The Retail Investor Should Be Protected

The role of the regulator in the capital markets has come under greater scrutiny following recent developments linked to the CRB scandal, the altercations with market players on the sub-broker registration issue and the signing of indemnity bonds by National Stock Exchange members. Management and accounting consulting house Price Waterhouse assisted the Securities and Exchange Board of India (Sebi) on several key issues through its financial institutions reform and expansion (FIRE) project. It is of the view that the regulatory framework for the Indian capital markets needs to be clearly defined as far as the retail investor is concerned.

In a path-breaking report, Price Waterhouse has called for a greater focus on who needs to be regulated and in what form. Tom Keyes, capital markets consultant of Price Waterhouse who has trained brokers in the US to improve the regulatory mechanism, talks to Rajas Kelkar and Salil J Panchal on the Indian capital markets lack of focus on the retail investor and how a proactive Parliament alone can strengthen Sebi further. Excerpts.

 

Q: How would you view existing regulations in the Indian market?

A: The Indian securities markets are in the process of a change that is similar to the changes that occurred in the US during 1970 to 1976 and in the UK from 1984 to 1988. This is a situation where the old systems are no longer functioning, and a new system is not yet in place. It is a rather complicated phase of transition. The process takes time, especially in democratic nations, as stockholders fight for their positions in the new system. Regulations also change but not always with the intended results. The disagreement among the market participants takes more time and creates havoc.

In India, one group of stockholders does not seem to be adequately represented in the discussion of new rules. This is the retail part of the securities market, the retail investor and his intermediary. The recent R Chandrasekharan Committee report also does not include this segment. The lack of representation is a clear message to retail investors and their intermediaries. We dont want you, or your money. We are not going to consider you. We are not going to protect you. We are not going to give you legal access. India should decide if it wants to include the retail investor and their intermediaries.

Q: How do you explain this? What has happened as a result of this ignorance?

A: Most of the publicity surrounding the bad delivery problem and solutions suggested focus on the investing institutions and the exchange members. Little has been focused on the retail investor. Amendments to the guidelines for good/bad delivery issued on August 19, 1996, included the amended Clause 62A, which says that transfer deeds dated June 1, 1997 and thereafter which have rubber stamps on reverse other than those of members of bourses or clearing houses or Sebi registered sub-brokers and remisiers registered with bourses, will be treated as bad delivery.

The effect of the above rule is to deny public investors access to the securities market. Their intermediaries have not been registered, and cannot be registered. Their intermediaries are not regulated within the market system and do not have a legal status. The retail investor has also found that their access to the depository is limited. They cannot use regular intermediaries to access the depository. If they choose banks that are depository participants, transfer of scrips for securities transactions appears to be time consuming.

Intermediaries for the retail investors will not encourage the depository use because they have no protection against the use of their customers name by the bank and the banks brokerage firm.

The existing rules, regulations and systems have created a tiered market, providing legal market access and protection to only institutions and high net worth individuals and not retail investors.

Q: What has been the international experience so far? How have other markets in the world addressed this issue?

A: International markets also witnessed a similar situation. However, countries have addressed this issue by deciding what they intend to do with the retail market. Some countries chose to limit their citizens to mutual funds. Italy, until the early nineties, had such a restriction. They distributed funds through universal banks, banks that combine deposit functions with merchant banking and securities broking activities. Then gradually they changed the system and now investors are allowed to choose individual securities.

Germany has had very few individual investors. Capital market services were available through the universal banks to Germanys banks and larger companies. High net worth individuals were serviced by the universal banks.In the last two years, they have amended their laws promoting the interest of shareholders and allowing more transparency. Germany is now trying to build the number of investors in the country. They used the recent Deutsche Telecom issue to build two million investors.

Q: What are the options for the Indian regulator?

A: The Sebi chairman D R Mehta has stated on several occasions that mutual funds are the appropriate investment vehicles for small investors. Sebi has played an instrumental role in improving the governance of mutual funds in India. If India opts for restricting investment of small investor to mutual funds then a proper distribution system needs to be developed. The current system does not provide asset management companies with a reliable distribution system nor does it protect investors from fraudulent distribution practices.

There is a need for a code for selling practices of mutual funds. A person who sells mutual fund to the small investor has to be a registered intermediary. The intermediary needs to understand the difference between selling a new issue product and a mutual fund. There is a need to encourage more professionalism in the market.

If a capital market structure for the institutional and high net worth individual is truly the choice, then it must be explicit and congruent. In recent times, words and actions have not been congruent. Words are about investor protection which makes retail investors feel that they might be included. However, through ensuing actions, they find out that it does not involve them.

India needs to choose the option to protect the retail investor. The investor in thousands of B group stocks are the retail investors. We have heard them complain and say why should they buy stocks when they have received bad paper that is difficult and time consuming to clear up. Sub-brokers, who bring them to the market, have informed them that they are not a part of the system. Brokers turn down their requests and ask them to go through mutual funds which are not performing either. There is competition around from fixed deposits and debentures, which offer higher and safer return.

India does not have a securities market, at least they do not have a delivery market. Other than a few institutional trades that are completed by delivery, the entire market volume belongs to the speculators.

Q: You have also suggested that India should adopt the US model for regulating plantation companies. Can you elaborate on this?

A: The plantation companies that have mushroomed all over the country would be the next embarrassment for the Indian regulators if no steps are taken to regulate them. The government needs to just say that units issued through plantation schemes by these companies are securities. Then they will automatically come under the purview of Sebi.

The Securities Contracts (Regulation) Act (SCRA), which defines the term securities, also contains a clause saying that any instrument that is indicated by the central government will be considered as a security.

In the US, the Securities and Exchange Commission (SEC) went to court and took the initiative for regulating the plantation companies. In India, regulators are not prepared to take on the responsibility because of lack of adequate infrastructure. However, there is a need for regulation.

We suggest that India should adopt the US model for regulating such companies. The SEC and courts have broadly construed a phrase called investment contracts, so as to apply the registration requirements of the 1933 Act to a wide variety of financial schemes. The traditional test for whether a property interest constitutes an investment contract is the so-called Howey test set forth by the Supreme Court in 1946. This case holds an investment contract as any contract or profit making scheme whereby a person invests his money in a common enterprise and expects to make a profit solely from the efforts of the promoter or a third party who is responsible for management.

This definition forces the registration of any such instrument and thus is regulated by the authority. The Indian regulators need to have a broader regulation on similar lines and force these players to register these securities. A minimum disclosure standard should be imposed on these companies when they issue brochures to the public. These disclosures should also include the cost incurred by the company to procure the land and cultivate it. Besides this, there must be a mechanism in place for continuous disclosures from such companies about the financials.

In recent times, words and actions have not been congruent. Words are about investor protection which makes retail investors feel that they might be included. However, through ensuing actions, they find out that it does not involve them.