MODULE 4

COLLECTIVE INVESTMENT UNITS

A collective investment scheme is a trust based scheme that comprises a pool of assets
that is managed by a collective investment scheme manager and is governed by the Collective
Investment Schemes Regulations given by SEBI. Collective Investment Schemes (CIS) are a
popular form of investment, and they are accessible to all. Each investor has a proportional
stake in the CIS portfolio based on how much money he or she contributed. The word ‘unit’
refers to the portion or part of the CIS portfolio that is owned by the investor. The ‘trust’ is
the financial instrument that is created in order to manage the investment. The trust enables
financial experts to invest the money on behalf of the CIS investor. Collective Investment
Schemes provide a relatively secure means of investing on the Stock Exchange, and other
financial instruments. The sum of money that are exchanged on the Stock Exchange and in
the Money Markets make them too pricey for most people. With a CIS, the money or funds
from a group of investors are pooled or collected together to form a CIS portfolio. A
collective investment fund (CIF), also known as a collective investment trust (CIT), is a
group of pooled accounts held by a bank or trust company. The financial institution groups
assets from individuals and organizations to develop a single larger, diversified portfolio.

UNIT TRUST OF INDIA (UTI)

Unit Trust of India (UTI) is a statutory private sector investment body. It was set up
on February 1, 1964 as per the Unit Trust of India Act of 1963. The primary objective of
setting up this institution was to channel corporate investments through encouraging
productive community savings. Therefore, it allows small-time savers to invest in risk-
diverse fields. People who hold units under this can sell them to UTI at a given rate as well.
A very particular reason why this is an attractive investment option is because the investment
in UTI has a certain rebate on income tax. Moreover, the income from UTI is also exempted
from income tax as per certain conditions.

Unit Trust is an investment plan where the funds are pooled together and then the investment.
The fund that has been pooled is later unitized. The investor is known as a unitholder. He or
she holds a certain number of units. On the other hand, the second party which is the manager
is responsible for the daily running of the trust and for investing the funds. The trustee,
governed by the Trust Companies act in the year 1967, is the third party. The role of the third
party is to monitor the manager’s performance against the trust’s deed. The purpose of the
deed is to outline the objectives and the vital information about the trust. Also, the assets of
the trust are held in the name of the trustee. Then they are held “in trust” for unitholders. Unit
Trust of India (UTI) provides the investor with a safe return of the investment whenever there
is a requirement of funds. The main objectives of the UTI can be summarized as:
 • Promotion of savings from lower and middle income groups of the country who may
not have the means to directly access the stock exchange market.

• Provide to these groups the beneficial results of investment returns and promote
industrialisation in all parts of the nation.

The Unit Trust of India Schemes

1. The unit scheme was introduced in 1964.

2. In 1917, the Unit Linked Insurance Plan was introduced.

3. In 1986, the Children Gift Growth Fund Unit Scheme was brought.
4. Rajlakshmi Unit Scheme was introduced in 1992.
5. The Senior Citizens Unit Plan was introduced in 1993, for the senior citizens of our
country.

6. Monthly Income Unit Scheme.

7. The Master Equity Plan was brought in the year 1995.
8. The Money Market Mutual Fund Scheme was introduced in 1997.
9. Unit Trust of India (UTI) Growth Sector Fund was established in 1999.
10. Growth and Income Unit Schemes.

The Unit Trust of India Act

The Unit Trust of India act was introduced in the year 1963 to provide for the establishment
of a co-operation. It was established with a view to encouraging saving and investment and
the participation in the income, profits, and the gains accruing to Co-operation from the
holding, management, and disposal of the securities.

VENTURE CAPITAL FUNDS

Venture Capital may be broadly defined as long-term investment in business, which

has potential for significant growth and financial returns. This is usually provided in the form
of equity apart from conditional loans and conventional loans. Venture Capitalists is thus not
a financier only, but bears the risk as well. His return from the enterprise depends upon the
extent of the success achieved by it. The most distinguishing feature of Venture Capital is
that it meets the needs of a business wherein the probability of loss is quite high because of
the uncertainties associated with the enterprise, but the returns expected are also higher than
normal. The entrepreneur intends to enter into an untrodden field. Thus, the Venture
Capitalist invests in a business where uncertainties have yet to be quantified into risks.
Venture Capital is thus termed as high risk, high return capital.

Venture Capital can be distinguished from other forms of finance on the basis of its special
characteristics which are as follows:

1) The most distinguishing feature of Venture Capital is that it is provided largely in the form
of equity, when the investee company is unable to float its equity shares independently in the
market, or from other sources in the initial stage.

2) The venture capitalist, though participates in the equity, does not intend to act as the owner
of the enterprise.

3) The Venture Capitalist does not intend to retain his investment in the investee company for
ever.

4) A Venture Capitalist intends to earn largely by way of capital gains arising out of sale of
his equity holdings, rather than through regular returns in the form of interest on loans.

5) A Venture Capitalist also provides conditional loans which entitles him to earn royalties on
sales depending upon the expected profitability of the business.

DISTINGUISHING FEATURES

Venture Capital can be distinguished from other forms of finance on the basis of its special
characteristics which are as follows:
1. Highly risky
2. High return
3. Moderate the financial burden of the startups

4. Chance of getting finance based as real time needs

STAGES OF VENTURE CAPITAL FINANCING

A venture capital fund provides finance to the venture capital undertaking at different stages
of its life cycle according to requirements. These stages are broadly classified into two, viz.
(i) Early stage financing, and (ii) Later stage financing. Each of them is further sub-divided
into a number of stages.

Early Stage Financing includes: (i) Seed capital stage, (ii) Start-up stage, and (iii) Second
round financing.

i) Seed Capital Stage: This is the primary stage associated with research and
development. The concept, idea, process pertaining to high technology or
innovation are tested on a laboratory scale. Generally, the ideas developed by
Research and Development wings of companies or scientific research institutions
 are tried. Based on laboratory trial, a prototype product development is carried
out. Subsequently, possibilities of commercial production of the product is
explored. The risk perception of investment at this stage if quite high and only a
few venture capital funds invest in the seed capital stage of product development.
Such financing is provided to the innovator in the form of low interest bearing
personal loans.
ii) Start-up Stage: Venture capital finance is made available at the start-up stage of
the projects which have been selected for commercial production. A start-up refers
to launching or beginning a new activity which may be the one taken out from the
Research and Development stage of a company or a laboratory or may be based
on transfer of technology from abroad. Such product may be an import substitute
or a new product/service which is yet to be tried. But the product must have
effective demand and command potential market in the country. The
entrepreneurs who lack financial resources for undertaking production, approach
the venture capital funds for extending funds through equity.
iii) Second Round Financing: After the product has been launched in the market,
further funds are needed because the business has not yet become profitable and
hence new investors are difficult to attract. Venture capital funds provide finance
at such stage, which is comparatively less risky than the first two stages. At this
stage, finance is provided in the form of debt also, on which they earn a regular
income.

Later Stage Financing: Even when the business of the entrepreneur is established it requires
additional finance, which cannot be secured by offering shares by way of the public issue.
Venture capital funds prefer later stage financing as they anticipate income at a shorter
duration and capital gains subsequently. Later stage financing may take the following forms:

i) Expansion Finance: Expansion finance may be needed by an enterprise for adding

production capacity once it has successfully gained market share and expects
growth in demand for its product. Expansion of an enterprise may take the form of
an organic growth or by way of acquisition or takeover. In the case of organic
growth the entrepreneur retains maximum equity holdings of the entrepreneur and
the venture capitalist could be in much higher proportion depending upon factors
such as the net worth of the acquired business, its purchase price and the amount
already raised by the company from the venture capitalists.
ii) Replacement Finance: In this form of financing, the venture capitalist purchases
the shares from the existing shareholders of the company who are willing to exit
from the company. Such a course is often adopted with the investors who want to
exit from the investee company, and the promoters do not intend to list its shares
in the secondary market, the venture capitalist perceives growth of the company
over 3 to 5 years and expects to earn capital gain at a much shorter duration.
iii) Turn Around: When a company is operating at a loss after crossing the early stage
and entering into commercial production, it may plan to bring about a change in
 its operations by modernising or expanding its operations, by addition to its
existing products or deletion of the loss-making products, by reorganising its staff
or undertaking aggressive marketing of its products, etc. For undertaking the
above steps for reviving the company, infusion of additional capital is needed. The
funds provided by the venture capitalist for this purpose are called turn around
financing. In most of the cases, the venture capitalist which supported the project
at an early stage may provide turnaround finance, as a new venture capitalist may
not be interested to invest his funds at this stage.
iv) Buyout Deals: A venture capitalist may also provide finance for buyout deals. A
management buyout means that the shares (and management) of one set of
shareholders, who are passive shareholders, are purchased by another set of
shareholders who are actively involved in the operations of the organisation. The
latter group of shareholders buyout the shares from the inactive shareholders so
that they derive the full benefit from the efforts made by them towards managing
the enterprise. Such shareholders may need funds for buying the shares, venture
capitalist provide them with such funds. This form of financing is called buyout
financing.

MODES OF FINANCING

The venture capital funds provide finance to venture capital undertakings through different
modes/instruments which are traditionally divided into: (i) equity, and (ii) debt instruments.
Investment is also made partly by way of equity and partly as debt. The VCFs select the
instrument of finance taking into account the stage of financing, the degree of risk involved
and the nature of finance required. These instruments are

• Equity Instruments:

Equity instruments are ownership instruments and bestow the rights of the owner on the
investor/VCFs.

They are: i) Ordinary Shares on which no dividend is assured. Non-voting equity shares may
also be issued, which carry a little higher dividend, but no voting rights are enjoyed by the
investors. There may be different variants of equity shares also, e.g. deferred equity shares on
which the ordinary shares rights are deferred till a certain period or happening of an event.
Moreover, preferred ordinary shares carry an additional fixed income. ii) Preference Shares
carry an assured dividend at a specified rate. Preference shares may be cumulative/non-
cumulative, participating preference shares which provide for an additional dividend, after
payment of dividend to equity shareholders. Convertible preference shares are exchangeable
with the equity shares after a specified period of time. Thus, the venture capital fund can
select the instrument with fIexibility

• Debt Instruments:
VCFs prefer debt instruments to ensure a return in the earlier years of financing when the
equity shares do not give any return. The debt instruments are of various types, as explained
below:

i) Conditional Loans: On conditional loans, no interest rate as lower rate of interest

and no payment period is prescribed. The VC funds, recover their funds, along
with the return thereon by way of a share in the sales of the undertaking for a
specified period of time. This percentage is pre-determined by VCFs. The
recovery by the VCFs depends upon the success of the business enterprise. Hence,
such loans are termed as ‘conditional loans’ .
ii) Convertible Loans: Sometimes loans are provided with the stipulation that they
may be converted into equity at a later stage at the option of the lender or as
agreed upon between the two parties.
iii) Conventional Loans: These loans are the usual term loans carrying a specified rate
of interest and are repayable in instalments over a number of years.

The venture capital funds and venture capital companies in India were regulated by the
Guidelines issued by the Controller of Capital Issues, Government of India, in 1988. In
1995, Securities and Exchange Board of India Act was amended which empowered SEBI
to register and regulate the Venture Capital Funds in India. Subsequently, in December,
1996 SEBI issued its regulations in this regard. These regulation replaced the
Government Guidelines issued earlier. The SEBI guidelines, as amended in 2000, are as
follows:

• A Venture Capital Fund may be set up either as a trust or as a company. The purpose
of raising funds should be to invest in Venture Capital Undertakings in the specified
manner.
• A Venture Capital Undertaking means a domestic company –

i) whose shares are not listed on a recognised stock exchange in India, and

ii) which is engaged in the business for providing services, production or manufacture of
articles or things and does not include such activities or sectors which have been included in
the negative list by the Board.

• The negative list of activities includes real estate, non-banking financial services, gold
financing, activities not permitted under Government’s Industrial Policy and any other
activity specified by the Board.

Registration of Venture Capital Funds

A venture capital fund may be set up either by a company or by a trust. SEBI is empowered
to grant a certification of registration to the fund on an application made to it. The applicant
company or trust must fulfil the following conditions:
1) The memorandum of association of the company must specify, as its main objective, the
carrying of the activity of a venture capital fund.

2) It is prohibited by its memorandum of association and Articles of Association from making

an invitation to the public to subscribe to its securities.

3) Its director, or principal officer or employee is not involved in any litigation connected
with the securities market.

4) Its director, principal officer or employee has not been at any time convicted of an offence
involving moral turpitude or any economic offence.

5) The applicant is a fit and proper person.

Resources for Venture Capital Fund

• A Venture Capital Fund may raise moneys from any investor –India, foreign or non
Resident Indian – by way of issue of units, povided the minimum amount accepted
from an investor is Rs. 5 lakh.

• This restriction does not apply to the employees, principal officer or directors of the
venture capital fund, or non-Resident Indians or persons or institutions of Indian
Origin.

• It is essential that the venture capital fund shall not issue any document or
advertisement inviting offers from the public for subscription to its securities/units.

• Moreover, each scheme launched or fund set up by a venture capital fund shall have
firm commitment from the investors to contribute at least Rs. 5 crore before the start
of its operations.

Investment Restrictions

While making investments, the venture capital fund shall be subject to the following
conditions:

a) A Venture Capital Fund shall disclose the investment strategy at the time of application
for registration.

b) A Venture Capital Fund shall not invest more than 25% of its corpus in one venture capital
undertaking.

c) It shall not invest in the associated companies.

d) It shall make investment in the venture capital undertakings as follows:

i) at least 75% of the investible funds shall be invested in unlisted equity shares or equity-
linked instruments (i.e., instruments convertible into equity shares or share warrants,
preference shares, debentures compulsorily convertible into equity),
ii) not more than 25% of the investible funds may be invested by way of

a) subscription to initial public offer of a venture capital undertaking whose shares are
proposed to be listed, subject to a lock in period of one year.

b) debt or debt instruments of a venture capital undertaking in which the venture

capital fund has already made investment by way of equity.

Prohibition on Listing

• The securities or units issued by a venture capital fund shall not be entitled to be listed
on any recognised stock exchange till the expiry of 3 years from the date of issuance
of such securities or units.

• A venture capital fund may receive moneys for investment in the venture capital
undertakings only through private placement of its securities/units.

Winding up of Venture Capital Fund Scheme

A Scheme of a Venture Capital Fund set up as a Trust shall be wound up, in any of the
following circumstances, namely:

i) when the period of the scheme, if any is over or

ii) if the trustees are of the opinion that the winding up shall be in the interest of the
investors, or

iii) 75% of the investors in the scheme pass a resolution for the winding up, or

iv) SEBI so directs in the interest of investors. A Venture Capital Company shall be
wound up in accordance with the provisions of the Companies Act.

Powers of the Securities and Exchange Board of India

SEBI has the following powers:

a) to appoint inspecting/investigating officers to undertake inspection/investigation of the

books of accounts, records and documents of Venture Capital Fund.

b) to suspend the certificate granted to a Venture Capital Fund if it contravenes any

provisions of the SEBI Act or these guidelines or fails or defaults in submitting any
information as required by SEBI or submits false/misleading information, etc.

c) to cancel the certificate in the following cases:

i) Venture capital fund is guilty of fraud or has been convicted of an offence involving
moral turpitude.

ii) Venture capital fund has been guilty of repeated defaults mentioned in (b) above.
 iii) Venture capital fund contravenes any of the provisions of the Act or the Regulations.

OTHER COLLECTIVE INVESTMENT UNITS

The term collective investment institution (CII) generally refers to incorporated

investment companies and investment trusts, as well as unincorporated undertakings (such as
mutual funds or unit trusts), that invest in financial assets (mainly marketable securities and
bank deposits) and/or non-financial assets using the funds collected from investors by means
of issuing shares/units (other than equity). Other terms referring to CIIs may also be used,
e.g. collective investment scheme, collective investment vehicle, collective investment
undertaking, and in certain cases, investment fund.

• The CII can be open-ended or closed-ended. If open-ended, there is no limit to the

number of shares/units on issue and the shares/units can be, at the request of the
holders, repurchased or redeemed directly or indirectly out of the undertaking’s
assets.
• If closed-ended, the number of shares/units on issue is fixed and investors entering or
leaving the fund must buy or sell existing shares

CIIs may be constituted:

• i) under the law of contract (as common funds managed by management companies),
or

• ii) under trust law (as unit trusts), or

• iii) under a statute (as investment companies), or

• iv) otherwise with similar effect. Some CIIs invest in other similar vehicles (e.g.
“funds of funds”).

CIIs may be classified broadly into two main categories:

a) ordinary or retail type entities and

b) other types of CII.

The ordinary/retail type CII may in turn be a contract type or a corporate type. A contract-
type retail CII is generally a mutual fund or unit trust or similar vehicle while a corporate-
type CII may be an investment trust or a corporation acting as an investment vehicle. There is
a variety of other types of CII which cannot be considered as retail in nature. The investors
into these CIIs can vary from private households to corporate entities and the asset classes
acquired can also vary considerably from liquid to illiquid types.

A number of different types of financial institution fall within the scope of the description
collective investment institution (CII).
● Investment funds.

● Mutual funds.

● Unit trusts.

● Variable capital companies.

● Investment limited partnerships.

● Feeder/master funds, umbrella funds/sub-funds, funds of funds.

● Hedge funds.

● Professional investor funds.

● Private equity funds.

● Distressed funds.

● Property and real estate funds.

● Money market funds.

An investment fund (IF) is a CII which issues shares (if a corporate structure is used) or units
(if a trust structure is used) to the public, and which invests the capital raised in financial
and/or non-financial assets. A mutual fund (MF) can be defined as an entity that issues shares
or units, which are purchased by investors. The basic scheme of a MF is quite common in
many other CIIs. The subscriptions collected may be invested in different types of asset (non-
financial as well as financial) and the investors may receive either regular income or, at
redemption, holding gains (or losses) or a combination of both. The MF can be open-ended or
closed-ended and the shares/units can be quoted or unquoted.

A unit trust (UT) operates as a CII established under a trust deed made between the fund’s
management company and its trustee. The legal structure of a unit trust may vary between
countries but, in general, it would appear that the trustee acts as the legal owner of the fund’s
assets on behalf of the group of investors who are each entitled to an undivided beneficial
interest in the fund. Similar to shareholders in an investment company, the unit holders are
entitled to attend and vote at meetings on matters affecting the fund. The trust deed is the
primary legal document which constitutes the trust and it sets out the various rights and
obligations of the trustee, the management company and the unit holders.

A variable capital company (VCC) is normally set up to invest its funds and property with
the aim of spreading investment risk. It is managed by a management company for the benefit
of its shareholders who enjoy limited liability status. The characteristics of VCCs are that
they can repurchase their own shares and that the issued share capital must at all times be
equal to the net asset value of the underlying assets.
 An investment limited partnership (ILP) is a partnership of two or more persons having as
its principal business the investment of its funds in financial and non-financial assets of all
kinds and consisting of at least one general partner and at least one limited partner. The
limited partner is equivalent to the shareholder in a company whilst the general partner is
generally the equivalent of the management company in a unit trust. The ILP generally does
not have an independent legal existence in the way that a company does. All of the assets and
liabilities belong jointly to the individual partners in the proportions agreed in the partnership
deed. Similarly the profits are owned by the partners

Feeder/master funds (FF, MaF), umbrella funds (UF) and funds-of-funds (FoF) are set up
with one of the main objectives being the facilitation of access by investors to greater asset
diversification than would be available through the more conventional CIIs. All types of
structures exhibit the characteristic that one fund invests in one or more other funds. The
arrangement must meet the statutory regulatory requirements of the authorities where the
funds are domiciled (i.e. legally registered). In this context, the different funds in a particular
investment arrangement may be domiciled in different jurisdictions and may also have
different legal structures. In general, the country of registration of the entity concerned is
taken to be the country of domicile of the fund.

Hedge fund (HF) is a term that covers a heterogeneous range of CIIs, typically involving
high minimum investments, light regulation, and a wide range of investment strategies that
tend to involve assets which are highly illiquid. The range of strategies include: hedging
against market downturns, investing in asset classes such as currencies or distressed
securities, and utilising return-enhancing tools such as leverage, derivatives, managed futures
and arbitrage (e.g. bonds, stocks and risk arbitrage). Many HFs target consistency rather than
magnitude of return as their primary goal.

A professional investor fund (PIF) is a fund authorised to require a relatively high level of
minimum subscription from eligible investors. Borrowing restrictions applied to other more
usual CIIs may also be relaxed.

A private equity fund (PEF) is established to enable partnerships of qualifying individual

investors or groups consisting of up to 100 qualifying individual investors to participate. Such
funds can include venture capital funds, as well as buying-out funds, whose investors tend to
be mainly institutional investors acquiring and selling shares in order to gain a long-term
interest through participation in the control or management of an enterprise for a specified
period to enhance its value.

Distressed funds (DF) are established to invest at deep discounts in equity, debt, or trade
claims, of companies undergoing or facing bankruptcy or reorganisation. In a property or real
estate fund (PF or REF), the term property is generally defined as a freehold or leasehold
interest in any land or building, with a specified minimum unexpired lease period. Partly paid
shares may be issued.

A money market fund (MMF) is a very special type of CII. It issues shares or units to the
public that are, in terms of liquidity, close substitutes for deposits, and it invests the proceeds
primarily in low risk short-term money markets instruments (treasury bills, certificates of
deposit, and commercial paper), MMF shares/units, as well as in bank deposits and
instruments that pursue a rate of return that approaches the interest rates of money market
instruments. In some jurisdictions and depending on their set-up constraints, some MMFs are
classified as monetary financial institutions

In general on the liability side, investment into CIIs involves the pooling of the investments
of a number of investors so that the units/shares acquired by each individual account for a
very small proportion (generally much less than 10%) of the total number of units/shares
issued by the scheme. There are some CIIs, however, which may have a small number of
investors (e.g. property/real estate funds, private equity funds, distressed funds) and the
investors in individual cases may contribute sizeable proportions (more than 10%) of the
overall capital invested. A CII may have resident investors, non-resident investors or a
mixture of both. It should be noted that occupational pension funds (i.e. those schemes
sponsored by employers on behalf of their employees) are generally not regarded as
collective investment institutions.

RATING CONTROL -REGULATING AGENCIES

Credit rating means rating or judging of financial and business prospects of an

individual or a business firm. The concept originated in USA is now practiced all over the
world. Credit rating is the opinion of the rating agency on the relative ability and willingness
of the issuer of a debt instrument to meet the debt service obligations as and when they arise.
The rating is intended to be an independent, unbiased and professional opinion of the rating
agency. Standard and Poors defines credit rating as “the current assessment of the credit
worthiness of an obligator with respect to specific obligation”. SEBI (Credit Rating
Agencies) Regulations 1999 defines credit rating as, “an opinion regarding securities,
expressed in the form of standard symbols or in any other standardized manner, assigned by a
credit rating agency and used by the issuer of securities, to comply with the requirements
specified in the regulations.

Objectives

1. Unbiased opinion: If credit rating is effectively done, it provides an unbiased opinion

about the credit standing of the institution.

2. Dependable information: Information provided by credit rating agencies are usually

dependable as they are based on scientific analysis.
 3. Understandable information: The information provided by credit rating agency is
easily understood even by a layman as the information is provided in a very simple
style.

4. risk return assessed: Credit rating helps to assess the risk and return associated with
the issue and thereby provides a basis for investment.

5. healthy discipline: In order to maintain and improve the credit rating, companies try to
induce healthy discipline in the organization.

6. formation of public policy: Regular credit rating and dissemination of the information
lead to creation of good public policy.

Credit rating factors

The following are the factors that generally influence the rating of the credit rating agency:

1. Ability to service debt: The ability of the issuer to service debt is an important factor
affecting credit. This is done by calculating the past and likely future cash flows and
comparing it with the fixed interest obligations of the issuer.

2. Nature of debt- The volume and composition of outstanding debt is an important

factor which influences credit rating.

3. Stability of cash flows and earnings: Credit rating is influenced by the stability of
future cash flows and earning capacity of the company.

4. Interest coverage ratio: This ratio indicates how many times the issuer is able to meet
its fixed interest obligations.

5. Liquidity position: Current ratio is calculated to assess the liquidity position of the
issuing firm.

6. Collateral security : The value of assets pledged as collateral security and the
security’s priority of claim against the issuing firm’s assets is again a factor which
influences credit rating.

7. Market position: This is judged by the demand for the products, competitor’s market
share, distribution channels etc.

8. Operational efficiency : It is judged by capacity utilisation, prospects of expansion,

modernization and diversification, availability of raw material etc.
 9. Track record: Track record of promoters, directors and expertise of staff also affect
the rating of a company.

A credit rating agency is a private company that looks at the credit worthiness of a large-
scale borrower, such as a company or country. It effectively ranks the borrower on their
ability to pay off their loan. A credit rating agency (CRA, also called a ratings service) is a
company that assigns credit ratings, which rate a debtor's ability to pay back debt by making
timely principal and interest payments and the likelihood of default. An agency may rate the
creditworthiness of issuers of debt obligations, of debt instruments, and in some cases, of the
servicers of the underlying debt, but not of individual consumers. The debt instruments rated
by CRAs include government bonds, corporate bonds, CDs, municipal bonds, preferred
stock, and collateralized securities, such as mortgagebacked securities and collateralized debt
obligations. The issuers of the obligations or securities may be companies, special purpose
entities, state or local governments, non-profit organizations, or sovereign nations. A credit
rating facilitates the trading of securities on a secondary market. It affects the interest rate that
a security pays out, with higher ratings leading to lower interest rates. Individual consumers
are rated for creditworthiness not by credit rating agencies but by credit bureaus (also called
consumer reporting agencies or credit reference agencies), which issue credit scores.

IMPORTANCE OF CREDIT RATING

1. It provides unbiased opinion to investors- Opinion of good credit rating agency is unbiased
because it has no vested interest in the rated company.

2. Provide quality and dependable information- Credit rating agencies employ highly
qualified, trained and experienced staff to assess risks and they have access to vital and
important information and therefore can provide accurate information about creditworthiness
of the borrowing company.

3. Provide information in easy to understand language- Credit rating agencies gather

information, analyse and interpret it and present their findings in easy to understand language
that is in symbols like AAA, BB, C and not in technical language or in the form of lengthy
reports.

4. Provide information free of cost or at nominal cost- Credit ratings of instruments are
published in financial newspapers and advertisements of the rated companies. The public has
not to pay for them. Even otherwise, anybody can get them from credit rating agency on
payment of nominal fee. It is beyond the capacity of individual investors to gather such
information at their own cost.

5. Helps investors in taking investment decisions- Credit ratings help investors in assessing
risks and taking investment decision.

6. Disciplines corporate borrowers- When a borrower gets higher credit rating, it increases its
goodwill and other companies also do not want to lag behind in ratings and inculcate
financial discipline in their working and follow ethical practice to become eligible for good
ratings, this tendency promotes healthy discipline among companies.

7. Formation of public policy on investment- When the debt instruments have been rated by
credit rating agencies, policies can be laid down by regulatory authorities (SEBI, RBI) about
eligibility of securities in which funds can be invested by various institutions like mutual
funds, provident funds trust etc.

BENEFITS OF CREDIT RATING

A. Benefits to investors.

B. Benefits to the rated company.

C. Benefits to intermediaries.

D. Benefits to the business world.

BENEFITS TO INVESTORS

1. Assessment of risk- The investor through credit rating can assess risk involved in an
investment. A small individual investor does not have the skills, time and resources to
undertake detailed risk evaluation himself. Credit rating agencies who have expert
knowledge, skills and manpower to study these matters can do this job for him. Moreover, the
ratings which are expressed in symbols like AAA, BB etc. can be understood easily by
investors.

2. Information at low cost- Credit ratings are published in financial newspapers and are
available from rating agencies at nominal fees. This way the investors get credit information
about borrowers at no or little cost.

3. Advantage of continuous monitoring- Credit rating agencies do not normally undertake

rating of securities only once. They continuously monitor them and upgrade and downgrade
the ratings depending upon changed circumstances.

4. Provides the investors a choice of Investment- Credit ratings agencies helps the investors
to gather information about creditworthiness of different companies. So, investors have a
choice to invest in one company or the other.

5. Ratings by credit rating agencies is dependable- A rating agency has no vested interest in a
security to be rated and has no business links with the management of the issuer company.
Hence ratings by them are unbiased and credible.

BENEFITS TO THE RATED COMPANY

1. Ease in borrowings- If a company gets high credit rating for its securities, it can raise funds
with more ease in the capital market.
2. Borrowing at cheaper rates- A favorably rated company enjoys the confidence of investors
and therefore, could borrow at lower rate of interest.

3. Facilitates growth- Encouraged by favorable rating, promoters are motivated to go in for

plans of expansion, diversification and growth. Moreover, highly rated companies find it easy
to raise funds from public through issue of ownership or credit securities in future. They find
it easy to borrow from banks.

4. Recognition of lesser known companies- Favorable credit rating of instruments of lesser

known or unknown companies provides them credibility and recognition in the eyes of the
investing public.

5. Adds to the goodwill of the rated company- If a company is rated high by rating agencies it
will automatically increase its goodwill in the market.

6. Imposes financial discipline on borrowers- Borrowing companies know that they will get
high credit rating only when they manage their finances in a disciplined manner i.e., they
maintain good operating efficiency, appropriate liquidity, good quality assets etc. This
develops a sense of financial discipline among companies who want to borrow.

7. Greater information disclosure- To get credit rating from an accredited agency, companies
have to disclose a lot of information about their operations to them. It encourages greater
information disclosures, better accounting standards and improved financial information
which in turn help in the protection of the investors.

BENEFITS TO INTERMEDIARIES

• Merchant bankers' and brokers' job made easy.

In the absence of credit rating, merchant bankers or brokers have to convince the investors
about financial position of the borrowing company. If a borrowing company's credit rating is
done by a reputed credit agency, the task of merchant bankers and brokers becomes much
easy.

BENEFITS TO THE BUSINESS WORLD

1. Increase in investor population- If investors get good guidance about investing the money
in debt instruments through credit ratings, more and more people are encouraged to invest
their savings in corporate debts.

2. Guidance to foreign investors- Foreign collaborators or foreign financial institutions will

invest in those companies only whose credit rating is high. Credit rating will enable them to
instantly identify the position of the company.

CREDIT RATING AGENCIES IN INDIA

There are 6 credit rating agencies which are registered with SEBI. These are CRISIL, IICRA,
CARE, Fitch India, Brickwork Ratings, and SMERA.
1.Credit Rating and Information Services of India Limited (CRISIL)

• It is India’s first credit rating agency which was incorporated and promoted by the erstwhile
ICICI Ltd, along with UTI and other financial institutions in 1987.

• After 1 year, i.e. in 1988 it commenced its operations

• It has its head office in Mumbai.

• It is India’s foremost provider of ratings, data and research, analytics and solutions, with a
strong track record of growth and innovation.

• It delivers independent opinions and efficient solutions.

• CRISIL’s businesses operate from 8 countries including USA, Argentina, Poland, UK,
India, China, Hong Kong and Singapore.

• CRISIL’s majority shareholder is Standard & Poor’s.

• It also works with governments and policy-makers in India and other emerging markets in
the infrastructure domain.

2.Investment Information and Credit rating agency (IICRA)

• The second credit rating agency incorporated in India was IICRA in 1991.

• It was set up by leading financial/investment institutions, commercial banks and financial

services companies as an independent and professional investment Information and Credit
Rating Agency.

• It is a public limited company.

• It has its head office in New Delhi.

• IICRA’s majority shareholder is Moody’s.

3. Credit Analysis & Research Ltd. (CARE)

• The next credit rating agency to be set up was CARE in 1993.

• It is the second-largest credit rating agency in India.

• It has its head office in Mumbai.

• CARE Ratings is one of the 5 partners of an international rating agency called ARC
Ratings.

4. ONICRA

• It is a private sector agency set up by Onida Finance.

• It has its head office in Gurgaon.

• It provides ratings, risk assessment and analytical solutions to Individuals, MSMEs and
Corporates.

• It is one of only 7 agencies licensed by NSIC (National Small Industries Corporation) to

rate SMEs.

• They have Pan India Presence with offices over 125 locations.

5.Credit Information Bureau (India) Limited (CIBIL)

• Of the four credit information companies, CIBIL is the most popular agency which
maintains credit files on 600 million individuals and 32 million businesses.
• CIBIL in India is part of TransUnion, an American multinational group. Hence, credit
scores are known in India as the CIBIL Transunion score.
• CIBIL Score is a 3-digit numeric summary of one’s credit history, rating and report,
and ranges from 300 to 900.

• The closer one’s score is to 900, the better would be his credit rating.
Credit rating process

The process or procedure followed by credits rating agencies in India are almost similar and
usually comprise of the following stages:

1. Receipt of proposal for rating: The rating process begins with the receipt of proposal
from a company who wishes to get its issue obligations rated.
2. Agreement : An agreement is entered into by the rating agency and the issuer
company. The agreement shall contain all the terms of the rating assignment.
3. Assignment to analytical team: Rating agency appoints a team consisting of analysts
who are qualified to carry out rating assignment.

4. Obtain information: The analytical team obtain the requisite information from the
client company.

5. Visits and meeting with management: To obtain clarification and better understanding
of the client’s operations, the term visits and interacts with the company’s executives.

6. Analysis: The team analyses the data and information obtained for the rating purpose.

7. Presentation of findings: After completing the analysis, the findings are discussed
with the internal committee, comprising of senior analysts of the credit rating agency.
An opinion of the rating is also formed. The findings of the team are finally presented
to the rating committee.

8. Rating Committee meeting: The committee is the final authority for assigning
ratings.
 9. Communication of decision: The rating arrived at is presented to the client who has
the option to accept or reject it.

10. Dissemination to the public: If the rating is accepted by the client, the agency gives it
for notification in press or website.

11. Monitoring for possible change: Rating is not a one-time process, the agency
constantly monitors all ratings with the trends in the market. Any change in rating is
made public.

Regulating Rating Agencies

In India, the Securities and Exchange Board of India (SEBI) primarily regulates credit
rating agencies and their functioning. However, certain other regulatory agencies, such as the
Reserve Bank of India (RBI), Insurance Regulatory and Development Authority, and Pension
Fund Regulatory and Development Authority also regulate certain aspects of credit rating
agencies under their respective sectoral jurisdiction. The SEBI (Credit Rating Agencies)
Regulations, 1999 govern the credit rating agencies and provide for eligibility criteria for
registration of credit rating agencies, monitoring and review of ratings, requirements for a
proper rating process, avoidance of conflict of interest and inspection of rating agencies by
SEBI, amongst other things. The SEBI (Credit Rating Agencies) Regulations, 1999 provide
for a disclosure-based regulatory regime, where the agencies are required to disclose their
rating criteria, methodology, default recognition policy, and guidelines on dealing with
conflict of interest. The Committee noted that SEBI is among the few regulators globally to
mandate public disclosure of rating criteria and methodology by the agencies.

DEPOSITORIES

According to the Depositories Act 1996, Depository means A company formed and
registered under the Companies Act, 1956 and which has been granted a certificate of
registration under the SEBI Act, 1992. The first depository was set way back in 1947 in
Germany. And the Depository is an institution or a kind of organization which holds
securities with it in De-Mat form, in which trading is done among shares, debentures, mutual
funds, derivatives, F&O and commodities. The intermediaries/ DP’s perform their actions in
variety of securities at Depository on behalf of their clients. Depository system essentially
aims at eliminating the voluminous and cumbersome paper work involved in the scrip-based
system and offers scope for ‘paperless’ trading through state-of-the-art technology. In
depository system, share certificates belonging to the investors are dematerialised (demats).
Currently there are two depositories operational in India.
 1. National Securities Depository Ltd. – NSDL
2. Central Depository Services Ltd. – CDSL

Depository system is also known as “Scripless Trading System”. It is an organization which

holds the securities of a shareholder in the form of electronic accounts (dematerialized form),
in the same way a bank holds the money. They are the custodian of its client’s securities and
Interfaces with its investors through its agents called “depository participants”

Dematerialisation or “Demat” is a process whereby investors’ securities like shares,

debentures etc, are converted into electronic data and stored in computers by a Depository.
Securities registered in investor’s name are surrendered to depository participant (DP) and
these are sent to the respective companies who will cancel them after “Dematerialization”
and credit investor’s depository account with the DP. The securities on Dematerialization
appear as balances in one’s depository account. These balances are transferable like physical
shares. If investors wish to have these “demat” securities converted back into paper
certificates, the Depository does this and their names are entered in the records of depository
as beneficial owners. The beneficial ownership will be with investor but legal ownership will
be with the depository.

The depository system comprises of:

i) Depository

ii) Depository Participants (DPs)

iii) Companies/Registrars

iv) Investors

Depository

Depository functions like a securities bank, where the dematerialized physical securities are
traded and held in custody. This facilitates faster risk free and low cost settlement. Depository
is much like a bank and performs many activities that are similar to a bank depository:

a) enables surrender and withdrawal of securities to and from the depository through the
process of ‘demat’ and ‘remat’,

b) maintains investors’ holdings in electronic form,

c) effects settlement of securities traded in depository mode on the stock exchanges,

d) carries out settlement of trades not done on the stock exchanges (off market trades).

In India a depository has to be promoted as a corporate body under Companies Act, 1956. It
is also to be Registered as a depository with SEBI. It starts operations after obtaining a
certificate of commencement of business from SEBI. It has to develop automatic data
processing systems to protect against unauthorised access. A network to link up with
depository participants, issuers and issuer’s agent has to be created. Depository, operating in
India, shall have a net worth of rupees one hundred crore and instruments for which
depository mode is open need not be a security as defined in the Securities Contract
(Regulations) Act 1956. The depository, holding securities, shall maintain ownership records
in the name of each participant. Despite the fact that legal ownership is with depository, it
does not have any voting right against the securities held by it. Rights are intact with
investors. There are two depositories in India at present i.e. NSDL and CDSL.

Depository Participants (DP)

A DP is investors’ representative in the depository system and as per the SEBI guidelines,
financial institutions/banks/custodians/stock brokers etc. can become DPs provided they meet
the necessary requirements prescribed by SEBI. DP is also an agent of depository which
functions as a link between the depository and the beneficial owner of the securities. DP has
to get itself registered as such under the SEBI Act. The relationship between the depository
and the DP will be of a principal and agent and their relation will be governed by the bye-
laws of the depository and the agreement between them. Application for registration as DP is
to be submitted to a depository with which it wants to be associated. The registration granted
is valid for five years and can be renewed. As depository holding the securities shall maintain
ownership records in the name of each DP, DP in return as an agent of depository, shall
maintain ownership records of every beneficial owner (investor) in book entry form. A DP is
the first point of contact with the investor and serves as a link between the investor and the
company through depository in dematerialisation of shares and other electronic transactions.
A company is not allowed to entertain a demat request from investors directly and investors
have to necessarily initiate the process through a DP.

FUNCTIONING OF A DEPOSITORY

• Depository system operates through depository account.

• An investor desiring to demat his holdings has to open a depository account where in
all details of investors’ transactions is recorded.

• Opening such account is as simple as opening a bank account.

• Investor can open a depository account with any DP convenient to him
There is no restriction on the number of depository accounts a person can open. However, if
existing physical shares are in joint names, one has to open a joint account submitting share
certificates for demat.

• To open an account one has to:

1. Fill up the account opening form, which is available with the DP.

2. Sign the DP-client agreement, which defines the rights and duties of the DP and the
person wishing to open the account.

3. Receive client account number (client ID).

 • This client ID along with his DP ID gives investor a unique identification in the
depository system.

• In depository account, transactions are through demat and remat.

Dematerialisation is also known as immobilisation of securities. Dematerialisation can be

done only on the request made by the investor through participant in a Dematerialisation
Request Form (DRF). ‘Dematerialisation’ is a process where by physical existence of
security certificates is made extinct and converted into electronic holdings.

Dematerialisation Procedure

1) Investor surrenders certificates for dematerialization to DP.

2) DP intimates depository of the request through the system.

3) DP submits the certificates to the registrar.

4) Registrar confirms the dematerialization request from depository.

5) After dematerializing, registrar updates accounts and informs depository of - the

completion of dematerialization.

6) Depository updates its accounts and informs the DP.

7) DP updates its accounts and informs investor.

Rematerialisation Procedure

1) Beneficial owner requests for rematerialisation.

2) DP intimates of the Depository request through the system.

3) Depository confirm Rematerialisation request to the registrar. Registrar updates

accounts and prints certificates.

4) Depository updates accounts and downloads details to DP.

5) Registrar dispatches certificates to investor.

Fungibility

Securities have been made fungible by deleting section 83 of the Companies Act,
1956. Now the certificates will not carry a distinct number and will form a part of a ‘fungible
mass’. Dematerialized shares do not have any distinctive or certificate numbers. These shares
are fungible which means that 100 shares of a security are the same as any other 100 shares
of that security. All the certificate of the same security will become interchangeable in the
sense that the owner of the security will lose the right to obtain the exact certificate. Each
security held in dematerialized form is given an identity and it is in form of a distinctive ISIN
(International Securities Identification Number). ISIN is a 12 character long identification
mark.

Benefits of Depository system

1. Elimination of bad deliveries

2. elimination of risks associated with physical certificates

3. Immediate transfer

4. Registration of securities

5. Faster disbursement of non cash benefits rights, bonus etc.

6. Reduction in brokerage

7. Reduction in handling of paper and periodic reports to investor

8. Elimination of problems related to change of address of investor, transmission etc.

Benefits of the nation

• Growing and more liquid markets

• Increase in competitiveness in the international market place attracting many investors

• Improved prospects for privatisation of public sector units by creating a conducive

environment

• Considerable reduction in delay

• Minimises settlement risk and fraud restoring investors faith in the capital markets

To the investing public

• Reduction of risks associated with loss, mutilation , theft and forgery of physical scrip

• Elimination of financial loss from loss of physical scrip

• Greater liquidity from speedier settlements

• Reduction in delays in registration

• Faster receipt of corporate benefits

• Reduced transaction costs through greater efficiency

To issuers

• Up-to-date knowledge of shareholders names and addresses

• Reduction in printing and distribution costs of new issues

 • Easy transfer of corporate benefits

• Improved ability to attract international investors without having to incur expenditure

of issuance in overseas markets.

SECURITIES AND EXCHANGE BOARD OF INDIA (DEPOSITORIES AND

PARTICIPANTS) REGULATIONS, 2018

SEBI Regulates Depositories and Depository Participants in India. Every depository shall be
registered with SEBI, for that an application shall be submitted before the SEBI. If the
application is not in proper format then SEBI can reject it. The Board may require the
applicant to furnish such further information or clarification regarding matters relevant to the
activity of the depository for the purpose of consideration of the application. SEBI can grant
permission if the application is in prescribed form with fixed fee. The depository shall
comply with the provisions of the Act, the Depositories Act, the bye-laws, agreements and
these regulations. The shareholding of the applicant in the depository shall be locked-in for a
period of five years from the date of grant of registration by the Board. The depository
complies with the shareholding and governance structure requirements specified in the
regulation.

• An employee of a depository shall not simultaneously be an employee of any other

company where the depository has invested.
• A director, committee member or employee of a depository shall not receive any
compensation or any other financial benefit from the companies where the depository
has invested, other than fees and expenses related to the governing board and
committee meetings.
• The shareholding of the applicant in the depository shall be locked-in for a period of
five years from the date of grant of registration by the Board.
• The depository complies with the shareholding and governance structure requirements
specified in these regulations
• if any information previously submitted by the depository or the applicant to the
Board is found to be false or misleading in any material particular, or if there is any
change in such information, the depository shall forthwith inform the Board in
writing;
• The depository shall redress the grievances of the participants and the beneficial
owners within thirty days of the date of receipt of any complaint from a participant or
a beneficial owner and keep the Board informed about the number and the nature of
redressals;
• The depository shall make an application for commencement of business under
regulation 11 within one year from the date of grant of certificate of registration under
this regulation; and
• The depository shall amend its bye-laws from time to time as may be directed by the
Board;
 • Any other condition as the Board may deem fit in the interest of securities market.

A depository who has been granted a certificate of registration under regulation 7, shall pay
annual fee. A depository which has been granted a certificate of registration under regulation
7, shall within one year from the date of issue of such certificate make an application to the
Board for commencement of business in Form C of the First Schedule.

Power to call for information 83A.

The Board may from time to time call for any information, documents or records from the
depository or its governing board or any shareholder or applicant thereof and from depository
participant

Board’s right to inspect

The Board may appoint one or more persons as inspecting officer to undertake inspection of
the books of account, records, documents and infrastructure, systems and procedures, or to
investigate the affairs of a depository, a participant, a beneficial owner an issuer or its agent
for any of the following purposes, namely:—

(a) to ensure that the books of account are being maintained by the depository, participant,
issuer or its agent in the manner specified in these regulations;

(b) to look into the complaints received from the depositories, participants, issuers, issuers’
agents, beneficial owners or any other person;

(c) to ascertain whether the provisions of the Act, the Depositories Act, the bye-laws,
agreements and these regulations are being complied with by the depository, participant,
beneficial owner, issuer or its agent;

(d) to ascertain whether the systems, procedures and safeguards being followed by a
depository, participant, beneficial owner, issuer or its agent are adequate;

(e) to suo motu ensure that the affairs of a depository, participant, beneficial owner, issuer or
its agent, are being conducted in a manner which are in the interest of the investors or the
securities market.

Notice before inspection and investigation.

Before ordering an inspection or investigation under regulation, the Board shall give not less
than ten days notice to the depository, participant, beneficial owner, issuer or its agent, as the
case may be.

Obligations on inspection by the Board

It shall be the duty of the depository, a participant, a beneficial owner, an issuer or its agent
whose affairs are being inspected or investigated, and of every director, officer and employee
thereof, to produce to the inspecting officer such books, securities, accounts, records and
other documents in its custody or control and furnish him with such statements and
information relating to his activities as a depository, a participant, a beneficial owner, an
issuer or its agent, as the inspecting officer may require, within such reasonable period as the
inspecting officer may specify. The inspecting officer, in the course of inspection or
investigation, shall be entitled to examine or to record the statements of any director, officer
or employee of the depository, a participant, a beneficial owner, an issuer or its agent. The
board also have the power to issue directions and levy penalty for its violation.

FOREIGN DIRECT INVESTMENT

Foreign investments involves the investments of funds abroad in exchange of financial return.
It is the investment made by a person resident outside India in capital instruments of an
Indian company or to the capital of an LLP(Limited Liability Partnership).

• FI can be generally classified into two type:

1. Foreign direct investment (FDI)

2. Foreign Portfolio investment(FPI)

FDI

Investment is through capital instruments by a person resident outside India. Any investment
from an individual or firm that is located in a foreign country into a country is called Foreign
Direct Investment.

Two type

1. In an unlisted Indian Company ,or

2. 10% or more of the paid up capital of a listed Indian company.

FPI

• Investment made by a person resident outside India in capital instruments

• Where the investment is less than 10% of the paid up capital of a listed Indian
company.

Foreign Direct Investment is an investment from a party in one country into a company in
another country with the intention of establishing lasting interest. It is an investment in the
form of a controlling ownership in a business in one nation by an entity based in another
nation. Foreign direct investment (FDI) is an investment made by a company or an individual
in one country into business interests located in another country. FDI is an important driver of
economic growth. Any investment from an individual or firm that is located in a foreign
country into a country is called Foreign Direct Investment. FDI is when a foreign entity
acquires ownership or controlling stake in the shares of a company in one country, or
establishes businesses there. It is different from foreign portfolio investment where the
foreign entity merely buys equity shares of a company. In FDI, the foreign entity has a say in
the day-to-day operations of the company. FDI is not just the inflow of money, but also the
inflow of technology, knowledge, skills and expertise/know-how. It is a major source of non-
debt financial resources for the economic development of a country. FDI generally takes
place in an economy which has the prospect of growth and also a skilled workforce. FDI has
developed radically as a major form of international capital transfer since the last many years.
The advantages of FDI are not evenly distributed. It depends on the host country’s systems
and infrastructure.

• The determinants of FDI in host countries are:

• Policy framework

• Rules with respect to entry and operations/functioning (mergers/acquisitions

and competition)

• Political, economic and social stability

• Treatment standards of foreign affiliates

• International agreements

• Trade policy (tariff and non-tariff barriers)

• Privatisation policy

Lasting interest and element of control

A foreign investment is considered as an FDI if it establishes a lasting interest. A lasting

interest is established when the investor obtains at least 10 percent of the voting power in a
firm. Another key element of Foreign Direct Investment is the element of control. It
represents intention of actively managing and influencing the operations of the foreign firm.
This is the major element which differentiated FDI from FPI, where the investor passively
holds securities and other financial assets with a goal of creating a quick return on his money.

FDI may be made

1. Inorganically

• By buying a company in the target country

2. Organically

• By expanding the operations of an existing business in that country.

• FDIs are commonly made in the open economies.

 • The reason is , it is the open economies which offer skilled work force and above
average growth prospects for the investors as opposed to tightly regulated closed
economies.

• All modern economies are open economies.

• Home Country- Home Country is the country from where the FDI originates.

• That is home country refers to a country that generates an outflow of FDI.

• Host Country is the country where the FDI goes.

• Host Country refers to a country that receives an inflow of FDI.

Types of FDI

• Horizontal FDI

• Vertical FDI

• Conglomerate FDI

• Platform FDI

Horizontal FDI

• The most common type of FDI

• FDI is said to be Horizontal FDI when the investor establishes the same type of
business operation abroad as it operates in its home country.

• Funds are invested in a foreign company belonging to the same industry as that owned
or operated by the FDI investor.

• Here the firm conducts the same type of activities in the foreign country relating to its
main business.

• Since both the companies belong to the same industry, the FDI is classified as
horizontal FDI.

Vertical FDI

• Vertical Direct Investment is one in which different but related activities of the
investors main business is established or acquired in a foreign country.

• Here investment is made on different levels of the supply chain.

• Each and every firms specializes only in some stages of the production process. As a
result the firm has to buy its raw materials from other firms or sell its output to firms
(other than the ultimate consumers).
 • For this the firm has to incur certain costs. So sometimes it is beneficial for the firm to
integrate vertically.

• Vertical FDI can be forward vertical FDI and backward vertical FDI.

Forward Vertical FDI-

• forward vertical FDI is said to happen when a company invest in a foreign company
which is ranked higher in the supply chain.

• It brings the company nearer to a market (distributorship).

• Eg:toyota buying car distributorship in America

Backward vertical FDI

• Backward vertical FDI occurs when a firm integrates its input (raw material)
supplying units.

• Here in backward vertical FDI the international integration goes back towards raw
materials.

• A firm may invest in production facilities in another country.

• And if the firm brings the goods or components back to its home country that is acting
as a supplier of raw materials then it is called backward vertical FDI.

• Eg: a coffee producer may invest in coffee plantation or

• A car manufacturer getting majority stake in a tyre manufacturer or in a rubber

plantation.

Conglomerate FDI

• It occurs when a business acquires an unrelated business in a foreign country.

• In the Conglomerate type of FDI an individual or company makes investment in a

foreign company that is unrelated to its existing business in the home country.

Platform FDI

• Platform FDI is the final type of foreign direct investment.

• In this case, the investor’s business works towards expansion in a foreign country,
with the ultimate aim of exporting the manufactured products to a completely
different, third country.

• For example, a clothing brand based in North America may outsource their
manufacturing process to a developing country in Asia, and sell the finished goods in
Europe.
 • Thus the expansion occurs in one foreign country, and the output is carried on to a
different foreign country.

• This type of FDI is generally seen in free-trade regions in countries that are actively
seeking FDI.

• Luxury clothing brands are a classic example of this type of FDI and manufacturing
process.

Advantages of FDI

• 1. FDI stimulates economic development

It is the primary source of external capital as well as increased revenues for a country.

It often results in the opening of factories in the country of investment, in which some local
equipment – be it materials or labour force, is utilised.

This process is repeated based on the skill levels of the employees.

2. FDI results in increased employment opportunities

• As FDI increases in a nation, especially a developing one, its service and

manufacturing sectors receive a boost, which in turn results in the creation of jobs.

• Employment, in turn, results in the creation of income sources for many.

• People then spend their income, thereby enhancing a nation’s purchasing power.

3. FDI results in the development of human resources

• FDI aids with the development of human resources, especially if there is transfer of
training, technology and best practices.
• The employees, also known as the human capital, are provided adequate training and
skills, which help boost their knowledge on a broad scale.
• But if you consider the overall impact on the economy, human resource development
increases a country’s human capital quotient.
• As more and more resources acquire skills, they can train others and create a ripple
effect on the economy.
4. FDI enhances a country’s finance and technology sectors

• The process of FDI is robust. It provides the country in which the investment is
occurring with several tools, which they can leverage to their advantage.

• For instance, when FDI occurs, the recipient businesses are provided with access to
the latest tools in finance, technology and operational practices.

• As time goes by, this introduction of enhanced technologies and processes get
assimilated in the local economy, which make the fin-tech industry more efficient and
effective.
 5. Second order advantages
• Apart from the above points, there are a few more we cannot ignore.
• For instance, FDI helps develop a country’s backward areas and helps it transform
into an industrial centre.
• Goods produced through FDI may be marketed domestically and also exported
abroad, creating another essential revenue stream.
• FDI also improves a country’s exchange rate stability, capital inflow and creates a
competitive market. Finally it helps smoothen international relations.

ROLE OF RBI IN FDI

Reserve Bank of India has a very vital role in managing all the foreign exchange. These
foreign exchanges are regulated under Foreign Exchange Management Act (FEMA) that is
governed by RBI. They give general or special permissions in every dealing of foreign
exchange. Similarly, FDI also comes under FEMA that is managed by RBI and it is
mandatory for every foreign investor to get their approval before investing as without it these
investments cannot proceed further. RBI though do not have the power to restrict any current
foreign transaction that only Central Government can but they have an important role to play
in the same as Central Government do consult with them before taking any action. RBI
basically acts as an advisor to the Government.

FDI in India has two routes, one is Automatic Route and the other is Government Route.
RBI again has important part to play in them. In both the routes, concerned regional offices
need to be submitted all the required documents. In Automatic Route, the regional office
should be notified and submitted with the basic details of the investment within 30 days of
investing and shareholding. In Government Route, based on RBI’s FDI policy, those
documents should have the following necessary information on receipt of money for
investment and on issue of shares to the investors:

1. Name and address of foreign investors.

2. Certificate from the Company Secretary of the company accepting investment from person
resident outside India certifying that:

• All the requirements of the Companies Act, 1956 have been complied with;

• Terms and conditions of the Government approval, if any, have been complied with;

• The company is eligible to issue shares under these Regulations; and

• The company has all original certificates issued by authorized dealers in India
evidencing receipt of amount of consideration;

3. Certificate from Statutory Auditors or Chartered Accountant indicating the manner of

arriving at the price of the shares issued to the person resident outside India.
 The process need to be followed and all the necessary details should be provided. Without
the required documents and necessary information, any FDI could not be proceeded further.
Also, it can be stopped in between the proceedings if the Government, in consultation with
RBI, decides so. The Reserve Bank of India (RBI) has a major role in regulating foreign
direct investment (FDI) in India. According to the Foreign Exchange Management Act
(FEMA) of 1999, FDI in India must be made in accordance with the rules and regulations set
by the RBI. The foreign investors considering investing in India must always be aware of the
FDI regulations and compliance requirements that must be adhered to.

In order to attract FDI, the government of India has introduced a number of incentives. The
Reserve Bank of India regulates FDI in India:

• 100% FDI is allowed for Indian companies under the automatic route, which does not
require any approval from RBI, Government of India and the Securities Exchange
Board of India.
• Investments in certain sectors such as defence, print media, broadcasting and tobacco
require prior approval from the Government.
• Regulations to make it easier for foreign companies to invest in India have been
framed by the Government, such as providing automatic approval up to a limit, and
relaxation in foreign equity caps.
• All FDI investments must be registered with the Foreign Investment Promotion Board
(FIPB) and must comply with the prevailing laws, rules and regulations of the
respective sector.
• Exchange rate risk should be taken into account by investors before making the
investment.
• All the FDI investments must adhere to the regulations set out by the Government of
India, as well as additional rules defined by the RBI in order to safeguard the integrity
of foreign currency funds.

New FDI Policy

According to the new FDI policy, an entity of a country, which shares a land border with
India or where the beneficial owner of investment into India is situated in or is a citizen of
any such country, can invest only under the Government route. A transfer of ownership in an
FDI deal that benefits any country that shares a border with India will also need government
approval. Investors from countries not covered by the new policy only have to inform the
RBI after a transaction rather than asking for prior permission from the relevant government
department. The earlier FDI policy was limited to allowing only Bangladesh and Pakistan via
the government route in all sectors. The revised rule has now brought companies from China
under the government route filter.
 INSIDER TRADING

Insider trading refers to the practice of purchasing or selling a publicly

traded company’s securities while in possession of material information that is
not yet public information. Material information refers to any and all
information that may result in a substantial impact on the decision of an investor
regarding whether to buy or sell the security. By non-public information means
the information is not legally out in the public domain and that only a handful of
people directly related to the information possess. An example of an insider
may be a corporate executive or someone in government who has access to an
economic report before it is publicly released. Insider trading is defined as a
malpractice wherein trade of a company's securities is undertaken by people
who by virtue of their work have access to the otherwise non-public information
which can be crucial for making investment decisions.

When insiders, e.g. key employees or executives who have access to the
strategic information about the company, use the same for trading in the
company's stocks or securities, it is called insider trading and is highly
discouraged by the Securities and Exchange Board of India to promote fair
trading in the market for the benefit of the common investor. Insider trading is
an unfair practice, wherein the other stock holders are at a great disadvantage
due to lack of important insider non-public information. However, in certain
cases if the information has been made public, in a way that all concerned
investors have access to it, that will not be a case of illegal insider trading.

The Securities and Exchange Board of India (Prohibition of Insider

Trading) Regulations 1992, does not directly define the term Insider Trading.
But it defines the term "Insider", "Connected Person" and "Price Sensitive
Information". Insider Trading is the trading of securities of a company by an
Insider using company's non-public, price-sensitive information while causing
losses to the company or profit to oneself.

Eg: The CEO of a company divulges important information about the

acquisition of his company to a friend who owns a substantial shareholding in
the company. The friend acts upon the information and sells all his shares
before the information is made public.
 Insider Trading has been around the United States from 1792. Hence,
Laws against Insider Trading was formed strictly in the United States of
America. The market crash in 1929 due to prolonged "lack of investor's
confidence" in securities market followed by the Great Depression of US
Economy, gave rise to the enactment of the Securities Act of 1933. The
foundation of Insider Trading law was laid down by the Supreme Court of US
in Strong vs Repide. Statutory Insider Trading Laws were first passed in the
year 1933 and the Securities Exchange act in 1934. The second act created SEC
(Securities Exchange Commission) to regulate the secondary trading of
securities. These Acts were meant to create more transparency among the
investors and placing due diligence on the preparers of the documents
containing detailed information about the Security.

In the United States vs Carpenter, 1986, the Supreme Court cited that the
usage of Inside Information received by virtue of confidential relationship must
not be used or disclosed and by doing so, the individual gets charged for Insider
Trading. In 1997, O'Hagans Case, the court recognised that a company's
information is it's property: " A Company's confidential information qualifies as
property to which the company has a right of exclusive use. The undisclosed
misappropriation of such information in violation of fiduciary duty constitutes
fraud akin to embezzlement-the fraudulent appropriation to one's own use of
money or goods entrusted to one's care by another." In 2007, representatives
Brian Baird and Louise Slaughter introduced a bill "Stop Trading on
Congressional Knowledge Act or STOCK Act".

Insider Trading in India:

1. In 1948, First concrete attempt to regulate Insider Trading was the

constitution of Thomas Committee. It helped restricting Insider trading by
Securities Exchange Act, 1934.

2. In 1956, Sec 307 & 308 were introduced in the Companies Act, 1956. This
change made it mandatory to have disclosures by directors and officers.

3. 1979, the Sachar Committee recognized the need for amendment of the
Companies Act, 1956 as employees having company's information can misuse
them and manipulate stock prices.

4. 1986, Patel committee recommended that the Securities contracts

(Regulations) Act, 1956 be amended to make exchanges reduce Insider Trading.
5. 1989, Abid Hussain Committee recommended that the Insider Trading
Activities be Penalized by civil and criminal proceedings and also suggested
that SEBI formulate the regulations and governing codes to prevent unfair
dealings.

6. 1992, India has prohibited the fraudulent practice of Insider Trading through
"Security and Exchange Board of India (Insider Trading) Regulations Act,
1992. Here, a person convicted of Insider Trading is punishable under Section
24 and Section 15G of the SEBI Act, 1992.

7. 2002, the Regulations were drastically amended and renamed as "SEBI

(Prohibition of Insider Trading) Regulations, 1992.

Controlling Insider Trading

• To protect general investors.

The manipulation of market by using Insider trading generally causes great

losses to a company, thus leading to loss for investors or great profit only for the
Insiders and no investor. It steals away the possibility of earning profit from an
investor.

• To protect the interest and reputation of the company.

Once a company faces a problem of Insider Trading, investors tend to lose

confidence in the company and stop investing in the company and also selling
all the stocks of the company.

• To maintain confidence in the stock exchange operations.

With SEBI also regulating all the trading’s, if any Insider gets a chance to get
past the laws, it decreases the investors’ confidence in the stock exchange
operations itself.

• To maintain Public confidence in the financial system as a whole.

Indian Financial Market is still very low in the domestic investment rate. To
have a healthy economy, a proper financial system is a must and for that,
confidence in the market is of utmost importance.
Reasons for prohibiting insider trading

1. Insider trading appears biased to investors as insiders have additional

price sensitive information before them and can use it to make profits
while the late reception of information makes investors suffer loss or not
gain the deserved profits.
2. If a market is integrated and free of illegal trading, it may lead to healthy
growth of the market and such markets can inspire the confidence of the
Investors.
3. Insider trading leads to loss of confidence of Investors on the market
which can lead to a halt in market dealings.

Under SEBI Act, 1992- Penalty for insider trading- Sec.15G.

If any insider who,—

(i) either on his own behalf or on behalf of any other person, deals in
securities of a body corporate listed on any stock exchange on the
basis of any unpublished price-sensitive information; or
(ii) communicates any unpublished price-sensitive information to any
person, with or without his request for such information except as
required in the ordinary course of business or under any law; or
(iii) counsels, or procures for any other person to deal in any securities of
any body corporate on the basis of unpublished price-sensitive
information, shall be liable to a penalty which shall not be less than
ten lakh rupees but which may extend to twenty-five crore rupees or
three times the amount of profits made out of insider trading,
whichever is higher.

Significant Penalties:

• SEBI may impose a penalty of not more than Rs. 25 Crores or three times
the amount of profit made out of Insider Trading; whichever is higher.

• SEBI may initiate criminal prosecution; or

• SEBI may issue order declaring transactions in Securities based on

unpublished price sensitive information; or

• SEBI may issue orders prohibiting an insider or refraining an insider

from dealing in the securities of the company.
Methods of Prevention of Insider Trading

1. Disclosure of Interest by corporate insiders.

a. Listed companies:
-If change exceeds 2% of the total voting right of persons holding more
than 5% of the shares/voting rights.
-If change exceeds Rs.5,00,000/25000 shares/ 1% of capital by Directors
and officers.

b. Other entities:

-Initial statement of holdings.

-Periodic statement of holdings. This can show any suspicious time based
and trading based activities by Insiders.

2. Disclosure of Price Sensitive Information:

• Limited access to price sensitive information, for ex.: Need to know

basis.
• Dissemination of information by the Stock Exchange.
• Transmitting information to news agency.

3. Chinese Wall:

Separate inside area from public areas and bringing over the wall.

4. Trading Window Facility:

• Decided by the company.
• Closed during the time price-sensitive information is not published.
• Opened 24 hours after the information is made public.
• Allowing the exercise of ESOP.

5. Minimum holding period:

• Securities to be held for minimum period of 30 days to be considered

investment.
• 30 days holding from the date of IPO allotment.
• Only personal emergency cases be excluded

6. Pre-clearance of trades prevents Front Running.

Legal and illegal Insider Trading

It is quite natural for an insider who is working in a company to come

across some inside information. It would be violation of human rights and
would defy the logic of freely tradable securities, if Insiders are not permitted to
trade for themselves. That would be unreasonable. It would be irrational to stop
promoters of a company from dealing in their securities. Thus, the restriction on
the corporate insider is directly or indirectly using the price sensitive
information that they hold to the exclusion of the other shareholders in arriving
at trading decisions. There is absolutely no restriction on insiders in trading in
securities of the company if they do not hold any price sensitive information
that the public is not already aware of. During the short while promoters and
insiders can use the information to their advantage by guessing market reaction
to the news or information.