On February 17, 2017, Reserve Bank of India (RBI) banned foreign portfolio investors (FPIs) from purchasing shares in HDFC Bank Ltd., as the foreign shareholding in the said listed company had already crossed the permissible limit of 74 percent. Since some trades by FPIs had taken place after the limit was breached, RBI reportedly directed custodians to not settle the trades executed after the issuance of the ban.
There are two big implications of this ask. One, that the breach of the FPI shareholding limit may be excused, if such breach is attributable to monitoring lapses by the regulator. Two, that trades executed on an Indian stock exchange are not sacrosanct and are capable of being voided.
Both these implications do not augur well for an economy that is globally competing for capital. They also show that the design of our regulatory framework governing foreign exchange management, is incompatible with the current structure of our trading platforms.
Under its current design, the Foreign Exchange Management Act, 1999 (FEMA) imposes a percentage-based cap on foreign shareholding in Indian companies. In an anonymous order matching system on an exchange, monitoring compliance with such a cap at the time a buy or sell order on the exchange is placed, is hard. Nobody, except the exchange itself, knows or is capable of identifying whether a buy order is placed by a FPI.
The policymakers sought to overcome this difficulty in the following way: at the end of each trading day, the custodians placing orders on behalf of their FPI clients would report their respective positions in Indian companies at the close of the day. Once RBI has a picture of the shareholding in a given company at the aggregate level, it would announce if the FPI shareholding in such a company was 2 percent below the prescribed cap. Thereafter, every subsequent purchase of shares in the company by FPIs, required RBI approval.
For example, where the FPI shareholding is capped at 74 percent (as in the case of HDFC Bank), every subsequent purchase after the FPI shareholding in the company has reached 72 percent, would require RBI approval. However, since the intra-day positions of FPIs are not monitored, the end-of-day position of FPIs in a given company, may end up breaching the cap. There are three possible alternatives for policymakers in such cases:
- Allow brokers to settle executed trades and ignore the breach of foreign shareholding norms
- Allow brokers to settle executed trades, but compel FPIs to subsequently divest the shares held by them in excess of the cap
- Instruct brokers to not settle executed trades that breach the cap
Each of these alternatives is problematic, as it has a negative externality for the market as a whole. Let us consider them consecutively.
The first option seems compelling. However, it has implications for rule of law in administering our foreign exchange regulation laws. Should such exemptions be allowed for every such breach? If not, how does one decide whether and when to allow such exemptions? Resorting to this alternative creates the political economy problems of case-by-case exemptions, and reduces the overall credibility of the legal framework governing foreign exchange management.
The second option, which has been reportedly resorted to previously, is problematic too. First, for the FPIs who are forced to sell, such a forced sale will most likely take place at a discount. Second, a refusal to comply with a direction to sell shares held in excess of the shareholding limit, is costless for the FPI. Third, the process of selecting FPIs who should be forced to sell, would only make the enforcement unduly complex.
Finally, the third option was reportedly resorted to by the RBI in the HDFC Bank case. However, as has been argued by multiple commentators, forcing brokers to not settle trades conducted on an exchange platform, implies a loss for the brokers who have already taken such positions on their balance sheets, a loss for the counterparties to such trades and a loss of credibility for Indian financial market institutions as a whole.
Since exchanges are already capable of monitoring intra-day FPI positions, we should leverage off their existing systems. If the existing FPI shareholding in a given company hits the prescribed cap, then exchanges must reject further buy orders in such a company placed by or on behalf of FPIs. This allows monitoring compliance with caps on a real-time basis. We will then not require to rely on forced divestments and voiding executed transactions. More importantly, exchange-level monitoring of shareholding caps avoids the time lag involved in approaching the RBI and awaiting a press release banning further purchases by FPIs. More importantly, we can then dispense with the approval requirements that kick in once a company is in RBI's caution list.
Having laid this out, there are three concerns with this solution too.
First, an exchange can only monitor orders placed on its own platform. An exchange will not, therefore, have a real-time consolidated view of the shareholding pattern of a company listed on both the exchanges. While this can be resolved by requiring the exchanges to share FPI-related trade data on a real time basis, integrating information from multiple platforms may end up introducing latencies in the trading time.
Second, an exchange-oriented solution increases the cost of trading for everyone.
Finally, some complexities of our foreign exchange regulatory framework render monitoring impossible and breaches inevitable. For example, under the current foreign investment norms, even indirect foreign shareholding is taken into account when computing the aggregate foreign shareholding in an Indian company. Where an Indian entity, that is owned or controlled by foreigners, makes a downstream investment, such downstream investment is deemed to be foreign investment. If, therefore, on an exchange, a buy order is placed on behalf of an Indian entity with 50 percent foreign shareholding, such an entity will be regarded as "foreign owned", and the shares bought by it, will be regarded as "foreign held". Neither the exchange nor the Indian investee company itself has the capacity to monitor such indirect foreign shareholding of the entity on whose behalf an order is placed.
Thus, while exchange-level monitoring and order blocking will help avoid lapses like the HDFC Bank incident, the sheer complexity of other aspects of our foreign exchange laws means that breaches of foreign shareholding caps may frequently go unnoticed. In such cases, we daresay that the adage that ignorance of the law is no excuse, will have to admit to exceptions.
The authors are researchers at the National Institute of Public Finance and Policy, New Delhi.
The views expressed here are those of the authors’ and do not necessarily represent the views of BloombergQuint or its editorial team.