Foreign investment in Indian mutual funds through unit confirmation receipts

In pursuance of the policy formulated by the Ministry of Finance, Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI) have liberalized the investment route for foreign investors in mutual fund (MF) schemes. Until now only FIIs and sub-accounts registered with SEBI and NRIs were allowed to invest in MF schemes. Pursuant to circulars dated August 9, 2011 of SEBI and RBI, permission has been granted to certain other foreign investors termed as qualified foreign investors or QFIs to invest in equity and debt schemes of MFs. Such QFIs can invest through either of the following two routes viz. direct route (holding MF units in demat account through a SEBI registered depository participant) or indirect route (holding MF units via unit confirmation receipts).

The indirect route wherein a QFI invests through unit confirmation receipt (UCR) is a novel concept in the area of mutual fund investments and is similar to the mechanism of issuance of depository receipts by Indian companies under the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 (DR Scheme). The DR scheme is a common method adopted by Indian companies to raise foreign funds and is currently the only legal mechanism available to Indian companies to raise foreign funds through the depository receipt mechanism.

The issue structure in an issuance of depository receipt under the DR Scheme is as follows: an eligible Indian company issues shares or bonds which are held with a domestic custodian bank. These shares or bonds form the underlying security and are denominated in Indian currency. Against these underlying securities, an overseas custodian bank, upon being authorized by the Indian company, issues depository receipts which may be denominated in any freely convertible foreign currency. Thus the depository receipt is a financial instrument created by the overseas depository bank outside India and is issued to non-resident investors against the issue of ordinary shares or bonds of an Indian company.

The SEBI circular lays down a similar mechanism as above, for investment by the QFIs. Accordingly, the MF would issue rupee denominated units of the MF which would be held as the underlying by the custodian in India. Against this underlying the UCR issuer based overseas would issue UCRs to be held by the QFIs. Thus, as is the case under the DR Scheme, there are four parties involved via the foreign investor, the receipt issuer, a domestic custodian and the Indian issuer.

Maintenance of due diligence records by merchant bankers

The latest board meeting of the Securities and Exchange Board of India took place on July 28, 2011. As per the press release about the board meeting, one of the issues that was discussed and decision taken was due diligence records to be maintained by merchant bankers.

SEBI noted that the merchant bankers are required to exercise due diligence in the pre-issue and post-issue activities of issue management, takeover, buyback and delisting of securities. However at present, they are not required to maintain any records as to how they exercised due diligence. As a result, the merchant bankers follow different standards of compliance and the level of due diligence cannot be checked during inspection of merchant bankers by SEBI. Accordingly, SEBI approved amendment to Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992, requiring merchant bankers to maintain records and documents pertaining to due diligence exercised in pre-issue and post-issue activities of issue management, takeover, buyback and delisting of securities. These amendments are yet to be notified by SEBI.

The foregoing is a welcome step since it would clarify what the securities market regulator expects of the merchant bankers in matters of due diligence. Accordingly the merchant bankers can revise their internal policy on maintenance of records without being in a state of uncertainty. This would also assist the merchant bankers in establishing due diligence during SEBI inquiries. Due diligence by merchant banks in public offers, takeover and other similar capital markets transactions has been judicially well recognized and reference can be made to various orders of the Securities and Appellate Tribunal during the years 2004 and 2008.

Further recognition by SEBI that currently the merchant bankers are not required to maintain any records as to how they exercised due diligence also clarifies an uncertain aspect on due diligence which is whether there is currently a legal obligation to maintain such records. In the context of stock brokers, a similar issue was recently adjudicated upon by the Adjudication Officer, Securities and Exchange Board of India on July 27, 2011 in the matter of UBS Securities India Private Limited (UBS). SEBI had alleged that UBS had failed to provide required information (telephonic records, Bloomberg messages and emails) that SEBI had sought in relation to dealings in securities by UBS as a stock broker. UBS successfully argued that there was nothing under the Securities and Exchange Board of India Act, 1992 and the rules and regulations framed thereunder which required it to retain emails, messages and telephonic records for a particular period of time. Hence it would be guided by its internal policy which it had followed.

Legal nature of the bank account in public offerings- II

In an earlier post, I had analysed the legal nature of the bank account for collecting subscription money in public offerings. A decision of the Madras High Court in Commissioner of Income Tax v. Henkel SPIC India Limited, [2004] 120 Comp Cas 189 (Mad) offers further guidance on this issue. The facts of the case were that the assessee, a public limited company, had come out with a public issue of shares in January 1, 1992 and the issue was closed in February 3, 1992. The application money received by the company was deposited with collecting banks. The interest earned on such share application moneys was sought to be taxed by the assessing officer as income for the assessment year 1992-93. The court was asked to determine the assessment year in which the interest earned on short-term deposits of share application money by the assessee would be deemed to have accrued and formed part of income from other sources for taxation purposes.

Applying section 73 of the Companies Act, 1956, the Madras High Court held that a company which comes out with a public issue is not required to keep the money in a bank account which yields interest. There is, however, no prohibition against the money being kept in a bank account which yields interest. The interest so earned, however, cannot be regarded as an amount which is fully available to the company for its own use from the time the interest accrued, as that interest is an amount which accrues on a fund which itself is held in trust until the allotment process (viz. obtaining the listing and trading permission from the concerned stock exchange after making the allotment) is completed. No part of this fund, either principal or interest accrued thereon, can be utilised by the company until the allotment process is completed and money repayable to those entitled to repayment has been repaid in full together with such interest as may be prescribed having regard to the length of period of delay in the return of money to them. It is only after the allotment process is completed and all moneys payable to those to whom moneys are refundable are refunded together with interest wherever interest becomes payable, the balance remaining from and out of the interest earned on the application money can be regarded as belonging to the company. Thus the interest money would form part of the income of the company at the time when the entire allotment process as envisaged by section 73 and as outlined above would be completed. Accordingly, the Madras High Court rejected the stance taken by the assessing officer that the interest money would form part of ‘income from other sources’ in the assessment year 1992-93 and upheld the position of the assessee that it should form part of the subsequent assessment year in which the entire allotment process was completed.

Inconsideration to legal provisions by SEBI: Vaswani Industries IPO

SEBI had passed an order dated May 26, 2011 (link) stalling the listing of the shares of Vaswani Industries Limited after the completion of the IPO. The order was passed because on receipt of investor complaints and on the basis of a preliminary examination SEBI had found that the order book, while the IPO was open for subscription, may have been manipulated by artificially inflating it, thereby inducing innocent investors to subscribe to the issue. As a result, SEBI ordered a detailed investigation.

After the completion of the preliminary investigation, SEBI came to the conclusion that there was more than reasonable possibility that the investors were beguiled by the artificial trends in the subscription. A major part of the subscription was subsequently found to be bogus and untrue. Consequently, SEBI, through its order dated July 11, 2011 (link) directed the company and the book running lead manager to, inter alia, do the following.

1. Give withdrawal option to all the investors who had been allotted shares in the non-institutional investors category and the retail individual investors category for such number of shares by which the allotment ratio was impacted due to withdrawals/rejections.

2. On the closure of the withdrawal option, if the subscription level after such withdrawals falls below the minimum level of subscription as required by law, the sole syndicate member cum book running lead manager, Ashika Capital Limited, would underwrite and may purchase or arrange purchase through any investor(s) identified by it of such number of shares so as to ensure that the subscription does not fall below the minimum level of subscription. Non-compliance of such condition shall result in refund of entire subscription money to the investors and cancellation of all the shares so allotted by the Company.

3. The company shall cancel those shares, which have not been underwritten or taken by other investors identified by the lead manager.

These directions of SEBI raise interesting legal issues and may be in complete heedlessness to the legal provisions:

1. As per SEBI’s order, upon exercise of withdrawal option, if the percentage of allotment falls below the minimum subscription level, the sole syndicate member has to underwrite. It’s unclear as to the legal basis for such an underwriting since underwriting (soft or hard) as a process, both under the underwriting agreement and in accordance with SEBI (Underwriters) Regulations, 1993, happens prior to allotment when the requisite subscription has not been achieved. In Vaswani’s case, subscription and allotment for the entire issue is complete and the sole syndicate has not been found guilty of any wrongdoing.

2. As per SEBI’s order, if minimum level of subscription is achieved, the company has to cancel the allotted shares which have been rejected by the investors. It’s unclear what sort of corporate action will be followed by the company for cancelling such allotments. As per companies act, allotments are voidable or void under sections 71 and 73 respectively, which do not apply to this case. The other method of cancelling allotted shares would be through buy back, the conditions of which Vaswani Industries may not be able to meet.

3. SEBI’s order seems to have ignored the applicability of section 73 (1A) of the companies act. The IPO closed on May 3, 2011. By the time Vaswani Industries completes complying with SEBI’s directions, the ten week period would be over without Vaswani Industries having received the listing permission. So as per section 73 (1A), the entire allotment made pursuant to the IPO would become void.