Stock Exchanges – IndiaCorpLaw

Is NSE’s Co-Location Facility Abusive: A Competition Law Analysis

Guest — Wed, 07 Jul 2021 08:58:31 +0000

[Rishabh Joshi is a 5^th year B.B.A., LL.B. (Hons.) student at Gujarat National Law University, Gujarat]

Recently in its decision of Manoj K. Sheth v. NSE, (Case No. 35 of 2019) dated 28 June 2021, the Competition Commission of India (CCI) rejected the charges surrounding abuse of dominance against the National Stock Exchange (NSE) concerning the co-location facility. The informant had filed a complaint against NSE under section 19(1)(a) of the Competition Act, 2002, alleging violation of sections 4(2)(b)(ii) and 4(2)(c) of the Act. The informant had alleged that NSE had granted preferential access to certain brokers which results in market manipulation and information asymmetry amongst the trading members.

Allegations by the Informant

The informant alleged, while relying upon the complaint made by a whistle blower in 2015 before the Securities and Exchange Board of India (SEBI) and the subsequent report by the Technical Advisory Committee and Deloitte, that NSE has allowed preferential access to the data servers to certain stockbrokers, which has created a disadvantage to others. The allegation was that NSE has also allowed Internet Service Providers to lay fibre within its infrastructure for some select stockbrokers, and was hence working in collusion with them. Further, due to the high costs of the co-location facility, only 188 out of total 1000 members of the NSE are able to avail the co-location facility despite the services having been offered for about 10 years now. The facility creates an information asymmetry, as those who are the users of the service or have their servers located in NSE can access the entire order-book ahead of others. There is further discrimination in favor of those stockbrokers who are in collusion with the officials of NSE and hence obtain faster access to its system. In its order dated 10 February 2021, SEBI has also held that the co-location facility is prone to manipulation and market abuse and it consequently violates regulation 41(2) of the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012 (the “SECC Regulations”).

Response by NSE

NSE stated that co-location facility is provided by recognized stock exchanges across the world such as NASDAQ and Chicago Stock Exchange to address latency issues and they have not been deemed to harm competition. In fact, SEBI has itself regulated this facility to address any potential discriminatory concerns. NSE also claimed that connecting to server does not necessarily result in data being received first. Further, the matter before SEBI concerning the issue of co-location facility has not yet attained finality as the appeal before the Securities Appellate Tribunal (SAT) is still pending. NSE also asserted that the CCI’s interference in the matter would result in parallel proceedings and thus go against the Supreme Court ruling in CCI v Bharti Airtel Ltd. and Ors. NSE claimed that if any trading member breaches the relevant guideline, it does not imply that NSE is liable. Moreover, the informant is committing a wrong by filing multiple petitions against NSE and not disclosing it to the CCI which is a mandatory requirement under The Competition Commission of India (General) Regulations, 2009.

Observation & Decision by CCI

In its preliminary observation, the CCI noted that a similar matter came before it in the case of Adv. Jitesh Maheshwari v. NSE but it refused to interfere in the matter because the issue was being investigated by SEBI then and there was a dearth of data. However, the CCI simultaneously also agreed with the informant that pendency of an appeal before SAT does not impose a moratorium on the Commission’s statutory function to deal with violation of Competition Act. The CCI further noted that pendency of a matter in another forum does not axiomatically place an embargo on CCI to stop from fulfilling its statutory obligations.

The CCI thus framed the following two issues: first, whether NSE has abused its dominance through its co-location facility; and second, whether the manner in which such facility has been provided is in derogation with the Competition Act.

The informant had submitted that the relevant market should be the entire securities market in India because the co-location facilities affect trade in all securities. The CCI however took a narrower approach while determining the relevant market and delineated the relevant market for the sake of this case to be the ‘market for providing co-location services for Algo-trading in securities to the trading members in India’.

The CCI agreed with the informant on the dominance of NSE in the relevant market. Reliance was placed on Annual Report 2019-2020 of SEBI, data published by World Federation of Exchanges, NSE’s own Annual Report for 2019-20 and the prior decisions of CCI itself in MCX Stock Exchange v. NSE and UPSE Securities Ltd. v. NSE.

Coming to the question of abuse, the CCI took note of the findings of SEBI where it was held that NSE has failed to exercise due diligence while establishing tick by tick (TBT) architecture which resulted in information asymmetry. The same was observed to be unfair, non-equitable and a failure on part of NSE to ensure equal access. SEBI thus held it to be a violation of regulation 41(2) of SECC Regulations, 2012. Despite this observation, the CCI noted that if the technology chosen by NSE is prone to manipulation by some person without being in collusion with NSE then such conduct shall not count as abuse of dominance. Since there was no fraudulent conduct found by SEBI in contravention of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003, the choice of technology may be considered bonafide and not in violation of section 4 of the Act. Further, co-location facility is being offered by BSE and other exchanges across the world as well. Thus the CCI did not find any prima facie case and thus closed the complaint under section 26(2) of the Act.

Critical Analysis of the Order

The first ambiguity that arises in this order is from the CCI’s preliminary observation. The commission chose not to interfere with the investigation of the proceeding earlier. However, according to the judgment of the Supreme Court in R. Rajagopal Reddy v Padmini Chandrasekharan, a suit includes appeals and further appeals because they are simply the continuation of suits. In such a scenario, the findings of SEBI that were relied upon in the CCI order could be overturned in the SAT appeal, which may in turn lead to the CCI’s observation becoming infructuous. The CCI may be correct in pointing out that a proceeding in another court on the same cause of action does not impose a moratorium on its statutory obligation. However, in situations where a strong reliance in placed on the findings of the other court or tribunal to determine the competition law issue, then it may be appropriate to hold off the adjudication till the matter reaches finality.

The second crucial point to consider in this decision was that despite noting SEBI’s order wherein the findings showed the activities of NSE to be “unfair”, “non-equitable”, “denying equal access” and “resulting in information asymmetry”, the CCI did not find a prima facie case of competition law violation in the matter. SEBI had clearly pointed out in its order that many trading members had resorted to accessing the Secondary Server without any checks and balances and actions by the regulator. Thus, NSE has failed to ensure a level playing field for trading members subscribing to its TBT data feed system. This finding in itself showcases the impact on competition due to the actions (or inactions) of NSE. Determining whether there was collusion in existence between such trading members could have been done through the investigation by DG at a later stage. Thus, closing the matter under section 26(2) of the Act prevented the CCI from living up to its own initial view that same cause of action may lead to violations in different laws, which appeared to be the case in this situation.

A reference could also be made here to the Essential Facilities Doctrine while determining abuse. As per the doctrine, when an enterprise controls some of the infrastructure or facility which is required to access the market and is not reproducible or interchangeable, the enterprise may not refuse to share it at a ‘reasonable cost’ without proper justification. Although it may not be necessary for traders to avail the services of NSE without the use of co-location facility, it does provide a considerable advantage (as noted from the SEBI order). Further, the cost of such facility is high and not reasonable.

Finally, the CCI had pointed out in its order that other stock exchanges such as BSE also use the co-location facility. It is important to consider here that other stock exchanges may not enjoy a position of dominance like NSE does in the relevant market and only an enterprise which holds a dominant position is capable of abusing it under section 4(1) of the Act.

Conclusion

Based on the aforementioned points, in my view, greater clarity may be required on when CCI can intervene into the matter considering an appeal is a part of trial, especially in situation where the findings of the lower court or tribunal are relied upon by the CCI in its decision. In such situations, an inclusionary approach by the adjudicating authority by taking up matter in tandem rather than at the same time may prove crucial. Further, a detailed investigation into the matter by DG was warranted in the present case to determine the issue concerning abuse of dominance by NSE.

– Rishabh Joshi

The post Is NSE’s Co-Location Facility Abusive: A Competition Law Analysis appeared first on IndiaCorpLaw.

Going for Gold: SEBI Proposes Gold Trading on Exchanges

Guest — Sat, 29 May 2021 07:12:02 +0000

[Arunimaa Jaiswal is a fourth-year student at Gujarat National Law University, Gandhinagar]

Through the Union Budget 2021-22, the Government of India notified the Securities and Exchange Board of India (“SEBI”) as the regulator for gold exchanges in India. Upon such notification and in pursuance of the Government’s intention of establishing regulated gold exchanges in the country, SEBI released a consultation paper on 17 May 2021. The paper presents the proposed framework for a Gold Exchange in India and annexed to it is a draft of the SEBI (Vault Managers) Regulations, 2021.

India is the second largest consumer of gold globally with an annual gold demand of approximately 800-900 tonnes. Presently, however, the Indian gold market is characterised by a high degree of fragmentation. There also exists lack of quality assurance and weak price transparency. To overcome these challenges, the World Gold Council suggests the establishment of a gold spot exchange. An integrated, uniform and transparent mechanism for gold trading will help India unlock the potential its gold market holds towards driving the economy to higher levels of growth. On the international front, India’s consolidated gold market will acquire a position from where it will be better capable of influencing global prices.

Accordingly, SEBI has identified the creation of a vibrant gold ecosystem incorporating the trading and physical delivery of the metal as a necessity in India. In its paper, SEBI suggests a mechanism to facilitate trading of gold in the form of electronic gold receipts (“EGR”) on a Gold Exchange. Since the advantages of an exchange are manifold, the paper posits that the proposed framework will lead to efficient and transparent spot price discovery, assurance in the quality of gold and augmented recycling of gold in India.

The Framework

Addressing various aspects that require attention, SEBI in its paper has covered a lot of ground in the proposed scheme for a Gold Exchange in India.

With respect to the transactions, SEBI proposes their division into three tranches. The first being the conversion of physical gold into EGR. The second being the trading of EGRs on the exchange and the third, conversion of EGR to physical gold. SEBI recommends that existing stock exchanges be allowed to deal in EGRs as opposed to setting up a new stock exchange exclusively for EGRs. The latter poses a less attractive option owing to cumbersome regulatory processes, investment requirements and delays associated with it.

Recognising the importance of appropriate and adequate market infrastructure institutions (“MII”), SEBI will develop a common interface among vault managers, depositories, stock exchanges and clearing corporations to facilitate these transactions. This would mean that, upon delivery of gold to the vault manager, depositors will be able to convert physical gold into EGRs tradeable on the exchange. EGRs will reflect in the depositor’s demat account maintained with the depository participant. Stock exchanges on receipt of information from the depository will list the EGR and permit trading. The clearing corporation will settle the trades executed on stock exchanges and will also notify changes in beneficial ownership of EGRs. Beneficial owners will be able to obtain physical gold against the EGR by surrendering it. Accordingly, the vault manager will extinguish such EGRs and request the depository to cancel the corresponding entry from the beneficial owner’s demat account.

Over the years, these MIIs have harmonised their functions to promote seamless trading of stocks, bonds and commodities. Therefore, it is reasonable for SEBI to propose that aspects such as the settlement cycle, clearing, risk management, the grievance redressal mechanism, know your client and know your depositor requirements along with participants in the Gold Exchange framework will be akin to the practices currently being followed in the securities market.

Moreover, SEBI’s proposal of fungibility of EGRs and their inter-operability between vault managers will translate into reduced costs making the trade process more robust. An efficient mechanism for collection of storage and delivery charges levied by vault managers has also been propounded. This would imply that requests of beneficial owners will be entertained only upon payment of these charges to the depository for onward payment to the vault managers.

Many Indians regard gold as an auspicious metal. Given the fondness of Indians, both rural and urban towards gold, it serves as a preferred opportunity for investment. However, the options presently available for such investment such as over-the-counter purchase of physical gold requires the buyer to find a trusted dealer and then haggle over prices. Sovereign gold bonds possess low liquidity for trade in the secondary market. Gold exchange traded funds have floor limits. Digital gold suffers from the lack of government regulation. Gold futures contracts and mutual funds cannot be converted into physical gold. Tackling these issues, it can be said that SEBI’s proposed framework will set the stage for unified and standardized gold trading procedures common to all buyers and sellers. This will eliminate regional price disparity, provide quality assurance and bolster transparent price discovery of gold.

Gold Exchanges in other Jurisdictions

China, Dubai, London, Turkey and the United States are certain jurisdictions which are already home to fully functional gold exchanges. Most noteworthy is the Shanghai Gold Exchange (“SGE”) which was established in October 2002. Today, it has successfully achieved its goal of becoming the central hub of the Chinese gold market. The consumption of gold in China is 1000 tonnes per year. This level of consumption is similar to India’s. Remarkably, the SGE trades in 49,000 tonnes per year. Therefore, the exchange is likely to have a significant impact on India’s gold market. That the government is conscious of the importance of this trade and is taking these steps to regularise the trading in gold is admirable.

In 2018, the NITI Aayog in its committee report acknowledged that gold exchanges in these jurisdictions played a pivotal role in the development of an efficient market for gold by way of channelling demand-supply information into a central mechanism, assuring standards in the quality of gold, acting as a channel for gold recycling by working through accredited refineries and prompting active retail participation and use of gold bars and coins for investment instead of jewellery. In its consultation paper, SEBI has taken cognizance of these factors and has meticulously devised a framework that may lead to actualization of a centralised gold trading platform in India as well.

SEBI as the Appropriate Regulator

For the burgeoning of the proposed electronic gold market, it is important to garner the trust of individual investors and institutions alike. SEBI’s designation as regulator of the Gold Exchange will create the necessary market integrity and maintain stability to allure investors to trade in EGRs. Since its inception, SEBI has operated on the philosophy of protection of the interests of investors in the securities market as has been enshrined in the Preamble to the SEBI Act, 1992.

In its paper, SEBI has advanced the treatment of EGRs as “securities”. It follows from this that EGRs will be assigned a meaning under the Securities Contracts (Regulation) Act, 1956. All features applicable to other securities would be made applicable to EGRs as well. This essentially means that SEBI’s extensive regulatory framework already in place to act as a check on securities market transactions will become applicable to transactions in EGRs as well.

Further, by way of the SEBI (Vault Managers) Regulations, 2021, SEBI proposes regulation of vault managers as intermediaries in the gold ecosystem. Vault managers and recognized vaults will be permitted to commence operations upon grant of a certificate of registration by SEBI. Thereafter, they will be required to conform with all the requirements specified by SEBI for the purpose of providing vaulting services including the “fit and proper” criteria as specified by SEBI in Schedule II of the SEBI (Intermediaries) Regulations, 2008.

It might be the case that retail investors will take a while before they acclimatize themselves with the EGR mechanism and develop faith in the electronic gold market. This reinforces requirement of maintaining high standards of integrity, credibility and accountability in the market – a job well fitted for the market watchdog. Regulation of the proposed Gold Exchange by SEBI will ensure transparency, symmetry of information and timely interception of undesirable practices that may act against the interest of investors.

Conclusion

The proposed framework will revolutionize trading in gold by giving rise to a national regulated gold market in India. An integrated whole, this national market will assimilate all fragments of the gold market currently dispersed across the country. In this regard, SEBI’s consultation paper can be lauded as a sincere attempt towards creation of a Gold Exchange. Consistent trading procedures coupled with sound SEBI regulations, the Gold Exchange and EGRs may in fact open an easier, safer and regulated avenue for gold investment. In the event that the Gold Exchange is brought into existence, whether it gains traction is something interesting that will invite keen observation in the future.

– Arunimaa Jaiswal

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Social Stock Exchange in India: Scrutinizing the Vision

Guest — Mon, 25 Jan 2021 13:42:50 +0000

[Prachi Agrawal is a 4th year B.B.A., LL.B. (Business Law Hons.) student and Stuti Bhargava a 4th year B.A., LL.B (Business Law Hons.) student, both at the National Law University, Jodhpur]

“It is time to take our capital markets closer to the masses and meet various social welfare objectives related to inclusive growth and financial inclusion.”

– Nirmala Sitharaman

In her budget speech in 2019-2020, the Finance Minister of India introduced the prospect of an electronic fund raising platform – a Social Stock Exchange (‘SSE’). While the concept in itself was not novel, envisioning it in the Indian setup was a bold move. As a preliminary introduction to the idea, she conceptualized the SSE as a platform that would list social enterprises and voluntary organizations (i.e., those without a profit motive) for the ‘realization of a social welfare objective’. In this envisioned plan, the SSE was to fall within the regulatory ambit of the Securities and Exchange Board of India (‘SEBI’). However, while its structure was still unclear, the aims were clear – first, to take the capital markets to the masses and second, to help these organizations and enterprises raise funds.

To further concretise the idea, the SEBI eventually laid the foundation by setting up a working group in 2019. The objective behind forming this working group was to come up with recommendations to give form and structure to the vision of SSE. Consequently, on 1 June 2020, the report of this working group (‘Report’) was brought into the public domain. While critiques have applauded the government for the idea and the recommendations that have followed, several questions have simultaneously been raised about the efficacy of such a plan.

Critical Analysis: Loose Ends In The Vision

While the report of the working group, without a doubt, paints a perfect picture of the ecosystem amenable for the growth of SSEs, it does not quite answer the questions as to the efficient implementation of intricacies involved in the functioning of the platform.

Firstly, while the Report acknowledges that the SSE requires a different and conducive environment for growth considering its social nature, at the same time it recommends that the SSE be housed within the existing stock exchanges i.e., Bombay Stock Exchange and/or National Stock Exchange. Consequently, the SEBI would act as the regulating body. Section 11 of the SEBI Act, 1992 lays down the functions of the Board. However, nothing in the aforementioned provision hints at SEBI’s obligation to create awareness among investors, something which is quintessential to kick-start an SSE in the country. If the primary idea behind an SSE is growth, development and increase in resources of the social sector, should the SEBI be designated with the additional responsibility of acting as the anchor to the SSE? The answer, in the opinion of the authors, is an emphatic no. This is primarily because the SEBI already has a list of powers and functions that it is supposed to perform or undertake. In theory, managing and regulating the SSE is only one additional responsibility. Practically however, it would overburden the SEBI.

Secondly, the report also fails to provide concrete definitions of terms like ‘for-profit social entreprise’. The working group, in its recommendations, emphasized upon the fact that there is diversity of interpretations as far as the meaning and scope of ‘for-profit social entreprises’ is concerned. In the authors’ opinion, it would then lead to the constant re-consideration of the entire discussion undertaken by the working group until a concrete definition is formed.

Thirdly, a necessary presumption with which such a system of an SSE operates is the equation of non-profit organizations with the for-profit social enterprises. Both the aforementioned categories of institutions have different structures and a distinct approach of achieving their goals. This would result in unwarranted entry of private profit-driven players into the social setup. It is not clear that for-profit entities will prioritise social benefits over profits. The second defect is with respect to the financial illiteracy and ignorance of the investors. With the retail investors accounting for almost 38% of the equity market in India, it is essential for them to understand the nature of organization that they would invest in. Providing a platform with two very different types of institutions is bound to create confusion for them, resulting in the SSE losing its appeal for the investors.

Fourthly, a combined reading of the intention and the consequent actions of the finance ministry poses uncertainty. The recommendations of the working group provide for tax incentives to invest in a social enterprise. However, the 2020-2021 Union Budget mandates that the not-for profit organizations will have to apply every five years for income tax registration to ascertain their charitable status and will also need to renew their 80(G) certificate that provides tax relief to the donors. Post the expiry of the five-year period, the institution as well as the investor would be subjected to uncertainty with respect to the tax exemptions, that the following period of non-registration would pose. Not only does such an announcement hint at the confused state of understanding and bolster several questions as to the survival of the not-for-profit sector, it would also leave the investors and the institutions prone to uncertainties, as has been explained above.

Lastly, the recommendations provide for the development of information repositories that would provide sector-level infrastructure and ensure availability of credible and standardized information. However, what remains amiss in such an argument is the idea that mere presence of such repositories/bodies does not ensure widespread, accessible information to all categories of stakeholders. With limited awareness about the SSE coupled with the ambiguity as to the role of regulating authority, the target audience would remain in a state of unawareness.

Recommendations: Tying the Loose Ends

The creation of an SSE in any country has to be a journey of trust building and maintaining relationships. Falling in line with this, the present proposed model of the SSE comes equipped with a number of loose ends that need tying. At this stage, it is only wise that the country can learn from the mistakes of other jurisdictions and come up with an improved plan customized to fit appropriately in the Indian setup.

To this end, the primary assertion of the working group that begs scrutiny is the SEBI acting as the regulatory authority for the SSE. While the authors concur with the understanding that the SEBI could aid in establishing the SSE, the same should not be accepted as the apposite form of regulation in the long run. Another issue is the lack of a legal structure and relevant definitions, as discussed above. In the words of the working group, “a declaration of intent to create social impact and a commitment to measuring and reporting such impact is the key to identifying a social enterprise”. While promising, the idea lacks certainty. This makes it important that a definite legal structure be accorded to the social enterprises. Besides this, objective definitions of important terms like social enterprises, social purpose, social impact, etc. should be made clear at this stage so that further developments may take place accordingly. An important lesson that can be borrowed from the UK SSE is the requirement of passing a ‘social impact test’. This test is conducted by independent authorities which ensure transparency and lessens the possibility of corruption creeping into the system.

From an Indian perspective, an important step could be to undertake sensitization and solicitation for and from different class of investors through both online and offline modes. Since the investment prospect in an SSE lacks the promise of financial return, it is of dire need to induce the investors to contribute. In order to induce, educate and encourage investors, India could consider following the footsteps of the UK government which sought to open regional social-enterprise development centres and sent ambassadors to educate local communities. Furthermore, a website maintained by the social enterprise publishing the information of the retail investors would help create a feeling of belongingness and trust between them and the enterprise. With respect to the institutional investors, the SSE could come up with an index of sorts where the institutions contributing the most would be ranked accordingly. Since the institutions would be able to use this to advertise themselves and gain profits in their own ventures, they might feel motivated to contribute. Considering the foreign investors are a major source of investment, special efforts to sensitize and incentivize them should be made.

Another important step would be to provide a hassle free exit option to the social enterprises. While complexity must be avoided, the relevant stakeholders and their rights and liabilities should be materially defined. Not only will this encourage smaller organizations to register themselves on the SSE, this would also avoid unnecessary disputes at the time of exit of these social enterprises.

Importantly, the working group in its Report suggested that a Covid-19 fund be set out “to support and fortify social structures that are in danger of collapsing because of Covid19.” While the objective of creating such a fund is clear and holds merit, it seems to have overestimated the reach and pace of the implementing authorities. The tools needed to fight in the aftermath of the Covid-19 pandemic have to be quick and effective. The possibility that the implementation of such a plan may take time, and possibly too much time before it actually materializes, is not duly considered.

Conclusion: The Way Forward

The idea of SSE has seen limited growth and success in foreign jurisdictions which adds to the skepticism with regard to the success of the platform. As far as India is concerned, while the idea of an exchange seems appealing in theory, its implementation would be a hefty task for the regulatory authority.

The Indian social enterprises are hardly investment ready in today’s time. Learning lessons from the UK SSE, we might need an independent social investment market builder, to help them understand the implications of being listed and raising equity capital, among other things.

The working group at a point in the Report observes, “fund raising through SSE also ensures accountability, transparency and periodic reporting of impact.” However, no concrete steps to achieve transparency, accountability and efficacy have been outlined. For the SSE to secure the objectives that have been set out, it is important that its reach be widened. While the working group espouses a self-declaration approach wherein the entities would be required to declare as to whether they would want to qualify as social enterprise and consequently adhere to the standards set for the same, it is imperative that it also provides a mechanism of sanctions for non-compliance with standards.

The central point of argument here is that there is much to be done, before the SSE can materialize in the form and vision that was initially set out. While the recommendations of the working group could definitely count as the first step towards setting up an SSE, there is no doubt as to the fact that the recommendations still leave much to be desired.

– Prachi Agrawal & Stuti Bhargava

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SEBI Working Group Report on Social Stock Exchange

Guest — Fri, 05 Jun 2020 11:09:05 +0000

[Rongeet Poddar is a 5^th year student at the West Bengal National University of Juridical Sciences]

The Working Group Report on Social Stock Exchange constituted by the Securities and Exchange Board of India (SEBI) has evaluated the prospect of introducing a ‘Social Stock Exchange’ (SSE). As acknowledged in the Report published on 1 June 2020, the Finance Minister of India had previously called for the introduction of such a trading platform for raising capital as equity, debt or mutual fund units and devoted for social welfare.

The panel opines that the initiation of a systematic regulatory framework would enable investors and donors to contribute to social sector spending in India. It would augment the capacity of private enterprise in response to the unique challenges posed by the Covid-19 pandemic by facilitating the infusion of capital from the private sector in the spheres of education, health and agriculture. The SSE would encourage trading in equities issued by profit-making entities with the help of tax incentives and governance practices such as a common reporting standard. It would include a pay-for-success mechanism that incentivizes increased funding for social enterprises based on performance.

Distinction between For-Profit and Non-Profit

The Report has recognized a distinction between for-profit enterprises (FPEs) and non-profit organizations (NPOs). The distinction between the two categories of social enterprises lies in the capacity of FPEs to raise equity and claim profits. FPEs include companies registered under the Companies Act, sole proprietorships, partnership firms, HUFs and limited liability partnerships. The owners of an FPE are expected to make financial gains. However, an exception has been carved out for section 8 companies. The law prohibits the payment of dividends to the shareholders of these firms. The shares in section 8 companies thus do not have ‘residual claims on profits’. On the other hand, NPOs include section 8 companies, trusts and societies.

The Report has observed that funding in the social sector has been plagued by insufficient funding in the NPOs. It highlights that funding is contingent upon the demonstration of results in the field. However, the absence of a standardized impact assessment has constrained NPOs from showcasing their potential. The philanthropic pursuits under the aegis of FPEs, however, have had greater success, according to the SEBI panel. It has relied on private sector endeavours and the statistics furnished by the Ministry of Statistics and Programme Implementation for its appraisal.

Proposed Architecture of the SSE

The Report recommends the creation of a separate SSE segment under the existing stock exchanges. A set of pre-determined listing criteria would filter entities that are consistently creating a measurable social impact and reporting such impact as well. The FPEs and the NPOs would be subject to a common minimum standard of governance for reporting social impact and operating practices, including financial reporting. The emphasis on transparency in the listing obligations is expected to gradually usher in a viable ecosystem for raising capital in the service of the social sector.

The definition of a social enterprise, according to the Report, would require a minimum reporting standard on the beneficiaries for the immediate term of the SSE. The framework would demonstrate a clear intent on the part of both FPEs and NPOs to create ‘positive social impact’ in the areas of environment, society and governance. It would ascertain the social problem to be addressed and calculate the intensity of social impact on the median individual of the target segment by considering income, social equity and diversity. The social enterprise would also have to furnish relevant information about the members of its governing body, its prior funding history and its financial health in addition to its registrations and licenses.

The Report adopts a ‘self-declaration’ model and deliberately avoids defining a FPE to avoid the pitfalls of a one-size-fits-all approach. The Report puts the onus on SEBI to subsequently work out an assessment mechanism for identifying the self-declared credentials of the FPEs that would certify their social impact capacity. The definition is thus entirely impact-centric. It offers considerable leeway for enterprises to structure their legal form in ways that would satisfy their goals in the best possible manner.

Interestingly, the Report attempts to replicate the monitoring mechanism under SEBI’s Business Responsibility Reporting Framework, which was adopted in 2012 (and presently reflected in the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015). The evaluation of social impact would be conducted through the lenses of the beneficiaries. While the instruments listed directly on the SSE will come under the ambit of SEBI’s regulatory jurisdiction, the NPOs will continue to operate outside SEBI’s remit. Therefore, the intervention of other regulatory bodies will also be required to exercise oversight.

The SEBI panel urges the government to evaluate the need for a new regulator at the end of the immediate term of four to seven years that could monitor the entire paradigm of social enterprises, social reporting and social auditors. Finally, it recommends the creation of a database of information providers that would keep track of the activities of the NPOs, including the compliance requirements of the SSE. However, registration with the intermediaries will not be mandatory for NPOs.

Fund-raising Norms

The Report has highlighted that section 8 companies have faced hurdles in fund-raising due to their inability to provide financial returns on investments. Since trusts and societies are not bodies corporate under the Companies Act, they cannot issue bonds and debentures, which can be defined as ‘securities’ under the Securities Contracts (Regulation) Act, 1956 (SCRA). However, zero-coupon bonds can be utilized for fund-raising by the NPOs and listed on the SSE.

The operation of the SSE will require SEBI to notify zero-coupon bonds of NPOs as a ‘security’ under the SCRA. The Working Group has proposed that the bonds will have a tenure equal to the duration of funding of the project. The bonds can be written off from the investee’s books after the completion of tenure. Under this framework, investors will be incentivized to channel their financial resources only to NPOs that have a proven record of social impact. Intermediaries will certify the track-record of the NPOs. SEBI and the stock exchanges have been urged to introduce procedural norms for compliance, including the provision of penalties to regulate the funding of NPOs.

The SEBI panel envisions the introduction of a Covid-19 Aid Fund at the SSE with the help of the ‘pay-for-success’ bonds to finance the operations of NPOs that can mitigate immediate concerns such as the migrant worker crisis. Institutional investors or banking institutions are expected to supplement the resources of philanthropic foundations and CSR. The social venture fund under SEBI’s Alternative Investment Fund Regulations has been identified as an attractive route for NPOs to raise funds.

Likewise, the equity-listing framework for FPEs would include financial reporting, social impact assessment and penalties for non-compliance. The Innovators Growth Platform, constituted by SEBI, would serve as a model for finalizing the listing requirements of FPEs as opined by the Report. It would require suitable changes to be made to the thresholds of minimum net worth, average operating profit, prior holding by qualified institutional buyers and the criteria for an accredited investor under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 as necessary.

The funding structures envisaged for the NPOs, such as the social venture fund may also be utilized under the pay-for-success model. It would require SEBI to constitute a mechanism involving social auditors for objectively assessing the self-declared social impact of the FPEs. The Report anticipates the gradual emergence of independent entities that will enable social enterprises to self-report much like the existing audit firms. It is particularly hopeful that the Covid-19 Aid Fund can be bolstered with the help of a ‘structured pooled loan with domestic banks and NBFCs as senior lenders’ and ‘philanthropic contributions, CSR spenders and impact investors as junior lenders’.

Structural Reform of CSR

The Report offers policy recommendations to overcome the regulatory obstacles for the implementation of a SSE. It proposes to do away with the mandatory registration of section 8 companies for CSR contribution under the draft CSR Policy Amendment Rules, 2020 released by the Ministry of Corporate Affairs (MCA). The direct listing of a NPO on the SSE or the presence of a beneficiary NPO in the SSE directory will be sufficient for establishing credibility. The CSR capital must be allowed to accumulate in an escrow account for three years following which the account will be liquidated and spent under Schedule VII of the Companies Act.

Furthermore, the board or management of the corporate diverting CSR funds must not be related to the NPO to avoid conflict of interest. The SEBI panel also recommends that the MCA be allowed to authorize the trading of CSR spends between companies with excess CSR spends and those with deficit CSR spends. The SSE would be utilized for this trading exercise to enable better utilization of resources. The expenditure incurred by corporate entities for capacity building of the SSE will also be included in the CSR contribution by amending schedule VII of the Companies Act, 2013.

Tax Incentives

The Report has recommended that all revenue generated by stock exchanges through the SSE route be made tax-deductible. It has proposed exemptions of securities transaction tax on trades and capital gains tax for the sale of securities on the SSE. Furthermore, philanthropic donors must be allowed to claim 100% tax exemption on their donations to the NPOs that ‘benefit from the SSE’ including a provision for tax deduction in all investments in securities or other instruments of NPOs listed on SSE.

Corporate entities should also enjoy the benefit of deducting CSR expenditure that is attributed to the SSE from their taxable income. Finally, the Working Group has recommended that the 10% cap on income eligible for 80G deductions under the Income-Tax Act will be scrapped. First-time retail investors will be allowed to avail a 100% tax exemption on their investments in the SSE mutual fund structures subject to an overall limit of one lakh rupees. Lastly, the Report has also advanced a proposal of a five-year tax holiday to the FPEs listed on the SSE from the time of first listing.

Conclusion

The advent of the SSE bears immense potential to reinvigorate the social sector in India. It is encouraging that the Working Group has highlighted the pitfalls in foreign jurisdictions before advocating for a SSE and not endorsed a complete transplant of an existing model. The Covid-19 pandemic has led to a demand for higher spending in critical sectors of the economy in India. However, gradual economic liberalization has led to a consistent reduction in government capacity to cater to the social sector and created space for private players to step into the fold.

The flexibility in funding norms and the tax benefits offered could stimulate the engagement of private entities. Moreover, the emphasis on a pay-for-performance paradigm may also ensure that the SSE has the desired impact at the ground level. However, facilitating a steady flow of capital from a distressed private sector is likely to be an uphill task in the immediate future. Regulators must collectively generate an impetus for sufficient incentives that can offset the economic impact of Covid-19. The regulatory oversight exercised must not create an onerous burden of compliance on social enterprises to stifle investments.

– Rongeet Poddar

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SEBI’s Karvy Order: Tightening the Screws on Stock Brokers

Umakanth Varottil — Mon, 25 Nov 2019 05:04:29 +0000

Late on Friday, 22 November 2019, the Securities and Exchange Board of India passed an order in the case involving Karvy Stock Broking Limited (KSBL). The circumstances surrounding the order are atypical. The urgency of the situation is evident in the fact that the SEBI order, passed very late on 22 November, relies upon a “preliminary” report that it received from the National Stock Exchange of India Limited (NSE) that very day. Moreover, the order is on an ex parte ad-interim basis.

The crux of the matter is that NSE’s investigations indicate the use by KSBL of client securities to create pledges to generate funds for KSBL. This was allegedly done so without the prior permission or knowledge of the clients. Moreover, funds belonging to clients are said to have been transferred to a group company, Karvy Realty Private Limited. Shortcomings were observed in reporting of certain transactions and their outcomes that had hitherto led to the regulators being kept in the dark regarding such situations.

In a nutshell, the allegations indicate the use of client securities and client funds either for benefiting other clients or for KSBL itself (through proprietary trading or accounts). While the transactions tend to betray the nature of a client-broker relationship, SEBI also found that they violate a catena of regulations issued by SEBI and the stock exchanges to prevent such conduct that put the interests of the clients in conflict with that of the brokers themselves. SEBI’s order lists out the various circulars that have been violated by KSBL’s actions.

The trajectory of the regulatory restrictions surrounding stock brokers, as listed out in SEBI’s order, indicates that SEBI has progressively tightened the regime for stock broking. In particular are measures it took in June 2019. After highlighting the various circulars, SEBI found widespread violations on the part of KSBL:

17. Thus, the facts of this case need to be looked at in the light of aforesaid legal position regarding the handling of clients’ securities by the stock broker. In the present case, the report of NSE observes that KSBL has misused power of attorney given by its clients. KSBL has sold client securities in the market in disguised manner through own controlled entities and have used the funds for its own purposes. KSBL in order to hide its misdeed has not even reported this DP account no. 11458979, named KARVY STOCK BROKING LTD (BSE) in the submissions made by it to NSE from January, 2019 to August, 2019. It is only during inspection by NSE, this account came to notice. NSE report finds that there are numerous transactions in DP account no. 11458979, named KARVY STOCK BROKING LTD (BSE) whereby securities of the clients have been moved. Securities of clients received in pay out are transferred from the pool account to this account and also securities lying in the demat account of the client(s) are also transferred into and from this account misusing power of attorney given by the client.

18. The securities lying in the aforesaid DP account actually belong to the clients which are the legitimate owners of the securities. Therefore, KSBL did not have any legal right to create any kind of pledge on these securities. Even if the client securities were pledged, it should have only been for meeting the obligation of the respective clients which was not observed in this case. Considering the issue of misuse of clients’ securities by KSBL in unauthorized manner, for its own use and purposely not disclosing the DP account no. 11458979, named KARVY STOCK BROKING LTD (BSE) to the Exchanges in their reporting create a serious doubt on the conduct and integrity of KSBL.

Based on these findings, SEBI has prohibited KSBL from taking on new clients in respect of its stock broking business. Moreover, it has asked the depositories to monitor the movement of securities to and from the depository account of KSBL, and also to not act upon instructions given by KSBL on behalf of clients under powers of attorney.

A number of questions emerge. Based on the evidence thus far available with SEBI, the violations appear egregious, given the stock brokers’ responsibilities to keep their funds, securities and transactions distinct from that of clients, and also among different clients themselves. Moreover, there continues to be some ambiguity regarding the extent of the problem. There is reason to be believe that the present situation is not limited to KSBL, and that several other brokers face a similar predicament. The trajectory of the regulatory developments also indicates that the tightening regulatory regime may have led to the present implosion. In particular, this has been attributed to SEBI’s June 2019 circular that imposes considerable obligations on stock brokers in this behalf, which KSBL and others may not have been able to cope up with.

At the same time, the situation continues to be fluid. KSBL now has the opportunity to defend itself before SEBI within a period of 21 days. Since SEBI’s present action is based on NSE’s “preliminary” investigation, it is not clear what direction the matter will take once more facts are unearthed. More importantly, this could very well be the tip of the iceberg in what could turn out be a broader systemic problem unearthed.

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Social Stock Exchange – A Breakthrough for the Impact Investing Sector

Guest — Sun, 17 Nov 2019 01:23:20 +0000

[Aditya Bhayal is a IV year student at NALSAR University of Law, Hyderabad]

In this year’s Budget Presentation, the Finance Minister announced the introduction of the Social Stock Exchange (SSE) in the Indian capital market. Following this, the Securities and Exchange Board of India (SEBI) recently set up a panel to provide recommendations on the working and implementation of this concept. In light of this unprecedented move, it is essential to examine the challenges that it is likely to face.

Impact investing is a unique form of investment which seeks to do social good by channelizing the market forces in a direction that addresses the pressing social issues. In order to achieve this goal, however, impact investors bear the task of striking a fine balance between two somewhat opposing imperatives, i.e., financial returns and social benefits. Impact investing lies at the crossroads between philanthropy and commerce and is a sort of hybrid which has an added objective of public welfare to go along with the conventional motive of attaining profits. SSE is a measure that will facilitate the investors’ objectives of achieving wide social impact through their investment. This exchange intends to list various social enterprises and voluntary organizations to enable them to mark their presence on a platform to raise the finances needed to sustain their working.

Functions of the Social Stock Exchange

In the absence of a SSE, the market lacks regulatory tools that can meticulously separate the social impact investors from their respective counterparts present in the stock exchange. These differences need to be drawn in an effective manner, failing which the social finance will not be able to achieve its stated objectives. This regulatory vacuum needs to be filled with significant rulemaking. One of the central functions of the SSE would be to assist these enterprises to commercialize their financing to enable them to raise their operations and reduce their dependency on grant funding. Secondly, the SSEs undertake the work of creating a separate marketplace for social finance, thereby differentiating them from the conventional financial market where the major aim of the investor is to obtain maximum return on their investment. The SSE can accomplish this by formulating listing criteria for the entities interested in listing on their platform; formulating rules to govern such transactions; laying down requirements to be complied with to stay listed; and establishing guidelines on the basis of which the investors would be permitted to ply their trade on the platform. Further, the SSE can lay down the mechanism for enforceability of its rules and the conditions for delisting. All such rulemaking processes will go a long way in concretising the difference between the conventional stock exchange and the SSE.

While the SSE would develop regulations that would govern the social dimensions of impact investing, the exchange itself and the entities listing with the exchange would have to remain compliant with the corporate laws and the rules laid down by SEBI. This would be essential as SEBI, as the regulatory authority over the capital markets, would seek to lay down certain additional criteria for the protection of investors. Listing requirements, disclosure requirements and corporate governance are some of the devices through which the conventional stock exchange regulates the financial market. The SSE can use some of these measures to regulate the impact investing sector. But a major challenge for the SSE would be to tailor the devices used by the conventional exchange in such a way that it effectively mitigates the risks brought about by social investing and addresses the new found challenges associated with it.

Key Takeaways from other Jurisdictions

Socially Inclined Decision Makers

While the conventional stock exchanges demand entities listed with them to make disclosures and comply with corporate governance norms to verify their financial integrity, the SSEs on the other hand will collect information to check the issuer’s social integrity. One way to ensure that the social mission of enterprises is not compromised is to mandate these enterprises to have personnel with proven social inclination on the decision making bodies. One viable option can be to appoint a social director whose role will be to monitor the activities of social enterprises and ensure that they stay true to their commitment. This is crucial to protect the interest of the investors, as these investors invest the capital with a social objective in mind and, if that capital is used to further the commercial purposes of the enterprise, then the whole objective of investing is defeated. Such a step has been taken by the Impact Exchange (IX) of Singapore and Mauritius where they have mandated the potential issuers appoint an Authorized Impact Representative (AIR) to ensure compliance. Having such representatives on board would increase the confidence of the investors as these representatives can ensure appropriate usage of the capital.

Regulating the Investors

In a SSE, it will be essential to regulate the conduct of investors as their activities might sacrifice the whole mission of the entity. The regulator will need to tackle the situation of short-termism as many investors compromise on long term opportunities to derive some short term returns. This phenomenon of short-termism is dangerous for the impact investing sector where the social impact can take years to materialize. It might be that the financial returns are not satisfactory for indefinite periods of time. If the investors exit too early, they could jeopardize the whole social aim of the issuers. Further, the investors might also pressurise companies to prioritize financial returns over the social impact, which could defeat the whole purpose of impact investing. Due to such reasons, there needs to be a proper screening of the investors who can be permitted to trade on the exchange. The process adopted by the SVX in Canada can be a good example to consider. There is an SVX investor agreement which states that the investor acknowledges the fact that its investment might not bear any financial returns. The Canadian practice effectively weeds out those investors who prioritize profit over any social gain. This agreement can also be used by the investors to decide if such investments really suit their needs.

Another policy that can be adopted is an Investors Code of Conduct. SSEs can ask the investors to subscribe to the code mandatorily before investing. This code can lay down some “dos and dont’s” for the investors, which seek to build their commitment towards the mission. It can explain what it takes to be a patient impact investor. It can also lay down a minimum holding period for the investors while also asking the investors to sell their securities only to those investors who have subscribed to the code. These measures would enable the SSE to ensure that investments are routed in the right direction and the necessary impact is also created.

Impact Assessment and Reporting Requirement

Just like the businesses currently listed on exchanges carry out financial reporting, the social enterprises listed on the SSE will have to embark on social reporting in the same way. Monitoring the reporting by social enterprises is challenging as there are no defined metrics or standards for capturing social reporting. It is difficult to ascertain the actual social impact brought about by the entity. This can lead to investor taking decisions based on incomplete information. This can also lead to a scenario where the investors shy away from investing in enterprises which actually have the impact but are failing in the quantitative assessment. If the SSE does not specify a concrete reporting standard, there are chances that the businesses might opportunistically select those standards which are easiest to satisfy. Then the burden will shift on the investors to unearth information about the enterprises listed on the exchange thereby increasing the cost for the investors. It will be an onerous task for the SEBI to identify well-defined and clear metrics for measurement of social impact. SEBI can engage with third parties like credit rating agencies to rate the performances of the social enterprises in terms of their social impact.

Concluding Remarks

Although such an initiative is a welcome step for the impact investing sector, there is a need for considerable planning before the SSE becomes operational. Whether or not this initiative will achieve its objective can only be ascertained once a proper roadmap with minute details has been laid down by SEBI. The regulator will have to decide on the kind of entities which are allowed to trade on the exchange while also deciding on the set of investors which can invest in these entities. The term “social enterprise” will have to be defined appropriately so that undeserving entities do not misuse the platform thereby endangering the funds of the investors. Further, the matter get complicated as there exist no accepted criteria to measure the returns on investment. In the absence of such criteria, there will be difficulty in assigning value to the instruments to be traded on the exchange. The most important task for SEBI would be to come up with some concrete assessment criteria so that the investors would have some measure to rely on while deciding the credibility of an enterprise. If properly implemented, this platform could provide the much-needed boost to social businesses that have not realized their potential and have not been able to create the intended effect due to lack of funding.

– Aditya Bhayal

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Mergers or Demergers involving Listed Transferor Companies and Unlisted Transferee Companies

Guest — Sat, 07 Sep 2019 10:07:28 +0000

[Aishwarya Singh is a lawyer based in Mumbai. The views expressed in the article are personal.]

This post discusses the regulatory framework relating to mergers or demergers involving a listed company and an unlisted company, wherein the whole or part of the undertaking, property or liabilities of a listed company, being the transferor company, are transferred to an unlisted company, i.e., the transferee company. The pertinent question is whether the transferee company is required to list its shares pursuant to such mergers or demergers.

Section 232(3)(h) of the Companies Act, 2013, which deals with mergers and amalgamations of companies, states:

where the transferor company is a listed company and the transferee company is an unlisted company, –

(A) the transferee company shall remain an unlisted company until it becomes a listed company;

(B) if shareholders of the transferor company decide to opt out of the transferee company, provision shall be made for payment of the value of shares held by them and other benefits in accordance with a pre-determined price formula or after a valuation is made, and the arrangements under this provision may be made by the Tribunal.

[emphasis added]

The above provision of the Companies Act in effect allows a company to delist its shares by entering into a scheme of arrangement for merger or demerger. The transferee company is not under an obligation to list its shares. This provision seemingly allows companies to circumvent the SEBI (Delisting of Equity Shares) Regulations, 2009 that prescribe a specific procedure for delisting and mandate the provision of an exit opportunity for public shareholders.

Regulation 37 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 mandates that the listed company proposing to undertake a scheme of compromise or arrangement has to file the draft scheme with relevant stock exchanges for obtaining their ‘observation letter’ or ‘no-objection letter’ before filing such a scheme with National Company Law Tribunal (NCLT). Regulation 94 of the aforesaid Listing Regulations further requires the concerned stock exchanges to forward such draft schemes to the Securities and Exchange Board of India (SEBI) for approval. Hence, schemes in violation of the Delisting Regulations may not receive SEBI’s approval.

In the past SEBI had raised objections to such schemes. SEBI in its observation letter dated 28 August 2015 objected to the scheme of arrangement between Sterlite Technologies Limited (STL) and Sterlite Power Transmission Limited (STPL). The scheme involved a demerger of power products and transmission grid business from STL, a listed company, into SPTL, which was an unlisted company. SEBI raised concerns over the partial delisting of the shares of STL without providing an exit opportunity to the public shareholders. SEBI observed that this was an attempt to circumvent the Delisting Regulations.

Similarly, SEBI in its observation letter dated 4 August 2015 observed that the scheme of amalgamation of Zodiac Ventures Limited (ZVL), which is a listed company, with Zodiac Developers Private Limited (ZDPL), an unlisted company, does not provide an exit opportunity to the public shareholders in violation of the Delisting Regulations. The scheme involved the amalgamation of the entire business and undertaking of ZVL with ZDPL and dissolution of ZVL.

It is important to note that the above observations were made by SEBI before its Circular on ‘Schemes of Arrangement by Listed Entities and (ii) Relaxation under Sub-rule (7) of rule 19 of the Securities Contracts (Regulation) Rules, 1957’ dated 10 March 2017. The 2017 Circular confers greater participation for the public shareholders. It provides that the votes cast by the public shareholders in favour of the scheme should be more than the number votes by public shareholders against it, if the scheme involves a transfer of ‘whole or substantially the whole of the undertaking’ of the listed entity and the consideration for the same is not in the nature of listed equity shares. The expression ‘substantially the whole of undertaking’ has the same meaning as set forth in section 180(1)(a)(i) of the Companies Act. However, the 2017 Circular does not provide any clarity on whether the unlisted transferee company is required to list its shares pursuant to scheme.

Following the Circular, most of the draft schemes filed with the stock exchanges provide that the unlisted transferee company will become listed consequent to the merger or demerger. However, interestingly, under the composite scheme of arrangement between Alembic Limited, Shreno Limited and Nirayu Limited which was filed with the stock exchanges on 20 November 2018, the real estate undertaking of Alembic Limited (listed company) was to be demerged and transferred to Shreno Limited (unlisted company). The shareholders of Alembic Limited were to be issued non-cumulative redeemable preference shares as consideration for the transfer. These shares were not be listed on stock exchanges pursuant to the scheme. The scheme further provided that it will be acted upon only if the votes cast in favour of the scheme by the public shareholders are more than the votes cast against it in accordance with the 2017 Circular. SEBI issued a no objection letter for the scheme on 25 January 2019.

Since the regulatory framework does not provide much clarity, companies have to rely on older precedents of draft schemes filed with the stock exchanges and SEBI’s observation letters for structuring the mergers or demergers involving a listed transferor company and an unlisted transferee company. This leads to uncertainty over whether SEBI would raise objections to such a scheme.

SEBI’s primary concern with such schemes is that they do not provide for an exit opportunity to the public shareholders of the listed company. The author suggests that there should be no bar to such schemes if the requirements under the 2017 Circular are followed, which ensure greater participation of the public shareholders in the approval process of the scheme. Section 232(3)(h)(B) of the Companies Act also provides that the NCLT can make provisions for shareholders to exit the transferee company and are paid for the value of the shares held by them by using a pre-determined price formula or valuation.

There is a need for SEBI to remove the ambiguity on the validity of such schemes. Further, since the listed companies have to seek a ‘no-objection’ letter before filing the scheme with the NCLT, the concerns regarding backdoor delisting can be addressed by ensuring that only those schemes are approved which provide a justifiable rationale for the proposed arrangement.

– Aishwarya Singh

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SAT Order: Stock Exchanges not to Follow SEBI’s Circulars and Directions Mechanically

Guest — Sun, 30 Jun 2019 08:06:05 +0000

[Anand Narayan is a corporate and securities lawyer currently working as an in-house counsel in Mumbai]

One has lately witnessed a trend that the stock exchanges, such as NSE, BSE and NCDEX, are following the circulars and directions issued by the Securities and Exchange Board of India (SEBI) mechanically without application of mind, which has not gone down well with the market participants. Much to the relief of the market participants, the Securities Appellate Tribunal (SAT) has passed an order in GRD Securities Ltd v National Stock Exchange Ltd on 10 June 2019, wherein it has been stated that the stock exchanges and their disciplinary authorities should not follow or implement SEBI’s circulars mechanically without their own application of mind. Moreover, in cases where SEBI’s circulars mandate mandatory imposition of penalty for ‘x’ violation, the stock exchange has to interpret those circulars keeping in mind the principles of doctrine of proportionality. In other words, where circumstances so warrant, the stock exchanges may assign a penalty less than the threshold defined by SEBI’s circulars.

In this case the SAT, NSE, during a regular inspection of the books and records of the GRD Securities Ltd, noticed that GRD falsely reported margin amounting to Rs. 2,05,43,947/- in the CD segment in respect of two clients on two occasions. The Disciplinary Action Committee (DAC) of NSE directed GRD Securities Ltd to pay a penalty of Rs. 2,05,43,900/- and face suspension of one trading day in the currency derivatives segment of the Exchange. The DAC imposed the said sanctions by taking shelter under SEBI’s circular dated 10 August 2011 which, inter-alia, states the following:

If during inspection it is found that a member has reported falsely the margin collection from clients, the member shall be penalized 100% of the falsely reported
amount along with the suspension of trading for one day in that segment.

The SAT held that the said circular does not differentiate between situations involving upfront collection of cheques but late depositing or late crediting of the said amount and no upfront collection at all and, hence, suffers from the proportionality
principle. In fact, the SAT held that proportionality is a basic principle to be
adhered to while interpreting any provisions relating to punishment where the consequences are serious, as in the instant case. Accordingly, the argument advanced by NSE and SEBI that the said circular provides no discretion to NSE while imposing penalty once the violations are established were summarily rejected by the SAT.

Further the SAT also observed that the word ‘shall’ in the circular has to be read as ‘may’ as it would enable the exchange authorities to distinguish between no collection of margin at all and delayed collection of margin, particularly in situations that have no impact on the settlement or market at all. This order from the SAT will perhaps provide relief to the market participants in their respective cases where stock exchanges are blindly following SEBI’s circular or directions, without applying their own mind.

– Anand Narayan

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Cross Listing of Shares: A Start

Guest — Tue, 08 Jan 2019 05:13:02 +0000

[Rahul Sinha is a consultant with EY]

The Securities and Exchange Board of India (“SEBI”) constituted the ‘Expert Committee for listing of equity shares of companies incorporated in India on foreign stock exchanges and of companies incorporated outside India on Indian stock exchanges’ on 12 June 2018 with a view to facilitating companies incorporated in India to directly list their equity shares on foreign stock exchanges and companies incorporated outside India to list on Indian stock exchanges. The Expert Committee submitted its report on 4 December 2018.

A cross listing (also termed a ‘secondary listing’) occurs where one company’s shares are listed on more than one stock exchange. The company generally starts with an initial or primary listing on one exchange, and then moves to list in another or multiple jurisdictions. Listing in another jurisdiction allows the company to access capital that it would not readily have access to within its primary listing jurisdiction.

A dual listed structure is a series of contractual arrangements between two listed entities under which they operate as if they were a single economic enterprise while retaining their separate legal identities. The shares of each entity are not convertible into the other, but the shareholders benefit from the combined profits of the companies.

The only available routes for companies incorporated in India to access the equity capital markets of foreign jurisdictions is through the American Depository Receipts (“ADR”) and Global Depository Receipts (“GDR”) regime. Companies incorporated in India can list their debt securities on foreign stock exchanges directly through the masala bonds and/or foreign currency convertible bond (“FCCB”)/foreign currency exchangeable bonds (“FCEB”) framework. On the other hand, companies incorporated outside India can access the Indian capital markets only through the Indian Depository Receipts (“IDR”) framework.

Why Cross Listing?

– Dual listing is an easy option as it can help avoid capital gains tax and other complex tax issues while offering the benefits of scale and merger synergies without the need for a disposal or transfer of shares.

– Another advantage from the company’s perspective is an increased profile and global presence, which can be valuable when expanding brands or operations into other markets or overseas.

– From shareholders’ perspective a secondary listing may offer diversification of their investment, increased liquidity of their shares, and potentially lower investment risk as the shares are exposed to two or more markets rather than one.

– The market works a lot on sentiments of investors, and getting a domestic company listed on NYSE or NASDAQ would demand better valuation for homegrown companies as well as enhance the status of organization.

– Domestic companies will have access to foreign currencies which can be used to fund project at a global level.

Highlights of the report submitted

1. The framework should allow listing only on specified stock exchanges in Permissible Jurisdictions outside India. A Permissible Jurisdiction includes a jurisdiction which has treaty obligations to share information and cooperate with Indian authorities in the event of any investigation. Permissible Jurisdictions have also been defined in the report. The criteria to determine permissible jurisdiction is like the one used by the Reserve Bank of India (“RBI”) for listing of masala bonds.

2. Amendments to the Foreign Exchange Management Act, 1999 (“FEMA”) along with its circulars, press notes, etc., the Companies Act, and SEBI regulations must be carried out to legally implement the framework.

3. The KYC and Anti Money Laundering requirement could be similar to ones issued by RBI for masala bonds in the permissible jurisdiction. The Significant Beneficial Owners rule, 2018 have to be extended to include persons residing in the permissible jurisdiction and the requirements could remain constant.

4. If a foreign company is listing on Indian stock exchanges then e-voting must be made mandatory, financial statements should be prepared in English and according to one of the following: Ind AS; IFRS; US GAAP; or the country of incorporation’s local GAAP.

5. The Department of Revenue could exclude foreign companies from requirements under Place of Effective Management (“POEM”) provisions solely because it being listed in India.

6. The taxation aspect of the cross listing will have to be undertaken by Income Tax Department.

The report is well intended and if cross listing is allowed it can take the Indian economy to new heights, and the brand ‘India’ will also get its due share in the financial market. The regulatory struggle is high, there would be requirements of higher accounting and governance standards, and amendments in a number of regulations and Acts have to be undertaken. There would be additional burden of regulation on SEBI, NSE and BSE. There are several tax issues to be resolved such as determination of fair market value of shares.

– Rahul Sinha

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FAQs on Borrowing by Large Corporates: Unveiling the Perplexity

Guest — Mon, 10 Dec 2018 22:22:40 +0000

[Pammy Jaiswal is a Partner at Vinod Kothari and Company and can be reached at corplaw@vinodkothari.com]

Background

The untiring efforts of the Securities and Exchange Board of India (SEBI) as well as the Government in uplifting the bond market is quite commendable. SEBI has started taking major steps towards the accomplishment of the budget announcement by the Government for the year 2018-19. These include the introduction of an electronic bidding platform for privately placed debt securities, consolidation of ISIN of debt instruments and introduction of a secondary market for debt instruments. Accordingly, India’s bond market is almost at par with the banking loans to stand at 422 billion dollars as compared to 561 billion dollars as on 31 March 2018.

However, a majority of bonds issued in the country are on a private placement basis. Despite gaining prominence, bonds issued in India currently lack an active secondary market. In its continued effort in deepening the bond market, SEBI issued a circular dated 26 November 2018 where it has mandated certain listed entities to borrow a certain percentage of its borrowings through the issuance of debt securities.

While it is true that SEBI does not want to leave any stone unturned in strengthening the Indian bond market, there certain grey areas in the framework, which need further clarification. This post intends to highlight these grey areas and potential answers to the problems. A summarised write-up on the said framework can be viewed here.

FAQ Section

When will the framework under the circular be applicable?

The framework under the circular is applicable with effect from the financial year (FY) 2019-20 (where the FY is from April to March) or FY 2020 (where FY is from January to December).

What is the meaning of the term ‘large corporate’?

The entities that fulfil all the three conditions provided below based on the financials of the previous year are termed as large corporates (LCs):

listed companies (specified securities, debt securities, non-convertible redeemable preference shares);
having long term (maturity of more than 1 year) outstanding borrowings excluding external commercial borrowings (ECBs) and borrowings between parent and subsidiary of Rs. 100 crore and above; and
carry a credit rating of AA and above of unsupported bank borrowings or plain vanilla bonds (highest rating to be considered in case of multiple ratings).

Whether the applicability of the said circular has to be examined every year?

LCs are required to check the applicability of the aforesaid circular every year and accordingly be termed as such.

What is the meaning of unsupported borrowings?

The circular speaks about the credit rating of unsupported borrowings or plain vanilla bonds. Clause (iii) of para 2.2 states:

have a credit rating of “AA and above”, where credit rating shall be of the unsupported bank borrowing or plain vanilla bonds of an entity, which have no structuring/ support built in; and in case, where an issuer has multiple ratings from multiple rating agencies, highest of such rating shall be considered for the purpose of applicability of this framework.

A supported borrowing may referred to as a borrowing backed by a collateral or some sort of a guarantee for ensuring its repayment. Therefore, an unsupported borrowing is nothing but an unsecured loan. The reason behind maintaining the requirement of credit rating of AA and above for unsupported borrowing is to mandate entities having good creditworthiness for not only secured but also unsecured borrowings to issue a specified percentage of their debt securities in accordance with this circular. Further, only such highly rated entities shall encourage an investor to invest.

What are the various stipulations with respect to bond issuances imposed by this circular?

There are basically two stipulations imposed under this circular:

(a) Initial requirement:

For the first two years in which the framework becomes applicable (i.e. FY 2020 and 2021), the LC is required to raise a minimum of 25% of the long term borrowings (maturity of more than 1 year) in each of the FY (for which the entity becomes an LC) excluding ECBs and borrowings between parent and subsidiary (incremental borrowings) by way of issuance of debt securities.

(b) Continuous requirement:

From the third year of the applicability (i.e. FY 2022 onwards), the LC is required to mandatorily raise a minimum of 25% of its increased borrowing in such year from the issuance of debt securities over a period of one block of two years.

Further, in case of any shortfall of borrowing in any year, such shortfall is required to be carried forward to the next year in the block.

What is the manner of adjusting the shortfall in any FY?

As one reviews the illustration provided in Annexure C of the circular, it becomes clear that for the first year of implementation there is no concept of carrying forward the shortfall to the second year, since the LC is required to explain the reason for not being able to comply with the borrowing requirements.

Further, the shortfall for the second year onwards is required to be carried forward to the next year. It would be useful to elaborate on the manner of adjustment by way of an illustration:

X Ltd is an LC as on the last day of the previous year being 31 March 2019.

[Rs. in crores]

	2020	2021	2022	2023	2024	2025 [Not an LC]
Increased Borrowing [IB]	200	500	700	600	650	100
Mandatory borrowing from debt securities of 25% of the IB [MB]	50	125	175	150	162.5	NIL
Actual Borrowing from debt securities [AB]	40	100	75	200	100	5
Adjustment of the shortfall of the previous year	NIL	NIL	NIL	100	50	12.5
Shortfall to carry forward	NIL	NIL	100	50	12.5	7.5
Penalty	NIL	NIL	NIL	NIL	NIL	7.5* 0.2% = 0.015

Basically, the LC shall first adjust the AB towards the shortfall of the previous year of the current block and then ascertain whether it has complied with the MB requirements. Further, the penalty shall be levied if there is a shortfall of the previous year in the current block that could not adjusted with the AB of the second year of the current block.

What are the penal consequence for non- compliance?

For FY 19-20 and 20- 21, no penalty but explanation will be required;
From FY 21-22 onwards, the minimum funding requirement has to be met over a block of two years;
In case any shortfall of the first year of the block is not met as on the last day of the next FY of the block, a monetary penalty of 0.2% of the shortfall amount shall be levied and paid to the stock exchanges;
The manner of payment of the penalty has not been provided in the circular but stock exchanges are expected to provide for the same.

What are the disclosure requirements?

The fact that the entity has fulfilled the criteria of being an LC based on the financials of previous year has to be disclosed to stock exchange within 30 days of the beginning of the FY. The format is provided in Annexure A to SEBI’s circular.
The details of incremental borrowings made in the FY have to be disclosed to stock exchange within 45 days of the end of the FY. The format is provided in Annexures B1 [(applicable for FY 19-20 & 20-21) and B2 (applicable for FY 21-22 onwards)] to the circular.
The aforesaid disclosures shall be certified both by the company secretary and chief financial officers.
The aforesaid disclosures shall also form part of the annual audited financial results.

Any other specific requirements?
1. The entity will need to choose any one of the stock exchanges (where the securities are listed) for payment of the penalty.
2. The entity being an LC for the previous year and carrying a shortfall for that year in the current year for which the entity is not an LC shall also be required to make the requisite disclosures within 45 days of the end of the current year.
Whether the requirements of the circular are relevant for all the LCs?

While the ambit of the circular is broad enough to cover both non-banking financial companies (‘NBFCs’) and non-banking non-financial Companies (‘NBNFCs’), the circular is more relevant for NBNFCs.

NBFCs are financial institutions and are engaged in lending and investing activities in their day to day operations and, therefore, the major chunk of the working capital and long term funding requirements anyway arises from issuance of debt securities considering the leverage issues.

Therefore, one may construe that the circular is more relevant for NBNFCs since they are not mandated to borrow from the issue of debt securities as the funding requirements of these entities can also be fulfilled by banks. Further, the circular should have laid down a specified threshold on the increased borrowing which, if met, should be required to constitute debt securities also to the tune of 25%.

Whether relaxation is for any first two year of implementation or the year mentioned in the circular?

This circular was led by a consultation paper issued by SEBI on 20 July 2018 which clearly stated that “[a] “comply or explain” approach would be applicable for the initial two years of implementation. Thus, in case of non-fulfilment of the requirement of market borrowing, reasons for the same shall be disclosed as part of the “continuous disclosure requirements”

However, the circular is clear on the initiation point of the said framework i.e. April, 2019; accordingly, one may take a view that FY 2020 and 2021 shall mandatorily be the first two years in which the relaxation of the “comply or explain” approach can be taken. Any entity that is covered by the aforesaid circular at a later date shall have to mandatorily comply with the borrowing requirements and be liable to penalty in case of non-compliance.

Whether the term ‘increased borrowings’ shall also cover Pass Through Certificates (‘PTCs’)?

According to the circular, “incremental borrowings” have been defined to include borrowings during a particular financial year with original maturity of more than one year, excluding ECBs and intercorporate debts between a parent and its subsidiaries. Further, IND AS 109 treats PTCs as collateralized borrowings. Here it is pertinent to note that the question of showing the investor’s share in PTC as financial liability arises only because the securitised pool of assets fails the de-recognition test.

The originator has no obligation towards the investors of the PTC. The investors are exposed to the securitised pool of assets and not to the originator. Therefore, merely because the investor’s share appears on the balance sheet of the originator as financial liability, according to Ind AS 109 it does not mean they are debt obligations of the originator. Accordingly, incremental borrowings shall not include PTCs.

In cases where an entity ceases to be an LC in one year and again gets covered by the circular in subsequent years, whether the initial disclosure to the stock exchange shall be required to be given again?

In our view, such entity should provide the exchange with the initial disclosure for the purpose and to enable the stock exchange to continuously monitor the compliance of the framework.

How will the stock exchange be apprised that an entity is not an LC anymore?

Ideally there should be an intimation to the exchange stating that the entity is not an LC anymore and accordingly the mandatory borrowing requirements should not be made applicable for such FYs in which it is not an LC. Further, this intimation may also indicate that the entity shall inform the exchange in terms of para 4.1 once it qualifies to be an LC.

What is the role of the stock exchange in terms of para 5 of the circular?

The exchange shall collate the information about the LC and submit the same to the Board within 14 days of the last day of the annual financial results;
The exchange shall collect the fine as mentioned under para 3.2(ii); and
The said fine shall be remitted by the exchange to the SEBI Investor Protection and Education Fund within 10 days of the end of the month in which the fine was collected.

Conclusion

SEBI has laid down penal provisions for not complying with the circular. However, if the issue size of mandatory borrowing is too small, then there may be a possibility that LCs may considering carrying out a cost-benefit analysis between the issue cost and the penalty amount. Therefore, SEBI should set a minimum threshold for increased borrowings and cover only those LCs to raise funds through bond market who exceed such threshold.

– Pammy Jaiswal

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