Restrictions on redemption of Indian depository receipts by sebi and its effects

By : Suman meena

Restrictions by SEBI

Introduction of IDR’s in India: Standard Chartered Bank

SCB opened its first branch anywhere in the world in Kolkata 152 years ago, in 1858. The first three branches were in Kolkata, Mumbai and Shanghai. India is the second largest contributor in terms of net profits for the bank and marginally behind Hong Kong. The key statistics for SCB indicate that India is a focus area for the bank.

Key markets for the bank are Hong Kong, Singapore, India, South Korea, Asia Pacific and Africa regions. It is interesting to note that during the global crisis at the end of the last quarter of 2008, SCB did not receive any support of any kind from any government. This is a testimony to the inherent strength of the bank.


Objectives of the Bank

• To provide Indian investors with an opportunity to invest in the Company and participate in its growth. The company has been established in India for many years, is committed to India’s future and believes that India will remain a growing and key market – the issue demonstrates that commitment;

• To increase the market visibility and brand perception of the Company in India.

• To support growth across the Company’s business globally. The current economic circumstances and related market dislocation have presented unique opportunities to deploy capital into selected areas where the competitive environment, pricing levels and returns are particularly attractive and

• To widen the Company’s investor base and to provide a new source of capital.

• Advantage that is available by investing in this issue and that is you get an international exposure without having to go abroad and it is in a bank which is global in nature and having adequate exposure to the fast growing economies of India, China, the Middle East and Asia Pacific.


Restrictions by SEBI on Redemption of IDR’s

• A recent circular dated June 3, 2011 (“the Circular”) issued by the Securities and Exchange Board of India (“the SEBI”) contains certain restrictions on the redemption of IDRs into their underlying equity shares. It came at a time close to the completion of the expiry of the one year lock-in period after which the redemption of Standard Chartered Bank, Plc (“Standard Chartered”) IDRs could take place.

• According to SEBI: “After the completion of one year from the date of issuance of IDRs, redemption of the IDRs shall be permitted only if the IDRs are infrequently traded on the stock exchange(s) in India. For this purpose, IDRs shall be deemed to be ‘infrequently traded’ if the annualized trading turnover in IDRs during the six calendar months immediately preceding the month of redemption is less than 5% of the listed IDRs.”

• That means that the IDR’s would be considered as ‘infrequently traded’ if the annualized trading turnover in IDRs during the six calendar months immediately preceding the month of redemption is less than 5% of the listed IDRs and the SEBI has described illiquidity as an annualized turnover for the previous six months which is less than 5% of the total number of IDRs issued. In the case of Standard Chartered, the turnover was 48%.

• The reason for not allowing redemption for now: “Allowing redemption freely in the absence of two-way fungibility could result in reduction of number of IDRs listed, thereby impacting its liquidity in the domestic market.”

• This means that the extant regulatory framework does not permit fungibility but only redemption. The SEBI regulations and the RBI circular state that automatic fungibility of IDRs is not permitted or the two-way fungibility, the ability to purchase existing shares on the London Stock Exchange and/or the Hong Kong Stock Exchange and deposit them into the IDR programme is not currently permitted. Therefore, fungibility of IDRs into the underlying shares would be permitted only after the expiry of one year period from the date of issue of IDRs and subsequent to obtaining RBI approval on a case-by-case basis.

• Further, the SEBI stated that the RBI circular, also said that Indian residents were required to comply with FEMA at the time of redemption/ conversion of IDRs into underlying shares.

• The issuer company is expected to make an announcement in English and Hindi language newspapers with wide circulation about the trigger of the redemption event, time period for submission of application and the approach for processing the applications as well as notify the stock exchanges. Such announcement shall be made within seven days of closure of the half year ending on which the liquidity criteria is tested.

• IDR holders may then submit their application to the domestic depository for redemption of IDRs within a period of 30 days from the date of public announcement and redemption of IDRs shall be completed within a period of thirty days from the date of receipt of application for redemption.

• After redemption, the domestic depository shall notify the revised shareholding pattern of the issuer company to the concerned stock exchanges within seven days of completion of redemption.

• SEBI has directed all stock exchanges, depositories, merchant bankers, registrar to issues and custodians to comply with the circular with immediate effect.


Consequences of Restrictions by SEBI on Redemption of IDR’s

The possible consequences of such a move may be that investor interest in IDRs would diminish and would lead them to become illiquid. SEBI would then be forced to re-examine its decision to place such restrictions on the exit options for investors. Following are the consequences of restrictions:

• In the case of Standard Chartered that listed in June last year and could have become eligible for its shareholders to redeem the IDRs in a few days from now this annualized trading turnover is estimated to be around half of its listed IDRs, making its investors ineligible for redemptions.

• The new norms and reaction of investors raises a question as to whether Standard Chartered PLC issued IDRs in haste even before SEBI had clarified on key matters for investor such as redemption.

• One more question is whether the new norms or rather clarifications related to redemption will become a deterrent for other multinational firms to issue IDRs.

• Institutional investors who were looking for a price arbitrage may not be excited about new IDRs as they can’t be possibly sure of meeting the ‘illiquid’ criteria for their IDRs to become eligible for redemption. This can certainly be a blow for MNCs who were hoping to float IDRs.

• On the other side, the new regulatory norm brings clarity on the subject which can be used by other prospective IDR issuers to attract a different set of investors who are not necessarily swayed by the arbitrage aspect.

• Indian Depository Receipts of Standard Chartered Bank fell 18% to a new low of Rs 94.55 after a SEBI directive placed restrictions on conversion of actively traded IDRs in shares.

• Since Indian market places restrictions on the kinds of investors who can buy IDRs -insurance companies cannot invest in the product-there is a price difference. Some investors were hoping to profit from this price difference by purchasing IDRs and converting them into shares. The restrictions on redeeming IDRs into shares has killed this opportunity.

• Effect on Chartered’s IDR-holders: An unstated fear could also be if all IDR-holders redeem, there would be no IDR left, which would mean one tick mark less in India’s claim to being a globally advanced capital market. But this is an unnatural obstacle in the way of Standard Chartered’s IDR-holders. Their holdings anyway trade at a discount to the underlying share, which is listed in London and Hong Kong.

• There are several restrictions on IDRs, stemming from India’s controls on inflows and outflows of foreign capital. Though Indian citizens are now allowed to own property and invest in overseas securities, these come with limits. RBI’s regulations prevent 2-way fungibility of IDRs. Investors cannot convert their IDRs into shares at will and vice-versa. SEBI allowing redemption, when fungibility is not permitted, will mean a lowering in the IDRs under circulation, lowering liquidity.

• An unintended consequence of the SEBI ruling on the Indian Depository Receipts (IDRs) of Standard Chartered Plc could be that, IDR investors may well get a chance to convert their holding in the underlying shares in a few months from now. That is because the IDRs could lose favour with institutional investors especially overseas ones leading to a drop in liquidity, thereby triggering the clause for conversion/redemption.

• But liquidity in the IDRs may still be affected, if foreign institutional investors keep away.

• Falling liquidity in turn could trigger a self-reinforcing cycle of falling prices (distress selling) and further illiquidity (as many investors may hold on, not wanting to sell at a steep discount).


Comments on of SEBI action of restrictions on redemption of IDR’s

• According to R. Balakrishnan, Independent analyst & columnist, SEBI not only has to ensure fairness in its action as a regulator but presumably also has a developmental role when it comes to the market and expanding the market. It also has a role to be equal-handed when it comes to dealing with various investor classes.

• There would be a hue and cry saying that SEBI will kill the future of IDR issuances. Liquidity is provided by market makers. The same set of people cannot now come back and say that liquidity is an issue. This action would be the factor that brings arbitrage down to minimal levels. Arbitrage in equity share that is driven by quirks is a high-risk game and beyond the realm of investment. The regulator is not bound to “protect” someone who invests anticipating regulatory action of a particular nature.

• A good regulator will change regulations in tune with the times and needs. Now, if everyone loses interest in the IDRs, two things should happen:

(i) The instrument would become illiquid due to lack of interest and force the regulator to take a relook at this decision;

(ii) Future IDR issuances will factor in the (equal) possibility of the absence of the two-way fungibility of an IDR.

• According to Seth R Freeman, CEO, EM Capital Management

“If I were on the SEBI board, I would set a regulation that tightly limits foreign ownership of IDRs but also eliminate fuzzy one-year hold rules.”

• In developed and developing markets, nothing annoys investors more than abrupt changes in rules and particularly those that are applied retroactively. In every offering document there is a “Risks Section” and in documents for emerging markets investments there is a section titled “Emerging Markets Risks”. The reality is that few investors carefully read these boiler-plate sections. Investors who have read the Risks Section must believe their investment will be immune to the potential risks described in the documents, including emerging markets risks.

• The Standard Chartered IDR listing for the most part failed to provide access to Indians. We have since learned that approximately 70 per cent of the Standard Chartered IDRs have been held by foreign investors with Indian retail investors owning only 8 per cent.

• Instead, the IDR created a new arbitrage opportunity for foreign professional investors. The sharp decline in the IDRs on June 6 underlines the fact that foreign investors were holding the shares with the sole intention of redeeming them for the underlying shares to realise a sizeable arbitrage profit based on their discount to Standard Chartered shares listed in London and Hong Kong.

• SEBI certainly risks institutional credibility by abruptly changing or simply issuing a rule clarification, in this case on day 360 of a one-year hold rule. It must have been obvious to the regulator that most of the issue is foreign-owned and what the IDR holders’ investment strategy has been most of the past year. This is precisely the kind of Emerging Market Risk a securities regulator should avoid.

• SEBI should create mechanisms and products that encourage domestic investors to buy and hold India equities. This will enable inclusive financial growth without creating new opportunities for foreign investors to scrape off short- and long-term gains that distort liquidity and valuations. In every case, regulatory consistency and transparency and the goal of eliminating India from the “Emerging Market Risks section will facilitate moving from emerging to developed.