and Corporatisation of Stock Exchanges in India

Business Law Project SYBFM

MEANING AND INTRODUCTION

According to the Securities Contracts (Regulation) Act, 1956, Stock Exchange is an association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing securities.

Demutualisation refers to the process whereby a mutually owned financial institution, for e.g. a stock exchange, is being converted into a stock company. Members usually receive shares in the new company and in some cases a cash windfall, in exchange for their ownership rights.

Corporatisation means stock exchange should be organized as a company. The idea is to separate ownership, management and trading rights from each other.

Example: -

An example for the same would be the demutualisation and corporatization of the Bombay Stock Exchange to Bombay Stock Exchange Ltd.

i. Before the scheme BSE was an Association of Persons and then after the scheme it became BSE Ltd. i.e. a limited company.

ii. Before the scheme both membership right and right to trade were held by the trading members only. Before demutualisation took place the 790 broker-members held 100% of the BSE.

iii. After the scheme of Corporatisation and Demutualisation, ownership and membership right have been segregated.

Historically, stock exchanges all over the world were mutual organizations owned by and run for the common benefit of their members, with no member taking profits. They were like "clubs" where the dealers transacted business through the open outcry system. Indian stock exchanges(except NSE and OTCEI) followed a mutual structure where the ownership and management rights of the exchange are bundled with trading rights as a broker and all three are represented by ownership of share of the exchange.

The disadvantage of such organization is that they primarily work towards the interest of members and not those of investors. The office bearers will have access to inside information which can be misused by them. There is clear conflict of interest. There is transparency and no professional approach. Moreover, they cannot raise large funds for modernization or up gradation by offering equity shares to others.

In view of this short comings of such ‘mutual stock exchanges’, a policy decision has been taken by Indian Government for corporatisation of stock exchanges, by which ownership, management and trading memberships of stock exchanges would be separated from each other.

The Stockholm Stock Exchange was the first exchange to demutualize in 1993.

1


FACTORS AND EVENTS

Factors leading to the Demutualisation and Corporatisation of Stock Exchanges in India: -

The conflict of interests between the owners, the members and the management since all the brokers are managing the exchange together

Investor’s interest was ignored as brokers were manipulating the market for their own advantage

Scams took place in pre-demutualization phase-1992- Harshad Mehta scam & 2001-Ketan Parekh Scam.

Lack of strict vigilance on the market-No one person or management was there to look after the affair of the exchange.

---------------------------------------------------------------------------------------------------------------------

Chronological Series of Events leading to Demutualisation and Corporatisation of Stock Exchanges in India: -

In 2001, Finance minister pledged on the floor of the parliament to demutualise all Indian Exchanges

SEBI appointed Kania committee to look in to the various issues relating to Demutualisation including questions relating to broker ownership

Kania Committee submitted its report to SEBI in August, 2002. Kania committee report’s essential recommendations:

i. Three stakeholders namely shareholders, brokers and investing public to be equally represented.

ii. Disbursal of majority shareholding post demutualisation to non-brokers.iii. Concept of converting part of reserves of the exchange into deposit from brokers and

issuance of sharesiv. Consolidation of exchanges recommendedv. No Government internationally has claimed any compensation for fiscal benefits given to

exchanges prior to demutualisation BSE submitted its duly approved scheme to SEBI in June 2003. Amendments to Rules and MOA and AOA also submitted in July 2003(based on Kania

committee report) to SEBI for approval. All required amendments in SCRA, Indian Stamp Act and Income Tax Act were then done. Government asks for demutualisation of regional stock exchanges in two ways:

i. Either by becoming trading arms of BSE & NSE, orii. Number of regional stock exchange joins hands to make a separate platform

NEW SEBI REGULATIONS

2


SEBI had issued directions on 10/1/2002 that no stock broker shall be an office bearer of stock exchange i.e President, Vice-president, Treasure etc.

SEBI issued its guideline on 31- 11- 2006 for investment in stock exchanges in India. Under these guidelines, shareholdings of trading Members have to be brought down to 49% which can be either by divestment or additional equity capital to be issued to make the shareholding of existing trading members to 49%. Therefore, it can be way of: -

i. Offer for sale by prospector by existing trading membersii. Placement of shares of shareholders having trading rights to such persons or institutions

may be short listed by the exchange with the approval of SEBI.iii. Issue of equity shares on private placement basis by the stock exchange to any person or

group of persons not having trading rights subject to approval of SEBI.

---------------------------------------------------------------------------------------------------------------------

Limitations: -

i. No person shall directly or indirectly acquire or hold more than5% in the paid up capital.ii. No person shall either individually or together with persons in concert with him acquire

and or hold more than 1% of the paid up capital.iii. Foreign investment up to 49% will be allowed in stock exchanges with a separate FDI

cap of 26% and FII cap of 23%.iv. No FII shall seek and get representation on the Board of Directors of stock exchanges. No

foreign investor including persons acting in concert will hold more than 5% of the equity in the exchange.

CASE STUDY

Harshad Mehta Scam (1992): -

3


The making of the 1992 security scam

They took advantage of the many loopholes in the banking system and drained off funds from inter-bank transactions. Subsequently, they bought huge amounts of shares at a premium across many industry verticals causing the Sensex to rise dramatically. The exposure of Mehta led banks to start demanding their money back, causing the Sensex to plunge.

The 1992 security scam and its exposure

"The crucial mechanism through which the scam was effected was the ready forward (RF) deal. The RF is in essence a secured short-term loan from one bank to another. Crudely put, the bank lends against government securities just as a pawnbroker lends against jewellery. The borrowing bank actually sells the securities to the lending bank and buys them back at the end of the period of the loan, typically at a slightly higher price. It was this ready forward deal that Mehta and his accomplices used with great success to channel money from the banking system."

--Sucheta Dalal, The Times of India (April 23, 1992)

In a ready-forward deal, a broker usually brings together two banks for which he is paid a commission. Although the broker does not handle the cash or the securities, this was not the case in the prelude to the Mehta scam. Mehta and his associates used this RF deal with great success to channel money through banks.

The securities and payments were delivered through the broker in the settlement process. The broker functioned as an intermediary who received the securities from the seller and handed them over to the buyer; and he received the check from the buyer and subsequently made the payment to the seller. Such a settlement process meant that both the buyer and the seller may not even know the identity of the other as only the broker knew both of them. The brokers could manage this method expertly as they had already become market makers by then and had started trading on their account. They pretended to be undertaking the transactions on behalf of a bank to maintain a façade of legality.

Mehta and his associates used another instrument called the bank receipt (BR). Securities were not traded in reality in a ready forward deal but the seller gave the buyer a BR which is a confirmation of the sale of securities. A BR is a receipt for the money received by the selling bank and pledges to deliver the securities to the buyer. In the meantime, the securities are held in the seller’s trust by the buyer.

Complicit lenders

Armed with these schemes, all Mehta needed now were banks which would readily issue fake BRs, or ones without the guarantee of any government securities. His search ended when he found that the Bank of Karad (BOK) and Metropolitan Co-operative Bank (MCB) two small and little known lenders, were willing to comply. The banks agreed to issue BRs when required.

4

http://en.wikipedia.org/wiki/The_Times_of_India


Once they issued the fake BRs, Mehta passed them on to other banks who in turn lent him money, under the false assumption that they were lending against government securities. Mehta used the money thus secured to enhance share prices in the stock market. The shares were then sold for significant profits and the BR retired when it was time to return the money to the bank.

Outcome

Mehta continued with his manipulative tactics, triggering a massive rise in the prices of stock. Upon the exposure of the scam, several banks found they were holding BRs of no value at all. Mehta had swindled the banks of Rs 4,000 crore. The scam came under criticism in the Indian Parliament, leading to Mehta's eventual imprisonment.

Ketan Parekh Scam (2001): -

“All my lifetime's savings are gone. I don't know how to feed my family."

- A small investor hit by the Ketan Parekh scam, in April 2001.

Making of the Scam: -

Almost everyone was eager to entrust their money with Parekh, which, he in turn used to inflate stock prices by making his interest obvious. Almost immediately, stocks of firms such as Visual soft witnessed meteoric rises, from Rs 625 to Rs 8,448 per unit. However, this fraudulent scheme did not end with price rigging. The rigged-up stocks needed dumping onto someone in the end and KP used financial institutions such as the UTI for this.

When companies seek to raise money from the stock market, they take the help of brokers to back them in raising share prices. KP formed a network of brokers from smaller bourses such as the Allahabad Stock Exchange and the Calcutta Stock Exchange. He also used share purchase in the names of poor people living in Mumbai’s shanties. KP also had large borrowings from Global Trust Bank and he rigged up its shares in order to profit significantly at the time of its merger with UTI Bank. While the actual amount that came into Parekh's kitty as loan from Global Trust Bank was reportedly Rs 250 crore, its chairman Ramesh Gelli is known to have repeatedly asserted that Parekh had received less than Rs 100 crore in keeping with RBI norms.

Parekh and his associates’ also secured Rs 1,000-crore as loan from the Madhavpura Mercantile Co-operative Bank despite RBI regulations that the maximum amount a broker could get as a loan was Rs15-crore. Hence, it was clear that KP’s mode of operation was to inflate shares of select companies in collusion with their promoters.

Notably, a day after the presentation of the Union Budget in February 2001, Parekh appeared to have run out of luck. A team of traders known as the bear cartel placed sell orders on KP’s favorite stocks and crushed their inflated prices. Even the borrowings of KP put together could

5


not rescue his scrips. The Global Trust Bank and the Madhavpura Cooperative were driven to bankruptcy as the money they had lent Parekh went into an abyss.

The exposure of the dupe

As with the Harshad Mehta scam, Ketan Parekh's fraudulent practices were first exposed by veteran columnist Sucheta Dalal.

“It was yet another black Friday for the capital market. The BSE sensitive index crashed another 147 points and the Central Bureau of Investigation (CBI) finally ended Ketan Parekh’s two-year dominance of the market by arresting him in connection with the Bank of India (BoI) complaint. Many people in the market are not surprised with Parekh’s downfall because his speculative operations were too large, he was keeping dubious company, and he was dealing in too many shady scrips.”

-Sucheta Dalal, Times of India

When the prices of select shares started constantly rising, innocent investors who had bought such shares believing that the market was genuine were about to stare at huge losses. Soon after the scam was exposed, the prices of these stocks came down to the fraction of the values at which they had been bought.

Dalal goes on to state that Parekh's scheme was not visible to a layman. Dalal added that KP’s arrest and similarity of his operations to securities scam of 1992 vindicated the miserable inadequacy of the country’s regulatory system.

SEBI’s damage control measures

SEBI investigations into Parekh's money laundering affairs revealed that KP had used bank and promoter funds to manipulate the markets. The trading cycle was cut short from a week to a day. SEBI formally introduced forward trading in the form of exchange-traded derivatives to ensure a well-regulated futures market. It also did away with broker control over stock exchanges.

---------------------------------------------------------------------------------------------------------------------

In both these cases, one can see complicity from insiders as a common factor. Both parties conspired to defraud the common investor with their intimate knowledge and control of the complex system. If the exchanges were not in their control but professionally run with proper checks and balances perhaps we would, perhaps, have not seen these two major scams occurring. The 2001 scam in particular speeded up the process.

REASONS, CHALLENGES & RESISTANCE

Reasons why Demutualisation and Corporatisation is needed: -

6


Rationalized Governance : - The corporate model will enable management to take actions that are in the best interest of customers and the exchange itself. There would be transparency.

Investors Participations : - A demutualised exchange provides both institutional investors and retail investors the opportunity to become shareholders. Institutional investors require much greater liquidity for block trading.

Competition from Alternate Trading System’s (ATS) and Electronic Communication Networks: - ATS and Electronic Communication Networks provide cheap and efficient access to quoted stocks unlike traditional stocks exchanges. To cope with competition, exchange required funds. While members have limitations in raising funds.

Globalization : - Historically brokers and exchanges were locally focused. Exchanges did not face meaningful competition from exchanges in distance places. Through alliances, exchanges seek to attract more investors by harmonizing distinct trading environment and by offering greater product variety.

Resources for capital investment : - One of the drivers of stock exchange demutualization is screen trading, which has replaced floor trading on most exchanges. Once customers have direct access to screens, exchanges memberships no longer have as much economic value and clearing firms rather than traders become a dominant force in exchange activities

---------------------------------------------------------------------------------------------------------------------

Challenges of Demutualisation and Corporatisation: -

There will be no changes in the conflict of interest if an exchange is converted from an association of persons into a limited liability company

The same board and the same organizational structure will continue to exist and nothing much will be achieved

The government cannot solve the exchange’s management problem by steering the demutualisation process

---------------------------------------------------------------------------------------------------------------------

Resistance to Demutualisation and Corporatisation: -

Though demutualisation is beneficial, many stock exchanges are hesitating to adopt it because they are afraid of losing their identity

They also have the fear of paying huge tax conversions This new revolution will become successful when the government will take the necessary

steps

BIBLIOGRAPHY

Corporatisation and Demutualisation of Stock Exchanges: - http://www.sebi.gov.in/commreport/demutes.html

7


What exactly is Demutualisation? – Economic Times, January 21, 2002 - http://articles.economictimes.indiatimes.com/2002-01-21/news/27334241_1_demutualisation-trading-rights-brokers

Demutualisation of Stock Exchanges – The Hindu, November 22, 2004 - http://www.hindu.com/biz/2004/11/22/stories/2004112200371600.htm

BSE Demutualisation Complete – Business Standard – May 19, 2007 - http://www.business-standard.com/article/markets/bse-demutualisation-complete-107051901004_1.html

Corporatization - http://en.wikipedia.org/wiki/Corporatization Demutualisation - http://en.wikipedia.org/wiki/Demutualization

8

Documents

and Corporatisation of Stock Exchanges in India