28 November 2017

Control Alt Delete for Promoters

I have a piece in today's FE - why the insolvency ordinance was a necessary moral imperative and unnecessary economic analysis will take us off track - linked here. The full piece is reproduced below:

The ordinance, by cutting the rot, will allow early but small failures, while penalising promoters who wait too long in the hope of being bailed out.

The greatest philosopher, who almost no one has read, Immanuel Kant, spoke about the categorical or moral imperative. He discussed the imperative as a principle of reason, which was an unconditional obligation to do the right thing regardless of our will or desires. The insolvency ordinance should also be seen from this perspective, ignoring a strictly economic explanation of the best financial outcome. In summary, the government brought out an ordinance which would debar promoters or rather former promoters from becoming buyers of their erstwhile company. In its own words, the government’s objective is “to keep-out such persons who have wilfully defaulted, are associated with non-performing assets, or are habitually non-compliant and, therefore, are likely to be a risk to successful resolution of insolvency of a company” and “to impose restrictions for such persons to participate in the resolution or liquidation process.”
In brief, the ordinance bars wilful defaulters, undischarged insolvents, persons convicted of an offence with over two-year imprisonment, individuals disqualified as directors under the Companies Act, persons banned by SEBI from securities market and persons banned under insolvency law for fraudulent activities. It also bars a person who executed enforceable guarantee in favour of a creditor in respect of an insolvent entity and promoters or sister concerns of companies with non-performing assets of more than one year. While few can quarrel with the first list even though the concept of wilful defaulter is not well-articulated by the central bank, it is the second list that has caused controversy. Should failed promoters be ineligible to purchase shares of the company they sank, however innocently? Should guarantors who guaranteed loan repayment be debarred from bidding for bad assets?
To give the context, we have lived in a decade where outrageous loans were made. While at it, both lenders and borrowers enjoyed the Omerta Code of keeping defaults very private. At help was a section of the RBI Act that seemed to support the dark web where the public was kept in the dark about the stratospheric debt of companies most of us had not even heard of. Clearly, RBI has not heard of the Right to Information Act. How many of us know that Bhushan Steel had a debt of `50,000 crore? Many loans were clearly crony capitalism at play. Many were just poor investment decisions in industries which bled because of macroeconomic conditions or global pricing pressures or even domestic competitiveness issues. With a decade since many were made, it is difficult to figure which ones were the crony offerings and which ones were genuine business failures.
In a court of law, this would be a near-impossible hypothesis to prove, whether or not, in a given case, bribes or other benefits were the cause of the loans. Even in the event of business failures, there is very little cause for letting the rot set so deep that hardly anything is salvageable in many of these companies. Imagine you or me getting a car loan which, after three years, is ten times the value of the car. It wouldn’t happen, so why did it happen when there were many more zeros involved and the degree of scrutiny ought to have been higher? Genuine business failure is no justification for being asleep on the wheel so long that the value of the loan exceeds the value of the asset by many times. It was almost as if the lenders thought that, by efflux of time, the rust will vanish.
This experience is so different from your and my experiences as borrowers. Not only would we not get more than the value of the car or house, but in the case of a depreciating asset, the cover would always comfortably exceed the due as on that date. Add to this, no one’s experience on a debt forgiveness of even a single rupee by a single month for our personal loans, and add to that the potent cocktail of justifiable outrage that it wasn’t bankers’ money that has been used to bail out such companies through haircuts. It was taxpayers’ money directly and depositors’ money indirectly, in terms of lower deposit rates on savings accounts. Contrary to what economists have convinced us, we live in a society rather than in an economy. And individual and societal outrage at this loss is both necessary and justified.
Yes, commentators have seen this from an economic lens and have argued against the introduction of a restriction on grounds of economic efficiency. Yes, the ordinance is a blunt tool. Yes, it will have the unintended effect of reduced salvage value. Yes, it will be challenged, like all laws which have a big financial impact. Yes, it will be unfair to some promoters who have failed, but want a second chance, while at the same time offering the most money to bankers and lenders. But seen from a moral or political lens, the ordinance makes a lot of sense. People’s sense of unfairness at fat cats buying houses abroad while their companies default in India needed to be resolved.
Similarly, going forward, the moral hazard of taxpayers paying the bills of failed or corrupt businessmen will reduce. And companies which needed to be laid to rest will finally be laid into the crematorium and the endless wait for the rust to vanish on its own, monsoon after monsoon, will also go away. Failing companies will be resolved within a year of the downslide, minimising the damage to lenders and equity shareholders alike. As a good entrepreneur would tell us, failing often is not the key to success, but failing small and early might be. The ordinance, by cutting the rot early, will allow early but small failures, while penalising promoters who wait too long either in the hope of being bailed out or based on unreal hope. India will see a new age of businesses from the ashes of the dead and this creative destruction will make India more competitive.
Ultimately, we should not underestimate the power of creative destruction. As I read at a reserve forest which saw several forest fires each year, “the forces of creation are at least as powerful as those of destruction.” I am also hopeful that an unintended benefit of this whole process will be a wider-held shareholding taking root in India rather than the promoter-driven model. That can have significant upsides in terms of better and more professional governance of Indian companies which are larger and more competitive. Yes, your and my outrage has helped bring this ordinance and our continuing outrage should ensure that public loot and imprudent lending does not continue. At this stage, our moral thirst is more than our economic thirst. That is for the present. With the ordinance, expect behavioural changes so that both the moral and economic thirsts are quenched simultaneously in the future. What is good for a car loan should be good for industry loan as well.

23 November 2017

Finsec Law Advisor recognised as the highest ranked law fim in financial services regulatory practice

We are pleased to announce that our firm, Finsec Law Advisors, has been recognised as the highest ranked law firm in India for Financial Services Regulatory practice by Asialaw Profiles 2018*. We have also been recommended in the Investment Funds practice and several other areas, details of which can be accessed at Asialaw.com

Getting this recognition from a Euromoney publication in our 7th year of existence - ahead of peers many times our size, truly humbles us. We are grateful to all our clients and well-wishers for their kind support to a relatively young specialist firm.

We take this opportunity to thank everyone who was part of this journey.

*Asialaw Profiles is published annually by the Euromoney publications and serves as the guide to Asia-Pacific's leading domestic and regional law firms. The annual rankings are primarily based on independent market survey and feedback received from other legal practitioners and clients.

12 October 2017

The Kotak panel on corporate governance should separate best practices from mandatory provisions

I have an op-ed piece in today's The Economic Times where I argue that implementing the Kotak Committee report on Corporate Governance should be proceeded with extreme caution and most recommendations should be implemented as best practices rather than new legal provisions. The piece is linked here.  The full article is also reproduced below:

You would be forgiven for thinking this is a parallel universe. A core private sector committee instituted by the Securities and Exchange Board of India (Sebi) is advocating stringent new corporate governance norms. And, bureaucrats are opposing it on grounds of ease of doing business.

For that reason, in a blind test, the Kotak Committee report on corporate governance could easily pass as drafted entirely by career regulators. The committee seeks to order a firm control over corporate India, which has often careened off its ideal highway. A fiat — or positivist law, in jurisprudence jargon — relies on the command followed by sanction in the event of disobedience. By contrast, best practices set non-mandatory targets, which have the benefit of flexibility.

This distinction is very different from the ‘rule-based vs principle-based’ debate many have engaged in over the last decade. The clearest example of the former is the listing regulations of Sebi. The best example of the latter is the ‘comply-or-explain’ provisions relating to Corporate Social Responsibility (CSR).

Before discussing the report, it is useful to remember that the influence of the board in driving a company is limited, even in the fragmented ownership model of the US and Britain. And this is not based on some ‘left-leaning’ opinion, but on a detailed study by that flag-bearer of capitalist thought, McKinsey. Only 10 per cent of directors surveyed felt that they fully understood the industry dynamics in which their company operated. Similarly, what is seen as a slam dunk in the report — that a split role between chairman and managing director (MD) is the best board structure — is based on the premise that there ought to be an alternate power centre.

However, the reality is more complex. There are companies where a chairman ought to also be the MD, as it requires an army-like commandand-control structure. Additionally, both leading corporate battles and corporate governance battles in the last year revolved around two power centres. This caused problems in functioning of the companies involved. So, there is significant downside to a split role.

Similarly, it isn’t clear whether mandating a woman director on the board alone is good enough. The woman director should, according to the norms, be an independent director (ID), under 70, and be paid, broadly, a minimum of Rs 50,000 for each meeting. Such level of detail is too intrusive.

In the Bored Room
Combined with incorporating these into a sanction-based law, this would mean a company and its directors not following any of the ‘ands’ would, in theory, be in violation of the law with collective and individual liability. The contrast couldn’t be more stark with the fact recently reported in ET that 40 per cent of the listed companies are not even in compliance with the womanon-board provision.
Ideally, some of the provisions should indeed have the force and mandate of law followed by penal consequences for their violation. These include having an independent director for the quorum of board meetings, limiting the directorship and committee memberships, introduction of declaration of true independence, introduction of the concept of lead ID with specific enabling roles, enhanced scrutiny of material subsidiary’s fund utilisation, enhanced monitoring of group companies, enhanced scrutiny and disclosure of related-party transactions, introducing transparency in ownership of global depositary receipts in Indian companies, full disclosure of credit rating assigned to securities, various enhanced disclosures and bringing chartered accountants under the purview of Sebi.

Some of the provisions, which require to be segregated into a ‘complyor-explain’ code of conduct include increasing the minimum size of the board to six from three, introducing a matrix of competence for directors, having a minimum number of five board and audit committee meetings from the earlier four, introducing an annual update programme for directors, a formal meeting between non-executive directors and senior management, splitting the chairman’s role from the managing director’s, formal training of IDs every five years, enhancing the role of the Nomination and Remuneration committee and the Stakeholder Relationship Committee, and introduction of a stewardship code.

Essentially, the segregation is based on whether violating the provisions should be met with a penalty of Rs 1 crore and a jail sentence of up to 10 years. Additionally, not every listed company is necessarily complex, requiring the same standards. For less complex companies, a single rigid rule would harm their ease of doing business.

However, even for those companies, setting best practices would set a good standard for corporate hygiene, so long as it is not immediately to be met with serious penalty. Many of the recommendations would also cause private companies to remain private, because the next Mark Zuckerberg of India is not likely to hand over control to a group of admittedly non-expert outsiders.

Inconvenient Directors
Some of the items discussed should be not be implemented as presented. These include putting a minimum compensation for IDs, or maximum compensation for executive directors, amendments to insider trading norms (which require a complete relook, rather than amending a part) and promoter reclassification (which also requires a complete relook).

Finally, the items missing from the report are the significant learnings from the Tata and Infosys governance fiascos and could have been specifically introduced. For instance, enhanced protection from removal of ‘inconvenient’ IDs.

11 August 2017

Shell Shocked - courtesy SEBI

I have a piece in the Business Standard in the all too familiar case of the 331 'shell' companies - passed by SEBI. I argue why the order should not have been passed. The article is linked here (paywalled) and the full text is as below.

We know from the Securities and Exchange Board of India (Sebi) circular that the Ministry of Corporate Affairs (MCA) forwarded a list of 331 companies (presumably listed ones from a larger list) to the market regulator on June 9, 2017 to take necessary action. On August 7, Sebi forwarded this list to the exchanges. We know that Sebi has not reviewed this list because the two numbers are identical — 331. Sebi has asked the exchanges to take the following action: To halt trading in the companies except once a month. Price traded can only go down and not up. People will need to pay 200 per cent of the agreed price and the extra amount to remain blocked for five months. The directors and promoters of these companies can buy shares only after exchange permission and cannot sell shares. The exchange to appoint auditors and forensic auditors to assess these companies. If found not to have proper “credentials”, exchanges should initiate delisting those companies.
Now this looks like harsh but swift and just action against presumable money launderers without giving them time to scoot. Only it’s not. So why is the order wrong?

First, it is clear from the Sebi circular that the MCA itself “suspects” these to be shell companies and in bureaucratese, the ministry had asked the market regulator to take “necessary action”. That really is code for, “we don’t know if being a shell company is a problem, but if it violates securities laws, you know best what action, if any, to take”, and also “we aren’t even sure these are shell companies”. Sebi has misread that routine letter to mean let’s behead these companies immediately.

Second, there appears no law in India which says being a “shell company” is an offence or violation of any law, leave alone the securities law. The Companies Act prescribes striking off a company where it has not been in operation for over two years after giving notice to the company and an exception to that provision is in fact listed companies. Besides striking the name of a company is not a penal provision, but more of a clean-up of defunct companies.

Third, many companies indeed shut their operations because their business is no longer viable. Anyone who has visited mid-town Mumbai has seen first hand, the hundreds of acres of textile land, which remained idle from the 1980s till they discovered value in the 2000s as commercial office plots. In other words, there are many listed companies which are no longer operating, but may have valuable assets which are owned by it. These companies are neither criminal in nature nor are they presumptively violating any laws, so long as they comply with their disclosure and listing norms among other laws.

Fourth, the outsourcing of regulatory work is also somewhat troubling. The MCA had some information, which we now know is not even fully accurate, of companies which suffered from the crime of being “shelly”. Its letter to Sebi with the names has been converted into a final order of the market regulator to be executed by the outsourced agency of exchanges. They in turn have been asked to outsource investigation to private auditors and forensic auditors. This is not only problematic because of privatisation of core regulatory function of investigation, but also because they have provided a provision for further enhancement of penalty if they cannot “verif[y]..the credentials/fundamentals” without reference to the regulator. Note again that the enhanced penalty is supposed to be imposed not for any violation of the law but for the high crime of not having credentials/fundamentals.

Fifth, Sebi has found a way to penalise companies, but has not provided for an exit from the harsh provisions. Say for some reason, the so called shell companies can immediately prove that they are not shell companies, or the shell companies can show that they are not operating companies but not committing any illegalities, the exchanges cannot give those companies a free pass out of the penalty provisions described. There is similarly, no provision or hearing provided before Sebi for any of the 331 companies. Principles of natural justice even at the most rudimentary level require a post decisional hearing.

Sixth, the whole concept of harsh enforcement action, not by quasi judicial action, but by a circular is an unacceptable mode of action. Sebi is trying to interpret a recent Supreme Court ruling which holds that non-quasi judicial circulars cannot be challenged in SAT, but only by way of writ in a high court. In fact, Sebi presented this argument before SAT. Labeling an enforcement order, with a virtual economic death penalty for the company and its million plus investors, with the word “circular” on top cannot make it immune to an appeal.

Seventh, as we discovered after this circular was unraveled on exchange websites on the morning of August 8, several of the companies were not only not shell companies but were active, highly profitable, fully compliant with laws and listing regulations with marquee investors and even working on prestigious government awarded projects like the Mumbai Metro.

Finally, Sebi has completely ignored the interests of millions of investors who have been impoverished overnight because of its shotgun actions.

Sebi has a fabulous top team, including intelligentsia from the industry, at the helm. It is time Sebi realises that processes are important and cannot be short-changed in its attempt to obtain rough and ready mass enforcement action against what it believes are companies choking up regulatory bandwidth. Indeed, India does suffer from hundreds maybe thousands of dubious listed companies which may frequently commit one mischief after another. But there has to be a better way to achieve its objective. This way is just too unjust and hurts many people who have failed and even more, people who invested in such companies.