130 - Capital Market

CAPITAL MARKET
(FOR PRIVATE CIRCULATION ONLY)

2018
PROGRAMME COORDINATOR
Dr. Prashant Ubarhande
COURSE DESIGN AND REVIEW COMMITTEE

Prof. Dalip Mehra Prof. Sudhir Gijre
Prof. Arun Vartak Prof. Prashant Ubarhande
Dr. Swati Oza Prof. Sudeep Limaye
Prof. Avinash Nene Dr. N.M. Vechlekar
Dr. Ravi Chitnis
COURSE WRITER
Mr. Anil Agashe Dr. Satish Inamdar
EDITOR
Ms. Neha Mule
Published by Symbiosis Centre for Distance Learning (SCDL), Pune

July, 2011 [Revision 03, 2018]
Copyright © 2018 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.
Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
PREFACE
Since 1991, India has entered the era of Liberalisation and its impact on Capital Market has been very
profound. In the last decade or so the capital market scenario in India has undergone a tremendous
change and more and more changes are taking place at a rapid pace. Since Indian industry depends
on the capital markets for raising funds in the form of equity or debt, the importance of this market
is all too evident.
Any students’ knowledge of Finance is incomplete without the knowledge of these markets. The
purpose of this SLM is to make students aware of these markets, the way they work, the regulatory
framework under which they are supposed to function. The Indian markets are getting integrated
with global markets slowly but surely, and this will have an impact on the way our markets will
work in future. Indian markets are the emerging markets on the world scenario and has attracted an
investment of around $14 billion until now form the Foreign from Financial Institutions. On the other
hand more and more Indians will have to turn to these markets for making investments. All these facts
make the study of these markets all the more important.
It has been our endeavour, while writing this SLM, to inform the students in simple terms the
mechanics of these markets, and introducing them to these markets without getting into specific
legalities. We have made an effort to appraise them of various regulations briefly. I have also made
an effort to encourage students to do some research by mentioning some case studies pertaining to
the issues of capital markets.
We are thankful to Symbiosis Centre for Distance Learning for providing me this opportunity to help
scores of students across India in understanding this subject.
we have taken care to incorporate the latest developments on this subject. However, there can be
some omissions and We shall be grateful to all our readers if they could bring these to our notice, so
that the necessary corrections can be made in the future editions.
Prof. Anil Agashe
Dr. Satish Inamdar
iii
ABOUT THE AUTHOR
Prof. Anil Agashe has a Master’s degree in Political Science and Public Administration from Pune
University, and a certificate in Foreign Exchange from Bankers’ Training College of Reserve Bank
of India. He has been a banker and has also worked in Corporates with an experience in the field of
Finance and Project Management. He has been associated with the most prominent leasing companies
of the country for the past sixteen years. For the past ten years he is associated as faculty to many
management institutes in Pune. He has conducted management training programs for the corporates.
Dr. Satish Inamdar holds a Master’s Degree in Commerce and Bachelor’s Degree in Law. He has
completed his Ph.D. in Management. He has done his research in the subject of Urban Co-operative
Banks. He is Fellow Member of the Institute of Chartered Accountants of India, Associate Member
of The Institute of Cost and Works Accountants of India and Associate Member of The Institute of
Company Secretaries of India. He is associated with the industry for almost three decades in various
senior capacities.
He has been working as the Director at Balaji Institute of international Business since 2007. Before that,
he was associated with Symbiosis Institute of Business Management as a Faculty of Finance for close
to two decades. He has conducted Management Development Programmes and Executive Development
Programmes for various private sector and public sector organisations. He has authored six books on
the subjects like Cost and Management Accounting, Financial Management and Management Control
Systems. He is the Charter Member of Rotary Club of Pune, Kothrud.
iv
CONTENTS
Unit No. TITLE Page No.

1 Introduction to Capital Market 1-28
1.1 Introduction
1.2 Constituents of the Capital Markets
1.3 Markets since the Liberalisation of the Indian Economy
1.4 Actions taken by the Government related to the Markets
1.5 Some Statistical Data and Further Developments
1.6 The Latest Developments
1.7 Introduction to Money Markets
1.8 Participants in Money Markets
1.9 Instruments in Money Markets
Summary
Keywords
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2 Securities and Exchange Board of India (SEBI) 29-50
2.1 Introduction
2.2 Objectives of SEBI
2.3 The Role assigned to SEBI
2.4 The Functions of the Board
2.5 SEBI Guidelines for Issue of Debt Instruments
2.6 SEBI and Individual Investor
2.7 What SEBI does with its Powers
Case Study
Summary
Keywords
Suggested Reading
3 Mutual Funds 51-70
3.1 Introduction
3.2 Technical Jargons used
3.3 Net Asset Value (NAV)
3.4 Asset Management Company (AMC)
3.5 Types of Schemes offered by the Mutual Funds
3.6 Regulatory Aspects
3.7 The Case of US - 64
Summary
Keywords
Suggested Reading
v
4 Merchant Banking 71-84
4.1 Introduction to Merchant Banking
4.2 Activities of Merchant Bankers
4.3 Issue Management
4.4 Underwriting
4.5 Guidelines for IPOs
4.6 What is Book Building
4.7 SEBI Guidelines for Merchant Bankers
Summary
Keywords
Suggested Reading
5 Recent Developments 85-100
5.1 Introduction
5.2 Rolling Settlement
5.3 Derivatives in Stock Markets
5.4 Depository and Dematerialisation and The National Securities
Depository Ltd. (NSDL)
5.5 Non-Voting Shares (NVS)
5.6 Bonus Debentures of HLL
5.7 E-Trading
5.8 Stock Lending Mechanism
5.9 Employees Stock Options Plan (ESOP)
5.10 Sweat Equity
Summary
Keywords
Suggested Reading
6 Stock Exchanges 101-118
6.1 Introduction
6.2 Introduction to Stock Exchanges
6.3 Importance and Operations of Depositories
6.4 Dematerialisation- Process and Operation
6.5 Introduction to National Stock Exchange
6.6 Stock Market Indices
6.7 Stock Holding Corporation of India Ltd. (SHCIL)
Summary
Keywords
Suggested Reading
vi
7 Venture Capital 119-134
7.1 Introduction
7.2 Characteristics of Venture Capital
7.3 Stages of Venture Capital Financing
7.4 SEBI Venture Capital Funds Regulation
7.5 Problems with VCs in the Indian Context
7.6 Current Trends
Summary
Keywords
Suggested Reading
8 Credit Rating 135-146
8.1 Introduction and Need of Credit Rating
8.2 Credit Rating
8.3 Factors that contributed to the Growth of Credit Rating
8.4 Factors considered by Credit Rating Agencies while Rating an
Instrument
8.5 Flow Chart of Rating Process
8.6 CRISIL’s Long Term Rating Symbols
8.7 Recent Developments
Summary
Keywords
Self-Assessment Question
Suggested Reading
9 Share Buy-Back 147-162
9.1 Introduction
9.2 The Method and Obligations of the Company in Share Buy-Back
9.3 The Effects of the Buy-Back
9.4 Types of Share Buy-Backs
9.5 Conclusion
Summary
Keywords
Suggested Reading
vii
10 Portfolio Management and Financial Engineering 163-176
10.1 Introduction to Portfolio Management
10.2 Types of Portfolio Management
10.3 Qualities of Portfolio Manager
10.4 Steps in Portfolio Management
10.5 Criteria for Portfolio Decisions and Factors that influence Portfolio
Decisions
10.6 SEBI Regulations governing Portfolio Management Activities
10.7 Code of Conduct - Portfolio Manager
10.8 Financial Engineering
10.9 Factors Responsible for the Growth of F.E.
10.10 Tools of Financial Engineering
10.11 Categories of Financial Engineers
10.12 Products developed by Financial Engineers
Summary
Keywords
Suggested Reading
11 Corporate Governance 177-190
11.1 Introduction
11.2 Background for Formation of Birla Committee
11.3 Mandatory Recommendations of Birla Committee
11.4 Some Recent Developments
11.5 Clause 49 of the Listing Agreement
Case Study
Summary
Keywords
Suggested Reading
viii
12 Mergers and Takeovers 191-208
12.1 Introduction
12.2 Procedure of Mergers and Takeovers
12.3 Case Studies in Hostile Takeovers
Summery
Keywords
Suggested Reading
13 Lease and Hire Purchase 209-220
13.1 Introduction to Lease Finance
13.2 Sources of Funds for the Finance Companies
13.3 Contents of Lease Agreement
13.4 Sale and Lease Back Transactions
13.5 Hire Purchase
13.6 Summary Regulations governing NBFCs Issued by RBI
13.7 Latest Developments
Summary
Keywords
Suggested Reading
References 221
ix
x
Introduction to Capital Market
UNIT
1
Structure:
1.1 Introduction
1.2 Constituents of the Capital Markets
1.3 Markets since the Liberalisation of the Indian Economy
1.4 Actions taken by the Government related to the Markets
1.5 Some Statistical Data and Further Developments
1.6 The Latest Developments
1.7 Introduction to Money Markets
1.8 Participants in Money Markets
1.9 Instruments in Money Markets
Summary
Keywords
Suggested Reading
Introduction to Capital Market 1

Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
●● Explain what capital markets are.
---------------------- ●● Identify the constituents of these markets.
---------------------- ●● Review and evaluate how these markets have developed over the years.
---------------------- ●● Assess the market related actions taken by the government.
---------------------- 1.1 INTRODUCTION

---------------------- Capital Market is generally understood as a market for long term funds and
investments in long-term instruments available in this market. However, now
----------------------
this market also includes short-term funds. Capital markets mean the market
---------------------- for all the financial instruments, short-term and long-term, as also commercial,
industrial and government paper.
----------------------
The capital market deals with capital. The capital market is a market
---------------------- where borrowing and lending of long-term funds takes place.
---------------------- Capital markets deal in both, debt and equity. In these markets productive
capital is raised and made available to the corporates. The governments
---------------------- both central and state raise money in the capital market, through the issue of
government securities. Capital market refers to all the institutes and mechanisms
---------------------- of raising medium and long-term funds, through various instruments available
---------------------- like shares, debentures, bonds etc.
With the pace of economic reforms followed in India, the importance of
---------------------- capital market has grown in the last ten years. Corporates both in the private
---------------------- sector as well as in the public sector raise thousands of crores of rupees in these
markets. The governments, through Reserve Bank of India, as well as financial
---------------------- institutes also raise a lot of money from these markets. The capital market
serves a very useful tool by pooling the savings of individuals and making them
---------------------- available to the business world. Well-developed markets augment resources
---------------------- by attracting and lending funds on a global scale. The global depository and
American depository markets perform these functions for companies across the
---------------------- globe. A well-developed capital market can solve the problem of paucity of funds
for the business enterprises. The rapid growth of corporate entities has been
---------------------- made possible by the growth of these markets. This is a global phenomenon.
----------------------
1.2 CONSTITUENTS OF THE CAPITAL MARKETS
----------------------
Capital market requires many intermediaries who are responsible to transfer
---------------------- funds from those who save to those who require these funds for investments.
---------------------- There are two important operations carried on in these markets.
1. The raising of the new capital
----------------------
2. Trading in the securities already issued by the companies
2 Capital Market
The efficiency of the markets is dependent on the specialisation attained Notes
by the intermediaries.
----------------------
The important constituents of the capital market are
1. The stock exchanges ----------------------
2. Banks ----------------------
3. The investment trusts and companies
----------------------
4. Specialised financial institutions or development banks
5. Mutual funds ----------------------
6. Post office savings banks ----------------------
7. Non banking financial institutions ----------------------
8. International financial investors and institutions
----------------------
The supply in this market comes from savings from different sectors of
the economy. These savings accrue from the following sources: ----------------------
1. Individuals ----------------------
2. Corporates
----------------------
3. Governments
4. Foreign countries ----------------------
5. Banks ----------------------
6. Provident funds
----------------------
7. Financial institutions
All these entities contribute to savings in the economy. Part of these ----------------------
savings naturally flows in the capital markets. Individuals invest in these ----------------------
markets directly by investing in shares or debentures of companies, through
bond issues of public sector units or through mutual funds. Corporates, who ----------------------
have more savings than their requirement for funds also, are participants in
these markets. ----------------------
----------------------
Check your Progress 1
----------------------
State True or False.
----------------------
1. Capital Market is generally understood as a market for long term funds
and investments in long-term instruments available in this market. ----------------------
2. Capital markets deal in both, debt and equity ----------------------
----------------------
Activity 1 ----------------------
1. Divide the activities of capital markets and money markets. ----------------------

2. Find out which of the above constituents participate in markets ----------------------
actively.

Notes 1.3 MARKETS SINCE THE LIBERALISATION OF THE
INDIAN ECONOMY
----------------------
Since the liberalisation of the Indian economy, we have seen that foreign
---------------------- financial institutions have come to Indian capital markets in large numbers.
---------------------- These institutions have invested close to $35 billions in Indian markets. Due
to this huge investment, these institutions have started influencing Indian stock
---------------------- markets. It is quite evident from the amount that are invested that the world
has started taking keen interest in Indian markets. Indian markets are also
---------------------- considered as the part of emerging markets across the world.
---------------------- Till some years ago many Indians were uncomfortable with the idea of
investing their money in stock markets. The things have of course changed now
----------------------
for the better. Many young Indians now look to stock markets as a good place
---------------------- to make investments. Much credit for this transformation has rightly been given
to late Mr. Dhirubhai Ambani, of Reliance Industries Ltd. It is Reliance, which
---------------------- was instrumental in spreading the equity culture in our country. This is due to
the fact that the investors of this company have over the years reaped many
----------------------
benefits and thus the company has become an icon in the Indian markets.
---------------------- Alongwith these developments the opening of mutual fund industry, first
for banks and then for private players, has also helped in the spread of equity
----------------------
culture. By investing in mutual funds individuals can acquire shares of various
---------------------- companies, without actually buying them. The mutual funds pool the savings of
individuals and invest them in corporate equities and debt instruments. We shall
---------------------- discuss the mutual funds in a separate unit later.
---------------------- There have been many other developments that have taken place in the
last few years. Some of these developments like scripless trading, e-trading
---------------------- and establishment of securities and Exchange Board of India as the regulatory
---------------------- authority for these markets have taken Indian markets to international standards.
We have been trying to incorporate best international practices of capital
---------------------- markets. The establishment of National Stock Exchange was the turning point,
in the working of Indian capital markets.
----------------------
Many Indian companies have used the capital markets in the last decade
---------------------- to raise large sums of money for their projects. Due to the vibrant markets, many
a projects have got funds from these markets and investors in these companies
---------------------- have got good returns on their investments.
---------------------- Another factor that has helped the development of these markets is that,
Government of India is slowly disinvesting from the public sector companies.
---------------------- As a part of this exercise the government offers equity to retail investors. The
---------------------- government has divested its stake in Maruti Ltd. in favour of retail investors.
This is a continuous process and it is expected that the government will continue
---------------------- to disinvest from PSUs. We have seen a lot of issues from PSU banks in the past
few years.
----------------------
----------------------
4 Capital Market
The secondary markets in India are also very active and volumes on the Notes
two premier stock exchanges National Stock Exchange and Bombay Stock
Exchange have shown healthy growth. There have been many innovations in ----------------------
the working of these markets. In last few years markets have taken big strides in
the Derivatives. We have moved away from the Badla system and have adopted ----------------------
the derivatives trading, as is the prevailing system in most of the developed ----------------------
markets.
----------------------
The stock market SENSEX which was around the level of 32,000 around
August 2017 had reached the level of 35,600 in June 2018. ----------------------
Indian debt markets are also sought to be made more vibrant. Recently,
----------------------
the Reserve Bank of India has allowed the participation of individuals in the
government securities markets which till now were dominated by the banks, ----------------------
financial institutions and mutual funds. This move is likely to open new avenues
for investment to individuals. ----------------------
As is evident from the above facts these are exciting times for the Indian ----------------------
capital markets. In the ensuing units, you shall get more details on the working
of these markets. ----------------------
In the recent past, many Indian companies have opted to split their ----------------------
stocks in the various denominations like Re.1 (HLL), Rs.2 (Hero Honda) Rs.5
(Infosys). The purpose for this was to enable the small investors to buy these ----------------------
stocks at the face value of Rs. 10. These stock prices were very high and small ----------------------
investors could not afford to buy these stocks. Many other companies are now
planning to split their stock prices. ----------------------
The Secondary Market Advisory Committee of SEBI has however ----------------------
recommended that stock splitting should be allowed only if the share price of
the company is more than Rs. 500 on the stock markets. Indications are that ----------------------
SEBI may accept these recommendations and many companies will thus not be
able to do share split. ----------------------
----------------------
Check your Progress 2 ----------------------
----------------------
Fill in the blanks.
1. It is _____ which was instrumental in spreading the equity culture in ----------------------
our country.
----------------------
2. The establishment of _________ was the turning point in the working
of Indian capital markets. ----------------------
----------------------
Activity 2 ----------------------
Find out what new procedures are now allowed in the markets. ----------------------
----------------------

Notes 1.4 ACTIONS TAKEN BY THE GOVERNMENT
RELATED TO THE MARKETS
----------------------
Presenting the Union Budget for 2014-15, the finance minister said that
---------------------- while foreign portfolio investors have invested more than Rs.8 trillion in India,
---------------------- fund managers continue to reside overseas on concerns related to taxation of
the fund income. With a view to put an end to this uncertainty and to encourage
---------------------- these fund managers to shift to India, it was proposed in the budget to provide
that income arising to foreign portfolio investors from transaction in securities
---------------------- will be treated as capital gains.
---------------------- In June 2013, the Securities and Exchange Board of India (Sebi) introduced
uniform entry norms for existing foreign institutional investors (FIIs), sub-
----------------------
accounts and qualified foreign investors (QFIs), and combined these entities
---------------------- under the category foreign portfolio investors.
This has given clarity and is expected to lead to many fund managers
----------------------
moving their base to India, which will also aid better fund management as
---------------------- all the investments are in Indian securities. This is also expected to plug tax
“leakages” and also help in generating capital market jobs in India.
----------------------
Clarity on foreign investor portfolios in the Union Budget was, however, just
---------------------- one of the measures announced by government to boost capital market sentiments.
---------------------- The finance minister also advised financial sector regulators to take steps
for a “vibrant, deep and liquid corporate bond market and deepen the currency
---------------------- derivatives market by eliminating unnecessary restrictions”.
---------------------- The government also proposed to liberalize the norms for depository
receipts by allowing issuance of American depository receipts (ADRs) and
---------------------- global depository receipts (GDRs) on all permissible securities.
---------------------- In addition, the government proposed to completely revamp the framework
for Indian depository receipts (IDRs) and introduce a “much more liberal and
---------------------- ambitious Bharat Depository Receipt (BhDR).
---------------------- The government has also decided to introduce uniform know-your-
customer (KYC) norms and inter-usability of the KYC records across the entire
---------------------- financial sector. Further, a single operating demat account for all financial assets
has also been proposed in the budget.
----------------------
---------------------- Activity 3
----------------------
Find out how the tax regime related to the markets has changed over the last
---------------------- five years.
----------------------
----------------------
----------------------
6 Capital Market
1.5 SOME STATISTICAL DATA AND FURTHER Notes
DEVELOPMENTS
----------------------
The government has decided to amend two acts namely Securities
Contracts (Regulation) Act, and the Depository Act to remove some legal ----------------------
hurdles to the corporatisation and demutilisation of the stock exchanges. This is ----------------------
a step in further liberalisation of the Indian capital markets.
The amendment to SCRA will facilitate the derivatives trading in the ----------------------
interest rate futures and options. The act at present allows derivative trading ----------------------
only if there is an underlying asset. However, the Mumbai Inter-Bank Offer
Rate (MIBOR) is not a security, derivatives based on this interest rate did not ----------------------
have a legal recognition under the act. The proposed amendment to the act will
remove this hurdle and derivative trading can commence. ----------------------
The corporatisation of stock exchanges is a reform long overdue. The ----------------------

conflict of interest due to the member brokers of stock exchanges being involved
in the governance of bourses will end with this. The demutilisation will help the ----------------------
transition of bourses from a mutual association of member brokers operating on ----------------------
a “not for profit” basis to a limited liability “for profit” company accountable to
the shareholders. It will separate ownership and management from the right of ----------------------
access to trading.
----------------------
The finance ministry and the banking and capital market regulators have
cleared the proposal to allow the banks to become members of stock exchanges ----------------------
and trade directly in the interest rate derivatives.
----------------------
Banks will be allowed to become members on retail debt segments of stock
exchanges. However, they will be allowed to undertake only their own trades ----------------------
for now. This measure will help banks surmount the problem of exposure limits
to brokers. They will also be able to maintain utmost secrecy in their dealings. ----------------------
Now with the screen based trading in place and the banks themselves getting ----------------------
into trading directly, there will be greater transparency in the deals besides a
clear audit trail. This is important in view of what had happened during the ----------------------
Harshad Mehta scam.
----------------------
Country’s largest bank State Bank of India has decided to enter the stock
markets. They have already done some deals in the secondary markets. ----------------------
Another important step initiated by SEBI is that it is going to allow Indian
----------------------
companies to issue equity simultaneously in the domestic and international
markets. These changes will allow the government to float equity of companies ----------------------
like BPCL and NALCO in both the domestic and international markets.
----------------------
Recent reports have also talked about the fact that of all the emerging
markets listed on NYSE and other overseas bourses, the India-specific funds ----------------------
have received unprecedented inflows since January 04. After 2017, Capital
Markets industry is ready for any challenge as participants cope with increasing ----------------------
competition and a stricter regulatory environment. Firms are leveraging and
----------------------
emerging technologies are available to support their transition to new and
differentiating levels that will enable efficiency efforts and profitability goals. ----------------------

Notes
Activity 4
----------------------
Find out the yearly in-flows and out-flows of FIIs for the past five years
----------------------
----------------------
1.6 THE LATEST DEVELOPMENTS
----------------------
1. New Measures of Risk Management System in Indian Capital Market
----------------------
Every shareholder or investor wants to protect his investment and promote
---------------------- it as his source of earning. So, my always concentration is on new measures
the Risk management system of SEBI which is the controller of Indian
---------------------- Capital Market. SEBI did several steps in this regards.
---------------------- (a) Measures for Reducing Price Volatility
---------------------- Price volatility is the relative rate at which the price of a security
moves up and down.
---------------------- But this technique of profit maximization which is used by bad guys
---------------------- for wrong purposes. They buys shares at very cheap rates and sell
when overpriced. Because, they get idea of trend of next price of
---------------------- shares with invalid source instead of using mathematical formula
which is given below
----------------------
----------------------
Using a simplification of the formulas above it is possible to estimate
---------------------- annualized volatility based solely on approximate observations. Suppose
you notice that a market price index, which has a current value near
----------------------
10,000, has moved about 100 points a day, on average, for many days.
---------------------- This would constitute a 1% daily movement, up or down.
Volatility is often viewed as a negative term in the market that represents
----------------------
uncertainty and risk. Higher volatility brings worry to the investors as they
---------------------- watch the value of their portfolios move wildly and decrease in value. To
reduce price volatility and stability in the prices of stock market, A major
---------------------- reform undertaken by SEBI was the introduction of derivatives products:
Index futures, Index options, stock options and stock futures.
----------------------
(b) Place Circuit Breakers
----------------------
This is another recent development in Indian Capital Market. We all
---------------------- know an excessive speculation is always risky for every investor.
For reducing it, SEBI has introduced place circuit breakers.
----------------------
A circuit breaker is the system which stops to trade in stock market
---------------------- when prices move after a specific level. For example, if a stock
is at Rs. 100 and circuit breaker is fixed at 5%, then stock trading
---------------------- will stop if it hit of Rs. 95 or Rs. 105. There are mainly two types
---------------------- of circuit breakers. One is index wise circuit breakers and other is
stock wise circuit breakers.
8 Capital Market
The index-based market-wide circuit breaker system applies at 3 stages Notes
of the index movement, either way viz. at 10%, 15% and 20%. These
circuit breakers when triggered bring about a coordinated trading halt ----------------------
in all equity and equity derivative markets nationwide. The market-wide
circuit breakers are triggered by movement of either the BSE Sensex or ----------------------
the NSE S&P CNX Nifty, whichever is breached earlier. In case of a 10% ----------------------
movement of either of these indices, there would be a one-hour market
halt if the movement takes place before 1:00 p.m. In case the movement ----------------------
takes place at or after 1:00 p.m. but before 2:30 p.m. there would be
trading halt for ½ hour. In case movement takes place at or after 2:30 p.m. ----------------------
there will be no trading halt at the 10% level and market shall continue ----------------------
trading. In case if the market hits 10% before 1 p.m. then as explained
there would be a one hour halt in trading and after resumption of trade in ----------------------
case if the market hits 15% in either index, then there shall be a two-hour
halt. If the 15% trigger is reached on or after 1:00p.m. but before 2:00 ----------------------
p.m., there shall be a one-hour halt. If the 15% trigger is reached on or ----------------------
after 2:00 p.m. the trading shall halt for the remaining part of the day.
----------------------
(c) Intraday Trading Limit
Intraday Trading, also known as Day Trading, is the system where ----------------------
you take a position on a stock and release that position before
----------------------
the end of that day’s trading session. Thereby making a profit for
yourself in that buy-sell or sell-buy exercise. All in one day. ----------------------
(d) Mark to Market Margin
----------------------
MTM margin is imposed to cover loss that a member may incur, in
case the transaction is closed out at a closing price different from a ----------------------
price at which the transaction has been entered. ----------------------
It is just collection in cash for all futures contracts and adjusted
against the available Liquid Networth for option positions. In the ----------------------
case of futures Contracts MTM may be considered as Mark to ----------------------
Market Settlement.
2. Investigations ----------------------
If any company law or SEBI Act’s rules regarding indian capital market ----------------------
are voilated, its investigation is done by SEBI. This is the list of cases
----------------------
resulted in compounding in the prosecution filed by SEBI (As on 30th
June 2010). ----------------------
3. Investor Awareness Campaign
----------------------
For making Indian capital market more secure for indian and foreign
investors, SEBI has started investors awareness campaign. For this, SEBI ----------------------
has made his official site’s sub domain at http://investor.sebi.gov.in/ ----------------------
Under this campaign, Workshops/ Seminars Conducted by Investor
Associations recognised by SEBI. There are following things are included : ----------------------
----------------------

Notes Caution to Investors
●● Do not enter into securities transactions with unregistered intermediaries.
----------------------
●● Do not get carried away by advertisements promising unrealistic gains
---------------------- and windfall profits.
---------------------- ●● Do not invest based on market rumours or unconfirmed or unauthentic
news.
---------------------- ●● Be aware that advice through television or print media does not mean that
---------------------- it is the opinion of the channel or publisher.
4. Ban on Inside Trading
----------------------
Insider trading is the trading of a corporation’s stock or other securities
---------------------- (e.g. bonds or stock options) by individuals with potential access to
non-public information about the company. In most countries, trading
---------------------- by corporate insiders such as officers, key employees, directors. To
---------------------- ban on inside trading, SEBI has made ( Prohibition of Insider Trading)
Regulations, 1992.
---------------------- 5. Trading Cycle Under T + 2
---------------------- ‘T’ represents the trade day. ‘T + 2’ implies the settlement on the 2th
trading day. SEBI has reduced the settlement cycle upto T +2 and in future,
----------------------
it may be T + 1 settlement cycle. But SEBI accepted shorter settlement
---------------------- cycles will mean more pressure on trade processing systems so that funds/
securities are ready for pay-in/pay-out on the next day.
----------------------
---------------------- 1.7 INTRODUCTION TO MONEY MARKETS
---------------------- The money market is a market for overnight to short term funds, and
for short-term money and financial asset that are close substitutes for money.
---------------------- Short term in Indian context means a period upto one-year. Close substitute for
money means any financial asset, which can be quickly converted into money.
----------------------
The major participants in this market are the commercial banks, the other
---------------------- financial intermediaries, large corporates and the Reserve Bank of India. The
RBI plays a major role and occupies a strategic position in these markets. It
----------------------
influences the availability and cost of credit. The objectives of these markets are
---------------------- to provide
1. A mechanism for evening out short-term surpluses and deficiencies.
----------------------
2. A focal point of central bank intervention for influencing liquidity in the
---------------------- economy.
---------------------- 3. A reasonable access to the users of short-term funds to meet their
requirements at realistic cost.
----------------------
In the money market the operations are for short duration as compared to
---------------------- capital markets. There is a large number of participants in money market. The
depth of this market depends on the number of participants. This is a whole
---------------------- sale market. The volumes here are very large, and therefore there is a need for
10 Capital Market
professionals to operate in these markets. Trading here is conducted mainly on Notes
telephones, followed by written confirmation from both the parties.
----------------------
Call - Money Markets
Another popular segment of these markets is the Call Money market. This ----------------------
market is essentially used by banks, financial institutions and mutual funds.
----------------------
The institutions that have excess funds would lend to the other institutions that
are in need of some short term funds. Many banks borrow in these markets for ----------------------
overnight liquidity. Banks many times require funds for settling their cheques,
clearing accounts and since they have to balance these accounts every day, they ----------------------
are forced to borrow overnight in these markets.
----------------------
The call money rates are normally determined by the demand supply
situation prevailing on almost day to day basis. ----------------------
The money market mutual funds are also an important player in these ----------------------
markets. They can park their funds in these markets. These funds are highly
liquid and a lot of funds can move in and out of these markets at a short notice. ----------------------
The Reserve Bank of India has said they would prefer to phase out ----------------------
these markets and switch the trades to the REPO markets as they are more
disciplined and can be tracked better. We will have to wait and see what type of ----------------------
developments take place in these markets in the future. ----------------------
1.8 PARTICIPANTS IN MONEY MARKETS ----------------------
Discount and Finance House of India Ltd. ----------------------
The RBI jointly with the public sector banks and the all India financial ----------------------
institutions set up the Discount and Finance House of India Ltd. as an
autonomous financial intermediary. It was conceived with the main objective ----------------------
of increasing the transactions of the money market assets. The main function ----------------------
of DHFI is to smoothen the short-term liquidity imbalances by developing an
active secondary market. DHFI participates in call/notice/term money markets ----------------------
both as borrower and lender, purchased and sold T bills, commercial bills,
commercial paper and certificate of deposits. ----------------------
Primary Dealers ----------------------

The objectives of PD’s include ----------------------
●● s trengthening the infrastructure in the government securities market
----------------------
including money markets, to make them vibrant.
●● t o ensure the development of underwriting and market making for ----------------------
government securities.
----------------------
●● to improve the secondary market trading system.
Money Market Instruments ----------------------
1. ‘T’ Bills ----------------------

2. Commercial Paper (CP) ----------------------

Notes 3. Certificates of Deposits (CDs)
4. Money Market Mutual Funds
----------------------
5. Repos and Reverse Repos Market
----------------------
T-bills were introduced to stabilise the money markets. They are sold
---------------------- on the basis of fortnightly auction, but the amount, however is not specified
in advance. These bills have been instrumental in reducing the net RBI credit
---------------------- to the government. They have become extremely popular due to their higher
yield coupled with liquidity and safety and are being used as benchmark. They
----------------------
have also widened the money market and provided an innovative outlet for the
---------------------- surplus funds.
---------------------- 14 - Days Intermediate T-Bills

The participants in these bills are state governments, foreign central
---------------------- banks, and specified bodies. These are non-transferable and are issued only in
---------------------- book entry forms and would be redeemed at par.
The government uses T-bills to tide over its short term mismatches between
---------------------- its revenues and expenditure. Since this is borrowings by the government they
---------------------- are absolutely safe and have almost no risk. Banks park their liquidity in these
instruments. The T-Bills are issued for 14, 91,180 or 364 days. This means that
---------------------- these are short term borrowings. T-Bills can also be traded in secondary markets
as well. This provides liquidity to the investors.
----------------------
---------------------- Check your Progress 3

---------------------- Fill in the blanks.
---------------------- 1. Short-term in Indian context means a period up to _____.
---------------------- 2. In the money market, the operations are for short duration as compared
to _________.
----------------------
----------------------
1. The RBI jointly with the public sector banks and the all India financial
---------------------- institutions set up the Discount and Finance House of India Ltd.
---------------------- 2. T-bills were introduced to stabilise the capital markets.
----------------------
---------------------- Activity 5
---------------------- 1. Find out if there can be common players in both the capital and money
markets. List the entities that can be present in both these markets.
----------------------
2. Make a list of largest five Primary Dealers in the market.
----------------------
----------------------
12 Capital Market
1.9 INSTRUMENTS IN MONEY MARKETS Notes
Commercial Paper Market ----------------------
Following the acceptance of Vaghul committee recommendations, RBI ----------------------
allowed the issue of CPs in 1989.
The CP is a short- term negotiable instrument, consisting of primary ----------------------
notes with a fixed maturity, indicating the short-term obligation of an issuer. ----------------------
Companies as a means of raising short-term debt issue it. It is issued on a
discount to face value basis but can also be issued in interest bearing form. The ----------------------
issuer promises the buyer a fixed amount at a future date but pledges no assets.
----------------------
A CP, as a short-term financial instrument, has several advantages to the
issuer. It involves very little documentation. It is flexible in terms of maturity. ----------------------
It is unsecured. There are no limitations on the end use of the funds used in this
----------------------
manner. They are negotiable and transferable instruments and are highly liquid.
The participants in this market are the corporate bodies, banks, mutual ----------------------
funds, UTI, LIC, GIC and others who have surplus funds and are on a lookout
----------------------
for opportunities for short-term investments. The DFHI also operates both in
the primary and secondary markets for CPs by quoting its bid and offering ----------------------
prices.
----------------------
The CP market is fairly popular these days, however a secondary market
in these is yet to develop. ----------------------
Certificate of Deposits ----------------------
A CD is a document title to a time deposit and can be distinguished from
the conventional time deposit in respect of its free negotiability and hence ----------------------
marketability. CD’s are a marketable receipt of funds deposited in a bank for a ----------------------
fixed period at a specified rate of interest. They are bearer instruments and are
readily negotiable. ----------------------
As per the RBI scheme, the CD can be issued only by scheduled ----------------------
commercial banks at a discount rate from the face value, and the discount rate
can be freely determined. It means that there is no restriction on the rate of ----------------------
interest that can be paid to a depositor.
----------------------
The CD can be issued to individuals, corporates, companies, trust funds,
association and so on. The NRI’s can also subscribe to them, but only on non- ----------------------
repatriable basis.
----------------------
The banks are required to maintain the usual SLR and CRR on the issue
price of CD’s, nor buy them back prematurely. They are freely transferable ----------------------
by endorsement and delivery after 45 days from the date of issue, and are in
----------------------
the form of usance promissory note payable on a fixed date without any grace
period. The maturity period of CD’s is 3-12 months. However, six all India ----------------------
financial institutions are allowed to issue CD’s with maturity of 1 to 3 years.
----------------------
----------------------

Notes RBI guidelines
●● he denomination of CDs is to be in the multiples of Rs. 5 lakhs, subject
T
----------------------
to a minimum size of an issue to a single investor being 25 lakhs.
---------------------- ●● The maturity period to range from 3 months to one year.
---------------------- ●● hey are freely transferable by endorsement and delivery after the initial
T
lock in a period of 45 days.
---------------------- ●● Premature buy back is not permitted.
---------------------- ●● he Development Financial Institutions can issue CDs with the maturity
T
period of more than one year.
----------------------
Commercial Bills Market
---------------------- Section 5 of negotiable instruments act defines Bill of Exchange as
---------------------- follows:
“An instrument in writing containing an unconditional order, signed by
---------------------- the maker, directing a certain person to pay a certain sum of money only to, or
---------------------- to the order of a certain person or to the bearer of the instruments.”
Commercial bill market is an important source of short-term funds for
----------------------
trade and industry. Commercial banks play a significant role in this market.
---------------------- It is observed that in spite of many advantages offered by bills finance
most businesses in India prefer cash credit as the preferred way of financing
----------------------
their working capital requirements. Even banks seem to be happy providing
---------------------- cash credit or in case of large borrowers, working capital term loans. Thus,
there is an absence of bills culture in India.
----------------------
The bills rediscounting market among the banks are very shallow. Though
---------------------- the RBI has allowed the Development Financial institutions to rediscount bills
discounted by the commercial banks, this market has not yet developed.
----------------------
New Bill Market Scheme 1970
---------------------- Following the recommendations of M. Narasimhan study group, RBI
---------------------- announced new bill market scheme. Under this scheme
1. All eligible banks can offer bills of exchange for rediscount.
----------------------
2. The bills of exchange have to be genuine trade bills.
----------------------
3. The bill should not have a maturity time of more than 90 days, but may
---------------------- in exceptional cases, have usance upto 120 days and when it is offered to
the Reserve Bank for rediscount its maturity should not exceed 90 days.
----------------------
4. The bills should have at least two good signatures, one of which should
---------------------- be that of a licensed scheduled bank.
---------------------- 5. It excludes bills arising out of sale of such commodities as may be

indicated by RBI from time to time.
---------------------- 6. The banks can retire the bills before due dates at their option. In such
---------------------- cases discount charged will be refunded on pro-rata basis.
14 Capital Market
The banks do not need to physically lodge the bills with the RBI for Notes
getting them rediscounted.
----------------------
Money Market Mutual Funds
To enable the small investors to participate in the money market, a money ----------------------
market mutual fund is a conduit through which they can earn market related
----------------------
yield.
MMMFs invest the funds collected from the investors in instruments ----------------------
like, a) Treasury bills and Government securities. b) Call/Notice money, c)
----------------------
Commercial bills, d) Commercial paper, e) Certificate of deposit.
They are free to determine the extent of their investments in each of the ----------------------
above instruments; in accordance with the guidelines laid down by the RBI. ----------------------
Repos and Reverse Repos
----------------------
Repo/ready forward/purchase (buy-back) transactions/deal is an
agreement between a seller and buyer stipulating the sale and later repurchase ----------------------
of securities at a particular price and a date. It is essentially a short-term loan
to the seller with securities issued as collateral. Similarly, the buyer purchases ----------------------
securities with an agreement to sell the same to the seller on an agreed date in ----------------------
future at a prefixed price. For the buyer of the securities it is a reverse repo deal.
In a standard ready forward transaction (repo) when a bank sells securities ----------------------
to another bank, it simultaneously enters into a contract with the latter to
----------------------
repurchase them at a predetermined date and price in future. Both sale and
repurchase prices are determined prior to entering in a deal. ----------------------
Securities Trading Corporation of India Ltd. (STCI)
----------------------
The RBI has set up STCI in 1994, with an authorised capital of Rs. 500
crores. The objective is to promote a secondary market in government securities. ----------------------
Its operations extend to dated government securities, treasury bills, in ----------------------
borrowing and lending in call money markets.
Market Stabilisation Bonds ----------------------
Due to the immense inflow of the foreign exchange in India the RBI has ----------------------
to issue bonds to suck out this excess liquidity from the markets. This helps RBI
to maintain stability in the Forex markets. However, this borrowing adds the ----------------------
government’s borrowing.
----------------------
The RBI will hold the amounts raised through bonds in a separate account.
These borrowings will add to the government’s debt, the move will not impact ----------------------
the fisc, except to the extent of the cost of servicing the interest on these bonds.
The maturity of these bonds, the timing of their launch will be decided by the ----------------------
RBI in consultation with the government. The tenor could be matched with ----------------------
the expected outflows based on RBI’s assessment. There will be put and call
options available on these bonds. It is expected that these bonds will be actively ----------------------
traded in the markets.
----------------------
----------------------

Notes What’s a repo or repurchase pact?
REPO, repurchase agreement or a ready forward sale, are all terms for a
---------------------- sale and repurchase agreement in money markets. It is a transaction whereby
---------------------- banks and other financial institutions raise and invest short-term funds.
Under this transaction a holder of securities (generally government bonds)
---------------------- sells them to an investor with an agreement to repurchase them at a fixed price
---------------------- on a fixed date. The security “buyer” in effect lends the “seller” money for
the period of the agreement, and the terms of the agreement are structured to
---------------------- compensate him for this.
---------------------- Thus, while the party which sells securities with a promise to buy them
back is actually borrowing money, the purchasers of the securities in the first
---------------------- instance finds the repo a money market investment.
---------------------- Dealers use repo extensively to finance their positions. But when the
Reserve Bank of India (RBI) is said to be holding a repo, it is the selling
---------------------- securities to mop up funds from the banking system.
---------------------- Who are the players suitable to do a repo?
---------------------- Although there are no restrictions on the persons who qualify for entering
into a repo transaction, by its very nature, such lending transactions are suitable
---------------------- for institutional players (mostly banks) who need an avenue to raise or invest
large amounts for the short-term.
----------------------
However, when it comes to repos in government securities, the government
---------------------- has come up with very strict guidelines following the money markets scam. It
has also limited the number of players who are allowed to do repos to very few
---------------------- market participants such as banks and primary dealers.
---------------------- What is the need for a repo transaction?
---------------------- Unlike a general borrowing or lending transaction in the money markets,
repos are much safer as the lender holds government securities in his own name,
---------------------- and it is therefore a zero risk transaction for him.
---------------------- The second purpose it solves is that it helps banks in meeting their
mandatory requirements for investing in government securities. Under the law,
---------------------- banks are required to invest a certain portion of their deposits in government
securities. If their holdings are not up to the prescribed level, they are liable
----------------------
for punitive action. So if a bank needs securities for a short period, the repo
---------------------- provides an excellent opportunity.
---------------------- How is the interest on a repo calculated?

Although there is no separate interest pay-out, there is an implicit interest
---------------------- cost in the form of the higher repurchase price. Thus, the interest cost on the
---------------------- repo is calculated by dividing the difference between the sale and repurchase
price by the initial sale price.
----------------------
----------------------
16 Capital Market
What is the period for which a repo transaction can be held? Notes
This is an area in which there is a certain ambiguity. Although there are
----------------------
no legal restrictions on the tenure for a repo agreement, the Securities Contracts
Regulation Act says that any agreement for the purchase of securities cannot ----------------------
be carried forward beyond 14 days. This means that the sale and delivery in a
securities transaction should be completed within 14 days. Although this applies ----------------------
to direct sales of securities, for lack of legal clarity it is assumed that even repo
----------------------
transactions have to be restricted to 14 days.
Why does the RBI hold repos? ----------------------
When the RBI announces a repo it has an entirely different objective. ----------------------
Following liberalisation, the RBI has decided to leave it to the market to
determine the interest rate and also the exchange rate for the rupee. However, as ----------------------
the central bank, it is the RBI’s job to maintain stability in the markets through
----------------------
interventions and open market operations.
The repo is one such market operation by the Reserve Bank of India. ----------------------
When an RBI does a repo, what it actually does is remove excess funds from the ----------------------
market. At the same time, its repo rate also provides an indication of its view on
what the interest rate should be. ----------------------
Sometimes, RBI also conducts a `reverse repo’. This transaction has the ----------------------
opposite effect to that of a repo and infuses funds into the market.
Options in FOREX markets ----------------------
Options price within a specified period of time. ----------------------

The writer grants this right to the buyer for a certain sum of money called ----------------------
the option premium. An option that grants the buyer the right to buy some
instrument is called a call option. An option that grants the buyer the right to sell ----------------------
an instrument is called a put option. The price at which the buyer can exercise
----------------------
his option is called the exercise price, strike price or the striking price.
Options agreement is a contract in which the writer of the option grants ----------------------
the buyer of the option the right purchase from or sell to the writer a designated ----------------------
instrument for a specified area available on a large variety of underlying assets
like common stock, currencies, debt instruments and commodities. Also traded ----------------------
are options on stock indices and futures contracts - where the underlying is a
futures contract and futures style options. ----------------------
Options have proved to be a versatile and flexible tool for risk management ----------------------
by themselves as well as in combination with other instruments. Options also
provide a way for individual investors with limited capital to speculate on the ----------------------
movements of stock prices, exchange rates, commodity prices etc. The biggest ----------------------
advantage in this context is the limited loss feature of options.
Types of Options ----------------------
As mentioned earlier, the underlying asset for options could be a spot ----------------------
commodity or a futures contract on a commodity. Another variety is the futures-
----------------------
style option.

Notes An option on spot foreign exchange gives the option buyer the right to
buy or sell a currency at a stated price (in terms of another currency). If the
---------------------- option is exercised, the option seller must deliver or take delivery of a currency.
---------------------- An option on currency futures gives the option buyer the right to establish
a long or short position in a currency futures contract at a specified price. If the
---------------------- option is exercised, the seller must take the opposite position in the relevant
futures contract. For example, suppose you had an option to buy a December
----------------------
DM contract on the IMM at a price of $ 0.58 / DM. You exercise the option
---------------------- when December futures are trading at $ 0.5895. You can close out your position
at this price and take a profit of $ 0.0095 per DM or, meet futures margin
---------------------- requirements and carry a long position with $ 0.0095 per DM being credited
to your margin account. The option seller automatically gets a short position in
----------------------
December futures.
---------------------- Futures style options are a little bit more complicated. Like futures
contracts, they represent a bet on a price. The price being betted on, is the price
----------------------
of an option on spot foreign exchange. Simply put, the buyer of the option has
---------------------- to pay a price to the seller of the option i.e. the premium or the price of the
option. In a futures style option, you are betting on the changes in this price,
---------------------- which, in turn depends on several factors including the spot exchange rate of the
currency involved. For instance, a trader feels that the premium on a particular
----------------------
option is going to increase. He buys a futures-style call option. The seller of this
---------------------- call option is betting that the premium will go down. Unlike the option on the
spot, the buyer does not pay the premium to the seller. Instead, they both post
---------------------- margins related to the value of the call on spot.
---------------------- Options Terminology
---------------------- To reiterate, the two parties to an options contract are the option buyer
and the option seller, also called the option writer. For exchange traded options,
---------------------- as in the case of futures, once the agreement is reached between two traders,
the exchange (the clearing house) interposes itself between the two parties
---------------------- becoming buyer to every seller and seller to every buyer. The clearing house
---------------------- guarantees performance on the part of every seller.
Call Option
----------------------
A call option gives the option buyer the right to purchase currency Y
---------------------- against currency X, at a stated price X/Y, on or before a stated date. For exchange
traded options, one contract represents a standard amount of the currency Y.
---------------------- The writer of a call option must deliver the currency if the option buyer chooses
---------------------- to exercise his option.
Put Option
----------------------
A put option gives the option buyer the right to sell a currency Y against
---------------------- currency X at a specified price on or before a specified date. The writer of a put
option must take delivery if the option is exercised.
----------------------
----------------------
18 Capital Market
Strike Price (also called exercise price) Notes
The price specified in the option contract at which the option buyer can
----------------------
purchase the currency (call) or sell the currency (put) Y against X.
Maturity Date ----------------------
The date on which the option contract expires is the maturity date. ----------------------
Exchange traded options have standardised maturity dates.
----------------------
American Option
An option, call or put, that can be exercised by the buyer on any business ----------------------
day from initiation to maturity. ----------------------
European Option
----------------------
A European option is an option that can be exercised only on maturity date.
----------------------
Premium (Option price, Option value)
The fee that the option buyer must pay the option writer at the time the ----------------------
contract is initiated. If the buyer does not exercise the option, he stands to lose
----------------------
this amount.
Intrinsic value of the option ----------------------
The intrinsic value of an option is the gain to the holder on immediate ----------------------
exercise of the option. In other words, for a call option, it is defined as Max
[(S-X), 0], where s is the current spot rate and X is the strike rate. If S is greater ----------------------
than X, the intrinsic value is positive and if S is less than X, the intrinsic value ----------------------
will be zero. For a put option, the intrinsic value is Max [(X-S), 0]. In the case
of European options, the concept of intrinsic value is notional as these options ----------------------
are exercised only on maturity.
----------------------
Time value of the option
----------------------
The value of an American option, prior to expiration, must be at least
equal to its intrinsic value. Typically, it will be greater than the intrinsic value. ----------------------
This is because there is some possibility that the spot price will move further
in favour of the option holder. The difference between the value of an option at ----------------------
any time “t” and its intrinsic value is called the time value of the option.
----------------------
At-the-Money, In-the-Money and Out-of-the-Money options
----------------------
A call option is said to be at-the-money if S = X i.e. the spot price is equal
to the exercise price. It is in-the-money is S > X and out-of-the-money is S < X. ----------------------
Conversely, a put option is at-the-money is S = X, in-the-money if S < X and
out-of-the-money if S > X. ----------------------
Option Pricing ----------------------
Black and Scholes, in their celebrated analysis on option pricing, reached ----------------------
the conclusion that the estimated price of a call could be calculated with the
following equation: ----------------------
Pc = [Ps][N(d1) - [Pe][antilog (-Rft)[N(d2)] ----------------------

Notes where
Pc - market value of the call option
----------------------
Ps - price of the stock
----------------------
Pe - strike price of the option
---------------------- Rf - annualised interest rate
---------------------- t - time to expiration in years
---------------------- antilog - to the base e
N(d1) and N(d2) are the values of the cumulative normal distribution, defined
----------------------
as follows:
---------------------- d1 = Ln (Ps / Pe) + (Rf + 0.5 s2)t
---------------------- sÖt
---------------------- d2 = d1 - (s Ö t)
where:
----------------------
Ln (Ps / Pe) is the natural logarithm of (Ps / Pe)
----------------------
s2 is the variance of continuously compounded rate of return on stock per time
---------------------- period.
Admittedly, the definitions of d1 and d2 are difficult to grasp for the
----------------------
reader as they involve complex mathematical equations. However, the basic
---------------------- properties of the Black-Scholes model are easy to understand. What the model
establishes is that the estimated price of options vary directly with an option’s
---------------------- term to maturity and with the difference between the stock’s market price
and the option’s strike price. Further, the definitions of d1 and d2 indicate that
----------------------
option prices increase with the variance of the rate of return on the stock price,
---------------------- reflecting that the greater the volatility, higher the chance that the option will
become more valuable.
----------------------
Relationship between the option premium and stock price
---------------------- It is obvious that the option premium fluctuates as the stock price moves
---------------------- above or below the strike price. Generally, option premiums rarely move point
for point with the price of the underlying stock. This typically happens only
---------------------- at parity, in other words, when the exercise price plus the premium equals the
market price of the stock.
----------------------
Prior to reaching parity, premiums tend to increase less than point per
---------------------- point with the stock price. One reason for this are that point per point increase
in premium would result in sharply reduced leverage for the option buyers -
---------------------- reduced leverage means reduced demand for the option. Also, a higher option
---------------------- premium entails increased capital outlay and increased risk, once again reducing
demand for the option.
----------------------
----------------------
20 Capital Market
Declining stock prices also do not result in a point per point decrease in Notes
option premium. This is because, even a steep decline in the stock price in a
span of a few days has only a slight effect on the option’s total value - its time ----------------------
value. This term to maturity effect tends to exist as the option is a wasting asset.
----------------------
Option Strategies
----------------------
This section deals with some of the most basic strategies that can be
devised using options. The idea is to familiarise the reader with the flexibility ----------------------
of options as a risk management tool. In order to keep matters simple, we make
the following assumptions: ----------------------
●● We shall ignore brokerage, commissions, margins etc. ----------------------
●● We shall assume that the option is exercised only on maturity and not
----------------------
prematurely exercise - in other words, we assume that we are only dealing
with European options ----------------------
●● All exchange rates, strike prices and premia will be in terms of dollars per
----------------------
unit of a currency and the option will be assumed to be on one unit of the
currency. ----------------------
Call Options
----------------------
A call option buyer’s profit can be defined as follows:
----------------------
At all points where S < X, the payoff will be-c
At all points where S > X, the payoff will be S-X- c, where ----------------------
S = Spot price ----------------------
X = Strike price or exercise price
----------------------
c = Call option premium
Conversely, the option writer’s profit will be as follows: ----------------------
At all points where S < X, the payoff will be c ----------------------
At all points where S > X, the payoff will be -(S-X- c)
----------------------
To illustrate this, let us look at an example and construct the payoff profile.
----------------------
Consider a trader who buys a call option on the Swiss Franc with a strike price
of $ 0.66 and pays a premium of 1.95 cents ($0.0195). The current spot rate is ----------------------
0.6592. His gain or loss at time T when the option expires depends upon the
value of the spot rate at that time. ----------------------
For all values of S below 0.66, the option buyer lets the option lapse since the ----------------------
Swiss francs can be bought in the spot market at a lower price. His loss then will
be limited to the premium he has paid. For spot values greater than the strike ----------------------
price, he will exercise the option.
----------------------
----------------------
----------------------
----------------------

Notes Let us look at the payoff profile of the call option buyer.
SPOT RATE GAIN (S-X-c) LOSS (-c)
----------------------
0.6000 - -0.0195
----------------------
0.6500 - -0.0195
---------------------- 0.6600 - -0.0195
---------------------- 0.6700 - -0.0195
0.6795 - -
----------------------
0.6800 0.0005 -
---------------------- 0.6900 0.0105 -
---------------------- 0.7000 0.0205 -
---------------------- Similarly, we can construct the payoff profile for the call writer. This will be as
follows:
---------------------- SPOT RATE GAIN (c) LOSS (S-X-c)
---------------------- 0.6000 0.0195 -
0.6500 0.0195 -
----------------------
0.6600 0.0195 -
---------------------- 0.6700 0.0195 -
---------------------- 0.6795 - -
0.6800 - -0.0005
---------------------- 0.6900 - -0.0105
---------------------- 0.7000 - -0.0205
---------------------- Put Option

A put option buyer’s profit can be defined as follows:
----------------------
At all points where S < X, the payoff will be X-S-p
---------------------- At all points where S > X, the payoff will be -p, where
---------------------- S = Spot price
X = Strike price or exercise price
---------------------- p = put option premium
---------------------- Conversely, the put option writer’s profit will be as follows:
At all points where S < X, the payoff will be -(X-S- p)
----------------------
At all points where S > X, the payoff will be p
---------------------- For example, let us take the case of a trader who buys a June put option on
pound sterling at a strike price of $ 1.7450, for a premium of $ 0.05 per sterling.
----------------------
The spot rate at that time is $ 1.7350.
---------------------- For all values of S greater than $ 1.7450, the option will not be exercised as the
sterling has a higher price in the spot market. For values between $ 1.6950 and
---------------------- $ 1.7450, the option will be exercised, though there will still be a loss. Here
---------------------- the option buyer is trying to minimize the loss. For values of spot rate below $
1.6950, the option will be exercised and will lead to a net profit.
22 Capital Market
At expiry, the put option buyer’s payoff profile can be depicted as follows: Notes
SPOT RATE GAIN (X-S-p) LOSS (-p)
----------------------
1.6600 0.0350 -
1.6800 0.0150 - ----------------------
1.6900 0.0050 - ----------------------
1.6950 - -
----------------------
1.7400 - -0.0450
1.7500 - -0.0500 ----------------------
1.7800 - -0.0500
----------------------
1.8000 - -0.0500
Similarly, we can construct a payoff profile for the put option writer. His gains ----------------------
and losses will look as follows: ----------------------
SPOT RATE GAIN (p) LOSS -(X-S-p)
----------------------
1.6600 - -0.0350
1.6800 - -0.0150 ----------------------
1.6900 - -0.0050 ----------------------
1.6950 - -
----------------------
1.7400 0.0450 -
1.7500 0.0500 - ----------------------
1.7800 0.0500 -
----------------------
1.8000 0.0500 -
Spread Strategies ----------------------
Spread strategies with options involve simultaneous sale and purchase of ----------------------
two different option contracts. The objective in these strategies is to realize a
profit if the underlying price moves in a fashion that is expected and to limit the ----------------------
magnitude of loss in case it moves in an unexpected fashion. Evidently, these ----------------------
are speculative in nature. However, these strategies are such that they provide
limited gains while also ensuring limited losses. ----------------------
Spread strategies involving options with same maturity but different strike ----------------------
prices are called vertical spreads or price spreads. The types of vertical spread
strategies are bullish call spreads, bearish call spreads, bullish put spreads and ----------------------
bearish put spreads. The expectation when going in for these strategies is that
the underlying rate is likely to either appreciate or depreciate significantly. ----------------------
Horizontal or time spread strategies involve simultaneous buying and ----------------------

selling of two options which are similar in all respects except in maturity. The
----------------------
basic idea behind this is that the time value of the short maturity option will
decline faster than that of the long maturity option. The expectation when going ----------------------
for this strategy is that the underlying price will not change drastically but the
difference in premia will over time. ----------------------
----------------------

Notes Vertical Spread Strategies
A bullish call consists of selling the call with the higher strike price and
----------------------
buying the call with the lower strike price. The expectation in the underlying
---------------------- currency is likely to appreciate. The investor however, would like to limit his
losses.
----------------------
Since a lower priced call is being bought i.e. higher premium is paid and
---------------------- a higher priced call is being sold i.e. lower premium is received, the initial net
investment would be the difference in the two premia. The maximum profit
---------------------- potential will be the difference in the strike prices minus the initial investment.
The maximum loss is the initial investment. This strategy thus yields a limited
----------------------
profit if the currency appreciates and a limited loss if the currency depreciates.
---------------------- On the other hand, if the investor expects the currency to depreciate, he
can go in for the bearish call spread. This is the reverse of the bullish spread i.e.
----------------------
the call with the higher strike price is bought and that with the lower strike price
---------------------- is sold. The maximum gain will be the difference in the premia. The maximum
loss will be the difference is premia minus the difference in the strike prices.
----------------------
A bullish put spread consists of selling a put option with higher strike
---------------------- price and buying a put option with a lower strike price. In this case, if there is
a significant appreciation in the underlying rate, neither put will be exercised
---------------------- and the net gain will be the difference in premia. Maximum loss will be the
---------------------- difference in strike prices minus the difference in premia. A bearish put spread
is the opposite of a bullish put spread.
---------------------- An extension of the idea of vertical spreads is the butterfly spread. A
---------------------- butterfly spread involves three options with different strike prices but same
maturity. A butterfly spread is bought by purchasing two calls with the middle
---------------------- strike price and selling one call each with the strike price on either side. The
investor’s expectation is that there will be a significant movement in the
---------------------- underlying rate - he is, however, unsure of the direction of this movement. This
---------------------- strategy yields a limited profit if there is a significant movement in the underlying
rate - appreciation or depreciation. But if the movements are moderate or not
---------------------- very significant, it tends to result in a loss.
---------------------- Selling a butterfly spread involves selling two intermediate priced calls
and buying one on either side. As opposed to the buyer of a butterfly spread,
---------------------- the seller here is betting on moderate or non-significant movements. He does
not expect drastic movements either way. Therefore, this strategy yields a small
---------------------- profit if there are moderate changes in the exchange rate and a limited loss if
---------------------- there are large movements on either side.
----------------------
----------------------
----------------------
----------------------
24 Capital Market
Horizontal or Time Spreads Notes
As mentioned earlier, horizontal or time spread strategies involve
----------------------
simultaneous buying and selling of two options which are similar in all respects
except in maturity. The basic idea behind this is that the time value of the short ----------------------
maturity option will decline faster than that of the long maturity option.
----------------------
Straddles and Strangles
A Straddle strategy consists of buying a call and a put both with identical ----------------------
strikes and maturity. If there is a drastic depreciation, the investor gains on the
----------------------
put i.e. by exercising the option to sell. If there is a drastic appreciation, the
investor exercises the call and purchases at the lower price. However, if there is ----------------------
a moderate movement either way, the investor will suffer a loss.
----------------------
A strangle is similar to a straddle. It consists of buying a call with strike
above the current spot rate and a put with a strike price below the current spot. ----------------------
Like the straddle, it yields a profit for drastic movements and a loss for moderate
movements. ----------------------
Currency options thus, provide the corporate treasurer a tool for hedging ----------------------
foreign exchange risks arising out of the firm’s operations. Unlike the forward
contracts, options allow the hedger to gain from favourable exchange rate ----------------------
movements while being protected against unfavourable movements. ----------------------
----------------------
Fill in the blanks.
1. An option that grants the buyer the right to buy some instrument is ----------------------
called a _______ option. ----------------------
2. The two parties to an options contract are the option buyer and the ----------------------
option seller, also called the _______.
----------------------
Activity 6 ----------------------
Find out the rates of REPO transaction prevailing at present. See how they ----------------------
have moved over the last one year. ----------------------
----------------------
Summary
----------------------
●● The capital market is a market where borrowing and lending of long-term
funds takes place. ----------------------
●● The participants in 14 - Days Intermediate T-Bills bills are state ----------------------
governments, foreign central banks, and specified bodies.
----------------------
●● The CP is a short- term negotiable instrument, consisting of primary notes
with a fixed maturity, indicating the short-term obligation of an issuer. ----------------------

Notes Keywords
----------------------
●● Demutilisation of stock exchanges: Exchanges are turned into limited
---------------------- companies.
●● Derivatives: The way to deal in stock in the forward markets instead of
---------------------- cash markets.
---------------------- ●● Disinvestment: Government selling its stake in the PSUs either to the
public or to a strategic investors.
----------------------
●● Public issue: When a company makes an open offer to sell its shares to
---------------------- public at large and then lists them on the stock markets.
---------------------- ●● Rights issue: When shares are offered to the existing shareholders of the
company.
----------------------
---------------------- Self-Assessment Questions
---------------------- 1. Describe the Indian Capital markets.

2. Who are the constituents of capital markets?
----------------------
3. What changes have taken place in the markets since the liberalisation of
---------------------- Indian economy?
---------------------- 4. What is the importance of capital markets for the Indian economy?
---------------------- 5. Which of the recent issues that have hit the market in the past one year
have done well post listing?
---------------------- 6. Which issues that came to the market in the last one year are quoting
---------------------- below their issue price? What are the reasons for this?
7. Do you believe that stock markets should turn themselves into limited
----------------------
companies? What will be the advantages of such a move?
---------------------- 8. Discuss the tax structure that is applicable to stock markets. What changes
made by the successive governments have helped in deepening of stock
----------------------
markets?
----------------------
----------------------
----------------------
----------------------
1. True
---------------------- 2. True
----------------------
----------------------
----------------------
26 Capital Market
Check your Progress 2 Notes
Fill in the blanks.
----------------------
1. It is Reliance, which was instrumental in spreading the equity culture in
our country. ----------------------
2. The establishment of National Stock Exchange was the turning point in ----------------------
the working of Indian capital markets
----------------------
Fill in the blanks. ----------------------
1. Short term in Indian context means a period up to one-year. ----------------------

2. In the money market, the operations are for short duration as compared to ----------------------
capital markets.
----------------------
1. True ----------------------
2. False ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. An option that grants the buyer the right to buy some instrument is called
a call option. ----------------------
2. The two parties to an options contract are the option buyer and the option ----------------------
seller, also called the option writer.
----------------------
Suggested Reading ----------------------
1.
Chisholm, Andrew M. 2002. An Introduction to Capital Markets: ----------------------
Products, Strategies, Participants. John Wiley and sons India.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
28 Capital Market
Securities and Exchange Board of India (SEBI)
UNIT
2
Structure:
2.1 Introduction
2.2 Objectives of SEBI
2.3 The Role assigned to SEBI
2.4 The Functions of the Board
2.5 SEBI Guidelines for Issue of Debt Instruments
2.6 SEBI and Individual Investor
2.7 What SEBI does with its Powers
Case Study
Summary
Keywords
Suggested Reading
Securities and Exchange Board of India (SEBI) 29

Notes
Objectives
----------------------
----------------------
●● Explain the objectives of SEBI.
---------------------- ●● Identify the role assigned to SEBI.
---------------------- ●● Classify the functions of the board.
---------------------- ●● Explain SEBI guidelines for issuance of debentures.
●● Analyse the powers that SEBI holds.
----------------------
●● Evaluate the role of SEBI.
----------------------
2.1 INTRODUCTION
----------------------
Securities and Exchange Board of India was formulated on the lines of
----------------------
Securities Exchange Commission of USA. The main role of SEBI is to act as a
---------------------- regulator of the capital markets and its constituents. These powers were initially
with the Central Government Ministries like Law, Finance and Company Affairs.
---------------------- These powers are now given to SEBI and it has become the sole regulator of the
Capital Markets.
----------------------
---------------------- 2.2 OBJECTIVES OF SEBI

---------------------- The Securities and Exchange Board of India was set up on April 12, 1988,
following the recommendations of the high powered G. S. Patel committee on
----------------------
Stock Exchange Reforms.
---------------------- SEBI seeks to create an environment, which would facilitate mobilisation
of adequate resources through the securities market and its efficient allocation.
----------------------
This environment would include rules and regulations, institutions and their
---------------------- interrelationships, instruments, practices, infrastructure within an appropriate
policy framework, and an overall air of fairness. The market must create
---------------------- confidence in the minds of the investors.
---------------------- SEBI has to be responsive to the needs of three groups, which constitute
the market:
----------------------
a) the issuers of securities
---------------------- b) the investors and
---------------------- c) the market intermediaries
---------------------- It must be understood that all investors carry certain risk and it is for
the investor to take risks and choose his investments judiciously. SEBI cannot
---------------------- eliminate all such risks or the consequences of the risks. The existence of SEBI
does not remove the need on the part of the investor to carefully consider where
----------------------
he wants to invest his money or the possibility that his investment decision may
---------------------- go wrong.
30 Capital Market
Notes
----------------------
----------------------
1. The main role of SEBI is to act as a regulator of the capital markets
and its constituents. ----------------------
2. The Securities and Exchange Board of India was set up on April 12, ----------------------
1999.
----------------------
----------------------
Activity 1
----------------------
Find out who are the market intermediaries.
----------------------
2.3 THE ROLE ASSIGNED TO SEBI ----------------------
1. SEBI shall create a proper and conducive atmosphere required for ----------------------
raising money from the capital market. The atmosphere includes rules, ----------------------
regulations. Trade practices, customs and relations among institutions,
brokers, investors and companies. SEBI is responsible for safeguarding ----------------------
the interests of small investors.
----------------------
2. SEBI shall educate investors and make them aware of their rights in clear
and specific terms. ----------------------
3. SEBI shall create proper investment climate to enable corporate sector to ----------------------
raise industrial securities easily, efficiently and at affordable cost.
----------------------
4. SEBI shall develop a proper infrastructure so that market automatically
facilitates expansion and growth of business of middlemen like brokers, ----------------------
banks, merchant bankers’ mutual funds etc. So it will ensure that they
provide efficient service to the constituents of the markets. ----------------------
5. SEBI shall make more effective laws in the existing statutes as far as they ----------------------
relate to the industrial securities, mutual funds, investments in Units, LIC
saving plans, Chit funds etc. ----------------------
6. SEBI shall create the framework for more open, orderly and unprejudiced ----------------------
conduct in relation to takeover and mergers in the corporate sector to
ensure fair and equal treatment to all the security holders and to facilitate ----------------------
such takeovers and mergers in the interest of efficiency by prescribing a ----------------------
mechanism for more orderly conduct.
----------------------
7. It shall devise laws with unified set of objectives, single administrative
authority and an integrated framework to deal with all the aspects of the ----------------------
securities market.
----------------------
8. It shall introduce a system of two-stage disclosure at the time of initial
issue and make compulsory for the companies to provide detailed ----------------------
information to all stock exchanges and investors on demand.
Notes 9. It shall work as an authoritative institution to see that the intermediaries
are financially sound and equipped with professional and competent
---------------------- manpower.
---------------------- 10. It shall ensure that the rules are versatile and non-rigid to provide automatic
and self regulatory growth.
----------------------
11. It shall establish effective inspection machinery, which is expected to act
---------------------- like an umpire.
12. It shall operate a security compensation fund in order to protect investors
----------------------
who suffer financial loss arising from the failure of a stockbroker to meet
---------------------- his contractual obligations.
---------------------- 13. It shall prohibit the malpractice prevailing in the market such as insider
trading, share cornering etc.
---------------------- The management of SEBI will be under the management board headed by
---------------------- a Chairman. The board shall consist of two members from amongst the officials
of the finance and law ministries. One member shall be from amongst the
---------------------- officials of Reserve Bank of India. Two more board members shall be appointed
by the Central government.
----------------------
The general superintendence, direction and management of the affairs of
---------------------- the board shall vest in a Board of members, which may exercise all powers and
do all acts and nothing which may be exercised or done by that Board.
----------------------
Save as otherwise determined by regulations, the Chairman shall also
---------------------- have powers of general superintendence and direction of the affairs of the board
and may also exercise all powers and do all acts and things which may be
----------------------
exercised or done by the Board. This provision makes the Chairman a very
---------------------- powerful person.

----------------------
Fill in the blanks.
---------------------- 1. SEBI shall create a proper and conducive atmosphere required for raising
---------------------- money from the _______.
2. The management of SEBI will be under the management board headed
---------------------- by a ________.
----------------------
---------------------- Activity 2
---------------------- Find out what role SEBI plays to educate investors.
----------------------
----------------------
----------------------
32 Capital Market
2.4 FUNCTIONS OF THE BOARD Notes
1. Regulating the business in stock exchanges and any other securities ----------------------
markets.
----------------------
2. Registering and regulating the working of stock brokers, sub-brokers,
share transfer agents, bankers to an issue, trustees to trust deeds, registrars ----------------------
to the issue, merchant bankers, underwriters, portfolio managers,
investment advisor and such other intermediaries who may be associated ----------------------
with securities markets in any manner. ----------------------
3. Registering and regulating the working of mutual funds.
----------------------
4. Promoting and regulating self-regulatory organisation.
----------------------
5. Prohibiting fraudulent and unfair trade practices.
6. Promoting investor’s education and training of intermediaries of the ----------------------
securities market.
----------------------
7. Prohibiting insider trading in securities.
----------------------
8. Regulating substantial acquisition of shares and take-over of companies.
9. Calling for information from, undertaking inspection, conducting, ----------------------
inquiring and audits of the stock exchanges and intermediaries and self- ----------------------
regulatory organisations in the securities market.
----------------------
No stock broker, sub-broker, share transfer agent, banker to an issue,
trustee of trust deed, registrar to an issue, merchant banker, underwriter, ----------------------
portfolio manager, investment advisor and such other intermediary who may
be associated with securities market buy, sell or deal in securities except under, ----------------------
and in accordance with the conditions of a certificate of registration obtained
----------------------
from the Board.
Every application for registration shall be in such manner and on payment ----------------------
of such fees as may be determined by regulations.
----------------------
The board may, by order, suspend or cancel a certificate or registration in
such a manner as may be determined by regulation. ----------------------
----------------------
----------------------
----------------------
1. Registering and regulating the working of mutual funds is not the
function of stock market. ----------------------
2. Every application for registration shall be in such manner and on ----------------------

payment of such fees as may be determined by regulations.
----------------------
----------------------
----------------------

Notes
Activity 3
----------------------
Find out what are self-regulatory organisations and list such organisations
----------------------
related to the participants in the capital markets.
----------------------
---------------------- 2.5 SEBI GUIDELINES FOR ISSUE OF DEBT

----------------------
INSTRUMENTS
---------------------- A company offering Convertible / Non-Convertible debt instruments

through public offer have to comply with the following guidelines:
---------------------- 1. Credit rating for these instruments is mandatory, irrespective of maturity
---------------------- or conversion period. The credit rating has to be disclosed in the offer
document.
----------------------
2. For an issue equal to or greater than Rs.100 crores two ratings from two
---------------------- different credit ratings have to be obtained.
3. If rating is obtained from two different credit rating agencies all ratings
----------------------
including the unaccepted rating shall be disclosed.
---------------------- 4. All the credit ratings obtained during the past three years preceding the
public or rights issue of debt instrument for any listed security of the
----------------------
Issuer Company shall be disclosed in the offer document.
---------------------- 5. In case of issue of debentures with maturity of more than 18 months, the
---------------------- issuer shall appoint a Debenture Trustee. The name of this trustee shall
be disclosed in the offer document. A trust deed shall be executed by the
---------------------- issuer company in favour of the debenture trustees within six months of
the closure of the issue. Trustees shall be vested with the requisite powers
---------------------- for protecting the interest of debenture holders.
---------------------- 6. The merchant banker shall alongwith draft offer document, file with SEBI
certificates from the bankers that the assets on which security is to be
---------------------- created are free from any encumbrances and the necessary permission
---------------------- has been obtained or a no-objection certificate from financial institutions
or banks for a second or pari passu charge in cases where assets are
---------------------- encumbered.
---------------------- 7. Trustees shall obtain a certificate from the company’s auditors in respect
of utilisation of funds during the implementation period of the project. In
---------------------- the case of debentures for working capital, certificate shall be obtained at
the end of each accounting year.
----------------------
8. A company has to create Debenture Redemption Reserve (DRR) in case
---------------------- of issue of debentures with a maturity period of more than 18 months.
---------------------- 9. DRR shall be treated as a part of General Reserve for consideration of
bonus issue proposals.
----------------------
34 Capital Market
10. A company shall create DRR equivalent to 50% of the amount of debenture Notes
issue before debenture redemption commences. Drawl for this reserve is
permissible only after the company has actually redeemed 10% of the ----------------------
debenture liability.
----------------------
11. In case of new companies, distribution of dividends shall require approval
of the trustees to the issue and the lead institution if any. Dividends may be ----------------------
distributed out of profit of particular years only after transfer of requisite
----------------------
amount to reserves.
12. The security shall be created within six months from the date of issue of ----------------------
debentures. If for any reason the company fails to create charge within 12
----------------------
months from the date of issue of debentures, the company shall be liable
to pay 2% penal interest to debenture holders. If security is not created ----------------------
even after 18 months, a meeting of the debenture holders shall be called
within 21 days to explain the reasons thereof and the date by which the ----------------------
security shall be created.
----------------------
13. In case no charge is created for debentures maturing in less than 18
months, the issuer company shall ensure compliance with the provisions ----------------------
of the Companies (Acceptance of deposit) Rules, 1975 as unsecured
----------------------
debentures/ bonds are treated as “ Deposits” for the purpose of these rules.
14. In case of roll over of debentures without the change of interest rate, ----------------------
following conditions will be followed: ----------------------
a) An option shall be compulsorily given to debenture holders to
redeem the debentures as per the terms of offer. ----------------------
b) Roll over shall be done only in cases where debenture holders have ----------------------
sent their consent for roll over. Non receipt of consent shall not be
considered as consent. ----------------------
c) Before the roll over fresh credit rating will have to be obtained. ----------------------
d) A fresh trust deed has to be executed. ----------------------
15. In case of conversion of instruments into equity capital by listed company, ----------------------
value of which exceeds Rs 50 lakhs and whose conversion price was not
fixed at the time of issue, holders of such instruments shall be given a ----------------------
compulsory option of not converting into equity capital. Conversion can
be done only in cases where instrument holders have sent their positive ----------------------
consent and not on the basis of non-receipt of their negative reply. ----------------------
SEBI Guidelines for Primary Markets
----------------------
1. A new company which has not completed 12 months commercial
production and does not have audited results and where the promoters ----------------------
don’t have a track record will have to issue shares only at par value.
----------------------
2. When a new company is being set up by an existing company having a
track record of five years of profitability and who holds 50% equity in the ----------------------
new company, such a company will be free to price its issue.
----------------------

Notes 3. The private and closely held companies having a track record of consistent
profitability for at least three years shall be permitted to price their issues
---------------------- freely.
---------------------- 4. Existing listed companies can price their issues freely.
5. In the case of composite issues i.e. Rights cum Public issue by existing
----------------------
listed companies differential pricing is allowed. This means that public
---------------------- and rights issue can be offered for different prices. However, justification
for the price difference should be given in the offer document.
----------------------
6. Lock in period is five years for the promoter’s contribution from the
---------------------- date of allotment or from the commencement of commercial production
whichever is later.
----------------------
7. Abridged prospectus must be attached with every application form.
---------------------- 8. Risk factors must be highlighted in the prospectus.
---------------------- 9. Objectives of the issue and the cost of the project should be disclosed in
the prospectus.
----------------------
10. Company’s management, past history and present business of the firm
---------------------- should be disclosed.
---------------------- 11. Particulars of the company and other listed companies under the same
management who have made public issues during the past three years are
---------------------- to be disclosed in the prospectus.
---------------------- 12. In case of premium issues the justification for the premium must be given.
---------------------- 13. Subscription for the issue has to be open for minimum three and maximum
ten working days.
---------------------- 14. The quantum of issue shall not exceed the amount specified in the
---------------------- prospectus. No retention of over subscription is permissible.
15. If minimum subscription of 90% has not been received the entire amount
----------------------
is to be refunded to investors.
---------------------- 16. Underwriting has been made mandatory.
---------------------- 17. In March 05 SEBI has hiked allocation for the retail investors in book-
built issues from 25% to 35%. On the other hand, the entitlement to non-
---------------------- institutional investors (High net worth individuals) has been reduced from
25% to 15%.
----------------------
18. SEBI has also redefined the retail investor by increasing the investment
---------------------- limit of this class in an IPO from the present Rs. 50,000 to Rs. 1,00,000.
---------------------- 19. SEBI has also recommended that the promoters’ holding in the companies
be capped at 55%.
----------------------
20. In book built issues SEBI has reduced the bidding period from current
---------------------- 5-10 days (including holidays) to 3-7 days.
----------------------
36 Capital Market
21. SEBI has provided more flexibility for listed companies to disclose price Notes
band/floor price during their public issues. They are allowed to disclose
the price one day before the opening of the bidding process. ----------------------
SEBI guidelines for Bonus Issue ----------------------
1. There should be a provision for issue of Bonus shares in the Articles of
----------------------
Association.
2. The issue has to be made out of free reserves built out of genuine profits ----------------------
or from the share premium account.
----------------------
3. Reserves created out of revaluation of fixed assets cannot be capitalised.
----------------------
4. The declaration of bonus in lieu of dividend is not allowed.
5. There should be no partly paid shares outstanding at the time of bonus ----------------------
issue. ----------------------
6. Bonus issue will not be allowed if the company has defaulted in the
----------------------
payment of statutory dues like provident fund, or in payment of principal
or interest on fixed deposits or debentures. ----------------------
7. No bonus issue can be made within 12 months of any public or rights
----------------------
issue.
8. Once the bonus issue is announced after the approval of the Board of ----------------------
Directors, it must implement the proposal within six months from the date ----------------------
of such proposal and shall not have the option of changing the decision.
9. Consequent to the issue of bonus shares, if the subscribed and paid up ----------------------
capital exceed the authorised share capital, a resolution shall be passed ----------------------
by the company at general body meeting for increasing the authorised
capital. ----------------------
10. Issue of bonus shares after any public/rights issue is subject to the ----------------------
condition that no bonus shall be made which will dilute the value or rights
of a holder of debentures, convertible partly or fully. ----------------------
Green-shoe-Option (GSO) in an IPO ----------------------
This was introduced in the Indian capital market in 2003 by SEBI. This
----------------------
mechanism is primarily introduced to protect the investors and give a boost to
the primary markets. ----------------------
In this mechanism one of the book running lead manager (BRLM) is
----------------------
appointed as a Stabilising Agent (SA). His main responsibility is to intervene in
the market when the share price of the newly issued shares falls below the issue ----------------------
price in the stock market. The BRLM can intervene and act as SA in the market
for a maximum of 30 days from the date of listing. ----------------------
The SA enters into an agreement with the issuer before the filing of the ----------------------
offer document with SEBI.
----------------------
----------------------

Notes How does GSO work?
The SA enters into an agreement with one of the promoters. Promoters
----------------------
lend their shares in case of the over subscription. A maximum 15% of the total
---------------------- issue size can be borrowed. The details of such an agreement are disclosed in
the Red herring prospectus.
----------------------
If the market prices of the shares fall below the issue price this mechanism
---------------------- is activated. When such a situation a rises, the SA starts buying the shares in the
market and there by creates an artificial demand in the market. Shares bought
---------------------- are credited to the demat account of the GSO. This can continue for maximum
of 30 days or till the time the funds in this account are exhausted. The shares
----------------------
bought and which are lying in the GSO demat account are then returned to the
---------------------- promoters from whom they are borrowed.
If there is profit in this transaction then that is credited to the Investor
----------------------
Protection Fund of the stock market and the issuer company does not get any of
---------------------- this money.
---------------------- In case the SA does not have to buy over-allotted shares, the issuing
company has to provide the shares in such a shortfall. These shares are then
---------------------- returned to the promoters from whom these shares are borrowed. SA transfers
the amount equal to shares issued into the issue price to the account of the
---------------------- issuer.
---------------------- Let us now look at the impact on different sections of the market due to
this facility:
----------------------
Issuers
----------------------
If the market price falls below the issue price then this mechanism is used
---------------------- as a technique for stabilisation.
If the prices open above the issue price then following can be the
----------------------
implications:
---------------------- The issue may have been potentially under priced.
---------------------- The issuer has lost an opportunity to get higher premium.
---------------------- The secondary market activities show that investors are willing to buy the
shares at a premium to its issue price.
----------------------
Investor’s point of view
---------------------- The shares borrowed from the promoter can be released in the market.
---------------------- If the market price is below the issue price, this mechanism has the
potential to store up the prices and that can be a comfort for the investors.
----------------------
Lead Bankers point of view
---------------------- Success of many issues may be dependent on the credibility of the lead
---------------------- managers to the issue.
GSO can help to win the confidence of the investors towards the issue.
----------------------
38 Capital Market
Gives out a signal to the investors that the issue is fairly priced and the Notes
promoters are willing to support the price post-issue.
----------------------
Activity 4 ----------------------
Which companies have issued debentures to the public in the last three ----------------------
years? Make a list of such companies and find out who are the trustees for
these issues. ----------------------
----------------------
2.6 SEBI AND INDIVIDUAL INVESTOR ----------------------
The investors in the past have suffered at the hands of inefficient stock exchanges ----------------------
and greedy and unprofessional brokers. This was one of the reasons why SEBI
was created. The investor today can look forward to redressal of his grievances ----------------------
through SEBI.
----------------------
Normally investors have complaints of following nature
----------------------
1. Delays in refund of application money.
2. Delay in receipt of dividend and /or interest warrants. ----------------------
3. Delay in receiving the maturity value of fixed deposits or debentures on ----------------------
redemption.
----------------------
4. Delay in receipt of share and debenture certificates after allotment.
SEBI receives many such complaints regularly and tries to redress all ----------------------
such grievances. SEBI has from time to time pulled up companies against whom ----------------------
the complaints are received and has also initiated action against the defaulting
companies. ----------------------
SEBI has encouraged the registration of investors associations in various ----------------------
parts of the country to organise investors into an effective force for protection
of their own interests. ----------------------
Some of the actions taken by SEBI can be summarised as below: ----------------------
●● The introduction of screen based trading
----------------------
●● The ban on Badla
----------------------
●● The dematerialisation of shares
●● The method of postal ballots so that small investor’s views are heard ----------------------
●● The book building process in buy-back of shares by the companies ----------------------
●● The capital adequacy norms for brokers
----------------------
Some of the important achievements of SEBI are:
1. Proper disclosure to investors through investors, through prospectus made ----------------------
mandatory. ----------------------
2. Guidelines for merchant bankers
----------------------

Notes 3. Advertising code for mutual funds
4. Mutual funds required to publish balance sheets
----------------------
5. Takeover code formulated
----------------------
6. Portfolio management service guidelines issued
---------------------- 7. Guidelines on insider trading
---------------------- 8. Registration of stockbrokers and sub-brokers
---------------------- 9. Underwriting made mandatory

----------------------
----------------------
1. The investors in the past have suffered at the hands of inefficient stock
---------------------- exchanges and greedy and unprofessional brokers.
---------------------- 2. SEBI has encouraged the registration of investors’ associations in

various parts of the country to organise investors into an effective
---------------------- force for protection of their own interests.
----------------------
Activity 5
----------------------
---------------------- Find out what was the Badla system.
----------------------
2.7 WHAT SEBI DOES WITH ITS POWERS
----------------------
The SEBI exercises power under Section 11 and 11 B of SEBI Act, 1992
---------------------- and 17 other regulations
---------------------- ●● It can ask any intermediary or market participant for information.
---------------------- ●● I t can inspect books of depository participants, issuers or beneficiary
owners.
---------------------- ●● I t can suspend or cancel a certificate of registration granted to a depository
---------------------- participant or issuer.
●● It can request the RBI to inspect books of a banker to an issue and suspend
---------------------- or cancel the registration of the banker to an issue.
---------------------- ●● It can suspend or cancel certificate issued to the custodian of securities.
●● I t can suspend or cancel registration granted to foreign institutional
----------------------
investor.
---------------------- ●● I t can investigate and inspect books of accounts and records of insiders.
(The case of Tata Finance.)
----------------------
----------------------
40 Capital Market
●● I t can investigate an acquirer, a seller or a merchant banker for violating Notes
the take over norms. (The case of Grasim’s takeover bid on L & T and
the sale of shares of L & T by Reliance to Grasim. You can also refer to ----------------------
the attempted takeover case of Bombay Dying by Bajoria. Also refer to
Sterlite Industry’s attempt on Indal.) ----------------------
●● It can suspend or cancel the registration of a merchant banker. ----------------------

●● I t can investigate the affairs of mutual funds, their trustees and asset ----------------------
management companies.
●● It can investigate any person dealing in securities on complaint of ----------------------
contravention of trading regulation. ----------------------
●● It can suspend or cancel the registration of errant portfolio managers.
----------------------
●● It can cancel the certificate of registrars and share transfer agents.
●● I t can cancel the certificate of brokers who fail to furnish information of ----------------------
transactions in securities or who furnish false information.
----------------------
According to SEBI, the Indian economy is estimated to have grown by
7.1 per cent during 2016-17 on top of a growth of 8.0 per cent in 2015-16. Gross ----------------------
value added (GVA) at basic prices grew at 6.6 per cent during 2016-17 against
----------------------
7.9 per cent in 2015-16
Insider Trading Regulations of SEBI ----------------------
As per the regulations, insider means any person who is or was connected ----------------------
with the company or is deemed to be so connected and who is reasonably
expected to have access, by virtue of such connection to unpublished price ----------------------
sensitive information, in respect of such securities of such company. A person
----------------------
is deemed to be a connected person if such a person is a group company or any
subsidiary, an official of stock exchange or stock brokers, merchant banker or ----------------------
a director or an official of the company, banker of the company, or relatives of
any of the persons mentioned above. ----------------------
If such persons have access to the unpublished price sensitive information ----------------------
and are proved to have used it for personal gain or profits or price manipulation,
they are liable to be penalised under these regulations. ----------------------
SEBI is investing the insider-trading angle in the case of Tata Finance. ----------------------
The inquiry is being conducted against the Ex M.D. Mr. Pendse, and the Ex
Director Mr. Talaulikar. ----------------------
Guidelines to Investors ----------------------

1. Deal only with the registered member of the stock exchange. ----------------------
2. Insist that all your deals be done through the stock exchange.
----------------------
3. Give specific orders to buy or sell within the fixed price limits and /or
time periods within which orders have to be executed. ----------------------
4. Insist on contract notes for the deals done on your behalf. ----------------------
----------------------

Notes In the recent past many Indian companies have opted to split their stocks in the
various denominations like Re.1 (HLL), Rs.2 (Hero Honda), Rs.5 (Infosys).
---------------------- The purpose for this was to enable the small investors to buy these stocks as at
the face value of Rs. 10 these stock prices were very high and small investors
---------------------- could not afford to buy these stocks. Many other companies are now planning
---------------------- to split their stock prices.
The Secondary Market Advisory Committee of SEBI has however, recommended
----------------------
that stock splitting should be allowed only if the share price of the company is
---------------------- more than Rs. 500 on the stock markets. Indications are that SEBI may accept these
recommendations and many companies will thus not be able to do share split.
----------------------
The recent controversy about the Participatory Notes
---------------------- What are participatory notes?
---------------------- Participatory notes (commonly known as P-notes) are instruments used
by foreign funds and investors who are not registered with the Securities and
---------------------- Exchange Board of India (SEBI) but are interested in taking exposure in Indian
---------------------- securities. Participatory notes are generally issued overseas by the associates of
India-based foreign brokerages and domestic institutional brokerages. They are,
---------------------- in fact, offshore derivative instruments issued by foreign institutional investors
and their sub-accounts against underlying Indian securities. Participatory notes
---------------------- are issued where the underlying assets are securities listed on the Indian bourses.
---------------------- Foreign institutional investors who do not wish to register with the Sebi
but would like to take exposure in Indian securities also use participatory notes.
---------------------- Brokers buy or sell securities on behalf of their clients on their proprietary
---------------------- account and issue such notes in favour of such foreign investors.
Why are P-notes so much in the news these days?
----------------------
Participatory notes have attracted significant market attention recently
---------------------- because of huge inflow of foreign funds into Indian stock markets through
this route. Since the ultimate beneficiary of transactions carried out using
----------------------
participatory notes is not known to the market regulator and the tax authorities,
---------------------- there is a scope for misuse and tax avoidance. Also, since participatory notes do
not attract the attention of the market regulators of the countries in which they
---------------------- are issued, the entities holding participatory notes virtually go unregulated.
---------------------- A significant portion of the investment through participatory notes is
also managed by just 14 entities. To put the matter in context, we could recall
---------------------- that the investigation of the ‘01 securities scam revealed that nearly $2 bn was
brought in or taken out of the country through overseas corporate bodies (OCBs)
----------------------
registered in Mauritius, whose beneficiaries were resident Indians.
---------------------- The overseas corporate bodies funds were largely unregulated and caused
---------------------- a lot of volatility and a subsequent crash in the markets. There have been reports
of late that market regulator - SEBI - had given the finance ministry a list of 30
---------------------- overseas corporate bodies, which were banned from investing in the domestic
stock markets after the ‘01 stock market scam, to whom six foreign institutional
---------------------- investors have issued participatory notes.
42 Capital Market
How has the Sebi reacted to all this? Notes
The SEBI is set to further tighten its foreign institutional investors
----------------------
regulations to ensure that participatory notes are not misused by non-resident
Indians, overseas corporate bodies controlled by Indians or by Indian promoters. ----------------------
The SEBI board has taken an in-principle decision to restrict the issue of
participatory notes by foreign institutional investors to only regulated entities. ----------------------
This would mean closing the door on issuance of participatory notes to ----------------------
entities like overseas corporate bodies, NRIs and Indian promoters, who the
market regulator suspects of having misused the instrument to manipulate the ----------------------
market. Once these norms are notified, foreign institutional investors could be
----------------------
asked to wind up the accounts relating to participatory notes issued to ineligible
entities over a prescribed time-frame. An analysis by SEBI in ‘03 had revealed ----------------------
that about 31 entities that had subscribed to participatory notes appeared to be
overseas corporate bodies. ----------------------
----------------------
Activity 6
----------------------
Visit SEBI’s website and find out what actions SEBI has taken in respect
----------------------
of suspected insider trading cases and find out against whom these actions
have been taken. ----------------------
----------------------
Case study
----------------------
Let us now take a look at some cases where SEBI was involved: ----------------------
Ketan Parekh Scam
----------------------
Ketan Parekh was a broker in the market. He was a serious investor; who
had a good market research team working with him and they were investing ----------------------
in fundamentally strong companies, which had low capital base and therefore
low floating stock. Ketan Parekh used to buy such stocks and accumulate these ----------------------
shares over a period of time. This would drive the market prices of these stocks. ----------------------
Parekh would then sell at a handsome profit. He would reinvest in these stocks
at lower levels. In short he was trading in these stock, buying at low prices ----------------------
and selling when the prices went up and earned profit. Ketan had his favourite
stocks like Global Tele, Zee Telefilms and Himachal Futuristic. The ten stocks ----------------------
in which he was mostly investing came to be known as K-10 stocks. It was ----------------------
alleged that the UTI and some other mutual funds were actually using this K-10
index instead of the official stock market indices like the sensex to determine ----------------------
their investments in the stock markets.
----------------------
All this operation required huge funds. Where did he get these?
----------------------
1. He had a line of credit sanctioned to him by banks against the security of
the shares that he purchased. The two banks whose involvement has come ----------------------
to light are GTB and Madhavpura Co-operative Bank Ltd.
----------------------

Notes 2. It is alleged that the companies in which he was investing and thus helping
these companies market price going up, were also funding his operations.
---------------------- This is a case of clear nexus between him and the promoters of some
companies at least. Zee Telefilms had in fact funded him and has accepted
---------------------- that the company gave funds to him.
---------------------- Ketan Parekh used Kolkata stock exchange for his buying operations,
because surveillance here was weak and he could indulge in unofficial Badla
----------------------
through the local brokers. This kept him away from the limelight of Mumbai.
---------------------- By January 1999, the stock markets had started bubbling with excitement,
as the sensex went up by 700 points in just three months. The K-10 stocks were
----------------------
in the forefront of this rally and the market seemed to be taking its clues from
---------------------- these very stocks. The international markets were also doing well at this time.
The U S markets were upbeat on the new economy stocks and the flavour of
---------------------- the market seemed to be what were known as the ICE stocks, viz. Information
Technology, Communications and Entertainment. On the day the union budget
----------------------
was presented i.e. 28th of February the BSE sensex was at the unprecedented
---------------------- level of 6000 points. The budget was welcomed whole heartedly by most.
However, just two days later the scenario changed for the worst. The news
----------------------
of unsavory dealing of Ketan Parekh started coming out. The American markets,
---------------------- which were nervous since December on the persistent fears of meltdown in
Dotcom sectors, were also falling. The celebrated K-10 stocks started loosing
---------------------- value much faster than the other stocks and the banks who had lent money to
him started getting nervous as there safety margins were being eroded at a very
----------------------
fast rate. They started asking the broker to either pledge more shares or repay
---------------------- the money. He now had to sell his shares, cut losses and pay the banks or he
had to take the gamble of holding on and hoping for the revival of the market.
---------------------- He made a fatal mistake of holding on. He sold some of his favourite stocks but
invested this money in some of his other favourite stocks. In short, his greed
----------------------
got better of his professional judgement. He also blocked his funds in some
---------------------- companies through the route of private placements.
---------------------- All this meant that he now had severe liquidity problems. His 70 brokers
in Kolkata stock exchange started feeling the heat, as he could not meet his
---------------------- obligations in Badla trades. Around 70 brokers defaulted on this exchange.
They together had an obligation of Rs.700 crores.
----------------------
It was at this time that Madhavpura bank episode exploded when they
---------------------- issued a pay order of Rs. 150 crores on his behalf to Bank of India. This pay
order bounced as Madhavpura Bank had no funds to clear it. As a matter of fact,
---------------------- this was a case of a blatant fraud. A bank cannot issue a pay order unless the
---------------------- buyer of the pay order deposits the money. In this case Parekh did not deposit the
money. The bank already had an exposure of Rs. 840 crores. It is also believed
---------------------- that Parekh was using the brokerage firm owned by the Madhavpura bank’s
Chairman’s son to put through his transactions.
----------------------
We now should take a look at the role of the regulators in this scam. RBI
---------------------- was unable to detect the mal practices that were taking place. There was also
44 Capital Market
the problem of dual control on co-operative banks, by RBI and co-operative Notes
department. It should be noted that only after this incident RBI was entrusted
with the complete responsibility of inspecting the co-operative banks. RBI till ----------------------
then was inspecting these banks every two years. It was reported that in the last
such inspection conducted by RBI, nothing untoward was found. ----------------------
There is hardly any doubt that SEBI also failed as the market regulator. It ----------------------
was very late in the date an investigation was conducted in the role of the bear
----------------------
cartel.
Tata Finance ----------------------
The scam in Tata Finance came to light on 12th April 2001 when a person ----------------------
named Shankar Sharma circulated a letter on the Dalal Street stating that the
company is in deep financial trouble. This happened just before the company’s ----------------------
Rights Issue.
----------------------
The company’s M D Pendse commenced extensive share market
operations through its subsidiary company Nishkalp at the end of 1999. The ----------------------
portfolio mostly consisted of the famous K-10 stocks. ----------------------
Tatas have accused Dilip Pendse of embarking upon carry forward
transactions between December 2000 and March 2001 in these stocks, which ----------------------
led to a loss of Rs. 300 million in the last quarter of fiscal 2001. THE TOTAL ----------------------
LOSS SUFFERED BY Nishkalp is estimated to be Rs 480 crores. Pendse is
accused of cheating, falsification of accounts, forgery and criminal breach of ----------------------
trust in the FIR filed against him and other employees of the company. The FIR
also alleges that the funds were siphoned off for Personal benefit. Pendse is ----------------------
accused of having given ICDs to the tune of Rs. 5 billions to Nishkalp for these ----------------------
transactions.
Pendse is held responsible for breaching the prudential norms of RBI ----------------------
that are applicable to NBFCs on two counts namely that he failed to maintain ----------------------
the capital adequacy ratio of 12% and lending over 25% of the company’s net
worth to a single entity i.e. Nishkalp in this case. ----------------------
SEBI suspects insider trading in the case of Chairman of Nishkalp Mr. ----------------------
Talaulikar’s selling of his personal holding of 100,000 shares of Tata Finance.
It is suspected that he used inside information, as he knew that the company’s ----------------------
shares would take a beating on the brouses, once the information of Nishkalp’s
----------------------
losses becomes public. It is alleged that Talaulikar devised an ingenious way
of transferring funds of Rs. 7 million from Nishkalp to the concerned share ----------------------
broker with a request to back date the sale contract to September 6th, 2000 that
is six months before the rights issue opened for subscription, when the price ----------------------
of the share was Rs.69/-. But SEBI has found that the shares were transferred
----------------------
from the respective accounts of members to broker’s demat account only in the
first week of April 2001. In May 2001 when Talaulikar realised that a detailed ----------------------
investigation was being planned by the Tatas to probe the Nishkalp affairs,
he immediately reversed the transaction and sold the shares at the prevailing ----------------------
market price of Rs. 34. He returned to the broker a sum of Rs. 3.5 million,
----------------------
which in turn was returned to Nishkalp.

Notes SEBI has hinted at a possible nexus between former Tata Finance M D
Pendse and Suzlon Energy and its affiliate Sarjan securities, which purchased
---------------------- 75,000 TFL shares in March 2001. Sulzon supplied wind mills to Tata group of
companies and it will not be surprising that on account of obligations to Pendse,
---------------------- shares were purchased by Sarjan at a price of Rs. 91 much higher than the market
---------------------- price of Rs.40. Incidentally, Sulzon gave Rs. 5 crores to Sarjan for purchase of
618,000 shares. According to the SEBI report Tata Finance purchased about 13
---------------------- windmills from Suzlon while Khuda Gawah Investments and Nalini Properties,
purchased one windmill each. During 2000-01, TFL purchased these at a cost
---------------------- of Rs. 350 crores. Pendse had proposed to buy these as a tax-planning measure.
---------------------- The connection between Pendse and Sarjan has been established in the SEBI
report as follows: Pendse’s wife Anuradha, his associate Anjali Beke, Nalini
---------------------- Properties and Ajudi Properties and Investments sold 290,000 share of TFL in a
off- market deals to brokers and they in turn sold the shares to India Emerging
---------------------- Companies and Sarjan Securities. In this connection SEBI has commenced
---------------------- investigation against stock brokers Jhunjhunwala Stock Brokers Pvt. Ltd. and
Malini Sanghvi Securities Pvt Ltd. for violation of the code of conduct for the
---------------------- market intermediaries, insider trading and unfair trade practices.
---------------------- The saga of L & T, Reliance and Grasim
On November 18, 2001, Reliance announced its decision to sale its 10.5%
----------------------
holding in L & T to Grasim for Rs. 306 per share. The price of L& T till then
---------------------- was languishing somewhere around Rs. 150/. Some people think that it was due
to the fact that the indecision on the demerger of its cement division was one
---------------------- of the main reasons for this. The company was talking about the demerger for a
very long time but no concrete decision and action was coming forth. The stock
----------------------
rose to Rs. 208 on the day the deal was announced. The question uppermost in
---------------------- the minds of many analysts was who was buying the stock and did these entities
or persons had any inclination about the sale by Reliance. In short, there was
---------------------- suspicion of insider trading.
---------------------- Mr. Kirit Somaya, a member of Parliament complained to SEBI that
just before the deal was concluded Reliance had increased its stake in L & T
---------------------- from 6.62% to 10.5%. During the period October 8, 2001 to November 9, 2001
Reliance bought 1.95 per cent of L&T’s equity, then again between November
----------------------
12 to November 15 it bought another 0.17 per cent of the capital. This means
---------------------- just three days before the sale of its stake to Grasim, Reliance was buying the L
& T stock in the market.
----------------------
On March 31, 2001 Reliance held 6.62 per cent of L&T equity. However,
---------------------- after September 11, 2001 when the BSE Sensex had touched a 10-year low of
around 2,600, Reliance says it had ‘used the opportunity of the then prevailing
---------------------- low and attractive prices to consolidate our equity share holding in L&T,
---------------------- thereby strengthening our position to make an open offer for L&T, if and when
considered appropriate at any point of time in the future.’
---------------------- Reliance’s response to SEBI contains an interesting little table, which lists
---------------------- its sale and purchase of L&T shares since April 1, 2001 when it had held 6.62
46 Capital Market
per cent of the equity. Then in May, June and July 2001 it sold large quantities of Notes
the scrip (0.04 per cent, 1.81 per cent and 0.78 per cent of its stake, respectively,
in those months) again in October 2001 it sold another 0.08 per cent of its stake. ----------------------
Its holding had thus dropped to just 3.92 per cent by October 1, 2001.
----------------------
This large-scale selling would have had a negative impact on the price.
Then, all of a sudden in October 2001, Reliance turned buyer. It picked up a ----------------------
hefty 6.17 per cent stake in L&T in under a month and took its total holding to
----------------------
10.09 per cent. The entire lot was off-loaded on to Grasim at a huge premium on
November 18, making a fantastic profit for Reliance. In other words, Reliance ----------------------
is a clear beneficiary of the upward and downward movement of L&T’s share
price. ----------------------
This raises another issue. If Reliance’s share had fallen below 5 per ----------------------
cent and later increased to 10 per cent, did it inform SEBI, as required under
the takeover regulations? It seems that it did not. Both the stock exchanges ----------------------
have confirmed that Reliance has not intimated them of the fluctuation in its
----------------------
shareholding. Had it done so, SEBI would have been alerted to Reliance’s large-
scale market activity in the L&T scrip and probably monitored it more closely. ----------------------
Even otherwise, failure to inform SEBI under Regulation 15A is punishable
with a Rs 500,000 fine. But that is less than an insignificant punishment. As a ----------------------
matter of fact, Reliance was later on fined this amount and quickly paid the fine.
----------------------
The real puzzle is if Reliance was holding just about 4% in October, and
if Grasim was interested in buying into L & T, then why did Grasim not acquire ----------------------
the shares in the open market at a price that was much lesser than the price it
----------------------
paid to Reliance to acquire its stake?
Sucheta Dalal, the famous columnist in one of her columns on this issue ----------------------
says that Grasim’s deal with Reliance also included the clause that the Ambani ----------------------
brothers would step down as non-executive Directors from the board of L &
T post acquisition of their stake by Grasim. According to her Grasim’s deal ----------------------
with Reliance included the clause that the Ambani brothers would step down
as non-executive directors of L&T and Reliance would agree not to ‘acquire or ----------------------
deal in L&T shares’ either directly or through its associates or subsidiaries for a ----------------------
minimum period of five years. Interestingly, the L&T management seems to be
a quiet approver of all that went on and quickly took the Birlas on board. ----------------------
----------------------
Summary
----------------------
●● The Securities and Exchange Board of India was set up on April 12,
1988, following the recommendations of the high powered G. S. Patel ----------------------
committee on Stock Exchange Reforms.
----------------------
●● Green-shoe-Option (GSO) in an IPO was introduced in the Indian capital
market in 2003 by SEBI ----------------------
●● Insider means any person who is or was connected with the company or is
----------------------
deemed to be so connected and who is reasonably expected to have access,
by virtue of such connection to unpublished price sensitive information, ----------------------
in respect of such securities of such company.
Notes Keywords
----------------------
●● Badla: Unofficial forward market that was in vogue in India.
---------------------- ●● Debenture: This is a debt instrument used by corporates to raise money
from investors.
----------------------
●● Insider trading: Trading done by persons who are connected to the
---------------------- company and are in passion of undisclosed information that they use for
personal benefit.
----------------------
●● P- Notes: These are issued by FIIs to their clients who wish to invest
---------------------- money in Indian markets through these FIIs.
----------------------
----------------------
1. What are the functions of SEBI?
----------------------
2. Write a note on the management of SEBI.
---------------------- 3. What actions has SEBI taken for the investors?
---------------------- 4. What lessons can be learnt from the cases described above?
---------------------- 5. Do you know of any other cases where SEBI has taken action?
6. Explain the SEBI guidelines for Debenture issues.
----------------------
7. What are P-notes?
----------------------
8. Explain the process of Green Shoe Option.
----------------------
----------------------
----------------------
----------------------
1. True
---------------------- 2. False
1. SEBI shall create a proper and conducive atmosphere required for raising
----------------------
money from the capital market.
---------------------- 2. The management of SEBI will be under the management board headed by
a Chairman.
----------------------
----------------------
----------------------
----------------------
48 Capital Market
----------------------
1. False
----------------------
2. True
State True or False. ----------------------
1. True ----------------------
2. True
----------------------
1. Gopalsamy, N. 1994. Capital issues and SEBI guidelines. Securities and ----------------------
Exchange Board of India, South Asia Publications. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
50 Capital Market
Mutual Funds
UNIT
3
Structure:
3.1 Introduction
3.2 Technical Jargons used
3.3 Net Asset Value (NAV)
3.4 Asset Management Company (AMC)
3.5 Types of Schemes offered by the Mutual Funds
3.6 Regulatory Aspects
3.7 The Case of US - 64
Summary
Keywords
Suggested Reading
Mutual Funds 51
Notes
Objectives
----------------------
----------------------
●● Explain what a mutual fund is.
---------------------- ●● List the technical words that are used.
---------------------- ●● Describe the concept of Net Asset Value.
---------------------- ●● Identify the functions of an Asset Management Company.
●● Compare the different types of schemes offered by a Mutual Fund.
----------------------
●● Evaluate the regulatory aspects relating to Mutual Funds.
---------------------- ●● Discuss the case of US-64.
----------------------
---------------------- 3.1 INTRODUCTION

---------------------- What is a Mutual Fund?
---------------------- Depending upon the risk profile, one should look at investing some part
of the savings or earnings in the stock market. But direct investing puts a person
---------------------- at great risk. So, the next best alternative is going for ‘mutual fund’.
---------------------- One can define a mutual fund as a trust that pools in the savings and funds
from a large number of investors who have a common financial goal. Mutual
---------------------- funds issue units to investors, which represent equitable rights in the assets of
the mutual fund.
----------------------
Mutual fund by its nature is diversified i.e. its assets are invested in many
---------------------- different securities.
---------------------- Investments in the mutual funds may be in the form of stocks, bonds or
money market securities or combination of these.
----------------------
These are professionally managed on behalf of the shareholders and each
---------------------- investor holds a pro-rata share of the portfolio entitled to any profits when the
securities are sold, but subject to any losses as well.
----------------------
There are a number of schemes of Mutual Fund and all of them have
---------------------- different character and objective.
---------------------- It is the skill of the investor to keep in view the objective and then take
decision where to invest.
---------------------- For example, in the wake of boom in the software sector, the Indian
---------------------- Mutual Fund launched various sector specific schemes that entailed only to
software stocks for that period.
---------------------- A lot of activity is taking place in the Mutual Fund industry in India,
---------------------- especially in the field of mergers and acquisitions.
----------------------
52 Capital Market
Recently, Principal mutual fund has acquired the entire stake of their Notes
partner IDBI in their AMC. On the other hand, it has also taken over the
operations of Sun & F C another mutual fund. This comes on the back of the ----------------------
acquisition of Pioneer-IIT by Franklin Templeton. It is believed that such
mergers and acquisitions will continue in future too. There are at present 31 ----------------------
players in the field, out of which 6 players are marginal. ----------------------
Diversification ----------------------
Professional Management
----------------------
----------------------
Mutual Fund
----------------------
----------------------
Convenience Liquidity Tax Benefit
----------------------
Fig. 3.1: Mutual Fund Conceptual Framework
----------------------
Regulators of the Mutual Fund
●● SEBI ----------------------
●● RBI ----------------------
●● MOF
----------------------
●● CLB
----------------------
●● STOCK EXCHANGE
●● PUBLIC TRUSTEE OFFICE ----------------------
Role of regulators ----------------------
SEBI
----------------------
●● Apex body to regulate capital market activities
----------------------
●● All mutual funds have to be registered with them
●● EBI guidelines govern mutual fund operations, investments, income-
S ----------------------
expense accounting, and disclosures for investor protection
----------------------
●● Market related and investor related
RBI ----------------------
●● Dual supervisory role in mutual fund regulation ----------------------

●● ank owned mutual fund: RBI and SEBI both jointly regulate mutual
B ----------------------
funds
●● Issues regarding ownership of AMC, fund mergers, capital adequacy for ----------------------
assured returns ----------------------
●● oney Market Mutual Fund guidelines were formulated in 1995. Bank
M
institutions and private sector were allowed to set up money market ----------------------
mutual fund. ----------------------
Mutual Funds 53
Notes Ministry of Finance
●● Supervises both RBI and SEBI
----------------------
●● Plays the role of appellate authority for disputes in SEBI guidelines
---------------------- Company Law Board, Department of Company Affairs, Registrar of
---------------------- Company
●● LB is the apex regulatory authority under Company’s Act. CLB is a
C
---------------------- body specially constituted by the Central Government for carrying out
---------------------- judicial proceedings with respect to company affairs. CLB has the legal
standing of a civil court, and may call for inspection of documents, enforce
---------------------- attendance.
---------------------- ●● verall responsibility for formulating and modifying regulations relating
O
to companies lies with the DCA.
---------------------- ●● OC ensures that AMC or the Trustee Company as the case may be is
R
---------------------- in compliance with all Companies Act Provision. All AMC accounts and
records are filed with the ROC. He plays the role of watchdog.
---------------------- Office of Public Trustee
---------------------- ●● he Board of Trustees or the Trustee Company is accountable to the
T
Office of Public Trustee.
----------------------
●● The Office reports to the charity commissioner.
---------------------- Self-Regulatory Organisations (SRO)
---------------------- ●● ROs are the organisations, which group market participants and have
S
been granted some powers to regulate their own members e.g. Stock
---------------------- Exchange regulating its broker under overall supervisory by SEBI.
---------------------- ●● SROs regulate admissions, set code of conduct, rules and by laws.
---------------------- ●● Every Trade Associations is not necessarily a SRO.

●● I nvestment Company plays the role as industry association for mutual
---------------------- funds in USA. AMFI is not a SRO as on date.
---------------------- ●● Stock Exchange is a SRO supervised by SEBI.
Who can invest?
----------------------
●● Banks and Insurance companies
----------------------
●● Primary Dealers
---------------------- ●● Provident Funds
---------------------- ●● Trusts
●● Mutual Funds
----------------------
●● Foreign Institutional Investors
---------------------- ●● Corporates and NBFCs
---------------------- ●● Retail Investors
----------------------
54 Capital Market
Non-Residents including Notes
●● Non-Residents Indians
----------------------
●● Overseas Corporate Bodies
Foreign Institutional Investors registered with SEBI can invest in mutual ----------------------
fund. ----------------------
Here, the important thing to remember is foreign citizens are not allowed
to invest in mutual fund. ----------------------
Investor’s Rights and Obligations ----------------------

●● Right in beneficial ownership of the assets ----------------------
●● Right to get dividend
----------------------
●● Right to get information from trustees
●● Right to receive dividend warrants within 42 days ----------------------
●● 75% of the unit holders can terminate the AMC ----------------------

●● Right to inspect major documents ----------------------
●● Fundamental attributes of a closed end fund can be changed by 75%
consent ----------------------
●● Right to receive financial statement, personal statement ----------------------
Investor Obligation
----------------------
●● Offer Document
----------------------
●● Financial Statement
●● Due diligence Certificate from compliance officer ----------------------
Advantages of mutual fund ----------------------
●● Portfolio Diversification
----------------------
Normally mutual funds invest in well-diversified portfolio. As each
investor is a part owner of all fund’s assets, so he can invest in diversified ----------------------
portfolio even with a small amount.
----------------------
●● Professional Management
----------------------
The investment management skills along with the needed research into
available investment options ensure a much better return than what an ----------------------
investor can manage on his own.
----------------------
●● Reduction or Diversification of risk
Diversification reduces risk of loss as compared to investing directly in ----------------------
one or two shares or debentures or other instruments. When an investor
----------------------
invests directly then the risk of loss is his own. But if he invests in well-
diversified securities then loss is automatically shared with the other ----------------------
investors.
----------------------
----------------------
Mutual Funds 55
Notes ●● Reduction of Transaction cost
A direct investor bears all the costs of investing such as brokerage or
---------------------- custody of securities, but if he goes through a fund he has the benefit of
---------------------- economies of scale, less cost due to large volume.
●● Liquidity
----------------------
An investor can liquidate the investment by selling the units to the fund if
---------------------- open-ended or selling them in the market if the fund is close end.
---------------------- ●● Convenience and Flexibility
Here investor can easily transfer his holdings from one scheme to the
---------------------- other, get updated information and so on.
---------------------- Mutual Fund industry is also rocked by some scandals from time to time.
There have been schemes of mutual funds, which are run almost like Portfolio
----------------------
management schemes. SEBI found out that some schemes seemed to have
---------------------- been devised for such a purpose itself. A leading MF in its discloser recently
has shown one investor accounting for 90% of the assets under management.
---------------------- The minimum number of investors per scheme is now proposed to be 20 and
maximum investment by a single investor is capped at 25% of the corpus and
----------------------
has set a time frame for existing schemes to comply with this rule. UTI has
---------------------- since foreclosed some of its schemes in line with these regulations. Bajaj Auto
has taken the UTI to court against this foreclosure. It will be interesting to see
---------------------- what stand the courts will take in this matter.
---------------------- There has also been the problem of dividend stripping that is getting
a lot of attention. The growth schemes, which are designed to allow capital
---------------------- appreciation to the investors, have declaring dividends and bonuses. It has also
been found that many funds are declaring in advance the dates on which the
----------------------
dividends will be declared and releasing advertisements asking investors to
---------------------- invest before the date and take immediate dividends. This is a new trend.
Indian MFs are also reported to have learnt from their American counterparts
---------------------- the art of indulging in late trading that has become a global practice, which
has sparked off a major investigation in the U.S. Late trading refers to the
----------------------
practice of buying and selling shares after the close of market hours, but at the
---------------------- closing price of the day. Recently, some Indian funds were found to be allowing
large investors to enter funds after the cut-off timing. This was done to allow
---------------------- these investors to take advantage of price sensitive information announced by
companies after the close of the markets. SEBI is now planning to take action
----------------------
against both these practices of dividend stripping and late trading deals.
---------------------- The latest scam reported by The Economic Times pertains to the assured
returns offered by some funds to Provident Funds, which is a violation of SEBI
----------------------
regulations. PFs are forced to generate a return of 9.5% in the face of falling
---------------------- interest rates and have turned to mutual funds for this. This is reminiscent of
Harshad Mehta scam, where banks in search of higher return turned to him to
---------------------- deal on their behalf in securities markets. This is indeed a dangerous thing.
One must realise that the interest paid on PFs will have to be brought in line
----------------------
56 Capital Market
with that available in the market. The PFs are allowed to invest in Gilts directly Notes
or through the MFs. However, these investments cannot at present generate
the returns that are required. There is a fear that the MFs may be diverting ----------------------
such investments in the equity markets to cash in on the Bull Run in the stock
markets. ----------------------
----------------------
3.2 TECHNICAL JARGONS USED
----------------------
Portfolio
----------------------
Portfolio is the group of securities that the fund managers plan to invest.
The fund manager can change the composition of securities. ----------------------
Asset Management Company (AMC) ----------------------
The AMC is formed by a group of trustees, which has been formed by the
----------------------
board of directors.
AMC has worth not less than 10 crores. ----------------------
Every Mutual Fund on behalf of the unitholders sets up an Asset ----------------------
Management Company (AMC) or assigns its fund to a AMC for managing its
funds. ----------------------
The AMC invests on behalf of the respective schemes. Regular expenses ----------------------
like Custodial fees, Cost of dividend warrants, registrar fees, AMC Fee are borne
by the individual schemes. However, these regular expenses cannot exceed 3% ----------------------
of the assets of a scheme in a year. ----------------------
----------------------
1. A mutual fund is a trust that pools in the savings and funds from a ----------------------
large number of investors who have a different financial goal. ----------------------
2. Investments in the mutual funds may be in the form of stocks, bonds ----------------------
or money market securities or combination of these.
1. ________ is the group of securities that the fund managers plan to ----------------------
invest. ----------------------
2. AMC has worth not less than _____ crores.
----------------------
----------------------
Activity 1
----------------------
Visit the website of AMFI and find out how many mutual funds are operating
in India and how many different schemes they offer to the investors. ----------------------
----------------------
Mutual Funds 57
Notes 3.3 NET ASSET VALUE (NAV)
---------------------- The net asset value of the fund is the cumulative market value of the assets
fund net of its liabilities. In other words, if the fund is dissolved or liquidated,
---------------------- by selling off all the assets in the fund, this is the amount that the shareholders
would collectively own. This gives rise to the concept of net asset value per
----------------------
unit, which is the value, represented by the ownership of one unit in the fund. It
---------------------- is calculated simply by dividing the net asset value of the fund by the number
of units. However, most people refer to the ‘NAV per unit ‘as ‘NAV’, ignoring
---------------------- the “per unit”.
---------------------- Calculation of NAV
---------------------- The most important part of the calculation is the valuation of the assets
owned by the fund. Once it is calculated, the NAV is simply the net value of
---------------------- assets divided by the number of units outstanding.
---------------------- Asset value is equal to
Sum of market value of shares/debentures Liquid assets/cash held, if any
----------------------
Dividends/interest accrued - Current liabilities - Expenses accrued but not paid.
---------------------- Asset value of the fund
NAV =
---------------------- No. of units outstanding
---------------------- Load
Some asset management companies (AMCs) levy service charges for
---------------------- allowing subscribers entry into or exit from mutual fund schemes. The service
---------------------- charge is termed as entry/exit load and such schemes are called “load” schemes.
With the vibrancy of capital markets in India and the returns available in
----------------------
these markets, it was natural that more and more people wanted to enter these
---------------------- markets. However, during the bad times in stock markets the small investors
did suffer heavy losses, mainly because of their lack of knowledge about
---------------------- the working of these markets. These investors also are unable to spread the
risks across securities and are carried away by market gossip, rather than the
----------------------
knowledge that is essential to make investments in these markets. The mutual
---------------------- funds are the natural answer to many of these problems. It is thought to be much
better for the investors to invest in capital markets, through the mutual funds.
---------------------- Professional portfolio managers, who can spread the risks inherent in these
investments, manage the mutual funds. The small investors thus get to invest
----------------------
their money in many companies as, members of the funds, something they are
---------------------- unable to do, due to their limited resources.
Until 1987, UTI was the only mutual fund in India. This was the year when
----------------------
public sector banks’ subsidiaries were allowed to start the mutual funds, followed
---------------------- by the state run insurance companies. The early entrants in this field were led
by State bank, Canara Bank, Bank of India and Life Insurance Corporation
---------------------- and General Insurance Corporation. Post 1992, mutual funds sponsored by
other public and private sector financial institutions, corporates in collaboration
----------------------
58 Capital Market
with foreign investment and fund managers, and foreign institutional investors Notes
emerged on the scene.
----------------------
Mutual funds are defined by SEBI regulations as funds established in the
form of a trust to raise money through the sale of units- that is, the interest of the ----------------------
unit holders in a scheme, which consists of each unit representing one undivided
share in the assets of a scheme-to public under one/more scheme for investing ----------------------
in securities including money market instruments consisting of commercial
----------------------
papers, commercial bills, etc. According to the procedure laid down by SEBI,
mutual funds have to be registered with SEBI. The application for registration ----------------------
together with a non-refundable fee should be made in the prescribed form.
----------------------
A mutual fund can be constituted in the form of a trust and the instrument
of trust should be in the form of a deed, duly registered under the Indian ----------------------
Registration Act, executed by the sponsor in favour of the trustees named in the
instrument. ----------------------
Trustees mean the Board of trustees or the Trustee Company who hold the ----------------------
property of the mutual fund in trust for the benefit of the unit holder.
----------------------

1. The ________ of the fund is the cumulative market value of the assets ----------------------
fund net of its liabilities.
----------------------
2. Until 1987, _____ was the only mutual fund in India.
----------------------
Activity 2 ----------------------
Find out which schemes of HDFC mutual fund have entry and exit load. ----------------------
(You can use Big Bucks supplement of Economic Times or search any ----------------------
website that may give this information.)
----------------------
3.4 ASSET MANAGEMENT COMPANY (AMC) ----------------------
The AMC appointed by the trustees with the prior approval of the SEBI ----------------------
would be responsible for floating schemes for the mutual fund after approval ----------------------
of the same by the trustees and managing the funds mobilised under various
schemes, in accordance with the provisions of the trust deed and SEBI ----------------------
regulations.
----------------------
It cannot undertake any other business other than the management of
mutual funds and activities as financial consultants and like, as long as they ----------------------
are not in conflict with the fund management activity itself without the prior
----------------------
approval of the trustees and SEBI.
----------------------
Mutual Funds 59
Notes The AMC has to ensure that no offer document of a scheme, key
information memorandum, annual results is issued without the trustee’s prior
---------------------- approval, and disclose the basis of calculating the repurchase price and NAV of
the various schemes of the mutual fund in the scheme particulars and disclose
---------------------- the same to the investors at such intervals as may be specified by the trustees
---------------------- and SEBI.
The Trustees have the right to obtain all information concerning the
----------------------
operations of the various schemes of the funds managed by the AMC. The MAC
---------------------- has to submit a quarterly report on the functioning of the schemes of the mutual
fund to the trustees or at such intervals as may be required by the trustees or
---------------------- SEBI.
---------------------- The trustees have the power to dismiss the AMC under specific events
with the approval of SEBI. They also have the right to obtain from the AMC
---------------------- such information as is considered necessary by them.
---------------------- Where the trustees have reason to believe that the conduct of business of
the mutual fund is not in accordance with the SEBI regulations and the fund
---------------------- scheme, they should forthwith take such remedial steps as are necessary by
them and immediately inform the SEBI of the violation and the action taken by
----------------------
them.
---------------------- The trustees must obtain consent of the unitholders:
---------------------- ●●
Whenever required to do so by SEBI.
---------------------- ●● W
henever required to do so on the requisition made by three-fourths of
the unitholders of any scheme.
---------------------- ●● W
hen the majority of the trustees decide to wind up or prematurely
---------------------- redeem the units.
●●
When a change is being made in the fundamental attributes of a scheme.
----------------------
●● The trustees are also governed by a code of conduct.
---------------------- Constitution of AMC
---------------------- ●● he AMC has to fulfill certain criterions for grant of approval by SEBI as
T
follows:
----------------------
●● n existing AMC should have a sound track record, reputation and
A
---------------------- fairness in transactions.
●● The directors should have adequate professional experience in finance
----------------------
and financial service related field.
---------------------- ●● he board of directors of AMC must have at least 50% independent
T
directors.
----------------------
●● The chairman of AMC should not be trustee of any mutual fund.
---------------------- ●● The AMC must have net worth of Rs. 10 crores.
---------------------- ●● o director of AMC other than an independent director can hold the office
N
as director in another AMC.
----------------------
60 Capital Market
Any change in controlling interest of the AMC can be only with the prior Notes
approval of trustees, SEBI and the unit holders.
----------------------
AMC cannot act as a trustee of any mutual fund or undertake any other
business activities expect activities in the nature of portfolio management ----------------------
services etc.
----------------------
The mutual fund should appoint a custodian to carry out the custodial
services for the schemes and send intimation of the same to SEBI within fifteen ----------------------
days of the appointment.
----------------------
Activity 3 ----------------------
Visit the website of SEBI and find out if SEBI has initiated action against ----------------------
any AMC for not following its guidelines.
----------------------
----------------------
3.5 TYPES OF SCHEMES OFFERED BY THE MUTUAL FUNDS
----------------------
Open-ended vs. Close-ended Schemes
----------------------
An open-ended scheme is a scheme, in which an investor can buy and sell
units on daily basis; the scheme has a perpetual existence and a flexible, ever ----------------------
changing corpus. The investors are free to buy and sell any number of units, any
point of time, at prices that are linked to the NAV of the units. In these schemes ----------------------
the investor can invest or disinvest any amount, any time after the initial lock
----------------------
in period. These schemes are extremely liquid and the funds announce sale and
repurchase prices from time to time. These are not listed in stock exchanges and ----------------------
can be only bought and sold to the mutual fund.
----------------------
A close-ended scheme is one in which, the subscription period for the
mutual fund remains only for the specific period, called the redemption period. ----------------------
At the end of this period, the entire corpus is disinvested and the proceeds
distributed to the various unitholders. Thus, after final distribution, the scheme ----------------------
ceases to exist. However, such schemes can be rolled over with the approval of
----------------------
the unitholders. They can be listed on the stock exchanges.
Pure Growth Schemes ----------------------
A pure growth scheme aims at generating long-term capital appreciation ----------------------
for the investors. The objective is achieved by investing a substantial portion of
the corpus in high growth equity shares or other equity-related instruments of ----------------------
corporate bodies. The dividend can be declared and distributed as and when the ----------------------
boards of trustees approve it but the principal remains capital appreciation.
Pure Income Schemes ----------------------
Their aim is to generate and distribute regular income to the investors. This ----------------------
is done by investing a substantial portion of the corpus in high-income yield/
----------------------
fixed income instruments, such as debentures, bonds and so on. Declaration of
----------------------
Mutual Funds 61
Notes regular dividends is the main objective of the scheme.
Balanced Schemes
----------------------
The aim of these schemes is both, to distribute regular income and also
---------------------- provide capital to the investors by balancing the investments of the corpus
between the high growth equity shares and the regular income earning securities.
----------------------
Tax Saving Scheme
----------------------
These are basically growth schemes, which also offer tax rebates to the
---------------------- investors under the Income tax act, under Section 80 (C), which entitles an
investor rebate in income tax upto a maximum investment of Rs. 1,00,000/ per
---------------------- annum. When EET regime will come into force, as it will shortly, this scheme
---------------------- will become more attractive as investments in equities is exempt from all taxes.
There are two types of mutual funds according to the investment target:
----------------------
Debt-oriented Schemes
----------------------
This type of schemes invest most of the funds in fixed income instruments
---------------------- like debentures of the private sector companies, public sector bonds, Government
securities and money market instruments, the balance is invested in equity
---------------------- shares. Given the portfolio composition of such schemes, a reasonably firm
indication is provided about the returns investors can expect from schemes.
----------------------
Equity-oriented Schemes
----------------------
As against the debt-oriented schemes, these schemes invest the bulk of
---------------------- their funds in equity shares and in fixed income avenues.
---------------------- Sector Funds

As the name suggests, sector funds specialise in the stock of single
---------------------- industry or market sector. The fund’s portfolio is invested among a handful of
---------------------- stocks in the same industry and thus these can be regarded as aggressive funds.
Such schemes concentrate their investments in the specified sector/industry
---------------------- such as Pharma/IT/FMCG etc. They also focus on Government securities. The
diversification is lower in the case of these funds and hence the risk borne by the
---------------------- investor is higher. These sector fund buyers are likely to be more sophisticated
---------------------- and look for a balance between the diversification of a conventional fund and
the narrow focus of buying shares in an individual company.
----------------------
Money Market Mutual Funds
---------------------- These are designed as a conduit through which the investors can earn
market related yield on the money market instruments. They have to operate
----------------------
within the framework of RBI guidelines.
---------------------- Under the guidelines issued by the RBI the domestic funds are allowed to
invest in foreign companies, which have more than a 10% stake in listed Indian
----------------------
companies. The regulations also stipulate that there will be a cap of $ 1 billion
---------------------- on the MF industry’s overseas investments and an individual MF investments
limit of Rs. 200 crores.
----------------------
62 Capital Market
The funds is an innovative concept that will allow investors to diversify Notes
their investments in blue-chip global equities for the first time.
----------------------
Tax Treatment of Mutual Funds
Income of notified mutual funds authorised by SEBI is exempt from tax ----------------------
provided 90% of the profit of a mutual fund is mandatorily distributed to the
----------------------
unitholders.
Units of mutual funds held for a continuous period of 12 months preceding ----------------------
the date of sale/transfer/redemption/repurchase are treated as long-term capital
----------------------
assets and taxed at 10% capital gain tax.
No discussion on mutual funds is ever complete without the mention of ----------------------
Unit Trust of India. The fund has gone through one crisis after the other in the ----------------------
recent past. Many investors in the fund’s flagship scheme US-64 have suffer
losses. There were almost 2 crores investors in this scheme. The government ----------------------
had to bail out this scheme first in 1998, by investing close to Rs. 3,500 crores.
The bigger crisis came three years later, when the fund suspended sale and ----------------------
repurchase in this scheme and also expressed its inability to pay any dividend ----------------------
for the first time in its history. These proposals were later rolled back and another
bail out had to be worked out. ----------------------
After the crisis of 1998, a committee was appointed under the chairmanship ----------------------
of Mr Deepak Parekh, which suggested many fundamental changes in the
working of the fund. All suggestions were not implemented before the crisis of ----------------------
2001. Since then many more investigations in the working of India’s largest and
oldest mutual fund have been conducted by a Joint Parliamentary Committee. ----------------------
Recently, the government has decided to split UTI into two. It has also ----------------------
constituted AMC to manage UTI-II and it is likely to privatise this in the future.
----------------------
The mutual fund industry is going through exiting times these days. Many
public sector and private sector banks who are active in mutual fund industry ----------------------
are restructuring their AMCs by inviting foreign funds to participate in their
----------------------
AMCs by investing in the equity of these companies. IDBI has recently decided
to disinvest in favour of their foreign partners Principal. State Bank of India is ----------------------
also looking for a partner for its AMC.
----------------------
Many Indian companies are already running their mutual fund schemes
in partnerships with foreign collaborators. HDFC and ICICI have both got such ----------------------
tie-ups.
----------------------
On the other hand, some foreign mutual funds like Zurich are in the
process of winding up their Indian operations. This fund has now been acquired ----------------------
by HDFC mutual fund.
----------------------
In another case of consolidation recently UTI has acquired the mutual
fund of IL & FS. ----------------------
In the future, mutual funds are likely to introduce innovative products for ----------------------
the, investors. There is already an application filed with the SEBI, by HDFC, to
start a scheme related to Real Estate markets. ----------------------
Mutual Funds 63
Notes Securitisation is a new product for Indian markets, and this is likely to
open up newer opportunities for mutual funds as well as, for investors.
----------------------
Indian investors will have to look towards mutual funds as investors seek
---------------------- to increase their returns on investments. This is going to be a major challenge
for the industry, as they must strive to give the investors, better returns than the
---------------------- average return available and to provide capital appreciation in equity oriented
schemes.
----------------------

---------------------- State True or False.
---------------------- 1. A close-ended scheme is one in which, the subscription period for
the mutual fund remains only for the specific period, called the
----------------------
redemption period.
---------------------- 2. A pure growth scheme aims at generating long-term capital
---------------------- appreciation for the investors.
----------------------
Activity 4
----------------------
Find out Money market schemes offered by any two AMCs.
----------------------
----------------------
3.6 REGULATORY ASPECTS
----------------------
The asset management company shall launch no scheme unless the
---------------------- trustees approve such scheme and a copy of the offer document has been filed
with the Board.
----------------------
Every mutual fund shall along with the offer document of each scheme
---------------------- pay filing fees.
---------------------- The offer document shall contain disclosures which are adequate in order
to enable the investors to make informed investment decision including the
---------------------- disclosure on maximum investments proposed to be made by the scheme in the
listed securities of the group companies of the sponsor. A close-ended scheme
----------------------
shall be fully redeemed at the end of the maturity period unless a majority of the
---------------------- unit holders otherwise decide for its rollover by passing a resolution.
The mutual fund and asset management company shall be liable to refund
----------------------
the application money to the applicants
---------------------- (i) If the mutual fund fails to receive the minimum subscription amount
referred to in clause (a) of sub-regulation (1).
----------------------
(ii) If the money is received from the applicants for units are in excess of
---------------------- subscription as referred to in clause (b) of sub-regulation (1).
----------------------
64 Capital Market
The asset management company shall issue to the applicant whose Notes
application has been accepted, unit certificates or a statement of accounts
specifying the number of units allotted to the applicant as soon as possible but ----------------------
not later than six weeks from the date of closure of the initial subscription list
and or from the date of receipt of the request from the unit holders in any open ----------------------
ended scheme. ----------------------
Rules Regarding Advertisement
----------------------
The offer document and advertisement materials shall not be misleading
or contain any statement or opinion, which are incorrect or false. ----------------------
Investment Objectives and Valuation Policies ----------------------
The price at which the units may be subscribed or sold and the price at ----------------------
which such units may at any time be repurchased by the mutual fund shall be
made available to the investors. ----------------------
General Obligations ----------------------
Every asset management company for each scheme shall keep and
maintain proper books of accounts, records and documents, for each scheme so ----------------------
as to explain its transactions and to disclose at any point of time the financial ----------------------
position of each scheme and in particular give a true and fair view of the state
of affairs of the fund and intimate to the Board the place where such books of ----------------------
accounts, records and documents are maintained.
----------------------
The financial year for all the schemes shall end as of March 31 of each
year. Every mutual fund or the asset management company shall prepare in ----------------------
respect of each financial year an annual report and annual statement of accounts
----------------------
of the schemes and the fund as specified in Eleventh Schedule.
Every mutual fund shall have the annual statement of accounts audited ----------------------
by an auditor who is not in any way associated with the auditor of the asset
----------------------
management company.
Procedure for Action in Case of Default ----------------------
On and from the date of the suspension of the certificate or the approval, as ----------------------
the case may be, the mutual fund, trustees or asset management company, shall
cease to carry on any activity as a mutual fund, trustee or asset management ----------------------
company, during the period of suspension, and shall be subject to the directions ----------------------
of the Board with regard to any records, documents, or securities that may be in
its custody or control, relating to its activities as mutual fund, trustees or asset ----------------------
management company.
----------------------
Restrictions on Investments
----------------------
A mutual fund scheme shall not invest more than 15% of its NAV in debt
instruments issued by a single issuer, which are rated not below investment ----------------------
grade by a credit rating agency authorized to carry out such activity under
the Act. Such investment limit may be extended to 20% of the NAV of the ----------------------
scheme with the prior approval of the Board of Trustees and the Board of Asset
----------------------
Management Company.
Mutual Funds 65
Notes A mutual fund scheme shall not invest more than 10% of its NAV in
unrated debt instruments issued by a single issuer and the total investment in
---------------------- such instruments shall not exceed 25% of the NAV of the scheme. All such
investments shall be made with the prior approval of the Board of Trustees and
---------------------- the Board of Asset Management Company.
---------------------- No mutual fund under all its schemes should own more than ten per cent
of any company’s paid up capital carrying voting rights.
----------------------
Such transfers are done at the prevailing market price for quoted
---------------------- instruments on spot basis.
---------------------- The securities so transferred shall be in conformity with the investment
objective of the scheme to which such transfer has been made.
----------------------
A scheme may invest in another scheme under the same asset
---------------------- management company or any other mutual fund without charging any fees,
provided that aggregate interscheme investment made by all schemes under
---------------------- the same management or in schemes under the management of any other asset
---------------------- management company shall not exceed 5% of the net asset value of the mutual
fund.
---------------------- The initial issue expenses in respect of any scheme may not exceed six
---------------------- per cent of the funds raised under that scheme.
Every mutual fund shall buy and sell securities on the basis of deliveries
---------------------- and shall in all cases of purchases, take delivery of relative securities and in all
---------------------- cases of sale, deliver the securities and shall in no case put itself in a position
whereby it has to make short sale or carry forward transaction or engage in
---------------------- badla finance.
---------------------- Every mutual fund shall, get the securities purchased or transferred in
the name of the mutual fund on account of the concerned scheme, wherever
---------------------- investments are intended to be of long-term nature.
---------------------- Pending deployment of funds of a scheme in securities in terms of
investment objectives of the scheme a mutual fund can invest the funds of the
---------------------- scheme in short term deposits of scheduled commercial banks.
---------------------- No mutual fund scheme shall make any investment in;
---------------------- i. Any unlisted security of an associate or group company of the sponsor;

or
---------------------- ii. Any security issued by way of private placement by an associate or group
---------------------- company of the sponsor; or
The listed securities of group companies of the sponsor which is in excess
----------------------
of 30% of the net assets [of all the schemes of a mutual fund]
---------------------- No mutual fund scheme shall invest more than 10 per cent of its NAV in
the equity shares or equity related instruments of any company. Provided that,
----------------------
the limit of 10 per cent shall not be applicable for investments in index fund or
---------------------- sector or industry specific scheme.
66 Capital Market
A mutual fund scheme shall not invest more than 5% of its NAV in the Notes
equity shares or equity related investments in case of open-ended scheme and
10% of its NAV in case of close-ended scheme. ----------------------
----------------------
Activity 5
----------------------
Find out from the SEBI web site the action taken by SEBI against any mutual
fund in respect of non-compliance with the regulations. ----------------------
----------------------
3.7 THE CASE OF US - 64 ----------------------
No discussion on the subject of mutual funds in India can be complete ----------------------
without a discussing the US 64 problem, which rocked our financial, markets a
couple of years back. ----------------------
US 64 was the first scheme floated by UTI and was by far the most popular ----------------------
scheme, as is evident form the fact that almost 2 crores investors had put their
money in this scheme. The reason was quite obvious; the scheme had given ----------------------
very good returns to the investors. This scheme was designed as a debt oriented ----------------------
one so that regular dividend could be paid to the investors. In the early 90s,
Indian stock markets were reaching dizzying heights at the height of Harshad ----------------------
Mehta led frenzy. During this time UTI top brass under the chairmanship of
Mr. Pherwani change the composition of this scheme to make it equity biased ----------------------
as opposed to debt, as returns in stock markets were phenomenal. Around the ----------------------
same time the government of India under its disinvestment program started
selling its stake in the public sector units. UTI was one of the major buyers of ----------------------
these equities. However, the prices of these shares in the stock markets did not
make this investment very profitable. UTI allegedly made many investments ----------------------
in unsustainable projects under political pressure. Many of these shares were ----------------------
bought at a high premium under the free pricing regime, and companies with
dubious background issued these. During all these years, UTI refused to be ----------------------
brought under the SEBI regulations for mutual funds. It also refused to disclose
its portfolio and the NAV of the units. UTI also started to feel the heat of ----------------------
competition as private sector mutual funds started eating away its market share ----------------------
steadily.
The crunch came in 1998, when the government had to bail out UTI by ----------------------
providing an amount of almost Rs. 3,500 crores to make the shortfall. This was ----------------------
done by buying back the PSU shares originally sold to the fund.
In 2001, UTI was rocked with even more serious trouble when in June it ----------------------
decided to suspend sale and purchase of units and also decided for the first time
----------------------
in its history that the fund will pay no dividend for that year. UTI was found
to be in some way involved with the Ketan Parekh saga which was unfolding ----------------------
around the same time. There was also the proposed merger of UTI Bank with
Global Trust Bank, which had to be called off, as GTB’s involvement in Ketan ----------------------
Parekh affair became clear.
----------------------
Mutual Funds 67
Notes Finally, the government had to come to the rescue of UTI once again. It
decided the scheme will pay a dividend of 10% and the scheme will be made
---------------------- NAV based. It also decided to buy the units held by small investors at a premium
to the NAV, which will go up by 10 paise every month peaking to Rs.12 per
---------------------- unit. It was decided that 5000 units per holder would be eligible to be sold under
this rescue package.
----------------------
The scheme has become NAV based now and UTI itself has been spilt
---------------------- into two. Recently, government has decided to offer tax free bonds to the unit
holders of this scheme who wish to quit the scheme in May 2003. It is expected
---------------------- that many investors will opt for this switchover, as this will offer them a good
return.
----------------------
In February 2004, UTI-I has sought the permission of SEBI to prematurely
---------------------- close 7 assured plans. Among these schemes are four long-term full assurance
schemes with remaining maturities ranging between 18 and 22 years. These
---------------------- schemes were launched with an assured return of 13-14%. However, due to the
---------------------- present market conditions the schemes are getting returns much below what has
been promised. This has been partly due to the fact that some of the investments
---------------------- made by UTI have turned into Non Performing Assets.
---------------------- The current shortfall in these schemes is expected to be around Rs. 8,000
crores. If these schemes are not foreclosed, then the government will have to
---------------------- pick up the tab for making good the difference.
----------------------
Activity 6
----------------------
Jot down the main points which led US 64 into problems.
----------------------
---------------------- Summary
----------------------
●● The net asset value of the fund is the cumulative market value of the
---------------------- assets fund net of its liabilities.
●● Mutual funds are defined by SEBI regulations as funds established in the
---------------------- form of a trust to raise money through the sale of units- that is, the interest
---------------------- of the unit holders in a scheme, which consists of each unit representing
one undivided share in the assets of a scheme-to public under one/more
---------------------- scheme for investing in securities including money market instruments
consisting of commercial papers, commercial bills, etc. According to the
---------------------- procedure laid down by SEBI, mutual funds have to be registered with
---------------------- SEBI.
●● After the crisis of 1998, a committee was appointed under the chairmanship
---------------------- of Mr Deepak Parekh, which suggested many fundamental changes in the
---------------------- working of the fund.
----------------------
----------------------
68 Capital Market
Keywords Notes
----------------------
●● Asset Management Company: The entity that manages the schemes of
the fund. ----------------------
●● ELSS: Equity Linked Saving Schemes are a special scheme offered by a
fund that enjoys income tax benefits. ----------------------
●● Load: Extra money paid while entering or leaving of the fund. ----------------------
●● Net Asset Value: Value per unit of the scheme that is calculated on the ----------------------
daily basis.
----------------------
Self-Assessment Questions ----------------------
1. What are mutual funds? ----------------------
2. Describe the different types of schemes offered by the mutual funds.
----------------------
3. Comment on the future of mutual fund industry in India.
----------------------
4. Discuss the case of US-64.
5. What are the SEBI guidelines for mutual funds? ----------------------
6. Explain the concept of Fund of Funds and discuss its usefulness or ----------------------
otherwise.
----------------------
7. Compare the mutual funds with the ULIP schemes of insurance companies.
----------------------
8. Explain what is meant by NAV and Load structure.
----------------------
----------------------
----------------------
----------------------
1. False
2. True ----------------------

1. Portfolio is the group of securities that the fund managers plan to invest. ----------------------
2. AMC has worth not less than 10 crores.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Mutual Funds 69
Notes Check your Progress 2
Fill in the blanks.
----------------------
1. The net asset value of the fund is the cumulative market value of the
---------------------- assets fund net of its liabilities.
---------------------- 2. Until 1987, UTI was the only mutual fund in India.

----------------------
1. True
----------------------
2. True
----------------------
----------------------
Suggested Reading
---------------------- 1. Mobius, Mark. 2007. Mutual Funds: An Introduction to the Core Concepts.
John Wiley & Sons.
----------------------
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----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
70 Capital Market
Merchant Banking
UNIT
4
Structure:
4.1 Introduction to Merchant Banking

4.2 Activities of Merchant Bankers
4.3 Issue Management
4.4 Underwriting
4.5 Guidelines for IPOs
4.6 What is Book Building
4.7 SEBI Guidelines for Merchant Bankers
Summary
Keywords
Suggested Reading
Merchant Banking 71
Notes
Objectives
----------------------
----------------------
●● Describe the importance of merchant bankers.
---------------------- ●● Discuss the functions of merchant bankers.
---------------------- ●● Evaluate the role of merchant bankers in an initial public issue.
---------------------- ●● Explain the concept of underwriting.
●● List the guidelines for IPO issued by SEBI.
----------------------
●● Evaluate the process of book building.
---------------------- ●● List the guidelines issued by SEBI for merchant bankers.
----------------------
---------------------- 4.1 INTRODUCTION TO MERCHANT BANKING

---------------------- Merchant Banks are a very important factor in the capital markets. They
have a big role to play especially, in placing equity in the primary markets,
---------------------- through the Initial Public Offers route.
---------------------- Public money or savings play a vital role in financing many big projects.
Thousands of crores are raised every year from the markets either through equity
---------------------- or debt from the market. The merchant banks play a crucial role in helping the
corporates raise money from these markets.
----------------------
The SEBI issued guideline for the merchant bankers in April, 1990.
---------------------- With the passage of time the role of merchant bankers has enlarged to
a great extent. It is mandatory for companies raising money from the capital
----------------------
markets (whether equity or debt) to appoint merchant bankers for this purpose.
---------------------- For the buy back of shares also the companies will need to appoint merchant
bankers to oversee the entire process.
---------------------- One of the major areas where these entities will henceforth play a major
---------------------- role is in the space of mergers and acquisitions. They will especially play a huge
role in hostile takeovers. This activity is relatively new in India but it is bound
---------------------- to grow in the coming years. We have already witnessed mega deals through
this route. The proposed acquisition of Sahara Air by Jet Airways is one such
---------------------- deal.
---------------------- Internationally merchant bankers are known as Investment bankers
mainly on account of their role valuing companies for possible takeovers and
---------------------- advising companies who are in the market for acquisitions. These bankers also
help raise money for these takeovers.
----------------------
Following the globalisation of the Indian economy we have witnessed
---------------------- that many Indian companies are now acquiring companies abroad. We have
already seen companies like Tata Motors, TISCO, VSNL, Reliance, Bharat
---------------------- Forge and Dr. Reddy’s, to name a few acquiring companies abroad. Many more
Indian companies will be in this field from now on. All these companies will
---------------------- need merchant bankers to help them in this endeavour.
72 Capital Market
4.2 ACTIVITIES OF MERCHANT BANKERS Notes
The merchant banks undertake the following activities: ----------------------
1. Project finances advice ----------------------
2. Project appraisal
----------------------
3. Capital restructuring
4. Issue management ----------------------
5. Loan syndication ----------------------

6. Foreign currency finances ----------------------
7. Investment management
----------------------
8. Mutual Funds
9. Lease Finance ----------------------
10. Bills Discounting ----------------------

11. Mergers and Acquisition ----------------------
12. Working Capital Finance
----------------------
13. Government Consents
----------------------
14. Arranging fixed deposits
15. Corporate counselling ----------------------
16. Underwriting ----------------------
17. Non-Resident investments
----------------------
18. Restructuring of sick units
----------------------
19. Hire purchase
20. Money market operations ----------------------
----------------------
----------------------
----------------------
1. The merchant banks play a crucial role in helping the corporates raise
money from these markets. ----------------------
2. Internationally merchant bankers are known as Investment bankers. ----------------------
----------------------
Activity 1 ----------------------
1. Find out the five most important merchant bankers in India. Find out ----------------------
how many of them have a foreign holding
----------------------
2. From the list that you have made in the previous activity, write which
activities are performed by the top five merchant bankers ----------------------
Merchant Banking 73
Notes 4.3 ISSUE MANAGEMENT
---------------------- The merchant bankers help corporates to raise money from the markets
through the issue of shares, debentures, bonds etc. They are designed as
---------------------- managers to the issue. Their main business is to attract public money to capital
issues.
----------------------
They usually render the following services:
----------------------
●● Drafting of prospectus and getting it approved from the stock exchanges.
---------------------- ●● Obtaining consent/acknowledgement from SEBI.
---------------------- ●● Appointing bankers, underwriters, brokers, advertisers, printers’ etc.
---------------------- ●● Obtaining the consent of all the agencies involved in the public issue.
●● olding road shows, to sell the issue. These shows are held for the
H
---------------------- analysts, brokers and institutional investors. The purpose of these shows
is to answer queries from these people about the company and the project
----------------------
for which the funds are being raised.
---------------------- ●● Deciding the pattern of advertising.
---------------------- ●● Deciding the branches where application money should be collected.
●● Deciding the dates of opening and closing of the issue.
----------------------
●● btaining the daily report of application money collected at various
O
---------------------- branches.
---------------------- ●● Obtaining subscription to the issue.
●● fter the close of the issue, obtaining consent of stock exchange for
A
---------------------- deciding basis of allotment etc.
---------------------- The merchant bankers help the companies to determine their capital structure.
---------------------- Corporate Advisory Services relating to the issue

In India the pricing of issues is now freely decided by the company,
---------------------- with valuable inputs from the merchant bankers, who have to sell the issue at
---------------------- the decided price. The pricing of the issue especially in a public issue is very
important. The pricing has to be such that the investors will be attracted to
---------------------- invest in the issue at that price, at the same time the company should get the
premium that it is looking for. After all, the premium can play a very big role in
---------------------- deciding the company’s capital structure, as larger the premium lesser will be
---------------------- the requirement for borrowed funds.
The promoter also needs to decide whether to go in for a fresh issue
----------------------
or go for a rights issue. However, this will depend mainly on the quantum of
---------------------- funds that the company needs to raise. The success of the issue is dependent on
the selection of the right type security. In this matter, the expert advice of the
---------------------- merchant bankers is of immense importance.
---------------------- In the issue management, the merchant bankers have to coordinate the
various agencies to the issue. The success of the issue depends on the cooperation
---------------------- of all the agencies involved.
74 Capital Market
The merchant bankers offer the following services during the public Notes
issues:
----------------------
●● Preparing an action plan and budget for the total expenses for the issue.
●● reparation of application to SEBI and assistance in obtaining the consent
P ----------------------
from SEBI.
----------------------
●● Drafting of the prospectus.
●● Selection of underwriters, brokers etc. ----------------------
●● Selection of bankers to the issue. ----------------------
●● Selection of advertising agency for publicity.
----------------------
●● btaining approval of the institutional underwriters and stock exchanges
O
for publication of the prospectus. ----------------------
Companies are free to appoint one or more agencies as Managers to an ----------------------
issue. SEBI guidelines insist that all issues should be managed by at least one
authorised merchant banker, functioning either as the sole or lead manager to ----------------------
the issue. Ordinarily, not more than two merchant bankers should be associated
----------------------
as lead managers, advisors and consultants to a public issue. In issues of over
Rs. 100 crores, the number could be up to a maximum of four. ----------------------
The responsibilities of merchant bankers in management of public issues
----------------------
are many. Some of these are as follows:
We have seen that many unscrupulous promoters have raised money from ----------------------
the market. This has hurt the investors a lot and has also made investors nervous ----------------------
about stock market investments. This in turn affects the functioning of stock
markets both the primary and the secondary markets. It is therefore, necessary ----------------------
that merchant bankers are satisfied with the viability of the project, which they
can then sell to the investors with confidence. It is therefore important for the ----------------------
reputation of merchant bankers, to only associate themselves with good issues. ----------------------
It has also been observed that many agencies associated with an issue
tend to make tall claims about the promoters, the projects and the profitability ----------------------
etc. The merchant bankers should act as the custodians of the investors’ money ----------------------
and this puts a lot of responsibility on them. To discharge this function the
merchant bankers have to exercise due diligence independently by verifying ----------------------
the contents of the prospectus and the reasonableness of the views expressed
therein. Though they do not have to sign the prospectus, they have to give a ----------------------
certificate to that effect to SEBI. ----------------------
It is the responsibility of the merchant bankers to get the securities listed
on all the stock exchanges mentioned in the prospectus. It can be especially ----------------------
true of companies, who cannot list their shares listed on either NSE or BSE, but ----------------------
promise listing on several regional stock markets, but actually list them only on
one or two exchanges. ----------------------
----------------------
----------------------
Merchant Banking 75
Notes Non-receipt of refund orders and allotment advice within the stipulated
period is a most common complaint of the investors. With the introduction of
---------------------- Demat accounts the complaints about allotment have surely gone down. It is the
responsibility of the lead mangers/merchant bankers to ensure timely refunds
---------------------- and allotment of securities to the investors.
---------------------- The merchant bankers have to certify that they have verified everything
and that they believe it to be true. This assures the investing public about the
----------------------
safety of their investment. The precautions by the merchant bankers would
---------------------- ensure that all the fake companies, whose intention is to defraud the investors,
do not have access to the market
----------------------
---------------------- 1. The _______ help corporates to raise money from the markets through
the issue of shares, debentures, bonds etc.
---------------------- 2. In the __________, the merchant bankers have to coordinate the
---------------------- various agencies to the issue.
----------------------
Activity 2
----------------------
---------------------- Find out what is the role of merchant bankers in the pricing of an issue. Find
out what factors need to be considered for doing this.
----------------------
---------------------- 4.4 UNDERWRITING

---------------------- Underwriting is like insurance against the failure of an issue. It is a
---------------------- guarantee to the issuing the company, that the money that it requires for its
project will definitely be raised. It means that even if the issue is not fully
---------------------- subscribed to by the public, the underwriters will make up the short fall.
Underwriting involves the underwriter agreeing to subscribe directly, or
----------------------
to procure subscription for the unsubscribed portion of the issue, which is not
---------------------- taken up. For the risk that the underwriter takes, he is paid commission. When
there is more than one underwriter to an issue the liability is shared by them on
---------------------- pro-rata on the basis of amounts underwritten by them.
---------------------- Underwriting is a device that ensures the success of new issues. New
companies entering the markets for the first time, always face a number of
---------------------- problems in raising funds from the market. One of the biggest problems of
course that the company is not well known to the investors and many of them
---------------------- will be unwilling to invest their money in such ventures. Many a times even
existing companies may find it difficult to raise money, due to some reasons.
---------------------- Issuing companies therefore approach different underwriters with a request to
---------------------- underwrite the issue.
76 Capital Market
Underwriters on their part need to satisfy themselves about the viability Notes
of the project and also about the integrity of the promoters of the company. It
must be noted that when an issue is undersubscribed, the underwriters will pick ----------------------
the shares and only if the project is good enough, then in future they can sell
the shares in the market and get not only their money back, but can also make a ----------------------
decent profit as well. ----------------------
The issues, which are backed by well-known underwriters, may receive a
high premium from the investing public. This gives some sort of comfort level ----------------------
to the investors. Underwriting assures both the issuing company as well as the ----------------------
investing public that the issue will be a success.
It is obligatory for the merchant bankers to accept a minimum 5% ----------------------
underwriting in the issue subject to a ceiling. By taking underwriting in an ----------------------
issue managed by them, they show their full commitment to the issue that
they are managing. The SEBI has made it mandatory for issuing companies to ----------------------
underwrite all issues.
----------------------

1. Underwriting is like insurance against the failure of an issue. ----------------------
2. Underwriters on their part need to satisfy themselves about the ----------------------
viability of the project and also about the integrity of the promoters
of the company. ----------------------
----------------------
Activity 3 ----------------------
Find out from the prospectus of any recent issue who had underwritten the ----------------------
issue and what the percentage of each underwriter was.
----------------------
----------------------
4.5 GUIDELINES FOR IPOS
----------------------
Public Issue
----------------------
What are the eligibility norms for an unlisted company for making a
public issue? ----------------------
An unlisted company has to satisfy the following criteria to be eligible to
----------------------
make a public issue
i. Pre-issue networth of the company should not be less than Rs.1 crore ----------------------
in last 3 out of last 5 years with minimum networth to be met during
----------------------
immediately preceding 2 years and
ii. track record of distributable profits for at least three (3) out of immediately ----------------------
preceding five (5) years and ----------------------
Merchant Banking 77
Notes iii. The issue size (i.e. offer through offer document + firm allotment +
promoters’ contribution through the offer document) shall not exceed five
---------------------- (5) times its pre-issue networth.
---------------------- In case an unlisted company does not satisfy any of the above criterions,
it can come out with a public issue only through the Book-Building process. In
---------------------- the Book Building process the company has to compulsorily allot at least sixty
percent (60%) of the issue size to the Qualified Institutional Buyers (QIBs),
----------------------
failing which the full subscription money shall be refunded.
---------------------- What are the eligibility norms for a listed company for making a public
issue?
----------------------
A listed company is eligible to make a public issue if the issue size (i.e.
---------------------- offer through offer document + firm allotment + promoters’ contribution through
the offer document) is less than five (5) times its pre-issue networth.
----------------------
If the issue size is more than or equal to 5 times of pre-issue networth,
---------------------- then the listed company has to take the book building route and allot sixty
---------------------- percent (60%) of the issue size to the Qualified Institutional Buyers (QIBs),
failing which the full subscription money shall be refunded.
---------------------- For details refer to unit 2 of SEBI (DIP) Guidelines and relevant
---------------------- clarifications issued subsequently.
Are there any restrictions on pricing by companies?
----------------------
The companies can freely price their equity shares. However, they have to
---------------------- give justification of the price in the offer document / letter of offer
---------------------- What are the requirements regarding promoters contribution and lock-in?
---------------------- In case of an Initial Public Offer (IPO), i.e. public issue by unlisted
company, the promoters have to necessarily offer at least 20% of the post issue
---------------------- capital.
---------------------- In case of public issues by listed companies, the promoters shall participate
either to the extent of 20% of the proposed issue or ensure post-issue share
---------------------- holding to the extent of 20% of the post-issue capital.
---------------------- In case of any issue of capital to the public the minimum contribution of
promoters shall be locked in for a period of 3 years, both for an IPO and Public
---------------------- Issue by listed companies.
---------------------- In case of an IPO, if the promoter’s contribution in the proposed issue
exceeds the required minimum contribution, such excess contribution shall also
---------------------- be locked in for a period of one year.
---------------------- In case of a public issue by a listed company, participation by promoters
in the proposed public issue in excess of the required minimum percentage
---------------------- shall also be locked-in for a period of one year as per the lock-in provisions as
specified in Guidelines on Preferential issue.
----------------------
Beside the above, in case of IPO the entire pre-issue share capital i.e. paid
---------------------- up share capital prior to IPO and shares issued on a firm allotment basis along
78 Capital Market
with issue shall be locked-in for a period of one year from the date of allotment Notes
in public issue.
----------------------
What is the basis of allotment?
In case of over-subscription in a fixed price issue the allotment is done in ----------------------
marketable lots, on a proportionate basis (for details refer to clause 7.6.1 of DIP ----------------------
Guidelines).
----------------------
In case of a book building issue, allotment to Qualified Institutional Buyers
and Non-Institutional Buyers are done on a discretionary basis. Allotment to ----------------------
retail investors is done on a proportionate basis as per provisions of Clause No.
----------------------
7.6.1 of Guidelines.
----------------------
How does one come to know of issues on offer and from where one can
get copies of the draft offer document? ----------------------
Every week SEBI issues press releases for information of the public, ----------------------
details of offer documents filed with SEBI and observations issued. Details can
be obtained from the Primary Market page of the SEBI website. The draft offer ----------------------
document can also be purchased from the SEBI office where the document is ----------------------
filed on payment of Rs.100/- by way of DD drawn in favour of SEBI. The draft
offer document/letter of offer remains posted on SEBI website for a period of ----------------------
21days from the date of filing the same to SEBI and can also be downloaded
----------------------
from there.
From where does one get the application forms and the prospectus? ----------------------
Application form can be obtained from the Lead manager and brokers to ----------------------
the issue. The application forms are also generally available at collecting bankers. ----------------------
Name and addresses of the Lead Manager are available in the prospectus/letter
of offer ----------------------
Can the public give their comments/complaints on the Issuer company or ----------------------
others connected with the issue?
----------------------
Yes, the objective of making offer document public is to invite public
comments. The comments should be given within 21 days of the filing of the ----------------------
Draft offer document with SEBI. ----------------------
Where does one complain in case of wrong/ non-disclosures/ mis-statement
----------------------
in the offer document?
The Primary Market Division in SEBI. ----------------------
Within how many days an investor should receive the refund order/ ----------------------
allotment advice? ----------------------
Despatch of refund orders / allotment advice is to be within two working
----------------------
days of finalisation of the basis of allotment
----------------------
Merchant Banking 79
Notes Companies are required to finalise the basis of allotment within thirty
days from the closure of the issue in case of a fixed price issue and within fifteen
---------------------- days from the closure of the issue in case of a book building issue or else they
---------------------- are liable to pay interest @ 15% p.a.
In case of non-receipt of the refund order / share certificate/ allotment
----------------------
advise what is the course of action available to the investor?
---------------------- The investor should give his complaint in writing to the Lead Manger/
---------------------- Registrar/ Investor Grievance Cell of SEBI.
Within how many days should the company get its securities listed after
----------------------
the issue?
----------------------
The post issue Lead manager ensures that all steps for completion of
---------------------- the necessary formalities for listing and commencement of trading at all stock
exchanges where the securities are to be listed are taken within seven working
---------------------- days of finalisation of basis of allotment.
---------------------- Is it mandatory to have a Demat Account for applying in public issue?
---------------------- An investor has the option to apply for and receive the shares in physical
form. However, it is advisable to get the allotment in Demat form, as the shares
----------------------
in IPO shall be compulsorily tradable in Demat segment in Stock Exchanges.
---------------------- Dealing of physical shares (allocated in IPO) will not be accepted. In case of an
IPO of any security of issue size of Rs. 10 crore or more, security shall be issued
---------------------- only in dematerialised form. In book built issues, for QIBs and large investors
---------------------- (applying for more than 1000 shares) allotment shall be only in Demat form and
hence they should have a Demat account.
----------------------
From where can I get the addresses of the companies and details of change
---------------------- of names etc.?
---------------------- From the stock exchanges and Registrar of Companies
---------------------- Activity 4
----------------------
Find out from any recent issue what the basis of allotment was.
----------------------
---------------------- 4.6 WHAT IS BOOK BUILDING

---------------------- SEBI Guidelines define Book Building as a process undertaken by which a
demand for the securities proposed to be issued by a corporate body is elicited
---------------------- and built up and the price for such securities is assessed for the determination
of a quantum of such securities to be issued by means of a notice, circular,
----------------------
advertisement, document or information memoranda or offer document.
----------------------
----------------------
80 Capital Market
What is the main difference between offer of shares through book building Notes
and offer of shares through normal public issue?
Price at which securities will be allotted is not known in case of offer of ----------------------
shares through book building while in case of offer of shares through normal ----------------------
public issue, price is known in advance to investor. In case of Book Building,
the demand can be known everyday as the book is built. But in case of the ----------------------
public issue the demand is known at the close of the issue.
----------------------
What is minimum number of days for which bid should remain open in
book building? ----------------------
Book should remain open for minimum of five days. ----------------------
Can open outcry system be used for book building?
----------------------
No. As per SEBI, only electronically linked transparent facility is allowed
to be used in case of book building. ----------------------
Is the issue price for placement portion and net offer to public the same? ----------------------
Yes
----------------------
What is the floor price in case of book building?
----------------------
Floor price is the minimum price at which bids can be made.
Can the Individual Investor use book building facility for making an ----------------------
application?
----------------------
Yes
----------------------
Can the bidder revise his bids?
Yes ----------------------
What proof can a bidder request from trading member for entering bids? ----------------------
A bidder can request for a transaction registration slip as the proof of ----------------------
his/ her having entered the bid. Whenever trading members in to the system
enters a bid, a unique transaction registration slip is automatically generated. ----------------------
Transaction registration slip gives details regarding number of shares bided for,
price, the client name etc. ----------------------
Is it possible to enter bids less than floor price? ----------------------
No. The system automatically rejects the bids if price is less than the floor ----------------------
price.
Corporate Services ----------------------
This kind of services can be of the following nature: ----------------------

They provide guidance in area of diversification and appraise projects for their ----------------------
clients. They help ailing companies to appraise their technology and processes,
and assessing their requirements and restructuring their capital base. They ----------------------
also interact with banks and financial institutions for rehabilitation of these
industries. They also monitor the rehabilitation of these schemes. ----------------------
The area of corporate counselling is vast which covers any matter worth the ----------------------
Merchant Banking 81
Notes benefit for a corporate unit, involving financial aspects, government regulations,
policy changes and the business environment.
----------------------
Project Counselling
---------------------- These relate to project finance and broadly cover the study of the project and
offering advisory assistance on the viability of the project and the steps for the
----------------------
implementation. This will also involve the study of the technical feasibility of
---------------------- the project. They also help in preparation of the project report.
Loan Syndication
----------------------
This involves the preparation and submission of applications to the financial
---------------------- institutions and banks. They help finalise the cost of the project. They also help
---------------------- in the estimation of working capital requirements. Finally, the funding for the
project is to be tied up with various lenders, who will take exposure in funding
---------------------- the total cost of the project.
---------------------- Merchant bankers need to possess the following qualities:

They must have knowledge and information about the various aspects of the
---------------------- capital markets, trends prevailing in the markets and the psychology of the
---------------------- investors.
They must have the ability to evaluate and analyse the various aspects
----------------------
concerning the formation of an industrial project and affecting the viability and
---------------------- the profitability of the project.
Integrity and maintenance of high professional standards are necessary for their
----------------------
success.
---------------------- Due to the new developments in capital markets, the needs of the corporate
---------------------- clients are changing rapidly. For this they must be more involved with the
clients and must update their knowledge.
----------------------
Activity 5
----------------------
---------------------- Compare fixed price issue mechanism with book building process and assess
which one is better.
----------------------
---------------------- 4.7 SEBI GUIDELINES FOR MERCHANT BANKERS

----------------------
They have to obtain an authorisation from them SEBI and strictly adhere
---------------------- to the guidelines laid down.
They should have necessary expertise, good financial standing, maintain
----------------------
high degree of professional integrity and fairness in their transactions and take
---------------------- greater responsibility in disclosures about issues and post issue allotments and
refunds.
----------------------
It is expected they would ensure that the company abides by the various
---------------------- requirements relating to disclosures, listing of instruments etc.
82 Capital Market
Categories of Merchant Bankers Notes
Due to the nature and range of activities of the merchant bankers, and
----------------------
their responsibilities toward, SEBI, investors, and the issuers of the securities,
it has been decided to have the following three categories of merchant bankers. ----------------------
Merchant bankers in this category must have a minimum networth of Rs.
----------------------
1 crore, in II category the networth requirement is Rs. 50 lakhs, and for category
three the networth requirement is Rs. 20 lakhs. Initial authorisation fee for the ----------------------
three categories is Rs. 5 lakhs, Rs. 3 lakhs and Rs. 1 lakhs.
----------------------
For issues upto Rs. 50 crores, the number of lead managers will not exceed
two, for issues above Rs. 50 crores and upto Rs. 100 crores the maximum ----------------------
number will be three and for issues above Rs. 100 crores the number can go up
to a maximum of four. There is no limit fixed for the number of co-managers. ----------------------
The company and the Lead mangers are free to decide the number.
----------------------
Activity 6 ----------------------
----------------------
Study the SEBI guidelines issued for merchant banker. Can you suggest any
changes? ----------------------
----------------------
Summary
----------------------
●● Merchant Banks have a big role to play especially, in placing equity in the
----------------------
primary markets, through the Initial Public Offers route.
●● The SEBI issued guideline for the merchant bankers in April, 1990. ----------------------
●● It is the responsibility of the merchant bankers to get the securities listed ----------------------
on all the stock exchanges mentioned in the prospectus.
●● The companies can freely price their equity shares. However, they have to ----------------------
give justification of the price in the offer document / letter of offer ----------------------
Keywords ----------------------
●● Allotment: Issuance of shares to the applicants. ----------------------
●● Book Building: A process of finding out the issue price through bidding. ----------------------
●● Initial Public Offer: When a company wishes to get listed on a stock ----------------------
exchange it has to make a public offer to sell its shares to the public at
large. ----------------------
●● Oversubscription: When a company receives offers to buy its shares in ----------------------
excess of its demand.
●● Underwriting: It is a sort of insurance against the failure of an issue. ----------------------
----------------------
----------------------
Merchant Banking 83
Notes
----------------------
1. Describe the role of merchant bankers in the capital markets.
---------------------- 2. What services are offered by the merchant bankers?
---------------------- 3. What is meant by underwriting?
---------------------- 4. Explain the SEBI guidelines for merchant bankers.

5. What is meant by Book Building process?
----------------------
6. Explain the SEBI guidelines for IPOs.
----------------------
7. Explain what is meant by Underwriting.
---------------------- 8. Do you believe that merchant bankers should be held responsible for the
---------------------- end use of funds by the companies?
---------------------- Answers to Check your Progress

---------------------- 1. True
2. True
----------------------
----------------------
---------------------- 1. The merchant bankers help corporates to raise money from the markets
through the issue of shares, debentures, bonds etc.
----------------------
2. In the issue management, the merchant bankers have to coordinate the
---------------------- various agencies to the issue.
----------------------
----------------------
----------------------
1. True
---------------------- 2. True
----------------------
Suggested Reading
----------------------
1. Machiraju, H. R. 2007. Merchant Banking, Principles and Practice. New
----------------------
Age International.
----------------------
----------------------
84 Capital Market
Recent Developments
UNIT
5
Structure:
5.1 Introduction
5.2 Rolling Settlement
5.3 Derivatives in Stock Markets
5.4 Depository and Dematerialisation and The National Securities Depository
Ltd. (NSDL)
5.5 Non-Voting Shares (NVS)
5.6 Bonus Debentures of HLL
5.7 E-Trading
5.8 Stock Lending Mechanism
5.9 Employees Stock Options Plan (ESOP)
5.10 Sweat Equity
Summary
Keywords
Suggested Reading
Recent Developments 85
Notes
Objectives
----------------------
----------------------
●● Discuss what rolling settlements in the stock markets are.
---------------------- ●● Explain what derivatives are.
---------------------- ●● Describe the working of depositories and dematerialisation.
---------------------- ●● Explain what non-voting shares are.
●● Analyse the issue of bonus debentures by HLL.
----------------------
●● Describe what e-trading is.
---------------------- ●● Evaluate the stock lending mechanism.
---------------------- ●● Evaluate the employees stock option plan.
●● Discuss what sweat equity is.
----------------------
---------------------- 5.1 INTRODUCTION
---------------------- In this unit, we shall try and see the latest developments that have taken
place in the different fields related to the capital markets. Rolling settlements
---------------------- are a new process, while bonus debentures, swat equity and ESOPs are new
---------------------- products that have been introduced.
---------------------- 5.2 ROLLING SETTLEMENT

---------------------- What is a rolling settlement?
---------------------- What is the difference between a rolling settlement and the prevailing
weekly settlement?
----------------------
A rolling settlement is one in which trades outstanding at the end of the
---------------------- day have to be settled (payments made for purchases or deliveries in the case of
sale of securities) at the end of the settlement period.
----------------------
In a T+5 rolling settlement, a transaction entered into Monday has to be
---------------------- settled on the fifth working day, which will be the subsequent Monday, when
either pay in or pay out takes place.
----------------------
As opposed to this, in a weekly settlement, the transactions made during
---------------------- any of the five trading days are permitted to be squared up - or purchases offset
against sales - during the same settlement period.
----------------------
Only those transactions, which are outstanding at the end of the last
---------------------- trading day, are required to be settled by payments or deliveries.
---------------------- Internationally, most developed countries follow the rolling settlement
system. For instance, both the US and the UK follow a rolling settlement (T+3)
---------------------- system, and the German stock exchanges follow a T+2 settlement cycle.
----------------------
86 Capital Market
In India, for equity trades, currently all trades are settled on T+2 settlement Notes
cycle and for derivatives/currency/commodities, currently all trades are being
mark to market at the closing price of contract and mark to market requirement ----------------------
are settled at T+1.
----------------------
What are the advantages of rolling settlements?
----------------------
In rolling settlements, payments are quicker than in the weekly
settlements. Thus, investors benefit from increased liquidity. For example, in a ----------------------
rolling settlement system, investors would receive the payments on the fifth day
after the sale. The National Stock Exchange was the first to introduce rolling ----------------------
settlements in the country.
----------------------
Rolling settlements could not be introduced earlier because India did not
have depositories. Rolling settlements necessarily require electronic transfers of ----------------------
funds and demat facilities in respect of securities being traded. This is because
----------------------
handling large volumes of paper on a daily basis is extremely difficult for the
clearinghouses of stock exchanges. ----------------------
It is only now that India has adequate facilities for electronic delivery of
----------------------
shares (demat shares), which facilitates trading and clearing large volumes on a
daily basis. However, transfer of funds in India still takes two to three days, as ----------------------
all banks are not yet connected electronically with all their branches.
----------------------
1. A ________ is one in which trades outstanding at the end of the day ----------------------
have to be settle at the end of the settlement period.
2. In India, we are presently following the settlement cycle of ____. ----------------------
----------------------
Activity 1 ----------------------
List the advantages of rolling settlements. What would be the impact if ----------------------
rolling settlements are done at T +1?
----------------------
5.3 DERIVATIVES IN STOCK MARKETS ----------------------
----------------------
Index Futures
The Securities and Exchange Board of India (SEBI) has recently taken a ----------------------
decision to expand trading in derivatives to options on stock market indices and
----------------------
on individual stocks. The risk containment and software related issues are being
worked out. ----------------------
Index futures have recently made their entry into Indian markets and even
----------------------
though the volumes are still small, these are picking up. When you buy or sell
an index future, you take a view on what the index (say the sensex) will be at ----------------------
some point in the future.
Notes Simply put, derivatives allow investors to trade in instruments derived
from the cash market, where typically buyers take delivery on payment of cash.
---------------------- Such instruments - futures and options - allow investors to hedge their risk or
even take speculative positions.
----------------------
How can you hedge using these instruments?
----------------------
This is how it works: if you feel the market is going to fall and the value
---------------------- of your portfolio is going to diminish you take a position on the futures market.
If it rises, then even though there is a loss on the futures position, the
----------------------
underlying cash portfolio rises and this help risk minimisation. It is for this
---------------------- reason that indices, which mirror closely a very wide basket of stocks, prove
successful in index futures trading.
----------------------
What is a futures contract?
---------------------- A futures contract is an agreement between a buyer and a seller for the
---------------------- purchase and sale of a particular asset at a specific future date. The asset in the
case of index futures is an index - it could be the S&P CNX Nifty index or the
---------------------- BSE30 sensex.
---------------------- With passage of time, several more indices are going to be allowed to be
traded on the futures markets. In a futures contract, the price at which the asset
---------------------- would change hands in the future is agreed upon at the time of entering into the
contract. A futures contract involves an obligation on both the parties to fulfill
---------------------- the terms of the contract.
---------------------- What is the period for which a futures position could be taken?
---------------------- Currently, both the stock exchanges have come out only with three
contracts: one month, two months and three months contracts each of which
---------------------- expires on the last Friday of the respective month. More flexibilities are expected
to be introduced as index futures catch up.
----------------------
What are the options?
----------------------
Options are contracts which go a step further than futures contracts in the
---------------------- sense that they provide the buyer of the option the right, without the obligation,
to buy or sell a specified asset at an agreed price on or upto a particular date.
----------------------
For acquiring this right, the buyer has to pay a premium to the seller. The
---------------------- seller on the other hand, has the obligation to buy or sell that specified asset at
that agreed price. This makes options more of an insurance product where the
---------------------- downside risk is covered for the payment of a certain fixed premium.
---------------------- So the loss would be minimised to the extent of the premium paid, like in
an insurance product.
----------------------
An option is a contract, which gives the buyer the right, but not the
---------------------- obligation, to buy or sell specified quantity of the underlying assets, at a specific
price on or before a specified time. The underlying asset may be physical
----------------------
commodities like wheat, cotton, gold oil or financial instruments like equity
---------------------- stocks, stock index, bonds etc.
88 Capital Market
An investor buys a call option to purchase equity shares of BSES Ltd. at Notes
the end of 30 days at a price of Rs. 200 at a premium of Rs. 10. If the market
price of the share on the day of expiry is say Rs. 230, the investor will exercise ----------------------
the option and buy the share at Rs. 200 and earn Rs.20 per share (Rs.230-
Rs.200-Rs.10). On the other hand, if the market price falls to say Rs. 170, then ----------------------
the investor will not exercise the option, and the maximum loss to him will be ----------------------
only Rs. 10 being the option premium paid. Thus, the losses are limited while
the profits are unlimited. ----------------------
While the American style option can be exercised on or before the ----------------------
expiration date, the European style option can be exercised only on the expiration
date. ----------------------
What is a call or put option? ----------------------
The right to buy is called a call option while the right to sell is called a put
----------------------
option. The buyer of the call option can call upon the seller of the option and
buy from him, the underlying instrument, at any point in time on or before the ----------------------
expiry date by exercising his option at the agreed price.
----------------------
The seller of the option has to fulfill the obligation on exercise of the
option. The right to sell is called the put option where the buyer of the option ----------------------
can exercise his right to sell the underlying instrument to the seller of the option,
at the agreed price. ----------------------
The technical group of SEBI has decided that stocks to be eligible for ----------------------
options trading should meet the following criteria
----------------------
The market capitalisation during the preceding six months and average
free float market capitalisation (non-promoter holding in the stock) should not ----------------------
be less than Rs. 750 crore.
----------------------
The stock should appear in the list of top 200 scrips based on the average
daily volume during the preceding six months which should not be less than Rs. ----------------------
5 crore in the underlying cash market.
----------------------
The stocks should be traded at least 90% of the trading days during the
preceding six months. ----------------------
Non-promoter holding in the company should be at least 30%. ----------------------
The ratio of daily volatility of the stock vis-a-vis daily volatility of index ----------------------
should not be more than 4, at any time during the preceding six months.
----------------------
1. Derivatives allow investors to trade in instruments derived from the ----------------------
cash market, where typically buyers take delivery on payment of cash.
----------------------
2. A futures contract is an agreement between a buyer and a seller for
the purchase and sale of a particular asset at a specific future date. ----------------------
Notes
Activity 2
----------------------
Find out from the past one month’s data which stocks have maximum
----------------------
turnover in Derivatives markets.
----------------------
---------------------- 5.4 DEPOSITORY AND DEMATERIALISATION AND THE

NATIONAL SECURITIES DEPOSITORY LTD. (NSDL)
----------------------
Shares were traditionally held in physical or paper form. This method
----------------------
has its own inherent weaknesses like loss / theft of certificates, forged / fake
---------------------- certificates, cumbersome and time consuming procedure for transfer of shares
etc. Therefore, to eliminate these weaknesses, a new system called Depository
---------------------- System has been established.
---------------------- A depository is a system, which holds your shares in the form of electronic
accounts in the same way like a bank holds your money in a saving account.
----------------------
Depository system provides the following advantages to an investor:
----------------------
●● Your shares cannot be lost or stolen or mutilated.
---------------------- ●● You never need to doubt the genuineness of your shares i.e. whether they
are forged or fake.
----------------------
●● hare transactions like transfer, transmission etc. can be effected
S
---------------------- immediately.
---------------------- ●● Transaction costs are usually lower than that in the physical segment.
●● There is no risk of bad delivery.
----------------------
●● onus / Rights shares allotted to you will be immediately credited to your
B
---------------------- account.
●● ou will receive the statement of account of your transactions / holding
Y
----------------------
periodically.
---------------------- ●● hen one decides to have the shares in electronic form, one should
W
approach Depository Participants (DP) who is an agent of the depository
----------------------
and open an account. The investor should surrender his share certificates
---------------------- in physical form and the DP will arrange to get them sent to and verified
by the company and on confirmation credit his account with an equivalent
---------------------- number of shares. This process is known as dematerialisation. The
investor can always reverse this process if he so desires and get his shares
----------------------
converted into paper form. This process is known as rematerialisation.
---------------------- ●● hare transactions like sale or purchase and transfer / transmission etc. in
S
the electronic form can be effected in a much simpler and faster way. All
----------------------
one needs to do is that after confirmation of sale / purchase transaction
---------------------- by the broker, one should approach one’s DP with a request to credit /
debit one’s account for the transaction. The depository will immediately
---------------------- arrange to complete the transaction by updating your account. There is no
90 Capital Market
need for separate communication to the company to register the transfer. Notes
Due to the advantages of dematerialisation of shares, it is advisable that
all investors should switch over to this system. As a matter of fact all securities ----------------------
in the group on both BSE and NSE are transacted only in dematerialsed form. ----------------------
SEBI has also permitted companies making initial public offering to allot share
only in this form. ----------------------
The National Securities Depository Ltd. (NSDL) ----------------------
IDBI, UTI and the NSE to provide electronic depository facilities for stock
----------------------
traded in the equity and debt market promote NSDL. NSDL has been registered
with SEBI and was launched on November, 7,1996 as India’s first depository to ----------------------
facilitate trading and settlement of securities in dematerialised form. Settlement
of securities in dematerialised form will eliminate problems that are normally ----------------------
associated with settlement through physical certificates, like tearing/mutilation
----------------------
of share certificates due to careless handling, loss of certificates in the post or
delays with registrars, problems of bad delivery of shares. Cases of forgery of ----------------------
certificates get eliminated in the electronic trading system. Settlement of trades
will be faster and hassle-free leading to shorter settlement cycles. ----------------------
Depository ----------------------
A depository is an organisation where the securities of a shareholder are
----------------------
held in the electronic form at the request of the shareholder through the medium
of a depository participant. ----------------------
A depository is a bank of securities. ----------------------
The depository can legally transfer beneficial ownership, which a
custodian cannot. ----------------------
The main objective of a depository is to minimise paper work involved ----------------------

with the ownership, trading and transfer of securities.
----------------------
Facilities offered by NSDL
----------------------
1. Enable surrender and withdrawal of securities to and from the depository.
2. Maintain the investors’ holdings in the electronic form. ----------------------
3. Effect settlement of securities traded on the exchanges. ----------------------
4. Carry out settlement of trades not done on the stock exchanges.
----------------------
1. A _______ is a system, which holds your shares in the form of ----------------------
electronic accounts in the same way like a bank holds your money in
a saving account. ----------------------
2. ________ has been registered with SEBI and was launched on ----------------------
November, 7,1996 as India’s first depository to facilitate trading and
settlement of securities in dematerialised form. ----------------------
Notes
Activity 3
----------------------
Give reasons as to why some people may be still holding their shares in
----------------------
physical stocks.
----------------------
---------------------- 5.5 NON-VOTING SHARES (NVS)
---------------------- Shareholders have two rights namely a) dividend and b) voting rights. In
case of non voting shares one right gets excluded i.e. the share holder looses the
---------------------- right to vote, even though he is the member of the company and may attend the
annual general meeting of the company. They usually are not entitled to rights
----------------------
or bonus issues of shares of the concerned company.
---------------------- NVS therefore have to be more attractive than those that carry full voting
rights. This can be done in two ways a) by giving discount on the issue price and
----------------------
b) by giving higher dividend on these shares.
---------------------- Theoretically, these shares will quote at a discount to the price of normal
shares.
----------------------
Industry needs resources for modernisation, expansion and new projects. But
---------------------- raising funds by way of equity has an inherent danger of loosing control to others.
---------------------- The ability to raise debt has its own limitations. NVS can provide a way out to
companies to garner equity without dilution of the promoters’ stake and control.
---------------------- There can always be investors who would prefer a higher return, rather
---------------------- than right to vote. It is evident that very few shareholders actually turn up for
the annual general meetings of the companies. As is evident from the recent
---------------------- experience of voting through postal ballot, it reinforces the view that many
shareholders are not really interested in the affairs of the company or wish to
---------------------- participate in the affairs of the company.
----------------------
Activity 4
----------------------
---------------------- Which are companies that have so far issued Non-voting shares and are they
listed in the stock markets?
----------------------
---------------------- 5.6 BONUS DEBENTURES OF HLL

---------------------- Hindustan Lever, one of the most respected companies in India had come
---------------------- out with a unique product called Bonus Debentures. This was the first time that
such a product was been introduced.
---------------------- The scheme, formulated under Section 391 to 394 of the Companies Act,
---------------------- entails issue and allotment of bonus debentures of the face value of Rs.6/- each,
in the ratio of one fully paid debenture of Rs.6/- each for every Re.1/- equity
---------------------- share held in the company on a record date to be fixed by the Board after the
92 Capital Market
scheme is sanctioned by the Bombay High Court. The debentures was to be Notes
secured, and redeemable at par in two equal instalments on the second and third
anniversary of the issue. Shareholders were allowed to trade on the debentures ----------------------
post allotment, since they would be listed on the NSE and the BSE. The
debentures were to carry an interest rate of 9% per annum payable annually. The ----------------------
debentures was to be considered as a ‘deemed dividend’ under the provisions of ----------------------
the Income Tax Act. HLL was to bear and pay, in addition, dividend distribution
tax at 10.2% on the issue from the General Reserves. ----------------------
The issue and allotment of the debentures was to account for approximately ----------------------
Rs.1320 crores from the General Reserves. The dividend distribution tax was
to account for about Rs. 135 crores from the General Reserves. Thus, a total ----------------------
amount of approximately Rs.1455 crores was to be utilised from HLL’s General
----------------------
Reserves of Rs. 1609 crores (as at December 31, 2000).
HLL decided to issue bonus debentures to enhance the efficiency of the ----------------------
balance sheet in the context of excess cash carried for several years. The scheme
----------------------
was to significantly increase HLL’s Return on Net Worth and reduce the cost of
capital. ----------------------
The scheme was equitable to each and every shareholder, including
----------------------
the parent company, Unilever, because every shareholder was to receive one
debenture each for every equity share held in the company. The scheme was ----------------------
predicated on improving the efficiency of HLL’s balance sheet, while benefiting
all shareholders. ----------------------
HLL had evaluated other options to deal with the issue of surplus cash. ----------------------
A cash dividend was ruled out because under the Companies Act, a company
can pay dividend out of General Reserves, within specified limits, only when it ----------------------
has incurred a loss or there is inadequacy of profits, neither of which is the case ----------------------
with HLL. In the circumstances, a special dividend could have been paid only
under a court scheme. The proposed bonus debentures scheme has the benefit ----------------------
of retaining access to the cash for exploiting any business opportunity that may
come up within a defined timeframe of three years, while at the same time ----------------------
unlocking value to the shareholders immediately. ----------------------
A buyback would not have been equitable to every shareholder, because
not all shareholders would have diluted their holdings. Apart from this, a ----------------------
buyback would have needed to be staggered over a period of at least three years, ----------------------
and would have accounted for only under 3% of HLL’s equity.
HLL also rejected the option of invoking Section 100 of the Companies ----------------------
Act reducing the face value of its Re.1/- shares to a lower amount, and returning ----------------------
the differential amount to shareholders with a suitable premium. Besides being
tedious and administratively cumbersome, there was no benefit in altering the ----------------------
basic share capital structure of the company.
----------------------
Bonus shares were not considered because it would have merely implied
conversion of General Reserves into equity shares without any underlying ----------------------
outflow of cash, the basic issue being addressed by this scheme. Bonus shares
----------------------
would also involve permanent increase in the company’s equity capital. In the
Notes case of a bonus issue, HLL would have continued to have cash and capital in
excess of needs, with the attendant dilution of Return on Net Worth/ Return on
---------------------- Capital.
---------------------- Hence, the proposed issue of bonus debentures came up as the most
viable route to improve the efficiency of HLL’s balance sheet, while benefiting
---------------------- all shareholders. Payment of interest on debentures would lead to a marginal
dilution in earnings, but it was estimated that the dilution would be in the order
----------------------
of about 40 paise per share in the first year of implementation. However, in real
---------------------- terms, shareholders would now have two streams of cashflow-one by way of
dividend on shares and the other by debenture interest/ redemption.
----------------------
The scheme contemplated that small debenture holders - holding less than
---------------------- 1000 debentures - who are original allottees can tender their debentures to the
company at any time on a first-come-first-serve basis for repurchase at par. This
---------------------- facility would be available to a maximum extent of Rs.100 crores in any year.
---------------------- The company also discussed with its merchant bankers (HSBC), to lead
a consortium of banks and financial institutions to formulate a scheme under
---------------------- which debenture holders could sell their debentures to them soon after their
allotment should they wish to do so within a defined timeframe. The company
----------------------
was advised that Sale/redemption of debentures at par (Rs.6/- per debenture)
---------------------- would not attract any capital gains tax in the hands of the shareholder, being a
deemed dividend; HLL would pay dividend distribution tax at 10.2% on this
---------------------- distribution. Interest on the debentures will be taxable on receipt in the normal
course.
----------------------
HSBC, which assisted the company in formulating the bonus debentures
---------------------- scheme, was appointed as the merchant bankers for the scheme.
---------------------- The Bonus Debenture did not in any way impair HLL’s capability to
make capital investments to fund the growth of existing businesses, enter into
---------------------- new businesses or to execute a large acquisition should such an opportunity
---------------------- arise. Even after the proposed restructuring of the General Reserves by issue
of debentures by way of deemed dividend out of the General Reserves, HLL
---------------------- would have a strong balance sheet. This would enable it to make significant
acquisitions.
----------------------
---------------------- Activity 5
---------------------- Name the other companies that have issued similar instruments.
----------------------
---------------------- 5.7 E-TRADING
---------------------- One of the most revolutionary things that happened at the end of the
twentieth century is obviously the revolution in communication through the
---------------------- Internet. The Net has become the way future business is heading towards. It is
therefore no surprise that the Net has made a big difference in the way stock
----------------------
markets around the world will function in future.
94 Capital Market
Developments like screen based trading in the place of traditional trading Notes
ring and the dematerialisation of the shares, have played a big role in making
E-trading a reality. Without these developments E-trading would not be as ----------------------
effective as it is now.
----------------------
Due to this new innovation one can now operate in the stock market from
the privacy of one’s home or office. The transactions can be put through in a ----------------------
matter of few minutes, to one’s satisfaction. This method guarantees complete
----------------------
secrecy in the transactions.
Various portals like Indiainfoline, Sharekhan, ICICI, Capitalmarkets have ----------------------
come up in the last few years. These portals are full of information about almost
----------------------
5000 companies listed on the stock exchanges. This enables the investors to
study the companies’ performance, before making investment decisions. They ----------------------
also provide latest information concerning the companies, which is essential
for the investors to make decisions. T.V. channels like CNBC also contribute a ----------------------
great deal in this effort by reporting latest happenings alongwith the necessary
----------------------
analysis by experts and by telecasting live the Investor meets, allowing investors
to get first hand information from the various company’s officials. ----------------------
On January 31, 2000, SEBI cleared the guidelines for Net based trading.
----------------------
The trading platform was created through VSAT operational since 1994. The
investors were now free to trade directly through their stockbrokers from the ----------------------
comfort of their homes.
----------------------
The preconditions for trading on Net are as follows:
1. A P.C. with net connection ----------------------
2. A registered account with a broker ----------------------

3. A demat account ----------------------
4. An account with a bank with payment gateway or online banking facility
----------------------
How to Trade On-line
----------------------
1. Log on to the Broker’s website
2. Register yourself as a client ----------------------
3. Fill in the client broker agreement on stamp paper ----------------------
4. Log on to the broker’s site using secure user ID and password
----------------------
5. The market watch page will show real time data
----------------------
6. Trade shares directly by entering the symbol of the securities
7. The brokers’ server will check the limit in the on-line and the demat ----------------------
account for the number of shares and execute the trade
----------------------
8. Usually the order is executed in about 20 seconds and you get the
confirmation ----------------------
9. The broker will send one e-mail confirmation and printed contract by mail ----------------------
10. On the settlement day, the demat and bank accounts will automatically
get debited and credited ----------------------
Notes
Activity 6
----------------------
Go to any website that offers this facility. Mention below the ways in which
----------------------
one can operate on -line account.
----------------------
---------------------- 5.8 STOCK LENDING MECHANISM

---------------------- This scheme was introduced by SEBI in 1997, to make capital market
active by putting idle stocks to work. The scheme became operational in
----------------------
1999. The National Securities Clearing Corporation Ltd. (NSCCL) is the first
---------------------- Approved Intermediary (AI) to implement this scheme.
All clearing members are eligible to participate in this scheme. All lending
----------------------
and borrowing transactions are backed by 100% collateral. The NSCCL bears
---------------------- all risks attached with these transactions. The investors willing to lend/borrow
securities approach their broker participant for putting through securities
---------------------- lending transaction.
---------------------- This transaction involves two parties one who is willing to lend and
the other who wishes to borrow securities at market related rates. The lender
---------------------- gets the benefit of a reasonable return called lending fee for parting with the
---------------------- securities for a specified time. The lender is assured of getting equivalent the
relevant securities by the NSSCL on the settlement date. If the borrower fails to
---------------------- return the securities on the settlement date, the NSCCL has powers to carry out
an auction, buy the shares on behalf of the lender and return them to him.
----------------------
This scheme has so far failed to take off in a significant manner. With the
---------------------- introduction of Derivative products, many investors seem to prefer to deal in
those products.
----------------------
---------------------- Activity 7
---------------------- Find out the relation between stock lending and short selling of shares.
----------------------
----------------------
5.9 EMPLOYEES STOCK OPTIONS PLAN (ESOP)
---------------------- There is a story that says that when Microsoft decided to go public it was
not because the company wanted money, but due to the fact that the employees
---------------------- wanted to cash their ESOPs, something that they could not do unless the
company was listed. Hence Microsoft went public!
----------------------
ESOPs is said to be the recipe to make employees millionaires apparently
---------------------- at no cost to the employer. This phenomenon is relatively new in India and the
IT industry was the first to adopt it wholeheartedly on the experience in the
----------------------
American markets. The distinguishing feature of ESOPs is that the reward is
---------------------- linked with the increase in the prices of shares of the company. But the other
96 Capital Market
point that is being increasingly faced by employees is what if the stock prices Notes
decline, below the price at which they bought these options in the first place?
Today this is the reality in India. ESOPs are granted in the form of shares ----------------------
directly allotted, stock options, stock appreciation rights etc. and each of these
can have many variants. ----------------------
A stock option is a right, but not an obligation, of the option holder to acquire ----------------------
the shares of a company during the specified period, at a predetermined price.
----------------------
ESOPs represent one of the methods of giving part ownership of the
company to the employees whereby they can work for and take part in the ----------------------
prosperity of the company. It is expected that when an employee becomes a part
----------------------
owner of the company, his motivational level would increase. This scheme is
also a step towards achieving the social objectives of the company. This is an ----------------------
incentive to the employee. The scheme comes with the rider of Lock in Period.
This means that the employees after exercising the option are not allowed to ----------------------
sell these shares for some time as stipulated by the company, and usually also
----------------------
cannot create a charge on them.
SEBI Guidelines ----------------------
Stock options can be issued under two methods, a) Employee’s Stock ----------------------
Option Scheme (ESOS) b) Employee Stock Purchase Scheme (ESPS).
----------------------
There has to vesting period during which the employees have to hold on
to the option, but cannot apply for the shares. After this there is the exercise ----------------------
period during which the option can be exercised. Then is the lock-in period
during which these shares cannot be sold. ----------------------
There are extensive disclosure requirements that need to be fulfilled. The ----------------------
promoters are not allowed to take part in this scheme. The scheme also needs to
be ratified by the shareholders before it can be implemented. The approval has ----------------------
to be in the form of a special resolution passed by the AGM. ----------------------
Under the corporate governance practices, the scheme has to be
implemented through a Compensation Committee of the Board of Directors of ----------------------
the company. This committee must have majority of independent directors. ----------------------
Considerable freedom has been granted to the companies as regards the
manner in which the scheme can be designed and implemented. ----------------------
The option granted to the employees is non- transferable. ----------------------
The schemes are available only to the employees and the non-promoter ----------------------
directors of the company.
These guidelines are applicable only to the listed companies. This however ----------------------
does not mean that companies that are not listed cannot offer this scheme to
----------------------
their employees.
There is no limit either of quantity or as a percentage of capital or the ----------------------
shares or stock options issued under any scheme.
----------------------
Under the ESPS the shares can be allotted without any waiting period.
----------------------
Notes A certificate has to be obtained from the Auditors of the company stating
that the scheme has been implemented in accordance with the SEBI guidelines
---------------------- and in accordance with the resolution passed in the AGM.
----------------------
5.10 SWEAT EQUITY
----------------------
The company’s Act says that “Sweat Equity Shares” means equity shares
---------------------- issued by the company to employees or directors at a discount or for consideration
other than cash for providing know-how or making available rights in the nature
---------------------- of intellectual property rights or value additions by whichever name called.
---------------------- The following are the essential features of this instrument:
---------------------- ●● he term is restricted to equity shares only and no other type of shares or
T
other instruments can be issued as sweat equity.
---------------------- ●● uch equity shares may be issued at a discount or for such consideration
S
---------------------- other than cash, as has been specified.
All companies can issue sweat equity as per the guidelines issued by
---------------------- SEBI. Unlisted companies also have to follow the guidelines applicable for
---------------------- them, while issuing sweat equity.
The issue of sweat equity shares has to be authorised by a special resolution
----------------------
passed by the AGM.
---------------------- The resolution should specify the number of shares, current market price,
and consideration, if any and the class or classes of directors or employees to
----------------------
whom such equity shares are to be issued. Upper limit need only be mentioned
---------------------- for a number of shares.
---------------------- Summary
----------------------
●● In this unit, we have studied what rolling settlements are, the derivative
---------------------- markets, how E-trading works. We have learnt about the bonus issue
of debentures of HLL depositories and dematerialisation. We have also
---------------------- studied what is sweat equity, what is stock lending scheme, and non-
voting shares.
----------------------
---------------------- Keywords
---------------------- ●● Bonus debentures: Debentures issued without receiving any consideration
from the beneficiaries.
----------------------
●● Derivatives: Non-cash markets where shares can be bought or sold at a
---------------------- pre-fixed price on a future date.
---------------------- ●● E-trading: Trades in stock markets on-line.
●● Non-voting shares: Investors holding these type of shares will have no
---------------------- voting rights, something that shareholders have.
---------------------- ●● Sweat equity: Equity shares issued as a part of compensation package to
the employees of the company.
98 Capital Market
Notes
----------------------
1. Write a note on derivative market instruments.
2. What is meant by rolling settlement? ----------------------
3. What are ESOPs? What are the guidelines issued by SEBI for ESOPs? ----------------------
4. Write a note on E-trading. ----------------------
5. What are Non Voting shares and why should the companies issue them?
----------------------
6. Explain the bonus debenture issue of HLL.
----------------------
7. What is Sweat Equity? What the issue of sweat equity in Reliance?
8. What is meant by e-trading? ----------------------
----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. A rolling settlement is one in which trades outstanding at the end of the
day have to be settle at the end of the settlement period. ----------------------
2. In India, we are presently following the settlement cycle of T + 3. ----------------------
----------------------
----------------------
1. True ----------------------
2. True ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. A depository is a system, which holds your shares in the form of electronic
accounts in the same way like a bank holds your money in a saving ----------------------
account.
----------------------
2. NSDL has been registered with SEBI and was launched on November
7, 1996 as India’s first depository to facilitate trading and settlement of ----------------------
securities in dematerialised form.
----------------------
----------------------
----------------------
----------------------
Notes
Suggested Reading
----------------------
1.
Adams, Charles F., Donald J. Mathieson, Garry J. Schinasi. 1999.
---------------------- International Capital Markets: Developments, Prospects, and Key Policy
Issues. International Monetary Fund.
----------------------
2. Torre, Augusto de la, Sergio L. Schmukler. 2007. Emerging Capital
---------------------- Markets and Globalization: The Latin American Experience. World Bank
Publications.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
100 Capital Market

Stock Exchanges
UNIT
6
Structure:
6.1 Introduction
6.2 Introduction to Stock Exchanges
6.3 Importance and Operations of Depositories
6.4 Dematerialisation- Process and Operation
6.5 Introduction to National Stock Exchange
6.6 Stock Market Indices
6.7 Stock Holding Corporation of India Ltd. (SHCIL)
Summary
Keywords
Suggested Reading
Stock Exchanges 101

Notes
Objectives
----------------------
----------------------
●● Assess the importance of Securities Contract Regulation Act.
---------------------- ●● Describe the constitution of exchanges and recent developments.
---------------------- ●● Evaluate the importance and the operations of a depository.
---------------------- ●● Discuss the process and operations of dematerialisation.
●● Evaluate the working of National Stock Exchange.
----------------------
●● Describe the concept of market indices.
---------------------- ●● Critically evaluate the Stock Holding Corporation of India.
----------------------
6.1 INTRODUCTION
----------------------
In this chapter we are going to learn about the working of stock exchanges.
---------------------- We shall learn about the stock market indices, the process of dematerialisation,
the role and functions of a depository etc. and we will also study about the
---------------------- different processes that are followed in these markets.
---------------------- Securities Contract Regulation Act
---------------------- Section 4 of the Securities contracts (Regulation) Act, 1956 defines the tern
Stock Exchange as an association, organization or body of individuals, whether
---------------------- incorporated or not, established for the purpose of assisting and controlling the
business of buying, selling and dealing in securities. A stock market can operate
----------------------
only if it is recognised by the government under the SCRA. The recognition
---------------------- is granted under Section 3 of the Act by the Central government, Ministry of
Finance, Stock Exchange Division.
----------------------
The government has far reaching powers under this Act.
---------------------- ●● It can grant and withdraw the recognition, approval or change of by-laws.
---------------------- ●● Call for periodical returns
●● Conduct inquiries against the members when required.
----------------------
●● Directing the stock exchange to make certain rules.
----------------------
●● Supersede or suspend the Governing Board of the Exchange.
---------------------- ●● Impose any other conditions or regulations for trading.
----------------------
6.2 INTRODUCTION TO STOCK EXCHANGES
----------------------
Some stock exchanges in India are voluntary non-profit making
---------------------- associations, while some others are joint stock companies limited by shares,
while some others are companies limited by guarantee.
----------------------
The government is now moving towards demutilisation of all the stock
---------------------- exchanges. Demutilisation would mean that the ownership and Management of
102 Capital Market

the stock exchanges would be separated. It is decided that the stock exchanges Notes
will now be joint stock companies. In NSE, this has already been done and BSE
is expected to follow suit shortly. The BSE is likely to make ownership public ----------------------
by issue of shares, which can be listed and traded.
----------------------
Without an efficient stock exchange, the savings of the community, which
are essential for economic progress would not be available for the business ----------------------
community. It provides for a mechanism in buying and selling the securities. It
----------------------
assists in reasonably correct evaluation of securities in terms of their real worth.
In evaluating the prices on the exchange, the operators take into account all the ----------------------
relevant factors, present and prospective, concerning the particular enterprise
and industry. It is because of this the price of one company’s share is different ----------------------
than the other company’s share price. This price difference can be attributed
----------------------
to the difference between the profitability and the future prospects of the two
companies. ----------------------
Stock exchanges constitute a market for trading in the existing listed
----------------------
securities and they also facilitate listing of new securities for trading. They also
provide a reasonable degree of safety and fair dealings to the investors. ----------------------
The stock markets are affected by practically anything, especially in
----------------------
India. Mr. Armstrong, an authority on stock markets says, “The winds that play
upon stock exchanges are as varying and inconsistent as those that blow upon ----------------------
the ocean. They are frequently just as disturbing.” Basically two sets of factors
affect the stock exchanges, one is known as the fundamental factors and other ----------------------
is the technical factor. The fundamental factors are related to the industry and
----------------------
are economic and financial in nature. The technical factors are related to the
techniques of stock evaluation methods. ----------------------
The governing body of a recognised stock exchange has wide powers ----------------------
and is the decision making body of the exchange. It has the power, subject to
governmental approval, to make, amend and suspend the operation of the rules, ----------------------
by laws and regulations of the exchanges. It also has complete jurisdiction over
all members and in practice, its power of management and control is almost ----------------------
absolute. The governing body has the power to admit and expel members, to ----------------------
warn, censure, fine and suspend members.
SEBI has over the years initiated many reforms in the working of the ----------------------
stock markets. We shall now take a quick look at some of these actions. ----------------------
It has initiated measures to prohibit unfair trade practices, manipulation
----------------------
of prices, misleading statements and other fraudulent practices to induce sales
or purchases of securities with a view to influence the prices and make undue ----------------------
profits or gains out of such practices.
----------------------
The lock in period for preferential allotment was removed for all categories
except for promoters. The disclosure norms and responsibilities of merchant ----------------------
bankers were tightened and revised guidelines were issued for ESOPs.
----------------------
The entry norms were tightened for companies who were making initial
public offerings. It was decided that a company should have a track record ----------------------
Stock Exchanges 103

Notes of dividend payment for a minimum of three years out of the immediately
preceding five years, to be eligible for listing on the stock exchanges. However,
---------------------- a manufacturing company, whose issue and project have been appraised by a
public financial institution or a bank, which has also participated in its funding,
---------------------- may make public issue to get its shares listed on a stock exchange.
---------------------- It has been announced that the allotment process must be completed
within 30 days. For any delay, the company has to pay interest @15% to the
----------------------
investors.
---------------------- The limit for aggregate investment of FIIs, NRIs, and OCBs etc. was
raised to 30%. It has since been revised to 40% is the AGM passes a resolution
----------------------
to this effect.
---------------------- The RBI has permitted the banks to invest in the capital market upto 5%
of their incremental deposits. This ceiling of 5% also includes any loans to
----------------------
stock brokers against shares and debentures and advances to individuals against
---------------------- such securities.
---------------------- IPOs through book building method were allowed and the public offering
under this scheme was reduced from 25% to 10%. Recently, SEBI has allowed
---------------------- book building to the extent of 100%.
---------------------- The primary market advisory committee of the SEBI has suggested
tightening norms for Initial Public Offerings. It should be noted that these are
---------------------- only suggestions as of now, and are yet to be approved and adopted by SEBI.
---------------------- A discussion paper of this committee has said the company opting for an
IPO should have net worth of at least Rs. 1 crore in each of the preceding two
---------------------- years.
---------------------- It has also suggested that if the company has changed its name in the last
one year then at least 50% of the company’s revenue for the preceding one year
---------------------- should be accounted for by the business, which the new name suggested. This
is to ensure that companies do not change their name with the sole purpose of
----------------------
the new name reflecting the latest sunrise sectors without actually having any
---------------------- operations in that area.
It has also suggested that the proposed IPO size should not exceed five
----------------------
times the pre-issue net worth of the company to prevent it from large amounts
---------------------- through initial offers. A company could make an initial offering, provided that
it has net tangible assets of at least Rs. 3 crores in each of the immediately
---------------------- preceding two full years. However, more than 50% should be held in monetary
assets (cash or cash equivalents such as securities). If more than 50% of the
----------------------
assets are held in the form of monetary assets, the company should have firm
---------------------- commitments to deploy such excess money in its business or projects.
---------------------- The committee has also suggested that the minimum post-issue capital
(face value) of the company should be Rs. 10 crore. This is to make sure that
---------------------- the listed capital is of a reasonable size so as to ensure liquidity. There should
be compulsory market making for at least two years from the date of listing of
---------------------- the shares to ensure liquidity in the counter.
104 Capital Market

It has also said that even if any of the criteria suggested for IPO is not Notes
met, the company can still come out with an IPO provided the issue is only
through the book-building process and at least 40% of the issue is allotted to ----------------------
Qualified Institutional Buyers (QIB). Alternatively, the project should have
at least 15% participation by financial institutions and scheduled commercial ----------------------
banks, of which at least 10% should come from the appraisers. The company ----------------------
also has to ensure there are at least 1,000 allottees in its issue in order to have
wider holding. ----------------------
----------------------
----------------------
----------------------
1. A stock market can operate only if it is recognised by the government
under the SEBI. ----------------------
2. The lock-in period for preferential allotment was removed for all ----------------------
categories except for Promoters.
----------------------
Activity 1 ----------------------
----------------------
1. Find out which stock exchanges have been penalised under this act.
2. Find out which stock exchanges in India other than BSE and NSE can ----------------------
be closed down. ----------------------
----------------------
6.3 IMPORTANCE AND OPERATIONS OF DEPOSITORIES
----------------------
What is a depository?
----------------------
Depository is an organisation, which holds securities of investor in
electronic form at the request of the investor through a registered Depository ----------------------
Participant. It also provides services related to transactions in securities.
----------------------
How is a depository similar to a bank?
It can be compared with a bank, which holds the funds for depositors. A ----------------------
Bank - Depository Analogy is given in following table: ----------------------
BANK DEPOSITORY - AN ANALOGY
----------------------
Bank Depository
●● Holds funds in an account ●● Hold securities in an account ----------------------
●● Transfers funds between accounts ●● Transfers securities between
----------------------
on the instruction of the account accounts on the instruction of the
holder. account holder ----------------------
●● Facilitates transfers without ●● Facilitates transfers of ownership
having to handle money without having to handle securities. ----------------------
●● Facilitates safekeeping of money ●● Facilitates safekeeping of shares.
----------------------

Stock Exchanges 105

Notes How many Depositories are registered with SEBI?
At present two Depositories viz. National Securities Depository limited
----------------------
and Central Depository Services (I) limited are registered with SEBI.
---------------------- Who is a Depository Participant?
---------------------- A Depository Participant (DP) is an agent of the depository through which
it interfaces with the investor. A DP can offer depository services only after it
---------------------- gets proper registration from SEBI. A Depository can be compared with a bank,
likewise a DP may be compared with a branch of a Bank.
----------------------
What minimum net worth required for a depository?
----------------------
The minimum net worth stipulated by SEBI for a depository is Rs. 100
---------------------- crore.
---------------------- How many Depository Participants are registered with SEBI?
As present approximately 390 DPs are registered with SEBI. A list of
----------------------
DP’s and their addresses can be downloaded from SEBI website.
---------------------- What are the benefits of availing depository services?
---------------------- Benefits are enumerated below:
---------------------- A safe, convenient way to hold securities;

Immediate transfer of securities;
----------------------
No stamp duty on transfer of securities;
----------------------
Elimination of risks associated with physical certificates such as bad
---------------------- delivery, fake securities, Delays, thefts etc.;
Reduction in paperwork involved in transfer of securities;
----------------------
Reduction in transaction cost;
----------------------
No odd lot problem, even one share can be sold;
---------------------- Nomination facility;
---------------------- Change in address recorded with DP gets registered with all companies in
which investor holds securities electronically eliminating the need to correspond
----------------------
with each of them separately;
---------------------- Transmission of securities is done by DP eliminating correspondence
with companies;
----------------------
Automatic credit into demat account of shares, arising out-of bonus/split/
---------------------- consolidation/merger etc.
---------------------- Account opening
---------------------- How can services of a depository be availed?

To avail of the services of a depository, you require to open an account
----------------------
with any of the depository Participant of any depository.
----------------------
106 Capital Market

How can one open an account? Notes
First an investor has to approach a DP and fill up an account opening
----------------------
form. The account opening form must be supported by
Proof of Identity: Signature and photograph of investor must be ----------------------
authenticated by an existing demat account holder or by investor’s bank.
----------------------
Alternatively, one can submit a copy of a valid Passport, Voters ID Card,
Driving License or PAN card with photograph. ----------------------
Proof of Address: A copy of ration card / passport / voter ID / PAN card/
----------------------
driving license / bank passbook as proof of address. (Investor should carry
original documents for verification by an authorized official of the depository ----------------------
participant, under his signature.)
----------------------
Further, investor has to sign an agreement with DP in a depository
prescribed standard format, with detail investor’s and DPs rights and duties. DP ----------------------
should provide investor with a copy of the agreement and schedule of charges
for your future reference. ----------------------
The DP will open investors’ account in the system and give an account ----------------------
number, which is also called BO ID (Beneficiary owner Identification number).
----------------------
What should be done if address of the investor changes?
----------------------
Investor should immediately inform his/her DP, who in turn will update
the records. This will obviate the need of informing different companies. ----------------------
Can multiple accounts be opened?
----------------------
Yes. An investor can open more than one account in the same name with
the same DP and also with different DPs. ----------------------
Does the investor have to keep any minimum balance of securities in my ----------------------
accounts?
----------------------
No
----------------------
Is it necessary to have account with the same DP as a broker has?
No. Depository / DP can be chosen by investor as per convenience ----------------------
irrespective of the DP of the broker.
----------------------
Can an investor open a single account for securities owned in different
ownership patterns such as securities owned individually and securities ----------------------
owned along-with others?
----------------------
No. The demat account must be opened in the same ownership pattern in
which the securities are held in the physical form. e. g. if one share certificate is ----------------------
in your individual name and another certificate is jointly with some other, two ----------------------
different accounts would have to be opened.
What is required to be done if one has physical certificates with the same ----------------------
combination of names, but the sequence of names is different i.e. some ----------------------
certificates with ‘A’ as first holder and ‘B’ as second holder and other set of
certificates with ‘B’ as first holder and ‘A’ as the second holder? ----------------------
Stock Exchanges 107

Notes In this case ONE may open only one account with ‘A’ & ‘B’ as the account
holders and lodge the security certificates with different order of names for
---------------------- dematerialisation in the same account. You will fill-up an additional form called
“Transposition cum Demat” form. This would help you to effect change in the
---------------------- order of names as well as dematerialise the securities.
---------------------- Whether investors can freeze or lock their accounts?
---------------------- Investors can freeze or lock their accounts for any given period of time, if
so desired. Accounts can be frozen for debits (preventing transfer of securities
---------------------- out of accounts) or for credits (preventing any movements of hindrances into
accounts) or for both.
----------------------

---------------------- 1. A _________ is an agent of the depository through which it interfaces
with the investor.
----------------------
2. The minimum net worth stipulated by SEBI for a depository is
---------------------- ________.
----------------------
Activity 2
----------------------
---------------------- 1. Visit a bank that offers the depository services and find out what one
has to do to open a Demat account.
----------------------
2. Find out what happened in the recent scam relating to multiple demat
---------------------- accounts.
----------------------
6.4 DEMATERIALISATION- PROCESS AND OPERATION
----------------------
What is dematerialisation?
----------------------
Dematerialisation is the process by which physical certificates of an
---------------------- investor are converted to an equivalent number of securities in electronic form
and credited in to the investor’s account with his/her DP.
----------------------
How can one convert physical holding into electronic holding i.e. how can
---------------------- one dematerialise securities?
---------------------- In order to dematerialise physical securities one has to fill in a DRF (Demat
Request Form) which is available with the DP and submit the same along with
---------------------- physical certificates one wishes to dematerialise. Separate DRF has to be filled
for each ISIN no. The complete process of dematerialisation is outlined below:
----------------------
Surrender certificates for dematerialisation to your depository participant.
----------------------
Depository participant intimates Depository of the request through the
---------------------- system.
108 Capital Market

Depository participant submits the certificates to the registrar. Notes
Registrar confirms the dematerialisation request from depository.
----------------------
After dematerialising certificates, Registrar updates accounts and informs
depository of the completion of dematerialisations. ----------------------
Depository updates its accounts and informs the depository participant. ----------------------
Depository participant updates the account and informs the investor ----------------------
What is an ISIN?
----------------------
ISIN (International Securities Identification Number) is a unique
identification number for a security. ----------------------
Can odd lot shares be dematerialised? ----------------------
Yes, odd lot share certificates can also be dematerialised.
----------------------
Do dematerialised shares have distinctive numbers?
----------------------
Dematerialised shares do not have any distinctive numbers. These shares
are fungible, which means that all the holdings of a particular security will be ----------------------
identical and interchangeable.
----------------------
Can Transfer - Cum dematerialisation be done simultaneously?
Yes. After the company/ registrar has transferred the shares in ones name ----------------------
they will request one to let them know whether one wishes to receive them
----------------------
in electronic mode. In case one opts to receive in electronic mode one should
inform the company / registrar through ones DP within 30 days of the date of ----------------------
option letter failing which company or registrar can dispatch the certificates and
the securities shall be credited to ones account. This facility is offered only for ----------------------
those scrips for which the Issuer company has agreed to provide this facility.
----------------------
Can ones electronic holdings be converted back into Physical certificates?
----------------------
Yes. The process is called Rematerialisation. If one wishes to get back his/
her securities in the physical form, one has to fill in the RRF (Remat Request ----------------------
Form) and request his/her DP for rematerialisation of the balances in his/her
securities account. The process of rematerialisation is outlined below: ----------------------
One makes a request for rematerialisation. ----------------------

Depository participant intimates depository of the request through the ----------------------
system.
----------------------
Depository confirms rematerialisation request to the registrar.
Registrar updates accounts and prints certificates. ----------------------
Depository updates accounts and downloads details to depository ----------------------
participant.
----------------------
Registrar dispatches certificates to investor.
----------------------
----------------------
Stock Exchanges 109

Notes Trading / Settlement
What is the procedure for selling dematerialised shares?
----------------------
The procedure for buying and selling dematerialised shares is similar
---------------------- to the procedure for buying and selling physical shares. The difference lies in
the process of delivery (in case of sell) and receipt (in case of Purchase) of
----------------------
securities.
---------------------- In case of purchase
---------------------- The broker will receive the securities in his account on the payout day.
---------------------- The broker will give instruction to its DP to debit his account and credit
investor’s account.
---------------------- Investor will give ‘Receipt Instruction to DP for receiving credit by filling
---------------------- appropriates form. However, one can give standing instruction for credit in to
ones account that will obviate the need of giving Receipt Instruction every time.
----------------------
In case of Sell
---------------------- You will give delivery instruction to DP to debit your account and credit
your broker’s account. Such instruction should reach to your DP’s office at least
----------------------
24 hours before the pay-in otherwise DP will accept the instruction only at your
---------------------- risk.
What is delivery instruction slip (DIS)? What precautions do one need to
----------------------
observe with respect to Delivery Instruction Slips?
---------------------- To give the delivery instruction to DP one has to fill one form called
---------------------- Delivery Instruction Slip (DIS). DIS may be compared to Chequebook of a
bank account. The following precautions are to be taken in respect of DIS
---------------------- Ensure and insist with DP to issue DIS book; do not use loose slips.
---------------------- Ensure that DIS numbers are pre-printed and DP takes acknowledgment
for the DIS booklet issued to investor.
----------------------
Ensure that your account number [client id] is pre-stamped.
----------------------
If the account is a joint account, all the joint holders have to sign the
---------------------- instruction slips. Instruction cannot be executed if all joint holders have not
signed.
----------------------
Avoid using loose slips.
---------------------- Do not leave signed blank DIS with anyone viz., broker/sub-broker.
---------------------- Keep the DIS book under lock and key when not in use.
---------------------- If only one entry is made in the DIS book, strike out remaining space to
prevent misuse by any one.
----------------------
Investor should personally fill in target account -id and all details in the
---------------------- DIS.
----------------------
110 Capital Market

Corporate Benefits Notes
Is it possible to get securities allotted in public offering directly in the
----------------------
electronic form?
Yes, it is possible to get securities allotted to in Public Offerings directly ----------------------
in the electronic form. In the public issue application form there is a provision
----------------------
to indicate the manner in which an investor wants the securities allotted. He has
to mention the BO ID and the name and ID of the DP on the application form. ----------------------
Any allotment made will be credited into the BO account.
----------------------
How are cash corporate benefit such as dividend / interest received?
The concerned company obtains the details of beneficiary holders and ----------------------
their holdings as on the date of the book closure / record date from Depositories. ----------------------
The payment to the investors will be made by the company through the ECS
(Electronic Clearing Service) facility, wherever available. Thus, the dividend / ----------------------
interest will be credited to your bank account directly. Where ECS facility is not
available dividend / interest will be given by issuing warrants on which your ----------------------
bank account details are printed. The bank account details will be those, which ----------------------
you would have mentioned in your account opening form or changed thereafter.
How would one receive non-cash corporate benefit such as bonus etc.? ----------------------
The concerned company obtains the details of beneficiary holders and ----------------------
their holdings as on the date of the book closure / record date from depositories.
Your entitlement will be credited by the company directly in ones depository ----------------------
accounts. ----------------------
Who should be contacted in case of discrepancies in corporate benefits?
----------------------
In case of discrepancies in corporate benefits, one can approach his/her
DP or the company / its R&T Agents. ----------------------
Pledging ----------------------
Can one pledge dematerialised securities? ----------------------
Yes. In fact, pledging dematerialised securities is easier and more
advantageous as compared to pledging physical securities. ----------------------
What should one do to pledge electronic securities? ----------------------

The procedure is as follows: ----------------------
Both investor (pledgor) as well as the lender (pledgee) must have
----------------------
depository accounts;
Investor has to initiate the pledge by submitting to DP the details of the ----------------------
securities to be pledged in a standard format; ----------------------
The pledgee has to confirm the request through his/her DP;
----------------------
Once this is done, securities are pledged
----------------------
All financial transactions between the pledgor and the pledgee are handled
as per usual practice outside the depository system. ----------------------
Stock Exchanges 111

Notes How can one close the pledge after repayment of my loan?
After one has repaid the loan, one can request for a closure of pledge
----------------------
by instructing the DP in a prescribed format. The pledgee on receiving the
---------------------- repayment will instruct his DP accordingly for the closure of the pledge.
Can one change the securities offered in a pledge?
----------------------
Yes; if the pledgee [lender] agrees, one may change the securities offered
---------------------- in a pledge.
---------------------- Who would receive the corporate benefits on the pledged securities?
---------------------- The securities pledged are only blocked in the account of pledgor in
favour of the pledgee. The pledgor would continue to receive all the corporate
---------------------- benefits.
---------------------- Transaction Statement

How does one know that the DP has updated the account after each
----------------------
transaction?
---------------------- The DP gives a Transaction Statement periodically, which will details
current balances and various transactions made through the depository account.
----------------------
If so desired, DP may provide the Transaction Statement at intervals shorter than
---------------------- the stipulated ones, probably at a cost. A format of statement of transactions is
reproduced as Annexure.
----------------------
At what frequency does one receive my Transaction Statement from DP?
---------------------- Transaction Statement is received DP once in a quarter. If a transaction
---------------------- has been carried out during the quarter, the statement is received within fifteen
days of the transaction.
---------------------- What is to be done if there are any discrepancies in transaction statement?
---------------------- In case of any discrepancy in the transaction statement, one can contact
his/her DP. If the discrepancy cannot be resolved at the DP level, one should
----------------------
approach Depository.
---------------------- Whom should one contact in case of any complaint / problem / query?
---------------------- In case of any complaint / problem / query one may first contact DP. If
DP is unable to solve complaint / problem / query one should approach the
---------------------- concerned depository. If one is not satisfied one may approach SEBI. One may
also approach the SEBI directly.
----------------------
What is a custodian?
----------------------
A custodian is basically an organisation, which helps register and
---------------------- safeguard the securities of its clients.
---------------------- What is the role of a custodian?

Besides safeguarding securities, a custodian also keeps track of corporate
----------------------
action i.e. collecting dividends, rights shares, bonus shares and other activities
---------------------- on behalf of its clients.
112 Capital Market

Notes
----------------------
Fill in the blanks.
----------------------
1. _________ is a unique identification number for a security.
----------------------
2. If one wishes to get back securities in the physical form, one has to fill
in the _________. ----------------------
----------------------
Activity 3
----------------------
1. Find from a bank how one can pledge one’s shares in demat form to ----------------------
avail a loan against them.
----------------------
2. Find out what is meant by odd lot trading.
3. Visit some bank and find out what the procedure of funding for IPO is. ----------------------
----------------------
6.5 INTRODUCTION TO NATIONAL STOCK EXCHANGE ----------------------
NSE was set up by IDBI and other financial institutions with paid equity ----------------------
capital of Rs. 25 crores. It started operations in whole sale debt market in June
1994 and in equity in November 1994. The wholesale debt market or money ----------------------
market segments cater to banks, F I s, etc. to encourage high value transactions
----------------------
in P S U bonds, units of UTI, Treasury bills, Government securities and call
money. ----------------------
There is no trading floor in this exchange. The trading is screen based,
----------------------
meaning that brokers are connected to the exchange by P C terminals. This
makes trading very transparent and it is also cost effective. The investment ----------------------
counters can be spread wide in the country under the electronic network.
The companies who wish to list their shares on this exchange should have a ----------------------
minimum paid capital of Rs. 10 crores. The settlement cycle on this exchange
----------------------
is at present T +3. This is likely to become T +2 by April, and some time in near
future it will become T + 1. This will mean that transactions on the exchange ----------------------
will be much faster, and sellers will get their money and buyers their securities
very quickly. ----------------------
NSE admits members separately to the wholesale debt market segment ----------------------
and capital market segment. Only corporate members are admitted on the debt
market segment whereas individuals and firms are eligible for membership in ----------------------
capital market segment.
----------------------
The exchange also has capital adequacy norms for both the segments. For
WDM this requirement is Rs. 2 crores, while for stock market the requirement ----------------------
for individuals and registered firms is Rs. 75 lakhs and for corporate bodies it is ----------------------
Rs. 100 lakhs.
----------------------
Stock Exchanges 113

Notes NSE does not look at membership as a property right that can be traded
upon. The members do not have to pay any membership fee at the time of
---------------------- becoming members; they pay only an annual subscription fee.
---------------------- The exchange provides facility of screen based trading with automated
order matching. The system is order driven and conceals the identity of all
---------------------- parties. The trading system operates on a price time priority. All orders received
are sorted with the best-priced order getting the first priority for matching i.e.
----------------------
the best buy order matches the best sell order. Within similar priced orders,
---------------------- they are sorted on time, i.e. the one that came in earlier than the other, get the
priority. The matching of the orders is done by the computers, thus making the
---------------------- whole process transparent, objective and fair.
---------------------- When an order does not find a match, it remains in the system and is
displayed to the whole market, till a fresh order comes in or this pending order
---------------------- is cancelled.
---------------------- This trading system is very flexible, and this enables the investors to place
several time, price and volume related orders. The system provides complete
---------------------- market information online. All key information is updated on a real time basis.
Due to this it is possible for the investor to know the actual position of the
----------------------
market, before placing the order. Investors can also know the status of their
---------------------- orders almost as soon as they are placed.
---------------------- Wholesale Debt Market

WDM or money market is a market where pure debt instruments such as
---------------------- government securities, treasury bills, public sector bonds, corporate debentures,
---------------------- commercial paper, certificates of deposits etc. are traded.
●● few large usually institutional investors and a very high volume of trade
A
---------------------- dominate this segment.
---------------------- ●● he exchange has set up systems to contain market risk by ensuring that
T
the primary responsibility of settlements rests with the participants. The
---------------------- exchange authorities closely monitor the settlements. Every participant
---------------------- sets up counter party exposure limits, which are automatically adjusted
each time a trade takes place.
---------------------- ●● Trades on this market are settled on the basis of trade for trade i.e. each
---------------------- transaction is settled individually. Each trade has a settlement date
specified upfront at the time of order entry and is used as a matching
---------------------- parameter. The actual settlement of funds and securities are effected
directly between participants.
----------------------
●● ilt securities are immobilised with the RBI and they maintain a book
G
---------------------- entry of holders. The RBI through book entry adjustments effects all
transfers in these securities.
----------------------
●● ecently, the RBI has allowed the individuals to buy and sell government
R
---------------------- securities. It will be interesting to see how this market develops in the
coming days.
----------------------
114 Capital Market

6.6 STOCK MARKET INDICES Notes
Everyone talks about Sensex, whenever the talk turns to stock markets. ----------------------
This is a way in which the movements on stock markets are known. Sensex
going up or down and the reasons thereof are matters of hot debate. Let us now ----------------------
take a look as to how the Sensex is constructed.
----------------------
In order to enable the market participants, analysts etc. to track the various
ups and downs in the Indian stock market, the BSE in 1986 introduced an Equity ----------------------
Stock Index called BSE-SENSEX that subsequently became the barometer of ----------------------
the movements of the share prices in the Indian stock market. It is a ‘Market
Capitalization-Weighted’ index of 30 component stocks representing a sample ----------------------
of large, well established and leading companies. The base year is 1978-79. The
Sensex is widely reported in both domestic and international markets through ----------------------
print and electronic media. ----------------------
Sensex is calculated using a market capitalisation-weighted method.
As per this method, the level of index reflects the total market value of all ----------------------
30 component stocks from the different industries related to a particular base ----------------------
period. The total market value of a company is determined by multiplying the
price of its stock by the number of shares outstanding. Statisticians call an index ----------------------
of a set of combined variables (such as price and number of shares) a composite
index. An indexed number is used to represent the results of this calculation ----------------------
in order to make the value easier to work with and track over time. It is much ----------------------
easier to graph a chart based on indexed values than one based on actual values.
World over majority of the well known indices are constructed using market ----------------------
capitalisation-weighted method.
----------------------
In practice, the daily calculation of SENSEX is done by dividing the
aggregate market value of the 30 companies in the index by a number called the ----------------------
Index Divisor. The Divisor is the only link to the original base period value of
----------------------
the Sensex. The Divisor keeps the index comparable over a period of time and
is the reference point for all the index maintenance adjustments. ----------------------
While choosing the companies for inclusion in the sensex many criterions
----------------------
are used. The market capitalisation, the volume of shares traded on a daily
average are two important criterions. The sensex must also represent industries ----------------------
across the spectrum. Before the 90s companies representing the ICE stocks vis.
Information Technology, Communication and Entertainment did not form a part ----------------------
of the sensex companies. However, now they are an integral part of the sensex.
----------------------
This is the reflection of today’s reality. The stock exchanges keep changing the
composition of the sensex from time to time so that they can take out companies ----------------------
which are no longer eligible to be in the sensex, by those which are now more
important. The companies are given a weightage in the sensex individually. Any ----------------------
change in the value of these companies affects the sensex. It goes up with high
----------------------
weightage companies’ share value going up and it goes down when share values
of these companies dips. It must be understood that the change in the value of ----------------------
sensex does not indicate change in the share value of all companies listed on
the exchange, in the same proportion. Out of the total turnover recorded on the ----------------------
Stock Exchanges 115

Notes stock exchange the index companies contribute mainly to the volume and the
value.
----------------------
The NSE also has its own index called NSE-NIFFTY, comprising 50
---------------------- companies. BSE also has an index called BSE-100. This is a broader index than
the Sensex.
----------------------
There are various other indexes popular on the stock exchanges, which
---------------------- reflect various industries like Pharma, IT, FMCG etc.
---------------------- Activity 4
----------------------
Find out which instruments have to be compulsorily listed on the Wholesale
---------------------- Debt Segment.
----------------------
---------------------- 6.7 STOCK HOLDING CORPORATION OF INDIA LTD.

(SHCIL)
----------------------
SHCIL was established in 1986 and was granted a status of a government
---------------------- company in 2014. SHCIL is known for its on-line trading portal with investors
---------------------- and traders. It is also responsible for e-stamping system around India. It is also
authorised by Reserve Bank of India as Agency Bank.
---------------------- The Objectives of SHCIL
---------------------- ●● ake it easy for investors to buy and sell securities in the secondary
M
markets.
----------------------
●● Freeze active share and debentures certificates in the safe custody.
---------------------- ●● Introduce scrip less trading
---------------------- ●● Computerise trading
●● redit dividend payment directly to the account of the shareholders in the
C
----------------------
bank through electronic clearing mechanism.
---------------------- ●● To act as a bank for shares
---------------------- Advantages of SHCIL
●● Transfer of shares will be fast and simple.
----------------------
●● ividends and interest can be electronically transferred to the investors’
D
---------------------- account.
---------------------- ●● Protection against loss and theft of securities.
●● Easier to maintain multicompany portfolio for the investors.
----------------------
●● here will be nothing like lot trading and the investors holding odd lot
T
---------------------- in physical form and unable to trade in them, can now be free to trade in
those shares.
----------------------
●● Brokers will be relieved of a lot of paperwork.
---------------------- ●● The settlement of transactions would be greatly simplified.
116 Capital Market

Summary Notes
●● In this unit we have studied the importance of Securities Contract ----------------------

Regulation Act and the constitution and the operations in stock markets.
----------------------
●● We have understood the process of dematerialisation and the working of
the depositories. ----------------------
●● We have learnt about National Stock Exchange and the stock market ----------------------
indices alongwith the working of Stock Holding Corporation of India.
----------------------
Keywords ----------------------
●● Demat accounts: It is mechanism through which, the investors hold their ----------------------
shares in electronic form instead of in physical form.
----------------------
●● Demutilisation: Conversion of stock exchanges into a company.
●● Market indices: The statistical tool used in stock markets to measure the ----------------------
movements in share prices on daily basis.
----------------------
●● Pledge: Shares are offered as security to a bank as security for an advance
granted to the borrower. ----------------------
●● Wholesale Debt Market: A segment of NSE where Debt instruments are ----------------------
listed and traded.
----------------------
1. Write a note on NSE. ----------------------
2. Write a note on SHCIL.
----------------------
3. What are stock market indices?
4. Explain what is the role of depositories. ----------------------
5. Explain the need for dematerialisation of shares. Should it be made
----------------------
compulsory?
6. What is a Wholesale Debt Market? ----------------------
7. Does India need so many stock exchanges? Justify your answer. ----------------------
8. What are the improvements that you wish to see in the working of stock
markets? ----------------------
----------------------
----------------------
1. False ----------------------
2. True ----------------------
----------------------
Stock Exchanges 117

Notes Fill in the blanks.
1. A Depository Participant (DP) is an agent of the depository through which
----------------------
it interfaces with the investor.
---------------------- 2. The minimum net worth stipulated by SEBI for a depository is Rs. 100
crore
----------------------
----------------------
---------------------- 1. ISIN (International Securities Identification Number) is a unique
identification number for a security.
----------------------
2. If one wishes to get back securities in the physical form, one has to fill in
---------------------- the RRF (Remat Request Form).
----------------------
Suggested Reading
----------------------
1. Machiraju, H. R. 2002. International Financial Markets and India. New
---------------------- Age International.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
118 Capital Market

Venture Capital
UNIT
7
Structure:
7.1 Introduction
7.2 Characteristics of Venture Capital
7.3 Stages of Venture Capital Financing
7.4 SEBI Venture Capital Funds Regulation
7.5 Problems with VCs in the Indian Context
7.6 Current Trends
Summary
Keywords
Suggested Reading
Venture Capital 119

Notes
Objectives
----------------------
----------------------
●● Explain the meaning of venture capital (VC).
---------------------- ●● Describe the characteristics of the V.C.
---------------------- ●● Discuss the stages of financing in a deal.
---------------------- ●● State the SEBI guidelines for VCs.
●● Identify the problems of VCs in the Indian context.
----------------------
●● Assess the current trends in VC.
---------------------- ●● Evaluate the changes taking place in VC.
----------------------
7.1 INTRODUCTION
----------------------
Definition: Venture Capital means start up and first stage financing and
---------------------- funding the expansion of companies that have already demonstrated their
business potential but do not have access to the public securities markets or to
---------------------- credit oriented institutional funding sources.
---------------------- Venture Capitalists also provide management/leveraged buyout financing.
The process is of investing of risk capital in an enterprise in which the venture
----------------------
investor shares ownership as well as Board of Directors level management
---------------------- responsibilities with the funding management team.
It is a risk finance for entrepreneurial growth oriented companies. It is an
----------------------
investment for the medium or long term, seeking to maximize medium or long
---------------------- term return for both the parties. The investor can add value to the company
because of his knowledge, experience and contact base.
----------------------
It is an actual or potential equity investment in companies through the
---------------------- purchase of stock, warrants, options or convertible securities.
---------------------- Venture Capital is an equity, equity featured capital seeking investment in

new ideas, new companies, new products, new processes or new services, that
---------------------- offer the potential of high returns on investment. It may also include investment
in turnaround situations.
----------------------
---------------------- 7.2 CHARACTERISTICS OF VENTURE CAPITAL

---------------------- ●● I nvestments are made in equity or equity featured instruments of
investment.
----------------------
●● oung companies that do not have access to public sources of equity or
Y
---------------------- other forms of capital.
●● I ndustry, products or services that hold potential of better than normal or
----------------------
average revenue growth.
---------------------- ●● Companies with better than normal or average profitability.
120 Capital Market

●● roducts/services in the early stages of their life cycle.
P Notes
●● Higher than average risk levels that do not lend themselves to systematic
quantification through conventional techniques and tools. ----------------------
●● Turnaround companies ----------------------
●● Long term and active involvement with investee
----------------------
The importance of venture capitalists is not on account of the volume
of capital it provides; it is more on account of its indirect benefits. These ----------------------
investments enable the development of entirely new lines of business. They
typically prefer to invest in knowledge based industries such as Information ----------------------
Technology and Biotech. This has in turn catalysed entrepreneurship amongst ----------------------
professional managers and technologists to a considerable degree.
Venture Capital has played an unparalleled role in bringing technologies ----------------------
to the market place. ----------------------
There has to be enabling environment for the venture capital activities to
flourish. ----------------------
Firstly, there must exist the culture of entrepreneurship. This could be one ----------------------
of the reasons why venture capital culture has not caught up in India and also
the absence of new ideas in the form of new product development. ----------------------
The next thing is the tax policy. In India, income from dividends and long ----------------------
term capital gains from equity investments made by the approved VC funds
or Veature Capital companies is exempted from tax. Such companies will be ----------------------
required to invest only in unlisted companies engaged in manufacturing.
----------------------
The Veature Capital can flourish only when there a well-developed capital
market. V.C.s require an exit route to make profits. The most preferred exit ----------------------
route for these companies is public offering of the portfolio companies stock.
Therefore, a vibrant capital market is an important pre-requisite for them. ----------------------
Innovation is the mother of V C investments. In a protected economy, ----------------------
with no compulsion or incentive to compete through innovation, V C may not
find many opportunities to invest. This is true of Indian scenario as well. ----------------------
The V C s normally does not finance the working capital requirements ----------------------
of the companies in whose capital they invest. It is therefore essential that
complementary financial institutions exist to take up these responsibilities. ----------------------
The ethos of building business for financial gains and the preparedness to ----------------------
sell them off to an acquirer provides an important exit route to the VC investor.
----------------------
1. Venture Capitalists cannot provide management/leveraged buyout
----------------------
financing.
2. In Venture capital, the investor can add value to the company because ----------------------
of his knowledge, experience and contact base. ----------------------
Venture Capital 121

Notes
Activity 1
----------------------
Find out which are the most active Indian venture capital funds.
----------------------
----------------------
7.3 STAGES OF VENTURE CAPITAL FINANCING
----------------------
Seed Financing: Relatively small amount of capital is provided to an
---------------------- entrepreneur to prove his concept.
---------------------- Start-up Financing: This is provided to companies completing product

development and initial marketing. Usually such firms will have made market
---------------------- studies and assembled the key management, developed a business plan and are
ready to do business.
----------------------
First Stage Financing: This is provided to companies that have expanded
---------------------- their initial capital and require funds to initiate full-scale manufacturing and
sales.
----------------------
Expansion Financing
----------------------
Second stage Financing: This is the working capital for the initial
---------------------- expansion of a company that is producing and shipping and has growing
accounts receivables and inventories.
----------------------
Third Stage or Mezzanine Financing: This is provided for major
---------------------- expansion of a company when sales volume is increasing and that is breaking
even or profitable. These funds are used for further plant expansion, marketing,
---------------------- working capital or development of an improved product.
---------------------- Bridge Financing: This type of financing is required at times when a
company plans to go public within six months to a year. Often it is structured so
---------------------- that it can be repaid from the proceeds of a public underwriting.
---------------------- Acquisition (Buyout) Finance: This kind of funding provides funds to
finance an acquisition of another company. Management/Leveraged buyout
---------------------- funds enable an operating management group to acquire a product line or
---------------------- business (which may be at any stage of development) from either a public or
private company. Often these companies are closely held or family owned.
---------------------- The Venture Investment process
---------------------- Generating a Deal flow: The V C investor creates a pipeline of deals or
investment opportunities that he would consider for investing in.
----------------------
It is common for V C funds/investors to develop working relationship
---------------------- with R & D institutions academicians etc.
---------------------- Due Diligence: It includes all activities that are associated with evaluating
an investment proposal carrying out reference checks on the proposal related
---------------------- aspects such as management team, products, technology, and market. V C due
diligence focuses on the qualitative aspects of an investment opportunity.
----------------------
122 Capital Market

Investment Valuation Notes
1. Evaluate future revenue and profitability.
----------------------
2. Forecast likely future value of the firm based on expected market
capitalisation, or expected acquisition proceeds depending upon the ----------------------
anticipated exit from the investments.
----------------------
3. Target on ownership position in the investee firm so as to achieve trained
appreciation on the proposed investment. ----------------------
The value of a firm is driven by a number of factors like ----------------------
a) Overall economic conditions ----------------------
b) Demand and supply of capital
----------------------
c) Specifics of the deal
----------------------
d) The degree of popularity of the industry / technology in question.
e) The standing of the individual V C ----------------------
f) Investors’ consideration ----------------------
Structuring the Deal ----------------------
The investor tries to ensure the following:
----------------------
a) Reasonable reward for the given level of risks.
----------------------
b) Sufficient influence on the management of the company through board
representation. ----------------------
c) Minimisation of taxes ----------------------
d) Ease in achieving future liquidity on the investment
----------------------
The Entrepreneur seeks
----------------------
a) The creation of the business that he has conceptualsied. (Operating /
strategic control). ----------------------
b) Financial rewards for creating the business.
----------------------
c) Adequate resources needed to achieve their goal.
----------------------
d) Voting control.
Common consideration ----------------------
a) Flexibility of structure that will allow room to enable additional ----------------------

investments later, incentives for future management and retention of
----------------------
stock if management leaves.
b) Balance sheet attractiveness to suppliers and debt financiers. ----------------------
c) Retention of key employees through adequate equity participation. ----------------------
----------------------
----------------------
Venture Capital 123

Notes
----------------------
----------------------
1. The Venture Capital can flourish only when there a well-developed
---------------------- capital market.
---------------------- 2. The Venture Capital does finance the working capital requirements of
the companies in whose capital they invest.
----------------------
----------------------
Activity 2
----------------------
Find out which Indian companies in IT and biotechnology sector have
---------------------- received V C funding and at what stage did they receive funding. For
---------------------- example, you can look at companies like Bharati Televenture or Biocon.
----------------------
7.4 SEBI VENTURE CAPITAL FUNDS REGULATION
----------------------
a) VCFs must be registered with SEBI and pay Rs. 25,000 as application fee
---------------------- and Rs. 5 lakhs as registration fee.
---------------------- b) VCF cannot carry on any other activity.
---------------------- c) VCFs are authorised to raise funds from 1) Indian, 2) Foreign and 3)
NRIs, by issue of units or shares.
----------------------
d) VCFs must disclose the investment strategy at the time of their registration.
---------------------- e) They cannot invest more than 25% of their corpus in one company.
---------------------- f) They are prohibited from investing in associate companies.
---------------------- g) At least 74% of the investible funds must be invested in unlisted

companies.
---------------------- h) Not more than 25% of the funds may be invested by way of
---------------------- i) Subscription to IPO of the company whose shares are proposed to
be listed subject to a lock in of one year and
----------------------
ii) Debt / debt instruments of a company in which the VCF has already
---------------------- made an investment by way of equity.
---------------------- i) No VCF would be entitled to get its units listed on any recognized stock
exchange, till expiration of three years from the date of issuance of units
---------------------- by it.
---------------------- j) It may receive money for investment in the VCF through only private
placement of its units.
----------------------
The scene in India on investments by Venture Capitalists seems to be
----------------------
124 Capital Market

shooting up. With the investments rising in BPO, this sector seems to have Notes
become a favourite destination for these funds.
----------------------
The old favourite ITES continues to attract investments.
In early 2017, many venture capitalists from US came to India to look ----------------------
for investment opportunities. These funds together have invested $17.6 billion
----------------------
(Rs1.17 lakh crore) into Indian companies. They have been very keen to invest
in India and have seen a lot of potential investment opportunities. ----------------------
----------------------
Fill in the blanks.
1. VCFs must be registered with SEBI and pay ____ as application fee ----------------------
and ____ as registration fee. ----------------------
2. VCFs are authorised to raise funds from Indian, Foreign and NRIs, by
----------------------
issue of _________.
----------------------
Activity 3 ----------------------
----------------------
Find out how many V/C s are registered under the SEBI guidelines.
----------------------
7.5 PROBLEMS WITH VCs IN THE INDIAN CONTEXT ----------------------
There are mainly three categories of venture capital funds. ----------------------
1. Funds promoted by All India Development Financial Institutions and ----------------------
State level Development Financial Institutions.
2. Funds promoted by commercial banks. ----------------------
3. Funds promoted by private sector financial services companies. ----------------------

Most V C investors in India do not seem to have any stated sectoral ----------------------
preferences.
----------------------
One can ask why venture funding is so successful in USA and faced a
number of problems in India. The biggest problem was a mindset change from ----------------------
‘collateral funding’ to high risk high return funding. Most of the pioneers in the
industry were people with credit background and exposure to manufacturing ----------------------
industries. Exposure to fast growing intellectual property business and services
----------------------
sector was almost zero. All these combined to a slow start to the industry. The
other issues that led to such a situation include: ----------------------
License Raj and The IPO Boom ----------------------
Till early 90s, under the license raj regime, only commodity centric
businesses thrived in a deficit situation. To fund a cement plant, venture capital ----------------------
is not needed. What was needed was ability to get a license and then get the ----------------------
Venture Capital 125

Notes project funded by the banks and DFIs. In most cases, the promoters were well-
established industrial houses, with no apparent need for funds. Most of these
---------------------- entities were capable of raising funds from conventional sources, including
term loans from institutions and equity markets.
----------------------
Scalability
----------------------
The Indian software segment has recorded an impressive growth over the
---------------------- last few years and earns large revenues from its export earnings, yet our share
in the global market is less than 1 per cent. Within the software industry, the
---------------------- value chain ranges from body shopping at the bottom to strategic consulting
at the top. Higher value addition and profitability as well as significant market
----------------------
presence take place at the higher end of the value chain. If the industry has to
---------------------- grow further and survive the flux it would only be through innovation. For any
venture idea to succeed, there should be a product that has a growing market
---------------------- with a scalable business model. The IT industry (which is most suited for
venture funding because of its ‘ideas’ nature) in India till recently had a service
----------------------
centric business model. Products developed for Indian markets lack scale.
---------------------- Mindsets
---------------------- Venture capital as an activity was virtually non-existent in India. Most
venture capital companies want to provide capital on a secured debt basis, to
---------------------- established businesses with profitable operating histories. Most of the venture
---------------------- capital units were offshoots of financial institutions and banks and the lending
mindset continued. True venture capital is capital that is used to help launch
---------------------- products and ideas of tomorrow. In abroad, this problem is solved by the
presence of ‘angel investors’. They are typically wealthy individuals who not
---------------------- only provide venture finance but also help entrepreneurs to shape their business
---------------------- and make their venture successful.
Returns, Taxes and Regulations
----------------------
There is a multiplicity of regulators like SEBI and RBI. Domestic venture
---------------------- funds are set up under the Indian Trusts Act of 1882 as per SEBI guidelines,
while offshore funds routed through Mauritius follow RBI guidelines. In
---------------------- broad, such funds are made under the Limited Partnership Act, which brings
---------------------- advantages in terms of taxation. The government must allow pension funds and
insurance companies to invest in venture capitals as in USA where corporate
---------------------- contributions to venture funds are large.
---------------------- Exit
The exit routes available to the venture capitalists were restricted to the
----------------------
IPO route. Before deregulation, pricing was dependent on the erstwhile CCI
---------------------- regulations. In general, all issues were under priced. Even now SEBI guidelines
make it difficult for pricing issues for an easy exit. Given the failure of the
---------------------- OTCEI and the revised guidelines, small companies could not hope for a BSE/
NSE listing. Given the dull market for mergers and acquisitions, strategic sale
----------------------
was also not available.
----------------------
126 Capital Market

Valuation Notes
The recent phenomenon is valuation mismatches. Thanks to the software
boom, most promoters have sky high valuation expectations. Given this, it ----------------------
is difficult for deals to reach financial closure as promoters do not agree to a ----------------------
valuation. This coupled with the fancy for software stocks in the bourses means
that most companies are preponing their IPOs. Consequently, the number and ----------------------
quality of deals available to the venture funds gets reduced.
----------------------
Angels
Angels are important links in the entire process of venture capital funding. ----------------------
This is because they support a fledging enterprise at a very early stage - sometime ----------------------
even before commercialization of the product or service offering. Typically, an
angel is an experienced industry-bred individual with high net worth. ----------------------
Angels provide funding by ‘first round’ financing for risky investments - ----------------------
risky because they are a young /start-up company or because their financial track
record is unstable. This venture capital financing is typically used to prepare the ----------------------
company for ‘second round’ financing in the form of an initial public offering
(IPO). Example - A company may need ‘first round’ financing to develop a ----------------------
new product line, (viz a new drug which would require significant research &
----------------------
development funding) or make a strategic acquisition to achieve certain levels
of growth and stability. ----------------------
It is important to choose the right Angel because they will sit on your
----------------------
Board of Directors, often for the duration of their investment and will assist in
getting “second round” financing. When choosing an ‘Angel’, it is imperative ----------------------
to consider their experience in a relevant industry, reputation, qualifications and
track record. ----------------------
Angels are people with less money orientation, but who play an active ----------------------
role in making an early-stage company work. They are people with enough
hands-on experience and are experts in their fields. They understand the field ----------------------
from an operational perspective. An entrepreneur needs this kind of expertise.
He also needs money to make things happen. Angels bring both to the table of ----------------------
an entrepreneur.
----------------------
There are a number of professionally qualified people, especially from
IITs who migrated to USA. Some of them have made their millions riding ----------------------
the IT boom in Silicon Valley. Having witnessed the maturity of the Silicon
----------------------
Valley into the global tech hotspot and thrived in the environment there, these
individuals are rich in terms of financial resources and experience. They are the ----------------------
latest angels in the Indian industry.
----------------------
The IndUS Entrepreneurs (TiE), a networking society that brings together
highly influential Indians across the US was set up in 1992. The aim of the ----------------------
organisation is to get the community together and to foster entrepreneurs and
wealth creation. The idea was sparked off in 1992, when a group of Silicon ----------------------
Valley entrepreneurs with roots in the Indian sub-continent met by chance for
a meeting with a visiting dignitary from India. A delayed flight kept the group ----------------------
waiting, and provided an opportunity for people to get to know one another. ----------------------
Venture Capital 127

Notes It turned out that most of the assembled invitees to the meeting had achieved
varying degrees of entrepreneurial success. The group saw value in getting
---------------------- together on a regular basis to network with one another. Thus, the idea of TiE
was born as a mechanism for high achievement-oriented IndUS entrepreneurs
---------------------- to network. TiECON is an annual TiE event. The March 2018 TiECON was
---------------------- held in Mohali.
Corporate Venturing
----------------------
Even though corporate venturing is an attractive alternative, most
---------------------- companies find it difficult to establish systems, capabilities and cultures that
make good venture capital firms. Corporate managers seldom have the same
---------------------- freedom to fund innovative projects or to cancel them midstream. Their
---------------------- skills are honed for managing mature businesses and not nurturing start up
companies. If a firm is to apply the venture capital model, it must understand
---------------------- the characteristics of the model and tailor its venture capital program to its own
circumstances without losing sight of these essentials.
----------------------
Success of Venture capital firms rest on the following characteristics
----------------------
Focus on specific industry niches and look for business concepts that will
---------------------- ●● lthough corporate managers have a clear focus in their business, they
A
run into ambiguity with venture programs. Their biggest challenge is to
----------------------
establish clear, prioritized objectives. Simply making a good financial
---------------------- return is not sufficient.
●● anage portfolios ruthlessly, abandon losers, whereas abandoning
M
----------------------
ventures has never been easy for large corporations, whose projects are
---------------------- underpinned by personal relationships, political concerns.
●● Venture capital firms share several attributes with start up they fund. They
----------------------
tend to be small, flexible and quick to make decisions. They have flat
---------------------- hierarchies and rely heavily on equity and incentive pay.
Apple Computers established a venture fund in 1986 with the dual
----------------------
objectives of earning high financial return and supporting development of
---------------------- Macintosh Software. They structured compensation mechanisms, decision
criteria and operating procedures on those of top venture capital firms. While
---------------------- they considered Macintosh as an initial screening factor, its funding decisions
were aimed at optimizing financial returns. The result was an IRR of 90 per cent
----------------------
but little success in improving the position of Macintosh.
---------------------- New ventures can be powerful source of revenues, diversification and
flexibility in rapidly changing environments. The company should create an
----------------------
environment that encourages venturing. An innovative culture cannot be
---------------------- transplanted but must evolve within the company. Venture investing requires
different mindset from typical corporate investors.
----------------------
----------------------
----------------------
128 Capital Market

Notes
Activity 4
----------------------
List the number of companies in India, which have received V C funding in
----------------------
the last three years.
----------------------
7.6 CURRENT TRENDS ----------------------
Capital is pouring into private Equity Funds ----------------------

The global private equity industry raised a record $452 billion from ----------------------
buyout funds alone in 2017, giving it more than $1 trillion surplus to pour into
companies and new business ventures. ----------------------
Bigger is Better ----------------------
The most established venture funds now have more partners and therefore ----------------------
are able to put more money to work effectively. Also, venture firms are doing
less deal syndication, which enables them to put more money to work in a ----------------------
single deal. Thirdly, many traditional early-stage venture firms have shifted to
a multi-stage investment approach. They will back companies in technologies ----------------------
and industries they know intimately, almost regardless of the stage. ----------------------
First-time firms never had it so good
----------------------
During the 1989-91 downturns, new venture capital firms faced a
problem in raising partnership capital, as there was a ‘flight to quality’ among ----------------------
investors who backed established funds in the private equity market. However,
----------------------
developments over the past few years have demonstrated that investing with an
established firm is no more a sure-bet than an investment in a ‘first-time fund’. ----------------------
The State Wants its Share of the Pie Too
----------------------
Registered AIFs in India have more than doubled over the past couple of
years and number approximately 346 in 2017. AIFs have also been a significant ----------------------
contributor to overall fund-raising in the Indian market and have helped raise
----------------------
$5.1 billion in 2017, more than double their 2016 total.
Venture firms are being run more like businesses ----------------------
One of the healthiest consequences of the growth in institutional funding ----------------------

has been increased scrutiny that venture firms have come under. Feedback from
previous investments and suggestions from the investors in these funds are ----------------------
helping to increase the sense of professionalism in the industry. ----------------------
No more men in gray suits
----------------------
Another trend that is emerging slowly is the change in the profile of a
fund manager. The venture capitalist is no longer a hybrid investment banker ----------------------
trying to cash in on another market boom while still keeping his cards close to
----------------------
his chest. The new-age venture capitalist is industry-bred and highly regarded
in the business and is fairly at ease with the technologies and processes in the ----------------------
market.
Venture Capital 129
Notes Tomorrow is coming faster
Rapid changes in technology have accelerated the pace and raised the
----------------------
efficiencies for getting from idea to market. Investors are specialising. Financing
---------------------- sources are becoming much more focused on their way to investment in today’s
competitive environment. Today, from venture capital firms to leveraged
---------------------- buyout (LBO) houses and corporations, investors are devising specific plans
for industries and technologies they want to be in.
----------------------
More venture funds are seeking traditional businesses
----------------------
More venture capital funds are going after low-tech or no-tech companies.
---------------------- For example, Draper International has picked up a stake in Shoppers Stop and
Indus League Clothing.
----------------------
Financing sources are more flexible
---------------------- More companies are acquiring new ideas, products and complementary
---------------------- operations to capture growth and gain market share. This means financing must
allow for covenants that permit mergers, acquisitions and continued investments.
---------------------- Financing sources and companies are building partnering relationships
---------------------- Companies need financing sources that allow them to move quickly and will
tolerate risk, including acquisitions. Although financing sources are risking
----------------------
more, the rewards of such a partnering relationship can grow and be profitable
---------------------- for all concerned.
Competition is affecting buyer prices
----------------------
Historically, there has been a big difference between strategic buyers who paid
---------------------- a premium for the potential of synergy and financial buyers and LBO houses.
Today, the two factions are more directly competitive.
----------------------
All businesses are not evaluated equally. Venture houses today are looking at
---------------------- what enhances the value of a company, with different ‘value drivers’ affecting
---------------------- various industry segments. For example, when evaluating a technology
company, investors may care about a unique technology or process with great
---------------------- potential. They won’t necessarily worry whether the company lacks audited
---------------------- financial statements or an organization structure. In a non-technology area,
however, there must be more than a new idea; ‘value drivers’ might include
---------------------- historical performance, gross margins and return on investment.
---------------------- Sector in focus: Consumer technology
---------------------- The consumer technology sector encompasses multiple segments.
E-commerce—which includes e-tailers Flipkart and Snapdeal, online travel
---------------------- companies, as well as taxi and other providers who channel services via mobile
phone and Internet—accounted for a significant chunk of investments in the
----------------------
sector in 2014. Social connectivity services represented the second-largest
---------------------- segment. Becoming increasingly popular on a daily basis, Facebook, Twitter,
LinkedIn and similar services, along with online classifieds, all fall into this
---------------------- bucket. Content-generating and -sharing companies, including entertainment
130 Capital Market

and data-generating companies, are also a part of the consumer technology Notes
sector. The new but fast-growing wearable technology segment, which includes
smart access devices and fitness devices, also falls in the consumer technology ----------------------
sector. The last portion comprises the enablers, which aid the functioning of
a part (or parts) of the operating model for other companies in this space; ----------------------
examples include providers of payment media, e/m-advertisers, application ----------------------
developers, analytics services and logistics and delivery services.
----------------------
As far as the Indian market is concerned, 2014 has been a very good year
for the consumer technology sector. The continued rise of Internet penetration ----------------------
was a key factor in the sector’s growth, and e-commerce has experienced
tremendous growth. From booking a taxi to buying groceries to purchasing ----------------------
furniture, Indians are rapidly turning to mobile phones and computers for their
----------------------
transactions. With mobile Internet driving a significant portion of the Internet
penetration, application development is also witnessing high growth. As mobile ----------------------
companies continue to focus on mobile Internet, and as logistics and payment
services become even more robust, this sector is well poised for further growth. ----------------------
The belief in the sector’s growth potential was reflected in investments: ----------------------
Consumer technology was the largest sector in terms of PE and VC investments
in 2014, contributing approximately 31% to overall deal value and accounting ----------------------
for approximately 35% of overall deal volume. Investments in the sector almost
----------------------
quadrupled over theb past year, from $1.2 billion to $4.7 billion, and the number
of deals grew by 18% to 280. Average deal size ballooned from $5 million to ----------------------
$17 million; the increase was driven primarily by the top three deals, which
accounted for 50% of the total deployed capital in the sector. ----------------------
Large consumer technology companies, including Flipkart, Snapdeal ----------------------
and Housing.com, raised multiple rounds of funding and saw a steep surge in
valuation. Flipkart, for instance, saw its valuation grow more than fivefold in ----------------------
2014, from approximately $2 billion in May to $11 billion in December, while
----------------------
Snapdeal’s valuation tripled, rising from about $700 million in February to $2
billion in November. GPs expect consumer technology valuations to remain ----------------------
high. Source - India Private Equity Report 2015 | Bain & Company, Inc.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Venture Capital 131

Notes Key factors for growth of venture funding in India
1. Macro-economic conditions
----------------------
2. Changes in exit environment
----------------------
3. Evolution in investor sentiment
---------------------- 4. Modification in regulation
---------------------- 5. Changes in valuation expectations
---------------------- 6. Number of attractive deal opportunities

7. Ability to generate value from portfolio companies
----------------------
8. Evolution in competitive intensity in the market
----------------------
9. Change in companies’ corporate governance
----------------------
Activity 5
----------------------
---------------------- Compare V C financing with bank funding.
----------------------
Summary
----------------------
●● e have studied in this unit about venture capital funds. We have also
W
---------------------- learnt the different stages in which they finance companies and the kind
of scrutiny that they conduct before making the investment decisions and
----------------------
also studied the SEBI guidelines for the venture capital funds, the present
---------------------- conditions in India with reference to venture capital funding.
---------------------- Keywords
----------------------
●● Angles: The funds that support fledgling companies in the very early
---------------------- stage.
●● Deal Flow: The way in which the venture capital funds structure a deal
----------------------
with a company.
---------------------- ●● Expansion financing: Financing done when a firm wishes to expand its
business.
----------------------
●● Licence Raj: The time when every industrial activity in India required a
---------------------- licence from the government.
---------------------- ●● Turnaround companies: Companies who are not currently doing well
and are trying to turn their operations around.
----------------------
----------------------
----------------------
----------------------
132 Capital Market

Notes
----------------------
1. What are Venture Capital funds?
2. Comment on the Venture Capital scenario in India. ----------------------
3. Describe the stages of Venture Capital financing. ----------------------
4. Which industries according to you are very attractive for investments by ----------------------
Venture Capital funds?
5. Write a note on Venture Capital funds in India, those are of Indian origin. ----------------------
6. What are the current trends in VC funding? ----------------------

7. What are SEBI guidelines for VCs in India? ----------------------
8. Should Government of India act as a V C in the fields which are risky? ----------------------
Answers to Check your Progress ----------------------

1. False ----------------------
2. True
----------------------
----------------------
1. True ----------------------
2. False ----------------------
----------------------
----------------------
Fill in the blanks.
1. VCFs must be registered with SEBI and pay Rs. 25,000 as application fee ----------------------
and Rs. 5 lakhs as registration fee. ----------------------
2. VCFs are authorised to raise funds from Indian, Foreign and NRIs, by
issue of units or shares. ----------------------
----------------------
Suggested Reading
----------------------
1. Ramsinghani, Mahendra. 2014. The Business of Venture Capital. John
----------------------
Wiley & Sons.
----------------------
----------------------
Venture Capital 133

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
134 Capital Market

Credit Rating
UNIT
8
Structure:
8.1 Introduction and Need of Credit Rating

8.2 Credit Rating
8.3 Factors that contributed to the Growth of Credit Rating
8.4 Factors considered by Credit Rating Agencies while Rating an Instrument
8.5 Flow Chart of Rating Process
8.6 CRISIL’s Long Term Rating Symbols
8.7 Recent Developments
Summary
Keywords
Self-Assessment Question
Suggested Reading
Credit Rating 135

Notes
Objectives
----------------------
----------------------
●● Explain the need for credit rating for different constituents in the
---------------------- market.
---------------------- ●● Eexplain what credit rating is.
●● Describe the factors that have contributed to the growth of credit
---------------------- rating.
---------------------- ●● Analyse the factors that are considered by the credit rating agencies
while assigning the rating for an instrument to be issued by a company.
----------------------
●● Explain the long term credit symbols used by CRISIL.
---------------------- ●● Critically analyse the recent developments.
----------------------
8.1 INTRODUCTION AND NEED OF CREDIT RATING
----------------------
The system of rating got institutionalised following the Great Depression
---------------------- in 1933, when the US Controller of Currency enacted a rule that banks could
only purchase securities, which have minimum investment rating.
----------------------
The need for credit rating is different for different parties depending on
---------------------- the benefits it offers to the various parties utilising these services viz. Investors,
---------------------- issuers, intermediaries and the regulatory authority.
Investors
----------------------
●● Rating will supplement the investors’ credit evaluation process.
---------------------- ●● It facilitates comparison of relative value between competing securities.
---------------------- ●● It helps in recognising the risk involved in the investment.
---------------------- Issuers
●● company with highly rated instrument has the opportunity to reduce the
A
---------------------- cost of borrowing by quoting less interest rates.
---------------------- ●● company with rating can approach a wider section of investors for
A
resource mobilisation.
----------------------
●● ompanies with rated instruments can avail of the rating as a marketing
C
---------------------- tool to create better image in dealing with its customers, lenders and
creditors.
----------------------
●● ating encourages the companies to come out with more disclosures about
R
---------------------- their accounting system, financial reporting and management pattern.
●● Smaller and not so well known companies can access markets.
----------------------
●● ncourages financial discipline as borrowers attempt to obtain ratings by
E
---------------------- improving financial structured reducing operating risks.
----------------------
136 Capital Market

Financial Intermediaries Notes
●● The ratings help them in pricing the debt.
----------------------
●● It shifts the burden of establishing credit quality from intermediary to a
rating agency thereby easing the due diligence requirement. ----------------------
●● ith high credit rated instruments, the brokers can convince their clients
W ----------------------
to select a particular investment proposal. This saves their time, cost and
manpower in convincing their clients. ----------------------
Regulatory Authority ----------------------
●● y identifying the risks, rating helps in channeling savings into productive
B
investments. ----------------------
●● Credit rating serves the objective of protecting the investors. ----------------------
8.2 CREDIT RATING ----------------------
----------------------
●● ating reflects the borrower’s accountability, expected capability and
R
inclination to pay interest and principal in a timely manner. ----------------------
●● Rating is an isolated function of a credit risk evaluation.
----------------------
●● Rating is useful in differentiating credit quality.
●● Rating will involve issue-specific evaluation. ----------------------
What Credit Rating is not? ----------------------

●● Rating is not a general purpose evaluation of the issuer. ----------------------
●● It is not a recommendation to buy/sell/hold a security.
----------------------
●● Rating is not an extensive audit of the issuing company.
●● ating is not a one-time assessment of creditworthiness valid over the
R ----------------------
future life of the security. ----------------------
1. Rating will supplement the investors’ credit evaluation process. ----------------------
2. A company with highly rated instrument has the opportunity to reduce ----------------------
the cost of borrowing by quoting less interest rates.
----------------------
----------------------
Activity 1
----------------------
1. As an investor, list down how you will make the investment decision
----------------------
based upon the ratings and the company that is issuing these instruments.
2. As an investor, what will you look at while making investment ----------------------
decisions other than the credit rating assigned to an instrument?
----------------------
Credit Rating 137

Notes 8.3 FACTORS THAT CONTRIBUTED TO THE GROWTH
OF CREDIT RATING
----------------------
●● High level of defaults in U.S. capital markets in 1970.
----------------------
●● Regulators stipulation for mandatory ratings.
---------------------- ●● Investor’s awareness of ratings for risk assessment and risk management.
---------------------- ●● It helps intermediaries for pricing and placement of financial instruments.
---------------------- ●● The increasing role of capital and money markets.

●● Globalisation of credit markets.
----------------------
●● The continuing growth of information technology.
---------------------- ●● The growth of confidence in the efficiency of the market mechanism.
---------------------- ●● he withdrawal of government safety nets and the trend towards
T
privatisation.
----------------------
8.4 FACTORS CONSIDERED BY CREDIT RATING
----------------------
AGENCIES WHILE RATING AN INSTRUMENT
----------------------
Rating is search for long term fundamentals and the probabilities for
---------------------- changes in the fundamentals.
---------------------- The analytical framework for rating methodology is divided into two
independent segments. The first deals with operational characteristics and
---------------------- the second with financial characteristics. Besides quantitative and objective
factors, qualitative aspects like assessment of management capabilities play
----------------------
a very important role in arriving at the rating for an instrument. The relative
---------------------- importance of qualitative and quantitative components of analysis varies with
the type of issuer.
----------------------
Credit rating is an opinion on the relative ability and willingness of an
---------------------- issuer to make timely payments on specific debt or related obligations over
the life of the instrument. Credit rating thus provides a relative ranking of the
---------------------- instrument of the credit quality of debt instruments.
---------------------- Credit rating is expressed in terms of rating symbols. This is required for
following reasons:
----------------------
A) They are easily comprehensible to lay investors.
---------------------- B) There are distinct symbols for different instruments.
---------------------- C) This differentiation is based on degree of safety which shows investment
grade and non-investment grades.
----------------------
D) Securities with same rating are of similar but NOT identical investment
---------------------- quality.
---------------------- Following are some of the key factors generally considered by the rating
agencies for the purpose of ratings:
----------------------
138 Capital Market

A) Business Analysis Notes
1. Industry risk
----------------------
2. Industry Structure
----------------------
3. Industry size and importance to Economy
4. Determinates of revenue growth ----------------------
5. Entry barriers ----------------------
B) Market position of the Company ----------------------
1. Nature and basis of competition
----------------------
2. Threat from imports and substitutes
----------------------
3. Presence of unorganized sector
4. Market share ----------------------
5. Competitive advantages like Brand Equity and Pricing Flexibility ----------------------

6. Product and customer diversity like proportion of exports and nature ----------------------
and type of customer diversity.
----------------------
C) Operating Advantages of the Company
1. Cost Structure ----------------------
2. Manufacturing Efficiency ----------------------
3. Production Flexibility ----------------------
4. Technology Risk
----------------------
5. Raw Material Sourcing
----------------------
6. Location Factors
D) Financial Risk Analysis ----------------------
1. Income recognition ----------------------
2. Expense capitalisation ----------------------
3. Depreciation and inventory valuation policies
----------------------
4. Off-balance sheet and contingent liabilities
----------------------
5. Non-operating income
6. Profitability measures ----------------------
7. Interest coverage ----------------------
8. Capital structure ----------------------
9. Debt service coverage
----------------------
10. Working capital indicators
----------------------
11. Return on capital employed
12. Adequacy of cash flows ----------------------
Credit Rating 139

Notes 13. Debt servicing requirements
14. Sustainability of funds from operations
----------------------
15. Ability to raise equity and debt funds
----------------------
16. Alternatives available in times of stress
---------------------- 17. Liquid assets available
---------------------- E) Project Risk
---------------------- 1. Project size in relation to existing operations
2. Means of financing
----------------------
3. Funding tie-up
----------------------
4. Extent of completion
---------------------- 5. Adherence to implementation schedules
---------------------- F) Management Evaluation
---------------------- 1. Strength of linkage to parent/group-operational, financial,
managerial support.
----------------------
2. Systems and track record
---------------------- 3. Project implementation record
---------------------- 4. Management talent and succession
---------------------- Legal position - Whether the company has complied with all the legal
requirements that they need to follow. If the company fails to follow the legal
---------------------- requirements, then it can get into trouble in the future and thus the credit rating
assigned could prove to be incorrect.
----------------------
Financial Analysis
----------------------
●● Accounting quality
---------------------- ●● Financial Ratios
---------------------- ●● Adequacy of cash flows
●● Financial flexibility
----------------------
Management Evaluation
---------------------- ●● Track record of management
---------------------- ●● Crisis management
---------------------- ●● Goal, philosophy and strategic
Regulatory and Competitive Environment
----------------------
●● Structure and regulatory framework of the financial system
---------------------- ●● Trends in regulation / deregulation and their impact on company
---------------------- ●● Fundamental Analysis
----------------------
140 Capital Market

●● Capital adequacy Notes
●● Liquidity management
----------------------
●● Financial position
●● Interest and tax sensitivity ----------------------
●● rom the above points it is very clear that the rating agencies go into the
F ----------------------
minutest details of the companies working before assigning any credit
rating to its instruments. ----------------------
One of the most important aspects that need to be given a great deal of ----------------------
importance is the track record of the issuer. Many a times we see that even
a relatively new company’s instruments also gets a very high rating simply ----------------------
because the company is promoted by an established business house with a solid
----------------------
track record.
----------------------
----------------------
1. Rating is search for ____ fundamentals and the probabilities for
changes in the fundamentals. ----------------------
2. Credit rating is expressed in terms of rating _____. ----------------------
----------------------
Activity 2 ----------------------
Find out if the rating agencies should consider any more facts before ----------------------
assigning the rating.
----------------------
----------------------
8.5 FLOW CHART OF RATING PROCESS
----------------------
1. Mandate Activity 1 & 2 Initial stage
2. Assign rating team ----------------------
3. Receive initial information Activity 1 to 5 Fact finding & analysis ----------------------
conduct basic research
----------------------
4. Meeting and visits
5. Analysis and preparation of report ----------------------
6. Preview meeting Rating finalisation
----------------------
7. Rating meeting Fresh inputs
8. Assign rating ----------------------
9. Communicate rating and the rationale Request for review ----------------------
10. Acceptance Non-acceptance
----------------------
11. Surveillance
----------------------
Credit Rating 141

Notes Preliminary analysis
The rating process starts with the rating request from the issuer. Thereafter,
----------------------
the rating agreement is signed.
---------------------- When this process is completed, an analytical team is assigned the
responsibility of analysing the issuer’s credit risk profile. This rating team
----------------------
(comprising at least two analysts) then collates preliminary information from
---------------------- the issuer to understand its business, management, and financial risk profiles.
Management interaction
----------------------
An open dialogue between the issuer and credit rating agency is conducted.
---------------------- Which enables rating agency to incorporate non-public information into its
---------------------- rating decision and also helps it arrive at forward-looking ratings.
Discussions during management interactions are wide - ranging, covering
---------------------- competitive position, strategy, financial policy, historical performance, and near
---------------------- and long - term financial and business prospects. In these discussions, the focus
is on business risk profile and strategies, in addition to reviewing financial data
---------------------- and the company management outlook.
---------------------- Rating committee and assignment of ratings

After interacting with the issuer’s management, the rating agency
----------------------
prepares a report detailing their assessment of business risk, financial risk,
---------------------- and management risk associated with the issuer. The report is based on rating
methodologies and criteria that are clearly spelt out, published, and consistently
---------------------- applied. The report is then discussed by the rating agency and rating is assigned.
---------------------- Communicating the rating to the issuer
On finalisation of a rating, the rating decision is communicated to the
----------------------
issuer with the rating rationale is shared with the issuer. This is to assist the
---------------------- issuer in understanding the key analytical factors that have been assessed for
arriving at the rating decision.
----------------------
The company would decide to accept the rating. If, the issuer disagrees
---------------------- with the rating decision, it can appeal for a fresh look at the rating assigned. In
such a case, the issuer needs to submit additional facts, data or new information
---------------------- to the ratings team, to be presented to the rating committee. If the rating is not
---------------------- changed and issuer continues to disagree with the rating, then the issuer has an
option of not accepting the rating. Unaccepted ratings are not published by the
---------------------- rating agency.
---------------------- Surveillance
All ratings are under continuous surveillance. After a rating has been
----------------------
assigned, the rating agency continues to monitor the performance of the issuer
---------------------- and the economic environment in which it operates
Withdrawal of ratings
----------------------
CRISIL ratings are not a one - time exercise and are under continuous
---------------------- surveillance over the life of the rated facility or instrument.
142 Capital Market

In today’s market driven economy, there is a genuine need for authentic Notes
investment information characterised by authenticity, quality analysis and good
presentation, and specifically designed to facilitate the decision-making process ----------------------
of investors and other participants in the financial services world.
----------------------
Types of Instruments Rated
----------------------
Credit rating is used extensively for evaluating debt instruments. These
include long term instruments like bonds and debentures as well as short-term ----------------------
instruments like commercial paper. In addition fixed deposits, certificates of
deposits, structured obligations including the non-convertible portion of PCDs ----------------------
and preference shares are rated. Equity shares are not rated.
----------------------
Activity 3 ----------------------
----------------------
Recommend any other instruments that you believe should be brought under
compulsory rating process. ----------------------
----------------------
8.6 CRISIL’S LONG TERM RATING SYMBOLS
----------------------
AAA : Highest safety
----------------------
AA : High safety
----------------------
A : Adequate safety (Change in circumstances can adversely affect
such issues.) ----------------------
BBB : Moderate safety (Change in circumstances is more likely to lead to ----------------------
weakened capacity.)
BB : Inadequate safety (Uncertainty could lead to inadequate capacity) ----------------------
B : High risk. (Currently obligations being met but adverse conditions ----------------------
could lead to lack of ability.)
----------------------
C : Substantial risk (Payment possible only if favourable circumstances
continue.) ----------------------
D : Default ----------------------
It should be noted that each credit rating company has its own symbols and
----------------------
they may use different symbols for rating different instruments. For example,
the symbols used for Commercial paper and Fixed deposits will be different. In ----------------------
India, there are presently four companies, in the business of Credit Rating, they
are CRISIL, ICRA, CARE and Fitsch. The last one is an international credit ----------------------
rating company.
----------------------
It is important to emphasise the limitations of credit ratings. They are
not recommendations to invest. They do not take into account many aspects, ----------------------
which influence an investment decision. They do not, for example evaluate ----------------------
the reasonableness of the issue price, possibilities for capital gains or tale into
account the risk of prepayment by issuer, or interest or exchange risks. Although ----------------------
Credit Rating 143

Notes these are often related to credit risk, the rating essentially is an opinion on the
relative quality of the credit risk.
----------------------
----------------------
8.7 RECENT DEVELOPMENTS
---------------------- There have been discussions for a long time now as to whether the IPOs
should be brought under compulsory rating process. In the past, we have seen
---------------------- that especially during the Bull Run in the stock markets many dubious companies
come out with IPOs and the gullible investors fall pray for such issues as they
---------------------- believe that all IPOs will give them a profit after listing. It has been argued that
---------------------- all issues are either appraised by the merchant bankers to the issue or by the lead
bankers who are taking exposure by way of funding to the project for which
---------------------- the issue has been brought out. However the counter argument is that the retail
investors are not in a position to understand all this. It may be useful therefore
---------------------- that the IPO is assigned credit rating related to the risk profile of the project on
---------------------- the whole.
Some new and the existing credit rating agencies have approached SEBI
---------------------- for allowing them to rate the IPOs. We are likely to see some developments in
---------------------- this direction shortly.
Some rating agencies have also started rating the companies as a whole on
----------------------
its overall performance. This rating obviously is much wider in nature than the
---------------------- issue related rating. We have also seen that some rating agencies have started
rating the corporate governance practices. This is a welcome development as
---------------------- investors will come to know as to which companies are practicing corporate
governance in the way it needs to be done.
----------------------
We have also seen some innovation in the ratings for the different schemes
---------------------- of various mutual fund schemes. This is also a good development. The experts
have always maintained that before making any investments in a mutual fund
----------------------
scheme, its past performance needs to be evaluated. The credit rating may make
---------------------- this decision making easier for the investors.
We have seen the emergence of Securatisation as a financial instrument
----------------------
in the market. This is gaining popularity and many players have started using
---------------------- this instrument very effectively. The pay-through and pass through instruments
that are issued in this process are presently being rated by the rating agencies.
---------------------- In future, the retail investors will be able to invest money in these instruments.
The credit rating for these will greatly help the retail investors to make the
----------------------
investment decision in these instruments.
---------------------- As per Reserve Bank of India (RBI) guidelines (please refer to RBI
---------------------- Master Circular DBOD o.BP.BC. 11 /21.06.001/2010–11/section 6.2.4 dated
July 1, 2011-Prudential guidelines on Capital Adequacy and Market Discipline-
---------------------- New Capital Adequacy Framework) rating agencies should review each bank
loan credit at least once in 15 months.
----------------------
----------------------
144 Capital Market

Notes
----------------------
----------------------
1. AAA indicates high safety.
----------------------
2. Each credit rating company has its own symbols and they may use
different symbols for rating different instruments. ----------------------
----------------------
Activity 4 ----------------------
List out some other financial instruments that you think should be brought ----------------------
under the rating process.
----------------------
----------------------
Summary
----------------------
●● We have studied the development of rating and reasons for it. We have
seen the usefulness of rating to various constituents in the markets and ----------------------
what credit rating is exactly. We have seen the process of credit rating and
----------------------
the factors that are considered by the rating agencies while assigning the
rating alongwith the flow chart of the rating process. ----------------------
●● We have also read the rating symbols for the long term investment
instruments as given by the rating agency CRISIL. The current scenario ----------------------
regarding the future of credit rating has also been highlighted in this unit. ----------------------
Keywords ----------------------
----------------------
●● Issuer: The company that issues an instrument.
●● Management analysis: Quality of management of the company that is ----------------------
seeking rating.
----------------------
●● Rating symbol: Alfa numerical code given by the credit rating agencies.
●● Rating agency: The entity that undertakes the rating. ----------------------
●● Turn around companies: Companies that are not doing well at present ----------------------
but those who can do better in future.
----------------------
1. What is meant by Credit Rating? ----------------------

2. What factors need to be considered while rating the companies? ----------------------
3. What is the importance of rating to issuers, investors and marketing
----------------------
companies?
4. What is meant by business analysis? ----------------------
Credit Rating 145

Notes 5. Why is management quality analysis important for rating process?
6. Which products that are not under rating should be brought under rating
----------------------
according to you?
---------------------- 7. Should an investor depend solely on rating agencies while making
investment decisions?
----------------------
8. Explain the various symbols used in rating and their significance.
----------------------

State True or False
----------------------
1. True
----------------------
2. True
----------------------
---------------------- 1. Rating is search for long term fundamentals and the probabilities for
changes in the fundamentals.
---------------------- 2. Credit rating is expressed in terms of rating symbols.
----------------------

----------------------
1. False
----------------------
2. True
----------------------
---------------------- Suggested Reading
---------------------- 1. Izzi, Luisa, Gianluca Oricchio, Laura Vitale. 2012. Basel III Credit Rating
Systems: An Applied Guide to Quantitative and Qualitative Models.
---------------------- Palgrave Macmillan.
---------------------- 2. Ong, Michael K. 2002. Credit Ratings: Methodologies, Rationale and
Default Risk. Risk Books.
----------------------
----------------------
----------------------
----------------------
----------------------
146 Capital Market

Share Buy-Back
UNIT
9
Structure:
9.1 Introduction
9.2 The Method and Obligations of the Company in Share Buy-Back
9.3 The Effects of the Buy-Back
9.4 Types of Share Buy-Backs
9.5 Conclusion
Summary
Keywords
Suggested Reading
Share Buy-Back 147

Notes
Objectives
----------------------
----------------------
●● Explain the process of share buy-back.
---------------------- ●● Assess the company’s obligation in share buy-back.
---------------------- ●● Describe the methods of buy back of shares.
---------------------- ●● Evaluate the effects of buy-back of shares.
●● Describe the types of buy-back.
----------------------
---------------------- 9.1 INTRODUCTION

---------------------- From October 1998, the public limited companies in India are allowed
to buy-back their shares from the shareholders. A company can buy-back their
---------------------- own shares or other specified securities including employees’ stock option from
---------------------- out of
1. Its free reserves
----------------------
2. The securities premium account
----------------------
3. The proceeds of an earlier issue other than fresh issue of shares made
---------------------- specifically for buy-back purpose. The share buy-back falls under Section
77 of Companies’ Act.
----------------------
However, a company can purchase its own shares only if following
---------------------- conditions are fulfilled:
1. The articles permit such buy-back.
----------------------
2. A special resolution in general meeting authorising buy-back. The
---------------------- company in the notice to shareholders must give an explanatory statement
---------------------- about the need for buy-back, the amount required for it, the time limit and
completion of the process.
---------------------- Following conditions have to be met in the process of buy-back:
---------------------- 1. The buy-back has to be completed within 12 months of passing the special
resolution.
----------------------
2. Buy-back cannot exceed 25% of the total paid capital plus free reserves
---------------------- of the company.
---------------------- 3. Post buy-back the debt equity ratio shall not exceed 2:1.
---------------------- 4. Shares that are eligible for buy-back have to be fully paid.
5. Before making purchases under this scheme companies have to file with
---------------------- the Registrar of Companies and SEBI a declaration of solvency.
---------------------- 6. The securities purchased under the buy-back arrangement should be
extinguished and physically destroyed within seven days of the last date
---------------------- of the completion of the buy-back.
148 Capital Market

7. A company which buys back its securities is prohibited from further issue Notes
of securities within a period of two years, expect bonus issues or issues
in the discharge of subsisting obligations such as conversion of warrants, ----------------------
stock option schemes, sweat equity or conversion of preference shares/
debentures into equity shares. ----------------------
8. Companies are not allowed to buy-back securities ----------------------

a) Through any / own subsidiary company ----------------------
b) Through any /group of investment company
----------------------
c) If default subsists in respect of repayment of deposits, term loans
to any financial institutions and redemption of debentures or ----------------------
preference shares.
----------------------
9. The explanatory statement annexed to the notice should contain following
additional disclosures: a) The minimum prices at which the buy-back of ----------------------
securities would be made. If the promoter intends to offer their securities;
the quantum of securities proposed to be tendered and the details of their ----------------------
transactions and their holdings for the last six months prior to the passing
----------------------
of the special resolution for the buy back including the information of the
number of shares acquired, the price and the date of acquisition. ----------------------
10. The company must open an escrow account and deposit the amount as
----------------------
required by the SEBI regulations. The company on or before the opening
the offer, deposit in an escrow amount 25% of the consideration payable ----------------------
up to Rs. 100 crores and 10% there after.
----------------------
11. The Company has to appoint a merchant banker for the purpose of the
buy back. ----------------------
12. The offer should remain open to the members for a period not less then
----------------------
fifteen days and not exceeding thirty days. The company should complete
the verification of the offers, received within fifteen days of the closure ----------------------
of the offer and the securities lodged should be deemed to be accepted
unless a communication of rejection is made within fifteen days from the ----------------------
closure of the offer.
----------------------
9.2 THE METHOD AND OBLIGATIONS OF THE COMPANY ----------------------
IN SHARE BUY-BACK
----------------------
The company has to ensure:
----------------------
1. The letter of offer, the public announcement should contain true, factual
and material information and not contain any misleading information and ----------------------
must state that the Directors of the company accept the responsibility of
----------------------
all this information.
2. The company should not issue any securities including by way of bonus ----------------------
till the date of closure of the offer made under these regulations.
----------------------
3. The company must pay the consideration only by way of cash.
----------------------
Share Buy-Back 149

Notes 4. The company should not withdraw the offer after the draft letter of offer
is filed with SEBI or the public announcement in this regard is made.
----------------------
5. The promoter or the person in control should not deal in the securities of
---------------------- the company in the stock exchange during the period when the buy back
offer is open.
----------------------
The methods of buy-back
---------------------- 1. From existing shareholders on a proportionate basis.
---------------------- 2 From the open market.
3. Through the purchase of odd lot shares held by the shareholders. (Under
---------------------- the demat format there is no concept of odd lot.)
---------------------- 4. By purchasing the securities issued to employees of the company under
the Stock options scheme or Sweat Equity scheme.
----------------------
---------------------- 1. Post buy-back, the debt equity ratio shall not exceed 1:2.
2. The Company has to appoint a merchant banker for the purpose of the
----------------------
buy back.
----------------------
---------------------- Activity 1
---------------------- Mention some points about the happenings in the buy back offer of Ingersoll
Rand Ltd.
----------------------
----------------------
9.3 THE EFFECTS OF THE BUY-BACK
----------------------
1. It is a way of returning surplus cash to shareholders.
----------------------
2. To increase the underlying shares value. The decrease in share capital will
---------------------- increase the Earnings per share.
3. It helps to support the prices during a period of temporary weakness in the
----------------------
stock markets.
---------------------- 4. It helps the company to maintain target capital structure.
---------------------- 5. It can also be used as the mechanism against a possible hostile take over
bid. By buying back the shares the company reduces the floating stock
---------------------- in the market, thereby reducing the scope of the raider to acquire enough
shares to gain the management control.
----------------------
6. This is a method used for down sizing, especially during declining sales.
---------------------- 7. Share buy-back leads to erosion of the net worth of the company. This has
---------------------- a negative effect on the creditors and lenders.
150 Capital Market

8. If the shares are not extinguished then the company becomes its own Notes
shareholder. In USA companies who buy-back shares are not required to
extinguish them and can reissue them. ----------------------
9. It is argued that unscrupulous promoters may deliberately keep markets ----------------------
subdued with a view to back shares at lower prices.
----------------------
1. ___________ is a way of returning surplus cash to shareholders. ----------------------
2. In buy- back, the decrease in share capital will increase ________.
----------------------
----------------------
Activity 2
----------------------
Find out what happened to the prices of the shares of companies who bought
----------------------
back their shares.
----------------------
9.4 TYPES OF SHARE BUY-BACKS ----------------------
1. Open market purchases: This is done by giving notice to the shareholders ----------------------
at least seven days prior to buy-back. The company has to disclose the
----------------------
total number of shares it intends to buy-back. Since the process is carried
out in the open market, no minimum price is mentioned for the buy-back. ----------------------
This is an easy, quick and simple process.
----------------------
2. Tender Offer: The buying company has to disclose the total number
of shares and the price at which it wishes to buy-back. The maximum ----------------------
price offered is 20% above the average price. The offer period could be
between 15 to 30 days. If shares tendered are more than the total number ----------------------
to be bought back, then buy-back is done on the proportionate basis.
----------------------
3. Dutch auction: In this method the price of buy-back is done by the
shareholders themselves. This is like the process of book building. ----------------------
India’s experience with buy-back ----------------------
In the early years when buy back was first allowed in India, we saw a big ----------------------
rush by many companies like Bajaj Auto Ltd, Thermax Ltd. Finolex Cables Ltd.
etc showing a lot of enthusiasm in buying back their shares. The market prices ----------------------
of these companies’ shares were quite high at that time. On top of it may be due
to the inexperience, these companies offered a very high price to purchase these ----------------------
shares. In some cases like Bajaj for example the buy back price offered was
----------------------
almost at 50% premium to the market price of these Companies’ shares.
The point that needs to be considered here is what prompted these ----------------------
companies to offer such a high price? Was it the sheer excitement of being able
----------------------
Share Buy-Back 151

Notes to buy back shares? Was it due to the novelty of the idea? It is really difficult for
us to guess.
---------------------- The point is that this offer then was made to all the shareholders of the
---------------------- company as required by law. It is quite natural that since the price offered was
very high, many retail shareholders must have accepted this offer. However,
---------------------- many of these buy back offers were oversubscribed and the buy back had to be
done on a proportional basis. This means that those shareholders who gave their
---------------------- shares for buy back, must have realised that all shares that were offered by them
obviously could not be bought back.
----------------------
As stated above the companies’ offered probably a very high price. The
---------------------- point that needs to be considered is what impact did this have on the remaining
shareholders. Obviously the company’s reserves came down due to this buy
----------------------
back. The second effect that was evident was the market price of the company’s
---------------------- shares for a very considerable time was quoting below the buy back price! One
of the effects of buy back actually is said to be that the prices of remaining shares
---------------------- is expected to go up post buy back. Here the situation was exactly opposite. So
the shareholders who did not sell their shares through buy back suffered a loss
---------------------- as compared to the ones who opted to offer their shares for buy back.
---------------------- Post buy back the promoters stake in these companies went up because
they cannot offer their shares for buy back. This resulted that their holding in
---------------------- their companies went up in percentage terms. But since the market price did not
---------------------- go up as they had probably expected to happen, in the short run they did seem
to have lost out.
---------------------- It must also be remembered that the shareholders themselves were not
---------------------- fully aware of the impact of buy back, as for them it was a very new experience.
One can be quite certain that many retail investors did not understand the
---------------------- significance of this offer at all, and in all probability did not even consider
accepting this offer. This would lead us to another conjuncture- did this whole
---------------------- exercise help only a handful of shareholders who were well versed in this?
---------------------- Over the years, both the managements of the companies and many a
shareholders have learnt lessons from the earlier buy back offers. Today, the
---------------------- shareholders are up against the managements if the buy back offers are below
---------------------- their expectations and the valuation of the company. This is especially true of
the MNCs who are buying back their shares for delisting them. We have seen
---------------------- that the shareholders have fought against managements like that of Citi Bank,
which was trying to buy back shares of its company E-Serve to delist it from
---------------------- the stock markets. Finally, SEBI had to intervene on behalf of the shareholders.
---------------------- SEBI then made reverse book building mandatory in such cases. In this system
the shareholders offer their shares in a buy back offer at a price which they think
---------------------- is the fair price for buy back.
---------------------- In effect most companies are buying back shares from the open market. In
this method, the company will obtain the approval of shareholders to buy back
---------------------- shares at a price not exceeding a particular amount per share. The offer will be
communicated to all the shareholders. The actual buy back will be conducted
----------------------
152 Capital Market

through the open market. The shareholders who wish to participate in buy back Notes
offer will have to sell their shares in the open market. If the market price goes
above the maximum price then the company will stop buying shares from the ----------------------
open markets.
----------------------
Objectives of Buy-Back
----------------------
Shares may be bought back by the company on account of one or more of the
following reasons: ----------------------
●● To increase promoters holding
----------------------
●● To increase earning per share
----------------------
●● o rationalise the capital structure by writing off capital not represented
T
by available assets. ----------------------
●● To thwart takeover bid
----------------------
●● To pay surplus cash not required by business
Relevant Laws ----------------------
●● Sections 77A, 77AA and 77B of the Companies Act ----------------------

●● SEBI (Buy Back of Securities) Regulations 1998 ----------------------
●● entral Government issued Private Limited Company and Unlisted Public
C
Ltd Company [Buy back of Securities] Rules 1999. ----------------------
[A] Companies Act 1956 ----------------------
Pursuant to Section 77A, 77AA, and 77B, a company may buy-back its ----------------------
own shares and other specified securities provided, inter alia, that:
----------------------
(i) the buy back should be authorised by the Articles of Association of
the company; ----------------------
(ii) it is to be made from the existing security holders on a proportionate
----------------------
basis, through open market, holding odd lots or purchasing securities
issued to the employees pursuant to a scheme of stock option or ----------------------
sweat equity;
----------------------
(iii) the sources of funds are free reserves, securities premium account,
or the proceeds of any shares or other specified securities; ----------------------
(iv) a special resolution has to be passed. The notice of the general ----------------------
meeting shall accompany an explanatory statement containing full
disclosures; ----------------------
(v) the buy-back should not exceed 25% of the total paid-up share ----------------------
capital and free reserves of the company and buy-back of equity
shares in any financial year should not exceed 25% of the total paid- ----------------------
up equity share capital in that financial year;
----------------------
(vi) the debt equity ratio should not exceed 2:1
----------------------
----------------------
Share Buy-Back 153

Notes (vii) all shares or specified securities for buy back are fully paid up. {It is
not clear what will be the position if there are shares on which there
---------------------- are calls-in- arrears};
---------------------- (viii) the buy back has to be completed within 12 months from the date of
passing of the special resolution;
----------------------
(ix) a Declaration of Solvency has to be made by the Board of directors,
---------------------- before buy back, to the effect that they have made full inquiry
into the affairs of the company and have formed an opinion that
---------------------- the company is capable of meeting its liabilities and will not be
rendered insolvent within a period of one year from the date of
----------------------
the Declaration. Such Declaration has to be signed by at least two
---------------------- directors, one of whom shall be managing director, if any. It has
then to be filed with concerned Registrar of Companies and SEBI;
----------------------
(x) where shares have been bought back from free reserves, a Capital
---------------------- Redemption Reserve Account has to be created which would be
equal to nominal value of the shares bought back. This Reserve can
---------------------- be used, among others, for issue of bonus shares;
---------------------- (xi) the shares have to be extinguished and physically destroyed within
7 days after buy-back;
----------------------
(xii) no further issue of same kind of securities is permitted within 24
---------------------- months of completion of buy-back except by way of bonus issue
or discharge of existing obligations such as conversion of warrants,
---------------------- preference shares, debentures, etc.
---------------------- (xiii) the company has to maintain a register of securities bought back
and file a return with the concerned Registrar of Companies and
---------------------- SEBI within 30 days of completion of buy back;
---------------------- (xiv) the company is not directly or indirectly allowed to purchase its
own securities through subsidiaries or investment companies; and
----------------------
(xv) buy back cannot be effected where there is default by the company
---------------------- in repayment of deposit or interest, redemption of debentures or
preference shares, payment of dividend, or repayment of loan or
----------------------
interest to financial institution or bank.
---------------------- [B] SEBI (Buy Back of Securities) Regulations 1998
---------------------- Under this law, a company is permitted to buy back its shares:
---------------------- (a) from the existing shareholders on a proportionate basis through the
tender offer i.e. by means of offer document,
----------------------
(b) from open market through stock exchanges, and book building
---------------------- process, and
(c) from shareholders holding odd lot shares.
----------------------
[1] Buy back is not allowed through negotiated deals or spot transactions
---------------------- or private arrangements.
154 Capital Market

[2] There is freedom to fix the price of shares for buy back. In case of Notes
buy back through tender offer including odd lot shares, the price will
be fixed through the special resolution and there is no provision for ----------------------
fixing maximum price. In case of buy back through stock exchanges
and book building process i.e. from open market, the maximum ----------------------
price has to be fixed through the buy back special resolution. The ----------------------
final price will be fixed accordingly. In book building, the merchant
banker and the company will have to determine the price based on ----------------------
acceptances received from the shareholders. The final price will be
the highest price accepted. ----------------------
[3] Promoters can sell their shares through tender offer and also through ----------------------
purchase offer of odd lots. They are not permitted to deal in shares
----------------------
on stock exchanges when the buy back offer is open. The company
is also not permitted to buy back shares from them. ----------------------
[4] The Explanatory Statement to be annexed to the notice of general
----------------------
meeting should have details, as per Schedule I. It has to contain a
confirmation from the Board of the company that they have made ----------------------
full enquiry into the affairs and prospects of the company and
formed the opinion that the company is/will be able to pay its debts, ----------------------
meet its liabilities and will not be rendered insolvent;
----------------------
The Explanatory Statement should also contain the following
particulars; ----------------------
[a] Necessity of Buy back ----------------------
[b]
Method ----------------------
[c] Maximum amount required and the source of funds
----------------------
[d] The maximum price per share and the basis of arriving at the
buy back price ----------------------
[e] The number of shares proposed to be bought back ----------------------
[f] Aggregate shareholdings of promoters and directors of ----------------------
promoters. Also particulars of sale/purchase made by them
during last six months preceding the date of Board meeting ----------------------
till the date of notice of general meeting
----------------------
[g] Intention of promoters to buy back
[h] A confirmation that there are no defaults subsisting in ----------------------
repayment of deposits, redemption of debentures, and term ----------------------
loans
----------------------
[i] A report of the auditors of the company, addressed to the
Board, stating that they have inquired into the company’s state ----------------------
of affairs and the amount of permissible capital payments for
the shares in question is in their view properly determined. ----------------------
Moreover, the Board has formed opinion of solvency of the
----------------------
company on reasonable grounds
Share Buy-Back 155

Notes [5] The contents of Public announcement and letter of offer (such
letter is only required in case of tender offer) have also been
---------------------- prescribed and appear in Schedule II and III of the Regulations,
respectively. These require more or less the same details stipulated
---------------------- for explanatory statement plus further details such as price, cost of
---------------------- financing, audited financial information, listing and stock market
data, the time table, management discussion and analysis on impact
---------------------- of buy back and so on.
---------------------- [6] Merchant bankers will have to be appointed.
[7] Special resolution has to be filed with SEBI and Stock Exchanges
----------------------
within 7 days from the date of passing the resolution.
---------------------- [8] A public announcement for buy back has to be made by way of
publication in English, Hindi and regional newspapers after passing
----------------------
of special resolution but before buy back. It shall specify the record
---------------------- date.
---------------------- [9] The consideration will have to be paid in cash.

[10] The company is not allowed to withdraw the offer after the offer
---------------------- document is filed with SEBI or public announcement is made.
---------------------- [11] No public announcement is permitted to be made during the scheme
of amalgamation, compromise or arrangement.
----------------------
[12] The company has to appoint compliance officer and establish an
---------------------- investor service centre.
---------------------- [13] The shares which are locked-in or which are non-transferable are
not allowed to be bought back.
----------------------
[14] The share certificates will have to be extinguished and destroyed in
---------------------- presence of the merchant banker and the auditor within 7 days from
the date of acceptance of shares. The details thereof and certificate
---------------------- will have to be given to stock exchanges and SEBI within 7 days of
---------------------- date of destruction.
[15] Advertisement has to be given in the newspapers within 2 days of
---------------------- completion of buy back.
---------------------- [C] What are special provisions for tender offer route including buy back
of odd lot shares?
----------------------
[i] Within seven working days of public announcement, the company
---------------------- has to file with SEBI, a letter of offer through merchant banker.
The declaration of solvency has also to be similarly filed. Any
----------------------
modification suggested by SEBI has to be incorporated in the offer
---------------------- document.
[ii] A record date has to be fixed for the purpose of determining who
----------------------
will be entitled to get the Letter of offer. It shall not be earlier
---------------------- than 30 days and not later than 42 days from the date of public
announcement.
156 Capital Market
[iii] Letter of offer has to be dispatched to the shareholders, as on the Notes
record date, not before 21 days from its submission to SEBI.
----------------------
[vi] The offer should open not earlier than 7 days and not later than 30
days after the record date. ----------------------
[v] The offer should remain open for minimum 15 days and maximum
----------------------
30 days.
[vi] The verification of offer has to be completed within 15 days from ----------------------
the closure date of offer.
----------------------
[vii] An Escrow account is to be opened and deposited therein specified
amounts/ securities etc. as security for performance of obligation of ----------------------
the company. ----------------------
[viii] A special account should be opened with the banker for payment in
respect of buy back. The amount in the Escrow account has to be ----------------------
transferred to that account immediately after the closure of offer. ----------------------
The balance amount has also to be deposited.
[ix] The company should make payment to the shareholders in cash, ----------------------
within 7 days from the expiry of 15 days fixed for completion of ----------------------
verification.
----------------------
[D] What are special provisions for open market operations through
stock exchanges? ----------------------
[a] Buy back process is allowed to commence at least 7 days after the
----------------------
public announcement.
[b] Buy back operations may remain open up to 12 months from the ----------------------
date of the general meeting passing the special resolution. ----------------------
[c] A copy of the public announcement has to be filed with SEBI within
two days of such announcement. ----------------------
[d] The details of the brokers and the stock exchanges through whom ----------------------
or which buy back will be made will have to be disclosed in the
announcement. ----------------------
[e] Buy back should be made only on stock exchanges with electronic ----------------------
trading facility and through order matching mechanism. ‘All or
----------------------
None’ order matching system be excluded.
[f] The company and the merchant banker have to inform the stock ----------------------
exchanges and publish in newspaper the information about shares
----------------------
bought back. This has to be done on a daily basis.
[g] The verification of shares has to be completed within 15 days from ----------------------
the date of payout.
----------------------
----------------------
----------------------
Share Buy-Back 157

Notes [E] What are special provisions for open market operations through
book building?
----------------------
[1] Buy back has to commence at least 7 days after the public
---------------------- announcement.
[2] An Escrow account has to be opened and deposit made before the
----------------------
public announcement. The law stipulated in this regard for tender
---------------------- offer route will apply.
[3] A copy of the public announcement has to be filed with SEBI within
----------------------
two days of such announcement.
---------------------- [4] Public announcement will have to contain the detailed methodology
---------------------- of the process.
[5] Offer has to remain open for minimum 15 days and maximum 30
---------------------- days.
---------------------- [6] Buy back has to be made through electronically linked transparent
facility. Moreover, number of bidding centers should be at least
---------------------- thirty and there has to be minimum one electronically linked
---------------------- computer terminal at all bidding centers.
[7] The provisions of verifications of acceptance, opening of special
----------------------
accounts and payment of consideration will be the same as specified
---------------------- for the tender offer route.

----------------------
Fill in the blanks.
---------------------- 1. _________ is done by giving notice to the shareholders at least seven
---------------------- days prior to buy-back.
2. In __________ method, the price of buy-back is done by the
---------------------- shareholders themselves like book building.
----------------------
---------------------- Activity 3
---------------------- What happened in the share buy back offer of Reliance Industries Ltd.
---------------------- during the trouble between the Ambani brothers? Write in a few sentences.
----------------------
9.5 CONCLUSION
----------------------
Recently, SEBI has allowed buy back of shares upto 10% of total shares,
---------------------- without the requirement of the special resolution. The only requirement is the
---------------------- board resolution passed to this effect. The company cannot issue fresh equity
for 12 months after such a buy back. This amendment was made to enable
---------------------- companies to buy back shares at the time when share markets were down.
158 Capital Market

The Indian experience of buy back has displayed some curious results so Notes
far. The companies, who went for buy back immediately after it was allowed,
seem to have paid a very high price for the buy back. Due to this the market ----------------------
prices post buy back did not rise. This trend is visible even today.
----------------------
One major criticism against buy back is that though the buy back is done
with companies’ funds, the actual beneficiaries of this are the promoters of the ----------------------
company. This is so because without actually investing any money directly in
----------------------
the companies, the promoters’ stake in the company goes up because of the buy
back. This according to some critics gives undue advantage to the promoters. ----------------------
The counter argument is that shareholders who give their shares for buy back
are adequately compensated as they normally get a price which is at a premium ----------------------
to the existing market price. It is also argued that if shareholders believe that the
----------------------
company’s performance and therefore its market price are likely to better, then
they should not participate in the buy back offer. ----------------------
Another trend that is visible these days is that many MNCs are buying
----------------------
back their shares from the domestic market with the express purpose of
delisting, these shares from the Indian stock markets. As per the company law if ----------------------
promoters hold more than 90% equity, then the company can be delisted. Many
MNCs like Phillips, Atlas Capco and Cadbury are doing this. ----------------------
When this happens these companies are not required to publish their ----------------------
financial results as many of them become 100% subsidiaries of their parent
companies. There are investors who do not give their shares in such buy back ----------------------
offer as they believe that post -delisting these companies will naturally give
----------------------
more dividends as the dividend will accrue to the promoters only. However,
the down side o this is that the investment in this scrip will become completely ----------------------
illiquid as there will be no market price and thus the investors will have no exit
route available to him in case he wishes to sell his investments. ----------------------
In the present Bull Run on the markets, very few companies are going for ----------------------
buying back of shares. It must be remembered that buy back will make sense in
the bear market and not in the bull market as the cost of buy back will be least ----------------------
in the bear markets. ----------------------
In the past two years we have also witnessed another type of buy back
which may not qualify to be strictly called as buy back in the traditional way. ----------------------
Infosys bought back shares from its Indian shareholders at a premium to their ----------------------
market prices and then issued these shares in the American markets as ADS at a
premium. The company thus increased the liquidity of their shares in the U. S. ----------------------
markets. Last but not the least Infosys also issued such shares in the Japanese
markets. ----------------------
----------------------
----------------------
----------------------
----------------------
Share Buy-Back 159

Notes Summary
---------------------- ●● In this unit, we have studied the process of buy back as well as the
obligations of the company that is buying back its shares. The methods
----------------------
of buying back of shares and its effect and also studied the recent
---------------------- developments in these markets over the past few years.
----------------------
Keywords
----------------------
●● Delisting: Buy back done for delisting shares from the stock markets.
---------------------- ●● Dutch auction: The shareholders quote the price at which they are willing
to participate in a buy back offer.
----------------------
●● Tender offer: The company gives offer to all shareholders.
----------------------
●● Reverse book building: It is similar to Dutch Auction.
---------------------- ●● Extinguishing of shares bought back: Physically destroying the shares
that are bought back.
----------------------

---------------------- 1. What are the benefits and limitations of buy back?
---------------------- 2. What is the Indian legal position on buy back of shares?
---------------------- 3. What are SEBI guidelines for buy back of shares?

4. Which companies according to you should be buying back their shares?
----------------------
5. Why should the market price of a company that has bought back its shares
---------------------- increase?
---------------------- 6. What are the different types of methods used for buying back shares?
7. Why are MNCs buying back their shares?
----------------------
8. It has been observed that the share prices of some companies who have
---------------------- bought back their shares have quoted the buy back price below, what may
---------------------- be the reasons for this?

---------------------- 1. False
2. True
----------------------
----------------------
----------------------
160 Capital Market

Fill in the blanks.
----------------------
1. Buy-back is a way of returning surplus cash to shareholders.
----------------------
2. In Buy- back the decrease in share capital will increase the Earnings per
share. ----------------------
Fill in the blanks.
----------------------
1. Open market purchase is done by giving notice to the shareholders at least
seven days prior to buy-back. ----------------------
2. In Dutch auction method, the price of buy-back is done by the shareholders ----------------------
themselves like book building.
----------------------
1.
Ogilvie, John. 2008. CIMA Official Learning System Management ----------------------
Accounting Financial Strategy. Elsevier. ----------------------
2. Vermaelen, Theo. 2005. Share Repurchases. Now Publishers Inc.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Share Buy-Back 161

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
162 Capital Market

Portfolio Management and Financial Engineering
UNIT
10
Structure:
10.1 Introduction to Portfolio Management

10.2 Types of Portfolio Management
10.3 Qualities of Portfolio Manager
10.4 Steps in Portfolio Management
10.5 Criteria for Portfolio Decisions and Factors that influence Portfolio
Decisions
10.6 SEBI Regulations governing Portfolio Management Activities
10.7 Code of Conduct - Portfolio Manager
10.8 Financial Engineering
10.9 Factors Responsible for the Growth of F.E.
10.10 Tools of Financial Engineering
10.11 Categories of Financial Engineers
10.12 Products developed by Financial Engineers
Summary
Keywords
Suggested Reading
Portfolio Management and Financial Engineering 163

Notes
Objectives
----------------------
----------------------
●● State the functions of a portfolio manager.
---------------------- ●● Describe the advantages of portfolio management for individuals.
---------------------- ●● Assess the different types of portfolios and their management list the
qualities essential for a portfolio manager.
----------------------
●● Explain the steps in the management of a portfolio and analyse the
---------------------- factors that influence the decisions in portfolio creation.
---------------------- ●● State the concept of financial engineering.

●● Identity the factors that have contributed to the growth of financial
---------------------- engineering and the three main categories of financial engineers.
---------------------- ●● Explain some products developed by financial engineers.
----------------------
10.1 INTRODUCTION TO PORTFOLIO MANAGEMENT
----------------------
A portfolio is a collection of assets. In portfolio management, these assets
---------------------- are financial in nature. The portfolio manager invests the money in diverse
assets with the aim of maximizing return and minimizing the risk.
----------------------
According to SEBI, portfolio means the total holdings of securities
---------------------- belonging to one person.
Portfolio manager means any person who, pursuant to a contract with a
----------------------
client, undertakes the management of a portfolio of securities or the funds of the
---------------------- client.
---------------------- Functions of Portfolio Management

1. To frame investment strategy and select an investment mix.
----------------------
2. To provide a balanced portfolio, this will hedge against inflation and also
---------------------- optimise returns.
3. To make timely decisions regarding sale and purchase of securities.
----------------------
4. To maximise after tax return by investing part of the portfolio in tax
---------------------- savings investments.
Portfolio management can be institutional in nature. The mutual funds
----------------------
are a kind of portfolio schemes. Recently, many new Pension funds have been
---------------------- launched. These funds also have to build a portfolio so that a return can be
generated for the participants.
----------------------
Advantages of Portfolio Management for Individuals
---------------------- 1. Capital markets over a long period have always given a better return than
---------------------- any other investment.
2. The investment in stock markets by individuals is a complicated business.
---------------------- It is better that a professional handles this.
164 Capital Market

10.2 TYPES OF PORTFOLIO MANAGEMENT Notes
1. The discretionary portfolio management service (DPMS) ----------------------
In this type, the clients gives his money for investment to the manager, ----------------------
who handles the paperwork, makes all investment decisions and gives a
good return to the investors and charges a fee for the service rendered. ----------------------
2. The non-discretionary portfolio management service ----------------------
In this scheme the manager functions as a counselor, but the investor is free
----------------------
to accept or reject the manager’s advice; the paperwork is also undertaken
by the manager for a service charge. The manager concentrates on stock ----------------------
market instruments with a portfolio tailor made to the risk taking ability
of the investor. ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. The portfolio manager invests the money in diverse assets with the
aim of maximizing the ________ and minimizing the _____. ----------------------
2. ________, over a long period, have always given a better return than ----------------------
any other investment.
----------------------
Activity 1 ----------------------
----------------------
Create an ideal portfolio for yourself.
----------------------
10.3 QUALITIES OF PORTFOLIO MANAGER ----------------------
1. Sound general knowledge ----------------------
This is an exciting and challenging job. The atmosphere is uncertain and ----------------------
ever changing. Any news can affect the stock markets. He therefore must
be aware and well informed and must be able to use the information that ----------------------
he gets. ----------------------
2. Analytical ability
----------------------
A Portfolio Manager has to be good at analysing the information so that
he can make a good prediction about the behavior of the markets. His ----------------------
ability to analyse the economy and the industry is very important.
----------------------
3. Marketing skills
----------------------
A Portfolio Manager has to be a good salesman. He has to convince the
clients about the securities he is buying for the client or is recommending ----------------------
to the client.
----------------------

Notes 4. Experience
It is said that stock markets are cyclical in nature. He therefore must be
----------------------
aware of these cycles. Such experience can help him in taking proper
---------------------- decisions.
---------------------- 10.4 STEPS IN PORTFOLIO MANAGEMENT

---------------------- This is an ongoing process and following steps are taken:
---------------------- 1. Specification and quantification of investor objectives, constraints and
preferences in the form of policy statement.
----------------------
2. Determination and quantification of capital market expectations for the
---------------------- economy, market sectors, industries and individual securities.
---------------------- 3. Allocation of assets and selection of individual securities.
---------------------- 4. Performance measurement and evaluation of the portfolio to ensure that

investor’s objectives are attained.
---------------------- 5. Monitoring the performance and responding to changes in investor
---------------------- objective constraints and capital market expectations.
6. Rebalancing the portfolio whenever necessary.
----------------------
---------------------- 10.5 CRITERIA FOR PORTFOLIO DECISIONS AND

FACTORS THAT INFLUENCE PORTFOLIO
----------------------
DECISIONS
----------------------
Emphasis is on identifying the collective importance of all investor’s
---------------------- holdings. Each portfolio has to be tailored to the particular needs of its owners.
The strategies are required to be moulded to the unique needs and characteristics
---------------------- of the portfolio owner. The risk can be reduced by diversifying the portfolio.
---------------------- Since risk and returns are related, the important decision to make is the amount
of risk, which is acceptable.
---------------------- Investor’s Characteristics
---------------------- A study of investor’s characteristics such as age, health condition, personal
habits, business or professional situation and tax status affect the risk taking
----------------------
ability of an investor, and therefore his requirement of different securities. A
---------------------- young person for example may put more emphasis on growth and lesser on
liquidity. The investor’s responsibilities towards his family and the number of
---------------------- dependents on him will have an impact on his investment needs and goals.
---------------------- Liquidity needs
Liquidity needs vary considerably among investors. For this the portfolio
----------------------
should be built on the securities which are highly liquid in nature, if liquidity is
---------------------- the main criteria.
----------------------
166 Capital Market

Tax considerations Notes
Different individuals have different incomes and hence different tax
----------------------
liabilities. Tax treatment form, income form investment can be different for
different securities. Investors in high marginal tax brackets are faced with ----------------------
complex portfolio decisions. High tax bracket investors are interested in
investments that are designed to postpone a tax, or to reduce tax or to avoid ----------------------
paying taxes. They also will be interested in investing in Tax-free instruments.
----------------------
They may be also interested in getting their income through capital gains, as tax
on capital gains is lower than the income tax. ----------------------
Safety of Principal
----------------------
The protection of the value of the investment is the most important
objective of an investor. The investor is expected to invest in such securities, ----------------------
which would increase in value proportionate to the inflation to protect from
----------------------
the purchasing power loss of the money. The relative importance of safety of
principal has bearing on the degree of the risk an investor is willing to take. ----------------------
Assurance of Income ----------------------
Investors have different current income needs. If an investment income is
needed for current consumption, then this will become the prime objective. If ----------------------
current needs are fulfilled through other means then the investors will look for ----------------------
capital appreciation.
Investment Risk ----------------------
All investment decisions revolve around the trade-off between risk and ----------------------
return. All investors want maximum possible return from their investments, but
----------------------
are not always willing to take the necessary risk for such returns.
Interest Rate Risk ----------------------
Interest rate risk is the risk of loss of principal brought about by changes ----------------------
in the interest rate paid on new securities currently being issued. Increase
or decrease in interest rate will have an effect on the market prices of such ----------------------
securities. The investor therefore should be aware of this risk while making the
----------------------
investments in the fixed-income securities.
Business and Market Risk ----------------------
Changes in a company’s business fortunes would have an impact on the ----------------------

market prices of the company’s share prices. When stock markets are going
up, then most stocks will also rise; on the other hand when the stock prices are ----------------------
falling then most stocks will fall. This behaviour may not be in line with the ----------------------
company’s financial and other fundamentals.
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
1. A Portfolio Manager has to be good at analysing the information so
---------------------- that he can make a good prediction about the behavior of the markets.
---------------------- 2. A Portfolio Manager has to be a good operation manager.
---------------------- 3. The protection of the value of the investment is the most important
objective of an investor.
----------------------
----------------------
Activity 2
----------------------
---------------------- Create a portfolio for a 30 years old person with a monthly income of Rs.
50,000/-.
----------------------
---------------------- 10.6 SEBI REGULATIONS GOVERNING PORTFOLIO

---------------------- MANAGEMENT ACTIVITIES
---------------------- 1. A portfolio manager must register himself with the SEBI.

2. The applicant needs to have necessary infrastructure.
----------------------
3. He must have in his employment at least two persons who are experienced
---------------------- in the business of portfolio management.
---------------------- 4. The applicant must fulfill the capital adequacy norms laid down from
time to time.
----------------------
5. The applicant must not be involved in any litigation connected with the
---------------------- securities market.
---------------------- 6. He must have the professional qualifications from a recognized institution
in finance, law, and accountancy or business management.
----------------------
7. The applicant has to pay registration fees as are in force.
---------------------- 8. Portfolio manager must enter into an agreement clearly defining the
---------------------- inter se relationship, and setting out their mutual rights, liabilities and
obligations relating to management of the portfolio of the client.
---------------------- 9. The funds of all clients shall be placed by the portfolio manager in a
---------------------- separate account to be maintained by his in a scheduled commercial bank.
10. The portfolio manager shall charge an agreed fee from the client for
---------------------- rendering portfolio management services without guaranteeing or
---------------------- assuring, either directly or indirectly any return and such fee shall be
independent of the return to the client and shall not be on a return sharing
---------------------- basis.
168 Capital Market

11. The portfolio manager shall not accept money or securities from his client Notes
for a period of less than one year.
----------------------
12. Any renewal of portfolio fund on maturity of the initial period shall be
deemed as a fresh placement and shall be for a minimum period of one ----------------------
year.
----------------------
13. The portfolio manager shall purchase or sell securities separately for each
client. ----------------------
11.7 CODE OF CONDUCT -PORTFOLIO MANAGER ----------------------
----------------------
1. In conduct of his business he shall observe high standards of integrity and
fairness in all dealings. ----------------------
2. The client’s money should be deployed as soon as possible and money
----------------------
due and payable to a client should be paid forthwith.
4. He shall render at all time high standards of services, exercise due ----------------------
diligence, ensure proper care and exercise independent professional
----------------------
judgment.
5. He shall not get involved in unfair competition. ----------------------
6. He should not disclose any confidential information about his client. ----------------------
7. A portfolio manager shall not be a party to: ----------------------
a) Creation of false market in securities.
----------------------
b) Price rigging or manipulation of securities.
----------------------
c) Passing of price sensitive information to any participants in the
market. ----------------------
10.8 FINANCIAL ENGINEERING ----------------------
----------------------
Financial engineering (FE) is a new discipline that has emerged in the late
80s. The bankers of London introduced the term. This innovative technology ----------------------
emerged in response to the rapid changes in corporate finance; bank finance
and investment finance to enable managers to deal better with the changes. ----------------------
New problems in the field of finance require new and innovative products.
----------------------
Financial engineering is R & D in the finance field. New products have to be
developed to overcome financial obstacles in the path of attaining the goals of ----------------------
the organisation.
----------------------
American Association of Financial Engineers (AAFE) defines financial
engineering as “the development and creative application of financial technology ----------------------
to solve financial problems and exploit financial opportunities.”
----------------------
Financial Engineering is very different from financial analysis. Financial
engineering starts where financial analysis ends. The analysis establishes the ----------------------
problems and the probable causes of the problem. On the other hand a financial
engineer puts together the established knowledge for the formulation and ----------------------

Notes implementation of new processes and products that he devises in response to
the existing problem, with the intention of solving the problem.
----------------------
Financial Engineering involves the design, development, and
---------------------- implementation of innovative financial instruments and processes. It seeks
to formulate creative solutions to manage financial risks or problems such as
---------------------- reduction in costs in the existing system and to develop new products, services
and markets.
----------------------
---------------------- 10.9 FACTORS RESPONSIBLE FOR THE GROWTH OF F.E.

---------------------- Price volatility
---------------------- Globalisation of financial markets
Tax asymmetries
----------------------
Technological advances
----------------------
Advances in financial theory
---------------------- Regulatory changes
---------------------- Increased competition
---------------------- Cost of information and cost of transaction
Intra firm factors such as liquidity needs of the business
----------------------
Risk aversion of managers and owners
----------------------
Pressure on profitability
---------------------- Greater levels of quantitative sophistication among investment managers
----------------------
----------------------
Fill in the blanks.
----------------------
1. A portfolio manager must register himself with the _________.
----------------------
2. The portfolio manager shall not accept money or securities from his
---------------------- client for a period of less than _________.
---------------------- 3. AAFE stands for _________.
----------------------
---------------------- Activity 3
---------------------- Can you find out any more factors specific to India that could be added to
the list above?
----------------------
----------------------
----------------------
170 Capital Market

10.10 TOOLS OF FINANCIAL ENGINEERING Notes
There are two types of tools that are used in F E. One is Conceptual and ----------------------
the other is Physical.
----------------------
Conceptual Tools
Ideas and concepts, which underlie finance as a formal discipline. They ----------------------
include Valuation Theory, Portfolio and Hedging Theory, Tax Treatment. ----------------------
Physical Tools
----------------------
Instruments and processes which can be pieced together to accomplish
some specific purposes e.g. fixed income securities, Equity/Swaps/Futures/ ----------------------
Options etc.
----------------------
The process of FE is to identify risks. Once the risks are identified, they
need to be measured. This has to be related to the outcomes that are to be ----------------------
achieved through the process of financial engineering.
----------------------
10.11 CATEGORIES OF FINANCIAL ENGINEERS ----------------------
The first are Deal Makers ----------------------

These are the Marketers. They are on the look out for corporates who are ----------------------
looking for innovative and creative solutions for their financial requirements.
----------------------
We can take an example here. Some finance companies like housing
finance companies lend money long term. This entails blocking of money over ----------------------
a long period of time and thus their requirement of funds is ever increasing.
The dealmakers realised this. When the idea generators addressed this problem, ----------------------
they came out with a solution of Securatisation, wherein illiquid assets can be ----------------------
converted into cash.
The second category is that of Idea Generators ----------------------
They are the innovators. They work on the requirements of corporates ----------------------
as identified by the dealmakers. Once they know what the client is looking for
they use all tools at their disposal to create a product that will serve the purpose ----------------------
of the client. They have to take care and see that the product that they develop ----------------------
will be attractive for the investors or the lenders. The real financial engineering
probably happens here. Therefore this is the crucial area for the success of the, ----------------------
product ultimately. These engineers have to be well versed in the theory of
finance and mathematics. The idea generators or all financial engineers for that ----------------------
matter view problems as personal challenge. ----------------------
Reliance Industries was the first company to introduce the concept of
----------------------
Convertible Debentures in India. This was a completely new product that was
developed, keeping in mind the company’s requirements. ----------------------
The final category of the financial engineers is known as Loophole
----------------------
Exploiter
----------------------

Notes They are also interestingly known as Outlaws. They do not do or propose
to do anything illegal. What they actually try and do is to find loopholes in
---------------------- the existing legal system that can be exploited to create an innovative product.
They, therefore, are required to the laws very well and they have to study the
---------------------- law in minute details to try and find the loopholes which can be exploited by
---------------------- them.
Few years back the dividend was made tax free in the hands of the receiver.
----------------------
However, the companies were asked to pay dividend distribution tax on the
---------------------- dividends paid by them. At this time the companies were not very happy that
they would have to pay this tax, enter the Outlaws. They found a way out, which
---------------------- would be available only for one year. The companies were asked to declare
interim dividends before the financial year-end of March end. They argued that
----------------------
in this case the dividend tax would not have to be paid by the companies for
---------------------- that year at least. The interim dividend was to be converted into final dividend
for that year. This worked out successfully for the companies who accepted
---------------------- this advice. When the government decided to make the dividend taxable in the
hands of the receiver again, the outlaws were again at work. This time also they
----------------------
decided to pay interim dividend to protect their shareholders from the tax for
---------------------- one year. But, this time the government had learnt the lesson of the last time and
they invoked provisions of the Company’s Act to stall this move successfully.
----------------------
---------------------- 1. The process of financial engineering is to identify risks.
---------------------- 2. TATA Industries was the first com
----------------------
Activity 4
----------------------
Find out the products that were developed in response to the changes /
----------------------
introduction of new taxes in India.
----------------------
---------------------- 10.12 PRODUCTS DEVELOPED BY FINANCIAL ENGINEERS

---------------------- We shall now take a look at some of the products that are developed by
the financial engineers over a period of time.
----------------------
One of the most effective products that was used in Indian stock markets
---------------------- for a long time was Badla. This product allowed investors who did not have
shares in their possession to sell them, while it made it possible for investors
----------------------
who had no funds to buy shares through this mechanism. Investors who had
---------------------- no shares were lent shares and investors who were short of funds were lent
funds, through the Badla mechanism at a rate of interest rate that was market
---------------------- determined. The Badla system has now been banned by SEBI.
172 Capital Market

The system of derivatives trading which has replaced the Badla is also Notes
a financial engineered product. Today, there is more trade done in the form of
options and futures not only in stock markets but also in the commodity markets ----------------------
and the forex markets. In India, the commodities future market was always
operative in commodities like turmeric. Now the scope of these markets has ----------------------
been widened to include many other products. This market is at the take off ----------------------
stage now.
----------------------
Another product that came to the market in the recent past was the
securatisation of future debts. This product was created for the Reliance Oil ----------------------
and was executed by ICICI. Reliance was given rights for oil exploration in
certain blocks by the government. Once it was established that the said block ----------------------
has potential of producing crude oil, the deal was developed. An assumption
----------------------
was made of the likely billing of the company from this oil field. Part of this
future sale proceeds were then securatised by ICICI. In short, through this deal ----------------------
Reliance got cash upfront, thus reducing their funds requirement. What helped
in this deal was the credit enhancement provided through a corporate guarantee ----------------------
given to Reliance Industries Ltd. in favour of ICICI.
----------------------
We have already discussed the issue of bonus debentures issued by HLL.
This is brilliantly engineered financial instrument that was innovated to take ----------------------
care of the requirement of the company and also keeping in mind the interest of
----------------------
the shareholders of the company.
Another financially engineered product that has been recently introduced ----------------------
in the markets by government of India is the Tax Free Bonds carrying tax-free
----------------------
interest of 6.75% for converting US 64 units into these bonds. This again is a
wonderful product. The investors, who were unable to get redemption for their ----------------------
holdings, got a new investment opportunity and also were able to get out of
their US64 investment. This also saved the government from finding Rs.3, 500 ----------------------
crores it was committed to give to UTI towards the redemption of these units.
----------------------
Another financially engineered product that was used by the government
was known as Oil Bonds. This was before the administered price mechanism ----------------------
in oil sector was abolished. When the oil prices went up in the international ----------------------
markets and the government was unable to increase the domestic prices, the
oil companies had to be compensated as their selling price was less than their ----------------------
purchase and processing cost. Since government in this situation had to fund
this deficit through the budget, the budget deficits would go awry. As they did ----------------------
not want to do this, a new product was devised. The government floated Oil ----------------------
Bonds. The banks subscribed to these bonds for their investment portfolio.
The bonds carried an attractive coupon rate to entice the investors. The amount ----------------------
thus raised was paid to the oil companies. These bonds were redeemed when
international oil prices fell, thereby generating surpluses in the oil pool account. ----------------------
Many mutual funds have developed new products. Some of these products ----------------------
are index-related funds, funds that track the PE of markets and individual
companies. The latest development in this market is likely to be mutual fund ----------------------
devoted to real estate markets. HDFC Mutual is already working on this. With ----------------------

Notes securatisation becoming popular in India, there is no doubt that many new
products related to this will soon come to the market.
----------------------
----------------------
Activity 5
---------------------- Find out new products that can be developed in the future in India.
----------------------
Summary
----------------------
●● I n this unit, we have studied about portfolio Management, functions of
----------------------
portfolio manager and advantages for individual investors. We have also
---------------------- learnt about the different types of portfolios and the qualities a portfolio
manager should possess. This unit has also acquainted us with the steps
---------------------- in portfolio management of the factors that are likely to influence the
creation of portfolio with special inputs of SEBI guidelines for Portfolio
----------------------
Management.
---------------------- ●● We have also studied about the concept of financial engineering with
factors that have contributed to the growth of financial engineering.
----------------------
Finally, we have dealt with some of the products that are developed by
---------------------- the financial engineers.
----------------------
Keywords
----------------------
●● Code of Conduct: The ethical way in which a portfolio manager is
---------------------- expected to behave.
●● Deal makers: They find out the corporates’ needs for new products.
----------------------
●● Interest rate risk: Risk that is inherent due to changes in the rate of
---------------------- interest.
---------------------- ●● Idea generators: The people who actually design a financial product.
●● Out laws: The financial analysts who spot loop holes in the law that can
---------------------- be exploited to create a new product.
---------------------- ●● Portfolio: The different types of assets invested in by an investor.
---------------------- ●● Tax asymmetries: The structure of taxes that may keep changing from
time to time, making it necessary to redesign a product.
----------------------
---------------------- 1. Describe the products that you think are financially engineered.
2. Write a note on what Financial Engineering is and what are the prerequisites
----------------------
of financial engineering.
---------------------- 4. What is meant by portfolio management?
---------------------- 5. What are the qualities and responsibilities of a portfolio manager?
174 Capital Market

6. Explain the code of conduct required for Portfolio Managers. Notes
7. “HLL’s Bonus debentures are financially engineered product.” Do you
----------------------
agree? Comment.
8. Why do you think financial engineering is important for financial markets? ----------------------
----------------------
----------------------
----------------------
Fill in the blanks.
1. The portfolio manager invests the money in diverse assets with the aim of ----------------------
maximizing the return and minimizing the risk.
----------------------
2. Capital markets, over a long period, have always given a better return
than any other investment. ----------------------
----------------------
----------------------
1. True
----------------------
2. False
3. True ----------------------
----------------------
Fill in the blanks.
----------------------
1. A portfolio manager must register himself with the SEBI.
----------------------
2. The portfolio manager shall not accept money or securities from his client
for a period of less than one year. ----------------------
3. AAFE stands for American Association of Financial Engineers. ----------------------
----------------------
----------------------
1. True ----------------------
2. False ----------------------
----------------------
Suggested Reading
----------------------
1. Reilly, Frank, Keith Brown. 2011. Investment Analysis and Portfolio
Management. Cengage Learning. ----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
176 Capital Market

Corporate Governance
UNIT
11
Structure:
11.1 Introduction
11.2 Background for Formation of Birla Committee
11.3 Mandatory Recommendations of Birla Committee
11.4 Some Recent Developments
11.5 Clause 49 of the Listing Agreement
Case Study
Summary
Keywords
Suggested Reading
Corporate Governance 177

Notes
Objectives
----------------------
----------------------
●● Describe the concept of corporate governance.
---------------------- ●● Appreciate the historical perspective of its growth.
---------------------- ●● Discuss the background to the formation of the Birla committee.
---------------------- ●● Explain the mandatory recommendations of the Birla committee.
●● Judge recent developments in the wake of greater awareness related
---------------------- to corporate governance.
---------------------- ●● Explain what Clause 49 is and its importance.
----------------------
11.1 INTRODUCTION
----------------------
How does one define CORPORATE GOVERNANCE? Essentially it
---------------------- covers the gamut of activities having a direct or indirect effect on the health of the
entity. Nobel Laureate MILTON FRIEDMAN stated “Corporate Governance is
---------------------- to conduct business in accordance with Shareholders’ desire while confirming
---------------------- to local laws and customs”. More recently the President, World Bank - J.
Wolfensohn made a more contemporary definition of the same. “Corporate
---------------------- Governance is all about promoting Corporate Fairness, Transparency and
Accountability”. How much of this is pertinent and is really followed today
---------------------- remains to be seen.
---------------------- Historical Perspective
---------------------- The concept of CORPORATE GOVERNANCE in its present form is
rather new. The seeds of CORPORATE GOVERNANCE were laid during
---------------------- the Watergate scandal that shook the presidential house in the United States.
Also, 1980’s were characterised by a string of high profile business failures. An
----------------------
investigation into these pinpointed the fault to.
---------------------- ●● Lack of proper internal controls
---------------------- ●● Absence of independent audits (internal as well as external)
---------------------- 11.2 BACKGROUND FOR FORMATION OF BIRLA

---------------------- COMMITTEE
---------------------- It was to prevent the reoccurrence of the same that the CADBURY
Committee was set up. The report submitted by Sir Cadbury proved to be a
---------------------- landmark in the field of CORPORATE GOVERNANCE. Concurrently, India
could not stand isolated in this fast changing scenario. A number of financial
----------------------
scams back home prompted the government to set up a committee under the
---------------------- chairmanship of Kumarmangalam Birla.
----------------------
178 Capital Market

The objective of the committee was “enhancement of the long-term Notes
shareholders’ value while at the same time protecting the interests of other
stakeholders.” ----------------------
The key recommendations of the report were; ----------------------
Board of Directors - It provides leadership, strategic guidance and objective
----------------------
judgement independent of management to the company and exercises control
over the company, while remaining at all times accountable to the shareholders. ----------------------
The Board has five basic responsibilities
----------------------
●● Overseeing Strategic Development and Planning
----------------------
●● Management Selection, Supervision and Upgrading
●● Maintenance of Good Member Relations ----------------------
●● Protecting and optimising the Organizations’ Assets ----------------------
●● Fulfilling Legal Requirements
----------------------
Composition of the Board of Directors - Lays emphasis on the caliber of the
non-executive directors. Independent directors have a key role. ----------------------
This is an important issue in the Indian context. A major chunk of shares ----------------------
were held by financial institutions like UTI, IFCI etc. which could be termed
as quasi - government institutions. They would appoint a director, who would ----------------------
generally not have any sector specific knowledge. In the process however it is
----------------------
the company that suffers.
Audit Committee ----------------------
Key components ----------------------
The board, the internal auditor and the outside auditors ----------------------
Disclosures of Remuneration Package
----------------------
Board meetings should be held at least four times in a year
----------------------
The report stressed the importance of the proxy voting / ballot system.
A few years back, companies would hold their AGM in the most remote location ----------------------
possible. It would be guaranteed to be the most inaccessible place. The reason ----------------------
for this obviously is to avoid facing shareholder’s wrath or get some crucial
resolutions passed. ----------------------
Functions of the Management ----------------------
Chief Executive, Executive-directors and the key managers are as follows:
----------------------
●● Assisting the board in its decision making process
●● Implementing the policies and code of conduct of the board ----------------------
●● Ensuring compliance of all regulations and laws ----------------------

●● Providing timely, accurate, substantive and material information ----------------------
----------------------

Notes The Shareholders
●● Have certain rights and responsibilities
----------------------
●● Effectively participate in General Body Meetings
---------------------- ●● Should demand complete information
---------------------- (Annual General Meetings in obscure places)
---------------------- However, the report ended with a note of Caution

It stated that no “one size fits all.” Structure possible
----------------------
ethics should play an important role.
----------------------
It is a continuously evolving system.
---------------------- Reasons for failure in spite of these norms
---------------------- ●● Ineffective leadership
---------------------- ●● Incompetence of the Board Members
●● Lack of mutual trust
----------------------
●● Time deficit
---------------------- ●● Constant change
---------------------- ●● Less predictability in decision making
●● Need for quicker decisions.
----------------------
●● Superficial commitment to vision, mission and values
----------------------
----------------------
---------------------- 1. Corporate Governance is to conduct business in accordance with

Shareholders’ desire while conforming to local laws and customs.
----------------------
2. A number of financial scams back home prompted the government to
---------------------- set up a committee under the chairmanship of Chole.
----------------------
---------------------- Activity 1
---------------------- Find out from any published balance sheet as to what a company has done
for the shareholders.
----------------------
----------------------
----------------------
----------------------
----------------------
180 Capital Market

11.3 MANDATORY RECOMMENDATIONS OF BIRLA Notes
COMMITTEE
----------------------
Board of Directors
----------------------
There should be a combination of Executive and Non-executive Directors.
The board should consist of not less than 50% of Non-executive Directors in case ----------------------
of an executive chairman and not less than 1/3rd of Non-executive Directors in
----------------------
case of a Non-executive Chairman.
Audit Committee ----------------------
a) The board should appoint a qualified and independent audit committee. ----------------------
The committee should have minimum three members, all being non-
executive directors, with majority being independent, and at least one ----------------------
director having financial and accounting knowledge. ----------------------
b) The chairman of committee should be independent director and should be
present at company AGM. ----------------------
c) The chairman should invite Finance director, Head of internal audit and ----------------------
representative of External auditor for committee meetings. Company
secretary should act as secretary of the committee. ----------------------
Powers of the Audit Committee ----------------------

The audit committee should look into the reasons for substantial default ----------------------
to depositors, creditors, debenture holders and shareholders.
----------------------
Frequency of meetings and quorum
The committee should meet at least thrice a year, once before finalisation ----------------------
of annual accounts and once compulsorily every six months. Quorum should be ----------------------
either two members or 1/3rd of audit committee, whichever is higher, and there
should be minimum two independent directors. ----------------------
Remuneration ----------------------
The board of directors should decide remuneration of non-executive
directors. ----------------------
All elements of the package inclusive of salary benefits, bonuses, stock ----------------------
options, etc. should be disclosed.
----------------------
Committee membership of directors
----------------------
Directors should not be members of more than ten committees and
Chairman of not more than five committees. Directors need to disclose about ----------------------
their membership with other committees to the company.
----------------------
Shareholders’ Committee
This committee would be framed to attend to shareholders’ grievances ----------------------
and board of the company should delegate power of checking share transfer to ----------------------
either officer or committee or to registrar and share transfer agents.
----------------------

Notes Information to be placed before Board of Directors
●● Annual operating plans, budgets and an updates.
----------------------
●● Capital budgets and any updates.
---------------------- ●● uarterly results for the company and its operating divisions or business
Q
---------------------- segments.
●● inutes of meetings of audit committee and other committees of the
M
---------------------- board.
---------------------- ●● he information on recruitment and remuneration of senior officers
T
just below the board level, including appointment or removal of Chief
---------------------- Financial Officer and the Company Secretary.
---------------------- ●● atal or serious accidents, dangerous occurrences, any material effluent
F
or pollution problems.
----------------------
●● ny material default in financial obligations to and by the company, or
A
---------------------- substantial non-payment for goods sold by the company.
●● ny issue, which involves possible public or product liability claims of
A
----------------------
substantial nature, including any judgement or order which, may have
---------------------- passed strictures on the conduct of the company or taken an adverse view
regarding another enterprise that can have negative implications on the
---------------------- company.
---------------------- ●● Details of any joint venture or collaboration agreement.
●● ransactions that involve substantial payment towards goodwill, brand
T
---------------------- equity, or intellectual property.
---------------------- ●● ignificant labour problems and their proposed solutions. Any significant
S
development in Human Resources/ Industrial Relations front like signing
---------------------- of wage agreement, implementation of Voluntary Retirement Scheme,
---------------------- etc.
●● ale of material nature, of investments, subsidiaries, assets, which is not
S
---------------------- in normal course of business.
---------------------- ●● uarterly details of foreign exchange exposures and the steps taken by
Q
management to limit the risks of adverse exchange rate movement, if
---------------------- material.
---------------------- ●● on-compliance of any regulatory, statutory nature or listing requirements
N
and shareholders service such as non-payment of dividend, delay in share
---------------------- transfer, etc.
----------------------
----------------------
----------------------
----------------------
----------------------
182 Capital Market

Notes
----------------------
Fill in the blanks.
----------------------
1. The board should consist of not less than ________ of Non-Executive
directors in case of an executive Chairman. ----------------------
2. ________ should not be members of more than ten committees and ----------------------
Chairman of not more than five committees.
----------------------
Activity 2 ----------------------
----------------------
From the same balance sheet, find out the disclosures reported in line with
the recommendations of the Birla committee. ----------------------
----------------------
11.4 SOME RECENT DEVELOPMENTS
----------------------
When Infosys decided that in AGM, the company will allow its 92,000
----------------------
shareholders to vote on the resolutions on the agenda through the postal ballots.
This is perhaps the first time that this is happening in the history of corporate ----------------------
India. The management in its notice for AGM says that it acknowledges not
all shareholders are able to attend the AGM of the company. Due to this, the ----------------------
response of the vast majority of shareholders to the proposals is not recorded.
----------------------
Infosys is making use of the Department of Company Affairs (DCA)
recent rules for the postal ballot, which requires that certain items of the business ----------------------
needing shareholders, consent necessarily need to be voted on through a postal
----------------------
ballot. Besides this Section 192 A of the Companies act allows the companies to
present other items of business not covered in the rules to be voted on through ----------------------
a postal ballot.
----------------------
To attract top quality professional to join the Boards of companies as
independent directors, the DCA is planning to substantially raise the ceiling on ----------------------
the sitting fees of the directors. There are reports that these fees may be raised
to Rs. 20 to 25,000 per meeting. The prevailing ceiling is Rs. 5,000 per meeting. ----------------------
Various industry groups have sent representations to the government ----------------------

for relaxation of the remuneration ceiling, citing difficulty in attracting top
professionals to join the boards of companies as independent directors. ----------------------
The responsibilities of Non-Executives directors have increased manifold ----------------------

in recent years but their compensation has not kept pace with this. The
----------------------
Government has now raised the maximum sitting fees of these directors to Rs.
20, 000. Many companies like Reliance, HLL, Tata Motors, HDFC, ICICI Bank ----------------------
and L & T have increased the sitting fees of their directors to this level. Many
more companies are likely to follow in the months to come. This is a good ----------------------
development. The companies will now be in a position to attract the required
----------------------
talent on their boards.

Notes The DCA is also considering a proposal that will allow ex-employees of
the company to join the boards of the companies as independent directors after
---------------------- a three year cooling period.
----------------------
Activity 3
----------------------
Find out which other companies have followed the example set by Infosys
---------------------- and what have they done in this respect.
----------------------
---------------------- 11.5 CLAUSE 49 OF THE LISTING AGREEMENT

---------------------- There has been a lot of discussion these days about this clause, which
has been amended recently by SEBI. Let us now understand what this clause
---------------------- means.
---------------------- Clause 49 lays down tighter qualification criterion for independent
directors to be appointed to the Board of the companies. It disqualifies material
---------------------- suppliers and customers, a shareholder with more than 2% stake in the company,
---------------------- a former executive of the company who left the company less than three years
earlier from being appointed as independent director. Partners of current legal,
---------------------- audit and consulting firms as well as partners of such firms that had worked in
the company in the preceding three years are also not eligible to be appointed
---------------------- as independent directors. A relative of a promoter, or an executive director
---------------------- or a senior executive one level below an executive director, too cannot be an
independent director.
---------------------- The minimum gap between two board meetings has been reduced from
---------------------- four to three months. The original Clause 49 has given freedom to the board
to decide whether a materially significant relationship between a director and
---------------------- the company affected his independence, the new clause has taken away this
discretionary power from the board.
----------------------
The new clause also makes it mandatory for the audit committee a
---------------------- minimum of four times in a year with a maximum gap of four months. It also
states that all members of this committee have to be financially literate and
----------------------
at least one should have financial or accounting management expertise. It has
---------------------- defined the terms ‘financial literacy’ and ‘accounting and related financial
management expertise’. It has also strengthened and widened the role and
---------------------- responsibility of the audit committee.
---------------------- The clause recognises nominee directors of financial institutions as
independent directors.
----------------------
This clause requires the board to lay down a code of conduct for all
---------------------- board members and the senior management of the company that they have to
compulsorily follow.
----------------------
----------------------
184 Capital Market

The CEO and the CFO will have to certify the financial statements and Notes
the cash flow statements of the company.
----------------------
At least one independent director of the holding company will be a
member of the board of a material non-listed subsidiary. ----------------------
The audit committee of the listed company shall review the financial
----------------------
statements of the unlisted subsidiary, in particular its investments.
While preparing financial statements, the company follows a treatment ----------------------
that is different from that prescribed in the accounting standards, it must disclose
----------------------
this in the financial statements and the management should also provide an
explanation for doing so in the corporate governance report of the annual report. ----------------------
The company will have to lay down procedures for informing the board ----------------------
members about the risk management and minimization procedures.
Where money is raised through public issues, right issues etc. the ----------------------
company will have to disclose the uses/applications of the funds according to ----------------------
major categories (Capital expenditure, working capital, marketing costs etc.)
as a part of quarterly disclosure of financial statements. Further, on an annual ----------------------
basis, the company will prepare a statement of funds utilised for purposed other
than those specified in the offer documents/prospectus and place it before the ----------------------
audit committee. ----------------------
The company will have to publish its criterion for making its payments to
non-executive directors in its annual report. ----------------------
It has been reported that many Indian companies are on the look out for ----------------------
good quality persons for appointing them as independent directors on their
----------------------
boards. Some companies have already moved forward in this direction.
One company that has moved rapidly in this direction is Godrej. The board ----------------------
meetings of Godrej Consumer Products last at least for half a day. The company
----------------------
also arranges a two days off-site strategic board meeting once a year. Mr. Adi
Godrej, Chairman of the group is quite clear about what he expects from his board ----------------------
and more specifically independent directors. He says, ‘Independent Directors’
are supposed to provide tremendous value to the company’s performance. We ----------------------
pay them well and expect them to spend quality time with the company.
----------------------
Infosys is of course the leading company to take tremendous initiatives
in this field. It pays the highest sitting fees to its Directors. Infosys also has ----------------------
a peer review system in place wherein the directors are required to rate each ----------------------
other on seven parameters. Every year the directors are also asked to list their
contribution to the board and areas where they think they could have done ----------------------
better.
----------------------
With the application of Clause 49 imminent the back of the envelope
calculations suggest that there is a requirement of around 2500 independent ----------------------
directors for just the top 500 companies listed on the stock exchanges.
----------------------
----------------------

Notes
----------------------
----------------------
1. The minimum gap between two board meetings has been reduced
---------------------- from four to three months.
---------------------- 2. The new clause also makes it mandatory for the audit committee a
minimum of four times in a year with a maximum gap of four months.
----------------------
----------------------
Activity 4
----------------------
Find out why some companies were opposing the implementation of
---------------------- Clause 49.
----------------------
----------------------
Case study
----------------------
Ambani vs. Ambani
----------------------
One of the most interesting cases in corporate governance that was news
---------------------- practically daily since the end of the 2004 was the case of Reliance Industries.
The Ambani brothers had been fighting it out in the full public glare the
---------------------- ownership issues in the flagship company and the status of Reliance Infocom.
The late Dhirubhai Ambani happened to have not left a will. The ownership
----------------------
of shares in Reliance Industries was shrouded in mystery as a lot of stock had
---------------------- been controlled by a slew of investment companies, apart from the promoters
holding that is of public knowledge. It seems that the voting rights of these
---------------------- shares are conferred on the Chairman of Reliance Industries.
---------------------- Having appointed Mr. Mukesh Ambani as Chairman of the company
after the death of Dhirubhai, he had total control on the flagship company,
---------------------- a fact that is resented by Mr. Anil Ambani. The company controls
controlling stake in many other group companies including Reliance
----------------------
Energy and Reliance Capital, which are under the management control of
---------------------- Mr. Anil Ambani. The parent company has also got a huge stake in Reliance
Infocom, wherein Mr. Mukesh Ambani has been shown as the promoter, though
---------------------- a lot of the investment has actually come from Reliance Industries.
---------------------- Mr. Mukesh Ambani has been allocated 12% equity in Reliance Infocom
as Sweat Equity for a sum of Rs. 50 crores and a large number of shares
---------------------- were allotted to two companies at face value on preferential basis. These two
companies have since surrendered these shares following the uproar caused
----------------------
after that disclosure. It has been argued that Reliance Industries were allotted
---------------------- shares in Infocom at a premium while the others got them at the face value, thus
defrauding the shareholders on Reliance Industries.
----------------------
186 Capital Market

It can thus be seen that India’s largest private sector group with a combined Notes
turnover of over Rs. 1,00,000 crore is in turmoil not because the stakeholders
or regulators have asked for strict disclosures but because of the infighting ----------------------
between the two brothers. If any proof is required that family run businesses
that are supposed to be professional do have a soft under belly and family feuds ----------------------
like this one can cause enormous harm not only to the shareholders but also to ----------------------
the economy at large.
----------------------
It must however be mentioned that in spite of this public feud the
performance of the most of the group companies does not seem to have been ----------------------
affected so far. At least in the operations part, the professional managers and the
brothers have behaved in a responsible manner. However, this has had an impact ----------------------
on the share prices of the group companies as the prices of the companies’
----------------------
shares have probably not been reflecting their fair value, especially in a bull
market. ----------------------
There have been efforts to resolve the ownership issue by dividing the
----------------------
companies and each brother getting management control over some of the
companies and buying the other out from the companies under his control. The ----------------------
valuation and compromise deal is to be worked out by Mr. Kamat, Chairman
of ICICI Bank, who is also close to the family. However, the final settlement ----------------------
seems to be still elusive.
----------------------
Recently, Mr. Anil Ambani refused to sign the final balance sheet of
Reliance Industries. He has accused the board and the management of the ----------------------
company of the violation of corporate governance practices. On the other
----------------------
hand, Reliance Industries has accused Reliance Energy of not having shared
some vital information with them, as they are the largest shareholders of that ----------------------
company.
----------------------
It must be noted that Reliance is not the only company where the holding
of promoters is a matter of concern. It is quite possible that this is the problem ----------------------
with many other private sector companies. It is high time that the regulators
get their act together and force the managements to revel their shareholding ----------------------
through investment companies. One of the most important things that need to ----------------------
be probed is the source of funds for these companies and the identity of the
shareholders of these companies. ----------------------
Mr. Anil Ambani has written many letters to the market regulator SEBI ----------------------
pointing out omissions on the part of Reliance Industries in respect to corporate
governance guidelines. He has also accused the board of ignoring the interests ----------------------
of the shareholders. The regulator has announced that it is looking at all matters
related to the Reliance. ----------------------
In the recent past, we have witnessed problems in Bajaj family over ----------------------
ownership, but that seems to be on its way to amicable settlement among the
family members after a lot of acrimony played publicly, though not in the same ----------------------
manner of Reliance. ----------------------
The Birla family is embroiled in the controversy of the Will left by
----------------------
Priyamwada Birla that gives all her rights to Mr. Lodha. This will has been

Notes challenged by Birla family in the High court. The final decision in this matter is
awaited.
----------------------
It has been argued in some quarters that the funds in these companies are
---------------------- actually brought in by the promoters themselves, by first siphoning the funds
off from the parent companies. It is argued that pre liberalisation was the most
---------------------- preferred way adopted by various owners and some of the funds may have also
come in through the Havala way.
----------------------
All this suggests that Indian corporate has still a long way to go before
---------------------- best practices of Corporate Governance become apparent. It is also true that
SEBI does not seem to be pro active in this matter to the extent it needs to
----------------------
be. There has been talk suggesting that the company’s Act may be completely
---------------------- overhauled to take into account the developments that have come to the fore
post liberalisation and due to the need for integrating Indian practices with the
---------------------- best practices of the world.
---------------------- The need of the hour is that the government and SEBI need to act together
and create an environment to foster the spirit of Corporate Governance.
----------------------
---------------------- Summary
---------------------- ●● In this unit, we tried to understand the meaning of corporate governance

and the historical background of the development of the corporate
---------------------- governance. We have also studied the background against which Birla
committee was formed in India.
----------------------
●● We have studied the mandatory recommendations of Birla committee. We
---------------------- have also looked at the recently introduced Clause 49. We have seen some
recent developments. Finally, we have taken a look at some cases related
----------------------
to the practice of corporate governance.
----------------------
Keywords
----------------------
●● Audit committee: One of the most important committee that must
----------------------
oversea financial operations of a company.
---------------------- ●● Birla committee: The committee that prepared the road map for corporate
governance practices in India.
----------------------
●● Committees of Board: Different committees that need to be formed from
---------------------- among the board members as required by the law.
---------------------- ●● Clause 49: This is the important clause that is added to the listing
agreement.
---------------------- ●● Non-executive Chairman: Person who is the Chairman of the board but
---------------------- does not participate in day to day management.
----------------------
----------------------
188 Capital Market

Notes
----------------------
1. What is meant by Corporate Governance?
2. Write a note on the importance of different committees of the Board. ----------------------
3. What are the different committees of the board that need to be formed? ----------------------
4. Explain the recommendations of Birla committee. ----------------------
5. Explain the Clause 49 and its importance.
----------------------
6. Write a note on Ambani problem and explain it with reference to the
corporate governance. ----------------------
7. Find out what are the recommendations of Narayan Murthy committee on ----------------------
corporate governance.
----------------------
8. Some credit rating agencies are rating companies on their adherence to
corporate governance practices. Find out how they have rated companies ----------------------
in the last two years.
----------------------
1. True
----------------------
2. False
----------------------

1. The board should consist of not less than 50% of Non-Executive directors ----------------------
in case of an executive Chairman.
----------------------
2. Directors should not be members of more than ten committees and
Chairman of not more than five committees. ----------------------
----------------------
----------------------
----------------------
1. True
2. True ----------------------
----------------------
----------------------
----------------------

Notes
Suggested Reading
----------------------
1. Joshi, Vasudha. 2004. Corporate Governance: The Indian Scenario.
---------------------- Foundation Books.
2. Tricker, Bob, Robert Ian Tricker. 2012. Corporate Governance:
----------------------
Principles, Policies and Practices. Oxford University Press.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
190 Capital Market

Mergers and Takeovers
UNIT
12
Structure:
12.1 Introduction
12.2 Procedure of Mergers and Takeovers
12.3 Case Studies in Hostile Takeovers
Summery
Keywords
Suggested Reading
Mergers and Takeovers 191

Notes
Objectives
----------------------
----------------------
●● Explain the concepts of mergers and acquisitions.
---------------------- ●● Describe its procedure and legal requirements.
---------------------- ●● Critically discuss some recent cases of takeovers.
----------------------
12.1 INTRODUCTION
----------------------
In the liberalised economy of our country, Mergers and Takeovers are
---------------------- destined to play a very important role in the coming years. If one looks at the
developed economies around the world, it will be clear that these countries
---------------------- allow these activities freely.
---------------------- In India, this phenomenon is still new and hence there is a need for a good
regulation to oversee this.
----------------------
SEBI therefore, had appointed a committee under the Chairmanship of
---------------------- the Retired Chief Justice of the Supreme Court of India, Justice P. N. Bhagwati,
to devise a code for mergers and the hostile takeovers. The guidelines issued for
----------------------
this activity are from the recommendations made by this committee. Recently,
---------------------- SEBI has taken overview of these recommendations and has incorporated
certain changes based on the experience so far.
----------------------
The takeover of Saurashtra cement by Autorider in March 1998, involving
---------------------- an open offer of Rs. 18 crs, was the first hostile take over under the new take
over code. This was followed by the take over of Rassi cement by India Cement
---------------------- for Rs. 100 crores. The other prominent instances were the take over of BSES
by Reliance, Indal by Hindalco.
----------------------
Many other managements were caught unawares by raiders who tried to
---------------------- raid their companies. Bombay Dyeing and Ballarpur Industries Ltd. were sought
---------------------- to be raided by Arun Bajoria. The shares of East India Hotels were picked up by
archrivals ITC Hotels.
---------------------- In the eighties, Lord Swaraj Paul mounted a take over bid on two
---------------------- companies viz. DCM and Escorts. This bid turned out to be very messy and the
incumbent managements were fully supported by the government of the day
---------------------- and the raider had to suffer huge losses. The managements of DCM and Escorts
controlled only 7 and 15% of equity and thus were really minority shareholders.
----------------------
For promoters who have meager holdings in their company’s hostile
---------------------- acquisition by others is a real threat. Many managements have moved quickly
to increase their holdings in their companies either through creeping acquisition
---------------------- or through buy back offers. Under the creeping acquisition, managements can
---------------------- acquire 5% equity in each financial year, without the requirement of open offer.
----------------------
192 Capital Market

Mr Ratan Tata, the Chairman of Tata Group has used this route to consolidate Notes
the holdings in the group companies.
----------------------
Promoters are obviously not very pleased with the new regulations as
they feel that the companies that they have built for generations can be acquired ----------------------
by others. On the other hand, there is a feeling that the promoters of successful
companies have not cared for their shareholders, and have been only interested ----------------------
in making money for themselves.
----------------------
At a time when most corporates are worried about hostile takeovers and
mergers, retail investors have gained about Rs. 5,000 crores from the new ----------------------
takeover code.
----------------------
The financial institutions have a very crucial role to play in takeovers.
Many of these institutions control large stakes in many companies. The raiders ----------------------
on such companies can only succeed in getting management control of these
----------------------
companies, if the institutions sell their shares to the raiders. The institutions
should be mainly guided by the price offered for their holdings. Recently, UTI ----------------------
refused to sell its holdings in ITC to BAT even though BAT was willing to pay
a hefty premium to the market price at a time when UTI’s finances were in bad ----------------------
shape and the government had to support it for redemption of assured return
----------------------
schemes. The decision making of institutions in such cases is subject to political
interference and therefore not based on sound financial and economic logic. On ----------------------
the other hand, in the Grasim’s bid on L&T the institutions were insisting that
that Grasim must buy them out entirely. ----------------------
----------------------
12.2 PROCEDURE OF MERGERS AND TAKEOVERS
----------------------
1. What is meant by Takeovers & Substantial acquisition of shares?
----------------------
When an “acquirer” takes over the control of the “target company”, it is
termed as Takeover. When an acquirer acquires “substantial quantity of ----------------------
shares or voting rights” of the Target Company, it results into substantial
acquisition of shares. The term “Substantial” which is used in this context ----------------------
has been clarified subsequently.
----------------------
2. What is a Target company?
----------------------
A Target company is a listed company i.e. whose shares are listed on any
stock exchange and whose shares or voting rights are acquired/ being ----------------------
acquired or whose control is taken over/being taken over by an acquirer.
----------------------
3. Who is an Acquirer?
----------------------
An Acquirer includes persons acting in concert (PAC) with him i.e. any
individual/company/any other legal entity, which intends to acquire or ----------------------
acquires substantial quantity of shares or voting rights of target company
or acquires or agrees to acquire control over the target company ----------------------
----------------------
----------------------

Notes 4. What is meant by the term “Persons Acting in Concert (PACs)”?
PACs are individual(s) /company(ies)/ any other legal entity(ies) who are
----------------------
acting together for a common objective or for a purpose of substantial
---------------------- acquisition of shares or voting rights or gaining control over the target
company pursuant to an agreement or understanding whether formal or
---------------------- informal. Acting in concert would imply co-operation, co-ordination for
acquisition of voting rights or control. This co-operation/ co-ordinated
----------------------
approach may either be direct or indirect.
---------------------- The concept of PAC assumes significance in the context of substantial
acquisition of shares since it is possible for an acquirer to acquire shares
----------------------
or voting rights in a company ‘in concert’ with any other person in such a
---------------------- manner that the acquisition made by them may remain individually below
the threshold limit but may collectively exceed the threshold limit.
----------------------
Unless the contrary is established certain entities are deemed to be persons
---------------------- acting in concert like companies with its holding company or subsidiary
company, mutual funds with its sponsor / trustee / Asset Management
---------------------- Company, etc.
---------------------- 5. How substantial quantity of shares or voting rights is defined?
---------------------- The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations,

1997 has defined substantial quantity of shares or voting rights distinctly
---------------------- for two different purposes:
---------------------- Threshold of disclosure to be made by acquirer(s)

1. 5% and more shares or voting rights: A person who, alongwith PAC,
----------------------
if any, (collectively referred to as “ Acquirer” hereinafter) acquires
---------------------- shares or voting rights (which when taken together with his existing
holding) would entitle him to more than 5% or 10% or 14% shares
---------------------- or voting rights of target company, is required to disclose at every
stage the aggregate of his shareholding to the target company and
----------------------
the Stock Exchanges within 2 days of acquisition or receipt of
---------------------- intimation of allotment of shares.
2. Any person who holds more than 15% but less than 75% shares
----------------------
or voting rights of target company, and who purchases or sells
---------------------- shares aggregating to 2% or more shall within 2 days disclose such
purchase/ sale along with the aggregate of his shareholding to the
---------------------- target company and the Stock Exchanges.
---------------------- 3. Any person who holds more than 15% shares or voting rights of
target company and a promoter and person having control over the
---------------------- target company, shall within 21 days from the financial year ending
March 31 as well as the record date fixed for the purpose of dividend
----------------------
declaration, disclose every year his aggregate shareholding to the
---------------------- target company.
---------------------- 4. The Target company, in turn, is required to inform all the stock
exchanges where the shares of Target Company are listed, every
194 Capital Market
year within 30 days from the financial year ending March 31 as well Notes
as the record date fixed for the purpose of dividend declaration.
----------------------
Trigger point for making an open offer by an acquirer
a) 15% shares or voting rights ----------------------
An acquirer who intends to acquire shares which alongwith his ----------------------
existing shareholding would entitle him to exercise 15% or more
voting rights, can acquire such additional shares only after making ----------------------
a public announcement (PA) to acquire at least additional 20% of
----------------------
the voting capital of Target Company from the shareholders through
an open offer. ----------------------
b) Creeping acquisition limit ----------------------
An acquirer who holds 15% or more but less than 75% of shares
or voting rights of a target company, can acquire such additional ----------------------
shares as would entitle him to exercise more than 5% of the voting ----------------------
rights in any financial year ending March 31 only after making a
public announcement to acquire at least additional 20% shares of ----------------------
target company from the shareholders through an open offer.
----------------------
c) Consolidation of holding
----------------------
An acquirer, who holds 75% shares or voting rights of a target
company, can acquire further shares or voting rights only after ----------------------
making a public announcement to acquire at least additional 20%
shares of Target Company from the shareholders through an open ----------------------
offer.
----------------------
6. How is ‘control’ defined?
----------------------
Control includes the right to appoint directly or indirectly or by virtue
of agreements or in any other manner majority of directors on the Board ----------------------
of the target company or to control management or policy decisions
affecting the target company. However, in case there are two or more ----------------------
persons in control over the target company the cesser of any one of such ----------------------
persons from such control shall not be deemed to be a change in control
of management nor shall any change in the nature and quantum of control ----------------------
amongst them constitute change in control of management provided this
transfer is done in terms of Reg. 3(1)(e). Also if consequent upon change ----------------------
in control of the target company in accordance with regulation 3, the ----------------------
control acquired is equal to or less than the control exercised by person
(s) prior to such acquisition of control, such control shall not be deemed ----------------------
to be a change in control.
----------------------
7. What is a Public Announcement (PA)?
A public announcement is an announcement made in the newspapers by ----------------------
the acquirer primarily disclosing his intention to acquire shares of the ----------------------
target company from existing shareholders by means of an open offer.
----------------------

Notes 8. What are the disclosures required to be made under Public
Announcement?
----------------------
The disclosures in the announcement include the offer price, number of
---------------------- shares to be acquired from the public, identity of acquirer, purpose of
acquisition, future plans of acquirer, if any, regarding the target company,
---------------------- change in control over the target company, if any, the procedure to be
followed by acquirer in accepting the shares tendered by the shareholders
----------------------
and the period within which all the formalities pertaining to the offer
---------------------- would be completed.
9. What is the objective of Public Announcement?
----------------------
The Public Announcement is made to ensure that the shareholders of the
---------------------- target company are aware of an exit opportunity available to them.
---------------------- 10. Can an acquirer make an offer for less than 20% of shares?
---------------------- No, the acquirer cannot make an offer for less than 20% of shares. The
acquirer has to make an offer for a minimum of 20% or the balance, if the
---------------------- balance is less than 20%.
---------------------- 11. Who is required to make a Public Announcement and when is the
Public Announcement required to be made?
----------------------
The Acquirer is required to appoint a Merchant Banker (MB) registered
---------------------- with SEBI before making a PA. PA is required to be made through the said
MB. The acquirer is required to make the PA within four working days of
---------------------- entering into an agreement to acquire shares or deciding to acquire shares/
voting rights of Target Company or after any such change or changes as
----------------------
would result in change in control over the target company.
---------------------- In case of indirect acquisition or change in control, the PA shall be made
by the acquirer within three months of consummation of such acquisition
----------------------
or change in control or restructuring of the parent or the company
---------------------- holding shares of or control over the target company in India. The offer
price in such cases shall be determined with reference to the date of the
---------------------- public announcement for the parent company and the date of the public
announcement for acquisition of shares of the target company, whichever
----------------------
is higher, in accordance with the parameters mentioned in the Takeover
---------------------- Regulations.
12. Whether appointment of Merchant Banker for the offer process is
----------------------
mandatory?
---------------------- Yes
---------------------- 13. What documents are to be filed with SEBI after making a PA and
when are these documents to be filed?
----------------------
Hard and soft copies of the PA are required to be submitted to SEBI
---------------------- simultaneously with the publication of the same in the newspapers.
----------------------
196 Capital Market

A draft letter of offer is required to be filed with SEBI within 14 days Notes
from the date of Public Announcement alongwith a filing fee of Rs.50,
000/- per letter of offer (payable by Banker’s Cheques / Demand Draft). A ----------------------
due diligence certificate as well as registration details as per SEBI circular
no. RMB (G-1) series dated June 26, 1997 are also required to be filed ----------------------
alongwith the draft letter of offer. ----------------------
14. Does SEBI “approve” the draft letter of offer?
----------------------
Filing of draft letter of offer with SEBI should not in any way be deemed
or construed that the same has been cleared, vetted or approved by SEBI. ----------------------
The letter of offer is submitted to SEBI for a limited purpose of overseeing
----------------------
whether the disclosures contained therein are generally adequate and
are in conformity with the Takeover Regulations. This requirement is to ----------------------
facilitate the shareholders to take an informed decision with regard to the
Offer. SEBI does not take any responsibility either for the truthfulness ----------------------
or correctness for any statement, for financial soundness of Acquirer, or
----------------------
of Persons Acting in Concert, or of Target Company, whose shares are
proposed to be acquired or for the correctness of the statements made or ----------------------
opinions expressed in the Letter of Offer. It should be understood that
while an Acquirer is primarily responsible for the correctness, adequacy ----------------------
and disclosure of all relevant information in this Letter of Offer, the
----------------------
Manager to the offer(a Merchant Banker) is expected to exercise due
diligence to ensure that the Acquirer duly discharges its responsibility ----------------------
adequately.
----------------------
15. What is a letter of offer?
A letter of offer is a document addressed to the shareholders of the target ----------------------
company containing disclosures of the acquirer/ PACs, target company, ----------------------
their financials, justification of the offer price, number of shares to be
acquired from the public, purpose of acquisition, future plans of acquirer, ----------------------
if any, regarding the target company, change in control over the target
company, if any, the procedure to be followed by acquirer in accepting the ----------------------
shares tendered by the shareholders and the period within which all the ----------------------
formalities pertaining to the offer would be completed.
16. What happens once SEBI gives comments on the draft letter of offer? ----------------------
The MB will incorporate in the letter of offer the comments made by ----------------------
SEBI and then send within 45 days from the date of PA of the letter of
offer alongwith the blank acceptance form, to all the shareholders whose ----------------------
names appear in the register of the company on the specified date. The ----------------------
offer remains open for 30 days. The shareholders are required to send
their Share certificate(s) / related documents to registrar or Merchant ----------------------
banker as specified in PA and letter of offer. The acquirer is required to
pay consideration to all those shareholders whose shares are accepted ----------------------
under the offer, within 30 days from the closure of offer. ----------------------
In their own interest, the shareholders are advised to send such documents
----------------------

Notes under registered post. Further, the shareholders may also note that under
no circumstances such documents should be sent to the acquirer.
----------------------
17. How is the price determined in an open offer?
---------------------- SEBI does not approve the offer price. The acquirer/ Merchant Banker
is required to ensure that all the relevant parameters are taken into
----------------------
consideration while determining the offer price and that justification for
---------------------- the same is disclosed in the letter of offer.
The relevant parameters are as follows:
----------------------
a) Negotiated price under the agreement, which triggered the open
---------------------- offer.
---------------------- b) Price paid by the acquirer or persons acting in concert with him
for acquisition, if any, including by way of allotment in a public or
---------------------- rights or preferential issue during the twenty six week period prior
---------------------- to the date of public announcement, whichever is higher;
c) The average of the weekly high and low of the closing prices of
---------------------- the shares of the target company as quoted on the stock exchange
---------------------- where the shares of the company are most frequently traded during
the twenty six weeks or the average of the daily high and low prices
---------------------- of the shares as quoted on the stock exchange where the shares
of the company are most frequently traded during the two weeks
---------------------- preceding the date of public announcement, whichever is higher.
---------------------- In case the shares of Target Company are not frequently traded then instead
of point (c) above, parameters based on the fundamentals of the company
----------------------
such as return on networth of the company, book value per share, EPS etc.
---------------------- are required to be considered and disclosed.
In case of non-compete agreement for payment to any person other than
----------------------
the target company, if the payment is more than 25% of the offer price
---------------------- arrived in terms of the Regulations, the same has to be factored into the
offer price.
----------------------
18. What are the criteria for determining whether the shares of the
---------------------- Target Company are frequently or infrequently traded?
---------------------- The shares of the Target Company will be deemed to be infrequently

traded if the annualised trading turnover in that share during the preceding
---------------------- 6 calendar months prior to the month in which the PA is made is less than
5% (by number of shares) of the listed shares. If the said turnover is 5%
---------------------- or more, it will be deemed to be frequently traded.
---------------------- 19. Are only those shareholders whose names appear in the register of
Target Company on a specified date, eligible to tender their shares in
---------------------- the open offer?
---------------------- No. Any shareholder who holds the shares on or before the date of closure
of the offer is eligible to participate in the offer.
----------------------
198 Capital Market

20. What is a Competitive bid? Notes
Competitive bid is an offer made by a person, other than the acquirer who
----------------------
has made the first public announcement.
21. What happens if there is a competitive offer and a person had availed ----------------------
the first offer at a lower price? Can the person switch his acceptance
----------------------
to a better offer?
Yes, switching of acceptances between different offers is possible. The ----------------------
shareholder has the option to withdraw acceptance tendered by him upto
----------------------
three working days prior to the date of closure of the offer.
To enable the shareholders to be in a better position to decide as to which ----------------------
of the subsisting offers is better and also not to cause last minute decisions/ ----------------------
confusions, the offer price and size are effectively frozen for the last 7
working days prior to the closing date of the offers. Shareholders may ----------------------
wait till the commencement of that period to be aware of upward revisions
in the offer price and size of the offers, if any. ----------------------
22. Can an acquirer withdraw the offer once made? ----------------------
No, the offer once made cannot be withdrawn except in the following ----------------------
circumstances:
----------------------
Statutory approval(s) required have been refused;
The sole acquirer being a natural person has died; ----------------------
Such circumstances as in the opinion of the Board merits withdrawal. ----------------------
23. How can a person avail of the offer if he/she has not received the ----------------------
letter of offer?
The Public Announcement contains procedure for such cases i.e. where ----------------------
the shareholders do not receive the letter of offer or do not receive the ----------------------
letter of offer in time. The shareholders are usually advised to send their
consent to Registrar to offer, if any or to MB on plain paper stating the ----------------------
name, address, number of shares held, Distinctive Folio No, number
of shares offered and bank details alongwith the documents mentioned ----------------------
in the Public Announcement, before closure of the offer. The public ----------------------
announcement and the letter of offer along with the form of acceptance
are available on the SEBI website at www.sebi.gov.in. ----------------------
24. Is there any compensation to a shareholder for delayed receipt of ----------------------
payment under the offer?
----------------------
Acquirers are required to complete the payment of consideration to
shareholders that have accepted the offer within 30 days from the date ----------------------
of closure of the offer. In case the delay in payment is on account of
non receipt of statutory approvals and if the same is not due to willful ----------------------
default or neglect on part of the acquirer, the acquirers would be liable to
----------------------
pay interest to the shareholders for the delayed period in accordance with
Regulations. ----------------------

Notes If the delay in payment of consideration is not due to the above reasons,
it would be treated as a violation of the Regulations and therefore, also
---------------------- liable for other action in terms of the Regulations.
---------------------- 25. Is the acquirer required to accept all the shares under the open offer?
No, if the shares received by the acquirer are more than the shares agreed
----------------------
to be acquired by him, the acceptance would be on proportionate basis.
---------------------- 26. What are the safeguards incorporated in the takeover process so as
to ensure that the shareholders get their payments under the offer/
----------------------
receive back their share certificates?
---------------------- Before making the Public Announcement, the acquirer has to open an
---------------------- escrow account in the form of cash deposited with a scheduled commercial
bank or bank guarantee in favour of the Merchant Banker or deposit of
---------------------- acceptable securities with appropriate margin with the Merchant Banker.
The Merchant Banker is also required to confirm that firm financial
---------------------- arrangements are in place for fulfilling the offer obligations. In case,
---------------------- the acquirer fails to make the payment, the MB has a right to forfeit the
escrow account and distribute the proceeds in the following way:
---------------------- a) 1/3 of amount to target company
---------------------- b) 1/3 to regional SEs, for credit to investor protection fund etc.
---------------------- c) 1/3 to be distributed on pro rata basis among the shareholders who
have accepted the offer.
----------------------
The Merchant Banker is required to ensure that the rejected documents
---------------------- which are kept in the custody of the Registrar / Merchant Banker are sent
back to the shareholder through Registered Post.
----------------------
Besides forfeiture of escrow account, SEBI can initiate separate action
---------------------- against the acquirer which may include prosecution / barring the acquirer
from entering the capital market for a specified period etc.
----------------------
27. Whether all types of acquisitions of shares or voting rights over and
---------------------- above the limits specified in the SEBI (Substantial Acquisition of
Shares and Takeovers) Regulations, 1997 necessarily require acquirer
---------------------- to make a public announcement followed up by an open offer?
---------------------- No. Certain type of acquisitions as stipulated under Regulation 3 of
Chapter I of the Regulations, are specifically exempted from the open
---------------------- offer process subject to the acquirer complying with the requirements/
---------------------- conditions, as may be applicable, for such acquisitions. Such exemptions
include acquisitions arising out of firm allotment in public issues, rights
---------------------- issues, inter-se transfer amongst group companies, relatives, promoters,
acquirer and PACs, Indian promoters and foreign collaborators and
---------------------- transfer of shares from state level Financial Institutions to co-promoters
---------------------- of company pursuant to the agreement etc.
----------------------
200 Capital Market

28. Which are those acquisitions/transactions where reporting to SEBI is Notes
mandatory?
----------------------
Reporting is mandatory under Regulation 3(4) in respect of acquisitions
arising out of firm allotment in public issues, rights issues, inter-se transfer ----------------------
amongst group companies, relatives, promoters, acquirer and PACs,
Indian promoters and foreign collaborators and transfer of shares from ----------------------
state level Financial Institutions to co-promoters of company pursuant to
----------------------
the agreement.
29. What is the time frame to submit such report and procedure fee ----------------------
thereof?
----------------------
The report is required to be submitted to SEBI within 21 days from the
date of acquisition / allotment alongwith a fee of Rs. 10,000/- per report. ----------------------
30. Is there any prescribed form of application for various reports/ ----------------------
documents mentioned above?
----------------------
YES, SEBI has specified the format, which is available on the SEBI
website at www.sebi.gov.in ----------------------
31. What information is required to be furnished to Stock Exchanges ----------------------
in compliance of the SEBI (Substantial Acquisition of Shares and
Takeovers) Regulations, 1997 and when is it required to be furnished? ----------------------
For transactions, which entail reporting requirements, details of the ----------------------
proposed acquisition need to be filed with SEs where shares of Target
Company are listed, at least four working days before the date of actual ----------------------
acquisition/ allotment.
----------------------
A person who, alongwith PAC, if any, (collectively referred to as ‘Acquirer’
hereinafter) acquires shares or voting rights (which when taken together ----------------------
with his existing holding) would entitle him to more than 5% or 10% or
----------------------
14% shares or voting rights of target company, is required to disclose at
every stage the aggregate of his shareholding to the target company and ----------------------
the Stock Exchanges within 2 days of acquisition or receipt of intimation
of allotment of shares. ----------------------
Any person who holds more than 15% but less than 75% shares or voting ----------------------
rights of target company, and who purchases or sells shares aggregating
to 2% or more shall within 2 days disclose such purchase/ sale along with ----------------------
the aggregate of his shareholding to the target company and the Stock
----------------------
Exchanges.
Further, annual disclosures have to be given regarding holding of ----------------------
promoters, persons in control and persons holding more than 15% shares ----------------------
or voting rights of the Target Company. Further, a copy of the Public
Announcement to acquire shares from public is to be given to the Stock ----------------------
Exchanges simultaneously with the publication in the newspapers.
Subsequently, upward revisions in offer, withdrawal of offer has also to ----------------------
be intimated to the Stock Exchanges simultaneously. ----------------------

Notes 32. What happens if the Acquirer / Target Company /Merchant Banker
violate the provisions of the Regulations?
----------------------
The Regulations have laid down the general obligations of acquirer,
---------------------- Target Company and the Merchant Banker. For failure to carry out these
obligations as well as for failure / non-compliance of other provisions of
---------------------- the Regulations, the Regulations have laid down the penalties for non-
compliance. These penalties include
----------------------
a) Forfeiture of the escrow account,
----------------------
b) Directing the person concerned to sell the shares acquired in
---------------------- violation of the regulations,
---------------------- c) Directing the person concerned not to further deal in securities,

d) Levy monetary penalties,
----------------------
e) Initiate prosecution proceedings.
----------------------
f) Directing appointment of a merchant banker for the purpose of
---------------------- causing disinvestment of shares acquired in breach of regulations
10, 11 or 12
----------------------
g) Directing transfer of any proceeds or securities to the Investors
---------------------- Protection Fund of a recognised stock exchange;
h) Directing the target company or depository to cancel the shares
----------------------
where an acquisition of shares pursuant to an allotment is in breach
---------------------- of regulations 10, 11 or 12;
---------------------- i) Directing the target company or the depository not to give effect to
transfer or further freeze the transfer of any such shares and not to
---------------------- permit the acquirer or any nominee or any proxy of the acquirer to
exercise any voting or other rights attached to such shares acquired
---------------------- in violation of regulations 10, 11 or 12;
---------------------- j) Debarring any person concerned from accessing the capital market
or dealing in securities for such period as may be determined by the
---------------------- Board;
---------------------- k) Directing the person concerned to make public offer to the
shareholders of the target company to acquire such number of
----------------------
shares at such offer price as determined by the Board;
---------------------- l) Directing disinvestment of such shares as are in excess of the
percentage of the shareholding or voting rights specified for
----------------------
disclosure requirement under the regulations 6,7 or 8;
---------------------- m) Directing the person concerned not to dispose of assets of the target
company contrary to the undertaking given in the letter of offer;
----------------------
n) Directing the person concerned, who has failed to make a public
---------------------- offer or delayed the making of a public offer in terms of these
---------------------- Regulations, to the shareholders, whose shares have been accepted
202 Capital Market

in the public offer made after the delay, the consideration amount Notes
along with interest at the rate not less than the applicable rate of
interest payable by banks on fixed deposits. ----------------------
Further, the Board of Directors of the target company would also be liable ----------------------
for action in terms of the Regulations and the SEBI Act for failure to carry
out their obligations specified in the Regulations. ----------------------
Action can also be initiated for suspension, cancellation of certificate of ----------------------
registration against an intermediary such as the Merchant Banker to the
offer. ----------------------
33. Are mergers and amalgamations of companies also covered under the ----------------------
SEBI (Substantial Acquisition of Shares and Takeovers) Regulations,
1997? ----------------------
No, only takeovers and substantial acquisition of shares of a listed ----------------------
company fall within purview of SEBI (Substantial Acquisition of Shares
and Takeovers) Regulations, 1997. Mergers and Amalgamations are ----------------------
outside the purview of SEBI as they are a subject matter of the Companies ----------------------
Act, 1956.
34. What is the Takeover Panel? ----------------------
An acquirer who proposes to acquire shares through a mode that is ----------------------

not specially covered under Regulation 3 may seek exemption from
----------------------
the applicability of the provisions of the offer process by making an
application. SEBI has constituted a panel consisting of independent ----------------------
persons to examine such applications, which is called the Takeover Panel.
----------------------
The present composition of the Takeover panel is as follows:
Chairman: Justice S. M. Jhunjunwalla - Retd. High Court Judge, Mumbai ----------------------
High Court
----------------------
Shri S. C. Bafna: Former Member of the Company Law Board
----------------------
Shri S. A. Dave: Former Chairman, SEBI and Former Chairman - UTI
Shri A. R. Gandhi: Sr. Partner, N M Raiji & Co. ----------------------
Shri Kamath: Former Banking Ombudsman and Former Chairman, Bank ----------------------
of Maharashtra
----------------------
35. What is the procedure for making an application to the Takeover
Panel for seeking exemption? ----------------------
The acquirer shall make an application in the standard format specified by ----------------------
SEBI giving all the relevant details of the proposed acquisition along with
a fee of Rs 25,000/-. The standard format is available on the SEBI website ----------------------
www.sebi.gov.in.
----------------------
36. How does SEBI process such application?
----------------------
SEBI forwards the application to the Takeover Panel within 4-5 days of
its receipt. The Takeover Panel would make a recommendation on the ----------------------

Notes application to SEBI within 15 days of receipt of the application from SEBI.
SEBI, after affording reasonable opportunity to the concerned parties,
---------------------- wherever necessary, would pass a reasoned order on the application
within 30 days thereof and publish the same.
----------------------
37. Are there any specific provisions for disinvestment of government
---------------------- shareholding in listed Public Sector Undertakings (PSUs)?
---------------------- To facilitate acquisition of shares or voting rights or control by strategic
partner from the Central Government in a listed PSU and to harmonise
---------------------- the process of disinvestment and investor protection.
---------------------- The said amendments include the following:
---------------------- Transfer of shares and control to the strategic partner/ acquirer even before
completing the open offer formalities in terms of the Regulations;
---------------------- The date of entering into the share purchase agreement would be the reference
---------------------- date for making the public announcement.
The date on which the Central Government opens the financial bids would be
---------------------- the reference date for classifying the shares of the company as frequently or
---------------------- infrequently traded and for determination of the offer price.
Non-applicability of requirement of second offer for subsequent stage of
----------------------
acquisition subject to certain conditions
---------------------- Prohibition from making a competitive bid.
---------------------- It may be noted that these amendments were made only for the purpose of PSU
disinvestment and are not available to other acquisitions.
----------------------

---------------------- 1. When an “acquirer” takes over the control of the “target company”, it
is termed as ________.
----------------------
2. The _____ is made to ensure that the shareholders of the target
---------------------- company are aware of an exit opportunity available to them.

1. SEBI had appointed a committee under the Chairmanship of Mr. P. N.
---------------------- Bhagwati to devise a code for mergers and the hostile takeovers.
---------------------- 2. Under the creeping acquisition, managements can acquire 10% equity
in each financial year, without the requirement of open offer.
----------------------
----------------------
----------------------
----------------------
204 Capital Market

Notes
Activity 1
----------------------
1. Find out which companies have been taken over and by whom in the
----------------------
year 2018.
2. Find out some cases where SEBI has penalised companies for not ----------------------
adhering to the takeover code.
----------------------
----------------------
12.3 CASE STUDIES IN HOSTILE TAKEOVERS
----------------------
Let us now briefly take a look at some of the takeover attempts:
Bombay Dyeing Ltd.: This company was attractive for a take over bid for ----------------------
various reasons. It was a cash rich company sitting over liquid cash worth Rs. ----------------------
450 crores, and its market price was below the book value.
Bajoria is a very shrewd businessman who made his fortune in jute ----------------------
industry in Kolkata. Bombay Dyeing was his big corporate raid. One day he ----------------------
claimed that he had acquired 14% equity in the company. This announcement
sent shock waves through the corporate world. Thus began the war between ----------------------
Bajoria and Wadia. Bajoria had picked up equity from the price levels of Rs.
40 and stopped once the price reached Rs 115 per share. It is estimated that he ----------------------
spent nearly Rs. 50 crores for this. ----------------------
Bombay Dyeing complained that Bajoria had violated the takeover code
by not informing the company and the stock market upon acquiring 5% equity ----------------------
as required by the regulations. The legal battle was now joined in earnest. ----------------------
However, during this battle Bajoria liquidated 8.5% of his holding in the
company. On the other hand, Wadia announced the share buy back scheme to ----------------------
consolidate his holding in the company.
----------------------
Two important points have emerged from Bajoria’s raid- a small mistake
in timely disclosing to the company when his stake crossed five percent limit ----------------------
has cost him lot of embarrassment and avoidable litigation.
----------------------
Gesco Corporation Ltd.: A H Dalmia group mounted a Rs. 35 crore raid to
take over Gesco Corporation Ltd. controlled by the Seth family. The Dalmia’s ----------------------
acquired 10.4% equity and made an open offer for another 45% at the rate of
----------------------
Rs. 27 per share.
Gesco originally was the real estate division of Great Eastern Shipping ----------------------
Company Ltd. In April 1999, it was spun off into an independent company. It
----------------------
had made investments in real estate in Mumbai, Pune, New Delhi and Banglore.
The book value of Gesco was around Rs. 50 and the market value of company’s ----------------------
assets was much higher than the book value. However, the share value was
only about Rs.10 resulting in market capitalisation of Rs. 30 crores. The equity ----------------------
capital of the company was Rs.29 crores and the reserves were to the tune of Rs.
----------------------
100 crores. The company was debt free. It had fixed assets worth Rs.90 crores,
liquid investments of about Rs. 38 crores and reserves and surplus of Rs. 24 ----------------------

Notes crores. This made the company an attractive target with the promoter’s holding
just 12% equity. The institutions were holding further 25% equity.
----------------------
The Dalmia’s began negotiations with the institutions for buying the
---------------------- equity held by them. If the open offer had been fully subscribed then Dalmia
would gain control over the company. The Seth’s now had only two choices-
---------------------- one to make a counter offer, or the other was to sell their holdings to Dalmia.
---------------------- The Seths appointed Kotak as their advisors for the counter offer. HDFC
Chairman Mr Deepak Parekh suggested to Mahindra’s to partner Seths in the
---------------------- counter offer. The counter offer was made for Rs. 36 per share. HDFC extended
a one-year credit line to Mahindra Realty and Infrastructure Developers Ltd.
----------------------
This is the first instance in Indian corporate history that a white Knight
---------------------- had been used to stave off a possible hostile takeover. Seths in the mean time
bought out the entire 6.34% stake of IFC Washington @ Rs.44 per share, in a
----------------------
negotiated deal. In view of this the counter offer price also now became Rs 44
---------------------- per share. Dalmia raise his offer to Rs.45 per share after this. Seths raised their
offer price to Rs.54 per share as their counter offer. Finally, Dalmia sold his
---------------------- holding of 10.4% to Seths for Rs. 54 per share.
---------------------- This is a classic case of takeover, where two companies fought out the
battle in the open and in a most transparent manner. This also helped the small
---------------------- shareholders in getting a very good price for their holdings.
---------------------- Many instances of hostile takeovers successful or unsuccessful can be
seen in the recent past. Some of the cases are as follows:
----------------------
---------------------- Activity 2
---------------------- Study the following cases of hostile takeovers.
---------------------- 1. Sterlite’s unsuccessful bid on Indal
---------------------- 2. Hindalco’s successful takeover of Indal
3. Abhishek Dalmia’s unsuccessful raid on GESCO
----------------------
---------------------- Summary
----------------------
●● In this unit, we have seen what is takeover and the brief history of what
---------------------- has happened in India. We have seen the SEBI guidelines for takeovers
and legal requirements that are to be followed by the acquiring company
---------------------- and also the rights of the target company.
---------------------- ●● We have also taken a look at some of the instances of takeovers that have
taken place in our markets.
----------------------
----------------------
----------------------
206 Capital Market

Keywords Notes
----------------------
●● Acquirer: The company that is mounting a take over bid,
●● Target Company: The company on whom the takeover bid is being ----------------------
mounted.
----------------------
●● Persons Acting in Concert: Persons including companies that are jointly
making a bid. ----------------------
●● White Knight: A company that is willing to defend the target company ----------------------
to fight a hostile takeover bid.
----------------------
1. Why is regulation for takeovers important? ----------------------
2. Discuss the case of Grasim’s takeover bid on L & T.
----------------------
3. Explain the case of Bajoria’s failure in the takeover of Bombay Dyeing.
----------------------
4. Discuss the Abhishek Dalmiya’s bid on Gesco.
5. Do you think that minority shareholders benefit in case of takeovers? ----------------------
6. Do you believe that hostile takeover provisions are against the interest of ----------------------
promoters of a company?
----------------------
7. Do you believe that the potential takeover threat makes managements
more responsive and responsible towards their companies? ----------------------
8. Which Indian companies are attractive for takeover bids according to ----------------------
you?
----------------------
Fill in the blanks.
----------------------
1. When an “acquirer” takes over the control of the “target company”, it is
termed as Takeover. ----------------------
2. The Public Announcement is made to ensure that the shareholders of the ----------------------
target company are aware of an exit opportunity available to them. ----------------------
----------------------
1. True
----------------------
2. False
----------------------
----------------------
----------------------

Notes
Suggested Reading
----------------------
1. Bruner, Robert F. 2004. Applied Mergers and Acquisitions. John Wiley &
---------------------- Sons.
2. Stahl, Günter K., Mark E. Mendenhall. 205. Mergers and Acquisitions:
----------------------
Managing Culture and Human Resources. Stanford University Press.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
208 Capital Market

Lease and Hire Purchase
UNIT
13
Structure:
13.1 Introduction to Lease Finance

13.2 Sources of Funds for the Finance Companies
13.3 Contents of Lease Agreement
13.4 Sale and Lease Back Transactions
13.5 Hire Purchase
13.6 Summary Regulations governing NBFCs Issued by RBI
13.7 Latest Developments
Summary
Keywords
Suggested Reading
Lease and Hire Purchase 209

Notes
Objectives
----------------------
----------------------
●● Describe the concept of lease finance.
---------------------- ●● List the advantages of lease finance.
---------------------- ●● Understand the service tax implications of a lease.
---------------------- ●● Identify the way companies raise resources.
●● Analyse the contents of a lease agreement.
----------------------
●● Describe the concept of a sale and lease back transaction.
---------------------- ●● Compare the differences between lease and hire purchase transactions.
---------------------- ●● State the Reserve Bank of India’s regulations that govern NBFCs.
----------------------
13.1 INTRODUCTION TO LEASE FINANCE
----------------------
An equipment lease can be defined as a contractual arrangement where
---------------------- the lessor of equipment transfers the right to use the equipment to the lessee
---------------------- for an agreed period of time in return for rental. At the end of the period the
asset reverts back to the lessor, unless there is a provision for the renewal of the
---------------------- contract or there is a provision for transfer of ownership to the lessee.
---------------------- At the end of each accounting period, the hire purchase price less the
installments received is shown as receivable (stock on hire) and the finance
---------------------- income component of these installments is shown as a current liability.
---------------------- Advantages of Lease

●● Flexibility
----------------------
●● User oriented variants
---------------------- ●● Tax Benefits
---------------------- ●● Less Paperwork and Expeditious Disbursement
---------------------- ●● Convenience
●● 100% Financing
----------------------
●● Better utilisation of own funds
---------------------- ●● Off Balance-sheet financing
---------------------- With the recent changes in the accounting standards lease is no more an
off balance sheet finance. The lessee is now expected to capitalise the leased
---------------------- assets in his book and claim depreciation on these assets as far as book profits
are concerned. The lessee, however, is allowed to claim lease rentals as tax
---------------------- deductible expense as far as Income Tax Act is concerned. It is essential that the
liability of the assets on lease be shown in the balance sheet for the knowledge
----------------------
of the lenders as well as the shareholders of the company.
----------------------
210 Capital Market

By and large most lease agreements in India are financial leases. The Notes
lease agreement does not provide for a transfer of ownership to the lessee either
at the end of the lease period or during the period of lease. The lease rentals are ----------------------
so structured as to recover the entire investment cost during the primary period.
Typically, the lease rentals are payable in equated monthly installments at the ----------------------
beginning of every month. Leasing companies satisfying certain criterions
are permitted to undertake leasing of imported equipment. But the existing ----------------------
regulatory framework imposes certain restrictions on undertaking cross-boarder ----------------------
lease transactions.
As per the existing provisions of income tax act, the lease income is taxed ----------------------
in the hands of the lessor as business income, and the lessor claims the tax
----------------------
relevant depreciation on the equipment leased as a tax-deductible expense. The
lessee is entitled to claim the lease rentals payable for each period over the lease ----------------------
period as a tax-deductible expense.
The excise duty on the assets on lease has been made modvatable, this ----------------------
means that the lessee can claim refund of the excise duty paid while acquiring ----------------------
the asset. This is of great benefit for the lessee.
There has been a great problem faced by the leasing industry, ever since ----------------------
service tax has been imposed on the interest portion of the lease rental. This has
----------------------
made leasing very expensive. This tax has been increased in this year’s budget
from 10% to 812%. Many leasing companies have obtained stay orders form ----------------------
High Courts against the levy of the service tax. The leasing companies argue
that assets under lease are capital assets and they suffer the imposition of excise ----------------------
duty as well as sales tax, and hence the levy of service tax is unjustifiable. They
also argue that no other lender has to bear this burden and this levy therefore is ----------------------
discriminatory in nature. The legal battle is still on and it will be quite some time
----------------------
before the courts will give their final judgement on this. Leasing companies say
that they are willing to pay service tax on the lease management fee that they ----------------------
charge from their clients. However things have changed now. The service tax
paid by companies is now refundable from their excise liability. Thus, this ----------------------
charge has now become revenue neutral.
----------------------
Some states also impose sales tax on lease transactions, following the
46th constitutional amendment. ----------------------
In a financial lease, lessee is under obligation to pay lease rentals
----------------------
regardless of its financial condition. It therefore follows that knowledge of the
future financial obligations under the finance lease contracts entered into by the ----------------------
lessee is absolutely essential for a proper assessment of the creditworthiness
and the borrowing capacity of the lessee. The lessee is therefore required to ----------------------
disclose the financial commitments outstanding under the finance lease as a part
of “ Notes on Accounts” in the Annual Report. ----------------------
----------------------
----------------------
----------------------
----------------------

Notes 13.2 SOURCES OF FUNDS FOR THE FINANCE
COMPANIES
----------------------
1. Equity and Preference Capital
----------------------
2. Debentures
----------------------
3. Term Loans from Financial Institutions & Banks
----------------------
4. Public Deposits
----------------------
5. Inter-corporate Deposits
---------------------- 6. Commercial Paper
---------------------- 7. Securitisation of receivables
---------------------- It has been reported in the news papers that Non Banking Finance
Companies may be allowed to access foreign capital. This is a part of the
----------------------
government’s policy towards capital account convertibility. If this measure
---------------------- comes through, these companies will have access to cheaper funds from abroad.
In a competitive market the fall in cost of borrowing will be very helpful for
----------------------
these companies. It is also quite possible that many foreign companies will start
---------------------- operations in India. Thus, Indian companies will have to brace themselves up
for fierce competition. We have already seen that companies G E have entered
----------------------
Indian markets. In the view of WTO requirements of opening of the financial
---------------------- sector, Indian financial sector will have to be opened.
---------------------- A finance company is required to maintain liquid assets at 15% on
deposits. At least two thirds of these liquid assets i.e. 10% of the deposits
----------------------
must be maintained in the form of Central or State government securities or
---------------------- government guaranteed bonds. The balance can be held either in the form of
accounts with commercial banks. This requirement is for leasing companies
----------------------
who are accepting public deposits. The eligibility for accepting public deposits
---------------------- is linked to the credit rating received by a company. This provision is essential
for safeguarding the interest of the retail investors. This provision came into
----------------------
effect in the late 90s when a slew of finance companies went under it and a lot
---------------------- of retail investors lost large amounts of money.
----------------------
----------------------
----------------------
1. It has been reported in the newspapers that Non-Banking Finance
---------------------- Companies may be allowed to access foreign capital.
---------------------- 2. A finance company is required to maintain liquid assets at 25% on

deposits.
----------------------
212 Capital Market

Notes
Activity 1
----------------------
Find out how many foreign finance companies have started operations in
----------------------
India. Why are banks not very keen to finance leasing companies?
----------------------
13.3 CONTENTS OF LEASE AGREEMENT ----------------------
Description clause: provides the description of the lessor, the lessee, the ----------------------
equipment and the location. ----------------------
Period clause: specifies the period for which the equipment is leased.
----------------------
Rental clause: specifies the amount of rentals to be paid, the periodicity and
----------------------
the mode of payment.
Exemption clause: clearly states the lessee has selected the equipment based ----------------------
on his own judgement and has not relied on any statements or representations ----------------------
made by the lessor.
----------------------
Ownership clause: unequivocally states that no right, title or interest in the
equipment shall pass to the lessee and the lessee shall, at no time contest or ----------------------
challenge the lessor’s sole and exclusive right, title and interest in the equipment. ----------------------
Repairs and Alteration clause: specifies that the lessee at its own cost and
----------------------
expense will keep the equipment in good repair, condition and working order.
Insurance in favour of the lessor and lessor’s lenders. ----------------------
Surrender clause: states that upon expiry of the lease term or earlier termination ----------------------
of the lease, the lessee must deliver the equipment to the lessor in good working ----------------------
condition.
----------------------
1. A lessee and a lessor can enter into an agreement whereby a lessee ----------------------
sells the existing assets to the lessor and take these assets back from
him on lease; this is known as _________. ----------------------
2. Leasing companies collect savings from individuals and use this ----------------------
money to help corporates create _________.
----------------------
----------------------
Activity 2
----------------------
Find out which companies were caught in the sale and lease back fraud
----------------------
cases.

Notes 13.4 SALE AND LEASE BACK TRANSACTIONS
---------------------- A lessee and a lessor can enter into an agreement whereby a lessee sells
the existing assets to the lessor and take these assets back from him on lease.
---------------------- This arrangement is known as sale and lease back transaction.
---------------------- The purpose of these transactions used to be that the company which had
invested its own funds in purchase of fixed assets in the past now may be facing
---------------------- liquidity crunch. The way to address this problem was to sell these assets to a
---------------------- leasing company and take it back on lease. This serves the dual purpose (a) the
company continues to use the fixed assets and (b) the company also gets the
---------------------- liquidity that it is looking for.
---------------------- However, what happened in some cases was that the assets were revalued
by the companies at the time of the sale and lease back transactions thereby
---------------------- inflating its price. This allowed them access to large amount of money. They also
got tax shield on their rental payments. At the same time, the leasing companies
---------------------- were charging depreciation on this inflated amount. The government’s revenues
---------------------- suffered because of this.
This provision was grossly misused in the late 80s and early 90s. The
----------------------
assets which were sold to lessor were revalued at an unrealistic value, before
---------------------- they were taken back on lease. In the aftermath of CRB fiasco, RBI clamped
down on such deals. The RBI issued guidelines for such deals by stating that
---------------------- these transactions can be done only at book value and revaluation of assets for
this purpose was disallowed.
----------------------
Leasing industry in India is going through a very bad phase for some time
---------------------- now. The collapse of several Non Banking Finance Companies, in the wake
of CRB scam in the late 90s, saw lots of small investors suffer, as their fixed
----------------------
deposits with these companies were stuck up. They were neither getting interest
---------------------- on their deposits nor were they able to withdraw their monies. This created an
atmosphere where everybody looked at all NBFCs very suspiciously.
----------------------
The policy of the government towards the industry is also not very clear.
---------------------- RBI wants these companies to convert themselves into banks. Two leading
NBFCs have adopted this course. They are the Centurion Bank and the recently
---------------------- established Kotak Bank.
---------------------- Leasing companies collect savings from individuals and use this money to
help corporates create productive assets. Today, when lots of funds are required
---------------------- for infrastructure development, the leasing companies can play a crucial role in
---------------------- mobilising savings for funding such projects.
----------------------
----------------------
----------------------
----------------------
214 Capital Market

Notes
----------------------
----------------------
1. Hire purchase transactions are not liable to sales tax.
----------------------
2. The cash purchase price of the asset is capitalised and the capital
content of the hire purchase installments is recorded as a liab ----------------------
----------------------
Activity 3
----------------------
Find out in what way the financiers are financing purchase of vehicles. ----------------------
----------------------
13.5 HIRE PURCHASE
----------------------
A H.P. can be defined as a contractual arrangement under which the owner
lets his goods on hire to the hirer and offers an option to the hirer for purchasing ----------------------
the goods in accordance with the terms of contract.
----------------------
Salient Features
----------------------
The finance company purchases the equipment from the equipment
supplier and lets it on hire to the hirer. ----------------------
The hirer may be required to make a down payment and the balance can ----------------------
be repaid in maximum 60 months.
The interest is calculated on the basis of flat rate of interest. ----------------------
During the currency of the contract the hirer can opt for an early repayment ----------------------
and purchase the asset. The hirer, exercising this option, is required to pay the
----------------------
remaining amount of hire purchase installments less an interest rebate.
Sales Tax Aspects ----------------------
Hire purchase transactions are liable to sales tax. The 46th amendment ----------------------
clearly states that the tax on the sale or purchase of goods includes the tax
on the delivery of goods on hire purchase or any other system of payment by ----------------------
installments. ----------------------
The state in which the goods have been delivered is the state entitled to
levy and collect sales tax. ----------------------
Accounting Aspects ----------------------

The cash purchase price of the asset is capitalised and the capital content ----------------------
of the hire purchase installments is recorded as a liability.
----------------------
Depreciation is charged on the cash purchase price of the asset in line,
with the depreciation policy of the hirer with regard to other owned assets. ----------------------
----------------------

Notes At the inception of the transaction, the finance company records the hire
purchase installments receivable as a current asset and the unearned finance
---------------------- income component of these installments as current liability under the head
“Unmatured finance charges.”
----------------------
At the end of each accounting period, the finance company recognizes
---------------------- an appropriate part of the unmatured finance income as current income of the
period. At the end of each accounting period, the hire purchase price less the
----------------------
installments received is shown as a receivable (stock on hire) and the finance
---------------------- income component of these installments is shown as a current liability.

----------------------
----------------------
1. The lessee is not allowed to claim lease rentals as tax deductible
---------------------- expense as far as Income Tax Act is concerned.
---------------------- 2. The excise duty on the assets on lease has been made modvatable;
this means that the lessee can claim refund of the excise duty paid
---------------------- while acquiring the asset.
----------------------
----------------------
Activity 4
---------------------- Find out from a balance sheet of a leasing company how they have treated
the lease transactions on their balance sheet.
----------------------
----------------------
13.6 SUMMARY REGULATIONS GOVERNING NBFCS
---------------------- ISSUED BY RBI
---------------------- 1. All NBFCs must register themselves with the RBI. No company can
undertake NBFC activities without the registration certificate issued by
----------------------
the RBI.
---------------------- 2. NBFCs having net owned funds of less than Rs. 25 lakhs cannot accept
public deposits.
----------------------
3. The ceiling on the quantum of public deposits for NBFCs has been
---------------------- linked to its level of credit rating and the type of activity conducted by
---------------------- the company. For leasing companies a triple A rated company can raise
deposits worth 4 times of its networth, a AA rated company can raise 2.5
---------------------- times of its networth and so on. The minimum investment grade is A-.
---------------------- 4. Deposits can be accepted for a maximum period of 5 years.

5. Maximum rate of interest on deposits 12%
----------------------
6. The capital adequacy ratio has been fixed at 12%
----------------------
216 Capital Market

7. Credit concentration per borrower and a group of borrowers not to exceed Notes
15% and 25% of its net owned funds.
----------------------
8. They are expected to maintain liquid assets equal to 15% of the outstanding
public deposits with them. ----------------------
9. Bank borrowings not to exceed 4 times of the net owned funds.
----------------------
10. They cannot borrow in excess of 10 times of their net owned funds.
Borrowings include deposits accepted from the public. ----------------------
----------------------
13.7 LATEST DEVELOPMENTS
----------------------
Opportunities of Indian Leasing Industry
----------------------
1. Convenience
2. Improved Cash Flow ----------------------
3. Fixed Lease Payments ----------------------

4. Upgraded Technology ----------------------
5. Foreign Deals
----------------------
6. Leasing Gaining Prominence In India with vehicle leasing.
----------------------
Going forward, it is expected that the market for simple finance leases
may slow down further with the impending introduction of new Direct Tax ----------------------
Code and would get limited to special situations where the lessor has a need
to resort to leasing as a structure to better secure his ownership rights on the ----------------------
equipment as compared to debt financing or hire-Purchase transactions. ----------------------
How ever, it is believed that strong customer demand drivers for operating
leases are falling in place in several business segments, which are likely to ----------------------
result in high annual growth rates of 25-30% over the next 5 years. ----------------------
Leasing of construction equipment is expected to rise with introduction
of large ticket size sophisticated equipments from International OEMs and ----------------------
significant demand for capital investments across all infrastructure sectors. ----------------------
Leasing of information technology and office equipment are expected
----------------------
to be driven by high pace of technological obsolescence, trend towards
outsourcing of non-core assets and rise in MNC culture of operating on an ----------------------
asset light model. Medical Equipments is another segment where leasing is
expected to pick up significantly, driven by introduction of equipments with ----------------------
rapidly changing technology from international manufacturers and emergence
----------------------
of corporate hospital chains.
As the changes in the taxation laws and regulations kick in over the next 12 ----------------------
- 24 months, we may even witness a higher growth rate for the leasing industry
----------------------
which has already found a strong business case in the emerging economic
scenario. ----------------------
----------------------

Notes Summary
---------------------- ●● In this unit we have seen what is meant by lease financing and its advantages.
We have also studied the sources of finance for these companies and have
----------------------
seen the contents of lease agreements.
---------------------- ●● We have studied the mechanism of sale and lease back transactions and
the problem associated with it. We have learnt about the hire purchase
----------------------
transaction and the differences between lease and hire purchase
---------------------- transactions. Finally, we have seen the RBI regulations for this sector.
---------------------- Keywords
----------------------
●● Hirer: The party that buys an asset under the hire purchase agreement.
---------------------- ●● Hiree: The party that finances the Hirer to acquire an asset.
---------------------- ●● Lessor: The party that owns an asset.
●● Lessee: The party takes an asset on lease from the lessor.
----------------------
●● Service Tax: Tax levied by the central government on services rendered.
----------------------
---------------------- 1. Differentiate between Lease and Hire purchase transactions.

2. What are sale and lease back transactions and explain the problems related
----------------------
to these transaction?
---------------------- 3. Explain the RBI regulations for NBFCs.
---------------------- 4. Why do you think leasing has its popularity?
---------------------- 5. What is meant by Big Ticket leasing?
6. Explain the Income Tax treatment of lease transactions with reference to
----------------------
AS 19.
---------------------- 7. What are the clauses of a lease agreement?
---------------------- 8. What are the advantages and disadvantages of lease?

----------------------
---------------------- 1. True
---------------------- 2. False
----------------------
----------------------
218 Capital Market

Fill in the blanks.
----------------------
1. A lessee and a lessor can enter into an agreement whereby a lessee sells
the existing assets to the lessor and take these assets back from him on ----------------------
lease; this is known as sale and lease back transaction.
----------------------
2. Leasing companies collect savings from individuals and use this money
to help corporates create productive assets. ----------------------
----------------------
----------------------
1. False
----------------------
2. True
----------------------
1. False
----------------------
2. True
----------------------
----------------------
1. Kothari, Vinod. 1986. Lease, financing & hire-purchase: including ----------------------
venture capital, mutual funds, factoring, and merchant banking. Wadhwa
and Co. ----------------------
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Notes
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220 Capital Market

References Notes
----------------------
1. Marketing of Financial Services - Avadhani
----------------------
2. Indian Financial System - M. Y. Khan
----------------------
3. moneycontrol.com
4. capitalmarket.com ----------------------
5. Money Life (Magazine) ----------------------
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References 221
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222 Capital Market

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224 Capital Market

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CAPITAL MARKET

(FOR PRIVATE CIRCULATION ONLY)

COURSE DESIGN AND REVIEW COMMITTEE

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

Copyright © 2018 Symbiosis Open Education Society

Unit No. TITLE Page No.

Introduction to Capital Market 1

---------------------- 1.1 INTRODUCTION

2. Capital markets deal in both, debt and equity ----------------------

1. Divide the activities of capital markets and money markets. ----------------------

Introduction to Capital Market 3

Check your Progress 2 ----------------------

Introduction to Capital Market 5

The corporatisation of stock exchanges is a reform long overdue. The ----------------------

Introduction to Capital Market 7

Introduction to Capital Market 9

---------------------- 1.7 INTRODUCTION TO MONEY MARKETS

1.8 PARTICIPANTS IN MONEY MARKETS ----------------------

Discount and Finance House of India Ltd. ----------------------

Primary Dealers ----------------------

1. ‘T’ Bills ----------------------

Introduction to Capital Market 11

---------------------- 14 - Days Intermediate T-Bills

---------------------- Check your Progress 3

---------------------- 2. T-bills were introduced to stabilise the capital markets.

Introduction to Capital Market 13

---------------------- 5. It excludes bills arising out of sale of such commodities as may be

Introduction to Capital Market 15

---------------------- How is the interest on a repo calculated?

Options price within a specified period of time. ----------------------

Introduction to Capital Market 17

Introduction to Capital Market 19

Introduction to Capital Market 21

---------------------- Put Option

Horizontal or time spread strategies involve simultaneous buying and ----------------------

Introduction to Capital Market 23

Check your Progress 4 ----------------------

Introduction to Capital Market 25

---------------------- Self-Assessment Questions

---------------------- 1. Describe the Indian Capital markets.

1. Short term in Indian context means a period up to one-year. ----------------------

Introduction to Capital Market 27

Securities and Exchange Board of India (SEBI) 29

---------------------- 2.2 OBJECTIVES OF SEBI

2.3 THE ROLE ASSIGNED TO SEBI ----------------------

---------------------- Check your Progress 2

2. Every application for registration shall be in such manner and on ----------------------

Securities and Exchange Board of India (SEBI) 33

---------------------- 2.5 SEBI GUIDELINES FOR ISSUE OF DEBT

---------------------- A company offering Convertible / Non-Convertible debt instruments

Securities and Exchange Board of India (SEBI) 35

Securities and Exchange Board of India (SEBI) 37

Securities and Exchange Board of India (SEBI) 39

---------------------- Check your Progress 4

---------------------- 2. SEBI has encouraged the registration of investors’ associations in

---------------------- Find out what was the Badla system.

●● It can suspend or cancel the registration of a merchant banker. ----------------------

Guidelines to Investors ----------------------

Securities and Exchange Board of India (SEBI) 41