C OMPANY LAW - I

CORPORATIZATION & DEMUTUALIZATION OF STOCK EXCHANGES IN

INDIA

Date: 16th October 2008

Submitted by: Mayank Jain, Roll # 410, V Sem., B.B.A L.L.B (Hons.)

Submitted to: Mr. Ashish Kumar Srivastav, Principle Faculty, Faculty of Law

NATIONAL LAW UNIVERSITY

R ESEARCH M ETHODOLOGY

Area: Corporatization of Stock Exchanges

Topic: Corporatization & Demutualization of Stock Exchanges in India.

Objectives:

1. To examine the present structure of stock exchanges including those set up as

companies and as unincorporated bodies and in this light examine the legal,

financial and fiscal issues involved to corporatise and demutualise the stock

exchanges, and

2. To look in to the specific steps those need to be taken for implementation.

3. To review and examine the present structure of stock exchanges including those

set up as companies and as unincorporated bodies and in this light examine the

legal, financial and fiscal issues involved to corporatise and demutualise the stock

exchanges, and

4. To recommend the specific steps that need to be taken for implementation, and

also to advise on the consolidation and merger of the stock exchanges.

Research Questions:

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1. What is the present legal structure of Stock Exchanges in India?

2. What is demutualization?

3. How is this process of Corporatization and demutualization to take place?

4. What should be the Structure of the governing boards of stock exchanges and

representation of brokers?

5. What are the statutory requirements and legislative changes necessary to give

effect to demutualization?

TABLE OF CONTENTS

1. Introduction3

2. Existing Structure of Stock Exchanges in India5

3. Models of Demutualization13

4. Recommendations23

5. Conclusion26

6. Bibliography28

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INTRODUCTION

Most of the Stock Exchanges around the world were set up as association of the Trading

members. The objective to set up association was aimed to create a formal institution for

mutually regulating the securities transactions among the members. Thus, most of the

Stock Exchanges were promoted as non-profit organizations. While, the management of

the Stock Exchange was generally vested with elected representative(s) of the trading

members, executives carried out the day-to-day functioning of the Stock Exchange.

However, during last two decades attempts have been made to change the profile of the

Stock Exchange by demutualising them and reconstituting them as commercial corporate

entities.1 Demutualization of a Stock Exchange entails that it is no longer remains entity

for mutual benefit of Trading members but beholds the larger objective of becoming the

system with adequate checks for proper mobilization of capital & protecting the interest

of investors at large.

Corporatisation is a critical enabler that would support the efforts in expanding and

strengthening the Indian capital market. While things are becoming more business-

oriented, the corporatized Stock Exchanges will improve its flexibility and efficiency in

terms of its responsiveness to market needs2.

The need for corporatization of Stock Exchanges in India has recently came into lime

light after functioning of Mumbai Stock Exchange is alleged to have been manipulated

by the some of the Trading members on governing Board of the exchange, which

followed by stock markets crash inspite of what was seen as one of the favorable &

progressive Union Budget in recent years3.

1 Dr. K. R. Chandratre et al., Bharat’s Compendium on SEBI, Capital Issues and Listing, 3rd ed., Vol.1,

Bharat Publishing House, New Delhi, 19962 Sucheta Dalal, Death of Indian Stock Exchanges, Indian Express Newspapers, Delhi, November 25’2002, 3 Sinha hints at laws for Corporatisation of SES, SEBI: IDBI soon, Indian Express, March 12’2003.

4

After the stock scam of March 2001, the Government finally announced that all stock

exchanges would have to mandatorily go in for demutualization within a specified

timeframe4. This was aimed at preventing conflict of interests, which arise when

stockbrokers are involved in the management of the stock exchanges also.

It is in this context it becomes necessary to study the need and impact of Corporatisation of

Stock Exchanges and its relevance in Indian context before a clear roadmap could be

prepared to take this process forward, for which SEBI constituted a Group under the

Chairmanship of Justice M. H. Kania, former Chief Justice of India comprising of eminent

personalities, in fields of law, accountancy, finance, company law affairs and taxation to

advise SEBI on this matter and to recommend the steps that need to be taken to implement

the announcement of the Government.

4Sinha unveils new measures to instill confidence in market, Indian Express Newspapers, March 18’2002

(Delhi)

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EXISTING STRUCTURE OF THE STOCK EXCHANGE IN INDIA

A Stock Exchange is an organized market for purchase and sale of listed Industrial and

financial securities. Securities traded on Stock Exchanges include shares and debentures

of Public Limited Companies, Government Securities, etc.

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 securities5.

Section 2 (f) of the above said Act defines recognized stock exchange as a Stock

Exchange, which is for the time being recognized by the Central Government under

Section 4. SEBI is empowered under Section 4 to grant recognition to Stock Exchanges.

In terms of the legal structure, the stock exchanges which are recognized under the

Securities Contracts (Regulation) Act in India, can be segregated into two broad groups –

20 stock exchanges which were set up as companies, either limited by guarantees or by

shares, and the 3 stock exchanges which are functioning as associations of persons (AOP)

viz. BSE, ASE and Indore Stock Exchange. The 20 stock exchanges which are companies

are: the stock exchanges of Bangalore, Bhubaneswar, Calcutta, Cochin, Coimbatore,

Delhi, Gauhati, Hyderabad, Interconnected SE, Jaipur, Ludhiana, Madras, Magadh,

Mangalore, NSE, Pune, OTCEI, Saurashtra-Kutch, Uttar Pradesh, and Vadodara. Of

these, the stock exchanges of Ahmadabad, Bangalore, BSE, Calcutta, Delhi, Hyderabad,

Madhya Pradesh, Madras and Gauhati were given permanent recognition by the Central

Government at the time of setting up of these stock exchanges. Apart from NSE, all stock

exchanges whether established as corporate bodies or Association of Persons (AOPs), are

5 Investment Laws, Stock Exchanges, (Bangalore: National Law School of India University, Distance

Education Department, Master in Business Laws – Part II, Course No. 1, Module No. 2 A,)

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non-profit making organizations. 7 stock exchanges are set up as companies limited by

shares and the remaining 13 are set up as companies limited by guarantee6.

It is thus clear that BSE, ASE and Indore Stock Exchange will have to be both

corporatized and demutualised, while of the balance 20 stock exchanges, 18 stock

exchanges that are already corporate entities, will only have to be demutualised. Two

stock exchanges, NSE and OTCEI, are not only corporatized but also demutualised with

segregation of ownership and trading rights of members. Further, NSEIL is a for-profit

company and the Board of NSEIL comprises of representatives of shareholders, (some of

whom have 100% stock broking subsidiaries) and outside non-shareholder directors. But

even these two stock exchanges may if necessary, have to undergo changes in

organizational structure consequential to the recommendations of the Group so that a

common structural model is adopted by the all the stock exchanges.

TRADITIONAL STRUCTURES OF STOCK EXCHANGES

Internationally (as well as nationally), stock exchanges have been the product of

circumstance, or of design. These differences in the origins of stock exchanges have

tended to lead to differences in perceptions of the role of stock exchanges, and in views

about what their relationship with the legal system should be. Stock exchanges have also

been subject to limited competition from other firms.

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

more like "clubs" where the dealers transacted business through the open outcry system.7

6 www.sebi.gov.in7 Kapoor N.D., Business and Economic Laws, Sultan Chand & Sons, New Delhi, 1995

7

DEMUTUALIZATION

Demutualization refers to the conversion of an existing non-profit organization into a

profits-oriented company. In other words, an association that is mutually owned by

members converts itself into an organization that is owned by shareholders. The company

can take different shapes and forms, that is, it could be either a listed or unlisted company

which may be closely held or publicly held.

This process involves the segregation of members' right into distinct segments, viz.

ownership rights and trading rights. It changes the relationship between members and the

stock exchange. Members while retaining their trading rights acquire ownership rights in

the stock exchange, which have a market value, and they also acquire the benefits of

limited liability8. The shareholders in a corporatized stock exchange may be a diverse

group, as members may decide to retain their shares or to sell them. Demutualization

however, does not insulate them from competition. A stock exchange whose management

does not effectively work to maintain its position in the market may soon become a take-

over target.

This term is not restricted only to corporatization of stock exchanges. Any organization

that is a non-profit body (which is not the same as loss-making), and is not distributing its

profits to owner-members but retains the same to develop infrastructure of the

organization, can demutualise.

For instance, Australia's life insurer and funds manager AMP recently demutualised, as

did Sun Life Assurance, the Canadian insurance firm. Recently, several stock exchanges

like the London Stock Exchange and two US stock exchanges, New York Stock

Exchange and Nasdaq, have announced that they will demutualise.9

8 Dalal Sucheta, Demutualization of bourses, The Indian Express, Feb 11’2002.

9 Prof. N. L. Mitra et al., Corporate Law, Vol.3, Distance Education Department, National Law School of

Indian University, Bangalore, 1997

8

Thus recapitulating once again Demutualization refers to the transition process of an

exchange from a "mutually-owned" association to a company "owned by shareholders".

In other words, transforming the legal structure of an exchange from a mutual form to a

business corporation form is referred to as demutualization. The above, in effect means

that after demutualization, the ownership, the management and the trading rights at the

exchange are segregated from one another.

A demutualised exchange is way different from a mutual exchange; the three

functions of ownership, management and trading are intervened into a single Group in a

mutual exchange. The broker members of the exchange over here are both the owners

and the traders on the exchange and they further manage the exchange as well. A

demutualised exchange has all these three functions clearly segregated.

SEBI had formed a Group on Corporatisation and Demutualization of Stock Exchanges

under the Chairmanship of Justice M H Kania, former Chief Justice of India, for advising

SEBI on corporatization and demutualization of exchanges and to recommend the steps

that need to be taken to implement the same. The Group submitted its Report to SEBI on

August 28, 2002. SEBI has taken up with Central Government to amend the SC(R) A to

affect Corporatisation and Demutualization.

THE PROCESS OF DEMUTUALIZATION TAKES PLACE IN THE FOLLOWING

MANNER:

The exchange values all its assets including the value of seats and arrives at a total value.

This is then divided into different shares and offered to the public. Later, the shares are

listed on the stock exchange itself, and the funds got by selling the shares will be

distributed among the members of the exchange as payment for their seats. If the

company is not being listed, the shares may be offered to the members, not for transfer.10

10 Ramaiya, A., A Guide to the Companies Act, 15th ed., Wadhwa & Company (P) Ltd., Nagpur, 200

9

On the other hand Corporatisation of Stock Exchanges is the process of converting the

organizational structure of the stock exchange from a non-corporate structure to a

corporate structure. Traditionally, some of the stock exchanges in India were established

as "Association of persons", like BSE, ASE and MPSE. Corporatisation of these

exchanges is the process of converting them into incorporated Companies.11

FORCES BEHIND THE DEMUTUALIZATION

Demutualization as a concept is neither a very new concept nor very sophisticated. The

essence lies with the separation of ownership and management. Thus it is well driven by

the good intentions of proper governance, which has taken a new turn after the collapse

of many large corporations in the year 2002. Although there is no exclusive definition of

mutual or demutual organization, a ‘mutual’ organization is an enterprise owned by its

members, providing a variety of service to the members for their benefit.12 This also

implies that mutual are not for profit organizations; are restricted in their capacity to raise

equity, and are characterized by diffused decision-making power. The expression

demutualization means the transition from a mutual company, in which there are no

shares, and every member has one vote, to a company limited by shares and one vote per

share. But it is also used to describe the process by which a company limited by shares in

which every member is required to have the same number of shares, converts to a more

usual economic model; or simply one where the link between membership in the

exchange company or ownership of a share in it, is broken. Thus the central idea with

demutualization does not only rests on the basic status of the organization i.e., whether it

is “for profit” or “not for profit”. It is found that there are many “for profit” organizations

even stock exchanges, which are not demutualized. The crux of the problem thus lies

with the ownership of the exchange. Separation of ownership and membership is the

fundamental ingredient of the demutualization as well as the essence of effective

governance. The issues addressed here are essentially those arising from permitting non-

11 S. C. Sen, New Frontiers in Company Law, Eastern Book Company, Lucknow, 197112 Clive M. Schmitthoff, Palmer’s Company Law, 14th ed., Vol.1, Stevens & Sons Ltd., London, 1987

10

brokers to own stake in the exchange, and brokers not to have an ownership interest of

any kind or to have ownership to a limited extent.

THE NEED FOR DEMUTUALIZATION

1. Stock exchanges owned by members tend to work towards the interest of members

alone, which could on occasion be detrimental to rights of other stakeholders. Division

of ownership between members and outsiders can lead to a balanced approach, remove

conflicts of interest, create greater management accountability, and take into

consideration the interest of other players.

2. To cope with competition, stock exchanges require funds. While member-owned stock

exchanges have limitations in raising funds, publicly owned stock exchanges can tap

capital markets.

3. Publicly owned stock exchanges can be more professional when compared to

member-owned organisations. Further, as a result of the role played by shareholders,

strengthening of the management and the organization, there is greater transparency in

dealings, accountability and market discipline.

4. This would enhance management flexibility. A publicly held company is better

equipped to respond to changes when compared to a closely held mutually owned

organization. Further, a company can spin-off its subsidiaries, get into mergers and

acquisitions, raise funds, etc.

A company can spin off subsidiaries, get into mergers and acquisitions, raise more

monies, etc. For instance, the NSE which started out as a corporate body has spun off

wholly-owned subsidiaries like the National Securities Clearing Corp and more recently,

NSE.IT, a dedicated info-tech company.

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The world's capital markets have changed remarkably owing to financial market

globalization trends and new information technology advancement technology growth,

which have resulted in much more sophisticated investor demands. Intensifying

competition among exchanges to attract issuers and investors have prompted leading

exchanges worldwide to change their organizational structures and business approaches

to become more flexible, efficient and responsive to market needs, with a greater

orientation on profitability.13 For Example In the Asia/Pacific region, the Australian

Stock Exchange has already transformed itself into a fully corporatized entity, while the

exchanges in Hong Kong, Singapore and Japan are also moving in the same profit-driven

business direction. These corporatized exchanges are aggressively targeting regional and

international companies and investors as potential sources of growth.

But, the trouble is that their decision-making is often painfully slow and conservative.

This is seen from the reluctance of smaller, regional exchanges in India to merge with the

larger exchanges just so that they retain their individual character. This, despite the fact

that many have no trades in a whole year. Internationally too, it was seen that the

members of London's International Petroleum Exchange had voted against

demutualising, and had rebuffed an overture for a merger from the New York Mercantile

Exchange.

There are many apprehensions and questions being raised as to if an exchange go

public, what would happen to its role as a self – regulatory organization.

However, the corporate structure by itself does not make any difference, as seen from the

example of the NSE. But, the conflict of interest could arise if the boards of the stock

exchanges are not independent as also at the time of listing of the demutualised exchange.

The conflict would arise due to a clash in the exchange's role as a regulator and its

commercial objectives. This issue needs to be looked into by the capital market regulators

in the country.

13 S. C. Sen, New Frontiers in Company Law, Eastern Book Company, Lucknow, 1971

12

In some jurisdictions regulators have reacted to a stock exchange’s demutualization by

removing regulatory responsibilities from the stock exchange while the stock exchange

itself runs like a business corporation.

Here some cues could be taken from the LSE, which, reportedly, has given up some of its

functions in preparation for its planned demutualization. The LSE has given up its role of

supervising new company listings to the UK's financial regulator who also oversees

regulation of capital markets, the Financial Services Authority. However, the LSE retains

the right to decide whether or not it will admit a particular security to trading through its

market, and it also has self-regulatory powers to set its own trading rules, and maintain an

orderly market, subject to other rules as the FSA may adopt, such as rules to check

market abuse.

The Australian Stock Exchange (ASX) retains the general power to regulate securities

listings, although its own listing on its own market is supervised by the Australian

Securities and Investment Commission (ASIC).

MODELS OF DEMUTUALIZATION

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The stock exchanges, which had demutualised have followed different models.

However, a common feature has been that members surrender their mutual

membership rights and in lieu thereof, they are issued shares in the demutualised

company. The number of shares issued has some relationship to the value of the

assets of the stock exchange. In several cases, a public issue of shares was also made.

A demutualised "for-profit" stock exchange will face an issue of conflict between its

regulatory responsibility and its desire to maximize profits for its shareholders, for

example,14

The profits of the stock exchange would vary with its fee structure. If it is in a

monopolistic situation, it could be tempted to charge fees, which could adversely

affect the interest of the trading members, the investing public or the companies

listed in the stock exchange.

The profits of the stock exchange would also vary with the number of companies

listed on the stock exchange. Thus there could be a temptation to relax the listing

requirements or the standards of monitoring to boost the number of listed

companies.

A stock exchange, which lists its own shares, may adopt a more relaxed attitude to

its own listing and its own compliance by the stock exchange of its regulations.

There could be disagreements between members of the Board who trade as

against those who do not, as regards the manner in which the affairs of the stock

exchange should be conducted.

While, competition among stock exchanges should mitigate most of these issues of

conflict and see the emergence of the stock exchanges which are more efficient as

also "image conscious", there is unfortunately no agreement as to whether

competition could produce a race to the top or the bottom as there is no way of

knowing what would happen if securities markets were allowed to compete freely.

14 Mayson, French & Ryan . Company law, 1st ed., Universal Law Publishing Co. Pvt. Ltd., Delhi, 2001

14

The process of demutualization of the stock exchanges would involve three broad steps

viz.

1. Corporatisation of three stock exchanges (BSE, ASE and MPSE) which currently

do not have a corporate structure,

2. Conversion of the stock exchanges limited by guarantees into ones limited by

shares

3. Incorporation in the memorandum and articles of association of existing stock

exchanges set up of relevant provisions to give effect to the Group’s

recommendations.

4. The transition of thirteen companies limited by guarantees to companies limited

by shares, so that all stock exchanges will have a uniform legal structure.

And subsequently a common model for corporatization and demutualization for all stock

exchanges. Moreover the clause (j) of section 2 of SCRA be amended to mean that the

stock exchanges could be companies incorporated under the companies act. The present

provisions under clause (j) of section of 2 of SCRA defines stock exchanges to "mean

any body of individuals, whether incorporated or not, constituted for the purpose of

assisting regulating or controlling the business of buying, selling or dealing in securities".

This clause would need to be amended to provide that a stock exchange should be a

company incorporated under the Companies Act.

THE TRANSITION FROM A NOT-FOR-PROFIT VOLUNTARY ENTITY INTO A FOR-

PROFIT CORPORATE BODY

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The basic character of the stock exchanges in India, saving NSE, irrespective of their

legal constitution, is that they are meant to be voluntary, not for-profit mutual entities.

Demutualization fundamentally alters this position of the stock exchanges, as these would

no longer retain their voluntary, not for-profit mutual character, but become for-profit

corporate bodies15

There are two parts to this transition. One, which involves the changing the voluntary

not-for-profit character of the entity into a for-profit one (in some cases into a corporate

body as well) and second, is the process of delinking of ownership of the entity by the

members from their trading rights. The first would involve the manner in which assets

would be transferred from the existing entities to the new corporate entity, wherever

demutualization has to be accompanied by corporatization as in the case of BSE, ASE

and MPSE. The second would involve the allocation of these assets to the members.

The twin rights of trading and an undivided interest in the ownership of the stock

exchange are embedded in the membership card of a stock exchange. The transition to a

demutualised stock exchange would involve the segregation of these twin rights into two

separate and independent rights viz.

1. The right to participate in the ownership of the assets of the stock exchange, and

2. The right to trade on the stock exchange.

TAX - WAIVER

When a trading right is acquired, and a share is allotted to a member of an stock exchange

by virtue of which he acquires a membership privilege against the extinguishment of the

previous right of membership, no transfer of assets effectively takes place and neither of

15 R.P. Maheswari., A Complete Course In ISC Commerce, Vol. 2, 3rd ed., Pitambar Publishing Private

Limited, New Delhi, 2000

16

the acquisitions should therefore be deemed to be a transfer within the meaning of the

word in the Income Tax Act16. However, at the point of sale of any of these two rights,

capital gains tax would be attracted.

Since the above processes are necessary to implement a policy announced by the

Government, and in the larger interests of the securities market in India as well as in the

interests of investors, it would be necessary to ensure that both the processes described

above are tax neutral and no additional tax liability is attached either to the stock

exchange or to a member of a stock exchange which is implementing an approved

scheme of demutualization17. Such tax neutrality was essential to nudge the process of

corporatization and demutualization and it would not be fair to the stock exchanges and

the members, nor will they be encouraged to expedite the implementation of

demutualization, if such neutrality was not provided.

The Income Tax Act has already made some provisions to facilitate the corporatization of

stock exchanges in India by way of the Finance Act, 2001 under which clause (xiii) of

Section 47 of the Income Tax Act was amended to provide that any transfer of capital

asset from an association of persons, for a body or individual under the scheme of

corporatization of a recognized stock exchange shall not be regarded as transfer for the

purposes of capital gains tax. The proviso to clause (xiii) has also been amended to

provide that this one time exemption from capital gains tax is available only if all the

assets and liabilities of the stock exchange immediately before the succession become

assets and liabilities of the corporatized stock exchange, and the scheme of

corporatization is approved by the SEBI.

In effect, the Finance Act has made three amendments, 2001, in clause (xiii) of Section

47, which has taken effect from April 01, 2002. Their effect is to indicate that the

16 www.IndiaInfoline.com

17Hema Ramakrishnan, Transfer of assets, trading rights of brokers, SEs -- One-time tax waiver on capital

gains likely, The Hindu, July16, 2002.

17

corporatization of a recognized stock exchange in accordance with a scheme approved by

the SEBI will not be a "transfer". This would be even if there is a transfer of capital assets

or intangible assets from the stock exchange which was originally a firm or an association

of persons to the stock exchange when it becomes a company under the approved

scheme.

This shall ensure that the past profits of a stock exchange which were not taxed when it

had the character of a not for profit entity should not be taxed when its character changes.

In other words, the accumulated reserves of the stock exchange as on the day of

corporatization should not be taxed. However, there would be no objection to taxation of

these reserves, in the hands of the shareholders when these are distributed to shareholders

as dividend at the net applicable tax rate; equally all future profits of the stock exchange

after it becomes a for profit company may be taxed.

Moreover there are necessary provisions that are being made in the Indian Stamp Act and

the Sales Tax laws to exempt from stamp duty and sales tax, the transfer of the assets

from the mutual stock exchange and the issuance of shares by the new demutualised for-

profit company, formed pursuant to an approved scheme of demutualization;

The next question is why to demutualize the stock exchanges. The recent transformations

in the global environment have added new dimensions to the trading, clearing/settlement

and listing functions of SEs. Many of these functions have been come under actual or

potential competitive threat. The need to meet the demand from its customers for lower

transaction costs; more efficient services and new products are now become more crucial

for the survival of SEs. The driving forces behind demutualization are found to be

growing competition among SEs, increasing listing of global companies

GOVERNANCE OF THE STOCK EXCHANGES

In the past, in almost all the stock exchanges, the broker members of the governing

boards have been critical in the governance of the stock exchanges. The reconstitution of

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the governing boards of the stock exchanges by SEBI, which reduced the broker

representation on these boards to 50%, had helped in making the boards more

independent and minimized the influence of brokers. However, in most stock exchanges

on account of the brokers retaining posts of the officer bearers of the stock exchanges till

recently viz. president, vice-president and treasurer, they continued to play a dominant

role in the management of the stock exchange. The fall-out of this practice has been that

most stock exchanges have failed to develop good corporate governance practices and

strong management teams18. This has not only been a perception but also a reality in most

stock exchanges. Conflicts of interest have bedeviled the operations of the stock

exchanges in the past to the detriment of the securities market. If the stock exchanges are

to function in a modern competitive environment these deficiencies would have to be

removed and they would have to adhere to the high standards of corporate governance.

Indeed this is one of the objectives to be achieved through this entire exercise of

demutualization of the stock exchanges.

The steps taken by SEBI recently to strengthen the governance of the stock exchanges

and to remove the conflicts of interest. As directed by SEBI, the brokers are not allowed

to hold the posts of president, vice president, treasurer or act as office bearers. Besides,

pursuant to this directive the brokers have stepped down from these posts in almost all

the stock exchanges. However there is a need to further strengthen the present

governance structure to compliment the demutualization exercise so that the purpose of

demutualization could be fruitfully served.

Divergent views have been expressed on the issue of broker representation on the

governing boards of stock exchanges. The case for broker representation has been made

by almost all stock exchanges and brokers' association. Their argument is that the brokers

are major stakeholders in a stock exchange and they are affected by the manner in which

an stock exchange functions19. They also have the experience and knowledge of the

market and therefore should have some representation on the governing boards of the

18 “Brokers Resistance to Market Reforms”, The Hindu, Aug 02 ‘2002.19Dalal Sucheta “Merge BSE and NSE”, The Indian Express, July 27’ 2002.

19

stock exchanges. Besides, the demutualised corporatised structure envisages that brokers

could continue to be shareholders and as such be eligible to be elected on the boards as

directors. The investors' association has made the case for not giving any representation

to the brokers. The argument against broker representation is one of conflict of interest

and the possibility of interference and exercising influence in the functioning of the stock

exchange. The investors' association have felt that in a sense the presence of brokers on

the governing boards affects the independence of the executives of the stock exchange

who may be answerable to the very persons whose actions they are expected to control20.

However in the newly constituted demutualised stock exchange, there would and should

be three major stakeholders – the shareholders, the brokers and the investing public

through the regulatory body. It was important that all the three stakeholders are

represented equally on the governing boards of the stock exchanges. The representation

of the brokers on the governing boards of stock exchanges is desirable since the stock

exchange would benefit from their expertise and experience about the working of the

stock exchange. It is expected that the 2/3rd of the board being non-brokers should be able

to provide the driving force behind the management of the stock exchange. But in no case

should the stock exchange have more than 1/3rd broker representations on its governing

board21.

According to the Kania Committee report22,

1. The three stakeholders viz. shareholders, brokers and investing public through the

regulatory body should be equally represented on the governing board of the

demutualised stock exchange;

2. There should be specific vacancies on the board for each group of stakeholders;

3. The shareholders’ representatives should not be functioning brokers;

20Iyer .P Vaidyanathan, Sebi tells SEs to Bar member-brokers from being office-bearers ,The Economic

Times, 11July’2002.

21 Dey Nilanjan, Panel for representation of brokers on exchanges — Report moots governance norms, ,

The Hindu, Sept 04’2002.22 Dalal Sucheta, Kania Committee Report : An Overview , Indian Express, Nov’28 ‘ 2002,.

20

4. The brokers representatives would be elected by the shareholders from among the

brokers of the stock exchange;

5. The representatives of the investing public would be nominated by SEBI from

among a panel comprising of academics, professionals, industry representatives,

public figures and investors association, none of whom should have any interest

in any broking firm;

6. Adequate disclosures about the background of the directors of the board should

be provided to the shareholders at the annual general meetings and the annual

reports;

7. The relevant provisions of the Companies Act will govern the maximum number of

directors on the board. 1956; and

8. Current restrictions on the tenure of broker directors should continue.

In most of the demutualised stock exchanges abroad, and even in non-demutualised stock

exchange such as NYSE and NASDAQ, brokers are represented on the governing boards.

In NYSE for example there are 4 broker members, 12 are providers of financial services,

8 are from financial institutions, 2 are CEOs of large corporates, 2 are representatives of

investing association and 4 are retired public servants who held important administrative

offices.

LATEST POSITION

The Securities and Exchange Board of India in its communication dated January 30,

2003, has given stock exchanges six months to prepare a scheme for implementing

corporatisation and demutualization as recommended by the Kania Committee.

SEBI has advised the exchanges to submit a scheme, together with the changes in rules,

byelaws and articles that would be required to implement the scheme, within the time

frame for its approval.

Since some of the recommendations of the Kania Committee require legislative changes

with regard to Securities Contract (Regulations) Act, 1956, Income Tax Act, 1956, and

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the Indian Stamps Act, 1899 to facilitate corporatisation and demutualization of the stock

exchanges and to grant fiscal exemptions to encourage this process23, the matter has been

taken up with the central government.

Any stock exchange that fails to comply with the requirement of corporatization and

demutualization by the appointed date, and is accordingly derecognized, will have to

distribute its assets in accordance with the provisions of the respective rules and laws, the

committee observed.

The Honorable Union Finance Minister in his budget speech for 2005-06 had announced

the corporatization and demutualization of stock exchanges. Accordingly SEBI had

notified the demutualization of stock exchanges except the Coimbatore Stock Exchange

and Mangalore Stock Exchange.24

In the post demutualization period, it has become crucial to decide the future role of

Regional Stock Exchanges (RSEs).

Currently there are two stock exchanges in India

The National Stock Exchange (NSE)

Over the Counter Exchange of India (OTCEI)

These are not only corporatized but also demutualised with segregation of ownership and

trading rights of members.

23 Shaji Vikraman, Corporatisation of Stock Exchanges may need changes in Act, Nov 21’2002, New Delhi24 http://www.sebi.gov.in/press/2006/2006188a.html

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RECOMMENDATIONS

The stock exchanges which are set up as association of persons and those which are set

up as companies limited by guarantee be converted into companies limited by shares.

Further a common model for corporatisation and demutualization be adopted for all stock

exchanges; and the clause (j) of section 2 of SCRA be amended to mean that the stock

exchanges could be companies incorporated under the companies act. The present

provisions under clause (j) of section of 2 of SCRA defines stock exchanges to "mean

any body of individuals, whether incorporated or not, constituted for the purpose of

assisting regulating or controlling the business of buying, selling or dealing in

securities". This clause would need to be amended to provide that a stock exchange

should be a company incorporated under the Companies Act.

23

Further as corporatisation and demutualization of a stock exchange is essentially a

conversion from a not-for profit entity to a for-profit company, and would result in a

distribution of assets, the Income Tax Act should be amended if necessary, so that the

past profits of an stock exchange which were not taxed when it had the character of a not

for profit entity should not be taxed when its character changes. In other words, the

accumulated reserves of the stock exchange as on the day of corporatisation should not be

taxed. However, there would be no objection to taxation of these reserves, in the hands of

the shareholders when these are distributed to shareholders as dividend at the net

applicable tax rate; equally all future profits of the stock exchange after it becomes a for

profit company may be taxed25.

Furthermore it shall be made a necessary provisions should also be made in the Indian

Stamp Act and the Sales Tax laws to exempt from stamp duty and sales tax, the transfer

of the assets from the mutual stock exchange and the issuance of shares by the new

demutualised for-profit company, formed pursuant to an approved scheme of

demutualization; and that as only the schemes for demutualization approved by SEBI will

qualify for the exemptions under the Income Tax Act, the Indian Stamp Act and the Sales

tax Act, each stock exchange would be required to submit a scheme drawn on the lines of

these recommendations to SEBI for approval.

A cogent suggestion in furthering the Corporatisation of Stock Exchanges would be that

the trading card system be replaced by the deposit system wherein the money deposited

by the member to obtain trading rights only, be considered as deposit with the stock

25 Notwithstanding any provision, judgment or order to the contrary or inconsistent therewith, a statutory

provision should be made in the Income Tax Act, so that the issue of shares and trading rights in lieu of the

card should not be regarded as transfer within the meaning of Section 47(xiii) of the Income Tax Act. The

byelaws, rules and articles of a stock exchange should be amended to provide for the allotment of shares

and trading rights to its members upon corporatisation (in applicable stock exchanges) and upon

demutualisation;

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exchange for trading purpose.26 While the Group favors the deposit system, it would like

to leave the choice of adopting either the card or the deposit system to the exchanges.

Furthermore the procedures to be adopted if the deposit system is accepted by an

exchange for the purpose of segregation of the trading rights and ownership.

In light of the status of the parties involved, these being the three stakeholders viz.

shareholders, brokers and investing public through the regulatory body should be equally

represented on the governing board of the demutualised exchange, in the same effect

there should be specific vacancies on the board for each group of stakeholders; the

shareholders’ representatives should not be functioning brokers and these brokers shall be

representatives would be elected by the shareholders from among the brokers of the

exchange.

The important norms with regards to the adequate disclosures about the background of

the directors of the board should be provided to the shareholders at the annual general

meetings and the annual reports and the membership norms shall also be so changed that

the maximum number of directors on the board will be governed by the relevant

provisions of the Companies Act. 1956.

The relevant provisions of the Securities Contract (Regulations) Act, 1956, the Income

Tax Act, 1961 and the Indian Stamps Act, 1899 be amended to facilitate corporatisation

and demutualization of the exchanges and to grant fiscal exemptions to encourage this

process. On the relevance of the regional stock exchanges, the Group felt that the concept

of regional stock exchanges needs to be abolished. On the issue of alternative use of the

existing infrastructure facility of the stock exchanges, the Group was of the view that that

some of the stock exchanges could explore the possibility of merger on the lines of

Euronext. The Group does not recommend any specific route as being mandatory as the

choice should be dictated on commercial considerations.

Another norm for mutualisation of stocks should be such that uniform model for

corporatisation and demutualization would have to be adopted by all the stock exchanges.

26 Avtar Singh, Company Law, 9th ed., Eastern Book Company, Lucknow, 1989

25

This model should not be made applicable selectively only for a few stock exchanges.

The merger of stock exchanges, before or after demutualization is a commercial decision

and the choice should be left to the concerned stock exchanges and it is not within the

purview of the Group to recommend a specific course of action. However, the Group

strongly feels that corporatisation and demutualization will facilitate the process of

consolidation of stock exchanges and while the Group does not wish to recommend

measures which may provide an exit route to the members of the stock exchanges, any

stock exchange which fails to comply with the requirement of corporatisation and

demutualization by the appointed date and is accordingly derecognised, will have to

distribute its assets in accordance with the provisions of the respective articles/ rules of

the stock exchange and the relevant tax laws shall become applicable.

CONCLUSION

With the advent of NSE and the trading by NSE and BSE on a national scale, most of the

stock exchanges have nil or negligible turnover. Further the regional stock exchanges

have invested considerable sums in computerization and on-line trading systems which

have now become virtually redundant. Many stock exchanges have therefore, formed

subsidiary companies which have become members of NSE and BSE and members of the

stock exchange function as sub-brokers of these companies. This has enabled brokers of

these stock exchanges to trade on NSE and BSE without acquiring the membership of

these stock exchanges. Under these circumstances, the prevailing view in most stock

exchanges and among the brokers seems to veer towards closure of the stock exchanges.

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In this context, the overwhelming concern is one of finding a suitable exit route that will

enable the members to recoup the investments made by them in those stock exchanges.

It is unlikely that all the 23 stock exchanges would continue to serve an economic

purpose even in the medium term; it was of the view that it would be up to the stock

exchange to choose whether it should merge with any other stock exchange or continue to

function independently. This choice would be predicated on the commercial

considerations of the concerned stock exchange. However corporatisation and

demutualization should facilitate the process of merger of stock exchanges.

The Justice Kania Committee on demutualization of stock exchanges has said that no

exchange would be able to float a subsidiary, which will make it difficult for regional

exchanges to survive by trading on larger national bourses. All these are signals that

smaller stock exchanges will have to prepare for closure since they can never hope to

compete with the reach and services that the nationwide bourses are able to provide.

Unfortunately, there is no sign of such planning or realization.

This process of Corporatisation has provided a big opportunity for regional stock

exchanges to merge, consolidate or close down their businesses. Sebi should use this as a

chance to nudge smaller bourses towards closure and encourage their broker-members to

merge and morph into larger corporate memberships that can trade on the BSE or the

NSE27. In fact, Sebi should even consider setting up a team of experts to offer counseling

and guidance on law, taxation and the corporatisation process to small regional brokers.

The Kania Committee’s recommendations could then lead to a massive restructuring of

27 Manna. Sujoy, Corporatised BSE likely to join hands with weak stock exchange , The Economic Times,

Aug’ 27, 2002

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the Indian capital market and reduce the number of bourses to a manageable and

revitalised five or six.

We would have taken another important step forward in the march towards globalization

The Group may during the deliberations call and hear the views of other legal experts,

stock exchanges and other market participants etc. The Group would submit its report

within two months from the date of its first meeting. The date of submission of the report

was further extended till August 31, 2002.

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BIBLIOGRAPHY

Books and Periodicals:

1. Avtar Singh, Company Law, 9th ed., Eastern Book Company, Lucknow, 1989.

2. Clive M. Schmitthoff, Palmer’s Company Law, 14th ed., Vol.1, Stevens & Sons Ltd.,

London, 1987.

3. Dr. K. R. Chandratre et al., Bharat’s Compendium on SEBI, Capital Issues and

Listing, 3rd ed., Vol.1, Bharat Publishing House, New Delhi, 1996.

4. Kapoor N.D., Business and Economic Laws, Sultan Chand & Sons, New Delhi, 1995.

5. Prof. N. L. Mitra et al., Corporate Law, Vol.3, Distance Education Department,

National Law School of Indian University, Bangalore, 1997.

6. Ramaiya, A., A Guide to the Companies Act, 15th ed., Wadhwa & Company (P) Ltd.,

Nagpur, 2001.

7. S. C. Sen, New Frontiers in Company Law, Eastern Book Company, Lucknow, 1971.

8. Mayson, French & Ryan . Company law, 1st ed., Universal Law Publishing Co. Pvt.

Ltd., Delhi, 2001.

9. R.P. Maheswari., A Complete Course In ISC Commerce, Vol. 2, 3rd ed., Pitambar

Publishing Private Limited, New Delhi, 2000

10. Paul L. Davis., Gower‘s Principles of Modern Company Law, 6th ed.., Sweet and

Maxwell, London, 1997.

WEBSITES:

1. http://www.lib.monash.edu.au/subjects/law/securities.htm

2. http //www.theHinduBusinessLine.com/Decade of SEBI regulations — When

will they start biting.htm

3. http://www.sec.gov/cgi-bin/goodbye.cgi?www.law.uc.edu/CCL/sldtoc.html

4. http://www.adb.org/Documents/Books/Rising_to_the_Challenge/India/india-

cap.pdf.

5. http://www.adb.org/Documents/Books/Rising_to_the_Challenge/India/india-

cap.pdf

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