COMPANY LAW - I

CORPORATIZATION & DEMUTUALIZATION OF STOCK EXCHANGES IN

INDIA

Date: 16th October 2008

Submitted by: Mayank Jain, Roll # 410, V Sem., B.B.A L.L.B (Hons.)

Submitted to: Mr. Ashish Kumar Srivastav, Principle Faculty, Faculty of Law

NATIONAL LAW UNIVERSITY

RESEARCH METHODOLOGY

Area: Corporatization of Stock Exchanges

Topic: Corporatization & Demutualization of Stock Exchanges in India.

Objectives:
1. To examine the present structure of stock exchanges including those set up as
companies and as unincorporated bodies and in this light examine the legal,
financial and fiscal issues involved to corporatise and demutualise the stock
exchanges, and
2. To look in to the specific steps those need to be taken for implementation.
3. To review and examine the present structure of stock exchanges including those
set up as companies and as unincorporated bodies and in this light examine the
legal, financial and fiscal issues involved to corporatise and demutualise the
stock exchanges, and
4. To recommend the specific steps that need to be taken for implementation, and
also to advise on the consolidation and merger of the stock exchanges.

Research Questions:
1. What is the present legal structure of Stock Exchanges in India?

2
2. What is demutualization?
3. How is this process of Corporatization and demutualization to take place?
4. What should be the Structure of the governing boards of stock exchanges and
representation of brokers?
5. What are the statutory requirements and legislative changes necessary to give
effect to demutualization?

TABLE OF CONTENTS

1. Introduction3
2. Existing Structure of Stock Exchanges in India5
3. Models of Demutualization13
4. Recommendations23
5. Conclusion26
6. Bibliography28

INTRODUCTION

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Most of the Stock Exchanges around the world were set up as association of the Trading
members. The objective to set up association was aimed to create a formal institution for
mutually regulating the securities transactions among the members. Thus, most of the
Stock Exchanges were promoted as non-profit organizations. While, the management of
the Stock Exchange was generally vested with elected representative(s) of the trading
members, executives carried out the day-to-day functioning of the Stock Exchange.
However, during last two decades attempts have been made to change the profile of the
Stock Exchange by demutualising them and reconstituting them as commercial corporate
entities.1 Demutualization of a Stock Exchange entails that it is no longer remains entity
for mutual benefit of Trading members but beholds the larger objective of becoming the
system with adequate checks for proper mobilization of capital & protecting the interest
of investors at large.

Corporatisation is a critical enabler that would support the efforts in expanding and
strengthening the Indian capital market. While things are becoming more business-
oriented, the corporatized Stock Exchanges will improve its flexibility and efficiency in
terms of its responsiveness to market needs2.

The need for corporatization of Stock Exchanges in India has recently came into lime
light after functioning of Mumbai Stock Exchange is alleged to have been manipulated by
the some of the Trading members on governing Board of the exchange, which followed
by stock markets crash inspite of what was seen as one of the favorable & progressive
Union Budget in recent years3.

After the stock scam of March 2001, the Government finally announced that all stock
exchanges would have to mandatorily go in for demutualization within a specified

1
Dr. K. R. Chandratre et al., Bharat’s Compendium on SEBI, Capital Issues and Listing, 3rd ed., Vol.1,
Bharat Publishing House, New Delhi, 1996
2
Sucheta Dalal, Death of Indian Stock Exchanges, Indian Express Newspapers, Delhi, November 25’2002,
3
Sinha hints at laws for Corporatisation of SES, SEBI: IDBI soon, Indian Express, March 12’2003.

4
timeframe4. This was aimed at preventing conflict of interests, which arise when
stockbrokers are involved in the management of the stock exchanges also.

It is in this context it becomes necessary to study the need and impact of Corporatisation of
Stock Exchanges and its relevance in Indian context before a clear roadmap could be
prepared to take this process forward, for which SEBI constituted a Group under the
Chairmanship of Justice M. H. Kania, former Chief Justice of India comprising of eminent
personalities, in fields of law, accountancy, finance, company law affairs and taxation to
advise SEBI on this matter and to recommend the steps that need to be taken to implement
the announcement of the Government.

4
Sinha unveils new measures to instill confidence in market, Indian Express Newspapers, March 18’2002
(Delhi)

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 EXISTING STRUCTURE OF THE STOCK EXCHANGE IN INDIA

A Stock Exchange is an organized market for purchase and sale of listed Industrial and
financial securities. Securities traded on Stock Exchanges include shares and debentures
of Public Limited Companies, Government Securities, etc.

According to the Securities Contracts (Regulation) Act, 1956, Stock Exchange is an

association, organization or body of individuals, whether incorporated or not, established
for the purpose of assisting, regulating and controlling business in buying, selling and
dealing securities5.

Section 2 (f) of the above said Act defines recognized stock exchange as a Stock
Exchange, which is for the time being recognized by the Central Government under
Section 4. SEBI is empowered under Section 4 to grant recognition to Stock Exchanges.

In terms of the legal structure, the stock exchanges which are recognized under the
Securities Contracts (Regulation) Act in India, can be segregated into two broad groups –
20 stock exchanges which were set up as companies, either limited by guarantees or by
shares, and the 3 stock exchanges which are functioning as associations of persons (AOP)
viz. BSE, ASE and Indore Stock Exchange. The 20 stock exchanges which are companies
are: the stock exchanges of Bangalore, Bhubaneswar, Calcutta, Cochin, Coimbatore,
Delhi, Gauhati, Hyderabad, Interconnected SE, Jaipur, Ludhiana, Madras, Magadh,
Mangalore, NSE, Pune, OTCEI, Saurashtra-Kutch, Uttar Pradesh, and Vadodara. Of
these, the stock exchanges of Ahmadabad, Bangalore, BSE, Calcutta, Delhi, Hyderabad,
Madhya Pradesh, Madras and Gauhati were given permanent recognition by the Central
Government at the time of setting up of these stock exchanges. Apart from NSE, all stock
exchanges whether established as corporate bodies or Association of Persons (AOPs), are

5
Investment Laws, Stock Exchanges, (Bangalore: National Law School of India University, Distance
Education Department, Master in Business Laws – Part II, Course No. 1, Module No. 2 A,)

6
non-profit making organizations. 7 stock exchanges are set up as companies limited by
shares and the remaining 13 are set up as companies limited by guarantee6.

It is thus clear that BSE, ASE and Indore Stock Exchange will have to be both
corporatized and demutualised, while of the balance 20 stock exchanges, 18 stock
exchanges that are already corporate entities, will only have to be demutualised. Two
stock exchanges, NSE and OTCEI, are not only corporatized but also demutualised with
segregation of ownership and trading rights of members. Further, NSEIL is a for-profit
company and the Board of NSEIL comprises of representatives of shareholders, (some of
whom have 100% stock broking subsidiaries) and outside non-shareholder directors. But
even these two stock exchanges may if necessary, have to undergo changes in
organizational structure consequential to the recommendations of the Group so that a
common structural model is adopted by the all the stock exchanges.

TRADITIONAL STRUCTURES OF STOCK EXCHANGES

Internationally (as well as nationally), stock exchanges have been the product of
circumstance, or of design. These differences in the origins of stock exchanges have
tended to lead to differences in perceptions of the role of stock exchanges, and in views
about what their relationship with the legal system should be. Stock exchanges have also
been subject to limited competition from other firms.

Historically, stock exchanges all over the world were mutual organizations owned by and
run for the common benefit of their members, with no member taking profits. They were
more like "clubs" where the dealers transacted business through the open outcry system.7

6
www.sebi.gov.in
7
Kapoor N.D., Business and Economic Laws, Sultan Chand & Sons, New Delhi, 1995

7
DEMUTUALIZATION

Demutualization refers to the conversion of an existing non-profit organization into a

profits-oriented company. In other words, an association that is mutually owned by
members converts itself into an organization that is owned by shareholders. The company
can take different shapes and forms, that is, it could be either a listed or unlisted company
which may be closely held or publicly held.

This process involves the segregation of members' right into distinct segments, viz.
ownership rights and trading rights. It changes the relationship between members and the
stock exchange. Members while retaining their trading rights acquire ownership rights in
the stock exchange, which have a market value, and they also acquire the benefits of
limited liability8. The shareholders in a corporatized stock exchange may be a diverse
group, as members may decide to retain their shares or to sell them. Demutualization
however, does not insulate them from competition. A stock exchange whose management
does not effectively work to maintain its position in the market may soon become a take-
over target.

This term is not restricted only to corporatization of stock exchanges. Any organization
that is a non-profit body (which is not the same as loss-making), and is not distributing its
profits to owner-members but retains the same to develop infrastructure of the
organization, can demutualise.

For instance, Australia's life insurer and funds manager AMP recently demutualised, as
did Sun Life Assurance, the Canadian insurance firm. Recently, several stock exchanges
like the London Stock Exchange and two US stock exchanges, New York Stock
Exchange and Nasdaq, have announced that they will demutualise.9

8
Dalal Sucheta, Demutualization of bourses, The Indian Express, Feb 11’2002.

9
Prof. N. L. Mitra et al., Corporate Law, Vol.3, Distance Education Department, National Law School of
Indian University, Bangalore, 1997

8
Thus recapitulating once again Demutualization refers to the transition process of an
exchange from a "mutually-owned" association to a company "owned by shareholders".
In other words, transforming the legal structure of an exchange from a mutual form to a
business corporation form is referred to as demutualization. The above, in effect means
that after demutualization, the ownership, the management and the trading rights at the
exchange are segregated from one another.

A demutualised exchange is way different from a mutual exchange; the three

functions of ownership, management and trading are intervened into a single Group in a
mutual exchange. The broker members of the exchange over here are both the owners and
the traders on the exchange and they further manage the exchange as well. A
demutualised exchange has all these three functions clearly segregated.

SEBI had formed a Group on Corporatisation and Demutualization of Stock Exchanges

under the Chairmanship of Justice M H Kania, former Chief Justice of India, for advising
SEBI on corporatization and demutualization of exchanges and to recommend the steps
that need to be taken to implement the same. The Group submitted its Report to SEBI on
August 28, 2002. SEBI has taken up with Central Government to amend the SC(R) A to
affect Corporatisation and Demutualization.

THE PROCESS OF DEMUTUALIZATION TAKES PLACE IN THE FOLLOWING MANNER:

The exchange values all its assets including the value of seats and arrives at a total value.
This is then divided into different shares and offered to the public. Later, the shares are
listed on the stock exchange itself, and the funds got by selling the shares will be
distributed among the members of the exchange as payment for their seats. If the
company is not being listed, the shares may be offered to the members, not for transfer.10

On the other hand Corporatisation of Stock Exchanges is the process of converting the
organizational structure of the stock exchange from a non-corporate structure to a

10
Ramaiya, A., A Guide to the Companies Act, 15th ed., Wadhwa & Company (P) Ltd., Nagpur, 200

9
corporate structure. Traditionally, some of the stock exchanges in India were established
as "Association of persons", like BSE, ASE and MPSE. Corporatisation of these
exchanges is the process of converting them into incorporated Companies.11

FORCES BEHIND THE DEMUTUALIZATION

Demutualization as a concept is neither a very new concept nor very sophisticated. The
essence lies with the separation of ownership and management. Thus it is well driven by
the good intentions of proper governance, which has taken a new turn after the collapse of
many large corporations in the year 2002. Although there is no exclusive definition of
mutual or demutual organization, a ‘mutual’ organization is an enterprise owned by its
members, providing a variety of service to the members for their benefit.12 This also
implies that mutual are not for profit organizations; are restricted in their capacity to raise
equity, and are characterized by diffused decision-making power. The expression
demutualization means the transition from a mutual company, in which there are no
shares, and every member has one vote, to a company limited by shares and one vote per
share. But it is also used to describe the process by which a company limited by shares in
which every member is required to have the same number of shares, converts to a more
usual economic model; or simply one where the link between membership in the
exchange company or ownership of a share in it, is broken. Thus the central idea with
demutualization does not only rests on the basic status of the organization i.e., whether it
is “for profit” or “not for profit”. It is found that there are many “for profit” organizations
even stock exchanges, which are not demutualized. The crux of the problem thus lies with
the ownership of the exchange. Separation of ownership and membership is the
fundamental ingredient of the demutualization as well as the essence of effective
governance. The issues addressed here are essentially those arising from permitting non-
brokers to own stake in the exchange, and brokers not to have an ownership interest of
any kind or to have ownership to a limited extent.

11
S. C. Sen, New Frontiers in Company Law, Eastern Book Company, Lucknow, 1971
12
Clive M. Schmitthoff, Palmer’s Company Law, 14th ed., Vol.1, Stevens & Sons Ltd., London, 1987

10
 THE NEED FOR DEMUTUALIZATION

1. Stock exchanges owned by members tend to work towards the interest of members
alone, which could on occasion be detrimental to rights of other stakeholders. Division
of ownership between members and outsiders can lead to a balanced approach, remove
conflicts of interest, create greater management accountability, and take into
consideration the interest of other players.

2. To cope with competition, stock exchanges require funds. While member-owned stock
exchanges have limitations in raising funds, publicly owned stock exchanges can tap
capital markets.

3. Publicly owned stock exchanges can be more professional when compared to member-
owned organisations. Further, as a result of the role played by shareholders,
strengthening of the management and the organization, there is greater transparency in
dealings, accountability and market discipline.

4. This would enhance management flexibility. A publicly held company is better equipped
to respond to changes when compared to a closely held mutually owned organization.
Further, a company can spin-off its subsidiaries, get into mergers and acquisitions,
raise funds, etc.

A company can spin off subsidiaries, get into mergers and acquisitions, raise more
monies, etc. For instance, the NSE which started out as a corporate body has spun off
wholly-owned subsidiaries like the National Securities Clearing Corp and more recently,
NSE.IT, a dedicated info-tech company.

The world's capital markets have changed remarkably owing to financial market
globalization trends and new information technology advancement technology growth,
which have resulted in much more sophisticated investor demands. Intensifying
competition among exchanges to attract issuers and investors have prompted leading

11
exchanges worldwide to change their organizational structures and business approaches
to become more flexible, efficient and responsive to market needs, with a greater
orientation on profitability.13 For Example In the Asia/Pacific region, the Australian
Stock Exchange has already transformed itself into a fully corporatized entity, while the
exchanges in Hong Kong, Singapore and Japan are also moving in the same profit-driven
business direction. These corporatized exchanges are aggressively targeting regional and
international companies and investors as potential sources of growth.

But, the trouble is that their decision-making is often painfully slow and conservative.
This is seen from the reluctance of smaller, regional exchanges in India to merge with the
larger exchanges just so that they retain their individual character. This, despite the fact
that many have no trades in a whole year. Internationally too, it was seen that the
members of London's International Petroleum Exchange had voted against demutualising,
and had rebuffed an overture for a merger from the New York Mercantile Exchange.

There are many apprehensions and questions being raised as to if an exchange go

public, what would happen to its role as a self – regulatory organization.

However, the corporate structure by itself does not make any difference, as seen from the
example of the NSE. But, the conflict of interest could arise if the boards of the stock
exchanges are not independent as also at the time of listing of the demutualised exchange.
The conflict would arise due to a clash in the exchange's role as a regulator and its
commercial objectives. This issue needs to be looked into by the capital market regulators
in the country.

In some jurisdictions regulators have reacted to a stock exchange’s demutualization by

removing regulatory responsibilities from the stock exchange while the stock exchange
itself runs like a business corporation.

13
S. C. Sen, New Frontiers in Company Law, Eastern Book Company, Lucknow, 1971

12
Here some cues could be taken from the LSE, which, reportedly, has given up some of its
functions in preparation for its planned demutualization. The LSE has given up its role of
supervising new company listings to the UK's financial regulator who also oversees
regulation of capital markets, the Financial Services Authority. However, the LSE retains
the right to decide whether or not it will admit a particular security to trading through its
market, and it also has self-regulatory powers to set its own trading rules, and maintain an
orderly market, subject to other rules as the FSA may adopt, such as rules to check market
abuse.

The Australian Stock Exchange (ASX) retains the general power to regulate securities
listings, although its own listing on its own market is supervised by the Australian
Securities and Investment Commission (ASIC).

MODELS OF DEMUTUALIZATION

The stock exchanges, which had demutualised have followed different models.
However, a common feature has been that members surrender their mutual
membership rights and in lieu thereof, they are issued shares in the demutualised
company. The number of shares issued has some relationship to the value of the
assets of the stock exchange. In several cases, a public issue of shares was also made.

13
A demutualised "for-profit" stock exchange will face an issue of conflict between its
regulatory responsibility and its desire to maximize profits for its shareholders, for
example,14

 The profits of the stock exchange would vary with its fee structure. If it is in a
monopolistic situation, it could be tempted to charge fees, which could adversely
affect the interest of the trading members, the investing public or the companies
listed in the stock exchange.
 The profits of the stock exchange would also vary with the number of companies
listed on the stock exchange. Thus there could be a temptation to relax the listing
requirements or the standards of monitoring to boost the number of listed
companies.
 A stock exchange, which lists its own shares, may adopt a more relaxed attitude to
its own listing and its own compliance by the stock exchange of its regulations.
 There could be disagreements between members of the Board who trade as
against those who do not, as regards the manner in which the affairs of the stock
exchange should be conducted.
 While, competition among stock exchanges should mitigate most of these issues of
conflict and see the emergence of the stock exchanges which are more efficient as
also "image conscious", there is unfortunately no agreement as to whether
competition could produce a race to the top or the bottom as there is no way of
knowing what would happen if securities markets were allowed to compete freely.

The process of demutualization of the stock exchanges would involve three broad steps
viz.

1. Corporatisation of three stock exchanges (BSE, ASE and MPSE) which currently
do not have a corporate structure,

14
Mayson, French & Ryan . Company law, 1st ed., Universal Law Publishing Co. Pvt. Ltd., Delhi, 2001

14
 2. Conversion of the stock exchanges limited by guarantees into ones limited by
shares
3. Incorporation in the memorandum and articles of association of existing stock
exchanges set up of relevant provisions to give effect to the Group’s
recommendations.
4. The transition of thirteen companies limited by guarantees to companies limited
by shares, so that all stock exchanges will have a uniform legal structure.

And subsequently a common model for corporatization and demutualization for all stock
exchanges. Moreover the clause (j) of section 2 of SCRA be amended to mean that the
stock exchanges could be companies incorporated under the companies act. The present
provisions under clause (j) of section of 2 of SCRA defines stock exchanges to "mean any
body of individuals, whether incorporated or not, constituted for the purpose of assisting
regulating or controlling the business of buying, selling or dealing in securities". This
clause would need to be amended to provide that a stock exchange should be a company
incorporated under the Companies Act.

THE TRANSITION FROM A NOT-FOR-PROFIT VOLUNTARY ENTITY INTO A FOR-

PROFIT CORPORATE BODY

The basic character of the stock exchanges in India, saving NSE, irrespective of their
legal constitution, is that they are meant to be voluntary, not for-profit mutual entities.
Demutualization fundamentally alters this position of the stock exchanges, as these would

15
no longer retain their voluntary, not for-profit mutual character, but become for-profit
corporate bodies15

There are two parts to this transition. One, which involves the changing the voluntary not-
for-profit character of the entity into a for-profit one (in some cases into a corporate body
as well) and second, is the process of delinking of ownership of the entity by the
members from their trading rights. The first would involve the manner in which assets
would be transferred from the existing entities to the new corporate entity, wherever
demutualization has to be accompanied by corporatization as in the case of BSE, ASE
and MPSE. The second would involve the allocation of these assets to the members.

The twin rights of trading and an undivided interest in the ownership of the stock
exchange are embedded in the membership card of a stock exchange. The transition to a
demutualised stock exchange would involve the segregation of these twin rights into two
separate and independent rights viz.

1. The right to participate in the ownership of the assets of the stock exchange, and
2. The right to trade on the stock exchange.

TAX - WAIVER

When a trading right is acquired, and a share is allotted to a member of an stock exchange
by virtue of which he acquires a membership privilege against the extinguishment of the
previous right of membership, no transfer of assets effectively takes place and neither of
the acquisitions should therefore be deemed to be a transfer within the meaning of the

15
R.P. Maheswari., A Complete Course In ISC Commerce, Vol. 2, 3rd ed., Pitambar Publishing Private
Limited, New Delhi, 2000

16
word in the Income Tax Act16. However, at the point of sale of any of these two rights,
capital gains tax would be attracted.

Since the above processes are necessary to implement a policy announced by the
Government, and in the larger interests of the securities market in India as well as in the
interests of investors, it would be necessary to ensure that both the processes described
above are tax neutral and no additional tax liability is attached either to the stock
exchange or to a member of a stock exchange which is implementing an approved
scheme of demutualization17. Such tax neutrality was essential to nudge the process of
corporatization and demutualization and it would not be fair to the stock exchanges and
the members, nor will they be encouraged to expedite the implementation of
demutualization, if such neutrality was not provided.

The Income Tax Act has already made some provisions to facilitate the corporatization of
stock exchanges in India by way of the Finance Act, 2001 under which clause (xiii) of
Section 47 of the Income Tax Act was amended to provide that any transfer of capital
asset from an association of persons, for a body or individual under the scheme of
corporatization of a recognized stock exchange shall not be regarded as transfer for the
purposes of capital gains tax. The proviso to clause (xiii) has also been amended to
provide that this one time exemption from capital gains tax is available only if all the
assets and liabilities of the stock exchange immediately before the succession become
assets and liabilities of the corporatized stock exchange, and the scheme of
corporatization is approved by the SEBI.

In effect, the Finance Act has made three amendments, 2001, in clause (xiii) of Section
47, which has taken effect from April 01, 2002. Their effect is to indicate that the
corporatization of a recognized stock exchange in accordance with a scheme approved by
16
www.IndiaInfoline.com
17
Hema Ramakrishnan, Transfer of assets, trading rights of brokers, SEs -- One-time tax waiver on capital
gains likely, The Hindu, July16, 2002.

17
the SEBI will not be a "transfer". This would be even if there is a transfer of capital assets
or intangible assets from the stock exchange which was originally a firm or an association
of persons to the stock exchange when it becomes a company under the approved
scheme.

This shall ensure that the past profits of a stock exchange which were not taxed when it
had the character of a not for profit entity should not be taxed when its character changes.
In other words, the accumulated reserves of the stock exchange as on the day of
corporatization should not be taxed. However, there would be no objection to taxation of
these reserves, in the hands of the shareholders when these are distributed to shareholders
as dividend at the net applicable tax rate; equally all future profits of the stock exchange
after it becomes a for profit company may be taxed.

Moreover there are necessary provisions that are being made in the Indian Stamp Act and
the Sales Tax laws to exempt from stamp duty and sales tax, the transfer of the assets
from the mutual stock exchange and the issuance of shares by the new demutualised for-
profit company, formed pursuant to an approved scheme of demutualization;

The next question is why to demutualize the stock exchanges. The recent transformations
in the global environment have added new dimensions to the trading, clearing/settlement
and listing functions of SEs. Many of these functions have been come under actual or
potential competitive threat. The need to meet the demand from its customers for lower
transaction costs; more efficient services and new products are now become more crucial
for the survival of SEs. The driving forces behind demutualization are found to be
growing competition among SEs, increasing listing of global companies

GOVERNANCE OF THE STOCK EXCHANGES

In the past, in almost all the stock exchanges, the broker members of the governing
boards have been critical in the governance of the stock exchanges. The reconstitution of
the governing boards of the stock exchanges by SEBI, which reduced the broker

18
representation on these boards to 50%, had helped in making the boards more
independent and minimized the influence of brokers. However, in most stock exchanges
on account of the brokers retaining posts of the officer bearers of the stock exchanges till
recently viz. president, vice-president and treasurer, they continued to play a dominant
role in the management of the stock exchange. The fall-out of this practice has been that
most stock exchanges have failed to develop good corporate governance practices and
strong management teams18. This has not only been a perception but also a reality in most
stock exchanges. Conflicts of interest have bedeviled the operations of the stock
exchanges in the past to the detriment of the securities market. If the stock exchanges are
to function in a modern competitive environment these deficiencies would have to be
removed and they would have to adhere to the high standards of corporate governance.
Indeed this is one of the objectives to be achieved through this entire exercise of
demutualization of the stock exchanges.

The steps taken by SEBI recently to strengthen the governance of the stock exchanges
and to remove the conflicts of interest. As directed by SEBI, the brokers are not allowed
to hold the posts of president, vice president, treasurer or act as office bearers. Besides,
pursuant to this directive the brokers have stepped down from these posts in almost all the
stock exchanges. However there is a need to further strengthen the present governance
structure to compliment the demutualization exercise so that the purpose of
demutualization could be fruitfully served.

Divergent views have been expressed on the issue of broker representation on the
governing boards of stock exchanges. The case for broker representation has been made
by almost all stock exchanges and brokers' association. Their argument is that the brokers
are major stakeholders in a stock exchange and they are affected by the manner in which
an stock exchange functions19. They also have the experience and knowledge of the
market and therefore should have some representation on the governing boards of the
stock exchanges. Besides, the demutualised corporatised structure envisages that brokers

18
“Brokers Resistance to Market Reforms”, The Hindu, Aug 02 ‘2002.
19
Dalal Sucheta “Merge BSE and NSE”, The Indian Express, July 27’ 2002.

19
could continue to be shareholders and as such be eligible to be elected on the boards as
directors. The investors' association has made the case for not giving any representation
to the brokers. The argument against broker representation is one of conflict of interest
and the possibility of interference and exercising influence in the functioning of the stock
exchange. The investors' association have felt that in a sense the presence of brokers on
the governing boards affects the independence of the executives of the stock exchange
who may be answerable to the very persons whose actions they are expected to control20.

However in the newly constituted demutualised stock exchange, there would and should
be three major stakeholders – the shareholders, the brokers and the investing public
through the regulatory body. It was important that all the three stakeholders are
represented equally on the governing boards of the stock exchanges. The representation
of the brokers on the governing boards of stock exchanges is desirable since the stock
exchange would benefit from their expertise and experience about the working of the
stock exchange. It is expected that the 2/3rd of the board being non-brokers should be able
to provide the driving force behind the management of the stock exchange. But in no case
should the stock exchange have more than 1/3rd broker representations on its governing
board21.

According to the Kania Committee report22,

1. The three stakeholders viz. shareholders, brokers and investing public through the
regulatory body should be equally represented on the governing board of the
demutualised stock exchange;
2. There should be specific vacancies on the board for each group of stakeholders;
3. The shareholders’ representatives should not be functioning brokers;

20
Iyer .P Vaidyanathan, Sebi tells SEs to Bar member-brokers from being office-bearers ,The Economic
Times, 11July’2002.

21
Dey Nilanjan, Panel for representation of brokers on exchanges — Report moots governance norms, ,
The Hindu, Sept 04’2002.
22
Dalal Sucheta, Kania Committee Report : An Overview , Indian Express, Nov’28 ‘ 2002,.

20
 4. The brokers representatives would be elected by the shareholders from among the
brokers of the stock exchange;
5. The representatives of the investing public would be nominated by SEBI from
among a panel comprising of academics, professionals, industry representatives,
public figures and investors association, none of whom should have any interest
in any broking firm;
6. Adequate disclosures about the background of the directors of the board should
be provided to the shareholders at the annual general meetings and the annual
reports;
7. The relevant provisions of the Companies Act will govern the maximum number of
directors on the board. 1956; and
8. Current restrictions on the tenure of broker directors should continue.

In most of the demutualised stock exchanges abroad, and even in non-demutualised stock
exchange such as NYSE and NASDAQ, brokers are represented on the governing boards.
In NYSE for example there are 4 broker members, 12 are providers of financial services,
8 are from financial institutions, 2 are CEOs of large corporates, 2 are representatives of
investing association and 4 are retired public servants who held important administrative
offices.

LATEST POSITION
The Securities and Exchange Board of India in its communication dated January 30,
2003, has given stock exchanges six months to prepare a scheme for implementing
corporatisation and demutualization as recommended by the Kania Committee.

SEBI has advised the exchanges to submit a scheme, together with the changes in rules,
byelaws and articles that would be required to implement the scheme, within the time
frame for its approval.

Since some of the recommendations of the Kania Committee require legislative changes
with regard to Securities Contract (Regulations) Act, 1956, Income Tax Act, 1956, and

21
the Indian Stamps Act, 1899 to facilitate corporatisation and demutualization of the stock
exchanges and to grant fiscal exemptions to encourage this process23, the matter has been
taken up with the central government.

Any stock exchange that fails to comply with the requirement of corporatization and
demutualization by the appointed date, and is accordingly derecognized, will have to
distribute its assets in accordance with the provisions of the respective rules and laws, the
committee observed.

The Honorable Union Finance Minister in his budget speech for 2005-06 had announced
the corporatization and demutualization of stock exchanges. Accordingly SEBI had
notified the demutualization of stock exchanges except the Coimbatore Stock Exchange
and Mangalore Stock Exchange.24

In the post demutualization period, it has become crucial to decide the future role of
Regional Stock Exchanges (RSEs).

Currently there are two stock exchanges in India

• The National Stock Exchange (NSE)

• Over the Counter Exchange of India (OTCEI)

These are not only corporatized but also demutualised with segregation of ownership and
trading rights of members.

23
Shaji Vikraman, Corporatisation of Stock Exchanges may need changes in Act, Nov 21’2002, New Delhi
24
http://www.sebi.gov.in/press/2006/2006188a.html

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 RECOMMENDATIONS
The stock exchanges which are set up as association of persons and those which are set
up as companies limited by guarantee be converted into companies limited by shares.
Further a common model for corporatisation and demutualization be adopted for all stock
exchanges; and the clause (j) of section 2 of SCRA be amended to mean that the stock
exchanges could be companies incorporated under the companies act. The present
provisions under clause (j) of section of 2 of SCRA defines stock exchanges to "mean
any body of individuals, whether incorporated or not, constituted for the purpose of
assisting regulating or controlling the business of buying, selling or dealing in
securities". This clause would need to be amended to provide that a stock exchange
should be a company incorporated under the Companies Act.

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Further as corporatisation and demutualization of a stock exchange is essentially a
conversion from a not-for profit entity to a for-profit company, and would result in a
distribution of assets, the Income Tax Act should be amended if necessary, so that the past
profits of an stock exchange which were not taxed when it had the character of a not for
profit entity should not be taxed when its character changes. In other words, the
accumulated reserves of the stock exchange as on the day of corporatisation should not be
taxed. However, there would be no objection to taxation of these reserves, in the hands of
the shareholders when these are distributed to shareholders as dividend at the net
applicable tax rate; equally all future profits of the stock exchange after it becomes a for
profit company may be taxed25.

Furthermore it shall be made a necessary provisions should also be made in the Indian
Stamp Act and the Sales Tax laws to exempt from stamp duty and sales tax, the transfer
of the assets from the mutual stock exchange and the issuance of shares by the new
demutualised for-profit company, formed pursuant to an approved scheme of
demutualization; and that as only the schemes for demutualization approved by SEBI will
qualify for the exemptions under the Income Tax Act, the Indian Stamp Act and the Sales
tax Act, each stock exchange would be required to submit a scheme drawn on the lines of
these recommendations to SEBI for approval.

A cogent suggestion in furthering the Corporatisation of Stock Exchanges would be that

the trading card system be replaced by the deposit system wherein the money deposited
by the member to obtain trading rights only, be considered as deposit with the stock

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Notwithstanding any provision, judgment or order to the contrary or inconsistent therewith, a statutory
provision should be made in the Income Tax Act, so that the issue of shares and trading rights in lieu of the
card should not be regarded as transfer within the meaning of Section 47(xiii) of the Income Tax Act. The
byelaws, rules and articles of a stock exchange should be amended to provide for the allotment of shares
and trading rights to its members upon corporatisation (in applicable stock exchanges) and upon
demutualisation;

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exchange for trading purpose.26 While the Group favors the deposit system, it would like
to leave the choice of adopting either the card or the deposit system to the exchanges.
Furthermore the procedures to be adopted if the deposit system is accepted by an
exchange for the purpose of segregation of the trading rights and ownership.

In light of the status of the parties involved, these being the three stakeholders viz.
shareholders, brokers and investing public through the regulatory body should be equally
represented on the governing board of the demutualised exchange, in the same effect
there should be specific vacancies on the board for each group of stakeholders; the
shareholders’ representatives should not be functioning brokers and these brokers shall be
representatives would be elected by the shareholders from among the brokers of the
exchange.

The important norms with regards to the adequate disclosures about the background of
the directors of the board should be provided to the shareholders at the annual general
meetings and the annual reports and the membership norms shall also be so changed that
the maximum number of directors on the board will be governed by the relevant
provisions of the Companies Act. 1956.

The relevant provisions of the Securities Contract (Regulations) Act, 1956, the Income
Tax Act, 1961 and the Indian Stamps Act, 1899 be amended to facilitate corporatisation
and demutualization of the exchanges and to grant fiscal exemptions to encourage this
process. On the relevance of the regional stock exchanges, the Group felt that the concept
of regional stock exchanges needs to be abolished. On the issue of alternative use of the
existing infrastructure facility of the stock exchanges, the Group was of the view that that
some of the stock exchanges could explore the possibility of merger on the lines of
Euronext. The Group does not recommend any specific route as being mandatory as the
choice should be dictated on commercial considerations.

Another norm for mutualisation of stocks should be such that uniform model for
corporatisation and demutualization would have to be adopted by all the stock exchanges.
This model should not be made applicable selectively only for a few stock exchanges.
26
Avtar Singh, Company Law, 9th ed., Eastern Book Company, Lucknow, 1989

25
The merger of stock exchanges, before or after demutualization is a commercial decision
and the choice should be left to the concerned stock exchanges and it is not within the
purview of the Group to recommend a specific course of action. However, the Group
strongly feels that corporatisation and demutualization will facilitate the process of
consolidation of stock exchanges and while the Group does not wish to recommend
measures which may provide an exit route to the members of the stock exchanges, any
stock exchange which fails to comply with the requirement of corporatisation and
demutualization by the appointed date and is accordingly derecognised, will have to
distribute its assets in accordance with the provisions of the respective articles/ rules of
the stock exchange and the relevant tax laws shall become applicable.

CONCLUSION

With the advent of NSE and the trading by NSE and BSE on a national scale, most of the
stock exchanges have nil or negligible turnover. Further the regional stock exchanges
have invested considerable sums in computerization and on-line trading systems which
have now become virtually redundant. Many stock exchanges have therefore, formed
subsidiary companies which have become members of NSE and BSE and members of the
stock exchange function as sub-brokers of these companies. This has enabled brokers of
these stock exchanges to trade on NSE and BSE without acquiring the membership of
these stock exchanges. Under these circumstances, the prevailing view in most stock
exchanges and among the brokers seems to veer towards closure of the stock exchanges.
In this context, the overwhelming concern is one of finding a suitable exit route that will
enable the members to recoup the investments made by them in those stock exchanges.

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It is unlikely that all the 23 stock exchanges would continue to serve an economic
purpose even in the medium term; it was of the view that it would be up to the stock
exchange to choose whether it should merge with any other stock exchange or continue to
function independently. This choice would be predicated on the commercial
considerations of the concerned stock exchange. However corporatisation and
demutualization should facilitate the process of merger of stock exchanges.

The Justice Kania Committee on demutualization of stock exchanges has said that no
exchange would be able to float a subsidiary, which will make it difficult for regional
exchanges to survive by trading on larger national bourses. All these are signals that
smaller stock exchanges will have to prepare for closure since they can never hope to
compete with the reach and services that the nationwide bourses are able to provide.
Unfortunately, there is no sign of such planning or realization.

This process of Corporatisation has provided a big opportunity for regional stock
exchanges to merge, consolidate or close down their businesses. Sebi should use this as a
chance to nudge smaller bourses towards closure and encourage their broker-members to
merge and morph into larger corporate memberships that can trade on the BSE or the
NSE27. In fact, Sebi should even consider setting up a team of experts to offer counseling
and guidance on law, taxation and the corporatisation process to small regional brokers.
The Kania Committee’s recommendations could then lead to a massive restructuring of
the Indian capital market and reduce the number of bourses to a manageable and
revitalised five or six.

27
Manna. Sujoy, Corporatised BSE likely to join hands with weak stock exchange, The Economic Times,
Aug’ 27, 2002

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We would have taken another important step forward in the march towards globalization
The Group may during the deliberations call and hear the views of other legal experts,
stock exchanges and other market participants etc. The Group would submit its report
within two months from the date of its first meeting. The date of submission of the report
was further extended till August 31, 2002.

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 BIBLIOGRAPHY
Books and Periodicals:
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London, 1987.
3. Dr. K. R. Chandratre et al., Bharat’s Compendium on SEBI, Capital Issues and
Listing, 3rd ed., Vol.1, Bharat Publishing House, New Delhi, 1996.
4. Kapoor N.D., Business and Economic Laws, Sultan Chand & Sons, New Delhi, 1995.
5. Prof. N. L. Mitra et al., Corporate Law, Vol.3, Distance Education Department,
National Law School of Indian University, Bangalore, 1997.
6. Ramaiya, A., A Guide to the Companies Act, 15th ed., Wadhwa & Company (P) Ltd.,
Nagpur, 2001.
7. S. C. Sen, New Frontiers in Company Law, Eastern Book Company, Lucknow, 1971.
8. Mayson, French & Ryan . Company law, 1st ed., Universal Law Publishing Co. Pvt.
Ltd., Delhi, 2001.
9. R.P. Maheswari., A Complete Course In ISC Commerce, Vol. 2, 3rd ed., Pitambar
Publishing Private Limited, New Delhi, 2000
10. Paul L. Davis., Gower‘s Principles of Modern Company Law, 6th ed.., Sweet and
Maxwell, London, 1997.

WEBSITES:
1. http://www.lib.monash.edu.au/subjects/law/securities.htm
2. http //www.theHinduBusinessLine.com/Decade of SEBI regulations — When will
they start biting.htm
3. http://www.sec.gov/cgi-bin/goodbye.cgi?www.law.uc.edu/CCL/sldtoc.html
4. http://www.adb.org/Documents/Books/Rising_to_the_Challenge/India/india-
cap.pdf.
5. http://www.adb.org/Documents/Books/Rising_to_the_Challenge/India/india-
cap.pdf

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