Act to examine how directors are appointed and the various factors that play out in that regard.

In India, the appointment of each director is to be voted on individually at a shareholders' meeting by way of a separate resolution. Each director's appointment is to be approved by a majority of shareholders present and voting on such resolution. Hence, controlling shareholders, by virtue of being able to muster a majority of shareholders present and voting on such resolution can control the appointment of every single director and thereby determine the constitution of the entire board. Similarly, controlling shareholders can influence the renewal (or otherwise) of the term of directorship. More importantly, shareholders possess significant powers to effect the removal of a director: all that is required is a simple majority of shareholders present and voting at a shareholders' meeting. The only protection available to directors subject to removal is that they are entitled to the benefit of the principles of natural justice, with the ability to make a representation and explain their own case to the shareholders before the meeting decides the fate of such directors. The removal can be for any reason, and there is no requirement to establish "cause," thereby making it a potential weapon in the hands of controlling shareholders to wield against directors (particularly those directors that the controlling shareholders see as errant to their own perceptions regarding the business and management of the company).

The absence of a specific procedure for nomination and appointment of independent directors makes it vulnerable to capture by the controlling shareholders. Assuming that one of the purposes of the independent directors is to protect the interest of the minority shareholders from the actions of the controlling shareholders, such a purpose can hardly be achieved given the current matrix of director appointment, renewal and removal. The absolute dominance of controlling shareholders in this process creates a level of allegiance that independent directors owe towards controlling shareholders. If controlling shareholders cease to be pleased with the efforts of an independent director, such a director can be certain that his or her term will not be renewed, even if such director is spared the more disastrous consequence of being removed from the board.

In the case of Mr. Wadia, he had to face the “most disastrous consequence” noted above, which makes this episode somewhat exceptional.

Of course, since the publication of the above paper in 2011, there have been significant corporate governance reforms in India culminating in the Companies Act, 2013 and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2013 (“LODR Regulations”). The roles and responsibilities of independent directors have been delineated more clearly. However, when it comes to their appointment and removal, there is only one significant change, which is that the requirement of a Nomination And Remuneration Committee has now become mandatory under section 178 of the Companies Act, 2013. This formalizes the process for appointment of directors, including independent directors, as it is required to determine qualifications, positive attributes and independence of a director. It allows for a great deal of transparency and minimizes the influence of management and promoters in the nomination of independent directors. However, as I have argued in the above paper, any system of nomination committee is acutely insufficient to address the problems facing board independence in countries like India:

… Even if an independent nomination committee were to nominate candidates without the influence of the controlling shareholders or management, those candidates would ultimately have to be voted at a shareholders' meeting, where the controlling shareholders would wield significant influence. … The nomination committee tackles the first process, but it does not touch upon the second. Controlling shareholders will continue to have the ability to sway the shareholder decision on whether the candidate nominated by the nomination committee should be appointed on not. Hence, nomination committees are compelled to function in the shadow of an ultimate shareholder decision (with controlling shareholder influence). For this reason, nomination committees are unlikely to pick a candidate who does not have the tacit acceptance of a controlling shareholder. It would be an embarrassment after all if the person nominated by the nomination committee fails to muster enough votes at a shareholders' meeting due to opposition from the controlling shareholders. …

Given that the present episode reveals inadequacies in the current board independence structure, it is imperative to consider potential reforms to the process. As I had noted:

Currently, independent directors in India are elected by shareholders through the "straight voting" system, whereby a majority of the shareholders present and voting for a resolution can determine whether or not a candidate for independent directorship is appointed. It is the straight voting system that confers dominance on controlling shareholders in the appointment of independent directors, as minority shareholders do not have any say at all. My proposal deals with the enhancement of minority shareholder involvement in independent director elections. This would make independent directors accountable to the shareholder body as a whole (including the minority shareholders) as opposed to the sole allegiance to controlling shareholders as currently practiced in India.

Minority shareholder participation can be introduced through two principal methods: (i) cumulative voting by shareholders; and (ii) election of independent directors by a "majority of the minority." …

a. Cumulative voting

Cumulative voting will ensure that minority shareholders will have the ability to elect such number of independent directors as is proportionate to their shareholding in the company, thereby reducing the dominance of controlling shareholders in the process. In this structure, each shareholder gets to exercise such number of votes determined as the product of the number of shares held by the shareholder and the number of independent directors to be elected. A shareholder can exercise all votes in favor of a single candidate or can split the votes among different candidates. In case all votes are cast in favor of a single candidate, then that candidate may have a chance of being elected depending on the total number of candidates that are in the fray. …

The advantage of cumulative voting is that it allows both controlling shareholders as well as minority shareholders to elect independent directors depending on the proportion of their respective shareholding.

b. Voting by 'majority of the minority'

In this schema, only the minority shareholders are entitled to vote for the election of independent directors. Each independent director will be elected so long as the candidate enjoys majority support within the constituency comprising the minority shareholders. In this approach, neither the controlling shareholder nor the management can influence the appointment as they have no role at all. The controlling shareholders will not be permitted to vote in independent director elections under this proposal. Furthermore, this is useful where the number of independent directors to be appointed is small whereby the system of cumulative voting would render itself ineffective. This will result in true representation of minority shareholders on corporate boards and instill accountability in the minds of the independent directors towards minority shareholders.

Of course, it is not sufficient if the regulatory process fixes issues relating to the appointment of independent directors: it must also address the question of removal which surfaced in the case of Mr. Wadia. As I had argued:

The procedure for renewal of the term of independent directors ought to be the same as that for a fresh appointment, i.e., through selection by an independent nomination committee and election through minority shareholder participation. As far as removal is concerned, there are some key issues to be borne in mind. There is no benefit in having a carefully considered election process for independent director if that can be undone in one stroke by a straightforward removal process. For example, if independent directors can be removed by a simple majority of shareholders, then the controlling shareholders can reverse the effect of appointing independent directors by removing them through exercise of their influence. In order to obviate such a reversal, along with minority shareholder participation in independent director elections, it is necessary to impose stringent removal requirements. Either independent directors can be removed by shareholders only for "cause" or they can be removed with a supermajority that requires a higher threshold (of say 3/4 or 2/3 majority of shareholders voting for the resolution). This would ensure that independent directors are capable of being removed only in extreme circumstances, and not simply because such directors no longer enjoy the trust of the controlling shareholders. Such a requirement is essential to ensure that independent directors remain outside the influence of controlling shareholders.

While some may argue against the theoretical nature of the debate or implying that such excessive reforms are unnecessary, the episode involving Mr. Wadia has demonstrated that these issues are real. It would to foolhardy to brush these issues aside. Other such as Professor Bala Balasubramanian too have long argued for “majority of the minority” voting in case of specific transactions, including in case of appointment of independent directors. Even an OECD document titled “Improving Corporate Governance in India” highlights the undue influence of controlling shareholders in the appointment and removal of independent directors, finding that “jurisdictions, like Italy and Israel, have provisions for the appointment of independent directors by minority shareholders, which ensures more independence”, thereby suggesting that “controlling shareholders not be allowed to vote in the election of independent directors so as to ensure the latters’ independence”.

Granted the recent round of reforms surrounding corporate law and governance have given more teeth to independent directors, but the current episode exposes the continued vulnerability of individuals who occupy that office. The legislators and regulators ought to take cognizance of these glaring loopholes, and address them in the appropriate manner.

Saturday, December 24, 2016

ESOP Shares and the Computation of Open Offer Triggers

Under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Regulations”), an acquirer must make a mandatory open offer to acquire the shares of the remaining shareholders when the acquirer acquires shares (with voting rights) beyond prescribed thresholds. Since the triggers are based on the acquisition of shares with voting rights, questions could arise whether shares issued by a company to an ESOP Trust under the SEBI (Share Based Employee Benefits) Regulations, 2014 (“SBEB Regulations”) would be considered for purpose of computing the triggers. This question came up in a request for informal guidance made by Capital Trust Limited to the Securities and Exchange Board of India (SEBI).

One of the promoters of Capital Trust holds 43.26% shares in the company. The company wishes to issue new shares to its ESOP Trust (set up for the benefit of the employees) and simultaneously wishes to convert certain pending warrants issued to the promoter into equity shares. Taken on a post-diluted basis after considering the issue of shares to the ESOP Trust, the increase in the promoter shareholding will be 4.99%, i.e. within the 5% creeping limit that would trigger the requirement for the promoter to make an open offer. The company requested SEBI’s informal guidance on two counts: (i) whether the shares allotted to the ESOP Trust would be taken as increase in share capital for the purpose of calculation of the conversion of warrants into equity shares; and (ii) whether the issue of shares to the promoter upon conversion of warrants is below the creeping acquisition limits prescribed in regulations 3(2) and 3(3) of the Takeover Regulations.

In response, SEBI issued an informal guidance on December 22, 2016. On the first question, SEBI examined the SBEB Regulations and found that under regulation 3(5) thereof the trustees of an ESOP trust are prohibited from voting on shares held by them “so as to avoid any misuse arising out of exercising such voting rights”. In other words, shares held by an ESOP Trust would effectively be disenfranchised.

This then leads to the answer to the second question on whether the mandatory offer requirements under the Takeover Regulations are triggered. Consequentially, SEBI found that the issue of shares to the promoter would exceed 5% of the voting rights in the company, and hence the promoter would be required to make an open offer to the other shareholders by virtue of creeping acquisition.

Although SEBI’s informal guidance is not explicit as to its reasoning, this outcome ensued because the shares held by the ESOP Trust would not be counted towards the computation of voting shares in the company. Since, in determining the open offer triggers, only the shares with voting rights are considered both in the numerator and denominator, the shares held by the ESOP Trust would be effectively disregarded for this purpose. Hence, the percentage of voting shares issued to the promoter would be computed without taking into account the shares issued to the ESOP Trust, and the issuance of such shares will exceed 5% thereby extending beyond the creeping acquisition limits and triggering and open offer.

In all, given that there is a prohibition on voting by trustees of an ESOP Trust, it is not possible circumvent creeping acquisition limits by structuring an issue of shares to the ESOP Trust, as the present informal guidance from SEBI categorically establishes.

Friday, December 23, 2016

Bombay High Court Clarifies Rights of Nominees in Shares

An intricate legal question that has befuddled various courts relates to the conflicts between the rights of nominees and those of successors in the case of ownership of various financial instruments, including shares of a company. As regards shares, the issue came to the fore in 2010 in the case of Harsha Nitin Kokate v. The Saraswat Co-operative Bank Limited (“Kokate”) wherein, after interpreting the provisions of sections 109A and 109B of the Companies Act, 1956, a single judge of the Bombay High Court ruled that the nominee of shares becomes a beneficial owner thereof after the death of the original owner, and that nomination effectively overrides succession. This decision was previously discussed on this Blog, including a strong critique by our contributor Somasekhar Sundaresan, as the decision seemed to flows against the tide of conventional wisdom at the time relating to the debate surrounding nomination and succession in the case of ownership of financial instruments.

The issue was hardly one to subside, and resurfaced with a decision of another single judge of the Bombay High Court in 2015 in Jayanand Jayant Salgaonkar vs. Jayshree Jayant Salgaonkar (“Salgaonkar”), wherein it was declared that the judgment in Kokate was per incuriam, and that legal heirs and not the nominees will obtain the ownership rights of share certificates. Sumit Agrawal discussed the development at the time on this Blog.

An appeal was preferred from the single judge’s decision in Salgaonkar to a division bench of the Bombay High Court in Shakti Yezdani v. Jayanand Jayant Salgaonkar (“Yezdani”), wherein the judgment was delivered on December 1, 2016. The division bench was effectively called upon to resolve the differences between the two single judges in Kokate and Salgaonkar. Ultimately, it ruled in favour of the position adopted in Salgaonkar and against that in Kokate, effectively circumscribing the scope of the nomination of shares under the provisions of the Companies Act, 1956.

In Yezdani, the facts were essentially that a deceased individual left behind several shares and investments (such as mutual fund units). While the individual made a bequest in the form of a will, certain others made claims as nominees of the shares. The nominees claimed that they were beneficial owners of the shares upon death of the nominator in view of such nomination.

In deciding on the issue of conflict between nomination and succession, the division bench was taken through a catena of cases relating to various financial instruments and other assets wherein nomination facility was provided for under different legislation. One of them was a decision of the Indrani Wahi v. Registrar of Co-op. Societies wherein the Court had considered the provisions of sections 69 and 70 of the West Bengal Co-operative Societies Act, 1983 and held that nomination does not bind the legal representatives of the deceased member of a society nor does it overrides the law of succession. This despite the said West Bengal legislation (in section 80) providing that in case of death of a member the share or interest of the member in the co-operative society shall stand transferred to the person nominated. The Court also considered various decisions of the Supreme Court under other legislation such as the Banking Regulation Act, 1949 and the Government Savings Certificate Act, 1959, wherein similar conclusions were arrived at. The Court found that sections 109A and 109B of the Companies Act, 1956 were not materially different from these legislation.

In the operative portion of its decision, the Bombay High Court noted:

32. In the present case, we find that the provisions of Section 109A and in particular Sub­section (3) thereof are not materially different from the provisions of Sub­section (1) of Section 6 of the Government Savings Certificates Act, 1959. Sub­section (2) of Section 45­ZA of the Banking Regulation Act, 1949 is also similar to Sub­section (2) of Section 109B. The same is the case with Bye­law 9.11 of the Depositories Act,1996. ...
34. The provisions relating to nominations under the various Enactments have been consistently interpreted by the Apex Court by holding that the nominee does not get absolute title to the property subject matter of the nomination. The reason is by its very nature, when a share holder or a deposit holder or an insurance policy holder or a member of a Co­operative Society makes a nomination during his life time, he does not transfer his interest in favour of the nominee. It is always held that the nomination does not override the law in relation to testamentary or intestate succession. The provisions regarding nomination are made with a view to ensure that the estate or the rights of the deceased subject matter of the nomination are protected till the legal representatives of the deceased take appropriate steps. None of the provisions of the aforesaid Statutes providing for nominations deal with the succession, testamentary or non­testamentary. As observed by the Apex Court, the legislative intention is not to provide a third kind of succession.

35. Considering the consistent view taken by the Apex Court while interpreting the provisions relating to nominations under various Statutes (including the view in the recent decision in the case of Indrani Wahi), there is no reason to make a departure from the consistent view. The provisions of the Companies Act including Sections 109A and 109B, in the light of the object of the said Enactment, do not warrant any such departure. The so called vesting under Section 109A does not create a third mode of succession. It is not intended to create a third mode of succession. The Companies Act has nothing to do with the law of succession. ...

By this, the Bombay High Court has circumscribed the scope of nomination, and treated it essentially as a temporary arrangement so that shares do not remain ownerless during the period that succession issues are resolved. In other words, nomination is only a means and not an end. Through this, the Court has largely harmonized the law relating to shares with that of other financial instruments and membership rights under other legislation. The upheaval caused by Kokate has now been ironed out.

Given that section 72 of the Companies Act, 2013 is in pari material with section 109A of the Companies Act, 1956, the tenor of the Bombay High Court’s ruling will be immensely relevant in interpreting the new legislation going forward.

Thursday, December 22, 2016

Towards a Conducive Framework for REITs – Recent SEBI Amendments

[The following guest post is contributed by Sumit Agrawal, Partner, Suvan Law Advisors and Arka Saha, a final year law Student from National Law University, Orissa. Views are personal]

Although the capital and commodities market regulator, the Securities and Exchange Board of India (SEBI), had introduced Real Estate Investment Trusts (REITs) Regulations on September 26, 2014, REITs are yet to gain momentum similar to developed markets such as the U.S., Singapore and Australia. The objective of introducing REITs was to mitigate the slump in the real estate sector mired by decreased cash flows and an ever-growing leverage crisis among the top real estate companies. It was also aimed at providing retail investors with access to a new asset class, traditionally the prerogative of a few large players due to high acquisition and maintenance costs. For real estate companies, REITs were to accord an alternative mode of financing and of stripping debt, while providing small investors an asset class to hedge against inflation.

Akin to mutual funds where one can invest in stocks without the difficulty of daily management responsibilities, REITs allow investment in income-generating real estate assets such as offices, residential apartments, shopping centres, hotels, garages, car-parks, warehouses etc. REITs are structured as Trusts managed by trustees, that raise funds (through an IPO, FPO etc.) from investors, in order to invest in income-generating real estate assets. Beneficial interest of the REITs in the form of units are listed in stock exchanges so that investors can trade those units. The investment objective of REITs is to provide unit holders with yields through dividends.

Due to concerns regarding double taxation and various infirmities in the law, the objectives so far remained unfulfilled. Recently, after public feedback, SEBI amended the REIT Regulations to provide a workable framework for the launching of REITs.

Structuring of Investments

A step that can change the landscape of REITs pertains to the structuring of investments. Earlier, a REIT could either hold assets by itself, or hold assets through a special purpose vehicle (SPV), in which it held both a controlling interest and at least 50% (now 51%) of the equity share capital or interest. Thus, investments were permitted to be structured through a single vertical layer. This impeded the formation of REITs due to huge expenses incurred in re-structuring of extant assets, as the real estate sector is characterised by confluence of multiple parties specific to a project, including joint development partners, land owners, and investors, resulting in investments being structured through various layers. Consolidation of assets into one SPV or multiple SPVs in the same horizontal level is expensive due to stamp duty payable on transfers. The amendments allow REITs to invest via a two-level structure through a holding company, subject to sufficient shareholding in the holding company and the underlying SPV. This substantially reduces costs of consolidation, further allowing for added capitalisation at the holding company level through the primary markets. Notably, the Companies Act 2013 permits a company to invest through two layers of investment companies, and now REITs have been brought on a similar footing.

Real estate assets jointly held under joint development arrangements by developers and land owners who come together to develop property, along with those held by different schemes of a Private Equity fund or different funds under common control, and those held by group companies of a developer, form a large constituent of assets in the sector. Until now, up to three sponsors were permitted in a REIT Owing to this limit, multiple co-owned assets were precluded from being transferred to a REIT as each party to it could not be identified as a sponsor. This has been done away with, and the concept of a 'sponsor group'  introduced, thus paving way for large scale participation.

Issue and Listing of Units

Recent changes do away with the minimum requirement of 200 public unit holders at all times, non-compliance of which could lead to de-listing of units. This was a grave impediment to the setting up of the investment vehicle as REITs had to keep a check on trading of its units post issue, a process beyond their control and oversight, due to inter-se transfer between unit holders and transfers to non-holders in the secondary markets being conducted on the basis of price time priority on the exchanges. Under the amended regulations, REITs are only mandated to ensure the presence of 200 unit holders at the time of offer of units to the public, and that the minimum public float requirements are met.

The requirements pertaining to minimum public shareholding and minimum size of initial offer to public have also been revamped to do away with the earlier requirement of an offer-size and minimum public holding of at least 25% for all REITs. This has been done to make it less onerous to market a product which is at its conception stage in the Indian markets, and to find takers for an extremely large number of units that REITs with immensely large valuations were obligated to issue to comply with such requirement. The amended regulations distinguish between REITs on the basis of their post issue valuation to set out different requirements. Large REITs, with a post issue valuation of over Rs. 4000 crores, have been permitted to make an initial offering of a lesser issue size of 10% of all outstanding units and units proposed to be offered, subject to them fulfilling the 25% minimum public float requirement within three years from the date of listing of such units. Another change of significance is the enumeration of responsibilities of merchant bankers in the public issue process of REIT units and mandating appropriate due-diligence. This move is likely to increase transparency and accountability, boosting investor confidence.

Investment Conditions

The recent changes permit up to 20% of investments (earlier 10%) in under-construction projects. This will provide greater flexibility to REITs to invest a higher amount in projects being constructed in stages. Though this may improve the returns for REITs in the long run; the risk involved in such investment product may also substantially increase.

The Way Forward

While the recent amendments  have potential to revitalise the real estate sector, certain issues continue to hamper the attractiveness of REITs.

Despite permitting REITs to hold assets through two vertical layers, establishment of a REIT structure may still take sufficient restructuring of assets because of section 186 of the Companies Act. To bring the REIT regulations in concurrence with the Companies Act, the holding company which currently is permitted to make investments in an SPV holding assets, should be allowed to make investments through two vertical layers. In effect, this will entail the REIT making investments through three such layers, reducing costs by diluting the need of restructuring as equity in companies that currently invest through two layers of investment companies can be transferred to the REIT. From a tax perspective, exemption from stamp duty on properties being transferred to a REIT, in line with the Singapore experience, will incentivise the establishment of the conduit. REITs in Singapore (S-REITs), at their inception in 2002, were exempted from paying stamp duty charged at 3% when acquiring properties - a benefit that was extended till 2015, resulting in the SGX S-REIT 20 Index crossing the fifty billion dollar mark.  

Globally, REITs are sold as a retail product for wealth creation. In Indian context, REITs have been designed in a way that keeps small investors out, given the application and minimum lot size of Rs. 2 lakh and Rs. 1 lakh respectively, raising doubts about there being sufficient takers of units. Perhaps the object is to protect smaller investors, due to the lack of transparency in the real estate sector. However, SEBI may have to revisit such position due to the recent enactment of the Real Estate (Regulation and Development) Act, 2016 which is bound to be a game changer, bringing in much needed credibility and accountability to the sector and boosting investor confidence. Other economic reforms such as Goods and Services Tax (GST), and relaxed foreign investment norms in the real estate sector are going to be additional catalysts in the development of the Indian real estate sector and consequently of REITs.

According to industry estimates, REITs in India will have investment opportunities up to $77 billion by the year 2020. However, there is a view that unless the returns from REITs are higher than FD rates, takers of REIT units may be few, hampering its success. With several real estate players evaluating how policies pan out in the times to come, the challenge for SEBI remains in creating a framework that assists in active participation of real estate companies while facilitating the marketing of this novel product as a viable alternative for investors.

- Sumit Agrawal & Arka Saha