25 March 2015

SEBI's IFSC Guidelines, Less 'Distress', Quick Disclosures!

My colleague Pragyan and I have a piece in the Firm on last weekend's board meeting of SEBI. Pasted below is the full text of the piece on International financial centre, disclosures by companies, conversion of stressed assets (loans) by banks into equity and Municipal bonds:


I.    SEBI Budget for 2015-16

The Board approved the budget, along with the following policy initiatives that may be taken during the FY 2015-16:

•    Extensive use of technology to ease the investing process in the securities market, e.g., e-IPO, Aadhaar based e-KYC, etc.
•    Proactive steps to address the financing and listing needs of start-ups with measures like Institutional Trading Platform (ITP), crowd funding, etc. or a separate carve out for them in the ICDR Regulations.
•    Collaborate with other agencies, empanel more Resource Persons and greater use of social media to enhance investor education and awareness efforts.
•    Upgrade SEBI website to improve interface of investors and other stakeholders.
•    Streamline the enforcement process to ensure uniformity and improve internal efficiency of enforcement proceedings.

Finsec Comment: In light of the greater powers which have been bestowed on SEBI it is seeking to play a larger role and help young entrepreneurs raise funds. SEBI aims to increase retail participation in the capital market, instead of largely relying on domestic and overseas institutions. These long overdue changes will improve the functioning of the securities and investment market. 

It may be noted that SEBI had released a discussion paper “Revisiting the capital raising process”, proposing the submission of ASBA applications through DPs and RTAs and removal of physical bid-cum-application forms by providing investors the option to fill and sign forms on digital platforms provided by the broker/SCSB/DP/RTA. With regard to non-ASBA bids, the discussion paper proposes a faster mechanism to collect the money from investors through a web based electronic transfer platform viz. NACH provided by the National Payments Corporation of India.

II.    SEBI Guidelines for International Financial Services Centre

The Board approved the SEBI (International Financial Services Centres) Guidelines, 2015, following the announcement in the Union Budget 2015-16 on Gujarat International Finance Tec-City (GIFT). The guidelines would regulate financial services relating to securities market in an IFSC created under Section 18(1) of the Special Economic Zones Act, 2005 and matters connected therewith or incidental thereto. 

•    The entities operating in IFSC will be governed by the overall framework of securities regulations, with certain carve outs as specified in the guidelines.
•    Indian and foreign stock exchanges, clearing corporations and depositories can set up subsidiaries to undertake the same business in IFSC, subject to certain relaxed norms on shareholding and net worth, etc. Stock exchanges can establish clearing corporations in IFSC. All entities in IFSC will need to comply with the IOSCO principles, Principles for Financial Market Infrastructures (FMIs) and such other governance norms as may be specified by SEBI. SEBI registered intermediaries or recognized intermediaries of foreign jurisdiction can operate as securities market intermediaries through a subsidiary or joint venture company.
•    The guidelines, inter alia, allow domestic and foreign companies to issue depository receipts and debt securities in IFSC, subject to the Foreign Currency Depository Receipts Scheme, 2014 and the SEBI (Issue of Capital and Disclosure Requirement) Regulations, 2009.  Further, the guidelines provide for listing and trading of equity shares issued by companies incorporated outside India, depository receipts, debt securities, currency and interest rate derivatives, index based derivatives and such other securities as may be specified by SEBI. Non Resident Indian, foreign investors, institutional investors, and Resident Indian eligible under FEMA may participate in IFSC.
•    Mutual Funds and Alternative Investment Funds constituted in IFSC can invest in securities listed in IFSC, securities issued by companies incorporated in IFSC and securities issued by foreign issuers.
•    SEBI will be issuing guidance notes or circulars specifying norms and relaxations for implementation of the guidelines. 

Finsec Comment: The Gujarat International Finance Tec-City (GIFT City), has come up near Ahmedabad and is expected to be the first such centre in India. The proposed norms will help set up capital market infrastructure in such centres with relative ease and lead to greater capital market activities. The guidelines allow foreign firms to raise capital with the designated zone via depository receipts and debt securities. Further, stock exchanges can undertake business with relatively low levels of capital. For instance, a stock exchange can be set up with Rupees 25 crore capital, as against the normal requirement of Rupees 100 crore (though this will have to be raised to Rupees 100 crore within 3 years). Initial capital requirement for a clearing corporation will be Rupees 50 crore, as against the current norm of Rupees 300 crore, which needs to be achieved in three years. The rule restricting ownership of exchanges also seems to be relaxed allowing both credible Indian and foreign exchanges to set up wholly owned subsidiaries in the GIFT City. They have been given 3 years to meet the norms on shareholding and demutualisation. GIFT City, given its infrastructure and cost advantage, will help bring tens of billions of dollars worth of financial services that currently goes to locations outside India, such as the considerable amount of rupee and equity derivatives trading taking place in centres like Singapore and Dubai. However there has to be clarity on issues relating to taxation of these entities operating in the financial special economic zones. Besides the tax regime, there has to be close coordination between the government of India, RBI and SEBI for this important venture to succeed. 

III.    Conversion of Debt into Equity by Banks and Financial Institutions
The Board approved a proposal, prepared in consultation with RBI, to relax the applicability of certain provisions of the SEBI (ICDR) Regulations, 2009 and the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 to the conversion of debt into equity of listed borrower companies which are in distress, by the lending institutions. The relaxation in pricing will be subject to, the allotment price being in accordance with a prescribed fair price formula and not being less than the face value of shares. Other requirements would be available if conversions are made as part of the proposed Strategic Debt Restructuring (SDR) scheme of RBI. This measure seeks to revive such listed companies and make it simpler for lending institutions to acquire control over the company while restructuring, thereby benefitting all stakeholders.

Finsec Comment: Currently, banks can convert debt into equity in case of bad loans, however there are regulatory issues with regard to distressed listed companies. Under the existing regime, the pricing of coversion of such debt/loan of troubled companies into equity is computed on a minimum price of the 26-week average or 2-week average price of the stock, with the date of CDR approval being treated as the reference date. The relaxation of norms for conversion of the distressed loans of listed companies into equity by banks and financial institutions would help lenders, especially many public sector banks, which have an alarming rate of bad debts/ non-performing assets, to improve their balance sheets. Instead of the existing market pricing formula, SEBI has opted for a fair price mechanism for conversion. However, there is a minimum floor price of par value, which may act as a dampner for many highly distressed situations. This ought to be done away with in a future reform. The easier conversion norms for lenders converting loans of distressed companies into equity will benefit banks and financial institutions since they were converting at a price that was often higher than the market price making the turnaround impossible or very costly. This may result in an increase in corporate debt restructuring. An exemption from the open offer requirement would also help banks change management and control of a badly run company without the costly and often impossible open offer requirement imposed on such banks.

IV.    Review of Continuous Disclosure Requirements for Listed Entities 

SEBI reviewed the requirements relating to disclosures being made by listed entities on a continuous basis to help investors make well informed investment decisions. The Board approved the following changes to the proposed SEBI (Listing Obligations and Disclosure Requirements) Regulations:

•    A listed entity shall disclose all events/ information, first to stock exchange(s), as soon as reasonably practicable and not later than 24 hours of occurrence of event/ information.
•    The outcome of board meetings shall be disclosed within 30 minutes of the closure of the meeting of Board of Directors.
•    In addition to the current requirement of making disclosure at the time of occurrence and after the cessation of the event, updation of disclosure on material developments shall be made on a regular basis, till such time the event/ information is resolved/ closed with explanations wherever necessary.
•    The listed entity shall disclose on its website all material events/ information and such information shall be hosted for a minimum period of 5 years and thereafter as per the archival policy of the listed entity, as disclosed on its website. 
•    The listed entity shall disclose all events/ information with respect to its material subsidiaries.
•    The listed entity shall provide specific and adequate reply to queries of stock exchange(s) pertaining to rumours and may on its own initiative, confirm or deny any reported information to the stock exchange(s).
•    The listed entity shall determine whether a particular event/ information is material, based on the following criteria:
>    the omission of an event/ information, which is likely to result in discontinuity/ alteration of publicly available information; or result in significant market reaction if the said omission came to light at a later date;
>    if the event/ information is considered material in the opinion of the Board of Directors of the listed entity.
•    The Board of the listed entity shall frame a policy for determination of materiality, which shall be disclosed on its website.
•    Rationalization, consolidation, enhancement and categorization of existing list of events into two parts:
>    events which are by nature material i.e., those that necessarily require disclosure without any discretion by the listed entity;
>    events which shall be considered to be material as per the guidelines for materiality, as specified by SEBI.
•    SEBI to specify an indicative list of information which may be disclosed upon occurrence of an event.

Finsec Comment: SEBI noticed that the existing level of discretion given to listed companies to decide which events are material or price sensitive, based on a broad list of material events provided under the Listing Agreement led to voluntary and inadequate disclosures by the listed companies in the securities market. In a measure to strictly monitor compliance with disclosure or listing guidelines, SEBI seeks to convert the same into regulations, whereby non-compliance will be met by strong penal action.  While the move aims to benefit investors and provide them with complete information, it may result in disclosures of a lot of unnecessary information which may not be material, relevant or required for public dissemination. Such disclosures may at times result in loss of trade secrets and interference with confidentiality. Further, companies may find it difficult to ascertain within a day whether an event/ information is required to be disclosed under the vague tests of materiality proposed to be introduced by SEBI. It should be clarified that merely because an information is material, does not impose an obligation to disclose it. Such a requirement would give away a lot of the competitive advantage and intellectual property of a company.

V.     SEBI (Issue and Listing of Debt Securities by Municipality) Regulations, 2015 

The Board approved the SEBI (Issue and Listing of Debt Securities by Municipality) Regulations, 2015, thereby providing a regulatory structure for the issuance and listing of debt securities/ bonds by Municipalities. The proposed regulations provide for public issuance and listing of privately placed municipal bonds and disclosure requirements for prospective issuers. The regulations are in line with the Government of India guidelines for issuance of tax-free bonds by Municipalities.  The regulations will facilitate investors to make informed investment decisions in relation to the bonds issued by such entities.  Some of the features of these regulations are:

•    Only revenue bonds can be issued in a public issue, while private placements can entail general obligation bonds or revenue bonds.
•    Issuers’ contribution for each project shall not fall short of 20 per cent of the project costs, which shall be contributed from their internal resources or grants.
•    Mandatory credit rating, which needs to be investment grade rating in case of public issuances.
•    Minimum tenure of 3 years.
•    Municipality should not have defaulted in repayment of debt securities or loans obtained from Banks/ Financial Institutions, during the previous 365 days.
•    Municipality should not have had negative net worth in any of the last 3 preceding financial years.
•    Banks/ Financial Institutions will be appointed as monetary agencies who will inter alia make periodic reports.

Finsec Comment: SEBI had published a concept paper titled “Proposed regulatory framework for issuance of debt securities by Municipalities” based on the report of the CoBoSAC. The proposed regulations therein permits either the ULB itself or a subsidiary of the ULB created in the form of a corporate municipal entity to undertake the issuance of general obligation bonds or revenue bonds. These guidelines for municipal bodies to raise money from the market will attract large institutional investors and pave way for municipal bonds for infrastructure projects in urban areas. Safeguards have been prescribed to protect investors, such as the issuer should not have a negative net worth and should have an investment grade rating. Revenue bonds will be the only kind of municipal bonds that can be issued through a public offering, as they are serviced by revenues from a particular project or a specific set of projects and, hence, provide greater safeguards to investors. The funds raised can be used only for the projects that have been specified in the offer document. They shall have a separate escrow account for servicing them with the earmarked revenue from the projects. The appointment of monitoring agencies will help keep the public and investors updated on a timely basis as to how the bonds are being serviced and will help to ensure compliance. The proposed regulations provide a clear mechanism for undertaking the issuance of municipal bonds and may play an important role in improving the regulatory conditions that presently hinder such issuances. Unlike government securities, these are not risk free bonds and therefore may not be suited for retail or unsophisticated participants who may assume them to be risk free.

VI.    Amendment to SEBI (Mutual Funds) Regulations, 1996, regarding managing/ advising of offshore pooled funds by local fund managers

As per extant requirements a domestic fund manager can manage an offshore fund, only if, (i) the investment objective and asset allocation of the domestic scheme and the offshore fund are same, (ii) at least 70 % of the portfolio is replicated across both the domestic scheme and the offshore fund, and (iii) the offshore fund should be broad-based i.e., there should be at least 20 investors with no single investor holding more than 25 % of corpus of the fund, etc. Otherwise, a separate fund manager needs to be appointed for an offshore fund. The Board has decided to remove the aforesaid restrictions for managing offshore funds, belonging to Category-I FPIs and appropriately regulated broad-based Category-II FPIs, by a local fund manager who is managing a domestic scheme. 

Finsec Comment: SEBI’s proposal is well-intended and would help domestic fund houses manage greater foreign capital. With the recent Budget announcement that the presence of the domestic fund managers in India will not considered the offshore fund as having a permanent establishment in India, such a measure will help domestic fund managers to effectively manage offshore funds. However certain problems may still remain, for instance, the relationship and transaction between the foreign fund and domestic fund manager may have transfer pricing implications. A higher income may flow to the Indian entity carrying out the fund management activities. The structure may be hit if it appears that the arrangement lacks commercial substance and was primarily designed to secure tax benefits. Generally, investors would prefer that the entity managing the fund is located closer to the jurisdiction in which the asset is present for better management of the asset and associated risks. From a commercial substance perspective, the presence of the fund manager in India may not be a sound justification for an offshore fund.

23 March 2015

Sebi's long journey in a short time

I have a short comment piece in today's Business Standard on how SEBI has come a long way - and of course areas where it needs to work on further. The full piece is linked here and copied below:

It's been a long journey in a short time for Sebi (Securities and Exchange Borad of India). To the older readers of this piece, a settlement of shares and funds after a trade to purchase and sell had been closed, if it were to exceed 60 days, would not be surprising. There was paper floating then, some real, some duplicate, theft and postal delays of several weeks, rejection based on incorrect cancellation of revenue stamps. This and a hundred other problems of delay, rejection, fraud and intervention by unscrupulous brokers resulted in a game of snakes and ladders for investors.

Today's investor would instead be surprised if the entire process did not complete fully within two days of the trade. Virtually any case of fraud or intermediary mischief in the market system is dealt with not only from a viewpoint of investigation and punishment, but also in terms of completing the exchange of securities and funds, with an institutional guarantee of performance within the two-day window. Most of the efforts have been towards automation on the one hand and swift and harsh punishment for wrongdoing on the other hand. While the exchange markets have been a great success, other areas of the market have also benefited from Sebi's oversight. Sebi has indeed proved a regulator both feared and respected in equal measure. It still needs to work on improving the speed of its investigation, adjudication process and sometimes passing preventive orders too swiftly - orders which can punish in fact if not in law, before a finding of guilt.

05 January 2015

Publication of 'Securities Regulation - Primary Market Offerings in India

I'm delighted to announce the publication of 'Securities Regulation - Primary Market Offerings in India' by my colleagues Anil Choudhary and Rajneesh Deka, published by CCH Wolters Kluwer. The second book from the Finsec stables in as many years.

22 December 2014

AIFs Allowed To Invest Overseas! Half Baked Reform?

I have a piece with my colleague Shashank Prabhakar published on the Firm's website - arguing that the RBI circular allowing AIFs to invest abroad is half baked and copy-pasted circular. Below is the full piece and the link to the original is here.

The Reserve Bank of India has issued a Circular dated December 9, 2014, permitting SEBI registered alternative investment funds ("AIFs") to invest overseas, in accordance its Circular No. 49 dated April 30, 2007 and Circular No. 50, dated May 4, 2007 (the 2007 Circulars). The RBI, by its 2007 Circulars had allowed domestic venture capital funds, registered with SEBI under the SEBI VCF Regulations, 1996, to invest only in equity and equity-linked instruments of off-shore venture capital undertakings, subject to an overall limit of US$ 500 million for all VCFs collectively. Registered VCFs interested in investing in equity and equity linked instruments of off-shore VCUs were required to obtain prior approval of the SEBI, but no prior approval of the RBI was required. The 2007 Circulars stipulated that SEBI would provide limits to individual VCFs investing in off-shore VCUs.

The 2007 Circulars followed the amendment made to Regulation 12 (b) of the SEBI VCF Regulations, which introduced Regulation 12(ba) allowing VCFs to invest in securities of foreign companies, subject to such conditions or guidelines laid down by SEBI or RBI, from time to time. Subsequently, Regulation 39 of the SEBI AIF Regulations, 2012 has repealed the SEBI VCF Regulations. New VCFs are now required to be registered with SEBI as “Category I Alternative Investment Fund – Venture Capital Fund,” under the AIF Regulations. The SEBI has carried through Regulation 12 (ba) of the erstwhile VCF Regulations in Regulation 15(a) of the AIF Regulations. Needless to state, investment by AIFs in off-shore VCUs would also be subject to other investment conditions laid down under Regulation 16 of the AIF Regulations.
Prior to the issuance of the Circular, there was no provision in the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (FEMA ODI Regulations) and its circulars, which specifically enabled AIFs to invest in instruments or securities issued by overseas entities. In that sense, the Circular has now fully enabled AIFs to invest overseas without any further amendments required to be carried out to the AIF Regulations.

However, the investment opportunities made available to registered AIFs through the Circular are quite narrow in scope given that the 2007 Circulars only allow investments in equity and equity-linked instruments of off-shore VCUs. Regulation 2(aa) of the AIF Regulations defines a VCU only from the perspective of a domestic company. The AIF Regulations do not shed any light on what would constitute an “overseas VCU” or as to whether the parameters would be any different from what has been specified in the definition under the AIF Regulations. It has to be kept in mind that the 2007 Circulars were issued specifically to domestic VCFs, registered with SEBI, under the erstwhile VCF Regulations. The AIF Regulations now cover not just VCFs but other investment funds, social sector funds, infrastructure funds, private equity funds, hedge funds, etc. The rationale for limiting investment opportunities for such AIFs only to equity and equity linked instruments of off-shore VCUs is not clear and the Circular also does not provide any reasons for such a limitation. The only explanation of such a restriction for domestic pools is that the requirements were copy pasted from the old provisions. While it may be justifiable to restrict a VCF to invest only in off-shore VCUs, there is no reason why a private equity fund or hedge fund registered in India should not be allowed to invest in instruments issued by off-shore funds or other off-shore entities.
Further, given the range of funds that the Circular applies to, the overall limit of US$500 million appears to be too small. As of today, there are more than 100 AIFs registered with SEBI. Theoretically, if all the 100 AIFs would want to invest in off-shore entities, it would potentially leave them each with room to invest less than US$ 5 million. Additionally, the requirement of having to obtain prior approval from SEBI could potentially be time consuming and a dampner. There is no requirement for the AIFs to obtain prior approval for their investments in onshore entities in the AIF Regulations. The FEMA ODI Regulations allow Indian entities to invest under both automatic and approval routes. Entities investing overseas under the approval route are required to obtain prior approval of the RBI. It is quite strange that the RBI has allocated the responsibility of granting prior approval to SEBI in what is essentially a foreign exchange transaction, which falls within the exclusive domain of the RBI under the Foreign Exchange Management Act. The Circular also does not stipulate any parameters for SEBI to follow while granting approval.

All these factors add up to making it seem like the Circular is unattractive and very conservative in its approach. One hopes that the RBI would be willing to consider these factors and make the required changes to the Circular.

21 November 2014

Insider trading law's new avatar

I have a piece in today's Financial Express - expressing my opinion on the newly announced law prohibiting insider trading. Though we do not know the exact regulation, the approach of the Justice Sodhi Committee seems to be broadly adopted. Here is the link to the full piece and below is the full article.

SUMMARY
The real new development is the expansion of the defences for honest conduct…
As was expected, Sebi came out with a spanking new regulation on insider-trading. While the new regulation is not yet in the public domain, a press release highlights the significant changes compared to the current regime. The new regulations seem to be squarely in line with the recommendations of the Justice Sodhi Committee report. The committee had done a great job with the report. There were some issues with the draft regulations the committee had attached to their report which, it is presumed, will be cleaned out. Similarly, some suggestions have been dropped from the regulations, such as the inclusion of public servants in the prohibition. There are significant changes in the new norms, but the changes are not the ones highlighted by most media.
There is no significant expansion of the definition of insider-trading, but there is an expansion of people who are deemed to be insiders. Thus, immediate relatives for example have been added to the list of deemed insiders. Such deemed insiders, if they trade in advance of publication of undisclosed price-sensitive information, would need to disprove that they in fact did not commit insider-trading. Or, as we lawyers like to call it, the burden of proof given a seemingly opportunist trade is on the deemed insider, and the person must disprove his guilt. The other class of people, or everyone else besides the deemed insiders, don’t have this albatross around their necks. So, Sebi must prove that they had access to privileged information which they misused. This is a useful expansion, but the real new development, which has not been highlighted by many, is the expansion of the defences for honest conduct.
Till now, many honest transactions used to fall within the prohibition. Many of those now have additional protection of the law. This is a great development, because the purpose of this law is to outlaw abuse of power, rather than outlaw legitimate commercial transactions. The Sebi press release specifically seeks to protect “legitimate purposes, performance of duties or discharge of legal obligations”. The classic example of such legitimate purpose is conducting of due diligence by an institutional investor or a private equity investor. Since due diligence, by its nature, means that the investor has access to price-sensitive unpublished information, the subsequent purchase after the diligence would fulfil the elements of the prohibition. That is, of trading based on access to unpublished price-sensitive information. This has been subjected to the requirement of advance disclosure of the information at least 2 days prior to the investment. The question of whether this condition imposed is practical will need to be debated. The exact impact of this to proprietary and confidential information which may become available to competitors will also need to be re-looked at by Sebi at some point of time. This point was of course hotly debated in the committee.
There has been a restriction on the definition of when price-sensitive information is considered generally available and, therefore, published. Information will be considered published only if made on the stock exchanges. This may unnecessarily chill the flow of information and reduce the flow of information. Thus, CNBC, which has viewers in the lakhs, would not be considered as a wide and simultaneous distribution of information even though many more live viewers would have simultaneous access to the information than those visiting the website of the exchange.
A provision of trading plans has been introduced as a defence to possible charges of insider-trading. The way this would work would be as follows. Let’s say a director who routinely has access to inside information needs to sell shares which are allotted to him by way of sweat equity or ESOPs. Such a person would find it quite difficult to sell shares since even though he is not exploiting an informational advantage of an insider, he could be charged of the offence. Such insiders now can plan to share their sale plans for the year ahead. For instance a sale of 50,000 shares each month, every month for the next year. Such a person would be obliged to sell, no matter how low the prices fall. But at the same time, he would be immune from charges of insider-trading since the sale was based not on the basis of inside information, but rather on the basis of a determinate and irrevocable plan. The problem with this well-meaning immunity is that it may not be practical. Since the plan has to be disclosed to the market at large, it would be easy for investors to front run the insider and exploit the fact that such insider is bound to sell no matter how low the price goes. There would be an incentive to cheat such an insider by artificially depressing prices just before the expected date of trading. This would therefore work only for companies whose shares are extremely liquid and where the trading plan is not for a very large quantity.
The scope of securities to which the prohibition applies has been expanded to include derivatives. This would be more by way of clarification, as even the old regulations would have covered such trades. A more explicit prohibition is good as an insider is more likely to use derivatives to maximise his exploits. After all derivatives provide the maximum bang for the buck if one has certain and privileged information.
Finally, a welcome move is to eliminate the multiple disclosures between the insider trading code and the takeover code. This norm of similar disclosures under different regulations caused multiplicity of disclosures, unnecessary compliance burden and no net benefit to investors.
Overall, the new regulations are welcome though they will need to be tested on the ground before a definitive conclusion can be drawn.
By Sandeep Parekh
Parekh is the founder of Finsec Law Advisors and author of the book Fraud, Manipulation and Insider Trading in the Indian Securities Market

14 February 2014

Statistical possibility of manipulation in the Indian securities markets.

My friends and colleagues at IIM,A have written a very interesting paper titled "High Frequency Manipulation at Futures Expiry: The Case of Cash Settled Indian Single Stock Futures", where they use a statistical/econometric tool to estimate the possibility of manipulation in the stock markets. The paper by Prof. Sobhesh Agarwalla, Prof. Joshy Jacob and Prof. JR Varma described in their own words is about:

Futures markets are known to be vulnerable to manipulation, and despite the presence of a variety of mechanisms to prevent such manipulation, instances of market manipulation have been found in some of the largest and most liquid futures markets worldwide. In 2013, the Securities and Exchange Board of India identified a case of alleged manipulation (in September 2012) of the settlement price of cash settled single stock futures based on high frequency circular trading. As is well known, it is easy for any well-endowed manipulator to manipulate the price; the real challenge for the manipulator is to make the manipulation profitable. The use of high frequency circular trading of the form alleged in the SEBI order makes many forms of manipulation profitable, and makes futures market manipulation a much bigger problem than previously thought. 

As argued by Pirrong (2004), it is more practical to detect and punish manipulation than to try and prevent it. We develop an econometric technique that uses high frequency data and which can be integrated with the automated surveillance system to identify suspected cases of high frequency manipulation at futures expiry. We then use these techniques to identify a few suspected cases of manipulation. Needless to say, human judgement needs to be applied to decide which, if any, of these cases need to be taken up for investigation (and, after that, possible prosecution). This judgement is beyond the scope of our paper, and we refrain from making any judgement on whether any of the identified cases constitutes actual market manipulation.

The paper can be downloaded from SSRN website.

Those who recall the US paper several years back by Prof. Erik Lie  which resulted in options backdating enforcement action or another paper further back in the 1990s by Prof. Christie and Schultz titled "Why do Nasdaq market makers avoid odd-eighth quotes"  on the Nasdaq's oddly priced trades which also resulted in extensive enforcement action against the exchange and the market makers would find this of substantial interest. This should of course be of interest to SEBI to dig deeper to uncover evidence of manipulation.

07 February 2014

Book review - Fraud, Manipulation and Insider Trading in the Indian Securities Market - Monika Halan

Sorry for the overload on my book. But the first review of the book Fraud, Manipulation and Insider Trading in the Indian Securities Markets is just out. Monika Halan, the reputed financial journalist has critiqued the book. Here is her piece which appeared in the FPSB's Financial Planning Journal:

"Fraud, Manipulation and Insider Trading in the Indian Securities Market
Sandeep Parekh
Publisher: CCH, a Wolters Kluwer business
Price: 795

Speak to average retail investors and they talk about the stock market with some bits of awe mixed with desire and fear. Awe, because smart looking people in movies seem to do complicated deals and get very rich. Desire, because of all the stories of the roulette-like stockmarket, that has the potential to make you seriously rich very quickly. You just need the right tip and do the trade. Fear, because of the frequent news stories about fraud and manipulation on the markets. How true are these stories? Is our stock market really a den of thieves as popular folk lore has it?

Those looking for answers may do well to read Sandeep Parekh’s book titled Fraud, Manipulation and Insider Trading in the Indian Securities Market. A racy Michael Lewis read this is not since the book is about regulations in the securities market, their evolution and the role of the regulator. The text-bookish treatment of the subject and the text-book like design feel will put off a casual reader, but for students of finance, would-be securities market lawyers, and other participants in the market will do well to invest time to read the book. Financial planners will find it useful as well, specially the chapter on ‘Mis-selling and Unsuitability’. Heavy reading the book may be, but persist and get rewarded with gems such as: “..the purpose of modern securities regulations is not to remove stupidity from the capital markets – only ignorance.” You chance upon another one while reading about how market upticks and bubbles are fertile grounds for fraud: “the beta of the market hides the negative alpha of frauds.”

The key focus of the book is how fraud, manipulation and insider trading is defined by regulators and how it is dealt with. In fact, stock markets have been in operation much longer than regulations and people have been defrauding each other since the beginning of time. It isn’t as if till the anti fraud regulations came into being there was no legal recourse for a person who felt cheated or defrauded in the market. Even before written law, fraud has been prohibited under common law, or “law as decided without statutes and passed on and evolved from generations through court decided cases”. Read through the Sebi (Prohibition of Fraudulent and Unfair Trade practices relating to Securities Market) Regulations 2003 (FUTP Regulations) and the use of common law principles of fraud show up clearly. The bedrock for anti-fraud regulations is the tort of deceit. Writes Parekh: “Since Pasley v Freeman in 1789, it has been the rule that A is liable in tort to B if he knowingly or recklessly makes a false statement to B with intent that it shall be acted upon by B, who does act upon it and thereby suffers damage.” The six ingredients that make up the common law fraud are intention, materiality, mis-representation of fact, transaction, loss and damage. Financial sector regulation and the appellate bodies have the delicate task of deciding ‘intent’ and that means either getting into somebody’s head or using circumstantial evidence to prove it.

Though the book is about the securities market and the regulations to prevent fraud and manipulation are about stocks, the book is relevant for those preparing for the future of Indian finance according to the road map laid down by the Financial Sector Legislative Reforms Commission (FSLRC). The draft Indian Financial Code envisages a collapse of the current multiple regulators into one United Financial Agency (UFA). Given the roots of current security market regulation from common law fraud, other regulators like the Irda, PFRDA and RBI must begin to use the common law fraud to think about fraud in their areas. The Rs 1.5 trillion of loss caused to individual investors in bundled life insurance products over seven years fits the five step definition of common law fraud to a T.

Ideally I would like Parekh to write a non-text book next, where he writes about securities market regulation for the interested, but lay reader. The glimpses of story in an otherwise dry book (and it needs to be dry because it deals with actual regulation) are fascinating. And the average reader would understand markets much better, lifting the veil of high finance and its seeming complication.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com"