Put/Call Options & Mandatory Buyback are invalid

SEBI's has recently issued an informal guidance stating that a pre-agreed buyback of shares from an investor through put/call option is not legal/valid under the Securities Contracts (Regulation) Act, 1956 ("SCRA"). SEBI has stated that since these options would be exercised on a future date, such transactions would not qualify as spot delivery contracts as defined in section 2(i) of SCRA. These put/call options would not qualify as valid derivative contracts as per section 18A of the SCRA as these are exclusively entered into between two parties and not traded on stock exchanges and settled on the clearing house of the recognised stock exchanges. This informal guidance from SEBI reaffirms the view taken by it in Vedanta-Cairn deal wherein it repudiated the call/put/pre-emptive rights in their share purchase agreement citing its illegality.

Repeated buy-back offers not to be encouraged: SEBI

SEBI has in its recent order, allowing the Deccan Chronicle Holdings Limited (“Deccan Chronicle”) to buy-back 3.45 crore shares, stated that “repeated buy-back offers by a company is not something that SEBI, as a regulator, would like to encourage, given the fact that it could be misused by entities to consolidate their holding at the expense of the company”. This was the second time in the last two years that Deccan Chronicle had sought the permission of SEBI for exemption from the requirements of Takeover Code to come out with an offer to buy-back its shares. In July 2009 SEBI had granted Deccan Chronicle exemption from the requirements under the Takeover Code for increasing its voting rights from 63% to 73.51% pursuant to buy-back offer proposed by the target company. Thereafter, the target company had made the buy-back offer during August, 2009, wherein 4.84% of the total voting capital of the target company was bought back. In the present case, the Promoters again sought exemption from the requirements under the Takeover Code for increasing their voting rights from 63.37% to 73.83% (assuming 100% response) pursuant to buy-back offer proposed by the target company. SEBI vide its order dated 15 April 2011 granted Deccan Chronicle Holdings exemption from the requirements under the Takeover Code for the second proposed buy back of shares. However SEBI directed Deccan Chronicle not to seek any further exemption pursuant to any further buy-back offers by the target company. SEBI also stated that repeated buyback offers could be misused by acquires to consolidate their holding at the expense of the company and this is not something that SEBI, as a regulator, would like to encourage.

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.

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.

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.

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.

SEBI postpones the deadline for implementing new valuation norms

SEBI vide circular Cir/IMD/DF/4/2010 dated June 21, 2010 has postponed the deadline for implementing new norms for valuation of mutual fund houses’ debt and money market instruments. The norms would be applicable from August 1, 2010 as opposed to the old deadline of July 1, 2010.


Earlier this year, SEBI had modified the provisions related to the valuation of debt and money market instruments by mutual fund houses (covered in this blog here).

A copy of the circular is available here.

SEBI amends master circular on AML/CFT

SEBI vide circular CIR/ISD/AML/2/2010 dated June 14, 2010 has amended the master circular on Anti Money Laundering (“AML”) Standards/Combating Financing of Terrorism (“CFT”). The major changes are as follows:

1. The scope of Customer Due Diligence (“CDD”) done by Registered Intermediaries (“RIs”) has been increased to include the periodic updation of all documents, data or information of all clients and beneficial owners (“CDD Data”) collected under the CDD process. However SEBI has not prescribed the frequency for such updation of the CDD Data or any triggers which would require the updation of the CDD Data.

2. It has been clarified that the internal audit function in RIs should be independent, adequately resourced and commensurate with the size of business and operations, organization structure, number of clients and other such factors.

3. RIs should revisit their CDD process (customer acceptance policies and other customer profiling policies) when there are suspicions of money laundering or financing of terrorism (“ML/FT”).

4. Usually RIs adopt simplified customer due diligence process for lower risk categories of customers. However SEBI has now clarified that low risk provisions should not apply when there are suspicions of ML/FT or when other factors give rise to a belief that the customer does not in fact pose a low risk.

5. RIs should independently access and consider publicly available information other than the Financial Action Task Force statements while dealing with clients in high risk countries.

6. SEBI has enhanced the CDD measures to determine whether a client/ potential client/customer is a politically exposed person.

7. As per the current regulations RIs should maintain the records of the identity of clients for a period of 10 years from the date of cessation of transactions between the client and RI. It has been clarified that the “date of cessation of transactions” would mean the “date of termination of an account or business relationship”.

8. SEBI has clarified that the prohibition against the ‘tipping off’ of the filing of Suspicious Transactions Reports (“STR”) by any officers of the RIs to the clients would extend not only to the filing of the STR and/or related information but even before, during and after the submission of an STR.

A copy of the circular is available here.

Public shareholding in listed companies to be 25%

The Government has notified the Securities Contracts (Regulation) (Amendment) Rules, 2010 with effect from 4 June 2010. The salient features of this amendment rules are the following:

a) The minimum threshold level of public holding will be 25% for all listed companies.

b) Existing listed companies having less than 25% public holding have to reach the minimum 25% level by an annual addition of not less than 5% to public holding.

c) For new listing, if the post issue capital of the company calculated at offer price is more than Rs. 4000 crore, the company may be allowed to go public with 10% public shareholding and comply with the 25% public shareholding requirement by increasing its public shareholding by at least 5% per annum.

d) For companies whose draft offer document is pending with Securities and Exchange Board of India on or before these amendments are required to comply with 25% public shareholding requirement by increasing its public shareholding by at least 5% per annum, irrespective of the amount of post issue capital of the company calculated at offer price.

e) A company may increase its public shareholding by less than 5% in a year if such increase brings its public shareholding to the level of 25% in that year.

f) The requirement for continuous listing will be the same as the conditions for initial listing.

g) Every listed company shall maintain public shareholding of at least 25%. If the public shareholding in a listed company falls below 25% at any time, such company shall bring the public shareholding to 25% within a maximum period of 12 months from the date of such fall.

h) ‘Public shareholding’ does not include shares which are held by custodian against depository receipts issued overseas like ADRs and GDRs.


A copy of the rules is available here.

SEBI guidelines for credit rating agencies

SEBI vide CIR/MIRSD/CRA/6/2010 dated May 3, 2010 has provided for certain transparency and disclosure norms for the Credit Rating Agencies (“CRAs”). The major measures taken in this regard are summarized below:

1. CRAs should maintain records of the rating committee, including voting details and notes of dissent, for a period of five years.
2. It has been made mandatory for CRAs to publish information about the historical default rates of their rating categories and whether the default rates of these categories have changed over time.
3. CRAs should ensure that its analysts do not participate in any kind of marketing and business development, including negotiations of fees with the issuer whose securities are being rated. Also, the employees involved in the credit rating process and their dependants cannot own shares of the issuer.
4. CRAs while rating structured finance products, are barred from providing consultancy or advisory services regarding the design of the structured finance instrument. This prohibition would apply to the subsidiaries of CRAs too. While publishing the ratings of structured finance products and their movements, CRAs apart from following all the applicable requirements in case of non-structured ratings should also disclose the track record of the originator and details of nature of underlying assets while assigning the credit rating.
5. In case of unsolicited credit ratings (the credit ratings not arising out of the agreement between the CRAs and the issuer), credit rating symbol should be accompanied by the word “UNSOLICITED” in the same font size.
6. CRAs should also disclose (i) the policies, methodology and procedures in detail followed by them regarding solicited and unsolicited credit ratings, (ii) the history of credit rating of all outstanding securities, (iii) the general nature of its compensation arrangements with the issuers and (iii) the details of any relationship it has with the issuer whose securities are being rated and any of its associate of such issuer and the CRAs or its subsidiaries.

SEBI commented that the recent events in global financial system have underlined the pivotal role that credit ratings play. Effective use of credit ratings by the users is crucially dependent upon quality and quantity of disclosures made by the CRAs. Reserve Bank of India had recently published two documents which review the role of CRAs in India.

A copy of the circular is available here.

SEBI permits derivative contracts on volatility index

SEBI vide circular CIR/DNPD/ 1 /2010 dated April 27, 2010 has permitted stock exchanges to introduce derivative contracts on volatility index like the Volatility Index (“VIX India”) of National Stock Exchange (“NSE’). The derivative contracts introduced on volatility index are subject to the following conditions:

(a) The underlying volatility index has a track record of at least one year.
(b) The exchange has in place the appropriate risk management framework for such derivative contracts.

SEBI also has asked stock exchanges to file details like contract specifications, position and exercise limits, margins, the economic purpose it is intended to serve, likely contribution to market development etc. to SEBI before introduction of such derivative contracts.

Earlier in January 2008, SEBI has permitted stock exchanges to adopt any of the volatility index computation models available globally or develop their own model for computation of volatility index. Last month SEBI has permitted in principle the introduction of derivative contracts on volatility indexes.

Volatility Index is a measure of market’s expectation of volatility over the near term. Volatility is often described as the “rate and magnitude of changes in prices” and in finance often referred to as risk. Volatility Index is a measure, of the amount by which an underlying Index is expected to fluctuate, in the near term, (calculated as annualised volatility, denoted in percentage e.g. 20%) based on the order book of the underlying index options. Currently, only the NSE has the Volatility Index, called India VIX. NSE has introduced this index in April 2008.

A copy of the circular is available here.

Indicative timelines for the proposed issue process

SEBI vide circular CIR/CFD/DIL/3/2010 dated April 22, 2010 has issued the indicative timelines for various activities in the proposed issue process, wherein the time period between issue closure and listing is reduced to 12 working days. Earlier on April 6, 2010 SEBI had decided to reduce the time period between issue closure and listing to 12 working days from the current 22 days for public issues opening on or after May 1, 2010.

A copy of the circular is available here.