The Hindu Business Line : The road ahead for SEBI

The regulatory agency needs to look closely at plugging those loopholes that favour insiders and speculative traders to protect the retail investor’s interests, says SUNIL KEWALRAMANI

Mr C. B. Bhave, Chairman, SEBI…Left with a lot to do.

Under Mr M. Damodaran, the Securities and Exchange Board of India (SEBI) witnessed many crucial reforms, including the removal of entry load on mutual funds with effect from January 4, 2008 and corporate governance norms to be followed by listed companies.

Through the latter, SEBI can ensure that at least 50 per cent of a board’s members are independent directors if the company’s chairman is the executive director and at least a third are independent directors if the chairman is a non-executive director. Despite severe pressure, SEBI stayed committed to its belief in enhancing the weight of independent directors on the board for better corporate governance.

The new director has taken Mr Damodaran’s place in trying times with a lot left to do. Here are some issues that Mr Bhave would do well to consider.

Monitoring Derivatives

There is a glaring need for regulatory action against errant stock market operators and brokers who thrive on investors’ urge to make quick money. When India integrates with the rest of the world, it integrates their practices, policies and procedures as well.

Heavy unwinding of leveraged positions has been witnessed in India, for example, in January 2008, where new retail participants were treated to fantastic leveraged treats of investing in expensive stocks contributing just 10 per cent or so. The total leveraged position (in excess of Rs 1 lakh crore, or Rs 1 trillion) contributed heavily to the stock market crash.

The majority of the stock-brokers have unwound their leveraged positions in the futures and options arena. Such was the intensity that the open interest in F&O fell by 17 per cent on January 21, 2008 and by further 15 per cent on January 22.

Whereas the utility of derivative instruments as a means of hedging risk remains unquestioned, the risk management essential to the proper utilisation of these derivative instruments has not been fully implemented by the financial institutions in the emerging economies (where the credit and leverage practices imported are still in an embryonic stage).

Futures and naked options are being sold by many brokerage houses (with growth targets set for their employees) mainly for speculative purposes rather than as instruments of hedging risk, using the hard-sell principles of marketing. Every broker should, at the time of entering into every F&O transaction with a retail client or an HNI, be mandatorily required to obtain the client’s written consent that the client is fully aware of the risks inherent in F&O transactions and the quantum of maximum loss he would be exposed to should the tide turn against him.

A great deal of volatility in the Indian stock market would be drastically reduced if this provision is seriously promulgated and implemented by SEBI. Also, to prevent such products being marketed to the wrong set of clients, the margins on F&O should be enhanced even at the outset. Besides, the Finance Ministry should treat profits/gains occurring within a short period, a week for example, as speculative gain/loss to encourage use of F&O for hedging and not pure speculation.

In this context, the budgetary increase in short-term capital gains tax from 10 per cent to 15 per cent is a step in the right direction. The idea is not to amass additional revenues, but to curtail increasingly rampant speculative trading that hurts the small retail investor most.

Participatory Notes

If the limit on participatory notes (PNs) issuance is restricted to 40 per cent of the assets held by an FII, it would simply amount to rationing and would force buyers of P-notes to seek the less efficient dealers at the least optimum price that money can buy. In rare circumstances, the SEBI should consider whether ‘mutual recognition’ can be granted to foreign brokers and exchanges from select jurisdictions skipping the full-registration route.

The mutual recognition model works on the assumption that a foreign regulatory regime provides protection comparable to those under Indian securities laws. After carefully screening the origins, foreign exchanges and brokers could become significant conduits for foreign issuer securities entering the Indian capital market.

Besides, SEBI’s attempt to ban P-notes that have a derivative as their underlying is misleading. This is because, if, for example, the P-notes are cash-settled using the cash price of the Nifty index, their underlying is the cash index and not the index future, even if the FII hedges the P-notes using index futures.

Insider Trading Code

On January 1, 2008, SEBI proposed to make ‘insiders’ surrender to companies their short-swing profits. It has defined short-swing profits as ones made from trading in securities within a six-month period, using ‘insider’ knowledge. The move is aimed at creating a level-playing field for a company’s ordinary shareholders who would not have access to such information.

The Code of Conduct for Prevention of Insider Trading (Internal Procedures and Control) was promulgated by SEBI on January 15, 2004. Most listed companies have drafted a document of Code of Conduct for Prevention of Insider Trading in line with the regulations formulated by the SEBI.

It is clearly in a company’s best interest to prevent insider trading violations of all types. SEBI needs to make sure that such errant companies cannot access the capital market in the future by keeping a track of errant companies, insiders and promoters in their database over, say, 50 years. The SEBI should widely allow public access to such information through Internet search engines and its own Web site. Besides, the designated person in a company should coordinate the reporting requirements in a proactive, rather than reactive, manner.

For example, since policy and decision-makers are considered insiders, the co-ordinator must make sure that whoever is responsible for reporting is evaluating various major corporate activities that may potentially influence the stock price, and that appropriate officers, directors or key employees are designated as ‘insiders’.

By appropriate coordination with such a responsible person in a company, SEBI should ensure that as the market-moving events unfold and become public, no trading in the company’s shares has taken place from the earliest time the insiders could possibly have been privy to such information.

The regulations also apply to ‘designated insiders’. The proposal does not define ‘designated insiders’ and suggests that the definition will be narrower than the existing definition of a “deemed insider” and broader than an “insider” as defined under the Insider Regulations.

The crux of this exercise is to determine who will fall in this category, considering that the Insider Regulations have detailed definitions for the terms “deemed insider”, “insider” and also an inclusive definition for the term “designated employee” which includes the top 3 tiers of the company management and the employees designated by the company. Insiders need to be comprehensively defined to include everyone with access to sensitive corporate data, which includes lower echelon employees in an organisation.

Robust mechanisms are needed to monitor and make sure all cases of ‘profits earned from access to price-sensitive information’ are effectively captured. Also, in India, between the time the information is ready for release to the stock exchanges and media and the time the information actually reaches the stock exchanges and the media, there are frequent leakages that need to be plugged.

(The author is a Mumbai-based financial consultant. He advises foreign financial institutions, foreign companies and NRI clients on FDI and portfolio investment matters.)

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