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FINANCIAL SERVICES Objectives: To provide an understanding of the working of Financial Services and the role of emerging financial Services. MODULE I

THE FINANCIAL SYSTEM IN INDIA The economic development of any country depends upon the existence of a well organised financial system. It is the financial system which supplies the necessary financial inputs for the production of goods and services which in turn promote the well being and standard of living of the people of a country. Thus, the financial system is a broader term which brings under its fold the financial markets and the financial institutions which support the system. The major assets traded in the financial system are money and monetary assets. The responsibility of the financial system is to mobilise the savings in the form of money and monetary assets and invest them to productive ventures. An efficient functioning of the financial system facilitates the free flow of funds to more productive activities ad thus promotes investment. Thus, the financial system provides the intermediation between savers and investors and promotes faster economic development. FUNCTIONS OF THE FINANCIAL SYSTEM 1. Provision of Liquidity : The major function of the financial system is the provision of money and monetary assets for the production of goods and services. There should not be any shortage of money for productive ventures. In financial language, the money and monetary assets are referred to as liquidity. The term liquidity refers to cash or money and other assets which can be converted into cash readily without loss of value and time. Hence, all activities in a financial system are related to liquidity

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either provision of liquidity or trading in liquidity. In fact, in India the R.B.I. has been vested with the monopoly power of issuing coins and currency notes. Commercial banks can also create cash (deposit) in the form of credit creation and other financial institutions also deal in monetary assets. Over supply of money is also dangerous to the economy. In India the R.B.I. is the leader of the financial system and hence it has to control the money supply and creation of credit by banks and regulate all the financial institutions in the country in the best interest of the nation. It has to shoulder the responsibility of developing a sound financial system by strengthening the institutional structure and by promoting savings and investment in the country. 2. Mobilisation of Savings : Another important activity of the financial system is to mobilise savings and channelise them into productive activities. The financial system should offer appropriate incentives to attract savings and make them available for more productive ventures. Thus, the financial system facilitates the transformation of savings into investment and consumption. The financial intermediaries have to play a dominant role in this activity. 3. Size Transformation Function : Generally, the savings, of millions of small investors are in the nature of a small unit of capital which cannot find any fruitful avenue for investment unless it is transformed into a perceptible size of credit unit. Banks and other financial intermediaries perform this size transformation function by collecting deposits from a vast majority of small customers and giving them as loan of a sizeable quantity. Thus, this size transformation function by collecting deposits from a vast majority of small customers and giving them as loan of a sizeable quantity. Thus, this size transformation function is considered to be one of the very important functions of the financial system.
4. Maturity Transformation Function :

Another function of the financial system is the maturity transformation function. The financial intermediaries accept deposits from public in different maturities according to their liquidity preference and lend them to the borrowers in
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different maturities according to their need and promote the economic activities of a country. 5. Risk Transformation Function : Most of the small investors are risk averse with their small holding of savings. So, they hesitate to invest directly in stock market. On the other hand, the financial intermediaries collect the savings form individual savers sand distribute them over different investment units with their high knowledge and expertise. Thus, the risks of individual investors get distributed. This risk transformation function promotes industrial development. Moreover, various risk mitigating tools are available in the financial system like hedging, insurance, use3 of derivatives etc. OVERVIEW OF FINANCIAL MARKET : Financial Market : Generally speaking there is no specific place or location to indicate a financial market. Wherever financial transaction takes place it is deemed to have taken place in the financial market. For instance issue of shares debentures, granting of loan by lending institutions deposit of money into bank etc. However financial markets can be referred to those centers and arrangements which facilitate buying and selling of financial assets, claims and services some times we do find the existence of place or location for financial market as in the case of stock exchange. * Financial Asset is one which is used for production or consumption or for further creation of assets.

CLASSIFICATION OF FINANCIAL ASSETS

Marketable Assets

Non-Marketable Assets

Shares

Gov. Securities

Bonds

M.I. Units

UTI Units

debentures

Bank Deposit

P.F.
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L.I.C. Schemes

Co., depostis

P.O. certificates

CLASSIFICATION OF FINANCIAL MARKET

Financial markets are basically classified into two categories.

1) Organised Market: In the organised market there are standard rules regulations

governing their financial dealings. In organised market institutions are controlled & supervised by the government through RBI various financial instruments are used in organised market. Organised market is further classified into two categories. a) Capital market

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b) Money market
a) Capital Market is a market for long term assets which have long or indefinite

maturity. Generally it deals with long term securities which have a maturity period of above one year. Capital market is further divided into three types namely. i) Industrial securities market ii) iii) i) Govt. securities market Long term loans market. Industrial Securities Market is a market for industrial securities they are
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Equity Shares or ordinary shares Preference shares Debentures or bonds

A. OWNERSHIP SECURITIES Equity share are also known as ordinary shares or common shares, represents the owners capital in a company. The holders of these shares are the real owners of the company. Characteristics of equity shares

Maturity : Equity share is a permanent share capital to the company and cant be redeemed during the life time of the company. Claims / right to income : Equity share holders have a residual claim on the income of a company they have a claim on income left after paying dividend to preference share holders.

Right to control or voting rights : Equity share holders are the real owners of the company. They are having voting rights in the meeting of the company and have control over the company.

Pre - emtive right incase of further issue of shares, Limited liability : liability of the shareholders is

existing shareholders get prior right to subscribe for shares. limited to the value of shares subscribed by them. ADVANTAGES OF EQUITY SHARES :
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For company :
-

Do not create any obligation to pay fixed rate of dividend. Can be issued without creating any charge on the assets of the company. Permanent source of finance. Real owners In case of high profit, share holders get high rate of dividend.

For share holders : -

Disadvantages for company :

-

Trading on equity is not possible if company depends upon equity share capital only. Equity capital cant be redeemed hence there would be danger of over capitalization. More issue of equity shares leads to dilution in the controlling power on the co., In case of high profit, high dividend will have to be declared which leads to speculation in the share market.

For Share holders : Risk is involved and they dot get fixed rate of return on this investment. Preference Share : These shares holders have preferential right over equity share holders to receive dividend during the existence of the company and to receive capital at the time of liquidation of the company. Type of preference shares :
a) Cumulative preference share : Whenever there are divisible profit,

cumulative preference share holders are paid dividend for the previous years in which dividend could not be declared.
b) Non-cumulative preference share : Holders of these share have no claim for

the arrears of dividend.

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7 c) Redeemable preference shares : These shares are redeemed or repaid by the

company after a period of time.

d) Irredeemable Preference shares : Those shares which cannot be redeemed

unless the company is liquidated are known as irredeemable preference share.

e) Participating preference shares : The holders of these shares can participate

in the surplus profit of the company after distribution of profit towards fixed rate dividend to preference share holders and reasonable rate of dividend to equity share holders. Non Participating preference shares : Holders of these shares are not eligible to participate in surplus profit they are entitled for fixed rate of dividend only. Convertible Preference shares : Holders of these shares may be given a right to convert their holdings into equity shares after a specified period. Non-convertible preference share : The shares which cant be converted into equity shares are known is Non-convertible preference share. Features of Preference Share Maturity : These shares are perpetual and company need not pay. The amount of these share not paid during its life time except in case of redeemable preference shares. Claims on Income: Preference share holders have first claim on income over equity shareholders. Claims on Assets : At the time of liquidation preference share holders claims on assets are superior to those of equity share holders. Control : Ordinarily preference share holders dot have any voting rights. They dot have any say in the management of the company. Hybrid form of security : Preference share capital is a hybrid form of security it has the features of equity as well as debt. Advantages or merits of preference shares : Companys point of view.
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There is no legal obligation to pay dividend on preference share. Dividend for them is payable only out of distributable profits.
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Provides long term capital for the company. There is no liability to redeem preference share capital. Incase of redeemable preference shares, there is no significant penalties for delaying redemption of preference shares.

Company can over come the situation of over capitalization by repayment of redeemable preference shares. As fixed rate of dividend is payable on preference shares these enable a company to adopt trading on equity i.e. increase the rate of earning on equity shares after paying a lower rate of and fixed dividend on preference shares.

Preference share capital is generally regarded as a part of companys net worth it enhances credit worthiness of a firm. There is no dilution in control as preference share holders dot have control in the management of the company. As no specific assets are pledged against preference stock, issue of share doest reduce creditworthiness of the company.

The company are conserved: Investors share holders point of view. -

It earns a fixed rate of dividend Preference shareholders are more secured than equity share holders. Preference shareholders have preferencial right to received dividend during life time of co., and to claim capital on liquidation of the company. Preshare holders although carry no voting rights, but they can vote or matter directly affecting there light.

Disadvantages : Companys point of view : It is a expensive source of finance as compared to debt because generally investors expect higher rate of dividend. Cumulative preference share becomes burden as co., has to pay accumulated dividend.

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Though there is no legal obligation to pay dividend if company does not earn adequate profit, but frequent delay and non-payment affect the credit worthiness of the company.

Preference dividend will not save tax as compared to interest on debt. Pre share holders remain at the mercy of the management for payment of dividend and their capital. Rate of dividend is lower as compared to equity shares. They dot have any charge on the asset of the co., Market price fluctuate more than that of debentures.

Share holders point of view :

-

OTHER TYPE OF SHARE SWEAT EQUITY: The term sweat equity means equity shares issued by a company to its employees or directors at a discount or for consideration other than cash for providing know how or making available rights in the nature of intellectual property rights ( say, patents or copyright) or value additions, by whatever name called. The idea behind the issue of sweat equity is that an employee or director works best when he has sense of belongingness and is amply rewarded. One of the ways of rewarding him is by offering him shares of the company at low prices, where he is working. It is termed as sweat equity as it is earned by hard work (sweat) of employees and it is also referred to as sweet equity as employees become happy on the issue of such shares. The purpose of sweat equity is to ensure more loyalty and participation of employees. Section 79A of the Companies Act, 1956 (inserted w.e.f. 31st October, 1998) allows companies to issue equity shares subject to the certain conditions. B. CREDITORSHIP SECURITIES The term creditor ship securities also known as debt capital, represents debentures and bonds. They occupy a very significant place in the financial plan of the company. A debentures or a bond is an acknowledgement of a debt. It is a certificate issued by a company under its seal acknowledging a debt due by it to its holders. In
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the U.S. A, bonds are secured by tangible physical assets of the company and debentures are secured only by the general creditworthiness of the of the company. But, in India and U.K., no such distinction is made between debentures and bonds. According to the Companies Act, 1956, the term debentures includes, debentures stock, bonds and many other securities of a company whether contributing a charge on the assets of the company or not. Hence, in our study, we have not made any distinction between the two terms, debentures and bonds and the two have been used interchangeably. The use of such creditorship securities in financing of a company generally tends to reduce the cost of capital and consequently helps it to improve the earnings for its shareholders. DEBENTURES OR BONDS A company may raise long term finance through public borrowings. These loans are raised by the issue of debentures. A debenture is an acknowledgement of a debt. According to Thomas Eyekyn. A debentures is a document under the companys seal which provides for the payment of principal sum and interest thereon at regular intervals, which is usually secured by a fixed or floating charge on the companys property or undertaking and which acknowledges a loan to the companys property or undertaking and which acknowledges a loan to the company. A debenture holder is a creditor of the company. A fixed rate of interest is paid on debentures. The interest on debentures is a charge on the profit and loss account of the company. The debentures are generally given a floating charge over the assets of the company. When the debentures are secured, they are paid on priority in comparison to all other creditors. Types of Debentures: The debentures are of the following types:
(a)

Simple, Naked or Unsecured Debentures. These debentures are not given any security on assets. They have no priority as compared to other creditors. They are treated along with unsecured creditors at the time of winding up of the company. So, they are just unsecured creditors.

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11 (b)

Secured or Mortgaged Debentures. These debentures are given security on assets of the company. In case of default in the payment of interest or principal amount, debenture holders can sell the assets in order to satisfy their claims. The debentures may be given a floating charge over all assets of company. In this case debentures are paid in priority to unsecured creditors. The sale proceeds of assets are first applied to pay debentures with a floating charge.

(c) Bearer Debentures. These debentures are easily transferable. They are just like negotiable instruments. The debentures are handed over to the purchaser without any registration deed. Anybody purchasing them with a consideration and in a good faith becomes the lawful owner of the debentures. The coupons for interest are attached to the debentures. The bearer can get interest from the companys bank when it becomes due. (d) Registered debentures. As compared to bearer debentures which are transferred by mere delivery, registered debentures require a procedure to be followed for their transfer. Both the transfer and the transferee are expected to sign a transfer voucher. The form is sent to the company along with the registration fees. The name of the purchaser is entered in the register. The coupons for interest are sent only to the persons in whose names the debentures are registered. Every transfer of debentures requires the same transfer procedure to be repeated. (e) Redeemable Debentures. These debentures are to be redeemed on the expiry of a certain period. The interest on the debentures is paid periodically but the principal amount is returned after a fixed period. The time of redeeming the debentures is fixed at the time of their issue. (f) Irredeemable Debentures. Such debentures are not redeemable on during the life time of the company. They are payable either on the winding up of the company or at the time of any default on the part of the company. The company can retain the right to redeem these debentures after giving due notice to the debenture holders. (g) Convertible Debentures. Sometimes convertible debentures are issued by a company and the debenture holders are given an option to exchange the debentures into equity shares after the lapse of a specified period. However,
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debentures issued at discount can be converted either into the equivalent number of shares( representing the nominal amount of debentures) credited as paid up in a proportion to the cash originally paid on the nominal value of debentures or in to the proportionately reduced number of fully paid up shares. Convertible debentures may be either Fully Convertible Debentures (FCDs) or Partly Convertible Debentures are converted in to equity shares after the lapse of a certain period specified at the time of issue of such debentures. (h) Zero Interest Bonds /Debentures. Zero interest bond is an instrument recently introduced in India by some companies. It is usually a convertible debenture which yields no interest. The company does not pay any interest on such debentures. But the investor in a zero interest bond is compensated for the loss of interest through conversion of such bond into equity shares at a specified future date. The issue of such debentures enables a company to service its equity in a better way as no interest is paid against such debentures and conversion takes place usually after the project starts bearing fruits. It also results in a reduction in the project cost to the extent of interest during the construction period. (i) Zero Coupon Bonds: Another instrument which has recently become popular in India is the zero coupon bond (ZCB) coupon bond does not carry interest but it is sold by the issuing company at deep discount from its eventual maturity value. The difference between the issue price and the maturity value represents the gain or interest earned by its investor. (j) First Debentures and Second Debentures. From the view of priority in the payment of interest and repayment of the principal amount, the debentures may be either first debentures or second debentures, etc. The debentures which have to be paid back first or who have preference over other debentures in payment of interest or called first debentures and the debentures who rank after these are known as second debentures. (k) Guaranteed Debentures. These are debentures or bonds on which the payment of interest and principal of guaranteed by third parties, generally, banks and Government. Etc.

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13 (l) Collateral Debentures. A company may issue debentures in favour of a lender

of money, generally the banks an financial in institutions, as a collateral, i.e., subsidiary or secondary, security for a long raised by it. These debentures are called collateral debentures and these become effective only when the company makes a default in the repayment of the loan against which these have been issued.
(m) Other Innovative Debt Instruments. In the fast changing capital market

scenario, the corporate sector has devised many other innovative debt instruments for raising funds from the market. Some of these are outlined below.
(i)

Equity Warrants: The equity warrant is paper attached to a bond preferred stock, that gives the holder the right to buy a fixed number of companys equity shares at a predetermined price at a future date. The equity warrant increases the marketability of debt instruments. When it is issued, it usually has no value but it becomes valuable when the market price of equity shares moves above the fixed price at which the investor is permitted to buy the equity shares.

(ii)

Secured Premium Notes (SPNs) The secured premium note is a tradable instrument with detachable warrant against which the holder gets equity shares after a fixed period of time.

(iii)

Collable Bond. A callable bond is a bond that can be called in and paid off by the issuer at a price, called the call price. stipulated in the bond contract. It gives the advantage to issuer company to call the existing bonds if the interest rates fall in the market below the bonds coupon rate.

(iv)

Floating / Variable or Adjustable Rate Bonds. The rate of interest payable on these bonds varies periodically depending up on the market rate of interest payable on the gilt-edged securities.

(v)

Inflation Adjusted Bonds (IABs)These are the bonds on which both interest a s well as principal are adjusted in line with the price level changes or the inflation rate.

Features of Debentures or Bond:

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Unlike shares or stock debenture or bond is a creditor ship security with a fixed rate of interest, fixed maturity period, perfect income certainty and low risk of capital. The salient characteristics of debentures are as below.
(i) Maturity. Although debentures provide long term funds to a company, they

mature after a specific period. Generally, the debentures are to be repaid at a definite time as stipulated in the issue. The company must pay back the principal amount on these debentures on the given date otherwise the debenture holders may force winding up of the company as creditors. (ii) Claims on Income: A fixed rate of interest is payable on debentures. Unlike shares, a company has a legal obligation to pay the interest on due dates irrespective of its level of earnings. Even if a company makes no earnings or incurs loss, it is under an obligation to pay interest to its debenture holders may take recourse to law for the same. (iii) Claims on /Assets. Even in respect of claim on assets, debenture holders have priority of claim on assets of the company. They have to paid first before making any payment to the preference or equity shareholders in the event of liquidation of the company. However, they have a claim for the principal amount and interest due only and do not have any share in the surplus assets of the company, if any Further, debentures may provide for a charge on the assets of the company as a security to its holders. The debenture holders may have either specific charge on the assets of the company or a gloating charge over all the assets of the company. The secured debentures entitle its holders to have a priority over other unsecured creditors of the company, against the assets mortgaged. (iv) Control Since, debenture holders are creditors of the company and not its owners, they do not have any control; over the management of the company. They do not have any voting rights to elect the directors of the company. Or on any other matters. But, at the time of liquidation of the company they have prior claim over shareholders and it remain unpaid, they may take control over the company. (v) Call Feature. Issue of debentures sometimes provides a call feature which entitles the company to redeem its debentures at a certain price before the maturity date.

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Since, the call feature provides advantages to the company at the expense of its debenture holders, the call price is usually more than the issue price. DIFFERENCE BETWEEN DEBENTURES AND SHARES After studying the features of debentures and shares, we can make out the difference between the two forms of corporate securities. The main points of difference can be put up as follows: Distinction between Shares and Debentures Shares Debentures 1. A share is a part of owned capital 1. A debenture is an acknowledgement of a debt. 2. Shareholders are paid dividend on the 2. Debenture holders are paid interest on shares held by them debentures. 3. The rate of dividend depends upon the 3. A fixed rate of interest is paid on amount of divisible profits and policy debentures irrespective of profit or of the Board of Directors. loss. 4. Dividend on shares is a charge against 4. Interest on debentures is a charge Profit and Loss Appropriation against Profit and Loss account. account. 5. Shareholders have voting rights. They 5. Debentureholders are only creditors of have control over the management of the company. They have no say in the the company. They are the owners of company. the company. 6. Shares are not redeemable (with the 6. Debentures can be redeemed after a exception of redeemable preference certain period. shares)during the life of the company. 7. At the time of liquidation of the 7. Debentures are payable in priority company, share capital is payable over share capital. after meeting all outside liabilities. (viii) Transactions have to be conducted (viii) Transactions have to be conducted without the help of brokers only through authorized dealers.

Intermediaries in Primary Market

MERCHANT BANKERS /LEAD MANAGERS It is now obligatory that all public issues are managed by merchant banker(s) who function as lead manger(s). They help the company in carrying out functions relating to new issues, such as, determination of securitymix to be issued, drafting of prospectus, application

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16 forms, allotment letters and a host of other documents, appointment of registrars for handling share applications and transfers, making arrangements for underwriting, placement of shares, selection and appointment of brokers and bankers to the issue, publicity of the issue, etc. Categories of Merchant Bankers Merchant bankers were categorised as follows : Category I: Those merchant bankers who can conduct all above-mentioned activities, relating to management of issues. They may, if they so choose, act only in an advisory/consultative capacity or as co-managers, underwriters or as portfolio mangers. Category II: Those merchant bankers who can act as consultants, advisers, portfolio managers and co-managers. Category III: Those merchant bankers who can act as underwriters, advisers and consultants. Category IV: Those merchant bankers who can act only as advisers or consultants to an issue. Only category I merchant bankers were allowed to act as lead managers to an issue. Merchant Bankers below Category I Abolished : On September 5, 1997, SEBI abolished all categories of merchant bankers below category I. Merchant bankers operating in the categories below one were allowed to continue till the end of their existing terms, after which they may apply for category I status or take up some other activity. Those functioning as category II, III and IV merchant bankers were given an option to upgrade themselves as the equivalent of the prevailing category I merchant bankers. Alternatively, they could seek separate registration as underwriters or portfolio mangers. SEBI also decided that henceforth only body corporate would be allowed as merchant bankers. The net worth requirement for category I merchant bankers, which in future will be the only category, is Rs. 5 crore. Maximum Number of Lead Mangers The maximum number of lead mangers to an issue depends on the size of the issue as detailed below: Size of Issue (i) Below Rs. 50 crore (ii) From Rs. 50 crore to below Rs. 100 crore (iii) From Rs. 100 crore to below Rs. 200 crore Notes on FMS Maximum Number of Lead Managers Two Three Four

17 (iv) From Rs. 200 crore to below Rs. 400 crore (v) Rs. 400 crore and above Registration of Merchant Bankers : Merchant bankers are to be compulsorily registered with SEBI. They should satisfy the following conditions for their registration and continuation of their registration: (i) (ii) (iii) (iv) (v) (vi) (vii) (ix) Satisfy a prescribed minimum capital adequacy norm in terms of its net worth. i.e., paid-up capital and free reserves. They have necessary infrastructure, such as, adequate office space, equipment and manpower for effective discharge of their duties and responsibilities. They employ at least two persons competent to handle merchant banking business. They are not involved in any litigation connected with securities market. They possess professional qualifications in finance, law or business management. Their registration is in the interest of the investors. They pay prescribed fee. They undertake to adhere to the prescribed code of conduct. Five More than five with With SEBI approval

(viii) They undertake to fulfill their obligations and responsibilities.

Renewal of Registration At the time of renewal of registration, the merchant banker should continue to fulfill all the conditions required at the time of registration, pay the prescribed renewal fee, and also make a declaration ( to be signed by two directors) that : (i) the applicant company, its promoter, director, partner or employee, has not at any time been convicted for any offence involving moral turpitude or has been found guilty of any economic offence: (ii) (iii) it is not involved in litigation connected with the securities market and there are no charges against the merchant banker as on date: none of the associate, subsidiary, interconnected or group company of the applicant company has applied for or has been granted registration by SEBI to undertake merchant banking activities; (iv) (v) scam. Notes on FMS the merchant banking company or its directors are not facing any charges / disciplinary action from any stock exchange; the applicant company or its associates have not been found involved in the securities

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(vi)

all investments indicated in the certified annual accounts are held in the name of the company only (if not, details of such holdings are required to be forwarded). No objection certificate from the stock exchange for functioning as a merchant banker. Separation of Merchant Banking and Fund based Activities of NBFCs : On September 5, 1997 SEBI banned merchant bankers and non-banking financial companies (NBFCs) from straying into each others territories. No merchant banker can now carry on fund- based activities other than those relating exclusively to the capital market like underwriting. Responsibilities/Obligations of Lead Managers/Merchant Bankers : A lead manger has following responsibilities towards the issuing company, SEBI and has own profession: (i) Enter into a contract with the issuing company clearly specifying their mutual rights, obligations and liabilities relating to the issue, particularly relating to disclosures, allotment and refund. (ii) Submit a copy of the above contracts to SEBI at least one month before the opening of the issue for subscription. In case of more than open lead manger, simultaneously submit a statement detailing their respective responsibilities. (iii) Refuse acceptance of appointment as lead manager, if the issuing company is its associate. (iv) Not to associate with a merchant banker who does not hold SEBI registration certificate.

(v) Accept a minimum underwriting obligation of 5 per cent of total underwriting commitment or Rs. 25 lakh, whichever is less, or else arrange for underwriting of an equal amount by a merchant banker associated with the issue and intimate the same to SEBI (iv) Submit Due Diligence Certificate to SEBI at least two weeks before the opening of the issue for subscription after verification of the contents of the prospectus/ letter of offer regarding the issue and reasonableness of the views expressed therein certifying that (a) they are in conformity with the documents, materials and papers relevant to

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19 the issue, (b) all legal requirements relating to the issue have been fully complied with, and (c) all disclosures are true, fair and adequate to enable the investing public to make a well informed decision regarding investment in the proposed issue. (vii) Submit to SEBI various documents such as, particulars of the issue, draft prospects/ letter of offer and other literature to be circulated to the investors/ shareholders , etc., at least two weeks before the date of filing them with the registrar of companies and regional stock exchanges. (viii) Ensure that modifications and suggestions made by SEBI regarding above documents have been duly incorporated. (ix) Continue to remain fully associated with the issue till the subscribers have received share/debenture certificates or the refund of excess application money. (x) Not to acquire securities of any company on the basis of unpublished price sensitive information obtained in the course of discharge of his professional assignment, whether obtained from the client or any other person. (xi) Submit complete particulars with SEBI within 15 days of the acquisition of securities of the company whose issue the merchant banker is managing. (xii) Disclose to SEBI the following (a) its responsibilities regarding the management of the issue, (b) any change in the information / particulars previously furnished with SEBI having bearing on certificate of registration granted to it. (c) details relating to the breach of capital adequacy norm, (d) names and addresses of the companies whose issues it has managed or has been associated with, and (e) information regarding its activities as manager, underwriter, consultant or adviser to the issue Code of Conduct for a Merchant Banker Every merchant banker has to abide by a certain code of conduct which can be discussed as dos and donts for the merchant banker. Dos for merchant Banker Merchant banker should do the following as part of his code of conduct: (i) (ii) (iii) Observe high standards of integrity and fairness in its dealings with the client and other merchant bankers. Disclose to the clients possible sources of conflict of duties and interest, if any, while accepting the assignment and while providing the services. Try his best to render the best possible advice to the clients having due regard to the clients needs ad his own professional skill. Notes on FMS

20 (iv) (v) Provide all professional services to the client in a prompt efficient and cost effective manner. Make available to the investors (a) true and adequate information relating to the issue without making any misguided or exaggerated claims, (b) attendant risks relating to the issue before any investment decisions are taken by them, and (c) copies of prospectus, memorandum and related documents. (vi) (vii) Take adequate steps for fair allotment of securities and refund of application money without delay. Adequately deal with complaints from the investors.

Donts for Merchant Banker In addition to the above a merchant banker has to adhere to the following donts as part of his code of conduct: (i) Do not practice unfair competition, i.e., do not make any statement or become party to an act which is likely to harm the interest of other merchant bankers. Do not make any exaggerated statement, whether oral or written, to the client

(ii)

regarding his qualifications or capability to render services or achievements regarding services to other clients.

(iii)
(iv) (v)

Do not divulge to other clients, press or any other party any confidential information Do not deal in securities of any client company without disclosing it to SEBI and

about his client, which has come to his knowledge. board of directors of the client company. Do not be a party to creation of false market, or price rigging or manipulations. Do not pass price sensitive information to brokers, members of stock exchanges and

(vi)

other participants in the capital market. (vii) Do not take any action which is unethical or unfair to the investors. Each merchant banker has to abide by the provisions of the SEBI Act and the rules and regulations framed by SEBI relating to its activities, both in the form of dos and donts.

FUNCTIONS OF MERCHANT BANKS

The basic function of a merchant banker or an investment banker is marketing of corporate and other securities. In the process, he performs a number of services concerning Notes on FMS

21 various aspects of marketing, viz., origination, underwriting and distribution, of securities. During the regime of Controller of Capital Issues in India, when new issues were priced at a significant discount to their market prices, the merchant bankers job was limited to ensuring press coverage and dispatching subscription forms to every corner of the country. Now, merchant bankers are being forced to design innovative instruments and perform a number of other services both for the issuing companies as well as investors. The activities or services performed by merchants banks, in India, today include : 1. Project promotion services. 2. Project finance. 3. Management and marketing of new issues. 4. Underwriting of new issues. 5. Syndication of credit. 6. Leasing services. 7. Corporate advisory services. 8. Providing venture capital. 9. Operating mutual funds and off shore funds 10. Investment management or portfolio management services. 11. Bought out deals. 12. Providing assistance for technical and financial collaborations and joint ventures. 13. Management of and dealing in commercial paper. 14. Investment services for non-resident Indians. 15. Servicing of issues etc. The large variety of functions / activities / services performed by most of the merchant bankers can be studied under the following heads.

I.

Corporate Counseling :
This service is, usually, provided free of charge to a corporate unit. Merchant bankers

render advise to corporate enterprises from time to time in order to improve performance and build better image / reputation among investors and to increase the market value of its equity shares. Counseling is provided in the form of opinions, suggestions and detailed analysis of corporate laws as applicable to the business unit. Areas of corporate counseling include :

Notes on FMS

22 (1) (2) After considering the existing Governments economic and licensing policies, it guides the corporate units as to areas of diversification. Merchant banks make a detailed market analysis so as to evaluate profitability of each product line, its growth or demand at present and in future. On the basis of analysis it advises whether to continue / expand or discontinue any product line. (3) It helps in reviving the old-line projects and sick units by assessing their requirements, studying their manufacturing process and technology in terms of its obsolescence. Based on their studies, merchant banker advises on the restructuring or reorganization of capital base.

II. Project Counseling :

Project counseling broadly covers the study of the project and providing advisory services on the project viability and procedural steps to be followed for its implementation. It covers the following aspects. (i) (ii) (iii) (iv) (v) (vi) Development of an idea of a project or review of the project idea / project profile. Preparation of project report after considering its financial, economic and market feasibility. Estimation of the cost of the project. Deciding the means of financing and the composition of various types of securities. Studying the procedural aspects of project implementation. Provide assistance in obtaining government consent for implementation of the project. Sometimes, merchant banks also encourage and guide Indian entrepreneurs to make investment in Indian projects in India and joint ventures overseas by offering all possible help in project appraisal an implementation. Other Services in the field of project counseling may also include : (i) Identification of potential investment opportunities. (ii) Capital structuring (iii) Shaping the pattern of financing. (iv) Negotiating with foreign collaborations and making all necessary arrangements. (v) Amalgamations, mergers and takeovers. (vi) Profitability study of the project and preparation of feasibility reports.

Notes on FMS

23 (vii) Assisting clients in preparing the applications for financial assistance to All India Financial Institutions / Banks. (viii) Assisting the clients in seeking approvals from the Government of India for foreign technical and financial collaboration agreements. (ix) Guiding young entrepreneurs as to investment opportunities in India.

III. Capital Restructuring Services

Merchant banks render different capital restructuring services to the corporate units depending upon the circumstances a particular unit is facing. It may include the following services : (i) Examination of the capital structure of corporate unit to decide the extent of capitalization. (ii) In case of bonus issue, it helps the clients in preparing the Memorandum for Controller of Capital Issue (CCI) and in obtaining his consent. (iii) For companies governed by Foreign Exchange Regulation Act (FERA), merchant bankers suggest an alternative capital structure which is in conformity with the legal requirements. (iv) For sick units, it suggests appropriate capital structure which will help the unit in revival. It also advises as to the extent and means of bringing fresh capital into business. (v) Merchant bankers also render advice on mergers, takeovers and amalgamations and help in their implementation. (vi) Merchant bankers also identify the areas of diversification of the existing production systems and suggest various strategies to widen and restructure the capital base accordingly.

IV. Portfolio Management

Merchant banks offer services not only to the companies issuing the securities but also to the investors. They advise their clients, mostly institutional investors, regarding investment decisions as to the quantum of amount of security and the type of security in which to invest. Merchant banks render necessary services to the investors by advising on the optimum investment mix, taking into account factors like : (i) Objectives of the investment. (ii) Tax bracket applicable to the investor. (iii) Need for maximizing return. Notes on FMS

24 (iv) Capital appreciation etc. Merchant bankers even undertake the function of purchase and sale of securities for their clients so as to provide them portfolio management services. Some merchant bankers are managing mutual funds and off share funds also. Services to Indian Nationals : Merchant banks provide portfolio management services to the Indian nationals in the form of : (a) the sale and purchase of securities ; (b) investing and purchase of securities ; (c) investing and managing fixed deposits ; (d) trust funds, pension funds and provident fund investments and their review ; (e) safe custody of securities in India and overseas ; (f) reinvesting the returns collected from investments in some profitable avenues ; (g) other investment advisory services etc. Services to Non-Resident Indians : In order to attract foreign capital resources for being invested in India, Union Government has offered various incentives to Non-Resident Indians (NRIs) and Persons of Indian Origin Resident Abroad (PIORA). Merchant banks provide special services on this account to encourage the NRIs to invest their savings in Indian industry. The services include : (i) Advice on selection of investment. (ii) Critical evaluation of investment portfolio. (iii) Securing approval from RBI for the purchase / sale of securities. (iv) Hold securities in safe custody. (v) Maintaining investment records and complying with ceiling requirements. (vi) Collecting and remitting interest and dividend on investment. (vii) Providing tax counselling and filing tax returns. (viii) Evaluation of investment portfolio periodically at the request of investors. (ix) Circulation of investment news for the benefit of the investors.

V. Issue Management
In the past, the functions of a merchant banker had been mainly confined to the management of new public issues of corporate securities by the newly formed companies, existing companies (further issues) and foreign companies in dilution of equity as required under FERA. In this capacity, the merchant bank usually acts as a sponsor of issues. They

Notes on FMS

25 obtain consent of the Controller of Capital Issues (CCI), now, SEBI and provide a number of other services to ensure success in the marketing of securities. The services provided by them include: (i) (ii) Preparation of the prospectus. Preparation of a plan and budget to estimate total expenditure of the issue. assistance in obtaining consent of the CCI. (iv) Selection of institutional and broker underwriters and underwriting agreements. (v) Appointment of registrars, brokers and bankers to the issue. (vi) Advertising and arranging publicity agency for post and pre-issue. (vii) Selection of issue house. (viii) Compliance of listing requirements of stock exchanges. (ix) Act as co-coordinator with underwriters brokers and bankers to the issue and stock exchanges. (x) Merchant banker advises the client whether to go for a fresh issue or additional issue or a bonus issue or a right issue of equity or preference or both, if both then, in what proportion it is to be made. If debentures are to be issued, it advises on the type of debentures, whether convertible or non convertible, whether redeemable or non-redeemable or whether linked with equity or preference shares etc. Merchant banks also performs the function of taking a decision as to the size and timing of the public issue in the light of prevailing market conditions, press coverage underwriting support from brokers institutional underwriters etc. Thus, merchant bankers not only act as experts of the type, timing and terms of issues of corporate securities and make them acceptable for the investors on the one hand and also provide flexibility and freedom to the issuing companies.

(iii) Preparation of CCI (Controller of Capital Issues) application and providing

VI. Loan / Credit Syndication

Merchant bankers provide specialized services in preparation of project, loan applications for raising short-term as well as long-term credit from various banks and financial institutions for financing the project or meeting the working capital requirements. They also manage Euro-Issues and help in raising funds abroad. Notes on FMS

26 To be more detailed, credit syndication does involve the following services: (i) Estimation of the total costs / expenditure on the project. (ii) Preparing a financial plan to meet the total cost of the project keeping into consideration the requirements of the promoters and their collaborators, financial institutions, banks government agencies and underwriters. (iii) Assisting the clients in the preparation of loan applications for financial assistance from term lenders / financial Institutions / banks and monitoring their progress. (iv) Making selection of the institutions / banks for participation in financing. (v) Follow-up of the term loan application with the financial institutions and banks and obtaining the satisfaction for their share of participation. (vi) Merchant banks also help in estimating the working capital requirements and assists the client in negotiating for the sanction of appropriate facilities. (vii) Arrange bridge finance which could be either as a part of the main loan sanctioned to the client by the term lenders or it could be amount against the issue of capital or may be both.

VII. Arranging Working Capital Finance :

Earlier, working capital finance was not considered to be a merchant bank activity but used to be a part of the commercial banks function. But some banks like Canara Bank, Grindlays Bank and Central Bank of India have started including working capital finance as one of the merchant banking service area. Finance for working capital is provided usually for new ventures or for existing companies through issue of debentures. Grindlays bank claims to offer expertise for meeting the requirements for long-term working capital for private placement of secured debentures. Grindlays Bank helps the company in obtaining the enhanced cash credit facilities for their customers or suppliers form banks. Canara Bank renders advisory service to the clients in the matter of working capital finance. It includes the following services : (i) Estimation of working capital requirements. (ii) Assistance in preparing the application for credit facilities for submission to the bankers and Reserve Bank of India. (iii) Assistance in negotiations for sanction of appropriate credit facilities. (iv) Helps in expediting documentation and other formalities for disbursements. (v) Advises the client for issue of debentures for meeting the increased long term working capital requirements of the client company.

Notes on FMS

27 Central Bank of India (CBI) helps the client companies in the calculation and provisions of working capital needed for a given project, management of non-convertible debenture issues, and management of fixed deposit.

VIII. Bill Discounting and Acceptance Credit :

In foreign countries, acceptance credit and bill discounting function is another important area which is recognised as a merchant banking activity. But in India this facility is not provided to the corporate units by the merchant bankers. The need for such services was recognised when Banking Commission 1972, in its report had recommended the establishment of acceptance and discount house in India following the development of bill market. A bills of exchange accepted by a house of established reputation automatically becomes acceptable to the seller of goods and to the lenders of money even though they do not have any knowledge of the credit worthiness of the drawer of the bill. Proposed functions of merchant banker would include the following : (i) finding out the reputation and financial standing of the acceptor (ii) the existence of a system for collection of information on borrowers. Commercial banks can undertake acceptance and discount business because they have the necessary expertise and broad network of branches. But at present only bill discounting facility is available to commercial banks under the RBIs formalized scheme for credit accommodations and under refinancing schemes. Indian merchant bankers have still to formulate the practices and procedure so that efficient services could be offered in acceptance and bill discounting.

Lease Finance
Many merchant bankers also provide leasing and finance facilities to their customers. Leasing is an arrangement that provides a firm with the use and control over assets without buying and owning the same. It is a form of renting assets. Lease in a contract between the owner of the asset (lessor) and the user of the asset called the lessee, whereby the lessor gives the right to use the asset to the lessee over an agreed period of time for a consideration called the lease rental. The lease contract is regulated by the terms and conditions of the agreement. The lessee pays the lease rent periodically to the lessor as regular fixed payments over a period of time. The rentals may be payable at the beginning or end of a month, quarter, halfyear or year. The lease rentals can also be agreed both in terms of amount and timing as per the profits and cash flow position of the lessee. At the expiry of the lease period, the assets

Notes on FMS

28 reverts back to the lessor who is the legal owner of the asset. However, in long-term lease contracts, the lessee is generally given an option to buy or renew the lease. Merchant bankers assist their clients by providing finance for the acquisition of asset taken on lease.

IX. Venture Capital

Many merchant bankers maintain venture capital funds to assist the entrepreneurs who lack capital to be risked. Capital funds may be provided for unproven ideas, products technology oriented or start-up funds. Venture capital has emerged as a new merchant banking activity. It is a form of equity financing especially designed for funding high risk and high reward projects.

X. Public Deposits
Merchant bankers also help companies in raising finance by way of public deposits.

XI. Specialised Services

In addition to the basic activities involving marketing of securities, merchant banks also provide corporate advisory services on issues like mergers and amalgamation, takeovers, tax matters, recruitment of executives and cost and management audit etc. Many merchant bankers have also started making of bought out deals of shares and debentures. The activities of the merchant bankers are increasing with the change in the money market. These specialised services which all the merchant banks in India have not been able to render excepting the ICICI, Canara Bank and Grindlays Bank and Punjab National Bank (PNB).

UNDERWRITERS
Underwriting in the context of a company means undertaking a responsibility or giving a guarantee that the securities (shares and debentures) offered to the public will be subscribed for. The firms which undertake the guarantee are called underwriters. Underwriting is similar to insurance in the sense that it provides protection to the issuing Notes on FMS

29 company against the failure of an issue of capital to the public. It ensures success of new issues of capital and if the shares or debentures are not subscribed by the public. Wholly, the underwriters will have to take them up and pay for them. Underwriting is, therefore, an act of undertaking the guarantee by an underwriter of buying the shares or debentures placed before the public in the event of non-subscription. According to SEBI Rules 1993, underwriting means an agreement with or without conditions to subscribe to the securities of a body corporate when the existing shareholders of such body corporate or the public do not subscribe to the securities offered to them. Underwriter means a person who engages in the business of underwriting of an securities of a body corporate. The underwriters, for providing this service to the issuing companies charge a commission generally calculated at an agreed specified rate on the issue price of whole of the shares or debentures under written. Such a commission is called underwriting commission which is payable on the whole of shares or debentures underwritten even if the public takes up all the shares or debentures offered. The issuing company has, thus, to enter into an agreement with one or more underwriter/s who may be either an individual, a firm, bank or some financial institution. In an English case, the learned Judge defined underwriting as an agreement entered into before the shares are brought before the public that in the event of the public not taking up the whole of them or the number mentioned in the agreement, the underwriter will, for an agreed commission take an allotment of such part of the shares as the public has not applied for In India, the Companies Act, 1956 limits the underwriting commission on issue of shares at 5% of the issue price of shares and in case of debentures at 2% of the issue price of debentures.

Forms of Underwriting
The nature and form of underwriting transactions depends mainly upon the nature of the project, the state of the capital market, the general response of the investors to the new issues, the reputation of the promoters and capacity of the underwriters. It may be undertaken on a commission basis. An issuing company may get underwriting from a single underwriter but where the size of the issue is so large that it is unmanageable by a single underwriter and the risk involved is also high, the company may approach a number of underwriters. Thus, an underwriting agreement may take any of he following forms :

Notes on FMS

30 1. Full Underwriting : It is an agreement under which the underwriter undertakes the guarantee of buying the whole of shares or debentures placed before the public in the event of non-subscription. The liability of the underwriter is to buy and pay for the entire unsubscribed portion of the issue. 2. Partial Underwriting : Under this type of agreement, the underwriter undertakes the guarantee for only part of the issue offered to the public and his liability is limited to the extent of unsubscribed portion of the issue underwritten by him. 3. Joint Underwriting : In case of a large issue which is unmanageable by a single underwriter and where the risk involved is too high, the issuing company may enter into underwriting agreement with more than one underwriter. Each underwriter undertakes the guarantee for the issue of a certain portion of the whole issue offered to the public. Thus, underwriters share the risk involved in the ratio of the number of shares or debentures underwritten by them. Sometimes the promoters of issuing company prefer joint underwriting from underwriters operating in different regions of the country so as to diffuse the issue over a number of investors scattered all over the country and retain control over management of the company. 4. Syndicate Underwriting : Under this type of underwriting, a number of underwriting firms enter into an agreement among themselves to undertake the guarantee of buying shares or debentures of a large issue offered to the public involving huge funds and risk. Syndicate underwriting is essentially different from joint underwriting so far as the agreement among the underwriters is concerned. Thus, in syndicate underwriting two types of separate agreements take place, one between the issuing company and the syndicate of underwriters, and the other among the underwriters who are members of the syndicate. 5. Firm Underwriting : When an underwriter undertakes to buy or subscribe a certain number of shares or debentures irrespective of the subscription from the public, it is called firm underwriting. The liability of underwriters in case of firm underwriting is both for shares underwritten as well as such part of the share as the public has not for. Firm underwriting generates confidence among investors and increases the chances of success of the issue. 6. Sub- Underwriting : Sometimes, the underwriter enters into agreement with some other underwriters to undertake guarantee for the issue of whole or part of the issue underwritten by him. Such an agreement between the underwriter and the other underwriters (called sub-underwriters) is known as sub-underwriting. The sub-underwriters have no

Notes on FMS

31 agreement with the issuing company and work under the main underwriter who pays them some commission out of his underwriting commission. 7. Outright Purchases of Issues : In all the six forms of underwriting agreements discussed above, the underwriters provide the services on commission basis. However, in some case the underwriters, instead of undertaking guarantee to buy shares or debentures not subscribed by the public, may enter into an agreement to out rightly purchase the issue (shares or debentures) at an agreed price and arrange to sell the same latter through their own arrangements.

Role of Underwriters in Corporate Financing :

Whenever new issues of capital are made, there is always certain risk of nonsubscription or under-subscription of securities by the public. The plans of the promoters of the companies remain unimplemented and their reputation adversely affected if the issues are not successful. Underwriting is a safer way of marketing securities for new issues of capital. It is an insurance in the sense that it provides protection against such risks. Thus, it is a very useful method of raising finance through issue of securities (shares and debentures). It is not only the issues of equity share capital that need be underwritten. The analysis of underwriting of issues indicates that almost 100 percent of the issues of preference share capital and debentures are underwritten in India. Although, the need for underwriting of initial issues of capital are also underwritten. The extent of underwriting required depends upon the nature of the project, the state of the capital market, the general response of the investors and the reputation of the promoters. Thus, underwriting plays a very significant role in corporate financing. The importance of underwriting can further be highlighted from the following functions performed by the underwriters : 1. Assurance of Adequate Finance : Underwriting is an act of undertaking guarantee by an underwriter to buy and pay for the shares or debentures placed before the public in the event of their non-subscription. Thus, through underwriting, an issuing company is assured of procuring the required funds from the issue of shares or debentures. In the event of non-subscription by the public, underwriters purchase the unsubscribed part of the issue and provide finance to the company. 2. Supplying Valuable Information to Companies : In addition to the protection of risk of the issuing companies with regard to the success of the issue, the underwriters supply valuable information in regard to capital market conditions, general response of the investors,

Notes on FMS

32 etc. to the issuing companies. These companies are, usually, benefited from the expert-advice of the underwriters. 3. Distribution of Securities : After purchasing securities, underwriters distribute the same to the real investors. The underwriters, through agents and others diffuse the issue over a large number of investors scattered in different part of the country. Thus, underwriting helps promoters to retain control over the management of the company. 4. Increase in Goodwill of the Issuing Company : The underwriting of capital issues by prestigious institutions generates confidence among investors and improve their response to the issues. Investors in advanced countries are influenced more by the prestige of the underwriting agencies than by the prestige of the issuing company. Underwriting, thus, ultimately increases the goodwill of the issuing company. 5. Service to Prospective Investors : Underwriters provide essential information about the issuing companies to the prospective investors and also advise them about various issues. They encourage people to save more and direct their savings in corporate securities. Thus, investors are also benefited through underwriting. 6. Service to the Society : The pace of industrialisation of a country depends to a great extent upon the successful flotation of capital issues. By mobilising resources and providing adequate finance, underwriters play a very important role in setting up of new projects, increasing employment, production and per capita income. Thus, it is not only the corporate enterprises but also the society at large which is benefited by underwriting.

SEBIs Guidelines on Underwriting Registration with SEBI

Only such person who has underwriter. Conditions for granting Registrations i) ii) iii) iv) v) I should have necessary infrastructure Has past experience in underwriting Meet capital adequacy requirement of net worth of not less than Rs. 20 lakhs Has not been convicted of an offence involving moral turpitude or found guilty of any economic offence. Undertake to abide by prescribed code of conduct. FEES FOR REGISTRATION: At the time of initial registration underwriter has to be fees of Rs. 2 lakh for first and second year and Rs. 1 lakh for the third year. And renewal fee of Notes on FMS obtained certificate of registration from SEBI, can act a

33 Rs. 20,000 should be paid every year from 4th year onwards. Since 1999 Registration fee has raised to Rs. 5 lakh an renewal fee of Rs. 2 lakh for every 3 year from 4 th year from the date of registration. OTHER GUIDELINES (a) As per the orginal Guidelines issued by SEBI on 11.6.1992, underwriting was mandatory for full issue and minimum requirement of 90% subscription was also mandatory for each issue of capital to public. However, as per the revised Guidelines issued by SEBI on 10.10.94, underwriting is not mandatory now and the issuers have the option of deciding whether the issue is to be underwritten or not. Number of underwriters would also be decided by the issuers. (b) If the issue is not underwritten and if the minimum subscription of 90% of the offer to the public is not received, the entire amount received as subscription would have to be returned in full. (c) If the issue is underwritten and if the company does not receive 90% of the issued amount from public subscription plus accepted development from underwriters, within 60 days of the opening of the issue, the company should refund the amount of subscription. In case of disputed development, the company should refund the subscription if the above conditions are not met. (d) The lead manger(s) must satisfy themselves about the net worth of the underwriters and the outstanding commitment and disclose the same to SEBI. A statement to this effect should be incorporated in the prospectus. (e) The underwriting agreement may be filed to SEBI.

REGISTRAR TO AN ISSUE AND SHARE TRANSFER AGENT

Registrars to an issue are also an intermediary in the primary market and perform the following functions 1) Collect applications from investors and keep a proper record of applications and money received from investors Notes on FMS

34 2) Assist issuing companies in determining the basis of allotment of securities as per stock exchange guidelines and in consultation with stock exchanges 3) Assist in finalizing allotment of securities and processing and dispatching allotment letters 4) Assist in processing and dispatching refund orders, share and debenture certificates and other documents related to the capital issue. 5) They can also function as Depository Participants (DPI) Appointment of a registrar to an issue for rights issue has been made mandatory. The SEBI also amended the SEBI Rules and Regulations, 1993 Share Transfer Agents Share transfer agents perform the following functions: i) ii) iii) Maintain records of holders of securities of the company for and on behalf of the company and Handle all matters related to transfer and redemption of securities of the company They can also function as Depository Participants Regulations concerning registrars to an issue and share transfer agents as stipulated by SEBI are briefly mentioned below. to provide for an arms length relationship between the issuer and the registrar to an issue.

Registration :
The regulations make it compulsory that registration with SEBI be sought by all persons acting as either registrars or transfer agents. All registrars to an issue and share transfer agents are required to enter into an agreement with the issuers and body corporate, clearly specifying the duties and responsibilities. A model agreement has also been provided by SEBI. Availability of infrastructure and trained manpower are ascertained before granting registration. The regulation recognises two categories of registrars and share transfer agents as mentioned below : Category I : To carry on activity as registrar to an issue and transfer agent. Category II : To carry on activity either as registrar or as a share transfer agent.

Capital Adequacy Norms

The capital adequacy norms prescribed by the regulations are : Category I : Rs. 600,000 Notes on FMS

35 Category II : Rs. 300,000 However, since November 1999, above said norms are not applicable for a department / division of a body corporate maintaining the records of holders of securities issued by them and dealing with all matters connected with transfer / redemption of securities.

Annual Fee
Category Category I Category II Initial Registration Fee Rs. 50,000 Rs. 30,000 Renewal Fee (for every there years) Rs. 40,000 Rs. 25,000

General Responsibilities
In addition to the performance of their functions already discussed registrars and share transfer agents are responsible for maintaining certain records and follow prescribed code of conduct.

Maintenance of Records & Books

The regulation stipulates the details of records, documents and books of accounts to be maintained by registrars and share transfer agents, for a minimum period or 3 years, and provide for periodical reporting to and inspection by SEBI. The registrars and share transfer agents have to maintain the following records i) ii) iii) iv) v) vi) Records relating to all applications received from investors relating to the issue Records of all rejected a applications together with the reasons for rejections Basis of allotment of securities in consultation with the stock exchanges Terms and conditions of purchase of securities Records relating to allotment of securities list of allot tees and non-allot tees, refund orders etc Names of transferors and transferees and the dates of transfer of securities

Code of Conduct for Registrar to an Issue and Share Transfer Agents. 1. Maintain high standards of integrity in the conduct of its business 2. Exercise adequate care, caution and due diligence before dematerialisation of securities by confirming and verifying that he securities to be dematerialised have been granted listing permission by the stock exchange(s).

Notes on FMS

36 3. Always endeavour to ensure that (a) inquiries from investors are adequately dealt with; (b) grievances of investors are redressed without any delay; (c) transfer of securities held in physical form and confirmation of dematerialisation / rematerialisation requests and distribution of corporate benefits and allotment of securities is done within the time specified under any law. 4. Make reasonable efforts to avoid misinterpretation and ensure that the information provided to the investors is not misleading. 5. Make appropriate disclosure to the client of its source or potential areas of conflict of duties and interest which would impair its ability to render fair, objective and umbiased services. 6. Not indulge in any unfair competition, which is likely to harm the interests of other registrar to the issue and share transfer agent or investors or is likely to place him in disadvantageous position while competing for or executing any assignment. 7. Not divulge to other clients, press or any other person any confidential information about its clients which as come to its knowledge except with the approval / authorisation of the client or when it is required to disclose the information under any law for the time being in force. 8. Maintain the required level of knowledge and competency and abide by the provisions of the SEBI Act, rules, regulations, circulars and directions issued by the SEBI and also comply with the award of the Ombudsman under the SEBI (Ombudsman) Regulations, 2003. 9. Take adequate and necessary steps to ensure that continuity in data and record-keeping is maintained and that the data or records are not lost or destroyed. Further, it should ensure that for electronic records and data, up-to-date back up is always available with it. 10. Endeavour to resolve all the complaints against it or in respect of the activities carried out by it as quickly as possible.

Credit Rating
Meaning of Credit Rating
To understand the meaning of credit rating, let us look at some definitions offered by well-known rating agencies.

Notes on FMS

37 Moodys: Rating are designed exclusively for the purpose of grading bonds according to their investment qualities. Australian Ratings: A corporate Credit rating provides lenders with a simple system of gradation by which the relative capacities of companies to make timely repayment of interest and principal on a particular type of debt can be noted. According to CRISIL, Credit rating is an unbiased and independent opinion as to issuers capacity to meet its financial obligations. It does not constitute a recommendation to buy/sell or hold a particular security. According to ICRA, Ratings are opinions on the relative capability of timely servicing of corporate debt and obligations. These are not recommendations to buy or sell. neither the accuracy nor the completeness of information is guaranteed From the above definitions it is understood that : (i) Credit rating is an assessment of the capacity of an issuer of debt security, by an independent agency, to pay interest and repay the principal as per the terms of issue of debt. A rating agency collects the qualitative as well as quantitative data from a company which has to be rated and assesses the relative strength and capacity of company to honour its obligations contained in the debt instrument through out the duration of the instrument. The rating given is based on an objective judgement through out the duration of the instrument. The rating given is based on an objective judgement of a team of experts from the rating agency. (ii) The ratings are expressed in code number which can be easily comprehended even by the lay investors. The ratings are the quickest way of understanding a companys financial standing without going into the complicated financial reports. Credit rating is only a guidance to the investors and not a recommendation to a particular debt instrument. The important element for investment decision making in debt security are (i) yield to maturity (ii) risk tolerance to investor and (iii) credit risk of the security. Clearly the focus of credit rating is on any one of these three elements viz., credit risk of the security and hence it can not by itself be a basis for investment decision making. It is only a current opinion on the relative capacity of firms to repay debt in time. (iii) Credit rating, as it exists in India, is done for a specific debt security and not for a company as a whole. No rating agency tells that it is an indicator of the financial status of the company. All that a rating agency claims is that the rating symbols indicate the capacity of the company to honour the terms of contract of a debt instrument.

Notes on FMS

38 (iv) A debt rating is not a one time evaluation of credit risk, which can be regarded as valid for the entire life of the security. It is an on going appraisal. Changes in dynamic world of business may imply a change in the risk characteristics of the security. Hence debt rating agencies monitor the business and financial conditions of the issuer to determine whether modification in rating is warranted. (v) A credit rating does not create a fiduciary relationship between the rating agency and the users of rating since there is no legal basis for such relationships.

FUNCTIONS OF CREDIT RATINGS

The credit rating firms are supposed to do the following functions: 1. Superior Information Rating by an independent and professional firm offers a superior and more reliable source of information on credit risk for three inter related risks. (a) it provides unbiased opinion. (b) due to professional resources, a rating firm has greater ability to assess risks. (c) it has access to lot of information which may not be publicly available. 2. Low Cost Information A rating firm which gathers, analyses, interprets and summarises complex information in a simple and readily understood format for wide public consumption represents a cost effective arrangement. 3. Basis for a Proper Risk-Return Trade Off If debt securities are rated professionally and if such ratings enjoy widespread investor acceptance and confidence, a more rational risk return trade off would be established in the capital market. 4. Healthy Discipline on Corporate Borrowers Public exposure has healthy influence over the management of issuer because of its desire to have a clear image. 5. Formation of public Policy Guidelines on Institutional Investment The public policy on the kinds of securities that are eligible for inclusion in different kinds of institutional portfolios can be developed with great confidence if securities are rated professionally by independent agencies.

ORIGIN

Notes on FMS

39 The credit rating concept originated in the USA. In 1860, Henry Vannum poor started publishing financial statistics of railroad companies. In 1909, Moodys Investors Agencies started rating Railroad giving more thrust to the concept. Since then the importance has grown extensively in the global market. System of ratings got institutionalised following the Great Depression. In 1933, the US controller of currency enacted a rule that banks could purchase securities rated only BBB/Baa or above. In 1970, Penn Central, the then largest Railroad company in the world went bankrupt with just under $ 100 million in outstanding commercial paper. This forced the investors to ask for rating for commercial paper. Consequently, today, almost 100% of the commercial paper volume and 99% of the corporate bond volume 99 % of the corporate bond volume are rated in the U.S.A.

CREDIT RATING IN INDIA

The environment that prevailed in America when first ratings were assigned, prevails in many developing countries today. The Indian capital market has witnessed a tremendous growth in the past few years. Companies are relying on capital markets for financing existing operations as well as for new projects rather than on institutions. In this process, the average size of debenture issued by companies, the number of companies issuing debentures and the number of investors have grown substantially. As the number of companies borrowings directly from capital market increases, investors find that the companys size or name is no longer a sufficient assurance of the timely payment of interest and principal. Default by large and well known companies recently in payment of interest on fixed deposits or debentures has reinforced this belief among investors. They felt the need for an independent and credible agency which judges the quality of debt obligations of different companies' and assists individual and institutional investors in making investment decisions. In this context the Credit Rating Information Services of India Limited was set up in 1987. Following this, Investment Information and Credit Rating Agency of India was promoted in 1991 and Credit Analysis and Research Limited was floated in 1993. All the three credit rating agencies have been approved by the Reserve Bank of India.

BENEFITS OF CREDIT RATING

(i) Low Cost Information

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40 Credit rating is a source of low cost information to investors. The collection, processing and analysis of relevant information is done by a specialised agency which a group of investors can trust. (ii) Quick Investment Decision In the present day complex world ratings enable investors to take quickest possible decisions based on associated ratings. (iii) Independent Investment Decision For rated instruments, investors need not depend upon the advice of the financial intermediaries. As the rating symbol suggests the credit worthiness of the instrument and indicates the degree of risk involved in it, the investors can make direct investment decisions. (iv) Investors Protection Hiring of credit agency implies that the management of the company is ready to show its operations for independent scruting. So, the investors who are not provided with confidential information can have overall assessment based on ratings. The creditible and objective rating agency can provide increased disclosure, better accounting standard and improved investor protection. BENEFITS TO RATED COMPANIES (i) Sources of Additional Certification Credit rating agency provides additional information to the issuers of debt/financial instruments. A highly rated firm can enter the market with great confidence. Indian experience shows that use of rating, benefit a great deal by getting larger amount of money from a wider audience at a lower cost. (ii) Increase the Investors Population A sound credit rating system gives an alternative method to name recognition as a determining factor in making investment and helps increase the population of those investing in debt obligations of the company.

(iii) Forewarns Risks

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41 Credit rating acts as a guide to companies which get a lower rating. It forewarns the management of the perception of risk in the market and prompts to take steps on their operating and marketing risks and thereby changes the perception in the market. (iv) Encourages Financial Discipline Ratings also encourage discipline among corporate borrowers to improve their financial structure and performance to obtain better rating for their debt obligations. (v) Merchant Bankers Job Made Easy Merchant bankers and brokers will be received of the responsibility of guiding investors as to the risk of a particular investment. Merchant bankers and brokers, in the absence of objective information, go on the basis of name recognition in guiding their clients. With the advent of credit rating, what they would be required to do is to bring to the attention of their clients the ratings of debt obligations. (vi) Foreign Collaborations Made Easy The foreign collaborators always ask for credit rating while negotiating with an Indian company. Credit rating enables to identify instantly the relative credit standing of the company. The importance of credit rating is being increasingly recognised in the Euro-markets. (vii) Benefits the Industry as a Whole Relatively small and unknown companies use ratings to instill confidence in investors. Higher rate companies get larger amount of money at a lower cost. Thus the industry as a whole can benefit from ratings by direct mobilisation of savings from individuals rather than from intermediary lending institutions. (viii) Low cost of Borrowing A company with highly rated instrument has the opportunity to reduce the cost of borrowing by quoting lesser interest rate on fixed deposits or debentures as the investors with low risk preference would invest in safe securities though yielding low rate of return. (ix) Rating as a Marketing /Tool Companies with rated instruments, use rating as a marketing tool to create better image in dealing with their customers, lenders and creditors.

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42

Credit Rating Agencies in India :

Currently there are five credit rating agencies in India: 1. Credit Rating Information Service Ltd. (CRISIL). 2. Investment Information and Credit Rating Agency of India (ICRA). 3. Credit Analysis and Research (CARE). 4 4. Duff Phelps Credit Rating Pvt. Ltd. (DCR India). 5. Onida Individual Credit Rating Agency Ltd. (ONICRA). (1) Credit Rating Information Services Limited Credit Rating Information Services Limited (CRISIL) the first credit agency was floated on January 1, 1988. It was started jointly by ICICI and UTI with an equity capital of Rs. 4 crores. Each of them holds 18% of the capital. The other promoters are Asian Development Bank (15%), the LIC and General Insurance Corporation and its subsidiaries and the SBI (5% each), the Housing Finance Development Corporation (6.2%), nine public sector and private sector banks (19.25%) and 10 foreign banks (7.55%). The principal objective of CRISIL is to rate the debt obligations of Indian Companies. Its rating guides investors about the risk of timely payment of interest and principal on a particular debt instrument.
Objectives of CRISIL

To assist both individual and institutional investors in making investment decisions in fixed income securities. To enable corporate to raise large amounts at fair cost from a wide spectrum of investors. To enable intermediaries in placing their debt instruments with investors by providing them with an effective marketing tool.

CRISIL has five offices one each in Mumbai Delhi, Kolkata, Chennai and Bangalore.

Rating Methodology
CRISIL commences a rating exercise at the request of a company. In accordance with industry practice all over the world, the methodology involves an analysis of the past performance of the company and assessment of its prospects. The first analysis relates to the past performance of the company. However, the past is viewed not as a guide, but to understand why the company performed in the way, it did, what problems it faced and what the managements response to these problems was.

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43 To assess the future prospects, CRISIL studies the industry or industries in which the company operates and the companys position within the industry. It also makes an evaluation of the management and cash flow projections of the company and identifies the key issues concerning the company. The industry is studied by analysing demand and supply growth, nature and basis of competition, Government policy for the company and the effect of change in Government policy on the future of the company. The position of the company within the industry is studied to understand how the company would fare in the future. CRISIL, therefore, looks at the operating efficiency in terms of locational advantage, raw material, power and labour situation; its cost structure as compared to that of its nearest competitors and the companys market position in terms of its market share, product strength, selling and distribution arrangements, competitive advantage, customer delivery etc. CRISIL, evaluates the management of the company with reference to its tract record, the recruitment and training system, planning and control system, depth of managerial talents and succession plans, goals for the company, the philosophy of doing business, attitudes towards taking business, risks and the strategies for the company. The tenacity, determination and drive of the management to overcome problems as they arise in the company is yet another factor assessed by the CRISIL. Then, CRISIL makes its own assessment of cash flows and decides the degree of comfort available from the cash flows to meet cash needs of the company for capital expenditure, working capital growth and debt servicing obligations. In addition, it assesses the companys ability to raise funds quickly in various ways in times of necessity to meet the requirements of servicing debt. The rating process seeks to identify the key issues concerning the company. For instance, if a company is putting up a new project, the key issue in the rating is the likelyhood of timely completion of the project. The rating is a composite assessment of all these factors with the key issue getting greater attention from the Rating agency. In evaluating the ratings, crisil employs both qualitative and quantitative criteria. The judgement made by the crisil is necessarily subjective and the quantitative analysis is meant to assist in making best possible overall qualitative judgement. CRISIL employs a multi-layered decision-making process in assigning ratings. When it receives a request for rating, it assigns two teams on the job. The first team meets officials and makes an assessment of the industry, company and management. The second team is also required make its own study of the industry. Then the first team interacts with the back up Notes on FMS

44 team. The findings of the interactions are presented simultaneously in a detailed note to the Branch Internal Committee comprising atleast three senior analysts of CRISIL and an Internal Committee of six senior executives and thereafter the note is presented with the recommended ratings to the Rating Committee comprising six directors of the company who are not connected with any shareholders of CRISIL. The Rating Committee comprising six directors of the company who are not connected with any shareholders of CRISIL. The Rating Committee members are chosen carefully so that they do not have any links with industries or investment or investment agencies connected with the units being rated. This multi-layered process ensures that no individual decides on rating and that prejudices and biases are eliminated. The evaluation of the company is made on a confidential basis. The rating process ensures complete confidentiality of information that may be provided by the company. Credit rating Symbols CRISIL uses the conventional rating symbols used in the USA and widely accepted in many other countries. The following table shows the investment-wise rating symbols assigned by CRISIL and the meaning of each rating from the angle of safety to the investors. CRISIL Debentures Rating Symbols High Investment Grades AAA (Triple A) AA (Double A ) Investment Grades A BBB (Triple B) Speculative Grades BB (Double B) B C D : : : : : : : : Highest Safety High Safety Adequate Safety Moderate Safety Inadequate Safety High Risk Substantial Risk Default

Notes: 1. CRISL may apply + (plus) or - (minus) sign for ratings from AA to C to reflect comparative standing within the category. 2. The contents within parenthesis are a guide to the pronunciation of the rating symbols.

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45 3. Preference shares rating symbols are identical to debenture rating symbols except the letters pf are prefixed to the rating symbols. e.g. pf AAA (pf Triple A). CRISIL Fixed Deposit Rating Symbols Investment Grades FAAA (F-Triple A) FAA (F-Double A) FA Speculative Grades FB FC FD

: : : : :

Highest Safety High Safety Adequate Safety In adequate Safety High Risk Default

Note: (1) CRISIL may apply + (plus) or - (minus) sign for ratings from FAAA to FC to indicate the relative position within the rating category. (2) The contents within parenthesis are a guide to the pronunciation of the rating symbols. CRISIL monitors the ratings it assigns constantly. The ratings may be upgraded, downgraded or withdrawn depending up on new information or developments concerning the company whose debt obligation is rated. It has the right widely disseminate the ratings through the media, through its own publications or through any other methods.

CREDIT RATING FOR SHORT TERM INSTRUMENTS Rating Symbol Indication (Each rating indicates that the degree of safety regarding timely payment on the instrument is shown against the symbol) P-1 P-2 P-3 P-4 Very Strong Strong Adequate Minimal

P-5 Expected to be in default on maturity or in default Note: CRISIL may apply + signs for ratings from PO-1 to P-3 to reflect a comparatively higher standing within the category. Operations of CRISIL During 1994-95, CRISIL rated 379 instruments covering a debt volume of Rs. 34,544 crores. The cumulative number of instruments rated by CRISIL since its inception in January

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46 1988, till the end of March 1995 has been 1305 and the value of instruments covered has been Rs. 78,151 crores. In 1994-95, CRISIL forged alliance with standard & Poors Rating Group, New York. In 1996-97, CRISIL introduced ratings on mutual funds, bank loan ratings, and public finance ratings. Standard & Poors acquired 9.68% of the share holdings in the company in the same year. CRISIL secured the certificate Registration under SEBI (Credit Rating Agencies) Regulations in 1999. The mutual fund ranking service or the domestic mutual fund market was introduced in the year 2000-2001. Evaluation services for firm and TV software producers and rating of personal loan securitizations transations were introduced in 2002-03. The name of the company was changed from the Credit Rating Information Services of India Lt d to CRISIL Ltd in 2003-04. During 2006, CRISIL launched 180 gradings to ananlyse the fundamental strength of IPO issues. During this year CRISIL small and medium Enterprise ratings received 570 requests and assigned 490 ratings and it assigned over 1000 SME ratings in the year 2007. At present Standard and Poors acquired a majority shareholdings in CRISIL. CRISIL has so far rated a cumulative debt volume exceeding $ 30 billions covering 1500 debt instruments covering 1000 companies. (2) Investments Information and Credit Rating Agency of India (IICRA) The IICRA was set up by Industrial Finance Corporation of India on 16 th January, 1991. It is a public limited company with an authorised share capital of Rs. 101 crores. The initial paid up capital of Rs. 3.50 crores is subscribed by IFC, UTI, LIC, GIC, SBI and 17 other banks. IICRA started its operations from 15th March 1991. During 1994-95, IICRA rated 212 debt instruments covering a debt volume of Rs. 5343 crores. The cumulative number of instruments rated since its inception till March 1995 has been 485 covering a total debt volume of Rs. 17,638 crores.

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IICRA RATING SCALE LONG TERM INCLUDING DEBENTURES LAAA LAA LA LBBB LBB LB LC LD : : : : : : : : Highest Safety High Safety Adequate Safety Moderate Safety In adequate Safety Risk Prone Substantial Risk Default, Extremely Speculative MEDIUM TERM INCLUDING

MAAA MAA MA MB MC MD

: : : : : :

Highest Safety High Safety Adequate Safety Inadequate Safety Risk Prone Default

BONDS AND PREFERENCE SHARES

DEPOSITS FIXED

Short term Including Commercial Paper A-1 A-2 A-3 A-4 A-5 Highest Safety High Safety Adequate Safety Risk Prone Default

Notes: (i) The rating symbols group together similar ( but not necessarily identical) concerns in terms of their relative capability of timely servicing of debts/obligations, as per terms of contracts , i.e., the relative degree of safety risk. (ii) The sign (+) or (-) may be used after the rating symbol to indicate the comparative position of the company within the group covered by the symbol. (iii) The letter P in parenthesis after the rating symbol indicates that the debt instrument is being used to raise resources by a new company for financing a new project and the rating assumes successful completion of the project. (i) The rating symbols for different instruments of the same company need not necessarily be the same.

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48

IICRA FIXED DEPOSIT RATING SYMBOLS MAAA MAA+ MAA MAAMA+ MA MAMB+ MB MBMC+ MC MCMD Highest Safety High Safety Adequate Safety Inadequate Safety High Risk Default

IICRA FIXED DEPOSIT RATING SYMBOLS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Very Strong Capacity Strong Capacity Adequate Capacity Inadequate Capacity Poor Capacity Default

(3) Credit Analysis and Research Limited (CARE) The CARE was promoted in 1993 jointly with investment companies, banks and finance companies. Services offered by CARE are (i) credit rating (ii) information service (iii) Equity research (iv) Rating of paralled market of LPG and kerosene. Since its inception till the end of December 2007, CARE has rated 3850 debt instruments covering a total debt volume of Rs. 80,716 crores. CARE Rating Services CARE provides rating services to the following debt instruments. Debentures Certificate of Deposits Commercial paper Fixed Deposits

CARE also undertakes Credit Analysis Rating of Companies for the use of bankers, other lenders and business enterprises.

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49

Sl.No. 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Investment Grade For Long term debt instruments Highest Safety High Safety Adequate Safety Inadequate Safety High Risk

CARE CARE AAA CARE AA CARE A CARE BB CARE B

FOR MEDIUM TERM DEBT INSTRUMENTS

Highest Safety High Safety Adequate Safety Inadequate Safety High Risk For Short term debt instruments Highest Safety High Safety Adequate Safety Inadequate Safety High Risk CARE AAA CARE AA CARE A CARE BB CARE C PR1 PR2 PR3 PR4

The rating division of CARE has over a decade long experience in rating debt instruments / Enterprise ratings coverings the full spectrum of Universe comprising: Industrial Companies Service Companies Infrastructure Companies Banks Financial Institutions (FIs) Non-Bank Finance Companies (NBFCs) Public Sector Undertakings (PSUs) State Government Undertakings Municipal Corporations Notes on FMS

50 Structured Finance Transactions Securitization Transactions SMEs SSI Micro Finance Institutions

In addition debt ratings CARE Ratings has experience in providing the following specilized grading / rating services: Corporate Governance Ratings IPO Grading Mutual Fund Credit Quality Ratings Insurance Claims Paying Ability Rating Issuer Ratings Grading of Construction Entities Grading of Maritime Training Institutes LPF /SKO Ratings

CARE Ratings is well equipped to rate all types of debt instruments like Commercial Paper, Fixed Deposit, Bonds, Debentures, Hybrid Instruments, Structured Obligations, Preference Shares, Loans Asset Backed Securities (ABS), Residential Mortgage Backed Securities (RMBS) etc. CARE Ratings has significant presence in all sectors including Banks/ FIs, Corporate, Public finance. Coverage of CARE Ratings has extended to more than 1075 entitles over the past decade and is widely accepted by investors, issuers and other market participants. CARE Ratings have evolved into a valuable tool for credit risk assessment for institutional and other investors, and over the years CARE has increasingly become a preferred rating agency. (4) Duff and Phelps Credit Rating India Private Ltd. (DCR) The Duffs and Phelps is a leading international credit rating agency. The J.M. Financial and Allance Group in joint venture with Duffs and Phelps has now set up DCR in India. Its main objective is to give credit rating to debt instruments. On special request it may undertake rating of companies and countries as well. The popular symbol employed by DCR is D1, D2, D3 etc. depending upon the credit status. For example the RBI has

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51 stipulated a minimum credit rating of D-2 DCR India for the purpose of issuing commercial papers by instructions. (5) Onida Individual Credit Ratings Agency Ltd (ONICRA) Almost all credit rating agencies established in India undertake credit analysis work of corporate bodies only. Unlike these agencies, the ONICRA Ltd, has taken up the individual borrowers. It has been sponsored by the Onida Finance Ltd. In all credit transactions relating to credit cards, Housing Finance, Rental / H.P. agreements, personal loan etc. it becomes imperative that one should know the quantum of default risk associated with such transactions before entering into those transactions. It is where the ONICRA comes into picture. It does into those transactions. It is where the ONICRA comes into picture. It does not rate the individual as such but the risk associated with entering in to those credit transactions with that individual at a certain period. Thus, it helps the users of this rating to know risks associated with credit transactions while dealing with individuals. It is gaining popularity among financial institutions. SEBI GUIDELINES 1999 1. No credit rating agencies shall rate a security issued by its promoters. 2. It has barred rating agencies from rating securities issued by any borrower, subsidiary or associate of the promoter if it has a chairman, director, employee of any such firm. 3. Dual rating is compulsory for public and rights issue of debt instruments of Rs. 100 crore or more. 4. SEBI has decided to incorporate a clause in the listing agreement of stock exchanges requiring companies to cooperate with agencies by providing correct information. Refusal to do so may lead to breach of contract between rating agencies and client. 5. The issues would be required to incorporate an undertaking in their offer documents promising necessary cooperation with the rating agency in providing factual information. 6. It is also suggested that a penal clause be introduced in the listing agreement of the information provided is proved to be incorrect at a later stage, to protect investors interest. 7. The net worth of rating agencies has been fixed at Rs. 5 crore. 8. Rating agencies can choose their methodology of operation but self regulatory mechanism will give a better maturity status for agencies.

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52 9. No chairman, director or employee of the promoters shall be a chairman, director or employee of the CRA or its rating committee. Promoter of CRA is a person who holds more than 107 of holdings of the CRA. 10. Period of validity of registration shall be 3 years PRACTICAL PROBLEMS 1. The absence of widespread branch net work of the rating agency may limit its skills in rating. 2. Inexperienced, unskilled or overloaded staff may not do justice to their job and the resulting ratings may not perfect. 3. Since rating exercise involves a number of factors, a rigid mathematical formula can not be applied to finalise rating and some element of subjectivity creeps in, thereby giving scope for bias. 4. The time factor greatly affects rating and gives misleading conclusions. A company which experiences adverse conditions temporarily will be given a low rating judged on the basis of temporary phenomenon. 5. Since the rating agencies receive a sizable fee from the companies for awarding ratings, a tendency to inflate the ratings may develop. 6. The rating is not permanent but subject to changes and moreover the agencies can not give any guarantee for the investors. 7. Investments which have the same rating may not have identical investment quality because the number of rating categories is limited and hence can not reflect small but meaningful differences in the degree of risk. 8. Borrowing entities give misleading advertisements about the rating symbols of their instruments. For example, X Co. Ltd, which has got AAX for its debentures may mobilise fixed deposits instead of revealing the low rating for fixed deposits. Such kind of window dressing should be curtailed.

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