UNIT 9 FINANCIAL MARKETS

Structure

9.0 Objectives
9.1 Introduction
\9.2 Concept of Financial Market
9.3 Types of Financial Markets
9.3.1 Money Market
9.3.2 Capital Market
9.3.3 Distinction between Money Market and Capital Market
9.4 Significance of Money Market
9.5 Characteristics of a Developed Money Market
9.6 Indian Money Market
9.6.1 Main Constituents
9.6.2 Deficiencies
9.6.3 Reform Measures
9.7 Let Us Sum Up
9.8 Key Words
9.9 Answers to Check Your Progress
9.10 Terminal Questions

9.0 OBJECTIVES
After studying this unit you should be able to :
explain the nature and functions of financial markets;
identify the types of financial markets;
distinguish between money market and capital market;
explain the importance of money market;
outline the main characteristics of a developed money market;
explain the nature and composition of Indian money market;
identify the deficiencies of Indian money market; and
describe the measures adopted for strengthening the Indian money market.

9.1 INTRODUCTION
You know that most business units have to raise short-term as well as long-term funds
from time to time for marketing their working capital and fixed capital requirements.
This necessitates not only the ready availability of such funds but also a transmission
mechanis~nwith the help of which the providers of funds (investors-lenders) can
interact with the borrowers-users (business units) and transfer the necessary funds to
them as and when required. This aspect is taken care of by the financial markets
which provide a place where, and/or a system through which, the transfer of funds by
Financial Markets and their investors-lenders to the business units is facilitated. In this unit, you will learn about
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the nature and functions of financial markets and their types; the importance,
composition and characteristics of a developed money market; and the structure,
constituents, and deficiencies of the Indian money market, and so also the measures
adopted for strengthening it.

9.2 CONCEPT OF FINANCIAL MARKET

A financial market is a transmission mechanism between investors-lenders and
borrowers-users through which transfer of fbnds is facilitated. [t consists of individual
investors, financial institutions and credit instruments like bills of exchange,
promissory notes, treasury bills, shares, debentures, bonds, etc. The financial markets
in essence are the credit markets that cater to the various credit needs of individuals,
firms and institutions on the one hand, and help in mobilisation of savings in the
economy on the other. Thus, the financial markets perform economic as well as
financial functions. Their principal economic function is in the form of transfer of real
eco~iomicresources from those who save a part of their earnings to those who desire to
have command over real resources for investment, and their financial function lies in
facilitating the transfer of funds to those who need them to implement their plans.

Briefly, the main functions of financial markets are :

I Providing facilities for interaction between investors and borrowers;
2 Providing pricing information resulting from the interaction between buyers and
sellers in the markets when they trade the financial assets;
3 Providing security or dealings in financial assets;
4 Ensuring liquidity by providing a mechanism for an investor to sell the financial
assets; and
5 Ensuring law cost of transactions and ready availability of necessary information.
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9.3 TYPES OF FINANCIAL MARKETS

Broadly speaking, the financial markets are classified as money market and capital
market. While the money market deals with short-term credit, the capital market
handles long-term credit. Let us have a brief idea about these two types of markets.

9.3.1 Money Market

Money market refers to the whole network of financial institutions dealing in short-tem
funds which provide an outlet to lenders and a source of supply for such funds to
borrowers. It may be noted that it does not deal in cash or money as such, but handles
the near money assets (short-term credit instruments) such as the bills of exchange,
promissory notes, commercial paper, treasury bills, etc. with the help of which funds
are borrowed for a short period by the business units, other organisations and the
government. The Reserve Bank of India describes money market as "the centre for
dealings, mainly of short-term character. in monetary assets. It meets the short-term
requirements of borrowers and provides liquidity or cash to them by the lenders. It is
the place where short-term surplus investible funds at the disposal of the financial and
other institutions and individuals are'bid by borrowers, again comprising institutions
and individuals, and also the government".
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Financial Markets
The demand for short-term funds comes primarily from the government, business units
and individual borrowers. The government probably has become the biggest borrower
everywhere, requiring short-term funds to meet its current details. The firms need them
for meeting their working capital requirements. The other important borrowers include
stock exchange brokers, dealers in government and other securities, merchants,
farmers, etc. The banks also need such funds at times and borrow from the central
bank or from each other. The supply of loanable funds comes mostly from the central
bank of the country, the commercial banks and other financial institutions. The central
bank is the primary source of credit to commercial banks while the commercial banks
constitute the most important sourcerof short-term credit for business houses and
individual borrowers.

9.3.2 Capital Market

Capital market refers to an organisation and the mechanism through which the
companies, other institutions and the government raise long term funds by issue of
securities such as shares, debentures, bonds, etc. It signifies the institutional
arrangement for raising long-term funds and providing facilities for marketing and
trading of securities. It symbolizes a system through which the public takes up long
term securities directly or through intermediaries, and thus, helps in mobilising savings
of the community and make them available to business units and others for long-term
use.

The demand for long-term funds is made in most countries by individuals, business
corporations, public corporations, the central bank, and the state and local
governments. On the supply side of the market for such funds, there are four categories
of lenders in any capital market, viz., individual investors, institutional investors, banks
and special industrial financing institutions known as development banks.

It may be noted that the capital market consists of primary and secondary markets.
The primary market deals with newlfresh issue of securities and is, therefore, known as
i new issue market. The secondary market, on the other hand, provides a place for
purchase and sale of existing securities and is often termed as stock market or stock
, exchange.

9.3.3 Distinction between Money Market and Capital Market

The capital market differs from the money market in various ways. T h e y are
summarised as follows.
1 While money market relates to short-term funds, the capital market relates to long-
term funds.
2 While money market deals with securities like treasury bills, commercial paper,
bills of exchange, deposit certificates etc., the capital market deals in shares,
I debentures, bonds and government securities.
3 While participants in money market are commercial banks, non-banking finance
I companies, indigenous bankers, etc., the participants in capital market are stock
brokers underwriters, mutual funds, financial institutions, and individual investors.
. 4 While rnoney market is regulated by the Reserve Bank of India, the capital market
is regulated by the Central Government.and Securities Exchange Board of India
(SEBI).
Financial Markets and their 5 While the main components of money market are call money market, acceptance
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market and bill market, the main components of capital market are primary market
and secondary market.

Nonetheless, both money market and capital market play an important role in meeting
the financial needs of the business and are interdependent in many ways. Most of the
institutions as serve money market as well as capital market, and funds freely flow
between the two markets.

We shall discuss various aspects relating to money market in the sections to follow, and
take up all important issues relating to capital market operations in units 10 and 11.

Check Your Progress A

1 Define financial market.

...................................................................................................

2 Fill in the blanks.

\
(a) Money market provides facilities for raising .............. funds.
(b) In money market funds are borrowed against various .......... instruments.
(c) New issue market is also known as ...........market.
(d) Money maiket is regulated by ........................
(e) Capital market signifies the ..............arrangement for borrowiilg long term
funds and provides facilities for marketing and trading of securities.

3 Distinguish between money market and capital market.

...................................................................................................

9.4 SIGNIFICANCE OF MONEY MARKET

The money market is one of the most important institutions in a modern economy. The
industrial growth and expansion of trac e are greatly facilitated by the existence of a
developed money market which, through a system of various financial instruments and
collateral loans, helps the busines ?!nits in meeting their working capital requirement
without any difficulty. Financing o; bgth domestic and foreign trade is highly
facilitated through the system of bills of e <change. The acceptance houses and the bill
market, two major components of the money market, contribute most in this respect.

The effectiveness with which the commercial banks operate in a country depends a lot
on the integration and organisation of the money market. In the absence of a call loan
market, the bank will have to maintain a high cash reserve ratio in order to meet the
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demands of their depositors. This may erode their capacity to lend. Similarly, without
a developed bill market, the banks will lack flexibility in operating their business.

A developed money market is equally important for the smooth functioning of the
central bank, particularly the implementation of its monetary policy. The prevailing
short-term rates of interest serve as a good measure of monetary and banking
conditions in the country and provide a valuable guide for the determination of the
central banking policy. In fact, the more organised a money market is, the greater is
the smoothness with which the central bank can exercise control over the banking
system.

The existence of a developed money market also facilitates carrying out the public debt
policy by the government more smoothly. The borrowing by the government, now-a-
days, is not only a measure to meet budget deficits but is also an important instrument
of fiscal management, as it can easily raise short-term funds in the market through
treasury bills. In the absence of money market, the government may have to take
recourse to such measures as issue of paper money or borrowing from the central bank
which would invariably lead to inflationary pressure.

9.5 CHARACTERISTICS OF A DEVLEOPED MONEY

MARKET
In every country of the world some type of money market exists. But, while some of
these are highly developed, a good number of them are still undeveloped. USA, UK
and West Germany, for example, have highly developed money markets. Not only
their organisation and instruments are superior to those of the undeveloped money
markets, their resources are also larger. Let us have a look at the chief characteristics
of a developed money market.

Highly organised commercial banking system : The.commercia1 banks constitute

the nuclear of the whole money market. They are the main suppliers of short-term
funds and serve as the necessary-link between the various segments of the money
market and the central bank.

Preserve of a central bank : This is another essential characteristics of organised

money market. A modern central bank, by virtue of its dominant position in the
banking system of a country, has become a powerful monetary and banking authority.
With powerful instrument of monetary control in its arsenal, it regulates the supply of
funds in the money market. It comes to the rescue of commercial banks and the
money market in times of shortage of funds by rediscounting eligible securities and
converting near money assets into cash, and performs a valuable service through open
market operations when it absorbs surplus cash during off-seasons. But for these
facilities, the money market will remain very much disorganized and chaotic. Now,
almost every country has a central bank. This has improved the organisation of money
market in many countries.

Continuous supply of short-term securities : Continuous and adequate supply of

securities such as bills of exchange, commercial bills and treasury bills is as important
as the existence of organised commercial banking for the evolution of a developed
money market. In fact, the strength and the efficiency of a money market very much
depends upon the quality of these short-term securities and the amount of their supply.
At the same time, there should be a number of dealzrs who are ready to buy and sell
Financial Markets and their -these securities. In fact, without their presence, there will be no life in the money
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market as their operations create active market of these securities.

Existence of a number of sub-markets : Another important characteristic of a

developed money market is the existence of a number of sub-markets, each specializing
in a particular type of short-term securities. For example, London Money Market
which has, for a long time, been pr~bablythe most developed money market in the
world, has the call money market, the acceptance market, the discount market, and so
on. It is said that, "larger the number of sub-markets, the broader and more developed
will be the structure of the money market". Moreover, the sub-markets should not be
independent or isolated but should form an integrated structure in which every segment
of the money market has intimate relationship with each other. This is essential to
ensure uniformity of interest rates in various sub-markets and also for the free flow of
funds from one sub-market to another and for the effective control of the entire money
market by the central bank.

Ample supply of funds : In developed money markets there is always ample supply
funds, both from domestic and foreign resources. It is observed that while developed
markets like London and New York attract funds from all over the world, the
undeveloped money markets face scarcity of funds as the backwardness of these
markets and absence of stable exchange rates inhibit flow of funds from foreign
sources.

Other factors : Apart from the above, there are many other factors such as large
volume of international trade leading to a well organised system of bills of exchange,
greater industrial development leading to a well established stock market, and larger
demand for funds that ultimately result in greater activity in the money market and
contribute to the building up a developed money market.

There are not many developed money markets in the world which have all the above
mentioned characteristic features. London and New York money markets are the best
example of developed money markets. Other examples of international financial
centres are Paris, Zurich, Frankfurt, Amsterdam and Vienna which contain most of the
characteristic features of developed money markets.

h e c k Your Progress B

1 How does money market facilitate the carrying out of the public debt policy by the
government ?
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2 Why is the money market treated as the preserve of a central bank ?
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3 Enumerate four characteristics of a developed money market.
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9.6 INDIAN MONEY MARKET

The Indian money market is broadly divided into two parts viz., the unorganised sector
and the organised sector. The unorganised sector of the money market consists of the
indigenous bankers and the money lenders called mahajans, seths, shroffs, chettiars,
etc. who pursue the banking business on traditional lines and their practices and
operations vary from place to place. Many of the indigenous bankers combine banking
business with trading and commission business, and mostly deal in hundies and
promissory notes. The organised sector, on the other hand, comprises the Reserve
Bank of India, the commercial banks (both nationalized and private), the foreign
exchange banks and the cooperative banks. The financial institutions like LIC, GIC,
UTI and mutual funds are the other institutions which operate in the organised sector.
Regional rural banks, chit funds and post office savings banks also play a significant
role in the semi-urban areas and small towns. However, the Reserve Bank of India is
the apex organisation in the Indian money market. Since it is the leader and controller
of the money market, it has great responsibility in respect of its smooth functioning. In
April, 1988, it set up the Discount and Finance House of India (DFHI) to perform the
function of stablising the money market in India.

9.6.1 Main Constituents

Broadly speaking, the principal constituents of Indian money market are : (1) call
money market, (2) treasury bill market, (3) rep0 market, (4) commercial bill market,
(5) certificates of deposits market, (6) commdrcial paper market, and (7) money market
mutual funds. Let us have a brief idea about their functioning.

Call Money Market : The call money market exists in almost all developed money
markets. In call money market, borrowing and lending transactions are usually carried
out for one day. These are often called call loans which may or may not be renewed
the next day. However, the renewals are allowed upto 14 days after which the
transaction has to be reversed. The call money market is also known as inter bank call
money market as the participants in the call money market are mostly banks who are
able to use their temporary cash surplus or neet their temporary cash deficits by mutual
transactions through this market. Of late, the financial intermediaries like LIC, GIC,
'JTI and NABARD have also started participating actively in the call money market.
To start with, they were allowed to act as lenders but later they were also allowed to
borrow.

The DFHI also jeined the call money market in July 1988 and it was allowed to operate
both as lender and borrower. The market practice is that borrowers / lenders inform
DFHI about the funds required by them or available with them at the negotiated interest
rate. After DFHI and the lender 1 borrower confirm the transaction, these indications
are converted into firm commitments. In case of borrowing by DFHI, a call deposit
receipt is issued to a lender against a cheque drawn on the Reserve Bank of India,
representing the amount lent. When DFHI lends, it issues the RBI cheque representing
the amount lent to the borrower against the call deposit receipt. The transaction is
Financial Markets and their reversed the next day. In case renewal is to take place, DFHI can confirm the
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extension of the transaction on the deposit receipt by recording the date of renewal and
the rate of interest. The aggregate lending by DFHI was Rs. 4,97,957 crore in 1996-97
with an average daily lending of Rs. 1,156 crore. Thus, its emergence as a major force
in call money market, contributed immensely to the deielopment of the market
smoothening of short-term liquidity imbalances.

Treasury Bill Market : In India, treasury bills are short-term liability of the Central
Government as these are mostly issued by Reserve Bank of India on behalf of the
Central Government for meeting its temporary deficits and financing the expenditure.
As such, the RBI holds most of the treasury bills. Other holders like state governments,
semi-government bodies and State Bank of India do not hold them in large quantities.

Treasury bills are usually of three months' (91 -days) duration issued on tap by the RBI.
The 91 -days treasury bills have been of two types, ordinary and adhoc. The ordinary
bills are issued by RBI to enable the government to meet its needs for supplementary
short-term finance, and the adhoc bills are created in favour of RBI to replenish
government's cash balances and provide the medium for employment of temporary
surpluses of state governments and semi-government bodies. With effect from April
1, 1997, the adhoc treasury bills have been discontinued by converting them into
special securities without any specific maturity carrying interest rate of 4.6% per
annum, and introduced 14-days intermediate treasury bills to provide them with an
alternate arrangement to invest their surplus funds. The RBI also introduced 14-days
auction treasury bills on a weekly basis with effect from June 6, 1997 to facilitate the
cash management requirements of various segments of the economy by the government
and help in forming a more comprehensive yield curve. However, the auction of both
of these treasury bills was discontinued from May 12,2001. The same thing happened
to 182-days auction treasury bills on a fortnightly basis re-introduced w.e.f. May 26,
1999. The 364-days treasury bills had been introduced in April, 1992. Since then
these are auctioned regularly on a fortnightly basis. These treasury bills are not
rediscountable with RBI. Mostly the banks UTI, LIC, etc. contribute to these bills as
they constitute a safe avenue for investmknt. It may be noted that there is no true
market for treasury bills in India as there are no further dealings in them. However,
these are higbly secured and liquid because there cannot be a better guarantee of
repaymentZhan the one given by the government and because the RBI is always willing
to purchase or discount them.

Repo Market : Repo is a money market instrument which helps in collateralized

short-term borrowing and lending through salelpurchase operations in debt
instruments. Under a repo transaction, securities are sold by their holders to a?
investor with an agreement to repurchase them at a pre-determined rate and date.
Similarly, the securities can also be purchased with an agreement to resell them at a
predetermined rate and date. Such transactions are known as reverse rep0 transactions
Repo helps to manage liquidity conditions at the short-end of the market spectrum. To
start with, repos were allowed only in treasury bills. But, gradually, the RBI allowed
rep0 transactions in all government securities and treasury bills, and so also in public
sector bonds and private corporate securities to broaden the rep0 market.

Commercial Bills Market : Commercial bill refers to bill of exchange drawn by one
merchant firm on the other when goods are sold on credit or money is lent for a short
period. You know that such bills can be discounted with the bank who, in turn, can
rediscount them with the RBI. The commercial bill market in India is not very active
and is highly underdeveloped as compared to its counterpart in UK and USA. In 1992-
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 Financial Markets
93, bills purcliased and discounted accounted for a mere 8.7 per cent of the total credit
of all scheduled commercial banks. In fact, over the years, the importance of bill
finance in India has diminished. A large amount of bills discounted consist of bills
created by the conversion of cash credit and overdraft accounts of customers of the
banks. Moreover, most of the bill finance provided by the commercial banks is by way
of loans against the security of bills and not by way of discount or purchase of bills.
Poor development of bill market in India can be attributed to lack of uniformity in
drawing of bills, absence of distinction between trade bill and finance bill, high stamp
duty, popularity of cash credit and overdraft arrangement, and practice of credit sales
without specified time limits. All said and done, Reserve Bank of India has all along
been making sincere efforts to develop the bill market in India and popularize the use
of bills. But, somehow, it has not been very successful as reflected in the amount of
commercial bills rediscounted by the banks with various financial institutions.

Certificate of Deposit Market : A certificate of deposit is a certificate issued by a

bank to its depositors for a term deposit. Banks issue CDs in multiples of Rs. 10 lakh
for deposits with maturities varying from three months to one year. Of late, the
financial institutions like LIC, IFCI, IRBI, SIDBI, and Exim Bank have also been
permitted to issue CDs.with a maturity period of more than one year and upto three
years.

CDs are issued at a discount to face valire and its rate is market determined. Banks
usually pay a high interest on CDs as there is no ceiling interest rate on them. Neither
loans are permitted against CDs nor they can be bought back by banks. But, they can
be freely transferred by endorsement and delivery. However, the holdss prefer to hold
them till maturity, and so the secondary activity in CDs has been non-inristent.

The RBI had introduced CDs with the objective of widening range of money market
instruments and provide investors greater flexibility in the deployment of short-term
surplus funds. To begin with, there was lack of interest among banks in issuing CDs.
But, the stringent conditions in money market in 1995-96 and the high of rate of
interest encouraged banks to mobilise resources through CDs on a large scale. As a
result, the outstanding amount on CDs issued rose considerably during 1996-97 but it
declined again later on as the situation eased. To bring CDs at par with other
instruments, the minimum maturity period of CDs was reduced to 15 days.

Commercial Paper Market : Commercial paper is a new money market instrument

introduced by the RBI in January 1990 for raising short-term funds by companies.
These are unsecured promissory notes issued by companies in multiples of Rs. 5 lakh
with a minimum size of Rs. 25 lakh with a maturity period ranging from three months
to six months. The initial investor who could be a bank, a company, an incorporated
body or an individual, would pay the discounted value of CP. Since the CP is an
unsecured instrument, its interest rate is higher than that of the interbank rate or bill
discount rate.

The company wanting to issue CPs have to obtain a specified rating (P2 or A*) from an
approved agepcy every six months. The issuing company should be a listed company,
have a current ratio 1.33 to 1, and its tangible net worth should not be less than Rs. 5
crore. It is observed that high rated corporates which can obtain funds at a cost lo\;ler
than the cost of borrowing from banks are particularly interested in issuing CPs. The
institutional investors also find them as an attractive outlet for their short-term surplus
funds. Easy liquidity conditions in the market and low cost of CPs in relation to other
money market instruments and bank finance gave fillip to the issue of CPs since the
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Financial Markets and their beginning of 1993 and, in March 1993 itself, the outstanding amount of CPs was more
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than Rs.2,500 crore and it rose to Rs. 8,762 crore as on December, 31,2003. This is
despite the fact that many companies have not been raising funds through CPs to the
extent they are permitted because of the high credit rating requirement for the purpose
and the unwillingness of banks who are the largest buyers of CPs.

Money Market Mutual Funds : Money market mutual funds enable small investors
to participate in the money market. The RBI announced the guidelines for setting up
of MMMFs by schedule banks and public financial institutions in April 1992 for
subscription by individual investors. Initially, the scheme did not receive a favourable
response as the initial guidelines were not attractive. Hence, the RBI introduced certain
relaxations in November, 1995 whereby the private sector was also allowed to set up
MMMFs, the ceiling of Rs. 50 crore on its size was withdrawn, and the limits on its
investments in individual instrument were deregulated. In April 1996, the scheme was
made more flexible by allowing investment in MMMF units by corporate and others,
and reducing the minimum lock-in period from 46 days to 30 days which was reduced
further to 15 days later on. The MMMFs have been brought under the jurisdiction of
SEBI with effect from March 7, 2000.

9.6.2 Deficiencies
,'
In terms of both organisation and development, the Indian money market is not
comparable to any of the developed money markets of the world like those in London
or New York. It cannot match the extent of resources, stability and elasticity of these
developed markets and suffer from a number of deficiencies which are enumerated
hereunder.

1 Existence of unorganised money market : The existence of an unorganised

sector of money market consisting of indigenous bankers and money lenders is an
important weakness of the Indian money market as the RBI has little control over
their activities because they seldom use the rediscounting facility. They follow
their own rules of banking and finance. Many attempts were made by the RBJ to
bring the indigenous bankers under the organised money market and under its own
influence and control, but it made little headway. Similarly, there are a number of
non-banking finance companies (NBFCs) who remain outside the organised part
of the money market.

2 Lack of integration : As stated earlier, the Indian money market consists of

organised and unorganised sectors. These are completely separate from each other,
their financial operations are quite independent, and what goes in one sector has
little effect on the other. Similarly, the various components of Indian money
market compete with each other rather than coordinating their activities. The
commercial banks, for example, compete among themselves rather than having
cooperation. This is so even between Indian banks and foreign banks. As a result,
there is lack of adequate integration in the money market and the monetary policy
of the RBI (specially the bhnkrate policy) has not been sufficiently effective.
,.%6-

Moreover, it is felt that$$::re,is hardly any all India money market in its true sense
though, of late, the Mumbai Money Market has been showing a tendency to
emerge as the national market.

3 Diversity in rates of interest : In India, the interest rates prevailing in different

parts of the country are not uniform. Not only that, the borrowing rate of the
government, the deposit and lending rates of commercial banks, the deposit and
 Financial Markets
lending rates of cooperative banks, the lending rate of development financial
institutions differ widely. Even the rates of interest charged by banks differ
depending upon the locality in which they operate, the type of security they offer
and the nature of the competition they have to face. It is primarily due to lack of
coordination between different banking institutions and lack of mobility of fund:
from one section of the money market to another. However, due to RBI's effort to
introduce some rationality in the interest rate structure, there has been some
improvement in recent years. But, the situation is still not comparable with that in
the London Money Market where the discount rate is sufficiently effective and the
market rates immediately respond to changes in the discount rate.

4 Absence of an organised bill market : Despite the fact that both internal and
foreign bills are being purchased and discounted by the commercial banks and a
New Bill Market Scheme had been introduced by RBI under which it rediscounted
the genuine trade bills, the bill finance (discount market) is not popular in this
country and a well organised bill market does not exist. It is primarily due to (i)
lack of uniformity in drawing bills between different parts of the country, (ii)
general preference for cash credit and overdrafts, and (iii) high stamp duty on
usance bills, etc. Moreover, due to the presence of inter bank call money market,
commercial banks never felt the need of an organised bill market.

5 Shortage of funds : The Indian money market suffers from shortage of funds as
demand for loanable funds always exceeds their supply. The shortage becomes
more pronounced in busy season. Moreover, low per capita income, the existence
of black money, lack of banking habit among the people, and diversified
investment~opportunitieshave considerably reduced the supply of funds in the
Indian money market.

6 Seasonal stringency of funds : Another striking feature of the Indian money

market has been the seasonal shortage of funds during a part of the year (November
to June) when farm operations and trading in agricultural products require
additional finance. The banks, on other hand, have surplus of funds during off-
season (July to October) which is a slack season in the country. Of course, the RBI
tries to offset the variations by pumping money into the market during busy season
and withdrawing the same during off-season, but the fluctuations do remain.

7 Inadequate banking facilities : Even after the expansion of branch banking in

the post national period, the banking facilities in the country have still been
inadequate. The coverage of rural sector leaves much to be desired and the money
lenders continue to be the primary source of credit for Indian farmers and village
artisans. This has also hampered the process of mobilisation of small savings in
the country side. Lack of specialised bank to provide credit to small and tiny
sectors is another problem area faced by the Indian money market.

9.6.3 Reform Measures

Looking at the deficiencies of the Indian money market, it becomes abundantly clear
that it is relatively still underdeveloped. The banking facilities are inadequate and the
country has failed to develop market in short-term assets. In the absence of pcpularity
of commercial paper, commercial bills and treasury bills, an active market has not
emerged. The acceptance and the bill markets have almost been non-existent. There is
no denying the fact that the RBI has been constantly making efforts to remove these
deficiencies and some of the shortcomings have even been overcome after
Financial Markets and their
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'
nationalisation of banks and the introduction of the new bill market scheme. But, the
overall organisation of the market remained underdeveloped and a lot more needed to
be taken up by the government and the RBI to improve its working. Hence, on
recommendations of the Chakravarty Committee on the Review of the Monetary
System and the Narasimham Committee report on the Working of the Financial System
in India, a few more reform measures have been introduced in recent years to
strengthen the Indian money market. These are :

1 Deregulation of interest rates : As part of its anti-inflationary policy, the RBI has
been following a policy of strict control over interest rates in the country. All
along the deposit rates and lending rates of banks, the interest rate on inter bank
call money and rediscounting of commercial bills have been subject to a ceiling.
However, with effect from May 1, 1989, the RBI took steps to deregulate the
money market interest rates and, based on recommendation of Narasimham
Committee in November 1991, the banking and financial institutions were told to
follow the market related interest rates. This has proved to be a significant step
towards the activation of the money market.

2 Introduction of new money market instruments: Traditionally, the 91-days

treasury bill has been the only instrument which could be traded in the Indian
money market. Over the last years, the RBI has introduced four new money
market instruments viz., 182-days treasury bills, 364-days treasury bills, certificate
of deposit (CDs) and commercial papers (CP). The 182-days trkasury bills were
the first security sold by auction for financing the fiscal deficit of the Central
Government and the DFHI developed a secondary market in these bills. As a
result, they became popular with the banks for effective management of short-term
liquidity. In 1992-93, it was decided to introduce 364-days treasury bills which,
like 182 days treasury bills, could be held by commercial banks for meeting their
statutory liquidity ratio. The fortnightly offerings of these bills bring in Rs. 20,000
crore per annum. CDs are another new instrument which gained a considerable
market in 1996-97 but, due to improvement in the liquidity position later on, the
outstanding amount of CDs steadily declined. However, since the last quarter of
2004-05, the issue of CDs by banks has started picking up. CPs as money market
instrument is now more than ten year old. However, the market for CPs is driven
by the demand for CPs by commercial banks which is determined by liquidity
conditions in the market.

3 Repos and reserve repos : Another important development has been the
introduction of repurchase auctions (repos) since December 1992 in government
dated securities. Repos are a regular feature of RBI's market operations. The RBI
has also important 'reverse repos' i.e., to sell dated government securities through
auction at fixed cut-off rate so as to enable the banks to park their surplus funds. It
has been using repos and reverse repos is a policy to influence the volume of
liquidity in the money market and, through it, stablise the call rates. This policy is
called Liquidity Adjustrnent Facility (LAF) and is regarded as a major instrument
of monetary policy these days.

4 Introduction of money market mutual funds : Money market mutual funds

introduced in April 1991 provide additional short-term avenue to investors. The
portfolio of MMMFs consists of short-term money maiket instruments which also
include the rated corporate bonds and debentures with residual maturity of upto one
year. Currently there are three MMMFs in operation.
5 Financial Market!.
Setting up of DFHI : DFHI was set up with the major objective of bringing into
the fold of the Indian money market the entire financial system comprising all
banks and financial institutions so that their short-term surpluses and deficits are
equilibrated at market related rates. It operated both as a lender and ajorrower in
the call money market. With its participation there has been a significance increase
in the turnover of the Indian money market.

All said and done, it is observed that the statutory pre-emptions on inter-bank
liabilities, the cash credit system of financing, the regulated interest rate structure
the high degree of volatility in the call money rates, the availability of sector
specific refinance, the scarcity of money market instruments of varying maturities
and the inadequate asset liability management discipline among banks have been
the major factors that inhibited the development of Indian money market. Since
most constraints have been gradually removed by the RBI in recent years there is
some activity in the money market. However, the volume of operations still
remains rather small and a lot more remains to be done which may include steps
like regulation of indigenous bankers, standardisation of hundies, establishment of
acceptance houses and discount houses, development of a system of agriculture
bills against standing crops, and expansion of rediscounting facilities.

Check Your Progress C

1 Distinguish between organised and unorganised money markets.

...................................................................................................

....................................................................................................
2 Enumerate four factors to which poor development of bill market in India can be
attributed to.

State whether the following statements are True or False.

(a) India has a highly developed money market at the national level.
(b) Treasury bills in India are of 91-days and 364-days duration.
( c ) Repo transaction refers to the purchase of securities with an agreement to resell
them at a predetermined rate and date.
(d) In Indian call money market money is borrowed for one day which can be
renewed from day to day upto a maximum of 14 days.
(e) Commercial bill market in India is inactive and highly underdeveloped.
(f) Certificate ofdeposit refers to a term deposit receipt issued by the bank to its
depositors.
Financial Mnrkcts and their
Regulation
9.7 LET US SUM UP
A financial market refers to a mechanism through which transfer of funds from
investors-lenders to borrowers-users is facilitated. Financial markets are broadly
divided into money market and capital market. While the money market deals with
short-term credit, the capital market handles long-term funds.
Money market refers to the network of institutions dealing in near money assets (short-
term credit instruments) such as bills of exchange, treasury bills, deposit certificates,
etc. with the help of which funds are borrowed for a short period by the business units,
other organisations, and the government. The supply of short term funds comes mostly
from the central bank, commercial banks and other financial institutions.
A developed money market helps the business in meeting the working capital
requirement and financing of both domestic and foreign trade through the system of
bills of exchange which facilitates the expansion of trade and industrial growth of a
country. It is equally important for smooth functioning of the central bank particularly
in implementation of its monetary and public debt policies and exercising control over
the banking system in a country.
The chief characteristics of a developed money market are : (1) Commercial banks
constitute the nuclear of the whole money market; (2) It is the preserve of a central
bank which regulates the supply of funds in the money market through open market
operations and, in times of shortage of funds, provide the rediscounting facility; (3)
Continuous and adequate supply of short-term credit securities ensures its strength and
efficiency; (4) It is composed of several sub-markets such as call money market
acceptance market and bill market; and (5) There is always ample supply of funds,
both from domestic and foreign sources.
The Indian money market is broadly divided into the unorganised sector and the
organised sector. While the unorganised sector consists of the indigenous bankers and
the traditional money lenders, the organised sector comprises the Reserve.Bank of
India (RBI), the commercial banks and the other financial institutions like LIC, GIC
UTI, etc. The RBI is the apex organisation in the Indian money market, and has major
responsibility for its smooth functioning.
The main constituents of the Indian money market are : ( 1 ) Call Money Market which
deals with extremely short period loans (called call loans) and has commercial banks as
the major participants; (2) Treasury Bills Market which helps in meeting the temporary
deficits of the Central Government by auction of 91-days bills by RBI; (3) Repo
market which helps in collateralised short-term borrowing and lending through
sale/purchase operations in debt instruments; (4) Commercial Bills Market which
provides facility for discounting and rediscounting in bills of exchange drawn by one
business firm on the other. Somehow, this market is not very active in India; (5)
Certificate of deposit market which deals with CDs issued at a discount by banks in
multiples of Rs. 10 lakh with maturities varying from 15 days to 12 months; (6)
Commercial Paper Market which deals with unsecured promissory notes issued by
companies in multiples of Rs.5 lakh with a minimum of Rs. 25 lakh having a maturity
period ranging from 3 months to 6 months; and (7) Money Market Mutual Funds which
enable small investors to participate in the money market.
In t e h s of both organisation and development the Indian money market is not
comparable with any of the developed money markets of the world like those in
 Financial Markets
London or New York. The major deficiencies of the money market in India are : (1)
existence of unorganised money market, (2) lack of integration in the unorganised and
organised sectors of the market and so also among the various components thereof, (3)
diversity in rates of interest prevailing in different parts of the country, (4) absence of
organised bill market, (5) shortage of funds, (6) seasonal stringency of funds, and
inadequate banking facilities.

Keeping in view the various deficiencies of Indian money market, the RBI has been
constantly making efforts to overcome the shortcomings, but a lot more was needed to
be done for the improvement of its working. Hence, on recommendations of the
Chakarvarty Committee and the Narasimham Committee, a few more reform measures
have been introduced in recent years to strengthen the market. These are : (1)
deregulation of money market interest rates; (2) introduction of new money market
instruments such as 364-days treasury bills, certificates of deposit, and commercial
paper; (3) introduction of repos and reverse repos; (4) introduction of money market
mutual funds; and (5) setting up of Discount and ~ i n a n c eHouse of India (DFHI) to
operate as a regular lender and borrower in the call money market. However, the
volume of operation in the Indian money market still remains rather small and a lot
more remains to be done which may include steps like regulation of indigenous
bankers, establishment of acceptance houses and discount houses, expansion of
rediscounting facilities, etc.

9.8 KEY WORDS

Acceptance Market : Market where bills of exchange are accepted by renowned
firms, known as acceptance houses, on behalf of its customers to enable them raise
short-term funds by getting them discounted in bill market.

Call Money : These are inter bank call loans taken for extremely short period (24
hours) which can be renewed from day to day upto the maximum of 14 days after
which the transaction has to be reversed.

Certificate of Deposit : A certificate issued at a discount by bank for a short-term

deposit in multiples of Rs. 10 lakh, and which is freely transferable by endorsement
and delivery.

Commercial Bill : A bill of exchange drawn by one business firm on the other when
goods are sold on credit or money is lent for a short period.

Commercial Paper : An unsecured promissory note issued by companies with a

maturity period of 3 to 6 months for raising short-term funds.

Indigenous Bankers : Firms providing short-term loans by drawing hundies and bills
of exchange on the borrowers.

Liquidity Adjustment Facility (LAF): Repos policy adopted by RBI to influence the
volume of liquiadity in the money market and, through it, stablise the call rates.

Money Market Mutual Funds : Mutual funds established by banks and other
financial institutions for subScription by individual investors for investment in money
market.
1
Financial Markets and their Near Money Assets : Short-term credit instruments such as bills of exchange,
Regulation
promissory notes, commercial paper, treasury bills, etc.
Repo : A window which enables a bank or a financial institution to borrow money for
a short period by selling dated government securities through auction with an
-
agreement to repurchase them at a predetermined date and rate.

Reverse Repo : ~ e n d i h gby purchase of dated governmeut securities through auction

at a fixed cut-off rate by a bank or financial institution with an agreement to resell them
at a predetermined rate and date.

Treasury Bills : Bills issued by RBI on behalf of the Central Government for meeting
its temporary needs for supplementary short-term finance.

9.9 ANSWERS TO CHECK YOLTR PROGRESS

A 2 (a) short-term (b) credit (c) primary (d) Reserve Bank of India
(e) institutional

C 3 (a) False (b) True (c) False (d) True (e) True (f) False

9.10 TERMINAL QUESTIONS

1 What do you mean by money market ? Explain its importance for a modern
economy.
2 Outline the characteristic features of a developed money market.
3 Discuss the main constituents of the Indian money market.
4 Distinguish between
(a) Repo and Reverse Repo
(b) Commercial Bill and Treasury Bill
5 Explain the deficiencies of the Indian money market.
6 What are the various measures introduced during recent years to strengthen the
Indian money market
7 Write short notes on :
(a) Call Money Market
(b) Certificate of Deposits Market
(c) Money Market Mutual Funds
(d) Discount and Finance House of India.

Note : These questions will help you to understand the unit better. Try to write
answers for them, but do not submit your answers to the university for
assessment
 UNIT 10 CAPITAL MARKET
Structure

10.0 Objectives
10.1 Introduction
10.2 The Primary Capital Market
10.2.1 Nature
10.2.2 Methods of Making Capital Issue
10.2.3 Importance and Growth
10.3 The Secondary Capital Market
10.3.1 Nature
10.3.2 Functions
1 0.3.3 Importance
Stock Exchanges in India
Listing of Securities
Trading
Settlement
10.7.1 Budla System and Derivatives
10.7.2 Depository System
10.7.3 Rolling Settlement
Speculation and Stock Exchanges
Recent Developments
Let Us Sum Up
Key Words
10.12 Answers to Check Your Progress
10.13 Terminal Questions

I 10.0 OBJECTIVES
After studying this unit you should be able to :

explain the nature of primary capital market;

describe the methods of making fresh issue of securities;
outline the importance and growth of primary capital market in India;
explain the nature of secondary capital market;
outline the functions and importance of stock market;
explain the concept of listing of securities and its advantages;
describe the traditional method of trading on the stock exchanges in India and the
improvement affected by the modern method of online trading;
describe the procedure of settlement for various types of contracts relating to
purchase and sale of securities at the stock exchange and explain the concept of
rolling settlement;
explain the system of carry forward of transactions from one settlement day to
another and its replacement by dealings in equity derivatives;
Financial hlnrkets and their
Regulation
describe the system of delivery and transfer of securities through electronic book
entries and the advantages thereof;
distinguish between a speculative and an investment transaction and outline the
impact of excessive speculation on dealings at the stock exchange; and
enumerate the various reform measures introduced during post-reform phase for
promotion and regulation of stock market.

10.1 INTRODUCTION

You have learnt that the capital market signifies the institutional arrangement for
raising long-term funds and providing facilities for marketing and trading of securities.
Broadly speaking, the capital market in India is divided into gilt-edged market and
corporate securities market. The gilt-edged market refers to the market for government
and semi-government securities, backed by Reserve Bank of India, and the corporate
securities market is the market for shares dnd debentures of companies. This market is
further divided into the primary market and secondary market. The primary market
deals with fresh issue of securities and is also known as 'new issue market', whereas
the secondary market provides a place for purchase and sale of existing securities and
is often termed as 'stock market' or 'stock exchange'. In this unit, you will learn about
the nature and significance of both primary and secondary capital markets, and the
working of stock exchanges in India including listing of securities, the method of
trading and the method of settlement. You will also have an idea about the measures
adopted in the post reform phase to put the Indian stock market on road to renewed
growth.

10.2 THE PRIMARY CAPITAL MARKET

10.2.1 Nature

As stated earlier, the primary capital market (or new issue market), consists of an
arrangement which facilitates the procurement of long-term funds through fresh issue
of various types of securities called capital market instruments. While the demand for
long-term funds comes predominantly from private sector companies, pubic sector
undertakings and the governments, the supply comes largely from individual investors,
corporate savings, banks insurance companies and the specialised financial institutions.
These borrowers and the lenders are brought together through the primary market
which works as a mechanism to facilitate the transfer of funds from the savers
(investors) to the borrowers (issuers of securities). You know that the various types of
securities through which the long term funds are usually raised are : (i) equity shares,
(ii) preference shares, (iii) deferred I founders' shares, and (iv) debenturedbonds.
You also know that the preference shares and the debentureslbonds can be of various
types and that, in recent years, a variety of new financial instruments such as zero
coupon bonds, deep discount bonds, PCDs/NCDs with buy back arrangement, NCDs
with detachable equity warrants, secured premium notes (SPN), warrants, etc. have
been introduced which are duly permitted by SEBI. It also needs to be recalled that
the deferredlfounders' shares can only be issued by private limited companies to its
promoters and directors and that these are usually of small denominations and carry
equal voting rights with equity shares which may be of higher denomination.

The companies usually make a fresh issue of securities at the formation stage and -A

subsequently for expansion.of their business, if need be. However, to sell securities is. .*
 Capital Market
not an easy task as the companies have to fulfil various legal requirements and decide
upon the appropriate timing and the method of issue. Hence it is quite normal to
obtain the assistance of various intermediaries such as merchant bankers, underwriters,
stock brokers, etc. to look after these aspects. It may be recalled that the public issue of
securities is often arranged through merchant bankers who also play the role of
advisory and certification intermediaries. The underwriters guarantee success of an
issue by their skill in pricing the new issue and their access to a network of investors to
whom they can distribute the issue. Then, there are stock broking firms and their
sub-agents who assist the managers and underwriters to the issue by distributing and
collecting the application forms from individual investors at different centres all over
the country. All these intermediaries form an integral part of the primary capital
market.

10.2.2 Methods of Making Capital Issue

The various methods usually adopted for making a fresh issue of securities are as
follows.

! 1 Public issue through prospectus : The most common method of making a public
issue of securities is through prospectus. The prospectus, as you know, is an
invitation to th2general pubic for subscribing to the shares andlor debentures of the
issuing company. It provides complete information about the company, particulars
of the issue, terms of payment, details of the project, management's perception of
the risk factors, etc. An investor is expected to study the prospectus and, if
convinced about the prospects of the company, may apply for shares.
i
2 Offer for sale : Under this arrangement, the company sells its shares or debentures
en block to a financial institution or an issue house at an agreed price for sale to the
public. The issue house publishes a document called an offer for sale, with an
application form attached, offering to the public shares or debentures for sale at the
same price or a.little higher price. The document is deemed to be a prospectus. On
receipt of applications from the public, the issue house renounces the allotment in
favour of the applicants.

3 Private placement : A private company limited by shares is prohibited from

inviting the public for subscription of shares or debentures. Hence, it issues shares
privately to a small number of persons known to the promoters or related to them
by family connections.

A public company can also raise its capital by placing the shares privately without
inviting the public for subscription to its shares or debentures. In this kind of
arrangement, an underwriter or a broker finds persons to buy shares. Since no
public offer is involved, there is no need to issue any prospectus. However, such a
company is required to file with the Registrar a statement in lieu of prospectus. In
I case of large placing, the services of merchant bankers or an issue house may also
be used who can communicate with mutual funds, pension funds, insurance
companies, FIIs etc. known as qualified institutional buyers (QIBs).

4 Book building : Initial public offer (IPO) of shares can also be made through the
process of book building which implies collection of bids from the investors based
on an indicative price. The issue price is fixed after the bid closing date. The
concept of book building is based on the assumption that the price of any scrip
I
depends mainly upon the perception of the investors about the issuing company.
Financial Markets and their Hence, the issue price is not fixed in advance. It is determined by the offer of the
Regulation
potential investors which they may be willing to pay for the issue. A company
which intends to make an IPO, issues a draft prospectus which does not mention
the issue price. The company, a day or two before opening of the issue, announces
the price band. The companies are allowed a maximum of 20 per cent range in the
price band. The investors can bid at a maximum of three price levels within this
range in multiples of the minimum lot size. Alternatively, one can bid at the cut-
off price (the actual issue price to be decided on allotment). In that case, the entire
bid must be at this price and payment made at the time of application at the
maximum price. It may be noted that, within the earmarked price band, the issuer
and the merchant banker who collate the bids have the discretion to decide the cut-
off price, and the only the bids at o r above the cut-off price are considered for
allotment.

The main advantage of the book building process, as against the normal IPO
marketing I;rocess, is that it allows for price discovery and demand discovery.
Further, the costs of public issue are reduced drastically and time taken for the
completion of the entire process is far less as compared to that in the normal public
issue. However, while the book building process has been in existence in the
international capital market since long, in India it is only a decade old. SEBI
announced its guidelines for the book building in October 1995, and later, issued
the new guidelines effective from December 1,2001. The ICICI Ltd was the first
company which made its IPO through book building process in July 1996. Later,
many companies followed this process for their IPOs. To name a few, these are
public sector undertakings like ONGC, NTPC, GAIL and PNB, and the private
sector companies like TCS, BIOCON and Reliance Petroleum. Now-a-days, it is"
the most common method used for public issue of shares.

5 Rights issue : The companies also make further issue of capital through rights
issue to the existing shareholders. Under the rights issue, the shareholders-have the
right to a certain number of shares in proportion to the share already held by them.

In any case, for raising capital from the public by issue of shares or debentures, a
public company has to comply with the relevant provisions of the Companies Act, the
Securities Contracts (Regulation) Act including the Rules made thereunder, and the
guidelines and instructions issued by the concerned government authorities the stock
exchange where their shares are to be listed, and the SEBI. Of these, the most
important is the set of guidelines issued by SEBI in this context, termed as 'SEBI
(Disclosure and Protection of Investors) Guidelines. These are discussed in the unit to
follow which deals with regulation of capital markets.

10.2.3 Importance and Growth

In developing countries like India plagued by paucity of resources and increased

demand for investment by industrial establishments, the importance of primary capital
market is self-evident in mobilising the savings of various sections of the population
for investment in corporate securities. It enables the investors to make investment in
securities conveniently and helps companies to raise long term funds without much
dificulty. In other words, it facilitates the transfer of resources from savers to users.
This accelerates the rate of capital formation and stimulates individual growth and
economic development in the country.
 Capital Market
The intermediaries and financial institutions participating in the primary capital market
provide a variety of services to the corporate sector. These are : (i) provisions of
underwriting facilities, (ii) assistance in promotion of companies, (iii) participation in
equity capital, and (iv) providing expert advice on management of capital issues which
includes choice of the class of security to be issued, price of the issue in view of the
market conditions, timing and magnitude of the issue, and the method of floatation.

It also pro~notesinvestor education for small investors who learn to apply for shares in
a company only after reviewing its track record and assessing its prospects and
justification of the premium charged. Thus, it enables them to act as a knowledgeable
investors.

It may be noted that since independence, the Indian capital market has been expanding
fast and the volume of savings and investment has shown steady improvement. An
important indicator of the growth of capital market is the growth in joint stock
companies. In 195 1 there were only 28,500 companies with a paid up capital of
Rs. 775 crore, while in 2000 there were 70,000 companies with a paid up capital of
Rs. 2,00,000 crore. The rate of growth of investment has also been phenomenal in
recent years. The number of new capital issues by the corporate sector was 1,040 in
1992-93 and the amount raised was Rs. 19,803 crore. These figures were 1,678 and
Rs. 26,417 crore in 1994-95. However, the market for new capital issues became
sluggish in later years, but the year 1999-2000 saw its revival which is evident from
the fact that IPOs of most companies were oversubscribed. It is particularly true of
companies related to information technology, telecom and entertainment. The number
of shareholders also ran into several millions which indicates the growth of equity cult.

The various factors which contributed to the phenomenal growth of the primary capital
market in India have been : (1) establishment of specialised financial institutions like
IFCI, ICICI, IDBI, IRCI, UTI, etc., (2) repeal of Capital Issues (Control) Act, (3)
setting up of SEBI, (4) resource mobilisation by mutual funds, (5) increasing awareness
of investment opportunities among the general public, and (6) setting up of credit rating
agencies like CRISIL, ICRA and CARE.

Check Your Progress A

1 Define primary capital market.
...................................................................................................

...................................................................................................
...................................................................................................
2 Name three intermediaries who form part of the primary capital market.
...................................................................................................
...................................................................................................

...................................................................................................
3 Fill in the blanks
(a) The most common form of making a public issue of securities in through
..............
(b) A public company can also raise its capitrl by placing the shares privately
without inviting the .....................for subscription of its shares or
debentures.
r ~ n a n c i a Markets
l and their
(c) Book building implies collection of bids from the investors based on an
Regulation
....................pr~ce.
(d) The companies make .............. ..issue 6f capital by making a rights offer to
the .............shareholders
(e) Where a company sells shares or debentures en block to a financial institution
or an issue house at an agreed price for resale to the public, the method of
making fresh issue is called ..................

10.3 THE SECONDARY CAPITAL MARKET

10.3.1 Nature

A secondafy capital market popularly known as stock exchange or stock market

provides a place where different types of existing securities (shares, debenturesf bonds
and government securities) can be bought and sold on a regular basis A stock
exchange is organised as an association, a society or a company with a limited number
of members. It is open for transactions only to its members, most of whom are brokers
acting as agents for the buyers and sellers of securities.

The Securities Contracts (Regulation) Act, 1956 defines stock exchange as an

"association, organisation or body of individuals, whether incorporated or not,
established for the purpose of assisting, regulating and controlling business of buying,
selling and dealing in securities". According to K.L Garg, stock exchange is "an
association of persons engaged in the buying and selling of stocks, bonds and shares for
the public on commission and guided by certain rules and regulations."

Based on the above definitions, the chief characteristics of stock exchanges are :
1 It is an organised market.
2 It provides a place where the existing and approved securities (shares,
debenturesfbonds and government securities) can be bought and sold.
3 In a stock exchange, transactions take place between members or their authorised
agents on their own behalf or on behalf of the investors.
4 All transactions are regulated by rules and bye-laws of the concerned stock
exchange.
5 It makes complete information available to the public with regard to prices and
volumes of transactions taking place every day.

It may be noted that only those securities can be traded on a stock exchange which
have been duly approved for the purpose (listed) by the stock exchange authorities.

10.3.2 Functions

The stock exchanges play a very important role in the economic development of a
country by virtue of the key functions they perform. These functions are enumerated
hereunder.
1 Provides ready and continuous market : By providing a place where listed
securities can be bought and sold regularly and conveniently, a stock exchange
ensures a ready and continuous market for the existing shares, debentures / bonds
' end government securities. This lends a high degree of liquidity to holdings in
 Capital Market

want.
2 Provides information about prices and sales : A stock exchange maintains
co~npleterecord of all transactions taking place in different securities every day
and supplies regular information on their prices and sales volumes to press and
other media. In fact, now-a-days, you can get information on minute to minute
movement in prices of selected shares on TV channels like CNBC, Zee Business,
NDTV Profit and Headlines Today. This enables the investors in taking quick
decisions on purchase and sale of securities in which they are interested. Not only
that, such information helps them in ascertaining the trend in prices and evaluating
the worth of their holdings as and when they want . This enables them to
conveniently get the bank loans, if required.
1
i 3 Provides safety to dealings and investment : Transactions on the stock exchange

i
I
are conducted only amongst its members with adequate transparency and in strict
conformity with its rules and regulations which include the procedure and timings
of delivery and payment to be followed. This provides a high degree of safety to
I dealings at the stock exchange and there is little risk of loss on account of non-
I
I payment or non-delivery. SEBI regulates the business in stock exchanges in India
and monitors the working of the stock brokers. This reinforces the security of
transactions at the stock exchanges. Not only that, a stock,exchange allows trading
I
I only in securities that have been listed with it; and for listing any security, it
I satisfies itself about the genuinenes? and soundness of the company and provides
I
for disclosure of certain information on regular basis. Though this may not
1I
f
guarantee the soundness and profitability of the company, it provides some
assurance on their genuineness and enables them to keep track of their progress.
4 Helps mobilisation of savings and capital formation : Efficient functioning of
stock market creates a conducive climate for an active and growing primary capital
market. Good performance of various shares in the stock exchanges imparts
buoyancy to the new issue market. This helps in mobilising savings for investment
in industrial and commercial establishments for meeting their financial
requirements without much difficulty. Not only that, the stock exchanges, by
virtue of providing liquidity and safety to dealings and investments in shares and
arranging investors' education, encourages the habit of saving, investment and risk-
taking among the common people and creates an equity cult. This greatly helps
mobilisation of savings for investment in corporate and government securities and
contribute to capital formation.
5 Barometer of economic and business conditions : Volume of business and the
prevailing prices in sock exchanges reflect the changing conditions and the
economic health of a country as the shares prices are highly sensitive to
developments in economic, social and political environment. It is observed that,
during periods of economic prosperity, the share prices tend to rise. Conversely,
prices tend to fall when there is economic stagnation or the business activities slow
down as a result of depression. Thus, the intensity of trading at stock exchanges
and the corresponding rise or fall in the prices of securities act as the barometer of
the economic health and prevailing business conditions in a country.
6 Better allocation of funds : As a result of stock market transactions, funds flow
from the less profitable to more profitable enterprises and those with greater
potential of growth. Thus, the stock exchanges provide mobility to capital and
facilitates sound investment and, in the process, the financial resources of the
economy are better allocated.
Financial hlarkets and their 10.3.3 Importance
Regulation

Having discussed the functions of stock exchanges, let us now look at their importance
from the point of view of (a) the companies, (b) the investors, and (c) the society as a
whole.

For companies : (i) The companies whose securities have been listed on a stock
exchange enjoy a better goodwill and credit standing than other companies because
they are supposed to be financially sound. (ii) The market for their securities is
enlarged as the investors all over the world become aware of such securities and have
an opportunity to invest in them. (iii) As a result of enhanced goodwill and higher
demand, the value of their securities increases and so does their bargaining power in
collective ventures, mergers, etc. (iv) While raising additional capital, the decisions
regarding the mix of securities to be issued, their quantities, their prices and the timings
of their issue become quite convenient.

For investors : (i) They enjoy the facility and convenience of buying and selling the
securities at will and at an opportune time. (ii) Because of the assured safety in
dealings at the stock exchanges, the investors are free from any anxiety about the
delivery and payment problems. (iii) Availability of regular information on prices of
securities traded at the stock exchanges, helps them in deciding on the timing oftheir
purchase and sale. (iv) It becomes easier for them to raise loans from banks against
their holding in securities traded at the stock exchange because banks prefer them as
collateral on account of their liquidity and convenient valuation.

For society : (i) Availability of lucrative avenues of investment and the liquidity
thereof induces people to save and invest in long-term securities which leads to
increased capital formation in the country. (ii) Facility for convenient purchase and
sale of securities at the stock exchange provide an indirect support to new issue market
which helps in promotion and expansion of industrial activity and contribute to
increase in the rate of industrial growth. (iii) Stock exchanges facilitate reallocation of
financial resources to more profitable and growing industrial units because investors
can easily reshuffle their investment. (iv) Volume of activity at the stock exchanges
and the movement in share prices reflect the prevailing economic health. (v) Since
government securities are also traded at the stock exchanges, the government
borrowing is highly facilitated.

Check Your Progress B

1 State four characteristic features of stock exchanges.

...................................................................................................

2 How does stock~exchangeprovide safety to dealings in securities.

 3 How do companies benefit from the existence of secondary capital market ? Capital Market
I

10.4 STOCK EXCHANGES IN INDIA

The first organised stock exchange in India was started in Mumbai in 1875 known as
Bombay Stock Exchange (BSE). It was followed by Ahmedabad Stock Exchange in
1894 and Kolkatta stock Exchange in 1908. The number of stock exchanges in India
went upto 7 by 1939 and increased to 2 1 by 1945 on account of heavy speculative
activity during Second World War. A number of unorganised stock exchanges also
functioned in the country without any formal set-up and were known as kerb market.
The Securities Contracts (Regulation) Act was passed in 1956 for recognition and
regulation of stock exchanges in India. Most of the stock exchanges that mushroomed
were derecognised and the number of stock exchanges was reduced to 7 only. By
1980, there were 9 stock exchanges in the country. As at present, however, we have 24
recognised stock exchanges in India. Of these, 22 are regional stock exchanges and 2
are national levels stock exchanges viz., National Stock Exchange (NSE) and Over the
Counter Exchange of India (OTCEI). Both are located in Mumbai.

NSE was promoted by the leading financial institutions in India. It was incorporated in
1992 and commenced operations in 1994. This stock exchange has corporate structure,
fully automated screen based trading, and nation wide coverage. OCTEI was also
promoted by the financial institutions like UTI, ICICI, IDBI, IFCI, LIC, etc. in
September, 1992, specially to cater to small and medium sized companies with equity
capital of more than Rs.30 lakh and less than Rs.25 crore, and help entrepreneurs in
raising finances for their new projects in a cost effective manner. It provides nation
wide offices in all major cities of the country. On this stock exchange, the securities of
, those companies can be traded which are exclusively listed at OTCEI only. In
addition, certain shares and debentures listed with other stock exchanges in India and
the units of UTI and other mutual funds are also allowed to be traded at OCTEI as
permitted securities. However, of late, turnover at this stock exchange has
considerably reduced and steps have been afoot to revitalize it.
It may be noted that the two stock exchanges which actually enjoy nation wide
coverage and handle most business in securities in the country are BSE and NSE.

In fact, ever since screen based and online trading have been introduced and regular
information on all relevant development and movement of prices is available on TV
channels, the distance has become irrelevant and so most clients prefer dealings at NSE
and BSE. As a result, most regional stock exchanges have little business to handle.

10.5 LISTING OF SECURITIES

As stated earlier, all securities issued by companies and other bodies are not traded on
the stock exchanges. Only those securities can be traded on a particular stock exchange
which have been duly approved for the purpose i.e., listed on that stock exchange.
Listing thus implies admission of securitigs of a company to dealings on a stock
exchange. In other words, if a joint stock company or any other body wants its
securities to be traded on a stock exchange and their prices duly published, it has to get
Financial Marktts and their the securities included in the list of the stock exchange. For listing, the company has
Regulation
to make an applicatioi~and furnish the prescribed information to the stock exchange.
Section 19(2) of the Securities Contracts (Regulation) Rules, 1957 lays down the
minimum requirement with respect to listing of securities on a stock exchange.
Moreover,'every recognised stock exchange has the powers to make its own rules and
bye-laws for the listing of the securities, suspension or withdrawal of securities' subject
and the prohibition of trading in any specified security to Central GovernmentJSEBI
approval. The basic eligibility criteria for listing of securities of a company are :(i)
minimum issued equity capital should be Rs. 5 crore (Rs. 3 crore where trading is
screen based and (ii) minimum public offer of equity capital shall not be less than 25%
(10% if certain conditions are satisfied).

It may be noted that normally it is not obligatory for a company to get its shares listed
on a stock exchange. But, according to Section 73(1) of the Companies Act, 1956 (as
amended in 1988) to every company intending to offer shares or debentures to the
pul$ic or subscription by issue of a prospectus shall, before such issue, make an
application for listing of security to one or more recognised stock exchanges for
permission for the securities intending to be so offered to be dealt with in the stock
exchanges, and the information that permission has been obtained from the stock
exchange or that an application has been made or will be made. shall be mentioned in
the prospectus. Not only that, it may become mandatory for a company when the
Central Government / SERI requires a company to do so under Section 21 of the
Securities Contracts (Regulation) Act, 1956 or when a public financial institution
stipulate a condition to the loan for the borrowing company to have its securities listed
on any recognised stock exchange.

The basic advantages of listing of securities are

1 It improves public image of a company and enhances its prestige and
creditworthiness.
2 It provides a continuous market for its securities and thus adds to their liquidity.
3 Banks and other financial institutions readily extend loan facilities to the company
and so also to investors on the strength of such securities.
4 It ensures disclosure of important financial information about the company on a
regular basis.
5 It leads to wide distribution of shares which helps in mobilisation of resources in
future by way of further issues.

However, listing of securities does not guarantee the financial soundness or

profitability of the company. It only indicates that at the time of listing the company
was legally incorporated, met the stock exchange requirements for listing, and will
continue to provide the requisite financial results to stock exchange and the investors at
regular intervals.(quarterly). This creates a favourable climate for the listed securities.

1006 TRADING
Only a member can transact buslness on a stock exchange either on his own behalf or
on behalf of his clients. According to Section 13 of the Securities Contracts
(Regulation) Act, all contracts in notified area (other than spot delivery contracts)
entered into otherwise than between members of a recognised stock exchange or
through a member of such stock exchange or with a member of such stock exchange
are to be treated as illegal contracts. .As for persons dealing in securities in areas other
30
 Capital Market
than notified areas (whether on his own behalf or on behalf of any other person) is \

required to obtain a licence from SEBI in this behalf. SEBI (Stock Brokers and Sub-
brokers) Rules, 1992 further provide that no person can act as a stock broker unless he
holds a certificate granted by SEBI.

The stock exchanges have trading floors where buying and selling of securities take
place. The member or his authorised clerk goes to the floor of the stock exchange to
make his own quotation of purchase or sale of the security to the other member or his
1 authorised clerk. The price acceptable to both the parties closes the bargain, and the
authorised clerks make a note of the transaction in a small notebook called a day book
or rhopri. The details of the business transacted during the day are entered into the
Sauda Book from the day book and a copy sent to the stock exchange. Alongside, the
contract notes in the prescribed form are prepared and sent to the clients. The contract
note gives full details of scripts bought and/or sold, the prices at which transaction took
place, and the brokerage charged.

The trading that takes place on the floor of the stock exchange called 'open outcry
system'; resembles an auction as members trying to sell strive to obtain the highest
price possible while those trying to huy strive to obtain the lowest price possible
through bid and offer strategy. When members announce their intention to buy or sell
a certain number of shares of a company, they receive bids or offers from other
members and accept the most suitable bid or hold until an acceptable bid is offered. It
t
I may be noted that transactions are facilitated by market makers who stand ready to buy
or sell specific securities in response to customers orders. Liquidity of stock market is
I enhanced by market makers because they are required to make a market at all times in
I
an effort to stablise prices. Whereas the brokers at the stock exchange match buyers
and sellers, the market makers serve not only as brokers but also as investors.

The open outcry method of trade matching by calling out bids and offers in trading ring
has been used for centuries. However, this physical order matching by them is now
being replaced by screen based system whereby the participants can trade through the
computer network. This has enabled a large number of participants spread through the
country, at high speeds, with greater transparency and low costs. In fact, the NSE and
OTCET were set up with screen based system only and most stock exchanges in India
have already switched over to the screen based trading popularly known as online
trading. Not only that, the high penetration of computer and internet connections has
contributed immensely to the drastic increase of online trading. Of late, internet based
trading facility has also been allowed which enables the clients to buy and sell shares
through the stock broker's website. This had made the transactions virtually paperless
as the client's trading account is linked to his demat and bank accounts. It also ensures
smooth transaction process and eases the normal procedure of a settlement in quick
time as the process of issuing a delivery note in the case of a sale, or arranging
payment in case of a purchase, is all taken care of the minute the order is executed.
However, in terms of volumes, the internet based trading currently accounts for just 10-
12% of trading at BSE and NSE. It is just the beginning as far as internet based
trading goes. Increasing connectivity and awareness shall certainly lead to its further
growth.
Financial hlarkets and their Check Your Progress C
Regulation

1 State the circumstances under which listing becomes obligatory for a company.
...................................................................................................

2 What do you mean by open outcry method of trading at the floor of the stock
exchange. Is it still prevalent ?
...................................................................................................

3 How does a market maker facilitate the transaction in securities the stock
exchanges ?
...............................................................................................

4 Which of the following statements are True or False.

(a) Every recognised stock exchange has the powers to make bye-laws for listing
of securities or prohibition of trading in any security subject to Central
Government ISEBI approval.
(b) Listing of securities on a stock exchange ensures the financial soundness and
profitability of the company.
(c) The NSE and OTCEI have only the screen based system of trading.
(d) The 'internet based trading7 which enables the clients to buy and sell shares or
debentures through the stock brokers web-site and 'online trading' mean one
and the same thing.
(e) In addition to the securities exclusively listed at OCTEI, certain shares and
debentures listed with other stock exchanges in India and the units of mutual
funds are also allowed to be traded at OCTEI.
(f) BSE, NSE and OCTEI are all located at Mumbai.

10.7 SETTLEMENT
Settlement involves the delivery of securities and the payment of the amount due.
Earlier, in every stock exchange a particular day had been fixed for the settlement of
transactions between buyers and sellers. This day could be every Monday or every
Saturday of the week. In other words, settlement was done on weekly basis. During a
settlement period, the buying and selling transactions in a particular share could be
squared up and, at the end of the settlement period, settled on a net basis. Since the
settlement period was 7 days and the settlement was for the net position, most of the
transactions were squared up within the settlement period by payment of price
differential.
From settlement point of view, the contracts relating to the purchase and sale of Capital Market

securities have been of three types as follows :

1 Spot delivery contracts : Such contracts are settled on the spot i.e., the delivery
and payment made on the day of the transaction itself or latest by the following day
This, however, has not been a common practice.
2 Ready delivery contracts : Such contracts are settled within a short period of
time. The settlement takes place on the following settlement day and no
postponement is allowed.
3 Forward delivery contracts : Such contracts are also due for settlement on the
following settlement day but they can be postponed to the next settlement day, if so
desired, on payment of the necessary charges. This facility is provided by the
stock exchanges only in case of transactions in scrips that are included in the
specified list (List A), and not in case of other securities.

10.7.1 Budla System and Derivatives

The settlement system in specified securities providing for carry forward of

transactions from one settlement day to another has been known as budla system and
the charges paid for carry forward termed as budla charges (contango or
backwardation) the amount of which depended upon the class of security, its quantity,
the amount involved and the iilterest rate prevailing in the market at the time of the
transaction. All along, it had been felt that this system led to excessive speculation
and, at times, to certain malpractices like price rigging, evasion of margins, and non-
reporting of transactions. Hence, it was abolished in December, 1993. This led to a
halt in trading of specified securities with carry over facilities and sharp decline in
turnover on the stock markets resulting in a liquidity crunch. So, efforts were made to
reintroduce the system in its revised and modified form subject to certain conditions
and precautions. But, somehow, they did not click because of the inherent weaknesses
of the system and a clamour for adopting other risk hedging devices. The experts
preferred equity derivatives, in the form of futures and options as prevalent in advanced
countries. As a result, in June 2000, index futures were launched at BSE and NSE
followed by its other variants like index options, stock futures and stock options. It
may be noted that NSE accounts for more than 90 per cent of India's equity derivatives
volume which is largely due to its effective monitoring, surveillance, netting timely
settlement and minimisation of settlement risks with the help of National Securities
Clearing Corporation Ltd. (SSCCL) which offers high quality risk mitigation in
settlement.

It may be noted that options are not all like budla. An option refers to a contract which
gives the investor (its holder) a right, not the obligation, to buy or sell the specified
quantity of a share at a specified price on or before a specified time called expiry date.
However, future may seem like budla to some as just like a forward contract, it is a
contractual obligation to buy or sell a standard quantity of a share at an agreed price at
a future date. But, unlike budla where cash market and all hture prices are mixed up in
one price, the future markets trade differ from the cash market sc that each future
prices and cash prices are different. Future markets, also do not have any counter party
risk through the institution of the clearing house which guarantees the trade coupled
with margining. This eliminates the risk premium which is embedded inside budla
financing charges. Moreover, in case of budla expiration date is unclear moving from
one settlement date to another, while in case of futures the expiration date is
predetermined and the holder is under obligation to settle the transaction.
Financial Markets and tbeir 10.7.2 Depository System
Regulation

Anotller important reform introduced meanwhile in respect of settlement of trades has

been the introduction of delivery through electronic book entry facilitated by
depositaries. Traditionally, trades have been settled by physical delivery of securities.
This implies that the securities have to physically more from the seller to the seller's
brokers, from seller's brokers to the buyer's broker (through the clearing house of the
exchange or directly), and from buyer broker to the buyer. Then the buyer has to lodge
the securities with the transfer agents of the company for getting them transferred in
his name, and the process of transfer would take 2 to 3 months. This system involved
huge paper work, high costs and long time. With introduction of holding securities in
dematerialised (demat) form with the depositories, the transfer takes place by means of
electronic book entries. It began with the establishment of National Securities
Depositories Ltd., (NSDL), India's first depository, in 1996. It has helped elimination
of all risks associated with physical certificates, no stamp duty, immediate transfer and
registration of securities, and faster settlement cycle. Most companies worth the name
have now provided for holding of their shares with depository participant in demat
form. SEBI guidelines on public issue of capital issue require that, to make a public or
right issue or an offer for sale of securities, it must enter into an agreement with a
depository. This had made trading and settlement paperless, convenient, fast, safe and
economical.

10.7.3 Rolling Settlement

For the capital market, rolling settlement is the next big landniark, after
dematerialisation. A small beginning was made in December 1999 with rolling
settlement introduced in 10 scrips. A rolling settlement refers to a system in which
trades outstanding at the end of the day have to be settled at the end of the settlement
period. In a T + 5 rolling settlement, for example, a transaction entered into on
Monday, has to be settled on fifth working day after Monday i.e., on the following
Monday. Similarly, a transaction entered into on Tuesday shall be settled the
following Tuesday. This is in contrast with the account period settlement, the earlier
practice, where positions are accumulated / squared up in a weekly cycle i.e., the
transactions made on any of the five trading days, whether on Monday or on Tuesday,
are permitted to be squared up and settled on the settlement day which may be Saturday
or the following Monday, as the case may be. It may be noted that the account
period settlement has been discontinued since January 1,2002 as per SEBI
directive. Rolling settlement in India started with T + 5 cycle which was later changed
to T + 3 and ultimately to T + 2 with effect from April 1 , 2003. This implies that, as of
now, trades executed on Monday shall be settled on Wednesday (considering 2
working days from the trade day) when the pay-in and pay-out shall take place on the
basis of the net obligation for the day. Pay-in means the payment or delivery of
securities by the broker to the stock exchange, and pay-out means the payment and
delivery of securities by the exchange to the broker. The exchanges have to ensure that
payout of funds or delivery of securities to the client is done by the brokers within 24
hours of the pay-out.

Apparently, the rolling settlement requires electronic transfer of securities and funds
which has been made possible by the introduction of depositories, computer network
and internet connectivity and the system has been a great success.

Thus, now a days, only ready delivery contracts are in operation, budla system
providing for carry forward of settlement has been replaced by trading in derivatives
 Capital Market
(futures and options), delivery is by book entries and settlement is rolling on T -t2
basis.

10.8 SPECULATION AND STOCK EXCHANGES

The word 'speculation' is derived from the Latin word 'speculate' which means to see
from a distance or take a decision in anticipation of future happenings. However, in the
context of share market, it means dealing in securities keeping in view the present and
future prices with the object of making profit from the difference in the two prices. In
the words of Emery, "Speculation consists of buying and selling commodities or
securities or other property, in the hope of a profit from anticipated changes of value".

Speculative transaction is different from an investment transaction. While an

investment transaction is based upon thorough analysis, promises safety of principal
and a satisfactory return, Speculative transaction is based on limited analysis and
involved high risk. Most often buyers and sellers at the stock exchange go in for both
types of transactions. Some buy securities primarily to earn a regular income from
such investment and possibly make some long term gain on account of price rise in
future. They take delivery of the securities and make full payments of the price. Such
transactions are investment transactions. But, many of them buy them with the sole
object of selling them in future at higher prices, or sale now with the intention of
buying at a lower price in future, are speculative transactions. The main objective of
such transactions is to take advantage of price differential at different times. The stock
exchanges also facilitate such transactions by allowing their squaring up i.e., the
settlement of transactions by receiving or paying, as the case may be, just the
difference in prices. For example, A bought 200 shares of Moser Baer Ltd at Rs.210 *
per share and sold them at Rs. 235 per share. He does not take and give delivery of the
shares, and settles the transactions by receiving the difference in prices amounting to
Rs. 5,000 (25 X 200) minus brokerage. In another case, R bought 200 shares of
Seshasayee Papers Ltd. at Rs. 87 per share and sold them at Rs. 69 per share. He
settles these transactions by simply paying the difference in prices amounting to Rs.
3,600 (1 8 X 200) plus brokerage. However, now-a-days, under the system of rolling
settlement, such facility is limited only to transactions of purchase and sale of a
security made on the same day as no carry forward is allowed.

Though speculation and investment are different in some respects but, in practice, it is
difficult to say who is a genuine investor and who is a pure speculator. Sometimes
even a person who purchased the shares as a long term investment may suddenly
\ decide to sell them to reap the benefit if the price of the shares goes up too high or he
may db so to avoid heavy loss if the prices starts declining steeply. But, he cannot be
called'a speculator because his basic intention has been to invest.. It is only when a
person's basic intention is to take advantage of a change in prices, and not to invest,
that the transaction may be termed as speculation. In strict technical terms, however,
the tr,ansaction is regarded speculative only if it is settled by receiving or paying the
difference in prices without involving the delivery of securities. It is so because, in
practice, it is quite difficult to ascertain the intention.

It may be noted that speculation is duly recognised by law and is considered a

prerequisite for the success of stock exchange operations. In fact, no stock exchange
can operate on the basis of investment buying alone as pure investors cannot provide
the requisite volume of business and the necessary liquidity to securities. However,
excessive and reckless speculation degenerates into gambling and often leads to wide
fluctuation in prices, market manipulations and malpractices by the vested interests.
Finanrial Markets and tbeir This adversely affect the interest of genuine investors and cause considerable damage
Regulat~on
to their confidence in dealings at the stock exchanges. Harshad Mehta and Ketan
Parekh episodes are still fresh-in the memory of many investors who suffered heavily
and are highly scared to stage a comeback. Hence, good amount of vigilance and
control has to be exercised over stock exchange operations by the stock exchange
authorities and the government. As a matter of fact, excessive speculation is not the
only problem area relating to stock exchange operations, there are many other
negative features that have continued to plague the stock market. This led to strict
control and regulation of capital market in India. This aspect shall be discussed in
detail in Unit 11 to follow.

Check Your Progress D

1 What is forward delivery contract ?

...................................................................................................

...................................................................................................
2 State four advantages of holding shares in demat form.

...................................................................................................
3 Tick Mark the correct answer.
(a) Prior to introduction of rolling settlement, the settlement on BSE and NSE was
done on
(i) fortnightly basis
(ii) weekly basis
(iii)monthly basis
(b) Budla system has been replaced by
(i) trading in equity derivatives
(ii) rolling settlement
(iii) depository system
(c) Transfer of securities in demat form takes place through
(i) transfer deed
(ii) hand delivery
(iii) electronic book entries
(d) Under T + 2 rolling settlement, for transactions made on Monday the pay-in
and pay-out shall take place on
(i) Wednesday
(ii) Thursday
(iii) Wednesday and Thursday respectively
(e) Normally, for a-stock exchange operations, speculation is considered
(i) harmful
(ii) a pre-requisite for its success
(iii) irrelevant to its success
( f ) Index futures were launched at BSE and NSE in
(i) April, 2003
(ii) December, 1999
(iii) /.,?June, 2000
 I

Capital Market
10.9 RECENT DEVELOPMENTS
In the post-reform phase i.e., the period after 1991, the Indian stock market has
witnessed a transformation and is firmly on the road to renewed growth. It is now
placed among the mature securities market in the world. In fact, the constitution of
SEBI heralded a new era in the Indian capital market with its heavy agenda to protect
investors' interest and promote and regulate the stock market. Since 1995-96 SEBI has
been showing a reformist will in more than one way. Several reform measures in
conjunction with stock exchange authorities were introduced. These are summarised as
follows.
1 Budla system has been replaced by trading in futures and options.
2 The establishment of depositories and introduction of delivery in demat form has
made trading and settlement convenient, fast and economical. This has also
enhanced the efficiency of the trading cycle.
3 Introduction of rolling settlement with T + 2 cycle has reduced the settlement
period resulting in fast payout and delivery to clients
4 BSE transformed itself into a corporate entity from being a brokers' association in
August, 2005.
5 The introduction of screen based and online trading has added to transparency and
speed in conducting the transactions.
6 The governments has allowed foreign institutional investors (FIIs), pension funds,
mutual funds, investment trusts, asset portfolio investment companies to invest in
the Indian capital market.
7 SEBI has started the process of registration of intermediaries such as stock brokers,
sub-brokers, share transfer agents, merchants bankers, etc. based on certain capital
adequacy, and infrastructure norms.
8 SEBI has notified regulation on insider trading to protect and preserve the integrity
of the stock markets and help investors" confidence in dealings at the stock
exchanges.
9 The facility of buy back of securities has been subjected to regulations and
guidelines laid down by SEBI.
10 National Securities and Cleaning Corporation has been set up which guarantees all
trades at NSE. It has freed every trade from the risk of counterparty defaulting and
payment crisis.
11 SEBI approved the establishment of Central Listing Authority for centralising the
listing function that currently takes place at the exchange level.
12 A division has been set up within SEBI to monitor unusual movements in prices in
coordination with all the stock exchanges which are required to set up surveillance
departments.
13 The major hock exchanges are required to set up Investor Information Centres and
educate the investors about their rights and obligations
14 SEliI hds 's,,ilched the Electronic Data Information Filing and Retrieval System
I (EDIFRS) website aimed at providing one point access to key information on all
i
listed companies.
1 1 5 Empowerment of SEBI to regulate takeovers and its adoption of the modified
takeover code has made the takeover process more transparent and ensures the
protectio~ofthe minority shareholders' interests.
Finnncinl Markets nnd their 16 SEBI has changed the management structure of stock exchanges which were stock
Regulation
brokers dominated. Now, 50 per cent of the directors are nonbrokers. It is further
mandated that a non broker professional be appointed as the Executive Director.
17 The process of book building has been introduced for initial public offers of shares
which has not only reduced the costs of public issues but also the time taken for
completion of the issue process.
18 SEBI has allowed private placement of listed securities to qualified institutional
buyers (QIBs) which will not have any lock-in period.

The institutional changes effected in the Indian capital market in the post reform phase
as outlined above have undoubtedly enhanced investors' confidence and helped the
market to grow strong in recent years. The stock market which had remained subdued
since February 2000, recorded a substantial rally in 2003. The BSE Sensex crossed
the 4,000 mark in the August 2003, touched the 6,100 mark in January 2004 and has
been hovering around 9,000 plus by the end of 2005.

10.10 LET US SUM UP

Capital market signifies the institutional arrangement for raising long-term funds and
providing facilities for marketing and trading of securities. It consists of two parts,
primary market and secondary market. While the primary market deals with fresh
issue of securities, the secondary market provides facilities for purchase and sale of
existing securities.

The primary market is also known as new issue market which acts as a mechanism for
raising long-term funds with the assistance of various intermediaries like merchant
bankers, underwriters and stock brokers who form an integral part of the primary
market. The methods usually adopted for making fresh issue are : public issue through
prospectus, offer for sale, private placement, and book building. For further issue of
capital, the company can also go in for rights issue to the existing shareholders.

The importance of primary market is self-evident in mobilising the savings for

investment in corporate securities. This accelerates the rate of capital formation and
stimulates the industrial growth and economic development in a country. Since
independence, the Indian capital market has been expanding fast. This has been made
possible by the establishment of various financial institutions, setling up of SEBI and
increasing awareness of investment opportunities among the public.

The secondary capital market is popularly known as stock exchange or stock market
which provides a place where the existing and approved securities like shares,
debentures and government securities can be bought and sold duly guided by certain
rules and regulations. It provides a ready and continuous market lending a high degree
of liquidity to holdings in securities and ensures safety to dealing. A stock exchange
maintains a complete record of all transactions, and supplies regular information on
prices and sales volumes. This helps the investors' in investment decisions and
evaluation of the worth of their holdings. The volume of business and the trend in
prices at the stock market also reflect the prevailing business conditions and the
economic health of a country. In fact, the stock exchanges offer many advantages to
the investors, the companies and the society at large.

At present, there are 24 stock exchanges in India. Of these, 22 are regional stock
exchanges and 2 are national level itock exchanges viz., OCTEI and NSE. The OCTEI
 Capital Market
has its offices all over the country and caters only to small and medium sized
companies that are exclusively listed with it. Ever since screen based online trading
has been introduced, the investors prefer dealings at NSE and BSE which now handle
most business in securities in the country.

Only those securities can be traded on a particular stock exchange which have been
duly approved (listed) for the purpose. In order to get its shares listed on a stock
exchange, the interested company has to make a formal application and meet the
eligibility criteria and other requirements laid down by SRC Rules and the Bye-laws of
the stock exchange concerned. The trading on a stock exchange can be conducted only
by members of the stock exchange who can act on their own behalf or on behalf of
their clients. SEBI (Stock Brokers and Sub-brokers) Rules further provide that any
person acting as stock broker has to get himself registered and hold a certificate
granted by SEBI.

All along, for trading at the stock exchanges, the physical order matching by calling out
bids and offers in the trading ring has been used. But, it has now been replaced by
screen based online trading. In fact, by virtue of high penetration of computers and
introduction of dematerialisation of securities, the trading, has become literally
paperless and eased the normal procedure of a settlement in quick time.

The settlement pracess at the stock ex-hanges involves delivery of securities and the
payment due, which had been taking place on weekly basis with a fixed settlement day.
The traditional settlement system provided for the carry forward of transactions in
specified securities from one settlement day to another, popularly known as Budla.
However, this system led to excessive speculation and certain malpractices at the stock
exchanges to the detriment of the genuine investors. This resulted in its replacement
by trading in equity derivatives in the form of futures and options. Another important
reform introduced in respect of settlement has been the introduction of delivery
through electronic book entries facilitated by depositories. The adoption of rolling
settlement with T + 2 cycle in place of the 7-day account period settlement has been the
next landmark. Thus, trading and settlement at stock exchanges has become highly
convenient, safe and economical. In fact, in the post-reform phase i.e., the period after
1991, several other reformist measures have been introduced which have transformed
the Indian stock market and put it firmly on the road to renewed growth.

KEY WORDS
Backwardation : Budla charges (udha badla) paid by a short seller against his sale to
seek postponement of the transaction to the next settlement date. In the context of
futures, it refers to a situation when the spot price is greater than the futures price.

Bid and Offer : Bid is the price of a share a prospective buyer is prepared to pay for a
particular scrip, and offer is the price at which a share is offered for sale.

Book Building : A process undertaken by which a demand for the securities proposed
to be issued by a body corporate is elicited and built up, and price for such securities is
assessed.

Broker Dealer : A member of the stock exchange who is licensed to buy or sell
securities on his own behalf.
I
Financial Markets and their Budla : Carry forward of a transaction from one settlemeni day to another on payment
Regulation
of some charges known as budla charges based on the value of the securities involved.

Contango : Budla charges (vyaj budla or seedha budla) paid to the seller for carrying
forward a transaction of purchase of shares to next settlement based on the value of
securities and the interest rate rates prevailing in the market.

Dematerialisation : The process by which securities in the physical form are

cancelled and credit in the form of electronic balances are maintained at the depository.

Derivatives : The products or instruments whose values depend on the value of

underlying assets which could be a stock index, a foreign currency, a commodity or an
individual stock (equity share). Thus, when the underlying asset is equity share it is
called equity derivative.

Futures : These are contractual obligations to buy and sell at an agreed price at a
future date just like a forward contract. The contract terms are standardised by future
exchanges and the obligation from both buyer and seller is confirmed when the initial
deposit or margin changes hands.

Insider Trading : Trading in a company's share by a person having non-public

(confidential) price sensitive information such as expansion plans, financial results,
takeover bids etc. by virtue of his association with that company.

Kerb-market : Unofficial trading in securities outside the recognised stock exchanie

or after normal trading hours of the stock exchange.

Margin : A deposit made by a client with the broker to cover the anticipated loss and
default risk.

Market Maker : Dealers who, unlike the general financial intermediaries, primarily
act as principals buying and selling specific securities on their own account at all times
in an effort to stablise prices in the market. They offer two way quotes for buying and
selling and are rewarded through bid-offer spread i.e., the difference between the bid
price at which they will buy a security and the higher offer price at which they will sell
it.

Merchant Banker : An entity registered under SEBI (Merchant Bankers) Regulation,

who float fresh securities on behalf of the companies or underwrite them, and act as
managers to the issue undertaking issue management and advisory services.

Offer for Sale : An arrangement whereby a company allots or agrees to allot shares or
debentures at a price to the financial institution or an issue house for sale to the public.

Open Outcry System : A system which resembles an auction where members trying
to sell strive to obtain the highest possible price while those trying to purchase, strive to
obtain the lowest price possible price through bid and offer strategy at the floor of the
stock exchange.
te

Options : A contract which gives the holder the right to, but not the obligation, to buy
or sell s$ecified quantity of the underlying assets at a specified (strike) price on or
before a specified time (expiration date). When the underlying,asset is equity share, it
is called stock option, and when it is stock index it is called index option.
40
Price Rigging : When a person or persons acting in concert with each other collude to Capital Market

artificially increase or decrease the prices of a security, the process is called price
rigging.

Private Placement : The direct sale of securities between an issuer and an investor
usually a financial institution, without using regular channels of capital market.

Qualified Institutional Buyer (QIB) :It refers to public financial institutions,

scheduled commercial banks, mutual funds, foreign institutional investors, venture
capital funds, multinational development financial institutions, and state industrial
development corporations.

Screen based Trading : When buying and selling of securities is done using
computers and matching of trades is done by a stock exchange computer.

Underwriter : An individual or an institution guaranteeing of

subscription, in part or in full, of a securities issue made to the public. If these are not
taken by the public, they themselves take them up to the extent they are not subscribed
by the public.

Squaring up : Settlement by a counter transaction and paying or receiving the amount

based on the difference in prices.

10.12 ANSWERS TO CHECK YOUR PROGRESS

--

A 3 (a) prospectus (b) public (c) indicative (d) further, existing*

(e) offer for sale
C 4 (a) True (b) False (c) True (d) False (e) True (f) True
D 3 (a) - (ii) (b) - (i) (c) - (iii) (d) - (i) (e) - (ii) (0 - (iii)

10.13 TERMINAL OUESTIONS

1 Define stock exchange and describe its key functions.
2 Discuss the importance of stock exchanges for (a) the investors, (b) the corporate
sector, and (c) the society.
3 What do you mean by listing of securities on a stock exchange ? State its
advantages from the point of view of a company and an investor.
4 Describe the traditional method of trading on a stock exchange, and explain how
has online trading improved the system of purchase and sale of securities and the
settlement of transactions.
5 Distinguish between
(a) Primary Capital Market and Secondary Capital Market
(b) Speculative Transaction and Investment Transaction
(c) Budla System and Equity Derivatives
6 What are the three types of contracts allowed on stock exchange for the purchase
and sale of securities from the settlement point of view? What is their position as
at present ?
Financial Markets and their 7 (a) Explain the depository system.
Regulation
(b) What do you mean by rolling settlement ? Explain it with the help of an
example.
8 What do mean by speculation? Do you consider it necessary for the success of
stock exchange operations ? Give your views.
9 Write short notes on the following
(a) Importance of Primary Capital Market
(b) Stock Exchanges in India
(c) IPO through Book Building Process

Note : These questions will help you to understand the unit better. Try to write
answers for them, but do not submit your answers to the university for
assessment. These are for your practice only.
UNIT 11 REGUALATION OF CAPITAL
MARKET
Structure

Objectives
Introduction
Need for Regulating Capital Market Operations
Regulation of Capital Markets -An Overview
Regulatory Framework for Issue of Capital - SEBI Guidelines
1 1.4.1 Eligibility Norms
1 1.4.2 Pricing of Securities 4

1 1.4.3 Promoters' Contribution Ishareholding

1 1.4.4 Pre-Issue Obligations
1 1.4.5 Post-Issue Obligations
1 1.4.6 Other Requirements
Regulatory Framework for Controlling Stock Market Operations
1 1.5.1 Powers of Central Government
1 1.5.2 Powers of SEBI in relation to Stock Exchanges
1 1.5.3 Amendment of SEBI Act in 2002
Regulation of Corporate Takeovers
1 1.6.1 Prevention of Secret Takeover Bids
11.6.2 Takeover Code as Modified by SEBI
Let Us Sum Up
Key Words
Answers to Check Your Progress
11.10 Terminal Questions

11.0 OBJECTIVES

After studying this unit you should be able to :

appreciate the need for regulating capital market operations;
outline the regulatory framework for capital markets;
describe SEBI guidelines for capital issues;
outline the provisions of the Securities Contracts (Regulation) Act, 1956 for
controlling stock market operations and the role of SEBI in respect thereof;
identify the need for takeover code; and
explain the main provisions of takeover code as modified by SEBI.

11.1 INTRODUCTION
You have learnt about the nature and significance of capital market and its two
principal segments viz., the primary or new issue market and the secondary market
predominantly comprising stock exchanges. Corporate securities issued in the primary
market and held by investors are traded through the stock exchanges on a continuous
basis. The capital market in India has experienced unprecedented growth during the
last two decades both in terms of new issues as well as daily turnover in the major
stock exchanges. The shareholding population in India now occupies the third place in
the world, next only to U.S. and Japan. The equity cult has captured the imagination
Financial Markets and their of small investors who were earlier shy of investing in corporate securities. The
Regulation
number of stock brokers and sub-brokers has also increased about ten fold even though
screen based electronic trading has largely replaced floor based dealings. However,
along with the developments in terms of growth, there have emerged certain
disquieting features for which more regulatory measures were called for.

In this unit, you will learn about the need for regulating capital market operations, and
analyse the regulatory framework with respect to public issue of capital and stock
market operations. In addition, you will have an idea about the regulation of corporate
takeovers and the takeover code as modified by SEBI.

NEED FOR 8EGULATING CAPITAL MARKET

OPERATIONS
I
Along with the phenomenal growth of Indian capital market, certain negative features
have continued to plague the capital market operations. The necessity of capital market
reforms and regulatory measures lay in those negative features which spread and
intensified particularly after decontrol and deregulation of capital issues. Some of the
major disquieting aspect have been as follows:

1 While dealing in securities consist mainly of equity shares, only a small proportion
of the shares listed are actively traded in stock exchanges. Analysis of the
frequency of transactions have revealed that about 90 per cent of the total .
transactions are confined to only 5 per cent of the scripts of listed companies.
Thus, there is high volatility in respect of a small proportion of the scripts and
poor liquidity in respect of a vast majority of scripts.
2 A practice of common occurrence in the context of issue of shares by companies is
the manipulation of share prices called price rigging. It starts with charging a high
premium on the first issue and continue with luring investors to the subsequent
issues. Later, when allotments have been made, the prices slide down to their
natural levels that are often below the offer prices. Attempt may alsq made at this
stage by the speculators, or their rival groups, to depress the prices to the detriment
of gullible investors.
3 Some companies which frequently enter the capital market with projects involving
expansion, diversification and modernisation are known to delay allotments and do
not return shares lodged for sub-division, consolidation and transfer on time. As a
result, an artificial scarcity is created so as to manipulate the prices in the
secondary market, seriously harming the genuine investors.
4 Another malpractice which has continued to vitiate the stock market operations is
the insider trading. It refers to trading in the scrip of a company by a person having
access to unpublished price sensitive information to make private gains or avoid
losses. Directors, promoters and someone connected with the company may often
have access to privileged information and make use of such information for private
gain on the stock market.
5 Preferential allotment of shares to promoters1 associates has been another
disturbing feature. There are instances of a number of companies which made
preferential allotment of shares at a substantial discount to the prevailing market
price and the allottees reaped windfall profits, while others suffered due to
weakening of prices resulting from a surge in the supply of shares.
6 Problems posed by brokers and sub-brokers also assume serious proportions at
times. Brokers indulge in what is known as 'front running' when they are advised
 by institutions to execute bulk orders to buy or sell securities. Since the bulk Regulation of Capital Market
orders have the potential to affect the market price, the brokers are known to make
deals in advance of institutional orders to make profits for themselves. It is also
observed that about 50 per cent of the complaints against stock brokers relate to
sub-brokers acting with scant regard to investors' interest. Sub-brokers have
proliferated all over the country and often issue contracts, bills memos, etc. in their
own names to lend authenticity to their operations even though these are invalid
and may not reflect the correct position. Gullible investors often fall a prey to such
acts of the sub-brokers.
7 Small investors' interest had been adversely affected while dealing in odd lots as
they would receive 10 to 15 per cent less than the market price when they sold and
had to pay 5 to 10 per cent more when they would buy. However, this problem
has been duly taken care of by the introduction of depository system which has
literally done away with settlement through physical delivery of securities.
8 The system of carry forward (badla) has been responsible for excessive
speculation, high price fluctuations and risk of loss. It is heartening to note that the
have badla system has been abolished after the introduction of dealings in
derivatives about which you have learnt in Unit 10.
9 A negative practice which affects the liquidity of investments is the inordinate
delay in admitting securities for trading in stock exchanges. The delay is caused
by the concerned companies as the collection of applications from different centres
across the country, the processing of applications, the issue of allotment
letterslshare certificates, etc. often take a long time after the date of closure of the
subscription list.

11.3 REGUALTION OF CAPITAL MAREKTS - AN

OVERVIEW
Before the establishment of SEBI, the principal legalisations governing the capital
market in India were (a) the Capital Issues Control Act, 1956 for regulating the
primary market, and (b) the Securities Contracts (Regulation) Act, 1956 for regulating
the secondary market. The regul~torypowers for the primary market were vested with
the Controller of Capital Issues and those for the secondary market with the Stock
Exchange Division in the Ministry of Finance.

In April 1988, the Securities Exchange Board of India (SEBI) was set up as a non-
statutory body to regulate the capital market on the strength of the Government of India
until January 30,1992 when an Ordinance was promulgated to make it a statutory
board. The Bill to replace the Ordinance was passed by both Houses of Parliament and
it became an Act on April 4, 1992 when it received President's assent. Meanwhile, the
Capital Issue Control Act had been repealed and the Companies Act amended to
make SEBI the Administrative authority for enforcement of the provisions of the
Act relating to capital issues. As a result, the primary market became the
preserve of the SEBI. Further, the Ministry of Finance transferred a number of
its powers under the Securities Contracts (Regulation) Act also to SEBI. Thus,
SEBI has also been entrusted with the main responsibility of adopting suitable
measures for protecting the interests of investors in securities and promoting the
development and regulation of stock market. Such measures include the following:

1 Regulating the business in stock exchanges and any other securities market;
2 Registering and regulating the working of market intermediaries viz., registrars and
transfer agents, portfolio managers, underwriters, etc; 45
Financial Markets and their 3 Restricting and regulating the working ot collective investment schemes including
Regulation
mutual funds;
4 Promoting and regulating self-regulatory organisations;
5 Prohibiting fraudulent and unfair trade practices in securities market;
6 Promoting investors education and training of intermediaries of securities markets;
7 Prohibiting insider trading in securities substantial acquisition of shares and
takeover of companies;
8 Levying fees other charges for the above purposes and perform such other
functions as may be prescribed.
9 Calling for information from, and undertaking inspection, conducting inquiries and
audit of stock exchanges, intermediaries and self regulatory organisations in
'

securities market. SEBI has been armed with some additional powers for ensuring
the orderly development of capital markets and to enhance its ability to protect
investors' interests.
10 Performing such functions and exercising such powers under the provisions of
SCR Act as may be delegated to it by the Central Government.

Let us now take up the SEBI Guidelines for regulating capital issues, followed by the
regulatory framework for controlling the stock market operations under the SCR Act
including SEBI guidelines in respect thereof.

Check Your Progress A

1 What were the principal legislations governing the capital market in India before
the establishment of SEBB
...................................................................................................

2 List any three malpractices prevailing on the stock exchange in India.

...................................................................................................

3 Fill in the blanks

(a) Shareholding in India now occupies place in the world.
(b) Analysis of frequency of transactions at the stock exchanges revealed that
about 90 per cent of the total transactions are confined only to , Per
cent of the scripts of listed companies.
(c) Inside trading refers to trading in the scripts of a company by persons having
access to price sensitive information to make private gains or
reduce losses.
(d) A negative practice which affects the ...........of investments is the inordinate
delay in admitting securities for trading in stock exchanges.
(e) The ................ Act was amended to make SEBI, the administrative authority
for enforcement of the provisions of the Act relating to capitsl issues.
 Regulation of Capitd Market
11.4 REGULATORY FRAMEWORK FOR ISSUE OF
CAPITAL - SEBI GUIDELINES
Till eighties, for raising capital from the public by issue of shares or debentures, a
public company had to comply with the provisions of the Companies Act, the Capital
Issues Control Act, 1947 including the Rules made thereunder, and the guidelines and
instructions issued by the concerned government authorities and stock exchanges. As
stated earlier, the Capital Issues Control Act was repealed in May 1992, and the capital
issues came under the preview of SEBI set up under the SEBI Act, 1992. In June,
1992, SEBI released its guidelines for capital issues known as SEBI (Disclosure and
Protection of Investors) Guidelines which lay stress on adequate disclosures, seek to
safeguard the interest of investors, and emphasises prudent controls. These, along with
provisions of the Companies Act, are applicable to all public issues of listed and
unlisted companies, and all offers for and rights issues by listed companies except in
case of rights issue where the aggregate value of securities offered does not exceed
Rs. 50 lakh. The procedural requirements for public issue as per SEBI Guidelines,
2000 (as updated till September, 2005) are as follows :

11.4.1 Eligibility Norms

Every company making an initial public after (IPO), to start with, have to satisfy the
following conditions.

Companies not barred from accessing the capital market : The Company planning
to make a public issue of securities should not be the one which has been banned by
SEBI from accessing the capital market.

Filing of offer document : To make an initial public offer of securities, the company
has to prepare the draft offer document (prospectus) in accordance with the specified
disclosure requirements and file it with SEBI through an eligible merchant banker at
least 21 days prior to the filing the same with the Registrar of Companies. In the case
of a rights issue by any listed company, if the aggregate value of securities including
premium, if any, exceeds Rs. 50 lakh, a letter of offer is to be filed with the SEBI,
through an eligible merchant banker, at least 21 days before filing it with the Regional
Stock Exchange.

Application for listing : No company can make any public issue of securities unless it
has made an application for listing of those securities in stock exchange (s).

Issue of securities in dematerialized form : To make a public or rights issue or an

offer for sale of securities, the company has to enter into an agreement with a
depository, registered with the Board, for dematerialization of securities. Further, the
company must also give an option to subscribers/shareholders/investorsto receive the
security certificates or hold securities in dematerialized form with a depository.

Initial public offering by unlisted companies : An unlisted company can make an

initial public offering (IPO) of equity shares or any other security which may be
converted into, or exchanged with, equity shares at a later date, provided -
(a) the company has net tangible assets of at least Rs. 3 crore in each of the preceding
3 full years, of which not more than 50% is held in monetary assets. However, if
more than 50% of the net tangible assets are held in monetary assets, the company
Financial Markets and their must have made firm commitments to deploy such excess monetary assets in its
Regulation \
business project;
(b) the company has a track record of distributable profits for at least three out of
immediately preceding five years;
(c) the company has a net worth of at least Rs. 1 crore in each of the preceding 3 full
years;
(d) the aggregate of the proposed issue and all previous issues made in the same
financial year in terms of size does not exceed five times its pre-issue net worth as
per the audited balance sheet of the last financial year; and
(e) there are no outstanding financial instruments or any other right which would
entitle the existing promoters or shareholders any option to receive equity share
capital after the initial public offering.
An unlisted company not complying with any of the above conditions can make an IPO
(i) if it is made through book building process with at least 50% of the net offer to the
public is allotted to Qualified Institutional Buyers (QIBs) or the project has at least
15% participation of Financial Institutions 1 Scheduled Commercial Banks, of which at
least 10% comes from the appraisers, and at least 10% of the issue size shall be allotted
to QIBs; and (ii) the minimum post-issue face value of capital of the company shall be
Rs. 10 crore or there shall be a compulsory market-making for at least 2 years from the
date of listing of the shares.

No unlisted company can make a public issue or equity shares of any security
convertible into equity share, if there are any outstanding financial instruments or any
other right which would entitle the existing promoters or shareholders any option to
receive equity share capital after the initial public offering.

Public Issue by listed companies : A listed company is eligible to make a public

issue of equity shares or any other security which may be converted into or exchanged
with equity shares at a later date provided the aggregate of the proposed issue and all
previous issues made in the same financial year does not exceed 5 times its pre-issue
net worth as per the audited balance sheet of the last financial year. In case it does not
fulfil the aforesaid conditions, it may still be eligible to make a public issue provided it
fulfils the conditions (i) and (ii) laid down with respect to s unlisted companies making
an IPO with similar limitations.

Exemption from eligibility norms : The provisions with respect to the eligibility of
unlisted companies making an initial public offering and listed companies making
public issue of equity shares and other securities are not applicable in the case of
private and public sector banks, rights issue by a listed company and an infrastructure
company whose project has been appraised by a Public Financial Institution (PFI) or
Infrastructure Development Finance Corporation or Infrastructure Leasing and
Financing Services Ltd. or a bank which was earlier a PFI, and if not less that 5% of
the project cost is financed by any of the aforesaid institutions.

No existing partly paid-up shares : No company.can make a public issue of equity

share or any security convertible at a later date into equity share unless all the existing
partly paid up shares have been made fully paid up or forfeited.

Firm arrangements of finance : To make a public or rights issue or securities, a

company must have made firm arrangements of finance through verifiable means
towards 75% of the stated means of finance, excluding the amount to be raised through
48 the proposed publiclrights issue. ,
 Regulation o f Capital Market
11.4.2 Pricing of Securities

Every company, which is eligible to make a public issue, may freely price their equity
shares or any securities convertible into equity at a later date.

Differential pricing : Any listed or unlisted company making public issue of equity
shares or securities convertible into equity, may issue such securities to applicants in
the firm allotment category at a price different from the price at which the net offer to
C
the public is made, provided the price at which securities are offered to the applicants
in firm allotment category is higher than the price at which securities are offered to the
public. Of course, justification for the price difference is to be given in the offer
B document. Similarly, a listed company making a composite issue of capital may issue
securities at differential prices in its public and rights issues.

Price band : Any issuer company can mention a price band of 20% (cap in the price
band should not be more than 20% of the floor price) in the offer documents field with
the Board, and actual price can be determined at a later date before filing offer
document with ROCs. The final offer document is to contain only one price and one
set of financial projections, if applicable.

Freedom to determine the denomination of shares : An eligible company has the

freedom to make public or rights issue of equity shares in any denomination
determined by it in accordance with the provisions of the Companies Act and in
compliance with the norms as specified by SEBI. Companies which have already
issued shares in the denomination of Rs. 10 or Rs. 100 may change the standard
denomination of the shares by splitting or consolidating the existing shares. However,
the denomination shall not be in decimal of a rupee in any case.

11.4.3 Promoters' Contribution / Shareholding

In a public issue by an unlisted company, the promoters have to contribute notrlessthan

20% of the post-issue capital. The promoters' shareholding after offer for sale is not to
be less than 20% of the post-issue capital. Similarly, in case of listed companies, the
promoters may participate either to the extent or 20% of the proposed issue or ensure
post-issue shareholding to the extent of 20% of the post-issue capital.

In case of composite issue of a listed company, the promoters' contribution may, at the
option of the promoter(s), be either 20% of the proposed public issue or 20% of the
post-issue capital. But the rights issue component of the composite issue must be
excluded while calculating the post-issue capital.

In case the promoters' participation is in excess of the required minimum percentage of

the post issue capital, it will be treated as preferential allotment and attract the pricing
provisions of guidelines on preferential allotment, if the issue price is lower than the
price determined on the basis of preferential allotment guidelines.
Promoters' contribution to be brought in before public issue opens : Promoters are
to bring in the full amount of their contribution including premium at least one day .
prior to the issue opening date, and the amount must be kept in an escrow account with
a scheduled commercial bank and the said amount is to be released to the company
along with the public issue proceeds. Where the promoters' minimum contribution
exceeds Rs. 100 crore, they have to bring in Rs. 100 crore before the opening of the
issue and the balance may be brought in as advance on pro rata basis before the calls
are made on public. - 49
Financial Markets and their Exemption from requirement of promoters' contribution : The requirement of
Regulation
promoters' contribution is not applicable in case of public issue of securities which has
been listed on a stock exchange for at least 3 years and the company has a track record
of dividend payment for at least 3 immediately preceding years. However, the
promoters must disclose their existing shareholding and the extent to which they are
participating in the proposed issue in the offer document.

Lock-in requirements : In case of any public issue of capital, the minimum

promoters' contribution is to be locked in for a period of three years. However, the
promoters' contribution / participation in excess of the required minimum contribution
1 percentage is to be locked in for a period of one year only, and in the case of public
issue by a company which has been listed on a stock exchange for at least three years
and which has a track record of dividend payment for at least three immediately
preceding years, excess promoters' contribution is not subject to lock-in requirements.
In case of an unlisted company, the entire pre-issue share capital, other than that locked
in as promoters' contribution, is to be locked in for a period of one year from the date
of commencement of commercial production or the date of allotment in the public
issue, whichever is later. The aforesaid lock-in requirements shall not be applicable to
the pre-issue share capital held by venture capital funds and foreign ventures capital
investors registered with SEBI. The same shall be locked in as per relevant SEBI
(Venture Capital Fund) Guidelines of 1996 and SEBI (Foreign Venture Capital
Investors), 2000 and any amendments thereto. The lock-in of pre-issue share capital
shall also not be applicable to such capital held for a period of at least one year at the
time of filing draft offer document with the SEBI and being offered to the public
through offer for sale.

11.4.4 Pre-Issue Obligations

Due diligence exercise : The lead merchant banker must exercise due diligence. The
standard of due diligence is to be such that the merchant banker satisfies himself about
all aspects of offering and the veracity and adequacy of disclosure in the offer
document.

Payment of fee : The lead merchant banker is to pay the requisite fee along with draft
offer document to be filed with SEBI.

Documents to be submitted : The following documents are required to be submitted

along with the offer document by the Lead Manager.
(a) Memorandum of Understanding (MOU) entered into between the lead merchant
banker and the issuer company specifying their mutual rights, liabilities and
obligations relating to the issue.
(b) Inter-se allocation of responsibilities must be demarcated as specified in Schedule
I1 of SEBI Guidelines in case the public or rights issue is managed by more than
One merchant banker.
(c) 3 u e Diligence Certificate as specified in Scheduled 111 of SEBI Guidelines is to be
furnished to the Board by the lead merchant banker along with the draft prospectus.
(d) Certificates signed by the company secretary or chartered accountant regarding
timely despatch of refund orders of the previous issue, security certificates, and
the listing of securities.
(e) An undertaking by the user to the effect that transactions in securities by the
promoters and their immediate relatives during the period between the date of
filing the offer documents and the date of closure of the issue, shall be reported to
the stock exchanges concerned within 24 hours of the transaction(s).
 Rcguhtion ofCapit8l Market
(f) A list of the persons who constitute the Promoters' Group and their individual
shareholding and some personal details to be submitted by the-Board.

Appointment of lead merchant banker : An eligible merchant banker must be

I
appointed to lead and manage the issue, and he is to ensure that registrars bankers to
the issue and the other intermediaries are d;ly appointed, and registered with the
Board, wherever applicable.

- Underwriting : The lead merchant banker is to satisfy himself about the ability of the
underwriters to discharge their underwriting obligations, incorporate a statement in the
offer document to the effect that, in their opinion, the underwriters' assets are adequate
w
to meet their underwriting obligations. In respect of an underwritten issue, the lead
merchant banker is also to ensure that the relevant details of underwriters are included
in the offer document. Moreover, in respect of every underwritten issue, the lead
merchant banker(s) have to undertake a minimum underwriting obligation of 5% of the
total underwriting commitment or Rs.25 lakh, whichever is less.

Draft Offer Document to be made public : The draft offer document filed with SEBI
is required to be made public for a period of 21 days from the date of filing the offer
document with the Board and make its copies available to the public.

While filing the draft offer document with the Board, the lead merchant banker is also
to file the document with the stock exchanges where the securities are proposed to be
listed, and obtain and furnish to the Board, an in-principle approval of the stock
exchanges for listing of the securities within 15 days of filing of the draft offer
documents with the stock exchanges.

Pre-issue advertisement : Soon after receiving the final observations, if any, on the
draft prospectus from the Board, the issuer company has to make an advertisement in
an English national daily, one Hindi national newspaper and a regional language
newspaper at the place where the registered office of the issuer is situated. This has to
be in the format and contain the minimum disclosures as given in Part A of Schedule
XXA of the SEBI Guidelines, both in case of fixed price issues as well as book built
issues.

Despatch of issue material : The lead merchant banker must ensure that for all public
issues, offer documents and other issues materials are despatched to the various stock
exchanges, brokers, underwriters, bankers to the issue, investors associations etc. in
advance. In the case of rights issue, the lead merchant banker must ensure that the
letters of offer are despatched to all shareholders at least one week before the date of
opening of the issue.

No complaints certificate : After 21 days from the date the draft offer document was
made public, the lead merchant banker must file a statement with the Board giving a
list of complaints received by it, along with a statement whether it is proposed to
amend the draft offer document or not, and also highlight those amendments.

Collection centres I Agents : The issuer company may appoint as many collection
centres as it deems fit. However, the minimum requirement of collection centres for
an issue of capital is four metropolitan centers, (b) all such centres where the stock
, exchanges are located in the region in which the registered off~ceof the co-mpany is
situated, and (c) the regional division of collection centres as indicated in Schedule VII
of the Guidelines. The Company can also appoint authorised collection agents in
Financial Markcts rod their consultation with the lead merchant banker subject to necessary disclosures including
Rzgulrlinr
the names and addresses of such agents in the offer document.

Advertisement for rights post issues : In the case of a rights issue, the lead merchant
banker must ensure that an advertisement giving the date of completion of despatch of
letters of offer are released at least 7 days before the date of opening of the issue. The
advertisement must indicate the centres other than registered office of the company
where the shareholders or the persons entitled to rights may obtain duplicate copies of
composite application forms.

Appointment of compliance officer : An issuer company is to appoint a compliance

officer who shall directly liaise with the Board with regard to the compliance with
various laws, rules, regulations and other directives issued by the Board and investor
complaint related matters. The name of the compliance officer must be intimated to the
Board.

Abridged Prospectus : The lead merchant banker must ensure that every application
form distributed by the issuer company is accompanied by a copy of the abridged
prospectus, of which the application form may be stapled to form a part, or may be a
stapled part.
I
11.4.5 Post-Issue Obligations

Post-issue monitoring reports : Irrespective of the level of subscription, the post-

issue lead merchant banker is to ensure submission of the post-issue monitoring reports
as per format specified in Schedule XVI of the Guidelines. These reports must be
submitted within 3 working days frok the due dates specified.

Redressal of investor grievances : The post-issue lead merchant banker is to active11

associate himself with post-issue activities, viz., allotment, refund and despatch, and
has to regularly monitor redressal of investor grievances arising therefrom.

Coordination with intermediaries : The post-issue lead merchant banker is to

maintain close coordination with thd registrars to the issue and arrange to depute its
officers to the offices of various intermediaries at regular intervals after the closure of
the issue to monitor the flow of applications fiom collecting bank branches, processing
of the applications, etc. till the basis of allotment is finalised, despatch of security
'
certificates and refund orders completed and securities listed. Any act of omission or
commission on the part of any of the intermediaries must be duly reported to the Board.

Underwriters : In case there is a devolvement on underwriters, the lead merchant

banker is to ensure that the underwriters honour their commitments within 60 days
from the date of closure of the issue. In case of undersubscribed issues, the lead
- merchant banker is to furnish information in respect of underwriters who have failed to
meet their underwriting developments to the Board in the format specified at Schedule
XVII of the Guidelines.

Bankers to an issue : The post-issue lead merchant banker has to ensure that money
received pursuant to the issue are kept in a separate bank are released by the said bank
only after the listing permission under the said section has been obtained from the stock
exchanges where the securities were proposed to be listed as per the offer document.
 Regulation of Capital Mark'
Post-issue advertisements : The post-issue lead merchant banker must ensure that in
case of all issues, advertisement giving details relating to (i) over subscription, (ii) basis
of allotment, (iii) number, value and percentage of applications, (iv) number, value and
percentage of successful allottees, (v) date of completion of despatch of refund orders,
(vi) date of despatch of certificates, and (vii) date of filing of listing application, is
released within 10 days from the date of completion of the various activities.

Basis of allotment : In a public issue of securities, the executive director I managing

director cf the designated stock exchange along with the post-issue lead merchant
banker and the registrars to the issue are to be responsible to ensure that the basis of
allotment is finalised in a fair and proper manner as specified in the SEBI Guidelines.
As per guidelines, if the issue is oversubscribed, the allotment must be made in
marketable lots on pr~portionate~basis within the specified categories subject tp
reservation for retail individual investors which is 50% of the net offer to the public.
Draw of lots, if required, can be made to finalise the basis of allotment.

Other responsibilities : The lead merchant banker is to ensure that (i) the despatch of
share certificates1 refund orders and demat credit is completed and the allotment and
listing documents submitted to the stock exchanges within 2 working days of
finalization of the basis of allotment, and (ii) all steps for completion of the necessary
formalities for listing and commencement of trading at all stock exchanges where the
securities are to be listed are taken within 7 working days of finalization of the basis of
allotment.

The post-issue lead merchant banker is to continue to be responsible for post issue
activities till the subscribers have received the sharesfdebenture certificates or refund of
application money, and the listing agreement is entered into by the issuer company
with the stock exchange and listing / trading permission is obtained.

11.4.6 Other Requirements

Public issue of NCDS / DSCE : The lead merchant banker is to ensure compliance
with the guidelines relating to public issue and listing of non-convertible debt securities
(NCDS) and debt securities convertible into equity after allotment (DSCE). An
unlisted company making a public issue of NCDS I DSCE can make a public issue and
make an application for listing its NCDS in the stock exchangels without making a
prior public issue of equity and listing thereof, subject to the conditions specified in the
guidelines.

The lead merchant banker can mention a price band of 20% in the offer document filed
with the Board and the specific coupon ratelprice can be determined by an issuer in
consultation with the lead manager at a later date before filing of the offer document
with the ROC. The issuer may, subject to the relevant provisions of the guidelines,
make the issue through book building process to ascertain and determine the coupon
rate and price /conversion price of the NCDS I DSCE.

Rule 19 (2) (b) of Securities Contracts (Regulation) Rules, 1957 : It specifies that
1 In case of a public issue by an unlisted company, the net offer to public must be at
least 10% or 25% as the case may be, of the post-issue capital;
2 In case of a public issue by a listed company, the net offer to public must be at least
10% or 25% as the case may be, of the issue size.
Financial Markets and their 3 An infrastructure company inviting subscription from the public shall not attract
Regulation
the provisions of the above two clauses.
4 The issuer company is free to make reservations and/or firm allotments to various
categories of persons such as employees, shareholders, mutual funds, FIIs,
development institutions, and scheduled banks for the remaining part of the issue
subject to other relevant provisions of the guidelines.

An unlisted company may make an application to the Board for relaxation from
applicability of Rule 19(2) (b) of SCR Rules, 1957, and for listing of its shares without
making an initial public offer, if it satisfies the prescribed conditions.

New financial instruments : SEBI in its guidelines of June, 1992 also permitted
companies to issue new financial instruments subject to certain conditions. Such
instruments include zero coupon debentures1 bonds, warrants, deep discount bonds,
PCD/NCD with buy back arrangement, secured premium notes, etc. The main
condition relates to adequate disclosures regarding the terms and conditions of
redemption, security, conversion and any other relevant features of the instruments.

Terms of the issue : The SEBI guidelines also provide for detailed requirements
relating to the following terms for the public issue.
1 Minimum application value to be within the range of Rs. 5,000 to Rs. 7,000.
2 If the subscription money is to be received in calls, the entire subscription must be
called within 12 months from the date of allotment.
3 No further capital issue in any manner during the period commencing from
submission of offer document to the Board till the securities offered in the said
' offer document have been listed or appiication money refunded on account of non-
listing.
4 Minimum and maximum period ii:: subscription to be kept open to be 3 to 12
working days. Rights issue h l ~ a l lbe kept open for at least 30 days and not more
than 60 days.
5 The particulars as per audited statements contained in the offer document not to be
more than 6 months old from issue opening date
6 Minimum subscription to be 90% of the total offer amount.
7 Over subscription to the extent of 10% of the net offer to public permitted for
'
purpose of rounding off to the nearest multiple of 100 while finalizing the
allotment.
8 No incentive to be offered to the prospective investors.
9 Compliance officer to be appointed to ensure that all rules, regulations, guidelines,
notifications, etc. issued by the Board, the Government of India and other
regulatory organisation are complied with.
10 Arrangement for monitoring the use of the proceeds of the issue by one of the
/
financial institutions.
11 Any safety net for buy back arrangement of the shares to be strictly in accordance
with the provisions in the guidelines.
12 In case of change in denomination of shares, the compliance with the provision
shall be ensured while making disclosure in the offer document.

The important procedural requirements' for issue of capital as laid down in the SEBI
(Disclosure and Investor Protection) Guidelines, 2000, updated till September 2005
i Regulalion of Capital Market
have been duly outlined above. However, SEBI guidelines cover many other aspects
of regulatory framework for capital i s ~ u e which
s have been kept in view. These
include those on green shoe options for stablising the post listing price of its shares,
employees, stock option scheme (ESOP), sweat equity shares to promoters
advertisements and research reports, issue of debt inhr,uments, book building, IPO
through the Stock Exchange, On-line system (e-IPO), issue of capital by designated
financial institutions, shelf prospectus, preferential issues, OTCEI issues, bonus issues,
contents of offer documents, prospectus, abridged prospectus and letter of offer, etc.
C

Check Your Progress B

. 1 Who are exempted from eligibility norms ?

...................................................................................................

2 State the lock-in requirements in respect of promoters' contribution to public issue.

...................................................................................................

3 What is the minimum requirement of collection centres in case of public issue of

capital ?

4 State which of the following statement are True or False.

(a) No company can make any public issue of securities unless it has made an
application for listing of those securities in a stock exchange.
(b) The eligibility norms for public issue of capital do not apply to an
infrastructure company whose project has been appraised by a public financial
institution.
(c) No Company can make a public issue of capital unless all the existing partly
paid shares have been made fully paid or forfeited.
(d) Every company which is eligible to make a public issue cannot freely price its
equity shares.
(e) In case the promoters' participation is in excess of the required minimum
percentage of the post issue capital, it will be treated as preferential allotment.
(f) In case of the rights issue, the lead merchant banker must ensure that the letters
of offer are despatched to all shareholders 21 days before the date of opening
of the issue.
Financ~rilMarkets arid their ,

Regulation 11.5 REGULATORY FRAMEWORK FOR

CONTROLLING STOCK MARKET OPERATIONS

The attention of the government was drawn from time to time to the ills of stock
exchanges as a result of which the Securities Contracts (Regulation) Act was passed in
1956 to regulate and control stock market operations in the wider interest of the
financial market institutions and the investors. The Act came into effect from February
20, 1957. It provides, inter alia, for : (a) recognition of stock exchanges, (b) general
control over their trading methods and practices, (c) regulation of contracts and
options in securities, and (d) listing of securities.

The Securities Contracts (Regulation) Rules were also framed in 1957. Among other
things, the Rules provide for the procedure to be followed for recognition of stock
exchanges, submission of periodical returns and annual reports, inquiry into the affairs
of recognized stock exchanges and their members, and requirements for listing of
securities. The rules are statutory and constitute a code of standardized regulations
uniformly applicable to all recognised stock exchanges.

11.5.1 Powers of Central Government

The Securities Contracts (Regulation) Act empowers the Central Government to take
appropriate measures to achieve the objectives of the Act. These powers are :
1 Grant and withdrawal of recognition to any stock exchange;
2 Approval of rules and bye-laws of stock exchanges;
3 Direct stock exchange to make or amend rules and by e-laws in certain cases;
4 Call for periodical returns and specific information from stock exchanges;
5 Conduct inquiry on the members or on the stock exchange;
6 Suspend business of stock exchange;
7 Supersede the governing body of the stock exchange; and
8 Regulation of listing of securities.

After the constitution of SEBI, all powers under the SRC Act had been transferred by
the Government to SEBI so as to make it the sole regulator of capital market in India.
However, certain power are concurrently exercised by the Central Government and
SEBI. These are summarized as follows:

Recognition of Stock Exchanges

For grant of recognition, a stock exchange is required to make an application to the

SEBI in the prescribed manner. Every application for recognition must contain such
particulars as may be prescribed and must be accompanied by a copy of the bye-laws of
the stock exchange for the regulation and control of contracts. It must also apach a
copy of the rules relating, in general, to the constitution of the stock exchange and, in
particular, to (a) the composition and powers of the governing body and the manner in
which its business is to be conducted; (b) the powers and duties of the office bearers of
the stock exchanges; (c) the eligibility admission, expulsion, etc. of various classes of
members; (d) the procedure for the registration of partnerships as members of the
stock exchange in cases where the rules provide for such membership, and (e) the
nomination and appointment of authorized representatives and clerks.
 Regulation of Capital M a r k t
Grant of recognition is subject to the conditions that (i) the rules and bye-laws of the
stock exchange are in conformity with such conditions as may have been prescribed
with a view to ensure fair dealing and protect the investors; (ii) the stock exchange is
willing to comply with any other conditions (including condition as to the number of
members)which SEBI may impose; and (iii) it would be in the interest of the trade and
also in the public interest to grant recognition to the stock exchange.

The conditions which may be prescribed for the grant of recognition may include,
among other matters, conditions relating to : (a) qualifications for membership of stock
exchange; (b) the manner in which contracts shall be entered into and enforced as
between members; (c) representation of the Central ~ o v e h m e nont each of the stock
exchanges by such number of persons not exceeding three as the Central Government
may nominate in this behalf; and (d) the maintenance of accounts of members and their
abdit by chartered accountants whenever such audit is required by the Central
Government.

Where recognition is refused, an opportunity must be given to the applicant stock

exchange to be heard in the matter. The reasons for such refusal must also be
communicated to the stock exchange in writing.

Rules of Stock Exchanges

Every stock exchange must have rules which provide for all or any of the following :
(a) restriction of voting rights of members in respect of any matter placed before the
stock exchange at any meeting;
(b) regulation of voting right in respect of any matter placed before the stock exchange
at any meeting so that each member may be entitled to have one vote only,
irrespective of his share of the paid-up equity capital of the stock exchange;
(c) restriction on the right of a member to appoint another person as his proxy to attend
and vote at a meeting of the stock exchange; and
(d) such incidental, consequential and supplementary matters as may be necessary to
give effect to any of the matters specified above in clauses (I), (2) and (3).
Rules made and amended as above have to be approved by the Central Government
ISEBI and then published in the Official Gazette
Bye-Laws of Stock Exchanges

Any recognized stock exchange may, subject to previous approval of SEBI, make bye-
laws for the regulation and control of contracts. Some of the important provisions
which may be contained in the bye-laws are those relating to
(a) opening and closing of markets and regulation of the hours of trade;
(b) a clearing house for the periodical settlement of contracts and differences
thereunder, delivery and payment for securities, passing on of delivery orders, and
regulation and maintenance of such clearing house;
(c) the number and classes of contracts in respect of which settlements shall made or
differences paid through the clearing house;
(d) regulation or prohibition of bank transfers;
(e) method and procedure for the settlement of claims'or disputes, including settlement
I
by arbitration;

I
(f) levy and recovery of fee, fines and penalties;

57
Financial Markets and their (g) fixing of scale of brokerage and other charges; and
Regulatiun
(h) regulation of dealings by members on their own account.

The SEBI is empowered to on the basis of a request received from the governing body
of a stock exchange, or on its own motion, to make or amend any bye-laws in
accordance with the SCR Act.

Furnishing of Information and Conduct of Enquiry

Every stock exchange shall furnish the Central Government with a copy of the annual
report containing all the particulars prescribed. Further, it shall furnish to the SEBI
such periodical returns relating to its affairs a w a y be prescribed.

It is also laid down that every recognised stock exchange and every member shall
maintain and preserve, for such period not exceeding five years, such books of
accounts and other documents as may prescribed by the Central Government. These
books of account and other documents shall be available for inspection by SEBI at all
reasonable time.

The SEBI can also call upon any recognised stock exchange or any member of such
stock exchange for explanation relating to the affairs of the stock exchange or the
member in relation to stock exchange. It can also order an inquiry in relation to the
affairs of the governing body of a stock exchange or the affairs of any member of the
exchange in relation to the stock exchange.

Power to Supersede Governing Body

If the Central Government has sufficient reasons to feel that the governing body of any
stock exchange should be superseded, it may do so after serving a written notice on the
governing body and giving it an opportunity to be heard in this matter. When the
governing body is superseded, the Government may appoint any person or persons to
exercise and perform all the powers and duties of the governing body for such period
as may be specified. The Government may call upon the stock exchange to
reconstitute the governing body before the termination of this period.

Power to Suspend Business of Stock Exchange

The Act empowers the Central Government to suspend the business of any stock
exchange, under certain circumstances, for a period not exceeding seven days in the
interest of trade or public interest. The period of suspension may be extended from
time to time but only after the governing body has been given an opportunity of being
heard in the matter.

Listing of Securities by Public Companies

Power of SEBI to compel listing : You know there is no obligation that every public
company should get its shares listed on a stock exchange unless it is seeking public
subscription to shares or debentures by issue of a prospectus. However,
notwithstanding anything contained in any other law for the time being in force, if
SEBI is of opinion, having regard to the nature of securities issued by any public
company or to the dealings in them, that it is necessary or expedient in the interest of
the trade or in the public interest so to do, it may require the company to comply with
such requirements as may be prescribed with respect to listing of its securities on any
i8
recognised stock exchange. But, before making the order, SEBI shall be required to Regulation o r Capital Market
give an opportunity to the company to make its representation.

Right of appeal against refusal of stock exchanges to list security : When a public
company has applied for listing on a stock exchange and the stock exchange refuses to
list its securities of the company is entitled to be furnished with reasons for such refusal
and appeal to the Central Government / SEBI against such refusal. The appeal should,
however, be preferred within 15 days from the date on which the reasons for such
refusal are furnished to it. The Central Government ISEBI, after giving the stock
exchange an opportunity of being heard, may (a) vary or set aside the decision of the
stock exchange, or (b) where the stock exchange has omitted or failed to dispose of the
application within the specified time, grant or refuse the permission.

Every listed company has to specify in each annual report the name and address of each
stock exchange at which the company's securities are listed and whether the company
has paid the annual listing fees to each such exchange.

Delisting of securities : Shares of a company may be delisted for non-payment of the

annual listing fees or for its failure or refusal to abide by the listing agreement. In case
the securities of a company have been delisted, directors in their report have to make a
disclosure to this affect. SEBI has also provided for voluntary delisting of securities
which is permitted by the stock exchange at the request of the companies. In such a
case, the Directors' Report of the company is to disclose the fact of delisting, together
with a statement of reasons and the jfistification for voluntary delisting. The re-
instatement of delisted securities may be permitted by the stock exchange within a
period of one year after the date of delisting, without requiring the company to make
application as if it were a case of fresh listing. However, if the listing of delisted
securities is sought after one year, it should be considered as a case of fresh listing.

11.5.2 .Powers of SEBI in relation to Stock Exchanges

As indicated earlier, almost all powers which were earlier exercised by the Central
Government under the SCR Act have been transferred to SEBI and that, while certain
powers are to be exercised concurrently the Central Government and SEBI, the others
are to be exercised by SEBI itself. These are summarized hereunder :

Registration of stock brokers, sub-brokers, share transfer agents and other

market intermediaries : Under Section 12 of the Act, provision has been made for the
registration of market intermediaries with the Board (SEBI). Since the
commencement of the Act the stock brokers, sub-brokers, registrars, share transfer
agents, bankers to the issue, merchant bankers, underwriters, portfolio managers,
investment advisers and such other intermediaries can deal in securities only if they
obtain a certificate of registration from the Board and the dealings are in accordance
with the terms and conditions of such certificate. All such persons who are already
functioning as above before the establishment of the Board were required to make an
application for registration within three months from the date uf establishment of the
Board. The application for registration is required to be made on payment of the
prescribed fees as determined by regulation made by SEBI in this behalf.

Under Section 28 of the Act, however, the Central Government is empowered to

exempt any person or class of persons buying or selling securities or otherwise dealing
with the securities market from the operation of the orovisions of sub-section (1) or
Financial Markets and their Section 12. In other words, any such persons may be allowed to trade or deal with
Regulation
securities without registration with SEBI if the Central Government so directs.

Licensing of dealers in securities : Any person dealing in securities in areas other

than notified areas (whether on his own behalf or on behalf of any other person) is
required to obtain a licence from SEBI in this behalf. Dealings in securities by or on
behalf of a member of any recognised stock exchange do not come within the purview
of the restriction. Even though the provision relating to licensing does not normally
apply to spot delivery contracts, the Central Government may, by notification, make
the said provision applicable to specific securities.

According to SEBI (Stock Brokers and Sub-brokers) Rules, 1992, no person can act as
a stockbroker unless he holds a certificate granted by SEBI subject to fulfilment of the
conditions laid down in the Rules. The regulations issued in October 1992,inter alia,
cover registration of brokers and sub-brokers, their general obligations and
responsibilities, procedures for inspection of their operations and action to be initiated
in case of default.

Inspection of stock exchange : SEBI has drawn up a programme for inspecting stock
exchanges to improve their functioning. Inspections have already been carried out on
some of the exchanges.

Measures aided at strengthening investor interest and confidence in the secondary

market : These measures include rationalization and refining of margin system,
relaxation of listing requirement in respect of securities in the IT sector by reducing the
stipulated minimum offering from 25% to 10% , incorporation of derivative
instruments in the definition of securities under relevant laws enacted by Parliament,
and introduction of rolling settlement for selected scripts.

Regulations pertaining to insider trading : SEBI issued regulations in 1992

prohibiting dealings, communications or counselling in matters relating to 'insider
trading'. These regulations were expected to help protection and preservation of
market integrity, and inspire investor confidence in the market over time.

Setting up clearing house or clearing corporations and providing trade guarantee

by stock exchanges : SEBI has directed all stock exchanges to set up clearing houses
or clearing corporations so as to reduce counter-party risks and enable investors to take
advantage of settlement of transactions through a depository. SEBI has also prescribed
uniform norms and procedures for timely resolution or bad deliveries.

Compulsory settlement of trades in depositories : Effective from January 1998,

SEBI decided that settlement of trades in the depository would be compulsory for
domestic financial institutions, banks, mutual funds, and foreign institutional investors
(FIIs) having a minimum portfolio of securities of Rs. 10 crore as on their latest
balance sheets. This measure was considered necessary for expediting the process of
dematerialisation of securities and settlement of transactions in the depository..

Inspection of mutual funds : Having been authorized to inspect mutual funds, SEBI
has undertaken inspection of some mutual funds, pointed out deficiencies of individual
funds in the inspection reports, and corrective actions have been taken to set them right.

Regulation of merchant banking : Since merchant banking is statutorily under the

regulatory framework of SEBI, they are not only to be authprized by SEBI, but also to
 Regulation of Capital Market
adhere to the capital adequacy norms and to abide by a code of conduct specifying
responsibility towards inspectors in respect of pricing and premium fixation of issues.
2
Guidelines for entry norms and for companies accessing capital market : In April,
1996, SEBI issued guidelines for entry norms for companies accessing capital market
to the effect that such companies should have a track record of dividend payment for a
minimum of 3 years out of the immediate preceding 5 years. In case a manufacturing
company does not have such a track record, it can access the public issue market
provided the projects have been approved by public financial institutions or any
scheduled commercial bank, and such apprqising entity is also participating in the
project fund.

Buyback of shares : The provisions of the Companies Amendment Act under Section
77 and 77B allowing companies to buy back their shares and the conditions stipulated
are also subject to regulations and guidelines laid down by SEBI.

Collective Investment Schemes (CIS) : In October 1999, SEBI notified regulations

for collective Investment Schemes (CIS) including any scheme or arrangement with
respect to property of any description which may enable investors to participate in the
scheme by way of subscriptions and to receive profits or income or produce arising
from the management of such property. Under the SEBI regulations, no person can
carry on any CIS unless he obtains a certificate of registration from SEBI.

Compulsorily rolling settlement and derivatives trading : In 2000, keeping in line

with international best practices, SEBI introduced compulsory rolling settlement in
scrips and trading in derivatives.

Centralised internet based filing system : In 2002, SEBl launched the Electronic
Data Information Filing and Retrieval System (EDIFRS) website at the same time as
they submit it to the exchange. The system is aimed at providing investors
simultaneous, one-point access to key information on all listed companies.

Posting all orders against errant companies and others on website : From July
2002, SEBI decided to post all orders passed by its Chairman against errant companies
ind market intermediaries on its website so as to provide such useful information to the
investors.

Takeover code and amendments thereto : Several amendments have since been
made in the takeover code, such as bringing preferential allotment under the ambit of
takeover code. So as to stop the practice of promoters making preferential allotments
to avoid making an open offer to other shareholders Acquirers are also required it
disclose their holdings more frequently which may increase transparency.

11.5.3 Amendment of SEBI Act in 2002

Certain key changes have been made in the SEBI Act, 1992 so as to provide adequate
powers to SEBI to perform its regulatory role more effectively.

1 Power of search and seizure : Under the amended provisions of the SEBI Act, the
Board's officers may be armed with a search warrant from a judicial magistrate,
and they can search any market player's premises and also seize documents.
Earlier, a SEBI officer could only ask an entity for specific documents which
allowed concealment of incriminatipg documents.

Financial Markets,and their
Regulation
*
2 Power to freeze bank accounts : In course of investigating transactions, SEBI is
now empowered to impound cash proceeds and securities connected with any
transaction. With authorization from a judicial magistrate, SEBI can also freeze
bank accounts for duration of one month of any person or entity involved in market
violation.
3 Power to impose higher penalties : The limit of fine which can be imposed by
SEBI has been substantially raised. Earlier, it was only Rs. 5 lakh. Now, for
market manipulation and insider trading, the maximum fine which can be imposed
is Rs. 25 crore or three times the profits made by he entity concerned. For other
\
violations like non-disclosure, the maximum monetary penalty can be upto Rs. I
crore.
4 Increase in board membership : The strength of the SEBI Board has been
increased from six to nine including three whole-time directors (excluding the
chairman). The number of member of the Securities Appellate Tribunal (SAT) has
also been increased from one to three. The objective of strengthening the Board
and SAT is to reduce the possibility of error of bias of an individual or a small
group.
Check Your Progress C
1 State a few important items to which the provisions contained in the bye laws may
relate to .
...................................................................................................
2 Is registration for brokers, sub-brokers etc with SEBI compulsory for deal in
securities at the stock exchange ? If so, are there any exceptions to it?
...................................................................................................
...................................................................................................
3 Enumerate the key changes made in the SEBI Act in 2002.
...................................................................................................
11.6 REGULATION OF CORPORATE TAKEOVERS
Combination or merger of enterprises in which one acquires the assets and liabilities of
another in exchange for cash or shares andlor debentures is generally known as merger
through acquisition, absorption or takeover. This is widely regarded as a strategy of
external growth. It may involve a cooperative friendly approach on the part of the
combining firms, or take place through a bid to take over of one firmby another with a
hostile approach. Thus, a friendly merger results in a negotiated acquisition of one
firm by another, while a hostile merger or takeover involves one firm acquiring control
over another against the will of its management generally by way of purchasing a
sizable number of shares of the target company in the open market.
 Regulation of Capital Market
In 1983, some instances of takeover bids in India made headlines due to the technical
and legal issues involved. For example, an attempt was made by a London based
industrialist, Swaraj Paul, to buy shares in DCM and Escorts, making a bid for
takeover of the management of the two companies. The purchase of shares was
apparently encouraged by the Non-resident Investment Scheme announced by the
Union Ministry of Finance, of which one implication was the possible destabilization
of the existing management of corporate enterprises, and the other possibility being that
of foreign multinationals making inroads in the Indian market. The Company Law
Board stepped in to prevent this takeover bid. Another case of a takeover bid came to
light in 1985 when R. G. Shaw & Co., UK, which held shares in Shaw Wallace & Co.
in India, was sold to a Hong Kong based company (Carrasco) controlled by a non-
resident Indian, Manu Chahabria. There was again apprehension that the management
of Shaw Wallace & Co. would be destablished. However, in this case, the Company
Law Board held that shares of Shaw Wallace had not actually been transferred, and
there was no case of intervention.

Usually it is expected that profitable growth companies would mainly attract takeover
bids. But, quite often, various other considerations underlie the decision of company to
go in for takeover of other companies. The benefits expected to be derived are : (a)
economies of large scale operation; (b) diversification of activities for stability and
higher profits; (c) securing necessary working plant and equipment more quickly than
building up capacity internally and also to secure access to scarce raw materials and
distribution network; (d) possibility of easy market in the context of competition
involving product differentiation and the operating efficiency and financial resources of
competitors; and (e) acquiring requisite managerial competence to implement the
growth process.

11.6.1 Prevention of Secret Takeover Bids

The Government of India amended Clause 40 of the Listing Agreement of companies

with stock exchanges in May 1990 so as to prevent clandestine takeover bids by any
company as also to protect the interest of minority shareholders. The amended clause
stipulated under Clause 40A that if any person acquired or agreed to acquire shares of a
company while the nominal value of shares already held by such persons exceeded the
aggregate 5 per cent of the voting capital of the company, the stock exchange must be
notified within two days of such acquisition or agreement for acquisition by the
company, by the authorised intermediary and also by the acquirer. It w3s also
stipulated that when any person held shares which, in the aggregate, carried less than
10 per cent of the voting rights in the company, he should not acquire any share
which, when aggregated with the shares already held by him, would carry 10 per cent
or more of the voting rights unless he notifies the stock exchange and fulfilled the
conditions specified in Clause 40B. Furthe.r, the company must notify the stock
exchange within 7 days any information which had an effect on its assets and liabilities
or financial position or on the general course of its business leading to substantial
movements in the price of the shares and in particular information about transactions
mentioned above.

Under Clause 40B of the amendment, it was provided that whenever a takeover bid was
made to a company, or by a company, whether voluntarily or compulsorily, a public
announcement to that effect must be made both by the offeror company and the offeree
company. If the offer was made by a person other than the ultimate offeror, the
identity of such other person must be disclosed at the outset in the public
announcement as also in the notification to the stock exchange. The offer with all
Financial Markets and their particulars in detail should be placed in the first instance before the Board of Directors
Regulation
of the offeror company. All information relating to the offer must be made available to
all the shareholders of the offeror company and the offeree company at the same time,
and also lodged with the SEBI.

Another stipulation was that the offeror company should, either before or immediately
after making the offer to the offeree company, make an offer to the remaining members
of the offeree company to purchase their shares at a price not lower than the highest
price during the immediately preceding six months or the negotiated price. The offer to
the remaining shareholders should be to acquire them an aggregate minimum of 20 per
cent of the total shares of that company. However, such offer must not result in the
public shareholding being reduced to less than 20 per cent of the voting capital of the
company, subject to the colidition that from each of the shareholders accepting such
offer, the acquirer must acquire his full holding up to 100 shares of Rs. 10 each or upto
10 shares of Rs. I00 each.

11.6.2 Takeover Code as Modified by SEBI

Takeover of companies was regulated by listing agreements with stock exchanges

under the amended Clause 40, as discussed above, till 1994 when SEBI was
empowered to regulate takeovers under the SEBI (Substantial Acquisition of Shares
and Debentures) Regulations. The primary objectives of the regulation were to make
the takeover process transparent and to protect the interest of minority shareholders. In
February 1997, SEBI adopted a modified takeover code to strengthen the regulations,
based on he recommendations of a Committee with former Justice P. N. Bhagwati as
Chairman (Bhagwati Committee). Under the modified Takeover Code, the "acquirer"
and persons "acting in concert" have been defined to cover direct as well as indirect
acquisitions i.e., acquisitions by mutual funds, their sponsored asset management
companies and trustees, foreign institutional investors and banks, financial advisors and
stock brokers.

The major provisions of the Takeover Code are as follows :

1 Any acquirer holding more than 5 per cent of the shares in a company must
disclose the shareholding to the company and all stock exchanges where the scrip
is listed.
2 It is mandatory for the acquirer to make a public offer when the holding of 10
percent of equity is crossed and there is change in control.
3 For the purpose of consolidation of holdings, acquirers holding not less than 10 per
cent but not more than 51 per cent equity are allowed 'creeping acquisition' upto 2
per cent in any period of 12 months. Any purchase for a holding of more than 51
per cent will have to be in a transparent manner through a public tender offer.
4 An acquirer, including persons presently in control of the company, should make a
public offer to acquire a minimum of 20 per cent in case the conditions for
mandatory public offer are valid.
5 SEBI is not to be involved in the pricing of the offer. Pricing hill be based on
parameters such as the negotiated price, average of the high and low prices for 26
weeks before the date of average of the high and low prices for 26 weeks before
the date of the public announcement, highest price paid by the acquirer for any
acquisition during 26 weeks period before the date of public announcement, and
the price of preferential offers, if any.
 Rqulrtion o f ~ r p G r Market
l
6 The 'Chain Principle' will be applicable requiring a public offer to be made to
shareholders of each company when several companies are acquired through the
acquisition of one company.
7 Disclosure requirement would include disclosure of additional details on financial
arrangement for implementing the offer, future plans of the acquirer of the target
company, etc. Misleading information will be deemed to be a violation of
disclosure requirement and attract penal action.

r
8 Conditional offer is allowed subject to either a mandatory acceptance of 20 per
cent equity with differential pricing, or with a deposit of 50 per cent of the value of
the offer in cash to be deposited in an escrow account, in cases where the bidder
does not want to be saddled with the 20 per cent acquisition.
9 During the offer period , the board of the target company is precluded from
inducting any person belonging to the hcquirer, or transfer shares in his name until
all formalities relating to the offer have been duly completed.
The above provisions to a great extent, ensured the necessary transparency and
protection of investors in case of takeover bids.

11.7 LET US SUM UP

Along with the growth of Indian capital market in terms of the number and size of
security issues and the daily turnover and market capitalization of stock exchanges,
certain negative features have also continued to plague the capital market operations.
Some of the major disquieting aspects have been, high volatility in respect of a small
proportion of scrips and poor liquidity in respect of a vast majority of scrips,
manipulation of share prices to the detriment of gullible investors, delay in allotment of
shares creating an artificial scarcity in the market, insider trading, preferential allotment
of shares to promoters/associates at a substantial discount to the prevailing market
price, 'front running' by brokers and sub-brokers acting with scant regard to investors'
interest, and inordinate delay in admitting securities for trading in stock exchanges, and
SO on.

Before establishment of SEBI, the main laws governing the capital market were the
Capital Issues Control Act, 1956 for regulating the primary market and Securities
Contracts (Regulation) Act for regulating the secondary market. In April 1988,
however, SEBI was set up to look after the investors' interest in both the markets.
Meanwhile, the Capital Issues Control Act had been repealed and the Companies Act
amended to make SEBI the administrative authority for regulating capital issues, and
the government transferred its power under SCR Act to SEBI to regulate the stock
market. Thus, SEBI was entrusted with the main responsibility of adopting suitable
measures for protecting investors' interests in securities.

Regulation of Public Issue of Capital

SEBI released its Guidelines for Capital Issues of June 1992, which are applicable to
all public issues of capital by listed and unlisted companies including offers for sale
and the rights issues. These guidelines (as amended till September, 2005) are as
-
follows:

Eligibility norms : The companies issuing securities through an offer document shall
ensure that a draft prospectus is filed with SEBI through an eligible merchant banker at
least 21 days prior to its filing with ROCs. The same thing applies to a letter of offer in
case of rights issue. The company is also to make an application for listing of the
Financial Markets and their securities to be issued, and enter into an agreement with a depository for
Regulation
dematerialisation of the securities.

An unlisted company can make an initial public offer (IPO) of securities subject to
certain conditions such as having net tangible of Rs. 3 crore and track record of
distributable profits, and a minimum net worth as specified, and so on. Similarly, for a
listed company to m a k ~public issue, the size of the proposed and previous issues must
not exceed 5 times of its pre-issue net worth, otherwise the company must meet the two
conditions of minimum tangible assets and distributable profits as laid down with
respect to unlisted companies making an IPO. However, these norms are not
applicable to banks and rights issue by a listed company and an infrastructure
company if certain conditions are met.

Unlisted companies cannot make a public issue of equity shares or convertible

debentures if there are outstanding financial instruments or any other right whereby
promoters rnay be entitled to receive equity shares after the IPO; and no public issue
can be made of equity shares unless the existing partly paid-up shares are fully paid up
or forfeited

Pricing of Securities : Both listed and unlisted companies may freely price the
securities while making a public issue, and such securities may be issued to applicants
in the firm allotment category at a price different from the price at which the net offer
to the public is made provided the former is higher than the latter. Companies have
also the freedom to determine the denomination of equity shares issued subject to the
provisions of the Companies Act and in compliance with the norms as specified by
SEBI and so also of splitting or consolidating the existing shares.

Promoters' Contribution/Shareholding : In a public issue by an unlisted company,

the promoters have to contribute not less than 20 per cent of the post-issue capital. For
listed companies, the promoters may either participate to the extent of 20 per cent of
the proposed issue or ensure post-issue shareholding to the extent of 20 per cent. If the
promoters' participation is in excess of the required minimGm contribution, it will be
treated as preferential allotment and attract the pricing provisions of the guidelines on
preferential allotment. There is also a lock-in requirement of 3 years for their share.
However, the requirement or promoters' contribution is not applicable in case of public
issue of securities listed on a stock exchange for at least 3 years and the company has a
track record of dividend payment for at least 3 preceding years.

Pre-Issue Obligations : The lead merchant banker must exercise due diligence, pay
the requisite fee and submit (i) MOU entered into between the lead merchant banker
and the issuer company, (ii) Inter-se allocation of responsibilities demarcated as per
schedule I[of SEBI Guidelines, and (iii) Due Diligence Certificate along with the offer
document filed with SEBI. In addition, the lead merchant'banker is also to furnish
certificates as per Schedule IV, V and VI. The issuer company has also to submit a list
to the Board of the persons who constitute the promoters' group and their individual
shareholding etc. Lead merchant banker is also to ensure compliance with all
regulations as regards appointment of other intermediaries, satisfy itself about the
ability of the underwriters to discharge their obligations, and ensure inclusion of
relevant details in the offer document.

The draft offer document is required to be made public for a period of 21 days, and the
lead merchant banker is also to file the document with the concerned stock exchanges
and make its copies available to the pubhi. The issuer company has to make an
 Regulation of Capital Markc
advertisement in English, Hindi and regional language newspapers containing
disclosures as given in Part A of Schedule XXA of the SEBI Guidelines.

The lead merchant banker must ensure that offer document and other issue materials
are despatched in advance to stock exchanges, brokers, underwriters, bankers to the
issue and investors associations. A statementiis required to be filed with the Board by
the lead merchant banker after 21 days from the date the offer document was made
public giving a list of complaints received and amendment, if any, proposed to be made
in the document.

The issuer company may appoint any number of centres as it may deem fit subject,
however, to the minimum requirement in this regard. It may also appoint authorised
collection agents in consultation with and at the discretion of lead merchant banker
subject to necessary disclosures in the offer document. In addition, it is to appoint a
compliance officer who will directly liaise with the Board on all matters regarding
compliance with various laws, rules and regulations, etc. Every application form must
be accompanied by a copy of the abridged prospectus.

Post-issue Obligations : Post-issue monitoring reports must be submitted as per

format specified in Schedule XVI of the Guidelines. This is to be ensured by the post-
issue lead merchant banker irrespective of the level of subscription and in accordance
with the due dates specified. The post-issue lead merchant banker is to actively
associate with post-issue activities, viz., allotment, refund and despatch, regularly
monitor redressal of investor grievances arising thereform, and maintain close
coordination with the registrars of the issue. He has to satisfy himself that the public
issue is fully subscribed before its closure is announced, and ensure that the
underwriters honour their commitments in case of devolvement, and that the money
collected on the issue is released only after the listing permission has been obtained
from the relevant stock exchanges.

A post-issue advertisement must be released giving details regarding oversubscription,

basis of allotment, number, value and percentage of successful allottees, dates of
despatch of refund orders and certificates, and date of filing of listing application. It
must be ensured that the basis of allotment is finalised in a fair and proper manner as
C
specified in the SEBI. Guidelines, and that despatch of share certificates 1 refund
orders and demat credit as also submission of allotment and listing documents to the
r
stock exchanges are completed within two working days of the finalisation of the basis
of allotment.

Other requirements : In case of public issue of non-convertible and convertible debt

securities, the lead merchant banker is to ensure compliance with the SEBI Guidelines
2000 (as revised from time to time, relating to NCDS and DSCE including conditions
specified under Rule 19(2) (b) of Securities Contracts (Regulation) Rules, 1957 which
provides for minimum net offer to the public and the limits of reservations and firm
allotments to various categories of persons. However, the unlisted company can make
an application to the Board for relaxation from applicability of this Rule and for IiSting
of its shares without making an initial offer provided it satisfies the prescribed
conditions. The companies are also permitted to issue new financial instruments such
as zero coupon bonds, warrants, deep discount bonds, etc. subject to certain
conditions.

SEBI guidelines also provide for detailed requirements related to minimum application
value, total period within which the calls are to fall due, minimum period of
ioancial Markets and their subscription to be kept open, the period to which audited statements contained in the
egulntion
offer document should relate, appointment of the compliance officer, the limit of
minimum subscriptioq~arrangement,monitoring the'use of the proceeds of the issue,
safety for buy back qfrangement, etc.

In additions, detailed guidelines are laid down by SEBI on green shoe option, employee
stock option scheme, book building, issue of debt instruments, e-IPO, preferential
issues, bonus, issue, etc.

Regulatory Framework for Controlling Stock Market Operations

To regulate and control stock market operations in wider interest of investors, the SCR
Act was passed in 1956. It provides for recognition of stock exchanges, general control
over their trading methods and practices, regulation of contracts and options in
securities, and listing of securities by public companies. In 1957, when the Act came
into effect, detailed rules were also framed for the purpose. Originally, the powers of
its administration vested with the Central Governments. But after SEBI was
constituted, most of these powers were transferred to SEBI.

For grant of recognition, a stock exchange is to make an application to SEBI

accompanied by a copy of bye-laws of the exchange and a copy of the rules relating to
its constitution. The grant of recognition is subject to a number of conditions
prescribed for the grant of recognition.

Every stock exchange must have rules regulating the voting rights of members in .
respect of matters to be placed before the stock exchange. These rules must have the
approval of the Central Government / SEBI and then published in the official Gazette.
Similarly, subject to previous approval of SEBI, the recognised stock exchange can
make necessary bye-laws for the regulation and control of contracts.

Every stock exchange is required to furnish the Central Government with a copy of its
annual report and prescribed periodical returns, and make its books account and
documents available for inspection by SEBI. SEBI can also order an enquiry in
relation to the affairs of the governing body or any member of the exchange. The
Government has the power to superside the governing body for a specific period and
also to suspend the business of a stock exchange for a short period, if need be.

Normally a company is not obliged to get its shares listed unless it is making public
issue. However, a company may be compelled by SEBI for listing of its securities on a
recognised stock exchange if it is necessary and expedient to do so in the interest of
trade or in the public interest. Where a company applies for listing and the stock
exchange refuses to list the securities, the company is entitled to be furnished with
reasons for such refusal, and it may appeal to the Central Government ISEBI against
such refusal. The shares of a company can also be delisted for various reasons, and
when it happens, this fact must be disclosed in Director's Report with a statement of
reasons for the same. There is also a provision for reinstatement of delisted securities
with a period of one year after of delisting.

The role of SEBI as regulator of capital market operations may be stated in the light of
the various measures adopted over time, viz., registration of intermediaries; inspection
of stock exchanges to improve their functioning; measures aimed at strengthening
investor interest and confidence in the secondary market; enforcing regulations
 Regulation of Capital Market
providing trade guarantee by stock exchanges; compulsory settlement of trades
through depositories; inspection of mutual funds; regulation of merchant banking; issue
of guidelines for entry norms for companies accessing capital market; regulating buy
back of shares and collective investment schemes; introducing compulsory rolling
settlement and derivatives trading; launching centralised internet based.filing system;
posting all orders against errant companies and others on website; adopting a takeover
code to regulate corporate takeovers; etc.

Certain key changes had been made in 2002 in the SEBI Act so as to provide adequate
powers to SEBI to perform its regulatory role more effectively, These include power of
search and seizure, power to freeze bank accounts, power to impose higher penalties,
and increase in Board's membership.

Regulation of Corporate Takeover

Corporate mergers through acquisition, absorption or takeover is widely regarded as a

strategy of external growth. It may involve a friendly approach or take place through a
bid to takeover with a hostile approach. Usually, the profitable growth companies are
expected to attract takeover bids. But, various other considerations and the benefits to
be derived from merger also underlie the decision of companies to go in for takeover of
other companies.
8

The Government of India amended Clause 40 of the Listing Agreement of companies

with stock exchanges in May 1990 to prevent clandestine takeover bids by any
company as also to protect the interest of minority shareholders. The amended clause
inter alia, provided for a public announcement of the takeover bid and making all
information relating to offer available to shareholders of both offeror and offeree
companies and also lodged with SEBI. Another stipulation related to the offeror
company making an offer to.the members of the offeree company to purchase their
shares at a negotiated price. In 1994, SEBI was empowered to regulate takeover under
SEBI (Substantial Acquisition of Shares and Debentures) Regulations. In February
1997, SEBI adopted a modified takeover code to strengthen the existing regulations.
Its major provisions include : anyone holding more than 5 per cent of the shares of a
company must disclose the shareholding to the company and all stock exchanges
L
concerned; the acquirer must make public offer when the holding of 10 per cent equity
is crossed and there is change in control; any purchase for a holding of more than 51
per cent will have to be in a transparent manner through a public tender offer;
disclosure requirements as specified must be implemented; the board of the target
company is precluded from inducting any person belonging to the acquirer of transfer
shares in his name until all formalities related to the offer have been duly completed.
These provisions have ensured, to some extent, the transparency and protection of
investors' interest in case of takeover bids.

11.8 KEY WORDS

Buy-Back Arrangement : A company buying its own shares and other specified
securities out of its free reserves, securities premium account or the proceeds of any
shares or other specified securities as per the provisions of Section 77A of the
Companies Act.

Composite issue : An issue of securities by a listed company on a public cum rights

basis offered through a single offer document wherein the allotment for both public and
rights components of the issue is proposed to be made simultaneously.
r~nancialMarkets and their Coupon Rate : The stated rate of interest on a bond or debenture.
Regulation

Deep Discount Bonds : Bonds issued at low values with a long maturity period when,
on account of compound interest, they fetch an extremely high amount. ICICI and
IDBI had issued such bond at Rs. 5 100 15300 to become Rs. 2,00,000 after 28/25 years
respectively with a call option exercisable on the expiry of 5 years.

Due Diligence : It is an exercise carried out generally by an expert to assess benefits

and problems of a proposed project, issue or acquisition based on enquiries documents
and other verifiable procedures to avoid bad buys.

Employees Stock Options : The options given to the whole-time directors, officers or
employees of a company to purchase or subscribe at a future date the securities offered
by the company at a pre-determined price.

E-IPO : Initial public offer through online system of the stock exchange for offer of
. securities.

Green Shoe Option :An option of allocating shares in excess of the shares included in
the public issue and operating a price listing price stabilizing mechanism (an option to
retain over-subscription).

Lock-in Period : The period within which shares and other securities cannot be
transferred by sale or otherwise.

Near Banks : These refer to financial institutions like that offer more specialised
services.

Retail Individual Investor : An investor who applies or bids for securities of a value
of not more than Rs. 1,00,000.

Reverse Merger : A situation wherein a small firm acquires a larger firm although
the former may be loss making while the later is the profit maker. May be it is
motivated for exploiting tax benefits.

Sweat Equity Shares : Equity shares issued by a company to its promoters, directors
or employees at a discount or for consideration other than cash. They may be issued
for providing know-how or making available intellectual property right or value
additions by whatever name called.

Takeover Bid : A bid to takeover which involves acquiring the control over another
company against the will of its management generally by way of purchasing a sizable
number of shares of the target company.

Warrants : A warrant is an option to the investor to buy a specified number of equity

shares at a specified price over a specified period of time.

Zero Coupon Debentures / Bonds : These are bonds sold at a large discount on the
nominal value. Their maturity period varies from 5 to 12 years when they are
redeemed at par. They were first issued by Mahindra and Mahindra Ltd. Since the
investor is not entitled to any interest on these bonds, the conversion price is suitably
adjusted to take care of interest loss to investors.
I

Regulation of Capital Market

11.9 ANSWERS TO CHECK YOUR PROGRESS
A 3 (a) third (b) 5 (c) unpublished (d) liquidity (e) Companies
B 4 (a) True (b) True (c) True (d) False (e) True (f) False

11.10 TERMINAL OUESTIONS

1 Why has it been necessary for Government of India to initiate capital market
r reforms and regulatory measures in the recent past ? isc cuss.
I 2 "SEBI has been entrusted with the main responsibility to adopt suitable measures
rt for protecting the interest of investors in securities and promoting the development
I
and regulation of stock market". Discuss.
3 . What are the conditions required to be fulfilled by (a) a listed company and (b) an
unlisted company to be eligible to make a public issue of shares as per SEBI
Guidelines?
4 State SEBI Guidelines in respect of following
(a) Underwriting
(b) Pre-issue advertisement
(c) Differential pricing
(d) Basis of allotment
5 State the SEBI Guidelines with respect to promoters' contribution in a public issue
of securities by (i) a listed company, and (ii) and unlisted company. Also state the
lock-in requirement in respect thereof.
6 ~ i sand
t state the nature of documents required to be filed by the lead manager with
SEBI alongwith the offer document for a proposed public issue of securities.
7 Discuss the post-issue obligations of the lead merchant banker to the public issue
of shares
8 (a) Explain briefly the provisions of Rule 19(2) (b) of Securities Contracts
(Regulation Rules, 1957).
(b) Outline the requirements related to the terms of issue under other issue
requirements relating to public issue of securities.
9 State the objectives underlying the Securities Contracts (Regulation) Act, 1956,
and the powers granted to Central Government to achieve these objectives.
10 What is the procedure laid down in the Securities Contract (Regulation) Act for
recognition of stock exchanges ? State the main requirements to be fulfilled for
grant of recognition.
1 1 Can SEBI compel a public company to get its securities listed on stock exchanges
while making a public issue ? On what grounds can the listed securities be delisted
by a stock exchange ? Explain the rules in this regard.
12 State the measures adopted by SEBI at strengthening investors' interest and
confidence in the stock market.
13 Discuss the role of SEBI in controlling stock market operations as reflected in the
measures adopted by it towards that end.
14 Write an explanatory note on regulations governing takeover bids by companies,
and state the main features of the Modified Takeover Code adopted by SEBI.
Financial Markets and their
Regulation
15 Write short notes on
(a) Rules of Stock exchanges
(b) Bye-laws of Stock Exchanges
(c) Licensing of Dealers in securities
(d) New Debt Instruments

I~ o t :e These questions will help you to understand the unit better. Try to write
1 answers for them, but do not submit your answers to the university for I
assessment. These are for your practice only. 1
-- -

UNIT 12 INVESTORS' PROTECTION AND

CORPORATE GOVERNANCE
Structure

Objectives
Introduction
Need for Investors' Protection
Protection of Investors' Interests - An Overview
Concept of Corporate Governance
Broad Objectives of Corporate Governance
Accountability as the Key to Good Corporate Governance
Requisites of Good Corporate Governance
Steps taken for Good Governance
Corporate Governance Code under Clause 49
Provisions under Companies (Amendment) Act, 2000
Renewed Challenges
Let Us Sum Up
Key Words
Answers to Check Your Progress
Terminal Questions

12.0 OBJECTIVES
After studying this unit you should be able to :
appreciate the need for investors' protection;
identify the provision made in various acts for investors' protection and the role of
SEBI in this regard;
explain the concept of corporate governance;
state the broad objectives of cotporate governance;
emphasise on accountability as the key to good governance;
outline the requisites of good governanqe;
identify steps taken to ensure good corporate governance;
explain the requirements of Corporate Governance Code and Clause 49 of the
listing agreement;
state the relevant provisions of the Companies (Amendment) Act, 2000; and
identify the new challenges with respect to good corporate governance.

12.1 INTRODUCTION
The growth of India's capital market, after the reformist economic policies announced
in 1 99 1, has brought about increasing awareness of investment opportunities and
interest in stock market operations among the general public. More than that, a sizable
number of individual investors who earlier shied away from the securities markets and
trusted bank deposits and post office savings schemes, have shown a marked
Financial Markets and their preference for investment in corporate securities (shares and debentures). This
Regulation
preference is partly attributable to growing awareness of new long-term investment
opportunities in the securities market and partly due to the facility of electronic trading
system across the country, introduced by NSE and followed by BSE. However, many
retail investors have suffered due to unhealthy speculation in stock markets,
manipulation of operations-and unfair dealings in securities on the part of promoters.
It is observed that the interest of minority shareholders and individual investors is often
ignored by promoters1 directors of companies so as to serve their personal interest.
Thus, while investors' protection is called for against manipulative practices in
securities transactions, it is also linked with good corporate governance involving
corporate responsibility and directors' accountability to the stakeholders.

You have learnt about the regulatory framework for controlling the operations at the
stock exchanges and SEBI's role in this context in Unit 11. In this unit you will learn
about the need for investors' protectidn, the role of SEBI in building investors7
awareness and handling their grievances, and the concept of corporate governance, its
role in strengthening investors confidence and the steps taken to ensure good corporate
governance. In addition, you will learn the details of Corporate Governance Code
under Clause 49 of the listing agreements, provisions of the Companies (Amendment)
Act, 2000, and the renewed challenges in this context.

12.2 NEED FOR INVESTORS' PROTECTION

Individual investors including small investors generally come to know about
investment opportunities in corporate securities from write ups in business newspapers
and financial journals. They may subscribe to initial public offers of debtlequity on the
basis of newspaper reports or on the advice of brokerslcommission agents, and invest
in existing shares on the basis of market trends, their track record, dividend payment,
etc. These investors need to be protected against losses that they are likely to suffer on
account of lack information and various lacunae, lapses, and malpractices in the
securities market. The more important of these are given below.
1 Public issues of shares by companies are often announced with attractive prospects
of dividend distribution and growth which may be exaggerated, if not misleading.
Promoters of greenfield companies are often able to allure gullible individual
investors due to their inability to judge the credibility of the prospects.
2 Public issues of shares by existing companies are known to attract subscription on
the basis of track record of the concerned enterprise. Past performance is usually
reflected in the financial statements of the company which, in many cases, are
lacking in transparency. Fresh issue of equity may be linked with expansion
projects which involvg risks of loses on account of uncertainties in future..
3 Investors are mostly attracted by the rising security prices and invest in shares of
listed companies to derive the benefit of capital appreciation over time. But, such
trend may not persist as prices are highly sensitive and are subject to wide
fluctuations. Not only that, the stock market quotations do not usually reflect the
intrinsic value of existing shares.
4 There are many listed companies having less than 100 public shareholders. Some
of these companies are sold, sometimes at a huge premium for reverse mergers,
whereby an unlisted company may be listed without having to make a public issue.
In such cases, promoters may manipulate share prices during bull runs and sell
their holdings to small investors at highly inflated price.
 Investors Protection and
5 Deficiencies in corporate governance also affect investors' interest, transparency in Corporate Governance
financial reporting and accountability of directors with respect to their
responsibility towards minority shareholders and small investors.
6 Above all, there is the retail investors' ignorance about their rights as shareholders,
absence of due diligence in the matter of financial and legal implications of
corporate shareholding, and delay in the redressal of investors' complaints and
grievances.

12.3 PROTECTION OF INVESTORS' INTERESTS - AN

OVERVIEW
In order to protect investors' interests, a variety of provisions have been made in the
Companies Act, the Securities Contracts (Regulation) Act and the,SEBI Act. The
Companies Act, for example, contains provisions in respect of issue of capital,
appointment of managerial personnel, limits on managerial remuneration, disclosure of
important information, special audit, inspection and investigation, protection of
minority interests, etc. The Securities Contracts (Regulation) Act provides for the
recognition of stock exchanges, general control over their trading methods and
practices, regulation of contracts in securities, listing of securities, etc. As for SEBI, it
was set up as a rion-statutory body in 1988 to regulate the capital market. It became a
statutory board under SEBI Act in 1992 and has been made the administrative authority
for enforcement of the provisions of the Companies Act with respect to several aspects
of capital issues. It has issued SEBI (Disclosure and Investor Protection) Guidelines
which are applicable to all public issues of capital and offers of sale by listed and
unlisted companies.

You have learnt about the above measures in Unit 1 1 . However, SEBI plays a much
wider role in protection of investors. It has been taking up a number steps to educate
the investors through various programmes such as SMAC (Securities Market
Awareness Campaign) which conducts workshops all over the country to acclimatise
the investors with the functioning of the securities market, preparing a standardised
reading material and audio-video clips on topics concerning investors, placing an
investor website (http ://semi investor.gov.in), setting up a simple and effective internet
based response to investors' complaints, and issuing advertisements relating to various
aspects of securities market. Another important activity of SEBI relates to taking up
investors' grievances on matters related to IPOs and capital market operations against
the intermediaries registered with it and get them redressed, and undertake
investigation in respect of issue related and market related matters such as market
manipulation, price rigging issue related manipulation, insider trading, takeovers, etc.
Thus, the investors are getting adequately educated and protected in primary and
secondary markets. Of course, a lot more still retrains to be done and there is need for
further strengthening the hands of SEBI with more legal and judiciary powers.
powers in this regard.

Check Your Progress A

1 State any three reasons emphasising the need for investors' protection.
...................................................................................................
klnnncial Markets and their 2 State any three steps taken by SF.$3I to educate the investors.
Regulation
...................................................................................................

3 Fill in the blanks.

(a) Public issues of shares are often announced with attractive prospects of
dividend distribution and which may be exaggerated, if not
misleading.
(b) The stock market quotations do not usually reflect the value of
existing shares.
(c) SEBI, under SEBI Act, has been made the administrative authority for
enforcement of the provisions of the Companies Act with respect to several
aspects of
(d) There is need for strengthening the hands of SEBI with more legal and
powers to protect investors' interest in securities market.
(e) Deficiency in corporate governance also affect transparency in financial
reporting and accountability of with respect to their
responsibility towards minority shareholders and .................investors.

12.4 CONCEPT OF CORPROATE GOVERNANCE

Corporate governance is another important concept related to inspiring and
strengthening investors' confidence by ensuring transparency in functioning and
reporting, and accountability and fairness to investors' interests besides respecting the
aspirations of multiple stakeholders including that of the society. Let us now
understand this concept and its basic features.

Given a narrow interpretation, corporate governance may be defined as the

accountability of senior management towards the shareholders. In a wider sense,
however, corporate governance may be said to include the entire network of
interactions in the corporate sector and its impact on the society as a whole. In the
present day context, the concept of corporate governance hinges on complete
transparency, integrity and accountability of the corporate management with a focus on
public interest and investor protection. It connotes a blend of rules, regulations, laws
and voluntary practices that enable companies to attract financial and human capital,
perform efficiently and, thereby, maximize long term value for the shareholders besides
respecting the aspirations of multiple stakeholders including that of the society. Thus,
it refers to a system by which companies are directed and controlled keeping in view
the long term interests of its stakeholders, viz., shareholders, employees, creditors,
customers and society.

Corporate governance was officially taken up as in issue in UK in 1990 as a result of a

series of business scandals in the late 80's which included public outrage at the
plundering of pension funds of Maxwell Communication Group, at the failure of
auditors to expose the impending bankruptcy of Bank of Credit and Commerce
International, and at the apparently underserved high pay raises of senior business
executives. A Committee headed by Sir Adrian Cadbury was appointed in 1991 to
recommend a code of good corporate governance and suggest ways and means to
ensure its compliance. The Cadbury Conimittee report mainly dealt with aspects of
financial transparency and the related role of directors and auditors. In USA, the Blue
Ribbon Committee on Corporate Governance also reported on similar lines.
--

Investors Protection and

The code of corporate governance cannot be identical for all countries. However, the Corporate Governa~ce
basic principles related with the concept of good governance, according to Sir Adrian,
are more or less valid for business corporations in every country. These include clear
responsibilities, a precise distinction between direction and management, check and
balances in the governance structure, effective financial control and transparency,
accountability and fairness to all stakeholders, and social and environmental concern.

12.5 BROAD OBJECTIVES OF CORPROATE

- GOVERNANCE

Analytically, the objectives of corporate governance may be considered from the

private and public perspectives. From the perspective of a company, corporate
governance is expected to be concerned with maximising value subject to the
company's financial, legal, and contractual obligations. The focus is on the
responsibility of the board of directors to balance the interest of shareholders with those
of the other stakeholders in order to achieve long-term sustained value for the
company. From the public perspective, corporate governance should involve nurturing
enterprises while ensuring accountability in the exercise of power and patronage of
firms. The role of public policy should be to provide incentives and enforce discipline
to minimize divergence between private and social returns and to protect the interest of
all stakeholders.

According to the Birla Committee on Corporate Governance, a committee appointed by

SEBI and headed by Kumar Mangalam Birla, the fundamental objective of corporate
governance is the enhancement of long-term shareholder value while protecting, at the
same time, the interest of other stakeholders.

Generally speaking, therefore, the broad objectives of corporate governance are: (a)
compliance with laws, (b) good performance, and (c) accountability with a view to
enhance long term shareholders' value by ensuring company's commitment to higher
growth and profits while protecting interests of other stakeholders.

12.6 ACCOUNTABILITY AS THE KEY TO GOOD

CORPORATE GOVERNANCE
There are three vital elements of corporate governance, viz., accountability,
transparency and equality of treatment of all stakeholders. Of these, accountability is
recognised as the key element of good corporate governance. Kumar Mangalam Birla
Committee on corporate governance had also observed that, "A system of good
corporate governance promotes relationships of accountability between the principal
actors of sound financial reporting - the board, the management and the auditor. It
holds the management accountable to the broad and the board accountable to the
shareho Iders".

Non-conformity with standards of financial reporting and absence of transparent

reporting practices often result in unscrupulous management of companies, and
investors suffer losses mainly due to lack of accountability on part of directors and
management. Henge, the board of directors has a pivotal role in any system of
corporate governance. While the board directs and controls management (chief
executive, executive directors and key managers), the directors are jointly and severally .
accountable to all the stakeholders. The board may be required periodically to report
Financial Markets and their on the activities and progress of the company in a transparent way to the all
Regulation
stakeholders.

The tools commonly prescribed for ensuring accountability are summarized as follows.
1 The board is balanced as regards the representation of sufficient number of non-
i
executive and independent directors who will take care of the interest of all
stakeholders.
2

3
The board adopts transparent procedures and practices and keeps the shareholders
duly informed of the relevant developments impacting the company.
A proper internal control system is put in place and the same is reviewed from time
I
to time. It facilitates the effectiveness and efficiency of operations, and ensures the
reliability of reporting.
4 There is periodic monitoring through internal audit which may ensure the
institutionalizing of the financial and operating control system in a company.
5 There exists a sound system of periodic financial reporting which ensures adequate
disclosures and transparency in governance.
6 There is an audit committee of independent directors. It is the most vital link in the
establishment of a system of accountability to promote good corporate governance.

12.7 REQUISITES OF GOOD CORPORATE

GOVERNANCE
For good corporate governance we expect management to provide appropriate
d~rection,achieve goals set for the organisation, provide transparency, remain
accountable for their actions, and protect the interests of all stakeholders. This
requires, as underlined by experts and various committees on corporate governance, the
system to ensure the following.
1 There is a properly structured broad, capable of taking independent and objective
decisions, put at the helm of affairs.
2 The broad has adequate number of non-executive and independent directors.
3 The board is aware of the concerns of all stakeholders and has an effective
ma'chinery to subserve their concerns.
4 The board takes well-informed and well-considered decisions and adopts
transparent procedures and practices.
5 There exists a proper system consisting of clearly and adequately defined roles,
authority and responsibility of the chief executive, executive directors and
managerial personnel in key positions.
6 There is a proper system for guiding, monitoring, reporting and control. Overall,
the responsibility of the board of directors is that of guiding the management and
overseeing the operations. The board is expected to ensure that the company has
necessary information, control and audit systems in place to guide the top
management in meeting the corporate objectives. It is also the board's
responsibility to ensure that the management complies with legal and ethical
standards in accordance with the provisions of law and the company's own
statement of values.
7 The board effectively and regularly monitors the functioning of the management
team and the implementation of the key decisions.
8 The board remains in an effective control of company's affairs.
 Imvestors Protection and
It may be noted that while the most important driver for good corporate governance is Corporate Governance
the leadership consisting of CEO and the Board within a good framework of corporate
laws, the other important players are the regulators and investors whose constant
vigilance will force the companies to perform and behave well.

12.8 STEPS TAKEN FOR GOOD GOVERNANCE

As a matter of fact, since the emergence of limited liability form of corporate business
organisation, the issues embracing corporate governance assumed a great deal of
importance and have b%en warranting close security. However, the concern for the
concept has been raised recently because of the growing level of fall outs in corporate
sectors leading to sever injury, not only to the interest of common investors but to the
whole economy. The prominence of the concept began with Cadbury Committee
Report after facing financial crisis due to business failures in UK. The
recommendations of the Cadbury Committee in 1992 and the Greenbury Committee in
1995 were included in a combined code which became part of the London Stock
Exchange guidelines. While the emphasis in the Cadbury Committee Report was on
audit committee, remuneration committee, directors' training, standards of conduct,
financial reporting, etc., the Greenbury Committee recommendations emphasized on
interim reporting, directors' responsibility statement, compliance certifications, voting
by institutional investors, etc. The Hampel Committee on corporate governance took
the concept further and included ideas of growth and shareholders prosperiiy in its
ambit. It was followed by Blue Ribbon Committee on corporate governance in USA.
The debate on corporate governance was on in many other parts of the world at the
same time, and India has not been far behind.

In India, right from the beginning, the style of corporate governance has been
influenced by the government and the regulatory bodies. The Ministry of Finance
appointed a three members committee in mid 1990 to study the current state of
corporate governance in the country. The committee observed that the corporate
governance in India was driven by collective conscience rather than such things as the
demands and interests of stakeholders or the pull and push of market forces. However,
somewhere in 1998, the Confederation of Indian Industry (CII) published a Code on
Desirable Corporate Governance , which included recommendations for management
and supervisory categories of board, consolidation of accounts, limited directorships,
inclusion of non-executive directors with well defined responsibilities, audit
committee, disclosure norms etc. to increase accountability and efficiency. Then in
May 1999, SEBI appointed Kumar Manglam Birla Committee on Corporate
Governance and, based on its recommendations, it directed stock exchanges on 2 1st
February, 2000 to amend the listing agreements and include Clause 49 on corporate
governance. This clause broadly covered the following points.
1 Board of Directors and its Composition
2 Audit Committee
3 Remuneration of Directors
4 Board Procedure
5 Management Discussion and Analysis Report
6 Shareholders / Investors Grievances Committee and other shareholders' issues
7 Report on Corporate Governance
8 Certificate of Compliance
Companies like Grasim, HDFC and Infosys Tech took the lead in implementing these
recommendations. Global Telesystems appointed Corporate Governance Task Force
Financial Markets and their and publishes its corporate governance report on company's compliance not only with
Regulation
Clause 49 but also with the Blue Ribbon Committee and CII Code.

Later, the Companies (Amendment) Act, 2000 laid down provisions for greater
transparency in corporate governance, voting through postal ballot, filing of a
secretarial compliance certificate with the concerned Registrar of Companies, insertion
of Director's Responsibility Statement in Director's Report, appointment of audit I
committee, protection of small depositors, and appointment of one director by small
shareholders, etc. Subsequently, on 29th October, 2004, SEBI also amended the
original Clause 49 and issued a new Clause 49 which all listed companies have to
comply with. It lays down higher qualification criteria for independent directors,
reduction of gap between two board meetings, more frequent meetings of audit
committees, and so on. The details of all these aspects have been discussed in sections
to follow.

Check Your Progress B

1 Define corporate governance.

...................................................................................................

2 State any four basic principles of good governance as enunciated by Sir Adrian
Cadbury.

3 What are the tools prescribed for ensuring accountability ?

4 State which of the following statements are True or False

(a) According to Birla Committee on Corporate Governance, the fundamental
objective of corporate governance is the enhancement long-term shareholder
value while protecting the interests of other stakeholders.
(b) The most important drivers for good corporate governance is the management
team consisting of executive directors and key managers.
(c) It is the Board's responsibility to ensure that management complies with legal
and ethical standards.
(d) Kumar Manglam Birla Committee on Corporate Governance was appointed in
1999 by the Ministry of Finance.
(e) Code on Desirable Corporate Governance was published by Blue Ribbon
Committee in USA.
 Investors Protection and
12.9 CORPORATE GOVERNANCE CODE UNDER Corporate Governance

CLAUSE 49
Under Clause 49 of the listing agreement as revised in October 2004, SEBI requires
companies having a paid up share capital of Rs. 3 crore and above, to comply with the
following stipulations which are mandatory.

I Board of Directors
(a) Composition of the board : The board of directors of the company is to have
an optimum composition of executive and of non-executive directors with not
less than 50 per cent of the board members comprising non-executive
directors. But where the chairman of the board is a non-executive director, at
least one-third of the board should comprise of independent directors, and if he
is an executive director, at least half of the board should comprise of
independent directors. An independent director means a non-executive
director of the company who, apart from receiving director's remuneration,
does not have any material pecuniary relationships or transactions with the
*
company, its promoters, subsidiaries and associates, which may affect
independence of the director. Also, such a director should not be related to
promoters or persons occupying managerial positions, and must not have been
an executive of the company in the preceding three years. Further, he is not to
have substantial shareholding in the company i.e., owning 2 per cent or more
of the block of voting shares. Nominees of institutions that have invested in or
lent to the company shall be deemed as independent directors.
(b) Compensation to non-executive directors : All fees/ compensation payable
to non-executive directors, including independent directors, are to be fixed by
the board and must have previous approval of shareholders in the general
meeting. The shareholders' resolution is to specify the limits for the maximum
number of stock options that can be granted to non-executive and independent
directors in any financial year and in aggregate.
(c) Board procedure : The board is to meet at least four times a year with a
maximum time gap of 3 months between two meetings. The minimum
information to be made available to the board is laid down. Further, a director
is not to be a member of more than ten committees or act as chairman of more
than five committees across all companies in which he is a director. Also, it
should be mandatory for every director to inform the company about the
committee position he occupies in other companies and notify changes as and
when they take place.
(d) Code of conduct : The board is to lay down a code of conduct for all board
members and senior management of the company, which should be posted on
the website of the company. All board members and senior management
personnel are to affirm compliance with the code on an annual basis. The
Annual Report of the company is to include a declaration to this effect signed
by the CEO.

I1 Audit Committee
(a) Qualified and independent audit committee : A qualified and independent
audit committee is to be set up, giving the terms of reference, with a minimum
of three directors as members, two-thirds of the members being independent
directors all members being financially literate and at least one member having
financial or accounting management expertise. The Chairman of the
Financial Markets and their
Committee is to be an independent director, who is to be present at Annual
Regulation
General Meeting to answer shareholders' queries. The Company Secretary is
to act as secretary to the committee.
(b) Meetings : The audit committee should meet at least four times in a year and
not more than four months should elapse between the meetings. The quorum is
to be either two members or one-third of the members of the committee
whichever is greater. But there has to be a minimum of two independent
members present.
(c) Powers : The powers of audit committee should include powers (i) to
investigate any activity within the terms of reference, (ii) to seek information
from any employee, (iii) to obtain outside legal or other professional advice,
and (iv) to secure attendance of outsiders with relevant expertise, if necessary.
(d) Role : The role of the audit committee encompasses (i) oversight of the
company's reporting process and disclosure of its financial information to
ensure that the financial statement is correct, sufficient and credible; (ii)
recommending to the board the appointment, reappointment, or removal or
replacement of the statutory auditor and fixation of audit fees; (iii) reviewing
with the management, the quarterly and annual financial statements before
submission to the board for approval; (iv) reviewing with the management,
performance of statutory and internal auditors and adequacy of the internal
control systems; (v) reviewing the adequacy of internal audit function and
discussion with internal auditors any significant findings and follow up 1
thereon; (vi) reviewing the findings of any internal investigations into matters I
of suspected fraud or irregularity a failure of internal control systems of a ' I
material nature and reporting the matter to the board; (vii) discussion with
statutory auditors before the audit commences about the nature and scope of
audit as well as post-audit discussion on any area of concern; (viii) to look into
the reasons for substantial defaults in the payment to depositors, debenture
holders, shareholders (of declared dividend) and creditors; and (ix) reviewing
the company's financial and risk management policies
(e) Review of information : The audit committee is mandatory required to
review the information relating to (i) management discussion and analysis of
financial condition and results of operations; (ii) statement of related party
transactions; (iii) internal control weaknesses and internal audit report on the
same; and (iv) appointment, removal and terms of remuneration of the chief
internal auditor.

I11 Subsidiary Companies

(a) At least one independent director of holding company is to be a member of the
board of directors of an unlisted Indian subsidiary company.
(b) The Audit Committee of the holding company shall review the financial
statements of the unlisted subsidiary company, in particular, its investments.
(c) The minutes of the board meetings of the unlisted subsidiary company have to
be placed at the board meeting of the listed holding company.

IV Disclosure
(a) Basis of related party transactions : Basis of related party transactions
should be placed periodically before the audit committee along with a
statement in summary form of transactions with related parties in the ordinary
course of business, and details of material individual transactions with related
 Investors Protection and
parties which are not In the normal course of business, or are not on an arm's Corporate Governance
length basis, together with the management's justification of the same.
(b) Treatment different from that prescribed in the accounting standard :
Disclosure is required to be made in the financial statements where, in the
preparation of statements, the treatment followed has been different from that
prescribed in an Accounting Standard, and the management's explanation in
the Corporate Governance Report as to why such alternative treatment was
believed to be more representative of the true and fair view of the underlying
business transaction.
(c) Risk management and minimization procedures : Disclosure is to be made
. by the company to inform board members about the procedures laid down for
risk assessment and its minimization.
(d) Application of funds raised through public, rights issue, etc : Proceeds
from public issues; rights issues and preferential issues are to be disclosed to
the Audit Committee with the uses/application of funds according to major
categories (capital expenditure, sales marketing costs, working capital, etc.) on
a quarterly basis as a part of their quarterly declaration of financial results.
Further, on an annual basis, the company is to prepare a statement of funds
utilized for purposes other than those stated in the offer document / prospectus
/ notice, and place it before the audit committee for making appropriate
recommendations to the board in the matter.
(e) Remuneration of the directors : All pecuniary relationship or transactions of
the non-executive directors vis-a-vis the company are to be disclosed in the
Annual Report. Further, remuneration of directors is to be disclosed in the
section on the corporate governance of the Annual Report including all
elements of remuneration package of individual directors, details of fixed
component and performance linked incentives, service contracts, stock option
details, etc. The company is also to publish in the annual report its criteria of
making payments to non-executive directors, as well as disclose the number of
shares and convertible instruments held by them. Further, the non-executive
directors are to disclose their shareholding in the listed company in which they
are proposed to be appointed as directors, prior to the appointment.
(f) Management discussion and analysis report : A management discussion
and analysis report is to form a part of the Annual Report of the company to
shareholders. It should include discussion on matters like industry structure
and developments, opportunities and threats, segment-wise and product-wise
performance, outlook, risks and concerns, internal control systems and their
adequacy, material developments in human resources/industrial relations, etc.
(g) Transactions with senior management's personal interest : Senior
management is to disclose to the board all material, financial and commercial
transactions wherein they have personal interest that may have a potential
conflict with the company at large.
(h) Appointment /reappointment of a director : In case of appointment of a new
director or reappointment of a director, the shareholders are to be provided
with the information such as brief resume of the director, nature of his
expertise in specific functional areas, and names of companies in which the
person also holds directorship and membership of committee of the board.
(i) Details of non-compliance by the company, penalties, strictures imposed on
the company by stock exchange or SEBI or any statutory authority, on any
matter related to capital markets.
Financial Markets and their
Regulation
(j) Information on website : Quarterly results and presentations made by the
company to analysts are to be put on the company's website, or set in a form so
as to enable the stock exchange concerned to put it on its own website.

V Shareholders Investors Grievance Committee

A board committee under the.chairmanship of a non-executive director has to be

formed to look into the redressal of shareholders and investors' complaints like transfer
of shares, non-receipt of annual report, non-receipt of declared dividends, etc.

VI CEO/CFO Certification

CEO i.e., Managing Director or General Manager, and the CFO i.e., the whole-time
Finance Director or any other person heading the finance function, are to certify to the
board that -
(a) they have reviewed financial statements for the year and that, to the best of their
knowledge and belief, these statement do not contain any materially untrue
statement or omit any material fact or contain misleading statements, and that the
statements present a true and fair view of the company's affairs and are in
compliance with the existing accounting standards, applicable laws and guidelines;
(b) to the best of their knowledge and belief, no transactions entered into by the
company are fraudulent, illegal or volatile of the company's code of conduct;
(c) they accept responsibility for internal controls and that they have evaluated the
effectiveness of the internal control systems, and have disclosed to the auditors and
the audit committee, deficiencies in the design or operation of internal controls, if
any, and the steps they have taken to rectify the deficiencies;
(d) they have indicated to the auditors and the audit committee about significant
changes in internal control and in accounting policies during the year, and also
about instances of significant fraud and involvement therein of the management or
any employee.

VII Report on Corporate Governance

There is to be separate section on corporate governance in the Annual Report of the

company along with a detailed Compliance Report on Corporate Governance. The
details of items to be included in this report are as follows:

(a) Company's philosophy on code of governance.

(b) Board of Directors composition and category, attendance of each director at
the board meetings and the last AGM, and the number and dates of board
meetings held.
(c) Audit Committee : Broad terms of reference, composition, on number of
meetings and attendance.
(d) Remuneration Committee : Brief description of the terms of reference,
composition, meetings and attendance, remuneration policy and details of
remuneration to all directors
(e) Shareholders Investors Grievance Committee : Functions, composition,
name and designation of the compliance officer, meetings and attendance,
details of shareholders' coniplaints received, number not solved, and pending
share transfers as on close of the financial year.
 Investors Protection and
(f) General Body meetings : Location and time of where last three AGMs held, Corporate Governance
details of special resolutions put through postal ballot and proposed to be
conducted through postal ballot, and procedure for postal ballot.
(g) Disclosures : On materially significant related party transactions with its
promoters and directors or the management, their subsidiaries or relatives etc.
that may have potential conflict with the interests of the company; details of
non-compliance by the company; penalties, strictures imposed on the company
by the stock exchanges or SEBI or any statutory authority on any matter related
to capital markets during the last three years; and the code of conduct for
prevention of insider trading.
(h) Means of Communications : Half yearly report sent to each household of
shareholders, newspaper in which quarterly and annual results published, any
website where displayed, presentations made to institutional investors or to the
analysts, management discussion and analysis.
(i) General shareholders information: Date, time and venue of AGM, financial
calendar, date of book closure, dividend payment date, listing on stock
exchanges, stock code, market price data and comparison, registrar'and share
transfer agents, share transfer system, nomination system, distribution of
shareholding, plant locations, address for correspondence, etc.

.VIII Compliance Certificate

The company is to obtain certificate from either the auditors or the practicing company
secretaries regarding compliance of conditions of corporate governance as stipulated in
Clause 49 and annex the same with the directors report which forms part of the Annual
Report of the company. This certificate is also to be sent to the stock exchanges along
with the annual returns filed by the company.

In addition to the above, the companies may also be advised to adopt the non-
mandatory requirements relating to (1) chairman's office, (2) remuneration committee,
( 3 ) sending of half yearly financial performance report including summary of the
significant events to each household of shareholders, and (4) provision of voting
through postal ballot on key decisions. If any of these are adopted by the company,
the same should also form part of its report on corporate governance.

12.10 PROVISIONS UNDER COMPANIES

(AMENDMENT) ACT, 2000
The Companies (Amendment) Act, 2000 was primarily devoted to corporate
governance. An outline of the important provisions is given hereunder.

Protection of small depositors : Under Sections 58AA and 58AAA, it is provided that
every company which accepts deposits from small investors (those who have deposited
upto Rs. 20,000), is to intimate the Company Law Board if any default was made in
repayment of any such deposits or interest on deposits. No company can, at any time,
accept further deposits from small depositors unless each small depositor, whose
deposit had matured, has been paid the amount of deposit and interest accrued thereon.
There is penalty stipulated for non-compliance with the above provisions.

Voting through postal ballot : In order to encourage wider participation of

shareholders, Section 192A has been introduced to allow them to vote on a particular
resolution through postal ballot. Through Rules made by the Central ~overnment,
Financial Markets and their postal ballot has been made mandatov for certain matters. Assent or dissent to each
Regulation
resolution is required to be ser.: within 30 days. I,

Autz. I C . 'Jnder Section 292A every public company having paid-up capital

of P ,;ore Gr more is to constitute an audit committee, consisting of not less than

three directors and such number of other directors as the board may decide. Two-thirds
of the total n u i b e r of members ofthe committee shall be directors other than
managing or whole-time directors. The audit committee shall have authority to
investigate into any matter relating to items specified or referred to it by the board. In
short, the major role of the audit committee will be to oversee the company's financial
reporting process and the disclosure of its financial information to ensure that the
financial statements are correct, sufficient and credible. Normally, it is also entrusted
with the tasks of reviewing adequacy of internal coiltrol system and the report of
internal and statutory auditors and ensure suitable follow up thereon.

Secretarial Compliance Certificate : Every company having paid-up share capital of

Rs. 10 lakh or more but less than Rs. 50 lakh which are not required to appoint a
whole-time secretary, are to file with the concerned Registrar of Companies a
certificate from a secretary in whole-time practice, in such form as may be prescribed,
to the effect that the company has complied with all provisions of the Act. A copy of
such certificate is to be attached with the annual report of the board of directors of the
company.

Directors Responsibility Statement : The scope of annual report of the board of

directors has been enlarged by the Amendment Act. Besides other matters, it is to
include a Director Responsibility Statement indicating that (i) in preparation of the
annual accounts, the applicable accounting standards had been followed along with
proper explanation relating to material departures, if any; (ii) the directors had followed
appropriate accounting polices consistently so as to give a true and fair view of the
state of affairs and profit or lass of the company; (iii) the directors had taken proper
and sufficient care for the maintenance of adequate accounting records so as to
safeguard the company's asset and to prevent and detect frauds and other irregularities;
and (iv) the directors had prepared the annual accounts on a going concern basis.

Director to represent small shareholdelis : The Amendment Act has laid down that
a public company having paid up capital af Rs. 5 crore or more and one thousand or
more small shareholders, may appoint at least one director elected by small
shareholders (holding shares of nominal value of Rs. 20,000 or less) on its board.

Check Your Progress C

1 What do you mean by an independent director ?

.....................................................................................................
2 What are the major aspects that CEO and CFO have to certify 7
...................................................................................................
 Investors Protection and
3 Explain thejules regarding disclosure of the basis of party related transactions. Corporate Governance
.................... ? ..............................................................................

4 Why has voting through postal ballot been introduced ? Is it Mandatory?

12.11 RENEWED CHALLENGES

In December 2004, the Government of India constituted a committee of experts under
the chairmanship of Dr. J. J. Irani, Director of Tata Sons Ltd., for a comprehensive
revision of the Companies Act. The objective was to make it simple, amenable to
modern technology and, in general, to make regulations easy to observe, prompt in
execution, and conform to the modern concept of corporate governance. The
Committee submitted its report in May 2005. Some controversial issues that rhe Irani
Committee considered and a few more are outlined below. These constitute the
renewed challenges of corporate governance.

Pyramidal structure : Corporate houses generally control diversified business

activities through a complex structure of holding companies. A holding company may
have a number of subsidiary companies, each of which can be a holding company for
another set of subsidiaries. This line can go on to any level forming virtually a
pyramidal structure. This leads to corporate abuses with promoters controlling all
group companies with small investment, indulge in undercover deals and escape
legitimate regulation in the shareholders' interest.

A concept paper had been circulated which sought to do away with the pyramidal
structure by suggesting that a subsidiary should not be allowed to act as holding
company to other subsidiaries. However, the corporate houses wanted the existing
structure to continue, and after deliberations on the issue, the Irani Committee also felt
that pyramiding was essential, particularly when Indian companies were going abroad
to enlarge business operations. Limiting subsidiary companies to one level, according
to the Committee, would definitely inconvenience the corporates and, in some cases,
would be a disadvantage in the international context of business. It observed that in
order to avoid misuse of the facility there should be a stricter control on the activities
of subsidiaries imposed through self-regulation and transparency. In Committee's
opinion, doing away with the pyramidal structure would be akin to throwing the baby
out with the bath water.

Independent directors as members of the board : The role of the board of directors
in corporate governance has been widely recognized in India, and the prevailing view
is that there should be an optimum combination of executive and non-executive
(independent) directors on the board of every public limited company. As per SEBI,
the listed companies with paid-up share capital of Rs. 3 crore and above are required to
have not less than fifty percent of the board of directors comprising of independent
directors where the chairman and managing director are one and the same person and,
Financial Markets and their
if the chairman is a non-executive director, at least one-third of the members of the
Regulation
board should comprise of independent directors. However, the Irani Panel hgs
recommended that a minimum of one-third of the board should be independent
directors and the audit committee should have a majority of independent directors.
These directors should be empowered not only to call for explanations from the
statutory auditors, but each of them should have the authority to call an independent
opinion on any matter concerning the company. The above stipulation, according to
the Panel, would ensure that independent directors really acted in the Interest of all
shareholders and not for the majority shareholders only. The Panel has also suggested
rules to be framed laying down duties of independent directors to ensure that they are
truly independent and are not, in any significant manner, concerned with the fortunes of
the company, on the board of which he or she is appointed as an independent director.
Thus, the Irani Committee's recommendation of having one-third of the directors as
independent directors could be regarded as a practical solution to the scramble by
companies to fill up the positions of independent directors.

Reducing intervention in companies by government / regulatory authority : The

Irani Panel is in favour of reducing government intervention and ending multiple
jurisdiction of regulators with respect to company affairs. Their contention is that, with
greater transparency and self-regulation, control over companies must rest in the hands
of shareholders and references to government and regulators should be reduced to an
absolute minimum to ensure smooth functioning of the corporates. In such a set up, the
role of independent directors also becomes extremely important. The Panel has also
recommended reduction of judicial intervention in case of minor technical offences.
They have suggested an inhouse structure for dealing with cases of technical default
involving imposition of monetary penalties under the Act, with powers to impose
penalties for offences other than those punishable with imprisonment, or imprisonment
and fine. This is expected to substantially reduce judicial intervention in case of
company law offences.

Disclosure and dissemination of information : Technology has no doubt played an

important role in the capital market on two fronts, viz., screen-based trading and
dematerialisation. However, these are essentially process-based changes and have little
impact on the quality of disclosure and dissemination of information which remains
poor due to bad formats. Not only that, in matter of dissemination of information, most
stock exchanges entrusted with the responsibility have not fully lived upto the
challenge and, reportedly, many stock exchanges do not have any system of
information management. Even the centralised corporate information effort through
SEBI's website (EDIFAR), launched two year age, is found to be extremely
unfriendly, and several types of information are missing or are outdated. The listed
companies also do not file all the mandated information and, what is filed is not
archived properly. As a result, when a listed company makes a follow-on offering, the
disclosures at the time of issue are huge as most of it had not been made public in
course of regular disclosures. At another' level, information is highly lacking in certain
key aspects, such as changes in the names of the companies, and indictments by
regulators of companies, intermediaries and individuals.

Certification by CEO and CFO : Clause 49 requires CEOs and CFOs to certify that
they have internal controls in place but it does not specify the areas of controls. It also
fails to clarify whether control means control over financial reporting processor or it
extends to the whole gamet of how companies manage their business risks. There is
no guidance even from SEBI as to what it covers. According to Ameet Parikh of Axis
Risk Consultancy Services, most corporates are adopting the Sarbanes Oxley Act of
 Investors Protection a d
the US as guiae~rnesi ~ i ,iilplementing
. this provision knowing full well that the focus Corporate Governance
in SOX Act is purely on financial processes. He also stated that Clause 49 is more in
line with the regulation in force in UK and South Africa where the controls are
restricted to just financial reporting as in the US. But, in the spirit of Clause 49, it is
felt that the controls should go beyond just financial reporting and cover a wider
spectrum so as to do justice to the concept of corporate governance.

What the above new set of issues have shown is that the responsibility of corporate
governance needs to be tackled at various levels within the company and, if corporate
governance has to succeed in India, it has to be accepted as a moral issue based on the
foundations of value and ethics. The former SEBI Chairman, G N Bajpai had said,
'Good corporate governance must fulfil the primary objective of coming into being of a
corporate i.e., through wealth creation, through wealth management and through
appropriately sharing the wealth with all the stakeholders. This can be facilitated only
if corporate governance moves from mere form to substance . Ethics will have to play
a promiilent role in corporate governance and instruments must be available to evaluate
quality of governance so that market is able to reward corporate governance practices".

12.12 LET US SUM UP

Individual investors need to be protected on account of their ignorance, lack of
information and various lacunae and flaws in the capital market. It is observed that (i)
public issues of securities are often announced with exaggerated and misleading
prospects, (ii) financial statements of existing companies issuing shares often lack
transparency and detailed information, (iii) rise in security price which attract investors
may be the result of manipulations, (iv) there are deficiencies in corporate governance,
and (v) delay in redressal of shareholders' grievances is a common practice. Hence, to
protect investors' interest against such practices, a number of provisions have been
made in the Companies Act, Securities Contracts (Regulation ) Act and SEBI Act. Of
late, SEBI has played a dominant role in taking care 6f their interests by issuing SEBJ
(Disclosure and Investor Protection) Guidelines, taking steps to educate the investors
through various programmes, and helping in the redressal of their grievances on
,
matters related to public issues and capital market operations. Ensuring good corporate
governance is another step in that direction.

I
1
Narrowly interpreted, corporate governance is defined as the accountability of senior
management team towards the shareholders. In p wider sense, it connotes a blend of
rules, regulations, laws and voluntary practices that enable companies to attract
i financial and human capital to perform efficiently and thereby maximize long-term
i value for the shareholders besides respecting the aspirations of multiple shareholders
t including that of the society. Thus, it hinges on complete transparency, integrity and
I accountability of the board of directors with a focus on public interest and investor
Ii protection. The broad objectives of corporate governance, therefore, are : (a)
compliance with laws, (b) good performance, and (c) accountability with a view to
t! enhance long-term shareholder value by ensuring company's commitment to higher
growth and profits while protecting the interests of other stakeholders.
1
L The guidelines of corporate governance vary according to the corporate environment in
I countries, but accountability is central to any model. The management and the auditors
have a pivotal role in any system of corporate governance. The tools commonly
I prescribed for ensuring accountability are : (1) balanced board of the directors, (2)
transparent procedures a ~ practices,
d (3j proper interna! c ~ n t r osystem,
l (4) periodic
Financial Markets and their monitoring through internal audits, (5) adequate disclosures in financial reporting, and
Regulation
(6) and audit committee of independent directors.

The requisites of good corporate governance consist of (1) properly structured board
with a number of non-executive independent directors capable of taking objective
decisions, (2) awareness of the concerns of all stakeholders, (3) a system with well
defined authority and responsibility (4) a proper system for guiding, monitoring,
reporting and control; (5) effective and regular monitoring of the functioning of
management team, and (6) the board remaining in effective control of company's
affairs.

The prominence of the concept of corporate governance began with Cadbury

Committee Report in 1992 followed by Greenbury Committee Report in 1995 in UK
and later the Blue Ribbon Committee Report in USA while debate was an in many
'9 world. In India, it began with a three members committee appointed
other parts gf the
by the ~ i n i h r yof Finance in 1990, but with little follow up action. In 1998, CII
published a kode on Desirable Corporate Governance. In 1999, SEBI appointed
Kumar Manglam Committee and, based on its recommendation, it directed stock
exchanges, in February 2000, to include Clause 49 on corporate governance in their
listing agreements. Later, the Companies (Amendment) Act, 2000 made certain
provisions for greater transparency in corporate governance. Subsequently, on October
29,2004, SEBI also made certain amendments in Clause 49 for improving its
effectiveness.

Under Clause 49 of the listing agreement, as revised by SEBI in October 2004,

companies having a paid up share capital of Ks.3 crore and above, are required to
comply with provisions relating to (1) composition of the board of directors, their
meetings and the code of conduct for its members, (2) setting up a qualified and
independent audit committee, its powers, role, etc., (3) governance of enlisted
subsidiary companies, (4) disclosures to be made by management on the basis of
related party transactions, deviations from accounting standards, risk management
procedures, use of proceeds from public issues, remuneration of directors,
management discussion and analysis report, etc., (5) Shareholders / Investors
Grievances7Committee for redressal of complaints, (6) CEO / CFO certification of
specified matters, (7) a detailed compliance report on corporate governance (to be
included in the Annual Report) and quarterly compliance reports to be submitted to
stock exchanges, and (8) certificate regarding compliance of the conditions of
corporate governance as stipulated in Clause 49 to be annexed with the directors'
report.

The Companies (Amendment ) Act, 2000 was primarily devoted to corporate.

governance. Its important provisions related to (a) protection of small depositors, (b)
voting through postal ballot, (3) audit committee to be constituted to oversee financial
reporting process and disclosure of financial information, (4) Secretarial Compliance
Certificate in prescribed from to be filed with the concerned ROC and copy to be
attached with Annual Report of the hoard in case of companies that are not required to
appoint a whole time company secretary, (5) Director's Responsibility Statement to be
included in the hoard's report, and (6) appointment of a director elected by small
shareholders.

In December 2004, Government of India appointed Irani Committee for a

comprehensive revision of the Companies Act. A few issues raised by the Committee
in its report constitute the renewed challenges of corporate governance which relate to
 Investors Protection and
(a) pyramidal structure of corporate houses, (b) independent directors as members of Corporate Governance
the board, (c) reducing intervention in company affairs by government 1 regulatory
authority, (d) disclosure and dissemination of information, and (e) Certification by
CFO and CEO. These new set of issues indicate that the responsibility of corporate
governance lies within the company at various levels and it has to be accepted as a
moral issue.

12.13 KEY WORDS

Corporate governance : A blend of rules, regulations and voluntary practices that
enable companies to perform efficiently and thereby maximize long-term value for the
shareholders besides respecting the multiple stakeholders including that of the society.

Independent Director : A non-executive director of the company who, apart from

receiving director's remuneration, does not have any material primary interest or
relationship with the company, its promoters, subsidiaries and associates.

Pyramidal Structure : It refers to a complex structure of holding companies whereby

a holding company may have a number of subsidiary companies, each of which may be
a holding company for another set of subsidiaries.

Related Party Transaction : Transactions with company's promoters, directors or the

management or their subsidiaries or relatives etc.

12.14 ANSWERS TO CHECK YOUR PROGRES

A 3 (a) growth (b) intrinsic (c) capital issues (d) judicial
(e) directors, small

B 4 (a) True (b) False (c) True (d) False (e) False

12.15 TERMINAL OUESTIONS

1 Discuss why investors' protection has become a matter of serious concern in

recent times and outline the provisions of various laws and the role of SEBI in this
regard.
2 Explain briefly the concept of corporate governance, and enumerate its broad
objectives.
3 State the requisites of good corporate governance, and explain as to why
accountability is regarded as the key to success in corporate governance.
4 Describe briefly the evolution of the concept of corporate governance and outline
the various measures adopted in India to ensure good corporate governance.
5 State, with reasons, the major provisions of the Companies (Amendment) Act,
2000 aimed at enhancing the quality of corporate governance.
6 Outline the major requirements under Clause 49 of listing agreement under SEBI
regulations.
Financial Markets and tbeir 7 State the composition of audit committee as per rules, and discuss its role in
Regulation
corporate governance.
8 Look at the corporate governance report as given in the Annual Report of a
company, and outline the requirements of such report and its importance for the
shareholders.
9 Discuss the main issues comprising renewed challenges of corporate governance
with special reference to the recommendations of the Irani Panel.
10 Explain the following in the context of corporate governance.
(a) Secretarial Compliance Certificate
(b) CEO/ CFO Certification
(c) Management Discussion and Analysis
(d) Directors Responsibility Statement

Note : These questions will help you to understand the unit better. Try to write
answers for them, but do not submit your answers to the university for
assessment. These are for your practice only.

SOME USEFUL BOOKS

Francis Cheunilam, Business Environment : Text and Cases, Himalaya Publishing
House, Mumbai.

Ghosh, P. K. and Kapoor, G. K., Business and Policy and Environment, Sultan Chand
& Sons, New Delhi.

Gopal, K., "Emerging Trends in Corporate Gavernance" in Indian Management,

October 1998.

Machiraju, H. R., Indian Financial System, Vikas Publishing House, New Delhi.

Misra, S. K., Money, Income and Financial Institutions, Pragati Publications, Delhi.

Ruddar Datt and Sundhram, KPM, Indian Economy, S. Chand & CO, New Delhi.