Cleaning up

After the crackdown on shell companies, time to completely phase out participatory notes

Sebi has restricted trading to once a month in more than 300 listed companies on suspicion of being vehicles for money laundering. Going beyond, the market regulator should examine when and how these companies got listed, the investment bankers who shepherded them and the auditors signing their books. The Insolvency and Bankruptcy Code, passed in May 2016, has blocked crony capitalists with a track record of defaults. The travails of a consumer durables company and a conglomerate with dreams of rivalling RIL are symptomatic of the changed times. Earlier, some helpful bankers would have bailed them out. Now, they are shedding businesses to survive. Ironically, both had interests in oil exploration and telecom, the two sectors with plenty of room for arbitrariness in awarding contracts and licences in the pre-May 2014 era. The recall of high value notes late last year flushed out unaccounted cash. The income tax department got a wealth of data to inspect and pursue. One lakh shell companies have been detected. Banks got low-cost funds. According to a Reserve Bank of India study, most of the deposits were later diverted into mutual funds, a departure from the earlier practice of opting for real estate and gold. Therefore, a major benefit of demonetization is the weaning away of the equity market from foreign investors. The introduction of the goods and services tax from 1 July 2017 will support listed companies to capture the share of the unorganized sector. Companies in the informal sector that have achieved scale but were reluctant to list due to the increased scrutiny will no longer be able to enjoy the edge of tax evasion. Investors should gear up for a booming primary market.

Despite some hiccups, the stock market has been stable during these surgical strikes. Previous attempts to staunch dodgy foreign inflows did not meet with a calm response. In October 2007, Sebi proposed curbs on participatory notes (PNs) issued by registered foreign institutional investors to overseas investors who wished to test the Indian stock market. It is not possible to know who owns the underlying securities. Hedge funds acting through PNs were the cause of much volatility. The instruments accounted for around 50% of investments made by FIIs then. Within a minute of opening for trading on 17 October, the BSE Sensex shed 1,744 points, or about 9% of its value, in the biggest intra-day plunge in absolute terms. Finance Minister P.Chidambaram had to clarify that there were no plans to immediately ban PNs. Stocks staged a remarkable comeback after opening at 10.55 am and ended down just 336.04. The Sensex tumbled 717.43 points, or 3.83%, its second biggest fall, next day. There was a 438.41-point slide the day after. Sebi chairman M Damodaran had to announce simplification of the FII registration process. The market gained 879 points, its biggest single-day surge. The regulator nonetheless banned FIIs from issuing fresh PNs and asked them to wind up their exposure within 18 months. In a couple of days, the benchmark crossed the 20,000 mark for the first time.

Five years ago, Sebi ordered FIIs to report monthly details of PN transactions within 10 days instead of six months after a Union government white paper on black money identified the instruments as one of the routes through which black money transferred outside India comes back. End 2014, new regulations were published to curb illegal fund inflows by tightening know-your-client norms and shutting out entities with opaque structure. A couple of months ago, a fee of US$1,000 was levied on each PN. Issuance for speculative purposes was barred. At the same time, entry was relaxed for FIIs willing to invest directly. In July, the regulator put in place restrictions on FIIs from issuing PNs for derivatives. These were to be used only for hedging. Besides, existing positions on un-hedged PN derivatives had to be liquidated by end December 2020. The market in the meanwhile has become more transparent. Disclosure norms are getting stringent. Companies have to inform the stock exchanges of any defaults within 24 hours. The usage of Aadhaar and KYC removes ambiguity about the identity of domestic investors. FIIs are now choosing the derivatives platform over the cash segment. Despite their falling share, to 6% end April, the opaque nature of PNs does not fit in the concept of New India propounded by Prime Minister Narendra Modi on 15 August. Concerns still remain that PNs are being misused for round-tripping. With mutual funds displaying capability to insulate the market from any external shock, it is time to bury the ghost of PNs once and for all.

Mohan Sule

Tough love

Indian companies’ stormy transition to transparency should be welcomed despite some short-term capital loss

Less than 10 months following the boardroom turbulence at one of India’s oldest conglomerates in the country, another high-profile exit has rocked the stock market. Parallels are being drawn between the spat involving the board and larger-than-life former honchos. The conflict at the Tata group and Infosys revolved around the direction of the companies under the successors. If the proposed write-downs and deleveraging of the balance sheet angered Ratan Tata, N R Narayana Murthy was annoyed with the splurging on compensation packages and an expensive acquisition. Both have been criticized for interference. In the meantime, the market value of their companies eroded as panicky investors dumped the stocks, unsure of future. The trigger for the bloodletting seems to be the downturn in the businesses. The global fund crunch turned the Tatas’ strategic buys to ramp up growth into costly mistakes. The shift in the market mood from back-office support to digital innovations after recovery from a decade-long slowdown caught the Indian tech sector including Infosys off-balance. The five large businesses of the Tatas that were the cause of the misery and the subsequent coup seem to have bottomed out due to the turn in the global economy. Though a massive buyback has failed to stem the slide in the stock for now, the turmoil at the tech major will be a distant memory shortly. The market is back with its preoccupation of how global and domestic winds will affect the flagships of the Tata group. In another couple of months, analysts will be examining Infosys’s revenue guidance for the second half of the fiscal to gauge the outlook of the sector.

An evolved market should really not care who the boss is as long as the company is delivering capital gains consistently. Transfer of power should take place without much ado, with replacements spotted and groomed at least a year in advance. Big investors are constantly pushing controlling shareholders to broad-base the pool to run their companies to ensure longevity. The Tata group was often cited as an excellent example of a promoter-driven enterprise managed by professionals. Some of them assumed legendary proportions till Ratan Tata arrived on the scene and carried out a putsch. JRD Tata’s choice of a relative to succeed him rather promoting one of the competent managers within the fold was disappointing but understandable. Who else but a part-owner to hold together disparate companies? Vishal Sikka was a lateral appointment and only after the co-founders had their turn at the wheel. The decision did not signal a desire to voluntarily step back but reluctance to let go the reins. The market is divided over Tata’s and Murthy’s refusal to lead a quite retired life despite both holding some equity. The irritation over the events leading to the departure of the new recruits in less than four years of their anointment is because of the uncertainty ahead and not out of concern for accountability. Surprisingly, there is no introspection over the inherent contradiction of exiting a counter that is the midst of cleansing process. Rather than wishing the issues to be swept away, investors who grumble being bypassed at annual general meetings should be using the opportunity to let their voices be heard. A debate is necessary to learn lessons.

The market’s reaction to succession points to an over-riding desire for a smooth transition irrespective of the choice. Despite their distaste for family-dominated businesses due to their opaque operations, the only time apart from financial performance that institutional investors take flight is when there are squabbles. The RIL stock suffered volatility post Dhirbubai Ambani’s failure to make public his preference for either of the two sons laying a claim on the business. Ordinary investors, who are told to prefer companies with large non-promoter presence for liquidity and enhanced scrutiny, cannot be faulted if they feel bewildered by the recent events. The combined shareholding of foreign and domestic institutional investors in Tata companies and Infosys is more than those of the promoters. Till the explosion, there was no hint from these investors about the shape of things. The regulatory emphasis on corporate governance is an acknowledgement of the limits of the auditors. They can only point to lapses in book-keeping. The recognition of the role of whistle blowers underscores the importance of corporate culture. The market is known to assign better discounting to transparent companies over peers. There is plenty of scope to earn fat profits from cyclicals such non-ferrous metals and sugar. Yet most risk-averse stay away from these counters because of their dependence on government support. How a company achieves growth is the crux.

Mohan Sule