FMC and NCDEX

A friend pointed me out to this very interesting ruling by the Forward Markets Commission (they regulate commodity futures and options) against NCDEX (a commodity exchange).

Art funds - illegal offerings - another Satyam?

Today's Mint reports on the first page about art funds indulging in all forms of illegal activities including inflating the price of art objects, tax evasion, money laundering, faking bills, price rigging, tax haven related party transaction, and quotes an anonymous government officer as stating:

"Art houses can use these fictitious purchase bills to set an inflated benchmark price for works by artists, causing genuine investors to pay more, according to the official. “Some of the art galleries have inflated the price of certain artists up to as much as 700%,” the official said."

Art funds are the current equivalents of plantation schemes of the 1990s - highly dubious and clearly illegal form of rasing money from investors. An art fund is required to register under the SEBI (Collective Investment Scheme) Regulations of 1999 and get a rating. Since none of the art funds which have raised money from investors has registered these are per se illegal activities. SEBI had in fact put out a warning to investors in Feb 2008 from which I quote:

"This message is issued by SEBI in the interest of investors with regard to their
investments in Art Funds, funds/schemes launched by companies or any entity formed for
the purpose. From the analysis of the characteristics of ‘art funds’ these are ‘collective
investment schemes’ as defined under section 11AA (2) of the SEBI Act, 1992. The
schemes/funds have been launched / floated by these entities without obtaining a
certificate of registration in accordance with the SEBI (Collective Investment Schemes)
Regulations, 1999 (the Regulations).

In terms of section 12 (1B) of the SEBI Act, 1992 no “person” shall sponsor or cause to
be sponsored or cause to be carried on a collective investment scheme unless he obtains a
certificate of registration from the Board in accordance with the regulations.

Regulation 3 of the Regulations permits only a ‘Collective Investment Management
Company’ having certificate of registration from Board to launch collective investment
scheme. Thus, only a company which has been granted certificate of registration by the
Board in accordance with the Regulations can launch or sponsor a collective investment
scheme. In other words, for a collective investment scheme to raise money from the
public it is prerequisite that the entity must (a) be a company and (b) registered with
SEBI as a Collective Investment Management Company.

Therefore, the launching/ floating of the ‘art funds’ or schemes without obtaining a
certificate of registration from the Board in terms of the provisions of the Regulations
amounts to violation of the provisions of section 12 read with section 11 and 11AA of the
SEBI Act and the Regulations. For such violations, appropriate actions, civil and
criminal, under the SEBI Act may be taken by SEBI against such funds/companies."

Since these entities have been given enough time to wind up or register their schemes, it is high time SEBI should take civil and criminal action so that the investors are compensated fully for these dubious investments. Or should we all wait till it blows up like Satyam?

Subhiksha and ICICI Ventures

Prof. TT Ram Mohan has posted an entry on the ICICI - Subhiksha rift. "Subiksha MD R Subramaniam holds 59% of equity but he apparently contends that the company is actually controlled by ICICI Venture because the latter has the right to appoint a majority of directors."

I have long argued with my friends in private equity that if they sign those wholly one sided agreements with the promoters (persons in control) of the investee company, they would become in charge of the company for various purposes including becoming promoters for the sake of disclosure norms. A vast majority of shareholder agreements and investment agreements between private equity and investee companies (I have drafted many) provide for wholesale unilateral powers not just for appointment of large number or majority of directors, but to take the PE's permission before any major transaction or vote - giving them powers even superior to that of the board of directors.

The whole point of private equity is to have a non passive investment - people who can help in the management of the business (though it may not always be the case factually). I'm therefore in support of the argument of the CEO of Subhiksha - if ICICI Ventures has legal powers to nominate the majority of directors of the company. You can't have power without responsibility - on the other hand whether you in fact exercised the overriding power assumed in the agreement may be relevant to dilute the investor's liability.

Satyam regulations

In an ad hoc move, the Indian securities regulator has created an amendment for Satyam in the takeover regulations. This is wrong in principle even though the regulator may have done it with good intentions. The amendment also reduces the scope of a fair competition in the bidding process. Also, as an amendment specifically targeted at Satyam, it will have unintended consequences in similar but not identical cases and would also be open to misuse.

To give a background - the takeover regulations prescribe that any substantial acquirer of shares or control of a listed company creates an obligation on the acquirer to make a tender offer for such target company at a minimum price. Since the minimum price is based on historical prices, and since the historical price of Satyam (before the discovery of the fraud) was substantially higher, no one would be able to make a tender offer for Satyam, making it difficult to sell the company in the market.

The 'Satyam amendment' as I call it, to the takeover regulations, exempts acquiring companies from the mandate of a compulsory tender offer (and other norms) if a) the Board of such troubled company is recomposed by the Central/State government b) the target directors set a competitive process to sell the company c) such relaxation is in the public interst.

There are already umpteen number of exemptions in the takeover regulations, and I am not sure whether this one was at all needed. Here are the list of exemptions already available a) Regulation 3 contains a series of 15 exemptions b) Takeover Panel based case by case exemption c) creeping acquisition exemption d) Regulation 12 proviso exemption (which is a bizarre relic of the past) e) bailout of companies exemption (Chapter IV).

It is not clear to me why the Satyam case could not be fitted into a Takeover Panel exemption. It could also perhaps be fitted into the exemption for bailout of companies (for which an entire part of the regulation is devoted). In addition, the regulation prohibits competitive bids to take place and thus reduces competition between acquirers and gives too much power to government appointed directors in the process. While we may be comfortable with the integrity of the Board of Satyam, clearly, these provisions could be grossly misused in other cases. In any case I'm not sure if all this brouhaha is worth anything, because the contingent liabilities from US and Indian courts is something which no regulator or government can protect against.

Corporate Governance reforms

I was on a conference call with the Asian Corporate Governance Association (ACGA) on the Satyam episode and it's lessons. I re-iterated that there were some areas including corporate disclosures which needed a wholesome overhaul in it structure and presentation (something I have blogged about recently - integrated disclosures). I also think there needs to be a lot of foundational rethinking of tolerating related party transactions, while it would be impossible to either prohibit such transactions or even take all of them through the shareholder, I think there is a case for a wholesome relook at the issue. Thirdly, I think we need to look at the opaque investment structures which we have been tolerating (though we are by no means unique) in listed companies.

On a contrarian note, I don't think there is a need to overhaul the existing corporate governance structure based merely on the Satyam episode, though some of the softer issues do need to be looked at (director interest alignment, compensation etc). As I mentioned in an IIM-A seminar, Leverage, two days back, we have more of a case of political reform rather than regulatory reform.