CHAPTER – 1

MERCHANT BANKING: NATURE AND SCOPE

INVESTMENT BANKING:
Investment banks in USA are the most important participants
in the direct market by bringing financial claims for sale. They
specialize in helping businesses and governments sell their
new security issues, whether debt or equity in the primary
market to finance capital expenditures. Once the securities are
sold, investment bankers make secondary markets for the
securities as brokers and dealers.

INVESTMENT BANKS V/S COMMERCIAL BANKS

Early investment banks in USA differed from commercial
banks which accepted deposits and made
commercial loans. Commercial banks were chartered
exclusively to issue bank notes and make short
term business loans. On the other hand, early
investment banks were partnership and were not subject to
regulations that apply to corporations. Investment banks were
referred to as private banks and engaged in any business they
liked and could locate their offices anywhere. While investment
banks could not issue notes, they could accept deposits as well
as underwrite and trade in securities.

The distinction between commercial banking and

investment banking is unique and confined to the United
States, where legislation separates them. In countries where
there is no legislated separation, banks provide investment
banking services as part of their normal range of business
activities. Countries where investment banking and
commercial banking are combined have
‘universal banking’ systems. European countries have
universal banking system which accept deposits, make loans,
underwrite securities, engage in brokerage activities and offer
financial services.

RESTRICTIONS ON COMMERCIAL BANKS

In India commercial banks are restricted from buying and
selling securities beyond 5% of their net incremental deposits
of the previous year. They can subscribe to securities in the
primary market and trade in shares and debentures in the
secondary market. Issue management activities which are not
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fund based are managed by wholly owned subsidiaries and
distinct from the Banks’ operations. Further, acceptance of
deposits is limited to commercial banks. Non-bank financial
intermediaries accept deposits for fixed term and are
restricted to financial intermediaries accept deposits for fixed
term and are restricted to financing leasing/hire purchase,
investment and loan activities and housing finance. They
cannot act as issue managers or merchant banks. Only
merchant bankers registered with Securities and Exchange
Board of India (SEBI) can undertake issue management and
underwriting, arrange mergers and offer portfolio services..

INVESTMENT BANKING IN USA

English and European merchant banks played a prominent
role in the United States until indigenous investment bankers
emerged in the 1880’s. In the early 19th century English and
European merchant bankers met the requirements of finance
for rail road construction and international trade. Later they
opened their own offices in USA. Kidder, Peabody & Co. was
setup in 1824 and John Eliot Thayar banking firm in 1857.
During 1850-60 several merchant banks were set up to arrange
capital and enterprise to promote railways, industrial projects
and trade and commerce. In the late 1890’s and 1900’s
investment bankers replaced brokers and promoters who
earlier played a prominent role in the issue of securities.
Investment bankers apart from launching and organization
industrial units and mergers helped transform privately held
companies into publicly owned companies.

Investment banking largely remained unregulated until

the Blue Sky laws were introduced in Kansas to protect
investors from fraudulent promoters and security salesman.
However, their growth was facilitated by the enactment of
federal Act in 1914, emergence of US dollar as leading
international currency and expansion of activities of US
banking system.

Prominent investment bankers in 1920’s were Kidder,

Peabody, Drexel, Morgon & Co., Brown Bros and J.P.Morgon
who bought and sold corporate bonds and stocks on
commission, dealt in federal, state and municipal securities,
trading and investing in securities on their own account,
originating and distributing new issues and participating in the
management of corporations whose securities they had helped
distribute or in which they invested.

INVESTMENT BANKING V/S MERCHANT BANKING

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 There is a subtle difference between merchant banking
and investment banking. Merchant banking purely fee- based
(except for underwriting) whereas investment banking is both
fee- and fund- based. Investment bankers commit their own
funds.

Evidence of the trend is the adoption of bought out deals

(BOD’s), initial placement of equity, compulsory sponsorship
on OTCEI, venture capital fund, influx of foreign investment
banks and acquisition of stake in Indian merchant banks by
foreign investment banks (Merill Lynch in DSP). ICICI can be
regarded as an investment banking outfit.

POTENTIAL FOR INVESTMENT BANKING IN INDIA

The bane of Indian Capital Markets today is the lack of

investor’s confidence. This is reflected in the poor performance
in both primary and secondary markets. The causes for the
existing situation are many but primary arise on account of
lack of liquidity, unscrupulous issuers and merchant bankers
and poor or unappraised issues. Investment, banking can solve
this problem because investors would be dealing with reputed
investment bankers in the primary market rather than
unknown issuers. The investment banks whatever are their
issue management techniques have their own capital on hold.
The issues are likely to be properly appraised and priced and
sponsors on OTCEI (Over The-Counter Exchange of India) have
a 2- year lock- in period. Similarly, investment banks would
hold the issues until market conditions are appropriate for
issue, thus reducing the risk of investors to gestation for issue.
Moreover, the price of reissue will be a better indicator of
issue’s performance. Investment banks make the primary
market for IPOs, thus assuring protection to the issue about
subscription.

In sum, the quality of pricing, appraisal, and primary

market function will improve resulting in substantial
improvement in investor confidence. Since the investment
bank lends its name to the issue it will imply that investors can
trust the issue.

UNIVERSAL BANKING

A good deal of interest is generated in Indian in the

concept of universal banking in view of the expansion of the
activities of all India development banks into traditional
commercial banking activity such as working capital finance
and the participation of commercial banks in project finance,
an area earlier confined to all India as well as state level
financial institutions. Further, the reforms in the financial

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sector since 1992 have ushered in significant changes in the
operating environment of banks and financial institutions
driven by deregulation of interest rate and emergence of
disintermediation pressures arising from liberalized capital
markets. In the light of these developments, the Reserve Bank
appointed a Working Group (Chairman Shri S.H. Khan) in
December 1997 to examine and suggest policy measure for
harmonizing the role and operations of development finance
institutions and banks.

DEFINITION OF UNIVERSAL BANKING

Universal banking refers to the combination of

commercial banking and investment banking including
securities business. “Universal Banking can be defined as the
conduct of range of financial services comprising deposit
taking and lending, trading of financial instruments and
foreign exchange (and their derivatives) underwriting of new
debt and equity issues, brokerage, investment management
and insurance”. The concept of universal banking envisages
multiple business activities.

MERCHANT BANKS V/S COMMERCIAL BANKS

There are difference in approach, attitude and areas of

operation between commercial banks and merchant banks. The
difference between merchant banks and commercial banks are
listed below:

1. Commercial banks basically deal in debt and debt related

finance and their activities are appropriately arrayed around
credit proposals, credit appraisal and loan sanctions. On the
other hand, the area of activity of merchant bankers is ‘equity
and equity related finance’. They deal with mainly fund raised
through money market and capital market.

2. Commercial banks are asset oriented and their lending

decisions are based on detailed credit analysis of loan
proposals and the value of security offered against loans. They
are generally avoiding risks. The merchant bankers are
management oriented. They are willing to accept risk of
business.

3. Commercial banks are merely financiers. The activities of

merchant bankers include project counseling, corporate
counseling in areas of capital restructuring, amalgamations,
mergers, takeover etc., discounting and rediscounting of short
term paper in money markets, managing, underwriting and
supporting public issues in the new issue market and acting as
brokers and advisors on portfolio management in stock
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exchange. Merchant banking activities have impact on growth,
stability and liquidity of money markets.

ORIGIN OF MERCHANT BANKING

The origin of merchant banking is traced back to Italy in

late medieval times and France during the 17th and 18th
centuries. The Italian merchant bankers introduced into
English not only the bell of exchange but also all the
institutions and techniques connected with an organized
money market. Merchant banking consisted initially of
merchants who assisted in financing the transactions of other
merchants in addition to their own trade. In France, during 17th
and 18th centuries a merchant banker (le merchand banquer)
was not merely a trader but an entrepreneur par excellence.
He invested his accumulated profits in all kinds of promising
activities. He added banking business to his merchant
activities and become a merchant banker.

MONEY CHANGER AND EXCHANGER

In the Late medieval to early modern times, a distinction
existed in banking systems between money changer and
exchanger. Money changers concentrated on the manual
change of different currencies operated locally and later
accepted deposits for security reasons. In course of time,
money changers evolved into public or deposit banks;
exchangers who operated internationally, engaged in bill-
broking, raising foreign exchange and provision of long term
capital for public borrowers. The exchangers were remitters
and merchant bankers. In the 17th century, a merchant banker
was a dealer in bills of exchange who operated with
correspondents abroad and speculated on the rate of
exchange.

Initially, merchant banks were not banks at all and a

distinction was drawn between banks, merchant banks and
other financial institutions. Among all these institutions, it was
only banks accepted deposits from public.

MERCHANT BANKS IN THE UNITED KINGDOM

In the United Kingdom, merchant banks came on the
scene in the late 18th century and early 19th century. Industrial
revolution made England into a powerful trading nation. Rich
merchant houses that made their fortunes in colonial trade
diversified into banking. Their principal activity started with
acceptance of commercial bills pertaining to domestic as well
as international trade. The acceptance of the trade bills and
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their discounting gave rise to acceptance houses, discount
houses and issue houses. Merchant banks initially included
acceptance houses discount houses and issue houses. A
merchant banker was primarily a merchant rather than a
banker but he was entrusted with funds by his customers.

The term merchant bank is used in the United Kingdom

(the oldest merchant bank in London was Baring Brothers and
it was very prominent in Europe during 19th century, and it had
considerable representation in North and South America) to
denote banks that are not merchants, sometimes for
merchants who are not bankers and sometimes for business
houses that are neither merchants nor banks. The confusion
has arisen because modern merchant banks have a wide range
of activities. Merchant banks in United Kingdom (a) Finance
foreign trade, (b) Issue capital, (c) Manage individual funds,
and (d) undertake foreign security business and (e) foreign
loan business. Many major merchant banking activities
(money-market lending, corporate finance, and investment
management), are also performed by money-market dealers,
commercial banks and finance companies share brokers and
investment consultants, and unit trust managers.

A merchant bank should have 11 characteristics: high

proportion of decision makers as a percentage of total staff;
quick decision process; high density of information; intense
contact with the environment; loose organizational structure;
concentration of short and medium term engagements;
emphasis on fee and commission services on a national and
international level; low rate of profit distribution; and high
liquidity ratio.

Since the end of the 2nd world war commercial banks in

Western Europe have been offering multiple services including
merchant banking services to their individual and corporate
clients. British banks set up divisions or subsidiaries to offer
their customers merchant banking services.

MERCHANT BANKING IN INDIA

As planning and industrial policy envisaged the setting
up of new industries and technology greater financial
sophistication and financial services are required.

Economic development requires specialist financial skills:

savings banks to marshal individual saving; finance companies
for consumer lending and mortgage finance; insurance
companies for life and property cover; agricultural banks for
rural development; and a range of specialized government or
government sponsored institutions. As new units were set up

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and businesses expanded, they required additional financial
services which were then not provided by the banking system.
Like the local banking system and the trade before, the local
system of family enterprises was unsuited for raising large
amounts of capital. A merchant equity or debt issue was the
logical source of funds.

Merchant banks serve a dual role within the financial

sector. Through deposits or sales of securities they obtain
funds for lending to their clients (SEBI forbids lending by
government): a function similar to most institutions. Their
other role is to act as agents in return for fee. SEBI envisages a
mandatory role for merchant banks in exercising due diligence
apart from issue management, in buy-backs and public offer
intake over bids. Their underwriting and corporate financial
services are all fees rather than fund based and their
significance is not reflected in their total assets of the
industry. SEBI has been pressing for merchant banks to be
primarily fee based institutions.

BANKING COMMISSION REPORT, 1972

The banking commission in its report in 1972 has
indicated the necessity of merchant banking service in view of
the wide industrial base of the Indian Economy. The
commission was in favor of a separate institutions (as distinct
from commercial banks and term lending institutions) to
render merchant banking services. The Commission suggested
that they should offer investment management and advisory
services particularly to the medium and small savers. The
Commission also suggested that they should be able to
manage provident funds, pension funds and trusts of various
types.

Merchant banking activity was formally initiated into the

Indian capital markets when Grind lays Banks received the
license from Reserve Bank in 1967. Grind lays which started
with management of capital issues recognized the needs of
emerging class of entrepreneurs for diverse financial services
ranging from production planning and systems design to
market. Apart from meeting specially, the needs of small scale
units, it provided management consultancy services to large
and medium size computers. Following Grindlays Banks,
Citibank set up its merchant banking division in 1970. The
division took up the task assisting new entrepreneurs and
existing units in the evaluation of new projects raising funds
through borrowing and issues of equity. Management
consultancy services were also offered.
Consequent to the recommendations of banking
commission in 1972, that Indian banks should start merchant
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banking services as part of their multiple services they could
offer their clients, State Bank of India started the merchant
banking division in 1972. In the initial years the SBI’s objective
was to render corporate advice and assistance to small and
medium entrepreneurs.

The commercial banks that followed State Bank of India in

setting up merchant banking units were Central Bank of India,
Bank of India and syndicate bank in 1977; Bank of Baroda,
Standard Chartered Bank, and Mercantile bank in 1978; and
United Bank of India, United Commercial Bank, Punjab National
Bank, Canara Bank and Indian Overseas Bank in late 70’s and
early 80’s. Among the development banks, ICICI started
merchant banking activities in 1973, followed by IFCI (1986)
and IDBI (1991).

ORGANIZATION OF MERCHANT BANKING UNITS

The structure of organization of merchant banks reveals
certain similar characteristics:
• A high proportion of professionals to total staff;
• A substantial delegation of decision making;
• A short chain of command;
• Rapid decision making;
• Flexible organization structure;
• Innovative approaches to problem solving; and
• High level of financial sophistication.

In the words of Skully, a Merchant Bank could be best

defined as a “financial institution conducting money market
activities and lending, underwriting and financial advice, and
investment services whose organization is characterized by a
high proportion of professional staff able to approach problems
in an innovative manner and to make and implement decisions
rapidly”.

Merchant banking activities are regulated by

(1) Guidelines of SEBI and Ministry of Finance,
(2) Companies Act, 1956 and
(3) Listing Guidelines of stock Exchange and
(4) Securities Contracts (Regulation) Act, 1956.

NATURE OF MERCHANT BANKING

The service of merchant banker could cover project

counseling and pre- investment activities, feasibility studies,
project reports, design of capital structure, issue management
and underwriting, loan syndication, mobilization of funds from
non- resident Indians, foreign currency finance, mergers,

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amalgamations and takeovers, venture capital, buy back and
public deposits. A category – 1 merchant banker can undertake
issue management only. Separate registration is not necessary
to carry on the activity as underwriter.

Merchant banking is a skill based activity and involves

servicing every financial need of the client. It requires focused
skill base to provide for the requirements of a client. SEBI has
made the quality of manpower as one of the criteria for
registration as merchant banker. These skills should not be
concentrated in issue management and underwriting alone,
which may have an adverse impact on business as witnessed in
1995. Merchant banker can turn into any of the activities
mentioned above, depending on resources, such as capital,
foreign tie- ups for overseas activities and skills. They can
provide the entire gamut of services or develop niche business.
The depth and sophistication in merchant banking business are
improving since the avenues for participating in capital market
activities have widened from issue management and
underwriting to private placement, bought out deals (BODS),
buy- back of shares, mergers and takeovers.

DEFINITION OF MERCHANT BANKER

The Notification of the Ministry of Finance defines a

merchant banker as, “ Any person who is engaged in the
business of issue management either by making arrangements
regarding selling, buying or subscribing to securities as
manager, consultant, advisor or rendering corporate advisory
service in relation to such issue management”. The
Amendment Regulations specify that issue management
consist of prospectus and other information relating to the
issue, determining financial structure, tie- up of financiers and
final allotment and refund of the subscriptions, underwriting
and portfolio management services.

CATEGORIES OF MERCHANT BANKERS

Initially, merchant bankers were classified into four

categories having regard to their nature and range of activities
and their range of responsibilities to SEBI, investors and
issuers of securities. The minimum net worth and initial
authorization fee depend on the category. Since September 5,
1997 only category 1 exists. The first category consist of
merchant banker who carry on any activity of issue
management, which will inter alia consist of preparation of
prospectus and other information relating to the issue,
determining financial structure, tie- up of financiers and final
allotment and refund of subscription and to act in the capacity
of managers, advisors or consultant to an issue.

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 Net worth: Minimum net worth for first category is Rs. 1crore.

Registration Fee: Registration fee for first category is Rs.5

lacks annually in the first 3 years, Rs. 25 lacks in fourth year.
Renewal is every 3 years.

In addition merchant banker has to pay fees per offer

document: Rs.10, 000 up to Rs. 5 crores; Rs. 15000 for Rs. 5 –
10 crores; Rs. 25,000 for 25 – 50 crores; Rs. 50,000 for Rs. 50 –
100 crores.

SERVICES OF MERCHANT BANKS

The financial institutions in India could not meet the

demand for the long term funds required by the ever
expanding industry and trade. The corporate sector
enterprises, therefore, meet their requirements through issue
of shares and debentures in the capital market. To raise money
from capital market, promoters bank upon merchant bankers
who manage the whole show by rendering multiple services.
The merchant bankers also advise the investors of the
incentives available in the form of tax reliefs and other
statutory obligations.

The services of merchant bankers are described in detail in the

following section.

1. Corporate counseling:

Corporate counseling covers the entire field of merchant

banking activities viz. project counseling, capital restructuring,
project management, public management, loan syndication,
working capital, fixed deposit lease financing, acceptance
credit etc.. The scope of corporate counseling is limited to
giving suggestions and opinions of the client and help taking
actions to solve their problems. It is provided to a corporate
unit with a view to ensure better performance, maintain steady
growth and create better image among investors.

2. Project counseling

Project counseling includes the preparation of project reports,

deciding upon financing pattern to finance the cost of the
project and appraising project report with financial institutions
or banks. Project reports are prepared to obtain government
approval, get financial assistance from institution and plan for
public issue. The financing mix is to be decided keeping in view
the rules, regulations norms prescribed by the government or
followed by the financial institutions. The projects are
appraised, as to the location, technical, commercial and
10
 financial viability of the project. Project counseling also include
filling up of application forms with relevant information for
obtaining funds from financial institutions.

3. Loan syndication:

Loan syndication refers to the assistance rendered by the

merchant banks to get mainly term loans for the projects. Such
loans may be obtained from a single development finance
institution or syndicate or consortium. Merchant bankers help
corporate clients to raise syndicated loans from commercial
banks.

Merchant bankers help clients approach financial institutions

for term loans. The decision as to which financial institution
should be approached depends upon industry, location of the
unit and size of the project cost. The merchant bankers first
make an appraisal of the project to satisfy that is viable. The
next step is designing the capital structure, determining
promoter’s contribution and arriving at a figure of approximate
amount of term loan to be raised. The merchant bankers
should ensure that the project adheres to the guidelines of
financing industrial projects. After verification that the project
would be eligible for term loan, a preliminary meeting is fixed
with financial institutions. If the financial institution agrees to
consider the proposal, the application is filled in and submitted
along with other documents. The merchant banker’s
involvement enables the company to state that it has exercised
its due diligence in the exercise of obligations under various
regulations.

4. Issue management:

Management of issue involves marketing of corporate

securities viz., equity shares, preference shares, and
debenture or bonds by offering them to the public. Merchant
banks act as an intermediary whose main job is to transfer
capital from those who own it to those who need it.

The issue function may be broadly divided in to pre issue

management and post issue management. In both the stages,
legal requirements have to be complied with and several
activities connected with the issue have to be coordinated.

The pre-issue management is divided into:-

• Issue through prospectus, offer for sale and private

placement.
• Marketing and underwriting.
• Pricing of issues.

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 (i) Public issue through prospectus

• The most common method of public issue is through

prospectus.
• Offers for sale are offers through the intermediary of
issue house of firm of stock broker. The company sells the
entire issue of shares or debentures to the issue house at an
agreed price which is generally below the par value.
• The direct sale of securities by a company to investors is
called private placement. The investors include LIC, UTI, GIC,
SFC etc.

To bring out a public issue, merchant bankers have to co-

ordinate the activities relating to issue with different
government and public bodies, professionals and private
agencies.
They have to ensure that the information required by the
Companies Act and SEBI are furnished in the prospectus and
get it vetted by reputed solicitor.

The copies of consent of experts, legal adviser, attorney,

solicitor, bankers, and bankers to the issue, brokers and
underwriters are to be obtained from the company making the
issue, to be filed along with the prospectus to the Registrar of
Companies. After the prospectus is ready, it has to be sent to
SEBI for vetting. It is only after clearance by SEBI, the
prospectus can be filed with the Registrar of Companies.

Brokers to the issue canvass subscription by mailing the

literature to the clients and undertaking wide publicity.
Members of stock exchange are appointed as brokers to issue.
Principal brokers, in addition to the functions of brokers assist
merchant bankers to devise strategy for success of the public
issue, keep liaison between merchant banker and stock
exchanges and canvass support for the issue among stock
brokers. Sometimes, they undertake centralized mailing of
prospectus, application forms and other publicity material at
the instant of the merchant banker.
Bankers to the issue accept applications along with
subscriptions tendered at their designated branches and
forward them to the Registrar. The brokers to the issue,
principal agent and bankers to issue are appointed by
Merchant Bankers.

(ii) Marketing

After dispatch of prospectus to SEBI, the merchant bankers

arrange a meeting with company representatives and
advertising agents to finalize arrangements relating to date of
opening and closing of issue, registration of prospectus,
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launching publicity campaign and fixing date of board meeting
to approve and sign prospectus and pass the necessary
resolutions.

Publicity campaign covers the preparation of all publicly

material and brochures prospectus, announcement,
advertisement in the press, radio, TV, investors conference
etc. the merchant bankers help choosing the media,
determining the size and publications in which the
advertisement should appear
The Merchant Bankers role is limited to deciding the number of
copies to be printed,
Checking accuracy of statements made and ensure that the
size of the application form and prospectus conform to the
standard prescribed by the stock exchange. The merchant
banker has to ensure that the material is delivered to the stock
exchange atleast 21 days before the issue opens and to
brokers to the issue, branches of brokers to the issue and
underwriters on time.

Security issues are underwritten to ensure that in case of

under subscription the issues are taken up by the
underwriters. SEBI has made underwriting mandatory for
issues to the public. The underwriting arrangement should be
filed with the stock exchange. Particulars of underwriting
arrangement should be mentioned in the prospectus.

The various activities connected with pre-issue management

are a time bound program which has to be promptly attended
to. The execution of the activities with clockwork efficiency
would lead to a successful issue.

(iii) Pricing of issues

The SEBI guidelines 1992 for capital issues have opened the
capital market to free pricing of issues. Pricing of issues is
done by companies themselves in consultation with the
merchant bankers. Pricing of issue is part of pre-issue
management.

An existing listed company and a new company set up by an

existing company with five year track record and existing
private closely held company and existing unlisted company
going in for public issues for the first time with two and half
years record of constant profitability can freely price the issue.
The premium has to be decided after taking into account net
asset value, profit earning capacity and market price.
Justification of price has to be stated and included in the
prospectus.

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 (iv) Post Issue Management

The post issue management consists of collection of

application forms and statement of amount received from
bankers, screening applications, deciding allotment procedure,
mailing of allotment letters, share certificates and refund
orders
Registrar to the issue plays a major role in post issue
management. They receive the applications, verify them and
submit the basis of allotment to the stock exchange. After the
basis of allotment is approved by the stock exchange and
allotted by the Board, he auditor/company secretary has to
certify that the allotment has been made by the company as
per the basis of allotment approved by the exchange.
Registrars have to ensure that the applications are processed
and allotment/refund orders are sent within 70 days of the
close of the issue. The time limit of 70 days has proved difficult
to adhere and applicants have to wait for anytime between 90
and 180 days. Merchant bankers assist the company by
coordinating the above activities.

5. Underwriting of public issue

Underwriting is a guarantee given by the underwriter

that in the event of under subscription the amount
underwritten would be subscribed by him. It is an insurane to
the company which proposes to make public offer against the
risk of under subscription. The issues packed by well-known
underwriters generally receive a high premium from the public.
This enables the issuing company to sell securities quickly.

All public issues have to be fully underwritten. Only

category I,II and III merchant bankers are permitted to
underwrite an issue subject to the limit that the outstanding
commitments of any such individual merchant banker at any
point of time do not exceed five times of his net worth (paid-up
capital and free reserves excluding revaluation reserves). This
criterion is applicable to brokers also. Lead managers have to
underwrite mandatorily 5% of the issue or Rs 2.5 lakh
whichever is less. Banks/ Merchant banking subsidiaries cannot
underwrite more than 15% of any issue.

6. Managers, Consultants or Advisers to the Issue

The managers to the issue assist in the drafting of

prospectus, application forms and completion of formalities
under the Companies Act, appointment of Registrar for dealing
with share applications and transfer and listing of shares of
the company on the stock exchange. Companies are free to
appoint one or more agencies as managers to the issue.

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 7. Portfolio Management

Portfolio refers to investment in different kinds of

securities such as shares, debentures or bonds issued by
different companies and securities issued by the government.
It is not merely a collection of unrelated assets but a carefully
blended asset combination within a unified framework.
Portfolio management refers to maintaining proper
combination of securities in a manner that they give maximum
return with minimum risk.

Merchant bankers provide portfolio management service

to their clients; today the investor is very prudent. Every
investor is interested in safety, liquidity and profitability of his
investment. But investors cannot study and choose the
appropriate securities.

8. Advisory service related to mergers and takeovers.

A merger is a combination of two or more companies in to

single company where one survives and others lost their
corporate existence. A takeover is the purchase by one
company acquiring controlling interest in the share capital of
another existing company. Merchant bankers are the
middleman in setting negotiation between the offeree and the
offeror.

9. off shore finance

The merchant bankers help their clients’ interpretation in the

following areas including foreign currency.

• Long tern foreign currency loans

• Joint venture abroad
• Financing exports and imports
• Foreign collaboration arrangements
The bankers render other financial services such as appraisal,
negotiation and compliance with procedural and legal aspects.

10. Non-resident investment

The services of merchant bankers include investment advisory

services to NRI in terms of identification of investment
opportunities, selection of securities, investment management
etc. they also take care of the operational details like purchase
and sale of securities, securing necessary clearance from RBI
for repatriation of interest and dividend.

MERCHANT BANKERS AS LEAD MANAGERS

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As per SEBI guidelines it is mandatory that all public issues
should be managed by merchant bankers in the capacity of
lead managers. Only in the case of rights issues not exceeding
Rs. 50 lakhs such an obligation are not necessary. The number
of lead managers to be appointed by a company depends upon
the size of the issue as shown below:

S. No Size of the Max. no. of

issue Lead
Managers

1 Less than 2
Rs.50crores

2 Rs.50crores 3
to Rs.
100crores

3 Rs. 100crores 4
to Rs.
200crores

4 Rs. 200crores 5
to Rs.
400crores

5 Above Rs. 5 or more as

400crores prescribed by
SEBI
DUTIES AND RESPONSIBILITIES OF LEAD MANAGERS

The most important aspect of Merchant Banking is to function

as lead managers to the issue management. As lead managers,
they have to exercise reasonable care and diligence in issue
management by paying attention to the following:

• It is the duty of every lead manager to enter into an

agreement with the issuing companies stating the details
regarding their responsibilities, liabilities, mutual rights,
functions, disclosures, refund, allotment etc. a copy of this
agreement should be submitted to the SEBI atleast one month
before the opening of the issue for subscription.

• One merchant banker cannot have association with

another merchant banker who does not hold a certificate of
registration with the SEBI.

• Similarly a lead manager cannot undertake the work of

issue management if the issuing company is its associate.

• Incase there are more than one lead managers to an issue,

the responsibilities of each of item should be clearly defined in
the agreement.

16
• A lead manager is under an obligation to accept a
minimum underwriting obligation of 5% of the total
underwriting commission or Rs. 25lakhs whichever is less. If he
is not able to comply with the above provision it is his duty to
make arrangements with another Merchant banker associated
with that issue to underwrite the said amount. Ofcourse it
must by duly intimated to the SEBI.

• A lead manager has to exercise due care and diligence in

the verification of prospectus or letter of offer.

• He has to submit due diligence certificate rating that the

prospectus or letter of offer is in conformity with the
documents relevant to the issue, the disclosures are true, fair
and adequate and all legal requirements connected with the
issue have been duly complied with.

GUIDELINES FOR MERCHANT BANKERS

Merchant banking has been statutorily brought within the

framework of the Securities and Exchange Board of India under
SEBI (Merchant Bankers) Regulations, 1992.

(1) In terms of guidelines during April 1990, all merchant

bankers will require authorization by SEBI to carry out
business.

The criteria for authorization include:

(i) Professional qualification in finance, law or business

management;

(ii) Infrastructure like adequate office space, equipment and

manpower;

(iii) Employment of two persons who have the experience to

conduct business of merchant bankers;

(iv) Capital adequacy;

(v) Past track of record, experience, general reputation and

fairness in all transactions.

(2) SEBI issued further guidelines classifying the merchant

bankers into four categories based on the nature and range of

17
activities and their responsibilities to SEBI investors and
issuers of securities. SEBI has issued revised guidelines on
December 22, 1992 classifying the activities of merchant
bankers as follows:

The first category consists of merchant bankers who carry on

any activity of issue management which will inter alia consists
of preparation of prospectus and other information relating to
the issue, determining financial structure, tie-up of financiers
and final allotment and refund of subscription and to act in the
capacity of managers, advisor or consultant to an issue,
portfolio manager and underwriter.

The second category consists of those authorized to act in the

capacity of co-manager/advisor, consultant, and underwriter to
an issue or portfolio manager.

The fourth category consists of merchant bankers who act as a

advisor or consultant to an issue.

Minimum net worth for first category is Rs. 1 crore, second

category Rs. 50 lakhs, third category Rs.20 lakhs, and fourth
category is nil.

The above classification was valid upto December 1997 only.

(3) An initial authorization fee, an annual fee and renewal

fee may be collected by SEBI.

(4) All issues must be managed at least by one authorized

banker, functioning as the sole manager or the lead manager.
Ordinarily not more than two merchant bankers should be
associated as lead managers. But, for issues over Rs. 100
crores and above, the number of lead managers may go up to a
maximum of four. The specific responsibilities of each lead
manager must be submitted to SEBI prior to the issue.

SCOPE FOR MERCHANT BANKING IN INDIA

In the present day capital market scenario, the merchant

bank play the role of an encouraging and supporting force to
the entrepreneurs, corporate sectors and the investors. There
is vast scope for merchant bankers to enlarge their operations
both in domestic and international market.

• Growth of new issue market

18
The growth of new issue market is unprecedented since 1990-
91. The amount of annual average of capital issued by non-
government public companies was only about 90 crores in the
70s, the same rose to over Rs. 1000 crs in the 80s’ and further
to Rs. 12700 crores in the first four years of 1990’s. This figure
could be well beyond Rs.40000 crores by the end of 1994-95.
The number of capital issues has also increased from 363 in
1990-91 to 900 in 1993-94. The trend is expected to continue in
future.

• Entry of foreign investors

All outstanding development in the history of Indian capital

market was its opening up in 1992 by allowing foreign
institutional investors to invest in primary and secondary
market and also permitting Indian companies to directly tap
foreign capital through euro issues. Within 2 years to March
1994, the total inflow of foreign capital through these routes
reached to about $5 billion. It is estimated that this figure may
go up to $ 35-40 billion by the turn of this century. Further,
foreign direct investment as investment by NRIs has risen
considerably due to number of incentives offered to them.
They need the service of Merchant Bankers to advice them for
their investment in India. The increasing number of joint
ventures abroad by Indian companies also requires expert
service of Merchant Bankers.

• Change policy of financial institutions

With the changing emphasis in the lending policies of financial

institutions from security orientation to project orientation,
corporate enterprise would require the expert service of
merchant bankers for project appraisal, financial management
etc. The policy of decentralization and encouragement of small
and medium industries will further increase the demand for
technical and financial services which can be provided by
merchant bankers.

• Development of Debt Market

The concept of debt market has set to work through National

Stock Exchange and the Over the Counter Exchange of India.
Experts feel that of the estimated capital issues of Rs. 40,000
crores in 1994-95, a good portion may be raised through debt

19
instruments. The development of debt market will offer
tremendous opportunity to Merchant Bankers.

• Innovations in Financial Instruments

The Indian capital market has witnessed innovations in the

introduction of financial instruments such as non-convertible
debentures with detachable warrants, cumulative convertible
preference shares, zero coupon bonds, deep discount bonds,
triple option bonds, secured premium notes, floating rates
bonds, auction rated debentures etc. This has further extended
the role of Merchant Bankers as market makers for these
instruments.

• Corporate Restructuring

As a result of liberalization and globalization the competition in

the corporate sector is becoming intense. To survive in the
competition, companies are reviewing their strategies,
structure and functioning. This had led to corporate
restructuring including mergers, acquisitions, splits,
disinvestments and financial restructuring. This offers good
opportunity to Merchant Bankers to extend the area of their
operations.

• Disinvestment

The government raised Rs.2000 crores through disinvestment

of equity shares of selected public sector undertakings in
1993-94. The government proposes to shift the present method
of periodic sale of public sector shares to round the year off
loading of shares directly on the stock exchange from the year
1995-96. The government will sell the shares of identified
public sector at any time during the year when they get a good
price above minimum stipulated level. This is likely to provide
good business to Merchant Bankers in future.

The above discussion highlights, that the scope of merchant

banking is vast and there lies immense opportunities ahead of
Merchant Bankers. They should develop adequate
infrastructure including expertise in order to provide full range
of merchant banking services to corporate sector.

CLASSIFICATION OF FINANCIAL MARKETS

20
 The classification of financial markets in India is shown in
Chart below:

Classification of Financial Markets

Organized Market
Unorganized Market

Capital Market Money Market

Money Lenders

Industrial Govt. Long term

Securities Securities Loans Market Call money Commercial Treasury Short term
Market Market Market Bill Market Bill Market Loan Market

Primary Secondary Term Market Market for

Market Market Loan for Mortgages Financial
Market Guarantees

Unorganized Markets
In these markets there are a number of money lenders,
indigenous bankers, traders etc., who lend money to the
public. Indigenous bankers also collect deposits from the
public. There are also private finance companies, chit funds
etc., whose activities are not controlled by the RBI. Recently
the RBI has taken steps to bring private finance companies and
chit funds under its strict control by issuing non-banking
financial companies (Reserve Bank) Directions, 1998. The RBI
has already taken some steps to bring the unorganized sector
under the organised fold. They have not been successful. The
regulations concerning their financial dealings are still
inadequate and their financial instruments have not been
standardized.

Organized Markets
In the organised markets, there are standardized rules and
regulations governing their financial dealings. There is also a
high degree of institutionalization and instrumentalisation.
21
These markets are subject to strict supervision and control by
the RBI or other regulatory bodies.

These organized markets can be further classified into two.

They are:

• Capital market

• Money market

Capital market

The capital market is a market for financial assets which have

a long or indefinite maturity. Generally, it deals with long term
securities which have a maturity period of above one year.
Capital market may be further divided into three namely:

• Industrial securities market

• Government securities market

• Long term loans market

(I) INDUSTRIAL SECURITIES MARKET

As the very name implies, it is a market for industrial securities

namely:

• Equity shares or ordinary shares

• Preference shares

• Debentures or bonds

It is a market where industrial concerns raise their capital or

debt by issuing appropriate instruments. It can be further
subdivided into two. They are:

• Primary market or New issue market

• Secondary market or Stock exchange

Primary market

Primary market is a market for new issues or new financial

claims. Hence, it is also called New Issue market. The primary
market deals with those securities which are issued to the
public for the first time. In the primary market, borrowers
22
exchange new financial securities for long term funds. Thus,
primary market facilitates capital formation.

There are three ways by which a company may raise capital in

a primary market. They are:

• Public issue

• Rights issue

• Private placement

The most common method of raising capital by new companies

is through sale of securities to the public. It is called public
issue. When an existing company wants to raise additional
capital, securities are first offered to the existing shareholders
on a pre-emptive basis. It is called rights issue. Private
placement is a way of selling securities privately to a small
group of investors.

Secondary market

Secondary market is a market for secondary sale of securities.

In other words, securities which have already passed through
the new issue market are traded in this market. Generally,
such securities are quoted in the Stock Exchange and it
provides a continuous and regular market for buying and
selling of securities. This market consists of all stock
exchanges recognised by the Government of India. The stock
exchanges in India are regulated under the Securities
Contracts (Regulation) Act, 1956. The Bombay Stock Exchange
is the principal stock exchange in India which sets the tone of
the other stock markets.

(II) GOVERNMENT SECURITIES MARKET

It is otherwise called Gilt-Edged securities market. It is a

market where Government securities are traded. In India there
are many kinds of Government securities- short term and long-
term. Long-term securities are traded in this market while
short term securities are traded in the money market.
Securities issued by the Central Government, State
Governments, Semi-Government authorities like City
Corporations, Port Trusts etc. Improvement Trusts, State
Electricity Boards, All India and State level financial
institutions and the public sector enterprises are dealt in this
market.

Government securities are issued in denominations of Rs 100.

Interest is payable half-yearly and they carry tax exemptions
23
also. The role of brokers in marketing these marketing
securities is practically very limited and the major participant
in this market is the “Commercial Banks” because they hold a
very substantial portion of these securities to satisfy their
S.L.R. requirements.

The secondary market for these securities is very narrow since

most of the institutional investors tend to retain these
securities until maturity.

The Government securities are in many forms. These are

generally:

• Stock certificates or inscribed stock

• Promissory Notes

• Bearer Bonds which can be discounted

Government securities are sold through the Public Debt Office

of the RBI while Treasury Bills (short term securities) are sold
through auctions.

Government securities offer a good source of raising

inexpensive finance for the Government exchequer and the
interest on these securities influences the prices and yields in
this market. Hence this market also plays a vital role in
monetary management.

(III) LONG-TERM LOANS MARKET

Development banks and commercial banks play a significant

role in this market by supplying long term loans to corporate
customers. Long-term loans market may further be classified
into:

• Term loans market

• Mortgages market
• Financial guarantees market

Term Loans Market

In India, many industrial financing institutions have been

created by the Government both at the national and regional
levels to supply long-term and medium term loans to corporate
customers directly as well as indirectly. These development
banks dominate the industrial finance in India. Institutions like
IDBI, IFCI, ICICI, and other state financial corporations come
under this category. These institutions meet the growing and
varied long-term financial requirements of industries by
supplying long-term loans. They also help in identifying

24
investment opportunities, encourage new entrepreneurs and
support modernization efforts.

Mortgages Market

The mortgages market refers to those centers which

supply mortgage loan mainly to individual customers. A
mortgage loan is a loan against the security of immovable
property like real estate. The transfer of interest in a specific
immovable property to secure a loan is called mortgage. This
mortgage may be equitable mortgage or legal one. Again it
may be a first Charge or second charge. Equitable mortgage is
created by a mere deposit of title deeds to properties as
security whereas in the case of a legal mortgage the title in the
property is legally transferred to the lender by the borrower.
Legal mortgage is less risky.

Similarly, in the first charge, the mortgager transfers his

interest in the specific property to the mortgagee as security.
When the property in question in already mortgaged once to
another creditor, it becomes a second charge when it is
subsequently mortgaged to somebody else. The mortgagee can
also further transfer his interest in the mortgaged property to
another. In such a case, it is called a sub-mortgage.

The mortgage market may have primary market as well

secondary market. The primary market consists of original
extension of credit and secondary market has sales and re-
sales of existing mortgages at prevailing prices.

In India, residential mortgages are the most common

ones. The Housing and Urban Development Corporation
(HUDCO) and the LIC play a dominant role in financing
residential projects. Besides, the Land Development Banks
provide cheap mortgage loans for the development of lands,
purchase of equipment etc. these development bands raise
finance through the sale of debentures which are treated
which are treated as trustee securities.

Financial Guarantees Market

A Guarantee marker is a centre where finance is provided
against the guarantee of a reputed person in the financial
circle. Guarantee is a contract to discharge the liability of a
third party in case of his default. Guarantee acts as a security
from the creditor’s point of view. In case the borrower fails to
repay the loan, the liability falls on the shoulders of the
guarantor. Hence the guarantor must be known to both the
borrower and the lender and he must have the means to
discharge his liability.

25
 Though there are many types of guarantees, the common
forms are:

• Performance Guarantee and

• Financial Guarantee

Performance guarantees cover the payment of earns money,

retention money, advance payments, non-completion of
contracts etc. On the other hand financial guarantees cover
only financial contracts.

In India, the market for financial guarantees is well organized.

The financial guarantees in India relate to:

• Deferred payments for imports and exports.

• Medium and long-term loans raised abroad.
• Loans advanced by banks and other financial institutions.

These guarantees are provided mainly by commercial banks,

development banks, government both central and states and
other specialized guarantee institutions like ECGC ( Export
Credit Guarantee Corporation ) and DTCGC ( Deposit Insurance
and Credit Guarantee Corporations). This guarantee financial
service is available to both individual and corporate customers.
For a smooth functioning of any financial system, this
guarantee service absolutely essential.

IMPORTANCE OF CAPITAL MARKET

Absence of capital market acts as a deterrent factor to capital

formations and economic growth. Resources would remain idle
if finances are not funneled through the capital market. The
importance of capital market can be briefly summarized as
follows:

i) The capital market serves as an important source for the

productive use of the economy’s savings. It mobiles the
savings of the people for further investment and thus avoids
their wastage in unproductive uses.
ii) It provides incentives to saving and facilities capital
formations by offering suitable rates of interest as the price of
capital.
iii) It provides an avenue for investors, particularly the
household sector to invest in financial assets which are more
productive than physical assets.
iv) It facilitates increase in production and productivity in the
economy and thus, enhances the economic welfare of the
society. Thus, it facilitates “the movement of stream command
over capital to the point of highest yield” towards those who

26
can apply them productively and profitably to enhance the
national income in the aggregate.
v)The operations of different institutions in the capital markets
induce economic growth. They give quantitative and
qualitative directions to the flow of funds and bring about
rational allocation of scarce resources.
vi) A healthy capital market consisting of expert
intermediaries promotes stability in values of securities
representing capital funds.
vii) More over, it serves as an important source for
technological up gradation in the industrial sector by utilizing
the funds invested by the public.

Thus, a capital marker serves as an important link between

those who save and those who aspire to invest their savings.

Money Market
Money market is a market for short term loans or
financial assets. It is a market for the lending and borrowing of
short term funds. As the name implies, it does not actually deal
in cash or money. But it actually deals with near substitutes for
money or near money like trade bills, promissory notes and
government papers drawn for a short period not exceeding 1
year. These short term instruments can be converted into cash
readily without any loss and at low transaction cost.

Money market is the centre for dealing mainly in short

term money assets. It meets the short term requirements of
borrowers and provides liquidity or cash to lenders. It is the
place where short term surplus funds at the disposal of
financial institutions and individuals are borrowed by
individuals, institutions and also the government.

The Money market does not refer to particular place

where short term funds are dealt with. It includes all
individuals, institutes and intermediaries dealing with short
term funds. The transactions between borrowers, lenders and
middlemen take place through telephones, telegraphs, mails
and agents. No personal contact or presence of the two parties
is essential for negotiations in a money market. However, a
geographical name may be given to a money market according
to its locations. For example, the London Money market
operates from Lambard Street and New York money market
operates from wall streets. But, they attract funds from all
over the world to be lent to borrowers from all over the globe.
Similarly, the Mumbai Money market is the centre for short
27
term loanable funds of not only Mumbai, but also the whole of
India.

DEFINITION

According to Geottery Crowther, “the Money market is

the collective name given to the various firms and institutions
that deal in the various grades of near money”.

The RBI defines the Money market as, “a market for

short term financial assets that are close substitutes for
money, facilities the exchange of money for new financial
claims in the preliminary market as also for financial claims,
already issued, in the secondary market”.

MONEY MARKET V/S CAPITAL MARKET

Money market Capital market

i) It is a market i) It is a market for

for short term long term funds
loanable funds for a exceeding a period
period of not one year.
exceeding one year.

ii) This market

supplies funds for ii) This market
financing current supplies funds for
business operations, financing the fixed
working capital capital requirements
requirements of the of trade and
govt commerce as well as
long term
iii) The requirements of the
instruments that are govt.
dealt in a money
market are bills of iii) This market
exchange, treasury deals in instruments
bills, commercial like shares,
papers, certificate of debentures, govt
deposit etc. bonds etc.

iv) Each single

money market iv) Each single
instrument is of capital market
large amount. A TB
28
 is of minimum for instrument is of small
one lakh. Each CD or amount. Each share
CP is for a minimum value is Rs. 10. Each
of Rs 25lakhs. debenture value is Rs
100.
v) The Central
bank and
Commercial banks
v) Development
are the major
banks and Insurance
institutions in the
companies play a
money market.
dominant role in the
vi) Money market capital market.
instruments
vi) Capital market
generally do not
instruments generally
have secondary
have secondary
markets.
markets.
vii) Transactions
vii) Transactions
mostly take place
take place at formal
over-the-phone and
place viz.. Stock
there is no formal
exchange.
place.
viii) Transactions
viii) Transactions
have to be conducted
have to be
only through
conducted without
authorised dealers.
the help of brokers.

FEATURES OF MONEY MARKET

The following are the general features of a money market:

i) It is a market purely for short term funds or financial

assets called near money

ii) It deals with financial assets having a maturity period

upto one year only.

iii) It deals with only those assets which can be converted

into cash readily without loss and with minimum transaction
cost.

iv) Generally transactions take place through phone i.e. oral

communication. Relevant documents and written
communications can be exchanged subsequently. There is no
29
 formal place like stock exchange as in the case of capital
market.

v) Transactions have to be conducted without the help of

brokers.

vi) It is not a single homogeneous market. It comprises of

several submarkets, each specializing in a particular type of
financing. E.g. calls money market, acceptance market, bill
market and so on.

vii) The components of a money market are the Central Bank,

Commercial Banks, non banking financial companies, discount
houses and acceptance houses. Commercial banks generally
play a dominant role in this market.

OBJECTIVES

The following are the important objectives of a money market:

• To provide a parking place to employ short term surplus

funds.

• To provide room for overcoming short term deficits.

• To enable the Central Banks to influence and regular

liquidity in the economy through its intervention in this
market.

• To provide a reasonable access to users of short term

funds to meet their requirements quickly, adequately and at
reasonable cost

IMPORTANCE OF MONEY MARKET

A developed money market plays an important role in the

financial system of a country by supplying short term funds
adequately and quickly to trade and industry. The money
market is an integral part of a countries economy. Therefore, a
developed money market is highly indispensible for the rapid
development of the economy. A developed money market helps
the smooth functioning of the financial system.

I. Development of Trade and Industry

Money market is an important source of financing trade and

industry. The money market, through discounting operations
and commercial papers, finances the short term working
capital requirements of trade and industry and facilitates the

30
 development of industry and trade both national and
international.

II. Development of capital market

The short term rates of interest and the conditions that prevail
in the money market influence the long term interest as well as
the resource mobilisation in the capital market. Hence, the
development of capital market depends upon the existence of
a developed money market.

III. Smooth functioning of Commercial banks

The money market provides the commercial banks with

facilities for temporarily employing their surplus funds in easily
realisable assets. The banks can get back the funds quickly, in
times of need, by resorting to money market. The commercial
banks gain immensely by economising on their cash balances
in hand and at the same time meeting the demand for large
withdrawal of their depositors. It also enables commercial
banks to meet their statutory requirements of cash reserve
ratio and statutory liquidity ratio by utilising the money market
mechanism.

IV. Effective Central bank control

A developed money market helps the effective functioning of

central bank. It facilitates effective implementation of the
monetary policy of a central bank. The central bank, through
the money market, pumps new money into the economy in
slumps and siphons it off in boom. The central bank, thus,
regulates the flow of money so as to promote economic growth
with stability.

V. Formalization of suitable monetary policy

Conditions prevailing in a money market serve as a true

indicator of the monetary state of an economy. Hence, it
serves as a guide to the government in formulating and
revising the monetary policy then and there depending upon
the monetary conditions prevailing in the market.

VI. Non availability source of finance to government

A developed money market helps the government to raise

short term funds through the treasury bills floated in the
market. In the absence of a developed money market, the
government would be forced to print and issue more money or
borrow from the central bank. Both ways would lead to an
increase in prices and the consequent inflationary trend in the
economy.

31
COMPOSITION OF MONEY MARKET

It consists of number of sub markets in which collectively

constitute the money market. There should be competition
within each sub market as well as between different sub
markets. The following are the main sub markets of money
market:

1. Call money market

2. Commercial bills market or discount market

3. Treasury bill market

4. Short-term loan market

Call Money Market

The call money market is a market extremely short period

loans say one day to fourteen days. So, it is highly liquid. The
loans are repayable on demand at the option of either the
lender or the borrower. In India, call money markers are
associated with the presence of stock exchanges and hence,
they are located in major industrial towns like Mumbai,
collated, Chennai, Delhi, Ahmadabad etc., The special feature
of this market is that the interest rate varies from day to day
and even from hour to hour and centre to centre. It is very
sensitive to changes in demand and supply of call loans.

Commercial Bills Market

It is a market for Bills of Exchange arising out of genuine

trade transactions. In the case of credit sale, the seller may
draw a bill of exchange on the buyer. The buyer accepts such a
bill promising to pay at a later date the amount specified in the
bill. The seller need not wait until the due date of the bill.
Instead, he can get immediate payment by discounting the bill.

In India the bill market is under developed. The RBI has taken
many steps to develop a sound bill market. The RBI has
enlarged the list of participants in the bill market. The discount
and finance house of India was set up in 1988 to promote
secondary market in bills. Inspite of all these, the growth of
the bill market is slow in India. There are no specialized
agencies for discounting bills. The commercial banks play a
significant role in this market.

Treasury Bills Market

32
 It is a market for treasury bills which have short term
maturity. A treasury bill is a promissory note or a finance bill
issued by the government. It is highly liquid because its
repayment is guaranteed by the government. It is an important
instrument for short term borrowing of the government. There
are two types of treasury bills namely

i) ordinary or regular and

ii) ad hoc treasury bills popularly known as ‘ad hocs’

Ordinary treasury bills are issued to the public, banks and

other financial institutions with a view to raising resources for
the Central Government to meet its short term financial needs.
Ad hoc treasury bills are issued in favor of the RBI only. They
are not sold through tender or auction. They can be purchased
by the RBI only. Ad hocs are not marketable in India but
holders of these bills can sell them back to RBI. Treasury bills
have a maturity period of 91 days or 182 days or 364 days
only. Financial intermediaries can park their temporary
surpluses in these instruments and earn income.

Short -Term Loan Market

It is a market where short term loans are given to

corporate customers for meeting their working capital
requirements. Commercial banks play a significant role in this
market. Commercial banks provide short term loans in the form
of cash credit and overdraft. Overdraft facility is mainly given
to business people whereas cash credit is given to
industrialists. Overdraft is purely a temporary accommodation
and it is given a sanctioned in a separate account.

FOREIGN EXCHANGE MARKET

The term foreign exchange refers to the process of

converting home currencies into foreign currencies and vice
versa. According to Dr. Paul Einzing “Foreign exchange is the
system or process of converting one national currency into
another, and of transferring money from one country to
another”

The market where foreign exchange transactions take place is

called a foreign exchange market. It does not refer to a market
place in the physical sense of the term. In fact, it consists of a
number of dealers, banks and brokers engaged in the business
of buying and selling foreign exchange. It also includes the
central bank of each country and the treasury authorities who
enter into this market as controlling authorities. Those
33
engaged in the foreign exchange business are controlled by
the Foreign Exchange Maintenance Act. (FEMA)

FUNCTIONS

The most important functions of this market are:

i) To make necessary arrangements to transfer purchasing

power from one country to another.
ii) To provide adequate credit facilities for the promotions of
foreign trade.
iii) To cover foreign exchange risks by providing hedging
facilities.

In India, the foreign exchange business has a three- tired

structure consisting of:

i) Trading between banks and their commercial customers.

ii) Trading between banks through authorized brokers.
iii) Trading with banks abroad.
Foreign exchange market in India comprises of
authorized dealers consisting mainly of commercial banks,
customers and Reserves Bank of India. There are seven major
centers in Mumbai, Delhi, Calcutta, Chennai, Bangalore, Kochi
and Ahmedabad with Mumbai accounting for the major portion
of the transactions. The Foreign Exchange Dealers Association
of India (FEDAI) plays an important role by laying down rules
for commission and other charges. The customer segment is
dominated by Indian Oil Corporation and other public sector
undertakings and Government of India for defense and debt
servicing and large private sector corporate like Reliance, Tata
Group, Larsen and Turbo on the other.

The foreign exchange market has a merchant segment

consisting of transactions put through by customers to meet
their transactions needs of foreign exchange and interbank
segment encompassing about 100 authorized dealers. The
interbank market is dominated by State Bank of India and a
few foreign banks. SBI, along with a few other banks act as
market makers quoting two-way prices in the spot and swap
segments. The normal spot market quote has a spread of 0.5 to
1 paisa while the paisa while the swap quotes available at 2 to
4 paisa spread. The merchant turnover varied between US$ 54
billion in April, 2004 to US $88.6 billion in March, 2005; and the
interbank turnover 4195.7billion to $237 billion. The ratio of
interbank to merchant turnover hovered in the range of 2.7 –
3.6 during the year. While the average daily global turnover
was US $2.4 trillion in 2004, India’s share was 0.3%

34
 Commercial banks finance foreign trade and help
administer the Foreign Exchange Management Act. Apart from
the correspondent or agency relationship with banks abroad,
commercial banks in India maintain accounts abroad to meet
the public’s requirements of foreign exchange. All sales and
purchases of foreign exchange are routed through the
accounts they maintain with the banks is important financial
centers abroad. They quote rates at which they buy and sell
foreign exchange in accordance with the rules and regulations
of the Reserve Bank and Foreign Exchange Dealers Association
of India. The rates quoted depend upon the rates prevailing in
interbank or international markets and the banks’ margin of
profit.

NEW ISSUE MARKET

MEANING

The industrial Securities market in India consists of new issue

market and stock exchange. The new issue market deals with
the new securities which were not previously available to the
investing public, that is, securities that are offered to the
investing public for the first time. The market, therefore,
makes available a new block of securities for the public
subscription in other words; new issue market deals with rising
of fresh capital by companies either for cash or for
consideration other than cash.

The new issue market encompasses all institutions dealing in

fresh claim. These claims may be in the form of equity shares,
preference shares, debentures, price issue, deposits etc. All
financial institutions which contribute, underwrite and directly
subscribe to the securities are part of new issue market.

STOCK EXCHANGE

The stock exchange is a market for old securities i.e. those

which have been already issued and listed on a stock
exchange. These securities are purchased and sold
continuously among investors without involvement of
companies. Stock exchange provides not only free
transferability of shares but also makes continuous evaluation
of securities traded in the market.

DISTINCTIONS BETWEEN NEW ISSUE MARKET AND STOCK

EXCHANGE

The distinctions between new issue market and the stock

exchange can be made on three grounds.

35
• Functional difference –

The new issue market deals with new securities which are
issued for the first time for the public subscription. The stock
exchange provides a ready market for buying and selling of old
securities.

• Organistional difference –

The stock exchanges have physical existence and are located

in particular geographic areas. The stock exchange is a place
where dealers of security meet regularly at appointed time
announced by the market. It is a well established organisation
with rules and regulations for a smooth conduct of the
business. The members are supplied with information about
companies and daily changes in prices of stocks.

The new issue market enjoys neither any tangible nor any
administrative organisational setup nor is subject to any
centralized control and administration for the execution of the
business. It renders service to the lenders and borrowers of
funds at the time of any particular operation and the services
are taken up entirely by banks, brokers and underwriters.

• Nature of contribution to industrial finance –

The new issue market provides the issuing company with funds
for starting a new enterprise or for either expansion or
diversification of an existing one by making a direct link
between companies which require funds and the investing
public. So, the contribution of new issue market is direct. The
role of stock exchange in providing capital is indirect as it
provides marketability to shares.

RELATIONSHIP BETWEEN NEW ISSUE MARKET AND STOCK

EXCHANGE

Despite the above mentioned differences, the new issue

market and the stock exchange are inseparably connected and
work in conjunction with each other.

The new issues first placed in the new issue market can be
disposed off subsequently in the stock exchange. The stock
exchange provides the mechanism for regular and continuous
36
purchase and sale of securities. This facility is of immense
utility to potential investors who are assured that they will be
able to dispose off the allotment of shares at any time. Thus
the two markets are complementary in nature.

Both the markets are connected to each other even at the time
of new issue. The company which makes new issue applies for
listing of shares on a recognized stock exchange. Listing of
shares adds prestige to the firms and widens the market for
the investors. The companies which want stock exchange
listing have to comply with statutory rules and regulations of
the stock exchange to ensure fair dealings in them.

The new issue market and stock market are economically an

integral part of a single market i.e., industrial securities. Both
are susceptible to the common influence of the environmental
conditions such as political stability, economic conditions,
monetary policy of the Central Bank and Fiscal policy of the
government.

FUNCTIONS OF NEW ISSUE MARKET

The main functions of new issue market are to facilitate

transfer of resources from savers to the users. The savers are
individuals, commercial banks, insurance companies etc. The
users are public limited companies and the government. The
new issue market plays an important role in mobilizing the
funds from the savers and transfers them to borrowers for
production purposes, an important requisite for economic
growth. In this basis the new issue market can be classified
as-:

• Market where firms go to the public for the first time for
initial public offering (IPO).

• Market where firms which are already trading raise

additional capital through Seasoned Equity Offering (SCO).

The main function of a new issue market can be divided into a

triple service functions.

1. Origination

Origination refers to the work of investigation, analysis and

processing of new project proposals. Origination starts before
an issue is actually floated in the market. There are two
aspects in this function:-

• A careful study of the technical, economic and financial

viability to ensure soundness of the project. This is a

37
preliminary investigation undertaken by the sponsors of the
issue.

• Advisory services which improve the quality off capital

issues and ensure its success.

The advisory services include:-

• Type of issue

• Magnitude of issue

• Time of floating an issue

• Pricing of an issue

• Methods of issue

• Technique of selling the security

The function of origination is done by merchant bankers who

may be commercial banks, All India Financial Institutions or
private firms. The origination itself does not guarantee the
success of the issue. Underwriting, a specialized service is
required in this regard.

2. Underwriting

Underwriting is an agreement whereby the underwriter

promises to subscribe a specified no. of shares or debentures
of a specified amount of stock in the event of public not
subscribing to the issue. If the issue is fully subscribed then
there is no liability for the underwriter. If a part of share issues
remains unsold, the underwriter will buy the shares. Thus,
underwriting is a guarantee for the marketability of shares.

METHODS OF UNDERWRITING

• Standing behind the issue –

Under this method the underwriter guarantees the sale of a

specified no. of shares within a specified period. If the public
do not subscribe to the specified amount of issue, the
underwriter buys the balance in the issue.

• Outright purchase –

The underwriter, in this method, makes outright purchase of

shares and resells them to the investors.
38
• Consortium method –

Underwriting is jointly done by a group of underwriters in this

method. The underwriters form a syndicate for this purpose.

ADVANTAGES OF UNDERWRITING

• The issuing company is relieved from the risk of finding

buyers for the issue offered to the public. The company is
assured of raising adequate capital.

• The company is assured of getting minimum subscription

within the stipulated time, a statutory obligation to be fulfilled
by the issuing company.

• Underwriters undertake the burden of highly specialised

function of distributing securities.

• They provide expert advice with regard to timing of

security issue, the pricing of issue, the size and types of
securities to be issued.

• Public confidence on the issue is enhanced when

underwritten is done by reputed underwriters.

The underwriters in India may be classified into two

categories:-

• Institutional underwriters

• Non – institutional underwriters

The institutional underwriters are Life Insurance Corporation of

India, Unit Trust of India, and Industrial Development Bank of
India. The non institutional underwriters are brokers. They
guarantee shares only with a view to any commission from the
company floating the issue. The brokers work with profit
motive in underwriting industrial securities.

Distribution

It is the function of sale of securities to ultimate investors. This

service is performed by rolers and agents who maintain a
regular and direct contact with ultimate investors.
39
 METHODS OF FLOATING NEW ISSUES

i) Public issue

ii) Offer for sale

iii) Placement

iv) Rights issue

1) Public issue

Under this method, the issuing company directly offers to the

general public/institutions a fixed number of shares at a stated
price through a document called prospectus.

The prospectus must state the following:

1. Name of the company

2. Address of the registered office

3. Existing and proposed activities

4. Location of the industry

5. Names of directors

6. Authorised and proposed issue capital to the public

7. Dates of opening and closing the subscription list

8. Min subscription

9. Names of brokers/underwriters/bankers/managers and

registers to issue

10. Statement by the company that it will apply to stock

exchange for quotation of shares.

Merits of issue through prospectus

1. Sale through prospectus has the advantage of inviting a

large section of the investing public through advertisement.

2. It is a direct method and no intermediaries are involved.

3. Shares are allotted to a large section of investors on a non

discriminatory basis.

Demerits

40
 1. It is an expensive method.

2. This method is suitable only for large issues.

2) Offer of sale

The method of offer of sale consists in outright sale of

securities through the intermediary of issue houses or
sharebrokers. In other words, the shares are not offered to the
public directly.

Price is called turn or spread. It is otherwise called Bought Out

Deals (BOD).

Let us take a simple example. ‘X’ a small company has a

turnover of RS.2 crore a year. It requires additional funding of
Rs.8 crore to expand its capacity. The merchant banker sees
potential business for the company. He asks the promoter of
the company to sell 8 lakh shares of its capital to it. The
company gets 8crore to expand its business. The merchant
banker or issue house is now holding 80% of the company’s
entire capital, in 12 months time. The company expanded its
operation marketed its products successfully and earned
sufficient profits. Now, the issue house decides to offload the
80% capital to the public at a premium of Rs.30 per share. In a
period of 18 months the merchant banker or the issue house
has earned a profit.

ADVANTAGES:

Bought Out Deal (BOD) enables an issuer with good project to

obtain funds with a minimum cost without the fear of
undersubscription. The intermediary i.e. Merchant banker or
issue houses get higher return than the conventional merchant
banking services.

Indbank Merchant Banking had gone in for a buy out

agreement with Madhya Pradesh based distillery to buy shares
worth Rs.2.5 crore each at Rs 60/- . After six months the shares
were sold at Rs 71.50 per share with a assured return of
38.33% for the sponsor.

The advantages of this method:

1) The company is relieved from the problem of printing

2) Advertisement of prospectus and making allotment of

shares.

41
 Offer for sale is not common in India. This method is used
generally in two instances:

1) Offer by a foreign company of a part of it to Indian

investors

2) Promoters diluting their stake to comply with

requirements of stock exchange at the time of listing of
shares.

3) Placement:

Under this method, the issuer house or brokers buy the

securities outright with the intention of placing them with their
clients afterwards. Here the brokers act as almost wholesalers
selling them in retail to the public. The brokers would make
profit in the process of reselling to the public. The Issuer
House or brokers maintain their own list of clients and through
customer contact sell the securities. There is no need for a
formal prospectus as well as underwriting agreement.

Placement has the following advantages:

1) Timing of issue is important for successful floatation of

shares : in a depressed market conditions when the issues are
not likely to get public response through prospectus,
placement method is a useful method of floatation of shares.

2) This method is suitable when small companies issue their

shares

3) It avoids delay involved in public issue and it also reduces

the expenses involved in public issue.

4) There are no entry barriers for a company to access the

private placement market. This route is also available to
unlisted and closely held public companies.

5) A private placement deal can be successfully executed

much faster than a public offering. The procedural formalities
for a private placement are minimal. A private placement deal
can be successfully closed in 4 to 6 weeks.

6) There is greater flexibility in the working out its terms of

the issue. The issues deals with only a few institutional
investors and hence renegotiating the terms of issue is easy

42
 7) This method is also suitable to first generation
entrepreneurs who are less known to the public which makes
the public issue less successful.

8) The issue expense in case of private placement is low. The

absence of several statutory and non statutory expenses
associated with underwriting, brokerage, printing, promotion
etc. makes the transaction cost of private placement
approximately to 2% of the total cost of issue.

The main disadvantage of this method is that the securities are

not widely distributed to the large section of investors. A
selected group of small investors are able to buy a large
number of shares and get majority holding in a company.

This method of private placement is used to a limited extend in

India. The promoters sell the shares to their friends, relatives
and well wishers to get minimum subscription which is a
precondition for issue of shares to the public.

Reliance industries raised the highest amount by way of

private placement of equity shares. It raised Rs. 945 crore by
privately placing shares with three financial institutions of
which UTI was the most important.

In the public sector, Konkan Railway Corporation placed tax

free bonds worth Rs.70 crore with banks and financial
institutions.

4) Rights Issue:

Rights issue is a method of raising funds in the market by an

existing company.

A right means an option to buy certain securities at a certain

privileged price with a certain specified period. Shares so
offered to the existing shareholders are called rights shares.

Rights shares are offered to the existing shareholders in a

particular proportion to their existing share ownership. The
ratio in which the new shares or debentures are offered to the
existing share capital would depend upon the requirement of
capital. The rights themselves are transferable and saleable in
the market.

Section 81 of the Companies Act deals with rights issue,

According to this section, where a company increases the
subscribed capital by the issue of new shares either after two
years of its formation or after one year of its first issue of
share whichever is earlier, these have to be first offered to the

43
existing shareholders with the right to reserve them in favour
of a nominee.

A company issuing rights is required to send a circular to all

existing shareholders. The circular should provide information
on how additional funds would be used and their effect on the
earning capacity of the company. The company should
normally give a time limit of atleast one month to two months
to shareholders to exercise their rights. If the rights are not
fully taken up, the balance is to be equitable still left over may
be disposed off in the market in a way which is most beneficial
to the company.

Advantages:

1) The cost of issue is minimal. There is no underwriting,

brokerage, advertising and printing of prospectus expenses.

2) It ensures equitable distribution of shares to all existing

shareholders and so control of company remains undistributed
as proportionate ownership in the company remains the same.

3) It prevents the directors from issuing new shares in their

own name or to their relatives at a lower price and get
controlling right.

SEBI GUIDELINES FOR ISSUE OF SECURITIES

SEBI has issued detailed guidelines in respect to issue of

securities to public. The guidelines were first issued on 11th
June 1992 and were amended subsequently from time to time.
SEBI as now issued consolidated guidelines as SEBI (Disclosure
and Investor Protection) guidelines 2000 vide its circular No. 1
dated 19-1-2000. These guidelines shall be applicable to all
public issues by listed and unlisted companies, all offers for
sale and rights issues by listed companies whose equity share
is listed, except in case of rights issues where the aggregate
value of securities offered does not exceed Rs.50 lacs. Broadly
there are three methods for issuing securities to the public (a)
conventional mode of receiving applications through bankers
(b) book building and (c) on line system of stock exchange (e-
IPO).

(I) Eligibility norms for companies issuing securities

(a) Filling of offer documents

44
1) No company shall make any public issue of securities,
unless a draft prospectus has been filed with the Board,
through an eligible merchant banker at least 21 days prior to
the filing of Prospectus with the Register of Companies.

2) No listed company shall make any issue of securities

through a rights issue where the aggregate value of securities,
including premium, if any, exceeds Rs 50 lacs unless the letters
of offer is filed with the Board, through an eligible merchant
banker at least 21 days prior to the filing of the letter of offer
to the Regional Stock Exchange.

3) No company shall make an issue of securities if the

company has been prohibited from accessing the capital
market under any order or direction of the Board

4) No company shall make any public issue of securities

unless it has made an application for listing of those securities
in the stock exchange.

5) No company shall make public or rights issue or an offer

for sale of securities, unless the company enters into an
agreement with a depository for dematerialisation of
securities, and the company gives option o investors to receive
the security certificates in dematerialised form with a
depository.

6) No company shall make a public or rights issue of equity

shares unless all the existing partly paid up shares have been
fully paid or forfeited in the specified manner.

7) No unlisted company shall make a public issue an equity

share, if there are any outstanding financial instruments or any
other right which would entitle the existing promoters or
shareholders any option to receive equity share capital after
the initial public offering.

8) Companies not fulfilling the aforesaid condition cab raise

their funds by listing in Over the Counter Exchange of India
(OTCEI).

(b) Public issue by unlisted companies

45
An unlisted company shall make a public issue of any equity
shares or any security convertible into equity shares at a later
date subject to the following:

1) It has a pre issue net worth of not less than Rs.1 crore in
three out of preceding five years, with a minimum net worth to
be met during immediate preceding two years.

2) It has a track record of distributable profits in terms of

section 205 of the companies Act 1956 for at least three out of
immediately preceding five years

3) The issue size i.e. offer through offer document + firm

allotment + promoters contribution through offer document
does not exceed five times the pre issue net worth

4) If an unlisted company does not comply with the

conditions to track record or is its size exceeds five times the
pre issue net worth, it can make a public issue of equity shares
or any security convertible into equity shares at a later date
only through the book building process provided that 60% of
the issue size shall be allotted to the qualified institutional
investor otherwise the full subscription moneys shall be
refundable.

(c) Public issue by listed companies

1) A limited company shall be eligible to make a public issue

of equity shares or any security convertible into equity shares
provided that the issue size does not exceed five times its pre
issue net worth.

2) If a company does not fulfil the above condition of issue

size it shall be eligible to make a public issue only through the
book building process provided that 60% of the issue size shall
be allotted to qualified institutional buyers

3) Special provisions have been laid in respect of companies

in the IT sector.
46
(II) Pricing by companies issuing securities:

1) There is no restriction on the price at which shares can be

issued. The price can be decided freely by the issuer company
and the lead managers

2) A company may charge different prices for firm allotment

and public offer, however price for firm allotment should be
higher than the price at which public offer is made

3) A listed company making a composite issue of capital may

issue securities at different prices in its public and rights
issues

4) Issuer Company can mention a price bond of 20% in the

offer documents with the Board and actual price can be
determined at a later date before filing of the offer document
with Register of Companies. The final offer document should
contain only one price

5) No payment, direct or indirect in the nature of a discount,

commission, allowance or otherwise shall be made either by
the issuer company or the promoters in any public issue, to the
persons who have received firm allotment in such public issue

6) An eligible company is free to make public or rights issue

of shares in denominations of Re 1, Rs 5, Rs 10, Rs 50 or Rs
100 etc. If shares are issued in demat form. The shares cannot
be issued or altered to a denomination of decimal of a rupee.

(III) Promoters contribution:

1) In a public issue by an unlisted company or offer for sale,

the promoters shall contribute not less than 20% of the post
issue capital

2) In case of public issues or composite issues by listed

companies the promoters shall participate to the extent of 20%

47
of the proposed issue or ensure post issue shareholding to the
extent of 20% of the post issue.

3) If promoters have acquired equity during proceeding

three years for consideration there than cash or by way of
bonus shares, such shares shall not be considered for
computation of promoters’ contribution.

4) In case of public issue by unlisted companies, securities

which have been issued to the promoters during the preceding
one year, at a price lower than the price at which equity is
being offered to public shall not be eligible for computation of
promoters’ contribution. However, if promoters bring the
difference, after passing necessary resolutions and filing of
revised returns of allotment the shares shall be considered
eligible.

5) Promoters’ shall bring in full amount of promoters

contribution including premium at least one day prior to the
issue opening date which shall be kept in an escrow account
with a scheduled commercial bank and the said amount shall
be released to the company along with the public issue
proceeds:

Provided that where the promoters’ contribution has been

brought prior to the public issue and has already been
deployed by the company, the company shall give the cash
flow statement in the offer document disclosing the use of
such funds.

Provided further that where the promoters’ minimum

contribution exceeds Rs.100 crores the promoters shall bring
in Rs. 100 crores before the opening of the issue and the
remaining contribution shall be brought in by promoters in
advance on pro rata basis before the calls are made on public.

6) The requirement of promoters’ contribution shall not be

applicable if (a) the company is listed on a stock exchange for
at least 3 years and has a track record of dividend payment for
at least three immediately preceding years. (b) in case of
companies where no identifiable promoter or promoter group
exists (c) in case of right issue. However, in case of (a) and (c)
the promoters shall disclose existing shareholding in the offer
document.

48
(IV) Lock – in of minimum specified promoters contribution

1) The lock in shall start from the date of allotment in the

proposed public issue and last date of the lock shall be
reckoned as three years from the date of commencement of
commercial production or the date of allotment in the public
issue whichever is earlier. Thus, the normal lock in period is 3
years.

2) In case of a public issue by unlisted company, if the

promoters contribution in the proposed issue exceeds the
required minimum contribution, such excess contribution shall
also be locked in period of 1 year

3) In case of a public issue by a listed company, excess shall

be locked in for a period of 1 year as per the lock in provisions
prescribed in guidelines on preferential issues

4) If shortfall in firm allotment category is met by the

promoters it will be locked- in for a period of one year

5) Securities issued last will be locked in first

6) The entire pre issue share capital, other than that locked
in as promoters contribution, shall be locked-in for a period of
one year from the date of commencement of commercial
production or the date of allotment in the public issue,
whichever is later

7) Locked-in securities held by promoters may be pledged

only with banks or financial institutions as collateral security
for loans

8) Transfer of locked in securities amongst promoters as

named in the offer document, can be made subject to the lock-
in being applicable to the transferees for the remaining period
of lock-in

9) The securities which are subject to lock-in shall carry

inscription ‘non-transferable’ along with duration on the fare
of the security certificates.

49
 (V) Pre issue and post issue obligations

SEBI has issued detailed guidelines with regard to both pre-

issue obligations as well as appointment of ‘lead merchant
banker’ to manage the public issue is compulsory. The lead
merchant banker is responsible for following various guidelines
issued by SEBI. He is expected to exercise due diligence and
the standard of due diligence shall be such that the merchant
banker shall satisfy himself about all aspects of offering,
veracity and adequacy of disclosure in the offering documents.
The liability of the merchant banker continues even after the
completion of issue process.

1. Documents to be submitted: The lead manager shall submit

following documents to SEBI:

i. Memorandum of Understanding (MOU) between lead merchant

banker and Issuer Company specifying their mutual rights,
liabilities and obligations relating to the issue.

ii. Due diligence certificate by lead merchant banker as specified

in schedule III along with draft prospectus.

iii. Certificates signed by the company secretary or chartered

accountant in case of listed companies making further issue of
capital with regard to (a) dispatch of all refund orders of
previous years in time and in prescribed manner, (b) dispatch
of security certificates, and (c) listing of securities on the stock
exchange.

iv.A list of persons who constitute the promoters group and their
individual share holdings.

v. Draft prospectus in computer floppy in prescribed manner.

vi.Ten copies of draft offer document.

vii. The issuer shall submit an undertaking to the Board to the

effect that transactions in securities by promoter, the
promoter group and the immediate relatives of promoters
between the date of filing of offer documents with registrar of

50
 companies or Stock Exchange as the case maybe and the date
of closure of issue will be reported to stock exchange within 24
hours of the transaction.

2. Appointment of intermediaries: In case a public or rights issue

managed by more than one merchant banker, the rights
obligations and responsibilities of each merchant banker shall
be demarcated as specified in Schedule II. Other intermediaries
such as advisors, bankers to the issue, registrars,
underwriters, etc shall be appointed in consultation with lead
merchant banker.

3. Underwriting: Underwriting of public issue is not mandatory.

However, if an issue is underwritten, the unsubscribed portion
has to be purchased by the underwriters. In respect of every
underwritten issue, the lead merchant banker shall undertake
a minimum underwriting obligation of 5% of the total
underwriting commitment or Rs. 25lacs whichever is less. The
outstanding underwriting commitments of a merchant banker
should not exceed 20 times its net worth at any point of time.

4. Offer documents to be made public: the draft offer filed with the
Board shall be made public for a period of 21 days from the
date of filing the offer document with the Board. The lead
merchant banker shall also fill the draft offer document with
the stock exchange where the securities are proposed to be
listed; and make it available to the public.

5. Appointment of the Compliance Officer: An issuer company shall

appoint a compliance officer who shall directly have liaison
with the Board with regard to compliance with various laws,
rules, regulations and other directives issued by the Board.

6. Mandatory collection centers: the minimum number of collection

centers for issue of capital shall be (a) four metropolitan cities
situated in Mumbai, Delhi, Calcutta and Chennai; (b) all such

51
 centers where the stock exchanges are located in the region in
which registered office of the company is situated.

7. Final offer of the Document: the offer document/prospectus

shall be finalized on the basis of complaints received and
observations made by SEBI, if any. Lead manager shall certify
that all amendments, suggestions or observations made by
SEBI have been carried out. Final prospectus is to be submitted
with the Registrar of Companies and the offer document with
the regional stock exchange.

8. Application forms: Application for must be accompanied by

abridged prospectus. Disclaimer clause of SEBI should be
printed in bold. Highlights and risk factors should be given
same prominence. It should also contain instruction to mention
application form number on the back of the cheque, demand
draft or the stocks invest as the case maybe.

9. Listing of securities: Minimum application money to be paid by

the applicant along with application shall not be less than 25%
of issue price. Application for shares or debenture should be
for such a number that total amount payable is not less than
Rs. 2000.

10.Listing of securities: The securities of public issues shall be

listed in the stock exchange. In case these are not listed,
entire application money becomes refundable.

11.Period of Subscription: subscription for public issues shall be

kept open for at least 3 working days and not more than 10
working days. However, in case of infrastructure company, it
may be kept open for 21 working days.

12.Oversubscription: The quantum of issue whether through a

rights or a public issue shall not exceed the amount specified
in the prospectus/letter of offer, however an oversubscription

52
 to the extent of 10% of the net offer to public is permissible for
the purpose or rounding off to the nearer multiple of 100 while
finalizing the allotment

Provisions of the SCRA and the SEBI and also the bye-laws and
regulations duly approved by the Government.

Any stock exchange which needs recognition under the SEBI

act has to submit an application in the prescribed manner to
the Central Government. This application must be accompanied
by the following documents:

i. A copy of the bye-laws of the stock exchange for its

operations

ii. A copy of the rules relating to its constitution, governing

body, powers and duties of the office-bearers, the admission
procedures etc.

GRANT OF RECOGNITION

Recognition will be granted by the Central Government

provided the following conditions are fulfilled:

i. The rules and bye-laws of the stock exchange applying for

registration must ensure fair dealing and protect the interest
of investors.

ii. The stock exchange concerned must be willing to comply

with any other conditions that may be imposed by the
government from time to time.

iii. The grant of recognition must be in the interest of trade

as well as in the public interest.

While granting recognition, the central government may

prescribe conditions regarding the qualifications for
membership, the method of entering into contracts, the
representation of the central government on the stock
exchange and the maintenance of accounts and their audit.

RENEWAL OF RECOGNITION

If any stick exchange intends to renew its recognition, it must

once again make an application to the central government in
the aforesaid manner three months before the expiry of the
period of recognition.

WITHDRAWAL OF RECOGNITION

53
 The central government may withdraw the recognition granted
to any stock exchange at any time if it opines that the
recognition granted is against the interest of trade or public
interest. While doing so, it must give sufficient opportunity to
the governing body of the stock exchange to explain its
position. However, such a withdrawal will have no effect on the
contracts entered into before the date of withdrawal.

I. ORGANISATION OF STOCK EXCHANGES IN INDIA

The first organized stock exchange in India was started in

Bombay in 1875 with the formation of the ‘native share and
stock broker’s association’. Thus the Bombay stock exchange
is the oldest one in the country. With the growth of joint stock
companies, the stock exchanges also made a steady growth
and at present there are 23 recognized stock exchanges with
about 6000 stock brokers.

TRADITIONAL STRUCTURE OF STOCK EXCHANGES

The stock exchanges in India can be classified into two broad

groups on the basis of their legal structure. They are:

i. Three stock exchanges which are functioning as

Association of Persons (AOP) viz. BSE, ASE and Madhya
Pradesh Stock Exchange

ii. Twenty stock exchanges which have been set up as

companies, either limited by guarantees or by shares. They
are:

Bangalore stock exchange

Bhubaneswar stock exchange

Calcutta stock exchange

Cochin stock exchange

Coimbatore stock exchange

Delhi stock exchange

Gauhati stock exchange

Hyderabad stock exchange

Interconnected stock exchange

Jaipur stock exchange

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 Ludhiana stock exchange

Madras stock exchange

Magadh stock exchange

Mangalore stock exchange

National stock exchange

Pune stock exchange

OTCEI

DEMUTUALISATION OF STOCK EXCHANGES

The transition process of an exchange from a ‘mutually-

owned’ association to a company ‘owned by shareholders’ is
called demutualization .

In other words, transforming the legal structure of an

exchange from a mutual form to a business corporation form is
referred to as demutualization.

In a mutual exchange, the three functions of ownership,

management and trading are intervened into a single group. It
means that the broker members of the exchange are the
owners as well as traders on the exchange and further they
themselves manage the exchange. These three functions are
segregated from one another after demutualization. The
demutualised stock exchanges in India are:

i. The National Stock Exchange (NSE)

ii. Over The Counter Exchange of India (OTCEI)

CORPORATISATION OF STOCK EXCHANGES

The process of converting the organizational structure of the

stock exchange from a non-corporate structure to a corporate
structure is called Corporatization of stock exchanges. As
stated earlier, some of the stock exchanges were established
as ‘Association of persons’ in India like BSE, ASE and MPSE.
Corporatization of these exchanges is the process of
converting them into incorporated companies.

MANAGEMENT

The recognized stock exchanges are managed by ‘Governing

Boards’. The governing boards consist of elected member
directors from stock brokers’ members, public representatives
55
 and government nominees nominated by the SEBI. The
government has also powers to nominate Presidents and Vice-
Presidents of stock exchanges and to approve the appointment
of the Chief Executive and public representatives. The major
stock exchanges are manages by the Chief Executive Director
and the smaller stock exchanges are under the control of a
Secretary.

The governing boards have wide powers such as :

i. Election of office bearers and setting up of committees

like Listing Committee, Arbitration Committee, Defaulter’s
Committee etc.

ii. Admission and expulsion of members

iii. Management of the properties and finances of the

exchange

iv. Framing and interpretation of rules, bye-laws etc. for the

regulation of stock exchange

v. Adjudication of disputes among members or outsiders

vi. Management of the affairs of the exchange in the best

interest of the investors and public interest.

MEMBERSHIP

To become a member of a recognized stock exchange, a person

must possess the following qualifications:

i. He should be a citizen of India

ii. He should not be less than 21 years of age

iii. He should not have been adjudged bankrupt or insolvent

iv. He should not have been convicted for an offence

involving fraud or dishonesty

v. He should not be engaged in any other business except

dealing in securities

vi. He should not have been expelled by any other stock

exchange or declared a defaulter by any other stock exchange.

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Apart from individuals a company is also eligible to become a
member provided it satisfies the conditions imposed by the
stock exchange concerned.

II. LISTING OF SECURITIES

Listing of securities means that the securities mean that the

securities are admitted for trading on a recognized stock
exchange. Transactions in the securities of any company
cannot be conducted on stock exchanges unless they are listed
the green signal given to selected securities to get the trading
privileges of the stock exchange concerned. Securities become
eligible for trading only through listing.

Listing is compulsory for those companies which intend to offer

shares/debentures to the public for subscription by means of
issuing a prospectus. Moreover, the SEBI insists on listing for
granting permission to a new issue by a public limited
company. Again, financial institutions do insist on listing for
underwriting new issues. Thus, listing becomes an unavoidable
one today.

The companies which have got their shares or debentures

listed in one or more stock exchanges must submit themselves
to the various regulatory measures of the stock exchange
concerned as well as the SEBI. They must maintain necessary
books; documents etc. and disclose any information which the
stock exchange may call for.

GROUP A, GROUP B AND GROUP C SHARES (BSE)

The listed shares are generally divided into two categories

namely

1. Group A Shares (Specified shares or cleared securities)

2. Group B shares (Non-specified shares or non-cleared

securities)

Group A shares represent large and well establish companies

having a broad investor base. These shares are actively traded.
Naturally, these shares attract a lot of speculative multiples.
These facilities are not available to Group B shares. However,
shares can be moved from Group B to Group A and vice-versa
depending upon the criteria for shifting. For instance, the BSE
has laid down several criteria for shifting shares from Group B
to Group A, such as, an equity base of Rs.10 Crores and a
market capitalization of Rs.25 to 30 crores, a public holding of
35 to 40%, share holding population of 15000 to 20000, a good
dividend paying status etc. Group B2 shares are again divided
into B1and B shares on the Bombay Stock Exchange B1 shares

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represent well-traded scrip’s among the B group and they have
weekly settlement.

Apart from the above, there is another group called Group C

shares. Under Group C, only lots and permitted securities are
included. A number of shares that are less than the market lot
are known as odd lots. Markets lot refers to the minimum
number of shares of a particular security that must be
transacted on a stock exchange. Odd lots have settlement once
in a fortnight or once on Saturdays. Permitted securities are
those that are not listed on a stock exchange but are listed on
other stock exchanges in India. So they are permitted to be
traded on this stock exchange. Odd lots cannot be easily
transacted on the stock exchange and so they are illiquid in
nature.

Advantages of Listing

The advantages of listing may be summarized as follows:

(i)Facilitates buying and Selling Securities

Listing paves way for easy buying and selling of securities.

Constant marketing facilities are assured for listed securities.

(ii)Ensures Liquidity

The prices of listed securities are quoted daily in the market.

Hence, securities cab be converted into cash readily at quoted
prices and thus listing ensures liquidity.

(iii)Offers wide Publicity

Listed securities give wide publicity to the companies

concerned. It is so because the names of listed companies are
frequently mentioned in stock market reports, T.V.,
Newspapers, Radio, etc. this has an advertising effect for such
companies and this will automatically widen the market for
their securities. According to Hasting, “A listed security will
receive more attention from investment advisory services than
an unlisted one”

(iv)Assures Finance

The very fact that a security is listed in a recognized stock

exchange adds the prestige of that company and it enables the
company to raise the necessary finance by the issue of such
securities expeditiously.

(v)Enables Borrowing

Listed securities are preferred as collateral securities by

commercial banks and other lending institutions because they
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are rated high in market quotations and there is a ready
market for them also. Thus borrowings are made easier against
the securities of the listed companies.

(vi)Protects Investors

Listing companies have to necessarily submit themselves to

the various regulatory measures by disclosing vital information
about their assets, capital structure, profits, dividend policy,
allotment procedure, bonuses etc. hence, listing aims at
protecting the interest of investors to a greater extent.

Drawbacks

At the same time, listing brings some bad effects also. The
disadvantages of listing are as follows:

(i)Leads to Speculation

Listed securities offer wide scope for the speculators to

manipulate the values in such a way as may be detrimental to
the interests of the company. In such a situation, artificial
forces play a more dominant role than the free market forces.
The stock market may not reflect the true picture of a listed
security. Again, the managerial personnel may themselves
indulge in speculative activities with regard to listed securities
by misusing the inside information available to them.

(ii)Degrades Company’s Reputation

Some times listed securities are subject to wide fluctuations in

their values. They may become a victim of depression. They
are immediately reflected on the stock exchange whereas
unlisted securities escape from this misery. These wide
fluctuations in their values have the effect of degrading the
company’s reputation and image in the eyes of the public as
well as the financial intermediaries.

(iii)Discloses Vital Information to Competitors

For getting the securities listed, a company has to disclose

vital informations such as, dividends and bonuses declared, a
brief history of the company, sales, remuneration to
managerial personnel and so on. It amounts to leaking of
secrecy of the company’s operations to trade rivals. Even trade
unions may demand higher wages and bonus on the basis of
these informations. Thus, listing may prove disadvantageous
to a company.

Listing Procedure

As stated earlier, listing enables a company to include its

securities in the official list of one or more recognized stock
59
 exchanges of the purpose of trading. A company which
requires its securities to be listed must comply with the
following formalities:

The company concerned must apply in the prescribed form

along with the following documents and details:

(i) Certified copies of Memorandum and Articles of Association,

Prospectus or Statement in lieu of Prospectus, Underwriting
agreements, agreements with vendors and promoters etc.

(ii) Specimen copies of shares and debenture certificates, letter of

call, allotment, acceptance and renunciation.

(iii) Copies of balance sheets and audited accounts for the last 5
years.

(iv) Copies of offers for sale and circulars or advertisements

offering any securities for subscription or sale during the last 5
years.

(iv) Certified copies of agreements with managerial personnel.

(v) Particulars of dividends and bonuses paid during the last 10

years.

(vii) A statement showing dividends or interest in arrears if

any.

(viii) A brief history of the Co since its incorporation, giving

details of its activities.

(ix) Particulars regarding its capital structure.

(x) Particulars of shares and debentures for which

permission to deal is applied.

(xi) A statement showing the distribution of shares along with

a list of highest 10 holders of each class or kind of securities of
the company stating the number of securities held by them.

(xii) Particulars of shares forfeited.

(xiii) Certified copies of agreements if any with the Industrial

Finance Corporation, ICICI etc.

(xiv) Listing agreement with the necessary initial and annual

listing fee.

REGISTRATION OF STOCK BROKERS:

A broker is none other than a commission agent who transacts

business in securities on behalf of his clients who are non

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 members of a stock exchange. Thus, a non-member can
purchase and sell securities only through a broker who is a
member of stock exchange. To deal is securities on recognized
stock exchanges; the broker should register his name as a
broker with the SEBI. A stock broker must possess the
following qualifications to register as a broker:

1. He must be an Indian citizen with 21 years of age.

2. He should neither be a bankrupt nor compounded with

creditors.

3. He should not be convicted for any offence, fraud etc.

4. He should not have engaged in any other business other

than of a broker in securities.

5. He should not be s defaulter of any stock exchange.

6. He should have completed 12th standard examination.

FUNTIONS OF THE BROKERS

The following are the important functions generally performed

by all the brokers.

I. Client registration:

First of all, a trading broker has to enter into an agreement in

the specified format with his client before accepting any orders
on his clients’ behalf. The said agreement has to be executed
on Non-judicial stamp paper, duly signed by both the parties
on all the pages. In addition to that agreement, the broker
shall seek other information about the client in the client
registration form. The information may relate to:

• Investors financial profile

• Investors risk profile and risk taking ability.

• Investor’s social profile.

• Investor’s identification details.

• Family, income, age and employment details.

• Details of investments in other assets

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 • Financial liabilities etc.

The broker has to obtain recent passport photos (3 copies) in

the case of individual clients and of all partners in case of
partnership firms. In case of corporate customers, he has to
obtain the photos of dominant promoters. The broker should
not forget to take proof of identification of the client. It is also
mandatory to give an unique code for each client for easy
identification. There is no limit on the maximum number of
clients for a broker.

II. Obtaining margin money:

It is also mandatory for the broker to collect margins from his

clients in all cases where the margin in respect to the client in
settlement, would work out to be more than Rs. 50,000. The
margins so collected must be kept separately in the client’s
bank account and it must be utilized to make
payment/settlement in respect of that client.

III. Execution of orders:

The important function of a broker is to execute his clients

orders swiftly and carefully. Hence, he has to obtain clear cut
confirmed order instructions from the clients so that the
necessary orders may be placed on the system. To execute a
trade order for a client, the broker must obtain specific
instructions as to:

• The name of the company whose securities have to be

bought or sold.

• The precise number of shares required.

• The limit /market price condition etc.

IV. Supply of necessary slips:

On the execution of trade, the broker, i.e., the trading member

should inform his client the order number. He should also give
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 copies of the trade confirmation slip, modification slip,
cancellation slip etc. to enable the client to take necessary
follow up action.

V. Issue of contract note:

The broker should then issue the contract note to his clients
for all trades, whether purchase or sale of securities, executed
with all relevant details. This contract note should be issued
within 24 hrs of the execution of the contract. It should be duly
signed by the broker or his authourised signatory or client
attorney. Each broker is expected to maintain a duplicate copy
of each contract note issued for 5 yrs.

VI. Statement of particulars in a contract note:

It is mandatory to mention the following particulars in a

contract note issued by a dtock exchange.

• The name, address and SEBI registration number of the

member broker.

• The name of partner/proprietor/authorized signatory

• Dealing office address, tel. no, fax no code no, of the

member given by the exchange.

• Unique identification number

• Contract number, date of issue of contract note,

settlement number and a period for settlement.

• Clients name and code number

• Order number and order time corresponding to trade

• Trade member and trade time

• Quantity and kind of security bought or sold by the client

• Purchase/sale rate and brokerage

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 • Service tax rates and any other charges levied by the
broker

• Affixing of appropriate stamps on the original contract

note as per the Stamp Act of the relevant state.

• Addition of a clause stating that ‘the client will hold the

security blank at his own risk’.

VII. Payment/delivery of securities:

It is the duty of every trading member (broker) to make

payments to his clients (in the case of sale) or deliver the
securities purchased within 24 hrs to pay out unless the client
has requested otherwise. All brokers have to exercise a great
caution in accepting deliveries of securities on behalf of their
clients to avoid the introduction of any fake/forged/stolen
securities into the market.

VIII. Charging of brokerage and other charges:

As per the SEBI guidelines, every broker is entitled to charge

brokerage not exceeding 2.5%. in addition to brokerage, the
following items are charged:

1. Service tax (5% of the brokerage)

2. Stamp duty as per the Stamp Act of the State

Government.

3. SEBI turnover fee

4. Transaction tax as presented by the Central Government

(Rs 1500 per crore trade)

IX. Maintenance of bank Account:

It is the function of a broker to maintain separate bank

accounts for his client’s funds and also for his own funds.
However, funds can be transferred from the client’s accounts
to the clearing accounts for the purpose of meeting pay in

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 obligations on behalf of the clients and vice versa in the case
of funds pay out.

X. Receipt of interest, dividends, rights etc.

In case securities are brought cum vouchers, cum coupons,

cum dividend, cum cash, cum bonus issues, cum rights etc.,
the client is entitled to receive all vouchers, coupons, dividend,
cash, bonus etc. in addition to original securities bought. In
such a case, it is the duty of the broker to receive all such
privileges on behalf of his client

XI. Settlement of Disputes:

In case any disputes arise between the broker and his client, it
is the duty of the broker himself to take the initiative and
resolve the dispute.

Kinds of offer document:

An offer document means ‘prospect’ in case of public issue or

an offer for sale and letter of offer in case of right issue, which
is required to be filled with the Register of Companies(ROC)
and stock Exchange. An offer document covers all relevant
information to help an investor in making wise investment
decision.

Draft Prospects: A company before making any public issue of

securities, shall file a draft prospect with SEBI, through an
eligible merchant bank, at least 21 days prior to the filing of
prospectus with the ROC .If any specific changes are suggested
by SEBI within said 21 days, the issuing company or the lead
merchant banker shall carry out such changes in the draft
prospects before filling the prospect with ROC.

Draft letter of offer: A listed company before making any right

issue for an amount exceeding Rs. 50 lakhs shall file a Draft
letter of offer with SEBI at least 21 days prior to the filing of
65
prospectus with the regional stock exchange and shall carry
out any changes as suggested by SEBI before filling the draft
offer letter with regional stock exchange.

Prospectus: A company issuing shares to public must issue

Prospects. It is an invitation to the public to take shares, or
debentures in the company or deposit money in the company.

Definition- “any document described or issued as a prospect

and includes any notice, circular, advertisement or other
document inviting deposit from the public or inviting offers
from the public for subscription or purchase of share in, or
debentures of , a body corporate.”

Abridged Prospectus: sec (2) of the company’s act 1956

defines abridged prospectus as “a memorandum containing
such salient features of a prospectus as may be prescribed.” A
company can not supply application forms for shares or
debentures unless the form is accompanied by abridged
prospectus.

Shelf Prospectus: Sometimes securities are issued in stages

spread over a period of time, particularly in respect of
infrastructure projects, where the size of the issue is large, as
huge funds have to be collected. In such cases, filling of
prospectus each time will be very expensive. In such cases,
companies act allows a prospectus called Shelf Prospectus to
be filed with ROC at subsequent stages only “information
memorandum” is required to be filled. It is valid for a period of
1 yr from the date of opening of first issue of security under
those prospects.

Information Memorandum (IM): The IM shall contain all

material facts relating to new charges created, change in
financial position as have accrued between the first offer,
previous offer and succeeding offer. The IM shall be filed with
period 3 months prior to making of 2nd and subsequent offer
of securities under Shelf Prospectus filed at the 1st stage of
offer. Where an update of IM is filed every time an offer of
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security is made, such memorandum, together with the Self
Prospectus shall constitute the Prospectus.

EQUITY SHARE CAPITAL

Equity means ‘equal’. Equity share is a share that gives equal

rights to holders. Equity share have to share the rewards and
risk associated with ownership of the company. For example
ABC Company has 10,000 Equity shareholders and it has
earned Rs. 10,000 profit last year and assumes it may earn a
loss of Rs. 10,000 in the next year. Here, the shareholders will
get Re. 1 as profit from last year and Re. 1 loss in the coming
year. It is also called as ordinary share capital. Equity share
holders are the owners of the company, who have control over
the working of the company. They are paid dividend at the rate
recommended by the Board of Directors (BOD). The dividend
rate depends upon the profits, no dividends will be payable.
But some companies pay dividend even if the company has no
profits to maintain dividend stability. The amount required to
pay dividends will be transferred from general reserve a/c. the
Equity shareholders take more risk when compared to
preference share holders.

FEATURES OF EQUITY STOCK

The following are the features of Equity stock:

• Permanent capital: An Equity source is the main long term

or permanent source of finance. They can be redeemed or
refunded only at the time of liquidation that too from the
residue left after meeting all the obligations. In other words
there is no agreement between Equity share holders and the
company with regard to refund of the capital. Shareholders
cannot sell shares to the company, but he can sell in the stock
market to others, if he wants to get back his money. Hence it is
a permanent source of finance for the company.
• Residual claim to income: Equity shareholders have a
residual claim to the income of the company. Residual claim
means the income left over after paying the outsider claims.
The residual income is also known as earnings available to
Equity shareholders, which is equal to profit after tax minus
preference dividend. But the total residual income may or may
not be paid as dividends, since the BOD’s have the right to
decide the portions of the earnings available to shareholders

67
that will be paid as dividends. Payment depends on retention
or plough back profits.
• Residual claim to assets: Equity shareholders have a
residual claim on the firm’s assets. In an event of liquidation of
a firm, the assets are used first to settle the claims of outside
creditors and preference shareholders. In other words Equity
shareholders have last priority on assets; hence their capital
becomes cushion to absorb losses on liquidation.
• Voting right/ right to control: Equity shareholders as real
owners of the company, have the voting right, in appointing
Directors and Auditors of the company, participate and vote in
annual general meeting, which helps to control the company.
BODs have the control power of the company, because the
major decisions are taken by the BODs
• Pre-emptive right: Equity shareholders have the pre-
emptive right, which means they have legal right to buy new
issues, before offering to public. Sec 18 of the companies Act,
1956 puts company under legal compulsion to offer new shares
to existing shareholders before offering to the public

ADVANTAGES OF EQUITY SHARES:

• ADVANTAGES TO THE COMPANY:

1. It is permanent source of long-term source of finance.
2. there is no repayment liability
3. it does not create ant obligation to pay dividend
4. this capital can be issued without creating any charge of
assets of the company
5. issue of Equity share capital increases the credit
worthiness of the company

• ADVANTAGES TO INVESTOR:
1. Equity shares provide more income
2. Equity shares give the right to participate in the company
and management of the company
3. capital appreciation(if share price increased when
compared to purchase price)

DISADVANTAGES OF EQUITY SHARES:

• DISADVANTAGES TO THE COMPANY:

1. high cost source of funds
2. involves high floatation costs
3. issue of additional shares dilutes control
4. no tax advantage
5. it makes capital structure rigid
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• DISADVANTAGES TO INVESTOR:
1. no guarantee or regularity in receipt of dividend
2. no guarantee in receipt of principle amount of investment
3. loss of capital due to fluctuation in share prices

TYPES OF EQUITY SHARES

1. Sweat equity shares: the companies act of 1999, has

inserted a new section 79A that allows issue of sweat equity
shares. Sweat equity shares defined as “equity shares issued
at a discount or for consideration other than cash for providing
know-how or making available rights in nature of intellectual
property rights or value additions by whatever mane called”.
Issue of sweat equity by listed company should be according to
SEBI guidelines. The issue should be authorized by a
specialized resolution passed by a company in the general
meeting, which specifies the number of shares, price and
consideration if any. However non-listed companies can issue
sweat equity in accordance with prescribed guidelines.

2. Par-value shares: Unlike bonds, which always have a par

value, equity stock may be sold with par value or without par
value. Par value means the nominal value of the shares in the
Memorandum of Association (MOA) established for legal
purpose. The par value decided by promoters of first directors
of the company such may be issued at par, at premium, or at
discount price to public.

3. No-par value shares: These type of shares are without par

value. In this arrangement MOA, specifies the number of
shares and not the price of the share. They will be issued to
the public at the stated price decided by the BODs. Payment of
dividend on this type of shares is much many rupees per share
i.e., Rs. 5 per share or Rs. 6 per share.

PREFERENCE SHARE CAPITAL

Capital stock which provides a specific dividend that is paid

before any dividend are paid to the common stock holders, and
which takes precedence over common stock in the event of
liquidation. Like common stock, preference share represent
partial ownership in the company, although preferred stock
shareholders do not enjoy any of the voting rights of common
stockholders. Also unlike common stock, preference shares pay
a fixed dividend that does not fluctuate, although the company
does not have to pay this dividend if it lacks the financial
ability to do so. The main benefit of owning preference shares

69
are that the investor has a greater claim on the company’s
assets than common stockholders. Preferred shareholders
always receive their dividend first and, in the event the
company goes bankrupt, preferred shareholders are paid off
before common stockholders. In general, there are four
different types of preferred stock:

1. Cumulative
2. Non-Cumulative
3. Participating
4. Convertible
It is also called as preferred stock.

Features of preference shares

1. Claim on Assets: Companies do not create any charge on

the assets while issuing the preference shares, still preference
shareholders have prior claim on assets of the company in the
event of liquidation. It means before payment of ordinary
shareholders, preference shareholders are paid.

2. Claim on Income: Not only the prior assets at time of

liquidation, they also have prior claim on income or profits.
Preference dividend must be paid in full before payment of any
dividend on the equity share capital. As the preference share
capital lies between debenture capital and equity share capital
with regard to claim on assets and income of company. Hence
it is called “senior security”.

3. Accumulation of dividends: Most of the preference share

dividend is cumulative. It means that all unpaid/ arrears
dividends are carried forward for the next year and paid with
the current year dividend before payment of any dividend to
the equity shareholders.

4. Redeemable: Preference share capital has limited maturity

period after that the share capital has to be refunded. It
provides flexibility in the capital structure which is beneficial
to the company.

5. Fixed rate of dividend: Issues of preference share are not

a fixed rate of dividend. The rate is at par value basis. It helps
the management to avoid the provision of equal participation
in earnings. The fixed dividend rate would be lower when
compared to ordinary shareholders’ dividend.

Advantages/Merits of Preference Shares:

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(a) Advantages/ merits to company
• There is no legal obligation to pay preference dividend
• There is no share in control of the company through
participation in voting
• They provide flexibility in the capital structure by issue of
redeemable preference share
• It enhances credit worthiness because preference share
capital is generally treated as a part of net worth.
• Preference share provides long term capital for the
company
• Mortgageable assets are conserved, due to the issue of
preference share capital without pledging assets
(b) Merits to investors
• stable rate of preference dividend
• prior claim on assets
• less risk when compared to equity shareholders

Disadvantages/ demerits of Preference Shares

(a) Disadvantages to company

• Tax disadvantage, because preference dividend is not a
tax deductible, which makes preference share capital a costly
source of finance
• Adverse effect on credit worthiness, if the company avoids
payment of dividend
• Permanent burden of payment of dividend, if preference
shares are cumulative in nature
(b) Disadvantages to investors
• Limited returns, as preference shareholders do not have
voting rights, their returns depend on managerial decision,
which is arbitrage and shareholders cannot force management
to pay more dividend
• Rate of preference dividend is generally less than the rate
of dividend on equity shares
• The market price of equity shares fluctuate more when
compared to debentures.

CLASSIFICATION OF PREFERENCE SHARES

1. Cumulative Preference Shares: they are those shares on

which the amount of dividend payable goes on cumulating until
it is fully paid. If the full dividend or partial dividend cannot be
paid in any year, the same can be paid out of future profits.
Even if the company is not able to pay the last year’s dividend
in the next year, the same is cumulated for the future period
till the full payment. Preference shares are generally
cumulative unless otherwise expressly stated in Articles of
Association or if there are terms of the issue of those shares.

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2. Non-cumulative preference shares: these are those shares
on which the unpaid dividend does not cumulate to the next
year’s dividend. It means in any year, if the company fails to
earn profit to pay fixed dividend for that year, the preference
shareholders cannot ask from the next year’s profit. Thus the
right to claim unpaid dividends will lapse.

3. Redeemable preference shares: these are those shares,

which can be redeemed or repaid to the holders after lapse of
the stipulated period, which is stated by issue of such a share.
A company limited by a share may redeem, if articles permit.

4. Irredeemable preference shares or perpetual shares: they

are those shares, which are not repayable and are redeemable
only at the time of liquidation. These shares are also called
perennial shares.

5. Participatory preference shares: these are the shares that

enjoy the right to participated in surplus profits that are left
out after payment of a fixed rate of dividend to equity
shareholders. This additional return apart from getting a fixed
rate of preference dividend. Not only a share in surplus profit,
may they also participate in surplus assets of the firm at the
time of liquidation.
6. Non-participatory preference shares: they have no claim in
the surplus profit or assets of the firm are deemed to be non-
participatory preference shares.

7. Convertible preference shares: here convertible means

equity and not cash. The preference shares, which are having
the right to convert their holdings into equity shares within a
specified period, are known as convertible preference shares.

8. Non-convertible preference shares: the preference shares

that do not enjoy the option of converting their holdings into
equity are known as non-convertible preference shares.

DEBENTURES/BONDS

Debentures/bonds are an important source of long-term

finance. Raising of funds by issue of debenture or bonds is
allowed to public limited companies. If Memorandum of
Association (MOA) is permitted.

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The term ‘debenture’ is derived from a Latin word ‘debere’
which means to be ‘debtor’. Companies Act of 1956
‘debenture’ as including debenture stock, bond and other
securities of a company, whether constituting the charge on
the assets of the company or not. It is not clear or does not
explain fully what is debenture. According to Naidu or Datta,
“a debenture is an instrument issues by a company under its
common seal acknowledgement a dent and setting forth the
terms under which they are issued are to be paid”. A person
who buys the debenture is the debenture holder and the
creditor of the company. Debenture can be priced in the same
manner as a share. In other words, that can be issued at face
(par) value, at the premium or at the discount.

FEATURES OF DEBENTURE:

1. Fixed rate of interest: in general, debentures are issued

at the fixed rate of interest but they may also be issued at
floating rate of interest or at zero interest. The fixed rate
debentures are more popular in India. The rate of interest is on
the face value of the debenture that will be out annually or
semi-annually. The interest payable on debentures is tax
deductable. Company is free to determine the interest rate,
which may be fixed or floated.

2. Maturity: the debenture capital is the cheapest form of

long-term finance, but it should be repaired after a fixed
period of time. In other words, debentures are issued for a
fixed period. The period in which debentures r issued or period
after which debenture capital is repaid is known as maturity
period. The maturity period may vary between 1year to 20
years. In India, non convertible debentures are redeemed after
7-10 years.
3. Redemption: debenture can be repaid either in
installment wise or lump sum. If it is repaid in one lump sum
amount, it can be done by creation of debenture redemption
reserve. It is compulsory for all debentures whose maturity
period exceeds 18 months.Company should create a dividened
redemption reserve (DRR) equivalent to atleast 50 % of the
amount of issue before commencement of repayment.

4. Call and put option: debenture may have “call” option,

which gives the right to ‘buy’ to issuing company at a certain
price before the maturity period. The buy back (call) price may
be more than the fac3 value of debenture generally 5% which
is known as premium on redemption. Sometimes, debentures
may also put an option, which gives a right to the determine
holder to seek redemption at specified times and at pre-
decided prices.

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5. Debenture Indenture: A debenture is a legal document, which
specifies the right of both the issuing company and the
debenture holder. The debenture indenture includes
descriptions of the amount and timing of the interest and the
principle amount payments (installments or lump sum), various
standards and restrictive provisions. The indenture gives the
responsibility to the trustee to protect the interest of he
debenture holders by fulfilling the above stated descriptions.

6. Security interest: Debenture may either be secured or

unsecured. A secured debenture is a debenture which is
secured by a charge on the company’s immovable assets and
floating charge on other assets. An secured debenture is one
which is without any charge on the firm’s assets, these are
known as naked debentures.

7. Convertibility: Companies can also issue convertible

debentures. It is the debenture that is convertible into equity
shares at the option of the debenture holder. The conversion
ratio and the period during which conversion can be affected
are specified at the time of issue of debentures.

8. Credit ratings: Before issue of debentures to the public, the

issuing company needs to get the debentures rated by anyone
of the credit rating agencies. The four credit rating agencies
are:

• Credit Rating Information Services of India Limited

(CRISIL)
• Investment Information and Credit Rating Agency of India
Limited (ICRA).
• Credit Analysis and Research Limited (CARL)
• FITCH India and Duff & Phelps Credit Rating India pvt. Ltd
(DCRI)

9. Claim on income and assets: Debenture interest is tax

deductible. In other words, debenture interest is paid form
earning before interest and taxes (EBIT) or operating profit.
The interest is payable before payment of tax, preference
dividend and equity dividend. So, debenture holders have
priority of claim on income. At the same time they also have
priority of claim on company assets at the time of winding up.
Failure of interest force to bankruptcy.

TYPES OF DEBENTURES.

1. From the redemption point of view, the debentures are

subdivided into two:
(a) Redeemable Debenture: They are those debentures, which
are to be repaid by the company at the end of a specified

74
period or with in the specified period at the option of the
company by giving a notice to the debenture holder with the
intention to redeem debentures either lump sum or
installments

(b) Irredeemable Debentures: Irredeemable Debentures are

those that are not redeemable during the existence of the
company. They are repayable either if the company fails to pay
interest to them or at the time of liquidation of the company.
These are also called as perpetual debentures.
2. From the conversion point of view, the debentures are
subdivided into two:
(a) Convertible Debentures: They are those debentures that
are convertible into equity shares at the option of debenture
holder after stating period at a predetermined price. The
debenture capital may be Fully Convertible Debenture (FCD) or
Partially Convertible Debenture (PCD). This type of debenture
is attractive, even though they carry a low rate of interest
when compared to non-convertible debentures.

(b) Non-convertible debentures: They are those debentures

that do not carry the option of conversion into equity.

3. From the transfer of registration of view, the debentures

are subdivided into two:
(a) Registered debentures: These are those debentures that
are registered with the issuing company. Name, addresses and
other particulars of the holders are recorded in the debenture
register, which is kept by the issuing company. Transfer of
these types of debentures need a regular transfer deed, at the
time of transfer of such debentures. The interest is paid only to
the person on whose name the debenture is registered.

(b) Bearer debenture: These are those debentures that are

payable to the bearer and the transferable by delivery only.
They are negotiable instruments and the company keeps on
records for them. The interest is paid to the bearer of the
debenture.

4. Other types of debentures:

(a) Zero interest debentures: These are innovative debt
instruments. These types of debentures do not carry any
interest rate. Generally, they are issued at a discount from
their maturity/ redeemable value. The return for the holders of
this type of debentures is the difference between purchase
(issue) price and maturity (redeemable) value.

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(b) Deep discount debenture/ bond (DDB): It is the same as
zero coupon bonds but deep discount bond is issued at a deep
discount from its redeemable value. In India, DDBs are being
issued by the public financial institutions. They are Industrial
Development Bank of India, Small Industries Development
Bank of India, etc. DDBs enable the issuing company to
consume cash during maturity period. The issuing company
need not serve the debt by paying interest. It reduces the risk
of reinvestment of interest, which is receivable at the end of
every year. However, DDBs are exposed to high risk since the
entail balloon payment at the end of the maturity period.

(c) Floating Rate Bonds (FRBs): These are bonds in which the
rate of interest and its linked interest rate on Treasury Bills,
bank rate, which are considered as benchmark. In India, State
Bank of India (SBI) was one of the earliest financial institutions
to successfully sell floating rate bonds. Later, IDBI also issued
these type of debentures. FRBs provide protection against
inflation risk to investors and bondholders.

(d) Secured Premium Notes: SPN is a type of secured

debenture redeemable at a premium over the face or purchase
price. It is like zero interest debentures, since there will be no
interest payment in the lock-in-period. SPN holders have the
option to sell back the debenture/note to the issuing firm at
face value after the given lock-in-period. SPNs are tradable
instruments.

(e) Guaranteed Debentures: these are debentures on which the

payment of interest and principle amount is guaranteed by a
third party at the time of their issue. The third parties are
financial institutions, governments, etc.

(f) Callable Bonds: these are bonds that can be called in and
purchased at a price. Companies generally call back bonds only
when the interest rates fall in the market less than the bond’s
interest rate. Companies redeem high interest bonds and raise
funds by issue of low interest bonds.

ADVANTAGES OF DEBENTURES/BONDS

Advantages to the Company

76
1. Debenture Capital is one of the cheapest source of long-
term finance, since interest payments on debentures is a tax-
deductible expenditure and low floatation cost.
2. Issue of debenture does not dilute control, since they are
not entitled to voting rights.
3. Debentures enable the company to take advantage of
trading on equity, which results in shareholder’s wealth
maximization.
4. Debenture capital provides flexibility in capital structure,
if they are issued as redeemable or if not so also, since they
have call option.
5. Debenture holders do not participate in the surplus profits
of the company since payments to them are limited to the
interest and principle amount.
6. Debenture capital provides protection against inflation
since the interest rate is fixed.

Advantages to Debenture Holders

1. Debentures provide a fixed, regular and stable source of

income.
2. Debenture holder’s investment is safe and secure since,
debentures with a charge on company is an asset.
3. Debentures are issued for a definite maturity period.
4. Debenture holder’s interest (payments of interest and
principle amounts) is protected by the debenture indenture.

DISADVANTAGES OF DEBENTURES/BONDS

Disadvantages to the Company

1. Raising debenture capital is a risky one, since it involves

payment of fixed interest charges and repayment of principle
amount, which are legal obligations of the issuing company.
Failure to do so may lead to bankruptcy.
2. Raising debenture capital increases financial leverages,
which will raise the cost of equity of the company.
3. Raising debenture capital involves restrictions like
borrowing limit, dividend payment limit, etc.
4. Debenture capital is a costly one, when the rate on
inflation increases. Since interest comes down in the market.
5. This is not the stable source of long-term finance for a
firm with variable earnings.

Disadvantages to the Debenture Holders

1. Debentures do not carry any voting rights, which give no

controlling power on the working of the company.

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2. Debentures holders do not have any claim on the surplus
profit since they are not the owners of the company.
3. Receipt of debentures is fully taxable under the head
income from other sources.
4. Debenture holders lose interest charges, if the inflation
increases.
5. Debenture prices are vulnerable with changing interest
rates.

BOOK-BUILDING- ABOUT BOOK BUILDING

Book building is basically a capital issuance process used in

initial public offer (IPO) aiding price and demand discovery. It
is a process used for marketing a Public offer of equity shares
of a company. It is a mechanism wherein during the period for
which the book for the IPO is open, bids are collected from
investors at various prices, which are above or equal to the
floor price. The process aims at tapping both the wholesaler
and retailer investors. the offer/issue price is then determined
after the bid closing date based on certain evaluation criteria.

THE PROCESS:

• The issuer who is planning an IPO nominates a lead

merchant banker as a ‘book runner’

• The issuer specifies the number of securities to be issued

and the price band for orders.

• The issuer also appoints syndicate members with whom

orders can be placed by the investors.

• Investors place their order with a syndicate member who

inputs the orders into the electronic book. This process is
called ‘bidding’ and is similar to open auction.

• A book should remain open for a minimum of 5 days.

• Bids cannot be entered less than the floor price.

• The bidder can revise the price before the issue closes.

• On the close of the book-building period, the ‘book no

evaluates the bids on the basis of the evaluation criteria which
may include:

 Price aggression

 Investor quality
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 Earliness of bids etc.

• The book runner and the company conclude the final price
at which it is willing to issue the stock and allocation of
securities.

• Generally the no of shares is fixed; the issue size gets

frozen based on the price per share discovered through the
book building process.

• Allocation of securities is made to the successful bidders.

• Book building is a good concept and represents a capital

market that is in the process of maturing.

SAFETY NET:

Safety net is a process under which a person or a company

(generally a finance company) undertakes to buy shares issued
and allotted in a new issue from the allottees at a stipulated
price. This is an agreement in relation to the issue of equity
shares. The main feature of the safety net is to provide the
equity investors of the safety of their investments from fall of
the share price below the issue price. This facility will be
generally provided in a bear market environment. Closely-held
companies that are going to issue shares to the public for the
first time may also provide safety net facility to the investors
in their shares where the investors have no benchmark price to
go by and therefore the safety net provide them a sort of
confidence regarding safety for their investment into equity
shares. The safety net scheme generally puts provision for
buying back the shares at a price lower than the issue price,
and the e difference will be the premium to the buyer for the
risk taken in purchase of shares back from the investors.

STOCKINVEST:

In case of over subscription of issue, there have been an

inordinate delays in refund of excess of application money and
large amounts of investors funds remain locked up in
companies for long periods, affecting the liquidity of the
investing public. To overcome the said problem a new
instrument called the stockinvest is introduced. The stock
invest is a non-negotiable bank instrument issued by the bank
in different denominations. The investor who has a savings or a
current a/c with the bank will obtain the stockinvest in
required denominations and will have to enclose it with the
share/ debenture application. The face of the instrument
79
provides for space for the investor to indicate the name of the
issues, the number and amount of shares/debentures applied
for and the signature of the investor. The stockinvest issued by
the bank will be signed by it and the date of issue will also be
indicated on the instrument. Simultaneously with the issue of
stockinvest, the bank will mark the lien for the amounts of
stockinvest issued in the deposit a/c of the investor. On full or
partial allotment of shares to the investors, the Registrar to
issue will fill the columns of the stockinvest indicating the
entitlement for allotment of shares/debentures, in terms of
number, amount and application no and send it for clearing.

The investors’ bank would get debited only after the shares/
debentures are allotted. In respect of the unsuccessful
applicants, the funds continue to remain in their a/c and earn
interest if the a/c is a savings or a term deposit. The excess
application money of partly successful applicants also, will
remain in their a/c s. there will be a lien on the funds for
maximum of 4 months period. The stockinvest is intended to
be only utilized by the a/c holders and that it should not be
handed over to any third party for use. In case the
cancelled/partly utilized stockinvest is not received by an
investor from the Registrar, lien will be lifted by the issuing
branch upon expiry of 4 months from the date of issue against
an indemnity bond from the investor.

LOAN SYNDICATION

INTRODUCTION

Loan syndication, a method used in Eurodollar market. Loan

syndication refers to assistance rendered by merchant banks
to get mainly term loans for projects. Such loans may be
obtained from a single development finance institution or a
syndicate or consortium as in the case of large term loans.
Merchant banks can also help corporate clients to raise
syndicated loans from commercial banks. Major benefits
reaped by corporate in syndication are amount, tenor and
price. The syndication method reverses the current practice
where the corporate borrower faces rigid terms in a take it or
leave it situation. The cost of syndication is likely to vary with
credit risk.

"Syndication is an arrangement where a group of banks, which may

not have any other business relationship with the borrower,
participate for a single loan."

"A syndicated facility is a lending facility, defined by a single loan

arrangement, in which several or many banks participate."

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WHY DO BANKS GO FOR LOAN SYNDICATION?

RISK DIVERSIFICATION

In syndication, many banks come together and fund a single

project, hence sharing the risks.
This also assists in getting competitive interest rates for the
banks. When a group of banks get together, they select a lead
bank which handles all the dealings with the company, such as
negotiating the interest rates, and hence a deal is signed
between the company and the banks. Loan syndication is
basically done to share the total loss or liability.

WHEN DOES A CORPORATE GO FOR SYNDICATION?

Corporate opt for syndication when: -

• The borrower wants to raise large amount of money

quickly and conveniently.
• The amount exceeds the exposure limits or appetite of any
one lender.
• The borrower does not want to deal with a large number
of lenders

PARTIES OF LOAN SYNDICATION

1. Arranger / Lead Manager:

The lead manager is a bank that is awarded the mandate by
the prospective borrower and is responsible for placing the
syndicated loan with the other banks and ensures that the
syndication is fully subscribed. They are entitled to the
arrangement fee and undergo a reputation risk during this
process. They prepare a placement memorandum and the loan
is marketed to other banks who may be interested in taking up
shares.
2. Underwriting Bank:
It is the bank that commits to supplying the funds to the
borrower - if necessary from its own resources if the loan is not
fully subscribed. The lead manager or another bank may play
this role. Not all syndications are underwritten. The risk is that
the loan may not be fully subscribed.
3. Participating Bank:

This bank participates in the syndication by lending a portion

of the total amount required. It is entitled to receive the
interest and the participation fee. But it, however, faces risks
such as:
* Borrower credit risk
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* Passive approval and complacency

4. Facility Manager / Agent:

This bank takes care of all the administrative arrangements

over the term of loan, e.g., disbursements, repayments,
compliance. This bank acts on behalf of all the banks
participating. This may be either the lead manger or the
underwriting bank.

STAGES INVOLVED IN THE PROCESS

1. Premandate Phase:

The prospective borrower may liaise with a single bank or it

may invite competitive bids from a number of banks. The lead
bank identifies the needs of the borrower, designs an
appropriate loan structure, develops a persuasive credit
proposal, and obtains internal approval. The mandate is
created. The documentation is created with the help of
specialist lawyers.

2. Placing the Loan:

The lead bank can start to sell the loan in the market place.
The lead bank needs to prepare an information memorandum,
term sheet, and legal documentation and approach selected
banks and invite participation. The lead manager carries out
the negotiations and controversies are ironed out. The
syndication deal is closed, including signing of the mandate.

3. Post Closure Phase:

The agent now handles the day-to-day running of the loan
facility.

DISADVANTAGES

1.Managing multiple bank relationships is no small feat. Each

bank needs to come to an
understanding of the business and how its financial activities
are conducted.

2. A comfort level must be established on both sides of the

transaction, which requires time and effort.

3. Negotiating a document with one bank can take days. To

negotiate documents with four to five banks separately is a
time-consuming, inefficient task.

4. Moreover, multiple lines require an inter-creditor agreement

among the banks, which takes additional time to negotiate.
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Depositary Receipt (DR)

A negotiable financial instrument issued by a bank to

represent a foreign company's publicly traded securities. The
depositary receipt trades on a local stock exchange. Depositary
receipts make it easier to buy shares in foreign companies
because the shares of the company don't have to leave the
home state. For eg -When the depositary bank is in U.S., the
instruments are known as American Depositary Receipts
(ADRs). European banks issue European depositary receipts.

One of the most common types of DRs is the American

depositary receipt (ADR), which has been offering companies,
investors and traders global investment opportunities since
the 1920s. Since then, DRs have spread to other parts of the
globe in the form of global depositary receipts (GDRs) (the
other most common type of DR), European DRs and
international DRs. ADRs are typically traded on a U.S. national
stock exchange, such as the New York Stock Exchange (NYSE)
or the American Stock Exchange, while GDRs are commonly
listed on European stock exchanges such as the London Stock
Exchange. Both ADRs and GDRs are usually denominated in
U.S. dollars, but can also be denominated in euros.

The DR functions as a means to increase global trade,

which in turn can help increase not only volumes on local and
foreign markets but also the exchange of information,
technology, regulatory procedures as well as market
transparency. Thus, instead of being faced with impediments
to foreign investment, as it often the case in many emerging
markets, the DR investor and company cab both benefit from
investment abroad. Depositary receipts encourage a global
shareholder base, and provide expatriates living abroad with
an easier opportunity to invest in their home countries.

The DR is created when a foreign company wishes to list

its already publicly traded shares or debt securities on a
foreign stock exchange. Before it can be listed to a particular
stock exchange, the company in question will first have to
meet certain requirements put forth by the exchange. Initial
public offerings, however, can also issue a DR. DRs can be
traded publicly or over-the-counter.

The Benefits of Depositary Receipts

The DR functions as a means to increase global trade,

which in turn can help increase not only volumes on local and
foreign markets but also the exchange of information,
technology, regulatory procedures as well as market
transparency. Thus, instead of being faced with impediments

83
to foreign investment, as is often the case in many emerging
markets, the DR investor and company can both benefit from
investment abroad. Let's take a closer a look at the benefits:

For the Company

A company may opt to issue a DR to obtain greater
exposure and raise capital in the world market. Issuing DRs
has the added benefit of increasing the share's liquidity while
boosting the company's prestige on its local market ("the
company is traded internationally"). Depositary receipts
encourage an international shareholder base, and provide
expatriates living abroad with an easier opportunity to invest
in their home countries. Moreover, in many countries,
especially those with emerging markets, obstacles often
prevent foreign investors from entering the local market. By
issuing a DR, a company can still encourage investment from
abroad without having to worry about barriers to entry that a
foreign investor might face.

For the Investor

Buying into a DR immediately turns an investors'
portfolio into a global one. Investors gain the benefits of
diversification while trading in their own market under familiar
settlement and clearance conditions. More importantly, DR
investors will be able to reap the benefits of these usually
higher risk, higher return equities, without having to endure
the added risks of going directly into foreign markets, which
may pose lack of transparency or instability resulting from
changing regulatory procedures. It is important to remember
that an investor will still bear some foreign-exchange risk,
stemming from uncertainties in emerging economies and
societies. On the other hand, the investor can also benefit from
competitive rates the U.S. dollar and euro have to most foreign
currencies.

American Depositary Receipt (ADR)

A negotiable certificate issued by a U.S. bank

representing a specified number of shares (or one share) in a
foreign stock that is traded on a U.S. exchange. ADRs are
denominated in U.S. dollars, with the underlying security held
by a U.S. financial institution overseas. ADRs help to reduce
administration and duty costs that would otherwise be levied
on each transaction. This is an excellent way to buy shares in a
foreign country/ company while realizing any dividends and
capital gains in US dollars. ADRs do not eliminate the currency
and economic risks for the underlying shares in another
country. For example, dividend payments in euros would be
converted to U.S. dollars, net of conversion expenses and
foreign taxes and in accordance with the deposit
agreement. ADRs are listed on the NYSE, AMEX or NASDAQ.
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 Each ADR is issued by a U.S. depositary bank and can
represent a fraction of a share, a single share, or multiple
shares of the foreign stock. An owner of an ADR has the right
to obtain the foreign stock it represents, but US investors
usually find it more convenient simply to own the ADR. The
price of an ADR often tracks the price of the foreign stock in its
home market, adjusted for the ratio of ADRs to foreign
company shares. In the case of companies incorporated in the
United Kingdom, creation of ADRs attracts a 1.5% stamp duty
reserve tax (SDRT) charge by the UK government.

Depositary banks have various responsibilities to an ADR

shareholder and to the non-US company the ADR represents.
The first ADR was introduced by JPMorgan in 1927, for the
British retailer Selfridges&Co. There are currently four major
commercial banks that provide depositary bank services -
JPMorgan, Citibank, Deutsche Bank and the Bank of New York
Mellon. Individual shares of a foreign corporation represented
by an ADR are called American Depositary Shares (ADS). The
main objective of ADRs is to save individual investors money
by reducing administration costs and avoiding duty on each
transaction. For individuals, ADRs are an excellent way to buy
shares in a foreign company and capitalize on growth
potential. ADRs offer a good opportunity for capital
appreciation as well as income if the company pays dividends.

Global Depositary Receipt (GDR)

A bank certificate issued in more than one country for

shares in a foreign company. The shares are held by a foreign
branch of an international bank. The shares trade as domestic
shares, but are offered for sale globally through the various
bank branches. A financial instrument used by private markets
to raise capital denominated in either U.S. dollars or euros.
GDR is very similar to an American Depositary Receipt.
These instruments are called European Depositary Receipt
(EDR) when private markets are attempting to obtain euros.
GDRs represent ownership of an underlying number of shares.
They facilitate trade of shares, and are commonly used to
invest in companies from developing or emerging markets –
especially Russia.

Several global banks issue GDRs, such as JPMorgan

Chase, Citigroup, Deutsche Bank, Bank of New York. They trade
on the Global Order Book (GOB) of the London Stock Exchange.
Normally 1 GDR = 10 shares.

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International Depository Receipt (IDR)

IDR is a negotiable bank-issued certificate representing

ownership of stock securities by an investor outside the
country of origin. An IDR is a non-U.S. equivalent of an
American Depositary Receipt (ADR). The IDR is denominated in
the local currency, and entitles the bearer to any dividends and
other benefits associated with the shares. IDRs can be traded
like any other security. Using IDRs shields the investor from
foreign exchange risk and any applicable tariffs he/she would
have had to pay if he/she had bought the stock outright. It also
exempts the investor from any requirements the foreign
exchange might have levied. The advantage of the IDR
structure is that the corporation does not have to comply with
all the issuing requirements of the foreign country where the
stock is to be traded.

External Commercial Borrowing (ECB)

ECB is a term used to refer to commercial loans availed

from non resident lenders with a minimum average maturity of
3 years in the form of bank loans, buyers credit, suppliers
credit, securitized instruments (eg:- fixed rate bonds). A
company is free to raise ECB from any internationally
recognized source such as banks, export credit agencies,
suppliers of equipment, foreign collaborators, foreign equity
holders, international capital markets etc.

ECB can be provided by eligible lenders which can be

defined as those persons who have share in the equity of
company or firm to which they have right to lend money.

Benefits of Raising Capital from International Markets

• Cost of funds, at times, works out to be cheaper to cost of

rupee funds.
• Availability of funds in international markets is huge.
• Corporate can raise a large amount of funds depending on
the risk perception of the international financial institutions.

Problems involved

• Arbitraging risk
• Political risk
• Exchange rate risk
• Inflationary risk
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Use of ECB

ECBs are being permitted by the Government as a source

of finance for Indian Corporate for expansion of existing
capacity as well as for fresh investment,
such as Power, oil Exploration, Telecom, Railways, Roads &
Bridges, Ports, Industrial Parks and Urban Infrastructure etc.
and the export sector. Development Financial Institutions,
through their sub-lending against the ECB approvals are also
expected to give priority to the needs of medium and small
scale units ECBs are to be utilized for foreign exchange costs of
capital goods and services (on FOB and CIF basis). Proceeds
should be utilized at the earliest and corporate should comply
with RBI's guidelines on parking ECBs outside till actual
imports.

Recent Trend In ECB

The cost of funds in the Indian Market has been relatively

higher than International Market and there is a growing
tendency for Indian Business Houses to raise funds from
International Markets. Such financing is arranged for reputed
corporate houses on prevalent rates of interest. The interest
rates are fixed in terms of Basic rate of LIBOR plus other
charges.The Registered Foreign Financial Institutions
interested in lending funds to Indian Business Houses can earn
handsome interest from Indian Markets. Demand for E.C.B is
rising rapidly in this market and the Govt.

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