11 September 2018

SEBI's anti-fraud and insider prohibition laws need a wholesome rehaul

I have a rather strong piece in today's Economic Times linked here. I discuss how the committee set up to review the law on securities market fraud, manipulation and insider trading has not done the rehaul that was required of the law, but rather tinkers with minutiae of the law. Copied below is the piece:

‘If it ain’t broke, don’t fix it’ has a corollary: ‘if it’s badly broken, redo it, don’t fix it’. This is why the approach of the Viswanathan Committee to improve Sebi’s regulations on fraud, manipulation and insider trading falls short.

The modern origins of addressing securities and financial frauds came from the ‘new deal’ of 1933-34 in the US, where the government rewrote a vast majority of economic laws. Interestingly, the law outlawing fraud did not define the term in any new-age fashion, but relied on what we lawyers call the common law, or judge-made law.

The American parliament, supplemented by a regulatory rule, not only fully adopted this simply phrased, briefly stated and incredibly complex law, but over 80 years has not changed a single word of this definition.

Back in India, the definition does not have such a constant or consistent story.

We have tried to grab the complexity of law by explicitly trying to capture the entire world of fraud in words.

Naturally, that has not worked, and instead of going back to the origins and introducing a simple definition, we have tried to glue plastic leaves to a diseased tree with multiple amendments.

The common law and US definitions of fraud have the following five elements: intention to commit fraud, misrepresentation, materiality, causation and ill-effect (damages).

The Indian definition in the anti-fraud regulation of Sebi, by contrast, does not have even a single of the five ingredients, and specifically say that intention, deceit and damages are irrelevant.

One can mathematically show that under the Indian definition of securities fraud, walking, running and swimming are included. While one can argue that no one walking has yet been charged with securities fraud, one wonders what the point of a definition is, if it is so broad as to be meaningless.

Similarly, there is no need to define manipulation or insider trading, because they have evolved from the same definition against fraud. But in India, we have chosen to define it as broadly as possible, so as to capture either innocent conduct or unfair conduct, not just necessarily what ought to be outlawed. Income inequality is unfair but not illegal. All informational advantage may be unfair but should not be outlawed as insider trading. It is interesting to note that the Indian Parliament has, in the Sebi Act, chosen to replicate the US law on fraud, almost to the word, but the delegated regulations have been chosen unwisely.

The committee report, on the other hand, ignores this elephant in the room and applies copious bandages to the patient in coma. It starts with ‘further strengthening’ of the regulations, by which one can assume that the report further expands the already meaninglessly broad definition. It goes into territories like ‘persistent’ negligence amounting to deemed fraud. Under any definition in the world, negligence can never amount to fraud, as the required degree of intent is missing. Repeated carelessness cannot be fraud.

The other shortcoming of the committee is not looking at the second elephant in the room. This is private enforcement of securities laws by investors. Under current laws, investors are barred from approaching a court where Sebi has power to take action. As a corollary, India will never have a securities class-action lawsuit, as it is prohibited by law. This law was passed to reduce multiplicity of proceedings, but has caused untold misery to investors. In the notorious Satyam scandal, US investors have obtained money as compensation, but Indian investors have received nothing because of this law (disclosure: I was an expert witness for plaintiffs in the New York suit).

The section on improving insider trading laws similarly suffers from definitional inchoateness, which the report reaffirms. In a famous US case of Dirks, a research analyst repeatedly approached the regulator to uncover a fraud, and was rebuffed. He then circulated a newsletter telling his clients about the fraud, leading to its ultimate discovery. He was charged with the offence of tipping inside information instead of being rewarded.

The US Supreme Court came to his rescue. Dirks in today’s India would be a criminal the way the regulations are drafted.

Finally, the report recommends a disturbing recommendation to enable Sebi to tap phones of people. The privacy concerns this raises are huge and no regulator, perhaps besides North Korea’s, has such powers. The famous Rajaratnam-Rajat Gupta phone taps were uncovered in the US as their criminal enforcement agencies suspected money laundering. The US SEC and almost every other jurisdiction’s securities or other regulator has no power to tap phones.

There is merit in some of the microproposals made by the report, but that is not possible unless the big picture issues of definitions and inchoate prohibitions are addressed. And, luckily, one doesn’t need to look beyond the Sebi Act itself that captures these prohibitions of fraud, manipulation and insider trading quite well and in line with hundreds of years of wisdom.

17 May 2018

Designated Offshore Securities Market recognition of BSE

Finsec Law Advisors acted as the sole counsel for BSE in securing the Designated Offshore Securities Market recognition from the US Securities and Exchange Commission (SEC). This makes BSE India’s first and only one of handful internationally. Thanks team BSE India led by Ashish Chauhan and the SEC for their expedited review.

14 May 2018

Bankrupt firms need enabling regulation

I have a piece in today's Economic Times on how companies facing resolution and bankruptcy need a lighter touch regulation from SEBI and the exchanges with respect to listing regulations:

The law applicable to listed companies needs to be relooked at when such companies are going through the near death experience of resolution and insolvency. SEBI has come out with a paper to solicit views on how to deal with various extant regulations in respect to such companies. The companies deserve a light regulation approach. As the poet William Blake said, the same law for the lion and the ox is oppression.

The seven ages of resolution
For a company going through severe distress, it experiences financial haemorrhaging, departure of senior management and lack of compliance with multiple regulations. Clearly, little information about the true condition of the company is available in public domain before and after it enters resolution. A company in such process undergoes several stages, from filing of an application before the company law tribunal for resolution, appointment of a resolution professional (RP) to replace the board of directors, consideration of revival plans by the creditors in consultation with the RP, receiving bids from suitors, choosing the best bidder, restructuring capital based on the bids and injection of capital by the bidder, conversion of some or all debt into new equity and a route back to a smaller but healthier company with new management, or liquidation if revival is impossible.

The RPs are expected to collect information about the company in a matter of weeks and also take it through the resolution/insolvency process within a very aggressive timelines. While the RPs are entitled to appoint financial and legal professionals, their main objective is to revive the company. In many if not most cases top management has departed, the board of directors have by law been superseded by the RPs and much of the information that is relevant to investors does not really exist in a well documented form because of the stress in the company and departure of key people.

Best effort disclosure of past events
A materiality threshold should be applicable on the disclosures which may be lower than regular listed companies. Being price sensitive information, events such as filing of application for initiation of resolution, admission of such application by NCLT, terms of the bids once the winning bid is announced should be mandatorily disclosed by the listed corporate debtor under the listing regulations. Other routine disclosures may be relaxed, for instance quarterly financials. In addition, some level of protection must be provided to RPs for disclosures made in good faith and diligently, as they may not be able to disclose routine information as mandated. They should disclose all relevant information after they have taken over though.

Trading in stock exchanges.
Trading should be allowed to be continued subject to enhanced restrictions, such as intra day circuit filters of 5%, restriction on trading in Futures and Options segment, etc. Trading permits those who wish to exit, to transfer the risk of success  or failure of the company to those who can better bear the risk return mix. There is a risk that trades occur at, above or below fair valuation, but that is a price worth paying. Freezing trading may appear optically sound but will in fact completely block the exit doors when the building is on fire. Other mechanisms could also be used like a ‘call auction’ or batch mode trading, say once a week to focus liquidity. In any case, there should be no inter-day circuit limit as that would also be akin to locking the doors. If the consensus price is say Rs. 50 (based on new information about resolution chances) and the last traded price the previous day was Rs. 30, trade will not edge up slowly within a 5% circuit limit per day, but would completely clot the arteries of stock orders. This is because no seller would sell at Rs. 30, that which they think is worth Rs. 50. Conversely, trading should be stopped for the few days when the bids are received till one has been accepted, as the information asymmetry becomes huge between a handful of RPs with creditors and the rest of the investor community.

Re-classification of Promoters
The existing promoters whose shareholding in the listed corporate debtor undergoing resolution has reduced significantly may be automatically re-classified as public shareholders. Post resolution, there would be various stakeholders including creditors converting their debt into equity, sometimes acting as a group or consortium of investors, who may acquire substantial shareholding of the listed corporate debtor, replacing the erstwhile promoters. It is suggested that SEBI may prescribe a test for determination of ‘promoters’ which is flexible. Typically, there would be mix of new acquirers getting shares and the creditors whose loans would stand converted into shares partially or fully. Ideally, the two should not be clubbed together as they are not acting in concert except for the purpose of taking the corporate debtor out of its near-death existence.

Compliance with Minimum Public Shareholding
Infusion of outside capital during resolution may reduce the public shareholding below the statutory minimum of 25%. The immediate obligation to fulfil the prescribed MPS norms may not be in the interest of a newly revived company. Thus, the period of 1 year for compliance with the required MPS norms should be extended for such companies to 5 years or 10 years. For a company which has gone through the resolution process, the important agenda is to revive the company and for which it would require several years of nurturing. Divestment while the company is still struggling would not be an ideal outcome and for a company in such position to revive and be partially divested would take a minimum of 5 years.

02 May 2018

Finsec Law Advisors enters into an exclusive agreement for cooperation with Excellence Enablers and Assoc. for Developement of Securities Market.

Excellence Enablers, Finsec Law Advisors and Association for Development of Securities Market enter into an exclusive agreement for cooperation on improving regulatory and governance standards in India.

ADSM, Excellence Enablers and Finsec Law Advisors have decided to come together by way of an exclusive agreement to build consensus to advocate a better regulatory structure and framework by making representations to government and regulators for improving the public policy on financial market regulations. They plan to advice specific industries in the financial sector and working with them to create best practices and standards of governance utilising the governance expertise of Excellence Enablers, the regulatory expertise of Finsec Law Advisors and the policy expertise of ADSM. Finally, they will work with institutional investors to create and adopt frameworks by investee companies by way of voluntary codes.

"The coming together of specialists in governance, regulation and policy aspects in the area of finance is a major step in the direction of promoting stakeholder democracy. With our shared passion for improving the standards of corporate governance, we expect to create the pull framework for companies to meet the highest benchmarks, to complement regulatory efforts which constitute the push framework of minimum standards set by law." said M. Damodaran of Excellence Enablers.

14 March 2018

ET Markets Global Summit


15 February 2018

Accessing India's Capital Markets - ASIFMA

Please register for what promises to be a good event - ASIFMA Conference "Accessing India’s Capital Markets".  http://asifma.org/events/

13 February 2018

Plan to end derivatives trading abroad is fraught with common sense

I have a piece in today's Economic Times on how it makes sense for NSE/BSE to end giving up their market share to their competitor and the outrage by some is just noise:

Self destruction is not a high principle
The last few days saw some interesting Chinese whispers where media reported some sort of fatwa by the market regulator SEBI to the exchanges to stop the trade of Indian indices in foreign exchanges. Based on these ‘facts’ opinions flew easy. Terms like de-globalisation, regressive, protectionist were offered. One commentator even argues that it would tempt MSCI index, a much followed international emerging market index to cut its India weightage. Another syndicated piece quotes someone as saying that this will in fact adversely impact the onshore market. In fact, the move is sensible. The comments are alarmist and simply wrong. If there is some high principle of killing your own business, perhaps that high principle has been compromised. There is no reason, India and Indian exchanges should not act in their self interest if current reality demands such a change.

Imagine if a corporate entity were to email a list of its vendors and customers on a daily basis to its nearest competitor. Really, this is what was happening. While BSE/NSE have shared data and branding for a fee when foreign exchanges were not competitors, now the very same entities are direct competitors. Now the loss to business is greater than the fee received from the foreign exchanges for data feeds and thus requires rethinking from a competitive landscape perspective. This is Adam Smith’s self interest and common sense, not some nationalist conspiracy theory of protectionism.

As the regulator has clarified, there has been no direction to the exchanges to stop any trading in foreign exchanges. Mainly because that is not how it happens, as SEBI has no power to ban trading in overseas exchanges and attempting that would plainly be silly. At most the regulator could have convened a meeting and nudged the exchanges to act, which really is in their own interest.

The only handle Indian exchanges have over overseas exchanges trading of Indian products is the data based on which trades take place. So, for instance, the Singapore exchange’s trading the Nifty futures would depend on the data of the index and also the data of the individual stocks comprising of the index to trade the contracts. If this data were stopped, there is a likelihood that the trading would become out of whack and inaccurate. A similar outcome is likely in single stock futures of Indian companies which have recently been announced by SGX and were probably the root cause of the action.

In other words, the life blood of several products, in particular the SGX Nifty contract, is the data feed of the prices of the underlying and to a limited extent the branding of Nifty itself. The Singapore exchange is clearly more competitive in terms of costs and taxes with no STT, stamp duty, capital gains tax etc. But it is wrong to compete with Singapore or Dubai in terms of lower taxation, though there is merit in some rationalisation of investment taxes as the RBI governor recently pointed out. India cannot and should not compete with tax havens or the likes for a race to the bottom of taxation. We simply can’t afford that.

The key issue is commercial in nature. Though the numbers are not published, one can assume that the revenue from brand lending of Nifty and the data feeds is less than the lost revenue from bringing the trades onshore. Thus, the decision to restrict trades would have been taken by NSE in its self-interest. Similarly, nothing would be achieved unless other exchanges cooperated, as the same component stock’s price could be obtained from BSE.

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Having said that, the task would be far more difficult if not impossible if the restriction were sought to be extended to currency derivatives. Any products which are not dependent on onshore data would not be impacted and there is no way to regulate or prohibit the same. However, such products are primarily highly competitive with little or no profits.

Finally, the end game for the exchanges is unclear, but there does appear to be some regulatory nudge towards the GIFT city SEZ. That is no bad thing, as that jurisdiction has exchanges which are owned by BSE and NSE, they offer a far lower tax impact and there is a policy reason to incentivise those rather than foreign owned trade venues. The very fact that the Singapore exchange lost nearly a tenth of its value on Monday’s early morning trade (and BSE gained) shows the impact on its profitability by its losing the index derivatives business. If SEBI does something to develop the Indian markets as it is mandated to do under its preamble, it is no bad thing. If the exchanges did anything else, it would breach their fiduciary duty to their own shareholders.