22 April 2011

Sebi's mandate on Cairn-Vedanta deal: Shareholders' option put down

I have a piece on the issue of SEBI's outlawing forward contracts - which is more detailed than my blog of day before on the same issue in today's Economic Times. Here are excerpts:

There is some interesting debate on the recent Sebi mandate to Vedanta-Cairn to repudiate a call/put/pre-emptive rights in their share purchase agreement. Sebi's stand is both interesting and dangerous. However, Sebi is mainly the messenger of an archaic law. And the message deserves to be shot. Luckily, Sebi owns the handgun that is capable of quickly shooting down this quixotic law.

The problem arises out of a section of the Securities Contracts (Regulation) Act, 1956 which enables the government, Sebi or the RBI to ban certain contracts in securities. In a different philosophical era, the government, suspicious of the evils of speculation banned all such forwards and options contracts in securities by a circular of 1969. The circular was drafted in the double negative and thus exceedingly broad, i.e., it banned all contracts which were not spot delivery contracts.
The width of the prohibition has been clarified by a 1997 Supreme Court ruling, which found certain contracts in an unlisted public limited company to be illegal because they were forward contracts.
The short opinion thus is that the law is not merely silly but also very dangerous.

The rationale for not continuing with the law in today's economy is clear. First, speculation is no longer a dirty word, and nearly all economists today would agree that speculators not only provide liquidity and price discovery in the market, but often offer trades on the other side of hedgers. In other words, if speculation was to be banned, traders who want to hedge their trades would be worse off and frequently be left without the ability to hedge their risk. 

Second, most trades in the secondary market (particularly exchange-traded futures) can be categorised as speculative. Why ban one type of speculative contracts and not others? Assuming that on-exchange speculative transactions are more desirable for some reason, shareholder contracts are not even speculative in nature, they allocate real world rights wholly devoid of a speculative nature based on commercial underlying and consideration. The width of the prohibition on non-spot or forward trades makes such non-speculative contracts illegal. This is really unintended and if implemented, would literally render millions of investment agreements, private equity deals, joint venture agreements and other commercial contracts partially illegal.

Luckily for us, the answer to this law of unintended consequences is not to go through the long route of parliamentary approval. If Sebi chooses to reverse this law, it can do so at short notice as a delegatee of the power by Parliament. Since there is only a Sebi law in the way by way of its circular of 2000, Sebi is empowered to rescind it. At the very least, Sebi needs to exclude non-speculative forwards, call/put options, buy-backs, right of first refusal, pre-emption rights in commercial agreements from the scope of the prohibition. Ideally, Sebi should completely withdraw the circular which just belongs to an age when we followed a suspicious thinking about speculators and the very evil dark-glasses-wearing-gold-smugglers.

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