Last year, Standard Chartered was welcomed with much gusto and fanfare to list its Indian Depository Receipts (“IDRs”) on the Indian bourses, as it represented a sort of coming of age for the Indian capital market. It was the first ever issue of depository receipts in India and was brought about after commendable efforts from the market regulator in tweaking the regime on IDRs. The Securities and Exchange Board of India (“SEBI”), in this regard, had relaxed several eligibility criteria for issuing IDRs in a bid to attract investors for this instrument, after the initial barren years following the introduction of regulatory framework for IDRs in India.

IDRs, like the American Depository Receipts (“ADRs”) or Global Depository Receipts (“GDRs”), are derivative instruments deriving their value from underlying shares listed outside India. The holders of IDRs in India would have a beneficial interest in these underlying shares and be eligible for dividends (and on occasions voting rights too). IDRs provide a means to increase the visibility and brand image of the issuing company in India, apart from being an additional means to raise capital. From the investors’ perspective, IDRs offer them a means to diversify their portfolio and hedge risks, and also provides a way to indirectly invest in a company listed in another country.

However unlike ADRs and GDRs, the Reserve Bank of India (“RBI”) does not allow for two-way fungibility for IDRs. As stated in the prospectus of the Standard Chartered IDRs, the conversion of IDRs into the underlying shares was permitted only after the expiry of one year from the date of their issuance and subsequent to obtaining an RBI approval, which is given on a case-by-case basis. However, with only days left for this one year lock-in period to be over, SEBI, with a single stroke, has undone all its prior good work in heralding the IDR era in India.

SEBI has now, through a circular dated June 3, 2011, mandated that conversion of IDRs after the one year lock-in period would be allowed only if the IDRs were ‘infrequently traded’ on stock exchanges, i.e., if the annualized trading turnover in the IDRs during the six calendar months immediately preceding the month of conversion was less than five percent of the listed IDRs. In case the IDRs were being infrequently traded, the conversion of IDRs into the underlying shares would be permitted during a thirty day window after a public announcement being made by the issuer in this regard. Consequently, the IDRs issued by Standard Chartered, which had an annualised turnover of around 49%, failed to meet the ‘infrequently traded’ criterion and thus could not be converted. The stated logic of this SEBI mandate was that in the absence of a two-way fungibility, the conversion of IDRs would result in an illiquid market for residual IDR-holders. Thus the investors should be encouraged to exit through the sale of IDRs rather than converting them, as long as the IDRs were liquid. There also seems to be an unstated objective of SEBI here- of not letting the Indian capital market bereft of any IDR listings, which could have ensued if its only listed IDR were entirely converted by the investors.

The SEBI mandate left the investors of the IDRs issued by Standard Chartered high and dry, as they were now unable to convert the IDRs. The foreign institutional investors (“FIIs”), who held a major chunk of these IDRs, were particularly disappointed as they were expecting to avail a significant price arbitrage on conversion, as these IDRs were trading at a discount in India. Soon, in a spate of distress selling, the prices of the IDRs, which were trading at around INR 116, tumbled to under INR 100 for the first time since their listing.

The new rules, by allowing conversion of IDRs into underlying shares only if the IDRs are illiquid, in fact, provides an incentive for illiquidity of IDRs in the market. This in itself is paradoxical to SEBI’s objective of maintaining liquidity of IDRs in the market. One could also make out several other cracks in the stated logic behind SEBI’s move. There would be mass conversions of IDRs, as SEBI feared, only if the investors could gain substantially through price arbitrage. However, if ever such a case arose, the ‘invisible hand’ of a free market would have ensured that any such arbitrage would soon disappear as the demand for these IDRs would have gone up. This was exactly what happened to the ADRs issued by the Indian companies after two-way fungibility was allowed for their holders. If the SEBI objective was to contain the outflow of money from India following the conversion by FIIs, that too now stands defeated, since the FIIs were the biggest sellers after the SEBI mandate came out, as the IDRs without conversion seem to have lost favour with them. Further, if the FIIs decide to stay away from these IDRs in the future, their liquidity would anyway get adversely affected.

The FIIs, in particular, would indeed feel short changed by the SEBI’s mandate. It must be noted that FIIs were initially not recognized as a class of investors in IDRs and were brought in by SEBI much later in order to spruce up the IDR market in India. One has to believe that when this decision was taken by SEBI, it would have been known to SEBI that the FIIs would invest in a company through a more circuitous route of IDRs, only because they aim to benefit through any arbitrage opportunity. Further, the RBI, in response to a query by certain institutional investors last year, had reportedly clarified that no prior approval would be required to convert IDRs into underlying shares after one year of listing. Thus, this change in the rules of the game just before the final whistle was against legitimate expectations of the FIIs.

It may seem that an unintended benefit could accrue to the existing holders of the Standard Chartered IDRs since, with the FIIs deciding to stay away, there would be a definite fall in liquidity of the IDRs which could satisfy the ‘infrequently traded’ criterion. However, this could give rise to a tricky loop as the fall in liquidity would be accompanied by substantial price arbitrage, which could again give rise to interest from the buyers which, in turn, would increase the liquidity till it breaches the ‘infrequently traded’ criterion. Thus, the existing holders would benefit only if they hold onto the IDRs even when there is substantial interest among buyers. However, such negative consequences could definitely not be what SEBI intended to achieve through its mandate to protect liquidity of IDRs in the market.

A greater question arising here is whether this regulatory U-turn by SEBI could spell doom for the future of IDR issues in India. One of the major objectives of multi-national companies (“MNCs”), through the issuance of IDRs, is to increase their visibility in the region. This objective still remains undiluted as the SEBI mandate does not seem to have affected the retail investors in India much. In fact, the drop in price of the IDRs may make it more attractive to the retail investors. However, the institutional investors staying away from an IDR issue would indeed be a body blow for MNCs hoping to raise capital through IDRs as retail interest in IDRs would be limited beyond a certain point due to the higher rate of tax attached to IDRs, among other factors. Also retrospective changes from the regulator, which substantially alters the rules of the game, would indeed dent investor sentiments and does not augur too well for our yet-to-be mature capital market.

There are already talks doing the rounds of several MNCs, which had waited and watched the Standard Chartered IDR issue, rethinking their IDR listing plans. Your guess is as good as mine whether we could see another IDR listing in the near future after this whimsical decision from the SEBI.