IFR India Offshore Financing Roundtable 2014: Part 1
In his own words …
Speaking at IFR’s recent Indian Offshore Financing Roundtable in Mumbai, MS Sahoo summarised the recommendations of the reports that his eponymous Committee submitted to the government on depositary receipt reform. One of the key tenets of policy since India’s new government took office earlier this year has been to open up the capital markets. There has been a swathe of new regulations or intent to create new regulations to liberalise access to the capital markets, including a much-needed update on the rules pertaining to inward and outward-bound depositary receipts. The Sahoo Committee submitted two reports on DR deregulation with a set of key recommendations that have been accepted by the new government. The recommendations of his key in-process report on External Commercial Borrowing are widely expected to lead to a liberalisation of the foreign borrowing regime for Indian borrowers; something the capital markets community is awaiting with vivid interest. Here’s what MS Sahoo told IFR’s delegates on DR reform:
“First of all, I must thank Keith Mullin for organising what I believe is the very first event on ADR/IDRs reforms in India since the Sahoo Committee reports were submitted. Thank you very much Keith for your interest in India and in these reports. Let me make it clear that it is a Ministry of Finance Committee and I am only borrowing your usage ‘Sahoo Committee’.
The very first reforms on the capital account front in India centred on depositary receipt issuance; the process started in 1991 and the scheme was formally launched in 1993. At that time the onshore Indian equity market was quite primitive and there was no way to connect foreign investors to it. Depositary receipts were the first instrument to connect Indian companies with overseas investors.
Over the last 20 years, there has been a sea-change in the onshore market as foreign investors have been allowed direct access to it; as a consequence the importance of ADRs and GDRs has declined. However, the onshore market became attractive for foreign firms and foreign investors to engage from outside. As a matter of reciprocation, India considered extending the same treatment to foreign investors and foreign firms as the country expects overseas jurisdictions to extend to Indian investors and Indian firms.
So in 2001, the Companies Act was amended to allow issuance of Indian Depositary Receipts. But it took quite some time to operationalise the new facility. It was only in 2004 that the government came out with rules and further modalities found their way into the SEBI rulebook in 2008. And there has been only one issue of IDRs so far – by Standard Chartered Bank in 2009. Irrespective of volumes either in ADR or in IDR, the availability of the facility to access each other’s market through DRs remains important as it puts pressure on both offshore and onshore markets to remain competitive. For example, if Indian firms can access foreign investors for their resource requirements, that puts pressure on the Indian financial sector to improve and be competitive. There is a feeling now that both the onshore and offshore markets are more or less at par and equally competitive. This competitive neutrality ensures that there is very little reason either for an Indian or a foreign firm to choose one market over the other.
However, despite competitive neutrality, there is something called home bias. Indians like to invest in Indian securities, and foreigners like to invest in foreign securities. This gives the comfort that they are at home and in case of need can seek relief from authorities in the home country. So DRs, despite onshore market improvements, still serve two purposes today: competitive neutrality and the needs of home bias.
Within the scope of capital controls
The basic premise the Sahoo Committee is the existing capital control regime. We took it as a given. Although there is ample scope for reforming it, we did not get into that. Let’s say the capital account regime allows an Indian to invest up to Rs125,000 in specified assets overseas. Why not give him the option to invest in those assets overseas directly or in depositary receipts issued in India on the back of those assets? So if Indian investors can invest in shares of IBM, let them have the option to invest in depositary receipts issued in India on the shares of IBM.
On the flip side, if a foreign investor has the option to invest in Indian companies directly either through the FDI route, FII route or by whatever means, let him also have the option to invest in Indian companies through depositary receipts issued abroad on Indian shares.
Essentially, we have four sets of economic agents: Indian investors, foreign investors, foreign firms and Indian firms. Let the Indian firm access foreign investors directly or through ADRs. Let the foreign firm access domestic investors directly or through ADRs. Similarly, also let the domestic investor invest in the shares of foreign firms directly or through IDRs. And let the foreign investor invest in a domestic firm directly or through ADRs. So each of the four agents must have four options and they must have full freedom to choose. There is no reason to restrict their freedom.
Investing in shares is as good as investing in depositary receipts; they are one and the same asset. So if I’m allowed to invest directly, why shouldn’t I be allowed to invest indirectly? Or if I’m allowed to invest indirectly, why not directly?
The basic philosophy of this Committee is that on the basis of competitive neutrality, let the four economic agents have full freedom within the existing capital control regime. The capital control regime has some restrictions, let those remain in force, but subject to those, the State should not intervene in the freedom or choice of investors unless there is a case for market failure. The Committee’s view, however, was that there is no case for market failure in ADRs as long as the basic norms of the existing capital control regime are met.
The capital control regime allows an Indian to invest in a basket of assets abroad. Similarly, it allows a foreigner to invest in a basket of assets in India. However, as of now, ADRs are available only on the equity of companies issued with the authorisation of those companies. Similarly, under the Companies Act, IDRs are depositary receipts issued only on the shares of a foreign company. Thus DRs are limited to equities of companies; so are not available on units of mutual funds or government securities which are otherwise directly accessible.
Our Committee has recommended that if assets are available to me as an Indian, let there be depositary receipts on all instruments. If I can invest in instruments abroad, I should also have the option to invest in the depositary receipts issued on the back of all instruments. The same logic applies to ADRs.
The Committee has gone far beyond companies, equity shares and the sponsored programmes that have the authorisation of issuers. We don’t see unsponsored DR programmes as being extra risky or carrying additional problems in comparison to the sponsored type. Therefore, there’s no reason to disallow unsponsored depositary receipts if we allow sponsored depositary receipts.
So let everybody have full choice: allow depositary receipts on all instruments available to Indian investors. Similarly, allow ADRs and GDRs on the back of all Indian securities that are otherwise accessible to foreign investors. We call the basket of securities accessible to investors as permissible securities. We recommend that DRs should be available on all permissible securities i.e. securities as defined under the Securities Contracts (Regulations) Act and similar instruments issued by private companies. As of now, the rules are limited to public listed companies.
We are going beyond that. Let it be private company, public company, listed company, unlisted company; let it be shares, bonds, debentures, units trusts, mutual funds or rights or interest in securities. Similarly we propose DRs on all securities be accessible to foreigners. We call these DRs Bharat Depositary Receipts (BhDRs). We have no issue about that. Let DRs be issued on everything – subject to only two conditions, for various purposes, including availability of information about headroom for fungibility: permissible securities must be in dematerialised form and, in order to deal with safety and security aspects, DRs must be issued only in permissible jurisdictions.
To allay concerns about money laundering, those jurisdictions must be members of the Financial Action Task Force. We have recently seen structured transactions that amount to money laundering coupled with market abuse. We are also concerned about manipulation of the DR market since we’re dealing with just one market; one market for shares as well as depositary receipts on the shares. Even if they are in two different locations, they are interconnected.
Abuse of depositary receipts or the market for depositary receipts can amount to abuse of the market in the underlying permissible securities; we are concerned about that. We want our regulator to have explicit powers to conduct investigations and gather information through an arrangement with IOSCO members. In short, jurisdictions have to be FATF-compliant and the securities regulator of that jurisdiction must be a member of IOSCO.
Our concerns around investor protection relating IDRs are clearly different from those relating to ADRs/GDRs. As regards the latter, we are not concerned about investor protection because we know there is a screening process overseas. For example, in the US, before ADRs are allowed to be issued, the US regulators have norms to allow screen DRs keeping in view the interests of their investors. The jurisdiction that allows depositary receipts issuance screen those depositary receipts as to whether they are suitable and whether the interests of their investors can be protected.
In the case of IDRs, we have more concerns around protecting the interests of Indian investors. We are taking care of that in two ways. Nobody is theoretically ineligible in the domestic market from doing a public issue – and we apply the same principle here to ADRs/GDRs and IDRs – unless they have been barred from accessing the capital markets as a penal measure.
The logic is: supposing Company A, an Indian company, is barred from accessing the capital market in India. If we allow that company to issue depositary receipts, these are fungible and can be converted into the underlying securities of that company in the Indian market. So except issuers who are barred as a penal measure, everybody should be eligible to issue DRs under the securities laws, subject to compliance with the regulatory norms.
However, the IDRs or Bharat DRs can be of different types; some can be available to sophisticated investors only and some others should be available to all, including retail investors. SEBI, the custodian of the securities market in India, should provide the framework for different kinds of BhDRs.
In the case of DRs on unlisted shares (where the issuer has not committed to listing discipline); unsponsored DRs (where the issuer has not submitted to Indian jurisdiction); or foreign DRs (i.e. depositary receipts listed on, say, the NYSE and issued on the shares of, say, a Singaporean company), we recommend that these kinds of DRs be available only to sophisticated buyers. And let’s define what we mean by sophistication. Instead of having that one size fits all, we are proposing a variety IDRs – or BhDRs – be made available depending on the sophistication or appetite of investors.
Secondly that BhDRs must be listed in India.
The world has moved away from merit-based regulations or approvals for various transactions. Domestically, no issue of securities requires any approval. So we have recommended that no approval should be required for issue of DRs. But we are not dispensing with approvals required under the Foreign Exchange Management Act. That means that while you don’t need any approval to issue DRs, if that issue requires any transfer of securities in a foreign currency, you do require FEMA approval and you have to comply with that.
As regards fungibility, in the case of IDRs/BhDRs we suggested that up to 25% of permissible securities be allowed to be issued as depositary receipts. After issue, there are some limits from SEBI and the Reserve Bank on fungibility: they say that only 25% of IDRs are fungible and that only after one year of issue. Their logic is that if you allow more than that, then the availability of IDRs in India would be much less and liquidity would be much lower.
Our response to that is research studies do not support the contention that liquidity will be reduced by provision of higher fungibility. The important point is if you allow fungibility up to 100%, and assuming liquidity would dry up, it is still not a concern because there is an option for an investor to exit. If he is not getting liquidity in the DR market, he can convert a DR to permissible underlying securities. Further, there is the possibility of unsponsored DRs getting into the market. We do not see any concern arising from allowing fungibility up to 100% of the DRs issued. However, we must allow the law of one price to prevail. That is possible only with full arbitrage and 100% fungibility
A couple of other things: DRs should be allowed to be issued up to the limit permitted under the capital control regime. We know that, let’s say, certain kinds of investors can invest in an Indian company up to x%, but with the approval of shareholders, they can invest up to y%. If that approval is not there, the investment can go up to x%. And that investment can come through FDI, FII, DR or any route, it does not matter, but it must be within the permissible limits under the capital control regime.
Second: there is no clarity around taxation. Many transactions associated with ADR, GDR, IDR or BhDR are not necessarily taxable because there is no transfer, gain or income. Starting from the issue of securities in the very first instance to a depositary; the issue of depositary receipts against these permissible securities; conversion of depositary receipts to permissible securities; and permissible securities to depositary receipts, and transactions in ADRs outside the country: these are not taxable events as there’s no change in beneficial ownership.
You would normally tax against profits and income. That arises only in the case of transfers or if you receive interest or dividend income. We are saying [to the relevant authorities]: tax only to that extent and please provide that clarification.
If we’re talking about BhDRs, transactions are happening in India. There is no market for BhDRs outside India. These are Indian securities, so please tax them as if they are Indian securities. If they are traded on exchange and the underlying are equity shares, apply securities transactions tax (STT). If they are traded outside the exchange, apply long-term capital gains tax. These are, by law, domestic securities and the market for them exists in India only. So tax them as Indian securities. As regards returns, these are the returns on foreign securities. BhDRs are issued on foreign securities. So treat that as income on foreign securities.Except for these two aspects, do not tax DRs at all.
As regards to BhDRs, we have one additional submission: from the perspective of investor protection, we are clear that IDRs are securities under the Securities Contracts (Regulations) Act but there are doubts as to whether BhDRs can be securities. We are saying: make it a little more explicit. Securities laws empower the government by notification to declare certain instruments as securities. Use that power to do it.”