23 August 2016

Sebi’s move to curb distributors may hurt MF investors - ET

I have a piece in today's Economic Times analysing SEBI's circular seeking to impose particular disclosure norms which are intended to dis-intermediate distributors. While disclosures and expense caps both have existed, the new development will hurt investors rather than help them. Please read the full piece below to see why or click here for the original piece on ET's website:

"A person with surplus money is likely to invest it in four broad classes of assets and investments: Real estate, gold, fixed deposits and other investments.
The last decade has been brutal to nearly all investors. Gold hasn’t performed well except in spurts, real estate has been disappointing.
Ulips and other toxic products which were hard-sold with up to 45% commission would take a decade just to reach the par value. Fixed deposits provided an optical illusion, with high inflation, they mainly yielded negative real returns.
The only real investment which has consistently delivered, over any 3-year or longer period after all expenses, has been equity mutual funds.

An investor is free to invest directly in the stock market, or free to pay a fee to a mutual fund for managing his money. Similarly, an investor is free to directly invest in a mutual fund or invest through a distributor.
Market regulator Sebi provides a cap on the total fees chargeable by mutual funds to the investor. This has prevented creation and sale of toxic mutual funds.
Sebi’s circular effective October mandates disclosure of absolute amounts, instead of percentage, of commissions paid by funds to distributors. It also obligates the disclosure of the expense ratio of the fund where a distributor is involved and where it is a direct sale. These appear at flush blush to improve transparency, but will push investors away from mutual fund investments.
Firstly, the disclosure of commission in absolute number for investments is likely to overstate the commission in later years.
For a distributor, investment advice, fulfilling suitability, KYC norms, cost of travelling and selling to the investor and other costs are incurred in the first year and the benefits are usually paid by way of trail commissions over many years.
Sebi has encouraged this underpayment initially with emphasis on the ‘trail’ as being useful for the cause of longterm investment. Clearly, the investor will be unhappy seeing a commission paid in year 5 when little service is provided.
Secondly, showing the expense of a direct plan versus showing the expense of a distributed plan every six months will goad the investor into believing the two products are identical and he is wasting money on the distributed plan. A distributor is no longer merely an agent of the fund as Sebi has imposed specific KYC and suitability norms on the distributor.
Thus pushing an investor away from the distributor is likely to push the investor away from the most suitable products. The average small retail investor in the absence of proper advice may buy over-risky products because they seem to produce better returns or buy under-risky product resulting in low income.
Of course, a sophisticated investor does not need a distributor, but the number of sophisticated retail investors is quite limited. Sebi has already made sufficient disclosures mandatory showing the different expense ratios between direct and distributed plans.
Thirdly, many costs are attached with creating a mutual fund product including asset management fees, trustee fees, registrar and transfer agent fees, legal and audit fees, advertisement and Sebi fees. It is unclear why only one of them is deemed important from a disclosure perspective, except to push a dis-intermediated model.

Finally, the real danger of a dis-intermediated model is this. Only 11% of equity funds are sold directly, the balance nearly 90% is sold through distributors. These distributors travel through smaller cities, or spread the message through bank branches and are spreading the word of the relatively safe, high-return investment with a small and capped expense ratio.
If these distributors are dis-intermediated, what will happen will be not sale of lower cost mutual funds as Sebi is aiming. But rather investors will move away to other push products like Ulips, which are toxic, fixed deposits, which post inflation reduce wealth, or non-productive assets like land and gold.
If India wants to build its equity markets, build its infrastructure, build a productive industry which requires capital, it must seek full disclosure and cap on fees as Sebi has rightly done till now, but it should not physically seek to dis-intermediate distributors. That will hurt most the investors, the regulator seeks to protect."

01 August 2016

Courts might hold guaranteed return of capital clause invalid - Business Standard

I have a piece in today's Business Standard on the Tata-Docomo dispute. Here is the link and below is the full piece:

The Tata Docomo deal poses one of the most interesting conundrums from a legal perspective. This piece is based on the broad contours of the arguments in public domain. And as a lawyer, I may disclaim my views on seeing the definitive agreement between the two. Broadly the issue is that Tata and Docomo entered into an agreement where Docomo invested in Tata’s telecom business. The agreement was signed with a clause guaranteeing at least 50% return of (rather than on) capital in case the company did not do well. While ordinarily, contracts are enforceable, this one had two legal issues.

The first was that for a foreign investor, RBI permits investment in Indian companies through equity or debt route. The debt route is quite restrictive and the equity rather liberal. The foreign exchange Act, FEMA, and RBI’s position on FEMA is that if you make an equity investment, you cannot get a guaranteed return on or of capital. In fact, if you so choose, the equity investment must come as debt and relevant regulations with respect to lending by a foreign entity would kick in. Tata and Docomo did not term it a debt issuance and therefore the investment was valid, but the condition guaranteeing return of capital was not.

The second issue is an old circular under the Securities Contracts (Regulations) Act which prohibits puts and calls in contracts in public companies. The rigour of the circular is now diluted, but it was a broader prohibition then.

While the Supreme Court has in case after case reduced the possibility of court intervention where an arbitral tribunal has passed an order, this may well be a case where courts may hold the clause in the agreement as being invalid. The twist in the tale is that Tata seems to support the payment while RBI is opposing the same. Ultimately, the case will likely take many twists and turns before finally getting decided in the Supreme Court. 

02 June 2016

Reforms at SEBI - my interview for cover story of Dalal Street Investment Journal

I was interviewed by the Dalal Street Investment Journal on the performance of SEBI till now and the future of the regulatory framework of the securities markets.

Below is the full interview:

01 June 2016

Fraud, Manipulation and Insider Trading in the Indian Securities Markets - 2nd Edition

Really excited to see (I don't have a copy with me yet) the 2nd Edition of my book "Fraud, Manipulation and Insider Trading in the Indian Securities Markets". It is now in hardcover and available online.

Thanks due to Mr. Damodaran for his foreward and kind words of praise for the 1st Edition from Mr. Fali Nariman, Senior Counsel, Mr. Ashish Chauhan, CEO of BSE, Mr. Janak Dwarkadas, Senior Counsel and Prof. Umakanth, National University of Singapore. Special thanks also to Monika Halan and PR Ramesh for reviewing the previous book in magazines.

You can buy a copy or review the contents by clicking here.

26 May 2016

Financial sector reforms: Move faster, sooner - Economic Times

I have a piece in today's Economic Times on the financial sector reforms in the two years of Modi rule and the way forward for the balance three years. Posted below is the full piece and here is the link to the original.

Financial sector reforms: Move faster, sooner

India’s financial sector and its regulators have much to be pleased about, though not enough to be complacent about. To start with, the RBI has always had a formidable reputation as a central banker. On the Sebi front, a World Bank ease of doing business study placed India at the 8th rank on investor protection. Incidentally, that was the only metric on which India performed in the top ten.
Archimedes said “give me a lever long enough and a fulcrum on which to place it, and I shall move the world”. The financial sector can be India’s lever and the regulators the fulcrum to improve the Indian economy by providing easier capital resulting in a Cambrian explosion of productivity and growth. The past two years have seen some significant changes in the financial regulatory structure.
The most dramatic of the changes, which will cast long shadows was the merger of the forward commodities futures regulator, with the securities regulator, Sebi. The merger has brought about significant improvements in the quality of regulation. The government should push for a more unified regulator with insurance, pension and even banking, falling under Sebi’s domain. This will prevent Sahara like problems arising out of regulatory gaps or turf fights like those seen between Sebi and the insurance regulator.
Significant reforms have been carried out in liberalising limits of foreign investments in areas such as insurance, defence, and railways. The FIPB is sought to be abolished.
The move would reduce pointless bureaucratic hurdles in foreign investments and unnecessary movement of files between three ministries and one or more financial regulators. More liberalisation in sectors would be key to further investments and draining the swamp of unnecessary procedure and multiple bodies should be the next important step.
The Jan Dhan Yojana has been a significant and impactful first step in financial inclusion. The objective to bank more people can be furthered with a removal of the requirement of ‘address proof’ which unnecessarily bars mobile citizens from opening bank accounts even though they have identity proofs. When I first moved to Ahmedabad to teach at IIM, I was unable to open a bank account for this reason. Imagine the plight of the uneducated and the poor.
The recent efforts to do away with tax havens and double nontax treaties is a tough step, which was long overdue and will end the apartheid against domestic investors. This should be carried to its logical conclusion and all investors, foreign or domestic should be treated fairly.
We need to improve the markets of corporate debt, securitisation, real estate trusts, infrastructure trusts for the development of India’s infrastructure. Similarly, developing the alternative investment fund market, currently pygmy-sized, would develop domestic investment of money which will go into productive use. Nearly 99% of the problems in all these areas relate to direct taxes or stamp duty.
The recent Narayana Murthy report constituted by Sebi hardly had any reform suggestions for the regulator — they were nearly all tax issues.
Finally, being able to raise capital is no good unless that capital is well deployed and the ease of doing business is improved with fewer permissions, forms and bureaucracy. That includes the modern ‘right to die’ for companies sought to be introduced by the new bankruptcy code.

12 May 2016

Mauritius tax treaty: A right move at an appropriate time

I have an opinion piece in today's Mint newspaper on how the use of tax treaties to skip taxes needed to go and how this government introduced the 'protocol' amending the old treaty with the right words, a smooth non disruptive transition and the best time in recent times for introducing it. Not only is the move right, it has virtually not moved the market (based on of course a two day record). I argue that capital importing countries tax source income while capital exporting countries tax global income of residents. Both are designed to maximise tax and India will be wrong to copy the western model. In fact I point out that even the western countries, though usually adopting the residency model, opportunistically switch to the source based model for real estate deals by foreigners. This is because foreigners often buy real estate in London, New York and Paris and these countries again act rationally in their self interest. I conclude by saying that the effective repeal of abusive treaties should be welcome by even foreign investors who will see better investments in infrastructure through their tax dollars. Here is the link to the original piece and pasted below is the full article:

"My first class on taxes in the early 1990s started with the professor telling the class “there is no equity in tax, there is no logic in tax, do not seek either”. I was not convinced, I’m not convinced still. The fundamentals of fairness and equity surround the entire ecology of rule of law and there is no reason taxation principles should live wholly outside that.
The power to tax, based on the legislative process, is an expression of national sovereignty. Two forms of taxation exist worldwide for income based in another country. The first is the “residence-based taxation”. Countries applying such a principle tax their residents on their worldwide income, wherever derived. The second is “source-based taxation” where tax income is derived from sources in their territory, regardless of the residence of the person deriving the income. Most countries apply a combination of residence-based and source-based taxation.
According to a UN paper (UNCTAD), double taxation most often occurs when both the source country and the country of residence concurrently exercise their taxing right without providing full relief for the other country’s tax. Countries enter into double tax treaties to minimize the double taxation arising out of this intersection and the resulting unfairness.
In this world, view of minimizing unfairness out of overtaxing, there is really no space for maximizing unfairness which arises out of use of tax havens to pay no tax anywhere. Secondly, in the world where Indians pay tax on capital gains, given that we are primarily a source-based tax system, it is apartheid for foreign residents to pay no taxes.
Thirdly, the gain occurs primarily in dubious cases. Where a resident, for example of the US, invests in India via Mauritius, the resident ends up paying zero tax in India but up to 50% tax in the US. If Mauritius were not placed between the countries, the Indo-US tax treaty would more evenly divide the tax between India and US.
In other words, Mauritius is a route for transferring India taxpayer money to the US government. These are the non-dubious cases. Dubious cases are where the profit is milked in the tax haven and the beneficiary is a resident of another tax haven. In other words, the profits are all secreted out and neither India nor US will get to tax. Fourth, the opacity of using tax havens means they are a breeding ground for parking bribe money, circulating money laundering proceeds or other movements of international crime money. Panama.
Most Western countries are capital exporting countries and therefore they maximize their revenues by charging their residents for global income rather than bothering about the source income. However, they impose source-based tax on sale of real estate as foreign investors often end up buying local real estate. So foreign investors in their shares, though not in property, are typically exempt. They use the residence test in their self interest, except when it doesn’t suit them.
Conversely, capital hungry countries like India do not deploy much money overseas and rather attract foreign capital. We use source-based income test as it will maximize our sovereign tax collections. Indeed, there are several countries in the West which tax source-based income of gains in their territory, for instance Spain and Israel. This is rational self-interest of India and there is no use copying Western countries which are doing what is in their self-interest.
No matter which way you cut it, unfairness of double taxation is never an excuse for encouraging tax havens. The provision of an anti-abuse provision has been in the works for many years and has been sought to be implemented with effect from 2017. This information of Mauritius going away as a haven has been in the works for a long time and foreign investors in fact would have seen it coming.
Secondly, in these relatively happy times for India, this is a good time to introduce a small tax (mainly on unlisted securities, as listed securities held for a year are exempt), on the outsized returns foreign investors can expect.
Thirdly, the announcement detracts from a sudden change in taxation and grandfathers all investments made till next year and is an added benefit and a shock absorber rather than an announcement for taking away a benefit.
The anti-apartheid law should be welcomed by all, even foreign investors whose tax will help make the infrastructure to further improve their post-tax return."

03 May 2016

3rd Annual Roundtable of Finsec Law Advisors

Finsec Law Advisors and the Association for Development of Securities Market (ADSM) proudly hosted its third roundtable on the 29th of April 2016. This year the focus was on Institutional Investors.  We were also happy to team up with Institutional Investor Advisory Services India Limited (IiAS) and the event was solely sponsored by BSE Ltd.

Investor protection is as crucial for sophisticated institutional investors as for retail investors. Although the tenets of investor protection may differ in range and tenor, an active and informed institutional investor not only safeguards its interests better but can also contribute towards better corporate governance and shareholder value.

The objective of the Roundtable was to bring together financial market experts and
decision makers within the industry and academia for an active, face-to-face discussion on key issues faced by institutional investors in the Indian capital market. The Roundtable, though moderated, took place without a centre of gravity and the wisdom from the discussions will result in an approach papers on issues discussed, which will be shared with policy makers.