Hedge fund activism in India

LEGAL EYE

Hedge fund tactics are often confused with shareholder activism, which traditionally involves investor's participation in the company's affairs on wider social concerns such as employment benefit policies, corporate governance norms and environmental performances. Informed shareholder monitoring can increase shareholder values and conventional institutional investors have been assuming this role replacing individuals.

How are hedge funds different from investment vehicles such as mutual, private equity or venture? Hedge funds are usually pooled and privately organised with carefully selected high net worth members, generally passive with no control in the hedge fund's business.

Hedge funds steer clear of regulatory constraints, particularly involving registrations, disclosures, capitalisation norms, and are managed by highly incentivised and professional managers who focus on private markets, not having any potential conflict of interest situations which restrict broad based funds acting for a diverse client base, who are less inclined to aggressive activism.

Hedge fund activism is not just directed at different aims, it adopts different strategies and entails higher costs. The involvement in corporate governance is with the objective of gaining control of the board and not just reforming it.

The main criticism against hedge funds is that while agitating for maximising shareholder value, it usually proposes changes in the capital structure such as issue of fresh equity or debt restructuring. Sale or spin-off of an existing business or intervention in a pending merger is another pet strategy. Such options are generally accompanied by financial assistance and intervention in board and operational matters, often economically meaningful.

Except that activist investment horizons have been viewed with suspicion as aiming for short-term payoffs at the expense of long term shareholder values and profitability.

Which is why the Japanese Supreme Court's judgement permitting a poison pill defence against a hostile takeover by Steel Partners, a major hedge fund activist for issuing them warrants for existing shares of Bull Dog Sauce, the target company, but restraining the exercise of the warrants, a discriminatory act significantly diluting Steel's holding, was upheld as it had 80 per cent shareholders support.

Are these judicial stands to be interpreted as being against shareholder and/or hedge fund activism? In so far as pure hedge fund activism is concerned it's a fight-out between the fund and the target as in the Bulldog Case.

Surveys indicate that in one-third of hostile cases, hedge funds attain their objective, while in another third they negotiate more than half their demands. Hedge funds are a prominent market reality, so the backlash is expected, whether in terms of regulatory or judicial intervention, legislation or containment /elimination, which SEBI has been trying to achieve.

In India, hedge funds operate through the Participatory Note (PN) route. Direct entry in capital markets is subject to multiple regulations and disclosures under the FII (Foreign Institutional Investors) regulations which cover pension funds, mutual funds, banks etc. PNs enable overseas investors including hedge funds access to Indian markets, without registering with SEBI.

FIIs are governed by the SEBI FII Regulations 1995 and the Custodian of Securities Regulations 1996 which contemplate diverse and broad based structures, so as to filter out scope of unregulated investment.

FII Regulations were amended in 2000 permitting foreign corporates and high net worth individuals to register as sub accounts, with the investment being made by the FII or its domestic custodian. FIIs are responsible for monitoring the sub-account transactions under the Custodian Regulations and anti money laundering regulations, maintain detailed records thereof, and verify clients identities on stringent KYC basis and furnishing details on SEBI's specific request.

SEBI's concern, which peaked earlier this month is based on allowing the market to be flooded with money from unregulated, undisclosed sources, possibly tainted, including Indian coloured currency laundered and routed back, which can exacerbate small economic problems by a large concerted withdrawal any time.

Hedge funds in particular borrow cheap and make a killing in the stock markets leveraging the local currency, often unleashing destabilising forces for which Indian economy is not prepared.

Kumkum Sen is a Partner at Rajinder Narain & Co. kumkumsen@rnclegal.com