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Thursday, May 15, 2014

Fixing the Indian capital controls against DR issuance by Indian firms

by Pratik Datta and Arjun Rajagopal.

Yesterday, the Ministry of Finance accepted the report of the Sahoo Committee on depository receipts. Depository Receipts, also known as DRs, are financial instruments that are issued on the back of domestic securities, for sale to investors abroad: Indian securities are deposited with a custodian in India, after which a depository institution in a foreign jurisdiction may issue corresponding DRs. Each DR represents one or more underlying Indian securities. In this way, issuers of Indian securities can access the international capital markets and foreign investors can gain exposure to Indian securities without directly holding the Indian securities.

Before we plunge into the details, here are the key links:

The importance of DRs

Investors around the world generally over-invest in their home country and under-invest in overseas securities. This is a phenonemon known as home bias. Despite improvements in financial infrastructure and communications technology, it can still be expensive and complicated to invest in foreign securities. DRs help to alleviate the problem of home bias: Though the underlying securities are foreign, the investor can take comfort in the fact that the DR itself is issued in her own jurisdiction, in her own currency and subject to her own jurisdiction's laws and regulations. DRs are thus attractive to investors because they offer a combination of simplicity, protection and flexibility as compared to direct investment in a foreign market.

DRs are also an important mechanism by which an economy can achieve competitive neutrality. The principle of competitive neutrality is a key component of a liberalised trade system. The principle mandates that foreign and domestic inputs be treated identically. India made large steps towards competitive neutrality in its real economy when it allowed domestic firms to purchase inputs from international markets at competitive global prices. When an Indian firm issues a DR abroad to be puchased by a foreign investor, it is seeking to procure another input - capital - at a competitive global price.

Why regulate DRs, and how?

In a market economy, any intervention by the State must be justified by the identifying market failures, and demonstrating that the proposed intervention addresses the identified market failure. The FSLRC report and the IFC identify four areas where regulation is legitimate: consumer protection, micro-prudential regulation, (regulation of individual firms), systemic risk regulation and resolution (orderly exit of failing firms). None of these four problems are present with DR issuance by Indian firms.

The investors in DRs are not participants in the Indian securities market. These investors are protected by the authorities and laws of the jurisdiction where the DRs are issued. For example, for an American DR (ADR) issued in the US against Indian securities, US laws provide for protection of investors in such ADRs in US. Indian laws need not provide additional protections to such investors for three reasons. First, such protection is already being provided by US laws. Second, Indian laws do not require an Indian regulator to protect foreign investors in foreign securities in a foreign country. Third, additional protection, if provided by Indian laws, will impose additional costs on the Indian issuer.
However, the DR mechanism can be utilised as part of a conspiracy to achieve market abuse and money laundering in the Indian securities market. This requires learning how to handle such problems through effective law enforcement. This approach has informed the Committee's decision to permit issue of DRs only in IOSCO and FATF compliant jurisdictions. (See Table 5.1, page 60, Sahoo Committee Report).

The need for reform

Prior to the Sahoo Committee, DRs are primarily regulated by the FCCB and Ordinary Shares (Through Depository Receipt Mechanism) Scheme 1993. In addition, DRs are subject to:

  • the existing capital controls regime (under FEMA) as administered by RBI;
  • regulations administered by SEBI;
  • companies law as administered by the Ministry of Corporate Affairs; and
  • the laws on taxation as administered by the Department of Revenue, Ministry of Finance.

In 2013, the Government felt the need to review the Scheme, primarily because of vast changes to the legislative landscape affecting the financial sector since 1993. Three new pieces of legislation had been introduced: the Companies Act, 2013; the Securities Laws Ordinance, 2013; and the Takeover Regulations, 2011. Along with these legislative developments, the macroeconomic and financial landscape had changed as well. The thinking underpinning the 1993 Scheme was no longer well-suited to the needs of Indian firms. The existing framework was riddled with interventions that could not be justified by the objective of identifying and addressing market failures. Further, two decades of incremental modifications to the Scheme had resulted in increased legal risk.

The Sahoo Committee's Recommendations

The report calls for the government and the other regulators to clarify certain critical aspects of the current regulations, in particular the fact that non-capital raising DRs, and both listed and unlisted DRs are all to be permitted. The report also recommends important changes such as:

  1. Unsponsored DRs should be allowed;
  2. There will be no restrictions under Indian law on who can serve as a foreign depository;
  3. DRs on the back of Indian securities must only to be issued in FATF and IOSCO compliant jurisdictions;
  4. A broader category of Indian securities should be allowed to serve as the underlying for DRs; and
  5. Listed voting DRs on the equity shares of a listed Indian company are to form part of the minimum public shareholding of the Indian company under Indian law.

The report is clarifies that it is not the government's job to promote the use of DRs but merely to remove impediments to their efficient use in the market based on the decisions made by private players. However, given the size of the DR market around the world, and the variety of strategic benefits that DRs provide to firms and investors, it is likely that these reforms will expand choice and liquidity in the market.

Participatory process, coherent output

Much of India's policy work is done behind closed doors, with the final recommendations or decisions being tersely communicated through press releases or circulars. Opacity and low public participation diminish the quality of policy outputs, and the legitimacy of any resulting regulations. In order to avoid these problems, the Sahoo Committee drew its members from the public and private sectors, as well as from academia, and held several in-depth consultations with market participants.
The report endeavours to provide a concise overview of the legal and economic context of its work, as well as an outline of the intellectual framework from which its recommendations flow. The report presents holistic recommendations in an accessible Q&A format that is targeted at practitioners and at a wider public who may not be familiar with the intricacies of the subject matter. It also provides a list of recommended specific technical changes to current laws and regulations, and presents these in the form of a draft Scheme that is ready for implementation.

Peering into the future

The Sahoo Committee report has been accepted by the Ministry of Finance. The changes to regulations that are required in implementing this are likely to take place in coming months. Once fully implemented, we may conjecture:

  • Legal risk surrounding DRs will go down.
  • Employees of government and financial agencies will spend less time on interventions which lack an economic justification.
  • The cost of doing business in India will go down.
  • The income of lawyers per unit DR issuance will go down.
  • More Indian firms will issue DRs.
  • The domestic Indian securities market will face greater competitive pressure as Indian firms and their investors will have a choice of meeting each other through exchanges outside India.
  • Home bias against Indian firms will go down.
  • Indian firms will obtain a reduction in the cost of capital for both equity and debt.


    1. How does this tie in with the general nature of Capital Controls in India? After all, we do have several impediments to a foreign investor investing capital in India, right?

      How is this any different?

    2. It ameliorates, to a certain extent, the effect of those impediments by creating foreign securities (not governed by Indian laws) which mirrors the Indian securities (governed by Indian laws). But I do agree with you that a lot more can be done.


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