New Delisting regulations of SEBI, 2024 - an important reform

I have a piece with Rashmi Birmole and Manas Dhagat in today's Financial Express on the newly introduced delisting regulations introduced by SEBI (not yet notified). These are long over-due and bring a 'right to exit' the public markets back into the Indian markets. Indian markets have long got the moniker of Hotel California - after the song, to mean that it's easy to list in India, nearly impossible to delist. Finally, reforms have arrived, which should not just make exits easier but also encourage more people to enter the markets. After all, how many would enter a room if the leaving the room were made into a maze? The full piece is produced below:  

Going public and getting listed on an exchange is, for the most part, considered a significant milestone for a company. However, due to factors beyond its control, such as sparse trading volumes or a minimum public float, a listed company may find itself at a crossroads, deciding whether to remain listed when the benefits of continued listing no longer justify the costs associated with being publicly traded. A company may also delist for strategic reasons, to do things which would not be possible with millions of shareholders to take care of. A reasonable next step is to pursue delisting, which is also an essential step in ‘take-private’ transactions. Since delisting is a crucial element in the mosaic of processes that shape the capital markets, it’s only logical that the mechanism by which a company can exit the public markets should be as efficient as other processes. However, instances of delisting in India are rather uncommon, so much so that the process is largely considered a hit and miss. Often what holds up the delisting is a small group of people who try to negotiate a price several times higher than the fair price. The resulting failure causes loss both to the company and the vast majority of shareholders.

On this precise issue, SEBI, in August 2023, proposed a review of the voluntary delisting norms under the SEBI (Delisting of Equity Shares) Regulations, 2021, to refine the delisting process and tackle hurdles faced by listed companies while exiting public markets, which included the introduction of fixed price mechanism as an alternate pricing method. SEBI, in the recent board meeting held on June 27, 2024, has approved these proposals, marking a pivotal moment in the evolution of the delisting framework.  Some of the noteworthy proposals related to eligibility thresholds for the counter-offer mechanism, use of the adjusted book value in determining the floor price and the setting of a reference date.

The delisting framework provided for the reverse book building process as the (nearly) sole price determination mechanism for voluntary delisting. In what has been hailed as a much-awaited move, SEBI has approved the introduction of a fixed price mechanism as an alternative to the reverse book building mechanism. The fixed price offered by an acquirer must include at least a 15% premium over the floor price and can only be availed for delisting of companies whose shares are frequently traded. The fixed price mechanism was proposed to allay concerns regarding the inherent price uncertainty associated with the reverse book building mechanism and the resultant increase in volatility and speculative activities in the scrip of the company. The proposal was premised on empowering shareholders to decide upfront whether to tender their shares at the given price and provide a transparent pricing strategy that is easily understood by all stakeholders.

The stringent conditions for making a counter-offer under the current delisting framework have often led to failed delisting attempts, even when a majority of shareholders are in favor. Acquirers are only eligible to make a counter-offer, if their post-offer shareholding amounts to 90% of the company’s total issued shares. It was noted that the high threshold deprived acquirers of the opportunity to make a counter-offer, even if a few shareholders who collectively hold major shareholding chose against bidding, while a majority of the shareholders favoured the proposal. SEBI proposed to lower the threshold for making a counter-offer to provide acquirers with more flexibility and increase the likelihood of successful delisting offers. The counter-offer price was proposed to be computed based on the volume-weighted average price (VWAP) of the shares tendered in the reverse book-building process or the initial floor price, whichever is higher. This approach was aimed at ensuring that the counter-offer reflects the general expectations of the shareholders. SEBI approved the proposal to lower the threshold to 75% in the case of delisting through the reverse book-building process, provided at least 50% of public shareholding is tendered. The lower threshold is designed to provide more flexibility in negotiating a price that is acceptable to both the acquirer and the public shareholders. However, pursuant to a counter-offer, the 90% threshold would still have to be met for the delisting to succeed.

Similarly, the determination of the floor price has also been a contentious issue, often resulting in disputes over fair valuation. SEBI had proposed that the adjusted book value be considered an additional parameter for determining the floor price. This metric considers the fair market value of the company's assets, ensuring that the floor price accurately reflects the intrinsic value of the shares. SEBI has approved this added parameter for both frequently and infrequently traded shares, with the exception of public sector undertakings (PSUs). 

The floor price is calculated based on a reference date, which was the date on which the exchanges are required to be notified of the board meeting in which the delisting proposal was approved. In its proposals, SEBI emphasized the importance of a clearly defined reference date for calculating the floor price to ensure consistency and fairness in the valuation process. The proposal was based on SEBI’s observation that the interval between the public announcement of the delisting proposal by the acquirer or prior intimation to exchanges in promoter-led delisting, and the date on which exchanges are notified, carried the risk of abnormal trading activity which may disturb the calculation of the floor price. To tackle this issue, SEBI proposed to calculate the floor price as on the date when information related to the proposed delisting is publicly disclosed for the first time, or based on an ‘undisturbed price’. Accordingly, SEBI has approved the modification of the reference date from the date of board approval to the date of the initial public announcement for voluntary delisting.

The changes approved by SEBI represent a significant enhancement in the delisting process. By incorporating a fixed price mechanism and lowering the counter-offer threshold, SEBI has addressed key issues that have historically hindered successful delisting. These modifications aim to reduce speculative trading activities, thus preserving the integrity of the delisting process and minimizing adverse influences. The updated methodologies for calculating the floor price and counter-offer price are particularly notable. The adjusted book value ensures the floor price is based on the actual value of the company's assets, ensuring shareholders receive a fair and reasonable exit and are not shortchanged. While specific amendments or circulars in relation to the above are yet to be notified, in summary, SEBI’s decision to streamline the process is expected to address the fault lines which have been exposed through past delisting attempts, without influencing the outcome, which ultimately depends on the shareholders and the company. By aligning the delisting process with market realities and investor expectations, SEBI’s reforms are poised to enhance market efficiency and foster a more robust investment environment in India. One is more likely to go to a movie theatre or a hotel in california where the exit door is not too small when one wants to leave. Similarly, easier exit is, counter-intuitively likely to make IPOs more common.

Regulations need a roadmap

I have a piece in today’s Financial Express with Parker Karia and Aniket Charan on the way forward for regulators to co-operate, not just for enforcement but also for development, not just within the financial sector, but across commercial, corporate and financial worlds. 

Over the last two to three decades, India has moved towards a multi-sectoral regulatory regime to handle the multitude of sector-specific issues. Today, we have the RBI, SEBI, CCI, IBBI, TRAI, IRDAI, PFRDA, CERC, and so many more, each of whom deal with the economic or industrial sector they are entrusted to regulate. Soon, India will have a regulator for data protection and privacy. Based on the nature, size, and business activities of a company, it interacts with one or more of these regulators. Naturally then, the company must structure its businesses, corporate governance, internal policies, practices, and procedures, etc. to ensure that it keeps all the concerned regulators satisfied. While this in itself has the potential for regulatory conflict, the real conflict starts to appear when someone wants to undertake an activity that requires the approval of more than one regulator.

An example helps explain this better. Consider a proposal of merger of conglomerates ‘A Ltd.’ and ‘B Ltd.’. Assume that they are in the business of providing, through their various listed and/or unlisted subsidiaries, banking, and financial services, including broking services and telecom services. This merger would then attract the scrutiny of the RBI, TRAI, CCI and SEBI. Each of these regulators would naturally be concerned with how the merger would be relevant to their field of regulation. For instance, the RBI would be primarily and broadly concerned with financial stability, impact on the (i) banking sector, (ii) depositors and borrowers, (iii)  banking operations, and customer protection. On the other hand, TRAI would be concerned with the impact on the telecom sector, and SEBI would examine the merger from the perspective of the effect on the broking arms of the merging entities and the interest of shareholders of the listed entities. The CCI would inter alia rule on the effect on competition in the relevant sectors, such as banking, financial services, telecom, etc, and whether any adverse effects on competition are there, and whether they are outweighed by the benefit to consumers, if any. In fact, regulators such as the RBI and TRAI, while examining the impact on their sectors, would have to take into consideration the impact on competition in those sectors. Based on the findings of each regulator, the companies would have to chart out their next steps. In some instances, what one regulator signs off on, is refused by the other, or the impact of the directions of one regulator are in conflict with another’s. To elucidate, the RBI may prioritise financial stability and risk management, arguing in favour of consolidation, as opposed to the CCI’s concerns on reduced competition, leading to higher consumer costs. On the other hand, jurisdictional conflicts may arise as well. Determination of which regulator has primary authority could lead to disputes and delays. All of this of course, does not even consider the application that would have to be made to the NCLT. Practically, it is a regulatory nightmare for a business to navigate.

Further, such regulatory tussles are not exclusive to corporate arrangements such as mergers, acquisitions, etc. It could very well apply to the launch of a particular product or service that has features regulated by more than one regulator. In the ever-evolving industry of financial services and cross-linking and tying of products and services, such a situation is no longer in the fictional realm. Diverse businesses being operated under one conglomerate with listed entities within it is also not unprecedented. Of course, this does not go to say that the due process is unwarranted, or not necessary. Assessing the consequences of an arrangement between entities that have an effect on the sector that is regulated is one of the functions of a vigilant regulator. But there remains significant room for improvement in harmonising the manner in which such assessment is carried out in instances where more than one regulator is required to apply its mind and issue necessary directions.

Regulatory conflict is not something that happens on a routine basis. But just because it isn’t frequent, does not mean it’s not necessary to address the issue. Further, each regulator would stand by its decision, as it is required to look at only the universe that falls under its regulatory purview. As stated above, each regulator has a specific mandate, which may not always align with the mandate of another, thereby giving rise to regulatory conflict, cause unusual second order impact on a company and invariably result in delays and pointless bureaucracy. It can get intractable when two regulators insist, probably rightly so, on following their respective statutes or regulations, causing an impossible impasse of the unmovable meeting the unstoppable.  

While regulators do liaise with each other, there exists no formal mechanism for regulators to act in cohesion. While Indian courts may not have tested the various issues that arise or may arise out of regulatory conflict yet, the prevailing judicial view in case two regulators having overlapping jurisdictions is that if a specialised regulator for the sector exists, it will take precedence over the general regulator, as was the case when the SC held the TRAI would have jurisdiction over the CCI while examining competition issues surrounding Reliance’s Jio.

Currently, the models that exist to tackle regulatory conflicts are (i) granting explicit and exclusive jurisdiction to regulators to remove ambiguity; (ii) regulators working jointly towards arriving at a decision by consulting each other; and (iii) mandatory consultation between regulators.

In the Indian context, the third approach seems to be appropriate. A standing committee, comprising of members nominated from each regulator, or the concerned ministry which supervises the regulator, could be created. The leadership of such committee could be on a rotational basis, and the members of such committee could perform a dual role, coming together when required to decide on an application. The decision of such committee, arrived at through a mandatory consultation among all regulators concerned with a particular arrangement or any matter that requires their consideration and/or approval, could be binding on all regulators. This results in a holistic view being taken, and a reasoned decision, even if it involves compromises on part of all parties involved. It serves as a single stop shop for businesses and would go a long way to ease the regulatory burden on such businesses. A forum does exist for discussing inter-regulatory issues in finance, but the Financial Sector Development Committee has had limited success till now on the ground. In fact, such an approach could be considered for enforcement purposes as well, wherein multiple regulators can act together as one, which will save time and costs on the regulator’s end as well as for the businesses. Indeed, the past few months have seen increasing cooperation between SEBI and RBI on enforcement.

 Laying the roadmap for companies and regulators to work with each other in an efficient manner is essential to ensure stable growth. In a growing economy such as India’s, where these issues are only starting to appear, we must take steps at this opportune moment to prevent irreparable harm or to avoid costly solutions later, and adopt a whole-of-government approach rather than working in silos.

Securing securities: Sebi’s steps are a paradigm shift with enhanced focus on clearing corporations

Under the current framework for settling a client’s buy transaction, the clearing corporation credits the securities to the broker’s pool demat account, after which the broker transfers them to the respective client’s demat account.

I have a piece with Manas Dhagat and Shivaang Maheshwari on SEBI's proposal to make direct payout of securities accounts without passing through the broker. The risks of a broker's negligence and given some past cases, even crooked behaviour, this will be a great step forward for both the efficiency, speed and safety of payment systems in the securities markets clearance and settlement. The full piece is as below:

 SEBI, in a recent consultation paper, has proposed to mandate direct payout of securities to clients’ demat account without any involvement of the stock broker’s pool account. Under the current framework for settling a client’s buy transaction, the clearing corporation credits the securities to the broker’s pool demat account, after which the broker transfers them to the respective client’s demat account. While the mechanism of direct payout of securities to clients was envisaged way back in 2001, the consultation paper has now proposed making it mandatory for all transactions with the objective of enhancing operational efficiency and reducing the risk to clients’ securities. 

The process would involve a clearing corporation or a clearing house reaching out to each clearing member (usually the stock broker) to obtain the beneficiary account details of the clients who are scheduled to receive a payout of securities. Once these details are obtained, the clearing member would send a payout instruction to the depositories, directing the credit of securities directly in the client’s demat account without any involvement of a broker’s pool account. The consultation paper also proposes that clearing corporations introduce a mechanism for clearing members to identify unpaid securities (i.e., securities that have not been paid for in full by the clients) or funded stocks under the margin trading facility, to provide clarity to stock brokers regarding the status of securities, ensuring they have up-to-date information on unpaid and funded stocks. 

The current process involves multiple entries, tracking, and reconciliation efforts on part of the stock broker while transferring securities from its pool account to the client’s demat account. With the direct credit of securities to the client’s demat account, the intermediary step of transferring from the pool account is eliminated, which significantly reduced the complexity of the brokers’ operational workflow. Handling transfers from the pool account to individual client accounts can be prone to discrepancies or potentially fraudulent activities by stock brokers. A number of cases have also been observed wherein the brokers were involved in misuse of clients’ securities kept in the pool account. Direct credit of securities reduces the touchpoints and hence the opportunities for errors and fraud, leading to more secure and accurate transactions. Additionally, brokers need robust IT systems to manage the complexities of transferring securities from pool accounts to individual client accounts, including handling exceptions and resolving issues. With a more straightforward process, the IT infrastructure can be simplified as well. Systems can be optimized for direct credit operations, reducing the need for complex transfer mechanisms and the associated support and maintenance.

This is not the first time SEBI has acted upon protecting an investor’s interest from a potential default by a stock broker. Last year, with a view to prevent misuse of clients’ funds, SEBI introduced a process for trading in the secondary market based on blocked funds in a client’s bank account. Under this process, funds would remain in the bank account of the client but will be blocked in favour of the clearing corporation, which will only be debited towards obligations arising out of the trading activity of the client. Thus, instead of transferring the funds upfront to the broker, funds are blocked in the bank account of the client itself, ensuring enhanced protection of cash collateral and preventing the misuse of clients’ funds by the broker. Similarly, the application supported by blocked amount (ASBA) method has been provided for retail individual investors for applying in an IPO. Under this process, funds are blocked in the bank account of the investor till the finalization of allotment, post which the amount equivalent to allotted shares would be debited or, in cases of no allotment or partial allotment, the balance amount will be unblocked.

A similar block mechanism has also been prescribed for undertaking sale of securities wherein clients’ securities lying in the demat account of a client are blocked in favour of the clearing corporation till such time a sell order is executed. If the sale transaction is not executed, securities would continue to remain in the client’s demat account and will be unblocked. This mechanism was introduced to do away with the movement of shares from client’s demat account for early pay-in and back to client’s demat account if the trade is not executed.

These steps taken by SEBI indicate a paradigm shift with less reliance on the broker for handling the securities and funds of its client and an enhanced focus on the clearing corporations to ensure smooth and transparent settlement processes. The direct crediting of securities to clients’ demat accounts represents a significant move towards increased market integrity and investor protection. Clearing corporations will now take on a more central role in the settlement ecosystem, overseeing the direct transfer of securities and ensuring that all transactions are accurately and efficiently processed. Clearing corporations will need to develop and implement robust systems to manage this increased responsibility. This includes upgrading technology to support real-time processing and direct crediting of securities, enhancing risk management frameworks to address any new risks associated with direct transfers and working closely with depositories to ensure seamless integration and synchronization of data, ensuring accurate and timely settlement.

Regulating AI in the securities markets

 I have a piece in today's Financial Express with Parker Karia on the impact of AI (artificial intelligence) on securities markets. The full piece is as follows:

Fast on the heels of development of AI, which has already resulted in transformations across various industries and professions, the European Union is the first jurisdiction to introduce legislation that regulates AI. Broadly, those AIs which pose an unacceptable risk would be prohibited, whereas minimal risk AI systems are unregulated. The former category would include AIs that affect people’s rights, biometric categorisation systems, scraping of facial images from sources to create a facial recognition database, social scoring, predictive policing, or such AI that manipulates human behaviour or exploits people’s vulnerabilities. Additionally, the EU’s AI Act establishes the EU AI Authority, which will be the nodal agency for implementation and enforcement of the AI Act, which, like the GDPR, has an element of extraterritorial jurisdiction.

What is actually regulated is AIs that fall into neither unacceptable risk, nor the minimal risk category. These are high-risk and limited risk AI systems. High-risk AI systems pose a threat as its uses include deployment in critical infrastructure, education, essential services, law enforcement, dispensation of justice, governance, etc. Such systems would inter alia be required to register with the relevant EU database, assess and mitigate risks, ensure transparency and accuracy, and more importantly, ensure human oversight. Moreover, people would have a right to submit complaints about AI systems and would be entitled to explanations about decisions in relation to high-risk AI systems that affects the right of the aggrieved person. Non-compliances with the AI Act will attract fines ranging from €7.5 million or 1.5 percent of revenue, up to €35 million or 7 percent of global revenue, depending on the violation and the entity.

GPAI

General-purpose AI systems, such as ChatGPT, Gemini, etc., would face new transparency requirements. Such software, including those that create manipulated images such as “deepfakes” would have to make clear that what people were seeing was generated by AI.

AI and the Securities Market

The securities market will not be, or rather, is not an exception to the infiltration of AI. Although recent breakthroughs have been largely in the space of generative AI, gigantic steps are being taken to equip AI with further abilities, as well as expand the data the AI has access to

To put the timeline and development in perspective, till three decades ago, activities related to trading in the securities market, such as research, placement of orders, etc., hardly incorporated technology. The focus on use of technology began with some seriousness upon the introduction of dematerialized shares. From then, to today, India has taken the lead in introducing a ‘T + 0’ settlement cycle. Today, any step or activity relating to trading in the securities market, cannot be imagined without the use of technology. Now, with the introduction of AI, the securities market is set to witness another transformation. Today, AI can analyze vast amounts of data, identify patterns, and make informed decisions in real-time, execute orders at lightning speed, create investment strategies by itself, etc., as a result of which, the manner in which trading is conducted, risk is managed, and investments are made, are rapidly evolving. One of the pertinent concerns in this regard would be around data privacy.

As AI and AI-generated algorithms permeate various sectors, including the securities market, regulators face the challenge of crafting laws that govern these technologies effectively. In the following paragraphs, AI’s impact on the securities market and its regulation, are discussed.

Algo Trading & Robo Advisory

Currently, algo trading is defined as trading carried out through automated means, i.e., order are placed without any human intervention. Recent suggestions by SEBI to regulate algo trading have received mixed reviews, while majority views agree with the need for regulating algo trading, SEBI’s approach towards meeting that end has been the subject of some criticism. It would also be required to be borne in mind that AI can effectively write codes based on instructions fed to it. Thus, creating an algo, in the near future, may not be the exclusive domain of a trained professional in the field of IT systems. In a situation where the deployment of an AI created algo results in a violation of securities laws, the question that arises out of this is on the extent of culpability to be fastened on the person who used AI to create the algo. The principle that the developer of an AI, or the human behind the ‘machine’ is responsible, exists, however, with the advancements in AI, which are unpredictable at this stage, the above principle may have to be revisited. As AI changes the landscape around us, our laws must keep pace to ensure that rights and obligations of the concerned parties are laid down in advance.

Additionally, robo advisory is presumably going to take the center-stage in the distant future. For instance, with the vast amounts of data points analysed in a few moments and investment strategies being created in seconds instead of weeks, it is not too far-fetched to presume a considerable shift in the manner in which investment advisory service is carried out today, which may warrant a revisit to the extant regulatory framework requiring both strengthening and rationalisation of regulations. Strengthening for the reasons described above, and rationalising because some of the restrictions may no longer be relevant with AI generated work product.

Grievance Redressal and Enforcement

AI may eventually be used for dispensation of justice by appropriately (and safely) integrating it in our judicial systems. In fact, it was recently suggested that AI may be used to resolve minor traffic challans, to begin with, upon adequately building up such capability. Similarly, the securities regulator may consider initiating the process to develop AI that can effectively monitor, supervise and assist in the enforcement of securities laws.

Additionally, with the recent focus on online alternative dispute resolution mechanisms for resolution of disputes in the securities market, minor issues, depending on the complexity, quantum of money/ assets and the nature of the dispute, AI can serve as an arbiter or mediator.

Pattern recognition and Predictive Analysis

In a potential game-changer for regulators, developing AI models are becoming increasingly efficient at recognizing patterns, and thus predicting the ‘future’, depending on the data points that the AI has access to, and how it is ‘coded’ to ‘think’. While algos are already deployed by financial sector regulators around the world to identify and/or track suspicious activity, AI can be of immeasurable assistance in this regard. For instance, SEBI has in the recent past issued circulars introducing the use of blockchain to verify information, and to ensure transparency amongst intermediaries and entities. The integration of AI in such systems can lead to predicting any defaults, or preventing violations, thus safeguarding investor interest. However, any such technology should be used with caution, and strict safeguards should be built around such systems to prevent any misuse.

To conclude, while the adoption of AI in the securities market would lead to increased efficiency, reduced costs, and enhanced decision-making capabilities for market participants, it raises significant concerns regarding market manipulation, algorithmic biases, data privacy and systemic risks, which warrants regulatory scrutiny and the need for comprehensive legal frameworks to address the issues emanating out of using AI. As AI continues to evolve and reshape the landscape of securities trading, regulatory authorities must remain vigilant, adaptive, and forward-thinking in their approach, and strike a balance between innovation and regulation, thereby navigating the complexities arising out of the intersection of AI and securities market. While this piece has focused more on the challenges posed, overwhelmingly, the use of AI will be a force for good, bringing speed, productivity, innovation and removal of human errors and biases. Thus, it would be better to delay introducing too many regulations till the dust has settled on the field.

Regulating Index Providers: Navigating the Transition from Carte Blanche

I have a piece in today's Financial Express with Rashmi Birmole and Navneeta Shankar on SEBI's new regulations on index creators (effective after 6 months). Good move, but a light touch regulation in practice would be recommended.

In the coming months, Indian bonds will feature in JP Morgan’s Government Bond Index – Emerging Markets, a move that is being heralded as a game-changer by many and that is expected to attract significant foreign investment into the country. The inclusion of Indian bonds on a globally recognized index, a milestone in its own right, also speaks to the significance of indices in the broader context of the financial landscape. Simply stated, an ‘index’ is simply a collection of traded securities (known as constituents), which represents a segment of the financial markets. One of its myriad functions is to serve as a benchmark to measure the performance of an actively managed fund or the economy, as a whole. The function that holds greater relevance for investors is an index’s use in the creation of passive investment products, which are typically present in most investment portfolios. These products may range from index funds, which mimic the performance of broad-based market indices, to thematic or sector-based funds, which rely on customized or bespoke indices, available in the public domain or designed at the behest of fund managers.

The construction and management of an index is based on methods and criterion adopted by index providers, who operate with a high degree of autonomy, with the inclusion or exclusion of a constituent security resulting in observable signaling effects in the financial markets. It stands to reason that, given that indices are foundational for the creation of passive products, any decisions regarding the constitution of an index can substantially impact the overall performance and direction of the markets. The resultant conflicts of interest that may arise, coupled with the steady rise in passive investing, were the key drivers of the SEBI (Index Providers) Regulations, 2024, which were notified on March 8, 2024. The regulations emanate from the recommendations of a working group, which were released for public comments in December 2022, to address the regulatory vacuum that index providers have operated hitherto, specially given the apprehensions that such providers enjoy an element of carte blanche despite their critical importance within the financial ecosystem. The regulations are modeled on the IOSCO Principles for Financial Benchmarks, a set of globally accepted standards adopted by index providers worldwide, and by and large, follow a principle-based approach and relegate the nitty gritties of implementation to the index provider. The regulations target index providers that administer ‘significant indices’ for use in the Indian securities market. This essentially means that only the indices, both paid or freely available, which consist of securities listed on Indian exchanges and which are tracked by domestic mutual fund schemes whose cumulative assets exceed a predetermined threshold shall be regulated. It follows that the framework will not apply to indices consisting of foreign securities or used exclusively in foreign jurisdictions.

The regulations, which are focused on addressing concerns around the discretion exercised by index providers, are framed on three overarching themes - conflict of interest, integrity and accountability.

The possibility of conflict of interest in index construction and rebalancing is apparent. For instance, in private arrangements where bespoke indices are designed by index providers for funds, the risk of the index construction being influenced to benefit certain players is inherent and cannot be ruled out. Moreover, individuals responsible for index construction may be incentivized to alter the indices in a manner that suits the commercial interests of the index provider. Information regarding confidential decisions on index composition, or weightage of constituents, also runs the risk of being leaked to the advantage of front runners.

To address conflicting interests, the regulations make it compulsory for index provider activities to be carried out through a separate legal entity. Appropriate governance arrangements will also need to be put in place to protect the index determination process and individuals responsible for index governance must be segregated from the commercial function of the index provider. Among the salient provisions include the constitution of an oversight committee, separate from personnel engaged in indexing activities on a day-to-day basis, to oversee the methodology employed to design indices, review the need for changes and examine whether such methodology reflects the description of the index. The regulations also place the onus of formulating policies and procedures to address conflict of interest on the index provider. These procedures must also effectively control exchange of information among personnel involved in activities involving potential conflicts of interest and ensure confidentiality of information. The regulations further require index providers to institute a control framework to facilitate early detection of potential misconduct and complaint management within the index provider.

Additionally, the regulations also provide for maintaining the quality of the index, the methodology used for index calculation and protecting the integrity of data. To maintain the quality of indices, the regulations mandate index providers to consider factors which represent the underlying interest that the index seeks to measure, while eliminating any factors that may result in distortion of price, rate or value. Index providers have also been given the leeway to formulate a code of conduct for their data submitters to address quality, oversight, conflict of interest management, record-keeping and whistleblowing and perform due diligence on such entities. The regulations also strive for complete transparency in dissemination of information so as to promote investor confidence by making it compulsory for index providers to document and make information relating to the methodology used for index calculation and maintenance publicly available. This will not only allow an understanding of the manner in which the index is derived but will also encourage a fair assessment of its representativeness, relevance and appropriateness as a reference for passive investments. Moreover, the regulations also place an obligation on regulated markets and stock exchanges to ensure equal, unrestricted, transparent and fair access of data to all index providers having a data sharing agreement with them so as to avoid any disparity in timing, format and manner of such information dissemination.

Another theme around which the regulations revolve is accountability and disclosure. The regulations mandate index providers to establish an accountability mechanism by putting in place a complaint redressal policy for facilitating submission of complaints pertaining to whether a specific index represents the underlying interest it seeks to measure and application of the methodology to a specific index calculation. Index providers are also required to provide for a dispute resolution mechanism for resolution of all claims, differences and disputes between their subscribers and them arising out of their business in the securities market. Apart from furnishing timely information to SEBI, when called upon to do so, index providers are also required to assess their adherence to the IOSCO Principles through an independent external auditor, on a biennial basis, to ensure fairness and complete transparency in such evaluation. Any evaluation report of an independent external auditor has to be compulsorily disclosed on the website of the provider.

Considering the explosive growth of passive investing in recent years, the regulator’s focus on index providers, which wield significant influence in the financial markets and are dubbed as ‘power brokers’ in the western markets, comes as no surprise. The principle-based nature of the regulations give index providers ample room to maneuver, providing necessary flexibility to support the passive investing momentum. It must be stated that index based investment has been a force for good, providing benchmarks for providing low cost and market based returns to investors, which have escaped major scandal with one big exception (the LIBOR scandal). Given the track record, a light touch approach in practice would be useful, where the regulator comes in only in relatively egregious actions.

Winning the battle only to lose the war – the saga of front-running

Aniket Singh Charan and I have a piece in today's Financial Express on the changing nature of 'front running' a type of securities fraud.

 

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” – said the Red Queen to Alice in Through the Looking Glass. There are many examples in the securities market that perfectly demonstrate the wisdom of the Red Queen – if you want to make a profit, you need to be faster than the rest.

While, ordinarily, asymmetry of information in the securities market is often exploited to achieve profits, front-running abuses this in a nefarious manner. Front running involves the use of non-public information pertaining to a “substantial order”, and trading ahead of it to make profits or avoid losses. Recent orders by the Securities and Exchange Board of India (“SEBI”), in the matters of Experts appearing on Zee Business and Ketan Parekh indicate a rise in the number of enforcement actions taken by the regulator for this particular offence and throws light onto the evolving forms of front-running. They also provide interesting perspectives on approaches adopted towards ascertaining what a “substantial order” is and the “impact” such an order may have on the price and volume traded of a security.

Although front-running is a fraudulent practice, in Ketan Parekh (no relation of the first author), SEBI has done away with the requirement to prove dishonest intention. What is essential, however, is an inducement to deal in securities, which is sufficient to demonstrate fraud. A parallel may be drawn to the Supreme Court ruling in SEBI v. Abhijit Rajan, a case involving allegations of insider trading. The Supreme Court held that it was immaterial if actual profit or loss occurred, what is required is a motive to make a profit from the alleged trade. This motive is a key element in such trades.

In Ketan Parekh, Quest Investment Advisors Private Limited, a portfolio management company registered with SEBI, indulged in front-running while in possession of advance knowledge of impending orders. A key factor in the analysis of front-running revolved around the interpretation of what constitutes a substantial order and the impact it may have on the price of the securities. SEBI interpreted the meaning of the substantial order by placing reliance on the “reasonable person test” while noting that there was very little guidance, precedentially, available on what constitutes a substantial order. As per the whole time member (“WTM”), in this matter, a substantial order is one which, in the estimation of a reasonable person, would impact the price of the concerned securities. The WTM further stated that “when it is only the estimation of reasonable person then the assessment of actual impact of such substantial order is not necessary to determine the substance of the order”. Ideally, determination of what constitutes a substantial order should be followed by an assessment of the impact such a substantial order may have on the price of the securities traded. In the present case, there was no calculation of impact and the reasonable person test was used to conclude that front-running did in fact, occur.

In another matter, the front runner had undertaken trades in advance of an impending order. SEBI held that front-running occurs when an entity makes a trade on the basis of non-public information regarding a “large trade” from an investor, which may impact the price of such security. SEBI matched trades undertaken by the noticee with that of the impending large trade and found that in almost all instances the trades executed matched that of the impending order. Interestingly, the WTM observed that for front-running to occur it was not mandatory that the front-runner’s trades should match with that of the impending order. The essential element in establishing front-running is that the trades were made on the basis of non-public information. Whether the trades executed by the front-runner match the large order and whether they resulted in profits, are secondary considerations.

In Zee Business, a far more complicated picture emerges. The alleged violators belonged to three categories – (i) experts appearing on news channels; (ii) profit makers; and (iii) enablers. Experts appearing on news channels provided advance information about the recommendations that were going to be made on the news broadcast (which was held to be non-public information) to the enablers, who then used trading terminals provided by profit makers to trade based on such advance information. SEBI, in its order, analysed the fluctuations in the price and volume of securities, being traded, pre and post the news broadcast. Notably, a key ingredient of front-running i.e. the existence of an impending transaction/ substantial order was not directly present in this case. It was held that the popularity of these shows had equipped the noticees, with a deep awareness of the impact that expert recommendations wielded over the price and volume of the securities so recommended. Though there was no substantial order in place, it was argued that the noticees had a reasonable expectation of an increase in the price and volume of the securities recommended immediately following the news broadcast. The favourable movement in the price and trading volumes of the securities once such recommendations were made, further strengthened this argument. SEBI utilised a host of strategies to establish links between the parties – from call data records, WhatsApp/Telegram chats to geographic location analysis to further prove a nexus. It is rather interesting to note, that the reasonable person test as employed in Ketan Parekh, was not relied on in this order. Furthermore, this order did not discuss who a reasonable viewer is, and the only metric used to show inducement was the price/volume fluctuations pre and post the broadcast. Nevertheless, this order has expanded the contours of front-running (from a plain vanilla pump and dump scheme) to accommodate situations where there is an intent to defraud investors by abusing the trust which investors keep with certain individuals- such as the financial pundits in this case and a substantial order’s existence can be ascertained on the basis of the quantifiable response which viewers have for guest recommendations on channels, like Zee Business, and the change in the volume of trading in such securities. As has been expressed earlier, the motive is what counts towards making a case of front running, divorced from any actual profit making.

In all three cases, SEBI utilised different approaches to ascertain impact and knowledge of impending orders. On the road to determining substantiality of orders, the approach adopted by SEBI has seen several variations and the ever changing contours of front-running pose new challenges in determining liability. SEBI may have to relook at how it defines front-running in light of these changing dimensions. After all, a front-runner is not the only one who has to run twice as fast.

India Inc gets global play: Allowing public companies to list on IFSC will make them more competitive

I have a piece with Shivaang Maheshwari in today's Financial Express on the amendments paving the way for direct listing of Indian companies at the exchanges on the GIFT city. The move could help capital raising by Indian companies and help foreign investors to deal in shares of India based companies without going through complex investment procedures and without converting their hard currency.

On January 24, 2024, the Central Government notified the Companies (Listing of equity shares in permissible jurisdictions) Rules, 2024 (LEAP Rules) and amended the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) paving the way for certain public companies incorporated in India to list their equity shares directly on international exchanges situated in GIFT International Financial Services Centre (IFSC). These notifications are based on the recommendations of the Working Group which was tasked with suggesting a regulatory framework that facilitated direct listing of public Indian companies on international exchanges in IFSC.

 

Until now, Indian companies could only issue and list their securities in the overseas market through depository receipts such as American Depository Receipts (ADR) or Global Depository Receipts (GDR). Under this process, a company intending to raise capital from foreign jurisdictions would issue securities to the depositories incorporated in that particular jurisdiction and such depository in turn would issue depository receipts in the name of the company to the investors. Presently, only a handful of companies have opted for this route, given the stringent and tedious regulatory framework along with the time and costs associated with issuance of depository receipts. Moreover, unlike equity shareholders, the holders of the depository receipts are not entitled to vote unless they convert them into underlying shares. Fraudulent issuance of a company’s GDR and its manipulation are other risks associated with depository receipts.

 

Thus, with a view to address these challenges, the recent notifications have introduced a regulatory framework that allows both listed and unlisted public Indian companies to issue and list their equity shares (including by way of offer for sale) on permitted stock exchanges in permitted jurisdiction viz., India International Exchange and NSE International Exchange set up by BSE and NSE respectively in GIFT IFSC. The significance of this framework is crucial for India as it not only presents a roadmap for direct listings of public Indian companies but also aims to enhance the appeal of GIFT IFSC as a distinguished global financial hub. In the pursuit of global competitiveness, it is imperative for Indian companies to secure capital at the most favorable cost of capital. Foreign investors, known for their inclination towards securities listed in their home country, often assign disproportionate weightage to such assets in their portfolios. This inherent home bias placed Indian companies at a distinct disadvantage when courting foreign investments. Opting for foreign listings in the IFSC emerges as a strategic solution to mitigate this bias, effectively reducing the cost of capital for companies as investments in these companies can now be made in hard currency. Notably, companies are not obligated to undergo domestic listings concurrently, granting them the flexibility to establish a presence solely on an international exchange in IFSC.

 

The opportunities expected to be generated by the revised regulatory framework are immense. Companies incorporated in India can unlock several advantages by accessing capital markets outside their home country. One significant benefit is that Indian companies can now attract funds from international investors which often have the capacity to provide huge capital funds, keeping in mind the valuation of these companies based on global standards. Listing in IFSC is also likely to open up a broader investor base for companies as a diverse pool of investors would be interested in acquiring and trading their shares thus ultimately increasing the demand for the company's shares. For instance, a company listed on international exchanges in IFSC gains access to numerous investment funds also situated in IFSC. This opportunity wouldn't have been possible otherwise, as these international funds might not have considered investing in Indian companies, given the necessity to register as a portfolio investor with SEBI and dealing with conversion of the dollar or euro into the rupee. However, foreign investors however may prefer investing in only well-established and thriving companies.

 

Foreign listings are also likely to lead to better valuation as companies listed on international stock exchanges benefit from sophisticated asset management infrastructure, resulting in more accurate valuations of their securities. Companies will now have the option to access both markets, i.e., domestic market for raising capital in INR and the international market at IFSC for raising capital in foreign currency from the global investors. Startups would now gain access to funds from foreign investors instead of the traditional ways of crowdfunding and seed funding.  Overall, exploring capital markets beyond India's borders offers a range of advantages that can significantly contribute to a company's growth and success on the global stage.

However, the framework provides that in order to secure listing on international exchanges, the public Indian company, as well as its promoters, promoter group, directors, and selling shareholders, must not be debarred from accessing the capital market. Additionally, it is also a prerequisite that none of the promoters or directors of the public Indian company is a promoter or director in any other Indian company that is debarred from accessing the capital market. Further, any company which is under inspection or investigation under the provisions of the Companies Act, 2013 or whose promoters or directors are wilful defaulter or fugitive economic offenders are also not allowed to list their equity shares on international exchanges. While these stringent conditions are implemented to ensure that only financially sound and reliable companies secure listings in IFSC, the ineligibility on account of pending inspection/investigation may be revisited.

Further, only permissible holders, i.e., persons who are not residents of India are authorized to buy or sell equity shares of public Indian companies that are listed on international exchanges. Thus, an Indian resident cannot hold such shares, however a non-resident Indian can hold such shares. It is also pertinent to note that permissible holders belonging to countries that share a land border with India will require approval from the Central Government to engage in transactions in IFSC. This provision is likely to cause friction, but necessary friction, given the nature of some of our neighbours.

It remains to be seen whether a framework could be adopted which paves the way for presently foreign listed Indian companies to move from global exchanges to exchanges situated in GIFT IFSC. With respect to direct overseas listing of Indian public companies already listed in India, SEBI is expected to clarify the mechanism by issuing detailed operational guidelines in furtherance of the framework. These notifications are not only aimed at benefitting Indian companies in fund raising but also marks a significant step in realizing the Central Government's vision of promoting GIFT IFSC as a global financial hub. Nonetheless, prudent implementation and development of a well-defined framework addressing potential loopholes are imperative for ensuring the long-term effectiveness and sustainability of direct listing.