The Securities and Insurance Laws (Amendment and Validation) Bill, 2010

The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 (“Bill”) was introduced on July 27, 2010 in Lok Sabha by Finance Minister Shri Pranab Mukherjee. It replaces the ordinance issued on June 18, 2010 to amend RBI Act 1934, Insurance Act 1938, SEBI Act 1992 and Securities Contract Regulations Act 1956 (“Ordinance”). The Bill clarifies that Unit Linked Insurance Policies (“ULIPs”) would be regulated by the Insurance Regulatory and Development Authority (“IRDA”) and not by the Securities Exchange Board of India (“SEBI”).

Background

On April 9, 2010, SEBI ordered that ULIPs are a combination of investment and insurance and therefore it can be offered/ launched only after obtaining registration from SEBI. The order stated that the investment components in ULIPs are in the nature of mutual funds which require registration with SEBI under section 12(1B) of the SEBI Act 1992. This order was been passed against 14 insurance companies which offered ULIPS to customers. IRDA disputed SEBI’s order and the matter was referred to the Supreme Court. Before the case was decided, the Government promulgated an Ordinance clarifying that life insurance business would include ULIPs or scripts or any such instruments. This brought a temporary end to the 2 months long battle between the regulators SEBI and IRDA, by giving IRDA the jurisdiction over ULIPs business.

Highlights of the Bill and analysis

The Bill states that ULIPs will be covered by provisions of the Insurance Act, 1938. Such policies are no longer ‘securities’ or ‘collective investment schemes’, as defined under the Securities Contracts (Regulation) Act, 1956 or the SEBI Act, 1992.

The Bill seeks to establish a joint committee, chaired by the Finance Minister, to resolve disputes between regulators over ‘hybrid’ or composite instruments. Such instruments are those which involve investments in the money market or the securities market, or have a component of insurance and which fall within the ambit of (a) Reserve Bank of India (b) SEBI (c) IRDA or (d) Pension Fund Regulatory and Development Authority. In addition to the Finance Minister, the committee shall consist of the heads of each the regulators specified above, as well as the Secretary (Department of Economic Affairs), and the Secretary (Financial Services) of the Government. Disputes over hybrid instruments can be referred to the committee by any of the regulators on it.

It should be noted that neither in the statement of objects and reasons of the Bill, nor in the explanatory statement accompanying the Bill, the Government has provided any reasons why ULIPs should be regulated by IRDA rather than SEBI. This silence becomes more relevant in the context of SEBI’s observation in its order dated April 9, 2010 banning ULIPs. SEBI observed that “In this regard I note from one of the products offered by one of the entities that for a sum assured of Rs. 15,00,000/- an annual premium of Rs. 1,50,000/- is collected for 10 years. The premium allocated for insurance out of this is Rs. 7500/- in the first year and Rs. 3000/- in subsequent years. (The annual premium for a term plan for 10 years for an identical sum assured for an identical life assured by the same company is Rs. 3,342/-) Here, the insurance component is 2% of the premium paid”. It simply means that in some ULIPs products the percentage of premium used to buy insurance is as low as 2% of the total premium, with the balance being invested in the securities markets.

A copy of the Bill is available here.

Report of the Takeover Regulations Advisory Committee

The Takeover Regulations Advisory Committee (“Committee”) constituted under the chairmanship of Shri. C. Achuthan has submitted its report to SEBI. Some of the main recommendations of the Committee are summarized below.

1. The Committee has recommended an increase in the acquisition threshold for the initial trigger of an open offer from the current level of 15% to 25% of the voting capital of a listed company.
2. The Committee has emphasized clarity in the trigger of an open offer pursuant to an indirect acquisition of shares, voting rights in, or control over a target company. The ability to indirectly exercise voting rights beyond the trigger threshold limits in, or exercise control over a target company, would attract the obligation to make an open offer, regardless of whether such target company is a predominant part of the business or entity being acquired.
3. The Committee has recommended that an open offer ought to be for all the shares of the target company to ensure equality of opportunity and fair treatment of all shareholders, big and small. The exception to this rule is the size of an open offer where the same is voluntary in nature.
4. Recognizing the need to enable transparent consolidation by persons already holding in excess of 25%, the Committee has recommended voluntary offers of a minimum size of at least 10% and a maximum size of such number of shares as would not result in a breach of the maximum non-public shareholding permitted under the listing agreement.
5. The Committee noted that the 100% open offer requirement could result in an acquirer ending up holding beyond the maximum permissible non-public shareholding, which may require the acquirer to either delist or bring down his holding to meet the continuous listing requirements. The Committee has recommended that the acquirer may state upfront his intention to delist if his holding in the target company were to cross the delisting threshold pursuant to the open offer.
6. Exemptions from open offer obligations have been made precise, streamlined and provided with clear conditions on the basis of the specific charging provision from which exemptions would be available. Some of the areas where clarity has been brought in include schemes of arrangement, certain inter se transfers, corporate debt restructuring and rights issues.
7. The minimum price payable as the offer price continues to be regulated. The minimum offer price is classified between the price payable for direct acquisitions and indirect acquisitions. The major changes proposed are: (i) market price to be based on 12 weeks volume weighted average of market prices as against higher of weekly averages of market prices for 26 weeks or 2 weeks; (ii) a qualitative improvement and expansion in the look back provision; (iii) in the case of indirect acquisitions, ascription of value to the target company under certain circumstances.
8. The Committee has brought in clarity on valuation in case offer price is being paid through shares. To ensure that the shares given in consideration for the open offer are indeed liquid and an acceptable replacement for cash, eligibility conditions have been stipulated.
9. The Committee has recommended certain changes such as increasing the period for making a competing bid, prohibiting acquirers from being represented in the board of target company, and permitting any competing acquirer to negotiate and acquire the shares tendered to the other competing acquirer, at the same price that was offered by him to the public.
10. The Committee has recommended that the execution of the agreement that triggered the open offer obligation may be completed during the pendency of the open offer provided 100% of the consideration payable under the open offer is deposited in escrow. Currently, an agreement which triggers an open offer can be consummated only after completion of the offer formalities.
11. The current Regulations restrict the target company from undertaking certain transactions during the offer period. The Committee thought it fit to bring in materiality concept as also to enhance the scope of such restrictions to include transactions by subsidiaries since potentially material transactions can be undertaken at the level of any subsidiary of the target company without approval of shareholders of the target company.
12. Timelines of various activities in the open offer process have been rationalized to compress the open offer period.

A copy of the press release is available here.
A copy of the report is available here.

Pre-open session to be introduced by NSE and BSE

SEBI vide CIR/MRD/DP/21/2010 dated July 15, 2010 has decided to introduce call auction mechanism in pre-open session. The pre-open session would be introduced on a pilot basis by BSE and NSE for the scrips forming part of Sensex and Nifty. The pre-open session would be for a duration of 15 minutes i.e. from 9:00 a.m. to 9:15 a.m., out of which 8 minutes would be allowed for order entry, order modification and order cancellation, 4 minutes for order matching and trade confirmation and the remaining 3 minutes would be the buffer period to facilitate the transition from pre-open session to the normal market.

Susan Thomas of Indira Gandhi Institute of Development Research in her recently published research paper Call auctions: A solution to some difficulties in Indian finance explains the concept of call auctions as follows:

“A call auction is an alternative mechanism through which electronic trading can be organised. It involves two critical differences. First, instead of a continous matching of orders, there is a period of time in which orders are accepted but no trades take place. Second, it is a `single price auction'. At the end of the call auction, all orders which can be matched are traded at a single price. A provisional market clearing price is computed as the intersection of supply and demand curves during the period of the call auction. It is the single price at which the maximal number of securities can be traded, given the orders present in the book at that point in time. It is displayed in real time on the computer screen. After a certain time period, the call auction is ended, and all orders which can be matched at this single price are executed. Call auctions can run for different periods, starting from as short as a minute. Once single-price matching has been done for an order book, there could be orders left in it that cannot be matched. These orders could be the natural starting point for continuous order matching.”

Thus in the call auction, buy and sell orders on the selected stocks (scrips forming part of Sensex and Nifty) would be collected for the first 8 minutes and order matching and trade confirmation would happen in the next 4 minutes. The equilibrium price would be the price at which the maximum volume is executable. In case more than one price meets the said criteria, the equilibrium price would be the price at which there is minimum order imbalance quantity (unmatched order quantity).

A copy of the circular is available here.

Stock exchanges to introduce physical settlement in F&O

SEBI vide CIR/DNPD/ 4 /2010 dated July 15, 2010 has decided to introduce physical settlement in equity derivatives. Stock exchanges have been allowed to settle stock options and futures contracts either on the basis of shares or cash. Stock exchanges may introduce physical settlement in a phased manner. On introduction, however, physical settlement for all stock options and/or all stock futures, as the case may be, must be completed within six months.

A copy of the circular is available here.

The concept of Chinese wall in financial institutions – Part I (origin & mechanisms)

Introduction

Recently, a major brokerage firm in India came out with two different reports on Punj Lloyd Ltd on the same day but with opposite recommendations. In one report, the firm wanted institutional investors to ‘sell’ shares of Punj Lloyd, with a 12-month target price of INR 97 or 29% lower than the then trading price of INR 137 as on 28th May. On the other hand, the second report issued on the same date recommended its private client group to ‘buy’ Punj Lloyd shares with a target price of INR 158. Later the firm stated that its retail and institutional research teams are separated by ‘Chinese walls’ and these groups are distinct and separate. A global investment bank was also in news recently for alleged violations in its Chinese wall policy.

The concept of Chinese wall is very relevant in today’s world of complex financial institutions wearing too many hats at the same time. Chinese walls are widely used by financial conglomerates to manage conflict of interest and to prevent insider trading. Lord Millett has defined Chinese walls as the existence of established organisational arrangements which preclude the passing of information in the possession of one part of the business to other parts of the business.¹ Conflicts of interest situations may arise as a result of the different activities/ roles undertaken by a financial institution. For example, if a financial institution extends credit facility to a company while its proprietary trading wing buys and sells securities issued by that company, it will result in a conflict of interest situation. ² Through a series of posts, I attempt demystify the concept of Chinese walls in financial institutions through an analysis of the origin of the concept, its importance, mechanisms and most importantly the current SEBI rules and regulations in this regard. This post will discuss the origin of the concept of Chinese wall and the major mechanisms used in implementing the Chinese wall.

Origin of the concept of Chinese wall

The use of Chinese wall to guard against the misuse of material, non public information was first endorsed by the Securities and Exchange Commission (SEC) in 1968 in an administrative proceeding involving Merrill Lynch, Pierce, Fenner & Smith, Inc³. Merrill Lynch was the lead underwriter for a potential public offering of debentures by Douglas Aircraft Company and it learned that the company was about to issue a revised estimate of its earnings with substantially lower figures. This information was passed on by the underwriters to the sales department, who in turn told several mutual funds and other large institutional clients. During the three-day period before Douglas publicly disclosed this information, Merrill Lynch and its clients sold the stock to avoid substantial losses. As part of the settlement Merrill Lynch reached with the SEC, the firm adopted a statement of policy that "prohibits disclosure by any member of the underwriting division of material information obtained from a corporation . . . and not disclosed to the investing public." In effect, this statement of policy was the first Chinese wall established in any financial institution in the history of financial institutions. Following this, various brokerage firms voluntarily implemented Chinese wall policy in their institutions. Later various regulators, around the world, felt the need to make Chinese wall policy, a mandatory requirement in every such institution and enacted laws which make it binding for firms to implement it.⁴

Mechanisms and arrangements under Chinese wall

Basel Committee of Banking Supervision recommended that the policies made by board of directors should ensure that the bank’s business activities that may give rise to conflicts of interest are carried out with a sufficient degree of independence from each other. This independence can be achieved by establishing information barriers between different activities and by providing for separate reporting lines and internal controls.⁵ Thus the prime objective of Chinese wall policy is to prevent the spill over of confidential information from one department to another. In order to achieve this, the financial institution has to separate departments with access to confidential information from the departments which deal with sale/marketing/investment advise or other departments providing support services. The various steps involved in this process are mentioned below.

Firstly, the institution should identify and designate “Insider Areas” and “Public Areas” in the institution. Insider Areas are those areas/ groups of the institution which routinely have access to confidential information. These areas are also known as “information recipients” as they receive confidential information as a part of conduct of their business. Public Areas are those areas/ groups of the organisation that trade securities or give investment advice or do sale/marketing and they depend on publicly available information for the conduct of their business. These areas are also known as “information processors”. Secondly, the institution should separate the information recipients (Insider Areas) from the others (Public Areas). The institution should also restrict access to confidential information only on a “need to know” basis and thus eliminate access by unauthorized persons.

The UK Law Commission⁶ defined Chinese wall as the compliance with the following requirements (subsequently approved by Lord Millett in Bolkiah⁷ and Jacobson J in Australian Securities and Investments Commission v. Citigroup Global Markets Australia Pty Limited⁸): -

• The physical separation of departments to insulate them from each other;
• An educational programme, normally recurring, to emphasize the importance of not improperly or inadvertently divulging confidential information;
• Strict and carefully defined procedures for dealing with situations where it is thought the wall should be crossed, and the maintaining of proper records where this occurs;
• Monitoring by compliance officers of the effectiveness of the Chinese wall; and
• Disciplinary sanctions where there has been a breach of the wall.

In the next post, I will discuss the requirements of Chinese wall under the SEBI rules and regulations.

Notes

1. Prince Jefri Bolkiah v. KPMG(A firm), [1998] UKHL 52; [1999] 2 AC 222.
2. Basel Committee of Banking Supervision, Enhancing Corporate Governance for Banking Organizations, Feb. 2006 (new version, first published 1999), Para. 27.
3. In re Merrill Lynch, Pierce, Fenner & Smith, Inc., SEC Rel. No. 34-8459.
4. Section 15(f) and Section 204A of the Investment Advisers Act, 1940 and Section 15D of the Securities Exchange Act of 1934 in USA, Section 1043F of the Corporations Act, 2001 in Australia, Regulation 3B (1) of SEBI (Prohibition of Insider Trading) Regulations, 1992 in India etc.
5. Supra n.2
6. Law Commission, United Kingdom, Fiduciary Duties and Regulatory Rules, Consultation Paper No 124 (1992) at [4.5]. The final report is Report No 236 (1995).
7. Supra n.1
8. [2007] FCA 963

ASBA forms to be made available on websites of the stock exchanges

SEBI vide circular CIR/CFD/DIL/7/2010 dated July 13, 2010 has stated that ASBA bid-cum application forms would be made available for download and printing, on websites of the stock exchanges which provide electronic interface for ASBA facility (i.e. BSE and NSE). The ASBA forms so downloaded would have a unique application number and can be used for making ASBA applications in public issues. The ASBA forms should be made availble on stock exchange's websites at least one day before opening of the public issue. This rule is applicable to all public issues opening on or after July 19, 2010. This move from SEBI would ensure wider availability of ASBA forms in addition to the ASBA forms available at the designated branches. It would also improve the popularity of the ASBA facility among the retail investors.

Review of the progress in implementation of ASBA facility

A memorandum circulated in the SEBI board meeting dated May 19, 2010 contains the following facts in relation to the progress of implementation of ASBA facility.

•  ASBA was introduced on July 30, 2008 wherein only ‘Retail Individual Investors’ could make applications in book built public issues by blocking the bid amount in their bank account subject to condition that bidding be done only at ‘cut-off’ price with no revision facility ("Phase–I"). Subsequently, on August 20, 2009, ASBA was made mandatory for rights issue.
• During Phase I, ASBA facility was used in about 23 public issues and 19 rights issues and ASBA applications as a percentage of total applications from retail individual investors category ranged from less than 1% to 28%.
• Later ASBA facility was extended to other investor categories also like Non Institutional Investors (NIIs) which include High Networth Individuals (HNIs), Corporate entities etc. The extension of ASBA facility ("Phase-II") involved changes in system software, procedure etc., and became effective from January 1, 2010 for all the public issues (book built and fixed price) and right issues.
• As on April 15, 2010, 27 banks having 3535 designated branches have certified their readiness for Phase II.
• Since January 1, 2010, ASBA facility was used in 24 public issues and 10 rights issues wherein the ASBA applications as percentage of total applications were in the range of 6.5% to 28% out of which applications by NIIs was in the range of less than 1% to 16%. 

More (previous) posts on ASBA are available here, here, here, here and here.

Revised exposure margin for exchange traded equity derivatives

SEBI vide its circular CIR/DNPD/3/2010 dated July 7, 2010 has revised the exposure margin for exchange traded equity derivatives. SEBI has now decided that the exposure margin should be higher of 5% or 1.5 times the standard deviation (of daily logarithmic returns of the stock price). Earlier in October, 2008, SEBI had stated that the exposure margin should be higher of 10% or 1.5 times the standard deviation (of daily logarithmic returns of the stock price) of the notional value of the gross open position in single stock futures and gross short open position in stock options in a particular underlying.

A copy of the circular is available here.