Financial Services, Markets & Regulations [1 ed.] 9789350440117, 9788184883480

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Financial Services, Markets l Regulations

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By

ANIL AGASHE

KO)jI Gflitnalaya Gpublishing Gflouse • Mumbai. Delhi. Bargalore. Hyderabad. Chennai • Ernakulam. Nagpur. Pune. Ahmedabad. Lucknow

© AUTHOR

No part of this book shall be reproduced, rerpinted or translated for any purpose whatsoever without prior permission of the publisher in writing.

ISBN First Edition

: 978-81-84883-48-0 2008

Published by : Mrs. Meena Pandey for HIMALAYA BOOKS PVT. LTD., "Ramdoot", Dr. Bhalerao Marg, Girgaon, Mumbai-400 004. Phones: 23860170/23863863 Fax: 022-23877178 Email: [email protected] Website: www.himpub.com Branch Offices : "Pooja Apartments", 4-B, Murari La! Street, Ansari Road, Darya Ganj, New Delhi-110 002 Phones : 23270392, 23278631 Reliance : 30180392 to 396 Fax: 011-23256286 Email: [email protected] Nagpur : Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur-440 018 Phone: 2721216, Telefax: 0712-2721215 Bangalore : No. 1611 (old 1211), 1st floor, Next to Hotel Highland, Madhava Nagar, Race Course Road, Bangalore-560 001 Phones: 22281541, 22385461 Fax: 080-2286611 Hyderabad : No. 2-2-1 167/2H, 1st Floor, Near Railway Bridge, Tilak Nagar, Main Road, Hyderabad-500 044 Phone: 26501745, Fax: 040-27560041 Chennai : No.2, Rama Krishna .Street, North Usman Road, T-Nagar, Chennai-600 017 Phone: 28144004,28144005 Mobile: 09380460419 Pune : No. 527, "Laksha" Apartment, First Floor, Mehunpura, Shaniwarpeth, (Near Prabhat Theatre), Pune-411 030 Phone: 020-24496333, 24496333, 24496323 Lucknow : C-43, Sector C, Ali Gunj, Lucknow - 226 024 . Phone: 0522-4047594 Ahmedabad: 114, Shail, 1st Floor, Opp. Madhu Sudan House, e.G. Road, Navrang Pura, Ahemdabad-380 009 Mobile: 9327324149 Eranakulam: No. 39/lO4A, Lakshmi Apartment, Karikkamuri Cross Road Eranakulam, Cochin-622 011, Kerala Phone: 0484-2378012, 2378016 Printed at : A to Z Printers, Daryaganj, New Delhi-llOOO2 Delhi

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Contents

1.

Introduction to Capital Markets ........................ ~ ........................................... 1 - 12

2.

Securities and Exchange Board of India (SEBI) .......................................... 13 - 54

3.

Money Markets ............................................................................................... 55 - 65

4.

Mutual Funds ................................................................................................ 66 -102

5.

Merchant Banking ...................................................................................... 103 -112

6.

Stock Exchanges .......................................................................................... 113 - 159

7.

Venture Capital .......................................................................................... 160 -176

8.

Credit Rating............................................................................................... 177 - 207

9.

Share Buy Back ........................................................................................... 208 - 227

10. Portfolio Management .....,. ........................................................................228 - 232 11. Corporate Governance ............................................................................. 233 - 241 12. Mergers and Takeovers ............................................................................242 - 255 13. Lease and Hire Purchase ...........................................................................256 - 274 14. Housing Finance.........................................................................................275 - 283 15. Financial Engineering ................................................................................ 284 - 287 16. International Markets ................................................................................ 288 - 294 AImexure .....................................................................................................295 - 334

1 Introduction to Capital Markets

Everybody these days seems to be talking about the Capital Ma'rkets. I have seen peoples moods swing with the swings in the SENSEX! Some of these people may not even have large investments in these markets. Talking about these markets has also become fashionable and what is called as The In Thing! I am very happy that the awareness about the market is on the rise. There are many reasons for this of course. The most important reason seems to be that the young Indians look at the markets very favorably than the earlier generations. They realise that they need to start investing in these markets to create wealth. The second reason seems to be that many people are participating in this market through the mutual funds and also through the ULIP route opened by the insurance companies. Also the fact that the Indian economy is one of the fastest growing economies in the world has helped in foreign funds coming to our markets. The SENSEX scaled its life time high in January 2008 to reach the level of 21000. Things have changed rapidly since then. The world economy is in the slow down phase. US economy is now firmly headed towards recession. The sub-prime crisis has written off a large amount of wealth. There is fear that the worst is still not over. International investors have pressed sales in India. In India the government is in fire fighting mode as inflation reached unacceptable level of 7.40% in April 2008. We have to remember that there are many global factors that have contributed to this inflation. The crude prices are at record high of $115 at the time of writing. Goldman Sachs believes that the prices may rise to hit $ 200 per barrel in not distant future. Most other commodity prices are also at their life time high. There has been food grain price spiral as well. The wheat crop has failed in Australia due to failure of rains for the last two years. The farmers in U S have shifted from wheat to Maize to produce Ethanol in the face of rising oil prices. All this has made impact in India. We have seen prices of cement and steel going up relentlessly. In view of all these developments the markets have naturally reacted and have lost almost 5000 points in the past 4 months. The market volatility has also increased while volumes have gone down. It is now expected that the Indian economy will grow slower in the fiscal 08-09 and the growth rate may fall to around 7.5%. We have to also keep in (1)

Financial Services, Markets and Regulations

2

mind that general elections are due in 09 and that will induce some political uncertainty in the markets. The early yearly results are indicating that the growth in the IT sector has gone down due to the appreciation of Rupee as well as slow down in the US outsourcing business. The results of Infosys, TCS and Wipro confirm this. However it will be better to wait and see the results of manufacturing companies. Reliance Industries have declared robust results Capital Market is generally understood as a market for long term funds investments in long term instruments available in this mark~t. However now market also includes short-term funds. Capital markets mean the market for all financial instruments, short term and long term, as also commercial, industrial government paper.

and this the and

The capital market deals with capital. The capital market is a market where borrowing and lending of long term funds takes place. Capital markets deals in both, debt and equity. In these markets productive capital is raised and made available to the corporates. The governments both central and state raise money in the capital market, through the issue of government securities. Capital market refers to all the institutes and mechanisms of raising medium and long-term funds, through various instruments available like shares, debentures, bonds etc. With the pace of economic reforms followed in India, the importance has capital markets have grown in lae last ten years. Corporates both in the private sector as well as in the public sector raise thousands of crores of rupees in these markets. The governments, through Reserve Bank of India, as well as financial institutes also raise a lot of money from these markets. The capital market serves a very useful purpose by pooling the savings of individuals and making them available to the business world. Well-developed markets augment resources by attracting and lending funds on a global scale. The global depository and American depository markets perform these functions for companies across the globe. A well-developed capital market can solve the problem of paucity of funds for the business enterprises. The rapid growth of corporate entities has b~en made possible by the growth of these markets. This is a global phenomenon. Constituents of Capital Markets :

Capital market requires many intermediaries who are responsible to transfer funds from those who save to those who require these funds for investments. There are two important operations carried on in these markets. 1.

The raising the new capital and

2.

Trading in the securities already issued by the company.

The efficiency of the markets is dependent on the specialisation attained by the intermediaries.

Introduction to Capital Markets

3

The important constituents of the capital market are: 1. The stock exchanges 2. Banks 3. The investment trusts and companies. 4. Specialised financial institutions or development banks 5. Mutual funds 6. Post office savings banks 7. Non banking financial institutions 8. International financial investors and institutions. 9. Sovereign wealth Funds. The supply in this market comes from savings from different sectors of the economy. These savings accrue from the following sources: 1.

Individuals.

2. Corporates.

3. Governments. 4. Foreign countries.

5. Banks. 6. Provident funds.

7. Financial institutions. All these entities contribute to savings in the economy. Parts of these savings naturally flow in the capital markets. Individuals invest in these markets directly by investing in shares or debentures of companies, through bond issues of public sector units or through mutual funds. Corporates, who have more savings than their requirement for funds also, are participants in these markets.

Markets since the liberalisation of the Indian economy Since the liberalisation of the Indian economy we have seen that foreign financial institutions have come to Indian capital markets in large numbers. These institutions have invested close to $60 billions in Indian markets. Due to this huge investment, these institutions have started influencing Indian stock markets. It is quite evident from the sums that are invested that the world has started taking keen interest in Indian markets. Indian markets are also considered as the part of Emerging markets across the world. Till some years ago many Indians were uncomfortable with the idea of investing their money in stock markets. The things have of course changed now for better. Many young Indians now look to stock markets as good place to make investments. Much credit

4

Financial Services, Markets and Regulations

for this transformation is rightly been given to late Mr Dhirubhai Ambani, of Reliance Industries Ltd. It is Reliance, which was instrumental in spreading the equity culture in our country. This is due to the fact that the investors of this company have over the years reaped many benefits and thus the company has become an icon in the Indian markets. Alongwith these developments the opening of mutual fund industry, first for banks and then for private players, has also helped in the spread of equity culture. By investing in mutual funds individuals can acquire shares of various companies, without actually buying them. The mutual funds pool the savings of individuals and invest them in corporate equities and debt instruments. We shall discuss the mutual funds in a separate chapter later. There have been many other developments that have taken place in the last few years. Some of these developments like scrip less trading, e trading and establishment of Securities and Exchange Board of India as the regulatory authority for these markets have taken Indian markets to international' standards. We have been trying to incorporate best international practices of capital markets. The establishment of National Stock Exchange was the turning point, in the working of Indian capital markets. Many Indian companies have used the capital markets in the last decade to raise large sums of money for their projects. Due to the vibrant markets many projects have got funds from these markets and investors in these companies have got good returns on their investments. During 2001-2004 the activities in the primary markets had slowed down to a great extent, due to the recessionary conditions prevailing in the Indian ecomlmy, not many corporates were making capital investments. However things were expected to improve considerably in the fiscal 2003-04. This has come true. The financial years 2004-05, 05-06, 06-07 and 07-08 were also exceptionally good for the markets. A large amount of money was raised from these markets through primary issues and follow on issues as well. The mutual funds have also been able to raise a large amount through NFOs. This trend has continued in the financial year 2007-08 as well. The market saw the successful IPO from Reliance Power Ltd and DLF has raised about Rs. 10,000 crs from its IPO some time back. The mutual funds have raised around Rs 20,000 crs in the first four month.s of 2006. By March 07 the total assets under management of mutual funds is around Rs 3, 25,000 crores. In March 08 this figure increased to more than Rs. 5,00,000 crores. Another factor that has helped the development of these markets is that, Government of India is slowly disinvesting from the public sector' companies. As a part of this exercise the government offers equity to retail investors. The government has divested its stake in Maruti Ltd. in favor of retail investors. This is a continuous process and it is expected that the government will continue to disinvest from PSUs. We have seen a lot of issues from PSU banks in the past few years.

Introduction to Capital Markets

5

The secondary markets in India are also very active and volumes on the two premier stock exchanges National Stock Exchange and Bombay Stock Exchange have shown healthy growth. There have been many innovations in the working of these markets. In last few years markets have taken big strides in. the Derivatives. We have moved away from the BadIa system and have adopted the derivatives trading, as is the prevailing system in most of the developed markets.

~

The stock market SENSEX which was around the level of 2900 around April 2003 had reached the level of 21,000 in January 2008. This was the record level seen by the SENSEX. There are some people who believe that as long as the economy continues to grow at about 8% the markets will keep going up. The combined turnover on BSE and NSE in cash and F & 0 has at times reached a level of Rs. 1, 00,000 crs in a day! Indian debt markets are also ·sought to be made more vibrant. Recently the Reserve Bank of India has allowed the participation of individuals in the government securities markets, which till now were dominated by the banks, financial institutions and mutual funds. This' move is likely to open new avenues for investment to individuals. ..

As is evident from the above facts these a~e exciting times for the Indian capital

markets. In the ensuing chapters you shall get more details on the working of these markets. The budget for 2003-04 had some good news for the capital markets. The Finance Minister had conceded the demand for the removal of income tax on dividend in the .. hands of the receiver. The companies will now pay dividend distribution tax @ 12.5% ' .. and the receiver will not be taxed on dividend income. This tax has been raised to 15% in the budget 07-08. Secondly the Finance Minister had proposed that there shall be no capital gains tax on investments made in equity after 1.3.03 and held for one year. This provision also has been extended. Both these announcements made investors think in terms of returning to stock markets. The Finance Minister had certainly hoped so and has been proved right. The Indian stock markets have risen consistently since June 2003. This growth has come on the back of several factors. The FIrs are putting more money in these markets, as they believe the valuations are very attractive and are likely to give good returns in short and medium term. Another thing that is visible across the global market is that the small investors are coming back to the markets for the first time since the IT meltdown. The statistics in India seems to suggest that more investors are now taking delivery of their purchases. The falling interest rates on bank deposits and bonds have probably forced many investors to look at stock markets again, as no other investment is likely to give the return that these markets can give, if the investors are careful and also learn to book profits. The investors when markets are rising become more and more greedy for more returns and refuse to sell investments and book profits. When the

6

Financial Services, Markets and Regulations

markets start going down these very investors instead of selling hold on to their stocks, hoping that the markets will recover. In the end they end up loosing heavily. At the beginning of this rally it was fuelled mainly by PSU and Bank stocks, as investors were bullish on these sectors. But as the rally is sustained it is becoming clear that it is now spreading across many sectors. One interesting point, to emerge is that the so-called old economy stocks are getting back in the limelight. The companies of Tata, Birla and Ambani groups have seen solid upward movement in their market capitalisation. After the spilt in Reliance group the wealth of the investors' in this group has gone up tremendously. Another trend visible has been, since the income tax on dividend income in the hands of the receiver has been abolished, many companies have declared increase in dividend payout. This is good news for the shareholders of these companies. However the major beneficiaries of this amendment to the income tax act are obviously the promoters of these companies. The government has decided to amend two acts naIl}ely Securities Contracts (Regulation) Act, and the Depository Act to remove some legal hurdles to the corporatisation and Demutilisation of the stock exchanges. This is a step in further liberalisation of the Indian capital markets. The amendment to SCRA will facilitate the derivatives trading in the interest rate futures and options. The act at present. allows derivative trading only if there is an underlying asset. However the Mumbai Inter-Bank Offer Rate (MIBOR} is not a security, derivatives based on this interest rate did not have legal recognition under the act. The proposed amendment to the act will remove this hurdle and derivative trading can commence. The corporatisation of stock exchanges is a reform long overdue. The conflict of interest due to the member brokers of stock exchanges being involved in the governance of bourses will end with this. The Demutilisation will help the transition of bourses from a mutual association of member brokers operating on a "not for profit" basis to a limited liability "for profit" company accountable to the shareholders. It will separate ownership and management from the right of access to trading. Recently the finance ministry and the banking and capital market regulators have cleared the proposal to allow the banks to become members of stock exchanges and trade directly in interest rate derivatives. Banks will be allowed to become members on retail debt segments of stock exchanges. However they will be allowed to undertake only their own trades for now. This measure will help banks surmount the problem of exposure limits to brokers. They will also be able to maintain utmost secrecy in their dealings. Now with the screen based trading in place and the banks themselves getting into trading directly, there will be greater transparency in the deals besides a clear audit trail. This is important in view of what had happened during the Harshad Mehta scam.

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Introduction to Capital Markets

7

Country's largest bank State Bank of India has decided to enter the stock markets. They have already done some deals in the secondary markets. Another important step initiated by SEBI is that it is going to allow Indian companies to issue equity simultaneously in the domestic and international markets. However the disinvestment from government companies has not been happening since the change of government in 2004. We will have to wait and see if the government starts its disinvestment program in future. However the government is seriously planning to offer equity of some of the unlisted PSUs to the general public in the near future. This will be good for the market and also for the retail investors at large. M S Verm& committee recommended the dual floatation in 2002. Sebi will now form the detailed guidelines for this shortly. It is recommended that the book running for both the floats should be done simultaneously. This will help settle the issue of pricing. The government has off loaded equity in ONGC for the first time. The size of this issue was around Rs. 10,000 crores. The government also disinvested equity in GAIL. Among the companies in which the government has sold large stake already, the government now proposes to sell the remaining stake. One of the most attractive proposals that have come from the government in this round of disinvestments is that the government has decided to issue the equity to the retail .investors at a discount to their market price. This will immensely benefit the investors. This gesture will also go a long way in many people now supporting the disinvestments program of the government. Mrs. Margaret Thatcher successfully used this method in the late seventies in England. We now have to wait and see how this works in India. New India specific funds have done very well in Japan. This is the first time that money is raised in these markets. We are also seeing flows of money from the Middle East in the Indian markets. The story of Indian market has continued in 2005 and also in the first three months of 2006. Last year FIls have pumped in. $ 10.2 billion. One of the most heartening features last year was the huge inflows· in the equity mutual funds: This trend continued in 2007 as well as FIls pumped in more than $ 10 billions. On top of that the markets also saw brisk activity in the PE space as these funds pumped in further $ 10-12 billions both in listed and unlisted companies.These funds have given excellent returns over the past almost three years now and the retail investors are finding it more prudent to invest money through this route. The investment in ELSS scheme upto Rs. 1 lakh is now eligible for deduction under Section 80 C of the Income Tax Act. The clause 49 of listing agreement has become applicable from 1st January 06. This it is hoped will be a major step in the implementation of corporate governance practices in India.

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Financial Services, Markets and Regulations

One must also remember that the Indian economy is one ~f the fastest-growing economies in the world. In past three years the economy has grown between 7 & 8% per annum, According to the Asian Development Bank the economy is likely grow by 8% for the next five years or more. The government on the other hand wants to push up the rate to 10% per annum. If this is what is going to happen the markets will attract more investments from abroad as well and then what is going up may keep going up! The experts are expecting the markets to recover most of the losses it has suffered on the back of the following news: 1. Prospects of good monsoon predicted for the year and the impact that will have on the rural economy. With increased incomes the rvral India is likely to spend more there by improving the performance of many companies.

2. The continuing good performance of most sectors: It is believed that the first quarter results for FY 07-08 will be very good and that should boost the market

sentiments further. 3. The recent announcement by the government that the government will go ahead with partial disinvestment of its stake in selected public sector companies. This proposal will surely face opposition not only from the Left parties but also from within the ruling party and its other allies. However the hope is that the government will stand firm and go ahead with its plans. If this happens this will be very positive news for the stock markets. 4. Current trends suggest that the Indian companies are buying a lot of companies abroad. This will force the markets to take close look at all these companies and this may lead to better valuations for these companies. We have seen two big deals. The first one is the acquisition of Corns by TISCO for a price of $ 12 billions, the largest overseas deal till date involvil}g an Indian company. We also saw a fierce battle in this takeover bid between TISCO and CSN of Brazil. The second big deal was the buying of Novalis for a consideration of around $ 6 billions by the Aditya Birla Group. 5. Indian companies are attracting a lost of attention of the private equity investors. They are pouring in or committing to pour in billions of dollars in many Indian companies. This news is definitely bullish in nature. It seems that the private equity players invested around $ 6 billions in calendar year 2006. This figure is likely to increase in the coming years. 6. One negative news is that the RBI is trying to control the rate of inflation which has breached the 8% mark is making money expensive and scarce. The RBI has increased the CRR to 7.5% while the REPO rate has gone up to 7.75%. This has resulted in the increase of interest rates across the board. The corporate sector will naturally have to pay higher interest on their borrowings. This will impact their profitability in the coming months.

Introduction to Capital Markets

9

7. The Indian currency has been gaining against the $ .It is now trading at the level of around Rs. 40 to Rs.40.50 levels. This will have a negative impact on the exporters. This means that the margins for IT companies will be affected adversely. Many investors are known to apply for IPOs especially during a bull market, as they can ' exit on listing of the shares at a profit. This strategy does work during the bull phase as most shares get listed at a premium to the issue price. However things can change rapidly if the market sentiment changes. After the recent drop in the markets many IPOs are actually trading at a discount to ' their issue prices. The following table will give you an idea of what is the situation as on 11th July 2006:

It must also be noted that a lot of good companies are likely to enter the market in the near future. State Bank of India has taped the market in 08. A lot many issues are likely

10

Financial Services, Markets and Regulations

to hit the markets from the reality sector. There are a lot of concerns raised already towards the quality of many of these companies. Many of these companies, even the smaller ones are raising capital in the foreign markets through yarlous instruments. It . is believed that a lot of foreign money is also coming to this s~ctor, which is booming, and the larid arid real estate prices have risen astronomically. Man~' experts believe that a .correctiori is inevitable. The RBI especially is very concerned about this trend and has time and again cautioned the banks in this regard. · . . A lot of money has flown in the Indian markets in the past few years. By December 06 the total investments of FIls has reached $ 50bi11i~·ns since the markets were opened (or them in 92. Out of this inflow ·almost· $35 billions ·ha,, "e come in ,sineeyear 2003! Government's estimate shows that the total FDI inflow for the current financial year, 0607 is likely to in excess of $ 10 billions. Private Equity is likely t~be to the tuqe ·o f around $ 6 billions. With all this liquidity and the perforinanceof "the e~onomy,which has grown @ 9.2% in the first half of FY 06-07, it is no surprise that markets seem to be firmly in the grips of the Bulls! The market PE has reached about 19 and is growing! The assets under management of Indian mutual funds have increased to Rs. 6,00,000 crores. Most of the inflows have been in the equity schemes, which show that the young Indians have started to invest big money in these markets. The mutual funds have come out with c1ose-:ended schemes to take advantage of positive sentiments of the investors. These schemes have received good response. In 2006 Indian companies have raised nearly $19 billions to fund growth opportunities as against $ 11 billion last year. The following table shows the money raised through different instruments:

(Allfigures in $ billions) All in all it seems that we are in for very exciting heady times ahead! As long as the markets rise based on the fundamental we should not worry. The regulators must however need to extra vigilant, as we have seen the scam of IPOs in the recent past. This is probably the first sustained bull run where so far there has been no shadows of scamsters seem to be lurking in the dark, unlike the 1994 and 2001 bull runs. The regulators must make sure there is no possibility of any manipulation by anyone. A scam would erode the confidence of investors in the markets.

Introduction to Capital Markets

11

Mr Anklesraiya Iyer has written in Economic Times in December that he believes that if the Indian economy grows @ 7.5% and if the corporate profits grow @ 18% p.a. then he sees the SENSEX at 30,000 levels by 2010. According to the Prime Data base reports 2007 is likely to see IPOs and Follow on Public Issues (FPO) worth $ 12 billion hitting the markets as against the 2006 figure of $ 5.4 billions. Currently about 450 companies are in the process of raising money in the next few years from these markets. The amount mentioned is a staggering $ 39 billions in the next 2 or 3 years. The experts are of the opinion that the intended figure for 2007 can be raised as 70% of the amount will come from the foreign players who have really deep pockets. According to the latest data Indian companies have raised Rs.25, 000 crores in 0607through the equity issues. The financial year 07-08 is likely to see some large issues from the banking sector. Some these issues are ICICI Bank Rs.20, 000 crores, SBI Rs. 15000 crores, and UTI Bank Rs.6000 crores. Out of these issues it is quite likely that ICICI Bank may issue shares both in India and abroad. The government has also decided to allow the subsidiaries of State Bank of India to issue fresh equity and some of these banks are likely to come out with IPOs in the current financial year. The real estate sector is likely to lead the race with $ 4 billions to be raised by them with DLF's offer likely to be the biggest in this sector. Some public sector banks like Central Bank, United Bank of India, Indian Bank, UCO bank and Vijaya bank are likely to make IPO offers this year. SBI is talking about a FPO worth Rs. 12,000 crs and Canara bank is talking about an offer of Rs. 4,000 crs. All together this sector is also likely to raise $ 4 billions this year. Indian Capital Markets are definitely witnessing exciting times on the back of strong economic growth that the country is witnessing and is expected to continue to witness in the coming years. Let us now look at some actual figures for the financial year 2007-08. India Inc has raised a record Rs 52,253 crore through public issues --IPOs and FPOs--in the fiscal 2007-08, despite the meltdown in the secondary market. Corporate India's mobilisation of funds through public equity offerings more than double this year as against Rs 24,994 crore mobilised in 2006-07, data compiled by primary market tracking firm Prime shows. Last fiscal's mobilisation is the highest ever. In 2005-06, companies had raised Rs 23,676 crore, followed by Rs 21,432 crore in 2004-05, Rs 17,807 crore in 2003-04 and Rs 1,039 crore in 2002-03. Positive tidings about the Indian economy combined with a fast-growing market have made India an attractive destination for foreign institutional investors (FIls). The number of foreign institutional investors (FIls) registered with the Securities and Exchange Board of India (Sebi) has increased to 1,219 at the end of 2007 as against

12

Financial Services, Markets and Regulations

less than 1000 at the end of significantly to 3,644.

200~.

The registered sub-accounts of these FIls also went up

FIls showed great interest in 2007, pumping in the highest ever net investment of US$ 17.2 billion in the equity markets and were instrumental in the BSE and NSE clocking record index levels of over 20,000 and 6,000 respectively. In fact, during the year, FIls were net buyers in 10 out of 12 months, turning net sellers in the rest primarily to make up the losses on account of the sub-prime crisis in the US. Out of the total net inflows, 70 per cent was invested through the instruments of FCCBs, QIPs and IPOs. The remaining 30 per cent was invested ~hrough overseas offers, preferential offers and conversion of warrants. This surge in FII investment has led to the cumulative net investments by FII in to Indian equities to total US$ 66.8 billion by the end of 2007, since December 1993, when FIls were allowed to enter India. Right now i.e. Jan. '08 the markets have come off their high levels and the sensex is now below 15000 level. The continuous increase in Oil prices - $138 per barrel and high rate of inflation has taken its toll on the markts. FIrs reported to have sold equities worth $4 billion in 0.8. Going forward their is some uncertainty both on eaconomic front as well as Pblitical front.

2 Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India was set up on April 12, 1988, following the recommendations of the high-powered G. S. Patel committee on Stock Exchange Reforms. SEBI seeks to create an environment, which would facilitate mobilisation of adequate resources through the securities market and its efficient allocation. This environment would include rules and regulations, institutions and their interrelationships, instruments, practices, infrastructure within an appropriate policy framework, should have an overall air of fairness. The market must create confidence in the minds of the investors. SEBI has to be responsive to the needs of three groups, which constitute the market: (a) The issuers of securities (b) The investors and (c) The market intermediaries. It must be understood that all investors carry certain risk and it is for the investor to

take risks and choose his investments judiciously. SEBI cannot eliminate all such risks or the consequences of the risks. The existence of SEBI does not remove the need on the part of the investor to carefully consider where he wants to invest his money or the possibility that his investment decision may go wrong. The role assigned to SEBI: 1.

SEBI shall create a proper and conductive atmosphere required for raising money from the capital market. The atmosphere includes rules, regulations. Trade practices, customs and relations among institutions, brokers, investors and companies. SEBI is responsible for safeguarding the interests of small investors.

2.

SEBI shall educate investors and make them aware of their rights in clear and specific terms.

3.

SEBI shall create proper investment climate to enable corporate sector to raise securities easily, efficiently and at affordable cost.

4.

SEBI shall develop a proper infrastructure so that market automatically facilitates expansion and growth of business of middlemen like brokers, banks, (13)

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Financial Services, Markets and Regulations

14

merchant bankers' mutual funds etc. So it will ensure that they provide efficient service to the constituents of the markets. 5.

SEBI shall make more effective the laws in the existing statues as far as they relate to the industrial securities, mutual funds, investments in Units, LIC saving plans, Chit funds etc.

6.

SEBI shall create the framework for more open, orderly and unprejudiced conduct in relation to takeover and mergers in the corporate sector to ensure fair and equal treatment to all the security holders and to facilitate such takeovers and mergers in the interest of efficiency by prescribing a mechanism for more orderly conduct.

7.

It shall devise laws with unified set of objectives, single administrative authority

and an integrated framework to deal with all the aspects of the securities market. S.

It shall introduce a system of two-stage disclosure at the time of initial issue and

make compulsory of the companies to provide detailed information to all stock exchanges and investors on demand. 9.

It shall work as an authoritative institution to see that the intermediaries are financially sound and equipped with professional and competent manpower.

10.

It shall ensure that the rules are versatile and non-rigid to provide automatic and self-regulatory growth.

11.

It shall establish effective inspection machinery, which is expected to act like an

umpire. 12.

It shall operate a security compensation fund in order to protect investors who

suffer financial loss arising from the failure of a stockbroker to meet his contractual obligations. 13.

It shall prohibit the malpractice prevailing in market such as insider trading, share cornering etc.

The management of SEBI will be under the lJlanagement board headed by a chairman. The board shall consist of two members from amongst the officials of the finance and" law ministries. One member shall be from amongst the officials of Reserve Bank of India. Two more board members shall be appointed by the central government. The current Chairman is Mr Bhave. The general superintendence, direction and management of the affairs of the board shall vest in a Board of members, which may exercise all powers and do all acts and nothing which may be exercised or done by that Board. Save as otherwise determined by regulations, the Chairman shall also have powers of general superintendence and direction of the affairs of the board and may also exercise all powers and do all acts and things which may be exercised or done by the Board. This provision makes the Chairman a very powerful person.

Securities and Exchange Board of India (SEBI)

15

Functions of the Board Regulating the business in stock exchanges and any other securities markets. 2. Registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees to trust de€ds, registrars to the issue, merchant bankers, underwriters, portfolio managers, investment advisor and such other intermediaries who may be associated with securities markets in any manner. 3. Registering and regulating the working of mutual funds. 4. Promoting and regulating self-regulatory organization. 5. Prohibiting fraudulent and unfair trade practices. 6. Promoting investor's education and training of intermediaries of the securities market. 7. Prohibiting insider trading in securities. 8. Regulating substantial acquisition of shares and take-over of companies. 9. Calling for information from, undertaking inspection, conducting, inquiring and audits of the stock exchanges and intermediaries and self-regulatory organisations in the securities market. 1.

No stock broker, sub-broker, share transfer agent, banker to an issue, trustee of trust deed, registrar to an issue, merchant banker, underwriter, portfolio manager, investment advisor and such other intermediary who may be associated with securities market buy, sell or deal in securities except under, and in accordance with the conditions of a certificate of registration obtained from the Board. Every application for registration shall be in such manner and on payment of such fees as may be determined by regulations. The board may, by order, suspend or cancel a certificate or registration in such manner as may be determined by regulation.

SEBI and Individual Investor : The investors in the past have suffered at the hands of inefficient stock exchanges and greedy and unprofessional brokers. This was one of the reasons why SEBI was created. The investor today can look fonvard to redressal of his grievances through SEBI. Normally investors have complaints of following nature: 1. Delays in refund of application money. 2.

Delay in receipt of dividend and lor interest warrants.

3. Delay in receiving the maturity value of fixed deposits or debentures on redemption. 4. Delay in receipt of share and debenture certificates after allotment.

16

Financial Services, Markets and Regulations

SEBI receives many such complaints regularly and tries to redress all such grievances. SEBI has from time to time p~lled up companies against whom the complaints are received and has also initiated action against the defaulting companies. SEBI has encouraged the registration of investors associations in various parts of the country to organise investors into an effective force for protection of their own interests. Some of the actions taken by SEBI can be summerised as below: The introduction of screen based trading.

The Ban on Badia The demateriaIisation of shares. The method of postal ballots so that small investors views are heard. The book building process in buy-back of shares by the companies. The capital adequacy norms for brokers. Some of the important achievements of SEBI are: 1.

Proper disclosure to investors through investors through prospectus made mandatory.

2. Guidelines for merchant bankers.

3. Advertising code for mutual funds. 4. Mutual funds are required to publish balance sheets. 5. Takeover code formulated .. 6. Portfolio management service guidelines issued. 7. Guidelines on insider trading. 8. Registration of stockbrokers and sub-brokers. 9. Underwriting made mandatory. 10. Ban on PN's issued by FIlS.

What SEBI does with its power The SEBI exercises power under section 11 and 11 B of SEBI act, 1992 and 17 other regulations • It can ask any intermediary or market participant for information. • It can inspect books of depository participants, issuers or beneficiary owners. • It can suspend or cancel a certificate of registration granted to a depository participant or issuer. • It can request the RBI to inspect books of a banker to an issue and suspend or cancel the registration of the banker to an issue.

Securities and Exchange Board of India (SEBI)

•

It can suspend or cancel certificate issued to the custodian of securities.

•

It can suspend or cancel registration granted to foreign institutional investor.

•

It can investigate and inspect books of accounts and records of insiders.

17

•

(The case of Tata Finance.) It can investigate an acquirer, a seller or merchant banker for violating the take over norms. (The case of Grasim's takeover bid on L & T and the sale of shares of L & T by Reliance to Grasim. You can also refer to the attempted takeover case of Bombay Dying by Bajoria. Also refer to Sterlite Industry's attempt on Indal.) It can suspend or cancel the registration of a merchant banker.

•

It can investigate the affairs of mutual funds, their trustees and asset manag-ze-

•

•

ment companies. It can investigate any person dealing in securities on complaint of contravention of trading regulation. It can suspend or cancel the registration of errant portfolio managers.

•

It can cancel the certificate of registrars and share transfer agents.

•

It can cancel the certificate of brokers who fail to furnish information of

•

transactions in securities or who furnish false information. SEBI investigated 202 cases of market manipulation and price rigging. In 12 cases it awarded the maximum penalty of suspension of registration and cancellation of registration of the intermediary. The company involved is denied access to capital market for the stipulated period" and criminal prosecution recommended. (The case of Videocon, Sterlite and BPL) SEBI in the last five years investigated 21 cases of Issue related manipulation. The maximum penalty for this is refund of issue proceeds and cancellation of registration of the intermediary. No body was found guilty of this offence. Criminal proceedings under section 24, regarding insider trading saw 28 cases in which investigations were conducted and in 2 cases maximum penalty was levied. In case of violation of takeover code 11 cases were investigated and in 7 cases maximum penalty was levied. The maximum penalty is forfeiture of the escrow account, directing the person concerned to sell shares acquired in violation of regulations, directing the person concerned not to further deal in securities, and monetary penalties of upto Rs. 5 lakhs. (In the L & T - Reliance case, Reliance was fined Rs. 5 lakhs, but this was revoked later).

Insider Trading Regulations of SEBI: As per the regulations Insider means any person who is or was connected \\ith the company or is deemed to be so connected and who is reasonably expected to have access, by virtue of such connection to unpublished price sensitive information, in respect of such securities of such company. A person is deemed to be a connected person if such a

Financial Services, Markets and Regulations

18

person is a group company or any subsidiary, an official of stock exchange or stock brokers,. merchant banker or a director or an official of the company, banker of the company, or relatives of any of the persons mentioned above. If such persons have access to the unpublished price sensitive information and are

proved to have used it for personal gain or profits or price manipulation, they are liable to be penalised under these regulations. SEBI is investing the insider-trading angle in the case of Tata Finance. The inquiry is being conducted against the Ex- M.D. Mr. Pendse, and the Ex Director Mr. Talaulikar. Recently SEBI has imposed a fine of Rs. 2 lakhs on Mr Talaulikar.

SEBI Guidelines for Issue of Debt Instruments : A company offering convertible / non-convertible debt instruments through public offer have to comply with the following guidelines: Credit rating for these instruments is mandatory, irrespective of maturity or conversion period. The credit rating has to be disclosed in the offer document. 1.

For an issue equal to or greater than Rs. 100 crores two ratings from two different credit ratings have to be obtained. 2.

3. If rating is obtained from two different credit rating agencies then all the obtained all ratings including the unaccepted rating shall be disclosed. 4. All the credit ratings obt~ined during the past three years preceding the public or rights issue of debt instrument for any listed security of the Issuer Company shall be disclosed in the offer document. S. In case of issue of debentures with maturity of more than 18 months the issuer shall appoint a Debenture Trustee. The name of this trustee shall be disclosed in the offer document. A trust deed shall be executed by the issuer company in favour of the debenture trustees within six months of the closure of the issue. Trustees shall be vested with the requisite powers for protecting the interest of debenture holders. 6. The merchant banker shall alongwith draft offer document, file 'With SEBI certificates from the bankers that the assets on which security is to be created are free from any encumbrances and the necessary permission has been obtained or a 110objection certificate from financial institutions or banks for a second or pari- passu charge in cases where assets are encumbered 7. Trustees shall obtain a certificate from the company's auditors in respect of utilisation of funds during the implementation period of the project. In the case of debentures for working capital; certificate shall be obtained at the end of each accounting year. 8. A company has to create Debenture Redemption Reserve (DRR) in case of issue of debentures with a maturity period of more than 18 months.

Securities and Exchange Board of India (SEBI)

19

9. DRR shall be treated as a part of General Reserve for consideration of bonus issue proposals. 10. A company shall create DRR equivalent to 50% of the amount 'of debenture issue

before debenture redemption commences. Drawl for this reserve is permissible only after the company has actually redeemed 10% of the debenture liability. 11. In case of new companies, distribution of dividends shall require approval of the . trustees to the issue and the lead institution if any. Dividends may be distributed out of profit of particular years only after transfer of requisite amount to reserves. 12. The security shall be created within six months from the date of issue of debentures. If for any reason the company fails to create charge within 12 months from the date of issue of debentures the company shall be liable to pay 2% penal lnterest to

debenture holders. If security is not created even after 18 months, a meeting of the debenture holders shall be called \\ithin 21 days to explain the reasons thereof and the date by which the security shall be created. 13. In case no charge is created for debentures maturing in less than 18 months, the issuer company shall ensure compliance \\ith the provisions of the companies (Acceptance of deposit) Rules, 1975 as unsecured debentures / bonds are treated as "Deposits" for the purpose of these rules.

14. In case of roll over of debentures \\ithout the change of interest rate following conditions \\ill be followed: (a) An option shall be compulsorily given to debenture holders to redeem the debentures as per the terms of offer. (b) Roll over shall be done only in cases where debenture holders have sent their consent for roll over. Non receipt of consent shall not be considered as consent. (c) Before the roll over fresh credit rating will have to be obtained. (d) A fresh trust deed has to be executed. 15. In case of conversion of instruments into equity capital by listed company, value of which exceeds Rs 50 lakhs and whose conversion price was not fixed at the time of issue; holders of such instruments shall be given a compulsory option of not converting into equity capital. Conversion can be done only in cases where instrument holders have sent their positive consent and not on the basis of non-receipt of their negatiye reply.

The recent controversy about the Participatory Notes: What are participatory notes? Participatory notes (commonly known as P-notes) are instruments used by foreign funds and investors who are not registered \\ith the Securities and Exchange Board of India (SEBI) but are interested in taking exposure in Indian securities. Participatory

20

Financial Services, Markets and Regulations

notes are generally issued overseas by the associates of India-based foreign brokerages and domestic institutional brokerages. They are, in fact, offshore derivative instruments issued by foreign institutional investors and their sub-accounts against underlying Indian securities. Participatory notes are issued where the underlying assets are securities listed on the Indian bourses. Foreign institutional investors who do not wish to register with the SEBI but would ·like to take exposure in Indian securities also use participatory notes. Brokers buy or sell securities on behalf of their clients on their proprietary account and issue such notes in favour of such foreign investors.

Why ar~ P-notes so much in the news these days? Participatory notes have attracted significant market attention recently because of huge inflow of foreign funds into Indian stock markets through this route. Since the ultimate beneficiary of transactions carried out using participatory notes is not known to the market regulator and the tax authorities, there is scope for misuse and tax avoidanc~. Also, since participatory notes do not attract the attention of the market regulators of the countries in which they are issued, the entities holding participatory notes virtually go unregulated. A recent survey by the market regulator estimates that of the total FII investment of Rs 90,000 crore in the country, nearly 25% (Rs 24,000 crore) is accounted for by issuance of participatory notes. A significant portion of the investment through participatory notes is also managed by just 14 entities. To put the matter in context, we could recall that the investigation of the '01 securities scam revealed that nearly $2bn was brought in or taken out of the country through overseas corporate bodies (OCBs) registered in Mauritius, whose beneficiaries were resident Indians. The overseas corporate bodies funds were largely unregulated and caused a lot of volatility and a subsequent crash in the markets. There have been reports of late that market regulator - SEBI - had given the finance ministry a list of 30 overseas corporate bodies, which were banned from investing in the domestic stock markets after the '01 stock market scam, to whom six foreign institutional investors have issued participatory notes. This included most reputed names in the industry. This has to be coupled with the fact that of the total foreign institutional investor's inflow of Rs 10,097 crore in October and November '03, Rs 5,756 crore came through participatory notes. Also, what has stoked concerns is that most of the investment in '03 through participatory notes started from May. Before April, such funds were to the tune of Rs 2,000 crore. Fortunately, this investment is spread over 200 scrips.

Securities and. Exchange Board of India (SEBI)

21

How has the SEBI reacted to all this? The SEBI is set to further tighten its foreign institutional investor's regulations to ensure that participatory notes are not misused by non-resident Indians, overseas corporate bodies controlled by Indians or by Indian promoters. The SEBI board has taken an in-principle decision to restrict the issue of participatory notes by foreign institutional investors to only regulated entities. This would mean closing the door on issuance of participatory notes to entities like overseas corporate bodies, NRls and Indian promoters, who the market regulator suspects of having misused the instrument to manipulate the market. Once these norms are notified, foreign institutional investors could be asked to wind up the accounts relating to participatory notes issued to ineligible entities over a prescribed time-frame. An analysis by SEBI in '03 had revealed that about 31 entities that had subscribed to participatory notes appeared to be overseas corporate bodies.

Let us now take a look at some cases where SEBI was involved: MS shoes: This case happened in 1995. The company was allowed to raise capital of Rs. 699 crores from the public. The issue opened on February 14 for fully convertible debentures, convertible in equity at a premium of Rs. 189 per share. The market price of the share on that day was Rs. 509. However this price was cum-rights, which means that post issue price per share would be much lower than this and so the comparison between the two prices was not really fair from the point of view of the investors. The company failed to disclose this fact to the public. When this fact came to the notice of SEBI, it asked the company to make a public statement in the press stating the price ruling was sumrights price. On 13th February the company did the needful. However the TV advertisements continued to compare the issue price of Rs.199, with the market price of Rs. 509. In view of this SEBI asked the company to give the option to the investors to the effect that any allottee who wishes to get the money refunded, can make the application within 20 days from the date of receipt of the allotment letter. It was soon realised that the MS Shoes issue was undersubscribed, and thus it led to

devolvement on the underwriters. But they refused to put the money, saying that the company had closed the issue on the earliest closing date, indicating that the issue was oversubscribed. The liability of the underwriters was estimated to be Rs. 500 crores. SEBI then initiated action against the company and its managing director and also handed over the case to CBI. CBl's investigations reveled that that the company and its M.D Pawan Sachdeva could be charged with criminal breach of trust, complicity "ith SEBI officials, dishonest intentions and concealment of facts in the issue. The complicity of SEBI officials was that they allowed Sachdeva 30 days of time waiver to bring in Rs.130 crores towards his share or rights.

22

Financial Services, Markets and Regulations

SEBI in this case failed to enquire into all omissions and commissions in the prospectus and in investigating the promoter's track record for personal honesty, integrity and dependability. In 2001a case of rigging and' short selling based on insider trading, was noticed in the case of the proposed merger of UTI Bank with GTB. The merger had to be called off due to the intervention of RBI and SEBI. It is alleged that the scam-tainted broker.Ketan Parekh was involved in this case. The mass short selling in these companies took place in April 2001 when the merger talks were on. The short selling was alleged to be masterminded by the bears led by the erstwhile President of BSE Anand Rathi. These activities were investigated by SEBI and action was taken against Rathi, who was forced to resign from his post, and brokerage houses including CSFB, Nirmal Bang and First Global were debarred from undertaking brokerage business. Madhavpura Mercantile Cooperative bank was also involved in all this as the bank had issued a pay order worth Rs. 150 crores on behalf of Ketan Parekh, though he had no money in his account, and the pay order bounced when it was presented for clearing. Ketan Parekh Scam:

Ketan Parekh was a broker in the market. He was a serious investor; who had a good market research team working :with him and they were investing in fundamentally strong companies, which had low capital base and therefore low floating stock. Ketan Parekh used to buy such stocks and accumulate these shares over a period of time. This would drive the market prices of these stocks. Parekh would then sell at a handsome profit. He would reinvest in these stocks at lowff levels. In short he was trading in these stocks, buying at low prices and selling when the prices went up and earned profit. Ketan had his favourite stocks like Global Tele, Zee Telefilms and Himachal Futuristic. The ten stocks in which he was mostly investing came to be known as K-10 stocks. It was alleged that the UTI and some other mutual funds were actually using this K-lO index instesd of the official stock market indices like the sensex to determine their investments in the stock markets. All this operation required huge funds. Where did he get these? He had a line of credit sanctioned to him by banks against the security of the shares that he purchased. The two banks whose involvement has come to light are GTB and Madhavpura co-operative bank ltd. 1.

2. It is alleged that the companies in which he was investing and thus helping these companies market price going up, were also funding his operations. This is case of clear nexus between him and the promoters of some companies at least. Zee Telefilms had in fact funded him and has accepted that the company gave funds to him. Ketan Parekh used Kolkata stock exchange for his buying operations, because surveillance here was weak and he could indulge in unofficial BadIa through the local brokers. This kept him away from the limelight of Mumbai.

Securities and Exchange Board of India (SEBI)

23

By January 1999 the stock markets had started bubbling with excitement, as the sensex went up by 700 points in just three months. The K-lO stocks were in the forefront of this rally and the market seemed to be taking its clues from these very stocks. The international markets were alsl( ~poing well at this time. The U S markets were upbeat on the new economy stocks and the flavor of the market seemed to be what were known as the ICE stocks, viz. Information Technology, Communications and Entertainment. On the day the union budget was presented on 28th of February the BSE sensex was at the unprecedented le,·el of 6000 points. The budget was welcomed whole-heartedly by most. Howeyer just two days later the scenario changed for the worst. The news of unsavory dealing of Ket1ll Parekh started coming out. The American markets, which were nervous since December on the persistent fears of meltdown in Dotcom sectors, were also falling. The celebrated K-lO stocks started loosing value much faster than the other stocks and the banks that had lent money to him started getting nervous as there safety margins were being eroded at a very fast rate. They started asking the broker to either pledge more shares or repay the money. He now had to sell his shares, cut losses and pays the banks or he had to take the gamble of holding on and hoping for the revival of the market. He made a fatal mistake of holding on. He sold some of his favorite stocks but invested this money in some of his other favorite stocks. In short his greed got better of his professional judgement. He also blocked his funds in some companies through the route of pri,·ate placements. All this meant that he now had severe liquidity problems. His 70 brokers in Kolkata stock exchange started feeling the heat, as he could not meet his obligations in BadIa trades. Around 70 brokers defaulted on this exchange. They together had an obligation of Rs.700 crores. In Mumbai another drama was unfolding as the bear cartel headed by the Mumbai stock exchange President Mr. Anand Rathi was trying to go after him. It is allegro that Rathi passed on sensitive information of the market to his friends in the cartel, helping them to dump the Parekh favourite stocks, pushing him in the corner. Anand Rathi was forced to quit his post by SEBI and investigations were launched against him. It was at this time that Madhavpura bank episode exploded when they issued a pay order of Rs 150 crores on his behalf to Bank of India. This pay order bounced as Madhavpura Bank had no funds to clear it. As a matter of fact this was a case of a blatant fraud. A bank cannot issue a pay order unless the buyer of the pay order deposits the money. In this case Parekh did not deposit the money. The bank already had an exposure of Rs. 840 crores. It is also believed that Parekh was using the brokerage firm owned by the Madhavpura bank's Chairman's son to put through his transactions.

We now should take a look at the role of the regulators in this scam. RBI was unable to detect the mal practices that were taking place. There was also the problem of dual control on co-operative banks, by RBI and co-operative department. It should qe. noted that only after this incident RBI was entrusted ,vith the complete responsibility of

Financial Services, Markets and Regulations

inspecting the co-operative banks. RBI till then was inspecting these banks every two years. It was reported that in the last such inspection conducted by RBI, nothing untoward was found. There is hardly any doubt that SEBI also failed as the market regulator. It was very late in the date an investigation was conducted in the role of the bear cartel.

Toto Finance: The scam in Tata Finance came to light on 12th April 2001 when a person named Shankar Sharma circulated a letter on the Dalal Street stating that the company is in deep financial trouble. This happened just before the company's Rights Issue. The company's M D Pendse commenced extensive share market operations through its subsidiary company Nishkalp at the end of 1999. The portfolio mostly consisted of the famous K-lO stocks. Tata's have accused Dilip Pendse of embarking upon carry forward transactions between December 2000 and March 2001 in these stocks, which led to a loss of Rs. 300 million in the last quarter of fiscal 2001. THE TOTAL LOSS SUFFERED BY Nishkalp is estimated to be Rs 480 crs. Pendse is accused of cheating, falsification of accounts, forgery and criminal breach of trust in the Fir filed against him and other employees of the company. The FIR also alleges that the funds were siphoned off for Personal benefit. Pendse is accused of having given ICDs to the tune of Rs. 5 billions to Nishkalp for these transactions. Pendse is held responsible for breaching the prudential norms of RBI that are applicable to NBFCs on two counts namely that he failed to maintain the capital adequacy qitiO of 12% and lending over 25% of the company's net worth to a single entity Le. Nishkalp in this case. SEBI suspects insider trading in the case of Chairman of Nishkalp Mr Talaulikar's selling of his personal holding of 100,000 shares of Tata Finance. It is suspected that he used inside information, as he knew that the company's shares would take a beating on the brouses, once the information of Nishkalp's losses becomes public. It is alleged that Talaulikar devised an ingenious way of transferring funds of Rs 7 million from Nishkalp to the concerned' share broker with a request to back date the sale contract to September 6th 2000 that is six months before the rights issue opened for subscription, when the price of the share was Rs. 69/-. But SEBI has found that the shares were transferred from the respective accounts of members to broker's demat account only in the first week of April, 2001. In May 2001 when Talaulikar realised that a detailed investigation was being planned by the Tatas to probe the Nishkalp affairs, he immediately reversed the transaction and sold the shares at the prevailing market price of Rs. 34. He returned to the broker a Sllm of Rs. 3.5 million, which in turn was returned to Nishkalp.

Securities and Exchange Board of India (SEBI)

25

SEBI has hinted at a possible nexus between former Tata Finance M D Pendse and Suzlon Energy and its affiliate Sarjan securities, which purchased 75,000 TFL shares in March 2001. Sulzon supplied wind mills to Tata group of companies and it will not be surprising that on account of obligations to Pendse, shares were purchased by Sarjan at a price of Rs. 91 much higher than the market price of RsAO. Incidentally Sulzon gave Rs. 5 crs to Sarjan for purchase of 618,000 shares. According to the SEBI report Tata Finance purchased about 13 windmills from Suzlon while Khuda Gawah Investments and Nalini Properties, purchased one windmill each. During 2000-01, TFL purchased these at a cost of RS 350 crs. Pendse had proposed to buy these as a tax-planning measure. The connection between Pendse and Sarjan has been established in the SEBI report as follre than 20 demat accounts bearing a common address. If any such accounts are found, then the genuineness of such accountholders has to be verified. Well anyone can escape this test, if he has 10 demat accounts with a CDSL-registered DP and 10 with the NSDL. The regulator has also made the permanent account number (PAN) an additional proof of identity for demat account-holders. But even PAN numbers are found to be bogus. Reportedly, there are 1 million bogus PAN numbers in circulation. As the demand for PAN numbers has now gone up; you won't get it for free in a place like Ahmedabad now. In fact, it is sold for as much as Rs 500. Therefore even the PAN number doesn't stand as a proof for a genuine person. Also, by planning to bring ba'ck unique identification number (UIN), SEBI hopes to check multiple or benami transactions. UIN will identify an individual investor on the basis of biometrics-based thumb impression. Introduced in 2003, it had caused a lot of resentment among investors for its thumb-impression technique as well as the cost. The MAPIN committee formed in 2005 and chaired by Jagdish Capoor, chairman of HDFC Bank and former RBI deputy governor, had said that UIN will not achieve the desired results. It stated· that if a fraudster cannot be traced through a broker, demat account, bank account or PAN number, then there is no guarantee that he will be traceable with UIN. "It should be recognised that benami entities can be created under the biometrics-based system and that the biometrics-based system is also not errorfree." Meanwhile, an Ahmedabad-based activist obsen es that there is no hope of such scams stopping in the near future. "In every broI-er's office ill the city, the security guard, the peon, the receptionist and the family members "ill have a demat and a bank account in their name." Hemantsingh Jhala claims that SEB! has just scratched the surface of the data mine of Pancha!. There is a lot more to come. Other IPOs that may have been affected by the scam Suz/, m Ellel'YY JPO: Rs 1,496.34 cr (September 23-29, 2005) Key operators used .1,6Y2 fictltiolls accounts to corner 3,

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Financial Services, Markets and Regulations

23,023 shares which is equal to 3.74 per cent of the total number of shares allotted to retail individual investors. Jet Airways ]PO: Rs 1899.3 crore (Feb 18-24, 2005)

Key operators used 1,186 fake accounts for cornering 20,901 shares which is equal to 0.52 per cent of the total number .of shares ,illotted to retail investors. National Thermal Power Corporation IPO Rs 5,368.14 C1'Ore (Oct 7-14,2004). 12,853 afferent accounts were used for cornering 27, 50,730 shares representing 1.3 per cent of the total number of shares allotted to retail investors. Tata Consultancy Services I PO: Rs 4,713.47 crores 14,619 'benami' accounts were used

to corner 2,61,294 shares representing 2.09 per cent of the total shares allotted to retail individual investors.

Case of Samir Arora ACMF: Alliance Capital Mutual Fund (ACMF) was a mutual fund registered with the Securities and Exchange Board of India (SEBI). This Fund has been sponsored by Alliance Capital Management Corporation of Delaware, USA, whose parent company is Alliance Capital Management LP (ACM), USA. Alliance Capital Asset Management (India) Limited (ACAML) is the asset management company of AcMF. ACAML is the subsidiary of Alliance Capital (Mauritius) P. Ltd. (ACMPL) whose parent company is' also ACM. Samil" C. -A1'O,:a· ·was·: working -as -Head/~sian· iJmergmy': Markets wit~::· >i4.iii~ncf{ Sinf}opor.e - (In'affiliate ofACM ::.: iri(l1Ulging equity furids oj-several affiliates":oJ;ACM' 91'OUP compail.ies iTl.~ludillg ACMF. He:Was 'also in charge ojlleM investments' In''india'

was

t/u0ugh.. the FOl'cigll Institutional ImksftllCllts (FIl) ~·oute.

SEBI vis Samir Arora : In 2003 SEBI had imposed a ban on Arora for dealing in the securities market for five years. SEBI said the strict action should act as a "deterrent for others of similar disposition." There were four main charges against Samir Arora. 1. That Arora played a pivotal role in thwarting Alliance Capital's efforts to sell its

India operations by resorting to unethical means. 2.

He did not make disclosures or sometimes made wrongful disclosures when some of Alliance's holdings in certain stocks breached limits that required informing t he respective companies.

:~.

There was a conflict of interest in Samir Arora's role in Alliance, and he acted in f he interest of sponsors to the detriment of the shareholders.

-~.

He sold his entire holding in Digital GlobalSoft based on unpublished, pricesellsitive information i.e. indulged in insider trading.

Securities and Exchange Board of India (SEBI)

35

Cases Against Samir Arora 1. ACMF Sale Towards the later half of the year 2002 ACM decided to sell its India business. When Samir Arora came to know about ACM's intention to sell its India business, he prepared a report recommending that the India business should not be sold. However, the company continued with the proposal and Arora received the final copy of the confidential information memorandum prepared by the merchant banker Blackstone Group for the proposed sale of ACAML. Arora again protested in writing but it seemed that ACM had made up its mind to sell. Arora then entered into an indicative memorandum of understanding with Henderson Global Investors on November 28, 2002 and informed the ACM management that since their decision to sell Indian business appeared to be final, despite his . opposition to this proposal he would also be bidding for the Indian Fund along with Henderson Global Investors. Negotiations started with various bidders from January 13, 2003 onwards and even while negotiations were on, Housing Development Finance Corporation (HDFC) made a pre-emptive bid and asked ACM to stop the further process of bidding. While this process was on, there was redemption pressure on the Fund as a result of which the assets under management (AUM) of ACAML came down very substantially. Finally because of withdrawal of most bidders and because of the bids not matching ACM's expectations the sale did not go through and ACM announced on February 3, 2003 that it had given up the idea of selling its India business. The redemption pressure ceased thereafter and things came back to normal. SEBI ordered an investigation on June 6, 2003 and came to the prima facie conclusion that the conduct of Arora was not in accordance "ith the standards of integrity, fairness and professionalism expected of a Fund Manager. Arora was therefore charged with professional misconduct inviting action under Section 11(4) and 11B of the SEBI Act, 1992.

SEBI's case Against Arora

o

SEBI's case against Arora was that when ACM decided to sell its India business; he opposed its sale vehemently; when he failed in his efforts to stop the sale; he joined hands with a third party, Henderson Global Investors, to acquire the India business from ACM; .

o

Against the Indian bidder, HDFC's bid of $40 to $50 million he made a relatively lower bid of $33 million in the belief that he would be a successful bidder; and his understanding with Henderson Global was loaded heavily in his favour.

o

In furtherance of this personal objective he proceeded to bring down the "aluation of the India business by spreading and later not denying the rumors about his

36

Financial Services, Markets and Regulations

impending exit from the India business if the sale was effected in favour of any bidder other than Henderson Global, thereby inducing redemption pressure on the mutual fund; and that by continuing to manage the assets of ACMF during this crisis period of redemption pressure; he actually brought down the net asset value (NAV) and the assets under management (AUM) of ACMF because of which almost all the bidders had to walk out of the bidding process; (;)

When the other bidders started reducing their bids, he and Henderson Global in fact raised their bid from $30 to $33 million to $32 to $35 million with a view to persuading ACM to sell the business to them; and that by these actions he aborted ACM's plan of selling its India business .. In bidding for the stock of ACAML in collaboration with Henderson Global Arora is alleged to have placed himself in a position of conflict of interest thereby aiding and abetting violation of Clause 4 of the Code of Conduct by ACAML and ACM Trust Company Limited.

(;)

Two senior equity analysts ".ith the fund - Mr. Dinshaw Irani Mehta - informed the Blackstone group, the merchant banker for that they had aligned with Mr. Arora. This was apparently done Samir Arora to pressurize the management and also to create panic.

and Mr. Dhawal the sale of stake at the behest of uncertainty and

The Defence Transparency : Samir Arora stated that he signed a memorandum of understanding with Henderson towards the end of November 2002 and transparently informed the Alliance management regarding the proposal on December 6, 2002. Therefore, at all points Arora kept the key personnel at Alliance Capital fully informed about his proposed association with Henderson, and the Alliance Capital senior management kept the entire bidding process confidential and fair and refrained from showing any special dispensation for Arora. Also, Arora submitted his bid ahead of others so that he could not be accused of using insider information. Redemptions: Samir Arora denied that large scale redemptions from ACMF in Nov 2002 to Jan 2003, the consequent forced selling by ACMF & the reduction of the value / NAY of ACMFs schemes was in any way caused / created by him. Arora further submitted that even prior to 28 Nov 2002 the ACAML / ACMFs had seen large redemptions - caused largely by .uncertainty as to the new holder buyer & his ability to manage the funds. The short-listed potential bidders came with their respective weaknesses. For instance, AIG had no experience in the Indian equity market, Sun F&C was itself not doing well at the relevant time, HSBC had raised less than a total of Rs. 35 crores in its initial equity fund and was a nO\ice in the market. Decline in NAV: Arora contended that the net asset value (NAY) of various schemes of ACMF did not change in any abnormal pattern and were consistent with normal performance benchmarks. There was no extraordinary fall in the NAY during

Securities and Exchange Board of India (SEBI)

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the releyant period that could be attributed to him. Also a fall in assets under management is an accepted consequence/ trend whenever there is a change in ownership of an Asset Management Company / Mutual Fund. This is a consequence of the uncertainty that such transactions generate in the minds of the investors. I nvariably, such fall in the assets under management occurs as new investors stop making fresh investments into the schemes of funds which are expected to undergo a change in management / ownership while some existing investors start pulling out money. To cite an example, when Zurich India Mutual Fund was taken over by HDFC Mutual Fund during broadly the same period under consideration, the assets under management of Zurich India Mutual Fund fell by Rs. 1,872 crores.

Case Judgment: SEBI had contended that Arora should have resigned before bidding for ACM because there was a conflict of interest in his capacity as a bidder and the manager of unit holders' funds. However, according to SEBI's own regulations, the responsibility for ayoiding conflicts of interests rests with the trustees and the asset management companies. The Securities Appellate Tribunal (SAT) thus maintained that if SEBI's case is that the conflict of interest situation was created because of Arora bidding for the mutual fund and still continuing to manage its equity investments, the liability should be fixed on the trustees and the asset management company, not on Arora. Further, the SAT maintained that there was nothing wrong legally, morally or ethically in Arora bidding for ACM since he had submitted his bid ahead of the others in a transparent manner. SAT ruled that there is no bar on bidding as per Mutual Fund Regulations. The question is entirely moral or ethical. Since 6 out of 7 schemes had their NAVs outperforming, the SAT also ruled out the claim that Arora had caused a decline in NAV. SAT ruled that no malafide intentions could be proved and hence this charge was ruled out.

Non-Disclosure of Alliance holdings The second charge against Arora is that of non-disclosure of share holdings when they crossed certain limits. According to SEBI, Arora was the only person who was aware of the combined shareholding of ACMF (Alliance Capital Mutual Fund, India) and ACM (Alliance Capital Management, USA) in various companies, like Balaji Telefilms and Mastek, and he failed to make proper disclosures. This raises the question of what precisely a fund manager is to do and what is the role of a compliance manager. Normally, all mutual funds companies are mandated to have a compliance officer to look after such issues.

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Financial Services, Markets and Regulations

Domestic fund managers who manage much smaller corpuses possible for fund managers to keep track of disclosures. Arora was a billion dollars across Asia Pacific, by no means a small amount. have a compliance officer called Piyush Surana. The case brings up of a compliance officer in a mutual fund.

affirm that it is not managing more than Besides, Alliance did the point of the role

Also, was the board of directors not aware that there is a SEBI regulation regarding disclosure of total holdings by all funds of Alliance taken together? It should have been the board's duty, as much as the fund manager's, to ensure that there were proper systems to avoid wrongful disclosure or non-disclosures. In November 2001 when Reliance Industries was pulled up by SEBI for not disclosing to L&T that its holding has crossed 5 per cent, the company got away with fine of Rs 5 lakh (Rs 500,000). But in the case of Samir Arora the offence was considered serious enough to impose a ban on him.

SEBI's case against Arora SEBI's case was that the equity investments of ACMF as well as of ACM, which was also operating in India through FII route, were required to be clubbed for the purpose of making disclosures under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 ('Takeoyer Regulations' hereinafter) and S E BI (Prohibition of Insider Trading) Regulation, 1992. While details of the companies in respect of which such disclosures are not made were not provided, it would be reasonable inference from the reading of the charge that while the disclosure requirements were met by ACMF and ACM separately, the two were required, according to SEBI, to aggregate their equity investments in different companies for the purpose of disclosure requirements. Since Samir Arora was in-charge of such equity investments in respect of both ACMF as well ACM he was held gUilty of professional misconduct.

Arora's Defence Samir Arora's defense in this regard was two fold. Firstly, he argued that he was only a fund manager and that the responsibility for meeting the disclosure requirements is that of the Mutual Fund, the AMC, the Trustees and the Compliance Officer and not that of the fund manager. Secondly, Arora has contended that since the matter was not free from doubt a reference had been made to SEBI by the Compliance Officer which had in fact clarified that no such clubbing was required for the purpose of disclosures even if the FII and the mutual fund were in the same parent group.

Case Judgment The SAT ruling held that disclosures are a compliance offic~r's responsibility; In May 2001, SEBI told Alliance that there was no need to club aggregate holdings of the MF and the FII for disclosures. Hence the court had no hesitation in exonerating Arora of

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these charges. It was held that compliance is the responsibility of the trustees and the Mutual Fund.

Digital Globalsoft Accusation: Samir Arora sold his entire holding in Digital GlobalSoft based on unpublished, price-sensitive information. This charge against Arora is the most crucial. SEBI alleges specifically that Arora was privy to information on the merger ratio of Digital Global Soft and a division of Hewlett-Packard India much before the announcement was made by the company. Arora sold the entire holdings of 14.66 lakh (Rs 1.466 million) shares of DGL, on behalf of ACMF and ACM, immediately after an independent valuer submitted his report but before the ratio was announced for the de-merger of the HP division which was to be merged with DGL.

SEBI's arguments •

Arora sold all of Alliance's holdings in DGL in four days flat (May 8-13), a day after the valuation report was submitted by Bansi Mehta & Co to DGL management. It is only much later (on May 30) that Digital appointed Deloitte Haskins Sells for a fairness opinion. The de-merger ratio was finally announced by Digital on June 7 after DHS gave its approval. • Entities managed by Arora held 10 per cent of (in September 2002) DGL's equity capital which was next only to the controlling holder - Compaq. Thus, Arora was by definition an insider. • SEBI is not required to show that any other insider shared unpublished pricesensitive information with Arora. • SEBI has not found any evidence against other persons like Bansi Mehta and CEO of DGL, Som Mittal. How can a fund manager be assumed to have legitimate access to information if he does not hold an official position in the company?

Unasked questions: • • •

How can independent valuer be appointed by just one company concerned in the deal, and that too informally? Was fairness opinion sought from DHS just a formality? SEBI has adopted a hit-and-trial method. Either SEBI recognises that insider trading is notoriously difficult to prove, so building up many accusations against Arora may strengthen its case. But can many weak cases equal one strong case?

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Financial Services, Markets and Regulations

Arora's Defence: • • •

• •

When a merger is talked about widely, the convening of a board meeting itself leads to speculation and uncertainty. CLSA analysts put out a 'sell' recommendation on DGL on May 8. The report was significant since CLSA Emerging Markets was rated India's No 1 FII broker. If Arora had inside information he would have known that the ratio would not be disclosed on that date and there would be no urgency to complete the sale before May 12. None of the Alliance fund managers or analysts including Arora met DGL officials in 2003 Being second largest holder cannot lead to the presumption of having unpublished price-sensitive information .. Can an event force a fund manager to wipe out his top holdings in four days flat?

Clean Chit to Arora In the case of the insider trading charges relating to Digital GlobalSoft, SEBI's accusations were restricted only to Arora. However, no questions were raised against Digital's chief executive officer Som Mittal. SEBI also completely believed Bansi Mehta's (the auditor who was given the mandate to suggest the merger ratio) version that he alone was privy to the information, ruling out the possibility of any leak. Not just that, other mutual funds were also spared. Apparently, Tata Mutual Fund and SBI Mutual Fund also sold their entire holdings in May, ahead of the announcement of the merger ratio. Other fund managers that sold part of their holdings include HDFC, Franklin and Deutsche. SEBI did not go beyond saying that Arora sold shares ahead of Digital's board meeting (even though the merger. ratio was annollnced only a month later, after it was vetted by a third party -- Deloitte & Haskins), and since he qualifies as an insider by definition, he is gUilty of insider trading. SEBI provided little evidence to establish how and from whom Arora could have got insider information or reason out the case based on the circumstances. The SAT order noted that while not suspecting the source where the information was generated or the channel of transmission of the information to the final destination and at the same time accusing some third party, though technically an insider as per SEBI's interpretation of the Regulation, of being in receipt of that information is, according to them, something in total defiance of elementary logic. It appreciated the difficulty that it is not possible for us to let mere suspicions, : conjectures and hypothesis take the place of evidence as described in the Indian Evidence Act.

Securities and Exchange Board of India (SEBI)

41

The questions SEBI asked were all legitimate though we do feel that the replies which SEBI received were thorough, forthright and spontaneous and could have been considered with a more open mind. SEBI strengthened Arora's credentials at the cost of its own.

Ambiguity of an Insider Section 2 (e) of the Insider Trading Regulations defines an insider as any person who is (or was) connected with a company, or is deemed to have been connected with the company and is expected to have access to unpublished price-sensitive information about the company. The enumeration of persons deemed to be connected with the company, as given in Section 2' (h), includes intermediaries, investment companies, trustee and asset management companies or employees of stock exchanges and clearing corporations. This clearly means that mutual funds and their officers are indeed covered under the definition. However, till recently, it was assumed that the \\ider ambit of the definition of 'insider' will be applied less in practice, with the focus being on direct insiders - those who work for the company in various capacities, and their relatives. The Arora case is the first instance of a fund manager being hauled up for insider trading charges despite not having a board seat or any direct official connection with the company. If Arora did indeed have access to any inside information on Digital GlobalSoft, it was not because of any official position in the company. Normally, to prove insider trading, SEBI would have to prove how Arora got pricesensitive information, and how his use of it was malafide. But an amendment made to the insider trading regulations in February 2002 dropped some crucial words in section 2 (e). Earlier, an insider not only had to be connected or deemed to be connected with a company, but had to have access to price-sensitive information "by virtue of such connection." Dropping the words "by virtue of such connection" makes it easier for SEBI to level charges without a firm degree of proof. Fund managers do admit that they meet managements of investee companies regularly and get insights and information that mayor may not be in the public domain. It will be naive to think that these management meetings are to discuss published financial results or any other publicly available information. Why would anyone want a private meeting if one is not expecting something that has already been said? Now the issue here is this unsaid part that fund managers and analysts look for.

Financial Services, Markets and Regulations

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Detrimental Action Accusation Charge against Arora is that of non-disclosure of shareholdings when they crossed certain limits. According to SEBI, Arora was the only person who was aware of the combined shareholding of ACMF (Alliance Capital Mutual Fund, India) and ACM (Alliance Capital Management, USA) in various companies, like Balaji Telefilms and Mastek, and he failed to make proper disclosures. This raises the question of what precisely a fund manager is to do and what is the role of a compliance manager. Normally, all mutual funds companies are mandated to have a compliance officers to look after such issues. Domestic fund managers who manage much smaller corpuses affirm that it is not possible for fund managers to keep track of disclosures. Arora was managing more than a billion dollars across Asia Pacific, by no means a small amount. Besides, Alliance did have a compliance officer called Piyush Surana. What was his role? Also, was the board of directors not aware that there is a SEBI regulation regarding disclosure of total holdings by all funds of Alliance taken together? Wasn't it the board's duty, as much as the fund manager's, to ensure that there were. proper systems to avoid wrongful disclosure or non-disclosures?

SEBI's Arguments: •

Arora invested in mid-cap stocks with low floating stock.

•

Arora and his team maintained close rapport with such companies for extracting crucial un-published, price sensitive information and used such information for making investment decisions.

Case Outcome Out of four cases - Balaji Telefilms, Mastek, United Phosphorous and Hinduja TMT -of price manipulation and mala fide intention (that Arora traded in a manner that benefited the foreign institutional investors' sub-accounts at the cost of the domestic funds), SEBI has not been able to establish even one of the cases. Instead, the regulator chose to call these instances "illustrative" without establishing the same with credible data. If SEBI's contention is that Arora was a chronic price manipulator, it should haye been easy to establish price manipulation at least in single'scrip, if not in all.

Securities and Exchange Board of India (SEBI)

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New Developments Rolling SeHlement What is a rolling settlement?

What is the diHerence between a rolling seHlement and the prevailing weekly settlement? A rolling settlement is one in which trades outstanding at the end of the day have to be settled (payments made for purchases or deliveries in the case of sale of securities) at the end of the settlement period. In a T +5 rolling settlement, a transaction entered into Monday has to be settled on the fifth working day, which will be the subsequent Monday, when either pay in or pay out takes place. As opposed to this, in a weekly settlement, the transactions made during any of the

five trading days are permitted to be squared up - or purchases offset against sales during the same settlement period. Only those transactions, which are outstanding at the end of the last trading day, are required to be settled by payments or deliveries. Internationally, most developed countries follow the rolling settlement system. For instance, both the US and the UK follow a rolling settlement (T+3) system, and the German stock exchanges follow a T +2 settlement cycle. In India we are presently following the settlement cycle of T + 3. It has· been proposed by SEBI that from April 1st 2003· T + 2 will come in force, with the intention of finally moving towards T + 1 settlement cycle.

What are the advantages of rolling seHlements? In rolling settlements, payments are quicker than in the weekly settlements. Thus, investors benefit from increased liquidity. For example, in a rolling settlement system, investors would receive the payments on the fifth day after the sale. The National Stock Exchange was the first to introduce rolling settlements in the country. Rolling settlements could not be introduced earlier because India did not have depositories. Rolling settlements necessarily require electronic transfers of funds and demat facilities in respect of securities being traded. This is because handling large volumes of paper on a daily basis is extremely difficult for the clearinghouses of stock exchanges. It is only now that India has adequate facilities for electronic delivery of shares

(demat shares), which facilitates trading and clearing large volumes on a daily basis. However, transfer of funds in IndIa still takes two to three days, as all banks are not yet connected electronically with all their branches.

Financial Services, Markets and Regulations

Derevatives in Stock Markets Index Futures THE Securities & Exchange Board of India (Sebi) has recently taken a decision to expand trading in derivatives to options on stock market indices and on individual stocks. The risk containment and software related issues are being worked out. Index futures have recently ~ade their entry into Indian markets and even though the volumes are still small these are picking up. When you buy or sell an index future, you take a view on what the index (say the sensex) will be at some point in the future. Simply put, derivatives allow investors to trade in instruments derived from the cash market, where typically buyers take delivery on payment of cash. Such instruments - futures and options - allow investors to hedge their risk or even take speculative positions.

How can you hedge using these instruments? This is how it works: if you feel the market is going to fall and the value of your portfolio is going to diminish you take a position on the futures market. If it rises, then even though there is a loss on the futures position, the underlying . cash portfolio rises and this help risk minimisation. It is for this reason that indices,

which mirror closely a very wide basket of stocks, prove successful in index futures trading.

What is a futures contract? A futures contract is an agreement between a buyer and a seller for the purchase and sale of a particular asset at a specific future date. The asset in the case of index futures is an index - it could be the S&P CNX Nifty index or the BSE30 sensex. With passage of time, several more indices are going to be allowed to be traded on the futures markets. In a futures contract, the price at which the asset would change hands in the future is agreed upon at the time of entering into the contract. A futures contract involves an obligation on both the parties to fulfill the terms of the contract.

What is the period for which a futures position could be taken? Currently, both the stock exchanges have come out only with three contracts: one month, two month and three month contracts each of which expires on the last Friday of the respective month. More flexibility is expected to be introduced as index futures catches up.

Securities and Exchange Board of India (SEBI)

What are options? Options are contracts which go a step further than futures contracts in the sense that they provide the buyer of the option the right, without the obligation, to buy or sell a specified asset at an agreed price on or upto a particular date. For acquiring this right, the buyer has to pay a premium to the seller. The seller on the other hand, has the obligation to buy or sell that specified asset at that agreed price. This makes options more of an insurance product where the downside risk is covered for the payment of a certain fixed premium. So the loss would be minimised to the extent of the premium paid, like in an insurance product. An option is a contract, which gives the buyer the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific price on or before a specified time. The underlying asset may be physical commodities like wheat, cotton, gold oil or financial instruments like equity stocks, stock index, bonds etc. E.g. An investor buys a call option to purchase equity shares of BSES Ltd. at the end of 30 days at a price of Rs. 200 at a premium of Rs. 10. If the market price of the share on the day of expiry is say Rs. 230, the investor will exercise the option and buy the share at Rs. 200 and earn Rs.20 per share (Rs.230-Rs.200-Rs.1O). On the other hand, if the market price falls to say Rs. 170, then the investor will not exercise the option, and the maximum loss to him will be only Rs. 10 being the option premium paid. Thus the losses are limited while the profits are unlimited. While the American style option can be exercised on or before the expiration date, the European style option can be exercised only on the expiration date.

What is a call or put option? The right to buy is called a call option while the right to sell is called a put option. The buyer of the call option can call upon the seller of the option and buy from him, the underlying instrument, at any point in time on or before the expiry date by exercising his option at the agreed price. The seller of the option has to fulfill the obligation on exercise of the option. The right to sell is called the put option where the buyer of the option can exercise his right to sell the underlying instrument to the seller of the option, at the agreed price. The technical group of SEBI has decided that stocks to be eligible for options trading should meet the following criteria The market capitalisation during the preceding six months and average free float market capitalisation (non-promoter holding in the stock) should not be less than Rs. 750 crore. The stock should appear in the list of top 200 scrips based on the average daily volume during the preceding six months which should not be less than Rs. 5 crore in the underlying cash market.

46

Financial Services, Markets and Regulations

The stocks should be traded at least 90% of the trading days during the preceding six months. Non-promoter holding in the company should be at least 30%. The ratio of daily volatility of the stock vis-a vis daily volatility of index should not be more than 4, at any time during the preceding six months.

Depository and Dematerialisation: Shares were traditionally held in physical or paper form. This method has its own inherent weaknesses like loss / theft of certificates, forged / fake certificates, cumbersome and time consuming procedure for transfer of shares etc. Therefore, to eliminate these weaknesses, a new system called Depository System has been esta blished. A depository is a system, which holds your shares in the form of electronic accounts in the same way a bank holds your money in a saving account. Depository system provides the following advantages to an investor: . . ..

Securities and Exchange Board of India (SEBI)

47

Due to the advantages of dematerialisation of shares, it is advisable that all investors should switch over to this system. As a matter of fact all securities in the group on both BSE and NSE are transacted only in dematerialised form. SEBI has also permitted companies making initial public offering to allot share only in this form.

The National Securities Depository Ltd. (NSDL) IDBI, UTI and the" NSE to provide electronic depository facilities for stock traded in the equity and debt market promote NSDL. NSDL has been registered "ith SEBI and was launched on November, 7, 1996 as India's first depository to facilitate trading and settlement of securities in dematerialised form. Settlement of securities in dematerialised form will eliminate problems that are normally associated with settlement through physical certificates, like tearing/mutilation of share certificates due to careless handling, loss of certificates in the post or delays with registrars, problems of bad delivery of shares. Cases of forgery of certificates get eliminated in the electronic trading system. Settlement of trades will be faster and hassle-free leading to shorter settlement cycles.

Depository: A depository is an organization where the securities where the securities of a shareholder are held in the electronic form at the request of the shareholder through the medium of a depository participant. A depository is a bank of securities. The depository can legally transfer beneficial ownership, which a custodian cannot. The main objective of a depository is to minimise paper work involved with the ownership, trading and transfer of securities.

Facilities oHered by NSDL: 1.

Enable surrender and withdrawal of securities to and from the depository.

2. Maintain the investors' holdings in the electronic for

3. Effect settlement of securities traded on the exchanges. 4. Carry out settlement of trades not done on the stock exchanges.

Non-Voting Shares (NVS) Shareholders have two rights a) dividend and b) voting rights. Incase of non Yoting shares one right gets excluded i.e. the share holder looses the right to vote, even though he is the member of the company and may attend the annual general meeting of 1he company. They usually are not entitled to rights or bonus issues of shares of the concerned company.

48

Financial Services, Markets and Regulations

NVS therefore have to be more attractive than those that carry full voting rights are. This can be done in two ways a) by ghing discount on the issue price and b) by giving higher dividend on these shares .. Theoretically these shares ""ill quote at a discount to the price of normal shares. Industry needs resources for modernization, expansion and new projects. But raising funds by way of equity has an inherent danger of loosing control to others. The ability to raise debt has its own limitations. NVS can provide a way out to companies to garner equity without dilution of the promoters' stake and control. There can always be investors who would prefer a higher return, rather than right to vote. It is evident that very few shareholders actually turn up for the annual general meetings of the companies. As is e\ident form the recent experience of voting through postal ballot, it reinforces the view that many shareholders are not really interested in the affairs of the company or wish to participate in the affairs of the company.

Bonus debentures of HLL Recently Hindustan Lever one of the most respected companies in India has come out with a unique product called Bonus Debentures. This is the first time that such a product has been introduced and promises to be a popuIar product in future. The scheme, formulated under Section 391 to 394 of the Companies Act, entails issue and allotment of bonus debentures of the face value of Rs.6/- each, in the ratio of one fully paid debenture of Rs.6/- each for every Re.1/- equity share held in the company on a record date to be fixed by the Board after the scheme is sanctioned by the Bombay High Court. The debentures wouId be secured, and redeemable at par in two equal instalments on the second and third anniversary of the issue. Shareholders can trade on the debentures post allotment, since they would be listed on the NSE and the BSE. The debentures would carry an interest rate of 9% per annum payable annually. The debentures would be considered as a 'deemed dividend' under the provisions of the Income Tax Act. HLL would bear and pay, in addition, dividend distribution tax at 10.2% on the issue from the General Reserves. The issue and allotment of the debentures will account for approximately Rs.1320 crores from the General Reserves. The dividend distribution tax will account for about Rs. 135 crores from the General Reserves. Thus a total amount of approximately Rs.1455 crores would be utilised from HLL's General Reserves of Rs. 1609 crores (as at December 31,2000). HLL will now make necessary applications to the Bombay High Court for its directions for conveni~g a meeting of shareholders to seek their consent. HLL decided to issue bonus debentures to enhance the efficiency of the balance sheet in the context of excess cash carried for several years. The scheme will significantly increase HLL's Return on Net Worth and reduce the cost of capital.

Securities and Exchange Board of India (SEBI)

49

The scheme is equitable to each and every shareholder, including the parent company, Unilever, because every shareholder receives one debenture each for every equity share held in the company. The scheme is predicated on improving the efficiency of HLL's balance sheet, while benefiting all shareholders. HLL had evaluated other options to deal with the issue of surplus cash. A cash dividend was ruled out because under the Companies Act, a company can pay dividend out of General Reserves, within specified limits, only when it has incurred a loss or there is inadequacy of profits, neither of which is the case with HLL. In the circumstances, a special dividend could have been paid only under a court scheme. The proposed bonus debentures scheme has the benefit of retaining access to the cash for exploiting any business opportunity that may come up within a defined ~imeframe of three years, while at the same time unlocking value to the shareholders immediately. A buyback would not have been equitable to every shareholder, because not all shareholders would have diluted their holdings. Apart from this, a buyback would need to be staggered over a period of at least three years, and would have accounted for only under 3% of HLL's equity. HLL also rejected the option of invoking Section 100 of the Companies Act reducing the face value of its Re.l/- shares to a lower amount, and returning the differential amount to shareholders with a suitable premium. Besides being tedious and administratively cumbersome, there was no benefit in altering the basic share capital structure of the company. Bonus shares were not considered because it would have merely implied conversion of General Reserves into equity shares without any underlying outflow of cash, the basic issue being addressed by this scheme. Bonus shares would also involve permanent increase in the company's equity capital. In the case of a bonus issue, HLL would have continued to have cash and capital in excess of needs, with the attendant dilution of Return on Net Worth/ Return on Capital. Hence the proposed issue of bonus debentures came up as the most \iable route to improve the efficiency of HLL's balance sheet. v. hile benefiting all shareholders. Payment of interest on debentures would lead to a marginal dilution in earnings, but it is estimated that the dilution would be in the order of about 40 paisa per share in the first year of implementation. However, in real terms, shareholders would now have two streams of cash flow-one by way of dividend on shares and the other by debenture interest/ redemption. The scheme contemplates that small debenture holders - holding less than 1000 debentures - who are original allottee can tender their debentures to the company at any time on a first-come-first-ser\'e basis for repurchase at par. This facility would be available to a maximum extent of Rs.100 crores ill a l1y .'"ear.

50

Financial Services, Markets and Regulations

The company is also in disc'ussion with its merchant bankers (HSBC), to lead a consortium of banks and financial institutions to formulate a scheme under which debenture holders could sell their debentures to them soon after their allotment should they wish to do so within a defined timeframe. The company has been advised that Sale/redemption of debentures at par (Rs.6/- per debenture) will not attract any capital gains tax in the hands of the shareholder, being a deemed dividend; HLL will pay dividend distribution tax at 10.2% on this distribution. Interest on the debentures will be taxable on receipt in the normal course. HSBC, which assisted the company in formulating the bonus debentures scheme, has been appointed as the merchant bankers for the scheme. The Bonus Debenture does not in any way impair HLL's capability to make capital investments to fund the growth of existing businesses, enter into new businesses or to execute a large acquisition should such an opportunity arise. Even after the proposed restructuring of the General Reserves by issue of debentures by way of deemed dividend out of the General Reserves, HLL would have a strong balance sheet. This would enable it to make significant acquisitions should such opportunities arise. The reduction of the General Reserves is thus not expected to impact HLL's ability to exploit longer term growth opportunities. In fact should opportunities come for profitable investment in core businesses, a balance sheet, which is appropriately geared, would be desirable from the point of view of HLL and its shareholders and would be in line with an optimal financial structure by way of debt-equity ratio which is efficient and in keeping with well accepted and prudent norms of financial management.

E-trading: One of the most revolutionary things to happen at the end of the twentieth century is obviously the revolution in communication through the Internet. The Net has become the way future business is heading towards. It is therefore no surprise that the Net has made a big difference in the way stock markets around world will function in future. Developments like screen based trading in the place of traditional trading ring and the dematerialisation of the shares have played a big role in making E-trading a reality. Without these developments E-trading would not be as effective "as it is now. Due to this new innovation one can now operate in the stock market from the privacy of one's home or office. The transactions can be put through in a matter of few minutes, to one's sati,sfaction. This method guarantees complete secrecy in the transactions. Various portals like Indiainfoline, Share khan, ICICI, Capital markets have come up in the last few years. These portals are full of information about almost 5000 companies listed on the stock exchanges. This enables the investors to study the companies' performance, before making investment decisions. They also provide latest information concerning the companies, which is essential for the investors to make decisions. T V channels like CNBC also contribute a great deal in this effort by reporting latest

Securities·and Exchange Board of India (SEBI)

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happenings alongwith the necessary analysis by experts and by telecasting live the Investor meets, allowing investors to get first hand information from the various company's officials. On January 31, 2000 SEBI, cleared the guidelines for net based trading. The trading platform was created through VSAT operational since 1994. The investors were now free to trade directly through their stockbrokers from the comfort of their homes. The preconditions for trading on Net are: 1.

A P.C. with net connection.

2. A registered account with a broker.

3. A demat account. 4. An account \"ith a bank with payment gateway or online banking facility. How to trade on-line 1. Log on to the Broker's website. 2.

Register yourself as a client.

3. Fill in the client broker agreement on stamp paper. 4. Log on to the broker's site using secure user ID and password. S. The markets watch page will show real time data. 6. Trade shares directly by entering the symbol of the securities. 7. The brokers' server \\i11 check the limit in the on-line and the demat account for the number of shares. And execute the trade. 8. Usually the order is executed in about 20 seconds and you get the confirmation. 9. The broker will send one e-mail confirmation and printed contract by mail. 10. On the settlement day the demat and bank accounts will automatically get debited and credited.

Stock Lending Mechanism: . This scheme was introduced by SEBI in 1997, to make capital market active by putting idle stocks to work. The scheme became operational in 1999. The National Securities Clearing Corporation Ltd. (NSCCL) is the first Approved Intermediary (AI) to implement this scheme. All clearing members are eligible to participate in this scheme. All lending and borrowing transactions are backed by 100% collateral. The NSCCL bears all risks attached with these transactions. The investors willing to lend / borrow securities approach their broker participant for putting through securities lending transaction. This transaction involves t" 0 parties one \\ ho is willing to lend and the other who wishes to borrow securities at market related rates. The lender gets the benefit of a

52

Financial Services, Markets and Regulations

reasonable return called lending fee for parting with the securities for a specified time. The lender is assured of getting equivalent the relevant securities by the NSSCL on the settlement date. If the borrower fails to return the securities on the settlement date, the NSCCL has powers to carry out an auction, buy the shares on behalf of the lender and return them to him. This scheme has so far failed to take off in a significant manner. With the introduction of Derivative products, many investors seem to prefer, to deal in those products.

Employees Stock Options Plan (ESOP) There is a story that says that when Microsoft decided to go public it was not because the company wanted money, but due to the fact the employees wanted to cash their ESOPs, something that they could· not do unless the company was listed. Hence Microsoft went public! ESOPs is said to be the recipe to make employees millionaires apparently at no cost to the employer. This phenomenon is relatively new in India and the IT industry was the first to adopt it wholeheartedly on the experience in the American markets. The distinguishing feature of ESOPs is that the reward is linked with the increase in the prices of shares of the company. But the other point that is being increasingly faced by employees is what if the stock prices decline, below the price at which they bought these options in the first place? Today this is the reality in India. ESOPs are granted in the form of shares directly allotted, stock options, stock appreciation rights etc and each of these can have many variants. A stock option is a right, but not an obligation, of the option holder to acquire the shares of a company during the specified period, at a predetermined price. ESOPs represent one of the methods of giving part ownership of the company to the employees whereby they can work for and take part in the prosperity of the company. It is expected that when an employee becomes a part owner of the company, his motivational level would increase. This scheme is also a step towards achieving the social objectives of the company. This is an incentive to the employee. The scheme comes with the rider of Lock in Period. This means that the employees after exercising the option are not allowed to sell these shares for some time as stipulated by the company, and usually also cannot create a charge on them.

SEBI Guidelines: Stock options can be issued under two methods, a) Employee's Stock Option Scheme (ESOS), b) Employee Stock Purchase Scheme (ESPS). There has to vesting period during which the employees have to hold on to the option, but cannot apply for the shares. After this there is the exercise period during which the

Securities and Exchange Board of India (SEBI)

53

option can be exercised. After this is the lock-in period during which these shares cannot be sold. There are extensive disclosure requirements that need to be fulfilled. The promoters are not allowed to take part in this scheme. The scheme also needs to be ratified by the shareholders before it can be implemented. The approval has to be in the form of a special resolution passed by the AGM. Under the corporate governance practices the scheme has to be implemented through a Compensation Committee of the Board of Directors of the company. This committee must have majority of independent directors. Considerable freedom has been granted to the companies as regards the manner in which the scheme can be designe~ and implemented. The option granted to the employees is non- transferable. The schemes are available only to the employees and the non-promoter directors of the company. These guidelines are applicable only to the listed companies. This however does not mean that companies that are not listed cannot offer this scheme to their employees. There is no limit either of quantity or as a percentage of capital or the shares or stock options issued under any scheme. Under the ESPS the shares can be allotted without any waiting period. A certificate has to be obtained form the Auditors of the company stating that the scheme has been implemented in accordance \yith the SEBI guidelines and in accordance with the resolution passed in the AGM.

Sweat Equity: The company's Act says that. "Sweat Equity Shares" means equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions by whichever name called. The following are the essential features of this instrument: (a) The term is restricted to equity shares only and no other type of shares or other instruments can be issued as sweat equity. (b) Such equity shares may be isslled at a discount or for sllch consideration other than cash, as has been specified. All companies can issue sweat equity as per the guidelines issued by SEBI. Unlisted companies also have to follow the guidelines applicable for them, while issuing sweat equity.

Financial Services, Markets and Regulations

The issue of sweat equity shares has to be authorised by a special resolution passed by the AGM. The resolution should specify the number of shares, current market price, and consideration, if any and the class or classes of directors or employees to whom such equity shares are to be issued. Upper limit need only be mentioned for number of shares.

London Stock Exchange-AIM AIM is world's leading market for smaller, growing companies from all over the world. Since its launch in 1995 about 2100 companies from all across the world have got listed on this market. Its success is built on the basis of its simple regulatory environment that has been specifically designed keeping in mind the requirements of smaller companies. One will find many kinds of companies on AIM some of which may be financed by Venture Capitalists, while others may be more established companies that are trying to expand. Reasons why companies are attracted to this market could be summed up as follows: Unlike most other markets AIM does not stipulate minimum criterion in relation to company's size, track record or a set number of shares in the public hands. All prospective companies will need to nominate an Advisor from the AIM's approved register who will ensure that the company is eligible to be listed on this exchange. Listing on this exchange allows companies to raise funds with initial floatation and also more floatation later on. Create a market for the company's shares, broadening its shareholders base and potentially given its existing shareholders exit option. Raise its profile with a view to expanding its operations into new overseas markets. Raise money for acquisitions;

3 Money Markets

Introduction to Money Ma.rkets . The money market is. a market for overnight to short term funds, and for short-term . money and financial asset that are close substitutes for money. Short term in Indian context means a period upto one-year. Close substitute for money means any financial asset, which can be quickly converted into money. The major participants in this market are the commercial banks, the other financial intermediaries, large corporates and the Reserve Bank of India. The . RBI plays a major role and occupies a strategic .position in these markets. It influences the availability and cost of dedit. The objectives of these markets are to provide 1. ~Anechanism for evening oij,t short-term surpluses and deficiencies. 2 ~ ' A focal point of . central bank intervention for influencing liquidity in the economv. / . ' . . 3. A reasonable access to the users of short-term fl\nds to meet their requirements / at realistic cost. In the money market the operations are for short duration as compared to capital markets. There is large number of participants in money market. The depth of this market depends on the number of participants. This is whole sale market. The volumes here are very large, and therefore there is a need for professionals to operate in these markets. Trading here is conducted mainly on telephones, followed by written confirmation from both the parties.

Participants in Money Markets: Discount and Finance House of India Ltd. The RBI jointly with the public sector banks and the all India financial institutions set up the Discount and Finance House of India Ltd. as an autonomous financial intermediary. It was conceived with the main objective of increasing the transactions of the money market assets. The main function of DHFI is to smoothen the short-term liquidity imbalances by developing an active secondary market. DHFI :participates in call/notice/term money markets both as borrower and lender, and purchaSed and sold T bills, commercial bills, commercial paper and certificate of -deposits. (55)

Fi nancial Services, ' Markets and Regulations

56

With an objective to strengthen the infrastructure of fixed income securities market in India, Discount and Finance House of India (DFHI) was incorporated by Reserve Bank of India (RBI) along with other Public Sector Banks (PSBs) and All-India Financial Institutions (FIs) under the Companies Act 1956, on March 8, 1988. After receiving certificate of commencement of business on April 25, 1988, the company started its operation with an initial paid up capital of Rs 100 crore (RBI - Rs 51 crore, PSBs - Rs 33 crore and FIs - Rs 16 crore). However, in order to broad base the activity of the company, the paid up capital was subsequently increased to Rs 150 crore in 1989-90 and further to Rs 200 crore during 1991-92. DFHI since its inception has been actively trading in all the money market instruments (viz. call/notice/term money, commercial bills, treasury bills, certificate of deposit and commercial papet-) and its business turnover has grown progressively over the years. With effect fro~ the year 1992-93, DFHI has been authorised to deal in Dated Government Securities ' also. After the company was accredited as a Primary Dealer (PD) in February 1996, its operations have increased significantly particularly ,rin Treasury Bills and Dated Government Securitie's. Meanwhile, over a period of time RBI took , a policy decision to divest their shareholdings in favor of the existing share holders. Thus State Bank of India (SBI) became the major shareholder and DFHI became a 'Subsidiary of SBI from 31.03.2003. SBI Gilts Ltd. a subsidiary of sin and established in the year 1996 was also an active participant in the market and one of the top five PDs. As both the companies were engaged in the same line of business, it was decided to merge SBI Gilts Ltd with DFHI Ltd in April 2004. Accordingly, from June 2004 the name of the merged entity was changed to SBI DFHI Ltd. The shareholding pattern of the Company underwent 'a change as under :

Primary Dealers The objectives of PD's include: Strengthening the infrastructure in the government securities market including money markets, to make them vibrant.

Money Markets

57

To ensure the development of underwriting and market making for government securities. To improve the secondary market trading system. Money Market Instruments 1. "T" Bills 2.

Commercial Paper (CP)

3. Certificates of Deposits (CDs) 4. Money Market Mutual Funds 5. Repos and Reverse repos market. T-bills were introduced to stabilise the money markets. They are sold on the basis of fortnightly auction, but the amount, however is not SpeCified in advance. These bills have been instrumental in reducing ' the net RBI credit to the government. They have become extremely popular due to their higher yield coupled with liquidity and safety and are being used as benchmark. They have also widened the money market and provided an innovative outlet for the surplus funds.

14-Days Intermediate Y-Bills The participants in these bills are state governments, foreign centrpl banks, and specified bodies. These are non-transferable and are issued only in book entry forms and would be redeemed at par.

Instruments in money markets Commercial Paper Market:· Following the acceptance of Vaghul committee recommendations, RBI allowed the issue of CPs in 1989. ~ The CP is a short- term negotiable instrument, consisting of usance primary notes with a fixed maturity, indicating the short-term obligation of an issuer. Companies as a means of raising short-term debt issue it. It is issued on a discount to face value basis but can also be issued in interest bearing form. The issuer promises the buyer a fixed amount at a future date but pledges no assets. A CP, as a short-term financial instrument, has several advantages to the issuer. It involves very little documentation. It is fle~ible in terms of maturity. It is unsecured. There are no limitations on the end use of the funds used in this manner. They are negotiable and transferable instruments and are highly liquid. The participants in this market are the corporate bodies, banks, mutual funds, UTI, LIC, GIC and others who have surplus funds and are on a lookout for opportunities for

58

Financial SerVi(:es~ Markets and Regulations

short-term investments. The OFHI also operates both in the primary and secondary markets for CPs by quoting its bid and offering prices. The CP marke~is fairly. popular these .days; lwwever a ·secondary market in these is yet to develop.

Frequently Asked Questions

i:j,:~: ~: : : : \~: ~IliI~:: I: : (III_i:: :Eiil;i:t.l:: ;fl:~: t:j: !: ;: ;i~:~: : :i:~:~: : :~:~:i:~:~i: : .: :~: : : :j: :it!~: :~: : ;: :;:i: : ;: :I:;~;~i;:::Ii::::::.:~:]:::::;::~:::·ii:.~·~:::·::;::;:.Iu;.::ij::;:;;:::m::·;·: Commercial Paper (CP) is an unsecured money . market instrument issued in the form of a promissory note.

!.1: :):: ~;!:;!i..iijl:I::lii.:: : iI.4_1:: : : ~:~: : : : :~: :;: : : : : : : : ~ : ;~:l: ;:!: : : : : i:ili: ;: : :.: i!i: ;: .: :~: : :!: : : :!: : : : : : : : : : : : i!: ~: : :~: : : : :~: : : : : ~:~: : l:~: :;: : ~: : : : :~: :!.:!: :i:~:i:~: : : ;: ~:~: i: i:l:~::ii~~: : : :~:~ It was .introduced in ,India in 1990.

jl:~:i: :i: i: : .J:: :ii:: :.::;mli.lii:: ;:):i: : : : : : : : : : ; :: : : :l: : : il~i: : :!:~: ~: :i: :~i:~ ~:~;:~ :~:~:~I:i: i: i ~: : : :i:i: ; i.i.: : :l: : :;: : : : :f: : : i.:il~i: : : :i:i,;:i.i: : : i,~(;i:~ :~; : ~: :il l: : : : : : : : : : :i: : :;: : :l~ j:~:~: :~::~::;:t;:; It was introduced in India in 1990 with a view to enabling highly rated corporate borrowers/ to diversify their .sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet . their short-term funding requirements for their operations.

iI4: ~;: : : i:;: :.;:: :~I:~ :.i:: :li:a: : ;:;~ :i: : i ;i:i: ~i: ;i :i: :i: :i:i:·:i :~:.:8: :i:i: : ;:i: : : : :~:~:~i:i: : i: : i: i: :i:!: : : i ~:~: :i l~:i;i;:i : : :;: : : : i : :;i;i;i: : : : :i~: :i: :i:i: :i:~: :i~:;: :i: :i: :*:i: : : 'i: : i i i:i :i : i: : : :i: i: : ~: : : :;: : : i: :~:i : :% Corporates, primary dealers (POs) and the All-India Financial IIistitution~lFIs)are . eligible -to issueCP. ". . :. . ~~;

:$.~~:i: : :~;i:~:;• •I1i.jf::·:i.d:: tli:: ;lI~~'••: ~:::iijiUit..ill••i:ii:: ~II.::~:.i.jl::i:I: : :_iAi:: : c.i:, . No. A corporate would 'be.eligible to issue CP provided (a) the tangible net worth.of the company, as per the lateSt audited balance sheet, is not less thanRs.4 crote . (b) company has been sanctioned working capital limit bybank/s or all-India financial institution/s; and ' . (c) the borrowal account of the company is classified as a Standarf 'a mutual fund not widely understood in any case. Many lay investors use the vernacular word for "interest" when they refer to US 64's annual dividend. Never has the UTI ever said in words or in any other form of direct communication that US 64 is a scheme \"ith minimum assured returns payable every year. However, over the years, its behavior has introduced and reinforced this perception. Some of the actions of the UTI that served to reinforce the popular perception that US 64 is a fixed return scheme are: •

The US 64 had never declared its NAV by giving the reason that its assets contain illiquid assets like term loans and real estate which cannot be easily valued due to lack of marketability. It has ~en arguing the matter with SEBI for almost 6 years on this matter. Instead of publishing NAV on daily basis, it publishes the sale and repurchase value. • The sale and repurchase prices never fluctuate in a manner that reflects the value of its underlying assets a-nd these prices are purely arbitrary based on some system which values investments at the original purchase price, The \"alue goes up almost every month and the pricing is designed to give a feeling of safety and predictability to investors. • Neither has the repurchase price gone up significantly when the stock markets were in a boom phase, nor did it go down when the markets "'ere ip a bear phase. • US 64 invests in equities, and almost 65% of the inyestments are in equities. The entire impression sought to be created is that US 64 has no connection to stock markets which most of its retail investors believe is "speculation", • The annual dividend of US 64 either remains constant or goes up irrespective of market conditions. In the one year that the dividend went down, US 64 declared a bonus issue and tried to give the feeling that the overall return did not go dO\\11. • The US 64 is one of the few instruments approved for investment by trusts like the various Port Trusts arid various religious and charitable trusts o,n the grounds that it is a "safe" instrument from a "government run" company giving "predictable", "annual" returns. The said approval for investment has been given by either the central government (Ministry of Surface Transport) for the port trusts or by the competent authority in various state governments. The same trusts have been denied permission to invest in debt/income schemes floated by private sector mutual funds on the grounds that they do not give "guaranteed" returns. • The UTI has consciously targeted individuals who have retired or nearing retirement as potential investors. Nowhere does its marketing literature declare the

Mutual Funds

81

extent or percentage of funds invested in shares and other volatile assets; instead the focus of the literature is on US 64's "consistent" dividend pa)ing track record. •

Up until 1992, the US 64 was one of the most active money market instruments with daily trading volumes ranging in hundreds of millions of rupees. It is a rare case where an instrument with more than 60% of underlying investments in equities was one of the most active instruments in a market which is focused completely on safe returns.

•

The last thing is the strong linkage evoked with the government. Most investors believed that if there is any "problem", the government will not allow the UTI to " go under" and bail them out.

The First Cracks •

In March 2001, the top management of the UTI received from a broker cartel in the Calcutta Stock Exchange (CSE) an offer of a number of shares in two "New Economy" firms - Himachal Futuristic Communications Ltd (HFCL) and DSQ Software Ltd - at specified prices. Both the offers were discounted against the prevalent prices then and the UTI seemingly did not pause to examine the fundamentals of the companies im·oh·ed. A little deliberation would have served it well.

•

Since a brief spell of public notoriety after being implicated in a collusive bid for teIecom licenses in the mid-1990s, when the tainted Himachal Pradesh politician Sukh Ram held the Communications portfolio, HFCL had sunk into obscurity. It reemerged rather mysteriously in 1999 as a star performer on the bourses. DSQ Software had similarly ridden the euphoria for IT scrips into a wholly inflated valuation of its share price on the market.

•

In March 2000, the DSQ share was trading at over Rs.2,600 in the Bombay Stock Exchange (BSE). By October that year, it had fallen to Rs.307. HFCL, according to the SEBI report, showed a roughly similar share price trajectory. Both scrips registered a minor recovery subsequently, but when the UTI picked up large volumes of these shares in March last year, on the basis of a telephonic understanding with CSE operators, they were rapidly plunging in value. A 10 per cent discount was offered by the CSE operators, but the UTI's sense of accomplishment in obtaining this bargain must surely have been short-lived, since the follO\\ing day values fell by 16 per cent and more. Today, the scrips of both HECL and DSQ are worth next to nothing. And it would strain credulity to argue that the UTI could have gone through these transactions without collusive intent. Behind the whole ignominious episode in the stock markets looms the figure of the Mumbai-based broker Ketan Parekh and an operation that was under way for at least two years prior to the final reckoning. Parekh controlled no fewer than 23 "entities" which operated in the markets, buying and selling shares in a bewildering maze of transactions. This conscious design of complexity succeeded for long in hiding the nexus between the sources from where

82

Financial Services, Markets and Regulations

Parekh was obtaining his funds - corporate houses and banks - and their ultimate destination in speculative ramping up of share prices. •

SEBI has made the observation that the large-scale transfer of funds to Parekh began when the shares of the corporate entities concerned were generally on a downward trend. But the derivative argument that the funds were not directly used to prime share values for the companies concerned may not quite stand scrutiny. It may be more credible in the estimation of some JPC members to believe that the funds were transferred "ith the intent of bolstering prices on the stock markets, so that the companies concerned could complete an ambitious sequence of planned mergers and acquisitions.

•

SEBI's findings on Cyberspace Infosys, which managed to ride the rollercoaster of a bull run ",ithout Parekh's benediction, constitute a telling narrative. Begun in obscure circumstances as a leasing and finance company, Cyberspace acquired its current identity in 1998 with a shrewd eye on the main chance that the hyperbole O\·er IT offered. It claimed to have technical arrangements and tie-ups with Microsoft, Oracle and Lotus, leaving few enterprises from the global hightecfmology pantheon outside its gaze. It began 1999 with a modest quotation of Rs.38 on the BSE and showed little promise as the year wore on. In September, however, it began a dizzying ascent, touching by mid-March 2000 a quotation of Rs.1,300 on the BSE. The rapid descent began shortly afterwards. Cyberspace closed the year 2000 quoting at just over Rs.140. After the bull run of March 2001 had ended, it was down to the rather pathetic level of Rs.ll.

•

The rise and fall of Cyberspace is a saga that directly implicates the UTI, which began large purchases of the share in September 1999 and continued doing so until March the following year. SEBI has seemingly sought to exculpate the UTI management by arguing that purchases of Cyberspace rarely triggered the circuit breakers that serve to stop trading in a share when prices ascend or descend too sharply on a given day. But this overlooks the simple fact that the circuit-breaker is a short-term remedy used to check speCUlative excesses on particular days. It has little efficacy in curbing a sustained speculative run on a scrip, as with the UTI's purchases of Cyberspace. AI}d rather revealingly the SEBI report has observed that of the UTI's purchases of this scrip, over 34 per cent were transacted with entities directly associated with some members of the Johri family, the promoters of Cyberspace who are now fugitives from justice.

•

III July last year, the UTI suspended repurchases in its pivotal US-64 scheme. Over

the preceding May, the fund had fa€ed redemptions of an unprecedented magnitude ill this scheme, five times higher than in April. This was considered unusual and slIggestive of a breach of confidentiality that benefited chosen corporate investors alld indi\ iduals.

83

Mutual Funds

Post US 64 UTI bifurcation The Government in order to protect the interests of 20-million-odd investors of Unit Trust of India (UTI) announced a structural reform package, covering a Rs 14,561-crore bail-out for the US-64 and all assured return schemes and eventual privatisation of UTI's schemes. To start with, UTI would be split into two entities - UTI-I and UTI-II. UTI-I would cover the US-64 and the Monthly Income Plan (MIP) schemes, while the various net asset value-based schemes ",11 be hived off to UTI-II. The latter would also include the units of US-64 issued after .January 2002, when the scheme became NAV-based. managed by a Government-appointed administrator and Further, while UTI-I team of officially-nominated advisors, UTI-II will be headed by a professional chairman and board of trustees. The brand equity of UTI, too, will go with UTI-II, which will eventually be disinvested or privatised. The bifurcation will be done through The Unit Trust of India (Transfer of Undertaking and Repeal) Bill, 2002, to repeal the UTI Act. Investors who redeem US-64 units even after May 2003 \\ill continue to get the administered repurchase price of Rs 12 per unit up to 5,000 units and Rs 10 per unit beyond 5,000 units, following the Government's decision to prmide open ended-support to old investors of the scheme. The move is expected to ease the redemption pressure in April and May 2003. Unfortunately, this plan did not eliminate the overhang of UTI's constant selling of stock in the secondary market. Wind-down time was June 2003 for the US 64; that is when the government promised to redeem the units at Rs 10. Since the government will pay only the shortfall between the Net Asset Value (NAV) and the redemption price, the balance will have to be realised by liquidating US-64. According to Narayan, the government's promise will cost it 'Rs 6,000 crore. US-64's corpus is already down to Rs 10,733 crore (from Rs 12,986 crore in March 2002) and according to its website 'a gross investment of Rs 4710 crore in US 64 has been funded by borrowing'. This will presumably be repaid first in order to avoid interest costs. Tax concessions will be extended for the US-64 scheme - on dividend income and capital gains - to make it attractive for unit holders to remain within the scheme. The Government will ,also reset the interest at a lower level in five MIP schemes, where only the principal amount is assured and the dividend can be reset. Foreclosure of some of the MIP schemes is also being considered, subject to this being permitted under SEBI regulations. Both UTI-I and UTI-II would be structured as per SEBI' regulations. The total asset value of all un-run schemes aggregates to Rs 42,000 crore as on June 30 - Rs 17,784 ~rore for the NAV-based schemes and about Rs 25,000 crore for the US-64 and other assured return schemes. .

t

",11

Financial Services, Markets and Regulations

The decision to spilt the fund into two entities forms the crux of the structural reform package for UTI. The objective is to have a working, healthy mutual fund run by a professionally-managed team. The Government has now moved two steps forward after the decision taken by the CCEA last year to -provide full assistance to the US-64 scheme. The first is the move to allow open-ended redemption for investors in US-64 and the second is the commitment to bridge the shortfall in the assured return schemes. The current shortfall in US-64 is estimated at Rs 6,000 crore, of which the UTI already been provided cash support of Rs 800 crore and another Rs 500 crore is in pipeline. The projected liability of the balance Rs 5000 crore will be met through issuance of bonds tradable in the market. A similar mechanism will be worked out assured return scheme where the estimated liability is around Rs 8,561 crore.

has the the for

The Government is fencing out the liabilities in the US-64 scheme and other assured return schemes. An investor who holds on to the US-64 unit beyond May 2003 can only sell it back to the UTI and it cannot be re-circulated in the market. UTI-I would effectively cease to exist once all investors move out of the US-64 and the assured return schemes. The basket of assets and liabilities of UTI will be transferred to the two entities after the repeal of the UTI Act. February 1, 2003 marked the birth of UTI Mutual Fund with 47 schemes and a modest corpus of Rs 15,000 crores, which is just a fifth the size of Unit Trust of India (UTI) at its peak. UTI Mutual Fund is now SEBI (Securities and Exchange Board of India) compliant, but is by no means out of government control. The sponsors to its Asset Management Company CAM C) are four public sector entities - Life Insurance Corporation, Bank of Baroda, State Bank of India and Punjab National Bank -each holding 25 per cent of the AMC's equity. The mutual fund will be truly out of government's clutches only when it divests 40 per cent of the equity in favor of a strategic investor. But that part of the plan seems to have gone on to the back burner. When the 39-year-old Unit Trust of India Act was repealed, a gigantic and badly battered institution was split into two. Its corpus had shrunk from a peak of Rs 72,000 crores to just over Rs 45,000 crores. It has already swallowed Rs 4,300 crores of taxpayers' money by way of bailouts since 1998 and the government had committed a massive Rs 14,500 crores for another bailout scheduled for the end of May this year. (Of course, government has already thrown in a sweetener to restrict its financial outgo by treating US-64 units as five-year, fixed coupon, tradeable, tax-free bonds with effect from June 1, 2003. This is bound to stem the mad rush to redeem units on May 31). But there was also an unstated commitment that this would be the last bailout for UTI. It was made clear that government wo~ld take steps to permanently end its liability for UTI's losses and get it out of the clutches of powerful netas and babus.

Mutual Funds

85

The Bailout •

The 'good plan' for Unit Trust of India (UTI) turned out to be a rather 'bad' one. In fact, it is not even a complete plan. Almost everyday after the bailout was announced, the finance ministry has been adding caveats and sweeteners to it, or modifying the plan itself. The result: an uneasy fear that this whopping second bailout of Rs 15,000 crore is just another in a series of future payouts to UTI. • In principal, all bailouts are bad. They create a moral hazard, allow investors to be irresponsible, let finance ministers (FM) lie or plead ignorance about financial problems and ha,-e no finality. They do not improve accountability, nor eliminate political interference or even guarantee an end to further bailouts. In UTI's case, the constant bearish pressure it has exerted Oil the capital market and the innumerable tragic cases of widows, pensioners, tru~ts and charities standing to lose large chunks of long term savings made a bailout politically inevitable. • The government is dipping deep into ta.xpayers' pockets to payoff middle class investors that too in the year of a major drought. Will it clarify that investors who remain with UTI in future, do so at their own risk and not because of tax sops and government guarantees? Or will it promise to keep politicians off UTI's back? • The bailout package promises nothing of that sort - in fact it threatens the opposite. In 1999, government handed out Rs 3,300 crore to UTI without fixing its core problem - lack of accountability and political interference. • The payout is five times bigger than the pre\,;ous one in 2001 where when UTI was on the verge of a collapse, the government opted for a sneaky cover up. It denied the magnitude of the problem and postponed its financial liability to May 2003. But as that deadline approached, finance ministry mandarins realised that they had to find another solution. • UTI's large borrowing of Rs 5,000 crore (Rs 3,000 crore from banks and Rs 2,000 crore from other schemes) at just over call rates and redemption demands forced it to be a continuous seller in the market exerting a perpetual bearish influence on stock prices. Also, if government only paid the difference between NAV and the guaranteed return then US-64 would have to wound up. • Let us look at the various pronouncements. Firstly, the bailout formula makes little sense. If government only plans to make good the shortfall in UTI and maybe take care of its borrowings (Rs 5,000 crore), it still does not prevent the scheme from selling assets to meet redemption demands. The government has to give UTI the money upfront to stop it from selling. But before ..it does that, we as citizens have to ensure that government promises a hands-off approach and a competent management. Even a promise not to pressure the present chairman M.Damodaran and permit him to get on \\ith the job of saving UTI would be good enough. Secondly, the plan to split UTI lIlto the good alld bad organisation may be the classic way of dealing with financial problems, but does 110t quite apply to UTI.' Government plans

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Financial Services, Markets and Regulations

to hawk the good organisation (which has no assured return schemes and hence no responsibility towards im"estors) or UTI-II, which has assets of nearly Rs 18,000 crore. But that won't fetch it any more than three percent of the value of the schemes - in effect, the asset management fee. As for goodwill, it is a moot question whether UTI-II has any good will or brand value. Will an acquirer continue to use the UTI brandname? Unlikely. • Several mutual fund chiefs who seem to have reached for their cheque books to buy UTI - II also seem to expect that it will come along with a distribution network and infrastructure. But so long as "the problem child, UTI-I exists, it will need the entire infrastructure that has built up over the last four decades. The second issue is tax sops. Clearlv the Rs 15,000 crore bailout may not be good enough to hold investors. So immediatel~ after the package was announced, the finance ministry began i~ add tax sops such as capital gain exemptions as sweeteners. • The value of these sops has not been quantified. Rival mutual funds have welcomed the bailout and not protested against the sops, because it is only a matter of time before they begin to lobby for parity and a level playing field. This means that the hidden cost to the exchequer through tax breaks to the entire industry will go up dramatically. Government needs to spell this out upfront as a part of the bailout package. The third disturbing aspect is government interference. No sooner was the bailout announced, finance ministry officials began to order UTI not to indulge in 'asset bleeding'. • This obviously referred to UTI's block sales and aims at protecting lTC's management and others like it who fear a takeO\"er. What the finance ministry babus forget is that all such sales were at a premium to the market. The taxpayer cannot be made to pay in order to keep Yogi Deveshwar in charge of ITC. If UTI's sale of ITC shares can fetch a hefty premium from BAT of UK (which already hold 33 per cent in ITC), it must be asked to sell the shares and use the proceeds to reduce the quantum of bailout -that is in national interest. • UTI's 60 per cent investment in UTI Bank, 33 per cent in Infrastructure Leasing & Financial Services, five per cent in the National Share Depository and all other nonremunerative investments including UTI Securities, UTI Capital markets etc., which are not part of its core activities should be sold within a finite time frame. These sale proceeds should also be used to pay back the government and reduce the quantum of bailout. UTI's middle class investors are being bailed out once again, but they now have a duty to ensure that government is forced to fix the problem.

Government Inacti~n •

First, there is a new chairman at UTI, who has an impeccable reputation but no experience as a fund manager. Secondly, he has already attempted to implement some of the recommendations of the Tarapore Committee and the Malegam

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Committee. Thirdly, the government has announced a four member advisory board that "ill supervise the performance of the chairman and its trustees. • However, nobody is quite clear what role this committee will play. Especially since some members say that their names have been announced without so much as seeking their consent. All it seems to do is to prO\ide another set of people with a lot of power and no statutory accountability. Can these steps be considered an adequate restructuring of the investment behemoth and will they be adequate to clean up 'the mess at UTI'? • It seems safe to say that it is unlikely. Simply tinkering with the present structure does not amount to comprehensive restructurir,g. What UTI needs more urgently' is an amendment to the UTI Act and some urgent decisions. Let us not forget that only three of the 19 recommendations of the Deepak Parekh Committee were not implemented in 1999-but they were good enough to cause a second and far bigger debacle at the Trust. • These were: That UTI should be NAV driven; that there should be a separate Asset Management Company and that the number of Trustees should be increased to five. After the second collapse of July 2001, only one of these recommendations remains relevant. It is, that UTI should have a separate AMC. But this would need an amendment to the UTI Act and some clarity on possible action. Will UTI have one AMC as suggested by Malegam or opt for the Tarapore prescription of three AMCs? It is likely that the government will push through a comprehensive restructuring package only if it is under some pressure to do so. However, what is not immediately clear is where this pressure would come from. Unit holders are only interested in wrangling a bailout from go\'ernment, while the JPC which is investigating the UTI crisis seems clueless and reluctant. Hopefully it is the fear that UTI's unending problems will act as a continuous bearish pressure on the capital market that ",ill filiillly force a clean tip.

On the settlement •

Uti's investors are a tiny and affluent segment of the Indian population. The cost to tllem cannot be at the cost to the general population. Look at the numbers. The government has already doled out Rs 33 billion to UTI in 1999 and will probably give it another Rs 20 billion in 2002 (for all schemes). This money would have funded the entire 120-kilometre, two-lane Skybus Metro project for Mumbai city - providing clean, fast and air-conditioned transport to 6 million daily commuters in Mumbai

Other excesses meted out to •

un

In .June 1998, Shriram Mutual Fund bought 1,20,600 shares of Videocon on the BSE through an associate firm in order to bail out a clutch of brokers who were on the verge of default. These brokers were involved in furthering scamster Harshad Mehta's big comeback attempt with price rigging as his main operating strategy.

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On February 2, the SEBI completed its investigations and decreed that Shriram Mutual Fund's actions were 'detrimental to the interest of its investors' and imposed stringent penalties against it. It asked the Fund's sponsors to pay up the price difference of Rs 19 per share between the purchase price and market price of Videocon shares;,it asked its MD and two of his executives to resign and ordered a change in the composition of Shriram's Board of Trustees. .

.

•

On March 9 2001" a bigger mutual fund followed in the footsteps of Shriram Mutual Fund and was involved in a similar bailout. It was none other than the mammoth Unit Trust of India CUT!), which bought a hefty 13,30,000 shares of DSQ Soft-ware to bail out the Calcutta Stock Exchange CCSE). According to UTI's executive director B G Daga, these shares were bought at a Rs 189, which was a discount to the ruling market price. Daga also says that the shares worth Rs 25 crore were bought directly from the CSE in order to help the bourse complete the controversial settlement No 148. These shares belonged to broker Dinesh Singhania.

•

UTI already held large quantities of DSQ stock, large chunks (around 56 lakh shares were purchased at an average price of nearly Rs 2,000 in February-March). It was only in Jan-Feb 2001 that it had begun to sell small chunks of the scrip (five lakh shares) in line with the decline in the slowdown in the' IT sector. In fact, UTI's average holding price for the 23.7 lakh DSQ Software shares that it owns is approximately Rs 760.

•

The price of DSQ Software has since halved from its bailout level of Rs 189 to around Rs 90, causing a loss of Rs 12.5 crore to investors in one single deal.

•

Even though UTI bought at a discount to market, it was surely obvious to everybody that all shares associated with stock broker Ketan Parekh would continue to drop for several weeks more. UTI's decision to bail out the CSE becomes even more controversial when one considers the fact that it has slashed payout on its MIP-95 and MIP-96 schemes to five per cent; and that it is already discussing a second bailout of the Unit 64 scheme with the government.

•

The US-64, it would be recalled, faces a shortfall of over Rs 6,000 crore between its Net Asset Value (NAV) and its repurchase price. So, if Shriram Mutual Fund has been punished for bailing out brokers at the cost of its unit holders, then so should UTI.

•

In Shriram's case, Sebi had said that the purchase price was 'not in the best interest of the investors and were made for extraneous considerations'. It also said that 'schemes of the MFs were not handled in a prudent, diligent manner." Sebi had held that the transactions were done in a manner that was "detrimental to the interest of the investors".

•

All of the above ·applies to UTI's decision to bail out the CSE. The shares of DSQ software have since halved, ana this is seriously detrimental to investors who

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already face the prospect of a steep cut in dividends by UTI. In the circumstances, the Fund has no business bailing out anybody, especially at a loss to unit holders. What makes the' situation even more bizarre is that the bailout of the CSE was supervised by none other than a divisional chief of Sebi with Daga of UTI acting as an observer. •

Moreover, the Sebi chairman himself oversaw the entire bailout effort. Daga argues that UTI's deal is 'not similar' to Shriram's, because the shares were the property of the CSE .and not the broker and the cheque was paid directly to the exchange. Secondly, Daga says that Shriram Mutual Fund had bought above the market, while UTI's acquisition was at a discount. That argument also seems immaterial because the scrip had been falling at 16 per cent a day since then, as was clearly expected to drop further.

•

Thirdly, Daga says that the CSE offered him shares of three other companies but UTI had only picked up DSQ Software. That seems rather irrelevant, since the Sebi inspection report indicates that in March 2001, UTI had clearly bailed out brokers holding Himachal Futuristic Communications, Global Telesystems and Zee Telefilms too. The CSE bailout shows that neither UTI nor Sebi seems to have the least notion of what constitutes fiduciary responsibility to unit holders. It is one thing for the Sebi to make efforts to try and avoid a contagion effect damaging investor sentiment:

•

Daga points out that over the last decade UTI has often been asked by the government to stabilise the market. The difference is, that in those days, the UTI was an extremely profitable institution. The US-64, its main scheme had an NAV, which was a closely guarded secret, but was always believe to be twice the average of its sale and repurchase price. Also, the situation is different today. UTI has already been bailed out once at the cost of the general public; it has drastically cut the returns on its monthly income schemes and has abandoned the Rajalaxmi scheme.

•

Also, if Sebi had wanted to bailout the CSE, it ought to have approached the finance ministry instead of suggesting a surreptitious deal with UTI. The question is, when a MF transgresses its fiduciary duty in consultation with or at the request of the regulator, who will play judge and decide the issue? It will have to be the job of the JPC, which has still to decide whether it plans to investigate all aspects of UTI's operations. Alternatively, UTI's disgruntled unit holders may decide to drag the MF as well as the regulator to the court. The government appointed various committees. A summary of these is given below:

Vaghul CommiHee With the formation of The Securities and Exchange Board of India (SEBI) in 1988 and its acquisition of statutory status, mutual funds became subject to SEBI regulation. In 1993, a three-member Committee of the Board under the Chairmanship of Shri ·N.

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Vaghul and with Shri S. H. Khan and Shri B. K. Jhawar as members, was formed to consider inter alia whether UTI should be subjected to SEBI regulation and if so, what special considerations would need to be built into the regulations to reflect UTI's special status.

The Committee noted that:•

UTI performed an important role in the national economy with regard to the mobilisation of savings of the community and the development of the capital market.

•

UTI had considerable strengths in terms of synergy, economies of scale, cost efficiency, investor confidence and return to investors which, together \\;th the large size of its investible funds and investor accounts offered to the country a unique opportunity for shaping UTI into a dh'ersified organisation that could effectively compete \\;th international players in the emerging em;ronment of globalisation of the Indian financial market.

•

The hybrid character of UTI's operations gave it a status of more than a mutual fund. The combination of equity, debt instruments and term loans in a single institution was certainly called for when the Indian economy was in the developmental stage.

•

There had, however, been a change in the economic scenario since 1991 \\;th the introd uction of the new economic reform package and contemplated reforms j 11 t!1t' financial sector and the opening out of the sector to private sector players. Tht' Government had accepted the broad concepts of free market economy based un the principles of competition, fair play and level pla);ng field and it would therefore not be logical to exclude UTI's mutual fund operations from the regulatory jurisdiction of SEBI only on the ground that UTI was a hybrid organisation and the mutual fund operations could be separated only at a considerable cost to synergy and loss of investor confidence. The Committee therefore recommended that :-

•

It would be in the interests of the UTI and UTI's investors if regulatory jurisdiction of SEBI is extended to UTI's mutual fund schemes;

•

UTI should form one or more Asset Management Companies, as may be necessary, as its subsidiaries to undertake the functions of management of mutual funds.

•

The existing schemes of l.JTI would fall into two broad categories viz "mutual fund" schemes and 'non-mutual' fund schemes. The management of the mutual fund schemes should be vested with the Asset Management Companies. UTI should however continue to manage the non-mutual fund schemes of w'hich the most notable example was Unit Scheme 1964 (US 64).

Following upon the recommendations of the Vaghul Committee, UTI lent itse~i ill 1994 to be under SEBI purview and governed by SEBI, guidelines fe-r n:t!t!L:~ f;,!l::1' Accordingly, all new schemes launched by UTI after July 1994 are g0\ rrf1E'd ai,~:

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supervised by SEBI regulations and many schemes which were in operation on that date were either terminated or made SEBI compliant. Currently out of 73 domestic schemes in operation, 67 schemes are under SEBI regulations. Of the balance 6 schemes, 4 schemes other than US-64 and SUS-99, have suspended sales and/or are nearing termination.

Deepak Parekh CommiHee UTI's problems today have their genesis in the soft-approach adopted by the Dee'pak Parekh Committee. While the committee was forthcoming about the true state of UTI's finances in 1999, its recommendations were too soft and incomplete. •

Parekh recommended a huge bailout of Rs 48 billion and tax exemptions for all mutual funds to muzzle their protests and those of investors. This led to a boom in the market and stock prices shot up. Ultimately the government infused only Rs 33 billion into the Special Unit Scheme 1999 to which public sector shares were transferred at book value.

•

But having recommended such a huge bailout at the exchequer's expense, the Parekh committee itself set the stage for the second bailout. It gave UTI three years to make the US-64 NAV-based, -although that was clearly the time to do so. Even more shocking was that UTI was allowed to resume July sales/repurchases at high prices that were completely out of line ,,;th NAV.

•

If that were not enollgh .. the Parekh Committee allowed US-64 to remain outside Sebi regulation and simply made Ill) effort to fix responsibility or make the scheme more accountable, other than to d'o'!l1:l flO restructuring of the board and setting up of audit committees.

•

The Parekh Committee also did not tOllch US 64's hybrid structure as a mutual fund and development institution, which allows its management to invest in real estate or set up a bank or lend to the corporate sector. In fact, it is this strange structure and absence of accountability, which has made UTI a virtual handmaiden of the successive governments and politicians. Here is what it said~ 'The committee is of the view that in the case of US-64 a period of about three years should suffice. By then it should be possible to bring the NA V of units in line with their repurchase price. The Committee also feels that even if this does not happen, the re-purchase price should not be delinked from their NA V indefinitely. If, therefore, a the end of th~ three year period the two are not in line, the Trust will be left with no alternative to see GOI support once again to provide the difference between NA V and repurchase price of units that the Trust will offer at that time. Only a clear commitment from GOI to stand by US 64 till it finally assumes the character of a NA V driven scheme will instill the required confidence in the US 64 investors".

•

The Parekh Committee clearly anticipated another bailout, but it still did not recommend strict accountability conditions for the chairman and key fund

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Financial Services, Markets and Regulations

managers. Consequently, the last two years have seen no decline in market reports • about UTI's links with fund managers or the manner in which several of its dotcom decisions were made. Shonkh Technologies and Cyberspace Infosys, are only two known examples, but UTI's less known investments would also make interesting news. UTI may even get away by justifying some 4Ibf its misguided investments in new economy stocks by blaming it on the 7Parekh Committee. •

Apart from separate schemes for new economy companies, the Parekh Committee had some strange suggestions: "In order to help revive the capital market, the Committee recommends that commercial banks be encouraged to contribute Rs 1000 crore to Rs 1500 crore towards the corpus of a new equity-related scheme to be promoted by the Trust".

•

To be fair, the government has also not implemented some of the Parekh committee's important recommendations. The US-64 has not been brought under SEBI regulation and the practice of assured returns has also not been scrapped. In addition, its suggestion that UTI make strategic sales of large blocks of equity did not make much headway. It is now time for more recommendations and fresh deliberations before yet another bailout can be justified.

High level Expert Committee In October 1998, UTI constituted a High Level Expert Committee under the chairmanship of Shri Deepak Parekh to undertake a comprehensive review of the functioning of US 64 to strengthen the scheme and to recommend measures for sustaining investor confidence. The terms of reference of the High Level Expert Committee were as under:1. Review of the objectives, features and structure of the scheme in the context of its role in the mobilisation of domestic savings and investment in the capital market. 2. Review of the policies of the scheme relating to pricing and income distribution, having regard to the profile of existing investors of the schenle. 3. Review of the policies and procedures about the portfolio composition of the scheme, as well as the asset management process. The High Level Expert Committee submitted its report on February 25, 1999 and the full report was made public on May 18, 1999. We are informed that of the 19 recommendations made by the Committee, 13 recommendations had been implemented and 3 recommendations were in the process of implementation. The remaining 3 recommendations on which action still remains to be taken are :1. US 64 should be NAV driven. 2. There should be a separate Asset Management Company for US 64 with an independent board. 3. The number of trustees should be increased by the addition of 5 trustees.

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4. implementation of the last two recommendations had to be kept pending as they needed an amendment of the UTI Act. 5. It is with this background that the UTI Board of Trustees at its meeting on July 3, 2000 set up a "Corporate Positioning" Committee. The Committee had the following terms of reference: 1. To review the competitive positioning of UTI in the light of the second generation reforms in the financial sector. 2. The emerging development in the area of mutual fund business and regulation as well as the trend towards broader financial services companies. 3. Globalisation of the Indian financial services sector. 4. The confidence of investors in financial organisation of different sizes and strengths. S. Obligations of UTI to the existing unit holder under UTI Act and the implications of any change in this context and progress of implementation of recommendations of the Deepak Parekh Committee. 6. To recommend appropriate follow up action plans including amendments to connected legislation for enabling UTI to fully meet with the Mutual Fund Regulations of SEBI and enhancing the competitive positioning of UTI. 7. The Committee had several meetings and had almost concluded its deliberations when the UTI Board, at its meeting held on 2nd July, 2001 announced that it had suspended the sale and repurchase operations in the US-64 scheme till December 31, 2001. This created an immediate outcry and loss of confidence of unit holders in UTI and demands for Government intervention and support. To meet the demands for liquidity and some amount of safety for small unit holders, UTI announced on 15th July, 2001 that unit holders would be offered an option for repurchase upto 3,000 units out of their aggregate holdings during the period up to 31st May, 2003 at prices which would progressively increase from Rs.lO to Rs.12 per unit. It was also announced that US-64 would be made NAV driven from 1st January 2002. The reason for the suspension of sale and repurchase operations was stated to be the fact that in April 2001 and May 2001, 8. US-64 faced massive redemptions aggregating to Rs,426 crores and Rs.3,767 crores respectively at the then repurchase prices which were later admitted to be well above the Net Asset Value of the units of the Scheme. Sales and repurchase in the scheme had been stopped with effect from 1st June 2001 for closure of books prior to payment of dividend for the year ended 30th June 2001.

Malegam & Tarapore Committees The Malegam committee was appointed in July 2000 by the UTI's board of trustees to review the recommendations of the Deepak Parekh Committee and to recommend followup action plans to enable UTI to fully meet with the mutual fund regulations of SEBI and enhancing the competitive positioning of UTI. The last bit was generally perceived

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Financial Services, Markets and R~gulations

as a politely couched euphemism for chalking out a blueprint for com'erti~g the UTI into a pl'(~fessionally-run mutual fund. Interestingly, the Malegam committee report has been passed on to the Joint Parliamentary Committee (JPC) probing the March 2001 stock scam, without it even being discu