Mumbai: On 23 June, in a speech during the Confederation of Indian Industry’s annual mutual fund summit at a suburban hotel in Mumbai, capital market regulator Chandrasekhar Bhaskar Bhave rued the inability of 3,000-odd mutual fund schemes to match investor needs. Investors are intelligent, Bhave said. “If we have not been able to convince them, even with thousands of mutual fund schemes, there’s some problem with the products. We are not getting to the heart of the matter.”
Bhave’s candid speech was directed at inducing the industry to do some soul-searching; instead, it had a different effect on players in India’s Rs6.75 trillion mutual fund industry. The moment Bhave left the venue, the knives came out, and fund managers blamed the regulator for “killing the industry”. India’s asset management companies have lost some 400,000 folios in the past few months, and even new fund offers are not receiving a good response. A folio refers to an investor account.
The speech at the mutual fund summit marked Bhave’s first public appearance after an ordinance on the regulation of unit-linked insurance plans (Ulips) put an end to the spat between the Securities and Exchange Board of India, or Sebi, and the Insurance Regulatory and Development Authority, or Irda. The 18 June ordinance settled the matter in favour of Irda and said Ulips, hybrid products that combine insurance and equity, fell under the purview of Irda and that Sebi had nothing to do with them.
Roughly a month later, MCX Stock Exchange Ltd (MCX-SX) moved the Bombay high court, seeking its intervention on Sebi’s inaction on an application seeking permission to serve as a platform for trading in equities.
Bhave is clearly in the eye of the storm. The mutual fund industry is baying for his blood for abolishing the entry load that has taken away the commission of distributors who are, as a result, no longer interested in selling mutual fund products. Irda and Sebi fought a hard battle that the former won with the government’s support. And now, a regulated entity has dragged Sebi to court for its silence on an application for equity trading. The Bombay high court will hear the case on Tuesday.
Many believe that the Ulip ordinance has made Bhave vulnerable and that it is a slap in the regulator’s face. It was promulgated when Bhave was in Canada attending the International Organization of Securities Commissions conference and he was not consulted on it. The other factor that is encouraging aggression against him is that he is nearing the end of his term. His three-year tenure comes to end in February. He will turn 60 by the end of August and is eligible for a second term, but the buzz in the corridors of power is that Bhave will not be considered for an extension. His predecessor M. Damodaran and G.N. Bajpai, who was regulator before that, too did not receive an extension. D.R. Mehta, who came before Bajpai, did get one. Many professionals tend to become a bit accommodative when their terms are to end because, by doing so, they think they can buy another term.
Bhave, however, doesn’t seem to be either vulnerable or accommodative. His actions do not display nervousness or resignation. Last week, Sebi slapped show-cause notices against Anil Ambani, the head of the Reliance Anil Dhirubhai Ambani Group, or R-Adag. It is also doggedly pursuing insider trading charges against Reliance Industries Ltd, India’s most valuable firm by market capitalization.
The phenomenon of market intermediaries blaming Sebi for killing the market is not a new one. In the regulator’s initial years, brokers were extremely upset when Sebi tried to reform practices in the secondary market. They opposed even simple proposals such as segregating brokerage charges from the price of shares in a contract note. Issues such as shorter settlement cycles, proper margining systems and automation of trading drew a lot of flak. There was opposition even to the depository system. Badla, or the hybrid cash and futures product rolled into one that flourished on the Bombay Stock Exchange (BSE), Asia’s oldest bourse, came under severe restrictions and was banned in former Sebi chairman G.V. Ramakrishna’s time.
Enemy No. 1
Bhave, a 1975-batch Indian Administrative Service (IAS) officer of the Maharashtra cadre and the executive director in charge of the secondary and later the primary markets in Sebi between 1992 and 1996, was branded Enemy No. 1 of the market. He had views and wasn’t hesitant to express them. The market heaved a sigh of relief when S.S. Nadkarni replaced Ramakrishna. Indeed, in his time as chairman, the Sebi board agreed to restore Badla, but only if certain conditions were met. Many market players still believe it was Bhave who was responsible for making these conditions tough, making it virtually impossible for Badla to be restored. Finally, Mehta, Nadkarni’s successor, restored it with less stringent conditions, but there was a serious settlement problem in BSE and Badla was banned in 2001 with rolling settlement becoming the norm. BSE was then known as a brokers’ club and Bhave was on the board of the exchange in his capacity as a representative of Sebi.
Bhave outraged BSE members even as they saw their profits dwindle. But there was a revolution on in the market, involving the establishment of the National Stock Exchange (NSE), the banning of Badla, the setting up of the clearing corporation and depository, and the onset of derivatives trading. Indeed, the profit margins in brokerages went down, but the market became safer and more transparent and the turnover of brokerages rose manifold.
Before joining Sebi, Bhave was additional industries commissioner of Maharashtra for three years and had earlier served as an undersecretary in the ministry of finance and deputy secretary in the ministry of petroleum. After his stint in Sebi, he resigned from the IAS in 1996 to create India’s first share depository that revolutionized the capital market by getting market players to accept the new system of dematerialized shares. The depository was set up for less than Rs100 crore and achieved paperless trading within three years.
A Chittapavan Brahmin—a group traditionally known for integrity and intellectual honesty—Bhave was not keen to be the chairman of Sebi because, as the head of National Securities Depository Ltd, or NSDL, he was fighting with the regulator and there was a clear conflict of interest. That story began in April 2006 when Sebi unearthed a scam involving depositories, depository participants (DPs) and two dozen market operators, who allegedly played a role in using 59,000 fictitious demat accounts to corner share allotments in initial public offers (IPOs) that were meant for small investors. Sebi found that the depositories “failed to exercise oversight over the DPs” and the promoters of NSDL (and another despository) were directed to take “all appropriate actions including revamping of management”. It also ordered NSDL and a few others implicated in the IPO scam to return Rs115 crore in “illegal profits” made from the IPO deals. NSDL’s share of this was Rs45 crore. In both instances, NSDL had claimed that the regulator did not hear its side of the story. It challenged the Sebi order with the appellate body of the capital market regulator. The tribunal did not see any merit in the Sebi order on “management revamp”. It also set aside the order on return of the illegal profits.
So, how do market participants see Bhave?
Mint has spoken to many but few want to be quoted for fear of antagonizing a regulator. And those who are willing to go on record are lavishing praise on him for his emphasis on investor protection. Overall, his critics outnumber his supporters, and at least a few of them say that after being snubbed by the government, Bhave is isolated and will give in if they mount an attack.
Rigid and inflexible
There are four sets of allegations against him.
First, that he is rigid and inflexible. His obsession with self-righteousness is his hubris, Bhave’s detractors say.
Second, there is something else behind his pro-investor image; he wants to teach the intermediaries a lesson. “When there are accidents on a road, if you put too many speed breakers, cars won’t be able to ply. Is this is the way one should protect the pedestrians from accidents?” asks a fund manager.
Third, he is fighting the battle for NSE and doesn’t want it to lose its monopoly.
Fourth and finally, there is yet another school of thought among market intermediaries that says Bhave has done well in terms of investor protection and market development but has failed in fostering competition. “I am not sure though whether it’s his job. There could be overlapping between the markets regulator and the Competition Commission of India (CCI). But this is one area where he could have been more active,” says the CEO of a regulated entity.
Bhave seems to be unfazed by criticism. On his so-called inflexibility, he says, “In public service jobs, you receive praise as well as criticism. Both can be motivated or genuine. It’s not easy to segregate the two but one needs to do that. The human mind pushes you to believe that praise is genuine and criticism motivated. One has to make constant efforts to avoid this and use criticism as an opportunity to improve. At Sebi, we try and take all stakeholders’ feedback and then take a decision. The decisions may not be liked by every constituent, but Sebi needs to act as per its mandate.”
But isn’t he choking the mutual fund industry? Fund managers allege that he was in a hurry to ban the entry load and in the process almost killed the industry. He does not agree with this. “The mutual fund advisory panel (of Sebi) started discussing this in November-December 2008. The discussion paper was prepared in January 2009 and the board took it up in June. In August, it took effect. Indeed, 90% distributors did not want it, but the regulator’s orientation is investor protection and not (that of) intermediaries. The matter was decided by the Sebi board, which has wide representation. It is the result of a process and not as per anybody’s likes or dislikes.”
Few in the industry agree with him, and many do not see any “method in his madness”. “His entire objective seems to be protection of investors because he feels the industry will survive only when investors are there. If caring for investors means he is anti-industry, so be it,” says one fund manager. Another lobbyist for the industry admits that while there will be short-term pain for the industry, in the long term, it will gain.
In August 2009, Sebi had barred the mutual fund industry from charging an entry load to investors. The regulator also restrained asset management companies from having different exit loads for different classes of customers. Besides, Sebi ordered the industry to calculate the value of investments in debt funds on a mark-to-market basis from August. The changes, many of them and in quick succession, have not gone down well with the industry. In the past year, equity investors have pulled out at least Rs70,000 crore from funds, but the net outflow from equity funds since August 2009 has been around Rs7,000 crore with fresh money coming in. The distributors are not aggressively selling funds and instead they are selling Ulips which continue to offer them a hefty commission.
Level playing field
Bhave wanted to create a level playing field by having a say in the regulation of Ulips, but could not do so. Both Sebi and Irda fought hard and when there was no solution in sight, the finance ministry stepped in and asked both to seek a legal solution that would be binding. Sebi moved the Supreme Court asking it to decide on two public interest litigations that were filed in two high courts on the regulatory spat. But before the court could take it up, the government issued the ordinance to settle the matter in favour of Irda.
Sebi could not sort out the Ulips dispute legally, but now MCX-SX wants a legal solution to Sebi’s silence on its proposal to start equity trading. After waiting for three months for the stock market regulator to clear its application seeking permission to serve as a platform for trading in equities and with time running out, it moved the Bombay high court for relief. Ahead of this, MCX-SX launched a high-voltage media campaign publishing a “fact sheet” on its regulatory compliance. It started its operations in October 2008 with currency derivatives trading and Sebi did not allow it to start equity trading since the company did not conform to MIMPS (Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchanges) regulations. It was given a year to do so. Under MIMPS, no single entity can hold more than 5% shares in a stock exchange except for certain intermediaries who can hold up to 15%.
According to the “fact sheet”, MCX-SX reduced its capital and recast its ownership structure through a scheme that was approved by its shareholders and the Bombay high court. Following this, the exchange’s capital was reduced from Rs173.99 crore to Rs54.33 crore and the combined stake of Multi Commodity Exchange of India Ltd (MCX) and Financial Technologies (India) Ltd (FTIL), its promoters, came down from 70.9% to 10%. Warrants were issued to shareholders whose equity capital was cancelled.The “fact sheet” says the warrants do not bear any voting rights and do not qualify for dividends. It also says they can be converted into equity shares only in compliance with MIMPS regulations. It claims that at every stage the exchange kept the regulator informed about the status of the equity restructuring. It did inform Sebi about shareholders’ approval of the scheme on 21 December and the approval of the high court on 7 April. It moved court when it ran out of patience.
It would appear that Sebi is not happy with the way the exchange has recast its capital. It may have followed the rules but not the principles. Bhave declined to answer any question on this issue, saying , “It is best not to deal with this at this stage, when one of the entities has filed a writ against Sebi, and such criticism should appropriately form a part of the judicial process now. We need to address the criticism in that forum if it is made there.”
While MCX-SX claims it has restructured the ownership with Sebi’s tacit approval and at every stage the regulator was involved, another industry player says, “Isn’t it strange that people believe in tacit approvals and not in expressly stated oral disapproval of a structure?” Does this mean Sebi had categorically told the exchange that it was not comfortable with this arrangement? Bhave says he would not like to comment on that, but at least two senior Sebi executives say that is the case.
Much ahead of moving the court against the regulator, MCX-SX had filed a complaint with CCI against NSE, India’s biggest stock exchange, alleging that the latter had abused its dominant position and resorted to predatory pricing in the currency futures space where it competes with MCX-SX. According to the exchange, NSE was able to waive transaction fees for members using its currency futures platform because it charged a fee of Rs400 per crore on the turnover in its derivatives segment. NSE’s waiver means MCX-SX is also unable to levy such a fee, leading to significant losses. Sebi insiders defend the regulator saying it cannot force NSE’s hand when a move is obviously to the benefit of investors. “How can a regulator ask an intermediary to charge for a service if it decides to give it free to investors? It can step in only when there is a cartelization,” says another intermediary. The commission is yet to pass its final verdict.
Affection for NSE
On Bhave’s proximity to and affection for NSE, a Sebi executive who does not want to be named, says, when currency derivatives guidelines were released in May 2008, the chairman met the BSE board and asked the exchange to prepare for currency trading.
The fact that MCX-SX was allowed to trade currency futures is also an indication that Sebi under Bhave encouraged competition, says another person. “He could have denied approval on the grounds that MCX-SX’s shareholding is not as per (the) guidelines. Giving it two years to comply with the shareholding guidelines indicates his flexibility,” he points out.
MCX-SX is, however, not convinced. According to a media report (The Economic Times, 6 August), MCX-SX has written to Sebi on its preferential treatment to NSE, particularly with regard to the timeframe for complying with the regulations. The report quoted an MCX-SX letter saying it was given one year to bring down the promoter’s stake while NSE was given a “fairly long time for compliance without any restrictive conditions”. It also said, “due to predatory pricing, MCX-SX has lost over Rs100 crore since it went live in October 2008 and continues to make a loss of over Rs4.5 crore per month even now.”
BSE’s top brass too feels that Sebi has not been proactive in helping resolve differences with NSE on issues such as smart order routing. With the advancement of electronic trading, an increasing proportion of orders are being sent to exchanges by automated systems. Smart order routing technology enables these systems to choose the best possible price, just like their human trading desk counterpart, but at the speed of a machine.
BSE feels NSE is going slow in approving smart order routing technology since it will lose some order flow to BSE. NSE, on the other hand, feels it has legitimate concerns that need to be addressed before this is introduced. Sebi has asked the exchanges to sort out differences between themselves.
“NSE’s concerns may not be justified, but I wouldn’t say Sebi is a bad referee. It has been open to BSE’s requests to introduce things such as expiry of derivatives in the middle of the month. Doesn’t it show regulator’s openness to competition?” asks an expert who tracks the market infrastructure closely.
While allegations of all kinds are flying around, Bhave does not seem to be in a mood to give up. Sebi is doggedly pursuing two high-profile cases. Its investigation into a dozen firms linked to Reliance Industries for possible violations of insider trading norms is on. Reliance Industries has offered to settle this issue through the so-called consent process—a sort of out-of-court settlement for alleged violations of norms—but the regulator has not yet closed it. A consent order is an order that settles administrative or civil proceedings between the regulator and an entity who may prima facie be found to have violated securities laws. Such an order may or may not include a determination that a violation has occurred, but it provides flexibility of a wider array of enforcement and remedial actions without resorting to litigation and long-winding proceedings.
More recently, Sebi has asked Anil Ambani and four senior officials belonging to his group for explanations over what it referred to as “certain dealings”. They have been given an opportunity to appear in person before the regulator on 3 September.
The heart of a financial regulator is the investigation and enforcement process, and the challenge is one of writing high-quality orders. These orders should show full reasoning about how wrongdoing has been proved. They should survive appeal in the specialized financial court. Sebi under Bhave has done well on this score.
All over the world, financial regulation is recognized as a complex field where the interests of the people often do not coincide with the interests of financial firms. The real test of governance in a country is about the extent to which the public interest shapes outcomes and not the interest of one party or one industry. This requires high-quality leadership of financial regulators in three dimensions—they need to be strong and not get pushed around, they need to be technically sound and they need to be uncorrupt. All three dimensions are essential.
Does Bhave possess all three? In 1990s, with Ramakrishna and Nadkarni, Bhave worked on reforms of the stock market, and all three gentlemen were pilloried by market players. Their efforts directly interfered with the rent-seeking of BSE members who were outraged at any attempt at reducing their profitability. Now, the context is different and too many constituents are involved. And the money involved is too big. For instance, the fees and commissions of distribution of mutual funds and Ulips run into thousands of crores annually.
Will Bhave be able to streamline the system? Or will he be sucked into it? Does the system need any cleaning up at all? Is Bhave a level-headed regulator with an iron hand or is he overstepping his brief? We need to wait till February to find answers to some of these questions.
There is also speculation that he has threatened to resign. But those who know him well say he will not threaten to resign.
And that he will simply resign if he chooses to.