Is Bhave siding with NSE to harm MCX-SX?

A court case filed by MCX-SX has brought under spotlight Bhave-led NSDL’s role in an earlier IPO scam; the questionable handling of that scam by Sebi under Bhave; Sebi’s partisan use of MIMPS norms and its actions that allegedly helped NSE at the cost of MCX-SX

Shahid Faridi

This is a story that highlights how regulators, who come into being to check foul play and ensure level-playing field, often become players themselves and start tilting the field to favour a few at the cost of others, thereby defeating the very purpose of their existence.

The government, therefore, needs to keep a close tab on these regulatory institutions and purge them of not only those individuals who actually seek to destroy them by their partisan conduct, but even those who are perceived to be partisan. Because, not just Caesar, even Caesar's wife should be above suspicion.

Here is a case where one of the regulated got so disappointed by the perceived partisanship of the regulator that it took the regulator to court.

The leading stock exchange of India, National Stock Exchange (NSE), was launched in 1993. It was allowed to trade in many segments in the first year of its existence.

The Ministry of Finance had initially granted recognition to NSE in April 1993 for a period of five years, and this five-year period enabled it to properly plan its market operations, strategies for growth, etc.

In the year 2006, the regulator, Securities and Exchange Board of India (Sebi), imposed shareholding restrictions in stock exchanges through Securities Contracts (Regulation) (Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchange) Regulations 2006 (briefly known as the MIMPS Regulations). Through this notification, Sebi, among other things, made it mandatory that no shareholders of any recognised stock exchange should hold more than five per cent shares in an exchange.

But Sebi asked NSE to comply with MIMPS regulations only in 2007. On October 17, 2007, NSE was given one year to comply with MIMPS. This time limit was further increased and NSE became fully compliant with the MIMPS regulations only in 2009.

From 2006, when the MIMPS regulations were first introduced, till the time in 2009 when NSE was not compliant with the MIMPS regulations, Sebi not only allowed NSE to operate in multiple segments, but even permitted it to add a few new segments.

The news segments that Sebi allowed NSE to introduce during the period when NSE was non-compliant with MIMPS regulations are:

Corporate Bond

Currency Derivative

Interest Rate Futures.

In the year 2008, a new stock exchange, MCX Stock Exchange (or MCX-SX), was set up. In contrast to a five-year initial recognition granted by the Ministry of Finance to NSE, Sebi granted recognition to MCX-SX for only one year at a time, thereby created uncertainty about the exchange's future.

Second, in contrast to permission granted to NSE to trade in multiple products/segments in the very first year of its existence, this new exchange was allowed to operate only in one product, namely, exchange traded currency derivatives.

Again in contrast to Sebi's accommodative conduct vis-à-vis NSE, the new exchange was asked to strictly comply with the MIMPS regulations within one year of commencing business.

MCX-SX was started by two companies - Multi Commodity Exchange of India Ltd (or MCX) and Financial Technologies ( India) Ltd (or FTIL). At the time of MCX-SX's incorporation, MCX held 51 per cent and FTIL held 49 per cent in MCX-SX.

As per Sebi's directions on MIMPS regulations, these two companies had to dilute their shares to five per cent each within one year. As MCX-SX was a new exchange and was allowed to trade only in one segment, it was incurring losses and, therefore, found it difficult to persuade investors to pick up equity.

Unlike the accommodative attitude adopted by Sebi in respect of dilution of holding in multi-segment/product, profit-making NSE, the regulator not only rejected repeated requests by MCX-SX to trade in additional segments/products but it responded in a manner that appears to be an attempt to penalise it for MIMPS non-compliance in the first year.

Sample this: By its notification dated September 18, 2008, Sebi, “being satisfied that it would be in the interest of the trade and also in the public interest so to do,” granted recognition to MCX-SX as a stock exchange for one year starting from September 16, 2008 to September 15, 2009 on the following conditions, among others:

“The exchange shall ensure full compliance with the provisions of the Securities Contracts (Regulation) (Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchange) Regulations 2006 within a period of one year.

The exchange shall comply with such other conditions as may be prescribed by Sebi from time to time.”

Along with the above-mentioned conditions stated in the notification dated September 18, 2008, Sebi informed MCX-SX through a letter, also dated Septebmer 18, 2008, that “it has been decided to grant you approval for initially operationalising the exchange traded currency derivative segment only.”

This, despite the fact that MCX-SX had sought permission for recognition for all purposes of the Securities Contract Regulation Act, 1956 "in respect of contracts in securities/futures and options/currencies futures etc."

Sebi renewed the recognition after the expiry of first year. The recognition was extended for one more year up to September 15, 2010. It was while giving this extension that Sebi inserted a new condition that tilted the playing field against MCX-SX.

In its notification dated August 31, 2009, Sebi said: "The exchange will be permitted trade only in securities in which trading was permitted hitherto and shall not be eligible for introduction of any new class of contracts in securities, till such time as the compliance referred to above is ensured." The compliance referred to "above" was about diluting holdings as per MIMPS Regulations.

The introduction of this new condition made it even more difficult for MCX-SX to get equity participants. Until Sebi had not specifically linked grant of permission to operate in other segments/products with MIMPS compliance, the potential investors had a reason to hope for such permission and a consequent turnaround in the company's fortunes. But all such hope evaporated once Sebi inserted the new condition in its renewal notification. So, while on one hand Sebi kept insisting of MIMPS compliance, on the other, it inserted a condition that made it difficult, if not impossible, to achieve the same.

Here is what MCX-SX chairman Ashok Jha, in a letter to Sebi (copy of which is in the possession of Realpolitik), had to say about Sebi's decision: "The divestment process that was going on smoothly till August 31, 2009, suffered a serious setback as the Exchange (MCX-SX) did not get approval for trading in interest rate futures (IRF) segment (though trading in IRF is part of currency derivative segment). This made prospective investors sceptical about the future of the Exchange."

This is, however, not what has driven MCX-SX to court. Even after MCX-SX managed to dilute its holdings, and got the process of dilution approved by the Bombay High Court, Sebi refused to play ball.

According to the regulator, the manner in which MCX-SX has attempted to comply with MIMPS regulations ran against the spirit of the regulations and failed to meet the objective set there in.

Sebi’s decision to link permission to trade in additional segments/products with MIMPS compliance made it even more difficult for MCX-SX to get equity participants. Until Sebi had not introduced this condition, the potential investors had a reason to hope for such permission and a consequent turnaround in the company’s fortunes. But all such hope evaporated once Sebi inserted the new condition in its renewal notification.

So, while on one hand Sebi kept insisting on MIMPS compliance, on the other, it inserted a condition that made it difficult, if not impossible, to achieve the same. Naturally, MCX-SX cried foul and was forced to take recourse to non-conventional method of divesting the shares of its promoters

This Sebi stand stumped not only MCX-SX but even the Union finance ministry. Sebi never communicated to MCX-SX its dissatisfaction with the manner in which the promoters of MCX-SX had diluted their holdings. Though MCX-SX had specifically informed Sebi as far back as December 21, 2009 about its decision to dilute the holdings of promoters MCX and FTIL using a non-conventional scheme.

“It may be noted that Section 4 of MIMPS talks about how to increase the public shareholding to 51 per cent but it, however, is silent on how (or the manner in which) the excess shareholding of a single entity may be brought down to five per cent. Hence, technically, one cannot find any problem with the method by which MCX-SX has reduced its shareholding to five per cent (through the issue of warrants),” noted Ministry of Finance

The scheme for divestment adopted by MCX-SX was in contrast to the normal practice of reducing holding by selling shares and realising value. In this case, the promoters decided to reduce their holdings without immediately realising any value.

As per the divestment scheme, the shareholdings of promoters FTIL and MCX was brought down to five per cent each and the excess shares were extinguished by corresponding reduction of paid up equity capital of the company.

MCX, FTIL and other shareholders whose equity shares were extinguished in this manner were allotted an equal number of warrants.

While adopting this non-conventional scheme, the board of the company emphasised that "the promoters once having reduced their shareholding to five per cent shall not be permitted to increase their holding beyond limits specified under MIMPS regulation, thereafter."

When MCX-SX wrote a letter to Sebi chief C B Bhave on April 7, 2010 to inform the board of its compliance of MIMPS regulations, all Sebi did was to ask for a copy of the Bombay High Court order approving the divestment.

So when the matter reached the Union finance ministry, the department of economic affairs observed in a note dated July 26, 2010 (copy of the note is with Realpolitik): "While the shareholding pattern technically complies with MIMPS regulation, Sebi has serious reservations about whether the same is complied in spirit of regulation or not. It needs to be verified from Sebi whether this displeasure with the manner of divestment was communicated to MCX-SX or not.

"It may be noted that Section 4 of MIMPS talks about how to increase the public shareholding to 51 per cent but it, however, is silent on how (or the manner in which) the excess shareholding of a single entity may be brought down to five per cent. Hence, technically, one cannot find any problem with the method by which MCX-SX has reduced its shareholding to five per cent (through the issue of warrants).

"A warrant is a security that entitles the holder to buy stock of the issuing company at a specified price. When the warrant issued by company is exercised, the company issues new shares of stock, so the number of outstanding shares increases, that is, ownership capital is diluted. The warrants are freely transferable after six months from the date of issue. Thus warrants are instruments that have implications for capital structure and shareholding patterns.

"However, MCX-SX has given an undertaking that they will not ask for the equity by surrendering the warrants if it increases their holdings beyond five per cent limit. We may see a clarification from Sebi as to how the issue of warrants goes against the spirit of regulation."

As Sebi continued to play dilatory games, an exasperated MCX-SX filed a petition on the Bombay High Court seeking its direction to the regulator to take a decision on its long pending request to grant it permission to operate in segments/products in addition to the exchange traded currency derivatives.

When Sebi was asked to explain its position, it termed MCX-SX petition as "merely an attempt to pressurise the Respondent (in this case Sebi) to take decision on the Petitioner's (in this case MCX-SX) application for commencement of operation in other segments/products in addition to the exchange traded currency derivatives without making adequate enquiry or looking into the intricacies of all that is set out in the said application."

MoF: “MCX-SX has given an undertaking that they will not ask for the equity by surrendering the warrants if it increases their holdings beyond five per cent limit. We may seek a clarification from Sebi as to how the issue of warrants goes against the spirit of regulation.”

Sebi further said: "While the application of the petitioners were under consideration, the respondents came across a news article published in Mail Today on 19th July, 2010 under the caption 'Select banks gain from MCX offer' indicating about certain buyback arrangement between the promoters of MCX-SX and banks who are the shareholders of MCX-SX… the respondent being a regulator was duty bound to look into the matter in the interest of the market… the information sought by the respondent has been received only recently while some of the shareholders are yet to respond, the respondent shall require some additional time to consider all the facts and intimate the petitioners of its decision…"

After making this submission, Sebi appealed to the court that "the petition (by MCX-SX) be dismissed as being pre-mature".

When Sebi, through its letter dated July 22, 2010, had asked MCX-SX to respond to the Mail Today article, MCX-SX managing director and CEO Joseph Massey, while categorically denying any buyback arrangement with any of the investors, seized the opportunity to highlight Sebi's partisanship.

Mr Massey wrote to Sebi saying: "At the outset we are a little surprised with your prompt action on the aforesaid news article, and the jet speed with which you are now seeking information, when we have been patiently waiting to hear response to our several letters/reminders for months now despite complying with the MIMPS regulations."

He accused Sebi of using the Mail Today article only "to somehow find fault with our compliance with MIMPS regulations and deny us our legitimate right to commencing operations in other segments; and/or to somehow further delay the hearing of the writ petition and consequently delay granting approval for commencing our operations."

While the allegations and counter-allegations flew thick and fast between Sebi and MCX-SX, Chief Justice of Bombay High Court heard the arguments of both sides and said that justice will be served if the petition is disposed of in terms of following directions:

a) "Respondent No 1, Sebi, will take a final decision in the matter latest by 30th September, 2010. In order to ensure that the aforesaid time limit is treated as mandatory and peremptory, Sebi shall write letters to the shareholders of the petitioner-company from whom such information is awaited, calling upon them to send necessary information to Sebi within 10days from today ( August 10, 2010).

b) "Respondents No 2 and 3 (FTIL and MCX, respectively) through petitioner-company shall also convey to Sebi the Board Resolution of the respective co-promoters that is respondent nos 2 and 3 indicating their resolve to comply with the requirement of statutory regulations regarding the shareholding not exceeding the prescribed percentage.

c) "Upon receiving such information from respondent nos 2 and 3 and other shareholders of the petitioner-company, if Sebi requires further information/clarification from petitioners or others, the same shall be brought immediately and an opportunity of hearing shall be given to the representatives of the petitioner-company within four weeks from today and thereafter a final decision shall be taken by Sebi latest by 30th September, 2010."

The regulator that had been going easy, to say the least, on the request of a regulated, had to be given a timeframe by the High Court to respond to the request. Sebi is now duty bound to pass the order by September 30, 2010.

While MCX-SX has alleged that it has been at the receiving end of Sebi's high-handedness, questions whether there is an NSE angle to Sebi’s alleged delay, and more pertinently if its present chief C B Bhave has deliberately delayed permission to MCX-SX are crying for an answer. MXC-SX has openly accused Bhave of delaying decision on their request only to strengthen the monopolistic grip of NSE on the market.

Why would Bhave do so? Is there any link between C B Bhave and NSE? The answer to these questions may be found in an IPO scam involving a company called National Securities Depositories Ltd (NSDL), headed then by Bhave, and its handling by Sebi when Bhave had shifted from NSDL to Sebi. NSDL is a subsidiary company of NSE.

The IPO scam goes back to 2005 when Sebi investigations discovered that shares reserved for retail investors in several Initial Public Offerings were illegally acquired by various entities through tens of thousands of fake demat accounts. On allotment of shares, they sold it on the listing day at a premium. NSDL's then head CB Bhave denied any responsibility for the scam even though RBI penalised banks that had opened the fake demat accounts. 

While MCX-SX has claimed that it has been at the receiving end of Sebi’s high-handedness, the question whether there is an NSE angle to it, and whether Sebi, and particularly its chief C B Bhave, has deliberately delayed permission to MCX-SX is crying for an answer. MXC-SX has accused Bhave of delaying decision on their request only to strengthen the monopolistic grip of NSE on the market

Sebi had charged NSDL with failure to prevent the fraudulent practice and not carrying out proper due diligence and imposed a penalty of Rs 5 crore.

Sebi also asked NSDL promoters to take all appropriate actions including revamping of management, which clearly had allowed matters to come to such a sorry pass.

As fate would have it, Bhave went from NSDL to Sebi as its chief. After Mr Bhave's appointment as Sebi chief, Sebi constituted a two-member committee to examine the three orders passed earlier against NSDL by the regulator. Bhave, who was heading NSDL at the time of the scam, recused himself from all proceedings related to NSDL.

The two-member committee, comprising Mohan Gopal, director of National Judicial Academy, and V Leeladhar, former RBI deputy governor, took up the three proceedings pending against NSDL and passed three separate orders.

This committee had directed NSDL to carry out an independent probe and fix individual responsibilities for the depository's failure to meet its legal duties and responsibilities.

A major fire-fighting, including an attempted cover-up, was launched by Sebi after the two-member committee passed the order against NSDL. First, Sebi did not put the orders of the committee on its website. It took a public interest litigation to pressure the Sebi board to meet and it was forced to allow the three orders of the committee to come into the public domain.

In November 2009, the Sebi board disposed of the orders passed by the committee saying the committee did not act within the framework and terms of reference that were established by the board resolution.

The move attracted criticism from members of the legal community, as the Sebi board's decision to overrule the orders of the committee was viewed as illegal by experts who felt that Sebi had overstepped its jurisdiction by overturning its own orders. Experts felt that the power to review Sebi's orders rests only and strictly with SAT and the higher courts of the country.

In an IPO scam, Sebi charged NSDL, which was then headed by Bhave, with failure to carry out proper due diligence and imposed a penalty of Rs 5 crore. After his stint at NSDL, Bhave became Sebi chief. All proceedings against NSDL were dropped and the company was given a clean chit after this. In spite of the fact that Sebi, under the previous management, and a two-member committee appointed by Sebi under Bhave had established that NSDL too was one of the culprits in the IPO scam

In February this year, Sebi exonerated NSDL for its alleged failure in preventing the IPO scam. SAT, in its latest order, said that it is satisfied in the light of the directions issued by Sebi.

With this, all the cases against NSDL were given quiet burial. But the irony of Bhave-led NSDL's involvement in the IPO scam and Bhave-led Sebi absolving NSDL of its wrongdoings was not missed by careful watchers of the stock market.

Current Gaps in India ’s Capital Markets

National Stock Exchange (NSE) is India's largest stock exchange with over 85% share in the equity cash segment and almost 100% share in the F&O segment. Therefore, the trading patterns on this monopolistic exchange is reflective of the prevalent trends in India's entire capital market space.

Some eye-opening facts:

Low retail participation on NSE signifying lack of broad-based participation and, therefore, no wealth distribution and capital formation among the masses

NSE had 30.91akh clients during April-June 2010 on its Cash segment. Out of Its total turnover in this segment, 48% was contributed by institutional and proprietary traders and the remaining 52% came from High Networth Individuals, corporate clients and retail investors

NSE had 5.571akh clients trading on its F&O segment during April-June 2010. Out of its total turnover in this segment, 48% was contributed by institutional and proprietary traders and the remaining 52% came from High Networth Individuals, corporate clients and retail investors

Concentrated participation on NSE signifying lack of depth, liquidity and reach

Out of total 30.9 lakh clients trading on NSE's cash segment, only 451 contribute 50% to NSE's total turnover

Top 25 trading members contribute 42% to its turnover in cash segment

Out of total5.57lakh clients trading on NSE's F&O segment, 106 clients contribute to 50% of its total turnover

Top 25 trading members contribute 43% to NSE's total turnover in F&O