Monday, March 31, 2008

Inadequacies of the FII Regime

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The FII Regulations are the broken window of the Indian capital markets that projects a bad image of India to the international community. It is time to fix it.”
The list of problems with the FII regime goes on, and I suppose it is only the word-limit of the column that imposed constraints on Somasekhar.

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

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

Friday, March 28, 2008

Tata-JLR Acquisition: The Legal Team

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

(In case you are unable to access the hyperlink above, please try copying the following and pasting on your browser:'s+1bn+Jaguar+sale.html)

Wednesday, March 26, 2008

Fairness Opinions: Art or Science?

It has been said that valuation of a company is more of an art than a science. This has manifested again in the Bear Stearns transaction that is currently hogging limelight among legal circles. In this case, Lazard issued a fairness opinion when JP Morgan’s transaction with Bear Stearns was first announced that a stock consideration of $2 per share was fair to Bear’s shareholders. Now, under the revised deal announced earlier this week, Lazard again provided a fairness opinion that the new consideration of $10 per share is also fair. The question that is being asked is how $2 per share could have been fair when $10 per share is also fair. For details of the views opposing and defending Lazard’s position, see Blog and The Harvard Law School Corporate Governance Blog.

Fairness opinions are not altogether alien to Indian corporate law. Though not statutorily required, it has become a matter of practice for courts to examine valuation reports (customarily issued by chartered accountants) that determine the valuation of companies involved in a merger transaction or other schemes of arrangement, before they grant their seal of approval to such transactions. Even shareholders (or other interested parties) that oppose mergers and similar transactions usually use the valuation as their main prong of attack while challenging such transactions, which requires courts to determine the fairness of the valuation to shareholders of the companies involved.

Fortunately, courts are reluctant to disturb valuation on the merits so long as they have been arrived at by qualified, competent and independent professionals who are well-versed in valuation matters. Courts would however, look into the credibility of the process by which valuation was undertaken – for instance whether the valuer did a proper job, which is justifiable on the face of the report, and whether it is a detailed report with necessary reasons and explanations for arriving at the conclusion. The jurisprudence on this count has been fairly well developed, especially in the Hindustan Lever and Miheer Mafatlal cases decided by the Supreme Court.

Since the court’s oversight on valuation is limited, problems as to differences in valuation are bound to arise even in Indian circumstances, and they have in fact done so in several instances in the past. While one valuer can arrive at a particular figure, another valuer may arrive at a completely different figure, although both are based on the same set of financial figures relating to the companies. It seems almost impossible to obliterate the element of subjectivity in valuation.

However, efforts have been taken to minimise the uncertainty involved by introducing better practices on valuation. For instance, in January 2003, an Expert Group under the chairmanship of Mr. Shardul Shroff had submitted a report suggesting a framework for valuation of companies, and to make the process more transparent. As far as I am aware, the recommendations are yet to be implemented. Fairness opinions and valuations therefore continue to be matters of practice to be regarded by courts while sanctioning schemes of arrangement.

Price Manipulation in Stocks: Evidentiary Problems

SEBI last week passed an order in relation to an investigation involving the promoters of Zee Telefilms Limited. This was under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 1995 (the SEBI (PFUTP) Regulations).

SEBI alleged that the promoters of Zee Telefilms Limited (now Zee Entertainment Enterprises Limited) provided funds to the Ketan Parekh (KP) group of companies so as to enable it to manipulate the price of the Zee stock and maintain it despite the drastic fall in global stock markets in 2000-2001. This was allegedly to ensure that one of the Zee promoters was able to sell off its stake when the price was high and also for Zee itself to justify its issuance of shares to a financial investor at a high price.

Although the order by SEBI’s whole time member considers the complex transactions that occurred between the parties, there was indeed no direct evidence to establish stock manipulation within the facts of the case. Hence, Zee’s promoters were let off with only a warning. Here are some excerpts:

“I am conscious of the fact that there is no direct evidence of the involvement of Zee and its promoter companies in manipulation of the scrip of Zee. I also note the contention of Zee that the transactions entered into between them and KP entities did not have the effect of manipulating the market price of Zee and synchronised trading per see is not violative of SEBI (PFUTP) Regulations. However I am also conscious of the fact that in almost all manipulation cases, considering the market dynamics involved, it is always difficult to prove the intention and the same has to be inferred from the mass of factual details, sequence of events, accompanying circumstances, conduct of the parties and the overall impact of such transactions etc. When seen from this angle, on balance it is difficult to infer that Zee group entered into transactions with KP entities with the intention of manipulating or maintaining the price of Zee at a particular level.

A cumulative view of the aforesaid findings, therefore, persuades me to conclude that though the noticees were not involved directly in manipulating the scrip of Zee but their conduct and actions give an impression that they aided and abetted KP entities in large scale market manipulation of various scrips including Zee.

Now therefore, I in exercise of powers conferred upon me under Section 11 and 11B read with Section 19 of the SEBI Act, 1992, hereby warn Zee Telefilms (since changed to Zee Entertainment Enterprises Ltd.) and its promoters viz., … I also direct Zee Telefilms Limited and its promoters to note that any similar activity and/or instance of violations or non-compliance of the provisions of Securities and Exchange Board of India Act and the Rules and Regulations framed there under, in future, shall be dealt with stringently.”
The order by SEBI’s whole time member is important as it demonstrates the difficulties faced by regulators in proving market manipulation actions against market players (relevant portions highlighted). This is because manipulation involves multiple layers and series of transactions imposing a strong burden on the regulator of proving the chain of causation. On the other hand, it is left for the defendants merely to establish a break in the link. The tone of SEBI’s order in this case suggests acute suspicion on its part of manipulation by Zee’s promoters but inability to prove the same. Hence, it had to settle for warning rather than penalty.

Tuesday, March 25, 2008

Pay Commission Recommendation for Regulatory Bodies Laudable

The Sixth Pay Commission Report has hogged headlines. An interesting and important recommendation that will help the administration of corporate law is the recommendation on payscales for full-time members of regulatory bodies set up under Acts of the Parliament of India.

The Commission has recommended that Chairmen of bodies such as the Securities and Exchange Board of India, the Central Electricity Regulatory Commission and the Competition Commission be paid Rs. 200,000 per month and wholetime members of such bodies ought to be paid Rs. 150,000 per month with housing and car allowance being taken care of by the regulatory body. Should these allowances not be paid, the recommendation is to pay Rs. 300,000 per month to the Chairmen and Rs. 250,000 to the wholetime members.

The Commission has underlined the need to attract outside talent to work in these organisations. This is a crucial recommendation. One hopes the government has the maturity and the will to accept this recommendation. It is tough to motivate people to do social service for the State and incur the obligations of a public office. While these payscales would be nowhere near market rates, they would at least signify the seriousness with which the State would treat these jobs.

The Commission Report, authored by Justice B.N. Srikrishna, who, in his days as a practising lawyer, was an known for his expertise in employment law has made an important contribution to the field of administering law in the corporate sector and the securities market. The Commission has also recommended that a tenure of at least three to five years should be assured in normal circumstances in these positions.

Bear Stearns: Some Legal Complications

JP Morgan Chase yesterday increased its bid for Bear Stearns to $10 per share from its previous bid of $2, fearing a refusal by shareholders to approve its takeover of the beleaguered broking entity. Several large shareholders of Bear Stearns had expressed disappointment at the initial offer price put out by JP Morgan Chase.

As the takeover battle progresses, some complications seems to have arisen in the deal documentation. This is primarily due to the hurried negotiations that preceded the announcement of the deal. Here’s an extract from the New York Times’ Deal Professor:

“A careful read of its guaranty agreement with Bear Stearns, part of its deal to acquire the troubled investment bank, suggests that the agreement may be much broader than JPMorgan intended. This apparent oversight likely played a role in JPMorgan’s decision over the weekend to consider raising its offer for Bear.

Under the merger agreement, if Bear’s shareholders vote down the takeover deal for a year, Bear can terminate the agreement. This we already knew. But it also appears that, in such circumstances, JPMorgan’s guarantee to backstop Bear’s liabilities stays in place — forever.

That is, even after the rejection from Bear’s shareholders, JPMorgan’s guarantee would continue to apply to any liabilities Bear accrued up to the termination of the agreement. This provision could allow Bear’s shareholders to seek a higher bid while still forcing JPMorgan to honor its guarantee.

The guarantee would not apply to liabilities accrued after termination of the agreement. Still, as The New York Times reported Monday, the agreement may have been much broader than JPMorgan and its law firm, Wachtell Lipton Rosen & Katz, meant it to be.

According to The Times, one participant in the negotiations described James Dimon, JPMorgan’s chief executive, as being “apoplectic” as he sought to have the sentence modified.”
All this points to the fact that the renegotiation of the price may not have occurred only to appease opposing shareholders, but also reportedly to overcome some of the “mistakes” that sprung up in the deal documentation.

Monday, March 24, 2008

Special Purpose Acquisition Companies: On the Rise

Special Purpose Acquisition Companies (SPACs) that are also known as “blank check companies” are gradually acquiring prominence in the Indian markets. It is worth briefly examining these entities and their advantages as well as the risks surrounding them.

SPACs are essentially shell entities with no business operations, and which raise funds from the public through an initial public offering (IPO). These funds are raised on the basis that they will be utilised by the SPAC to acquire one or more companies in the future so as to provide returns to their shareholders. The details of the future acquisitions or even the identity of the target entities are not known at the time of the IPO. The investors in the IPO largely rely on the management skills and reputation of the founders of the SPAC while making investments. SPACs are usually committed to a time-frame within which they are required to make acquisitions. In case the committed time elapses without any acquisitions, the investments will have to be returned to the shareholders with certain carrying costs. A detailed explanation of SPACs and the offering process is available at

SPACs have acquired prominence internationally, especially in the US and in Europe. The New York Times’ Dealbook cites a Dealogic report which states that last year, there were 66 initial public offerings for SPACs, raising a total of $12 billion. Many of these SPACs have also successfully implemented acquisitions. What is important to note, however, SPACs are yet not traded on the main stock exchanges around the world. For example, neither the NYSE nor NASDAQ permits listing of SPACs, resulting in most of the existing US listings taking place on the American Stock Exchange (AMEX). It is only lately that both these exchanges are considering proposals for listing SPACs as reported by the Blog. Even on the London Stock Exchanges, SPACs are usually listed on its AIM segment. The cautious approach adopted by the more prominent exchanges is owed to the innate risks and uncertainties involved in listing entities that do not have existing businesses (or even fairly concrete business plans) at the time of their public offering of securities.

The SPAC phenomenon is catching on in India as well. It has been reported by VC Circle that several SPACs have been formed in order to pursue acquisitions of Indian companies. These SPACs have been listed on both the AMEX as well as the LSE AIM. The reverse trend is also assuming importance, whereby Indian companies are contemplating SPACs that would be used to aid their acquisition of foreign companies. This trend can be gathered from VC Circle's report about HCL’s plans to set up an SPAC for overseas acquisitions. HCL’s example is important on two counts. First, it indicates the utility of SPACs for Indian companies as a means of financing overseas acquisitions. Second, it indicates that SPACs are not confined to financial investors, and that it can be used by strategic investors as well for acquisitions. With more avenues being made available for SPAC listings (in case the current NYSE and NASDAQ proposals to allow SPAC listings take effect), it is likely that SPACs would become more prominent in acquisitions both by Indian companies and of Indian companies.

That leaves the crucial question of whether SPACs can be listed in India. It seems to me that the current disclosure requirements of SEBI as well as the listing requirements of the stock exchanges would not permit a company such as an SPAC to be listed on the Indian stock exchanges. This is because the SPAC has no business whatsoever or even a track record, but only certain broad business plans to acquire target companies that are yet to be identified. This creates uncertainties and risks to investors. Unless the existing regulations are amended to create a separate category of listings for SPACs, or unless specific waivers are granted from the applicability of the disclosure guidelines for IPOs to such companies, Indian listings would be unlikely. At the same time, it would be prudent for the regulatory authority (being SEBI) and the Indian stock exchanges to tread cautiously on this front, and to permit such listings only after assessing the experience (and success) of SPACs world-over and those specifically involving Indian promoters or Indian target companies. SPAC investors need proper protection as they are signing “blank checks” after all.

Sunday, March 23, 2008

Impact of Global Crisis on the Indian Economy

It could have been worse. That is the message emanating from leading commentators on the Indian economy. This is attributable to the Reserve Bank of India’s conservative policies that have largely staved off a deeper crisis within the country.

Today’s Business Standard carries a column by its editor T.N. Ninan, where he argues:

“For years, the wunderkinds of the financial world have railed at the Reserve Bank’s dullness and stupidity, its unwillingness to allow innovations, and its excessive caution. But the RBI seems about to have the last laugh. Those super-bright financial brains who created those wondrous hedging options, innovated away with structured products till no one knew or understood what was going on, and who thereby created massive value for their firms (the profits of financial firms in the US have grown to account for 41 per cent of all US corporate profits!) while earning fat bonuses for themselves, have to explain why they and their firms have to be saved by the American taxpayer. The US fiscal giveaway is already $150 billion, and the Fed has shelled out more and more money to keep the financial wheels greased while crashing interest rates despite the risk of inflation — all this to salvage the wreckage created by Manhattan’s ‘masters of the universe’.

So why is India safe amidst this turmoil? Because the Reserve Bank has done the things that people laughed at. It issued market stabilization bonds and absorbed dollars; now if overseas investors suck out dollars after selling shares, there is no shortage of dollars to sell to them; and, there will be no domestic liquidity crisis because the RBI can buy back those bonds and pump rupees into the market. Further, the RBI has made banks keep 7.5 per cent of their deposits in cash, and another 25 per cent of their deposits in government bonds. So even if there were to be a run on a bank — as with Northern Rock and Bear Stearns—they would have the liquidity to tackle the situation, so long as they are solvent; and bank solvency has improved because of financial reforms over the past 15 years.

This is therefore playing out as a repeat of 1997 — India was seen then as being free from the East Asian virus because it had not fully integrated with the region, on trade or capital flows. Now, the lack of sophistication in the Indian financial market is providing protection in a world marked by financial contagion. Hastening slowly when it comes to financial innovation seems to be a wise rule.”
This indicates the benefits of an economy maintaining some level of controls, without fully integrating into the global economy. I am also reminded of arguments of the same nature made by Joseph Stiglitz (a Nobel-prize winner for economics) in his book “Globalization and its Discontents”. Specifically, in the context of the East Asian Crisis of 1997, he demonstrates that countries like Malaysia that were quick to impose capital controls suffered less than others like Thailand and Indonesia that did not impose such controls.

On a more specific aspect of the Indian economy, i.e. the idea of establishing an Indian sovereign wealth fund (SWF), Swaminathan S. Anklesaria Iyer considers an interesting dynamic in a Times of India column. While the establishment of a sovereign wealth fund by the Indian Government will augur well in the longer term (a matter that we have argued too earlier on this blog - here and here), the incumbent Government may have scored a political victory by avoiding the establishment of an SWF that could potentially have lost value of its investments in the current market crisis. Iyer says:

“Sonia Gandhi should thank Finance Minister Chidambaram for resisting proposals to put part of India's foreign exchange reserves into a Sovereign Wealth Fund, which would buy equity shares in top global companies. Such a Sovereign Wealth Fund (SWF)—an idea backed by eminent economists, the Prime Minister and the Planning Commission—would have suffered huge losses because of the collapse of global stock markets since January. Neither Opposition politicians nor the public would have been satisfied by explanations that stock markets yield high long-term gains, notwithstanding short-term fluctuations. The Left Front would have accused Chidambaram of gambling away the country's precious assets in casino capitalism. Others would have accused top Congress politicians of having been bribed or arm-twisted into making dubious investments.

However, Chidambaram and RBI Governor Y V Reddy opposed any SWF for India. Reddy said SWFs were appropriate for countries with mineral windfalls (such as oil exporters), but not India. Indeed, India ran a modest current account deficit, and so needed to import dollars. Now, the world had flooded India with far more dollars than it could absorb, but this was not a structural surplus. Chidambaram took refuge in a further technical argument. He said that SWFs made sense for countries with excess savings, reflected in a fiscal surplus. But India ran a large fiscal deficit. However, these technical economic arguments pale besides the political ones. The stock market is seen by both Opposition politicians and the general public as a dodgy place full of crooked manipulators (remember Harshad Mehta and Ketan Parekh). Making money on the stock market is seen as risky, if not actually sinful. Indeed, the Left front has stymied attempts to put pension/provident fund money into Indian equities. In these circumstances, Chidambaram has shown sound political judgement in refusing to set up an SWF. This might in the long run yield some financial gains. But it carries short-term risks, as has just been demonstrated by the slump in stock markets. So, it needs to be avoided in the run-up to the next general election.”
While these political arguments may support short-term policies, they may overshadow the longer-term benefits of creating an Indian SWF.

Friday, March 21, 2008

Indian Corporate Law: Now on Television

No! It is not this blog that is on television – but the subject-matter of the blog.

CNBC-TV18 has launched a series titled “THE FIRM – Corporate Law in India”. The series is expected to deal with issues such as hostile takeovers and defences, corporate governance and other issues pertaining to Indian corporate law. It debuts with the first episode TODAY.

Thursday, March 20, 2008

Derivatives - a constructive critique

In what i thought could come in as an observation to an earlier post by Kartik - see below - turned out slightly differently. so here goes:

In considering law governing derivatives in India, couple or more items are noteworthy:

Firstly, a very significant development in the Indian legal regime governing derivatives was the amendment in 2006 to the RBI Act, 1934.

It introduced a new Chapter IIID, and also specifically ensured that any concerns regarding validity of derivatives (including the concern of whether derivative contracts could be a contract of wager) were obviated by providing expressly for the validity of such contracts when concluded with RBI itself, or with any bank or any regulated entity (regulated under RBI Act, BR Act or FEMA – essentially, NBFCs, Primary Dealers, Authorised Money Changers) notwithstanding any other law – which would extend to the Indian Contract Act, 1872 & section 30 thereof. The amendment act also took a further safeguard – that of making this particular amendment retrospective (and in fact dating back to 1934, when the RBI Act was enacted).

45U. Definitions.-- For the purposes of this Chapter,--.
(a) "derivative" means an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called "underlying"), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options or such other instruments as may be specified by the Bank from time to time;
(b) "money market instruments" include call or notice money, term money, repo, reverse repo, certificate of deposit, commercial usance bill, commercial paper and such other debt instrument of original or initial maturity up to one year as the Bank may specify from time to time;
(c) "repo" means an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed;
(d) "reverse repo" means an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent;
(e) "Securities" means securities of the Central Government or a State Government or such securities of a local authority as may be specified in this behalf by the Central Government and, for the purposes of "repo" or "reverse repo", include corporate bonds and debentures.

45V. Transactions in derivatives.--(1) Notwithstanding anything contained in the Securities Contracts (Regulation) Act, 1956(42 of 1956) or any other law for the time being in force, transactions in such derivatives, as may be specified by the Bank from time to time, shall be valid, if at least one of the parties to the transaction is the Bank, a scheduled bank, or such other agency falling under the regulatory purview of the Bank under the Act, the Banking Regulation Act, 1949(10 of 1949), the Foreign Exchange Management Act, 1999(42 of 1999), or any other Act or instrument having the force of law, as may be specified by the Bank from time to time.
(2) Transactions in such derivatives, as had been specified by the Bank from time to time, shall be deemed always to have been valid, as if the provisions of sub-section (1) were in force at all material times.

45W. Power to regulate transactions in derivatives, money market instruments, etc.--(1) The Bank may, in public interest, or to regulate the financial system of the country to its advantage, determine the policy relating to interest rates or interest rate products and give directions in that behalf to all agencies or any of them, dealing in securities, money market instruments, foreign exchange, derivatives, or other instruments of like nature as the Bank may specify from time to time:
Provided that the directions issued under this sub-section shall not relate to the procedure for execution or settlement of the trades in respect of the transactions mentioned therein, on the Stock Exchanges recognised under section 4 of the Securities Contracts (Regulation) Act, 1956(42 of 1956).
(2) The Bank may, for the purpose of enabling it to regulate agencies referred to in sub-section (1), call for any information, statement or other particulars from them, or cause an inspection of such agencies to be made.

45X. Duty to comply with directions and furnish information.--It shall be the duty of every director or member or other body for the time being vested with the management of the affairs of the agencies referred to in section 45W to comply with the directions given by the Bank and to submit the information or statement or particulars called for under that section.'.

Secondly, even prior to the amendment, the legal view on validity had never been in doubt – the conclusive view around has been that as long as one of the parties to a derivatives contract has a genuine business need (whether of hedging, reducing costs or risks or shifting the risks into a different currency/tenor/rate or basis of calculation of interest or risk management), it is not wagering.

Separately, listed companies in India & their Board of Directors, and particularly, the Audit Committee of the Board, are charged with reviewing the company’s financial & risk management policies, as well as mandatorily reviewing regular reports relating to risk management – under the very same Clause 49 that’s had a dramatic change in governance of listed companies since its introduction. This places the onus on the governance framework of ensuring that the management is really both operating and reporting back on what it does – including on derivatives as a tool of risk management – and doing it right. This receives further elaboration – there are to be procedures in place to inform Board members about the risk assessment and risk minimization procedures, which are required to be regularly reviewed through means of a properly defined framework. Lastly, a report on business risks, measures to address and minimize risk, and any limitation to the risk taking capacity of the company, are also required to be furnished on a quarterly basis.

Such governance framework atleast insofar as listed companies are concerned militate against media reports of companies not having understood the risks or undertaken transactions without properly factoring in the risks. Further, given these requirements of governance, a party dealing with the corporates can indeed sustain a claim that corporates have suitable machinery in form of governance standards and framework to adequately understand (and assure the Board/audit committee) of what they are upto. Equally, if corporates held out – by contract or conduct – that they not only understood what they were getting into & also that they had underlying FX exposure to do these derivative deals, and now choose to state that they had not understood nor had underlying FX exposure, and hence that the contracts are ab initio null and void, should probably have their lawyers advising them sent back to law schools for a refresher course – if the corporates held out & it really wasn’t so, then they committed misrepresentation. That entitles the counterparty to decide whether to avoid or continue the contract, and doesn't render the contract null and void itself.

Also, the very same corporates have participated in and had earnings from derivative dealings – so when the going was good, the legality was not in doubt, and it is when the losses have come home to roost caused them to raise alarm over legal validity. Apart from the hypocrisy, from a legal viewpoint, this is probably unjust enrichment & courts should require dis-gouging of the profits made by way of deposit into courts as a precondition to hearing the matters.

Separately, and a on a deeper level – the point of caution that both Kartik & Mr Warren Buffet (great minds think alike!) seem to make – requires a bit of evaluation & introspection.

To take Mr Buffet’s case – the latest Berkshire Hathaway annual report talks of the derivative contracts that they have undertaken. What it really signifies is that Mr Buffet doesn’t exactly shy away from engaging in undertaking derivatives – or indeed undertake proliferation of WMDs.

His concerns around derivatives are (and for those interested in further details mentioned in the Berkshire Hathaway 2002 annual report, available at: the following – am paraphrasing some of this for ready reference:

  • Derivative contracts are a lot like reinsurance – which is Berkshire’s main business – in his words: In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability. Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

the real problems, again in Mr Buffet’s words are:

  • “Parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.”
  • Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 14 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.
  • The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”
  • I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.
  • Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.
  • Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times
  • Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.
  • Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

I would tend to believe that its transparency – in valuing, accounting & indeed disclosure – which derivative dealings require. As again, the accounting profession has stepped up, and introduced AS 30 for Indian companies – under which greater disclosure and transparency as to derivatives is expected – however, this AS is as of now only recommendatory and not binding. For Indian companies following US GAAP or IFRS, this is already mandatory (see

What Indian derivatives markets doesn’t require is doubts as to legal correctness, validity, enforceability or indeed challenges in courts – it can have a chilling effect on dealings itself; pretty much the effect that sub-prime crisis has had - & which Fed intervention is trying to encourage – drying up of any fresh credit being given.

The chilling effect will deny those corporates and firms - desirous of derivatives as a tool for risk management / cost reduction / hedging / conversion of risk – at a time that they need most, given the turbulent times that the markets have entered, and make them the real victims of a different type of WMDs - welshers making a disaster.

The National Investment Fund

Day before yesterday, SEBI has amended the DIP Guidelines to include the National Investment Fund in the definition of ‘Qualified Institutional Buyers’ (QIBs).
The National Investment Fund was set up from the proceeds of disinvestment of public sector undertakings. It is intended to be used primarily for funding health and education projects. See this article in
The Hindu for more details.
By amending the definition of QIBs to include the National Investment Fund, SEBI has allowed the National Investment Fund to invest in the portion reserved for QIBs in all Public Offers. This implies that more public funds would be ploughed into the stock market. Given the high volatility in the stock markets, its not clear whether this would be beneficial.

Monday, March 17, 2008

Enforcement of Corporate Governance Norms

A new paper “Corporate Governance, Enforcement, and Firm Value: Evidence from India” authored by Dhammika Dharmapala & Vikramaditya Khanna has been posted on SSRN. Here is the abstract:

“This paper analyzes the effects of corporate governance reforms and enforcement on stock market development and firm value, using a sequence of corporate governance reforms in India. Our results, taken together, present a strong case for a causal effect of the reforms on firm value, and also underscore the importance of enforcement. The reforms (referred to as Clause 49 of the listing agreement) were phased in over the period 2000-2003. A large number of firms were completely exempt from the new rules, and the complex criteria for the application of Clause 49 created considerable overlap in the characteristics of affected and unaffected firms. Severe financial penalties for violations were introduced in 2004, providing an opportunity to test the effect of sanctions and enforcement independently of the substantive law. Using a large sample of over 4000 firms over 1998-2006, a difference-in-difference approach (controlling for various relevant factors and for firm-specific time trends) reveals a large and statistically significant positive effect (amounting to over 10% of firm value) of the Clause 49 reforms in combination with the 2004 sanctions. This result is robust to various checks, and in particular holds when comparing only the smaller firms that were subject to Clause 49 and the larger firms among those unaffected by Clause 49. A regression discontinuity approach focusing on the thresholds for the application of Clause 49 also leads to similar conclusions. There is no robust evidence that the reforms led to improved accounting performance, a reduction in tunneling within business groups, or an increase in foreign institutional investment over the sample period. Rather, it appears that the increase in firm value capitalized expectations of longer-term benefits of the reforms.”

Sunday, March 16, 2008

Pitfalls in Emerging Market Investments

A recent unsuccessful bid by Singapore Airlines (SIA) and Temasek to take a 24% stake in China Eastern Airlines is symptomatic of several pitfalls that exist in large investments in emerging markets. Knowledge@Wharton carries an interesting analysis of that case, a synopsis of which is as follows:

“It was a perfect deal and it had approval from the top levels of the Chinese government. Singapore Airlines (SIA) and its parent company, Temasek, were set to purchase a 24% stake in Shanghai-based China Eastern Airlines. But circumstances can change very quickly in China, and a few weeks after it was announced, the deal fell through: A rising stock market, an apparent government about-face, some behind-the-scenes maneuvering by a competitor and a dose of old-fashioned Chinese nationalism combined to scuttle the acquisition. Whatever happens, the case has already become a landmark.”
In India too, there are potential roadblocks in large foreign investment transactions that investors and their advisors are required to navigate through from time to time; this is in spite of considerable liberalisation of the foreign investment regime. Some of the roadblocks include (i) the obtaining of Government approval (through the Foreign Investment Promotion Board, or FIPB) in the case of sensitive industries that have not been transitioned to the automatic route, (ii) in such cases, the requirement of obtaining board approval of the target company (that scuttles hostile acquisitions) before making an application to the FIPB, (iii) obtaining the approval of the Cabinet Committee on Economic Affairs for transactions exceeding Rs. 600 crores (Rs. 6 billion), and (iv) seeking the consent of a prior joint venture partner in cases that fall under Press Note 1 of 2005. These are just some of the many barriers that foreign investors have to overcome while investing in India, which makes such investment exciting as much as it is challenging, as it requires careful planning and thought in terms of structuring of the investments.

Let me clarify though that these observations apply more directly to large investments, involving high stakes, in sensitive sectors of the economy and those that require prior approvals. Liberalisation has made foreign investment fairly straightforward and hurdle-free in most sectors that have now been increasingly placed under the automatic route

Saturday, March 15, 2008

Trading in Futures – Financial Instruments of Mass Destruction?

The exposure of Indian corporates and banks to derivatives has been receiving a lot of attention lately. For example, see LiveMint (here and here), Financial Express and Economic Times. But, what are some of the key legal considerations that arise in the case of derivative transactions? To examine those, we have a guest contribution.

Image: Wikimedia Commons

The following post has been contributed by H. Karthik Seshadri, Advocate and Partner, Iyer & Thomas, Chennai


The name Jerome Kerviel would almost go unnoticed, but he has the credit of having been involved in probably the biggest fraud ever in the history of banking. On January 25, 2008, it was revealed that Jerome Kerviel, a futures trader of the Societe Generale had entered into unauthorized transactions that cost France’s second largest bank Euro 4.9 billion (US$ 7.8 billion), approximately Rs. 32,000 crores. However, primary investigations revealed that Jerome Kerviel did not personally profit out of any of these transactions.

On March 4, 2008, the Economic Times in India carried an article wherein it was mentioned:

“In the past few weeks, more than 100 companies have cancelled their derivative contracts with banks to cut their losses. The fear of large derivative hits has suddenly deepened following the abnormal surge in currencies like the Swiss franc and yen against the dollar. Amid a relentless dollar hammering in the international markets, these currencies have appreciated 3-4% against the greenback in the past one week — a swing big enough to wipe out much of what companies had earned from these deals. Between June and September 2007, there were a flurry of deals as corporates entered into swap contracts to convert their liability into Swiss francs and yen. It looked irresistible: since interest rates on these currencies were significantly lower, converting local loans into these currencies was a quick way to cut cost, and improve profits. The bet turned sour when the currencies began to rise. Today, many banks are advising their clients to exit these deals.”
What are these instruments? What is the legal backing for these financial instruments?

A “derivative” has been defined in the Securities Contracts (Regulation) Act, 1956 (SCRA)[1]. It is clear that this security therefore has no independent value but derives its value from the underlying asset. The underlying asset can be any form of securities, bullion, stock, currency, livestock, etc. A futures contract is one where parties to the contract agree to buy or sell a security or a commodity at an explicit price on a future date.

The Reserve Bank of India (RBI) has also issued circulars pursuant to the Foreign Exchange Management Act (FEMA) laying down guidelines for regulating residents and the banks while dealing with forward contracts or other forms of derivatives.[2] The essence of the circular is that the transactions would be permitted provided that these transactions are entered into through an Authorised Dealer and in respect of transactions where sale and purchase of foreign exchange is otherwise permitted under the provisions of the Foreign Exchange Management Act and the various rules & regulations of the RBI. The onus also appears to have been cast on the authorised dealer to verify certain documents which disclose the nature of the transactions and the genuineness of the underlying exposure. The authorised dealer is also required to ensure that the board of directors of the corporate that is engaging in the transactions draws up a risk management policy with clear guidelines for concluding transactions and an annual audit for verifying the compliance with the regulations provided by the RBI Circular.

Obviously, these guidelines have been provided with a view to ensuring that the corporate as well as the bank / authorised dealer are not exposed unduly to the vagaries of the market conditions and to minimise the risks involved in entering into forward contracts.

Are these Wagering Contracts?

Even though meticulous care has been taken by the SCRA, the FEMA and the RBI while defining and providing for the guidelines while dealing with the derivatives, we are lately witnessing a spate of litigations that have been commenced wherein parties to various derivative contracts have now approached the courts with a plea that the contract is vitiated as it amounts to a “wager”.

Section 30[3] of the Indian Contract Act, 1872 declares that a contract that is in the nature of a wager would be void ab initio, and no action can lie to either recover anything that is due under a wager or for performance of a contract that is in the nature of a wager. The expression “wager” has not been defined in the Indian Contract Act. A classic definition is however available in the case of Carlill v Carbolic Smoke Ball Co., 1891-94 All ER Rep 127. A wagering contract is one by which two persons, professing to hold opposite views touching the issue of a future uncertain event, mutually agree that, dependant on the determination of that event, one shall win from the other, and that other shall pay or hand over to him, a sum of money or other stake; neither of the parties having any other interest in that contract than the sum or stake he will so win or lose, there being no other consideration for making of such contract by either of the parties. If either of the parties may win but cannot lose, or may lose but cannot win, it is not a wagering contract.

The Master Circular issued by the RBI provides that the banks and authorised dealers are to cover their exposure by back-to-back contracts. Therefore, any money given to the counterparty or received from the counterparty is passed on to the other parties with which banks/authorised dealers have taken their back-to-back positions. In a situation where a bank would have paid a certain amount from the derivative transactions to the counterparty, the bank would not lose the equivalent amount. Similarly, where a payment is received from a counterparty, such money would not be there on the books of the bank as profit. Taking this logic further in case a counterparty which had become obliged to pay a certain money under the derivative transaction does not pay such money, the position of the bank does not remain neutral as bank has to honour the payment of similar obligations in respect of back-to-back contracts and thus bank loses even by winning in such contract from its counterparty.

On the face of it, an argument by certain parties that these derivative transactions are wagering contract is clearly on account of legal ingenuity and only to be rejected. However, there is one aspect that requires serious introspection. Were the banks / authorised dealers’ diligent while advising the counter parties at the time of entering into these derivative transactions? Did they not have a duty of care thrust on them, by the RBI Circular? Were these risks properly analysed, examined and the consequences thereof understood by the boards of directors of the counter parties? Was it prudent on the part of the board to first of all enter into transactions without properly appreciating the risks involved and the dangers that it exposed the company to? These are interesting and important questions that will have to be answered by the courts.


It is most likely to be presumed that persons of commerce are likely to know what transactions they are entering into and what would be the risks they are likely to be exposed to. If that be the case, is it a mere coincidence that more than a 100 corporates get involved in these financial transactions and are having to cancel the derivative contracts? The answer lies somewhere in between. Only the future will reveal what the truth is.

One cannot forget what Warren Buffet, had to comment on financial derivatives to the shareholders of his company way back in 2002:

“We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

[1] Section 2(ac) “derivative” includes – (A) a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security; (B) a contract which derives its value from the prices, or index of prices, of underlying securities;
Section 2(h) Securities include (ia) derivatives…

[2] RBI Master Circular No./6/2007-2008.

[3] Section 30 – “Agreements by way of wager void: Agreements by way of wager are void; and no suit shall be brought for recovering anything alleged to be won on any wager, or entrusted to any person to abide the result of any game or other uncertain event on which any wager is made.”

Update (March 17, 2008): Further references - Banks` derivatives exposure may be capped in Business Standard, The time bomb in our financial system in Rediff Money & Stung firms want banks to pay in Livemint.

Friday, March 14, 2008

Changes in FDI Policy

There were some significant changes to the foreign direct investment (FDI) policy earlier this week. The Department of Industrial Policy & Promotion issued as many as six press notes on March 12, 2008 (available here).

The changes are in the following sectors:

1. Credit Information Companies;
2. Commodity Exchanges;
3. Industrial Parks;
4. Civil Aviation Sector;
5. Petroleum & Natural Gas Sector; and
6. Mining of titanium-bearing minerals and ores.

However, as Rediff Money notes, there was no liberalisation on the foreign investment policy in the real estate sector despite anticipation on that front.

Wednesday, March 12, 2008

India Business: A Few Updates

1. Indian Acquisitions in the United States

One of our regular readers, Mohit Gogia, who is a lawyer currently based in New York, brings to our attention a report titled “US-Bound Acquisitions by Indian Companies” that has been prepared by Virtus Global Partners.

This report contains a snapshot of Indian acquisitions of US companies, both quantitatively and qualitatively. The gist of their findings is that Indian acquisitions in the US are growing despite the economic slowdown. The deals in the last few years have been on a steep growth trajectory as can been seen below from the numbers reported:

Year: No. of Deals

2005: 23
2006: 48
2007: 83
2008 (first 2 months): 10

The reports states that the cumulative deal size for the transactions in 2007 aggregate US$ 10 billion. Unsurprisingly, the industry that takes the cake is IT, which bagged 51% of the deals by volume.

The report sets out various factors fueling US-bound acquisitions and also key considerations for cross-border acquisitions in the US.

From a corporate lawyer’s standpoint, it seems to me that the principal aspects in such transactions would involve navigating through the local requirements that govern the target company (e.g. due diligence), the structuring of the acquisition (particularly from a taxation standpoint), and the financing of the transactions by the acquirer. Since the guidelines prescribed by the Reserve Bank of India as to overseas acquisitions have now become quite liberal, such transactions usually tend not to face too many impediments at the Indian end.

This is especially because (as the Virtus Global Report observes), most of the transactions are acquisitions for cash. Deals tend to become more complex if they are stock transactions, as the Indian acquirer company would then have to issue shares or other instruments (such as ADRs or GDRs) as consideration to the shareholders of the US target company, and these could involve compliance with various requirement of SEBI and Ministry of Finance that would require careful structuring. As transactions become larger in size and leverage may become difficult to obtain (due to declining market conditions), it might well be the case that stock transactions will become more common.

2. The World in 2050: Beyond the BRICs

A report by PriceWaterhouse Coopers that looks at emerging market growth prospects provides a bullish outlook for India and China. It notes: “China is expected to overtake the US as the largest economy in around 2025 in these updated projections, while India is now assessed as having the potential to nearly to catch up with the US by 2050.” This report is an update of PWC’s earlier report in March 2006.

What comes as a surprise in this report is that India tops the growth league tables among all emerging economies, even ahead of China. The factors that emerge from an India-China comparison are as follows:

“- significantly slower labour force growth in China due in particular to the effects of its one child policy; this will lead to a rapid ageinig of the Chinese population over the next 45 years and a projected decline in its working age population, while India’s working age population is projected by the UN to continue to growth at a healthy rate …

- the fact that average productivity and education levels across the population are currently lower in India than in China, giving the former greater scope to catch up with the OECD countries in the long run, provided that India can maintain the right kind of institutional policy framework to support economic growth (and also gradually overcome cultural barriers to female education in rural areas of India in particular); and

- China’s growth to date has been driven by very high savings and capital investment rates, but experience with Japan and other earlier ‘Asian tigers’ suggest that such investment driven growth eventually runs into diminishing returns once income levels approach OECD levels; as China ages, it is also likely that its saving rate will drop as assets are ‘cashed in’ to pay for the retirement of its ageing population, though we still assume its saving and investment rates remain somewhat above the OECD average in the long run.”
The outlook for Indian economic growth is indeed optimistic, judging by this report.

Hat tip: US-India Friendship

3. India: Growing @ the Speed of Thought

… is the theme for this year’s India Business Conference that is organised annually by the Columbia Business School. This year’s conference will be held on April 19, 2008 at the Columbia University, New York, NY.

The conference may be of particular interest for lawyers and other business professionals based in the US who are interested in Indian business and economic matters. I attended this conference last year and found it to be useful.

Tuesday, March 11, 2008

Libido can't dilute Spitzer’s contribution to clean markets

Some sections of Wall Street are in celebration mode. Others are deeply disappointed. Eliot Spitzer, governor of New York, once the fire-spitting crusader attorney general of the State of New York, who had cleaned up the capital market with his incisive prosecution of questionable practices on Wall Street, has owned up to having availed of the services of a high-premium prostitution ring.

Spitzer had broken new ground in ensuring cleanliness in financial services. He had been bang on target in questioning the credibility of authors of equity research in relation to securities whose offerings were managed by the firms that employed the researchers. He pushed for accountability from the top brass of New York Stock Exchange, questioned practices in the insurance industry, and even trained his guns on New York travel agencies that promoted planned sex tourism trips to Asia.

Spitzer extracted fantastic settlements, and came to be regarded as a dreaded moral force in the United States. In a nutshell, the “Sheriff of New York” changed the way Wall Street functioned. For instance, many firms, for fear of how their e-mail records would be interpreted years later, shifted from e-mail writing to voice-message recording as the primary means of transmitting messages.

Ironically, it is the voice records of Spitzer that have landed him in trouble. Investigators, who were hoping to trap Spitzer with evidence of profiting from flesh trade, tapped his phone calls, e-mail and text messages. They have so far only found that he was a customer of an expensive high-end escort service – a weakness he seems to share with men who would typically be at the receiving end of his efforts against market impropriety.

So far, there is no sex-for-favours finding or finding on financial fraud by Spitzer. The family man indeed had had paid sex. Surely, the revelations could badly damage the political career of a man who was considered the epitome of righteousness. Ethicists and moralists would be disappointed that one of the crusaders for high moral standards has fallen by the wayside. Conservative right-wing political opponents whose skin he got under, with his drive to legalize illegal immigrants in New York, would bay for blood for sexual misdemeanor by a family man.

However, Spitzer’s libido cannot take away the contribution he made to keeping markets clean. The rule of law came back to the forefront thanks to Spitzer. We must not forget that the United States is a country where another Democrat politician survived impeachment proceedings despite committing perjury while in the President’s office, to conceal his sexual conduct.

- Somasekhar Sundaresan

Monday, March 10, 2008

Buyouts & Law Firms

Thus far, I could only imagine law firms being involved in private equity funding and buyouts as legal advisors on deals.

But, now it appears that we may begin to witness private equity funding and buyouts OF law firms. For details: and TimesOnline.

Hostile Takeovers & Embedded Defences

The Financial Times reported last week in the context of EADS (the maker of the Airbus aircraft) that “France and Germany are finalising changes to EADS’ corporate by-laws to prevent foreign investors building significant stakes in – or even taking over – Europe’s flagship aerospace and defence company.” The plan is to restrict any investor deemed predatory from owning more than 15% in the company.

This report reminded me of a previous discussion on this blog on hostile takeovers and possible defences. The EADS proposal is a classic case of an embedded takeover defence where the company and its controlling shareholders amend the charter documents of the company (or even a contract the company enters into) so as to impose restrictions on hostile acquirers. While the Financial Report news item implies that such restrictions would be enforceable under the laws governing EADS, an entirely different outcome would ensue under Indian law.

Following certain amendments to the Companies Act, 1956 in 1996 and the introduction of Section 111A(2), all shares of a public company (and therefore a listed company as well) are freely transferable. Any restrictions on transferability of shares of a public limited company in the articles of association would not be enforceable as it would violate the provisions of the Act. Hence, any provision (such as the one proposed for EADS) in the articles of association of an Indian company restricting an acquirer from acquiring shares in a company beyond a specified percentage will not be valid in India. The only restrictions that can be validly imposed are those specified in sub-section (3) of Section 111A, which is essentially for transfers involving violations of specific laws such as the SEBI Act, or other law for the time being in force.

Moreover, since shares of a public company are traded in dematerialised form, any acquirer may acquire shares from the market and such transfer does not required submission to, or approval of, the board of directors of the target company. Hence, there is no question of the board of directors even getting an opportunity to block transfers (that are in excess of stipulated limits) before they are actually effected. Of course, in the case of foreign acquirers, the applicable policy on foreign direct investments (FDI) would have to be complied with. Therefore, these types of embedded defences that restrict acquirers from building up stakes in a company would not come to the rescue of controlling shareholders in Indian companies.

Promoter Shareholding

Our earlier analysis on the best form of takeover defence in India had concluded as follows:

“In the Indian context, the most successful defence against hostile takeovers is the high stakes that promoters hold in their companies. Often, promoters also gradually shore up their stake (through the creeping acquisition route) to fend hostile bids. High promoter stakes make it difficult for raiders to take control without bringing the promoters to the negotiating table.”
There is some recent evidence of this phenomenon, where promoters are shoring up their stake in companies in the wake of a falling market. Yesterday’s Business Standard has a report, stating:

“Promoters of 54 small- and mid-size firms buy 8.3mn shares between Jan 10 - Feb 27.

Promoters of mid- and small-cap companies are grabbing the opportunity provided by a falling market to raise their holdings in their respective companies.

In most cases, the shares of their companies are trading at over 30 per cent discount to the all-time high market prices.”

Immediate agenda for reform before SEBI

When a new chairman takes charge at the Securities and Exchange Board of India (“SEBI”) the media tends to be full of what the new chairman ought to be doing. Here are some action items that SEBI ought to address as a matter of priority:-

a) The SEBI (Foreign Institutional Investors) Regulations, 1996 (“FII Regulations”), which govern foreign institutional investors (“FIIs”) await a comprehensive review and redraft. The FII Regulations do not yet reflect the policy on offshore derivative instruments announced by SEBI last year. There is also a range of unwritten rules that SEBI has in its files, which the world is not transparently made aware of. For instance, neither the erstwhile antipathy to hedge funds and stock brokers as FII applicants, nor the current acceptability of hedge funds is reflected in the FII Regulations. A transparent codification will ensure the road to investing in India represents a clear path.

b) The administration of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Takeover Regulations”) requires attention. Every acquirer is required to file a draft letter of offer with SEBI for “observations”, which are supposed to be provided within 21 days. However, the number of cases where such observations are held up, particularly in the wake of any suspected past violation of the Takeover Regulations even by persons other than the acquirers, is on the rise. Making an open offer is an expensive proposition – there is a need to create an escrow and to tie up a material quantum of funds. Besides, the share purchase agreement that triggered the open offer cannot be closed until the open offer is completed. There are restrictions on what the target company may do from the time a public announcement is made and until the open offer is completed. A hold-up of the open offer leads to severe implications, and therefore, the Takeover Regulations should be saved from becoming an impediment to M&A activity.

c) The SEBI (Delisting of Securities) Guidelines (“Delisting Guidelines”) were to be converted into formal regulations. This is a controversial body of law, with SEBI itself having acknowledged in a consultative paper that the “reverse book building” mechanism (which entails public shareholders quoting the price at which they would like to be bought) gave rise to abuse. However, the revised regulations that would replace the Delisting Guidelines are not yet notified. The consultative paper also entailed avoidable tinkering (imposing a non-public target delisting threshold of 90% for companies that are mandated to have minimum public shareholding of 25% and a 96% threshold for companies that are mandated to have minimum public shareholding of 10%).

d) The SEBI (Disclosure & Investor Protection) Guidelines, 2000 (“DIP Guidelines”) represent a bundle of some of the most-terribly drafted securities law provisions. Conflicting and anomalous provisions abound. Besides, form has come to prevail over substance. Underwriting activity is a mockery of sorts with no IPO being truly underwritten. More about the DIP Guidelines in a later blog.

e) Greater co-ordination with the Ministry of Finance would be required. Recently, the Ministry of Finance invited comments on proposed legislation in the form of the Securities Contracts (Regulation) Rules on the concept of ‘public shareholding’ and how it ought to be regulated. This would be a direct overlap with Clause 40A of the Listing Agreement and care ought to be taken to ensure that there is no conflict between two regulators framing law on the same subject.

f) SEBI has been conferred with wide-ranging enforcement powers, all of which are important to ensure that the regulator is well-empowered. The same offence can be dealt with using criminal prosecution, imposition of civil penalty through adjudication proceedings, issuance of directions using omnibus powers under Section 11 and 11B of the Act, and in the case of registered intermediaries, through enquiry proceedings that could result in suspension or cancellation of registration. SEBI needs to initiate a transparent policy on the circumstances in which it would use a specific nature of power. The Securities Appellate Tribunal has commented adversely on the initiation of parallel proceedings and the embarrassing outcome it can have on proceedings before SEBI. The Supreme Court of India has observed that the doctrine of separation of legislative, administrative and quasi-judicial powers has not been followed in the Act, and has advised caution.

g) A single-point electronic filing for disclosures under various provisions of securities laws is a crying need. Every filing under the Listing Agreement is required to be sent to every stock exchange where the securities are listed. With some exchanges, it is difficult to even prove delivery of the filings since they are near-defunct. Filings on the same subject are mandated in the Takeover Regulations and also the SEBI (Prohibition of Insider Trading) Regulations, 1992. Within the Takeover Regulations, filing of the same information is imposed on several persons (Regulation 7 and Regulation 8 have provisions that require disclosure first by the acquirer and then again by the target company). Failure to make a filing has a potential civil penalty liability of Rs. 100,000 per day of continued default. SEBI would do well to rationalise these filing requirements.

Sunday, March 9, 2008

Readings on India Knowledge@Wharton

The current issue of India Knowledge@Wharton contains a few interesting readings that pertain to the Indian corporate and financial sector.

First, “India's 2008 Budget: Few Incentives for Global Investors, but a Windfall for Farmers” discusses the Budget and its implications, primarily to foreign investors.

Second, in The Public Benefits of Public Offerings, Vinay B. Nair, a Senior Fellow at the Wharton Financial Institutions Centre, sets out the various benefits that emanate from a company going public through an IPO. He finds that there are several benefits from IPOs than just returns in terms of an increase in the market price (which may not always be available, especially in case of an ailing market such as the present one). Those benefits include transparency (by occasioning release of information into the market), promoting innovation (by enabling venture capital funding that seeks exits through public listings), and in spurring a market in mergers and acquisitions.

Third, Are Bank Mergers in India Entering a New Era? looks at consolidation in the banking sector, especially in the context of the recent merger announcement by HDFC Bank and Centurion Bank of Punjab. Specifically, the article notes that this is one of the few instances of a merger among equals in the banking industry, as most earlier mergers involved a strong bank taking over a weaker one, typically at the instance of the Reserve Bank of India (RBI). In an earlier post on this blog, we had discussed some instances of regulatory mergers effected by the RBI.

Fourth, it is now very common for India to be referred to in the world economic arena as an “emerging market”. But, that expression lacks a clear definition and there have not been serious efforts in pinning down the contours of that concept. When Are Emerging Markets No Longer 'Emerging'? delves into the genesis and the rationale behind coinage of the term, essentially as an alternative to the expression “third world” that was found to be distasteful. As far as India is concerned, the article observes that it is still a long way away from graduating from the emerging market bracket.
Industry can play an important role in reservation policy

Last weekend, as part of a panel discussion at the Annual Day of the Pune Chapter of the Confederation of Indian Industry, I was pleasantly surprised to hear about CII Pune having run finishing school sessions in collaboration with a local educational institute for members of the “scheduled castes” and “scheduled tribes”.

The “reservation policy” – Indian phrase for affirmative action policy for members of certain castes and tribes listed in a schedule to orders passed in terms of Article 341 and 342 of the Constitution of India, and for members of certain other under-privileged castes outside these schedules – has always been viewed with great trepidation by Indian corporates. Some segments of India’s Union Government proposing to impose the reservation policy on private sector corporates, too has led to greater suspicion. Only one leading Indian industry house is known to have voluntarily adopted some form of affirmative action in its recruitment policy.

The constitutional validity of a law imposing state policy on the private sector would have perhaps been successfully challenged for the asking. While it is but natural for the State to use the institutions available under its control to implement social justice measures, and thereby reserve seats and jobs in its educational institutions and organizations, forcing private enterprises to reserve jobs and seats would have raised a very serious constitutional issue. The Indian Constitution guarantees freedom to carry on business or profession, and restrictions on whom to employ, were not likely to be upheld as reasonable restrictions on the constitutionally-guaranteed freedom.

This blog entry is not intended to provoke a debate on the merits of reservation, although, this writer, once a bitter opponent as a student, now feels with the benefit of hindsight, that the policy is not such a bad idea after all.

The finishing school is a great idea. Many beneficiaries of reserved jobs and seats still end up as outcastes for not having the social finesse to blend in with the majority. Holding a prestigious government job or having graduated from a prestigious school does not fully help. The difference in cultural, economic and social background can continue to perpetrate diffidence in social settings (not knowing how to use the fork and knife with finesse, or not knowing to differentiate between different types of alcohol, are classic examples).

“Sarkari Brahmins” as some upper castes derisively call them, being members of a caste listed in the Constitutional schedules, or the very history of having benefitted from the reservation policy, could perpetually dilute the perception of their merits.

The finishing school – where one would get trained in social niceties and formal graces – will work towards obliterating the ability to tell one caste from another in the workplace or in work-related social settings. Whether an individual has been a beneficiary of the reservation policy should become completely irrelevant. Only then would the reservation policy have its intended effect. Indian industry would do well to do all in its power to support such an endeavour, even while it should remain opposed to impostion of any State-imposed interference in its recruitment policies.

Friday, March 7, 2008

Taxing Sovereign Wealth Funds

Just as hearings are being conducted before two subcommittees of the U.S. House of Representatives in relation to sovereign wealth funds (SWFs), and as the International Monetary Fund is stepping up efforts to formulate a code of conduct to regulate SWFs, a new story has emerged regarding the possible tax position of SWFs in the US.

Victor Fleischer, who is now an Associate Professor at the University of Illinois College of Law, has a post on the Conglomerate Blog. He notes that currently sovereign wealth funds are not subject to taxation in the US at all as they are entitled to take advantage of provisions relating to sovereign immunity. This puts them at a substantial advantage over other financial investors such as private equity, venture capital and strategic investors who will be subject to taxation on their investments in the US. Referring to taxation of SWFs in the US, he notes:

How They Are Taxed Currently. Section 892 of the Internal Revenue Code exempts foreign sovereigns from income tax on their passive investment activities. Foreign individuals and corporations, by contrast, pay taxes on most passive investment activities at rates ranging from 0% to 30%, depending on treaty agreements and the nature of the investment. With the exception of certain real estate investments, foreign investors generally don't pay tax on capital gains from portfolio investments. The tax code thus has the unintended effect of subsidizing state-owned capital over private capital, particularly on debt investments.

What To Do About It. The policy objective is to tax Sovereign Wealth Funds as we tax private foreign investors, and perhaps only on the condition that they are investing in a manner consistent with commercial portfolio investment.”

His call for taxing sovereign wealth finds is likely to have serious takers among US policy makers. He is currently researching on this issue and is likely to publish a paper on the topic.

After all, it was an earlier paper of Victor Fleischer that stirred up a hornet’s nest among US policy makers and private equity players, when he argued against the current system of taxing private equity players on their carried interest, whereby they were paying tax on the amounts as long-term capital gains (at a lower rate) rather than as business income (which was pegged at a higher rate). Reforms have been proposed in tax laws that are currently pending in the US Senate.

It would not be long before this issue gains prominence in the Indian context. Unlike the US tax laws, the Indian Income Tax Act, 1961 does not seem to contain any specific provision for taxing financial or commercial activities of foreign sovereigns in India. However, it is likely that the general principles of sovereign immunity as understood in international law will apply. This would largely leave it to the courts to discern the principles as they apply them to the facts of each case. Specific provisions of the double taxation avoidance treat between India and the country whose sovereign invests would also require consideration.

SEBI Rationalises Filing Fee Structure

The following post is contributed by Somasekhar Sundaresan

The first board meeting under the new Chairman of the Securities and Exchange Board of India (“SEBI”) has taken a very significant decision. SEBI has slashed the ad valorem fee rates attendant with filing of various draft offer documents, by nearly 80%, and has capped the total fees.

Eyebrows were raised when SEBI introduced the ad valorem fees for various securities transaction document filings. The fee rates were quite out of line with the perceived benefits from the service rendered by SEBI to the capital market. Despite the huge increase in filing fees, adherence to the self-imposed timelines for clearing offer documents was more the exception than the norm.

Mutual funds had to pay SEBI a fee of 0.03% of the funds raised subject to a maximum of Rs. 10 million. Filings of draft letters of offer under the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Takeover Regulations”) required a payment of a fee of 0.5% for any offer having a size of more than Rs. 10 crores (virtually every open offer), without any outer limit.

Such an imposition of fees, in economic terms (leaving the legality aside), had increased transaction costs in the capital market.

The mutual fund document filing fee has now been brought down to 0.005% subject to a maximum fee of Rs. 5 million. The filing fee for draft letters of offer under the Takeover Regulations has been brought down to 0.125%, subject to a cap of Rs. 30 million. The reduction is a sensible measure, since the size of the open offer hardly made any difference to the burden shouldered by SEBI in reviewing these documents.

The securities market witnessed a watershed in Indian jurisprudence when the Supreme Court had to consider a challenge to the constitutional validity of a turnover-linked registration fee that was imposed on stock brokers in April 1992. It is noteworthy that the new SEBI Chairman, who had then led negotiations with the brokers, had offered a much smaller ad valorem fee to the broking community, provided the brokers withdrew the constitutional challenge. The brokers rejected the offer and persisted with a constitutional challenge to the fee, on the ground that it was a tax.

Nearly ten years later, in February 2001, a constitutional bench of the Supreme Court of India upheld the validity of the ad valorem fee, ruling that SEBI was indeed providing a general service to the market at large. Eventually, the ad valorem fee model was extended to all securities offering document filings.

Constitutionally-valid fees can indeed be economically taxing. SEBI has been well-advised to reduce the fee rates, bringing down transaction costs in the capital market.

Wednesday, March 5, 2008

Insider Trading Regulations to Undergo Further Amendments

Readers may recall that the SEBI (Prohibition of Insider Trading) Regulations, 1992 underwent detailed amendments in 2002. This was primarily to plug several loopholes in the law, some of which were exposed in the few insider trading cases that came up for hearing under the original regulations, the Hindustan Lever Case being the more prominent among them. Thereafter, earlier this year, SEBI proposed to introduce the “short swing profits” regulations, a matter we covered earlier.

SEBI yesterday issued a consultative paper containing further amendments to the regulations. The key changes proposed are:

- Harmonization of disclosure requirements under the Insider Trading Regulations and the Takeover Regulations. As of now, companies have to make disclosures under both the regulations, and the requirements somewhat vary making it cumbersome to companies. This harmonization would streamline the disclosure process.

- Restrictions on trading during the period when the window is closed will be eased. For example, harmless transactions are to be excluded from the prohibition—bonus shares do not affect price of the stock, and hence information regarding a bonus share issuance should not prevent trades by insiders. SEBI proposes to follow a principles-based approach rather than a rule-based approach.

- Time period for execution of pre-cleared trades will be enhanced from the present one-week time frame to up to four weeks.

- The regulations are proposed to cover a wider class of securities such as derivatives, rather than just “shares” that the present regulations largely encompass.

- A recipient of information (popularly known as a tippee) is presently to captured fully within the regulations. The impact is largely on insiders. Hence, the present regulations seek to capture tippees too within the prohibitions on insider trading. This is an important extension of the concept of insider trading to persons outside the company as well.

In all, while there is an effort to ease the restrictions on insider trading on the procedural aspects (such as disclosures, reporting and pre-clearance), the proposed amendments seek to widen the scope of the regulations on a few important substantive counts (such as in the case of derivatives, and tippee liability).

Comments are due on the consultative paper by March 27, 2008.