MCX-SX verdict may create ripples across financial sector

The landmark judgement by the Bombay High Court, which has upheld an innovative divestment method followed by the MCX Stock Exchange (MCX-SX) to comply with shareholding norms, may have far-reaching impact on various financial sector regulators and entities governed by them. The judgement, has opened possibilities for others who are facing similar regulations across the financial services industry, say legal experts.

Pavan K Vijay of Corporate Professionals said, “They (MCX-SX) have shown the way. Others might also look to use similar structures to bring down holdings for compliance. Competition is good for everyone, as long as the new players expand the pie, rather than eat into the existing market.”

The court set aside an order by the Securities and Exchange Board of India (Sebi), which had rejected the divestment process followed by MCX-SX, that involved several steps, including a capital reduction scheme, an issue of warrants and several buyback agreements. The court held existing regulations do not limit the modes of divesting stake. Sebi’s lawyers said they will study the order thoroughly before deciding on an appeal.

While the direct impact is on Sebi and other potential players interested in launching stock exchanges, the verdict also affects other regulators like the Reserve Bank of India (RBI), the Forward Markets Commission and the Department of Industrial Policy and Promotion (DIPP), lawyers said, adding, these regulators may have to amend rules to protect their rights. “There may be a case for amendment of laws,” said Ramesh Vaidyanathan, partner, Advaya Legal. The court seems to have followed the principle that future possibilities cannot affect present legal status. “However, as a regulator, I have to look at both the possibilities, present and future.”

He cited the example of a convertible instrument, like the share warrants issued by MCX-SX in an industry where there is a cap on FDI. “Say, a convertible instrument is issued to a foreign investor. If the equity, on dilution at a future date, exceeds the prescribed caps for the sector, should DIPP allow it or not?” he questioned. Similar questions on legality of buyback arrangements could prop up, said Kumar Desai, advocate, Bombay High Court.

The high court held the buyback agreements entered into by MCX-SX could not be held illegal on the grounds cited by Sebi. “A buyback confers an option on the promisee and no contract for the purchase and sale of shares is made until the option is exercised. The promissor cannot compel the exercise of the option and if the promisee were not to exercise the option in future, there would be no contract for sale and purchase of shares. Once a contract is arrived at upon the option being exercised, the contract would be fulfilled by spot delivery and would therefore, not be unlawful.”

Desai, who has represented Sebi in several cases, said, “The judgement gives an aura of legitimacy to buyback agreements. Both RBI and Sebi may not be comfortable with this. While in this case, the agreements might have been genuine, not all buyback agreements are.”

Some lawyers point out that many angel investments by foreign investors are often in the nature of loans masquerading as equities. These agreements have riders, which assure a specific IRR and specific terms of repayment, against the very nature of equity investments.

BROADBASING OWNERSHIP
Regulator	Entity	Shareholding cap on individual shareholders
Sebi	Stock  exchange	15% by banks and public financial institutions, 5% by all others
FMC	Commodity exchange	26% by promoter, 5% by  any single investor, 5% by a stock exchange shareholder
RBI	Bank	5% by single investor; can go up to  10% with permission from RBI, promoters to bring down stake to 10%

Like Sebi, which has put the maximum holding by an individual entity in a stock exchange at five per cent, the central bank and the commodities regulator have also put caps on shareholding in their respective domains to ensure public financial institutions, like banks, and market infrastructure institutions, like exchanges, have broad-based ownership.