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Report of the Group on

Corporatisation & Demutualisation of Stock Exchanges


1. Introduction

1.1 The Government had announced its proposal to corporatise the stock exchanges by which ownership, management and trading rights would be segregated from each other and legislative changes, if required, would be proposed accordingly to give effect to the corporatisation and demutualisation of stock exchanges. The Finance Minister has also emphasized in his Budget Speech for the year 2002-03 that this process would be completed during the course of the year to implement the decision to separate ownership, management and operation of the stock exchanges.

1.2 Corporatisation and demutualisation of stock exchanges are complex subjects and involve a number of legal, accounting, Companies Act related and tax issues. These issues would need careful examination, before a clear roadmap could be prepared to take this process forward. SEBI felt that it would be desirable to appoint a Group comprising of eminent personalities, in fields of law, accountancy, finance, company law affairs and taxation to advise SEBI on this matter and to recommend the steps that need to be taken to implement the announcement of the Finance Minister.

1.3 Accordingly, SEBI, by order (Annexure 1) of Chairman, Shri G N Bajpai has constituted a Group under the Chairmanship of Justice M. H. Kania, former Chief Justice of India with the following members:
      1. Justice M.N. Chandurkar – former Chief Justice of the Bombay High Court and the Madras High Court.
      2. Shri Y. H. Malegam, Chartered Accountant and Managing Partner, S.B. Billimoria & Co.
      3. Shri Hemendra Kothari, Chairman, DSP Merrill Lynch and former President of BSE.
      4. Shri Nimesh Kampani*, Chairman, JM Morgan Stanley.
      5. Shri G. Anantharaman, Chief Commissioner of Income Tax (IV), Mumbai.
      6. Shri Rajiv Mehrishi, Joint Secretary, Dept. of Company Affairs.
1.4 *Shri Nimesh Kampani later on expressed that as he was not keeping well he would not be able to attend the meetings of the Group for some time and hence would not be able to continue as a member of the Group. His resignation was accepted.

2. Terms of reference

2.1 The terms of reference of this Group were as under:
      1. to review and examine the present structure of stock exchanges including those set up as companies and as unincorporated bodies and in this light examine the legal, financial and fiscal issues involved to corporatise and demutualise the stock exchanges, and
      2. to recommend the specific steps that need to be taken for implementation, and also
      3. to advise on the consolidation and merger of the stock exchanges.
2.2 The Group may during the deliberations call and hear the views of other legal experts, stock exchanges and other market participants etc. The Group would submit its report within two months from the date of its first meeting. The date of submission of the report was further extended till August 31, 2002.

3. Methodology

3.1 The Group held in all 10 meetings. The fundamental issues involved in the process of corporatisation and demutualisation of the stock exchanges were first identified. To obtain a better assessment and appreciation of these issues, the Group felt that it would be useful to first hear the different points of view of the major stakeholders in the process of corporatisation and demutualisation viz. the stock exchanges, brokers and investors. Accordingly, the Stock Exchange, Mumbai (BSE), which had already done some work on the subject, and other stock exchanges were invited by the Group to make presentations. BSE presented their views before the Group on two occasions. The Group also invited the National Stock Exchange (NSE) to present their views. A questionnaire (Annexure 2) was also sent to all the stock exchanges for eliciting their views in writing. The responses to the questionnaire were compiled and analysed (Annexure 3). Delhi Stock exchange (DSE), the Federation of Indian Stock Exchange (FISE), representatives from the BSE Brokers’ Forum and Association of Members of National Stock Exchange of India (AMNI) also made presentations before the Group. Some of the investor association viz. Consumer Education and Research Centre (CERC), Ahmedabad, Jagrut Grahak Mandal and Investor Grievance Forum (IGF) were also given an opportunity to make presentations, but of these, only CERC made their submissions before the Group.

3.2 The Group studied the proposal of BSE on demutualisation submitted to SEBI. The Group also generally examined the existing articles of association, charters, trust deed, rules, regulations and bye laws of the various stock exchanges and in particular the peculiarities of the charter of BSE, for a better understanding and appreciation of the present legal structure and status of the stock exchanges in India. The present tax status of these stock exchanges in the light of the judgments given by the Income Tax Tribunal and the matters pending before the Income Tax Department, the tax implications of the process of corporatisation and demutualisation were also generally studied by the Group. The Group also took note of the experiences of other countries where the stock exchanges were already demutualised viz. Australia, London, Hong Kong, Singapore and Toronto. In India the NSE stands out as one example of a demutualised stock exchange; the Group felt that it would be helpful if the capital, organizational and management structure of NSE, the shareholding pattern, could be compared with those of other demutualised international stock exchanges (Annexure 4).

4. Existing structure of the stock exchanges in India

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

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

4.3 The present status as above along with the details of the assets and liabilities of some major stock exchanges in India is enclosed in (Annexure 5A and 5B).

5. International developments in demutualisation

5.1 The pressures which have forced the demutualisation of stock exchanges internationally, have been different from those driving the process in India. Internationally, the pressures have come from within the system, while in India, these have predominantly been external.

Traditional structures of stock exchanges

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

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

Impact of technological changes on stock exchange

5.4 In recent years dramatic changes have occurred in the financial markets. Developments in computing power and applications have changed markets significantly. Technological changes have broken down some of the barriers to entry into the business of making markets in investments. Even the pure economics of inaugurating and maintaining new markets have changed. In contrast to the more customary expenses of physical market venues; the new economics of modern organized markets are measured in kilobytes, nanoseconds and bandwidth. Whereas, in the past, people who established a securities market needed to make significant expenditures on premises and equipment, today they may set up their securities market in a small office with a computer.

5.5 Under pressure from the twin forces of globalisation and technological advancement, the stock markets worldwide experienced a churning, resulting in increasing competition. Technological development also changed the conditions of competition in the securities markets, and, as a result, stock exchanges now have to face domestic and international competition from other firms. A stock exchange, if it had to stay relevant, under these conditions needed to innovate consistently in the contemporary arena. Stock exchanges were therefore forced to redefine their roles.

Demutualisation – the new governance structure

5.6 This redefinition of the roles and the new paradigm of competition, forced changes in the traditional governance structures of stock exchanges. Countries responded to these pressures by converting their traditional "not for-profit" stock exchanges into a "for profit" company. This process of transition from "mutually-owned" association to a company "owned by shareholders", in other words transforming the legal structure from a mutual form to a business corporation form and privatising the corporations so constituted, is referred to as demutualisation. Further, the company so constituted may choose to be a listed or an unlisted, closely held public company. The concept of demutualisation can be applied to any "non-profit" organisation or association as well.

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

Why demutualise?

5.8 The arguments in favour of demutualisation could be summarised as follows:
      • Stock exchanges owned by members tend to work towards the interest of members alone, which could on occasion be detrimental to rights of other stakeholders. Division of ownership between members and outsiders can lead to a balanced approach, remove conflicts of interest, create greater management accountability, and take into consideration the interest of other players.
      • To cope with competition, stock exchanges require funds. While member-owned stock exchanges have limitations in raising funds, publicly owned stock exchanges can tap capital markets.
      • Publicly owned stock exchanges can be more professional when compared to member-owned organisations. Further, as a result of the role played by shareholders, strengthening of the management and the organization, there is greater transparency in dealings, accountability and market discipline.
      • This would enhance management flexibility. A publicly held company is better equipped to respond to changes when compared to a closely held mutually owned organisation. Further, a company can spin-off its subsidiaries, get into mergers and acquisitions, raise funds, etc.


      Models of demutualisation

5.9. The stock exchanges, which had demutualised have followed different models. However, a common feature has been that members surrender their mutual membership rights and in lieu thereof, they are issued shares in the demutualised company. The number of shares issued has some relationship to the value of the assets of the stock exchange. In several cases, a public issue of shares was also made.
5.10 A demutualised "for-profit" stock exchange will face an issue of conflict between its regulatory responsibility and its desire to maximise profits for its shareholders, for example,
      • The profits of the stock exchange would vary with its fee structure. If it is in a monopolistic situation, it could be tempted to charge fees, which could adversely affect the interest of the trading members, the investing public or the companies listed in the stock exchange.
      • The profits of the stock exchange would also vary with the number of companies listed on the stock exchange. Thus there could be a temptation to relax the listing requirements or the standards of monitoring to boost the number of listed companies.
      • A stock exchange, which lists its own shares, may adopt a more relaxed attitude to its own listing and its own compliance by the stock exchange of its regulations.
      • There could be disagreements between members of the Board who trade as against those who do not, as regards the manner in which the affairs of the stock exchange should be conducted.
5.11 While, competition among stock exchanges should mitigate most of these issues of conflict and see the emergence of the stock exchanges which are more efficient as also "image conscious", there is unfortunately no agreement as to whether competition could produce a race to the top or the bottom as there is no way of knowing what would happen if securities markets were allowed to compete freely.

Conflict of interest and the need for regulation

5.12 A demutualised stock exchange, which has an incentive to make profits, unless properly regulated may not be a reliable gatekeeper. This issue surfaces in particular in relation to listings. At the same time the stock exchanges continue to provide a public service. Demutualisation of stock exchanges thus increases the need for monitoring by the regulator. In some jurisdictions regulators have reacted to a stock exchange’s demutualisation by removing regulatory responsibilities from the stock exchange while the stock exchange itself runs like a business corporation. The Australian Stock Exchange (ASX) retains the general power to regulate securities listings, although its own listing on its own market is supervised by the Australian Securities and Investment Commission (ASIC).

5.13 When the LSE demutualised, it lost its designation as the UK Listing Authority. The function of determining and applying the listing rules was transferred to the Financial Services Authority (FSA). However, the LSE retains the right to decide whether or not it will admit a particular security to trading through its market, and it also has self-regulatory powers to set its own trading rules, and maintain an orderly market, subject to other rules as the FSA may adopt, such as rules to check market abuse.

5.14 Regulators have reacted to the demutualisation of an stock exchange market by requiring it to separate regulatory functions from market-operating functions.

5.15 The Toronto Stock Exchange (TSE) decided to separate its regulatory services from the market operation function after its demutualisation. On the other hand, the NYSE has resisted a suggestion that if it demutualises it should spin off its regulatory functions into a separate entity, on the basis that this would do lasting damage to the NYSE brand. In contrast, NASD has separated from the NASDAQ market and plans a future as a self-regulatory organisation.

Questionnaire and its responses

5.16 The names and status of some the international stock exchanges that have been demutualised are given in (Annexure 6).

5.17 A questionnaire was sent to some of the international stock exchanges which have been demutualised. The responses received from the ASX the Singapore Stock Exchange Limited (SGX) and the LSE are discussed below:

a) Legal constitution and ownership structure of the stock exchange prior to demutualisation

i) The Australian Stock Exchange (ASX) was a mutual company, 100% owned and controlled by its brokers. It was incorporated and operated under the Australian Corporation’s Law. The members had one vote per member in the general meetings and all directors on the ASX Board were appointed by the members. On the other hand, prior to demutualisation, the Stock Exchange of Singapore (SES) and the Singapore International Monetary Stock Exchange (SIMEX) and Securities Clearing and Computer Services (Pte) Limited (SCCS) were independent entities. Each was 100% owned by its members, who were themselves companies carrying brokerage business therein. The share capital of SES comprised 34 shares, each held by a member company of SES, while that of SIMEX comprised 40 shares, each held by a corporate clearing member of SIMEX. Moreover the respective owners of SES, SIMEX and SCCS created a new entity, Singapore Stock Exchange Limited (SGX) through the Merger Act. The LSE was set up as an association of Stock Brokers and subsequently after the 'Big Bang' became a limited company with B-class shareholders in 1986. The LSE was 100% owned by member firms. In order to be a shareholder prior to demutualisation, one had to be a member firm. In 2000 it became a for-profit company and got listed on itself.

b) Composition of the governing boards before and after demutualisation

i) Prior to demutualisation there were 15 directors on the ASX Board, with a substantial majority of directors having primarily a stock-broking background. Upon demutualisation, the ASX Board was reduced to 11 directors, and then from 11 to 9 directors one year later at the following Annual General Meeting. Both reductions came from the number of directors having primarily stock broking experience. Among these 9 directors: 1 is executive (the Managing Director), 4 do not have a stock broking background and are directors of a number of other companies; 4, including the Chairman, have a primarily stock broking background. The term of appointment is 3 years for all non-executive directors, with the ability to be re-elected. There is no maximum term. The only restrictions on the directors of ASX are on self-dealing of securities listed on the ASX. The general prohibitions of the law on any insider trading are applicable to all.
        ii) The Board of SES prior to demutualisation had a representation of members and non-members. Post demutualisation in SGX, there are 11 Board members: 2 are executive and non-independent (the chairman and the chief executive officer) and hold shares in SGX. Of the remaining 9 non-executive, independent directors 3 hold shares in SGX (either deemed interest or directly) and the remaining 6 do not hold shares in SGX. 6 out of these 9 non-executive, independent directors have primarily a stock broking background. There are no special restrictions on trading placed on the brokers who are directors on the Board of the stock exchange.

        iii) The LSE never had a Board, which guaranteed representation of any particular community. Immediately after demutualisation, the Board had 13 members. Of these only 2 were independent for the purpose of the Combined Code i.e. not connected with the City or markets. Three of these are Executive Directors and one was the Chairman. The current Board strength is 12: non-executive Chairman, 3 Executive Directors and 8 Non-executive Directors, 5 of whom are considered independent under the Combined Code. Apart from the normal restrictions imposed on directors of any company by the Companies Act there are no other restrictions.

c) Merger of national stock exchanges prior to or after demutualisation

i) In several countries, which had more than one stock exchange, set up as mutual companies, stock exchanges merged into one single mutual company. This was the case in Australia where the ASX was formed in 1987 through incorporation under legislation of the Australian Parliament enabling the amalgamation of six independent stock exchanges that formally operated in the State capital cities. Each of those stock exchanges had a history of share trading dating back to the last century. This also happened in UK where following the Big Bang in 1986, all the stock exchanges in UK merged into a single mutual company, the LSE.

d) Ownership of assets prior to and after demutualisation

i) Prior to demutualisation, the assets of ASX and LSE, were owned by the stock exchanges which in turn were owned by the brokers and the stock exchanges were set up as trusts. However in the case of SGX, the Fidelity Fund and the SIMEX compensation fund were held in Trust, with the investors as the main beneficiaries.

ii) These stock exchanges however, have imposed a ceiling on individual shareholdings in the demutualised entity. Most stock exchanges such as LSE, SGX and several others have maintained the ceiling at 5%. In the case of ASX, the ceiling was initially 5%, which is being increased to 15%. The initial shareholders of the stock exchange were restricted to the 606 broker members. However, after demutualisation and listing of ASX on the same stock exchange, the number of shareholders expanded to over 6000 with more than 5000 having fewer than 5000 shares each.
        e) Listing of the demutualised stock exchange
    A number of the demutualised stock exchanges are listed as companies on the stock exchanges themselves. This is true for example for ASX, SGX, LSE and Hong Kong Stock Exchange are examples of demutualised stock exchanges which were listed following demutualisation and Initial Public Offer for each of these stock exchanges.

    f) Transfer of assets upon demutualisation

    i) The ASX and LSE were created out of the same entity, although reconstituted, and so the question of any transfer of assets did not arise. In the case of SGX, the respective share capital of SES, SIMEX and SCCS was deemed to be cancelled and replaced by new shares that were held by the new company, SGX.

    ii) Each member of the ASX received 166,000 shares in the new entity against the only consideration provided by the brokers of relinquishment of mutual ownership rights. There was no cash consideration.

    iii) The SGX also issued shares in the new entity to the brokers in lieu of their earlier ownership. Fully paid up shares in SGX to each former shareholder of SES and SIMEX and to each holder of a SIMEX seat (as the existing SIMEX seats were abolished upon merger) were allotted. The Merger Act determined the number of shares were to be allotted to each member of SES or SIMEX as follows: (i) a value of S$6 million was attributed to each SES share (except for 1 SES share held by a shareholder that was in involuntary liquidation; (ii) a value of S$115,000 was attributed to each SIMEX share; (iii) a value of S$170,000 was attributed to each SIMEX seat.

    iv) The LSE made a bonus issue of 99,999 shares for every 1 share held. Each shareholder had only one share, therefore after the bonus issue each shareholder had 100,000 shares.
g) Fiscal Benefits prior to demutualisation

i) Besides exemption from income tax, the ASX did not enjoy any other fiscal benefit. The SGX also enjoyed exemption from corporate income tax on all types of its operating incomes. The corporate income tax rate in Singapore is currently 24.5%, which is assessed on an individual entity, not on a consolidated, basis. When the Derivatives Market was created, the government of Singapore exempted substantially all types of its operating income from corporate income tax in order to support its growth. This tax exemption is due to expire in 2003. No information in this regard was available for LSE. In no case however did the Government / any regulatory authority take away any assets or any part thereof from the stock exchange after the demutualisation on account of fiscal concessions enjoyed by the stock exchanges prior to demutualisation.

h) Enactment of any special legislation to facilitate the process of demutualisation
        i) The ASX enacted a special act of parliament for the purpose of demutualisation. SGX also passed a statute, The Stock Exchanges (Demutualisation and Merger) Act, 1999, for facilitating the process. However, no such enactment was required in the case of LSE. In the case of LSE, demutualisation was not as big an issue as it was for other stock exchanges, as the stock exchange at the time of Big Bang in 1986 had changed from an unincorporated association to an incorporated association and so at demutualisation LSE had in place a Board of Directors than a Council of Members.
ii) The terms and conditions of the demutualisation of each stock exchange and the merger were fixed by the Merger Act and did not involve approval by the members. Pursuant to the Merger Act, the Monetary Authority of Singapore (MAS) is also given the power to issue directives of a general or specific nature to SGX if necessary or expedient for ensuring fair and orderly securities and futures markets or for ensuring the integrity of, and proper management of systemic risks in, the securities and futures markets. Such directives may be issued in respect of the amendment of rules of SGX, the corporate governance or management of SGX, the books and records of SGX, or other matters. The Merger Act also requires any auditor of SGX to report certain matters to the MAS. The Merger Act also contains restrictions on acquisitions of substantial shareholdings in SGX.
  6. Comparison between the NSE model and internationally demutualised stock exchanges
      6.1 Since the model of NSE is closest to the international model for a demutualised stock exchange, the Group felt it would be useful to compare this model to the international model using certain common comparators such as legal constitution and ownership structure of the stock exchange, composition of the Governing Board, transfer of assets and issue of shares to members, trading restrictions on broking members, restrictions on voting rights and corporate governance norms. The comparative table is given below.
Comparison of the NSE model and the international models of demutualised stock exchanges


Sl.No
Comparators
International Model
NSE Model
1 Legal Structure  Company Company
2 For Profit / Not for Profit  For Profit Company  For Profit Company
3 Ownership Structure Owned by Shareholders which includes brokers Owned by Shareholders which are financial institutions which also have broking firms as subsidiaries.
4 Listing  Several stock exchanges are listed on themselves after Initial Public Offer. Not a listed company. No Initial Public Offer made. 
5 Ceilings on shareholding  Mostly 5% of voting rights for a single shareholder  No ceiling
6 Segregation of ownership, trading rights and management These are segregated. To become a member of the demutualised stock exchange, it is not necessary to own a share in the company. Thus, members may or may not be shareholders and members who own shares may sell off their trading rights and all shareholders are not necessarily members.  These are segregated. The trading rights and ownership are segregated. The broking firms are not shareholders. 
7 Board Structure  The Governing Board comprises of directors who are elected by shareholders. Some of the directors are brokers but majority do not have stock broking background.  The Board comprises of representatives of shareholders, academics, chartered accountants, legal experts etc. Of these, 3 directors are nominated by SEBI and 3 directors are public representatives approved by SEBI. 
8 Fiscal benefits  As mutual entities, stock exchanges enjoyed fiscal benefits prior to demutualisation, but when converted into for profit companies these are taxed. NSE was set up as a demutualised for profit company and is taxed. So the question of fiscal benefit prior to demutualisation does not arise. 
9 Transfer of assets Assets were transferred from the mutual entity to the for-profit demutualised company and shares were given to the members in lieu of the ownership in the old entity. There was no cash consideration paid. Since an Initial Public Offer (IPO) was also made in many cases, the valuation of the shares were done by the market and no separate valuation exercise was required as for example in the case of LSE where a bonus issue was made.  The question of transfer of assets did not arise because NSE was set up by the institutions as a demutualised company itself. 
10 Enactment of legislation to give effect to demutualisation In several countries a separate legislation was necessary as in the case of Australia, Hong Kong, Toronto and Singapore. In several others no legislation was necessary as in the case of UK. Not applicable as NSE was set up as a demutualised company.
6.2 It would be seen from the table that NSE model compares well with the international models of demutualised stock exchanges except that NSE is not a listed company and as such its shareholders are not diversified. Besides, there is no ceiling on the ownership of shares by a single entity and there is no broker representation on the board, except that board includes members who are nominees of institutions which have broking subsidiaries.
 

7. Presentation by various entities before the Group

The Group invited various market entities like stock exchanges, Brokers' association and Investors' association to present their views before the Group. Written representations were also received from various stock exchanges. The details of the same are given in Annexure 7 of the Report.

8. Issues before the Group

8.1 The discussions in the foregoing paragraphs on the experiences of demutualisation in other countries, the present constitution and governance structure of the stock exchanges in India and the views expressed by various segments of stake holders, distil into the following issues. The Group felt that these issues would need to be addressed, as these are germane to any model of demutualisation.
      1. Desirability of demutualisation.
      2. Form in which demutualisation should take place – through the process of corporatisation or otherwise.
      3. The manner in which transition from a mutual structure to a for-profit structure be achieved.
      4. The manner in which trading rights are to be given to members - through refundable deposits or through transferable cards.
      5. Structure of the governing boards of stock exchanges and representation of brokers.
      6. Necessity of functional segregation between Chairman of the Governing Board and the Chief Executive.
      7. Professional restrictions on the Chairman of the Governing Board in case he is a practicing broker and restrictions on brokers if elected as directors in the governing boards.
      8. Share ownership pattern of stock exchanges and share ownership by brokers.
      9. Listing of the corporatised stock exchanges.
      10. Restrictions on voting rights in the corporatised stock exchanges.
      11. Role and relevance of the regional stock exchanges.
      12. Need for multiple category of stock exchanges that is stock exchanges segregated according to the size of the issue listed and whether in each category there should be more than one stock exchange.
      13. The statutory requirements and legislative changes necessary to give effect to demutualisation.
9. Recommendations of the Group Desirability of demutualisation and sequencing of the process
      9.1 On the desirability of demutualisation, the Group noted that stock exchanges, representatives of brokers association and investors association were unanimous. The Group also noted that the Government has announced that stock exchanges will be corporatised by which ownership, management and trading membership would be segregated from each other. This clearly implies that the process of demutualisation would have to take place through corporatisation of the stock exchanges.

      9.2 Presently, three stock exchanges namely, BSE, Ahmedabad Stock Exchange (ASE) and Madhya Pradesh Stock Exchange (MPSE) have been set up as voluntary non-profit making association of persons; 7 stock exchanges are set up as companies limited by shares and the remaining 13 are set up as companies limited by guarantee.

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

      1. corporatisation of three stock exchanges (BSE, ASE and MPSE) which currently do not have a corporate structure,
      2. conversion of the stock exchanges limited by guarantees into ones limited by shares
      3. incorporation in the memorandum and articles of association of existing stock exchanges set up of relevant provisions to give effect to the Group’s recommendations.
9.4 With the corporatisation of three stock exchanges and the transition of thirteen companies limited by guarantees to companies limited by shares, all stock exchanges will have a uniform legal structure. The Group therefore recommends that
        a) the stock exchanges which are set up as association of persons and those which are set up as companies limited by guarantee be converted into companies limited by shares;
b) a common model for corporatisation and demutualisation be adopted for all stock exchanges; and

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

 Effecting the transition from a not-for-profit voluntary entity into a for-profit corporate body
      9.5 A basic character of the stock exchanges in India, saving NSE, irrespective of their legal constitution, is that they are meant to be voluntary, not for-profit mutual entities. It is on this ground that the stock exchanges (except NSE) have claimed tax exemptions, though in dispute in some cases. Demutualisation fundamentally alters this position of the stock exchanges, as these would no longer retain their voluntary, not for-profit mutual character, but become for-profit corporate bodies. The most critical part of demutualisation exercise is to work out a blue print to manage this transition in a smooth manner.
      9.6 The Group noted that there are two parts to this transition. One, which involves the changing the voluntary not-for-profit character of the entity into a for-profit one (in some cases into a corporate body as well) and second, is the process of delinking of ownership of the entity by the members from their trading rights. The first would involve the manner in which assets would be transferred from the existing entities to the new corporate entity, wherever demutualisation has to be accompanied by corporatisation as in the case of BSE, ASE and MPSE.
      9.7 The second would involve the allocation of these assets to the members. All stock exchanges, with the exception of the NSE, OTCEI and ICSEI have the concept of membership cards for their members. The twin rights of trading and an undivided interest in the ownership of the stock exchange are embedded in the membership card of a stock exchange. The transition to a demutualised stock exchange would involve the segregation of these twin rights into two separate and independent rights viz.
      1. the right to participate in the ownership of the assets of the stock exchange, and
      2. the right to trade on the stock exchange.
      9.8 This decoupling of the two rights would have to be effected through the cancellation of the card against a consideration of creation of two assets or two rights - one, an interest in the assets of the stock exchange and the other interest in the trading right. The interest in the asset is created by issuance of shares in the new entity in lieu of the consideration of extinguishment of cards currently owned by the members in the mutual entity. Internationally also, stock exchanges have followed the same procedure for demutualisation. The manner in which the interest in the trading rights would be created is discussed in paragraphs 9.20 to 9.22 of this report.

      9.9 At the point of time, when a trading right is acquired, and a share is allotted to a member of an stock exchange by virtue of which he acquires a membership privilege against the extinguishment of the previous right of membership, no transfer of assets effectively takes place and neither of the acquisitions should therefore be deemed to be a transfer within the meaning of the word in the Income Tax Act. However, at the point of sale of any of these two rights, capital gains tax would be attracted. This would also imply that the cost of acquisition would have to be split and valued. The manner in which this could be done has been elaborated in Paragraph 9.22 of this report.

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

      9.11 The Group noted in this context that the Government had in the past given such encouragement to the stock brokers for corporatisation of their cards by exempting from tax any capital gains that may arise on corporatisation of membership brokers subject to certain conditions.

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

      9.13 In effect, three amendments have been made by the Finance Act, 2001, in clause (xiii) of Section 47, which has taken effect from April 01, 2002. Their effect is to indicate that the corporatisation of a recognized stock exchange in accordance with a scheme approved by the SEBI will not be a "transfer". This would be even if there is a transfer of capital assets or intangible assets from the stock exchange which was originally a firm or an association of persons to the stock exchange when it becomes a company under the approved scheme.

      9.14 The changes are

      1. The main part of clause (xiii) of section 47 was substituted to include any transfer of a capital asset to a company in the course of corporatisation of a recognized stock exchange in India, as a result of which an association of persons or body of individuals is succeeded by such company.
      2. The words "or of the association of persons or body of individuals" were added in proviso (a), which earlier covered all the assets and liabilities of the firm only.
      3. Clause (e) was added in the proviso to carry out the corporatisation of a recognized stock exchange in India in accordance with a scheme of corporatisation which is approved by the SEBI.
      9.15 Corresponding amendments have been made in Sections 43 (1) and 43 (6) of the Income Tax Act to provide for definitions of ‘actual cost’ and ‘written down value’ of assets transferred under such a scheme of corporatisation, and in Section 55 (2) of the Act, to provide for definition of cost of acquisition of equity shares allotted to a share holder of the corporatised stock exchange.

      9.16 Explanation 12 was inserted by the Finance Act, 2001, to take effect from April 01, 2002. This Explanation provides that the actual cost of an asset acquired by an assessee on the corporatisation of a recognized stock exchange in India under a scheme approved by the SEBI will be deemed to be the amount which would have been regarded as the actual cost had there been no corporatisation.

      9.17 Explanation 5 was added to Section 43 (6) -
       

        Explanation 5 was inserted by the Finance Act, 2001, with effect from 01.04.2002 to provide the written down value of a block of assets transferred by a recognized stock exchange in India to a company under a scheme of corporatisation approved by the SEBI. It will be the W.D.V. of the transferred assets immediately before such transfer. Section 55 (2) (ab) was inserted by Finance Act, 2001 w.e.f. 01.04.2002 to give meaning to the cost of acquisition of shares allotted to a shareholder of a recognized stock exchange under a scheme of corporatisation approved by SEBI. The effect of this clause is that the cost of acquisition of the shares allotted to a member of a recognized stock exchange in India under a scheme of corporatisation approved by SEBI will be the cost of acquisition of his original membership of the stock exchange.


      9.18 In view of the arguments in the foregoing paragraphs, the Group recommends that-

i) as corporatisation and demutualisation of a stock exchange is essentially a conversion from a not-for profit entity to a for-profit company, and would result in a distribution of assets, the Income Tax Act should be amended if necessary, so that the past profits of an stock exchange which were not taxed when it had the character of a not for profit entity should not be taxed when its character changes. In other words, the accumulated reserves of the stock exchange as on the day of corporatisation should not be taxed. However, there would be no objection to taxation of these reserves, in the hands of the shareholders when these are distributed to shareholders as dividend at the net applicable tax rate; equally all future profits of the stock exchange after it becomes a for profit company may be taxed;
        ii) notwithstanding any provision, judgment or order to the contrary or inconsistent therewith, a statutory provision should be made in the Income Tax Act, so that the issue of shares and trading rights in lieu of the card should not be regarded as transfer within the meaning of Section 47(xiii) of the Income Tax Act. The byelaws, rules and articles of a stock exchange should be amended to provide for the allotment of shares and trading rights to its members upon corporatisation (in applicable stock exchanges) and upon demutualisation;

        iii) necessary provisions should also be made in the Indian Stamp Act and the Sales Tax laws to exempt from stamp duty and sales tax, the transfer of the assets from the mutual stock exchange and the issuance of shares by the new demutualised for-profit company, formed pursuant to an approved scheme of demutualisation; and that

        iv) as only the schemes for demutualisation approved by SEBI will qualify for the exemptions under the Income Tax Act, the Indian Stamp Act and the Sales tax Act, each stock exchange would be required to submit a scheme drawn on the lines of these recommendations to SEBI for approval.
         

      Segregation of trading rights and ownership
    9.19 For the purpose of segregation of ownership and trading rights, the Group examined the present systems of membership prevailing in the stock exchanges in the country. It was noted that except for NSE, which offers trading rights against deposits, all other stock exchanges have the concept of membership cards for their members. In some stock exchanges e.g. BSE, the trading right is exercised through the ownership of a trading card, which subject to BSE's approval can be transferred for a consideration. Cards can be sold by members and also by the stock exchange when new members are introduced.

    9.20 The representations received by the Group from the stock exchanges, brokers' association and investors' association suggest that there are several advantages in the deposit system as opposed to the card system. The major advantages are:-
        i. The deposit provides a valuable source of funding for the stock exchange, which needs to make large investments in technology.
ii. The deposit is considered as part of the deposit required by the member for his trading operations as also as part of his "net worth" unlike the card system where the amount invested by a member in the purchase of the card is not considered for either purpose. It neither forms a part of member’s capital for the purpose of computing his base minimum capital, nor is it taken into account for exposure norms. 9.21 The Group noted from the representations received by it that the stock exchanges favoured the deposit system as opposed to the card or the seat system. The Group therefore recommends that-
  a) the trading card system be replaced by the deposit system wherein the money deposited by the member to obtain trading rights only, be considered as deposit with the stock exchange for trading purpose. While the Group favors the deposit system, it would like to leave the choice of adopting either the card or the deposit system to the stock exchanges; and

b) the following procedures be adopted if the deposit system is accepted by an stock exchange for the purpose of segregation of the trading rights and ownership. As an illustration only, some figures have been assumed.
 

 Members of an stock exchange currently own an asset viz. a card whose value can be assessed on two different parameters viz.:-
      1. the market value of the card as evidenced by the actual transactions which have taken place in recent years.
      2. the fair value of the card derived by dividing the fair value of the stock exchange by the number of cards. This value can be determined by using some of the well-established bases like "the underlying asset" approach, the "income" approach etc. and the task can be entrusted to professional valuers.
      3. Based on the above, a value of the card can be determined.
The value of the card represents the aggregate value of two independent rights of the holder viz.

(a) the right to a share in the net assets and goodwill of the stock exchange and

(b) the right to trade on the stock exchange.

Since trading rights are in future to be made conditional on the placement of a deposit with the stock exchange and such deposit will also be collected from new members, the amount of such deposit may be considered as the value of the right to trade and the excess of the fair value of the card over that amount may be considered as the value of the right to share in the net assets and goodwill of the stock exchange.

Assuming purely for the purpose of illustration, that the value of a card is determined at Rs.125 lakh and the amount of deposit at Rs.75 lakh the value of the card can be apportioned as under :-
(a) Value of share in net assets and goodwill of the stock exchange Rs.50 lakh
(b) Value of trading rights Rs. 75 lakh
    Rs.125 lakh
The stock exchange will therefore issue to each member, on cancellation of the card, shares, which have an aggregate value of Rs.50 lakh and a deposit receipt of Rs.75 lakh. The shares may be issued at par or at premium as may be considered appropriate.

In the books of the stock exchange, the aggregate value of the shares issued and deposit receipts issued will represent the total consideration. The excess of total consideration over the book value of the net assets will represent goodwill and will be recorded as such. Goodwill will have to be written off over a specified period say 20 years.

A trading member can liquidate a part of his investment by selling all or part of the share capital. However, so long as he remains a trading member he has to retain the deposit.

If the member wishes to terminate his membership, he can demand refund of the deposit but in order to ensure the liquidity of the stock exchange, there should be an initial "lock-in" period of three years and thereafter such "lock-in" period as the stock exchange may stipulate to provide assurance against non-notified claims.

Governance of the stock exchanges

9.22 The Group noted that in the past, in almost all the stock exchanges, the broker members of the governing boards have been critical in the governance of the stock exchanges. The reconstitution of the governing boards of the stock exchanges by SEBI, which reduced the broker representation on these boards to 50%, had helped in making the boards more independent and minimised the influence of brokers. However, in most stock exchanges on account of the brokers retaining posts of the officer bearers of the stock exchanges till recently viz. president, vice-president and treasurer, they continued to play a dominant role in the management of the stock exchange. The fall-out of this practice has been that most stock exchanges have failed to develop good corporate governance practices and strong management teams. This has not only been a perception but also a reality in most stock exchanges. Conflicts of interest have bedeviled the operations of the stock exchanges in the past to the detriment of the securities market. If the stock exchanges are to function in a modern competitive environment these deficiencies would have to be removed and they would have to adhere to the high standards of corporate governance. Indeed this is one of the objectives to be achieved through this entire exercise of demutualisation of the stock exchanges.
      9.23 The Group noted the steps taken by SEBI recently to strengthen the governance of the stock exchanges and to remove the conflicts of interest. As directed by SEBI, the brokers are not allowed to hold the posts of president, vice president, treasurer or act as office bearers. Besides, pursuant to this directive the brokers have stepped down from these posts in almost all the stock exchanges. The Group felt that there is a need to further strengthen the present governance structure to compliment the demutualisation exercise so that the purpose of demutualisation could be fruitfully served.

      9.24 Divergent views have been expressed on the issue of broker representation on the governing boards of stock exchanges. The case for broker representation has been made by almost all stock exchanges and brokers' association. Their argument is that the brokers are major stakeholders in a stock exchange and they are affected by the manner in which an stock exchange functions. They also have the experience and knowledge of the market and therefore should have some representation on the governing boards of the stock exchanges. Besides, the demutualised corporatised structure envisages that brokers could continue to be shareholders and as such be eligible to be elected on the boards as directors. The investors' association have made the case for not giving any representation to the brokers. The argument against broker representation is one of conflict of interest and the possibility of interference and exercising influence in the functioning of the stock exchange. The investors' association have felt that in a sense the presence of brokers on the governing boards affects the independence of the executives of the stock exchange who may be answerable to the very persons whose actions they are expected to control.

      9.25 It was a view of the Group that in the newly constituted demutualised stock exchange, there would be three major stakeholders – the shareholders, the brokers and the investing public through the regulatory body. It was important that all the three stakeholders are represented equally on the governing boards of the stock exchanges. The representation of the brokers on the governing boards of stock exchanges is desirable in the view of the Group, as it felt that the stock exchange would benefit from their expertise and experience about the working of the stock exchange. It is expected that the 2/3rd of the board being non-brokers should be able to provide the driving force behind the management of the stock exchange. But if it is decided by a stock exchange to have broker representations on its governing board, the ratio of the brokers should not be more than 1/3rd. In most of the demutualised stock exchanges abroad, and even in non-demutualised stock exchange such as NYSE and NASDAQ, brokers are represented on the governing boards. In NYSE for example there are 4 broker members, 12 are providers of financial services, 8 are from financial institutions, 2 are CEOs of large corporates, 2 are representatives of investing association and 4 are retired public servants who held important administrative offices.

      9.26 The issues of conflict of interest which may have arisen in the stock exchanges in the past could be further addressed separately, by building up strong management teams and putting in place appropriate systems and procedures which would ensure that brokers are not able to interfere in the day to day functioning of the stock exchanges. The Group therefore recommends that –

      1. the three stakeholders viz. shareholders, brokers and investing public through the regulatory body should be equally represented on the governing board of the demutualised stock exchange;
      2. there should be specific vacancies on the board for each group of stakeholders;
      3. the shareholders’ representatives should not be functioning brokers;
      4. the brokers representatives would be elected by the shareholders from among the brokers of the stock exchange;
      5. the representatives of the investing public would be nominated by SEBI from among a panel comprising of academics, professionals, industry representatives, public figures and investors association, none of whom should have any interest in any broking firm;
      6. adequate disclosures about the background of the directors of the board should be provided to the shareholders at the annual general meetings and the annual reports;
      7. the maximum number of directors on the board will be governed by the relevant provisions of the Companies Act. 1956; and
      8. current restrictions on the tenure of broker directors should continue.
Management of the stock exchange
      9.27 The need for a strong management set up for a stock exchange cannot but be overstated. While the revamping of the governing boards on the lines of the foregoing recommendations would strengthen the board structure, there is a need for a strong and independent management team headed by a professionally qualified Chief Executive Officer (CEO). For all practical purposes, as in the case of any other corporate body, the CEO would be solely responsible for the day to day functioning of the stock exchange which would also include compliance with various regulations and risk management practices. To strengthen the management of the stock exchange, the stock exchanges should also appoint a professionally qualified Whole time Director on the Board of the stock exchange. It is important that both the CEO and the Whole time Director should be permanent members of the Board of the stock exchange. In addition to the above-mentioned posts, the stock exchanges may appoint a Chief Financial Officer (CFO) who need not be a member of the stock exchange Board. In the view of the Committee, once the demutualisation exercise is carried out and the twin rights of ownership and trading now embedded in a membership card are segregated and the representation of the brokers reduced in the governing boards, the scope of interference by the brokers in the day to day functioning of the stock exchange would be greatly diminished. The Group also felt that in the demutualised set up, the stock exchanges must imbibe and put in place corporate governance practices, systems and procedures which are similar to those followed by listed companies. These would include standards of financial reporting, audit committees, shareholders’ grievances committee, disclosures in the annual reports, disclosures to shareholders in the annual general meeting, etc.
9.28 On the issue of the role of the Chairman of the Board and that of the Chief Executive, there were divergent views. Some of the stock exchanges had represented that the posts of the Chairman and Chief Executive of the Board should be combined into a single post and the incumbent should be a person who has intimate knowledge of the working of the stock exchange. The other view was that the two functions should be segregated as this segregation recognises the requirement of good corporate governance. According to this view, the management of the company is distinct from that of the board and functions under the overall direction of the board. To make this possible, the roles and hence the posts of Chairman and Chief Executive would need to be segregated.

9.29 On the qualifications of the Chairman of the Board, there were divergent schools of thought. One view was that the Chairman of the Board could be a practicing broker. The proponents of this view have argued that in several of the stock exchanges abroad, the boards are headed by practicing brokers with the restriction that during the tenure of the chairmanship, the persons disassociate themselves from the working of the broking firms they represent. The other school of thought is that if the chairmanship is given to a practicing broker or the head of a broking firm which is a member of the stock exchange, there could be a possibility that the independence of the Chief Executive of the stock exchange may be prejudiced and the strong support which the Chief Executive could expect from the Chairman of the Board could be diluted. The Group therefore recommends that–
      1. the roles and hence the posts of the Chairman and Chief Executive should be segregated. The Chairman should be a person who has considerable knowledge and experience of the functioning of the stock exchanges and the capital market;
      2. the Chairman of the Board should not be a practicing broker;
      3. the demutualised stock exchanges should follow the relevant norms of corporate governance applicable to listed companies in particular, the constitution of the audit committee, standards of financial disclosure and accounting standards, disclosures in the annual reports, disclosures to shareholders and management systems and procedures;
      4. the stock exchange must appoint a CEO who shall be responsible for the day to day functioning of the stock exchange. The CEO would be solely responsible for the day to day functioning of the stock exchange which would also include compliance with various regulations and risk management practices;
      5. it would be optional for the stock exchange to appoint a CFO in addition to the CEO; and
      6. the board should not constitute any committee whose effect would be to dilute the independence of the CEO of the stock exchange and the day to day functioning of the stock exchange.
Dispersal of shareholding of the stock exchange after demutualisation
      9.30 Demutualisation demands that shareholding in the stock exchange company should not remain exclusively with the brokers on the stock exchange. Dispersal of membership can be achieved in one of two ways:-
      1. by the shares of the stock exchange initially issued to brokers being offered for sale to the public; and
      2. by the stock exchange making an issue of shares to the public.
    The Group therefore recommends that -

    no specific form of dispersal need be prescribed but there should be a time limit prescribed, say three years which can be extended by a further maximum period of two years with the approval of SEBI, within which at least 51% of the shares would be held by non-trading members of the stock exchange.

    Listing of the demutualised stock exchange

    9.31 The Group noted that there is no uniform pattern in demutualised stock exchanges abroad on listing of stock exchanges. In some countries such as Australia, Hong Kong, Singapore, Canada, UK and Sweden the demutualised stock exchanges are self listed i.e. listed on their own stock exchanges. To avoid conflicts of interest in such cases, the monitoring of the listing conditions have been relinquished to the securities market regulator. In India, the NSE, which is a demutualised stock exchange, is not listed on any stock exchange. The advantage of listing is that it gives a degree of liquidity to the share and therefore encourages public participation. Besides, it enforces a higher degree of transparency in the functioning of the stock exchange and forces higher standards of corporate governance. The stock exchanges in their representation to the Group have favoured the listing of the demutualised stock exchange. The Group felt that while listing of the stock exchange should be a desirable objective, it may not be made mandatory. The Group therefore recommends that -

    it would be desirable for a demutualised stock exchanges to list its shares on itself or on any other stock exchange. However, this should not be made mandatory; in case the stock exchange is listed the monitoring of its listing conditions should be left to the Central Listing Authority or SEBI following the pattern obtained in UK and Australia where the market regulators viz. FSA and ASIC supervise the listing.

    Ceiling on voting rights of shareholders

    9.32 The Group was of the view that having regard to the public interest in the efficient functioning of stock exchanges, it is important that no single entity or groups of related entities should be allowed to control a stock exchange through cornering the shares of the stock exchange. In most countries, there are restrictions on the voting rights, which can be exercised by a single entity or groups of related entities. These rights are generally restricted to 5% of the issued and paid up share capital of the demutualised stock exchange though Australian Stock Exchange is contemplating to increase this ceiling to 15%. A ceiling on the voting rights have also found favour with the various stakeholder groups who have expressed their views before the Group though a specific figure for the ceiling has not been mentioned. The Group therefore recommends that -

    there should be a ceiling of 5% of the voting rights which can be exercised by a single entity or groups of related entities, irrespective of the size of ownership of the shares.
     
     

    Merger of the stock exchanges and exit route for the existing members of the stock exchange

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

    9.34 The Group was of the view that it was not within its purview to suggest an appropriate exit route for the members of the stock exchange. The recommendations of the Group are relevant to the processes by which the stock exchanges should be corporatised and demutualised. While the Group recognised that it is unlikely that all the 23 stock exchanges would continue to serve an economic purpose even in the medium term, it was of the view that it would be up to the stock exchange to choose whether it should merge with any other stock exchange or continue to function independently. This choice would be predicated on the commercial considerations of the concerned stock exchange. The Group however felt that corporatisation and demutualisation should facilitate the process of merger of stock exchanges.

 9.35 The Group was also of the view that after the regulatory framework for corporatisation and demutualisation is put in place, the stock exchanges have clearly two choices left. They could either draw up a scheme of demutualisation and seek the approval of SEBI or may choose not to demutualise and seek derecognition under the provisions of SCRA. In case of the latter the winding up of the stock exchanges would have to be carried out in accordance with the winding up provisions laid down in the articles and rules of the respective stock exchanges.
      9.36 Some of the stock exchanges and brokers' association have represented to the Group that demutualisation should only be carried out by those stock exchanges which have business and are financially viable. It has also been suggested that the stock exchanges, which have set up broking subsidiaries, should be allowed to merge with the subsidiary and continue to act as a broking entity. The Group was of the view that the proposals for corporatisation and demutualisation should not be made applicable on a selective basis. These should be applicable uniformly to all stock exchanges and it would be up to the stock exchange whether to accept the proposal or not. The choice of non-acceptance would carry with it the consequence of derecognition and as mentioned earlier, derecognition would lead to winding up of the stock exchange in accordance with its articles and rules.

      9.37 The Group also felt that the question of a stock exchange merging with its subsidiary is impractical, because the subsidiary of the stock exchange owes its existence to the stock exchange. The route of subsidiary has been introduced by SEBI only as a measure to provide trading opportunity to the brokers of stock exchange and these subsidiaries have been permitted on the strength of the stock exchange. When the stock exchange itself loses its existence with its merger with the subsidiary, the entire structure falls through and the latter also loses its independent existence. The Group therefore did not accept the suggestion of an stock exchange merging with its subsidiary.

      9.38 The Group did not wish to express any view regarding the formation of subsidiaries and the subsidiaries becoming members of BSE and NSE. The Group however noted that, at present, the exposures and risks inherent in this practice are to some extent managed through the fact that at least 51% of the share capital is held by the stock exchange and its organization and assets are used by the subsidiary. If the stock exchange closes down or is merged with another stock exchange, this arrangement will no longer exist.

Relevance of regional stock exchange

9.39 With the automation of all the stock exchanges and the expansion of trading terminals of BSE and NSE across the country, investors have an easy access to the securities market. The nationwide reach of two large stock exchanges has affected the market structure in two ways. First, the business of other stock exchanges has declined significantly, as investors have preferred to trade in BSE and NSE, which offer deeper markets. Second, with the declining of trading volumes in other stock exchanges, the issuers feel that hardly any purpose is served by remaining listed in the regional stock exchanges. The concept of regional stock exchange, which was introduced in the days of manual trading and open outcry system to encourage mobilization of resources and development of equity cult across the country, has thus lost its relevance in the days of automated trading. The Group therefore felt that the concept of regional stock exchange needs to be abolished. The Group was informed that a similar recommendation has been made by the Committee on Delisting of Shares set up by SEBI.

Alternative use of existing infrastructure facility of the stock exchanges – the EURONEXT model

9.40 In order to explore the possibilities of utilisation of the existing IT infrastructure put in place by all these stock exchanges the Group examined the Euronext initiative in Europe, which has led to the merger of the stock exchanges of Paris, Brussels and Amsterdam. The Euronext stock exchange now allows for the creation of a common order book for any share listed on any of the three stock exchanges. The trading is done on a common trading platform. The Euronext trades are settled through Clear Net, which acts as a common clearing house acting as counter party and the Euro Clear which acts as a depository. The key to the success of the Euronext appears to be the unification of the back offices, the order book, harmonization of the trading platforms of the three stock exchanges and a single clearing house have contributed to the success of Euronext despite the stock exchanges being under three different regulatory regimes.
      9.41 The Group felt that if three stock exchanges in different regulatory regimes could be merged may be such a merger could be explored even in India by some of the stock exchanges. The Inter Connected Stock Exchange of India (ICSEI) had attempted such an exercise but could not succeed mainly because the order book remained split between the stock exchanges which are the 14 constituent stock exchanges of ICSEI and the order book of ICSEI. The splitting of the order book fragmented the market. Also, the clearing for the same security took place in multiple stock exchanges, which added to the cost. The Group therefore felt that some of the stock exchanges could undertake a more meaningful exercise following the example of a single order book and setting up of single clearing corporation at the national level or using the services of either Clearing Corporation / Clearing House of BSE and NSE. This exercise could serve another important economic purpose as the markets grow, as it is possible that the two large stock exchanges may raise the minimum capital requirement for an issue to be listed on these stock exchanges.

      9.42 Further in a competitive environment, there is a possibility of abolishing of concept of multiple listing and leaving the choice of listing in more than one stock exchange to the issuer. This would not leave any avenue for raising capital for a medium size company, which may have smaller issues. A stock exchange modeled on the Euronext could play an important economic role for the listing and trading of such issues.

9.43 The Group therefore was of the view that some of the stock exchanges could explore the possibility of merger on the lines of Euronext. The Group does not recommend any specific route as being mandatory as the choice should be dictated on commercial considerations. The Group however feels that it would be in national interest that the infrastructure available with the stock exchanges be put to best economic use. In case the stock exchanges adopt the Euronext model, SEBI will have to work out the eligibility criteria for the brokers, model rules and bye-laws for such an stock exchange, the risk containment measures, and the listing guidelines.
 

9.44 In sum, the Group is of the view that –
      1. a uniform model for corporatisation and demutualisation would have to be adopted by all the stock exchanges. This model should not be made applicable selectively only for a few stock exchanges;
      2. if the recommendations are adopted and suitable legislative changes carried out to implement the recommendations, the stock exchanges will be required to submit a scheme of demutualisation to SEBI by an appointed date, and non-compliance in this regard would result in lapse of recognition granted to an existing stock exchange, whether permanent or temporary;
      3. merger of stock exchanges, before or after demutualisation is a commercial decision and the choice should be left to the concerned stock exchanges and it is not within the purview of the Group to recommend a specific course of action. However, the Group strongly feels that corporatisation and demutualisation will facilitate the process of consolidation of stock exchanges; and
      4. while the Group does not wish to recommend measures which may provide an exit route to the members of the stock exchanges, any stock exchange which fails to comply with the requirement of corporatisation and demutualisation by the appointed date and is accordingly derecognised, will have to distribute its assets in accordance with the provisions of the respective articles/ rules of the stock exchange and the relevant tax laws shall become applicable.
Legal changes required

9.45 The Group felt that some of the provisions in the various relevant statutes would have to be amended to implement the recommendations. Without these amendments it would be difficult to enforce the recommendations. The Group noted that the stock exchanges and the representatives of brokers have also suggested similar changes. The Group also noted that in several countries such as Australia and Singapore, a separate Act was passed to give effect to demutualisation. Among the statutes which require changes here are the Securities Contract (Regulations) Act, 1956, the Income Tax Act, 1961 and the Indian Stamps Act, 1899. The Group therefore recommends that -

the relevant provisions of the Securities Contract (Regulations) Act, 1956, the Income Tax Act, 1961 and the Indian Stamps Act, 1899 be suitably amended to facilitate corporatisation and demutualisation of the stock exchanges and to grant fiscal exemptions to encourage this process.
 

Acknowledgement

The Group records its appreciation of the assistance received during its deliberations from the representatives of the various stock exchanges, broker associations, investor associations and the concerned officials of SEBI.

M. H. Kania
M. N. Chandurkar
Y. H. Malegam
Hemendra Kothari
G. Anantharaman
Rajiv Mehrishi

Mumbai
Dated : August 28, 2002