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New Depository Receipts Scheme!

Published on Sat, Nov 29,2014 | 15:39, Updated at Mon, Dec 01 at 22:22Source : CNBC-TV18 |   Watch Video :

November will go down as a month of good news and bad news for foreign investors in India. This week SEBI imposed new restrictions on P-Note investors. Now investors in Overseas Derivative Instruments will have to meet almost the same eligibility criteria as Foreign Portfolio Investors. But on the other hand last week the Government Of India opened the door to a new class of foreign investors. In a bold new step for the Indian capital markets, the Depository Receipts Scheme, 2014 permits listed and unlisted Indian companies and their equity investors to issue new kinds of depository receipts. Will debt securities be included as well? Will this attract new foreign capital to India? Will this impact pricing and liquidity of Indian equities? Joining me on The Firm This Week are Deutsche Bank’s Anjali Mohanty, Citi’s Aashish Mishra & NDA’s Pratibha Jain.

Doshi: The one big new thing that this depository receipt scheme 2014 brings about is that level 1 ADRs i.e. sponsored or unsponsored non capital raising depository receipts (DRs) will be permitted now thanks to this scheme. Unsponsored being where the issuer company’s approval is not required. So far we have seen Indian companies to level 3 depository receipts essentially which are sponsors where the company is fully involved and that they are capital raising whereby you raise capital from foreign investors. This introduction of level 1 was amongst the most important new things that the scheme brings about. What else would you add to it?

Jain: What it does really is it allows both listed and unlisted Indian issuers to provide depository receipts globally whether through a listed route or an unlisted route through capital raising or non capital raising and whether sponsored or unsponsored and as you mentioned unsponsored basically means that you don’t need approval from the issuer of the security. Now that is as broad a framework as it can get and it is in line with global standards in terms of allowing capital raising or secondary transactions in capital markets.

Who Can Do DRs?
-    Any Indian Listed/Unlisted/Private/Public Company & Any Other Issuer of Permissible Securities
-    Any person holding ‘permissible securities’
Permissible Securities: Shares, scrips, bonds, debentures of a company + Derivatives + CIV scheme units + Security Receipts + MF units + Govt securities

Sponsored ADR: In which the issuer enters into agreement directly with US Depository Bank

Unsponsored ADR: In which ADR may be initiated by a broker-dealer, without cooperation of the issuer

Doshi: Anjali, Listed and unlisted Indian companies, private or public Indian companies can in fact now issue depository receipts overseas. This is a big new development for the unlisted space firstly to begin with. We had in a sense indications in the beginning of the year that this was going to be permitted. It is finally being enabled. This is very good news for companies like Flipkart or a variety of new e-commerce companies in this country or digital companies in this country who may want to test the appetite of foreign investors?

Mohanty: Absolutely, as you rightfully said it is a combination of listed and unlisted. Till today ADRs were allowed, so companies could go do capital raising in the US, a listed entity in India could already do that. What this has done now is actually allow companies to go and do non-capital raising and just access the deep investor pool. So capital raising in the US obviously comes at its own set of disclosures and cost and all of that if you had to do that. Today you could do that if you had a listed company in India just riding on those disclosures that are already there, you can now go and create a sponsored or an unsponsored program in the US which is called as level 1 ADR and have a wide range of investors who can actually come and participate in your stock which is actually fantastic.

Doshi: Three new things Ashish; the fact that unlisted companies can also now issue depository receipts, the fact that the holder of the security can also participate in creating an ADR so to speak and that any kind of security can be the underlying. So, there are several doors opening up in this, isn’t it?

What’s New
-    Listed companies can do non-capital raising DRs
-    Unlisted companies can issue DRs
-    Holders of securities can do DRs
-    Underlying can be equity, debt/Govt bonds…

Mishra: Absolutely, and just to echo what the panellists said, I think to me the most fundamental thing about the committee report is that it kind of plugs in a key gap in the Indian capital markets. So if you look at any other markets you have direct onshore products where the investor comes to the market and then you have access product which so far for the Indian markets has primarily been Participatory Notes (P-Notes), maybe Exchange-Traded Funds (ETFs) for example if you count them and this was a key components, which was missing which the regulators have rightly plugged, so that is fundamental.

If you just look in terms of how the local issuers are impacted, technically there was always a mechanism and this was brought in two years ago for unlisted Indian companies to raise capital directly overseas without necessarily listing on Indian exchanges. I don’t think it really took off in a big way for various reasons. Maybe it was the timing of the market conditions and so on but with the new measure of the level 1 DRs it is a great way for people to test the waters. So it is a very easy way to trade in the US. There are very low compliance requirements. You can gauge investor demand, and the second thing which was bang on which was in terms of increasing the breadth of products on which you could offer DRs.

Doshi: The fact that the underlying can be equity, it can be an equity derivative, it can be debt, it could be pretty much anything, that is fairly revolutionary for us because still now we were doing depository receipts only on the basis of an underlying equity, right?

Mishra: Absolutely, so to me that is the other significant part. That will play a very important part especially as far as the fixed income space is concerned. So, if you ask my own view on the basis of what investors tell us there is a lot of play in it for equity and for government bonds and then moving on to corporate bonds.

Doshi: Who is the target investor, if I may put it that way?

Mohanty: As you rightfully said this program is going to be more led by the investor demand. If you look at the Sahoo committee report the big thing they were trying to address is most of the large investors have a home country bias and they are much more comfortable investing in their own countries, that is what this is going to address. So, investors who does not necessarily want to come to India yet or wants to test the waters or has certain restrictions in their own charter which does not allow them to invest beyond a certain amount in international equity markets can now test the markets by accessing this level 1 which is in the US, in their time zone, cost efficient, highly efficient for them to invest.

Doshi: So is the US the main market for this?

Mohanty: If you look at the current set of level 1 ADRs both sponsored and unsponsored they are mainly in the US.

Doshi: And this is all OTC trading in the US, so it is not listed on the New York Stock Exchange (NYSE) or NASDAQ or anything like that, right?

Mohanty: So, they could be either listed or unlisted but a bulk of them are OTC and they prefer to be OTC. So even in this situation obviously if the company ultimately does not want to raise capital there is no value in going and listing it in the US because then you have to go through all the regulatory requirements and local compliance.

Doshi: Where will most of this demand come from, which kinds of companies will be drawn to level 1 ADRs because level 3 we are familiar with, we have got a bunch of Indian companies listed on NYSE, NASDAQ. Who will be drawn to level 1 first?

ADR Level 1: Sponsored/Un-sponsored + Non-capital raising + OTC Trading
Minimal regulations, No GAAP compliance required

ADR Level 3: Sponsored + Capital Raising + Trades on national securities exchange
Fully regulated by SEC , Full GAAP compliance

Mishra: If you just focus on the investor base first and we did a quick study on this in terms of the existing level 1 DR market in the US. So there are approximately 2,200 odd actively traded DR programs in the OTC markets in US. The total investments held in those markets are nearly upward of USD 70-80 billion, this was 2013 end numbers. So it is a very active, very big market and the investor base today comprises mainly of a large number of long only US investors across asset managers, insurance, pension and the likes. Anjali dwelled upon the reasons why they do this, it is no different than why they would do P-Notes for that matter, any access product that they don’t want to come to India for whatever rhyme or reason. It could be income tax filing related, it could be the access mechanism.

Doshi: It is just easier to be able to do this in your home jurisdiction?

Mishra: It is easier and some of them by the charter are bound to only invest in US dollar nominated securities.

Doshi: And depository receipts will give them that.

Mishra: Absolutely, so to that extent it is a very good pool of capital which today does not access the Indian market. So to that extent it gives us access, us as in the Indian capital market.

Doshi: So it is a new pool, very important to say. It is a new pool of capital that we will be reaching out.

Jain: In terms of the companies that would access it, the initial demand just given historically where these investors would invest because supply will follow the demand, it would initially be the listed companies or the big names. You mentioned the e-commerce companies; I can see them accessing the markets. For the listed companies it is easy, they can do the level 1 program, the global investors know these names. So, it is easier for them to jump in.

Doshi: And what about the holders of securities?

Jain: The holder of securities I would think would be the sophisticated investors in India currently, whether in listed companies to start with, there are still questions around how the unlisted companies do it. Just talking to the depositories you realise that they are still trying to work out how the whole structure for the unlisted companies will work out. So the first step for the existing investors of the companies would be the listed companies.

Mishra: My own sense is that in the first few months you will see activities largely in the top 100 listed companies. Unlisted, theoretically they can but we need to work out the structures and so on. There are Foreign Direct Investment (FDI) rules which need to looked into. But in terms of holders of securities and that is interesting because so far DRs the way it would work is that once the company created the headroom and issued the DRs a lot of the program building up again used to happen by secondary market activity.

Now the Sahoo Committee says that you can continue with the secondary market base build up of the program. Additionally an existing holder theoretically under the Sahoo Committee can just surrender his shares and get it issued in the DR format overseas, but there are tax challenges to that. So I don’t think it is going to happen until some of those tax guidance gets clarified.

Doshi: I just want you to explain it through an illustration so that our viewers understand it fully.

Mohanty: So if there is an investor, say, XYZ Fund Management company in the US which wants to participate in an unsponsored or a sponsored of a certain company. So, they will go their brokers or they will go to the depository and say this is a company that we are interested in. Now flipside what happens is, in turn they will place an order with a broker in India who will buy. So their counterpart broker in India will buy those shares deposited with the custodian, such as Deutsche bank or one of the custodians that you have who in turn will then convert it into an ADR and deposit it into the depository in the US. So for a person holding a share, if you are holding the share or we it is no different from selling in the market locally.

Mishra: I have a couple of thoughts, just two points. One is in terms of the changes besides what Anjali mentioned. The point I was trying to bring out and that is new with this committee is that today the way you create DRs is exactly what Anjali described. So what the notification also allies in addition to what was just described is, forget someone placing an order in the US coming to a local broker, forget all of that. An investor has existing shares of company X in India. What the notification allows is that the investor can just surrender those shares to a custodian so no, secondary market transaction. You can just surrender your shares to a custodian and take it in an ADR form in the US. That is new and that has taxation challenges.

Doshi: Why would an investor want to do that?

Mishra: It could be arbitrage, it could be reasons for liquidity, he wants to trade in a US instrument, the same reason we strive trading in the ADR market even today.

Doshi: So, companies would do level 1 to gauge foreign investor interests and let’s assume that step 1 to be wanting to potentially do a capital raising ADR, so to speak. So that is why they do it, to get a sense of what is the appetite for my securities in another market somewhere else in the world. That is why companies would do it. Holders would do it for the reasons that you just articulated which is that it may be arbitrage, the ADR of that company which is already listed on the NYSE or NASDAQ is trading at a higher price than the domestic security, you want to be able to benefit of that or a variety of other personal reasons is what you are saying.

Doshi: I want to come to some of the more technical aspects. Now having understood the concept, the demand and the supply to some extent, will pricing or listing be an issue?

Mishra: I think in terms if you look at what the notification says, they have streamlined and liberalised the pricing norms essentially saying that the pricing should not be less than the price at which you need to issue to domestic investors.

Underlying securities to be issued to Foreign Depository at price not less than such transfer to domestic investors
ie: company’s preferential allotment to Foreign Depository to be at preferential allotment  price under ICDR
ie:  company’s QIP to Foreign Depository to be at minimum pricing norms under ICDR

Doshi: In the case of an unsponsored DR how will it get priced?

Mishra: There is no pricing in an unsponsored DR; it is driven by the market price.

Mohanty: The challenge is in an unlisted unsponsored -- in a listed there is already a price point.

Mishra: There is a market price.

Doshi: So who decides the design of the DR, will the DR represent one share, two shares. When it is a level 3, the company works with the bankers to do all of this?

Mishra: It is decided by the depository bank.

Doshi: Could you have for instance in the case of unsponsored level 1 DRs a variety of different depository banks in different countries?

Mohanty: You could have multiple unsponsored programmes of one company. Most of them would be in the US like I said because of bulk of the unsponsored market is there. So to give you an example like L’Oreal which is a French company has four-five unsponsored DRs in the US, so you could have it.

Doshi: So that was one question I wanted to ask. I don’t suppose voting rights is an issue at all because we have already been through what that means for level 3 ADRs, I suppose exactly the same has happened in this case.

Mohanty: It has voting rights, absolutely.

Mishra: Except that for unsponsored, the market practice internationally is not to have voting rights. So that is something which the depository banks are working together to enable for the Indian market but otherwise as a market practice, you don’t have voting rights.

Doshi: That is very interesting because here the existence of the DR depends on there being a voting right.

Unsponsored Depository Receipts
-    Must grant Voting Rights
-    Must be listed on an International Exchange
International Exchange: Platform for trading DRs + In a permissible jurisdiction + accessible to public + pre & post trade transparency

Mishra: Yes and they made specific requirement for unsponsored.

Doshi: Yes, they have.

Mishra: So it is something unique for the Indian market, which we all as a depository bank, will work together and have that in place.

Mohanty: Another little nuance since you are picking up little nuances, for an unlisted company, it says that you could have an unlisted company and go and have a sponsored or an unsponsored but the challenge that in the US, the exemptions that are allowed under the SEC for disclosures, etc is only given if you are also listed in your home market. So technically if you are not listed, you have to do full disclosure to have a sponsored and unsponsored programme.

Doshi: So it is not as pretty as it looks for unlisted company?

Mishra: Yes.

Mohanty: Absolutely.

Doshi: The next question is how does this get counted towards foreign limits? For instance, two instances, we have two illustrations, one a company does sponsored level 1. There is an FII cap applicable to all listed companies in India, there is an FDI cap applicable to all sectors or whichever sectors that we are talking about here, so would these DRs be counted if it is a sponsored level 1 towards those FII and FDI limits and what happens if it is an unsponsored DR? The holder of the securities infact, the one doing it, the company is not involved at all, does it still get counted towards the company’s FII/FDI limits?

Shares transferred for DR issue may not exceed foreign ownership limits
DRs may be converted to underlying permissible securities

Mishra: Irrespective of whether it is sponsored or unsponsored, DR investments get counted as a part of the FDI investments. The challenge is that so far DR limit monitoring was a fairly simple process, the company based on the number of shares that issued on day one, DRs that are issued; the entire programme had to be within that cap in the life of the programme. Now it will get capped by the FDI sectoral cap for that company and who does it monitoring because there is no central repository as of date for the FDI investments or for someone to be able to track that. So I think some operational changes will have to be done in the way the market works, maybe have a central monitoring system, it could be the issuer, it could be the depositories in India, so those things will need to be worked upon.

Doshi: Anjali, you want to add to that, anything different?

Mohanty: No, I agree with that.

Mishra: The interesting thing will be when you get to DRs on government bonds for example because till date, government bonds investments are only FII or foreign portfolio investors (FPI), FDI is not permitted but if you enable DRs, today DRs are FDIs.

Doshi: A foreign investment in government bonds is capped. So if you participate through this kind of unsponsored DR, will it be counted towards the cap?

Mishra: It will be.

Doshi: But somebody will have to do the monitoring as you pointed out. My final question is this then from the listed company point of view, if they are doing a sponsored level 1 DR then they are testing the waters, it is fairly easy for them, they are in control of the process to some extent. But if the unsponsored level 1 DR becomes a big rage, what is it going to mean for companies here and also the combined impact of two to have all of these depository receipts trading on OTC markets, what will be the impact of the liquidity and price of the underlying security here in India?

Mohanty: If you ask me, there has to be a price parity between the price onshore and these DRs. So today if you have to see some of the ADRs that we have, there is a bit of arbitrage purely because there is a demand/supply constraint issue but the minute you have this, ultimately it has to come at a common point between the local price and the price overseas. So if you look at historically, all the unsponsored DRs which are there, you will find that they trade very close to the onshore listed security itself. So it will find its equilibrium.

Mishra: We did a quick study in the other markets where this prevails and we found that approximately on an average one and a half percent of the float of the company moves to a level 1 DR format. So from a liquidity impact, it is not significant, it is not that the liquidity gets exported overseas, having said that there are a lot of positive benefits in terms of as we said, access to new investor pool, a lot of trading driven by price parity arbitrage, so it induces liquidity in the markets to the extent you have instruments with price parity in the US and in India.

Doshi: Praibha, do you want to come in on the last bit in terms of what boxes still need to get ticked for this to become operational, the notifications as it is effective December 15th, but when will we see the first level 1 ADR on the back of this notification?

Jain: We still need certain boxes to be ticked. We need tax clarity; I think nobody would want to jump in till tax clarity comes in. We also need FEMA to be updated to include the new notification, you need the same for the income tax act, we will have to see if SEBI wants to put any other bells and whistles around it, for example they need to monitor for abuse of market. So if they are going to put any specific regulations for that. The key one will be the tax clarity, the rest can happen very quickly.

Mohanty: Pratibha, I am with you on the unlisted and the debt and other securities that have been opened up but the listed companies today wanting to do level 1 sponsored, unsponsored, do you see a tax challenge there as well?

Jain: If it is unsponsored where I don’t have clarity is when there is a transfer on the market price. From the not the issuer but he buys in the market, gives it to the depository or the custodian and then the depository, there needs to be clarity that there is no taxation there.


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