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Pro-business reforms such as reduced taxes and licensing reforms came to be introduced in 1980s. The Government had also come to recognize the importance of capital market for the acceleration of industrial and economic development. Trading activity exploded in 1980s with a sharp rise in the number of listed companies and their paid-up capital. Despite this, retail participation remained little.
SCRA completed its 30 years of being on the statute book in 1986. At this juncture in 1984, a high-powered committee on stock exchange reforms was set up under the leadership of GS Patel, erstwhile chairman of Unit Trust of India (“Patel Committee”). Its mandate was to study the functioning of stock exchanges and make recommendations thereof.
The Patel Committee’s observations and recommendations were significant and also descriptive of the time period. This blogpost attempts to provide a picture of things as they were basis the observations and recommendations of the Patel Committee Report. For readers who have read SCRA and SCRR, it may be insightful to note the genesis of some requirements that have developed further today and some that seem unnecessary or obtuse now. Singular reference for this entire blogpost thus is the flipbook containing the official Patel Committee Report.
Primary Market
Intermediaries such as merchant bankers, investment companies, registrars to transfers of issues (“RTIs”), etc had emerged now to fill the structural gaps in the primary market. They offered a range of sophisticated services to issuers such as preparation and issue of prospectus, obtaining government approvals, underwriting arrangements, marketing for the issue, processing of applications till the final stage of allotment, issue of certificates and refund of monies. They had undoubtedly raised the efficacy of primary market and its capacity to absorb new issues. Yet issues plagued the market.
Malpractices by issuers and brokers
Problems included unofficial transactions before issues opened for subscriptions whereby premia on new issues was rigged by cornering and rate manipulations by promoters and others to entice unwary investors. Certain promoters would also paint rosy picture of companies through handouts, promising better returns and capital appreciation and offering shares by private placement from promoter quota before the issue opened for public placement. Such promoters would offload shares after subscription leaving investors with eroded premia. Kickbacks were also offered by brokers on their own behalf or on behalf of promoters/management to lure investors to apply for issues, particularly, non-convertible debentures.
Rising cost of issuance
Companies seeking to list needed to apply both to the regional stock exchange (“RSE”) and the exchange it desired to list on along with the documents required by both, adding to delays and expenses. Further, underwriting commissions, brokerages and fees charged by managers to the issue used to be prescribed by government and were high, e.g., underwriting commission was ~30% of equity issues and ~50% for debenture issues.
Patel Committee recommended reduction of these rates and simplification of listing application procedure. RTIs also faced significant costs on account of the large number of applications and monies received. Patel Committee recommended streamlining of this process including changing the lot sizes for subscription to reduce the large number of new applications.
Secondary Market
Secondary market was plagued with several issues as well, discussed below.
Brokers failed to execute client orders, traded on their own and failed to make timely payments in respect of sale proceeds. Patel Committee recommended mandating members to issue contract notes for each and every bargain put through for clients including the price at which securities were bought/sold with brokerage charged, time of putting through the transactions and disclosure of whether broker is acting as dealer.
Exchanges were observed to be managed by governing bodies primarily comprising elected brokers whose decisions naturally tended to subserve investor interests. Exchanges were found weak at preventing crisis and in ensuring their healthy functioning. Rules, regulations and byelaws of exchanges were found exacerbating the problem.
Trading Malpractices
Badla continued beyond the prescribed 90 day limit and settlement of price difference at the end of each settlement period was on basis of making up price fixed by exchange authorities.[1] Sometimes in oversold positions in any security due to large short selling to the extent that sellers found themselves unable to tender actual delivery of shares demanded by the buyers, the sellers also had to pay backwardation to the purchasers.
Trading in specified shares was subject to carry over margin (the making up price fixed by exchange authorities at the end of each settlement period), daily margin and ad hoc margin (for members trading beyond their financial capacity and whose outstanding business was excessive). Margins were required to be paid in cash or by deposit of securities approved by exchanges.
Patel Committee noted that SCRA had been enacted to regulate exchanges and transactions in securities dealt on them with a view to prevent undesirable transactions therein. It observed that though byelaws and regulations of exchanges were framed thereunder for settlement of speculative transactions and for resolving problems therefrom, they were deficient in genuine investor protection. The Committee attributed the excessive speculation to overtrading by brokers on their own account, the absence of a proper provision prohibiting insider trading, illegal option trading and kerbside trading by brokers.
Options are contracts permitting its holders to buy/sell shares of a company at a certain price (striking price) for a certain period of time irrespective of share price fluctuation in such period. Its consideration amount is called premium, payable by option holder and fluctuated constantly as options were traded continuously. In a call option, holder gains right to buy anticipating price rise whereas put grants right to sell anticipating price fall.
In India, option trading used to be popularly called Teji Mandi whereby speculators reinsured and limited exposure to risks and adverse share price rise/fall wherein they speculate.[2] Such trading used to occur on a large scale by non-members in Bombay, Ahmedabad and Calcutta despite its ban under Section 20 of SCRA and its criminalisation. These transactions were regularized by reporting them to exchange authorities during trading sessions after the validity period of different types of option trading were over. Orders for purchases/ sales emanating from such trading were instrumental in share price manipulation accentuating speculative activity and distorting the normal rhythm and trends in the functioning of exchanges.
Most big non-member operators on the exchange continued having close links with commodity markets and in association with some members they would speculate heavily, accumulating large business in leading scrips of specified lists, upsetting the normal functioning of the market. They rigged share prices using finance arranged from outside at the turn of each settlement, took temporary deliveries of scrips and created artificial scarcity to accentuate the upward trend in prices and profiteer out of the price fluctuation. This distortion affected gullible investors. They often formed syndicates to manipulate markets and even spread rumours.
Regulation by Exchanges
The machinery for reporting, monitoring, inspection and audit of market operators was also inefficient. The trades reported to exchange authorities accounted for little of the actual trading as part of speculative business was settled by adjustments before the settlement day and reported for privately recording to brokers. Some contracts were squatted up within the 14 days period and a huge volume of daily business done by authorized clerks and taravaniwalas on their account was also not reported.
Even for the available information, exchanges were handicapped by the lack of technology to process and take action. Effective mechanism to check on activities of brokers to ensure settlement of contracts concluded by them to check whether they speculate beyond their financial means or involve themselves in kerb/option market was also absent.
Further, though Rule 15 of SCRR required brokers to maintain books of accounts and registers, ledgers etc, giving particulars of the shares and securities received and delivered, there was no regular machinery for exchanges to inspect its compliance. This also led to a lack of check on overtrading, kerb trading, harmful trading before listing, involvement in financial improprieties, other irregularities, evasion of margin payments etc., by brokers. Though MoF had issued detailed guidelines for audit of books of accounts and other requirements for brokers under Rule 15, the nature and scope of this audit was found insufficient to enforce discipline or to compel them to make fuller disclosures to the exchanges for their dealings.
What made things worse was the hesitance by governing bodies of exchanges to deal with crisis situations efficiently and the outdated nature of byelaws and regulations. This was evidenced by the continuance of forward trading in shares despite its ban in 1969 and the lack of revision of byelaws to reflect this ban. This system enabled and encouraged carry forward and short selling. At times, this led to sudden delivery demands by bull operators at the time of settlement leading to unhealthy impact on the entire market. Benefitting from the lack of regulatory control over short selling in market emergencies, operators resorted to large scale short selling to depress prices to make quick profits. Considering the narrowness of markets then, large scale short selling often led to crisis situation. Patel Committee recommended specific parameters to be fixed for short sales to limit them to price ranges in a security for the day.
The Committee noted that a margin of 3% for both sale and purchase for too marginal to impact speculative transaction, especially as the shares whose delivery is taken by arranging finance can be used for margin purposes. The margin system, it noted, had failed to consider the speculative build up in individual scrips and lacked inbuilt mechanisms to appositely distinguish and deal with bullish and bearish trends. The 90 day settlement period was found long enough to delay fulfilment of contract and enabling operators to indulge in speculative trading. The liberal facilities for carry over of transactions including imposition of mere nominal margins at the end of the settlement periods was found to encourage speculative transactions making market prone to crisis.
Patel Committee recommended reforms to margin system, including the adoption of front end margin (i.e., pre purchase or sale) of 25% of ruling market price and of 20% for trading for settlement (to be stepped up when warranted). It recommended requiring maintenance of margins by brokers in a separate bank account to the credit of each investor and constant monitoring and follow up of margin so deposited and the margin required to be deposited with the exchange. For prevention of overtrading, introduction of minimum liquidity margin was suggested whereby a broker may be asked to maintain sufficient financial stake in the business at all times and his volume of activity may be related to such resources.
Other factors aiding speculative activity
The lack of timely and prompt disclosure of sufficient corporate information led to guesswork and market gossip as well as false rumors leading to speculation, fluctuation and provided scope for market manipulation to unscrupulous operators. Further, the lack of coordination and common policies by different stock exchanges regarding trading hours, settlement procedures, lack of uniformity of margins etc. encouraged unhealthy speculation. Due to narrowness of market then and shortage of adequate floating stock of good scrips, trading remained concentrated in specified and non specified securities with high volatility and manipulations whereas for others it was non-existent.
The governing bodies though vested with wide discretionary powers were lax in enforcing the norms in place including prevention of cornering of shares by prohibiting further dealings in those securities (while allowing existing contracts to close out or liquidate); by shifting vulnerable securities out of specified list in case of excessing overtrading/cornering; expulsion/suspension of members for contravention of exchange rules/regulations/byelaws etc. Patel Committee noted their limitations on conducting searches against members and power to direct members not to deal with any non-members who may upset market equilibrium.
Patel Committee strongly recommended the reorganization of stock exchanges by increasing professional members, simplifying and rationalizing antiquated systems, procedures and traditional methods of conducting business as well as improving operational and managerial efficacy and infrastructure facilities. It recommended criminalizing kerb markets, price rigging, market manipulation, insider trading, cognizable offences and changing policy and practices of exchange’s governing bodies. It recommended also a review of the rules, regulations and byelaws of exchanges to curb speculation more effectively. Further, it recommended improvement in overall liquidity in the market to ensure better transferability and negotiability of securities and augmenting supply thereof.
Recommendations to achieve statutory objectives of SCRA
The Patel Committee noted that the essence of regulation of the market, as rightly laid out by the Gorwala Committee in 1951 was to control the speculation in the stock exchanges and the crux of the control of speculation is its confinement to the right sphere, the right persons and the right type and volume of business. It observed that this had not happened. To rectify this situation Patel Committee made several recommendations.
The recommendations included proper regulation and control of trading for settlement business; close scrutiny of list of specified shares (to be made common for all exchanges), tightening criteria for inclusion of scrips in it and its enlargement to include more scrips; constant review of the list to eliminate scrips with insufficient trading volumes/ where management tends to speculate etc.; uniformizing practices covering all aspects of trading in securities in all stock exchanges with common tools of regulation and control.
Other recommendations by Patel Committee included automatic suspension of brokers for transgression of dealing with an outside party which had failed to honor business commitments with any broker of the exchange. It also recommended reporting of scrip-wise list of transactions with names of parties, individuals and groups who have purchased/sold shares of value > Rs. 1 Lakh on cash/settlement basis, apart from the daily volumes on the stock exchange.
Further, it recommended that byelaws and regulations must provide that exchange authorities can direct members not to deal with any non-member without assigning any reason and that a member should not be allowed to arrange finance from outside by offering shares under purchase with blank transfers as security for speculative trading on his own account.
It recommended capping carrying over a transaction to 4 times, i.e., four settlements of 14 days’ duration each and members must settle such positions once in 60 days and certified statements to that effect should be filed by members with exchange authorities. It was suggested that breach of this requirement should attract suspension/ expulsion of brokers. This was because the 90 day period was found contributing to speculative activity and ineffective.
Patel Committee noted that exchange operations had become highly complex, requiring complicated documentation consequently leading to a lot of manual bookkeeping, paperwork etc. acting as a danger to expansion of business. During this time, a typical request from a client required the broker to carry out as many as 27 distinct operations connected with bookkeeping along dragging the period between placing the order by an investor and the time it was actually transferred. This led to huge delays. The committee thus recommended simplifying procedures.
Some of the many documents that brokers were required to maintain under rule 15 of the SCRR were also not being maintained, particularly contract notes. To this tune, Patel Committee recommended that an electronic system comprising instantaneous record of transactions and prices for the use of offices of brokers and stock exchange was needed to replace the blackboard systems. The Patel Committee also noted that BSE and CSE had fully computerized settlement for specified share transactions, but the other still followed manual practices. It recommended automation of processes.
The committee noted that there was a glaring need to lay down code of conduct for brokers and it recommended putting the same into place. Further, it noted that the existing rules, byelaws and regulations of exchanges lacked provisions for payment of dues to non-member clients whenever a member is declared a defaulter. In this regard, the committee recommended creation of a compensation fund to take care of legitimate investors (to be initially financed by levy on turnover of members).
The Committee also highlighted the need to regulate the workings of not only exchanges but also of all activities associated therewith including members, authorized clerks, sub-brokers, RTIs, etc. as also the newly emerging investment advisors, consultancy firms and investment fund companies.
[1] Making up prices were fixed taking into account the closing price of the specified shares on the last business day of the settlement cycle.
[2] The SCRA defined an option in securities to mean a contract for sale/purchase of a right to buy/sell, a right buy and sell in securities in future and included a teji, a mandi, a teji mandi, a gulli, a put, a call, or a put and call. A teji is a call option, mandi a put option, a jota (in Bombay markets) is a put and call / teji mandi depending on the market trend.
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