Equity Markets In India

Equity Markets: The stock market reforms received a major impetus with the recommendation of high a powered committee (G S Patel) instituted in 1985. The Committee was established by the Ministry of Finance, Government of India for suggesting structural reforms in the constitution and other matters relating to capital markets in general and stock exchanges in particular. The establishment of Securities Exchange Board of India (SEBI) in 1988 was based on the recommendation of the GS Patel Committee Report. After the establishment of SEBI, most of the reforms in the Indian equity markets have been instituted under the section 11 of the SEBI Act.

One of the most important concerns of SEBI was that all stock exchanges were owned, controlled and managed by the brokers. The process of the Corporatization of Stock Exchange was commenced, to separate the ownership of the exchange, management and the trading interests. This facilitated transparency and efficiency in a non-partisan environment. This process is usually referred to as “Demutualization”. The process of demutualization was instituted at a faster pace based on the roadmap provided by the Justice Kenia Committee – appointed by SEBI. This process was also made easier by way of providing tax breaks – announced in the budget of 2003-04. With this process, the stock exchanges were converted into companies under the Companies Act, 1956, wherein, shareholding, membership and management of the stock exchange would not be interlinked. 

Subsequently, broking firm and sole proprietorship concerns were encouraged to convert themselves into companies registered under the Companies Act, 1956. To facilitate this transformation, suitable changes were brought into the Securities Contract Regulations Act, 1956 as well as in the byelaws of the stock exchanges. These have also been supported by way of tax breaks in the form of a one-time tax exemption for capital gains, arising out of such conversion. By March 2003, almost 40 of the brokers registered with SEBI were corporate entities. Corporatization of broking businesses resulted in greater transparency and also enabled the broking houses to conduct business (trading) operations with the advantage of limited liability. 

SEBI also have facilitated multiple types of membership in stock exchanges – depending on specific criteria such as net worth, deposit requirement and function of the member based on clearing/trading/both clearing and trading.

Another major change instituted by the reform’s agenda was the permission of SEBI to allow Foreign Institutional Investors (FII) to trade in Indian Stock Markets – based on specific criteria. Also, overseas trading terminals were permitted to be established – to facilitate Non-Resident Indians (NRI) to trade on Indian stocks on a real-time basis.

Other major development in the reform agenda aid down by SEBI for regulation of equity markets include:

• Compulsory SEBI registration of all brokers and sub-brokers.
• Documentation by way of “Know Your Client” norm between brokers and clients.
• Maintenance of books of accounts and transaction records.
• Monitoring and inspection of stock exchanges.
• Adherence to code of conduct for different market participants.
• Capital adequacy norms for brokers – minimum net worth criteria.
• Restructuring of Governing Boards of Stock Exchanges.
• Compulsory audit of books of stockbrokers.

The reforms instituted in the primary markets clearly demarcated the role and responsibilities of different market participants and intermediaries. The process of issue of new shares has become transparent. The roles and responsibilities of specialist merchant banks, lead managers, underwriters, bankers to an issue, registrars to an issue, share transfer agents, portfolio managers, brokers depositories, FIIs, custodians, ratings agencies, venture capital funds and mutual funds have been demarcated. These intermediaries offer specialist institutional services under the SEBI guidelines. The pre-issue and post-issue procedures and activities have been streamlined. Rigorous compliance procedures have been laid down. 

In the context of secondary markets, the established exchanges such as Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) as well as regional exchanges operate under the purview of SEBI regulations.

The NSE introduced screen-based trading at its inception in 1992. Online electronic trading provides transparency and increases geographical reach for the participants. The transactions are anonymous, and order driven. Order matching is done strictly on price-time priority. Screen-based trading has improved the depth and liquidity of the markets.

Equity is viewed by the market as an ownership “share” in the revenue stream of a corporation’s income after all prior obligations (including outstanding debt) has been satisfied. The “share” price is the relative value given to the corporate’s earning potential based on a number of factors. These include general economic conditions, both in the industry and in the overall economy, earnings projection, projected corporate growth, stage of development and financial ratio analysis.

Generally, the structure of equity is that a “share” of the corporation represents the current market value of the firm, and secondary to this is the potential for dividend income. There are various classes of equity for the individual investor to consider.

Major Reforms in Primary Markets: Equity Major reforms in the Primary Markets for Equity since 1990’s are as follows:

• Merit based regime to disclosure-based regime.
• Disclosure and Investor Protection Guidelines issued.
• Pricing of Public Issues determined by the market.
• System of proportional allotment of shares introduced.
• Banks, FI and PSU allowed to raise funds from the primary markets.
• Acceptance of International Accounting Standards.
• Corporate Governance guidelines issued.
• Discretionary allotment system to QIBs withdrawn.
• FIIs allowed to invest in primary issues within the sectoral limits (including G-Secs).
• Mutual funds are encouraged both in public and private sectors and they have been permitted to invest overseas.
• Guidelines for Private Placements of debt issued.
• SEBI promoted Self-Regulatory Organizations (SRO).
• Allocation to retail investors increased.
• Separate allocation of 5% to domestic mutual funds within the QIB category.
• Freedom to fix value of shares below Rs. 10 per share only in cases where the issue price is Rs. 50 per share or more.
• Shares allotted on a preferential basis as well as the pre-allotment holding are subject to a lock-in period of six months to prevent sale of shares.

Major Reforms in Secondary Markets: Equity: Major reforms in Secondary Markets since 1990’s are as follows:

• Mandatory Registration of Market Intermediaries.
• Capital Adequacy norms specified for the brokers, sub-brokers of exchanges.
• Guidelines issued for listing agreement between stock exchanges and corporate.
• Shortening of settlement cycle for cash segment to T+2 and derivatives segment to T+1.
• Regular inspection of stock exchanges and other intermediaries including mutual funds put in place.
• Regulation of Substantial Acquisition of Shares and Takeovers.
• FIIs allowed to invest in Indian Capital Market since 1992.
• Order driven, fully automatic, anonymous screen-based trading introduced. 
• Depositories Act enabled.
• Guidelines on Corporate Governance issued. 
• SEBI has prohibited fraudulent and unfair trade practices, including insider trading.
• Separate trading platform called Indonext for SME. 
• Corporatization and Demutualization of stock exchanges notified.
• Settlement and Trade Guarantee fund/Investor Protection Fund established.
• Comprehensive Risk Management system established – capital adequacy, trading limits, exposure limits, margin requirement, index-based market wide circuit breaker, online position monitoring, automatic disablement of terminals.
• Comprehensive surveillance system established for tracking circular trading, price manipulation, market abuse. 
• Securities Appellate Tribunal (SAT) established.
• Mutual Funds, FIIs to enter Unique Client Code (UCC) pertaining to parent entity at the order entry level.
• Clients provided with Unique Client Code.
• Introduction of exchange traded derivatives including futures and options on stocks and indices.
• Introduction of SPAN based margining system based on Value at Risk measures (Exponential Weighted Moving Average).

Types of Equity: The primary three groups into which equity may be subdivided are common stock, preferred shares and warrants.

Types of Ordinary Shares (Based on Industry Classification)

• Blue Chips: Corporate who are considered to have established business model with large market capitalization.
• Utilities: Infrastructure companies (including power generation, transmission and distribution companies, construction, etc.).
• Established Growth: Corporate who have successful business model (may be cash-cows in their segment.
• Emerging Growth: Corporate whose business have opportunities for future growth.
• Penny Stocks: Small-cap stocks (with small market capitalization including SME).

List of different Types of Preference Shares

• Convertible Preference shares
• Cumulative and Non-Cumulative Preference Shares
• Redeemable Preference Shares
• Participating and Non-Participating Preference Shares

Generally, equity refers to the ownership interest in a company, of holders of its common and preferred stock. An ordinary (or common) equity share represents the form of fractional ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a business venture. The holders of such shares are members of the company and have voting rights.

Types of Share Capital: The equity share capital is of several types

• The Authorized Equity/Share Capital represents the maximum amount that a company can arise from the ordinary shareholders.
• The portion of the authorized share capital offered by a company to investors is the Issued Capital.
• Subscribed Share Capital is that part of the issued share capital that has been issued and accepted/subscribed by the investors.
• The actual amount paid by the subscribers is the Paid-up share capital.

Par Value (Face Value) and Book Value: Ordinary shares have a “Par” or “Face Value” in terms of the price of each share. This usually denomination of the Face Value (FV) is Rs. 10/-. SEBI has specified that companies can reduce the face value of a share to a minimum amount of Rs. 1.

The price at which equity shares are issued is referred to as the “Issue Price“. The issue price for new companies is usually equal to the face value. For existing companies, the issue price may be greater than the face value, in which case, the excess amount over and above the face value of each share, is called the “Share Premium“.

The “Book Value” (BV) of each ordinary shares refers to the paid-up capital plus reserves and surplus (net worth) divided by the number of outstanding shares. The price at which equity shares are traded in the market is called the “Market Value“.

Features of Equity Shares: Features of Equity shares are as follows:

Residual Claim to Income or Assets: Equity shareholders have the right to the profits/surplus/assets of the company, after all outside claims to bond holders, creditors, preference shareholders, etc. are met. The amount of dividend distributed to shareholders depends on the Board of Directors of the company, which would be subject to shareholders’ approval. This is in sharp contracts to debenture holders, whose obligations need to be honored by the company. In case of liquidation of the company due to bankruptcy, if the liquidation value of the assets is insufficient, then the claims to shareholders may be unpaid. 

Right to Control: Equity shareholders have “indirect” right to control the operations of the company. The Board of Directors are appointed by the company’s shareholders, through a nomination and voting process in the shareholder’s meeting. The Board appointed management is responsible for the day-to-day operations. The shareholders have the legal right / power to elect the board of directors and to vote on every resolution placed in various meetings of the company. Usually, the individual or entity, which holds the majority of shares have direct control over the affairs of the company. The most commonly used system of voting in the shareholder’s meeting is the “majority rule voting”, whereby, each share is eligible for 1 vote. Thus, the number of shares owned by the shareholder is directly proportional to the extent of votes that may be cast. As a result, shareholders who have more than 50% of the shares in a company would be able to have substantial say in the functioning of the company. An alternative to this system is the “Proportionate Voting Rule”, by which the number of votes held by a shareholder equals the number of shares owned, multiplied by the number of directors to be elected. Thus, in this situation, the total votes cast may be spread out between different candidates, based on shareholder’s discretion. The proportionate voting system has the advantage of allowing even some minority shareholders to elect representatives to the Board of Directors.

Pre-Emptive Rights: If a company was to issue new shares, then the existing shareholders would have the first right of refusal of such shares, on a pro-rata basis, based on the number of shares held by the shareholder as compared to the total number of outstanding shares, before the rights issue.

Limited Liability: The liability of the shareholders of a company is limited to the investment made to own their respective shareholding.  

Advantages of Equity Share Capital: The advantages of equity share capital are as follows:

– Equity shares are a permanent source of funds, without any mandatory repayment obligation. Even if the company is bankrupt, the shareholders would not be eligible to receive funds against outstanding shares held by them, in case of insufficient funds to meet creditor’s demand.

– There is no obligatory dividend payment.

– Equity shareholders form the basis for determining the extent of long-term borrowing that a company can mobilize. The creditors would have more confidence in a company that is well capitalized in terms of the issued and paid-up share capital. This is the reason for closely tracking the “debt to equity” ratio.

– The major advantage for the shareholders is that, even with a limited liability, they can exercise major control over the affairs of the company.

Disadvantages of Equity Share Capital: The disadvantages of Equity Share Capital are as follows:

– The cost of equity capital is higher for the company. This is a function of the higher required rate of return for investors, as compared to the risk undertaken by them. 

– Equity dividends, which are usually paid out of post-tax profits, are no tax deductible. At the time of issuing dividends, the company needs to make the tax on the dividend being issued.

– At the time of issue of the equity shares, the floatation costs incurred by the company for brokerage, underwriting, issue expenses – for media publicity – is usually high. 

– The issue of new shares to the public may also result in dilution of the stake held by the promoter of the company. 

– For the stakeholders of the company, equity capital is a risk, as the shareholders have the last right towards any claim made for the asset – at the time of possible liquidation of the company, due to bankruptcy.

– Also, the minority shareholders may not be able to exercise adequate influence due to the promoter possibly have majority control over the company, due to the larger shareholding.

– Also, share price are highly volatile and this form of investment involves high risk. 

Issue of Equity Shares: Following are the mechanism usually utilized by companies to distribute equity shares in the Primary Markets:

• Initial Public Offering (IPO): Issue of new securities by companies.
• Right Issue or Follow-on Public Offering to issue Right Shares: The issue of new securities to existing shareholders at a ratio to those already held.
• Bonus Shares: Shares issued by the companies to their shareholders free of cost by capitalization of accumulated reserve from the profits earned in the earlier years. 

Preferred Stock/Preference Shares: Preference share (or preference capital) is a long-term capital market instrument that combines the features of an ordinary equity share as well as a debenture. It is a hybrid security.

Feature of Preference Shares: 

• Preference shareholders are eligible for a fixed rate of dividend.
• Preference shareholders are ranked higher in the hierarchy as compared to ordinary shareholders, for being a claimant of income and assets.
• Preference shareholders usually do not have voting rights.
• Preference shareholders do not have a share in the residual earnings or assets – because they have a fixed rate of dividend.
• The dividend for preference shares is payable based on the capital invested. It is paid-out from after tax-profit – thus, the dividend is not tax deductible.
• The payment of most types of preference share dividends is at the discretion of the management – hence, it is not obligatory on part of company’s management. The terms of the dividend policy are established at time of issue of the preference shares.
• In the event of liquidation, their claims rank below the claims of the company’s creditors, bondholders / debentures holders.

Types of Preference Shares: Following are some of the types of preference shares issued by companies.

Cumulative Preference Shares: A type of preference shares on which dividend accumulates if remains unpaid. All arrears of preference dividend have to be paid out before paying dividend on equity shares.

Cumulative Convertible Preference Shares: A type of preference shares where the dividend payable on the same accumulates, if not paid. After a specified date, these shares will be converted into equity capital of the company.

Participating Preference Share: The right of certain preference shareholders to participate in profits after a specified fixed dividend is paid. Participation right is linked with the quantum of dividend paid on the equity shares over and above a particular specified level.