SEC now fuels new mark-to-market conspiracy theories

Investors Feel The Regulator Is Giving Companies Leeway For Avoiding Big Writedowns

ONCE again, the Securities and Exchange Commission is fuelling suspicions that it has crafted yet another new accounting loophole for financial institutions trying to avoid big writedowns. Now for the strange part: The confusion, which centres on how the SEC interprets the rules for mark-to-market accounting, is unnecessary. That’s because, this time, there doesn’t seem to be any such loophole.
The SEC could clarify this point. It refuses to do so, choosing to stay silent when asked where it stands. That, in turn, is fanning concerns that maybe the SEC really is trying to give large banks and insurance companies a free pass. Given the SEC’s recent track record, it’s hard to blame investors for thinking this way.
Here’s what happened. On March 28, the SEC’s staff released a much-anticipated letter to unspecified companies that hold lots of hard-to-value financial instruments. The impetus was a new Financial Accounting Standards Board rule called Statement 157, which for most companies took effect last quarter.
While Statement 157 doesn’t expand the use of fair-value accounting, it does require companies to disclose how much of their financial instruments are valued using quoted market prices, how much are measured using valuation models, and how much come from models using inputs that aren’t observable in the market.
In its letter, the SEC’s staff recommended a broad range of disclosures companies should make in the discussion-and-analysis sections of their next quarterly reports, when describing how they calculated the values of those assets and liabilities. That part isn’t what drew the firestorm, though. Rather, it was these two introductory sentences. (The emphasis below is mine.) “Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, UNLESS THOSE PRICES ARE THE RESULT OF A FORCED LIQUIDATION OR DISTRESS SALE,” the letter said. “Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability.”
The reaction was a flurry of press and analyst reports, concluding that the SEC had cut Wall Street firms a huge break. Here are a couple examples.
“The distress sale caveat looks like an escape clause,” the Financial Times wrote March 31 on its Alphaville blog, under the headline “Marking to moral hazard”. “To wit: if asset prices fall too much, just ignore the price falls. In fact, create, buy or hold, whatever structured rubbish you like in the future because it doesn’t have to lose its value if you don’t want it to.”
Dennis Gartman, an economist in Suffolk, Virginia, and editor of the Gartman Letter, wrote this in a March 31 note to clients: “We’ve asked friends in the business for their take, and after two days we’ve come to the conclusion that markto- market has quietly died with this letter, and with it transparency in financial accounting.” Actually, the SEC’s letter merely repeated what Statement 157 already says. Or so it seems. The standard says “a fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants”. It goes on to say an orderly transaction “is not a forced transaction,” such as “a forced liquidation or distress sale”. That’s the same language the SEC’s staff used.
The reason for this exception? Take a situation like the 2006 collapse of Amaranth Advisors. — Bloomberg

(Source: Economic Times 3rd April)

Sign up for the ‘Teach Neta’ campaign

Looks like the whole country and its youth want to become master-jis and masternis. We thought that they only wanted to be Paanchvi Pass or take part in Ekta Kapoor’s new tele-dance contest, but instead they have been signing up in droves for the TOI’s ‘Teach India’ campaign. Strange. They haven’t even been offered a free Dubai shopping holiday, let alone an invite to the Tiger Balm Filmfare Awards Nite. On the contrary, they have to do all the free giving, two hours a week to teach underprivileged kids. Miss, Miss, i am not understanding this lesson. Young-young peoples in colleges and bigbig peoples in corporates want to help smallsmall kids instead of hanging out at in lounge bars? They’ve gone mad or wot?
Yet it’s a fact. ‘Teach India’ has sparked a huge response, and i’ve been trying to figure out what has really caused this Buzz of the Spelling Bee. On the surface, the campaign might appear to be the long-awaited answer to the common dilemma of ‘I want to climb out of my selfish life, but don’t know where to find the ladder.’
It’s all very grand to turn the whole of India into a classroom without walls and windows, not just without blackboards, but you can’t fool me. It can’t be as simple as that. There has to be some hidden agenda behind this altruistic giving of time and talents. Remember, we are now in the India which has flung out its socialist baggage, and drooling-ly jumped aboard no-malls-barred materialism. Face it, baby, no one ever got a foothold on that train by giving someone else a leg-up.
My theory is that this whole campaign is not about Illiteracy Hatao, but about hataoing ethically illiterate politicians. I suspect that ‘Teach India’ is secretly about teaching our leaders a lesson, creating a huge mass of empowered citizens who will be able to sternly order them,‘Get out of the ruling class!’; ‘Stand in the corner!’; ‘Stand on the bench. No, not on the Opposition Benches!’
What i can’t figure out is, why did the TOI have to resort to this elaborate ‘Teach India’ guise? Why didn’t it khullam khulla and straightaway launch a ‘Teach Neta’ campaign? The public would have signed up even more eagerly because this is the glaring need. Once again our leaders have shown that they are lacking in even the basic 3Rs. The Left cannot read the writing on the wall, and every party thinks arithmetic is a zero sum game. They keep waving their numbers as if they are the Tambola Queen of the Karol Bagh kitty party circuit.
The BJP urgently needs memory-strengthening lessons because even its head boys can’t remember what they wrote in their previous nuclear test. The CPM needs a lesson in chemistry instead of going hammer and sickle at whoever it supposedly supports. The Congress does not need any more physics lessons on the correlation between external pressure and hot air. The SP and the BSP strangely seem to be in the same spirituality class because, for both of them, it’s nothing but Maya.
Fortunately, the hard-pressed ‘Teach Neta’ campaign can defer its Einstein’s formula lessons to the next term. In any case, that entire school knows that Elections=Manipulation, Corruption 2 times over.
So, it is obvious that the TOI campaign first needs to educate the political Class of 2008. Or those notorious netas will turn ‘Teach India’ into ‘Leech India’. Just as they have been distorting their mandate of ‘Lead India’ into ‘Bleed India’.
Alec Smart said: ‘‘What’s the new Sinhalong? ‘Old Manmohan has a deal. IAEA-O!’’

(Source: Times of India)

Arming Sebi to regulate DVR share issues

Market Regulator’s Inability To Act On Differential Voting Rights Can Land Minority Shareholders In A Spot

CLASS WAR: More equal than equals?

IT IS perhaps the most important development in recent years concerning listed companies and minority shareholders. Differential voting rights (DVR) will change the promoter-minority shareholder equation in the years ahead. Tata Motors' proposed Rs 7,200 crore rights issue comprises DVR shares (including convertibles) worth up to Rs 5,000 crore. This issue will be watched closely as it will set precedents for subsequent issues to follow. That's because there are no clear Sebi guidelines for the issue and pricing of DVR shares by listed companies. And, more surprisingly, Sebi's ruling in the Jagatjit Industries case indicates it cannot regulate the issuance of DVR shares.
In India, companies have hardly felt the need for DVR shares. Promoters usually own sizeable stakes in companies and hostile takeovers are rare. Still, the government obliged big business by amending the law to allow such issues. Voting rights are crucial for investors. They come into play when critical meetings are held, be it board meetings, shareholder meetings or voting through postal ballots. In India, so far all shares have conferred equal voting rights, the only exception being banks. DVR shares were legalised after an amendment under Sec 86 of the Companies Act, with the rules notified in 2001.
Under these rules companies should, among other things, have a three-year profit record, the articles of association should allow issuance of such shares, and shareholder approval is needed. DVR shares cannot exceed 25% of the total capital. They are not convertible, so Class A shares, for example, cannot be converted into Class B shares and vice versa. Now, all share issues by listed companies are regulated by Sebi. So, for DVR shares too, Sebi would safeguard minority shareholder interests.
But the Jagatjit Industries case casts a cloud on that. The case deals with the issue of DVR shares to promoters in 2004, in which the legality of the issue has been questioned by a co-promoter. While the shares have been issued, they have not been listed as the stock exchanges did not accept the listing application.
Without going into the details of the case, which are not relevant here, in its order, Sebi asks a question to which it then responds. The question is: "Whether under the provisions of the Companies Act, 1956 and the Sebi Act, 1992, Sebi has the power to decide the legality and propriety of allotment of DVRs and take action for violations?"
The answer is quite startling. Sebi's powers have been carved out of some sections of the Companies Act, 1956, on the issue and transfer of securities of listed or to be listed companies. Section 55A of the Companies Act lists those sections, which come under Sebi. Section 86, which deals with DVR shares unfortunately is not among these sections. The Sebi order says: "Therefore, under the present statutory provisions, Sebi does not have any power to regulate the issuance of the DVR shares." So, in the Jagatjit case, the Company Law Board will decide whether the issue of these shares was legal.
Sebi's lack of jurisdiction does not mean it can do nothing about the issue of DVR shares freely. It can influence the listing of such shares and the takeover regulations can also be used, if there is any violation. Most companies would follow the prevailing guidelines for share issue, to avoid falling foul of Sebi. In 2004, for example, Reliance Infrastructure (earlier known as Reliance Energy) had issued 80 lakh shares with zero voting rights to its promoters. That went through without causing much furore. The Sebi order also says that the issue and listing will 'attract the applicability of the DIP guidelines and the listing agreement'.
But Sebi needs powers to govern the issuance of DVR shares. Apart from applying DIP guidelines that are applicable to all share issues, these shares will require some special provisions. Pricing these shares is a key issue, for example. Internationally, if one class of shares can be converted into another, the conversion factor can be used as a benchmark. Say, if one Class A share can be converted into 10 Class B listed shares with a market price of Rs 10, one Class A share price will be worth Rs 100.
But the current guidelines stipulate that conversion is not possible. In that case, it becomes tricky because voting rights will have to be used to determine the premium or discount. Higher voting rights should automatically mean a premium, usually to be paid by the promoter for retaining a larger share in the company. If a promoter can increase his stake from 30% to 51% through a DVR issue, how will the control premium be determined? In the submissions made to Sebi, Jagatjit says that as there were no specific guidelines for pricing of DVR shares, existing guidelines were used to the extent applicable.
The other aspect that needs to be studied is how DVR can affect various issues like restructuring of companies and takeover regulations. For example, say Class A shares are held by promoters and Class B shares are held by the public. If Class A shares are sold leading to a change in control, how will the open offer price for Class B shares be decided? Moreover, when restructuring of companies, involving reduction of share capital, which requires shareholder approval, appropriate checks need to be in place to ensure that minority shareholders don't get shortchanged. Even now, buyback of shares are passed off in the guise of a reorganisation of capital under the Companies Act.
In 2002, in fact, Sebi's Primary Market Advisory Committee had made recommendations on various issues, including DVR shares. That committee had concluded that Sebi's equity issue guidelines apply to such shares too. While that is in doubt now, it had made several other observations, including prohibiting an IPO of DVR shares, they should be compulsorily listed, and they will have to fulfil all listing agreement conditions. These are, of course, recommendations but bring to light the impact on other crucial areas like IPOs.
More issues will come to the fore once companies start issuing DVRs, if a Sebi framework is not in place soon enough. For example, Jagatjit said in its submission to Sebi that initially it did not intend to list these shares. Instead of having patchwork solutions, it would be better if the market regulator moves the government to include Section 86 under its ambit, and frame a discussion paper on guidelines for the issue of DVR shares. That would make minority shareholders feel more secure.

Source: Economic Times
Ravi Ananthanarayanan, Mumbai.

Can India Inc swallow the ‘poison pill’?

The reason for utilising the poison pill defence is to protect shareholder value and interest while stalling entities such as asset strippers

THE contemporary global history of mergers and acquisitions may be tidily divided into two eras marked by the introduction of the defence strategy called the poison pill and the subsequent landmark ruling of the Delaware Supreme Court in 1985 which upheld its legality. Before that, hostile acquirers repeatedly struck terror in the hearts of corporate boards. If these wealthy dealmakers wanted to take over a company in a hostile acquisition, bite it into pieces, and then spin those pieces off for a profit, there wasn’t much that the boards of a target company could do to stop the massacre. The poison pill quickly transformed the takeover law and fortified the preemptive defences of companies.
The classic poison pill strategy (aka the shareholders’ rights plan) is one wherein the target company gives existing shareholders the right to buy stock at a bargain price if a hostile acquirer purchases more than a predetermined amount of the target company’s stock. The purpose of this move is to devalue the stock worth of the target company and dilute the percentage of the target company equity owned by the hostile acquirer to an extent that makes any further acquisition prohibitively expensive for him. There are many equally effective variations of the classic poison pill defence. This article examines the applicability of the poison pill in the present legal and regulatory framework in India.
The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 1997, commonly referred to as the Takeover Code, makes it difficult for the hostile acquirer to sneak up on the target company. It forewarns the company about the advances of an acquirer by mandating that the acquirer make a public disclosure of his shareholding or voting rights to the company if he acquires shares or voting rights beyond a certain specified limit. However, the code does not present any insurmountable barrier to a determined hostile acquirer.
In fact, the code, vide Regulation 23, imposes a general prohibition on the corporate actions of a target company during the offer period, such as transferring of assets or entering into material contracts and even prohibits the issue of any authorised but unissued securities during the offer period. However, these actions may be taken with approval from the general body of shareholders.
Regulation 23, however, makes an exception to the above situation by permitting the target company to issue shares carrying voting rights upon conversion of debentures already issued or upon exercise of option against warrants, as per predetermined terms of conversion or exercise of option. It also allows the target company to issue shares pursuant to public or rights issue in respect of which the offer document has already been filed with the Registrar of Companies or stock exchanges, as the case may be. However this may be of little respite as the debentures or warrants, contemplated earlier must be issued prior to the offer period. Further the law does not permit the board of the target company to make such issues without the shareholders approval either prior to the offer period or during the offer period (as it is specifically prohibited under Regulation 23). During a takeover scenario it may be critical for the board to quickly adopt a defensive strategy to help ward of an hostile acquirer or bring him to a negotiated position. In such a situation, it may be time consuming and difficult to obtain the shareholders’ approvals especially where the management and the ownership of the company are independent of each other.
We have to read the Takeover Code along with the SEBI Disclosure & Investor Protection Guidelines 2000, which are the nodal regulations for the methods and terms of issue of shares/warrants by a listed Indian company. They impose several restrictions on the preferential allotment of shares and/or the issuance of share warrants by a listed company. Under the DIP guidelines, issuing shares at a discount and warrants which convert to shares at a discount is not possible as the minimum issue price is determined with reference to the market price of the shares on the date of issue or upon the date of exercise of the option against the warrants. This creates an impediment in the effectiveness of the shareholders’ rights plan which involves the preferential issue of shares at a discount to existing shareholders.
The DIP guidelines also provide that the right to buy warrants needs to be exercised within a period of eighteen months, after which they would automatically lapse. Thus, the target company would then have to revert to the shareholders after the period of eighteen months to renew the shareholders’ rights plan.
Without the ability to allow its shareholders to purchase discounted shares/ options against warrants, an Indian company would not be able to dilute the stake of the hostile acquirer, thereby rendering the shareholders’ rights plan futile as a takeover deterrent.
As seen above, for the poison pill strategy to work best in the Indian corporate scenario certain amendments to the prevalent legal and regulatory framework are required. Importantly a mechanism must be permitted under the code and the DIP guidelines which permits issue of shares/warrants at a discount to the prevailing market price. These amendments would need to balance the interests of the shareholders while allowing the target companies to fend off hostile acquirers.
That said, history is ripe with examples of how a little legal ingenuity and a few pre-emptive strategies can fend off the advances of the most ardent hostile acquirers. One of the advantages of the poison pill strategy is that there is no rigid structure to it and it can be tailored to suit the particular needs of a company. As a result, Indian companies are not restricted to adopt the classic version of the pill i.e., the shareholders’ rights plan.
For example, DIP guidelines do not prescribe any pricing restrictions on the issue of non-convertible preference shares, nonconvertible debentures, notes, bonds and certificates of deposit. Thus, we may consider structuring a poison pill in place whereby backend rights which permit the shareholders to exchange the rights/shares held for senior securities with a backend value as fixed by the board, are issued to existing shareholders when the hostile acquirer’s shareholding crosses a predetermined threshold. As most takeovers are carried out through borrowed funds, the use of backend rights reduces the profitability of the takeover because of the mounting interest rates on borrowings; thus deterring the hostile acquirer and more importantly sets the minimum takeover price, which is the price at which the shares have been exchanged for senior securities.
Further, company could put in a provision in its articles whereby a hostile acquirer who succeeds in taking control of that company and/or its subsidiaries is prohibited from using the company’s established brand name. It is believed that different Tata companies have in place an arrangement with the Tata Sons holding entity, whereby any hostile (or otherwise) acquirer of any of those entities is not permitted to make use of the established Tata brand name. Consequently, the bidder might be able to take over the target Tata company but will be shortchanged as it will not be entitled to a significant bite of its valuation — the valued brand name!
Another variation of the poison pill that may be explored in India brings the Employee Stock Options Scheme (ESOS) into action. ESOS is governed by the SEBI guidelines of 1997, whereby a company granting options to its employees pursuant to ESOS has the general freedom to determine the exercise price, subject to the adherence to the accounting policies prescribed under the SEBI guidelines in this regard. Thus, an effective poison pill defence may be achieved by issuing ESOS at a discount, which would serve to dilute the share value of the hostile acquirer over the target company.
Indian companies need to shift from desperate defensive play to sitting ready on the offensive. It is time we introduce the poison pill to the Indian business world and adapt it to make it our own. However, the reason for utilising the poison pill defence is to protect shareholder value and interest while stalling entities such as asset strippers that do not have the best interest of the company in mind or add any value to it. LTTE cadres swallowed the cyanide pill around their necks and committed suicide as a last resort. Given the parallel between the LTTE’s cyanide pill and the corporate poison pill defence, companies need to ensure that this defence is not misused by errant management. So a company is welcome to utilise its benefits but warned not to convert it into its Achilles’ heel.

- Author is Rajiv K Luthra
Economic Times

The Tight Rope Act

Walking the Tight Rope

With inflation hitting new highs, the regulators have a daunting task of keeping the growth engines running and controlling inflationary conditions.

With fears of an economic slowdown looming large and with US already in recession, the last tranche of bad news needed was a spiraling interest rate. The rising interest rate phenomenon has been witnessed across most emerging market economies. And the men who has been left asking for a fine balancing act is the RBI governor, Mr. Y.V Reddy and the Finance minister, Mr. P. Chindambaram. The sub 7% interest rate number is way above the RBIs comfort zone. The FM has already come out all guns blazing saying that the govt. will introduce a slew of monetary and fiscal measures to control inflation. So where does this leave us and what are the various tricks the govt. has in its sleeve ?

The government has a very tough task on its hand. If the central bank were to raise interest rates further, it would lead to a slowdown on the economic growth front with the credit growth already dwindling. The sale for various credit sensitive items has already taken a beating over the past year on the back of high interest rate regime. And each time we increase the interest rates, the interest rate differential between India and other developed economies increases further, encouraging arbitragers and other investors to pour in dollars leading to a weaker dollar. The export sector has already been pressed hard to make ends meet and a further strengthening in rupee would be the last thing they could have asked for. A developing economy like India which has been running a rather huge current account deficit cannot afford to hurt exports of goods and services which would have serious ramifications for the sustainability of the growth in the future. The interesting thing to watch out for would be the instruments which the central bank uses, in the hope of deflating the inflation bloat.

Another move the govt hopes to make use of is reduction in import duties. A reduction in import duties coupled with a stronger rupee might make imports competitive but I doubt if it could result in any meaningful reduction in prices because of high price levels being witnessed in the global commodity markets. The global commodity prices have hit the roof on back of low food grain surplus, if any and on concerns of continued availability of non renewable energy resources in the distant future. The real solution to taming inflation in the long run lies in improving our agricultural productivity and removing infrastructure bottlenecks for which lies no easy make fix solutions. But for now the persons at the helm of the affairs have been left with walking the Tight Rope to reign in inflation.

Split Wide Open

The Community of Economists and bankers are in splitsville with opinions differing significantly on the effectiveness of the policy actions mentioned above, in controlling inflation. One sect of economists houses the view that the present inflationary conditions which are being witnessed is because of supply constraints and hence increase in interest rates cannot address such an issue. Infact it would have a negative impact by effecting demand adversely, and when the inflationary pressures have really bottomed out in the form of improved supply, the demand for them would have taken a beating. All this would derail the economic growth engine. At the same time another group of Economists believe that the central bank should act swiftly, and justify the first mentioned approach to tame inflation.

It remains to be seen as to which path the central bank threads to control inflation. And hence walking the fine line of inflation and growth is becoming a daunting challenge.