ADRs and GDRs – a world of opacity

I appeared on “The Firm” on CNBC this weekend and spoke about the regulatory loophole in the takeover regulations for ADRs/GDRs. I also wrote for them a piece explaining the issue in some more detail.
Besides the issue of ADR/GDR voting rights – I also raise the issue of shareholding disclosures by ADR/GDR holders. Since there is no exemption from disclosure norms for them – clearly, people holding ADR/GDRs over 1 or 5% are today violating the disclosure norms under the takeover regulations and the listing agreement.

Here is the video and here is the piece at thefirm.moneycontrol.com

Thank you Menaka for plugging for the IPO blog to your viewers on the show.

Revised norms: a step in the right direction

Sebi yesterday at its board meeting decided to extend the compulsory tender offer requirements in the takeover regulations to ADRs/GDRs. While this is a step in the right direction, it does not go far enough in correcting the deeply flawed view Sebi had taken in its regulations.

The issue in brief is that acquisition of a large number of shares or control of a listed company obliges the acquirer to make a compulsory offer to shareholders to acquire another 20% of the shares of the company. This is to enable such shareholders to have an exit opportunity. The regulations exempted acquisition of ADR/GDRs from this compulsory offer under the deeply flawed view that ADRs/GDRs do not carry voting rights ’till converted into shares’. In fact, ADRs and GDRs do carry voting rights. They are as much shares as are Indian shares held in Indian depositories.

ADR/GDRs are convenient means of holding equity of another country without worrying about the logistics of buying those shares overseas using an overseas broker, converting dividends into local currency etc. For this purpose two sets of ‘depositories’ are used (to take the example of an Indian company with listed ADRs) in India which effectively holds say 10 million shares of that company and thus taking them out of circulation from the Indian market. Simultaneously, the foreign depository issues ADR/GDR securities for the same number (though often they are issued in a ratio — say 1 ADR to represent 2 shares) to depository receipt holders in the US market. These DR holder have all of the same rights as an Indian shareholder, for example, right to receive dividend, right to vote and right to residual value on liquidation of the company.

As far as the right to vote is concerned, it is governed by the contract between the DR holder and the depository. There are four types of contract terms which could govern this contract a) the depository will take instruction from the DR holder and vote according to that wish b) the depository will vote according to what is in the best interest of the shareholders c) the depository will vote in favour of existing management d) the depository will not vote the shares. Only in the last case are votes not exercised. However, even then, the shareholder has the power to vote the shares – it is just that he has contracted away the power to someone else who will abstain from voting. If the shareholders had collectively negotiated, they could have got these rights and can always claim these by amending their agreement. This is similar to an Indian shareholder who agrees with another person (whether an individual, company or institution) by way of a shareholder agreement that he will not vote the shares.The law cannot be influenced by the terms of a private agreement on voting arrangements particularly as there is no need for votes not to be exercised by the depository. The key to understanding takeover regulations is the power to exercise rather than its actual exercise.

The regulations treated ADR/GDRs as securities without voting rights and thus exempt them from the applicability of the tender offer requirements on substantial acquisition. Sebi’s treatment of ADRs/GDRs as not having voting rights particularly where it gives exemptions from the applicability of the takeover regulations was wrong in principle. This is particularly perverse where the ADR/GDRs are held by the promoter group itself and they get all the rights without the obligation to make a tender offer to shareholders on large acquisitions. It mixes up the power of voting rights with its actual exercise. The amendment means that where voting rights are in fact exercised, the exemption will be removed. However, the exemption is still retained for cases where the DR holder gives up his rights to the depository. Having corrected three forths of the inappropriate law, we now need to move forward and correct this perversity as well.

Takeover regulations – new committee

SEBI has appointed a new advisory committee to advice SEBI on amendment to the takeover regulations. For sure there are many small things which need to be ironed out and couple of major issues which need closure, but here is my two bits of advice to the advisory committee, since they are seeking suggestions – please don’t change any of the numbers in the takeover regulations. Our takeover regulations have suffered totally random changes in the threshold limits of disclosure and compulsory tender offer over the years without any major changes in the philosophy – merely because one person thought that 2% was better than 5% and then another that the original 5% was better than 2%. The US law has not changed in over 40 years in their disclosure thresholds and we have been so trigger happy that we keep playing with numbers all the time, thinking we are smarter than our predecessors. Though that is possible, I’m not sure that is the case with the half dozen amendments in the regulations in the past decade. Can the committee recommend that the numbers not be changed for the next 20 years at least?

I am always amused at how the media tries to preempt other media. One media person I spoke to said that even before the chairman of the takeover advisory committee received a formal invite to chair the committee, experts were talking about what the amendments are going to be based on their recommendations. Reminds me of two media channels last month who claimed they had confirmed that the deceased chief minister of Andhra Pradesh was in fact alive after a chopper crash and people had in fact spoken to him. They wanted to be the first ones to report his survival – just in case…

SEBI proposals on financial disclosures - viva short term

SEBI's advisory committee on disclosures and accounting standards has come out with several recommendations for improvement of disclosures standards of listed companies. One of the proposals is to increase the frequency of the disclosure of the balance sheet from the current annual basis to a semi annual basis. This is being recommended on the basis of:

"In the wake of the recent global financial crisis and subsequent cases of global corporations going bust, the issue of solvency and not merely the profitability of entities come to the forefront from the shareholders’ perspective. It was felt that a more frequent disclosure of the asset-liability position of companies would assist the shareholders in assessing the financial health of the companies, thereby helping them in making informed investment decisions."

I disagree with the proposal. Firstly, none of the big crisis affected entities went under because of infrequent disclosures - they went under either because of unsustainable leverage or because of hidden liabilities. Secondly, the recommendation misses the quality of disclosures and seeks to remedy the problem of poor disclosures with making the poor disclosures more frequent. I also disagree with the recommendations because we are going in towards a more and more short term view of the performance of a company. In fact, even the quarterly profitability numbers in vogue today encourage the management of a company to play the stock market game of matching predictions of profitability - losing sight of the longer term operational goals of a company. We clearly don't need to import the short term philosophy of the American markets. Finally, we all forget the substantial costs of management time spent in preparing financial disclosures, which could be instead spent on improving the operations of the company - the proposal in my opinion fails on the cost-benefit analysis. Even if Satyam came out with its balance sheet on a quarterly or half yearly basis, we would still not be addressing the problem of the poor quality of its disclosures. We will just have trash churned out more frequently. We need a better enforcement of existing disclosures through forensic accounting by the regulator (or an agency appointed by the regulator till it forms a competent cadre of such persons within).

The recommendations titled "Discussion paper on proposals relating to amendments to the Listing Agreement" can be found here.

SEC blames itself - the report

I wrote this week about the report of the Inspector General of the US regulator SEC severely criticising the workings of the SEC in not uncovering the Bernie Madoff scam. The report is now public and I was impressed that such a self critical report was put up on the main page of the SEC's website.

Here is the 22 page executive summary of the report.

High Court states the law, let the SC obey

In a wonderful and rare event, the high court has shown enormous spinal righteousness in holding the correct law on right to information - that Supreme Court and other judges are not above the law and must respond to right to information (or freedom of information) requests. This was contrary to the hopeless argument of the Supreme Court judges that they were above the law. Their arguments starting with 'we are not public servants' but constitutional authorities and later expanded were severely criticised by one and all in the media. RTI Act, btw, does not apply to public servants but to public authority. The event is rare because a bench of the high court decided against the explicit arguments of the Supreme Court of the country.

This is a victory of governance and accountability over self interest. It would be a national shame if this ruling was appealed before the Supreme Court - even though the specific case of assets of judges is a gray area of RTI - as the Act itself gives an exemption based on privacy. But whether RTI Act applies to judges is a straight and simple - yes.

See here for some detailed commentary. And here for getting the full judgment (you will need to look for case No.W.P.(C) 288 of 2009). More after reading the 72 page ruling.

SEC - serious about introspection

Here is some news from across two ponds. An internal review of the US Securities and Exchange Commission has resulted in a stinging report about its working with respect to the biggest fraud in the history of mankind (in dollar terms). Watch this space once the report is made public.

"The inspector general of the Securities and Exchange Commission delivered what's expected to be a stinging report late Monday on the agency’s failure to prevent or detect Bernard Madoff’s $65 billion Ponzi scheme.

SEC inspector general H. David Kotz launched an investigation into the agency’s Madoff dealings in December, shortly after federal agents arrested Madoff. Madoff, who turned himself in to the authorities, pleaded guilty in the case and is now serving a 150-year prison sentence.

In a statement issued Monday, Kotz said, “The Securities and Exchange Commission Office of Inspector General [OIG] has issued today a Report of Investigation entitled, ‘Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme.’ The Report of Investigation is an exhaustive summary of the investigative work that the SEC OIG has conducted over the past 8 months and has been issued directly to the Chairman of the SEC. It is a comprehensive review of the complaints issued to the SEC regarding Madoff, and the investigations and examinations that the SEC conducted of the Madoff firm. The Report is 450 pages long, and contains over 500 exhibits.”