05 September 2019

Promoter-hood - an albatross around corporate India's neck

I have an opinion piece in today's Economic Times about doing away with the concept of promoters and keeping the concept of a more fluid 'controlling shareholder'.

The concept of promoter imprisons people who have nothing to do with the company and also those who no longer have any dealings with the company. Seeking a shareholder resolution to change the status is akin of seeking shareholder vote on whether the Sun rises in the east or west.

Also applying the concept to defunct companies and their promoters causes grave injustice in many cases. It’s like a dysfunctional car parked on the roadside for decades being told to move or be challaned.

Finally, the 35% shareholding announced in the budget should be pushed with a nudge and a carrot rather than a stick.

Link to the article

14 May 2019

DVRs - an instrument whose time has not come

I have a piece in today's ET arguing that the time is not right for the introduction of DVRs in its liberal avatar. In the words of EM Foster 'now here, not now'. Indian minority protection levels need to be substantially strengthened before such an introduction. Here is the piece linked and the entire piece is below:

DVRs - an instrument whose time has not come

In the old adage ‘put your money where your mouth is’ the mouth may be moving away from the money. SEBI’s recent move seeking to amend differential voting rights is a move whose time has not come. Differential voting rights are essentially certain shareholders having different number of votes. So a promoter may have say 10 votes per share, while a mortal shareholder may be lucky to have only one per share. While DVRs have been around for some time under the old Companies Act as also under the 2013 version, SEBI has permitted them for over a decade with the restriction that no company may provide shares with superior voting rights, though it may issue shares with inferior voting rights. This follows a nearly century old jurisprudence, where a shareholder once issued shares cannot be diluted, because he or she never bargained to be short-changed in the future with the promoter getting say ten votes per share.

Lack of demand for DVRs: The popularity of DVRs among investors has not picked up in the Indian securities market. Even though a handful of listed companies have issued DVRs in the past as highlighted in the Consultation Paper itself, they continue to be traded at a steep discount and they are barely liquid even at that price. This goes to show that Indian investors continue to value their voting rights/powers and are not keen on trading it for higher dividends or other benefits. Because of their unpopularity, domestically there is little empirical evidence with respect to such companies.

Inherent disadvantages of issuing DVRs: The known downsides in several western countries are clear. DVRs can mis-align incentives, be a tool for mismanagement and oppression of minority shareholders, encourage entrenchment of promoters with little skin in the game, result in excess compensation and typically companies with DVRs lag other companies in performance if you take out a handful of the super-successful companies like Facebook from the equation. However, they have been allowed on the premise that providing such flexibility would encourage companies where promoters don’t want to give up control, to come to public markets. There is also an argument that promoters would act in the long term interest of the company without regard to the outcome of the next quarter.

SEBI proposes: Now SEBI proposes to introduce superior voting rights (SR). Under the proposed paper of SEBI, superior rights can be issued to promoters before an IPO. SEBI has introduced several dis-incentives so that these are not mis-used. The dis-incentives include lock in of shares, inability to trade them in the market, a sunset or expiry clause on superiority, inability to pledge them, cap on number of votes and DVRs becoming ordinary shares in certain kinds of resolutions.

Dis-enfranchisement: SR shares are just a euphemism for dis-enfranchisement. It is unclear how having superior voting rights and ignoring the votes of the many would improve long term strategy. SEBI should implement evidence based laws and there is no evidence world-wide that providing SR shares improves firm value. In fact, the evidence clearly shows that over the medium and long term they are value destructive. The most comprehensive academic study on dual-class shares published in 2010 by three professors from Harvard, Stanford and Yale found evidence that dual class shares reduce firm value in US companies, result in weakened takeover and market checks, diminished board independence and effectiveness, and reduced institutional investor oversight. Such boards have been shown to be statistically less independent and consequentially more deferential to management. Further, as per the Asia Corporate Governance Association, the introduction of DVRs in Hong Kong and Singapore have adversely impacted the reputation of their securities market. The introduction would take us on a regulatory race to the bottom.

Poor investor protection standards in India: Adopting western standards directly and looking at the benefits without looking at the poor status of investor protection in India, begs the question whether we should transplant a western standard without the investor protection means available to the western investor. Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, says that “when you have dual-class shares, what you are doing is exporting the monitoring function to third parties - to the government, the courts, the regulators. This is because dual class shares will severely inhibit the role of directors, shareholders and markets in corporate governance.” Issuance of DVRs in this governance vacuum may be detrimental to the interest of the minority shareholders of companies.

India IS different: Usually the statement that India is different, should always be taken with a fistful of salt, but in the case of DVRs, that is indeed the case. With poor investor rights, mis-management rife and a complete lack of class action law suits, India simply doesn’t have the tools to manage even more power to the promoter class. Already, promoters in India own 45% of listed company shares on average. Give both the dominance of promoters and poor minority rights in fact, India is simply not ready to give another tool to corporate India to shortchange regular investors like you and me. Giving the investors a Hobson’s choice of a good company with poor governance is not a standard we should adopt.

15 April 2019

Mutual Funds - FMP Imbroglio - time for fund managers to be humble and smarten up

I have a strong piece on the current controversy on fund managers' investments into the Zee promoter group companies in today's Economic Times. Three things require closer scrutiny. a) Better disclosure by fund managers b) policy relook at lending against shares to promoters and c) cute structures bypassing the 10% exposure limits to one corporate entity (concentration norms). Most importantly, fund managers need to be humble and not aggressive. If they cant feel for the investors, maybe its time to use some glycerine.

‘Mutual fund sahi hai’ and ‘mutual fund products are subject to market risks’ are both important messages to investors. Both are points of highlight this week. The ‘sahi hai’ has become the butt of a joke on Twitter while fund managers have been at pains to aggressively assert that the products were “always risky”.
As a lawyer, I decided to do a deeper dive into the offer documents of a few of the fixed maturity plans, or FMPs, to unravel the story in a bit more depth.
The context in brief is that several FMPs which were maturing this week had exposure to debt instruments of the Zee promoter group. In January this year, several mutual funds came to an understanding with the promoter companies —the borrowers — that they would not insist on a timely payment in order to give the borrowers time to unwind assets and pay the mutual funds fully.
The private limited companies of promoters had borrowed money from mutual funds based on the collateral of the listed securities of Zee, and if all mutual funds had sold along with other lenders, the price of the stock would have fallen and the security cover would likely have become inadequate. While many have criticised the arrangement, calling it a sweetheart deal similar to ‘evergreening’ of loans by banks, the criticism is unfair. Fund managers have taken a good faith call that they are more likely to get the money if they forbear for a few months and it would be wrong to cynically second-guess them.
However, there are many important policy questions which need to be tackled. The FMPs reviewed could invest in ‘listed or unlisted, secured or unsecured, rated’ securities. It’s also stated in the scheme document: ‘the Scheme is expected to maintain a high quality portfolio and manage credit risk well. Investments may be made in instruments, which, in the opinion of the fund manager, are of an acceptable credit risk and chance of default is minimum’. Finally, the schemes are restricted from investing more than 10% of their assets issued by a single issuer and the total exposure in a group cannot not exceed 20% of the assets of a scheme.
The problem lies with the instruments. While funds cannot directly lend to promoters against collateral of shares, if the promoters set up corporate entities which issue bonds with the collateral of shares of the listed company, that would be permissible. This is legal, but debatable from a policy perspective, as to whether mutual funds should be in loan against shares market, rather than lending to corporate India. Additionally, in senseless chasing of yields, some mutual funds have scraped the bottom of the barrel trying to get that extra half percentage of yield, but taking on huge risk along the way. The liquidity risk, as we are learning as investors, is somewhat binary – liquidity evaporates not on a slide, but in a flash. When crisis hits, you cannot sell corporate bonds at any price.
The second problem which is apparent from the restriction on single borrower limits set at10% is that some of the funds have acted cute. While no scheme can invest more than 10% with a single issuer, there is technically no bar to lending, say 30%, to three promoter entities against shares of a single listed entity. This needs to be addressed and Sebi needs to clearly state that the 10% limit cannot be breached by creating multiple holding companies to bypass the limit. The point of the limit is to contain concentration risk in a single entity.
Finally, the quality of disclosures and general messaging by mutual funds has been poor. There had to be a very clear articulation by the funds as to the negotiation, why they believe the deferral was in the best interest of the investors and also a very clear articulation on the date of the maturity of the FMPs as to why they are deferring part of the payment, stated with clarity and with humility. The television appearances by fund managers stating it’s a risky product could not have been worse-timed.
Here is a hint to fund managers, leave the defending of your actions to lawyers, when you speak in public media, be humble and shed a tear for your investors, even if you need to use glycerine. To be sure, there is still a lot of pain ahead for investors, and cute structures are going to be scrutinised closely by the regulator. Funds need to be not only true to fine print, true to label but also true to their fiduciary duty. Beyond that investors must assume the market risks and know that they are not investing in fixed deposits, and be aware that risk and returns go hand in hand.

16 March 2019

Regulator regulate yourself

I have an op-ed in today's Economic Times. In summary I believe that interim ex parte orders though useful should be used very rarely and narrowly by SEBI. Here is the piece from the paper and linked here:
While appearing in the securities appellate tribunal for a matter, I saw aperson upset. He was the CEO of a large company that had been barred by Sebi by way of an ex parte interim order — that is, his company was barred without hearing, without as much of an investigation. All its demat account and bank accounts had been frozen. To top it all, the CEO’s personal bank accounts and demat accounts had also been frozen, even though there was no allegation of any personal misconduct.
I later reviewed the order passed by Sebi that reflected injustice in the way the regulator rather regularly passes ex parte interim orders. To be sure, these powers can be very effective in preventing harm. For instance, where a massive fraud is underway and third party rights are being created, Sebi would rightly block the transfer of securities by way of such an order.
An ex parte interim order virtually freezes the business, securities and bank accounts of dozens of people in one swift order. Few facts are available and the order is passed on merely a prima facie view. Since the order is passed without a hearing, a hearing is given within a few weeks.
Once this hearing is given, again, without any additional facts, Sebi often confirms the barring order.
So, a person presumably not guilty is barred from accessing his own bank account. Sometimes, such orders extend to the entire family of the promoter of a company. After this ‘confirmatory order’, Sebi goes into ‘fact-finding’ mode, which can last well over a year. If the interim freeze order has not been qualified or raised, a person must suffer the freezing of his bank accounts and mutual fund/demat accounts till the time Sebi completes its investigation, gives another hearing to the accused and passes a final order.
This process currently takes 1-3 years. In an ordinary criminal case, an accused is usually given bail, a chance to defend himself before a final conviction. In ex parte interim cases, Sebi first passes the economic ‘beheading’ order, gives a hearing and then investigates whether the beheading was justified.

Three issues are at play. One, that once you have ‘beheaded’ someone, it is difficult to justify letting that person off. That would suggest that the interim action was wrong in the first place. Two, the availability of such orders gives Sebi the appearance of being a merciless regulator even when it is not needed to be merciless.
Three, the interim order gives Sebi afree pass to investigate for an indefinite period, all the time barring the suspected violator not just from acting in the market, but also restricting any withdrawal of personal bank funds.
The longer the order stays, the more harsh the penal consequences. So, should the process be consigned to the dustbin of history? Not at all.
We have seen cases where the powers have been effectively used to prevent further harm to the market. Almost none of these cases relied on freezing bank accounts and securities accounts, and powers used have been very specific in their scope. For instance, where bogus securities are created, afreezing order of those counterfeit securities is in order to prevent third party victims.
Second, apart from in the most exceptional cases, freezing of bank accounts, particularly personal bank accounts, is almost always disproportionate. In most cases where some violation has occurred — say, insider trading — the promoters have a lot of skin in the game, and there is almost no chance of them running away to Antigua or London to evade paying whatever amount they are alleged to have made, assuming they have committed the violation.
Finally, in the few cases where such an order is warranted, Sebi should set an internal deadline of finishing its investigation within two weeks, or lift the interim order automatically. In short, Sebi should stop behaving like a swashbuckling Tarantino character.

20 December 2018

Give credit where it's due

I have an op-ed piece in today's Economic Times which defends Credit Rating agencies from much of the criticism they are currently facing. Hiding the mirror does not make you more beautiful:

It is easy to blame credit rating agencies for the current problems of the debt markets. But much of the opprobrium investors heap on them is undeserved. They are indeed behind the curve when it comes to critical information about defaults. But that is a design problem. The system is designed to fail investors. In tech jargon, it is a feature not a bug.

Clearly no one can sit on a computer inside a building and start getting visions of default. Rating agencies are no oracles of Greek mythology. Even oracles were somewhat overrated. Croesus, king of Lydia in 560 B.C., tested the oracles of Greece to discover which of them gave the most accurate prophecy. He sent out emissaries to seven sites who were each to ask the oracles on the same day what the king was doing at that very moment. Croesus proclaimed the oracle at Delphi to be the most accurate. He then consulted Delphi before attacking Persia, and according to Herodotus was advised: "If you cross the river, a great empire will be destroyed". Believing the response favourable, Croesus attacked, but it was his own empire that ultimately was destroyed by the Persians.

We have of course our companies, banks, NBFCs, mutual funds and many other borrowers and lenders who lend to each other on the basis of rated paper. Much of debt paper is traded and listed, though the listing is nominal. The rating is sought by the borrower, because most lenders insist on buying rated paper. Many regulators and internal charters prohibit investing in non rated paper. This is important, because the borrowers don’t really want a rating, they are expected to get it.

Move to the future when one of the rated paper defaults, the lender could be a bank, NBFC, mutual fund, insurance company or one of the many large investors. Before the borrower defaults on interest or principal, there are usually hectic parleys between the borrower and lender to resolve, restructure or re-define their relationship. Clearly, the lender wants its money back. But it is smart enough not to want egg on its face and even smarter, not to trigger other events which will make the borrower’s situation worse and thus repayment more remote. The borrower’s interest is of course not to disclose the default. As things go downhill, what is a little lie to your rating agency? Not a big deal. It’s merely a contractual violation.

What about the lender? Clearly the lender, wants to push the can down the road. In the case of public sector or even private sector bank, a restructured loan, is a good way to make an additional loan to enable the borrower to meet the interest payment. Voila, no non performing asset for a few years. The bank is healthy, but with an even bigger debt. Gamblers don’t often give up their game, they usually double up. This is a commercial lending equivalent. In addition, the current MD of the bank has a clean NPA record, and the problem is of a future hapless MD, who discovers this albatross across her neck. Thus the incentives at play, ensure that neither borrower nor lender inform the rating agency about the default. Borrower happy, check, lender happy, check, regulator also relatively happy with the NPA issues pushed down the road. Of course, it is not all black and white and all cynical. Many restructuring exercises are done in good faith and many of the companies which are given a lifeline, do indeed overcome the temporary liquidity crunch and pay back the money. Which gets us to the question of why not just do the restructuring above board, and inform the rating agencies of the issues. RBI’s concern does have some validity though. Financial intermediaries are highly leveraged and almost all of them including banks and NBFCs have by the nature of their funding, have an asset liability mis-match.

There is clearly a need to move a contractual arrangement between the issuer company and the rating agency, to a legal obligation to disclose. This would push much of the ‘adjustments’ bilaterally achieved into public domain.

Here, the vision of financial regulators come into play. While SEBI has been batting for prompt disclosure at the first sign of default, RBI has pushed back, believing this would cause panic in the market. Though SEBI’s circular of last year was indeed over-broad, as every delay or payment could fall within the scope of default, the absence of a new circular is problematic. RBI’s view that immediate disclosure of every default situation will cause panic is too simplistic. It assumes the marketplace is not smart enough to figure out the distinction between a short term liquidity crunch and a life threatening event for a company. Indeed, companies can while disclosing default explain its position, so that there is no run on the company. Similarly, the norm of immediate reporting can be relaxed to a few months, and subsequently tightened.

Just as an opaque system which pushes the can down for years, creates a larger problem for the successor, enables crony capitalism, makes for an uncertain position on what the networth of an organization is, an immediate reporting may cause panic. There is a need for an Aristotelian mean, where defaults are disclosed with a short cooling off period. And while we are at it, let’s stop blaming all problems on the rating agencies. Hiding the mirror does not make us more beautiful.