Niveshak jul14

Niveshak THE INVESTOR

VOLUME 7 ISSUE 7

July 2014

BRICS: The Growth Driver OF THE WORLD

FROM EDITOR’S DESK Dear Niveshaks,

Niveshak Volume VII ISSUE VII July 2014 Faculty Chairman

Prof. P. Saravanan

THE TEAM Akanksha Gupta Apoorva Sharma Gaurav Bhardwaj Jatin Sethi Kocherlakota Tarun Mohit Gupta Mohnish Khiani Priyadarshi Agarwal S C Chakravarthi V All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong www.iims-niveshak.com

The month of July 2014 saw a lot of company declaring Q1 2014 results starting with Infosys. A lot of them beat the market expectations and the stock market indices had a roller coaster ride. The Nifty ended July series F&O at 7721.30, down 70.10 points.

The Sensex fell 192.45 points or 0.7 percent at 25894.97. Banks were hurt most in the last trading day of July 2014.

A major initiative during the month was the New Development Bank (NDB). The New Development Bank (NDB), formerly referred to as the BRICS Development Bank, is multilateral development bank operated by the BRICS states (Brazil, Russia, India, China and South Africa) as an alternative to the existing World Bank and International Monetary Fund. The Bank is setup to foster greater financial and development cooperation among the five emerging markets. It will be headquartered in Shanghai, China. Unlike the World Bank, which assigns votes based on capital share, in the New Development Bank each participant country will be assigned one vote, and no countries will have veto power.

The cover story of this issue delves deep into the growing role of the BRICS to help these economies recover fast from the global financial crisis. On the international front, we had the news of Alibaba IPO, which is the biggest name on the 2014 IPO market, because it will easily raise the most money of any initial public offering this year. The Article of the Month (AOM) discusses about the India’s next Alibaba, i.e.

Flipkart. It has been doing well by peaking at the right time and the recent acquisition of Myntra is a live example. The major question that is haunting the company is profitability. Once the company gets its internal controls right and is able diversify into related products and platforms, there is no reason why the company cannot be profitable. There are huge expectations related to the growth of the company and the company cannot falter in this process.

FinSight discusses the impact of SEBI’s measures to boost the primary market in India. SEBI has proposed compulsory 25% public shareholding for all listed public sector undertakings (PSUs) within three years and unveiled new norms for research analysts, employee stock option schemes as well as reforms to boost the primary market.

FinGyaan article on GAAR (General Anti Avoidance Rules) talks about the nuances of the same from an Indian perspective. FinView has the excerpts from Mr. Neeraj Sehrawat, Assistant Professor, University of Delhi, who gives his views on the Union Budget and GST. Classroom section shares knowledge on stock splits. We would like to thank our readers for their immense support and encouragement. You remain our prime motivation factor that keeps our spirits high and give us the vigor and vitality to keep working hard. Thank you.

Stay invested!

Team Niveshak

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Cover Story Niveshak Times

04 The Month That Was

Article of the month

14 BRICS: The Growth Driver of

Flipkart: Are we witnessing the World another Alibaba?

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FinGyaan 20

General Anti - Avoidance Rules - The Indian Perspective

Finsight

28 Modifying the Game Rules

FinPact

24 Enron Scandal

FINVIEW

31 Mr. Neeraj Sehrawat,

Assistant Professor, University of Delhi

CLASSROOM

33 Stock Split

The Month That Was

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The Niveshak Times Team NIVESHAK

IIM Shillong The Indian markets continued to make newer HDFC & HDFC Bank Merger Plan Back In Focus The scrapping of reserve requirements for infrastructure funding and affordable home loans through long-term bonds, eliminates the lone publicly discussed stumbling block for the merger.

Reserve requirements mandate a bank to keep 22.5 per cent of its deposits in government bonds and 4 per cent of deposits in cash with the RBI. A possible merger of the two group companies could create a financial behemoth that could eliminate costs of doing the mortgage business for both. HDFC, which is at the receiving end during days of high interest rates, may benefit more from the merger. Benefits for HDFC Bank, which earns fee income from originating mortgages for its parent, will be lesser. The merger will help HDFC Bank build a healthy priority sector loan portfolio since the average ticket size of the loan given by HDFC is Rs 22 lakh, which falls within the affordable housing category. Ever since ICICI Bank and its parent ICICI, a development financial institution, merged, there is speculation that the fate of HDFC and HDFC Bank may be similar. The additional benefit will come from the regulation that banks do not have to set aside CRR and SLR on bonds raised over 7 years and that infrastructure loans and affordable housing would be classified as priority sector loans. “If it happens, it could be the mother of all deals.”

Coal India Shuts 3 Mines In Odisha After the recent protests, Mahanadi Coalfields Ltd., a unit of Coal India Ltd. Has stopped operations in three of its mines in Odisha. This was followed by the protests by locals over the company’s decision to relocate them for planned mine expansion. More than 100 families were asked to shift to a place 15 kms away from their homes around the mines.

The halted mines produce around 1,00,000 tons of coal per day and the company had forecast a 15% rise in production to 127 million tons for the fiscal year ending March, 2015. The shutting down of these 3 coal mines means shortage of power supply to Tamilnadu, Telangana and Andhra Pradesh.

The company urgently needs this land to expand Bhubaneswar OCP (Open Cast Project) capacity to 25

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MT and meet the production target allocated under Jagannath area, as it has almost evacuated coal from existing location. The company is ready to reinstate the terminated workers provided they hand over vacant possession of land and give way for mining.

June CPI At 7.31% - Retail Inflation Cools The CPI data stood at 7.31% in June as against 8.28% on month-on-month. The rural inflation stood at 7.72% as compared to 8.8%, while urban inflation was at 6.82% vs 7.5%. The June core CPI seen at 7.3% vs 7.74% in May. The June CPI vegetable price at 8.75% The June combined fuel, light inflation at 4.58% vs 5% in May. India’s wholesale price index eased to a four-month low in June. Wholesale prices rose 5.43% year-on-year last month, their slowest pace since February. In May, prices rose 6.01% from a year earlier. The BSE Sensex closed at 25,006 down 17 points, while NSE Nifty closed at 7,454 down 5 points over the previous close. The Reserve Bank has decided to conduct a 3 day term repo variable rate auction for a notified amount of Rs. 10,000 crore on July 15, 2014 (Tuesday). The Central Statistics Office (CSO), Ministry of Statistics and Programme Implementation releases Consumer Price Indices (CPI) on base 2010=100 for all-India and States/ UTs separately for rural, urban and combined every month with effect from January, 2011.

M&A Values In India Up 31% At $23 Bn Value of mergers and acquisitions in India during the first half of this year increased by 30.68 per cent to USD 23 billion year-on-year, a Grant Thornton report said today. In the first six months of 2014, mergers and acquisitions deals worth USD 23 billion took place, while the value in the same period in the previous year was USD 17.6 billion.

The number of M&A deals was 560, as against 460 in the year-ago period. India saw USD 23 billion worth of M&A and PE deals (560 deals) in the first half of 2014, as compared to USD 17.6 billion from 460 deals first half of 2013. This reflects 31 per cent growth in value terms and 22 per cent in volume terms. The top deal first half of this year has been Sun Pharma’s acquisition of Ranbaxy.

Sebi Issues Draft Guidelines For Infrastructure Investment Trusts

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SEBI put out a draft regulation for the infrastructure investment trusts that would provide easier finance to developers of public works. This is expected to reduce the pressure on the banking sector and make fresh equity available. Such trusts will be able to invest in infrastructure projects only directly or through special purpose vehicles (SPVs). Sebi said that if an investment trust proposes to invest at least 80% of its assets in completed and revenue generating infrastructure assets, it has to raise funds through a public issue of units. These sales will need to have a minimum subscription size and trading lot of at least Rs.5 lakh. Of the remaining 20%, such trusts can invest a maximum of 10% in under-construction infrastructure projects. If such a trust proposes to invest more than 10% of its assets in under-construction public works, it has to mandatorily raise funds through private placement from qualified institutional buyers (typically banks and other financial institutions) and corporate bodies only. For such trusts, the minimum investment and trading lot will be of Rs.1 crore and a part of the assets under such trusts will have to be mandatorily invested in at least one completed and revenue generating project and in at least one pre-COD (commercial operation date) project.

RBI Sets A Minimum Paid-Up Capital Of Rs. 100 Crore For Small And Payments Banks In its recently released draft guidelines for licensing, The Reserve Bank of India (RBI) has set Rs. 100 crore floor capital for those who want to set up payments and small banks. It has also stated that the promoters will have to have an initial minimum capital of at least 40% and has prescribed a lockin period of 5 years for promoters’ holding. If the promoters’ stake is in excess of 40% , it will have to be brought down to this level within three years of the commencement of the business of the bank. The stake has to be further reduced to 30% within 10 years and 26% within 12 years from the date of commencement of business. The existing authorized non-bank pre-paid instrument issuers (PPIs), NBFCs, co-orporate business correspondents, mobile telephone companies, super market chains, companies, real sector co-operatives and public sector entities are eligible for setting up a payments bank. The guidelines allow even banks to take equity position in a payments bank as permitted under the Banking Regulation Act, 1949.

Finance Ministry Is Giving Top Priority To Recapitalization Of PSU Banks Our newly appointed finance minister Mr. ArunJaitley has given top priority to recapitalization to the tune of Rs 2.4 lakh crore in public sector banks to meet Basel III norms. According to the finance ministry new financial stability is the foundation of rapid recovery and there is a need for the Indian banking system to be further strengthened. To be in line with Basel-III norms, there is a requirement to infuse Rs 2,40,000 crore as equity by 2018 in our banks.

Finance Ministry is trying to take necessary steps to infuse capital without diluting their stake in the PSB’s.

TCS Market Capitalization Shoots Past Rs 5 Lakh Crore Tata Consultancy Services (TCS), India’s most valuable company based on the market capitalisation, crossed the mark of Rs 5,00,000 crore in market cap during the month of July. It’s market cap now stands taller than the combined market cap of the other top four IT players as well as that of the other listed companies in the stable of the parent, Tata Sons. The combined market cap of the other four IT players in the pecking order including Infosys, Wipro, HCL Technologies, and Tech Mahindra was Rs 4,88,066 crore.The combined market cap of 30 odd listed companies other than TCS in the Tata Group was Rs 3,44,460 crore. The TCS stock has gained 47% over the past year following a stellar financial performance. It has remained a stock of preference among portfolio managers despite the recent exodus of market participants to stocks in core sectors.

Alternative Investment Funds income to be taxed at 30 per cent Income of the Alternative Investment Funds (AIFs) will be taxed at the maximum rate of 30 per cent, the revenue department has said. AIFs are mostly funds established or incorporated in India for the purpose of pooling in capital from Indian and foreign investors for investing as per a pre-decided policy.

The circular clarified, however, that the new norms will not operate in area falling in the jurisdiction of High Court, which has taken or takes contrary decision on the issue. CBDT has issued the circular in view of representations received on taxation of AIFs, which are treated as venture capital funds.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

The Month That Was

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Article ofSnapshot the Month Market Cover Story

Market Snapshot

Source: www.bseindia.com www.nseindia.com

MARKET CAP (IN RS. CR) BSE Mkt. Cap

91,30,576.75 Source: www.bseindia.com

CURRENCY RATES INR / 1 USD INR / 1 Euro INR / 100 Jap. YEN INR / 1 Pound Sterling INR/ 1 SGD

LENDING / DEPOSIT RATES Base rate Deposit rate

10.00%-10.25% 8.00% - 9.05%

RESERVE RATIOS 60.00 80.68 59.13 102.19 48.42

CURRENCY MOVEMENTS

CRR SLR

4.00% 22.50%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: www.bseindia.com 26th June 2014 to 25th July 2014 Data as on 25th July 2014

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BSE Index Sensex MIDCAP Smallcap AUTO BANKEX CD CG FMCG Healthcare IT METAL OIL&GAS POWER PSU REALTY TECK

Open

Close

% change

25313.74 9208.66 10012.79 15260.32 17459.71 8693.08 15772.1 6618 10857.53 9047 13261.59 11425.69 2256.43 8672.78 2096.75 5123.01

26210.09 9237.86 10133.94 15752.39 17719.01 8525.58 15630.09 7131.05 12028.73 9727.99 13360.86 10939.63 2174.16 8197 1954.62 5463.51

3.54% 0.32% 1.21% 3.22% 1.49% -1.93% -0.90% 7.75% 10.79% 7.53% 0.75% -4.25% -3.65% -5.49% -6.78% 6.65%

% CHANGE

© FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article Market of Snapshot the Month Cover Story

Market Snapshot

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Flipkart: Are we witnessing another Alibaba?

Article of the Month Cover Story

NIVESHAK

Sarath Vellanki

Forty years ago, an average adult usually followed a career path largely determined by his birth and education with limited opportunities.

Now, the era has changed. With the advent of internet, which happened in the mid-90s when ARPANet was transformed from military safety net to civilian internet, the availability of information was revolutionized. Teens as young as 12 are now coding websites, producing films, opinionating on social media etc. By the time they grow as adults, they would have prior information related to real world experiences.

All this wouldn’t have been possible without internet. It has increased the flexibility to various businesses and E-commerce industry is the one which could make maximum out of internet revolution. Started in 1996 in India with B2B portals, E-commerce is all set to become a large medium for business transactions.

We are currently at a stage where China was some 10 years back in terms of E-commerce industry is. The mix of population with internet users, the number of tech-savvy people and all other external factors are very much similar in India when compared to that of China. In the

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IIM Shilong

recent past, there were many companies that emerged in e-commerce space. The likes of Flipkart, Myntra, Jabong, Snapdeal are some of the prominent ones. It is estimated that online shopping of physical goods in India, will grow to $8.5Bn in 2016 and number of online shoppers will more than double to 40 mn. Among the e-commerce majors, Flipkart Internet Pvt Ltd is the largest player in India and it seeking to emulate Alibaba (e-commerce giant in China) in going beyond e-commerce business to logistics, payment systems etc. With Flipkart seeking to script similar path as that of Alibaba, are we witnessing another Alibaba in action in India?

Growth Potential of E-Commerce Greater customer choice and improved convenience are the key drivers for the rapid growth of e-commerce in India. Strong business model coupled with a first class level of service are key factors of success. According to industry reports, online businesses are only going to get bigger. There will be a major change that can be observed within a year or two, since there is an entire generation that has grown up with the

NIVESHAK

This deal making frenzy is to take on the world’s largest online retailer Amazon that is furiously expanding in the Indian e-commerce space.

Following on the lines of Alibaba, Flipkart has expanded it horizon from just selling online to having separate payment gateways, logistic services such as e-kart, and other value added services such as One Day Delivery, Next Day Delivery, and Cash on Delivery to its valued subscribers.

Although, there are a lot of similarities with China in many aspects like supply chain, thought process of management and customers etc., the major aspects that are confronting the Indian e-commerce giant is the scale and competition. As the scale increases, it is not very easy to keep a check on operations and to have controls at all levels. It is inherent that the scale leads to exposure of the weaknesses of the company. At the same time, the increase in competition is creating price war which ultimately is having an impact on bottomlines. This ultra-competitive e-commerce space is extremely fragmented with rivals existing in each and every product category. For a company like Flipkart which wants its presence to be felt across all the product categories, it becomes even more difficult to sustain. Rivals are unleashing massive advertising campaigns which made Flipkart’s multi-million dollar IPL campaign not so attractive. With the FDI rules easing up for foreign competitors, global players likes Amazon and ebay are building impressive portfolios, hence further intensifying the competition. The deal therefore left for Flipkart is to go for consolidation in order to gain from the other firms’ technology, supply chain and other synergies.

The Growth Path of Alibaba The growth of Alibaba is quite interesting. It all started when Jack Ma, the founder of Alibaba searched for the word “beer” and to his surprise, he could find American beer, German beer and no Chinese beer. This has led Ma to create China Pages after which he got a chance to meet Jerry Yang, the cofounder of Yahoo, who eventually invested an amount of $1 billion in Alibaba. Alibaba.com, although initially had

For Flipkart, the game is not just beating Seattle-based Amazon on Indian home turf, but to become the Indian version of Chinese e-commerce giant Alibaba. © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article of the Month Cover Story

Internet at home and school and they will be ready to spend online. If we look at the numbers, there are around 200 million internet users in India, out of which around only 20% might have performed online transactions and the rest are only content consumers. According to industry projections, within a year the number of online users is estimated to increase to 300 million internet users, which is the population of the U.S and around 50-60 million people are likely to make online transactions. Indian E-commerce market has a potential to grow between $125 billion and $260 billion by 2024-25, according to a report by First Data Corporation and ICICI Merchant Services. While China being the star of international e-commerce and India, the second most populous country has started to show some energy. Even the likes of Alibaba are investing in Indian E-commerce space. The growth of e-commerce in India and China offers an instructive comparison between the world’s largest democracy and the world’s largest communist country. Both have a huge base of internet population, both of them have similar poverty levels and inequalities in urban and rural internet access. Both the countries were exposed to technology almost at the same time (with some lag in India).

Among the major e-commerce companies of India, Flipkart is one such a company whose role model is Alibaba. For Flipkart, the game is not just beating Seattle-based Amazon on Indian home turf, but to become the Indian version of Chinese e-commerce giant Alibaba.

Flipkart is a leading e-commerce giant in India, started by two IIT graduates Sachin Bansal and Binny bansal who were earlier employed with Amazon. It is the first company to have been introduced so many innovations in the arena of Indian e-commerce. Until last year, the company was following inventory based model and due to FDI regulations and the limitations that are inherent to this model, the company moved on to market-place model. This new model allows the company to reduce storage and other inventory-related costs and to scale much faster. The recent merger of Flipkart with Myntra created an annual sales of over $1.5 billion, out of the total market of $2.3 billion.

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a tough time in generating revenues realized that customers were willing to pay for better display of goods. The company was able to attract around 1 million users in that year (2002) and the company became profitable in that very year. To counter Ebay’s expansion in market place model, Alibaba started Taobao.

And by starting public relations battle, for every dollar spent by Ebay helped to feed buzz about Alibaba’s Taobao. Alibaba was compared to as crocodile in the Yangtze river and Ebay to a shark in the ocean. So, to win the battle Alibaba waged a war in the river and not in the ocean where the shark is strong i.e. Alibaba used its ties with Yahoo to make Taobao listings free for merchants and thereby making Ebay’s business unprofitable. This led to closing of Ebay in China. Ma has handpicked the next generation leaders of Alibaba, thus ensuring the longterm sustainability of the company. Although there are several challenges associated with mobile-commerce, the company is throwing billions of dollars in the process of figuring out how to thrive as half a billion people of China are going online via mobile. Alibaba is trying to improve its position in mobile even as the competition surges ahead. The company has driven mobile percentage of GMV (total value of goods transacted through its business) to 27.4% of the group’s total GMV in January-March, up from 10.7% during the same period in last year. Since 2012, the company is poised for the biggest initial public offering and it was decided the IPO would be raised in the U.S. (Newyork Stock Exchange). The reason for the company to go to the U.S. for IPO is that Hongkong’s bourse doesn’t allow share classes with different voting rights.

Lessons From Alibaba And Plausible Actions The Alibaba experience offers some of the important business lessons and insights. The primary learning from Alibaba is that Flipkart should concentrate on the acquisition of the customers and hence improving the market share. This was the sole strategy which made Alibaba a profitable venture. To take on the competition, it is very important for Flipkart to

use its brand image on the home turf so that any action by the rivals could fetch the company additional advertising and hence additional market share. In order to build networks which are crucial in business success, it is essential to go into B2B marketplace. Increasing awareness of the brand further strengthens the company’s power to build a larger customer base and to acquire more revenues. A two way interaction platform between buyers and sellers can help in reducing the communication gap between them. In order to improve the customer experience, Flipkart can start working on customization of products on display as per the needs of the customer. Flipkart can still work on diversification by venturing into creation of a separate platform for classified ads, discussion forums etc. Down the line, private labels can play a major role in e-commerce business.

So, by betting on these private labels, there are chances for the company to improve its margins. Once the company is able to build its customer base, it should work hard to achieve economies of scale. On the expectation that the company is going for an IPO soon, it has to become profitable if it wants general public to invest in it. But one may argue that Amazon which has started making profits after 20 years of its existence, but is still doing well in the stock markets. Well, to be profitable before IPO or not may be a strategic decision. Because it is trade-off for the company whether to chase money or to chase growth. While chasing growth, especially in this highly competitive industry it is very difficult to be profitable and Flipkart is no exception to that fact. At the end of the day, the business should see some profits for long-term sustainability.

Hence, it can be summarized that e-shopping market is still losing money and the main reason for it is that all the companies are concentrating on building scale, not profits.

There is ample opportunity available in e-commerce space. Currently only 1% of total online users are transacting online and with the advent of smart-phones and mobile commerce, this percentage is expected to reach 5-10% by 2020 and by no means this

Alibaba is poised for the biggest initial public offering and it was decided the IPO would be raised in the U.S. (NYSE). The reason being that Hongkong’s bourse does not allow share classes with different voting rights.

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Š FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article of the Month Cover Story

percentage is less. Flipkart has been doing well by peaking at the right time and the recent acquisition of Myntra is a live example. The major question that is haunting the company is profitability. Once the company gets its internal controls right and is able diversify into related products and platforms, there is no reason why the company cannot be profitable. There are huge expectations related to the growth of the company and the company cannot falter in this process. Yes, we are in the process of making a history of Indian e-commerce and we hope to see another Alibaba in India and make the presence of Indian e-commerce felt by the entire world.

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BRICS: THE GROWTH

DRIVER OF THE WORLD

Jatin Sethi

IIM Shillong Overview of BRICS BRICS is the acronym for an association of five major emerging national economies- Brazil, Russia, India, China and South Africa. The grouping was formerly known as “BRIC” before the inclusion of South Africa in 2010. BRICS are all newly industrialized or developing countries, but they are distinguished by their large, rapidly growing economies and significant impact on regional and global matters which made them the engines of the global recovery process. At present, these five countries include over 40 per cent of the world’s population and account for nearly 25 per cent of total global GDP in terms of PPP. Each of the BRICS countries has a huge potential to develop. Brazil is extremely rich in resources while Russia too is well-known for its massive deposits of natural gas, oil and minerals. India is a strong service provider with a growing manufacturing base, whereas China is seen as the manufacturing workshop

of the world with a highly skilled workforce and relatively low wage costs. South Africa is the world’s largest producer of platinum and chromium and has the world’s largest reserves of important metals. Also, South Africa generates 45 per cent of Africa’s electricity.

It is broadly perceived that over the next few decades the growth generated by the largest developing countries (particularly the BRICS) could become a much more substantial force in the world economy. The intrinsic strength of the BRICS comes from strong domestic demandbased economies in the case of India and Brazil and the significant outward linkages of China and Russia. South Africa benefits from proximity to untapped growth potential of the African continent. The continued economic reforms and improved macroeconomic fundamentals together with a buoyant macroeconomic environment contributed to the enhanced growth performance of the BRICS and this can

Fig 1: GDP Growth Performance

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Brazil, which had important trade linkages with Mercosur, the Euro zone, the US and China, also observed a fall in external demand. However, real GDP growth in India and China continued impressive due to growth driven by domestic sectors, though they also saw some moderation on the face of fading global demand.

Future Outlook of BRICS Promising Growth Earlier, BRIC economies, as a group, added 36.3% to the growth of world GDP (in PPP terms) during the first decade of the century (2000-10) and accounted for about a quarter of the global GDP. This trend is set to continue over the coming decades. By 2020, the BRIC grouping is projected to account for a third of the global economy (in PPP terms) and contribute about 49% of global GDP growth. By 2050, BRIC will displace most of the current G-7 countries. Only the United States and Japan are expected to be counted amongst the largest economies of the world. South Africa was added to the BRICs grouping in 2011. BRICS (including South Africa) accounted for 19.88% of the world GDP in nominal terms and 26.78% of the world GDP in PPP terms (in 2011). Figure 2 maps the GDP and cumulative year-on-year growth in each of the BRICS economies over the period 2004-12. The results are remarkable.

China’s GDP increased four-fold from $1.932 trillion in 2004 to $8.227 trillion in 2012. India has also outpaced global GDP growth and has grown almost three-fold from $722 billion in 2004 to $1.842 trillion in 2012. Brazil clocked robust growth over the last 20 years and is now a $2 trillion plus economy. Russia’s year-on-year growth trajectory has been more erratic, but on the coat-tails of high energy prices it has also grown more than three-fold during the same period.

As far as GDP growth rate is concerned, the effect of Eurozone Crisis could be seen by dropping growth rates, especially in case of Russia and

Fig 2: GDP Current Prices ($ Billion)

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Cover Story

be seen in Figure 1 in which BRICS countries are greener than the rest of the world.

Impact of Financial Crisis on BRICS The global financial crisis plunged almost all economies. Bad policy actions such as extreme leverage combined with insufficient regulation, lack of apt financial supervision, faulty credit ratings, and failure to properly identify the build-up of risks associated with financial innovations, led to crisis. The crisis spread to the BRICS through the four channels—trade, finance, commodity, and confidence channels. Tighter trade credit and the slump in exports triggered a deceleration in aggregate demand. The reversal of capital flows led to equity market losses and currency depreciations, which resulted in lower external credit flows. Nevertheless, the banking sectors of the BRICS economies performed comparatively well. In Brazil, the local currency and stock market saw enormous fluctuations as foreign investment declined, demand for commodity exports dried up, and external credit shrunk. The financial markets in Russia froze due to a increase in risk aversion and substantial correction of equity markets. In the early phase of the crisis, the Indian economy remained relatively insulated, but witnessed a slowdown in GDP annualized growth. The impact of the financial crisis on China took the shape of a sharp drop in external demand, which in turn resulted in economic slowdown and increased unemployment. In South Africa, portfolio inflows, which had accounted for the majority of the financing of South Africa’s large current account deficits in the years leading up to the crisis, rapidly turned to large net outflows, although total net private flows remained positive as South African banks ran down foreign assets.

The global financial crisis caused significant loss in output in all the BRICS economies. In terms of real GDP growth, Russia saw the sharpest fall in growth on account of worsening oil prices aggravated by a fall in other commodity prices.

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Fig 3: GDP Growth Rate (in %)

Brazil. India suffered from domestic policy paralysis which led to fall in growth. In South Africa, mining sector blocks slowed the growth but it is expected to kick off soon. However, China has strong economic fundamentals and it has recorded a growth of 7.7% in the last quarter, showing signs of high growth ahead.

Figure 3 displays the GDP growth rate of BRICS countries and there is a forecast of sustained growth of BRICS in future.

Trade Promotion The share of BRICS in global trade has increased significantly over the last two decades. In 1990, BRICS accounted for only 3% of global trade. This share doubled by the turn of the century. In 2011, BRICS accounted for 19% of global exports and 16% of global imports of goods and services. The year-on-year double digit growth in merchandise trade made China the largest exporter and the second largest importer of merchandise goods in 2011. Russia and India have also entered into the list of top 20 world merchandise exporters and importers. On the trade in services side, all the BRICS economies, barring South Africa have recorded robust double digit growth in export and import. China and India are in the top 10 world rankings for trade in services.

The trade to GDP ratio illustrates the growing importance of trade in BRICS. The trade to GDP ratio in every BRICS economy has shown an upward trend except during the period of 2008-09 crisis (Figure 4). There are year-on-year fluctuations, most marked in the case of Russia.

By 2011, the trade to GDP ratio was over 45% in each of the BRICS except Brazil. This trend was most pronounced in India where the trade to GDP ratio more than doubled from under 20% in 1990 to over 50% by 2012.

Moving to intra- BRICS trade, China is the largest trade partner for each of the other BRICS with a trade share ranging between 72% and 85%. India has a share ranging between 8% and 26% in intra-BRICS trade. Brazil’s trade share is in single digits except with China where its share is 30%.

Russia too has a small slice of the intra-BRICS trade pie in all markets barring China where its share is 28%. South Africa’s share is the smallest in each of the other BRICS markets.

Increase in Foreign Direct Investment (FDI) Worldwide FDI flows from BRICS have increased incredibly. UNCTAD-statistics show a steadily growing tendency in outward FDI for all BRICS, despite a decline in 2009 due to the financial crisis (Figure 5). South Africa’s share in total

Fig 4: Trade (% of GDP)

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Fig 5: Outward FDI flows in $ millions

numbers is rather negligible, Brazil and India account for about 15 % while China and Russia claim more than 70 % of total BRICS’ FDI in 2012.

Moreover, Chinese FDI has increased the most to outnumber Russia.

BRICS do not have a common approach on FDI. South Africa, India and Brazil are focusing on neighboring countries, but the latter two are also active in SSA (Sub-Saharan Africa). Key targets of FDI are raw materials (mining), communication, energy and infrastructure, while manufacturing is playing a minor role only. Chinese FDI, is much more diversified both regionally and sectorial.

Russia is mainly acquiring assets in developed countries - partly due to its European connection, but is also active in SSA, especially Nigeria and Angola. Regarding the sectorial focus, Russian private and state owned enterprises are heading for natural resources mainly.

BRICS Contribution to World Development Brazil Brazil’s foreign aid is concentrating on the social sector, health, education and poverty reduction.

The country has experiences in emergency aid and, being one of the largest exporters of agricultural goods, is providing technical knowhow regarding agricultural development. The main part of bilateral development assistance is going to neighbouring countries, especially Bolivia, Paraguay and the Andean region. Brazil is also the biggest stakeholder of the regional organization Mercosur (comprises of Argentina, Brazil, Paraguay, Uruguay, Venezuela), and 50 % of its aid goes to Mercosur and the InterAmerican Development Bank.

Russia Almost 50% of Russia’s development aid is

concentrated on neighboring Eurasian countries and the other regional focal point is SSA. The key aspects are food security and health and within the last 10 years, Russia contributed more than USD 260 million to the Global Fund to Fight Tuberculosis, AIDS and Malaria and the country is promoting research centres and cooperation in fighting HIV/AIDS and tropical diseases. Largely, the development policy is supposed to be a “reasonable balance” between the Millennium Development Goals, the national foreign concept and the national security concept. In opposition to other BRICS, Russia’s aid is much more in line with traditional DAC (Development Assistance Committee) donors.

Also, a considerable amount of financial aid is transmitted through multilateral organizations such as Eurasian Economic Community, World Bank and UN. India India founded the Technical and Economic Cooperation in 1964 as a “flagship program” for training and technical assistance. India is supporting LICs worldwide, but especially in its neighborhood. The main recipients of India’s aid programmes have been Bhutan, Nepal, Bangladesh, Sri Lanka, Maldives and Myanmar.

An increasing amount of aid is spent within SSC (South-South Cooperation), especially with Mauritius. India has contributed USD 200 million to the New Partnership for Africa’s Development (NEPAD) initiative and is improving technology based know-how through the Pan-African E-Network Project and the TEAM-9 Initiative (Techno-Economic Approach for Africa-India Movement, a credit facility for the promotion of socio economic development in eight African countries with the backing of Indian technology).

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India added a lot to Afghanistan’s reconstruction and is a significant supporter of African peace keeping missions. India’s foreign aid is primarily focusing on technical cooperation but includes debt relief and loans for infrastructure too. Main sectors are rural development, education and health. About 80% of India’s aid is distributed through bilateral channels.

China Today China is the biggest and most influential

actor among BRICS concerning international development cooperation. Chinese efforts go as far back as the 1950s, when bordering Asian nations received medicine and food supply.

Also, the African continent has been a major recipient throughout the Cold War. South Africa South Africa’s economy is the most developed one in Africa. The Department of International Relations and Cooperation (DIRCO) is responsible

Fig 6: BRICS Contribution to IBRD/IDA/IFC Trust Funds and Financial Intermediary Funds (FIFS)

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shared among founding members. The first chair of the Board of Governors shall be from Russia. The first chair of the Board of Directors shall be from Brazil. The first President of the Bank shall be from India. The headquarters of the Bank shall be located in Shanghai. Also, the New Development Bank Africa Regional Center shall be established in South Africa concurrently with the headquarters. The Finance Ministers are supposed to work out the modalities for the Bank’s operationalization.

The long-awaited bank is the first major achievement of the BRICS since its formation in 2009 to press for a bigger say in the global financial order created by Western powers and centered by the International Monetary Fund and the World Bank. The new bank reflects the growing influence of the BRICS, which account for almost half the world’s population and nearly one-fifth of global economic output.

Conclusion The growing role of the BRICS is confirmed by the rapid recovery of these economies from the global financial crisis. The contribution of the BRICS has been rising. From an aggregate share of around 7 percent of global output in 1995, the share rose to a little over 20 percent of global GDP in 2012 in PPP terms. Inward FDI flows to these economies have increased indicating their growing importance as destinations for global capital and as production bases. Growth in outward FDI from these countries has been even more striking, growing more rapidly than global FDI flows. Likewise, reflecting their evolving competitiveness and integration with world markets, exports and imports of goods and services by the BRICS have more than trebled between 2000 and 2012, more rapidly than global trade flows over this period. The BRICS are an increasingly important group in the world economy, in terms of their contribution to global trade, investment, market size and labour force. BRICS as donors is heavily contributing to the global development cooperation. This demonstrates that optimal global economic development policymaking cannot be undertaken without including the BRICS economies at the highest level.

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for South Africa’s foreign policy, comprising development assistance, which is mainly Afro-centric. One main focus of development assistance policy is regional security and stability, both of which are seen as central to Africa’s socio-economic development. South Africa will play an important role within the African Union (AU) in conflict prevention, peace, and post-conflict reconstruction. Specifically, in its Strategic Plan for 2011 to 2014, DIRCO has made promises for aid to the Sudan, DR Congo and Comoros with post-conflict reconstruction and development and to continue working with the Southern African Development Community (SADC) and the AU to facilitate peace building efforts in Sudan, Madagascar, Zimbabwe and the Great Lakes Region. Another main component of regional integration is strengthening sub regional initiatives, such as the SADC, the NEPAD (New Partnership for Africa’s Development) and the AU. Other main objectives are strengthening regional integration and increasing intra-African trade.

Revolutionary Outcome of 6th BRICS Summit: New Development Bank The 2014 BRICS summit, held at Fortaleza and Brasília, Brazil, was the sixth annual summit attended by the heads of government of the BRICS nations. The Summit facilitated the formation of much awaited BRICS Development Bank.

BRICS, as well as other EMDCs, continue to face considerable financing constraints to address infrastructure gaps and sustainable development needs. This promoted the signing of the Agreement establishing the New Development Bank (NDB), with the resolution of mobilizing resources for infrastructure and sustainable development projects in BRICS and other emerging and developing economies. The NDB is supposed to strengthen the cooperation among member countries and will add-on to the efforts of multilateral and regional financial institutions for global development, thus contributing to accomplish the goal of strong, sustainable and balanced growth.

The Bank shall have an initial authorized capital of US$ 100 billion. The initial subscribed capital shall be of US$ 50 billion which will be equally

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AVOIDANCE RULES – THE FinGyaan

FinGyaan

GENERAL ANTIINDIAN PERSPECTIVE Kocherlakota Tarun

IIM, Shilong

The areas of tax avoidance and tax evasion have raised a lot of concern, internationally, among several countries. This is evident from the fact that countries are either strengthening their existing tax codes or introducing new legislations. In India, there have always been Specific Anti-Avoidance Rules under the tax laws, to prevent impermissible tax avoidance, which the Parliament has envisaged as representing arrangements which may have already happened or which may happen in future.

However, the revenue authorities have over the years challenged various forms of transactions entered into by the taxpayers, specifically with regard to cross-border transactions and focused on bringing aggressive tax structures under scanner. The pressure on bringing the innovative tax avoidance structures under the tax web led to a series of litigations at courts. One famous example in this regard is that of Vodafone International’s. All these finally culminated with the introduction of General Anti-Avoidance Rules

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(GAAR).

What is GAAR? The doctrine of GAAR is a set of rules designed to give Indian revenue authorities the right to scrutinize the tax transactions which they believe are structured solely to avoid taxes. They try to disregard any potential tax avoidance arrangements which are considered to be impermissible. The rules would be usually applicable to all taxpayers of the country. Unlike the SAAR, GAAR necessarily involves granting discretion to the tax authorities to invalidate a transaction arrangement as impermissible tax avoidances. This would help in effectively countering the taxpayers’ ‘out of the box thinking’ in devising new strategies of tax avoidance. This has still not been legislated in India. It has been a subject of great debate since it was first tabled as part of the Direct Tax Code (DTC) 2010. The DTC was first drafted on 12 August, 2009 and subsequently a revised discussion paper was released on June 2010.

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Fig 1: Lot to Worry for FIIs

It was then tabled in Indian Parliament on 30 August, 2010. This new tax code is meant to create an efficient direct tax system by replacing the archaic Income Tax Act of 1961. The need for a general anti-avoidance rule was observed for the following reasons: • Tax avoidance seriously undermines the objectives of the public finance systems of collecting the revenues in an efficient, equitable and effective manner. The sectors that provide a greater opportunity for tax avoidance tend to distort the allocation of resources. It is also observed that it is the better-off community that tends to benefit from such tax avoidance schemes which would lead to a cross-subsidization of rich. Hence, the tax authorities feel that tax avoidance like any tax evasion is economically undesirable and causes inequalities. On the grounds of economic efficiency and fiscal justice, the taxpayers are expected not to use any sort of legal or illegal constructions or transactions to violate the equitability.

• In the past, there was SAAR in India to deal with tax avoidances. The response to any such tax avoidances has been by the introduction of new legislative amendments. Since the country was first liberalized in 1991, the taxpayers have increasingly adopted new and sophisticated forms of tax avoidances. The tax avoidance schemes spanned across several jurisdictions and severely eroded the tax base of the country.

Further, the higher authorities and the courts

have been placing a heavy onus of the revenue systems when dealing with the matters of tax avoidance even though the taxpayer might not choose to disclose certain facts which are in his exclusive knowledge.

• Hence, in order to be consistent with the international trend and serve as a strong deterrent to such practices, the application of GAAR has become imperative.

Under the provisions of GAAR, a transaction can be considered as an impermissible tax avoidance arrangement if it is undertaken with the main purpose of obtaining a tax benefit and it: • Was not implemented according to the arm’s length principle which essentially states that the conditions of commercial and financial transactions between associated enterprises should not differ from the conditions that would be made between independent enterprises in comparable circumstances • Results directly or indirectly in the misuse of the code • Lacks commercial substance, i.e., when sham transactions are created to generate revenue and profits • Is carried out by means which would not have been adopted under normal circumstances for bonafide purposes Therefore, if a transaction is regarded as an avoidance arrangement, such an arrangement can be disregarded and GAAR provisions will

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be invoked in respect to it if the avoidance is found to be beyond a particular threshold limit.

Under the code, the commissioner of income tax is empowered to declare a transaction as if it underwent with the sole objective of obtaining a tax benefit and lacks any commercial substance or bonafide purpose. The terms like bonafide purpose, commercial substance etc. that we have come across have been defined in a very wide manner.

It must be noted that in the recent times, the Government of India has been specially focusing on tax avoidance and tax evasions by entering into Tax Information Exchange Agreements (TIEAs) with several countries. Now that we have understood that GAAR is essentially implemented to counter the tax avoidance by taxpayers, let us try to understand the difference between tax planning, tax avoidance and tax evasion.

Tax Planning, Tax Avoidance & Tax Evasion The interface between these terms has always been a matter of debate between the taxpayers, tax authorities and the judicial authorities. Nowadays, we find that the tax and judicial authorities across the globe have started taking significant measures to closely scrutinize transactions that entail tax reduction arrangements. A taxpayer can reduce his tax incidence through Tax Planning, Tax Avoidance and Tax Evasion. It is observed that there is just a thin line of difference between the concepts of Tax Planning and Tax Avoidance. Legitimate tax planning may reduce the tax incidence but impermissible tax avoidance may lead to penalties. Also, while tax planning and tax avoidance can be legal, tax evasion is completely illegal.

Tax planning may be defined as those financial affairs in which arrangements have been made to take full advantage of all eligible tax exemptions, deductions, concessions, rebates and allowances that are permissible under the Income Tax Act of 1961 so that tax burden on the taxpayer is minimized without the violations of any legal provisions. An example of this could be investing in an SEZ unit.

Tax avoidance is reducing one’s tax liability in legally permissible ways by structuring one’s affairs in possible ways. This is completely legal but would be valid only when the transaction has a commercial substance and is not a colourable device. In deciding whether an arrangement is genuine or coloured, it is

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open to the tax authorities to go behind it and examine the substance and not just form. The recent Vodafone controversy is an attempt by the revenue authorities in this direction.

Tax evasion is methods using which tax is illegally avoided through unacceptable means.

Examples could be deliberately suppressing the income, inflating the expenditures, recording fictitious transactions etc.

Pre GAAR Concept – The Indian Experience Indian laws though providing for special antiavoidance measures (SAAR), do not have the general anti-avoidance rules. The judiciary has over the years drawn out general parameters and principles in outlining whether an arrangement would be considered as tax planning, tax avoidance or tax evasion. Hence there has always been an uncertainty in it. Some instances where the Indian judiciary has implemented the existing provisions are provided below.

• In one case, the assesse company (second owner) purchased a furnace from another company (first owner) and leased it back to the same company at a higher value. It then claimed depreciation on the higher value and thereby a tax benefit. The tax officer observed that the furnace built several years ago and used ever since, cannot appreciate in value. Hence, he noted this as a sham transaction.

• In another case, the assesse bought units of mutual funds at Rs. 17.23 each and immediately became entitled for a dividend of Rs. 4 per unit.

Hence, the per-unit value of asset has fallen to Rs. 13.23. Now, the assesse redeemed the units at Rs. 13.23 each and claimed a loss. The tax officer rejected the claim of loss calling it artificial as the transaction was pre-meditated.

The abovementioned examples were success stories. The case where the tax authorities recently failed was the Vodafone controversy.

The Supreme Court of India in its ruling has unequivocally reiterated that every tax planning cannot be illegal/illegitimate or impermissible and that genuine strategic planning is allowed.

Apprehensions over GAAR in India Several apprehensions were raised that the GAAR is sweeping in nature and there is no distinction between tax mitigation and tax avoidance. The tax authorities may consider any arrangement as an impermissible avoidance arrangement. The hardest hit when the GAAR will be implemented could be money managers who invest in India via tax havens like Mauritius. Since India has

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Fig 2: GAAR Implementation

a double-tax avoidance treaty with Mauritius, investors who invest through this route need not pay the high capital gains tax. If GAAR comes into place, it would override the tax treaty and investors will have to pay more taxes.

Otherwise, to avoid any taxation, the company will have to show commercial substance in that country. Since a lot of investments from FIIs come through this route, stock investors became worried resulting in dragging the S&P Sensex lower on some occasions.

Though such anti-avoidance rules already exist in countries like Germany, France and Canada, tax experts say that there is some concern among investors that Indian tax officers could get quite heavy handed while implementing the GAAR. Current Status Recently, the Minister of State for Finance, Ms. Nirmala Sitharaman put rest to the uncertainty over the implementation of GAAR and confirmed that the rules would be applicable from April 1, 2015. This has disappointed the investors who were expecting the implementation to be postponed to April 1, 2017. Though there is a lot of confusion surrounding the implementation of GAAR, analysts remain optimistic and opine that it will only have a short term impact on the markets and FIIs would not avoid India for

a long time.

Conclusion Certain experts feel that there is a good reason to defer the implementation of GAAR by a couple of years. This is because they say that right now, the atmosphere of certainty, stability, predictability, trust was a little missing over the last couple of years given the tax environment and given that there was a new government must try to restore the trust, confidence, stability and certainty aspect of the tax regime.

Another reason that they cite is there is a need of detailed guidelines with very clear guidance to tax payers as to how and when will the GAAR be invoked which would give a lot of comfort to taxpayers and bring at least some element of certainty and predictability over its implementation. As of now, the Government of India wants to go ahead with its implementation as on the prescribed date. Time will only tell whether they will defer it again or go ahead with it as on the decided date. But one thing is sure that India wants to position itself as one of the toughest tax regimes in the world and make its systems effective and efficient and collect the revenues in the most equitable manner possible to avoid any cross-subsidization of rich.

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Article of the Month FinPact Cover Story

ENRON SCANDAL Nidhi Garg

IIM Shillong

Enron’s History Enron was a Houston-based natural gas pipeline company formed by the merger of Houston Natural Gas and Omaha-based InterNorth. It transformed itself in a span of sixteen years from an obscure gas pipeline to the world’s largest energy-trading company. Enron transformed itself into the 7th largest U.S. Company and became the largest buyer/seller of natural gas and electricity in U.S. by early 2001 with 37,000 miles of pipe. Enron was majorly involved in energy brokering, trading of electronic energy and global commodity. It experienced a drastic rise and ranked 22nd in the Fortune’s 100 companies list in 2000. The company had offices around the world and it expanded its operations by establishing itself in UK, after the electric industry in the UK was privatized, as the first foreign company to begin construction of power plant.

Enron’s Major Business Enron had three main business units: 1. The Wholesale Services unit that was responsible for marketing wholesale commodity products which helped industrial companies to manage commodity delivery and price risk 2. The Energy Services unit, the retail arm of Enron. It offered the companies better ways of developing and executing their energy related strategies.

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3. The Global Services unit that included North American pipeline business of Enron Transportation Services. It encompassed engineering businesses, Enron Wind, EOTT Energy Corp, Azurix and Wessex Water on an international level. EnronOnline became the world’s largest e-commerce site for global commodity transactions, which provided realtime transaction tools and information for commodity transactions.

Case Summary At its peak, Enron was America’s seventh largest corporation. The sudden and unexpected collapse of Enron Corp. because of its corporate accounting scandals resulted in its shareholders and Enron workers loosing tens of billions of dollars. Enron was in a terrible financial shape as early as in 2000. It was burdened with debt and money-losing businesses, but it had successfully manipulated its accounting statements to hide these problems. This was made possible by masterly designed accounts and morally questionable acts by traders and executives. Enron’s stock price, in mid-2000 hit a high of US$90 per share that caused shareholders to lose nearly $11 billion when it fell to less than $1 by the end of November 2001. The United States Securities and Exchange Commission (SEC) began an investigation which subsequently led Enron to file for bankruptcy on 2nd December, 2001 under Chapter 11 of the

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Employees Countries in which Enron Operates Assets Miles of Pipeline Owned Power Projects under Construction Power Projects in Operation Fortune 500 Ranking

1985 15,076 4

2000 18,000+ 30+

$12.1 billion $33 billion 37,000 32,000 1

14 in 11 countries

1

51 in 15 countries

Not Ranked

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Table 1: Enron’s Changing Business Structure

What Actually Happened?

Enron activities involve trading through Internet and offer free services that attracted a vast number of customers. Enron boasted about the value of products that it bought and sold online to be around $880billion, in just a small period of two years, but the company always remained silent about whether these trading operations were actually making any money.

Enron’s rapid growth in late 1990s involved large capital investments not expected to generate significant cash flows in short term that led to maintaining a good credit rating at investment bank (e.g. BBB- or higher by S&P), which was vital for Enron’s energy trading business.

Enron began to use sophisticated accounting techniques to keep its share price high, raise investment against its own assets and stock and maintain the impression of a highly successful company. These techniques are referred to as aggressive earnings management techniques. One perceived solution for doing this was by creating partnerships structured as special purpose entities (SPEs) that could borrow from outside investors without having to be consolidated into Enron’s balance sheet according to SPE 3% Rule, which says that no consolidation is needed if at least 3% of SPE total capital was owned independently of Enron. It had thought of these partnerships as temporary

solutions for solving cash flow problems.

Enron also set up independent partnerships whereby it could also legally remove losses from its books if it could pass these “assets” to these partnerships. Equally, investment money flowing into Enron from new partnerships ended as its profits, even though it was linked to specific ventures that were not yet up and running.

Enron created over 3000 partnerships by 1993 when it teamed with Calpers (California Public Retirement System) to create JEDI (Joint Energy Development Investments) fund. Enron later used SPE partnerships under 3% rule to hide bad debts it had made on speculative assets by selling these assets to the partnerships in return for IOUs backed by Enron stock as collateral.

In Nov 1997, Calpers wants to cash out of JEDI. To keep JEDI afloat, Enron needed a new 3% partner. It created another partnership with Chewco to buy out Calpers’ stake in JEDI for $383 million. Enron planed to back short-term loans to Chewco to permit it to buy out Calper’s stake for $383 million. Chewco needed $383 million to give to Calpers of which $240 mil it would have got as loan from Barclay’s bank guaranteed by Enron and $132 mil as credit from JEDI (whose only asset is Enron stock). Chewco still wanted 3% of $383 million (about $11.5 million) from some outside source to avoid inclusion of JEDI’s debt on Enron’s books. Chewco Capital Structure turned out be: Outside 3%, $125,000 from William Dodson & Michael Kopper (an aide to Enron CFO Fastow) and $11.4 mil loans from Big River and Little River (two new companies formed by Enron expressly for this purpose who will get a loan from Barclay’s Bank). But Barclay’s Bank begins to doubt the strength of the new companies Big River and Little River. It required a cash reserve of $6.6 million to be deposited (as security) for the $11.4 million dollar loans. This cash reserve is paid by JEDI, whose net worth by this time consists solely of Enron stock, putting Enron in the at-risk position for this amount.

Enron’s Revenue Model 1. Enron sets up partnership using stocks as funding 2. Partnership sets up SPE 3. SPE agrees for a contract to pay Enron if its investment declines in value 4. Payment made as investment declines 5. Payment posted as profit, even though it is Enron’s own money

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United States Bankruptcy Code. This turned out to be the largest corporate bankruptcy in U.S. history.

Enron’s Changing Business Structure

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Article FinPact of the Month Cover Story

Brief Timeline of Enron With the deregulation of the energy sector in the early 1980s, Enron’s rose as a giant in energy sector.

Before Power Utilities Gener- owned staation tions sold directly to customers

Fig 1: Enrons Revenue Model

The main reason behind these practices was to accomplish financial statement benefits and not to achieve economic objectives or transfer risk.

These partnerships would have been considered legal if reported according to present accounting rules known as “Applicable Accounting Rules”.

Enron used complex & dubious accounting schemes to reduce tax payments, to increase Enron’s income and profits, to show positive trend in Enron’s stock price and credit rating, to hide losses in balance-sheets because of subsidiaries, to engineer off-balance-sheet schemes to funnel money to themselves and to fraudulently misrepresent Enron’s financial condition in public reports.

It used “Death Star” Energy Trading Strategy to take advantage of a loophole in the market rules governing energy trading in California. The strategy adopted was that it would schedule electric power transmission on a congested line from Bus A to Bus B in the direction opposite to demand, thus enabling them to gain a “congestion reduction” fee for seemingly relieving congestion on this line. Then it scheduled the routing of this energy back to bus A so that no energy was actually bought or sold by Enron.

Gains made by Enron Enron received $10 million in guarantee fee + fee based on loan balance to JEDI. It received a total of $25.7 mil revenues from these sources. In the first quarter of 2000, the increase in price of Enron stock held by JEDI resulted in $126 million profits to Enron. But when Enron’s share price started to drop in 2000 then everything fell apart. Enron admitted to the SEC that Chewco was not truly independent of Enron the led to Chewco’s bankruptcy.

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After New owners compete to sell utilities

Impact Mixed. Critics Attack removal of strategic planning

Competition among utilities to win Consumers and contracts on basis of price Indus- Prices Stiff market try charged to competition Regu- consumsets prices lations ers are but properly some conmonitored trols also by special remains commissions

Enron searched and created new markets focusing on energy trading Mixed political reaction; unhindered markets were opposed by some legislators

Power MonopoDistri- lies were bution in proper control to protect consumers

Table 2: Energy Deregulation norms in the US

In 1990s: Enron became a massive player in the US energy market, controlling a quarter of all gas business. The company started expanding internationally, moving into water in the UK and power generation in India.

In August 2001, Jeff Skilling resigned as Chief Executive because of personal reasons. But actually Skilling’s departure was because of concerns over Enron’s bungled accounting and bad management.

In August 2001, Sherron Watkins, Enron’s Corporate Development Executive wrote a letter to Kenneth Lay warning him of accounting irregularities that could pose a threat to the company.

In November 2001, the company took the highly unusual move of restating its profits for the past four years. Enron effectively admitted that it had inflated its profits by concealing debts in its complicated partnership arrangements (Special Purpose Entities).

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banks: JP Morgan and Citigroup had overlooked some lending standards to win investment business from Enron. This allowed the energy giant to become over-leveraged.

• The Securities and Exchange Commission (SEC) was deeply troubled by the underlying events that resulted in Andersen’s conviction.

Accordingly, the SEC considered implementing changes to its corporate disclosure rules, including speedier and fuller explanation of significant events. In addition, the Financial Accounting Standards Board (FASB), planned changing its rules on accounting for off-balancesheet vehicles.

• In Relation to The Exchange (CASE): Great care and due diligence should be undertaken in the listing of foreign companies on CASE to avoid having any similar case Importance of educating investors about the importance of disclosure of listed companies and how to a read financial statements of listed companies Imposing penalties on listed companies that are engaged in fraud or have misguided its investors • In Relation to The Regulator (CMA): Market regulators should be aware of sophisticated accounting practices that firms can use to hide losses from investors and report unrealized profits Capital market regulators should exert effort in the regulation on credit rating agencies, their competency and the credibility of the ratings they publish to the market • In Relation to Auditing & Accounting Practices: The presence of Chinese walls between the auditing and consultancy divisions in big auditing firms Expected dramatic changes in the way information is presented in financial statements or corporate report modeling. More emphasis should be placed on the value of reporting where it is expected that capital markets will punish companies whose financial statements are regarded opaque or uncommunicative • In Relation to Investors: nvestors must not follow market rallies blindly Investors should understand the underlying reasons for the rise and fall in stock prices Investors should be wary of poor recommendations and approvals by market participants, credit rating companies and auditors.

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Enron filed for bankruptcy in December 2001.

Enron’s share price collapsed from around $ 95 to less than $ 1. Enron’s employees lost their savings as well as their jobs. Mr. Kenneth Lay, the chairman of the firm, resigned in January 2002.

Learnings from the Enron Scandal • Need for accounting firms to separate their consulting activities from their auditing businesses because of conflict of interest between auditing and consulting activities • Maintaining transparency with stakeholders and investors: Need to securitize financial deals in sufficient depth and detail • Management has to be free from material conflicts of interest since private investors rely on them for their business judgment • Need for a basis that distinguishes between the structured financial transactions that should be allowed and those that should be restricted • The importance of taking corporate codes of conduct seriously and implementing them firmly • Forcing firms to routinely change auditors and accounting firms to separate their consulting business from their auditing businesses Reforms undertaken to avoid any such scandal in future • Sarbanes-Oxley Act (SOX) of 2002 : Compliance with comprehensive reform of accounting procedures is must for the performance of material risks. Associated control now required for publicly held companies Boards of Directors must have Audit Committee whose members are independent of company senior management Boards of Directors must have Audit Committees members independent of company SPE 3% Rule raised to 10% in 2003 following Enron scandal After increased illegal use of rule during Subprime Financial Crisis, Financial Accounting Standards Board (FASB) replaced this rule with stricter consolidation standards on all assets in 2009 Auditors would be directed to take a “top down” approach, beginning with the company’s own financial statements, rather than the actual financial operations of the company • The Reinstatement of Chinese Walls The reinstatement of the act was brought up in response to allegations that the two investment

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Modifying the Game Rules A deeper look at the impact of SEBI’s recent measures to boost the Primary Market in India Preetinisha Gupta & Aseem

TAPMI

The Indian stock market has witnessed a decline in the companies going public since the start of the new decade. One of the main reason for the decline in IPOs can be ascribed to the considered ‘stringent’ regulations by the supervisory and regulatory body, SEBI, and the averse mind-set of the promoters.

No doubt, that the economic as well as the political scenario in our nation have also served as resistance for the companies to go for IPO and raise funds through the equity markets. The figure below displays the decline in the number of IPOs made in the Indian Stock Exchange.

Although the capital raised from the public issues has increased 2003-04 onward, the number of issues have not substantially

increased, substantiating that in recent years larger issue size with lesser number of issues have been made.

Modification of Rules

On May 16th, 2014, prior to election verdict for India’s 16th Lok Sabha, Mr. Narendra Mod’s win was expected. The catch was that whether National Democratic Alliance (NDA) would be able to get majority votes or it would also have to form a coalition with other parties like previous Governments of India. The coalition governments had been a major hindrance in implementing effective economic reforms in the past 10 years.

With the NDA election win, an economic reform now seemed plausible, it was time

Fig 1: Number of IPOs in Indian Stock Exchanges

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Fig 2: Ratio of amount raised through of IPOs

for SEBI to play its role, to give life and promise “Acche Din Aane Wale Hai”( Good days are about to come). So on 19th June, 2014 SEBI proposed new regulations which raises hope for “Acche Din” (Good Days) to both Equity issuers as well as investors on a single day.

SEBI has recommended to the Union Ministry of Finance that even public sector companies have a minimum public shareholding of 25 per cent and suggested this be achieved in three years. If accepted, the Indian Government will have to divest its stake in a lot of companies including Coal India, Central Bank, NMDC and National Aluminium. There are estimates that the government will have to divest $9-10 billion in the next three years.

As a regulatory relaxation, SEBI has proposed the offer-for-sale (OFS) route for secondarymarket Share sale. SEBI has granted permission to the top-200 companies by market capitalization and non-promoter entities which hold more than 10% stake to dilute through this route.

Also, the regulator has made it compulsory for companies to reserve 10 per cent share for retail investors in the Offer for Sale route.

SEBI has also proposed uniformity in public shareholding patterns. It has made it compulsory for even Public sector companies

to have a 25% minimum shareholding in the next years. Under this proposal PSU companies like NMDC, Coal India and the like will have to dilute their stocks in the public to reach the 25% minimum target.

SEBI’s proposed reforms and rules on 19th June, 2014 for the primary market

Accentuating ‘Anchoring’ In IPOs When a company makes a public issue, these are the allocation bucket which is available to investors: IPO Allocation Breakup Qualified Institutional Buyers (QIBs): Financial Institutions, Banks, Financial Institutional Investors and MFs who are registered with SEBI. High Net-worth Individuals (HNI): These are investors who have subscription size of more than Rs. 2 lacs in one bid.

Retail Investors: They are allotted a maximum 35% of the IPO issue size. Retail investors are those individuals who cannot have subscription of more than Rs. 2 lac in an issue.

Anchor Investor: Anchor investors are part of Qualified Institutional Buyers to whom allocation is done prior to opening of issue.

This allocation is discretionary, on the basis of a mutual agreement between the issuer

Fig 3: Returns to Anchor Investor (30 Days)

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Fig 4: 3Company Valuation vs Minimum Issue Float size

and QIBs interested to subscribe to the issue. To be qualified as an anchor investor, one has to invest at least Rs 10 Crore to the public issue with a maximum limit of Rs. 250 Crore, and cannot be the merchant banker related to the promoter group. The anchor investors pay 100% of the purchase price when placing the order.

According to new guidelines SEBI has doubled the portion meant for anchor investors in IPOs — the old limit was 15% for these investors which has now been increased to 30% of the issue size.

Advantages of increase in anchor investment The increase in subscription limit for anchor investors provides better chances of an Initial Public Offering being successful, better surety of minimum subscription, increase in confidence of investors, brings conviction to the issue and helps promoters create a demand for their shares and get a better price discovery.

Additionally, it sends out a positive signal to the market, due to confidence which the anchor investor brings. The anchor investors would benefit from this move, as they could divest their ownership on the expiration of the 30-day period. A quick look at recent IPOs in which allotment is done to anchor investors will show that about 80% of the time anchor investors were in profit at the end of 30 Days. It shows this allocation is also beneficial to anchor investors.

Changes in minimum issue size In its second reform which is focused on promoters of company to encourage them to raise equity from capital markets, SEBI has relaxed the minimum public offering which has to be made by promoters of company in an IPO. The earlier norms forced companies with valuations of less than Rs. 4,000 crore to sell a minimum of 25% stake in IPOs, and

JULY 2014

those with valuations greater than Rs. 4,000 crore had to sell only 10%. But this has led to companies deliberately increasing their valuations to greater than Rs. 4,000 crore.

Now, regulator has also introduced a new threshold of ₹400 crore. Going ahead, a company will have to divest either at least Rs. 400 crore or 25%, whichever is lower, through an IPO. This measure is observed as a persuader for companies to go for an IPO, as decrease in the percentage issue to the public would help the current owners still maintain a high percentage stake in the company, without risking the loss of control. This amendment would provide an opportunity for companies to divest in a phased manner, with minimal risk.

However, the odds that companies with lesser valuations would like this measure and go ahead with an IPO is doubtful bearing in mind the high fixed cost in raising equity capital through the primary market.

The darker side is that the selection of anchor is discretionary, and without stringent provisions. This may create chances of lobbying and may cause various market misrepresentation.

Also the higher stake in the IPO, would give a greater control to the anchor investors, which may later lead to price manipulation.

Further measures that SEBI could take to make the IPO process transparent and attractive are • To make the anchor investor allocation process non-discretionary • Increase the lock-in period for anchor investors to a minimum of 180 days At the end of the day, it is the liquidity condition and the sentiment that determine market flows but redirecting the rules never really hurts.

MR. NEERAJ SEHRAWAT Assistant Professor, University of Delhi

What are your views on increase in Tax exemption slab from 2 Lakh to 2.5 Lakh in the maiden union budget presented by Mr. Arun Jaitely? How would it impact Indian government tax revenues?

Let I believe it’s a positive move of increasing the tax exemption as well as the increase in savings limit in section 80C. These put money in the hands of middle-class. One can save up to Rs.10000 in your income tax payments if you are in 10% tax bracket. People in 20% tax bracket can save up to Rs.15000 and 30% bracket up to Rs.20000. Consumers may have been expecting more given that already faced a railway price rise, petrol and diesel increase and rising inflationary pressure. However, I think this is the best the government could have done when the economic condition of the country does not appear impressive as the monsoon has been below expectation and also India fears an oil crisis due to the Iraq troubles.

Also, they have gone on to increase the indirect tax for various commodities. So I think, the increase in tax exemption slab should not impact government’s revenue significantly.

Having a negative view on retrospective taxation policy in the current budget and at the same time mentioning it as the federal right of the state. What do you think that whether adequate clarity has been given by the government in order to make India an investment attractive state?

It would have definitely been a highly positive move had the government explicitly stated that there would be no retrospective taxation policy from encouraging investment’s perspective, instead of merely touching on it. However, things

need to work within given boundaries. States have always been given complete autonomy on their tax policies. Hence, I believe we should give government more time on this.

How important is it for Indian Finance Ministry to emphasize on GST and take relevant decisions in order to standardize taxation system across states and improve the ease of doing business in India?

It is indeed highly important. It is estimated that the GST would add about 1.5 percent to the GDP, and cumulatively, we have already lost one whole years’ growth, if we count the delay from 2010 alone. A much smaller economy like Malaysia is jumping onto the GST bandwagon in 2015. Even if we are able to achieve Phase I of GST in the next couple of years, it will mean a lot to the industry. GST introduction will support the Government’s effort to make India a businessfriendly destination, since it affords simplicity, ease of transaction and transparency.

Sensex has been rallying since last 3 months, where do you see it stabilizing.

Currently what do you think are the most attractive sectors for equity investments?

Indian shares have been on a roll since the start of this year on hopes that a Narendra Modi-led government will bring back the good times by using a rare majority in Parliament to promote the economic revamping and infrastructure spending the economy needs. However, I do believe that market-correction will happen soon because you can’t expect the impact of reform process trickling in at least before next year.

My personal favorite sectors have always been

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healthcare and FMCG. Gold imports for Jun 14 rose by 65% compared to last year and trade deficit widened. The budget had the import duty on gold unchanged at 10%. How can this be curtailed?

The demand for the yellow metal is seen mainly from non-resident Indians who are buying jewellery because of the depreciating rupee which has fallen 5.4% in the past one year. So even if the government would have hiked the import duty by 1-2%, jewellery demand would probably still remain strong. It will be difficult to wean off Indian consumers from a 2000-yearold tradition of buying gold, by raising taxes, because there are not too many alternatives to gold which has given steady returns since 2008.

While the Reserve Bank of India in a draft report of the Working Group to Study the Issues Related to Gold has suggested inflation-linked savings scheme and gold-linked financial products to curb imports, financial penetration in India is still around 50%, and it may not be an easy task to implement such schemes.

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According to you, was the valuation of Myntra by Flipkart was justified? How do you think the acquisition would bring synergies to Flipkart operations?

I believe when it comes to acquisitions, numbers do lie at times. People questioned acquisition of Instagram by Facebook as much as the what’sapp acquisition. However, the former which was claimed to be highly overvalued gave significant returns. Hence, it is difficult to comment on the valuation. But I do see a lot of synergies between Myntra and Flipkart.

Both Flipkart and Myntra were also notching up losses as their revenues went up. It really isn’t such a bad idea for the two to merge and gain from the scale.

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FinFunda of the Month

stock split PRIyadarshi agarwal IIM Shillong

How is it then different from stock dividend?

Sir, yesterday one of my friends told me that he almost got a shock when he saw one of his stocks having plummeted significantly compared to the price he last saw it trading at. But later on when he came to know that it was because of stock split, he was relieved. What is stock split all about?

The effects of stock dividend and stock split are essentially the same. In stock dividend, the existing shareholders get shares (instead of cash) as dividend for the number of shares held by them previously. The market automatically adjusts for the reduction in the share price. However, in stock split the decision and terms are issued for a particular objective of increasing liquidity and to make shares more accessible to a broader range of investors.

If the stock split happens, how is the investor benefitted?

Stock Split is a corporate action in which a company divides its existing shares into multiple shares. In this event, there is an increase in the number of outstanding A stock split may not immediately result shares but the market capitalization remains the in benefits for investors who bought the same because the share price reduces in the same split share at a lower price. However, the proportion as the number of shares increases. increase or decrease in the share price will Market capitalization is total number of shares issued depend on the parameters which help in identifying multiplied by its price. the valuations of the company. If the split happens for an overvalued company, chances are that there If there is no change in the market can be a decline in its share price after a split and capitalization, why do stock splits occur? vice versa. But the stock split is used primarily by those companies that have seen their share prices Stock Splits mainly happen for the purposes surge substantially, thereby providing not only higher of increasing liquidity. Once the price per liquidity but also marketability. share falls, more investors might be in a Then can I say that stock splits do not result in position to buy the share which they were any cash movement? Who takes the decision not in a position to do before. For example, the regarding the stock split? shares of ABC Ltd. are trading at ₹ 3,000 and there are 1,000 shares outstanding. If the company feels Yes, stock splits do not change company that there is a liquidity problem in the market, it may fundamentals. When a split is announced it announce a 3:1 stock split. Post-split the number of is often considered the same sort of decision shares outstanding would increase to 3,000 and price as a dividend or a stock buyback. The key would reduce to ₹ 1,000. Therefore, investors who difference being that no cash is required to change were unable to afford share of ₹ 3,000 previously hands. The decision of stock split is generally taken but wanted to invest in the company can now do by the Board of Directors. that. © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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