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Posted on 03-May-2019 Comments  0

Regulating FMPs

SEBI is absolutely correct on the need to regulate Debt Funds

The SEBI chairman recently underlined the need to regulate debt funds and FMPs in a more stringent way. While the contours of such regulation were not spoken about, the statement was clearly dictated by what had been happening to mutual funds in the last few months. Of course, we are talking about MFs unilaterally deciding to postpone the redemption of FMPs. How to regulate?

Greater disclosure is the key

FMPs and debt funds have a lot of leeway. In the last few years, there has been a glut of money flowing into MFs without adequate avenues to invest. The gap was filled by desperate promoters and fund managers willing to structure promoter lending via pledge of shares. The whole problem is that such promoter funding requests are not disclosed by the fund. On the face of it, it looks like any normal bond investment and the problem, explodes as it happened when the FMP comes up for repayment. Greater disclosure will call for making a disclosure when shares are taken as pledge, as soon as the promoter defaults on payments or when the bonds are downgraded. Above all, the key lies in educating retail and HNI investors about the risks of debt fund investing, especially with respect to credit opportunity funds and FMPs. The standards of disclosure required are quite poor today and as a result funds are able to get away with an extremely opaque fact sheet; which says nothing!

Treat them like banks

One way to put the pressure on the mutual funds is to put them on the same regulatory space as the banks. As the SEBI chairman noted; mutual funds lending against promoter shares is nothing short of banking. That means; mutual funds must be subjected to the same degree of responsibility with respect to capital adequacy and asset recognition that banks are subjected to. There is a third possibility where the regulator must compel the sponsoring AMCs to take part of the responsibility for the losses caused to the investors. After all, when funds do charge a total expense ratio of 2% to 2.5% to investors, they must be held financially liable to make the losses that occur from such rash decisions of fund managers.

Fix individual accountability

Unlike bankers, fund managers are a fairly privileged lot as they don’t have to worry about the ED chasing them in case of loans gone awry. While that may not be required, you surely need greater accountability for fund managers, CIOs and CEOs. More so, when it comes to taking rash decisions that are harmful to the interests of the unit holders. One can argue that such measures could be detrimental to the fund industry but SEBI is ultimately committed to the small investor and not to the fund manager. That should be the driving theme of debt fund regulation!

Royalty Payments

Why SEBI is correct in closer regulation of MNC royalty payouts

While royalty payments are nothing new and most MNCs with a global parent do pay royalties, the quantum of royalties has come under question in recent times. Just a few months back, there was the entire debate about how much royalty payments should be permissible. There have been two diverse thoughts on the subject. On the one hand, the Ministry of Finance is not keen to get into the micros as it needs to attract foreign capital and technology. On the other hand, SEBI is worried about the loss of value to the existing share holders, especially small investors, due to royalty payouts. How big is the issue?

It is actually quite big

SEBI is keen to peg the total royalty payments at 2% of the net sales of the Indian company. Currently, there are a lot of large companies with global partners which pay differing amounts to the parent as royalties. Consider the numbers. Hindustan Unilever pays less than 2% although it does pay additional 1% to Unilever for use of central services. But the numbers are much higher for others. For example, Colgate pays out 4.97% of sales as royalties while Nestle and Maruti pay 4.36% and 4.72% respectively. This is the norm for most of the MNC players operating out of India. Kotak Committee suggested capping royalties at 5% but SEBI is keen to peg it at 2% and then relax it on a case-by-case basis. Actually SEBI may have a case on hand!

Why SEBI is justified?

It needs to be remembered that the royalty is paid as a percentage of sales revenues. The impact on profits will depend on the pre-tax margin. For pre-tax margin of 50% the impact of 5% royalty is nearly 10% reduction in profit but for a MNC with net margins of about 20%, the impact on the pretax profit is about 25%. That is a very large impact, especially in the absence of an acceptable model to measure and justify the royalty payments. Since the royalties take away a chunk of the pre tax profits of the Indian company, it turns out to be unfair to the Indian shareholders. In the process, the company tends to create more value for its global parent than to the Indian shareholders to whom the local unit has sold shares. That is the reason SEBI has insisted on a lower cap of 2% on royalties!

A transparent model

The actual answer could lie in a more transparent model for such royalties where the same can be correlated to the benefit derived from the association. Currently it is arbitrary. SEBI is willing to look at an arrangement wherein the cap is kept at 2% for generic cases which can be enhanced if there is genuine technology transfer to the Indian side of the business. Royalties have long been a bone of contention for global players. It is time SEBI looks at an acceptable model for the same!

Pledging Shares

New Insider Trading rules create complications for pledged shares

When the new insider trading rules of SEBI took effect on April 01st, it was seen as a normal move to bring about more transparency in insider trades and ensure better corporate governance. But there was a catch. Under the modified rules, pledging shares were also covered under the purview of insider trading rules. Why does it matter so much?

Insider rules modified

Let us first look at how the basic insider rules have been modified as of April 01st this year. Under the previous regime, till March 31st, all insiders including directors, promoters, advisors, auditors etc could not buy or sell the stock 2 days prior to the results announcement and up to 2 days after the results. That effectively meant a freeze of around 4 trading days and the insiders could trade in the stock before or after these said days. The new rules effective from April 01st have made the freeze period start from the last day of the relevant quarter itself. For example, for the March quarter, the freeze on insiders trading will be effective from March 31st and if the results were declared on April 20th, then the freeze will extend all the way to 22nd of April. During this period of 22 days, insiders will not be able to either sell or buy the shares. Normally companies declare quarterly results between 10 and 45 days from the quarter ending. From the end of the quarter till 2 days after the results, the trading for insiders will be frozen.

All about pledging of shares

While the longer freeze period is a challenge enough, the new rules also include pledging of shares under the definition of insider activity. That means; promoters and insiders cannot even pledge their shares or even revoke their pledges during this freeze period. There are still some questions that are not answered. Can the pledgee sell the shares during the freeze period and whether it will be treated as a violation of insider trading rules? That is not too clear. With more than Rs.3 trillion of shares pledged, predominantly, by small and mid cap companies, this could pose a real challenge for promoters.

What could be the outcome?

This move apparently looks like an effort to prevent promoters compromising the interests of the minority shareholders by pledging a major chunk to bankers. This has created tremendous volatility in the past and small shareholders have lost out in the bargain. There is also another angle to this. In the last few years, many mutual funds have invested in private companies floated by promoters via NCDs secured by promoter holdings. This was not an investment but a form of quasi promoter funding. Clearly, SEBI is not too happy with this methodology. By bringing pledged shares under insider trading rules, it could change the rules of the pledging game. Clarity on this topic can be expected soon!

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