The much-awaited decision of the Securities and Exchange Board of India (Sebi) on MCX Stock Exchange’s application has finally been announced. Thus far, Sebi officials have said off-the-record that MCX-SX’s procedure of extinguishing shares and issuing warrants in exchange may meet the letter of its law, but not its spirit. The 68-page order issued late last week throws ample light on this issue.
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One argument that has been repeatedly made is that Sebi shouldn’t have a problem with the large number of warrants held by MCX-SX’s promoters, since these can not be converted into shares in breach of the shareholding restrictions placed by Sebi. In other words, promoters’ stake in the equity capital would always be at 5%, in accordance with Sebi’s shareholding requirements.
The order by whole-time member K.M. Abraham states, “The standard that Sebi has adopted here is simply that excluding the warrants held by a shareholder in computing the limits of ownership in an exchange would violate the spirit of the MIMPS regulations and would not be in consonance with it… It has to be viewed in the context of the MIMPS regulation itself and its objective of ensuring wider ownership in a stock exchange. For the purpose of this regulation, it would be fallacious to argue that holding ‘equity shares’ (in excess of the shareholder limits) is not permissible, but holding the ‘right to equity shares’ would be permissible… I am of the considered view that converting ‘equity shares’ into ‘right to equity shares’ is an attempt to work around the requirements and attempting to merely meet the letter of regulation 8(1) of MIMPS regulations.” MIMPS stands for Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchanges Regulations, 2006.
Another argument against Sebi’s stance is that the warrants do not carry voting rights or dividends and hence will not give rise to control of the company or confer any economic interest in the company. But as Sebi states in its order, the value of the warrants is part of the economic interest of a shareholder in an exchange. Consider, for example, a situation where the value of an MCX-SX share rises from Rs 10 to Rs 100. While shareholders would be able to sell their shares at around Rs 100 per share, even warrant holders would be able to sell warrants at the rate of around Rs 100 each. This is because each warrant can be converted into an equity share with voting rights and normal dividend rights. So whether a shareholder holds 100 shares or 100 warrants, the economic value of both the holdings are the same. In all of Sebi’s deliberations about economic interest, therefore, it has considered the percentage of the total of shares and warrants issued as a measure of economic interest of the promoters in the stock exchange. Using this measure, MCX-SX’s promoters hold a 71.9% stake and the order states that such an excessive concentration of economic interest is not acceptable to it.
The main reason Sebi is uncomfortable with concentration of economic interest is that stock exchanges are market regulatory institutions, watching out for fraud and manipulation in the market, protecting the interest of investors and ensuring compliance by companies via listing agreements. Besides, stock exchanges are in the possession of the entire trading information pertaining to clients. The order states that given this position of a stock exchange, it becomes necessary to ensure that it is not vulnerable or appear to be vulnerable even to the slightest degree, to any deviant commercial incentive on the part of its shareholders, big and small, promoters and non-promoters.
Sebi’s main arsenal to ensure this is to restrict the shareholding of certain institutions at 15% and other shareholders at 5%. This leads us to the argument that because of Sebi’s shareholding restrictions, there is no economic incentive for a competent entity to set up a stock exchange. If all one can own in an exchange as a non-institutional shareholder is 5%, why go through the effort of setting up an exchange? The argument goes that few people would see reason in this and hence Sebi’s current rules protect the existing monopoly situation in the stock exchange space.
Prima facie, this looks like a case of unintended consequences. Even so, the lack of competition in the exchange space is an undesirable outcome and policymakers must look at correcting this.
This column has argued in the past that India could adopt the model followed by some exchanges in developed markets, where the regulatory function of these exchanges is separated and overseen by a non-related entity. For instance, Financial Industry Regulatory Authority performs market regulation under contract for major US stock markets, including the New York Stock Exchange, NYSE Arca, NYSE Amex, the Nasdaq Stock Market and the International Securities Exchange. If such a model is adopted in India, exchanges can outsource the regulatory function and can then be free to make purely commercial decisions. In such an environment, Sebi needn’t worry about concentration of economic interest in the exchange, but that of the regulatory organization.
Of late, J.R. Varma, a professor at the Indian Institute of Management, Ahmedabad, has been advocating that the market regulator should take up regulatory functions such as market surveillance and compliance with listing agreements. Policymakers would do well to consider such a model to ensure greater competition in the exchange space, without compromising on their concerns about the integrity of the market.
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