promoter of the stock exchange activities and to act as a regulatory authority of new issue activities of companies. The SEBI was established with the vital objective, \"to protect the interest of investors in securities market and for matters connected therewith or incidental thereto.\" The main functions of SEBI are as follows: To control the business of the stock market and other securities market. To promote and regulate the self-regulatory organizations. To forbid fraudulent and unfair trade practices in securities market. To promote awareness among investors and training of intermediaries about safety of market. To prohibit insider trading in securities market. To regulate huge acquisition of shares and takeover of companies. However the stock market remained primeval and poorly controlled. Companies who want to access the capital market needed prior permission of the government which also had to approve the price at which new equity could be raised. While new issues were strictly controlled, there was insufficient regulation of stock market activity and also of various market participants including stock exchanges, brokers, mutual funds, etc. The domestic- capital market was also closed to portfolio investment from abroad except through a few closed ended mutual funds floated abroad by the Unit Trust of India (UTI) which were committed to Indian investment. The practice of reform of the capital market was started in 1992 along the lines recommended by the Narasimham Committee. It was intended to remove direct government control and replacing it by a regulatory framework based on transparency and disclosure supervised by an independent regulator. The first step was taken in 1992 when the Securities and Exchange Board of India (SEBI), which was initially established as a non-statutory body in 1988, was raised to a complete capital market regulator with statutory powers in 1992. The requirement of prior government permission for accessing capital markets and for prior approval of issue pricing was stopped and companies were permissible to access markets and price issues freely, subject only to disclosure norms laid down by SEBI. 3.7 THE REGULATORY FRAMEWORK As the time passed, SEBI has implemented a modern regulatory framework with rules and regulations to control the behaviour of major market participants such as stock exchanges, brokers, merchant bankers, and mutual funds. It has also sought to control activities such as takeovers and insider trading which have implications for investor protection. The governing structure of stock exchanges has been changed to make the boards, of the exchanges more broad based and less dominated by brokers. The new regulatory framework intended to support investor protection by ensuring disclosure and transparency rather than through direct control. SEBI acts as a supervisor of the system undertaking supervision of the activities of 51 CU IDOL SELF LEARNING MATERIAL (SLM)
various participants including stock exchanges and mutual funds and violations of the rules are punishable by SEBI. The regulatory framework is new and there is a need to be advanced with experience gained and also as gaps and insufficiencies are identified. SEBI needs to be further strengthened in some areas and its disciplinary powers. 3.8 MUTUAL FUNDS Presently, the mutual funds industry is controlled under the SEBI (Mutual Funds) Regulations, 1996 and amendments thereto. With the issuance of SEBI rules, the industry had a framework for the setting up of many more companies, both Indian and foreign firms. The Unit Trust of India is biggest mutual fund controlling a quantity of nearly Rs.70,000crores, but its share is going down. With the growth in the securities markets and tax advantages granted for investment in mutual fund units, mutual funds became widespread. The foreign owned AMCs are the ones which are now setting the pace for the industry. They are introducing new products, setting new standards of customer service, improving disclosure standards and experimenting with new types of distribution. 3.9 OVERALL APPROACH TO REFORMS It is assessed that since last many years, there have seen major improvements in the working of various financial market contributors. The government and the regulatory authorities have followed a step-by-step approach. The entry of foreign companies has helped in the start of international practices and systems. Technology developments have enhanced customer service. Some gaps however remain such as lack of an inter-bank interest rate benchmark, an active corporate debt market and a developed derivatives market. In general, the cumulative effect of the developments since 1991 has been quite encouraging. An indication of the strength of the reformed Indian financial system can be seen from the way India was not affected by the Southeast Asian crisis. 3.10 SUMMARY The financial sector is main element of the Indian economic system. Financial experts suggested that there is a need for effective reforms to ensure that this remains competitive and attractive for investors from across the world. The economic reforms have preferred the need for changing the policy objective to promotion of industries and the formation of more integrated infrastructural facilities. Financial sector reforms are centre point of the economic liberalization that was introduced in India in mid-1991. 52 CU IDOL SELF LEARNING MATERIAL (SLM)
It was witnessed that national financial liberalisation has brought about the deregulation of interest rates, dismantling of directed credit, improving the banking system, enhancing the functioning of the capital market that include the government securities market. Regulators and economic experts put more emphasis on banking reforms to enhance economy and enable people to access numerous facilities. Fundamental objective of financial sector reforms in the 1990s was to create an effectual, competitive and steady that could contribute in greater measure to inspire progression. 3.11 KEYWORDS Financial advisor: A financial adviser or financial advisor (considered cognates with interchangeable spelling), is a professional who suggests and renders financial services to clients based on their financial situation. In many countries financial advisors have to complete specific training and hold a license to provide advice.. Financial consultant:A financial consultant is essentially the same as a financial advisor. They often offer a number of services, with their financial advice being based on the client’s specific needs and goals. In some cases, a financial consultant may have more financial planning experience than the typical financial advisor. Financial reforms: Financial sector reforms refer to the reforms in the banking system and capital market. An efficient banking system and a well-functioning capital market are essential to mobilize savings of the households and channel them to productive uses. The high rate of saving and productive investment are essential for economic growth. 3.12 LEARNING ACTIVITY 1. According to which of the following organisations, theAssume that the operating leases are treated as capital leases. In other words, do constructive globalisation is “a shift from a world of distinct national economies to a global economy in which production is internationalised and financial capital flows freely and instantly between countries” ?comment. WTO OECD IMF European Union ___________________________________________________________________________ ___________________________________________________________________________ 3.13UNIT ENDQUESTIONS A. Descriptive Questions Short Asnwer Questions 53 CU IDOL SELF LEARNING MATERIAL (SLM)
1. Whom do u call as a financial consultant? 2. What is a mutual fund? 3. who are market regulators? Long Questions 1. What do you understand by Financial Sector Reforms? Elucidate some Financial Sector Reforms in Context with the Banking Industry in India. 2. What were the objectives behind Trade and Investment Policy reforms? 3. Explain the changing role of state in Indian economy since introduction of reforms. B. Multiple Choice Questions 1.How many industries still need license for its operations? a. 4 b. 8 c. 10 d. 6 2.When government disinvests its shares to the extent of 5 to 10 percent to meet the deficit in the budget, this is termed as a. None b. Partial privatisation c. Token privatisation d. Denationalisation 3.LPG stands for: a. Liberalization, Production and Global Cooperation b. License, Privatization and Globalization c. Liberalization, Privatization and Globalization d. License, Permit and Goods 4.CRR is a. None b. The percentage of total deposits which the banks have to keep in the form of cash. c. The percentage of total deposits which the banks have to keep with the RBI. d. Both Answers 1( c) , 2( c) ,3(c ), 4(d) 3.14 REFERENCES 54 CU IDOL SELF LEARNING MATERIAL (SLM)
Gupta, P.K., Insurance and Risk Management, Himalaya Publishing House, NewDelhi. Mathew,M.J.,Insurance,RBSAPublishers,Jaipur. Ganguly, Anand, Insurance Management, New Age Publishers, New Delhi.Mishra,M.N.,Insurance,S.ChandandSons,NewDelhi. 55 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT -4 LEASING STRUCTURE 4.0 Learning objectives 4.1 Introduction 4.2 ConceptandEssentialsofLeasing 4.3Classificationof Leasing 4.4StepsinvolvedinLeasingTransaction 4.5AdvantagesofLeasing 4.6LimitationofLeasing 4.7HirePurchase 4.8Summary 4.9Keywords 4.10 Learning activity 4.11 Unit EndQuestions 4.12 References 4.0 LEARNING OBJECTIVES After studying this unit, students will be able to: Defineleasingandexplainitsessentials. Discusstheadvantages,limitationsandclassificationofleasing. Explainthevariouslegalaspectsofleasing. Definehirepurchaseanditsfeatures. 4.1 INTRODUCTION Traditionally firms acquire productive assets and use them as owners. Thesources of finance to a firm for procuring assets may be internal or external. Over theyears there has been a declining trend in the internally generated resources due to lowprofitability. The financial institutions experience paucity of funds at their disposal tomeettheincreasingneedsofborrowers.Further,modernbusinessenvironmentisbecoming more and more complex. To succeed in the situation, the firms aim at growthwithstability.Toaccomplishthisobjective,firmsarerequiredtogoformassiveexpansion, diversification and modernisation. Essentially such projects involve a hugeamount of investment. High rate of inflation, severe cost escalation, heavy taxation andmeagreinternalresourcesforcedmanycompaniestolookforalternativemeansoffinancingthepr ojects.Leasinghasemergedasanewsourceoffinancingcapitalassets. 56 CU IDOL SELF LEARNING MATERIAL (SLM)
4.2 CONCEPTANDESSENTIALSOFLEASING Leasing,asafinancingconcept,isanarrangementbetweentwoparties,theleasing company or lessor and the user or lessee, whereby the former arranges to buycapital equipment for the use of the latter for an agreed period of time in return for thepaymentofrent.Therentalsarepredeterminedandpayableatfixedintervalsoftimeaccording to the mutual convenience of both the parties. However, the lessor remains theowneroftheequipmentovertheprimaryperiod. Byresortingtoleasing,thelesseecompanyisabletoexploittheeconomicvalueof the equipment by using it as if he owned it without having to pay for its capital cost.Leaserentalscanbeconvenientlypaidovertheleaseperiodoutofprofitsearnedfromtheuseofthe equipmentandtherentiscentpercenttaxdeductible. Conceptually, a lease may be defined as a contractual arrangement /transaction inwhichapartyowninganasset/equipment(lessor)providestheassetforusetoanother/transfers the right to use the equipment to the user (lessee). Over a certain/for anagreed period of time for consideration in the form of/in return for periodic payment(rentals)withorwithoutafurtherpayment(premium).Attheendoftheperiodofcontract (lease period), the asset/ equipment reverts back to the lessor unless there is aprovision for the renewal of the contract. Leasing essentially involves the divorce ofownership from the economic use of an asset/equipment. It is a device of financing thecost of an asset. It is a contract in which a specific equipment required by the lessee ispurchased by the lessor (Financier) from a manufacturer/vendor selected by the lessee.The lessee has possession and use of the asset on payment of the specified rentals over apredeterminedperiodoftime.Leasefinancingisthusadeviceoffinancing/moneylending.Therealf unctionoralessorisnotrentingofassetbutlendingoffunds/finance/credit and lease financing is in effect a contract of lending money. Thelessor (financier) is the nominal owner of the asset as the possession and economic use tothe equipment vests in the lessee. The lessee is free to choose the asset according to hisrequirements and the lessor dose not take recourse to the equipment as long as the rentalsareregularlypaidto him. Theessentialelementsofleasingarethefollowing: Parties to the Contract : There are essentially two parties to a contract of leasefinancing, viz, the owner and the user, respectively called the lessor and the lesseeLessorsaswellaslesseesmaybeindividuals,partnerships,jointstockcompanies,corporations or financial Institution. Sometimes.there may be joint lessors or jointlessess, particularly where the properties or the amount of finance involved isenormous. Besides, there may be a lease-broker who acts as an intermediary inarrangingleasedeals.Merchant bankingdivisionsof certainforeignbanksinIndia, subsidiaries of some Indian banks and even some private merchant bankersareactingasleasebrokers.Theychargecertainpercentageoffeesfortheirservices, ranging between 0.50 to I per cent. Besides, a lease contract may involvea 'lease financier', 57 CU IDOL SELF LEARNING MATERIAL (SLM)
who refinances the lessor, either by providing term loans or bysubscribingtoequityorunderaspecificrefinancescheme. Asset :The asset, property or equipment to be leased is the subject matter of acontract of lease financing. The asset may be an automobile, plant and machinery,equipment, land and building, factory, a running business, aircraft, etc. The assetmust,however,beofthelessee'schoicesuitableforhisbusinessneeds. Ownership Separated from user :The essence of a lease financing contract isthat during the lease tenure, ownership of the asset vests with the lessor and its useis allowed to the lessee. On the expiry of the lease tenure, the asset reverts to thelessor. Term of Lease :The term of lease is the period for which the agreement of leaseremainsinoperation.Everyleaseshouldhaveadefiniteperiod,otherwiseitwillbe legally inoperative. The lease period may sometimes stretch over the entireeconomic life of the asset (i.e., financial lease) or a period shorter than the usefullife of the asset (i.e, operating lease). The lease may be perpetual, i.e., with anoptionattheendoftheleaseperiodtorenewtheleaseforafurtherspecificperiod. Lease Rentals :The consideration which the lessee pays to the lessor for theleasetransactionistheleaserental.The leaserentalsaresostructuredastocompensatethelessorfortheinvestmentmadeintheasset(inthefor mofdepreciation),theinterestontheinvestment,repairs,etc.ifanybornebythe lessorandservicingchargesovertheleaseperiod. ModesofTerminatingLease:Attheendottheleaseperiod,theleaseisterminatedandvarious coursesarepossible,viz., Theleaseisrenewedonaperpetualbasisorforadefiniteperiod, Theassetrevertstothelessor, Theassetrevertstothelessorandthelessorsellsittoathirdparty, Thelessorsellstheassettothelessee. Thepartiesmaymutuallyagreetoandchooseanyoftheaforesaidalternativesatthebeginningoft heleasenature. 4.3 CLASSIFICATIONOFLEASING An equipment lease transaction can differ on the basis of (1) the extent to whichtherisksandrewardsofownershiparetransferred,(ii)numberofpartiestothetransaction, (iii) domiciles of the equipment manufacturer, the lessor and the lessee, etc.Risk with reference to leasing refers to the possibility of loss arising on account of under- utilizationortechnologicalobsolescenceoftheequipmentwhilerewardmeanstheincremental net cash flows that are generated from the usage of the equipment over itseconomiclifeandtherealizationoftheanticipatedresidualvalueonexpiryoftheeconomiclife.Ont hebasisofthesevariations,leasingcanbeclassifiedintothefollowingtypes: a) Financeleaseandoperatinglease 58 CU IDOL SELF LEARNING MATERIAL (SLM)
b) Salesandleaseback,anddirectlease c) Singleinvestorleaseandleveragedlease d) DomesticleaseandInternationallease (a) FinanceLeaseandOperatingLease FinanceLease:AccordingtotheInternationalAccountingStandards(IAS- 17),inafinanceleasethelessortransferstothelessee,substantiallyalltherisksandrewardsincidental to the ownership of the asset whether or not the title is eventually transferred. Itinvolves payment of rentals over an obligatory non-cancelable lease period, sufficient intotal to amortize the capital outlay of the lessor and leave some profit. In such leases, thelessorisonlyafinancierandisusuallynotinterestedintheassets.Itisforthisreasonthat such leases are also usually not interested in the assests, It is for this reason that suchleasesarealsocalledfullpayoutleasesastheyenablealessortorecoverhisinvestmentin the lease and device a profit types of assets. Included under such lease are ships,aircraft, railway wagons, lands, building heavy machinery, diesel generating sets and soon. The IAS-17 stipulates that a substantial part of the ownership related risks andrewardsinleasingaretransferredwhen: 1. The ownership of the equipment is transferred to the lease by the end of the leasetermor 2. The lease has the option to purchase the asset at a price which is expected to besufficientlylowerthanthefairmarketvalueatthedatetheoptionbecomesexercisable and at the stipulation of the lease it is reasonable certain that the optionwillbeexercise 3. The lease term is for a major part of the useful life of the asset. The title may noteventuallybetransferred.Theusefullifeofanassetreferstotheminimumofits: Physicallifeintermsoftheperiodforwhichitcanperformitsfunction, Technological life in the sense of the period in which it does not becomeobsolete. Product market life deemed as the period during which its product enjoyssatisfactorymarket. Thecriterion/cut- offpointisthatiftheleasetermexceeds75percentoftheusefullifeoftheequipment,itisafinancelease. 4.Thepresentvalueoftheminimumleasepaymentisgreaterthan,orsubstantiallyequal to, the fairmarket value of the asset at the inception of the lease (cost orequipment).Thetitlemayormaynotbeeventuallytransferred.Thecut-offpointis that the present value exceeds 90 per cent of the fair market value of theequipment. The present value should be computed using a discount rate equal totherateimplicitintheleaseinthecaseoflessorand,inthecaseofthelessee,upontheincrementalborr owingrate InIndia,however,aleaseisafinancelease,ifoneofthelasttwoconditions, is satisfied. A lease agreement with any of the first two conditions istreatedashire-purchaseagreement. Afinanceleaseisstructuredtoincludethefollowingfeatures: Thelessee(theintendingbuyer)selectstheequipmentaccordingtohisrequirementfromitsmanu facturerordistributor. 59 CU IDOL SELF LEARNING MATERIAL (SLM)
The lessee negotiates and settles with the manufacturer or distributor, the price, thedeliveryschedule,installation,termsofwarranties,maintenanceandpayment,etc. Thelessorpurchasestheequipmenteitherdirectlyfromthemanufacturerordistributor (under straight-forward leasing) or from the lessee after the equipmentisdelivered(undersaleandleaseback). The lessor then leases out the equipment to the lessee. The lessor retains theownershipwhilelesseeisallowedtousetheequipment. A finance lease may provide a right or option, to the lessee, to purchase theequipmentatafuturedate.However,thispracticeisrarelyfoundinIndia The lease period spreads over the expected economic life of the asset. The lease isoriginallyforanon-cancelableperiodcalledtheprimaryleaseperiodduringwhich the lessor seeks to recover his investment along with some profit. Duringthis period cancellation of lease is possible only at a very heavy cost. Thereafter,the lease is subject to renewal for the secondary lease period, during which therentalsare substantiallylow. The lessee is entitled to exclusive and peaceful use of the equipment during theentire lease period provided he pays the rentals and complies with the terms of thelease. As the equipment is chosen by the lessee, the responsibility of its suitability, therisk of obsolescence and the liability for repair, maintenance and insurance or theequipmentrestwiththelessee. Operating Lease: An operating lease is one which is not afinance lease. In an operating lease, the lessor does not transfer all the risks and rewardsincidental to the ownership of the asset and the cost of the asset is not fully amortizedduring the primary lease period. The lessor provides services (other than the financing ofthe purchase price) attached to the leased asset, such as maintenance, repair and technicaladvice. For this reason, operating lease include a cost for the services provided, and thelessor does not depend on a single lessee for recovery of his cost. Operating lease isgenerallyusedforcomputers,officeequipments,automobiles,trucks,telephones,etc. Anoperatingleaseisstructuredwiththefollowingfeatures: An operating lease is generally for a period significantly shorter than theeconomic life of the leased asset. In some cases it may be even on hourly,daily, weekly or monthly basis. The lease is cancelable by either party duringtheleaseperiod. Sincetheleaseperiodsareshorterthantheexpectedlifeoftheasset,theleaserentalsarenotsuffici enttototallyamortizethecostoftheassets. The lessor does not rely on the single lessee for recovery of his investment.He has the ultimate interest in the residual value of the asset. The lessor bearsthe risk of obsolescence, since the lessee is free to cancel the lease at anytime. Operating lease normally include maintenance clause requiring the lessor tomaintaintheleasedassetandprovideservicessuchasinsurance,supportstair,fuel,etc. ExamplesofOperatingleasesare:- Providingmobilecraneswithoperators, 60 CU IDOL SELF LEARNING MATERIAL (SLM)
Charteringofaircraftandships,includingtheprovisionofcrew,fuelandsupportservices. Hiringofcomputerswithoperators, Hiringoftaxiforaparticulartravel,whichincludesserviceofdriver,provisionformaintenance,f uelimmediaterepairs,etc. b)Sale and Lease Back and Direct Lease Sale and Lease back : In a way, it is an indirect from of leasing. The owner of anequipment/asset sells it to a leasing company (Lessor) which leases it back to the owner(lessee). A classic example of this type of leasing is the sale and lease back of safedeposits values by banks under which banks sell them in their custody to a leasingcompany at a market price substantially higher than the book value. The leasing companyin turn offers these lockers on a long-term basis to the bank. The bank subleases thelockerstoitscustomers.Theleasebackarrangementinsaleandleasebacktypeofleasingcanbeinth eformoffinanceleaseoroperatinglease. Direct Lease :In direct lease, the lessee, and the owner of the equipment are twodifferententitiesadirectleasecanbeoftwotypes: BipartiteandTripartiteLease. BipartiteLease:Therearetwopartiesintheleasetransaction,namely, equipmentsupplier-cum-lessor lessee. Such a type of lease is typically structured as an operating lease withinbuiltfacilities,likeupgradationoftheequipment(UpgradeLease),additiontotheoriginalequi pmentconfigurationandsoon.Thelessormaintains the asset and, if necessary, replaces it with a similar equipment inworkingconditions(SwapLease). Tripartite Lease :Such type of lease involves three different parties in the leaseagreement:equipmentsupplier,lessorandlessee.Aninnovative variant of tripartitelease is the sales-aid lease under which the equipment supplier arranges for lease financeinvariouscompany; Providingreferenceaboutthecustomertotheleasingcompany, Negotiating the terms of the lease with the customer and completing all theformalitiesonbehalfof theleasingcompany, Writing the lease on his own account and discounting the lease receivableswith the designated leasing company. The effect is that the leasing companyownstheequipmentandobtainsanassignmentofleaserental. The sales-aid lease is usually with recourse to the supplier in the event of defaultby the lessee either in the form of offer from the supplier to buy back the equipment fromthelessororaguaranteeonbehalfofthelessee. c. SingleInvestorLeaseandLeveragedLease Single Investor Lease :There are only two parties to the lease transaction – the lessorandthelessee.Theleasingcompany(lessor)fundstheentireinvestmentbyanappropriate mix of debt and equity funds. The debts raised by the leasing company tofinance the asset are 61 CU IDOL SELF LEARNING MATERIAL (SLM)
without recourse to the lessee, i.e. in the case of default in servicingthedebtbytheleasingcompany,thelenderisnotentitledtopaymentfromthelessee. LeveragedLease:Therearethreepartiestothetransaction: (i)lessor(equityinvestor), (ii) lender and (iii) lessee. In such type of lease, the leasing company (equity investor)buys the asset through substantial borrowing. The lender (loan participant) obtains anassignment of the lease and a first mortgaged asset on the leased asset. The transaction isroutedthroughatrusteewholooksaftertheinterestofthelenderandlessor.Onreceiptoftherentalsfr omthelessee,thetrusteeremitsthedebtservicecomponentoftherentaltotheloanparticipantandtheb alancetothelessor. Likeotherleasetransactions,leveragedleaseentitlesthelessortoclaimtaxshieldsondepreciationan dothercapitalallowancesontheentireinvestmentcostincluding the non-recourse debt. The return on equity (profit after tax divided by networth) is, therefore, high. From the lessee's point of view, the effective rate of interestimplicit in the lease arrangement is less than on a straight loan as the lessor passes on theportion of the tax benefits to the lessee in the form of lower rental payments. Leveragedleasepackagesaregenerallystructuredforleasinginvestment- intensiveassetslikeaircrafts,ships,etc. d. DomesticLeaseandInternationalLease DomesticLease:Aleasetransactionisclassifiedasdomesticifallpartiestotheagreement, namely, equipment supplier, lessor and the lessee, are domiciled in the samecountry. International Lease : If the parties to the lease transaction arc domiciled in differentcountries, it is known as international lease, this type of lease is further sub- classifiedinto(I)ImportLeaseand(2)cross-borderlease. Import Lease :In an import lease, the lessor and the lessee are domiciled in the samecountry,buttheequipmentsupplierislocatedinadifferentcountrythelessorimportstheassetan dleasesittothelessee. Cross-borderLease:Whenthelessorandthelesseearedomiciledindifferentcountries, the lease is classified as cross-border lease, The domicile of the supplier isimmaterial. Operationally, domestic and international leases are differentiated on the basis ofrisk. The latter type of lease transaction is effected by two additional risk factors, i,e,country risk and currency risk. The country risk arises from the need to structure the leasetransaction in the light of an understanding of the political and economic climate and aknowledgeorthetaxandregulatoryenvironmentgoverningthemintheforeigncountries concerned. As the payment to the supplier and the lease rentals are denominatedindifferentcurrencies,anyvariationintheexchangeratewillinvolvecurrencyrisk. 4.4 STEPS INVOLVED IN LEASING TRANSACTION Thestepsinvolvedinaleasingtransactionaresummarisedasfollows: 62 CU IDOL SELF LEARNING MATERIAL (SLM)
1. First, the lessee has to decide the asset required and select the suppler. He has todecide about the design specifications, the price, warranties, terms of delivery,servicingetc. 2. The lessee, then enters into a lease agreement with the lessor. The lease agreementcontainsthetermsandconditionsoftheleasesuchas, a. Thebasicleaseperiodduringwhichtheleaseisirrecoverable. b. Thetimingandamountofperiodicalrentalpayments duringtheleaseperiod. c. Details of any option to renew the lease or to purchase the asset at the end oftheperiod. d. Detailsregardingpaymentofcostofmaintenanceandrepairs,taxes,insuranceandotherexpense s. 3. Aftertheleaseagreementissignedthelessorcontactsthemanufacturerandrequests him to supply the asset to the lessee. The lessor makes payment to themanufactureraftertheassethasbeendeliveredandacceptedbythelessee. 4.5 ADVANTAGEOFLEASING TotheLessee:Leasefinancinghasthefollowingadvantagestothelessee: Financing of Capital goods :-Lease financing enables the lessee to have financefor huge investments in land, building, plant, machinery, heavy equipment’s, etc.,up to 100 per cent, without requiring any immediate down payment. Thus, thelesseeisabletocommencehisbusinessvirtuallywithoutmakinganyinitialinvestment(ofcourse, hemayhavetoinvesttheminimalsumofworkingcapitalneeds). Additional Source of Finance :-Leasing facilitates the acquisition of equipment,plantandmachinery,withoutthenecessarycapitaloutlay,and,thus,hasacompetitive advantage of mobilizing the scarce financial resources of the businessenterprise.Itenhancestheworkingcapitalpositionandmakesavailabletheinternalaccruals forbusinessoperations. LessCostly:-Leasingasamethodoffinancingislesscostlythanotheralternativesavailable. Off-BalanceSheetFinancing:- Neithertheleasedassetisdepictedonthebalancesheet,northeleaseliabilityisshown,exceptthatthefa ctofleasearrangement is mentioned by way of a footnote. Lease financing, therefore, doesnot affect the debt raising capacity of the enterprise, the lessor's security being alsoconfirmedtotheleasedasset. However, the advantage is by, and large, more apparent than real. Developmentbanks and other lending agencies do not base their decision to lend solely on the apparentstrengthofthebalancesheetoftheborrower.Theycertainlycallforinformationregardingth eoff-balancesheetliabilitiestoassesstherealborrowingcapacity. But the off-balance sheet financing can be misleading to lenders who rely on thefinancial statements. In brief, the non- disclosure of outstanding lease obligations and thevalue of the leased assets in the balance sheet would result in (i) understatement of debt -equity ratio and (ii) Over statement of asset turnover ratio as well as return on investment.They under-estimate the real risk and over- 63 CU IDOL SELF LEARNING MATERIAL (SLM)
estimate the value of the firm as they areaffectedbythesevariables.Inrecognitionofthedistortionsimplicitinthenon-disclosures of finance lease in the financial statements of the lessee. Ownership Preserved: - Leasing provides finance without diluting the ownershiporcontrolofthepromoters.Againstit,othermodesoflong- termfinance,viz,equityordebentures,normallydilutetheownershipofthepromoters Avoid Conditionalities:-Lease finance is considered preferable to institutionalfinance, as in the former case, there are no conditionalities. Lease financing isbeneficial since it is free from restrictive covenants and conditionalities, such as,representations on the board, conversion of debt into equity, payment of dividend,etc,whichusuallyaccompanyinstitutionalfinanceandtermloansfrombanks. Flexibility in Structuring of Rentals:-The lease rentals can be structured toaccommodate the cash flow situation of the lessee, making the payment of rentalsconvenienttohim.Theleaserentalsaresotailor-madethatthelesseeisabletopay the rentals from the funds generated from operations. The lease period is alsochosensoastosuitthelessee’scapacitytopayrentalsandconsideringtheoperatinglife- spanoftheasset. Simplicity:- A lease finance arrangement is simple to negotiate and free fromcumbersomeprocedureswithfasterandsimpledocumentation.Asagainstit,institutionalfinan ceandtermloansrequirecomplianceofcovenantsandformalitiesandbulkofdocumentation,causin gproceduraldelays. Tax Benefits:- By suitable structuring of lease rentals, a lot of tax advantages canbe derived. If the lessee is in a tax paying position, the rental may be increased tolowerhistaxableincome.Thecostofassetisthusamortizedmorerapidlythanina case where the asset is owned by the lessee, since depreciation is allowable at theprescribed rates. If the lessor is in tax paying position, the rentals may be loweredto pass on a part of the tax benefit to the lessee. Thus, the rentals can be adjustedsuitablyforpostponementoftaxes. ObsolescenceRiskisAverted:-Inaleasearrangementthelessorbeingtheowner bears the risk of obsolescence and the lessee is always free to replace theassetwiththelatesttechnology. TotheLessor:-Alessorhasthefollowingadvantages: Full Security :-The lessor's interest is fully secured since he is always the ownerof the leased asset and can take repossession of the asset if the lessee defaults. Asagainstit,realisinganassetsecuredagainstaloanismoredifficultandcumbersome. Tax Benefit :-The greatest advantage for the lessor is the tax relief by way ofdepreciation. If the lessor is in high tax bracket, he can lease out assets with highdepreciation rates, and thus, reduce his tax liability substantially. Besides, therentalscanbesuitablystructuredtopassonsometaxbenefittothelessees. 64 CU IDOL SELF LEARNING MATERIAL (SLM)
High Profitability :-The leasing business is highly profitable since the rate ofreturn is more than what the lessor pays on his borrowings. Also, the rate of returnismorethanincaseoflendingfinancedirectly. Trading on Equity :-Lessors usually carry out their operations with greaterfinancialleverage,Thatis,theyhaveaverylowequitycapitalanduseasubstantial amount of borrowed funds and deposits. Thus, the ultimate return onequityisveryhigh. High Growth Potential :-The leasing industry has a high growth potential.Leasing financing enables the lessees to acquire equipment and machinery evenduringaperiodofdepression,sincetheydonothavetoinvestanycapital.Leasing,thus,maintains theeconomicgrowthevenduringrecessionaryperiod. 4.6 LIMITATIONSOFLEASING Leasefinancingsuffersfromcertainlimitationstoo: RestrictionsonUseofEquipment:-Aleasearrangementmayimposecertainrestrictions on use or the equipment, or require compulsory insurance, etc. Besides, thelesseeisnotfreetomakeadditionsoralterationstotheleasedassettosuithisrequirements. LimitationsofFinancialLease:-Afinancialleasemayentailhigherpayoutobligations,if the equipment is found not useful and the lessee opts for premature termination of thelease agreement. Besides, the lessee is not entitled to the protection of express or impliedwarrantiessinceheisnottheowneroftheasset. Loss of Residual Value:-The lessee never becomes the owner of the leased asset. Thus,heisdeprivedoftheresidualvalueoftheassetandisnotevenentitledtoanyimprovements done by the lessor or caused by inflation or otherwise, such as appreciationinvalueofleaseholdland. Consequences of Default:-If the lessee defaults in complying with any terms andconditions of the lease contract, the lessor may terminate the lease and take over thepossession of the leased asset. In case of finance lease, the lessee may be required to payfordamagesandacceleratedrentalpayments. Understatement of Lessee's Asset :-Since the leased assets do not form part of lessee'sassets, there is an effective understatement of his assets, which may sometimes lead togross under-estimation of the lessee. However, there is now an accounting practice todisclosetheleasedassetsbywayorfootnotetothebalancesheet. DoubleSalesTax:-Withtheamendmentofsale-taxlawinvariousstates,aleasefinancing transaction may be charged to sales tax twice-once when the lessor purchasestheequipmentand again when it is leased to the lessee. 4.7 HIREPURCHASE Hirepurchaseisamethodofsellinggoods.Inahirepurchasetransactionthegoodsareletoutonhirebya financecompany(creditor)tothehirepurchasecustomer(hirer). The buyer is required to pay an 65 CU IDOL SELF LEARNING MATERIAL (SLM)
agreed amount in periodical instalmentsduring a given period. The ownership of the property remains with creditor and passes ontohireronthepayment oflastinstalment. FeaturesofHirePurchaseAgreement Underhirepurchasesystem,thebuyertakespossessionofgoodsimmediatelyandagreestopayth etotalhirepurchasepriceininstallments. Eachinstallmentistreatedashirecharges Theownershipofthegoodspassesonthehireronthepaymentoflastinstallment. In case the buyer makes any default in the payment of any installment theseller has right to repossess the goods from the buyer and forfeit the amountalreadyreceivedtreatingitashirecharge. Thehirerhastherighttoterminatetheagreementanytimebeforetheproperty passes. He has the option to return the goods in which case he neednot pay installments falling due thereafter. However, he can not recover thesums already paid as such sums legally represent hire charge on the goods inquestion . LegalPosition The Hire Purchase Act, 1972 defines a hire purchase agreement as, 'an agreementunder which goods are let on hire and under which the hirer has an option to purchasetheminaccordancewiththetermsofagreementunderwhich: Paymentistobemadeininstallmentsoveraspecifiedperiod. Thepossessionisdeliveredtothepurchaseratthetimeofenteringintoacontract. Thepropertyinthegoodspassestothepurposeonpaymentofthelastinstallment. Eachinstallmentistreatedashirechargesothatifdefaultismadeinpaymentofanyoneinstallmen t,thesellerisentitledtotakeawaythegoods. Thehirer/purchaserisfreetoreturnthegoodswithoutbeingrequiredtopayanyfurtherinstalmentsfall ingdueafterthereturn. HirePurchaseAgreement There is no prescribed form for a hire purchase agreement, but it has to be inwritingandsignedbybothpartiestotheagreement.Ahirepurchaseagreementmustcontainthefollo wingparticulars: Thedescriptionofgoodsinamannersufficienttoidentitythem. Thehirepurchasepriceofthegoods. Thedateofcommencementoftheagreement. Thenumberofinstalmentsinwhichhirepurchasepriceistobepaid,theamount,andduedate. HirePurchaseandCreditSale Higher purchase transaction is different from credit sale. In case of actual sale, the title inthe property i.e, ownership and possession is transferred to the purchaser simultaneously,inhirepurchasetheownershipremainswiththeselleruntillastinstalmentispaid. HirePurchaseandInstalmentSale 66 CU IDOL SELF LEARNING MATERIAL (SLM)
Hire purchase transaction is different from instalmentsystem. Incase of instalmentsystem it is not only the possession but also the ownership of goods which is transferredtothebuyerimmediatelyatthetimeofagreement.Further,whenthebuyerstopspayment of dues, the seller, has no right to repossess the goods. He has the only right tosue the buyer for the non payment by returning the goods but has the right of disposing ofthe goods in any manner as he likes. Any loss of goods should be borne only by the buyerasrisklieswiththeownership. HirePurchaseandLeasing HirePurchaseisalsodifferentfromleasingonfollowinggrounds: Ownership In a contract of lease, the ownership rests with the lessor throughout and the lessee(hirer)hasnooptionpurchasethegoods. MethodofFinancing Leasingisamethodoffinancingbusinessassetswhereashirepurchaseisamethodoffinancingbothbu sinessassetsandconsumersarticles. Depreciation In leasing depreciation and investment allowance can not be claimed by the lessee.In hire purchase, deprecation and investment allowance can be claimed by thehirer. TaxBenefits The entire lease rental is tax deductible expense. Only the interest component ofthehirepurchaseinstallmentistaxdeductible. SalvageValue Thelessee,notbeingtheowneroftheasset,doesnotenjoythesalvagevalueofthe asset. The hirer, in purchase, being the owner of the asset, enjoys salvage valueoftheasset. Deposit Lessee is not required to make any deposit whereas 20% deposit is required in hirepurchase. Rent-Purchase Withlease,werentandwithhirepurchasewebuythegoods. ExtentofFinance Lease Financing is invariably 100 per cent financing. It requires no immediatedown payment or margin money by the lessee. In hire purchase, a margin equal to20- 25percentofthecostoftheassetistobepaidbythehirer. Maintenance The cost of maintenance of the hired asset is to be borne by the hirer himself. Incaseoffinanceleaseonly,themaintenanceofleasedassetistheresponsibilityofthelessee. Reporting The asset on hire purchase is shown in the balance sheet of the hirer. The leasedassetsareshownbywayoffootnoteonly. BankCreditforHirePurchaseBusiness 67 CU IDOL SELF LEARNING MATERIAL (SLM)
The subsidiary of commercial banks lend to the dealer or to finance intermediarywho has already financed articles sold by the dealer to the hirer under a hire purchasecontract. While considering proposals from dealers or hire purchase financing companies,the bank subsidiary has to take extra precautions, looking to the particular nature oftransactionunderhirepurchasecontract. Whenofferedthistypeofbusiness,thebanksubsidiarywouldmakeanassessment of the standing and financial position of the dealer or of the hire purchasecompany, and take into consideration the principles of good lending and carry out theprocedurebelow: Customer Whenapproachedforhirepurchasefacilitythesubsidiaryshouldtakecaretomaketheassessmentoft hestandingandfinancialpositionofthebusinesscustomer. Purpose The type of goods being used to finance in the hire purchase transaction is of greatimportance.Intheeventofdefaultthebankmayreconsiderrepossessingthegoods and selling them to clear the advance. Thus, if the goods can be readily soldelsewhere (e.g. a relatively new car), then these agreements are better security thanthosefor(say}cameras.whichwillhavealowerresalevalue. Amount Bank subsidiaries taking up hire purchase business would do well to discouragesmallindividualloans.Inordertoensureproperservicingandmonitoring,itisalso essential to a have floor limit in the amount of individual hire purchasetransactions. While it may be about Rs. 50,000 for automobile sector, it may beaboutRs.10,000forconsumerdurables. Period Thefacilitywillnormallybeextendedovertothreeyears. Repayment Repayment are spread evenly, or agreed, over the loan period. The repaymentshould be adaptable to the hirer's needs. The repayment can usually be tailor madeto suit the income generated from the use of asset so that it is self-financing.Sometimes, repayment holidays can be allowed and repayment is delayed until theasset is operational or producing profit. To ensure timely recovery in the case orcar two-wheeler, and consumer durable financing, it could be preferable to haveinstitutional tie-ups with employers/employees' cooperative societies for the whicheligibilitycriteria can belaiddown. Security Technically hire purchase advance is against hypothecation of equipment/vehiclesand pledge of hundis / pronotes and lodgements of hire purchase agreements. Thebank subsidiary will ask the borrower to complete the bank's form of security tocharge the security under an equitable/hypothecation charge. If the borrower is alimitedcompanywhichisnotofsufficientstrengthtoallowequitable/hypothecation facility and if 68 CU IDOL SELF LEARNING MATERIAL (SLM)
suitable security is not available it is normal to obtaina debenture over the assets of the company under which a floating charge isobtained. If necessary the bank subsidiary will ask the hirer to furnish a guarantor ofmeans and the bank would in such a case insist that the guarantor should alsoaccept the hundies. It is a practice with some banks to insist for insurance policy toindemnify the bank against the default of the hirer. The premiums will be chargedtothehirer.In view of the cost and difficulty of the repossession of a fast depreciatingasset,thecustomer'sabilitytorepayisvitalandnorelianceisplacedonsecurity. MonitoringandControl Thebankneedstoexercisecontrolovertheon-goingsituation.Aperiodicalcertificate should be obtained from the finance company at the monthly intervals,statingthetotalamountofoutstandingbutexcludingthosehirepurchaseagreements which have become in arrears and are, therefore, suspect. One or twomonths in arrears may be acceptable but more than that suggest that the particularhirer is in permanent default. The bank will keep a running total of these amounts,returningagreementswhichhavebecomelapsedtotheircustomers. 4.8 SUMMARY A financial arrangement that provides a firm with the advantage of using an assetwithout owning it is known as leasing. A lease is of various types. The participants in alease include the lessor and the lessee. The lessor extends several benefits to the partiesinvolved in a lease arrangement. Leasing is of immense use to both the lessor and thelessee. Leasing facilitates accelerated production and sale of goods, provides tax benefitsto lessee, gives a fillip to the capital market, provides a cheaper source of capital funds,and helps avoid capital outlay. However, leasing is fraught with many drawbacks. Hirepurchase is a contractual arrangement under which the owner lets his goods on hire to thehirer and offers an option to the hirer for purchasing the goods in accordance with thetermsofthecontract. 4.9 KEYWORDS Lease:Leaseisarentalagreementwherebyonepersonacquirestheuseofanassetonpaymentofp eriodicalrentals. Lessor:Heisapersonwhoconveystoanotherpartytherighttouseanassetinconsiderationofaper iodicalrentalpayment. Lessee:Lesseeisapersonwhoobtainstherighttousetheassetfromthelessorforaperiodicalrenta lpaymentforanagreedperiodoftime. Financial Lease:Aleaseisdefinedasafinancialleaseifittransfersasubstantialpartoftherisksandrewardsassoc 69 CU IDOL SELF LEARNING MATERIAL (SLM)
iatedwithownershipfromthelessortothelessee. OperatingLease:Anleaseotherthanafinanceleaseisknownanoperatinglease. Hire Purchase: Hire purchase refers to a transaction of finance whereby goods areboughtandsoldundercertaintermsandconditions,suchaspaymentofperiodicinstalments,imme diatepossessionofgoodstothebuyeretc. 4.10 LEARNING ACTIVITY 1. Quality Supermarkets has taken occupancy of a retail building and has a long-term lease. As part of their fit-up, they bolt to the floor their meat and check-out stands.When quality Supermarkets vacates the property at the end of the lease, will Quality Supermarkets be legally entitled to remove these fixtures? ___________________________________________________________________________ ___________________________________________________________________________ 4.11UNIT ENDQUESTIONS A. Descriptive Questions Short Questions 1. Defineleasing.Explainthedifferentkindsofleasing. 2. Discusstheadvantagesanddisadvantagesofleasing. 3. Define hire purchase. discuss its features. Long Questions 4. Discussthesuperiorityofleasefinanceoverotheralternatives. 5. DiscussthestatusofincometaxandsalestaxincontextofleasinginIndia. B.Multiple Choice Questions 1. One difference between a financial lease and operating lease is that a. there is a often a call option in a financial lease. b. there is often an option to buy in an operating lease. c. an operating lease is often cancellable by the lessee. d. a financial lease is often cancellable by the lessee. 2. The principal reason for the existence of leasing is that: a. intermediate-term loans are difficult to obtain. b. this is a type of financing unaffected by changes in tax law. c. companies, financial institutions, and individuals derive different benefits from owningassets. dleasing is a renewable source of intermediate-term funds. 70 CU IDOL SELF LEARNING MATERIAL (SLM)
3. A way to analyze whether debt or lease financing would be preferable is to: a. compare the net present values under each alternative, using the cost of capitalas the discount rate. b. compare the net present values under each alternative, using the after-tax costof borrowing as the discount rate. c. compare the payback periods for each alternative. d. compare the effective interest costs involved for each alternative. 4. A conventional revolving credit agreement allows a firm: a. to borrow a fixed amount for the entire commitment period. b. to borrow for a short-period with a right to renew the loan during the commitmentperiod. c. to possibly include a provision to convert the credit agreement into a term loancontract at maturity. d. All of these 5. The type of lease that includes a third party, a lender, is called a(n): a. sale and leaseback. b. direct leasing arrangement. c. leveraged lease. d. operating lease. 6. One advantage of a financial lease is that: a. it has a shorter maturity than term loans. b. it never appears as a liability on the balance sheet. c. it eliminate the needs to make periodic payments. d. it provides a way to indirectly depreciate land. 7. Medium-term notes (MTNs) have maturities that range up to a. one year (but no more). b. two years (but no more). c. ten years (but no more). d. thirty years (or more) 8. A direct lease, a sale and leaseback, and a leveraged lease are all examples of a. operating leases. b. financial leases. c. full-service leases. d. \"off-balance sheet\" methods of financing. 71 CU IDOL SELF LEARNING MATERIAL (SLM)
Answers 1(b) ,2(b) ,3(c) ,4(c) ,5(b) ,6(c) ,7(b) ,8(b) 4.12REFERENCES Text Books: Bhalla, V. K.“ Management of Financial Services” Anmol Publications Clifford Gomez “ Financial Markets, Institutions and Financial Services”, PHI Learning Rose, Peter and Hudgins, Sylvia,“ Bank Management and Financial Services”, McGraw Hills. Reference Books: Padamlatha ,“ Management of Banking and Financial Services”, Pearson Education. Saunders, Antony and Cornett, Marcia,“ Financial Institutions Management: A Risk Management Approach” McGraw Hills 72 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 5LEGAL ASPECTS OF LEASING STRUCTURE 5.0 Learning Objectives 5.1Introduction 5.2LegalAspectsof Leasing 5.3ContentsofaLeaseAgreement 5.4IncomeTaxProvisionsrelatingtoLeasing 5.5SalesTaxProvisionspertainingtoLeasing 5.6 Accounting 5.7StructureofLeasingIndustryinIndia 5.8 Public Sector Leasing 5.9ProblemofLeasing 5.10 ProspectsofLeasing 5.11Summary 5.12 Keywords 5.13 Learning activity 5.14Unit End questions 5.15 References 5.0 LEARNING OBJECTIVES After studying this unit, students will be able to: Explainthevariouslegalaspectsofleasing. Discuss the problem and prospects in leasing 5.1 INTRODUCTION Toaccomplishthisobjective,firmsarerequiredtogoformassiveexpansion, diversification and modernisation. Essentially such projects involve a hugeamount of investment. High rate of inflation, severe cost escalation, heavy taxation andmeagreinternalresourcesforcedmanycompaniestolookforalternativemeansoffinancingthepr ojects.Leasinghasemergedasanewsourceoffinancingcapitalassets. 5.2LEGAL ASPECTS OF LEASING There is no separate statute for equipment leasing in India. The provisions relating to bailment in the Indian Contract Act govern equipment leasing agreements as well Section 148 of the Indian Contract Act define bailment as : - 73 CU IDOL SELF LEARNING MATERIAL (SLM)
The delivery of goods by one person to another, for some purpose, upon a contract that they shall, when the purpose is accomplished, be returned or otherwise disposed off according to the directions of the person delivering them. The person delivering the goods is called the' bailor' and the person to whom they are delivered is called the ‘bailee’. Since an equipment lease transaction is regarded as a contract of bailment, the obligations of the lessor and the lessee are similar to those of the bailor and the bailee (other than those expressly specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian Contract Act. Essentially these provisions have the following implications for the lessor and the lessee. 1. The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement. 2. The lessee has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor's title to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period. 5.3 CONTENTS OF A LEASE AGREEMENT The lease agreement specifies the legal rights and obligations of the lessor and the lessee. It typically contains terms relating to the following : 1. Description of the lessor, the lessee, and the equipment. 2. Amount, time, and place of rental payments. 3. Time and place of equipment delivery. 4. Lessee's responsibility for taking delivery and possession of the leased equipment. 5. Lessee's responsibility for maintenance, repairs, registration, etc and the lessor's right in case of default by the lessee. 6. Lessee's right to enjoy the benefits of the warranties provided by the equipment manufacturer/supplier. 7. Insurance to be taken by the lessee on behalf of the lessor. 8. Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives. 9. Option of lease renewal for the lessee. 10. Return of equipment on expiry of the lease period. 11. Arbitration procedure in the event of dispute. 5.4 INCOME TAX PROVISIONS RELATING TO LEASING The principal income tax provisions relating to leasing are as follows: 1.The lessee can claim lease rentals as tax-deductible expenses. 2.The lease rentals received by the lessor are taxable under the head of 'Profits and Gains of Business or Profession’. 3.The lessor can claim depreciation on the investment made in leased assets. 74 CU IDOL SELF LEARNING MATERIAL (SLM)
5.5 SALES TAX PROVISIONS PERTAINING TO LEASING The major sales tax provisions relevant for leasing are as follows: 1.The lessor is not entitled for the confessional rate of central sales tax because the asset purchased for leasing is meant neither for resale nor for use in manufacture. (It may be noted that if a firm buys an asset for resale or for use in manufacture it is entitled for the confessional rate of sales tax). 2.The 46th Amendment Act has brought lease transitions under the purview of 'sale' and has empowered the central and state government to levy sales tax on lease transactions. While the Central Sales Tax Act has yet to be amended in this respect, several state governments have amended their sales tax laws to impose sales tax on lease transactions. 5.6 ACCOUNTING TREATMENT OF LEASE Presently the accounting treatment of lease transactions in India is as follows: 1. The leased asset is shown on the balance sheet of the lessor. 2. Depreciation and other tax shields associated with the leased asset are claimed by the lessor. 3. The entire lease rental is treated as income in the books of the lessor and as expense in the books of the lessee. In nutshell, from the point of view of the lessee, a lease transaction represents an off-the balance-sheet transaction and this appears to be an important advantage associated with leasing. It may be noted that in countries like the United States and the United Kingdom, where leasing is very popular, leases which meet certain criteria are capitalised in the books of the lessee. This essentially implies that: (a)the leased asset and the corresponding liability (reckoned at the present value of the stream of rental payments) are shown on the balance sheet of the lessee. (b)depreciation charges are claimed by the lessee, and (c)the lease rental is split into two parts, the interest component (which is charged to the profit and loss statement) and the principal repayment component 5.7 STRUCTURE OF LEASING INDUSTRY IN INDIA The present structure of leasing industry in India consists of (i) Private Sector Leasing and (ii) Public Sector Leasing. The private sector leasing consists of : (i) Pure Leasing Companies. (ii) Hire Purchase and Finance Companies and (iii) Subsidiaries of Manufacturing Group Companies. The public sector leasing organisation are divided into: (i) Leasing divisions of financial institutions. 75 CU IDOL SELF LEARNING MATERIAL (SLM)
(ii) Subsidiaries of public sector banks. (iv) Other public sector leasing organisations. (i)Pure Leasing Companies These companies operate independently without any link or association with any other organisation or group of organisation. The First Leasing Company of India Limited, The Twentieth Century Finance corporation Limited, and the Grover Leasing Limited, fall under this category. (ii)Hire Purchase and Finance Companies The companies started prior to 1980 to do hire purchase and finance business especially for vehicles added leasing to their activities during 1980. Some of them do leasing as major activity and some others do leasing on a small scale as a tax planning device. Sundaram Finance Limited and Motor and General Finance Limited belong to this group. (iii)Subsidiaries of Manufacturing Group Companies These companies consist of two categories vendor leasing and in house leasing (a)Vendor Leasing : This type of companies are formed to boost and promote the sale of its parent companies products through offering leasing facilities. (b)In house leasing : In house leasing or capture leasing companies are set up to meet the fund requirements or to avoid the income tax liabilities of the group companies. 5.8 PUBLIC SECTOR LEASING (i) Financial Institutions : The financial institution such as IFCI, ICICI, IRBI and NSIC have set up their leasing divisions or subsidiaries to do leasing business. The Shipping Credit and Investment Company of India offers leasing facilities in foreign currencies for ships, deep seas fishing vehicles and related equipment to its clients. (ii) Subsidiaries of Banks: The commercial banks in India can under section 19(1) of the Banking Regulation Act, 1949, set up subsidiaries for undertaking leasing activities. The SBI was the first bank to start a subsidiary for leasing business in 1986. Leasing in SBI is transacted through, Strategic Business Unit (SBU) of the bank. Each SBU is manned by specially trained staff and is equipped with the latest technological aids to meet the needs of top corporate clients. For the bank as a whole, leasing is considered as a high growth area. Other Public Sector Organisations: A few public sector manufacturing companies such as Bharat Electronics Limited, Hindustan Packaging Company Limited, Electronic Corporation of India Limited have started to sell their equipment through leasing. 5.9 PROBLEM OF LEASING Leasing has great potential in India. However, leasing in India faces serious handicaps which may mar its growth in future. The following are some of the problem : 76 CU IDOL SELF LEARNING MATERIAL (SLM)
1.Unhealthy Competition The market for leasing has not grown with the same pace as the number of lessors. As a result, there is over supply of lessors leading to competition. With the leasing business becoming more competitive, the margin of profit for lessors has dropped from four to five per cent to the present 2.5 to 3 per cent. Bank subsidiaries and financial institutions have the competitive edge over the private sector concerns because of cheap source of finance. 2.Lack of Qualified Personnel Leasing requires qualified and experienced people at the helm of its affairs. Leasing is a specialised business and persons constituting its top management should have expertise in accounting, finance, legal and decision areas. In India, the concept of leasing business is of recent one and hence it is difficult to get right man to deal with leasing business. On account of this, operations of leasing business are bound to suffer. 3.Tax Considerations Most people believe that lessees prefer leasing because of the tax benefits it offers. In reality, it only transfers, the benefit i.e. the lessee's tax shelter is lessor's burden. The lease becomes economically viable only when the transfer's effective tax rate is low. In addition, taxes like sales tax, wealth tax, additional tax, surcharge etc. add to the cost of leasing. Thus leasing becomes more expensive from of financing than conventional mode of finance such as hire purchase. 4.Stamp Duty The States treat a leasing transaction as a sale for the purpose of making them eligible to sales tax. On the contrary, for stamp duty, the transaction is treated as a pure lease transaction. Accordingly a heavy stamp duty is levied on lease documents. This adds to the burden of leasing industry. 5.Delayed Payment and Bad Debts The problem of delayed payment of rents and bad debts add to the costs of lease. The lessor does not take into consideration this aspect while fixing the rentals at the time of lease agreement. These problems would disturb prospects of leasing business. 5.10 PROSPECTS OF LEASING Leasing today accounts for six per cent of the total capital investment in India. Leasing will play a significant role to account for at least 15 per cent of gross capital formation. The world leasing industry grew at a rate of about 10 per cent. As the economy is opened up there will be substantial demand for a variety of leasing products such as foreign currency leases, cross border leases, leverage leases etc. Leasing companies set for substantial growth in line with international trends. Leasing has great prospects in India. It is on the threshold of a major break through in industrial development due to liberalised economic policy measures initiated by the government. Leasing as a convenient and flexible financing option can play a vital role in the process of industrial development. The leasing industry has taken the centre stage with the 77 CU IDOL SELF LEARNING MATERIAL (SLM)
government and public sector undertakings are looking to industry to finance railway, telecommunication, transport, power and infrastructure sectors. The infrastructure financing so crucial for an economic growth can not be accelerated without leasing industry. The government has indicated that it is open to suggestions for reviewing the existing policies. Such conduciveness and the willingness to prevent bottlenecks in the area of taxation and other areas will go a long way in speeding up the growth of the industry. 5.11 SUMMARY Leasing companies may be non-banking finance companies, or non-banking non- financial companies. Financial leasing is regarded as a financial activity; operating leasing is not. Hence, if an entity is principally engaged in either financial leasing or other lending activities, it will need to register itself as a Non-Banking Financial Company (NBFC) with the RBI. Companies principally engaged in operating leases are non-banking non-financial entities, and do not come under regulatory purview of the RBI. If a leasing entity is an NBFC, it will need to adhere to several prudential guidelines of the RBI. The tax nuances of leasing are with regard to applicable direct tax provisions, the tax issues are seemingly addressed with regard to indirect tax with GST coming into effect. In terms of direct taxation, the income from leasing business is taxable after granting depreciation deduction. While the law does not specifically lay down distinction between financial and operating leases, from the point of income tax incidence, it is generally believed that it is only in case of operating leases that the depreciation is claimed by the lessor. In case of a financial lease, it is the Lessee who claims the depreciation. Depreciation rates for most common-use assets in India ranges between 15%-20% on declining balances method; as a result, most lease transactions do not result into a significant tax advantage to the lessor. 5.12 KEYWORDS Incidental expenses - Your costs on top of base rent. These can include property tax, insurance, utilities, maintenance, common area costs and repairs. Common area maintenance - An incidental expense in some commercial real estate leases. All tenants generally share common area costs. Examples include fees for snow removal, janitorial services, landscaping, grass cutting and property management. Gross rent lease - A type of commercial real estate lease under which you pay a single amount to the landlord that covers base rent and all incidental expenses. Modified gross lease - A type of a commercial real estate lease under which you and the landlord share certain incidental expenses. Net lease - A type of commercial real estate lease under which you typically pay for one incidental expense directly. In a single net lease, you usually pay the base rent plus 78 CU IDOL SELF LEARNING MATERIAL (SLM)
property taxes (though in some cases, you might pay for insurance or utilities instead). The landlord pays all other expenses. Double net lease (NN) - A type of commercial real estate lease under which you usually pay the base rent plus two incidentals—for example, property taxes and insurance. The landlord covers all other expenses. Triple net lease (NNN) - A type of commercial real estate lease under which you typically pay the base rent, plus property taxes, building insurance and utilities, as well as other operating and maintenance costs. The landlord assumes no costs, other than those for structural repairs. Percentage rent lease - A type of commercial real estate lease under which you pay a base rent plus a percentage of gross sales over a certain minimum. These are usually used in malls and other multi-tenant retail locations. Tenant improvement allowance - A cash amount offered by a landlord to help you pay for renovations to a leased space. The allowance is usually a certain amount of money per square foot of rented space. It is sometimes offered as a tenant inducement. Tenant inducements - Incentives offered by a landlord to encourage you to rent a space. Examples include several months rent free or help with paying for leasehold improvements. Trade fixtures - Items in a leased space that you can take with you when you move out. A trade fixture can generally be easily removed without damaging the property. Examples include furniture, inventory and computers. Get advice from a commercial real estate lawyer before signing a lease to clearly define trade fixtures and to seek exclusions for assets you want to take with you when you leave. Turnkey improvements (also known as turnkey buildouts) - Renovations that a landlord carries out at your request when you sign a lease. A landlord may agree to these as a tenant inducement. Leasehold improvements (also known as tenant improvements) Renovations to a leased commercial real estate space to make it suitable for your business. Unless otherwise specified in the lease, any improvement that is attached to the building usually becomes the property of the landlord 5.13LEARNING ACTIVITY 1. State the difference between operating and Finance Lease technically ___________________________________________________________________________ ___________________________________________________________________________ 5.14UNIT ENDQUESTIONS A.Descriptive Questions 79 Short Questions CU IDOL SELF LEARNING MATERIAL (SLM)
1. What is finance lease? 2. Mentions the types of leases available. Long Questions 1. Discussthesuperiorityofleasefinanceoverotheralternatives. 2. DiscussthestatusofincometaxandsalestaxincontextofleasinginIndia. B. Multiple Choice Questions 1. One difference between a financial lease and operating lease is that: a. there is a often a call option in a financial lease. b. there is often an option to buy in an operating lease. c. an operating lease is often cancellable by the lessee. d. a financial lease is often cancellable by the lessee. 2. The principal reason for the existence of leasing is that: a. intermediate-term loans are difficult to obtain b. this is a type of financing unaffected by changes in tax law. c. companies, financial institutions, and individuals derive different benefits from owningassets. d. leasing is a renewable source of intermediate-term funds. 3. A way to analyze whether debt or lease financing would be preferable is to: a. compare the net present values under each alternative, using the cost of capitalas the discount rate. b. compare the net present values under each alternative, using the after-tax costof borrowing as the discount rate. c. compare the payback periods for each alternative. d. compare the effective interest costs involved for each alternative. 4. A conventional revolving credit agreement allows a firm: a. to borrow a fixed amount for the entire commitment period. b. to borrow for a short-period with a right to renew the loan during the commitmentperiod. c. to possibly include a provision to convert the credit agreement into a term loancontract at maturity. d. All of these 5. The type of lease that includes a third party, a lender, is called a(n): a. sale and leaseback. b. direct leasing arrangement. c. leveraged lease. 80 CU IDOL SELF LEARNING MATERIAL (SLM)
d. operating lease 6. One advantage of a financial lease is that: a. it has a shorter maturity than term loans. b. it never appears as a liability on the balance sheet. c. it eliminate the needs to make periodic payments. d. it provides a way to indirectly depreciate land. 7. Medium-term notes (MTNs) have maturities that range up to a. one year (but no more). b. two years (but no more). c. ten years (but no more). d. thirty years (or more) 8. A direct lease, a sale and leaseback, and a leveraged lease are all examples of a. operating leases. b. financial leases. c. full-service leases. d. \"off-balance sheet\" methods of financing. Answers 1(b) ,2(d) ,3(c) ,4(c) ,5(c) ,6(c) ,7(b) ,8(d) 5.15REFERENCES Text Books: Bhalla, V. K.“ Management of Financial Services” Anmol Publications Clifford Gomez “ Financial Markets, Institutions and Financial Services”, PHI Learning Rose, Peter and Hudgins, Sylvia,“ Bank Management and Financial Services”, McGraw Hills. Reference Books: Padamlatha ,“ Management of Banking and Financial Services”, Pearson Education. Saunders, Antony and Cornett, Marcia,“ Financial Institutions Management: A Risk Management Approach” McGraw Hills 81 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT -6MERCHANTBANKING STRUCTURE 6.0 Learning Objectives 6.1Introduction 6.2Concept and Nature of Merchant Banking 6.3Functions of Merchant Banker 6.4Merchant Banking Regulations 6.5Parameters of Evaluating a Merchant Banker 6.6Features of Merchant Banking in India 6.7Summary 6.8Keywords 6.9 Learning activity 6.10 Unit End Questions 6.11 References 6.0 LEARNING OBJECTIVES After studying this unit, students will be able to: State theconceptofmerchantbanking. Explainthefunctionsofmerchantbankers. DiscussthefeaturesofmerchantbankinginIndia. 6.1 INTRODUCTION Financial Service is rendered through numerous intermediaries who are known bydifferent names. One of the prominent intermediaries is known as merchant banker. Theirscope of operation differs from country to country. Merchant banking as it is known inpresent days had its origin in U.K and U.S.A in early fifties. But the roots of this servicerendering industry can be traced as back as in late eighteenth century and early nineteenthcentury. There were merchants, who traded overseas, built reputation and later sharedtheir goodwill with newer traders to facilitate their merchant activities especially byproviding guarantees for payments. Subsequently they entered any field which added totheirbusinessdependingonthedemandoftime.Thus,astimechangedtheirrolechanged, consequently it has never been possible to pinpoint their role. As Sir EdwardReidofBaringBrothers&Co.commented,itis(merchantbanking)sometimesappliedto banks which are not merchants, merchants who are not banks and sometimes to houseswho are neither merchants nor banks.\" Report of the Committee on the Working ofMonetary System (1961) observed that origin of merchant bankers is associated with avarietyoffinancialservicesincludingaccepting.Thisiswhymerchantbankersarepopular as 'issue 82 CU IDOL SELF LEARNING MATERIAL (SLM)
houses' or 'accepting houses' in U.K. In U.S.A investment bankers havebeen performing the task being performed by merchant bankers elsewhere. Whether theseare called accepting house or investment banker or merchant bankers, their commonobjectistofacilitatetradeandindustry.Meetingtheirdiverseanddynamicneedswiththe change in time and complexities in business has always been a challenge for merchantbanking. 6.2 CONCEPTANDNATUREOFMERCHANTBANKING Despitethefactthatmerchantbankingisemergingasoneoftheprominentsegment of financial service sector, it is difficult to define what merchant banking is. Thereason is very obvious as its limits have never been adequately and strictly defined and itcaters to wide variety of financial activities. Dictionary of Banking and Finance explainsmerchantbankasanorganisationthatunderwritessecuritiesforcorporations,advisessuchc lientsonmergersandisinvolvedintheownershipofcommercialventures.SecuritiesandExchangeB oardofIndia(MerchantBankers)Rules1992definesmerchant bankers as “any person who is engaged in the business of issue managementeither by making arrangement regarding selling, buying or subscribing to securities oracting as manager, consultant, adviser or rendering corporate advisory services in relationto such issue management. The Guidelines for Merchant Bankers (issued by Ministry ofFinance, Deptt. of Economic Affairs, Stock Exchange Division on 9-4-1990) instead ofdefining merchant banking stated that these guidelines shall apply to those presentlyengaged in merchant banking activity including as managers to issue and undertakesauthorisedactivities.Theseactivitiesinteraliaincludeunderwriting,portfoliomanagem ent etc. Thus.to defines merchant bankers a definite better approach is toincludethoseagenciesasmerchantbankerswhichdowhatamerchantbankerdoes. Tounderstandnatureofmerchantbanking well, a contrast may be involved,between commercial banking and merchant banking. Although the terms 'Merchant' and'Commercial' have similar connotations yet commercial banking and merchant bankingare different. Commercial bankers are basically a financing agency where as merchantbanksprovidebasicallyfinancial(notfinancing)services.Commercialbankersarecompa ratively retail banking activity where as merchant banking is a whole sale banking(even if it provides financing services also). A merchant banking firm does not undertakecommercialbankingwhereasits,reverse ispossible.Commercialbankinginvolvescollections of savings and putting it, to optimum use as per plans and guidelines where asmerchantbankingreferstojustanagencyfacilitatingtransfercapitalfromthosewhoown to those who can use it without handling the amount of its own. Merchant bankers ismoreofanintermediary.Inthesamecontextamerchantbankcanbedistinguishedfroma development bank since the latter is more involved in fund raising and lending. Likecommercialbanks,developmentbanksmayalsohaveseparatemerchantbankingdivision. 83 CU IDOL SELF LEARNING MATERIAL (SLM)
6.3 FUNCTIONS OF MERCHANT BANKER Settingupofnewindustrialunits,expansion,diversificationandmodernisationofexisting units have been the central plank of the rapid industrialisation in any economy.Thisprocessbesidesadequatefinancialresourcesrequiressoundtechnicalandmanagerial inputs. Though, a number of financial agencies are instituted to cater to theneeds of rapid industrialisation, the task of financing has become more complicated, thusrequiring a fresh look. In view of increasing specialisation in every sphere the process ofindustrialisation from the primary planning stages of setting up a new unit to that ofresearch and development including expansion, diversification or modernisation requiresthe services of specialists or professionals. Thus, the need for having expert advice,guidance of specialists or professionals in the field has become an absolute necessity withrapid economic growth and spectacular industrial development in India. It has also beennecessitated by the plethora of regulations for industry, capital, issues, foreign investmentand collaboration, amalgamations, Companies Act, SEBI, Government policy regardingbackwardareadevelopment,exportpromotionandimportsubstitutionetc.Afewagencies are able to provide expert advice in the diversified areas mentioned above. But itis inconvenient to entrepreneurs industrialists to knock at the doors of several agencies ingetting the guidance of specialists and professionals. Hence, it is highly essential toprovide expert advice in diversified areas under a single roof to provide a comfortablecushion to entrepreneurs to accelerate industrial development. This is where merchantbankers come to picture. Although is it is very difficult to spellout all the areas wheremerchant bankers can interact, yet, some important areas where merchant bankers havedecisive role are discussed here. These role can broadly be divided into two parts. One isservicebasedanotherisfundbased. ServicebasedFunctions: 1.Projectcounselling The first step to launch a business unit is selection of a viable project. Merchant bankersundertake this assignment on a very large scale since they have experts with them indiverse fields. Project counselling covers a variety of sub assignments. Illustrative list ofserviceswhichcanberenderedunderthiscategoryis: Guidance in relation to project viability i.e. project identification and counselling.Itmaybeforsettingupnewunits,expansionorimprovementofexistingfacilities. Selectionofconsultantsforpreparationofprojectreports/marketsurveysetc.Sometimesmerch antbankersalsoengageinpreparationofprojectreportsormarketsurveys. Advice on various procedural steps including obtaining of governmental approvalsclearanceetc.e.g.forforeigncollaboration. Proposingasuitablecapitalstructurelayingbroadaswellasspecificfeatures. Teachno- economic soundness of the project and marketing aspects. Financialengineering i.e. selection of right mix of financing pattern specifically for 84 CU IDOL SELF LEARNING MATERIAL (SLM)
shorttermrequirements. Organisation and management set up for a strong base and efficient working of theproject. 2.Creditsyndication Normally every project has to raise debt funds for different sources as per need.Substantial debt raising may be required for a new and capital intensive project. For suchproject merchant bankers may undertake credit syndication. Credit syndication is creditprocurement service. As per the requirements, such syndication can be from national aswell as international sources. Some of the important credit syndication services offeredare. Preparingapplicationsforfinancialassistancetobesubmittedtofinancialinstitutionsandbanks. Monitoringthesanctionoffundswhileactingasaspecialisedliaisonagency. Negotiatingthetermofassistanceonbehalfofclient. Postsanctionformalitieswiththeseinstitutionsandbanks. Assistanceindrawloftermloansandorbridgingloans. Assessingworkingcapitalrequirementsandarrangingit. Needofsyndicationarisesduetothefactthatspeciallyinbigprojectsoneinstitution may hesitate to meet the whole debt requirement of the project. They want tospread the risk. Further shortage of funds availability with one lender also requires creditsyndication. The merchant banker by rendering credit syndication services saves the timeoftheborrower. Themodusoperandiofasyndicationisreallyquitesimple.Theborrowerapproaches several banks which might be willing to syndicate a loan, specifying theamount and the tenor for which loan is to be syndicated. On receiving a query, thesyndicator scouts for banks who may be willing to participate in the syndicate. Based onan informal survey, it communicates its desire to syndicate the loan at an indicative priceto the corporate borrower, all in a matter of days. After reviewing the bids from variousbanks,theborrowerawardsthemandatetothebankthatoffershimthebestterms. The syndicator, on his part, can underscore his willingness to syndicate the loan onafirmcommitmentbasisoronabest-effortsbasis.Theformerisakintounderwritingand will attract capital adequacy requirements. That may reduce the bank's flexibility. \"InIndia, given the fact that banks may not be willing to maintain capital in the interimperiod,mostsyndicatesthelikelytobedoneonabest-effortsbasis.\" Best-efforts, as the name suggests, limits the obligation of the syndicator, as he isnotcompelledtoprovidetheloanonhisown,incasehefailstoarrangetheloan. However, more often than not, the syndicator would try to fulfill his commitments for theinability to do so would tarnish his reputation. Once the syndicator has been awarded amandate, the borrower has to sign a 'clear market clause' which stops him from seeking asyndicatedloanfromanyotherbank,tillsuchtimeasthedocumentationforthesyndicationisdrawnu pbythesyndicatemanager.Thismaytakeaboutthree-fourweeks. In the interim period, the syndicate manager gets the banks to agree to syndicatingthe loan. It can do this on a 'broadcast' basis, by sending taxes to the concerned banksinviting participation. If the company is well known, the loan uncomplicated and themarket liquid, 85 CU IDOL SELF LEARNING MATERIAL (SLM)
such a method would work well. However, if the corporate tends to keep alow profile and the loan structure is complicated, the syndicate manager would have towoo the participant banks with offer documents or an information memorandum on thecompany. The document is similar to a prospects but less detailed. Nevertheless drawingup such a document does call for a lot of homework. The syndicate manager has to beverycarefulbecausehecan beheldresponsibleforanyinaccuracyoromissionofmaterialfacts. The participants, after reviewing the prospects, decide whether or not to join thesyndicate. However, given the fact that most of the participants may be smaller Indianbanks, they may take weeks to give the final nod. Once the bank decides to become amemberofthesyndicate,itindicatestheamountandthepricethatitislikelytochargeon the loan. Based on information received from all participants, the syndicate managerprepares a common document to be signed by all the members of the syndicate and theborrowing company. The document usually lists out details of the agreement with regardtotenor,interestprepaymentclause,security,covenants,warrantiesandagencyclause. 3. Issuemanagement Traditionally this is one of the main functions of merchant banker. When ever anissue is made whether it is public issue or private placement and further whether it is forequity shares, preference shares or debentures, the merchant banker has a crucial role toplay.Raisingoffundsfrompublichasmanydimensionsandformalitieswhicharenotpossible for the concerned. companies to comply with, where merchant banker comes totheirrescue.Marketingefforttoconvincetheprospectiveinvestorneedsspecialattention. Here again merchant bankers are specialists. The specific important activitiesrelatedtoissuemanagementperformedbymerchant banksarementionedhere: Advisethecompanyaboutthequantumandtermsofraisingfunds. Advice as to what type of security may be acceptable in the market as wellastotheconcernedlendinginstitutionsatthetimeofissue. Advise as to whether a fresh issue to be made or right issue to be made or ifboth, then in what proportion, obtaining the desired consents, if any, fromgovernmentorotherauthorities. Adviceontheappointmentofbankers,brokerstotheissue. Advice on the selection of issue house or Registrar to the issue, printeradvertisingagencyetc. Fixingthetermsoftheagenciesengagedtofacilitatemakingapublicissue. Preparationofacompleteactionplanandbudgetfortotalexpensesoftheissue. Draftingofdocumentslikeprospectus,letterofofferandgettingapprovalfromconcernedagencie s. Assistinginadvertisementcampaigns,holdingthepress,brokers'andinvestors'conferencesetc.f orgroomingtheissue. Advisethecompanyfortheissueperiodanddaysofopeningandclosingtheissue. Monitoringthecollectionoffundsinpublicissue. 86 CU IDOL SELF LEARNING MATERIAL (SLM)
Coordinationwithunderwriters,brokersandbankerstotheissueandstockexchangeetc. Strictcomplianceofpostissueactivities. 4. Corporatecounselling Although the functions discussed up till now are also covered under corporatecounselling but here other dimensions will be deliberated. Corporate counselling is torejuvenatethecorporateunitswhichareotherwisehavingsignalstolowproductivity,low efficiency and low profitability. The merchant bankers can play a substantial role inreviving the sick units. They make mergers and acquisition exercise smooth, They canadviseonimprovementinthesystemsoperatinginmanagingtheshowofacorporateunit.Someoft hespecificassignmentsforthemerchantbankerare:- Rejuvenatingoldlineandailing/sickunitorappraisingtheirtechnologyand process, assessing their requirements and. restructuring their capitalbase. Evolving rehabilitation programmes/packages which can be acceptable tothefinancialinstitutionsandbanks. Assisting in obtaining approvals from Board for Industrial and FinancialReconstruction(BlFR)andotherauthoritiesundertheSickIndustrialCompanies(sp ecialprovisions)Act1985(SICA). Monitoringimplementationofschemesofrehabilitation. Adviceonfinancialrestructuringinvolvingredeploymentofcorporateassetstorefocuscompan ieslineofbusiness. Adviceonrearrangingtheportfolioofbusinessassetsthroughacquisitionetc. Assistinginvaluingtheassetsandliabilities. Identifyingpotentialbuyersfordisposalofassetsifrequired.Identifythecandidatesfortakeover . Adviceontacticsinapproachingpotentialacquisition. Assistingindecidingthemodeofacquisitionwhetherfriendlyorunfriendlyorhostile. Designingthetransactiontoreapthemaximumtaxadvantages.Actingasan agent for leveraged buyout (LBO) involving heavy use of borrowedfundstopurchaseacompanyordivisionofacompany. Facilitating Management Buy outs (MBO) i.e selling a part of business totheirownmanagersbyacompany. Clearlyspelling out organisationgoals. Evolvingcorporatestrategiestoachievethelaiddowngoals. Designingorrestructuringtheorganisationalpatternandsize. EvolvingManagementInformationSystem. Corporate advisory services should offer real value addition to the client. Highlyspecialised in nature, these services should be clearly distinguished from the gamut ofotherfinancialservicesofferedbyNBFCssuchasunderwritingorfund-basedactivitiesof leasing and hire purchase. In India corporate advisory has a good potential. The 87 CU IDOL SELF LEARNING MATERIAL (SLM)
Indianindustry is going through an unprecedented churning, bracing itself for global com-petition. The Indian corporate sector has been on a restructuring spree. Groups have beenshedding companies. Companies in turn, have been dropping divisions as they struggle tobecome fit to survive in the new milieu. Free pricing of issues and the opportunity to tapthe international market through the Euro-issue route has greatly enhanced the need forexpertadvisoryservices.Inareasofrestructuring,strategicalliancesandcorporateplannin gisnowadvisingforeigncompaniesintheirplansfordevelopmentofinfrastructureinIndia.Me rchantbankershaveagreatroletoplay. Strategic product consolidation is another recent phenomenon. Units in which thecompanydoesnotplantobecomeamarketleaderarespunofftoothers.Agoodcorporate advisor is always on the alert to seize such opportunities. The process ofacquisition cannot be done overnight. It requires a patient search for the right companywhich can be acquired, the proper evaluation of the financial impact of the acquisition, asound strategy in blending the business acquired within the fold of the group, followed bynegotiationandexecutionoftheagreement.Occasionally,advisoryservicesarerequiredin cases of splits within the family group. In such cases, there is a need to split thecompanyintodifferentunitsamongstthedisputingfamilymembers.Atthesametime,thesharehol dersinterestistobekeptinmindbythecorporateadvisor. 5.Portfoliomanagement Merchant bankers as a body of professionally qualified persons also undertakeassignmentsofmanaginganindividualinvestor'sportfolio.Portfoliomanagementisbein gpractisedasaninvestmentmanagementcounsellinginwhichtheinvestorisadvisedtoseekfinancial assetslikegovernment securities,commercialpapers,debentures, shares, warrants etc. that would grow in value and/or provide income. Theinvestors whether local or foreigner with substantial amount for investment in securitiesseek portfolio management services of authorised merchant bankers. The functioning ofportfolio manager can be regulated or unregulated. Portfolio manager may use totally hisdiscretion or may act only after getting signal from investor for each transaction of sale orpurchase.Adiverserangeofserviceswhichmayberenderedbymerchantbankerinclude:- Advisingwhatandwhentosellandbuy. Arrangingsaleorpurchaseofsecurities. Communicatingchangesininvestmentmarkettotheclientinvestor Complianceofregulationsofdifferentregulatingbodiesforsaleofpurchaseofportfolio. Collectionofreturnsandreinvestasperdirectionsofclients. Evaluatingtheportfolioatregularintervalsoratdirectionofinvestors. Advisingontaxmatterspertainingtoincomefromandinvestmentinportfolio Safecustodyofsecurities. 6.Stockbrokinganddealership 88 CU IDOL SELF LEARNING MATERIAL (SLM)
The merchant bankers who have requisite professional knowledge and experiencemayalsoactassharebrokeronastockexchangeandevenasdealerforOverTheCounter trading. To venture into this area it is normally desired that the merchant bankerhas reasonable network. Their actions and activities are regulated by rules and regulationsof the concerned stock exchange. They are at liberty to appoint sub brokers and subdealerstoensurewidernetworkoftheiroperations.Theycanbebrokerforinlandaswell as foreign stock exchanges. In India the merchant bankers who desire to act asbrokersareregulatedby SEBI(StockBrokerandSub-brokers)Rules1992. 7.Jointventureabroad Depending on economic and political considerations many countries may permitjoint ventures by local businessmen abroad. Here again merchant bankers can play adecisive role. They facilitate meeting of foreign partner, get sanctions under variousprovisions, make techno economic surveys, legal documentations under local as well asforeignlegalprovisionsetc. 8.Debenturetrusteeship Themerchantbankerscangetthemselvesregisteredtoactastrustee.Thesetrustees are to protect the interests of debenture holders as per the terms laid down in trustdeed. They are, as trustees, to undertake redressal of grievances of debenture holders.Theyaretoensurethatrefundmoniesarepaidanddebenturecertificatesaredispatchedin accordance with the Companies Act. Debenture trustees are expected to observe highstandardsofintegrityandfairnessindischargingtheirfunctions.Theycancallforperiodicalrepo rtsfromthebodycorporate.Theychargefeeforsuchservices. FundbasedFunctions 1.Billdiscounting Bill discounting is a service against which merchant banker has to arrange fundsagainst the bills which have been discounted. This service is undertaken by merchantbankers generally if bill market is big as well as mature. Otherwise bill discounting isundertaken by banks only. Depending on their credibility they may also undertake theassignment of bill acceptance. These bills accepted and or discounted can be foreign andmerchant bankers can specify what types of bills they entertain. They charge commissionfortheseservices. 2.Venturecapital Venture capital is the organized financing of relatively new enterprises to achievesubstantial capital gains. Such new companies are chosen because of their potential forconsiderablegrowthduetoadvancetechnology,newproductsorservicesorothervaluable innovations. A high risk is implied in the term and is implicit in this type ofinvestment.Sincecertainingredientsnecessaryforsuccessofsuchprojectsaremissingin the begging but are added later on. Merchant bankers undertake to arrange and ifnecessary, to provide such venture capital since traditional sources of finance like banks,financial institutions or public issue etc. may not be available. Since expected returns onprojects 89 CU IDOL SELF LEARNING MATERIAL (SLM)
involving venture capital is high, these are normally provided on soft terms.Such scheme is also popular as seed capital or risk capital scheme. Merchant bankersdeeplystudysuchproposalsbeforereleasingthemoney.Atopportunetimesuchinvestmentc anbedisinvestedtokeep thecycleofventurecapitalmoreon. 3.Boughtoutdeals When a promoter envisages that if public issue made to raise capital will notclinch, he may approach merchant bankers (bought out dealer or sponsor) and places thesharesofcompanyinitiallywithhimwhichareofferedtopublicatalaterstage,thisroute is known as bought out deal. Many a time a syndicate of merchant bankers jointlysponsor a bought out deal to spread the risk involved. In contract to venture capital, thereis no role to be played by non traditional technology. Such bought shares by sponsor canbedisposedoffatanopportunetimeon‘overthecounter’orotherstockexchanges. 4.Leasefinancingandhirepurchase Depending on the funds available, merchant bankers can also enter the field oflease or hire purchase financing. Lease is an agreement where by the lessor (merchantbanker in our case) conveys to the lessee (the user), in return for rent, the right to use anasset for an agreed periodof time. On the other hand in hire purchase the user at the endof the agreed period has an option to purchase the asset which he has used till date. Themerchant bankers can advise the client to go in for leasing or hire purchase system offinancing an asset. A comparative study may be communicated to the prospective clientshowing benefits of these alternatives. The client can also depend on merchant banker foracquiringtheneededassetandcomplyingwithallformalities. 5.Factoring Factoring is a novel financing innovation. It is a mixed service having financial aswell as non financial aspects. On one hand it involves management and collection ofbooks debts which arise in process of credit sale. The merchant bankers can take up thisassignment and are required to perform activities like sales ledger administration, creditcollection, credit protection, evolving credit policy, arranging letter of credit etc. On theother hand there is involvement of finance. Against factored debts the merchant bankermay provide advance with a certain margin. The released funds can be used by client tomanage its liquidity and working capital. Merchant bankers are entitled to service chargesforfactoringservices.Themerchantbanker’sroleisthusto: Maintainthebooksofaccountspertainingtocreditsales Makeasystematicanalysisofrelevantinformationforcreditmonitoringandcontrol. Providefullorpartialprotectionagainstbaddebtsandacceptingtheriskofnonrealization. Providefinancialassistancetotheclient. Provideinformationaboutprospectivebuyers. Providefinancialcounselingandassistingmanagingtheliquidity. 6.Underwriting 90 CU IDOL SELF LEARNING MATERIAL (SLM)
Itreferstoacontractbymeansofwhichmerchantbankergivesanassurancetothe issuing company that the former would subscribe to the securities offered in the eventof non-subscription by the persons to whom it was offered. The liability of merchantbanker arises if the issue is not fully subscribed and this liability is restricted to thecommitment extended by him. The merchant bankers undertaking underwriting makeefforts on their own to induce the prospective investors to subscribe to the concernedissue.Suchassignmentisacceptedafterevaluatingviz: Company’sstandinganditspastrecord. Competenceofthemanagement. Purposeoftheissue. Potentialsoftheprojectbeingfinanced. Offerpriceandtermsoftheissue. Businessenvironment. The financial involvement of merchant banker in underwriting arises in case ofdevelopment.Toget theirblockedfundsreleased,themerchantbankershavestockexchangeasexitroute.Theygetunderw ritingcommission.These are some of the prominent activities being undertaken by merchant bankersworldover.Thepracticesmaydifferfromcountrytocountrydependingonmaturityoffinanci al sector of their economy. The multifarious activities of the corporate sector andspectacular growth of industry gives new dimensions to merchant banking activities. Inthe phase of globalisation of economies merchant bankers are facing new challenges. Thechanging international financing environment has rather pushed merchant bankers tooperate at international level creating more opportunities to serve the world businesscommunityindiverseways. 6.4 MERCHANTBANKINGREGULATIONS SEBI (Merchant Bankers’) Regulations 1992 define merchant banker as “anypersonwhoisengagedinthebusinessofissuemanagementeitherbymakingarrangements regarding selling, buying or subscribing to securities or acting as manager,consultant,adviserorrenderingcorporateadvisoryserviceinrelationtosuchissuemanage ment.” Thus regulations are applicable only to limited activities undertaken bymerchantbanker.Onthebasisofregulations,merchantbankingactivitiescanbecategorised as ‘authorised’ and ‘not authorised’ activities. The merchant bankers arerequired to get themselves registered under regulations only for authorized activities. Theauthorizedactivitiesareundertakingissuemanagementassignment,asmanager,consultant,adv iser,underwriterportfoliomanager. 1.MerchantBankingActivitiesnotrequiringSEBI’sregistrationare: a) ProjectCounselling b) CorporateCounselling 91 CU IDOL SELF LEARNING MATERIAL (SLM)
c) Factoring d) CreditRating e) Billacceptanceanddiscounting f) Loansyndication g) Mergerandamalgamation 2.MerchantBankingActivitiesrequiringSEBI’sregistrationunderdifferentregulationsbutnot underMerchantBankingregulations: a) VentureCapital b) MutualFunds c) Depository d) PortfolioManagement e) Trusteeshipofdebentures f) ShareBroking g) CustodianService h) ForeignInstitution ofInvestor i) ShareTransfer Another angle from which authorized activities can be identified is the activitiesspecifiedforeachcategoriesofmerchantbanker. CategoriesofMerchantBankers The merchant banking regulations require that any body seeking registration asmerchantbankerhasto applyinoneofthefollowingfourcategories: Category I :These merchant bankers can carry on any activity of the issue management,whichwillinter- aliaconsistofpreparationofprospectusandotherinformationrelatingto the issue, determining financial structure, tie up of financiers and final allotment andrefund of subscription. They can also act as adviser, consultant, manager, underwriter,portfoliomanager. CategoryII:Suchmerchantbankerscanactasadviser,consultant,co-manager,underwriter and portfolio manager. This means they can not undertake issue managementoftheirown. Category III :These merchant bankers can neither undertake issue management nor actas co- manager. They cannot conduct business of portfolio management. Thus the area oftheiroperationrestrictstoactasunderwriter,adviserandconsultanttotheissue. Category IV :Such merchant bankers do not undertake any activities requiring funds.Theycanactonlyasadviserorconsultanttoanissue. Registration Any agency to operate as merchant banker has to register it self under SEBIRegulations. Application is to be submitted in the prescribed format. To get registrationandcertificatetooperateasmerchantbanker,theagencyhastofulfilltwosetsofcriteria 1) Operationalcapabilities. 2) Capitaladequacy. 92 CU IDOL SELF LEARNING MATERIAL (SLM)
1)Operationalcapabilities:Asmentionedearlier,theregulationsdesirethemerchant banker to be professional, fair and competent to serve investors. In this contextSEBIbeforegranting‘certificatetooperateasmerchantbanker’makessurethatconcernedag encyiscompetentontheseparameters.Tobemorespecifictheseare: a) Itisnecessarythattoservetheclientsandinvestorsthemerchantbankershouldhavesufficientphys icalinfrastructure.Itisdesiredthattheapplicanthas the necessary infrastructure like adequate office space, equipments andmanpowertoeffectivelydischargehisactivities. b) Toensurethatservicesrenderedarethebest,SEBIdesirestheapplicanttohave atleast two persons who have the experience to conduct thebusinessofthemerchantbanker. c) In order to avoid excessive registration SEBI makes sure that a person directlyorindirectlyconnectedwiththeapplicanthasnotbeenalreadygrantedregistration. Such persons include an associate, subsidiary, interconnected orgroupcompanyoftheapplicant. d) The applicant or his partner or director should be man of integrity. SEBIrequires that applicant or its main officials should not be involved in anylitigation connected with the securities market which has an adverse bearing onthebusinessoftheapplicant. They should not at any time be convicted for any offence involving mortal turpitude or has been found guilty of any economic offence. The applicant is to have professional qualification from any recognized institution. SEBI is to make sure that such registration should be in the interest of Investors. Onlythoseapplicantswhoqualifyonallthesepointsaregrantedregistration. 2)Capital adequacy :In the categories where in fund based activities are involved,SEBI desires them to have sufficient capital. The concept of adequate capital is expressedin terms of ‘net worth’. ‘Net worth’ means the value of capital contributed to the businessplus free reserves. At the time of registration as well as subsequently following pattern of‘networth’shouldbeatleastmaintained: CategoryofMerchantBanker MinimumNetworth CategoryI Rs. 5,00,00,000 CategoryII Rs.50,00,000 CategoryIII Rs.20,00,000 CategoryIV NIL Thoseapplicantswhoqualifyonbothfrontsaregrantedregistration.Theregistered applicants are granted certificate of registration in ‘Form B’ in which SEBIspecifies for which category registration has been granted. If the applicant is granted acategorylowerthanappliedfor,theapplicantisfreetoapproachSEBIforhighercategory but with in one year from date of such registration. When certificate is finallygrantedtheregisteredmerchantbankersaretosubmitrequiredfees.Registrationisgrantedfort hreeyearsatonetime.Tokeeptheregistrationoperative,merchantbankersaretopayregistrationfee. Theregistrationfeepatternisasunder: Category Feeforfirst twoyears Thirdyear 93 CU IDOL SELF LEARNING MATERIAL (SLM)
CategoryI Rs. 2.5lakh peryear Rs. 1lakh CategoryII Rs. 1.5lakh peryear Rs. 0.5lakh CategoryIII Rs.1lakhperyear Rs.0.25lakh CategoryIV Rs.5,000peryear Rs.1,000. Once registration granted is about to expire, merchant bankers are to get thisregistration renewed. Application for such renewal is again to be made. To ensure thatthere is no break in registration, such application has to be made with in 3 months beforethe expiry of the certificate. Although it is termed as renewal, but application is processedasfornewregistration,thatiswhyapplicationisagainmadein‘FormA’.Onceregistrationi srenewedduefeeistobepaidwhichisasunder: Category Feeforfirst twoyears Thirdyear CategoryI Rs.1lakhperyear Rs.0.2lakh CategoryII Rs.0.75 lakhper year Rs.0.1 lakh CategoryIII Rs.0.50peryear Rs.0.05lakh CategoryIV Rs.0.05peryear Rs.0.02 lakh CodeofConduct Once merchant bankers are registered to ensure that they maintain high standardof services, regulations require them to adhere to a code of conduct specified in theScheduleIIIoftheRegulationswhileactingasmerchantbankers.Someimportantprovisionsofco deareasunder: Maintainhighstandardofservice. Exercise due diligence,ensurepropercareandexerciseindependentprofessionaljudgement. Disclose to the clients, possible sources of conflicts of duties and interest whileprovidingunbaisedservices. Conductbusinessobservinghighstandardofintegrityandfairnessinallhisdealingswithclient sandothermerchantbankers. Maintainsecrecyaboutclient. Donoengageinunfaircompetition. Nottomakemisrepresentation. Providetrueandadequateinformationtoinvestors. Nottocreatefalsemarketorengageinpricerigging. LeadManager Itisrequiredunderregulationsthateveryissueshouldbemanagedbyatleastonemerchantbankeract ingas‘leadmanager’.Suchleadmanagerisnotrequiredif: theissueisrightissue. thesizeofissueisnotexceedingrupees50lakh. 94 CU IDOL SELF LEARNING MATERIAL (SLM)
Themerchantbankeractingasleadmanagermustenterintoanagreementwiththe concerned company. This agreement must state their mutual rights, liabilities andobligationsrelatingtosuchissue.Agreementtermspertainingtoparticularstodisclosures, allotmentandrefundshouldbeclearlydefined,allocatedanddetermined. In bigger issues more than one lead managers can be appointed but their number issubjecttonormslaiddownbySEBI. Sizeofissue Maximumnumberofleadmanager Lessthanrupeesfiftycrore Two Rupees50crorebutlessthanRs.100crore. Three Rs.100crorebutlessthanRs.200crore Four Rs.200crorebutlessthanRs.400crore Five Rs.400croreandabove Five or more asagreedbySEBI DutiesofMerchantBanker/LeadManager a) Incasemorethanonemerchantbankersareengagedasleadmanager,theyhaveto clearly demark their duties and responsibilities. A statement of such division ofjob and responsibilities is to be furnished to SEBI at least one month beforeopeningoftheissue.Wherethecircumstanceswarrantjointandseveralresponsibility of lead manager for a particular activity, a coordinator designatedfromamongtheleadmanagersshallfurnishtoSEBIwithreport,commentsetc.on the matters relating to the joint responsibility. The activities where division isnormallysoughtison‘pre- issueactivities’and‘postissueactivities’,SEBIrequiresthat‘postissueactivities’shouldbetherespo nsibilityofoneleadmanager.Itinvolvesessentialfollowupstepslikefinalisationofbasisofallotment /weeding out multiple applications, listing of instrument, dispatch ofcertificatesand refunds etc. b) A merchant banker can not be a lead manager to an issue made by any bodycorporatewhichisanassociateoftheleadmerchantbanker. c) A lead manager is not to associate with an issue if any merchant banker associatedwiththeissueisnotholderofcertificateofregistration. d) A lead manager who is category I merchant banker has to accept a minimumunderwriting obligation of 5 per cent of the total underwriting commitment orRs.25 lakh which ever is less. This is to ensure his financial involvement in theissue. e) It is his duty to submit SEBI a due diligence certificate in ‘Form C’. This is toensure that the contents of the prospectus or letter of an offer are verified and arereasonable. This certificate is to reach at least two weeks prior to opening of anissue. f) SEBIrequires lead manager to submit specified documents like particulars to theissue,draftletterofofferorprospectus. g) Leadmanagertoincorporatechanges in prospectus etc. if desired bySEBI. h) Lead manager has to continue as lead manager with the issue till the 95 CU IDOL SELF LEARNING MATERIAL (SLM)
subscribershavereceivedthecertificatesorrefundsofexcessmoney. i) Merchant bankers are prohibited from entering into any transaction, directly orindirectly in securities on the basis of unpublished price sensitive informationobtained by them during the course of any professional assignment. It is referringtoinsidertrading.SEBI is to be informed, by merchant banker about the acquisition of securities oftheboycorporatewhoseissueisbeingmanagedbythemerchantbanker,within15daysfromthedate ofenteringintosuchtransaction. j) AmerchantbankerhastodisclosetoSEBIthefollowinginformation: hisresponsibilitieswithregardtothemanagementoftheissue. anychangeintheinformationorparticularspreviouslyfurnishedwhichhaveabearingonthecerti ficategrantedtoit. thenameofbodycorporatewhoseissueshehasmanagedorhasbeenassociatedwith. anydefaultincapitaladequacyrequirements. hisactivitiesasamanager,underwriter,consultantoradvisertoanissueasthecasemaybe. Every merchant banker shall keep and maintain the required books of accounts,records and documents like balance sheet, income statement, auditor’s report, astatement of financial statement. Such records are to be maintained for 5 years.They are to submit half yearly unaudited financial results when required by SEBIwithaviewtomonitorthecapitaladequacyofthemerchantbanker. When SEBI initiates inspection of the said records, the merchant banker has tocooperate.SEBIshallgivenoticebeforeinspection. Debit Cards, Credit Cards and Microcredit The concept of money in form of cards such as credit cards and debit cards, instead of the use of actual currency is what we call plastic money. In India, in the recent years, online transactions and bank cards have seen a huge upsurge. Let us learn more about these cards and how they work. Debit Cards A debit card is a bank card used to make payments from your own bank account. Debit cards were introduced in 1966 and have been around since. They are actually a linked to the cardholders bank account. So they basically provide an electronic access to the bank account of the cardholder. Debit cards can be used to conduct online transactions. They can also be used at products or services at the various point of sales. When you use a debit card it withdraws the balance from your bank account, i.e. it debits your bank account. So if there is insufficient balance in the account, the transaction will be unsuccessful. Usually, there is a magnetic strip in the card that reads the debit cards information. But recently due to security concerns, banks have started issuing chip debit cards. The computer chip authenticated the debit card and is considered safer than the magnetic cards. Credit Cards 96 CU IDOL SELF LEARNING MATERIAL (SLM)
Credit cards are also payment cards that banks or other financial institutes. But unlike debit cards, they are also a tool of short-term lending. Because a credit cardholder can withdraw money beyond the limits of their bank accounts. So a cardholder can borrow money from the bank using his credit card. So credit cards offer the cardholders a line of credit. The money has to be repaid to the bank with the interest that the bank charges. The time of the repayment will depend according to the terms and conditions of the credit cards. Also, there is a credit limit on the card. This is the maximum credit the cardholder can run up on a card. Credit cards can be used for online purchases; purchases at a point of sales, to withdraw cash from the ATM. Credit cards also allow cardholders to transfer money to other bank accounts. Micro Credit Microcredit is a tool for microfinance services. It is the lending of very small amounts of money to the ones most in need of funds. The terms of such a loan are very lax. The interest rate charged is negligible and the repayment policy is not very strict. These types of loans are generally availed by new small business and the agricultural sector. In India, the microcredit is considered a Non-banking financial activity. One popular form of microcredit in India is financing through Self Help Groups. The RBI has given the commercial banks the full freedom to plan their own policies when it comes to microcredit in order to encourage it further. LiabilitiesofMerchantBankers Many provisions are incorporated in the MB Regulations to regulate the activitiesofmerchantbankers.TomakethemmoreresponsibleandaccountableSEBIhasprovisions to impose penalty in case of defaults by them. The merchant bankers aresubjecttopenaltyifthey failtocomplytheconditionssubjecttowhichcertificatehasbeengranted failtocomplywiththeprovisionsoftheconcernedrulesandregulations TwotypesofpenaltiescanbeimposedbySEBIondefaultingmerchantbankers.Oneissuspensionofr egistrationandsecondiscancellationofregistration. Suspensionof registration Underthefollowingcircumstancestheregistrationofamerchantisbankerstandssuspendedwhen amerchantbanker: violatestheprovisionsoftheAct,rulesandregulationsandtermsofregistration failstofurnishrequiredinformationtoSEBIorprovidesfalseinformation failstosatisfytheinvestorsandSEBIaboutthecomplaintsofinvestors manipulatesorrigsthepriceofsecurities misconductsoradoptsunprofessionalpractices failstomaintainrequiredcapitaladequacyorpaytherequiredfees Cancellationofregistration 97 CU IDOL SELF LEARNING MATERIAL (SLM)
Incaseswheretherearegravemisconductsordefaults,theregistrationofamerchant banker can even be cancelled. Some of such situations are where a merchantbanker: indulgesindeliberate manipulationorpriceriggingorotheractivitiesagainsttheinterest of investors. failstomaintainsatisfactoryfinancialstatuswhichmayleadtodilutioninservicesto investors. involvesinfraudorisconvictedofacriminaloffence indulgesrepeatedlyindefaultsresultinginsuspensionofregistration. IntheseregulationsSEBIhasdeviatedfrom theearlierpenaltypointsystemannouncedbySEBIinguidelinesformerchantbankersin1991.D efaultswerecategorizedinfourtypes,generaldefault(TypeI),minordefaults(TypeII),majorde faults (Type III) and serious defaults (Type IV). Penalty points are assigned to eachtype of defaults these being one, two, three and four respectively. The defaults in eachtypewasspecifiedspecificallye.g. a) non-receiptof: draftprospectus, inter-seallocationofresponsibilities, duediligencecertificateetc.constitutedgeneraldefault, exaggerated information noncompliance of advertisement code delay in refunds allotment of securities etc. constituted minor default, failure to take mandatory underwriting, engaging more lead manager than warranted under guidelines association with unauthorized merchant banker etc. were termed as major defaults and unethicalpractices violationofcodeofconduct non-cooperationwithSEBIconstitutedseriousdefaults. Anymerchantbankerreachingcumulativepenaltypointsof‘eight’attractedactionfromSEBI. 6.5 PARAMETERSOFEVALUATINGAMERCHANTBANKER Merchant bankers can be evaluated by their clients (issuers or companies andinvestors)ontwobroadparametersdiscussedhere: i) Qualitative If refers to those factors which hint at quality of service rendered by merchantbanker. The most important feature here is quality of the staff with the merchant banker.The employed officials should be professionally qualified having expertise specially infinance, project evaluation, marketing, operation research. It is not sufficient to recruitprofessionals. Their knowledge should be up dated regularly so that they are near tointernational practices. To evaluate qualitative aspects, the merchant bankers can bejudged on their ability to advise the 98 CU IDOL SELF LEARNING MATERIAL (SLM)
clients on matters like capital structure, innovativeinstrument, ability to get clearances for client from different agencies, his association andrapport with otherintermediaries like registration to the issue, bankers to the issue,underwriter etc. Even the investor evaluate the merchant banker because they will like tosubscribetotheissuesofonlyreliablemerchantbankerandthisismoreimportantinview of SEBI’s move not to vet prospectus for any issue. Features like what is the abilityto evaluate promoters, techno-economic feasibility of projects and assessing the investorfriendlinessofthepromotermatterforinvestors.Issuersalsoconsidertheabilityof merchantbankertobeperfectmarkettimer.Pricingstrategyisanaspectwhichinvestoras well as issuer both should evaluate before having business with a merchant banker. Tohigh price is a loss to investor and low prices are not appreciated by the issuers. Despitethespecifieddisclosurerequirements,investorsdependmoreonmerchantbankerwhohas a practice of more and more and dependable disclosures. Concern of merchant bankerfor after issue services and investors protection is another parameter used by investors toevaluatemerchantbankers. (ii) Quantitative Themainparameterhereishisstatisticsofactivitiesundertakenlikethenumberof issues handled, the amount of funds managed, the organizations which have been hisclient, the size of the issue handled etc. The statistics as to the issues being quoted atdiscount or at premium after handling the issues is very significant parameter. How manyunderwritingshavebeendone andtheamountinvolvedintheprocessalsoindicatequalityofmerchantbanker.Amerchantbankerwi thhighnetworthisgenerallyconsidered to be efficient. How many professionals and other qualified staff members areassociatedalsomatters. MerchantBanker’sEnvironment Merchant bankers rendering financing services are influenced by a number offactors. These factors also assist us assessing the quality of services rendered by them.These environmental components may continue to be the same but their impact is alwayslikely to be dynamic. Investor’s expectations increase as they become more aware andeducated.Regulatoryagenciesgoonamendingtheirrulesandregulationstodisciplinethe merchant bankers. Such changes in regulations etc. may be more frequent till the timethereisprofessionalmaturity.Thefastdevelopmentontechnologyfrontcertainlyimproves the quality of services if adopted. Any one not changing as per technology issuretolagbehind.Innovationsalwayspayinprofession. 6.6 FEATURESOFMERCHANTBANKINGININDIA Types MerchantbankinginIndiahasbeengivenaspecificdirectionbySEBI(Merchant Bankers)Regulation.Sincetheirroleinpublicissueisexhaustiveandtheirresponsibilities absolute, professional expertise is needed. Thus after SEBI, merchantbankers emerged from all 99 CU IDOL SELF LEARNING MATERIAL (SLM)
segments of the economy. It was no longer a monopoly ofinstitutionalandbankermerchantbankers. Insimpletermsthemerchantbankingactivitycanbedividedamongstfoursegments: InstitutionslikeIDBI,ICICI,IFCIfloatedmerchantbankingsubsidiariesordivisions ForeignbankslikeGrindlays,Standard Chartered, HonkongBank, City Banklaunchedmerchantbankingdivisions NationalisedbankspromotedsubsidiariestocarryoutmerchantbankingactivitieslikeSBICaps ,PNBCaps,Canfina Private sector merchant bankers like JM, Kotak Mahindra, DSP, Master Trustwhowereeitherbrokersorunderwritersorportfoliomanage Registration In a period of 2 years since SEBI took over merchant bankers, the primary marketwas in boom so there was a line of professionals to get themselves registered as merchantbankers. It was generally felt that the merchant banking profession being regulated, onlycompetent and well equipped organizations should be granted such recognition to act asmerchant bankers. However, it was strongly felt by a large number of professionals inmerchant banking that SEBI’s liberal grant of recognition might not augur well for longterm growth of this specialised business. SEBI, on the contrary expressed a view that thelarge number of new players brought in a sense of competition to the profession andultimately their success was dependent on how well they served their clientele. WhileSEBI had a strong rationale to support its viewpoint,many feel that this resulted in ageneraldilutioninthequalityofservices.SEBIcontemplatedenhancingtheminimumnetworthreq uirementfromRs.10milliontoRs.25million.Inanascentliberalizedcapitalmarketenvironment,SE BI’staskofregulatingtheintermediarieswascertainlynot very easy . Whatever critics might pointed out, the fact remained that SEBI instilled alotofdisciplineintothemarketplace. Asaresultofunrestrictedentry,over350CategoryIMerchantbankersgotregistered with SEBI till 1995. Assuming that each outfit had at least two other branchoffices in India (most of them have over six branches), in effect there are 1,050 outfits.Even assuming that each outfit independently churned out three issues in a year (which isthe bare minimum if one has to meet the expenses of running the office), there shouldhavebeenover3000issueshittingthemarketsinayearoronanaverage250issueseverymonths . QualityofService Such keen competition for business led to a large number of merchant bankerscompromisingonqualityandturningablindeyetoprettyobviousmisrepresentations,and reducing the importance of the due diligence certificate to a mere formality, whichwas totally devoid of any kind of moral responsibility. SEBI guidelines were flouted on aregular basis by taking advantage of any loophole which could be found. They treated theSEBI Acknowledgement Card as a clean-chit given by SEBI which absolves them formallresponsibilities.Matterscametosuchastatethattherewasnosinglepersonresponsible for 100 CU IDOL SELF LEARNING MATERIAL (SLM)
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