Bimal Jalan Committee report- some interesting remarks

The recommendations in the report of the Bimal Jalan Committee (the “Committee”) (discussed in a previous post) has generated a lot of buzz. These recommendations have mostly been met with criticism, the most criticised being the stand taken by the Committee to disallow the listing of the stock exchange. A column in a newspaper (available here) reports the sharp exchanges between the stakeholders and the Committee members over the recommendation to disallow the listing of stock exchanges in a meeting organised by CII.

Further, in an open letter published in newspapers (see Economic Times and Financial Express- 21st December 2010) by a minority stakeholder in NSE to the NSE's managment, the view expressed is that- “Without listing, minority shareholders feel trapped". To the contrary, the MD of NSE seems to be supportive of the Committee’s recommendations, as is evident from this news report available here. He is reported as stating that “Some people have argued that this conflict is not serious or that a poorly governed exchange will collapse. If the conflict is not serious, how is it that every developed market has taken out the regulatory role from an exchange.” This is apparently demonstrating a rift between the minority shareholders and the management of NSE, reflecting the wider debate and lobbying over the Committee’s recommendations. This is portrayed in another news column available here.

The most interesting remark to the Committee’s recommendation has been that- “Jalan panel disrespects Parliament”, which is in a news column available here, wherein the author brings out the contradictions between the Committee’s recommendation and the previous report of committee headed by former Chief Justice of India M.H. Kania, pursuant to which major amendments were brought to the Securities Contract (Regulation) Act, 1956. The author therein remarks that “The Jalan Committee takes us back not just in time but to the soviet philosophy of 1970s” [emphasis mine].

SEBI amends the Listing Agreement

SEBI has made some significant changes to the equities listing agreement (the “Listing Agreement”) by a circular (available here) on 16th December, 2010. The changes introduced are as under:

1. Changes to clause 35
Clause 35 of the Listing Agreement mandates companies to file the details of their shareholding pattern with stock exchanges on a quarterly basis within 21 days of end of each quarter. SEBI has now added two more reporting requirements in clause 35 which are (i) companies should disclose their shareholding one day prior to the listing of its securities and the stock exchanges are required to disseminate these details before the first trade (this ensures wider public dissemination of shareholding pattern), and (ii) companies should report within 10 days any capital restructuring resulting in a change exceeding +/-2% of the total paid-up share capital.

Another change introduced in clause 35 is with respect to the details of ‘shares held by custodians and against which DRs(depositary receipts) have been issued', which are presently required to be disclosed in Table (I) (a) of Clause 35, should from now on be further segregated as those pertaining to the ‘promoter/promoter group’ and to the ‘public’.

This will ensure a holistic and true picture of the promoter/promoter group holding.

2. Changes to clause 5A
Clause 5A of the Listing Agreement contains the procedure to be followed by the companies with respect to the unclaimed shares pursuant to public or any other issue. Before the amendment, the clause only dealt with the shares issued in electronic and provided nothing for shares issued in the past in physical mode. Vide this amendment, SEBI has inserted specific provision for procedure to be followed in respect of unclaimed shares issued in physical form.

This will end the difficulties faced by the companies which have in the past issued shares in physical form.

3. Changes to clause 20
Clause 20 of the Listing Agreement mandates the companies to intimate the exchange of the outcome of the board meeting to consider payment of dividends or buyback. The existing clause does not require the companies to intimate the date of payment/dispatch of dividends to the exchange. Vide this amendment, SEBI has made it mandatory for the companies to also inform the exchange the date on which dividend would be paid.

This will enhance transparency and enable the investors to manage their cash/securities flows efficiently

4. Changes to clause 22
Clause 22 of the Listing Agreement mandates the companies to intimate the exchange within 15 minutes of the closure of the Board meeting the particulars of the decisions taken therein pertaining to increase of capital by issue of bonus shares, re-issue of forfeited shares/securities or any other alterations of capital. Vide this amendment, SEBI has made it mandatory for the companies to also inform the exchange the date on which the bonus shares would be credited/ dispatched.

5. Changes to clause 40A
Clause 40A of the Listing Agreement contains the condition for minimum public float to be adhered to by a listed company. The Government in June 2010 through the Securities Contracts (Regulation) (Amendment) Rules, 2010 (a copy of which is available here), had mandated listed companies to achieve at a 25 percent public shareholding in the next three years. This amendment had also prescribed annual floors of 10%/ 5% by which the listed companies should reach the 25% public shareholding. However, there was a further amendment in August 2010 vide Securities Contracts (Regulation) (Second Amendment) Rules, 2010 (notification no. GSR662(E) dated 9th August 2010 available at MANU/EAF/0142/2010), whereby the 25% requirement was reduced to 10% for public sector enterprises and flexibility was provided to the listed companies to attain the 25%(10% for public sector enterprises) within three years without any annual floor.

Clause 40A has now been amended to bring it in alignment with this second amendment to the Securities Contract (Regulation) Rules, 2010 (the “Rules”). The amended clause 40A now specifically provides that a listed company has to comply with the requirements of the Rules and can reach the required level of public shareholding by issuance of shares to public through prospectus/offer of promoters’ shares to public through prospectus/sale of promoters’ shares through secondary market.

6. Insertion of new clause 53 and 54
The following new clauses have been inserted in the Listing Agreement by this amendment:
• “53. The issuer company agrees to notify the stock exchange and also disseminate through its own website, immediately upon entering into agreements with media companies and/or their associates, the following information:-
a. Disclosures regarding the shareholding (if any) of such media companies/associates in the issuer company.
b. Any other disclosures related to such agreements, viz., details of nominee of the media companies on the Board of the issuer company, any management control or potential conflict of interest arising out of such agreements, etc.
c. Disclosures regarding any other back to back treaties/contracts/agreements/MoUs or similar instruments entered into by the issuer company with media companies and/or their associates for the purpose of advertising, publicity, etc. “

• “54. The issuer company agrees to maintain a functional website containing basic information about the company e.g. details of its business, financial information, shareholding pattern, compliance with corporate governance, contact information of the designated officials of the company who are responsible for assisting and handling investor grievances, details of agreements entered into with the media companies and/or their associates, etc. The issuer company also agrees to ensure that the contents of the said website are updated at any given point of time.”

These added clauses seek to ensure public dissemination of details of agreements entered into by corporates with media companies. This change is basically a bye-product of an earlier SEBI press release available here, which has been discussed in a previous post.

The amendments to clauses 5A, 35, 40A and insertion of clause 53 comes with immediate effect, while the amendments to clauses 20, 21 and 22 would be applicable for all board/shareholders meetings held on or after 1st January, 2011. The insertion of clause 54 is to take effect from 1st April, 2011.

SEBI should be consistent in its approach: SAT

In a recent order, the Securities Appellate Tribunal ("SAT") made this striking remark- “It must be remembered that it is in public interest that a statutory regulator like the Board (read SEBI) should be consistent in its approach as that would send the right signals to the capital market and would also insulate the Board from the charge of discrimination.”

This remark was made in the concluding paragraph of its order in an appeal from a SEBI’s order (“Impugned Order”). Through the Impugned Order, SEBI refused to grant exemption to a promoter group from making a public offer to the existing shareholders to acquire further shares in the company under Regulations 10 and 11(1) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997 (“Takeover Regulations”). The appellants in the appeal pointed out to the SAT a few earlier orders passed by SEBI wherein SEBI had granted exemption from Regulations 10 and 11 of the Takeover Regulations in a similar factual matrix of appellant’s case.

Briefly stated, the facts of this case were that a listed company (the "Company/Target Company") required finance for expanding its business for which it approached the banks. The banks agreed to sanction the required loan with a pre-disbursement condition that the company raises an upfront equity of Rs. 50 crores (to comply with the debt-equity ratio norms). To raise this amount the company decided to do a preferential issue to its promoters and another entity (whose holding post the issue was to be 13.82% of the shares of the Target Company) who agreed to subscribe to the requisite number of shares. The Company got the necessary shareholders approval through a postal ballot, wherein the resolution for this purpose was passed by 99.1% (7586 postal ballots received out of 71589 shareholders). In the explanatory statement sent to the shareholders, all the necessary details of this issue were brought to the notice of the shareholders including inter-alia the fact that there will be no change in the management or control of the company; and that a rights issue is not being resorted to by the Company as it would delay the process. Since this preferential issue was to increase the holding of the promoters/promoters acting in concert group from 25.32% to 45.91%, the proposed acquirers made an application for exemption from Regulations 10, 11(1) and 12 of the Takeover Regulations. This application was rejected by SEBI against which an appeal was filed in SAT, which reversing the order of SEBI, granted the exemption to the appellants.

SEBI was of the view that the method of preferential allotment denied to the shareholders an equal opportunity in the fund raising exercise, and being denied this equal opportunity, they should be given an exit option through an open offer by declining an exemption.

SAT termed this order of SEBI as ‘wrong in approach and perception of the shareholders’ interest’ and observed that “….. it is not for the Board (read SEBI) to advise or insist on any company as to how and in what manner it should raise its further equity capital when the law gives the aforesaid three options [i.e. a Further Public Offer/ Rights Issue/Preferential Allotment] to a company. Of course, it must ensure that whichever method a company may adopt for raising equity capital, the procedure prescribed by law for that method has been followed in letter and spirit.”

It was argued by SEBI that only 10 per cent of the shareholders had participated in the postal ballot and that this percentage does not represent the majority of the shareholders. This argument was rejected by the SAT on the premise that the majority had been provided with an opportunity to caste their vote and those who did not caste their votes were in silent agreement with the proposed resolution for the preferential allotment. In this regard, the SAT opined that- “Their silence cannot be taken otherwise in the absence of any statutory provision to the contrary. The matter would have been different if the majority had not been provided with an opportunity to cast their votes.”

The most important observation made by the SAT in the matter was this- “we cannot forget that the primary object of the acquisition was to provide additional financial assistance to the target company for its new project.” This order of SAT has some interesting aspects. In a way it can be seen as laying down the proposition that if the funds are required to meet the expansion activities and the objective of acquisition of shares is to provide financial assistance then the exemption under Regulation 3(l) of the Takeover Regulations should be granted. Of course this will be with the rider of ‘no change in control’.

To raise an upfront equity, a company has three options- it can go to public and ask for funds or it could approach the existing shareholders with a rights issue or it can do a preferential allotment to a select group of persons. A company can opt for any of these options as per its requirements. SAT agreed with the appellant's submission that preferential allotment was not only the quickest but also the surest way of raising equity. SAT appears to be highlighting the benefits of a preferential allotment in this order!

Dr. Bimal Jalan committee report on ownership and governance of the Market Infrastructure Institutions

SEBI, in January 2010, had appointed a committee under Dr. Bimal Jalan (former Governor of the Reserve Bank of India) to study and recommend changes on the ownership and governance of the Market Infrastructure Institutions ("MIIs") like stock exchanges, depositaries and clearing corporations. The committee, on November 22, 2010, has submitted its report ("Report") to SEBI and is available here for public comments. The report makes some particularly strong recommendations including not allowing such entities to get listed on stock exchanges.

The Report examines the nature of these institutions and the reasons for such institutions being referred to as MIIs in the light of doctrines like 'Essential Facilities', 'Natural Monopolies', 'Economies of Scale' and emphasizes on the systematic importance of these MIIs for the economy. The report views these MIIs as producers of public good and says that '….. the three MIIs in the securities holding-trading-clearing-settlement chain are engaged in the business of producing a valuable public good for society, which are essentially the price signals produced by a transparent and efficient market mechanism'.

The Report says that it is not possible to sever the regulatory role of the MIIs from their more obvious role of serving as providers of infrastructure of the market and goes on to describe the characteristics and functions of these MIIs emphasizing the following characteristics of such institutions:-

1. In general, MIIs are in the nature of public utilities.
   
2. All of them are vested with regulatory responsibilities, in varying degrees.
   
3. They have systemic importance to the economy.
   

In the above background, the Report highlights the conflict in the 'regulatory role' of these MIIs with their 'economic interests'.

The key recommendations in the Report are the following:

1. Changes to Securities Contracts (Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchanges) Regulations, 2006: The Committee has proposed the replacement of these regulations by a comprehensive set of regulations on the ownership and governance of stock exchange. By way of a transit, the committee recommends changes for the existing provisions of these regulations which inter-alia contains a recommendation that- ' All anchor institutional investors put together shall not hold more than 49% of the total equity capital of an exchange'. Currently depositories, clearing corporations, banks, insurers and public financial institutions are allowed to hold, individually, up to 15% in a stock exchange.

2. Ownership and Control of a MII in another classes of MII: As regards the ownership and control of MII, the committee has proposed the following:

• Clearing Corporations and Depositories may not be allowed to invest in other class of MIIs .
  
• at least 51% of the paid-up equity capital of the Clearing Corporation should be held by one or more recognised Stock Exchanges.
  
• the holding of stock exchanges in depositories may be restricted to a maximum of 24%.
  
• In case of all MIIs, FIIs should be allowed to acquire the shares through off market transactions including through initial allotment, as allowed for any other shareholders, subject to the limits specified by the Government from time to time.
  

3. Governance of MIIs: As regards the governance of MIIs, the committee has proposed the following:

Stock Exchanges:

• no trading /clearing member (irrespective of exchange where he operates) shall be allowed on the board of any of the stock exchange
  
• the number of public interest directors ("PIDs") on the board of a stock exchange shall at least be equal to the number of shareholder directors without trading/ clearing interest.
  

  Clearing Corporations:
  

• the number of PIDs on the board of a clearing corporation shall at least be equal to the number of shareholder directors without trading/clearing interest.
  

  Depositories:
  

• same as prescribed for listed companies under clause 49 of the listing agreement.
  

4. Disclosures by board members of MIIs: All transactions in securities of the board members of the MII and their family have to be disclosed to the board of the MII.

5. Disclosure and corporate governance requirements: The committee recommends that the disclosures and corporate governance requirements of the listing agreement applicable to listed companies shall be made applicable to MIIs too. The information required to be disclosed under the listing agreement should be posted on the website of the MII.

6. Mandatory appointment of Compliance Officers: SEBI has mandated various registered intermediaries and also depositaries to appoint a compliance officer to ensure that the intermediary complies with the rules, regulations, circulars and directives of SEBI. The committee recommends that such appointment should be made mandatory also for the stock exchanges and clearing corporation.

7. No listing of these MIIs: The committee is not in favour of listing of MIIs and observes that- '... MII should not become a vehicle for attracting speculative investments. Further, MIIs being public institutions, any downward movement in its share prices may lead to a loss of credibility and this may be detrimental to the market as a whole'.

8. Networth Requirements: The committee recommends that Stock Exchanges should have a net worth of INR 100 crores at all times. As regards depositories, the SEBI prescribed net worth of INR 100 crores is suggested to be retained with a rider that '…all other investments in related, unrelated/other business shall be excluded while computing the net worth'. For clearing corporation, the committee recommends an ongoing net-worth requirement of INR 300 crores in the form of liquid assets.

Apart from above, a recommendation in the report which may cause significant outcry is putting of a cap on the maximum return that can be earned by MII on its net worth and can be distributed / allocated to its shareholders. The committee observes '…MII being a public utility should endeavor to earn only reasonable profits at par with average earnings of the corporate sector in India'.

It would be interesting to see how much of these recommendations are implemented by the regulator. These recommendations are seen as a disappointment and have been met with criticism (here, here, here and here) on the lines that it would protect the monopolistic market structure and perverse anti-competitive practices by some and prevent new entrants on the stock exchange space. Also, the buzz in media is that the government is unsure of implementing these recommendations.

[The above post has been contributed by Vaibhav Kumar, who is an Associate at the law firm, Desai & Diwanji, Mumbai.]

SEBI (Issue of Capital and Disclosure Requirements) (Fourth Amendment) Regulations, 2010 notified

SEBI has notified the SEBI (ICDR) (Fourth Amendment) Regulations, 2010, amending the SEBI (ICDR) Regulations, 2009. This amendment regulations came into effect from November 12, 2010. The major changes made to ICDR regulations by this amendment regulations are the following:

1.                  Investment limit for retail investors has been raised from the current Rs 1 lakh to Rs 2 lakh. (see previous post)

2.                  Insurance funds, set up and managed by department of posts, to be recognised as a QIBs.

3.                  Issuers coming out with public offer to make a simultaneous public announcement (in newspapers) about the filing of draft offer document with SEBI.

4.                  The merchant bankers to submit a compliance certificate in the specified format to SEBI certifying as to whether the contents of the news reports appearing after filing of draft offer document are supported by disclosures in the offer document or not.

Amendment in relation to conditions for initial public offer

SEBI has also amended regulation 26(5) of the ICDR Regulations. The amended regulation reads as follows:

“No issuer shall make an initial public offer if there are any outstanding convertible securities or any other right which would entitle any person with any option to receive equity shares.”

The regulation originally read as follows:

“No issuer shall make an initial public offer if [as on the date of registering the prospectus with the Registrar of Companies] there are any outstanding convertible securities or any other right which would entitle any person any option to receive equity shares [after the initial public offer].”  The words “as on the date of registering the prospectus with the Registrar of Companies” and “after the initial public offer” has now been deleted.

The implication of this amendment is that the issuing company should not have any outstanding convertible securities at the time of filing red herring prospectus/ prospectus with the ROC. This is evident from the second amendment made in the same regulation. A new proviso (c) has been added to regulation 26(5) wherein SEBI exempts fully-paid up outstanding convertible securities which are required to be converted on or before the date of filing of the red herring prospectus (in case of book-built issues) or the prospectus (in case of fixed price issues) from the purview of the above mentioned rule. This means the following:

1. An issuer company can have certain outstanding convertible securities at the time the time of filing the draft red herring prospectus with the SEBI, provided that (a) such securities are fully paid up and (ii) such securities are required to be converted on or before the date of filing of the red herring prospectus/ prospectus with the Registrar of Companies.

2. An issuer company cannot have:
(a) any partly paid up outstanding convertible securities; or
(b) fully paid up outstanding convertible securities which are required to be converted at a date after the filing of the red herring prospectus/ prospectus with the Registrar of Companies,
 at the time of filing of the draft red herring prospectus/ draft prospectus with the SEBI.

[Apologies for certain typos in the original post. They are now corrected. - Emil]

A copy of the amendment regulations is available here.

SEBI allows stock exchanges to offer European style options

[The following post has been contributed by Vaibhav Kumar, who is an Associate at the law firm, Desai & Diwanji, Mumbai.]

In a significant development, SEBI by a circular dated 27th October has provided the Stock Exchanges with the flexibility of offering either European Style or American Style Stock Options. At present, it is only American style options which are allowed as per the SEBI circular of 20th June, 2001.

Simply stated, a stock option is a right but not an obligation to buy (call) or sell (put) a stock at a specified price on or before a given date in future. In an option contract, there are two parties- the buyer/holder/owner who takes a long position, and the seller/writer who takes a short position. The American Style options are those which can be exercised at any time during the subsistence of the contract, whereas, the European style options can be exercised only on the date of expiry of the option, i.e. on the agreed date.

As per the circular, after opting for a particular style, a stock exchange shall offer options contracts of the same style on all eligible stocks. It further directs the stock exchanges to put in place the systems, procedures, rules and regulations required for the introduction of European style options. Stock exchanges are to notify all the market participants, including general public at least one month in advance of implementing the switchover in the exercise style.

The interesting part of the circular is the leeway given to stock exchanges to change to another style of stock option after opting for a particular style, with the prior approval of SEBI. This is certainly helpful as it will not give rise to any kind of rigidity in the bourses.
This is seen as a progressive step taken by SEBI as it will boost the trading volume in options for the risk involved is more in American Options. In European-style options, the seller is aware about the timeline he has until the option is exercised. Further, on a separate note, as regards the European style options, there cannot be any option assignment unlike the American-style where there can be assignment prior to expiration of the option.

In furtherance of this circular, the NSE has already announced that it will offer European style stock options.

This circular is available here.

Investment limit for retail investors increased to 2 lakh, Rights issue framework for IDRs, Norms for public issues by insurance companies etc.

SEBI vide PR No.231/2010 dated October 25, 2010 has published the decisions taken by the SEBI Board in its meeting held on the same date. The highlights of the press release are as follows: -

Norms for public issues by insurance companies

SEBI has stated that SEBI (ICDR) Regulations, 2009 would be applicable to public issues by insurance companies. SEBI and IRDA have been working together for finalizing a framework for life insurance companies to raise funds from the market and list in the capital markets. The new framework stipulates more disclosures wherein insurance companies need to put in the risk factors specific to insurance industry in the offer document. Other changes include amendments to the ICDR regulations which allow monitoring agencies like one for banks in India where RBI is monitors banks, IRDA will be allowed to monitor life insurance companies who come into the capital markets.

Preferential issue of equity shares or convertible securities or warrants to promoters and promoter group

SEBI stated that in case of preferential issues, where any promoter or any promoter group entity has previously subscribed to the warrants of the company but failed to exercise the warrants, the promoters and promoter group would be ineligible for issue of equity shares or convertible securities or warrants for a period of one year from the date of expiry of the currency /cancellation of the such warrants. In case of any member of the promoters/ promoter group has sold shares in the previous six months, then the promoters/ promoter group would be ineligible for allotment on preferential basis.

The SEBI (ICDR) Regulations, 2009 allows preferential allotment of warrants subject fulfillment of certain specified conditions. These warrants give promoters an option to convert warrants into shares at a pre-determined price. The price of such conversion is decided based on the average price of the last six months or last two weeks, whichever is higher. Promoters have 18 months to convert the warrants into shares at that price. They generally convert the warrants in a rising market and book profits but tend to let them lapse when markets fall. Thus the allotment of warrants allowed promoters to enrich themselves in booming markets and getaway in crashing markets. SEBI, taking note of this issue, had earlier proposed to increase the upfront margin to be paid by allottees of equity warrants to 25% from the earlier 10%.

Rights issue framework for IDRs

SEBI stated that it will soon notify the framework for rights issue of IDRs. This would facilitate simultaneous rights offering by the foreign issuers (who have listed their Indian Depository Receipts (IDRs) in Indian Stock Exchanges) in their home jurisdiction and in India. Even though the Companies (Issue of Indian Depository Receipts) Rules, 2004 were issued in 2004, only one company has so far issued IDRs in India for raising capital.
 
Investment limit for retail investors increased to 2 lakh

SEBI has increased the maximum application size for retail individual investors to Rs.2 lakh across all issues.

Regulation 2 (1) (ze) of SEBI (ICDR) Regulations, 2009 currently defines "retail individual investor" to mean an investor who applies or bids for specified securities for a value of not more than one lakh rupees. Earlier in August 2009 SEBI had released a discussing paper which proposed to raise the investment limit for retail investors from the current Rs 1 lakh to Rs 2 lakh. SEBI felt that the retail individual investors who have the capacity and appetite to apply for securities worth above one lakh rupees were constrained from doing so because of the one lakh limit and they do not make application under the non institutional investor category because the allocation there is limited to 15% as against 35% for retail individual investor category. Another reason which prompted SEBI for such a move is the inconvenience faced by merchant bankers in big offerings to get enough number of retail investors because of the limit of one lakh rupees. It is also felt that the huge public offerings of PSUs which are in pipeline have prompted the Government for such a move to ensure that the offerings are fully subscribed in the retail segment.

Requirement of promoters' contribution not be applicable to FPOs

SEBI has stated that the requirement of promoters' contribution would not be applicable to FPOs where equity shares of the issuer are not infrequently traded in a recognised stock exchange for three years and the issuer has a track record of dividend payment for three years.

News reports appearing after filing of draft offer document to be consistent with disclosures in the offer document

SEBI has stated that the merchant bankers may submit a compliance certificate as to whether the contents of the news reports that appear after filing of draft offer document are supported by disclosures in the offer document or not. This would apply in respect of news reports appearing in newspapers stipulated in ICDR for issue advertisements, major business magazines and also in the print and electronic media controlled by any media group where the media group has a private treaty/shareholders' agreement with the issuer company/promoters of the issuer company. Earlier in August, 2010 SEBI had asked media companies to disclose the details of the stake held by such media companies in various companies.

A copy of the press release is available here.

SEBI amends ICDR Regulations: Draft offer documents of public issues upto 100 crore to be filed with regional offices

SEBI vide circular CIR/CFD/DIL/9/2010 dated October 13, 2010 has mandated that draft offer documents in respect of public issues of size upto 100 crore should be filed with the concerned regional office of the SEBI under the jurisdiction of which the registered office of the issuer company falls. Earlier offer documents of issues upto 50 crore were filed with the concerned regional offices of SEBI. SEBI has now increased this limit from 50 crore to 100 crore. This circular comes into force with immediate effect.

A copy of the circular is available here.

ASBA forms can be collected by syndicate/ sub-syndicate members

SEBI vide circular CIR/CFD/DIL/8/2010 dated October 12, 2010 has allowed syndicate/ sub-syndicate members to collect ASBA forms from the investors and to submit it to Self Certified Syndicate Banks ("SCSBs"). Earlier only SCSBs were allowed to collect ASBA forms, while the syndicate/ sub-syndicate members collected the non-ASBA forms. Under the new scheme syndicate/ sub-syndicate members would be required to upload the bid and other relevant details of such ASBA forms in the bidding platform provided by the stock exchanges and forward the same to the respective SCSBs. SCSBs should carry out further action for such ASBA forms such as signature verification, blocking of funds etc. and forward these forms to the registrar to the issue.

A copy of the circular is available here.

More on ASBA process (previous posts):

SEBI extends ASBA facility to QIBs

ASBA Phase II – Facility extended to HNIs and corporate investors

SEBI amends rights issue norms: ASBA introduced

SEBI modifies the rule of dividend transfer under SLB

SEBI vide circular CIR/MRD/DP/ 33 /2010 dated October 07, 2010 has modified the Securities Lending and Borrowing ("SLB") framework. As per the modified framework, the lenders of shares under SLB scheme will now get dividend on the record date. Currently the borrower who is in the possession of share gets the dividend on the record date and he transfers the dividend to the lender at the time of repayment of the shares borrowed.

A copy of the circular is available here.

Draft listing agreement for securitized debt instruments

SEBI has placed on its website, the draft listing agreement for securitized debt instruments, for public comments/ suggestions. The highlights of the draft listing agreement are the following:

• Performance related information to be disseminated on a monthly basis.
  
• The burden of disclosures is placed on the Special Purpose Distinct Entity (SPDE)/ SPV which is the issuer of securitized debt. In order to facilitate flow of information, the draft requires the SPDE/ SPV to enter into back to back arrangements with the originator, servicer and the trustee.
  

A copy of the draft listing agreement is available here.

New norms for PMS fees

SEBI vide its circular dated October 5, 2010 has streamlined the fees and charges levied by portfolio mangers. This move by SEBI is pursuant to the consultative paper issued by SEBI on the regulation of fees and charges levied by the portfolio managers in July 2010. Through this circular, SEBI has effected the proposed changes in the consultative paper. A brief background and the highlights of the circular are posted below:

Background

Usually in Portfolio Management Services ("PMS") the portfolio manager, pursuant to a contract with the client, advises or directs or undertakes on behalf of the client the management/ administration of a portfolio of securities or the funds of the client. There are two kinds of PMS, namely (i) discretionary PMS and (ii) non-discretionary PMS. A discretionary portfolio manager individually and independently manages the funds of each client in accordance with the needs of the client. A non-discretionary portfolio manager manages the funds in accordance with the directions of the client.

The relationship between the portfolio manager and client including their mutual rights, liabilities and obligations are specified in the agreement between the portfolio manager and the client. Recently SEBI had received complaints from clients relating to fees and charges levied by portfolio managers and upon scrutiny SEBI noticed that the clauses relating to fees and charges in the portfolio manager-client agreement do not always clearly reflect the fees and charges payable by the client. Thus in order to bring about greater uniformity, clarity and transparency with regard to fees and charges, SEBI has come out this circular.

Highlights of the circular

1. Fees charged by portfolio managers to be based on high water mark principle: High water mark is the highest value that the portfolio account has reached. The portfolio manager should charge performance based fee only on increase in portfolio value in excess of the previously achieved high water mark. High water mark principle would be applicable only for discretionary and non-discretionary services and not for advisory services. In case of interim contributions/ withdrawals by clients, performance fees would be charged after appropriately adjusting the high water mark on proportionate basis.

2. Maximum liability of a client towards the portfolio manager limited to his investment with the portfolio manager.

3. Agreement with the client to contain an annexure containing all fees and charges payable to the portfolio manager: This annexure should contain details of levy of all applicable charges on a sample portfolio of Rs.10 lacs over a period of one year. The fees and charges shall be shown for 3 scenarios viz. when the portfolio value increases by 20%, decreases by 20% or remains unchanged.

4. Disputes between the portfolio manager and the client in relation to the fees and charges to be settled through arbitration under the Arbitration and Conciliation Act, 1996.

A copy of the circular is available here.

New rules in relation to trading and dematerialisation of shares

SEBI vide circular SEBI/Cir/ISD/ 1 /2010 dated September 2, 2010 has come out with the following rules in relation to the trading and dematerialization of shares.

50% of non-promoter holding should be in demat form for the shares to be traded in normal segment

At least 50% of non-promoter shares of a company have to be in dematerialized form in order for the shares of that company to be traded in the normal segment of the exchange. If the listed companies do not satisfy the above criteria by October 31 2010, the trading in such shares would be moved to the trade for trade segment (TFT segment) from the normal segment.

This move from SEBI aims at improving volumes and participation of public in trading of shares. Also as the volume increases the possibility of price manipulation comes down as there will be enough liquidity in the stock. There will not be any supply constraint and this reduces the scope for operators to manipulate the price.

“Dematerialization” is a process by which physical certificates are converted into electronic form. According to the Depositories Act, 1996, an investor has the option to hold securities either in physical or electronic form. Part of holding can be in physical form and part in demat form. However, SEBI has notified that settlement of market trades in listed securities should take place only in the demat mode. Under the trade for trade segment, the National Securities Clearing Corporation Ltd (NSCCL) does not undertake clearing and settlement of the deals executed. Primary responsibility of settling these deals rests directly with the members and the exchange only monitors the settlement. The parties are required to report settlement of these deals to the exchange.

Trading to take place in TFT segment for the first 10 trading days in case of merger, demerger, amalgamation, capital reduction/consolidation, scheme of arrangement etc.

In case of companies undergoing merger, demerger, amalgamation, capital reduction/consolidation, scheme of arrangement, in terms of the Companies Act and/or as sanctioned by the Courts, rehabilitation packages approved by the BIFR and Corporate Debt Restructuring (CDR) packages, the trading of shares of such companies would take place in TFT segment for first 10 trading days with applicable price band while keeping the price band open on the first day of trading. This rule will not be applicable to original scrips, on which derivatives products are available, or included in indices on which derivatives products are available. 

A copy of the circular is available here.

Media companies to disclose details of ad-for-equity business

SEBI vide press release PR No.200/2010 dated August 27, 2010 has published the new Press Council of India ("PCI") guidelines for media companies. These guidelines require media companies to disclose the details of the stake held by such media companies in various companies. Disclosures regarding such stake should also be made in the news report/ article/ editorial in newspapers/television relating to the company in which the media group holds such stake. Not surprisingly, the mainstream media in India has abstained from reporting this new requirement from SEBI.

Ad-for-equity business model

Under the ad-for-equity business model a company ("Client") buys ad space in newspaper/ television in lieu of its shares. The Client does not pay cash to the media company but issues its own shares to newspapers (in turn, media company buys equity in the Client). The media company gets paid only when it sells the shares of the Client after a period of time. These agreements between the Client and the media company are usually known as 'Private Treaties'. It has been alleged that apart from ad space in newspaper/ television, these Clients also get editorial (advertorial) coverage in newspapers owned by these media companies.

SEBI and the new disclosure requirements

Earlier this year SEBI had taken up its concerns with PCI, on the practice of many media groups entering Private Treaties with Clients as it felt that such agreements may give rise to conflict of interest and may result in dilution of the independence of press. SEBI also felt that such biased and motivated dissemination of information without appropriate and adequate disclosures, guided by commercial considerations can potentially mislead investors in the securities market and would not be in the interest of securities market.

PCI has accepted the following suggestions of SEBI and has issued the following guidelines vide press release PR/3/10-11/PCI dated August 2, 2010.

1. 
   
   
   Disclosures regarding stake held by the media company should be made in the news report/ article/ editorial in newspapers/television relating to the company in which the media group holds such stake.
2. 
   
   
   Disclosure on percentage of stake held by media groups in various companies under such 'Private Treaties' on the website of media groups should be made.
3. 
   
   
   Any other disclosures relating to such agreements such as any nominee of the media group on the board of directors of the company, any management control or other details which may be required to be disclosed and which may be a potential conflict of interest for media group, should also be mandatorily disclosed.
   
   
   

PCI also has expressed its apprehension that the brand building activities pursuant to Private Treaties without appropriate and adequate disclosures would not be in the interest of securities market.

Issues and challenges

1. 
   
   
   Ensuring strict compliance of these disclosure requirements would be tough task for SEBI as well as PCI. Firstly, it is the PCI, which have issued these guidelines and as such SEBI would have no role in the enforcement of these disclosure requirements. It means that the PCI would have to ensure compliance of these guidelines. The enforcement capabilities of PCI are questionable when compared to the capabilities of SEBI. Secondly, the guidelines merely states that 'the above suggestions may be kept in mind by the media'. Thus these guidelines are just recommendatory in nature. The PCI does not prescribe any penalty for non compliance with these guidelines.
2. 
   
   
   The guidelines have failed to define the scope of media companies. Under the ad-for-equity business model, it may not be necessary that the media company (which runs the newspapers/television channels) itself acquires stake in the Client. It might also be an associate company of the media company which acquires stake in the Client. Thus, in order to ensure full compliance, the disclosure requirements should also be extended to investment by associate companies in the Client.
3. 
   
   
   Apart from the above issues, one may also wonder about the locus standi of SEBI in taking up these issues with PCI. In its press release SEBI has stated that 'such brand building strategies of media groups, without appropriate and adequate disclosures may not be in the interest of investors and financial markets'. In most cases of ad-for-equity business/ Private Treaties, both the media company and the Clients are unlisted. Thus these companies (both media company and the Client) do not possess any threat to the interest of investors or financial markets. If SEBI's aim was to cover companies which may come out with public issues in future, these disclosure requirements should have been made a part of the issue documents/ prospectus.
   
   
   

Existing ad-for-equity business models

The Times Group has a 'Private Treaties' division known as the Times Private Treaties ("TPT"). TPT invests with potential, emerging or established brands with the objective of building brand value by advertising in Bennett, Coleman & Co. Ltd.'s media properties (like ET, ET Now, TOI etc.). Currently TPT has entered into 'Private Treaties' with companies (complete list is available here) including Multi Commodity Exchange of India Ltd., India Infoline Ltd., Artha Money etc. (Source: http://www.timesprivatetreaties.com).

Implications

These guidelines, if fully implemented, would bring in transparency in the reporting of news by media houses. All reports/ news/ editorials published by a media house in relation to a company (who is Client) should be followed by a disclosure that the media company holds a stake in such company (Client) or that the media company has entered into a Private Treaty with such company. This may also restrict the freedom of a media house to criticize a particular stance taken by Regulator (including SEBI) against a company (who is a Client), because the readers may, pursuant to such disclosure, link such criticism with the interest of the media house in the Client.

A copy of the PCI guidelines is available here.

A copy of the SEBI press release is available here.

IOSCO report on Principles for Direct Electronic Access to Markets/ Direct Market Access and the SEBI regulations

What is Direct Electronic Access to Markets/ Direct Market Access?

Direct Market Access ("DMA") is a facility which allows brokers to offer clients direct access to the exchange trading system through the broker's infrastructure without manual intervention by the broker. In different markets, different terminologies are used for DMA. These include 'direct access', 'direct market access', 'pure direct market access', 'intermediated access', and 'sponsored access'. The International Organization for Securities Commission ("IOSCO") calls the DMA arrangement as 'Direct Electronic Access' ("DEA"), and defines it as the process by which a person transmits orders on their own (i.e., without any handling or re-entry by another person) directly into the market's trade matching system for execution.

IOSCO Report on Principles for Direct Electronic Access to Markets

On August 13, 2010, the technical committee of the IOSCO has published the report on the 'Principles for Direct Electronic Access to Markets' – containing principles designed to guide intermediaries, markets and regulators in relation to the areas of pre-conditions for DEA, information flow and adequate systems and controls. This final report is based on analyses of market and regulatory developments and of the responses received to the original consultation report. The report contains eight principles that should govern DEA to markets around the globe. They are as follows:

Principle 1 - Minimum Customer Standards: Intermediaries should require DEA customers to meet minimum standards, including that:

1. Each such DEA customer has appropriate financial resources;
2. Each such DEA customer has appropriate procedures in place to assure that all relevant persons:

• Are both familiar, and comply, with the rules of the market; and
• Have knowledge of and proficiency in the use of the order entry system used by the DEA customer.  

Principle 2 - Legally Binding Agreement: There should be a recorded, legally binding contract between the intermediary and the DEA customer, the nature and detail of which should be appropriate to the nature of the service provided.

Principle 3 - Intermediary's Responsibility for Trades: An intermediary retains ultimate responsibility for all orders under its authority, and for compliance of such orders with all regulatory requirements and market rules.

Principle 4 - Customer Identification: Intermediaries should disclose to market authorities upon request and in a timely manner the identity of their DEA customers in order to facilitate market surveillance.

Principle 5 - Pre and Post-Trade Transparency: Markets should provide member firms with access to relevant pre and post-trade information (on a real time basis) to enable these firms to implement appropriate monitoring and risk management controls.

Principle 6 - Markets: A market should not permit DEA unless there are in place effective systems and controls reasonably designed to enable the management of risk with regard to fair and orderly trading including, in particular, automated pre-trade controls that enable intermediaries to implement appropriate trading limits.

Principle 7 - Intermediaries: Intermediaries (including, as appropriate, clearing firms) should use controls, including automated pre-trade controls, which can limit or prevent a DEA customer from placing an order that exceeds a relevant intermediary's existing position or credit limits.

Principle 8 - Adequacy of Systems: Intermediaries (including clearing firms) should have adequate operational and technical capabilities to manage appropriately the risks posed by DEA.

SEBI regulations in relation to DMA in India

In India, SEBI vide circular MRD/ DoP/SE/Cir- 7 /2008 dated April 03, 2008 has allowed brokers to offer DMA to clients after obtaining permission from the respective stock exchanges. SEBI also stated that stock exchanges can specify from time to time the categories of investors to whom the DMA facility can be extendd. However, initially the permission was restricted to institutional clients.

An analysis of the current SEBI regulations in the light of the IOSCO report reveals that the current SEBI regulations do not fully address issues like minimum customer standards (principle 1 of IOSCO report), customer identification (principle 4 of IOSCO report), pre and post-trade transparency (principle 5 of IOSCO report) and the roles and capabilities of clearing houses (principles 7 and 8 of IOSCO report).

SEBI proposes to double the retail investor’s cap to Rs 2 lakh

SEBI has released a discussing paper which proposes to raise the investment limit for retail investors from the current Rs 1 lakh to Rs 2 lakh. Regulation 2 (1) (ze) of SEBI (ICDR) Regulations, 2009 defines "retail individual investor" to mean an investor who applies or bids for specified securities for a value of not more than one lakh rupees. The discussion paper seeks to increase this limit to two lakh rupees on account of the following reasons:

• SEBI feels that retail individual investors who have the capacity and appetite to apply for securities worth above one lakh rupees were constrained from doing so because of the one lakh limit nor do they make an application under the non institutional investor category because the allocation there is limited to 15% as against 35% for retail individual investor category.
  
• Inconvenience faced by merchant bankers in big offerings to get enough number of retail investors because of the limit of one lakh rupees.
  
• Due to factors like inflation, currently one lakh rupees can buy only lesser number of shares as compared to 2005 (when the one lakh limit was fixed).
  

A copy of the discussion paper is available here.

Norms for investment by mutual funds in derivatives and related disclosures

SEBI vide circular Cir/ IMD/ DF/ 11/ 2010 dated August 18, 2010 has made the following modifications to the rules in relation to the investments by mutual funds in derivatives:

• Regulation 59 of the SEBI (Mutual Funds) Regulations, 1996 (“Regulations”) states that all mutual fund companies should publish half yearly results and it should contain the details as specified in twelfth schedule of the Regulations. As per the twelfth schedule, mutual funds should disclose, any exposure in derivative products for more than 10 per cent of the net assets of any scheme. However, the Regulations did not prescribe a format for this disclosure and as such and the disclosures being made by various mutual funds were not uniform across the industry. Now SEBI, vide this new circular, has prescribed the format and other details for such disclosure. SEBI has also defined the expression ‘exposure in derivatives’ and has also prescribed a manner for computation of the same. 
• The cumulative gross exposure through equity, debt and derivative positions should not exceed 100% of the net assets of the scheme.
• Mutual Funds cannot write options or purchase instruments with embedded written options (derivative instrument against another derivative).
• The total exposure related to option premium paid should be limited to 20% of the net assets of the scheme.
• However mutual funds can enter into plain vanilla interest rate swaps for hedging purposes. The counter party in such transactions has to be an entity recognized as a market maker by RBI. 

The rules will be effective from October 1, 2010 for all new schemes as well as the existing schemes.

A copy of the circular is available here.

The concept of Chinese wall in financial institutions – Part II (SEBI regulations)

The Chinese wall policy, in the context of financial institutions, was introduced in India by the Securities and Exchange Board of India (Insider Trading) (Amendment) Regulations, 2002. These regulations made it mandatory for (i) all listed companies and (ii) other organizations associated with securities markets (financial institutions), to have a Chinese wall policy as a part of their code of internal procedures and conduct (“Internal Code”). It also recognized implementation of a Chinese wall policy as a valid defense against insider trading allegations.

Chinese wall policy as a part of Internal Code

Financial institutions, by virtue of being organizations associated with securities market (broker/ sub-broker, depository participant, clearing/ trading member, merchant banker, custodian etc.) are under an obligation to implement an Internal Code which contains provisions of Chinese wall framework. Regulation 12 of the SEBI (Prohibition of Insider Trading) Regulations, 1992 (“Regulations”) requires such organizations to frame an Internal Code in accordance with the ‘model code’ specified in Schedule I of the Regulations (“Model Code”). The Internal Code should be framed ‘without diluting’ the Model Code prescribed by SEBI and the organizations should adopt appropriate mechanisms and procedure to enforce such Internal Code. Apart from the entities mentioned above, other entities like public financial institutions, all intermediaries registered with SEBI, asset management companies, trustees of mutual fund, self regulatory organizations, stock exchanges and professional firms who assist or advise listed companies are also under the obligation to frame such Internal Code.

The Model Code acts as the basic framework of Chinese wall policy in India, in the context of financial institutions. It contains two parts namely, (i) Part A which contains the model code for listed companies (the title reads as ‘Model code of conduct for prevention of insider trading for listed companies’) and (ii) Part B which contains the model code for organizations associated with securities markets (the title reads as ‘Model code of conduct for prevention of insider trading for other entities’). It appears from the Regulations that if the entity is associated with securities market and is listed, such an entity should implement an Internal Code which is a combination of Part A and Part B.

Part A (Model Code for listed companies)

Clause 2.1 of the Model Code (Part A) for listed companies requires the employees/ directors of such organisations to maintain confidentiality of all price sensitive information. They are prohibited from passing on such information to any person directly or indirectly by way of making a recommendation for the purchase or sale of securities. Clause 2.2.1 states that price sensitive information should be handled on a “need to know” basis. This means that such information should be disclosed only to those within the company who need the information to discharge their duty. Clause 2.3.1 mandates that the files containing confidential information should be kept secure and should have adequate security of login and pass word etc.

Part B (Model Code for other entities)

The Model Code for other entities (Part B) contains, in addition to the above mentioned restrictions under Part A, certain other requirements which details out Chinese wall policy, in further. Clause 2.4 and 4 require the organisation to adopt a "Chinese Wall" policy which separates “inside areas” from “public areas” for preventing the misuse of confidential information. The “inside areas” are defined as those areas of the organization which routinely have access to confidential information and “public areas” are defined as those areas which deal with sales, marketing, investment advise or other departments providing support services. The Regulations stipulates the following measures to be adopted by organizations for separating “inside areas” from “public areas”.

• The employees in the “inside area” should not communicate any price sensitive information to anyone in “public area”.
• The employees in “inside area” may be physically segregated from employees in “public area”.
• Demarcation of the various departments as “inside areas”
• Only in exceptional circumstances, employees from the public areas may be brought "over the wall" and be given access to confidential information on the basis of "need to know" criteria.

The Model Code for other entities (Part B) also requires that securities or shares of a listed company should be put on a “restricted/grey list” while the organization is handling any assignment for such listed company or while preparing appraisal report or while handling credit rating assignments and is privy to price sensitive information. Additionally, any security which is being purchased or sold or is being considered for purchase or sale by the organisation on behalf of its clients/schemes of mutual funds, etc. should also be put on the “restricted / grey list”. The effect of putting/ adding a security on the “restricted / grey list”’ is that any trading in such securities by employees/directors/partners of the organization would require the pre-clearance of trade by compliance officer. As a result of this, trading in these securities may be blocked or may be disallowed at the time of pre-clearance by the compliance officer after taking into account, all the relevant circumstances. This can be explained by way of simple example. If ‘Company A’ (a listed company), appoints ‘Only profit’ (an investment banker/ merchant banker) to find out an investor in ‘Company A’ to fund its new projects. This would be followed by ‘Company A’ sharing confidential information (which may be price sensitive) with ‘Only profit’ for preperation of IM, financial projections etc. In such a case ‘Company A’ would be added to the “restricted/grey list” maintained by the compliance officer of ‘Only profit’ and henceforth any trade made by employees/directors/partners of ‘Only profit’ would require pre-clearance of such trade by compliance officer of ‘Only profit’. The compliance officer would also have the option to restrict such trades, taking into account ‘relevant circumstances’.

In the next post, I will discuss the scope of “Chinese wall policy” as a defense to insider trading.

“The concept of Chinese wall in financial institutions – Part I (origin & mechanisms)” is available here.

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