In the iconic Bollywood movie, Sholay, a number of policemen have been featured. There is the bumbling jailor who relies on weak market intelligence and ends up burning his fingers. Then, there is the stereotypical Bollywood cop who arrives after all the action is over in the last scene.
In the recent furore over fancy structures used by mutual funds for promoter financing, market regulator Securities and Exchange Board of India (Sebi), unfortunately, displays similar weaknesses.
To start with, its market intelligence comes across as extraordinarily poor, if not absent. Reports say the regulator is now concerned about undue risks taken by mutual funds, although there was no inkling of any concerns of the kind anytime in the past. Likewise, while market participants are now calling for better disclosures of such financing structures by listed companies, Sebi is yet to make a statement on this.
J.N. Gupta, managing director, Stakeholders Empowerment Services (SES), says: “Sebi will have to revisit regulations governing mutual fund investments."
The trigger for Sebi’s examination of the issue was a sharp drop in the shares of Zee Entertainment Enterprises Ltd and Dish TV Ltd after some lenders sold pledged shares in the market. With a large number of such pledges outstanding, there may well have been a cascading impact if other lenders too followed suit and sold shares.
Promoters of the group later said that the lenders had agreed to a standstill, adding they had been granted time till September to reduce leverage. Reports that mutual funds agreed to such a deal, without receiving additional collateral, has the regulator worried as well. Some experts worry that this is akin to the “ever-greening" phenomenon that got Indian banks into trouble with bad debts.
There are related worries about the structure used for such lending, which masks the extent of leverage of some promoters. The modus operandi is as follows: A promoter entity approaches a credit rating agency asking for a rating on bonds to be issued by it, based primarily on the comfort that the value of underlying shares held by it will always be 150-200% of the value of bonds outstanding. For instance, for ?100 crore worth of bonds outstanding, ?150-200 crore worth of shares are said to be backing the bonds. Armed with an investment grade rating, these bonds are then placed before mutual funds.
In case the value of the share price falls, the promoter entity is expected to add more shares, such that the value of the total number of underlying shares remains above the agreed upon threshold, or redeem some bonds. When funds are raised in such fashion, the underlying shares are not technically pledged. This was first reported by Bloomberg columnist Andy Mukherjee, who said that these debt covenants are as fluffy as cotton candy. “These are essentially unsecured loans to private investment companies, not suitable for mutual funds," he wrote.
While it’s bad enough that Sebi’s own market intelligence didn’t pick up the increasing use of such instruments by the mutual fund industry, what’s even worse is that it did not see any need to act when reports of their use emerged over two months ago.
Apologists at mutual funds argue that such transactions are clearly permitted under existing regulations, and that they should be free to assess credit risk of a promoter entity and take such investment calls. “If, as some are suggesting, there is a blanket ban on such structures, we need to realize that there will be a cloud over financing any promoter that uses a holding structure. Even groups such as Tata Sons raise funding based on the value of their holding in other group companies," says a fund manager, requesting anonymity.
“You may not curb the freedom of mutual funds to invest, but you have to ask them to make more disclosures," says SES’s Gupta. Whether Sebi demands more disclosures or a step-up in risk management, it is high time it made its stand clear. To be sure, there is another view that Sebi doesn’t hold the keys to the problem. “Sebi cannot stop all misdeeds. It is for the mutual fund industry to do what is right for investors, rather than side with promoters" says Shriram Subramanian, founder and managing director, InGovern Research Services Pvt. Ltd.
But there is a growing chorus for better disclosures, which is something that falls within Sebi’s realm. The lack of reporting of promoter financing using the above-mentioned structure is a matter of concern. “The cascading impact on the stock prices triggered by unwinding of promoter pledges often tends to be quite severe. Hence a continuous monitoring of pledge holdings becomes extremely crucial," analysts at Edelweiss Securities Ltd said in a note to clients.
After the fraud at Satyam Computer Services Ltd, Sebi had mandated disclosures on pledged shares to safeguard investors against the risk of over-leveraged promoters. Such risks were mostly unknown earlier. BSE data suggests the total value of shares pledged by promoters stands at ?2.15 trillion currently, spread across 2,947 companies. This amount excludes funds raised using the modus operandi described above, which could be a significantly high amount as well.
“All pledges should be disclosed. Pledges for raising funds for third-party use are non-benign for minority shareholders, as promoters continue with their voting rights, but reduce financial exposure. Once there is a separate disclosure of non-benign pledges, the market will weigh in the risk factors, and discount it in the price," says Gupta. The reference to a non-benign pledge is with regards to pledges made for outside needs, or ventures unrelated to the company.
Sanjeev Prasad, managing director and co-head of Kotak Institutional Equities, also joined the chorus for additional disclosures on promoter holding, pledges and the indebtedness of promoter entities, in a research note. It’s quite likely that Sebi will pay heed and issue new guidelines on these matters. If only, it had acted sooner.
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