India
Securities Infrastructure a Big Problem for Investors!

India - last year's favorite choice for the worst securities market in the world - came under heavy competition in 1996 by a new entrant - Russia. Both countries received high marks for the most difficult countries to provide global custody services to institutional investors.

India... Lot's of paper, a retail market mind-set and fraud.

"India remains the most challenging market due to the labor intensive effort needed to do just about anything. The numerous share scandals this year involving blue chip companies created additional havoc in the market," comments one custodian. The conditions result in long delays for trade settlement, registration and dividend collection processing.

"The market infrastructure was designed for the smaller investor buying 50 to 100 shares and not the foreign institutional investor," observes another custodian." Another custodian agrees "India, essentially structured as a retail market, cannot effectively cope with current volume and suffers a paper deluge. Every transaction involves a physical transfer of stock, complete with certificates of ownership, bills of sale, and some 121 separate stamps and signatures."

India is a very paper-intensive, securities market. In 1994, the sudden popularity with global investors added to an already difficulty processing environment. Capacity constraints in local bank vaults placed an unwieldy restraint on foreign institutional investors -- limiting purchases to Institutional Board Lots or "jumbo certificates" representing 1,000 shares or more. These certificates, considered non-marketable lots by the stock exchanges, are not easily sold in the market. To address the problem, one bank sub-custodian expanded vault space and installed a policy "against" accepting delivery of jumbo certificates, including bonus shares or subscriptions from an IPO.

Normal trade settlement takes three to four months rather than the theoretical 10 to 20 days. Frequently mentioned are problems at the local registrar where, in many cases, three to six month delays are encountered to establish legal title. During this time period, investors may not sell shares until registration is completed.

"Problems stemming from the severe capacity shortage in the custody sector are due to physical settlement and registration, prevalence of "objections" upon registration, difficulty in obtaining information on corporate events and the existence of multiple classes of securities, to name but a few issues," adds another custodian.

The custodian further laments, "Another area of difficulty in this unsophisticated environment with complicated market practices is in income collection." Several custodians mentioned that the physical securities environment sometimes results in entitlements paid to the incorrect party. Objection shares and the relatively high rate of securities fraud endanger entitlements, as well as ownership of the principal. The use of Paripassu and non-Paripassu securities - which trade as equals but have different dividends - and dealing with the broker claims that result from high fail rates are further complications.

The Investor Application Process is Very Slow and Complex

"Although the application procedures were recently simplified, the process remains problematic and slow," says one custodian. This custodian is experiencing severe delays in obtaining investment approval from the local authorities, apparently due to the volume of applications submitted and under staffing at Securities and Exchange Board of India (SEBI) - the regulatory agency for Indian Capital Markets.

A second custodian agrees, "Market entrance requirements are extremely troublesome - involving a complicated foreign investor identification process." In late 1995, SEBI announced that all new and existing Foreign Institutional Investors required a Certificate of Registration for a mere $10,000 registration fee. This certificate is valid for five years. Some foreign investors may find the market participation cost to be prohibitive.

Foreign Institutional Investors register with the SEBI and the Reserve Bank of India prior to investment. SEBI's prescribed application format requires foreign investors to describe investment plans, ownership, and financial history. Also required are supplemental documentation, including certified copies of the trust deed and audited financial statements and annual reports for the last five years.

Affiliated and subsidiary companies of a foreign investor may be considered as separate entities for SEBI registration purposes, but not for the foreign ownership restrictions. The investor is also required to provide a power of attorney to the local bank for share registration purposes on behalf of the foreign owner. The power of attorney is notarized and certified by an Indian consular official in the foreign institutional investor's country of domicile.

Certificate Registration ...Uh?

"The mountainous paperwork and the endless delays create an excellent opportunity for counterfeiting. In all this mountain of paper, if one signature should be missing, the trade does not settle on time," comments a custodian. One huge bottleneck in the process is the local registrar in India. Despite close scrutiny of the certificates and transfer deeds, local subcustodians are unable to guarantee the validity of certificates until submitted to the registrar. A discrepancy in the registration literally stops the settlement cycle; re-registration does not occur and the buyer having fully-paid for the securities, is left with no legal title to the shares. Rejected shares are returned to the broker.

The industry estimates that 15% to 20% of all share certificates are rejected by registrars. A frequently noted reason for registration objection/rejection is the difference between the seller's signature on the transfer deed and the signature on file with the registrar. Fraudulent certificates were reported by one custodian to account for approximately 1% of objection/rejection incidents.

In theory, Stock Exchange regulations allow a securities buy-in procedure to occur if the selling broker is advised of the registrar rejection. However, local brokers have difficulty replacing these certificates within this time limit due to lack of capital and the extremely limited number of shares available on the market.

Primary risks associated with objected/rejected shares are: 1) the investor is unable to sell the shares until registration is complete, 2) an investor is at risk of losing entitlements such as rights, bonus shares, and dividends, and 3) the local broker may go out of business for any reason before rectifying the rejection problem.

Global Custodians Offer Practical Measures to Investors

Foreign investors are exposed to risks in India because of a host of difficulties in many areas such as application procedures, registration, settlement, legal title and corporate actions. Illiquid holdings and an inability to confirm validity of shares' positions are additional concerns. Based on their firsthand experiences in India, the global custodians provided a number of suggestions for the investor to limit risks in this emerging market, namely:

• The Settlement Clearing House actually exacerbates risk. The clearing house system requires investors to pay for trades prior to receipt of certificates, while the over-the-counter settlement method allows the subcustodian to inspect the securities presented prior to payment. A number of custodians suggested that investors consider paying the broker premium to settle over-the-counter .

• To limit the length of time a client is exposed to settlement risk due to objection shares, one custodian implemented a standard procedure of squaring off all objection shares with local brokers after 90 days. The normal practice is to have clients square off objection shares.

• To improve services to Foreign Institutional Investors, one custodian opened a fully licensed custody branch, forming an exclusive partnership with the Stock Holding Corporation of India, Limited (SHCIL), the largest domestic custodian. The partnership with SHCIL is reported to increase operating capacity and market knowledge.

• Investors - with existing positions in jumbo certificates - should registrar shares to be split into marketable lots.

• For trade executions, one custodian expressed a preference for The National Stock Exchange over the Bombay Stock Exchange; the former exchange is said to have a more favorable rectification policy.

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