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Evolution of the Indian Securities Markets David Winkler

University of Iowa Center for International Finance and Development

Securities Market Development under British Colonization 1833 – 1947

Securities Markets from 1947 – 1960

Securities Markets from 1960 – 1980s

Securities Market Liberalization 1991 – 2007

OPTIONALLOGO HERE

OPTIONALLOGO HERE

Indian corporate and securities law has its roots in English common law. England passed a homogenous set of company laws throughout the British Colonies to assist British entrepreneurs via a common investment framework. Managing Agency SystemBritish owners used a governing structure known as the managing agency system.

This system operated as a holding company that held and controlled several companies across several industries.

A managing agency house had control over promotional, financial, and managerial functions.

Boards of Directors performed very few decision-making functions. This gave the shareholders in the holding company effective control over the

subsidiaries even though their equity stake was often very small. Companies Act of 1856India modeled the Indian Companies Act of 1856 after the English Companies Act of 1855. The Indian Companies Act of 1856 introduced limited liability for the first time.

Maintaining Control:From the mid-1960s until the economic reforms of 1991, the government viewed the financial system as a source of public finance. During this time, the government controlled the banks and their lending decisions and used this to control competition. Commercial and cooperative banks provided companies with working capital. Indian development banks and a few government-funded financial institutions provided most of the medium- to long-term financing of companies. • 1969 Monopolies and Restrictive Trade Practices ActThe Act placed additional licensing restrictions on the private sector, further limiting competition and restricting investment. The Act defined a monopoly based on asset size instead of on market share.

Rapid Liberalization:Sri Lankan Tamil rebels assassinated Prime Minister Ghandi in May 1991. Following the assassination of the Prime Minister, India chose P.V. Narashimha Rao as the new Prime Minister. During this time India’s financial system faced a foreign exchange crisis and its economy was in shambles. The new administration immediately began liberalization efforts in capital and trade. • Initial reformsThe first major liberalization effort occurred when the Indian government issued a new Industrial Policy Act on June 24, 1991. The act repealed most industrial licensing requirements, relaxed the restrictions on foreign investments, and replaced the Monopolies and Restrictive Trade Practices Act of 1969. The removal of licensing requirements allowed private firms to make decisions without government input and allowed private industries to compete with state-owned industries.

• AftermathThe Sensex dropped 7.3% on the day the fraud was announced as investors lost confidence in Indian markets. In April, the Board successfully sold the company.• Responsible Parties The following parties share responsibility for the fraud as each either was directly responsible or missed red flags:

Company Management (CEO Mr. Raju, Internal Auditor, CFO); the Board of Directors; and Global Accounting Firm Price Waterhouse Coopers (PWC).

• Corporate Governance Challenges and Reform Post-Crisis The Satyam scandal revealed some persistent corporate governance problems in India.

Family business groups dominate the ownership of Indian corporations, controlling approximately 50% of the largest 500 Indian companies. Independent directors often succumb to serve the interests of the family over the minority shareholders. Indian corporations are often organized within a pyramid structure, allowing groups to control more of the operations than their equity claims represent. This makes it difficult for outside shareholders to monitor performance. Following Satyam, several experts called for increasing internal control monitoring by adopting something similar to U.S. Sarbanes Oxley Section 404. The government has resisted attempting to reform corporate governance in a comprehensive manner, and instead has taken a piecemeal approach.

The securitization market in India is still in its early stages of development. Currently, the Indian securitization market consists primarily of single loan collateralized obligation securities (CLO) and asset backed securities (ABS). There are three broad types of ABS securitized in India: 1) vehicle loans, two-wheeler loans, three-wheeler loans, 2) construction and agricultural equipment loans, and 3) unsecured personal and consumer durable loans. In 2007, the government passed an amendment to the Securities Contracts (Regulation) Act vesting the SEBI with regulatory powers over the market in an attempt to encourage its development. Significant regulatory hurdles still exist that are preventing the rapid development of the securitization market. The credit crisis also caused the Indian

Beginnings of Dalal Street During the 1850s and 1860s, stockbrokers gathered around Banyan Trees across from city hall in Bombay to trade stocks. The self proclaimed “cotton king” of India, Premchand Roychand, set trading rules and assisted in organizing trading. In 1875, a group of stockbrokers formally organized the modern day Sensex as the Native Share and Stock Brokers Association. The picture to the left is a banyan tree in Bombay under which trading took place in the 1860s and 1870s. The stock exchange is the oldest stock exchange in Asia.

The period under colonization was marked by the defrauding of Indian shareholders and operating inefficiencies. One prominent scholar, Radhe Shyam Rungta, commented, “The Acts provide examples of a complete disregard and an utter failure on the part of legislatures to take into account the peculiarities of conditions in India. If there is any underlying theme running through the company legislation of a full half-century in India…it is a steadfast adherence to the policy that what was good for Britain must also be good for India.”

• Companies Act 1956The 1956 Companies Act effectively abolished the managing agency system. The Act still somewhat tracked the English Companies Act; however, it also contained provisions that severely restricted investment.

It prohibited, “individual firm, group, constituents of a group, body corporate or bodies corporate under the same management” to accumulate more than 25% of the shares of any company.

The Act granted the government power to prevent the transfer of 10% or more of shares if the transfer would alter the board of directors and “is prejudicial to the interest of the company or the public interest.”

It prohibited individuals from transferring shares to foreign firms. • Securities Contracts (Regulation) Act 1956The Securities Contracts Act heavily regulated the stock exchanges and prohibited the trading of options. The Act’s preamble stated its purpose as, “An Act to prevent undesirable transactions in securities by regulating the business of dealings in therein, by prohibiting options and by providing for certain other matters connected therewith.” It emphasized investor protection and government control and placed little emphasis on market development.

• Controller of Capital Issues Abolition The most significant reform involving capital markets was the government’s abolition of the Controller of Capital Issues in 1992. After the government abolished the Act, companies were free to set the price of their issues. • Formation of Securities and Exchange Board of India (SEBI)The SEBI received legislative backing in 1992. The SEBI’s mandate included the promotion and development of the securities markets. This was a dramatic shift from the focus of the Securities Contracts Act of 1956, which primary focused on investor protection through heavy regulation and disregarded market promotion. The Act granted the SEBI the responsibility of registering and regulating market participants. • Formation of the National Stock Exchange (NSE)The Indian government formed the NSE in 1992. Prior to the NSE’s formation, the Sensex was a monopoly and it was plagued with manipulative practices.

The government created the NSE to compete with the Sensex and drive down transaction costs.

The NSE was set up as an automated electronic exchange allowing stock brokers from all over the country to link to the NSE computers and trade with automatic buy and sell order matching.

Fraud Hits• Howard Mehta Scam The first securities market fraud struck almost immediately following economic liberalization. Between December 1991 and April 1992, the Sensex rose by nearly 150%. A fraud involving manipulating settlement practices helped fuel the rally. The fraudulent settlement practices induced large banks to unknowingly make unsecured loans to smaller banks that then made money available to brokers. This diverted substantial sums of money from the banking sector to the stock market. After the fraud was discovered, the Sensex fell nearly 40%. • Vanishing Companies 1992 – 1994Vanishing companies also plagued the primary Indian securities markets, destroying investor confidence in the markets. Between July 1993 and September 1994 the Indian stock market gained 120%. Hundreds of companies took advantage of the hot IPO market and raised substantial sums of money. Several of these companies then proceeded to vanish after raising the capital. • Multinationals In 1994, multinationals took advantage of the lack of a developed regulatory structure by issuing preferential equity allotments to controlling shareholders at steep discounts to prevent takeovers. These issuances substantially diluted minority shareholders.

During the global financial crisis, Indian companies lost 64% of their market capitalization. Near the height of the global credit crisis, a major accounting scandal – Satyam − threatened the entire “Brand India” and its stock markets. Satyam was a globally-recognized information technology company.

Source: Securities Market Regulations: Lessons from US and Indian Experience (Bose)

• Corporate Governance Reform and Clause 49After the series of frauds shook investor confidence, the Confederation of Indian Industry formed a task force to improve corporate governance.

In April 1997, the task force published a draft of “Desirable Corporate Governance, A Code,” and defined “good” corporate governance as “maximizing long term shareholder value.”

The SEBI adopted Clause 49 in 1999, making many of the Code’s recommendations mandatory.

Clause 49 requires at least 50% of the Board to be independent when the CEO is also the chairman of the board.

It works in coordination with company listing standards on exchanges.The clause requires the CEO and CFO to certify the financial statements.The standard mandates meeting requirements for the audit committee.

government to moderate its market development efforts. As part of its review of monetary policy in 2009, the RBI asserted its desire to avoid adopting the originate- to-distribute model. It proposed both a seasoning requirement and retention criteria. Source: IRCA and (Wells , Zibel)

• Policies from 1960s – 1991 The government prohibited the development of an equity market through control directed by the Controller of Capital Issues.

Public financial institutions such as the Unit Trust of India, the General Insurance Corporation, and development financial institutions such as the Industrial Finance

Corporation of India and the Industrial Development Bank of India were the

largest shareholders of all major Indian firms, holding approximately 40-45% of share capital. Large state ownership resulted in an underperforming corporate structure as

the state institutions failed to monitor the corporations’ management. This prolonged the inefficiencies of the managing agency system, as

promoters often had effective control over companies with little investment. High tax rates encouraged fraudulent accounting practices and the

manipulation of earnings.

Independence : Nationalism through Self-SufficiencyIndia’s culture had a strong sense of nationalism when it gained independence. India desired to become self sufficient and adopted socialism and central planning as a means of accomplishing that goal. Prime Minister Nehru believed that state control of foreign investment was necessary to prevent foreign capital, foreign interests, and foreign businesses from dominating India. Developing the Framework for Control:• Capital Issues Controls Act 1947The Act provided government with the power to regulate equity issuance. It required companies to obtain approval from the Controller of Capital Issues to raise money. The government restricted the price of equity issuances to a complex accounting formula rather than letting the market set the price. The government used the control over equity issuances to ensure companies that raised money served the government’s goals and priorities. • Industries and Development Regulation Act of 1951The Act restricted investment by requiring all existing and proposed industrial units to acquire licenses from the central government. Business owners that had existing companies and political connections used the licensing regime to extract monopolistic and oligopolistic privileges in new and existing industries. The licensing requirements grew stricter over the years as the government thrust itself into an increasingly central planning role.• Industry Policy Resolution 1956The Act mandated that the public sector would dominate the economy and specified industries in which the state increasingly or exclusively would assume responsibility. This severely restricted both private industrial development and the development of equity markets.

• Fraud UncoveredIn December 2008, Satyam’s Board of Directors approved the purchase of two companies unrelated to the IT sector in which the CEO, B. Ramalinga Raju, owned significantly larger stakes than in Satyam. Company shareholders viewed the transaction as a way for Mr. Raju to siphon money out of Satyam and into the hands of the Raju family. The Board of Directors quickly aborted the transactions after the

Securitization Issue by Asset Type

Investigation and Enforcement by the SEBI over the years

The capital markets went through a series of minor reforms during the mid-1990s. Several of these efforts including improving transparency and corporate governance. The SEBI did not have many enforcement or investigatory powers under the original SEBI Act. Through a series of reforms, the government significantly strengthened SEBI’s enforcement and regulatory power. As the chart below shows, the number of investigation and enforcement actions increased dramatically after the reforms.

investors revolted. On January 7th, Merrill Lynch sent a letter to the Sensex stating that it had to withdraw from its engagement with Satyam because it had discovered material accounting irregularities. Hours later, Mr. Raju informed the Board of Directors about the fraud. Mr. Raju apparently perpetrated the fraud by creating fictitious bank accounts on his personal computer.

Securitization in India

Satyam and the Credit Crisis

Reform in the mid-1990s