Depository Receipts-ADR, GDR, IDR

Description
It describes international Finance like American Depository Receipts, Global Depository Receipts, Indian Depository Receipts.

ADR, GDR, IDR, FDI and FII
Meaning, Impact, Advantages & Disadvantages

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Table of Contents

International Stock Market Fungibility Dual Listing American Depository Receipts (ADRs) Global Depository Receipts (GDRs) Indian Depository Receipts (IDRs) Foreign Direct Investment (FDI) Foreign Institutional Investment (FII) Annexure

3 5 6 9 19 21 25 29 35

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INTERNATIONAL STOCK MARKET
International Stock Market is not a single market but comprises of a number of closely integrated markets. This is the market which consists of all the stocks that are bought and sold outside the issuer?s home nation. The buyers of these stocks, are often other companies, banks, mutual funds, individual investors, as well pension funds. Some of the major international markets are New York Stock Exchange (NYSE), Tokyo Stock Exchange, Nasdaq, Luxemburg Stock Exchange. Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are the only two international stock exchanges of India and are at 11th & 14th position in terms of Market Capitalization. There are four facets that are responsible for the past growth of the international equity market: spread of privatization; economic development in developing nations; investment bank activity; and the inception of cyber markets. BENEFITS OF INTERNATIONAL STOCK EXCHANGE

?Improved Returns and Diversified Risk: Experts often point to diversification as
one hallmark of successful investing. Within an Domestic Portfolio adding few international stocks can help smooth out returns. That?s because historically, domestic stock markets and abroad has not performed in lockstep. Therefore, by holding a diversified portfolio that includes both domestic and international funds, disappointing performance in market may be counterbalanced by strong performance in another. ?World-Class Performance: Although world markets are cyclical and past performance cannot predict future returns, the recent performance of foreign stock markets has been impressive. ?Explore Emerging Markets: By expanding one?s investment horizons to include foreign markets that are considered developing or emerging (such as Brazil, India or Taiwan), an investor can also discover attractive companies that have not yet been fully valued by the market. These opportunities can add significant upside potential.

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? Investment Opportunities in Familiar Companies abroad: Foreign investing may seem, well, foreign to many. However, many foreign companies make very familiar products. In fact, some firms, like Nokia (Finland), Sony (Japan), Heineken (the Netherlands) and Adidas (Germany), some of the most popular models in world.

HURDLES IN INTERNATIONAL INVESTMENT ?Information Barrier: Language difference, different account standards and methods, and the high cost of sources of information on companies in some market all act as information barrier to investment. ?Political and Capital control risk: When invested in a foreign stock market, money is under another jurisdiction and foreign investor might be treated different to a domestic investor. The government exert their sovereignty by restricting companies activities, by taxing them in one form or another, and when under pressure, perhaps restricting outflow of capital that has been invested. ?Foreign exchange Risk: The currency fluctuation have an effect on the value of international portion of portfolio. ?Restriction on foreign investment and control: Some countries fearing that flows of foreign-portfolio investment could distort values in a small domestic market and cause inflation restrict foreign purchases of domestic stock. ?Taxation: Many countries impose or retain right to impose a special tax on dividends and interest paid to foreigners. Tax treaties may permit reduction of these taxes, and one may get credit for taxes paid abroad, but latter is cumbersome ?Higher Cost: Cross border investment faces additional management fees, custodial costs and communication charges

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FUNGIBILITY
Fungibility allows the foreign institutional inventers to raise funds with the use of GDRs/ADRs. (Global or American depository receipts). Fungibility means division or conversion into smaller parts. In the context of depository receipt, Fungibility means division of depository receipts into local shares. Types of Fungibility ? One Way Fungibility: The fungibility is the conversion process. It implies that an investor can convert the ADRs/GDRs into local shares. An arbitrage opportunity, in the form of premium quoted in the stock exchange, is created due to market segmentation. Say for example, A GDR/ADR is traded in the international market at Rs 1,000. The local share is traded in domestic market say Rs 1,300. Then there is an arbitrage opportunity. The ADR/GDR can be converted into local share by utilizing the arbitrage opportunity and a profit of Rs 300 can be earned in the domestic market of the local share. ? Two Way Fungibility: Two-way fungibility implies that an investor can convert ADRs/GDRs into local shares and re-convert local shares into ADRs/GDRs up to a limit of the original ADRs/GDRs issue. If, the investor converts the ADRs/ GDRs into the local shares by arbitrage opportunities, it is called the forward fungibility. After the conversion of ADRs/GDRs into the local shares and if that local shares are reconverted to the ADRs/GDRs by arbitrage opportunities again, then it is called reverse fungibility. Considering above example using forward fungibility investor has made a profit of Rs 300. But when dual fungibility is possible if global prices of ADR/GDR rises, he can convert reconvert local shares to ADR/GDR to utilize arbitrage opportunity.

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DUAL LISTING
A Dual-Listed Company or DLC (also referred to as a Siamese twin) is a corporate structure which involves two listed companies with different sets of shareholders sharing ownership of one set of operational businesses. A dual listing of a company is a way for a company to have two equal listings (neither being a secondary) in different markets. The usual way in which this is done is by creating an ownership structure of two holding companies, each of which is listed in a different market. These then own 50% each of the group of companies that is the actual business. In a conventional takeover one business acquires the shares of another. However when a DLC is created, both companies continue to exist, and to have separate bodies of shareholders, but they agree to share all the risks and rewards of the ownership of all their operating businesses in a fixed proportion, laid out in the equalization agreement. The equalization agreements are set up to ensure equal treatment of both companies? shareholders in voting and cash flow rights. Benefits of Dual Listing ? A capital gains tax could be owed if an outright merger took place, but no such tax consequence would arise with a DLC deal. Differences in tax regimes may also favour a DLC structure, because cross-border dividend payments are minimized. ? Issues of national pride may sometimes also be involved; where both parties to a proposed merger or takeover are in a strong position and don't need to merge or accept a takeover. ? A third motive is the reduction of investor flow-back, which would depress the price of the stock of one of the firms in their own market if the merger route were used instead. That is, some institutional investors cannot own the shares of firms domiciled outside the home country or can only own such shares in limited quantity. In addition, in a merger, the non-surviving firm would be removed from all indices.
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? A fourth motive is that DLCs do not necessarily require regulatory (anti-trust) consent and may not be constrained by the requirement of foreign investment approval. ? Finally, the access to local capital markets may be reduced when a quotation disappears in a regular merger. This is based on the idea that local investors are already familiar with the company from the pre-DLC period.

Is Dual Listing Permissible in India? Dual Listing is not allowed in India and it will need major amendments to key corporate laws of the country. Some of the examples are as follows: ? The existing Companies Act and its proposed successor would both need to be amended as Company Act does not allow Dual Listing. In the case of a dual listed company, an investor can buy shares in one country and sell it in an overseas market. That would need the Indian rupee to be fully convertible, something that the central bank is yet to allow. ? The Foreign Exchange Management Act (FEMA) too would need to be amended. Besides, domestic trading in shares denominated in

foreign currency cannot happen without the permission of the Reserve Bank of India. ? It will need permission for trading of shares denominated or expressed in a foreign currency (if shares are expressed in Rupee and shares of foreign company are expressed in local currency, the equalization will be disturbed). Therefore, it may be necessary to permit trading of shares expressed in a common currency, say dollar. ? Another important bottleneck that the government of India should consider is removing the cap on capital account convertibility. Only if this is done Indian rupee will be made fully convertible, thus enabling investors to buy shares of a dual listed company in one country and sell it in an overseas market

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FEW TERMINOLOGOIES
Depositary Receipts (DRs): Receipts are certificates indicating your ownership in the stock of a company. They are marketed outside the company?s home country to increase its visibility in the world market and to increase access to investment capital in other countries. They are structured such that they resemble typical stocks so that foreigners can buy the stock of another country?s company without worrying about differences in currency, accounting practices (i.e. either GAAP or IFRS standards are followed) or concerned about other risks of investing in foreign stocks. In Indian context, DR are treated as Foreign Direct Investment. Custodian Bank: It is a financial institution responsible for safeguarding the financial assets(bonds and stocks) of individual or firm, settling any purchase or sale of assets, performing foreign exchange transactions where required and providing regular reporting on all their activities to their clients. Custodians are known as global custodians if they hold assets for their clients in multiple jurisdictions around the world using their own local custodian banks which hold assets of the underlying clients. Depository Bank: A US bank that holds American Depository Shares or shares of corporations based outside the US and sells ADRs to US investors. The depository Bank ensures that investors receive dividends and capital gains. When a depository receipt is issued by the depository bank, an equivalent number of shares are purchased in the local market and are deposited it at the custodian bank. If by any chance depository receipt is cancelled and it is no longer getting traded in the American market then ADRs are returned back to the depository bank and the shares held by the custodian are released into the local market.

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AMERICAN DEPOSITORY RECEIPTS
These depository receipts allow companies not domiciled in US to capture the US capital market. Each ADR represents a specific number of ADSs (American Depository Shares) so that the price of these shares of the issuing company becomes equivalent to typical price of an American company. ADRs are structured to resemble ordinary shares listed on American Exchange with comparable share price, dollar is used for the sale and purchase of ADRs and for dividend payments also so the US people need not to worry about the currency fluctuations. Working of ADRs: Suppose Reliance, an Indian company is trading on Bombay Stock Exchange at Rs 300. If one ADR represents one share then it will trade at $7.5(suppose) on NYSE or American stock Exchange. US investors won?t be willing to invest in such penny stocks. So the depository fixed a ratio of 10:1(known as ADR ratio) i.e. 1 ADR for every 10 shares of Reliance. So to make ADRs an attractive category they are usually traded at price between $10 - $1000. Two important factors for determining the price of ADR- one is ADR ratio and other is exchange rate of home country. Structure of ADR: Investors can purchase ADR through stock exchange (NYSE, NASDAQ, and AMSE) or over the counter. Types of ADR: 1. Unsponsored ADR programme 2. Sponsored ADR programme a. ADR programme Level1 b. ADR programme Level2 c. ADR programme Level3 3. Restricted Programs (Rule 144 (a) ADR or Regulation S) 1. Unsponsored ADRs:

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(i)

An ADR that is issued without the involvement of foreign company whose stock underlies the ADR. Shareholder benefits, voting rights cannot be extended to holders of these securities.

(ii) (iii)

They are traded over the counter. They are issued due to market demand and there is no formal agreement between the foreign company and depository bank.

(iv)

They are usually issued by more than 1 depository bank.

2. Sponsored ADR: An ADR that is issued in consultation with the company whose stock underlies the ADR. The investors of these securities carry all the shareholder benefits, voting rights. When a company issues an ADR it has one designated depository bank which will act as its agent. It can be classified into 3 ADR programme Levels. a. ADR Programme Level1: (i) (ii) These are the lowest level of depository receipt that can be issued. Level1 shares can only be traded on the OTC and has minimal requirements with the US Securities and SEC (Securities Exchange Commission). (iii) Companies with shares trading under Level1 programme can upgrade it to Level2 or Level3 in later stage to get better exposure in the US market. Advantages of ADR Programme Level1: ? It avoids full compliance with SEC regulations. ? By issuing an ADR through a single Depositor Bank , you have a full control over ADR programme rather than raising money through unsponsored ADRs in which more than one Depository Bank can issue ADRs. ? It is relatively inexpensive to upgrade ADR level1 to level2 or level3 because you have to deal with only one depository unlike unsponsored ADRs in which you have to negotiate for cancellations or up gradation with several depositories.
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Disadvantages Of ADR Programme Level1: ? Capital Raising is not permitted under Level1 programme. ? It cannot be listed in any of the US exchanges thus its disadvantageous for both the issuer and investor. Prevent the issuer in getting accurate information about the company and restrict the issuer?s ability to enhance its name recognition in the US.

b. ADR Programme Level2: ? After getting upgrading to Level2 , the foreign company can raise money by getting listed on exchange. ? The issuing company will now come under the supervision of SEC and the company must follow the minimum listing requirements of the Exchange. Failing to do so will delist the company and it will be forced to downgrade its ADR. Advantages Of ADR Programme Level2: ? It is more attractive to US investors than Level1 as it got listed in exchange and thus increases the liquidity and marketability of ADR. ? Listing regulations enhance the issuer?s ability to enhance its recognition in US. ? Regulations allow US investors to monitor their ownership of stocks. Disadvantages Of ADR Programme Level2: ? Capital raising is not permitted through this instrument. ? It requires more detailed Sec disclosures than for a Level1 programme. Example- The company?s financial statements must adhere to US GAAP or the reconciliation between the standards followed in home country and the US must be submitted.

c. ADR Programme Level3: ? It is the highest level of ADR a foreign company can issue.
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? The company is required to adhere to the strict rules as are followed by the other US companies. ? From the issuer perspective they can easily found information on the foreign company which has issued the highest level of ADR and therefore will be more willing to invest in the issuing company. Advantages Of ADR Programme Level3: ? All the advantages of ADR Programme Level2. ? Capital raising is permitted for acquisition or for giving ESOPs for employees of US based subsidiary. Disadvantages Of ADR Programme Level3: ? SEC reporting is more complex than Level2 and Level1. ? Set up costs and maintenance costs are high. Set up costs include legal, accounting, road shows.

3. Restricted Programmea. Rule 144(a) ADRUnder this rule, the foreign companies can issue shares to Qualified Institutional Buyers (institutional investors that can trade privately placed unregistered securities with other qualified institutional buyers. These securities cannot be bought on the public exchanges or over the counter) through a private placement and they are not subjected to the same rules and regulations as other ADRs. They are traded through NASD(National Association of Securities Dealers) PORTAL (Private Offerings, Re sales and Trading Through Automated Linkages). This system provides market to privately traded securities as Restricted ADRs.

Advantages of Rule 144(a) ADR: ? ADRs offered under Rule 144(a) provides a cheap way of raising equity than through public offering and it takes less time to raise money.
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? They do not have to conform to full SEC reporting and registration requirements.

Disadvantages of Rule 144(a) ADR: ? Restricted ADRs can only be sold to QIBs. Therefore the market for QIB is not as liquid as the public listed securities. ? They cannot be issued for already classes of shares listed on US exchange. Regulation S – Shares issued under this regulation will not be registered with any US securities regulation authority. These shares cannot be traded by any US person, they are registered and issued to offshore, non-US residents. Advantages For Companies in Issuing ADR: ? Diversifying company?s US investor base. ? Enhancing company?s visibility in the US and internationally among investors, consumers. ? A new avenue for raising equity capital. ? Giving incentives to US employees in the form of stock options. ? Increasing US liquidity by attracting new investors. ? Helps a company in facilitating acquisition in US. Advantages For Investors(Individual and Institutional Investors): ? With increasing globalization, investors wants to diversify their portfolios and investing in ADRs without worrying about exchange rate or buying complexities involved in purchasing foreign stock turn out to be a good option. ? Investors do not have to worry about dividends as they are also paid back in US dollar. ? Many institutional investors are restricted from trading in securities that does not trade in US exchange so listed ADRs represent a way to add international exposure in their portfolio. ? Publicly traded ADRs are listed on US exchange which gives confidence to investors to invest in foreign companies stocks.
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? ADRs trade in US dollars through US clearing houses. ? Investors of emerging markets like India has found an option to invest in highly liquid markets having low bid ask spread. ? They offer lower trading and custody costs when compared with the stocks bought directly in the foreign market. Few Examples of Indian ADRs: 1. ICICI bank 2. Patni 3. Infosys 4. Wipro 5. Tata Motors 6. HDFC Bank 7. Sterlite

Issue Of Shares by Indian Companies under ADR/GDR: The Process ? DR are negotiable instruments issued outside India by a Depository Bank on behalf of an Indian Company which represent the local Rupee denominated equity shares of the company held as deposit by a Custodian bank in India. ? DRs traded and listed in the US markets are known as ADR and those listed and traded elsewhere are known as GDR. ? The company can issue ADRs/GDRs if it is eligible to issue shares to persons resident outside India under the FDI Scheme. However an Indian listed company which is not eligible to raise funds from the Indian Capital Market by SEBI will not be eligible to issue ADRs/GDRs. ? Voting rights on shares issued under the Scheme shall be as per the provisions of Companies Act, 1956 and in a manner in which restrictions on voting rights imposed on ADR/GDR issues shall be consistent with the Company Law provisions. RBI regulations regarding voting rights in the case of banking companies will continue to be applicable to all shareholders exercising voting rights.
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? The pricing of ADR/GDR issues should be made at a price not less than the higher of the following two averages: ? The average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange during the six months preceding the relevant date ? The average of the weekly high and low of the closing prices of the related shares quoted on a stock exchange during the two weeks preceding the relevant date. ? The "relevant date" means the date thirty days prior to the date on which the meeting of the general body of shareholders is held, in terms of section 81 (IA) of the Companies Act, 1956, to consider the proposed issue.

ADR Termination: Termination of ADR is at the discretion of the foreign issuer and the reason in most of the cases is that the issuer is undergoing merger or reorganization. Owners of ADRs
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are notified around thirty days prior to termination. Termination will lead to cancellation of all the depository receipts and subsequent delisting from all the stock exchanges where they trade. Once notified, an owner can surrender their ADRs and take delivery of the foreign securities represented by the receipt. Usually up to one year after the effective date of termination, the depository bank will terminate the ADRs and allocate the proceeds to the respective clients. ADR, GDR norms (i) Level1 ADR issue is not permitted under Indian regulations. (ii) Any Indian company which has issued ADRs/ GDRs can acquire shares of foreign companies engaged in the same core area up to $ 100m or an amount equivalent to 10 times of their exports in a year whichever is higher. Earlier this facility was available only in certain sectors.

(iii) In India, 2 way fungibility is permitted and therefore GDRs are freely convertible without restriction to the extent of original issue size.( Earlier once a company issued ADR / GDR and if the holder wanted to obtain the underlying equity shares of the Indian Company then such ADR / GDR would be converted into shares of the Indian Company. Once such
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conversion took place, it was not possible to reconvert the equity shares into ADR / GDR. The present rules of the RBI make such reconversion possible, to the extent of ADR / GDR which have been converted into equity shares and sold in the local market. Re-issue of ADRs/ GDRs would be permitted to the extent of ADRs/ GDRs that have been redeemed. For this a) Stock Brokers in India have been authorized to purchase shares of Indian Companies for reconversion b) The Domestic Custodian would coordinate with the Overseas Depository and the Indian Company to verify the quantum of reconversion which is possible and also to ensure that the cap is not breached. c) The Domestic Custodian would then inform the Overseas Depository to issue ADR / GDR to the overseas Investor. (iv) Companies have been allowed to invest 100% of their proceeds of ADR/ GDR proceeds for acquisitions of foreign companies and direct investments in joint ventures and wholly owned subsidiaries overseas. (v) The proceeds of the GDR issued have to be repatriated into India within a period of one month from the closing of the issue. However the proceeds of the issue can also be retained abroad to meet the foreign exchange requirements of the company and this facility has been extended indefinitely until a further notice. The proceeds can also be invested in 1. Certificate of Deposit or other instruments offered by banks who have been rated by Standard and Poor, Fitch, Moody's etc. and such rating not being less than the rating stipulated by Reserve Bank from time to time for the purpose. 2. Deposits with branch outside India of an authorized dealer in India, and 3. Treasury bills and other monetary instruments with a maturity of one year or less.

(vi) The issue related expenses are subject to a ceiling of 4% of issue size in case of public issue of GDR and 2% of issue size in case of private issue of
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GDR. The issue expenses will be passed on to the shareholders on a prorata basis. (vii) Unlisted companies which have not yet accessed the ADR/GDR route

for raising capital in the international market would require prior or simultaneous listing in the domestic market while seeking to issue such overseas instruments. Unlisted companies which have already issued ADRs/GDRs in the international market have to list in the domestic market on making profit or within three years of such issue of ADRs/GDRs whichever is earlier. (viii) There are no end use restrictions except for a ban on investment of such funds in Real Estate or the Stock Market. There is no monetary limit up to which an Indian company can raise ADRs / GDRs. (ix) Indian companies are allowed to raise capital in the international market through the issue of ADRs/GDRs. They can issue ADRs/GDRs without obtaining prior approval from RBI if it is eligible to issue ADRs/GDRs in terms of the Depository Receipt Mechanism Scheme, 1993 for Issue of Foreign Currency Convertible Bonds and Ordinary Shares and subsequent guidelines issued by Ministry of Finance, Government of India.

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GLOBAL DEPOSITORY RECEIPTS
This financial instrument is similar to ADR but is sold not only outside the home country of the issuing company but also outside the US market. Regardless of the geographical market, GDRs are denominated in US dollar but sometimes they trade in Euros or British sterling. Although ADRs were the most prevalent form of depositary receipts, the number of GDRs has recently surpassed ADRs because of the lower expense and time savings in issuing GDRs, especially on the London and Luxembourg stock exchanges. Example – An investor from Japan can purchase GDR of an Indian company listed on Luxemburg Stock Exchange. Later on he can sell these GDRs to another investor from Brazil. This makes the program truly global in the sense that funds can be raised from different countries at one single point. This is the primary reason for these depository receipts being called as Global Depository Receipts. GDRs are traded in Europe on one of the Euromarkets clearing system- Euroclear and Clearstream.

Differences between ADR and GDR
1. GDR is compulsory for foreign company for trading in any other country?s share market. But ADR is compulsory for non-US companies to trade in stock market of US. 2. Indian companies prefer to get GDR due to its global use for getting foreign investment for its projects. 3. GDR is negotiable instrument all over the world but ADR is only negotiable in USA. 4. Americans use equity trading account for buying ADRs but not for GDRs. 5. No technical difference exists between ADR and GDR.GDR are usually listed on LSE makes no demand requiring companies to give holders the right to vote. The NYSE insists on this point.

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6. Comprehensive disclosure required for F-1, the US prospective which must accompany a public offering whereas detailed information required on the company but less onerous for GDR listing than full equity. 7. Foreign companies listing in the US must reconcile their accounts to US GAAP whereas there is no problem if for GDR issue, reconciliation is done between UK and Indian Accounting Standards. 8. US listing is around 8-10 times more expensive than LSE listing. 9. In GDR issue offering can be made only to QIB?s whereas in ADR public issue offer can be made to retail investors thus maximizing demand.

Procedure For An Initial Issue Of GDR: GDRs are marketed through a syndication process which is the responsibility of lead managers. The lead manager is involved in the issue structuring, pricing and timing. The lead manager also prepares in depth research and offer document for circulation to prospective institutional investors. The lead manager also assists in choosing the foreign depository and foreign legal advisors. Tentative Weekly Plan: Week 0-4: Lead Manager is nominated. Depository, bankers and auditors to the issue provide information to the Lead Manager for drafting of offer documents and agreements. Week 5-7: Meetings between Lead Manager, auditors happen and offer Circulation is completed. Week 8: Lead Manager completes the offer document and send it to co-Managers

and auditors. Week 9: Road Shows happen in this week. Investors meet abroad. Week 10: Foreign Listing and trading approvals received.

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INDIAN DEPOSITORY RECEIPTS
IDR are like ADR and GDR except that the issuer is a foreign company raising funds in the Indian market. IDRs are rupee denominated and created by the domestic depository against the underlying equity shares of foreign company. The actual shares underlying the IDRs would be held by an Overseas Custodian, which shall authorize the Indian Depository to issue the IDRs. The Overseas Custodian is required to be a foreign bank and needs approval from the Finance Ministry for acting as a custodian while the Indian Depository needs to be registered with SEBI.

Criteria for Issuing IDR 1. Any company listed in the country of incorporation can issue IDR and 2. The issuer needs pre-issue capital and free reserves of at least 225 crore and should have a market capitalization of 450 crore or more during the last three years 3. The company should also have made profits in three of the preceding 5 years. 4. The pre issue debt-equity ratio should not be more than 2:1. 5. Must not be prohibited by any regulatory body to issue securities. 6. Must have a good track record of compliance with securities market regulation. 7. Must comply with additional criteria set up by SEBI. Process Of Issuing IDR: 1. Issuing company needs approval of IDR before raising it. 2. An application seeking permission of SEBI must be made at least 90 days prior to SEBI and a non-refundable fee of US $10,000 and in such form it must furnish information as may be notified from time to time. 3. Once an approval has been obtained from SEBI, the company must pay an issue fee of half a percent of issue value subject to a minimum of Rs 10 lakh where the issue is upto an Rs 100 crore .If the issue size is greater than Rs 100 crore

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every additional value of issue should be subject to a fee of 0.25% of the issue value. 4. The SEBI on receipt of the application can call for further information and explanations as necessary. 5. The issuing company appoints an overseas Custodian, domestic depository and merchant banker for the issue of IDR. 6. The issuing company will deliver the underlying equity shares to an Overseas Custodian Bank and the bank will authorize the domestic depository to issue IDRs. 7. The issuing company through a merchant Banker files a prospectus or letter of offer certified by two authorized signatories of the issuing company one of whom shall be a whole-time director and other the Chief Accounts Officer. 8. The draft prospectus is filed with SEBI, through the merchant banker, at least 21 days prior to the filing. If within 21 days from the date of submission of draft prospectus SEBI specifies any changes to be made therein, the prospectus shall not be filed with the SEBI/Registrar of Companies unless such changes have been incorporated therein. 9. The issuing company appoints underwriters registered with SEBI to underwrite the issue of IDRs.

Fungibility: The Indian Depository Receipts shall not be fungible into underlying equity shares of issuing company. Benefits To Stakeholders: Foreign companies: 1. Any foreign company listed in its home country and satisfying the eligibility criteria can issue IDRs. 2. A company which has significant business in India can increase its value through IDRs by reaching trapped pools of liquidity, achieving global

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benchmark valuation, accessing international shareholder base and improving its brand?s presence through global visibility. 3. The company can also benefits from differences in tax structure, regulatory restrictions and informational constraints between the countries. 4. The foreign entities of Indian companies may find it easier to raise money through IDRs for their business requirements abroad.

Investors: 1. Investing in IDRs can help the investors diversify their portfolio and invest into stocks of reputed companies abroad. 2. Since it is not possible to list equity shares of foreign companies in India. IDRs are a way for Indian investors to own an interest in foreign company.

Employees: 1. Foreign companies which do not have a listed subsidiary in India can give employee stock options (ESOPs) to the employees of their Indian subsidiaries through the IDR route. This will enable the local employees to participate in the parent companies success. For Example, Microsoft USA may want to give ESOPs to employees of Microsoft India, which is not listed in India, by floating an IDR for Microsoft USA.

Regulator: 1. IDRs will lead to more liquid capital markets and a continuous improvement in regulatory environment, thereby increasing transactional revenues for the regulator.

Reasons for IDRs Not Taken Off: 1. Stringent Eligibility Norms: The stringent eligibility criterion, disclosure and corporate governance norms though it is in investors interests but the higher compliance costs for mid-sized companies to tap the Indian market.

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2. No fungibility: The GDRs/ADRs enjoy two way fungibility option but the retailers cannot enjoy this option till 1 year. The fungibility enables an investor to benefit from arbitrage opportunities that exist because of the exchange rate fluctuations. 3. Volatility in Indian Financial Markets: Developed countries markets have less political flux to their financial market. Indian market is perceived to be rumor driven which lends to heightened volatility.

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FOREIGN DIRECT INVESTMENT
FDI refers to long term participation by country A into country B. There are two types of FDI Inward Foreign Direct Investment and Outward Foreign Direct Investment, resulting in a net FDI inflow which can be either positive or negative. FDI is a measure of foreign ownership of productive assets, such as factories, mines and land.

Routes of FDI in India ? Automatic Route: No Government approval is required if the investment to be made falls within the sectoral caps specified for the listed activities. ? Foreign Investment Promotion Board(FIPB) route: Investment proposals falling outside the automatic route would require prior Government approval. ? CCFI Route: Investment proposals falling outside the automatic route and having a project cost of Rs. 6,000 million or more would require prior approval of Cabinet Committee of Foreign Investment (“CCFI”). Statistics: ? Cumulative amount of FDI flows into India from April 2000 to March 2010 – US $ 1, 61, 536. ? Amount of FDI Flows into India in Financial Year 2009-2010 – US $ 34, 167. ? Amount of FDI Equity Inflows into India in Financial Year 2009-2010 – US $ 25, 888. ? Percentage growth of FDI Equity Inflows in 2009-2010 over last year – (-) 5%.

A foreign company planning to set up operations in India has the following options: As an incorporated entity by incorporating a company under the Companies Act 1956 through (i) (ii) (iii) (iv) Joint Ventures Wholly owned Subsidiaries By acquiring shares in an associated enterprise Through a merger or an acquisition of an unrelated enterprise
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%age of total inflows (US$)(Apr '00 to Mar'10)
Japan Germany 4% 4% Cyrus 5% Netherlands 5% U.K. 6% U.S.A. 10% Singapore 11% Mauritius 53% U.A.E. France 1% 1%

FDI incentives may take the following formsi) (ii) (iii) (iv) (v) (vi) (vii) (viii) Low corporate tax and income tax rates Tax holidays Special Economic Zones Export Processing Zone Soft Loan or Loan Guarantees Free Land or land subsidies Research and Development Support Job Training Subsidies

FDI takes on two main forms: ? Green Field Investment which involves the establishment of a wholly owned operation in a foreign country. ? Brown Field Investment involves acquiring or merger with an existing firm in the Foreign country.

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FDI takes on two main kinds: ? Horizontal FDI i.e. market expansion investment which is investment in the same industry abroad. ? Vertical FDI i.e. resource seeking investments which comprises two forms further i.e. first is backward vertical FDI investment in an industry abroad that provides inputs for a firm?s domestic production process and the second is forward vertical FDI in which an industry abroad sells the products of firm?s domestic production processes. Advantages of FDI: (i) Avoidance of Trade Restrictions: Many countries might make it impractical in many ways for companies to reach their market potential through exportation only. The primary form of impediment to exporting is import barrier and tariffs imposed on imported goods. Thus for countries that place import restrictions and have a large growing market such as China, many firms prefer FDI to expand their foreign markets. (ii) Advantage Of Tax Incentives: In developing countries, where the government need to place tariffs on imported goods to protect their own firms, they also strive to create a favorable climate to attract FDI which brings capital and facilitates the transfer of technological and managerial skills as well as an access to international market. Therefore some developing countries offer tax incentives and get the investments from the multinationals located in high tax rate nations such as US and UK. (iii) Advantages of an uncertain cost structure created by foreign exchange: An exporting firm faces risk of foreign exchange due to mismatch between cost incurred and revenue earned ( Ex- A strengthening home currency may make it difficult for exporting countries to cover their costs with income generated.). To the contrary, FDI makes sure that all costs and revenue are derived from the same currency and thus reduces the foreign exchange risk. (iv) Avoidance of consumer- imported restrictions: Ex- in South Korea, many Koreans prefer to buy domestically produced goods even though they are more expensive, largely because of nationalism. In this situation, FDI is a better option than exporting.
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(v) Different tastes: Different countries have different tastes and requirements to the same goods. Thus a multinational must alter its products to suit local tastes and requirements. In this way, exporting is difficult and best way to expand foreign market is FDI. (vi) Protections to firms know how: Some companies enjoy the competitive advantage because of management, technological and marketing know-how and expand in the foreign market by giving licensing to other firms. In this way licenser could earn return on its know-how in the form of royalty fees without bearing the costs and risks of FDI. On the other hand, licensee can gain

advanced technologies from licensor and use it to directly compete against licensor. To the contrary, FDI can prevent firm?s know-how from being used by other firms. Disadvantages of FDI: (i) Expensive: FDI involves investing in either green- field projects in new facilities and acquisitions or merger with an existing firm. When other things become equal, firms will have to spend a large amount of money on establishing production facilities in a foreign country. On the other hand when a firm exports, it can avoid the cost of FDI. And when a firm licenses its know-how, it doesn?t need to pay any costs and can gain from profits from licensee. (ii) Risk: One of the most important factors for a MNC to invest abroad is stable political circumstance and open free market. However this factor is sometimes unpredictable. In FDI, a firm has to face more political risks than exporting and licensing.

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FOREIGN INSTITUTIONAL INVESTMENT
An entity/fund established or incorporated outside India which proposes to make investment in securities. FII?s are those investors that indirectly invest into the

companies through the stock market. FII investments into a country are usually not associated with the direct benefits in terms of creating real investments. However, they provide large amounts of capital through the markets. The indirect benefits of the market include alignment of local practices to international standards in trading, risk management, new instruments and equities research. These enable markets to become more deep, liquid, feeding in more information into prices resulting in a better allocation of capital to globally competitive sectors of the economy. FIIs can invest in ? Securities in the primary and secondary markets including shares, debentures and warrants of companies. ? Units of schemes floated by domestic mutual funds. ? Dated Government Securities. ? Derivatives traded on a recognised stock exchange. ? Commercial paper. ? Security Receipts. Who can be FII? Entities who propose to invest their proprietary funds or on behalf of "broad based" funds or of foreign corporate and individuals and belong to any of the under given categories can be registered for FII. ? Asset Management Companies ? Pension Funds ? Mutual Funds
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? Investment Trusts as Nominee Companies ? Incorporated / Institutional Portfolio Managers or their Power of Attorney holders ? University Funds ? Endowment Foundations ? Charitable Trusts & Charitable Societies Eligibility Criteria: As per Regulation 6 of SEBI (FII) Regulations, 1995, Foreign Institutional Investors are required to fulfill the following conditions to qualify for grant of registration: ? The applicant should have track record, professional competence, financial soundness, experience, general reputation of fairness and integrity; ? The applicant should be regulated by an appropriate foreign regulatory authority in the same capacity/category where registration is sought from SEBI. Registration with authorities, which are responsible for incorporation, is not adequate to qualify as Foreign Institutional Investor. ? The applicant is required to have the permission under the provisions of the Foreign Exchange Management Act, 1999 from the Reserve Bank of India. ? The Applicant must be legally permitted to invest in securities outside the country or its in-corporation / establishment. ? The applicant must be a "fit and proper" person. ? The applicant has to appoint a local custodian and enter into an agreement with the custodian. Besides it also has to appoint a designated bank to route its transactions. ? Payment of registration fee of US $ 5,000.00

Sub-Account A „Sub-account? is the underlying fund on whose behalf the FII invests. Sub- Accounts can include those foreign corporate, foreign individuals, and institutions, funds or
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portfolios established or incorporated outside India on whose behalf investments are proposed to be made in India by a FII. It is possible for a registered sub-account to transfer from one FII to another. In such a case, the FII to whom it is proposed to be transferred has to request SEBI with the following documentation. ? A declaration that it is authorized to invest on behalf of the sub-account. ? A no-objection letter for the transfer of the sub-account from the transferor FII.

Investment by FII is restricted to 24% of paid-up capital of the company which can be extended up to 49% per sectoral cap by board resolution followed by special resolution. Single FII investment can?t exceed 10% of paid-up capital of the company and single sub-account investment can?t exceed 5% of the paid-up capital. FII Regulations Investment by FIIs is regulated under SEBI (FII) Regulations, 1995. Following are some of important regulations by SEBI and RBI: ? A Foreign Institutional Investor may invest only in the instruments mentioned earlier. ? The total investments in equity and equity related instruments (including fully convertible debentures, convertible portion of partially convertible debentures and tradeable warrants) made by a Foreign Institutional Investor in India, whether on his own account or on account of his sub- accounts, should be at least seventy per cent of the aggregate of all the investments of the Foreign Institutional Investor in India, made on his own account and through his subaccounts. ? The cumulative debt investment limit for FII investments in Corporate Debt is USD 15 billion. The amount was increased from USD 6 billion to USD 15 billion in March 2009. ? USD 8 billion will be allocated to the FIIs and Sub-Accounts through an open bidding platform while the remaining amount is allocated on a „first come first served? basis subject to a ceiling of Rs.249 cr. per registered entity. ? The debt investment limit for FIIs in government debt in G-secs currently
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capped at $5 billion and cumulative investments under 2% of the outstanding stock of G-secs and no single entity can be allocated more than Rs. 1000 cr of the government debt limits.

With regard to investments in the secondary market SEBI states that: ? The Foreign Institutional Investor is allowed to transact business only on the basis of taking and giving deliveries of securities bought and sold ? Short selling in securities is not allowed. However, in December 2007, abroad regulatory framework enabling short selling by FIIs was put in place. Which stipulated that naked short selling was not permitted and settlement of securities sold short would be through a mechanism for borrowing of securities ? FIIs are not permitted to short sell equity shares which are in the caution list of RBI; ? Equity shares can be borrowed by FIIs only for the purpose of delivery into short sale. ? No transactions on the stock exchange can be carried forward ? Transaction of business in securities can be carried out only through stock brokers who has been granted a certificate by the Board ? A Foreign institutional Investor or a sub-account having an aggregate of securities worth rupees ten crore or more, as on the latest balance sheet date, can settle their only through dematerialized securities.

Securities have to be registered in the name of the Foreign Institutional Investor, if he is making investments on his own behalf or in his name on account of his sub-account, or in the name of the sub-account, in case he is investing on behalf of the sub-account.

Advantages of FII’s: ? Enhanced flows of equity capital. ? FIIs have a greater appetite for equity than debt in their asset structure. The opening up the economy to FIIs has been in line with the accepted preference for non-debt creating foreign inflows over foreign debt. Enhanced flow of
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equity capital helps improve capital structures and contributes towards building the investment gap. ? Managing uncertainty and controlling risks. ? FII inflows help in financial innovation and development of hedging instruments. Also, it not only enhances competition in financial markets, but also improves the alignment of asset prices to fundamentals. ? FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. ? Equity market development aids economic development. ? By increasing the availability of riskier long term capital for projects, and increasing firms? incentives to provide more information about their operations, FIIs can help in the process of economic development. ? Improved corporate governance.

Disadvantages of FII’s: ? Problems of Inflation: Huge amounts of FII fund inflow into the country creates a lot of demand for rupee, and the RBI pumps the amount of Rupee in the market as a result of demand created ? Problems for small investor: The FIIs profit from investing in emerging financial stock markets. If the cap on FII is high then they can bring in huge amounts of funds in the country?s stock markets and thus have great influence on the way the stock markets behaves, going up or down. The FII buying pushes the stocks up and their selling shows the stock market the downward path. This creates problems for the small retail investor, whose fortunes get driven by the actions of the large FIIs. ? Adverse impact on Exports: FII flows leading to appreciation of the currency may lead to the exports industry becoming uncompetitive due to the appreciation of the rupee. ? Hot Money: "Hot money" refers to funds that are controlled by investors who actively seek short-term returns. These investors scan the market for short-term, high interest rate investment opportunities. "Hot money" can have economic
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and financial repercussions on countries and banks. When money is injected into a country, the exchange rate for the country gaining the money strengthens, while the exchange rate for the country losing the money weakens. If money is withdrawn on short notice, the banking institution will experience a shortage of funds.

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Annexure
Lahiri Committee report was referred to while understanding the implications of FII in India. It is attached as an annexure to the report.

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REPORT OF THE COMMITTEE ON LIBERALISATION OF FOREIGN INSTITUTIONAL INVESTMENT

GOVERNMENT OF INDIA MINISTRY OF FINANCE DEPARTMENT OF ECONOMIC AFFAIRS

June 2004

Dr. Ashok K. Lahiri Shri U.K. Sinha Shri Umesh Kumar

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Executive Summary I II III IV V Introduction Evolution of FII Investment Policy Sectoral Caps Supply and Demand Pros of FII Investments A. Enhanced flows of equity capital B. Managing uncertainty and controlling risks C. Improving capital markets D. Improved corporate governance VI Cons: Management Control and Risk of Hot Money Flows A. Management control B. Potential capital outflows VII Recommendations ANNEX – I SECTOR SPECIFIC GUIDELINES FOR FOREIGN DIRECT AND PORTFOLIO INVESTMENT ANNEX – II SECTORS WITH PORTFOLIO INVESTMENT LIMITS – CURRENT AND PROPOSED ANNEX-III RESTRICTIONS ON FOREIGN OWNERSHIP OF COMPANIES IN EMERGING MARKETS

5 6 7 9 11 12 12 12 13 13 14 14 14 15 18

30

33

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Preface Following the Budget 2002-2003 announcement by the Finance Minister regarding relaxation of investment limits for Foreign Institutional Investors (FIIs) from the sectoral limits on foreign direct investment, a committee was set up to examine the issues. The committee, which was reconstituted twice, has made certain recommendations after due consultations with the administrative Ministries, FICCI, CII and SEBI. These recommendations contained in this report, I believe, will help in increasing investment in the country and facilitating growth. I would like to thank Shri U.K. Sinha and Shri Umesh Kumar, members of the Committee for their active participation and valuable contribution. Dr. Shashank Saksena, Joint Director (SE) and Shri P.R. Suresh, OSD(CM &I) of the Department of Economic Affairs, assisted the Committee in its work and on behalf of the Committee, I would like to place on record our appreciation.

Ashok K. Lahiri Chairman

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Executive Summary Following the announcement by the Government in the Budget 2002-03 that suggested that foreign institutional investors? (FII) portfolio investments would not be subject to the sectoral limits for foreign direct investment except in specified sectors, a Committee was constituted with representation from the Department of Economic Affairs as well as the Department of Industrial Policy and Promotion. The Committee was reconstituted twice. After the second reconstitution, the Committee had 5 meetings, the last being held on June, 24, 2004. The report gives an evolution of FII policy in India, examines the pros and cons of FII investment, especially in an era with no balance of payment pressures, and also provides a perspective on FII investment restrictions in peer countries in Asia. The recommendations are as follows: A. (i) In general, FII investment ceilings, if any, may be reckoned over and above prescribed FDI sectoral caps. The 24 per cent limit on FII investment imposed in 1992 when allowing FII inflows was exclusive of the FDI limit. The suggested measure will be in conformity with this original stipulation. (ii) Special procedure for raising FII investments beyond 24per cent upto the FDI limit in a company may be dispensed with by amending the relevant SEBI (FII) Regulations. (iii) In order to provide dispersed investments and prevent concentration, the existing limit of 10per cent by a FII in a single company may continue. B Recommendations in para A above would apply, in general, to all sectors. Specific recommendations are being made for the following sectors with overall composite caps : a. Telecom services. b. Defence production c. Public sector banks. d. Insurance companies. FII investments are currently not permitted in print media, sectors which are not yet opened for private investment and in gambling, betting, lottery. The Committee recommends the same may continue. FDI investment in retail trading is prohibited. FII investments, however, are permitted up to 24 per cent in all listed companies, except in print media companies. The Committee recommends the same may continue as this would help in developing supply chains in a wide range of products including that of agriculture.
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I.

Introduction

In his Budget Speech on February 28, 2002, the Finance Minister announced that: “Foreign Institutional Investors (FIIs) can invest in a company under the portfolio investment route beyond 24 per cent of the paid-up capital of the company with the approval of the general body of the shareholders by a special resolution. I propose that now FII portfolio investments will not be subject to the sectoral limits for foreign direct investment except in specified sectors. Guidelines in this regard will be issued separately.” 2. Following this announcement, with the approval of Finance Minister, a committee was set up on March 13, 2002 to identify the sectors in which FIIs? portfolio investments will not be subject to the sectoral limits for Foreign Direct Investment (FDI). The Committee comprised the following: (i) Dr. Rakesh Mohan,Adviser to Union Finance Minister - Chairman (ii) Sh. G.S. Dutt, Joint Secretary, Dept. of Economic Affairs - Member Ministry of Finance, Government of India (iii)Sh. M.S. Srinivasan, Joint Secretary, Dept. of Industrial - Member Policy and Promotion, Government of India 3. The terms of reference for the committee were: a) identify the sectors in which FII portfolio investments will not be subject to the sectoral limits for Foreign Direct Investment; and b) consultation with the administrative Ministries concerned in this regard to identify such sectors. 4. On December 27, 2002, the Committee was reconstituted with the following members: (i) Dr. Ashok K. Lahiri, Chief Economic Adviser Chairman (ii) Sh. G.S. Dutt, Joint Secretary, Dept. of Economic Affairs, Member Ministry of Finance, Government of India (iii) Sh. M.S. Srinivasan, Joint Secretary, Dept. of Industrial, Member Policy and Promotion, Government of India. 5. The Committee met on February 11, 2003, and March 10, 2003. The Committee was reconstituted again on May 17, 2004 with the following members: (i) Dr. Ashok K. Lahiri, Chief Economic Adviser Chairman (ii) Shri U.K. Sinha, Joint Secretary (Capital Markets), Member Dept. of Economic Affairs, Ministry of Finance, Government of India (iii) Sri Umesh Kumar, Joint Secretary, Member Dept. of Industrial Policy and Promotions, Government of India. 6. After the second reconstitution, the Committee had 5 meetings, the last being held on June, 24, 2004.
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II.

Evolution of FII Investment Policy

7. India embarked on a gradual shift towards capital account convertibility with the launch of the reforms in the early 1990s. Although foreign natural persons – except NRIs – are prohibited from investing in financial assets, such investments were permitted by FIIs and Overseas Corporate Bodies (OCBs) with suitable restrictions. Ever since September 14, 1992, when FIIs were first allowed to invest in all the securities traded on the primary and secondary markets, including shares, debentures and warrants issued by companies which were listed or were to be listed on the Stock Exchanges in India and in the schemes floated by domestic mutual funds, the holding of a single FII and of all FIIs, Non-resident Indians (NRIs) and OCBs in any company were subject to the limit of 5 per cent and 24 per cent of the company?s total issued capital, respectively. Furthermore, funds invested by FIIs had to have at least 50 participants with no one holding more than 5 per cent to ensure a broad base and preventing such investment acting as a camouflage for individual investment in the nature of FDI and requiring Government approval. 8. Initially the idea of allowing FIIs was that they were broad-based, diversified funds, leaving out individual foreign investors and foreign companies. The only exception were the NRI and OCB portfolio investments through the secondary market, which were subject to individual ceilings of 5 per cent to prevent a possible “take over.” Individuals were left out because of the difficulties in checking on their antecedents, and of their lack of expertise in market matters and relatively short-term perspective. OCB investments through the portfolio route have been banned since November, 2001. 9. In February, 2000, the FII regulations were amended to permit foreign corporates and high net worth individuals to also invest as sub-accounts of Securities and Exchange Board of India (SEBI)-registered FIIs. Foreign corporates and high net worth individuals fall outside the category of diversified investors. FIIs were also permitted to seek SEBI registration in respect of sub-accounts for their clients under the regulations. While initially FIIs were permitted to manage the sub-account of clients, the domestic portfolio managers or domestic asset management companies were also allowed to manage the funds of such sub-accounts and also to make application on behalf of such sub-accounts. Such sub-accounts could be an institution, or a fund, or a portfolio established or incorporated outside India, or a broad-based fund, or a proprietary fund, or even a foreign corporate or individual. So, in practice there are common categories of entities, which could be registered as both FIIs and sub-accounts. However, investment in to a subaccount is to be made either by FIIs, or by domestic portfolio manager or asset management company, and not by itself directly. 10. In view of the recent concerns of some unregulated entities taking positions in the stock market through the mechanism of Participatory Notes (PNs) issued by FIIs, the issue was examined by the Ministry of Finance in consultation with the Reserve Bank of India (RBI) and SEBI. Following this consultation, in January 2004, SEBI stipulated that PNs are not to be issued to any non-regulated entity, and the principle of "know your clients” may be strictly adhered to. SEBI has indicated that the existing non-eligible PNs,
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will be permitted to expire or to be wound-down on maturity, or within a period of 5 years, whichever is earlier. Besides, reporting requirement on a regular basis has been imposed on all the FIIs. 11. The following entities, established or incorporated abroad, are eligible to be registered as FIIs: (a)Pension Funds, (b)Mutual Funds, (c)vestment Trusts, (d) Asset Management Companies, (e) Nominee Companies, (f) Banks, (g) Institutional Portfolio Managers, (h) Trustees, (i) Power of Attorney holders, (j) University funds, endowments, foundations or charitable trusts or charitable societies. 12. Besides the above, a domestic portfolio manager or domestic asset management company is now also eligible to be registered as an FII to manage the funds of subaccounts. 13. The FIIs can also invest on behalf of sub-accounts. The following entities are entitled to be registered as sub-accounts: i) an institution or fund or portfolio established or incorporated outside India, ii) a foreign corporate or a foreign individual. 14. FIIs registered with SEBI fall under the following categories: (a) Regular FIIs – those who are required to invest not less than 70 per cent of their investment in equity-related instruments and up to 30 per cent in non-equity instruments. (b) 100 per cent debt-fund FIIs – those who are permitted to invest only in debt instruments.

15. A Working Group for Streamlining of the Procedures relating to FIIs constituted in April, 2003 by the Government, inter alia, recommended streamlining of SEBI registration procedure, and suggested that dual approval process of SEBI and RBI be changed to a single approval process of SEBI. This recommendation has since been implemented. 16. Forward cover in respect of equity funds for outstanding investments of FIIs over and above such investments on June 11, 1998 was permitted. Subsequently, forward cover up to a maximum of 15 per cent of the outstanding position on June 11, 1998 was also permitted. This 15 per cent limit was liberalized to 100 per cent of portfolio value as on March 31, 1999 in January 2003. 17. Like in other countries, the restrictions on FII investment have been progressively liberalized. From November 1996, any registered FII willing to make 100 per cent investment in debt securities were permitted to do so subject to specific approval from SEBI as a separate category of FIIs or sub-accounts as 100 per cent debt funds. Such investments by 100 per cent debt funds were, however, subject to fund-specific ceilings specified by SEBI and an overall debt cap of US$ 1-1.5 billion. Moreover, investments were allowed only in debt securities of companies listed or to be listed in stock exchanges. Investments were free from maturity limitations.

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18. From April 1998, FII investments were also allowed in dated Government securities. Treasury bills being money market instruments were originally outside the ambit of such investments, but were subsequently included from May, 1998. Such investments, which are external debt of the Government denominated in rupees, were encouraged to deepen the debt market. From April, 1997, the aggregate limit for all FIIs, which was 24 per cent, was allowed to be increased up to 30 per cent by the Indian company concerned by passing a resolution by its Board of Directors followed by a special resolution to that effect by its General Body. 19. While permitting foreign corporates/high net worth individuals in February, 2000 to invest through SEBI registered FII/domestic fund managers, it was noted that there was a clear distinction between portfolio investment and FDI. The basic presumption is that FIIs are not interested in management control. To allay fears of management control being exercised by portfolio investors, it was noted that adequate safety nets were in force, for example, (i) transaction of business in securities on the stock exchanges are only through stock brokers who have been granted a certificate by SEBI, (ii) every transaction is settled through a custodian who is under obligation to report to SEBI and RBI for all transactions on a daily basis, (iii) provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (iv) monitoring of sectoral caps by RBI on a daily basis. 20. In 1998, the aggregate portfolio investment limits of NRIs/PIOs/OCBs and FIIs were enhanced from 5 per cent to 10 per cent and the ceilings of FIIs and NRIs/OCBs were declared to be independent of each other. 21. Aggregate FII portfolio investment ceiling was enhanced from 30 per cent to 40 per cent of the issued and paid up capital of a company [March 01 2000]. The enhanced ceiling was made applicable only under a special procedure that required approval by the Board of Directors and a Special Resolution by the General Body of the relevant company. The FII ceiling under the special procedure was further enhanced [March 08 2001] from 40 per cent to 49 per cent. Subsequently, the FII ceiling under the special procedure was raised up to the sectoral cap in September, 2001. III. Sectoral Caps

22. Quite apart from the ceilings on FII investment, there were and are ceilings on FDI, and in some cases, unified ceilings for nonresident investments. There are two types of ceilings on FII investment: statutory and administrative. 23. Currently non-resident investments in public sector banks and insurance sector are capped under Acts at 20 per cent and 26 per cent respectively. Accordingly, FDI plus portfolio investments by FIIs and NRIs are capped at 20 per cent and 26 per cent under the above statutes. 24. There are also sectors where administrative caps for non-resident investments have been prescribed. In these sectors (viz. telecom services, media, private sector
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banks) FDI plus portfolio investments by FIIs and NRIs cannot exceed the administrative caps fixed. 25. Caps can be of three types: i) a separate cap on FDI, ii) a separate cap on FII, and iii) a composite caps on FDI and FII combined together.

Separate caps on FDI and FII, in turn, can be of five types: I) ban on both FDI and FII (e.g. lottery business, gambling and betting), II) non -zero separate caps on both FDI and FII ([e.g., DTH-broadcasting]), [DTH has composite ceiling with a sub-ceiling for FDI at 20 per cent] III) a composite non-zero cap on FDI and FII (banking, insurance, telecom, ), IV) ban on FDI with a non-zero cap on FII (e.g.,Terrestrial broadcasting FM, retail trading), and V) ban on FII with a non-zero cap on FDI (e.g. print media). 26. For example, for private sector banks falling within the purview of the RBI?s regulatory jurisdiction, no distinction is made either between different categories of nonresident investors or the nature of foreign investment, whether portfolio or FDI. Similarly, no distinction is made either between different categories of sub-sectors of FM radio broadcasting and satellite uplinking, cable network and Direct-to-home. The sectoral equity caps as of May 13, 2004 are given in Table 1 (at annex1). 27. In August, 2002, the Steering Group on Foreign Direct Investment headed by Shri 1 N.K.Singh, Member, Planning Commission, submitted its report. In this report, six reasons given for imposing caps and bans on FDI national security, culture and media, natural monopolies, monopoly power, natural resources, and transition costs, were discussed in some detail. 28. The Steering Group observed that while all governments prefer vital defence industries to be controlled by their own resident nationals, there was not much justification for restrictions on the production of civilian goods used by the defence forces, and production of those goods that are either imported or are banned for exports from developed countries for strategic reasons. On culture and media, the Steering Group observed that there was a need for true cultural globalization – not a one-way process of only India having access to the culture of the rest of the world but a two-way street – and in the field of current affairs and news programmes, editorial control must vest with Indian nationals and eventually could be replaced by limits on aggregate market share (25 – 49 per cent) that can accrue to foreign controlled news/current affairs companies taken together. 29. As regards natural monopolies, the Steering Group observed that in the absence of a proper regulatory system with the requisite expertise, “It can be argued that when such
1

“Report of the Steering Group on Foreign Direct Investment”, Planning Commission, Government of India, New Delhi, August 2002.

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expertise does not exist in the regulatory system it may be better for monopoly profits to accrue to resident nationals than to foreigners. Though this argument has some validity in the short term it is a defeatist approach in the long term. Domestic monopolies are more likely to succeed in distorting the regulatory process in their favour („regulatory capture?) than foreign monopolies, because of their more intimate knowledge of and association with domestic political processes. Any such restrictions therefore must be temporary with continuous efforts made to improve regulatory structures and skills.” On abuse of monopoly power, the Steering Group argued that foreign investment can in fact enhance domestic competition and any potential problem arising from a foreign producer with very high global share tying up with an existing domestic producer should be addressed under the Competition Law. 30. With ownership of natural resources, such as, the electro-magnetic spectrum and sites for dams and harbours vesting with the people and their Government, the Steering Group noted that if extraction of the resource rent, which arises from the difference between the market price and efficient costs of exploitation of the particular resource, is effectively designed to maximize such resource rent to Government through appropriate tax and auction systems there would be no need to discriminate between foreign and domestic investments. 31. Considerable difficulties were encountered in the monitoring of the sectorspecific composite ceilings on foreign investment because of the problems in identifying the sector of investment merely by the name of the company and the existence of companies with diversified activities.
IV.

Supply and Demand

32. Various supply and demand factors have made investing via institutions a rapidly 2 growing sector in many developed countries. There is enhanced supply of funds from investors to institutions because of the aging of population, funded pension systems, and growing wealth. Institutions are also able to give better services and attractive returns because of ease of diversification, better corporate governance, liquidity, deregulation and fiscal incentives. Given this background, there is likely to be a large and growing demand for Indian stocks by FIIs. 33. It is of some importance to note that the bouts of liberalization of the FII regime has coincided with pressure on the foreign exchange and balance of payments fronts, for example, in the aftermath of the 1991 crisis and around the 1997 East Asian crisis. Now that there is no apparent balance of payments problem, the critical question is whether there are any reasons for liberalizing the FII regime. 34. FIIs have a natural advantage in processing information. One of the problems noted for such investment in emerging markets consists in the lower amount of reliable and quality information available in such countries relative to developed ones. It can be
2

See E. Philip Davis: “Institutional Investors, Financial Markets and Financial Stability”, Discussion Paper PI-0303, The Pensions Institute, Birkbeck College, London, January 2003.

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expected that with rapid progress in disclosure norms, accounting standards, shareholder rights, legal framework, and corporate governance in general, FII investments are going to accelerate in India. FII investments in some companies are already at their ceiling level, and the ceiling is much below the stakes that FIIs have acquired in some of the top Korean chaebols. 35. Countries that have liberalized their FII regimes did not do it out of balance of payments compulsions. Taiwan, for example, removed all restrictions – previously 10 per cent individually and 25 per cent collectively until March 1998, and 15 per cent and 30 per cent until January 1, 2001 – from the beginning of 2001. People?s Republic of China, without a balance of payments problem, opened itself up to FII investment in 2003. Swiss Bank UBS, by buying into four of China?s A-share stocks – Baoshan Iron and Steel, Shanghai Port Container, Sinotrans Air, and ZTE Corp – became the first FII to enter the Chinese market on Wednesday, July 9, 2003. V. Pros of FII Investment

36. The advantages of having FII investments can be broadly classified under the following categories. A. Enhanced flows of equity capital

37. FIIs are well known for a greater appetite for equity than debt in their asset structure. For example, pension funds in the United Kingdom and United States had 68 per cent and 64 per cent, respectively, of their portfolios in equity in 1998. Thus, opening up the economy to FIIs is in line with the accepted preference for non-debt creating foreign inflows over foreign debt. Furthermore, because of this preference for equities over bonds, FIIs can help in compressing the yield-differential between equity and bonds and improve corporate capital structures. Further, given the existing savings-investment gap of around 1.6 per cent, FII inflows can also contribute in bridging the investment gap so th that sustained high GDP growth rate of around 8 per cent targeted under the 10 Five Year Plan can materialize.
B. Managing uncertainty and controlling risks

38. Institutional investors promote financial innovation and development of hedging instruments. Institutions, for example, because of their interest in hedging risks, are known to have contributed to the development of zero-coupon bonds and index futures. FIIs, as professional bodies of asset managers and financial analysts, not only enhance competition in financial markets, but also improve the alignment of asset prices to fundamentals. 39. Institutions in general and FIIs in particular are known to have good information and low transaction costs. By aligning asset prices closer to fundamentals, they stabilize markets. Fundamentals are known to be sluggish in their movements. Thus, if prices are aligned to fundamentals, they should be as stable as the fundamentals themselves.
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Furthermore, a variety of FIIs with a variety of risk-return preferences also help in dampening volatility.
C. Improving capital markets

40. FIIs as professional bodies of asset managers and financial analysts enhance competition and efficiency of financial markets. Equity market development aids 3 economic development. By increasing the availability of riskier long term capital for projects, and increasing firms? incentives to supply more information about themselves, the FIIs can help in the process of economic development. D.
Improved corporate governance

41. Good corporate governance is essential to overcome the principal-agent problem between share-holders and management. Information asymmetries and incomplete contracts between share-holders and management are at the root of the agency costs. Dividend payment, for example, is discretionary. Bad corporate governance makes equity finance a costly option. With boards often captured by managers or passive, ensuring the rights of shareholders is a problem that needs to be addressed efficiently in any economy. Incentives for shareholders to monitor firms and enforce their legal rights are limited and individuals with small share-holdings often do not address the issue since others can freeride on their endeavour. What is needed is large shareholders with leverage to complement their legal rights and overcome the free-rider problem, but shareholding beyond say 5 per cent can also lead to exploitation of minority shareholders. 42. FIIs constitute professional bodies of asset managers and financial analysts, who, by contributing to better understanding of firms? operations, improve corporate governance. Among the four models of corporate control – takeover or market control via equity, leveraged control or market control via debt, direct control via equity, and direct control via debt or relationship banking – the third model, which is known as corporate governance movement, has institutional investors at its core. In this third model, board representation is supplemented by direct contacts by institutional investors. Institutions are known for challenging excessive executive compensation, and remove under performing managers. There is some evidence that institutionalization increases dividend payouts, and enhances productivity growth.

3

Demigrüç-Kunt, A. and R. Levine (1996): “Stock Market Development and Financial Intermediaries: Stylized Facts”, World Bank Economic Review, Vol. 10, pp. 341-69.

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VI.

Cons: Management Control and Risk of Hot Money Flows

43. The two common apprehensions about FII inflows are the fear of management takeovers and potential capital outflows.
A. Management control

44. FIIs act as agents on behalf of their principals – as financial investors maximizing returns. There are domestic laws that effectively prohibit institutional investors from taking management control. For example, US law prevents mutual funds from owning more than 5 per cent of a company?s stock. 45. According to the International Monetary Fund?s Balance of Payments Manual 5, FDI is that category of international investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise resident in another economy. The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the investor in the management of the enterprise. According to EU law, foreign investment is labeled direct investment when the investor buys more than 10 per cent of the investment target, and portfolio investment when the acquired stake is less than 10 per cent. 46. Institutional investors on the other hand are specialized financial intermediaries managing savings collectively on behalf of investors, especially small investors, towards specific objectives in terms of risk, returns, and maturity of claims. 47. All take-overs are governed by SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, and sub-accounts of FIIs are deemed to be “persons acting in concert” with other persons in the same category unless the contrary is established. In addition, reporting requirement have been imposed on FIIs and currently Participatory Notes cannot be issued to un-regulated entities abroad.
B. Potential capital outflows

48. FII inflows are popularly described as “hot money”, because of the herding behaviour and potential for large capital outflows. Herding behaviour, with all the FIIs trying to either only buy or only sell at the same time, particularly at times of market stress, can be 4 rational. With performance-related fees for fund managers, and performance judged on the basis of how other funds are doing, there is great incentive to suffer the consequences of being wrong when everyone is wrong, rather than taking the risk of being wrong when some others are right. The incentive structure highlights the danger of a contrarian bet going wrong and makes it much more severe than performing badly along with most others in the market. It not only leads to reliance on the same information as others but also reduces the planning horizon to a relatively short one. Value at Risk models followed by FIIs may destabilize markets by leading to
4

See Bikhchandani, S and S. Sharma (2000): “Herd Behaviour in Financial Markets”, Working Paper No. WP/00/48, International Monetary Fund, Washington DC, 2000.

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simultaneous sale by various FIIs, as observed in Russia and Long Term Capital Management 1998 (LTCM) crisis. Extrapolative expectations or trend chasing rather than focusing on fundamentals can lead to destabilization. Movements in the weightage attached to a country by indices such as Morgan Stanley Country Index (MSCI) or International Finance Corporation (W) ( IFC) also leads to en masse shift in FII portfolios. 49. Another source of concern are hedge funds, who, unlike pension funds, life insurance companies and mutual funds, engage in short-term trading, take short positions and borrow more aggressively, and numbered about 6,000 with $500 billion of assets under control in 1998. 50. Some of these issues have been relevant right from 1992, when FII investments were allowed in. The issues, which continue to be relevant even today, are: (i) benchmarking with the best practices in other developing countries that compete with India for similar investments; (ii) if management control is what is to be protected, is there a reason to put a restriction on the maximum amount of shares that can be held by a foreign investor rather than the maximum that can be held by all foreigners put together; and (iii) whether the limit of 24 per cent on FII investment will be over and above the 51 per cent limit on FDI. There are some other issues such as whether the existing ceiling on the ratio between equities and debentures in an FII portfolio of 70:30 should continue or not, but this is beyond the terms of reference of the Committee. 51. It may be noted that all emerging peer markets have some restrictions either in terms of quantitative limits across the board or in specified sectors, such as, telecom, media, banks, finance companies, retail trading medicine, and exploration of natural resources. Against this background, further across the board relaxation by India in all sectors except a few very specific sectors to be excluded, may considerably enhance the attractiveness of India as a destination for foreign portfolio flows. It is felt that with adequate institutional safeguards now in place the special procedure mechanism for raising FII investments beyond 24 per cent may be dispensed with. The restrictions on foreign ownership of companies in emerging markets have been summarised in AnnexIII. VII. Recommendations

52. Given the necessity of boosting agricultural growth through development of agroprocessing, and expanding industry by at least 10 per cent per year to integrate not only the surplus labour in agriculture but also the unprecedented number of women and teenagers joining the labour force every year, there is an urgent need to scale up investment in the economy. FII inflows can help in augmenting the investible resources in the economy, and the following measures may be considered for increasing the availability of stocks eligible for such portfolio investments:A (i) In general, FII investment ceilings, if any, may be reckoned over and above prescribed FDI sectoral caps. The 24 per cent limit on FII investment imposed in
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1992 when allowing FII inflows was exclusive of the FDI limit. The suggested measure will be in conformity with this original stipulation. (ii) Special procedure for raising FII investments beyond 24per cent upto the FDI limit in a company may be dispensed with by amending the relevant SEBI (FII) Regulations. (iii) In order to provide dispersed investments and prevent concentration, the existing limit of 10per cent by a FII in a single company may continue. B Recommendations in para A above apply, in general, to all sectors. Specific recommendations are being made for the following sectors keeping in mind their special nature: (i) For telecommunications services, defence production, public sector banks and insurance companies, where composite limits on FDI and FII investments apply, the following is recommendeda) Telecom services: As recommended by the earlier Group of Ministers to the Union Cabinet and taking into account security considerations, while the Composite cap may be maintained, it may be enhanced to 74 per cent of the paid up capital without separate sub-ceilings. (b) Defence production: In this strategic sector a limit of 26 per cent applies on FDI. A composite cap of 49 per cent may be imposed with no subceiling for FDI and FII. (c) Public sector banks: In public sector banks where a composite cap of 20 per cent for foreign investments applies, FII investment up to 20 per cent over and above the existing cap of 20 per cent should be allowed. However, FIIs will have no representation on the board of these banks. If necessary, the statutes may be amended for this purpose. (d) Insurance companies: In insurance companies, a composite cap of 26 per cent for FDI and FII investments applies. Like in defence production, this composite cap may be enhanced to 49 per cent by amending the relevant statutes. (ii) In print media, FII investment is prohibited under regulation 5(2) of FEMA notification No.20 dated May 3, 2000, (as amended in terms of FEMA Notification No.35/2001-RB dated February 16, 2001). The same may continue for the time being (iii) Similarly, gambling, betting, lottery, which are areas of dubious value added and where FDI is prohibited, may also be kept out of bounds for FII investments.

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(iv) In retail trading currently FDI is prohibited. FII investments, however, are permitted up to 24 per cent in all listed companies, except in print media companies. Accordingly, FII investments in retail trading cannot exceed 24 per cent as no FDI is permitted. This restriction may continue, as it will help develop supply chains in a wide range of products, including that of agriculture. (v) Sectors which are not yet open for private investments, e.g., terrestrial broadcasting and postal services (delivery of letters) should explicitly be prohibited for FII investments, as no investible securities are available. Details of sector specific guidelines for foreign direct investment and portfolio investments are at Annex-I, and proposed portfolio investment limits in sectors currently with investment limits is at Annex – II. C. The Committee recommends that this liberalization be reviewed later for delinking portfolio investments from FDI ceilings.

( Umesh Kumar )

(U.K. Sinha)

(Dr. Ashok K. Lahiri)

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