Column : Game, SAT, match

Written by Sunil Jain | Updated: Sep 25 2010, 05:45am hrs
Now that Sebi has rejected MCX-SXs application that it be allowed to deal in interest rate derivatives, equity, futuresessentially, allow it to work as a full-fledged stock exchange like the BSE and the NSEMCX-SX will go to the Securities and Appellate Tribunal (SAT), the appellate authority for rulings made by Sebi. SAT will decide whether, as Sebi has ruled, MCX-SX approached it with unclean hands (jargon for suppressing information); whether the MCX-SX promoters scheme to lower their equity to the Sebi-prescribed ceiling of 5% each was aimed at meeting the letter of the law instead of its spirit; whether, as Sebi says, even the letter of the law was vitiated by the buyback arrangements the two promoters of MCX-SX had entered into.

The real issue, however, is different and SAT cant possibly go into that. The real issue is something only the finance ministry, or a high-level committee set up by it, can resolve, the issue of common standards for different aspects of financial marketsstock exchanges, insurance firms, banks, commodity exchanges and so on.

The brief facts first. MCX-SX, which was promoted by commodity exchange MCX and tech solutions firm FTIL, applied to Sebi for a stock exchange licence and got this in September 2008. Sebi gave this permission, subject to MCX and FTIL complying with whats called MIMPS (Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchanges). MIMPS essentially said that no promoter could have more than a 5% stake in any stock exchange (there are some exceptions, of which later). MCX-SX was given a year to do this, couldnt and so got another year to do so. The promoters first started selling their equity to other partners like IL&FS, IFCI and Punjab National Bank. In some casesPNB and IL&FSthey even entered into what Sebi says was a buyback deal. Later, it decided to extinguish a part of its sharesin return, the promoters got warrants which could be converted to shares later, presumably to sell to other investors later, while keeping their shareholdings to the stipulated 5%.

Sebi rejected this on various counts. One, it said, MCX-SX should have come clean on the buybacks on its own. Second, it says that while the warrants would technically help reduce MCX and FTILs shareholdings to 5%, the spirit behind the law was to get more players to own the exchangethis didnt really do that.

Its not quite clear how Sebi reaches this conclusion. MCX and FTILs warrants could get converted to shares after six months, but since MIMPS made it clear neither could own more than 5% each of MCX-SX, these converted shares would have to be sold to other investors. So, the spirit of the law would also be met, the only thing the warrants were doing was to give MCX and FTIL more time.

It is here that the finance ministry comes in. It is near impossible to start any business with 20 persons with a 5% equity each. So, the normal solution is that a few people start a business with a higher amount of equity and, once the business gets profitable, they can sell their equity to others, either through a private placement or through an IPO. This is MCX-SXs grouse, one that Sebi has dismissed as saying the promoters were being greedy; MCX-SX argues that it could not get investors in unless it had a viable business and Sebi was preventing it from getting this viable business. Chicken and egg, basically.

The point, however, is that other financial regulators have very different rules. The RBI, for instance, keeps the promoters equity at a minimum of 40% (as opposed to Sebis 5%); promoters can come in with more, but RBI allows them a year to reduce this; this time period can be changed with RBIs permissionthere are some private banks where promoter holdings are more than even 50%, more than 5 years after they began business. In the case of commodity exchanges, the minimum is 26% and there is no restriction on the maximum. Insurance firms have a maximum of 26%, but a promoter gets 10 years to divest down to this level. In all these cases, the banks/commodity exchange/insurance firm can do all business from day one; in the case of MCX-SX, however, Sebi allowed it to operate in just currency futures. So, the ministry of finance needs to figure out why the rules should be different for different segments of the financial market. Also, if the rules are to remain the way they are, is it possible for a well-capitalised stock exchange to come into being

It does appear, though, that Sebi was aware of the problem this could cause so, in 2008, it came up with an amendment to the original 2006 rule. A discussion paper talked of representations Sebi had got from certain shareholders of NSE and OTCEIin December 2008, Sebi said that the 5% rule would be relaxed to 15% per promoter in case the promoters were a stock exchange, a depository, a clearing corporation, a banking company, an insurance company and a public financial institution. The finance ministry needs to see, SAT cant, as to whether this exception needs to be extended to other groups of investors (by the way, if the Sebi amendment had said exchange instead of stock exchange, MCX would have found the going easier).

Postscript: For those looking at the lighter side, Sebi has said the buyback arrangements were in the nature of forward contracts in securities and in contravention of the Securities Contract Regulation Act (SCRA). MCX-SXs lawyers argued the SCRA applied only to securities that were listed on stock exchanges. Sebi then cites various judgements, both for and against, to show the SCRA applies even to securities that are not listed!