Business Law-some finer points-Part 2

1. Reasons to apply for patents outside India would be due to 
1. software patents issue in India, and friendly jurisdictions such as USA, Australia, Japan; and if technical problem related EU too
2. Pre grant opposition very easy in India(no need to be interested party also)
3. Ease of enforcement abroad easier, and thus valuation better
2. Non economic considerations(beyond market potential) is to increase startup valuation via patent applications :D and quantify sweat equity brought in by promoters. Further, cross border patents allow for potential total addressable markets(TAM) in valuations.
3. Ways to speed up arbitration
1. Allow arbitrator the power to impose fines for delaying tactics(such as non filing reply)
2. Time limit for counter claims/setoff, to include in statement of defence, ensures endless pleading won't  happen. 
3. CPC provision for max 3 adjournments and reasons recorded in writing/show cause
4. Dispute resolution is a skill not just a subject. Further, clients classified as as follows
1. Startups just hate lawyers who complicate thing
2. Seek same advice from multiple lawyers/too many cooks
3. those who come after problem arises and facts usually compex/verbal/not in place.
4. Those who seek advice from the very inception. 
5. Exclusive jurisdiction clause helpful to allow anti-suit injunction later

Business Law-some finer points-Part 1

Below points basis general reading and the NUJS DEABL Course material/videos. Comments welcome

1. Deadlock situations more common in JVs than in financial/strategic investments
2. Strategic investor values business on a more long term basis than financial investor, and often enters at different life-cycle(angle-VC-PE-Distressed/Strategic) and pays a premium as they enter into established business
3. For PIPE transaction, valuations usually predetermined due to pricing rules/formula, and better for foreign investors as helps them avoid issues in exchange purchase. Here however, no exit clause as listed shares already liquidity there. So enter in negotiated deals and exit on exchange, and less scope of reps/warranties as there is already greater scrutiny/compliance and lot more information enabling buyers to do their own diligence. Due diligence is an issue due to insider trading regulations and risk of triggering change of control norms(hence limited affirmative rights, and conservative view on negative rights). Also, mostly equity and no convertibles/warrants. 
4. Picking up a block on the market is difficult since prices increase exponentially, hence it is better to purchase from the company. 
5. However, new trend of complete buyouts of startups but this is not strategic investment per se.
6. Commercial/Business law is complex, needs quick turnarounds(eg change agreements across multiple documents) and levels of understanding not available on Google. Long term solution is to follow a checklist approach and be through, till you develop your own framework. 
7. NDA(Non disclosure agreement) may have non compete and non solicit provisions. So READ the agreement w/o presuming it is only NDA. Also, disclosing party usually wants broad scope , while receiving party wants narrow scope, and differ on wish to 'Mark' Documents as confidential which is usually difficult. Also, right/requirement to return/retain copies depends on form(physical/electronic) and also on need for referrals/retention rules. If really needed, then virtual cloud/data room is must with locked/monitored spreadsheets.
8. Due diligence forms the bread and butter for transactional lawyers especially those representing the target. It is not a judgemental exercise it just brings the relevant('Material') facts to the table to draft representations and warranties, and proceed with txn in best tenable manner avoiding defects/deal killers and bad deals. Be prepared for the worst-due diligence helps you know the worst, and also confirm the business is what is appears to be.
9. Business due diligence involves business experts(like AT Kearney/BCG), inventory physical checks, people due diligence especially key folks and change of control provisions in their contracts like gratuity, and legal/tax document review to examine present/threatened/potential risks, IPR ownership reviews(does company OWN the IPR part of deal,corporate History/Capitalization review-check for ROFR/lockups/agreements binding the shareholding, financial indebtedness review for mortgage/prior consent
10. There are multiple procedural ways to frustrate the process(eg no consent for valuer, delay to submit bids) for mechanisms like Russian roulette, so in practice not done. However, this is having both parties submit sealed bids at which they will buy/sell stakes. Even if loan documentation/JV documentation for funding is clear, establishing default is very difficult in terms of choice of instrument, timing, valuation level etc. So to avoid bad blood, even if clause exists to buyout at discount due to failure to fund, done at negotiated deals typically. 
11. Exit waterfall is usually IPO, strategic sale, put option to company/promoters. However, IPO cannot ever be forced upon on company and there are timing, economic and commercial factors to decide to do it, as also third party cooperation. Strategic sale needs promoter to dilute and share control, as also need for cooperation/continue at times. Drag Along rights are usually value destructive(PE/Fund need to exit at lifecycle end and may not care about IRR, also diversified, but promoter may believe value exists and would not want to take that decision) and hard to negotiate, contractually tough and unless escrow, impossible to enforce. Usually, company not doing well  hence no IPO/drag along works, so unlikely it will be able to buyback the stake
12. The investor relies on the founder to manage the business and grow his money. Hence, clauses exist on founders such as full time, no competing business, tag along, anti dilution(unless ability to subscribe at same valuation)
13. Usually, reserved matters consent given by nominee of investor, and meeting to vote needs the mandatory quorum of that representative. 
14. M&A transactions usually have term sheet, due diligence, definitive agreements, signing and closing interposed by standstills/actions(operational surveillance in the meanwhile). 
15. Inhouse counsels usually have a kickoff internal meeting, understand business thresholds and imperatives, and then take a look at the contract wrt allocation of risks, liabilities and responsibilities if it meets. This would then result in discussion points(key issues) which when resolved conceptually in meeting/call(eg payment terms, title, O&M) could then go to the wording. To cut the information asymmetry, identifying the deal team including correct persons who can take a CALL on that subject will be must. Also, need to balance timeliness(deal was needed yesterday!), cost and quality. 
16. Usually, large groups have standard, non negotiable contracts for ordinary course of business, to manage legal risk, with some provisions negotiable. This makes in-house job easier. These depend on your bargaining power, nature and scope of contract and the perspective/importance of items(eg 1 issue with tender)
17. Also, inhouse counsel not bound by billable hours need to rack up, and often wants to cut to the chase and focus on vital issues

How management affects financial reporting-the case of Tata Power and Adani Power

As a veteran reader of annual reports would know, accounts (even audited ones) are subject to several adjustments/interpretations. This is because on the same facts, different people can take the same view. Auditors merely ensure that the management interpretation does not cross canons of incorrectness.

Facts in brief
Adani and Tata had bidded for coal based power plants respectively with capacities tied up under power purchase agreements (“PPAs”) for twenty five years with substantially fixed tariffs. The PPAs for these plants were made based on the commitments / understanding that domestic coal linkages would be available to meet the fuel requirements. However, adequate coal linkages were not made available due to various reasons not attributable to the respective subsidiary companies. In response to pleas for compensating the losses due to above, the respective state electricity regulators had granted part relief in form of interim compensatory tariffs, however this matter was litigated and has not reached finality as of now.

Stance taken by Adani Power-Recognize revenue
As per the assessment by the Management, it would not be unreasonable to expect ultimate collection of an equivalent amount as the CT towards relief due to impact of Force Majeure events which is predicated on the legal advice that the CERC may be guided by the principles of restitution / mitigation of the impact of the promulgation of the Indonesian Regulations and non-availability of short supply in determining the extent of impact of Force Majeure events. In view of the aforesaid, the Company has continued to recognise total revenue of H3,374.66 Crores on account of the CT upto 31st March, 2016 (including H674.19 Crores for the year ended 31st March, 2016 and H857.35 Crores for the year ended 31st March, 2015) based on the formula and methodology prescribed by CERC vide its order dated 21st February, 2014 considering the same as the most appropriate basis for measuring impact of the Force Majeure

Stance Taken by Tata Power-No revenue recognition-Director's report for FY 2015
CGPL has been legally advised that it has a good arguable case. However, in view of the pending appeal as mentioned above and considering that the amounts associated are significant, CGPL has not recognised revenue amounting to ` 757.89 crore for the year ended 31st March, 2015 and ` 1,019.06 crore for the period from 1st April, 2012 to 31st March, 2014. 
Above stance not expected to change as the company has not recorded this income in the audited accounts for the year ended 31 Mar 2016.


Takeaway
Both the below companies are audited by the same Big 4 auditor Deloitte. Yet on very similar facts and the identical rulings, the companies took a very different view to revenue recognition, and the . Tata Power conservatively chose not to record revenue considering the high stakes involved, while Adani Power decided to record it basis management assessment. Accounting risk is therefore higher in the latter, from an investor perspective. While the statutory auditor has qualified the audit report in Adani possibly for this reason citing it as an internal control weakness, this is more a process rebuke than calling it wrong accounting
According to the information and explanations given to us and based on our audit, a material weakness has been identified as at 31st March, 2016 in the Company relating to inadequate internal financial controls over financial reporting in respect of revenue recognition on account of additional tariff claims pending determination by regulator, and final outcome of the litigations.

The Indian power sector should wait before celebrating the CERC order on PPA tariff revision

Two days ago, the order of the CERC made headlines nationally when it agreed to the demand of Adani Power for escalation in tariffs, to compensate for the 'unexpected' increase in imported coal prices after the Indonesian Government passed a law forbidding miners from selling coal below a benchmark price(so that its its revenue based royalty would not reduce due to transfer pricing by coal mining companies selling at lower rates to their parent/group companies). The favourable order can be read here  http://www.cercind.gov.in/2013/orders/SOSJ.pdf and the dissent can be read here http://www.cercind.gov.in/2013/orders/SOALL.pdf Both orders agree that the 'change in law' should only apply to Indian law, and that unexpected price rise does not constitute force majure. However, what they differ on is the regulator's power to intervene in the pricing mechanism of fixed price contracts. For some background, let me reproduce the  main facts below, and my views on it

1. The power procurers i.e State electricity boards had sought bids for long term power supply. The bids had left room for the bidders to quote escalation based on fuel, foreign currency fluctuation etc. Adani Power, "relying on the Govt of India policy and its coal supply LOAs" in its infinite commercial wisdom, chose to quote a fixed rate, and then won the contract. While the procurers had initially satisfied themselves about the coal linkage, this was entirely the power company's responsibility.
2. The Adani parent company Adani Enterprises owned 74% of the Indonesian coal company which supplied coal to Adani Power UMPP. Hence, most of the coal price hike went to the parent company. yet, instead of merging the coal company into the power project like how Tata Power did, Adani Power preferred to pocket the coal profits, but pass on the increase to the power purchasers

While the CERC agreed that Adani Power did not have any contractual case for compensation, it interpreted its regulatory power widely under Section 79 to state that since power sector investments were to be encouraged, it could not allow the power project to become sick. It also stated that since the replacement cost of the project(and resultant tariffs) would far exceed even the requested tariff increase, it was in the overall sectoral interest to increase the tariffs. It is with this interpretation that I have the following issues

1. Suppose the coal prices had fallen instead of rising, and power procurers had sued Adani Power asking for discounts, then it would have cried foul about policy changes/nationalization etc. Why should only the downside be borne by shareholders?
2. If there was a commercial mistake by Adani Power, let the plant turn bankrupt, and the proceeds be distributed amongst the utilities which can then run the plant themselves using imported coal. 
3. The bidders who quoted variable price linked escalations related to coal, and who lost for their being realistic, should not be prejudiced. 
4. Unlike the infamous 2G spectrum allotment which was an opaque process, the results of transparent power procurement by bidding should not be adversely shifted by regulators.
5. Assuming the parent company guaranteed the power project performance, then encash all possible securities/performance guarantee then only ask consumers to pay more. 

 The ruling has already been appealed, and I hope that the courts will be saner. Also, what persuaded the CERC was the chance of project turning sick. Now, for financially stable companies like Reliance Power, Tata Power etc, especially where parent companies have given guarantees, turning sick would mean even larger monetary losses, or may not be required after considering overall parent resources. Hence, there is a case even before the CERC, to differentiate their case from Adani's.

TCIs lawsuit against Coal India-legally and morally flawed

I wrote a post on this at my other blog, do take a look(http://apoliticallyincorrect.blogspot.com/2012/05/tci-sues-coal-india-morally-and-legally.html). While I rarely toe the Government line, this issue seemed too unfairly portrayed in the mainstream media to pass up!

How power sector increasingly needs lobbying to navigate regulation/policy

On the face of it, one would liken the power sector to any other manufacturing/services firm that transforms raw materials into outputs. But for the power sector, the heavy interdependence of it on other sectors has resulted in its being affected by power games(including those it plays itself). The analysis follows below

1. Land Acquisition:-In India, land and politics are inseparable, and when you throw in the heady cocktail of R&R(relief and resettlement) of project affected people who are displaced, things become really difficult. And India has very few land banks, which complicates matters. Companies would need quick ground work/lobbying to tie up favoured land parcels.
2. Capital Goods import restrictions:-The 'China price' applies for power turbines as well, and naturally domestic producers like BHEL, L&T are not overjoyed. Press reports earlier this week hinted of a 18% import duty on imported capital goods, which would hike the capex cost of sector players, which even if allowed as pass through would increase capex needs. In this batttle of duty between consumers and producers, the producers seem to have won.
3. China concern'-security issues:-This is so far only in telecom(insisting on source code etc), there are chances of standards etc being imposed in power sector also to target Chinese equipment, which would make imports from China more complicated.
4. 'Force majure' coal prices hike endangering UMPPs;-The UMPP bidders had bid assuming coal prices to be 'business as usual'. But after the Indonesian export price lower ceiling and the Australian mining taxes, bidders are trying to get the Government to treat those taxes are force majure, otherwise the project may become unviable. While Tata Power merged Indonesian coal mines into itself to avoid net impact on itself, others have not done so. So the result of this lobbying would be interesting not only for power, but for all UMPPs
5. Natural Gas Allocations-tussle with other sectors:- Presently, ONGC supplies about 28% of its gas to 'non priority' sectors like petrochemicals. And as RIL's gas supplies have not started as promised, there is this tussle for gas allocations, where affected sectors like power/fertilizers etc are jockeying with the eGOM(empowered Group of Ministers) to get the maximum allocation for their plants to avert idle capacity. All this unde
6. Domestic coal supply uncertainty:-Earlier this month, Coal India was compelled to sign formal FSAs(Fuel Supply Agreements) with those producers to whom it had issued proforma letters of arrangement. While that reduced the fuel risk of those producers, it is surprising that a seemingly innocuous contract law issue had to be settled at the level of the Prime Minister's office
7. Power Trading margin cap:-Companies like Jindal Power had minted money selling power on the open market, till the CERC stepped in with its monitoring, margin trading cap and other restrictions. While the segment is still very profitable, the El Dorado days are gone for now.
8. 'Independent state regulators' delaying tariff hikes:-The very purpose of establishing 'independent regulators' under the Electricity Act 2003 was to reduce the risk of populist policies crowding out economic rationale. But in states like Delhi, UP etc, the regulators did not hike tariffs as requested/on time, thus making the distribution utilities incur losses and go on appeal for timely hikes, and the risk of a tariff shock looms ahead when the requested tariffs are passed
9. SEBs delaying payments to generation utilities:-Even if companies generate and sell the power, the State Distribution utilities face power theft, remunerative prices and NPAs thus reducing their own cash flows and prompting them to delay payments to generators. Despite the implicit sovereign guarantee, delay in payments makes the recipient lose interest, and makes the stock market investors antsy. This fear is a major reason why private power stocks underperformed the broader market in 2011.
10. Renewable energy Issues
1. Subsidy dependent companies may suffer like their Spanish peers:- Spain was the poster child of solar energy till its bulging budget deficits made it pare those subsidies to the bone. In response, generators and equipment suppliers suffered. For subsidy dependent Indian players like solar, this is a big risk presently.
2. Solar energy Price War due to bidding rules:-In the solar energy bids last year, new entrants were willing to supply solar energy at prices around 50%-60% of the benchmark ceiling. I'm sure the incubents will try pushing for track record/capitalization and other rules to prevent this becoming a frequent occurrence.
3. No antidumping protection for Solar cell manufacturers:-Players like Moser Baer/Indosolar have been demanding anti dumping protection for their solar photovoltaic cells, but the Government has not relented till date. If it relents, the stocks will shoot up
4. Food security concerns for biofuel:-While molasses or corn may seem the most logical feedstock, even Indian players are angling towards jatropha and rice husk where the accusations of 'fuel over food' will not arise. This is more of a global issue however.

Hence, any investor in the energy sector(to a lesser extent renewable energy) should be concerned about the political, regulatory and legal environment. The company with the best lobbyists would win many of the above disputes..

Understanding how do banks work-some FAQs for investors

The inspriration for this post came from the fact that banks are difficult to understand, and even more difficulty to invest in. For this, I referred publicly available documents like RBI master circulars, NCFM banking sector module(http://www.nseindia.com/content/ncfm/ncfm_bsme.pdf) amongst others.

1. What does a bank do? The basic functions are intermediation and payment services. Any other services like advisory etc are icing on the cake.
2. What do investment banks invest in? They do not themselves invest(atleast thats not an essential attribute) but act as an intermediary between issuers and investors, for which they can often get fees/commission from both
3. Why do banks eventually become conglomerates offering A-Z financial services? Though banks claim that this allows them to service the customer better/have all services under one roof, the real reason in my view is the benefit of cross selling, economies of scale and the wider scope for knowledge management. For example, a commercial bank may have an excellent knowledge base on some industries, which can be leveraged into good research reports for the investment banking/broking arm. Or the same online banking platform can be used as single sign on login to give the customer access to other services, without incremental customer acquisition cost. And more the products per customer, the higher should be the customer retention rate. 
4. Explain the CAMELs model to evaluate a bank's performance: This model is implicitly used without acknowledging in many banking analyst research reports, but I notice that they often miss out on the liquidity and asset quality aspects, which came back to haunt the sector in the later part of 2011, with power sector NPAs, defaults in farm loans/student loans, more CDRs etc, all culminating in the downgrading of some banks by the credit rating agencies. Anyways, CAMEL is
1. Capital Adequacy;-This is a measure of financial strength, in particular its ability to cushion operational and abnormal losses. It is calculated based on the asset structure of the bank, and the risk weights that have been assigned by the regulater for each asset class. Post the subprime crisis, I think we should give bonus for "Too Big to Fail"
2. Asset Quality:-This depends on factors such as concentration of loans in the portfolio, related party exposure and provisions made for loan loss
3. Management:-Management of the bank obviously influences the other parameters. Operating cost per unit of money lent and earnings per employee are parameters used. In Indian context, I think implicit government guarantee for PSU banks, is a +ve here.
4. Earnings:-This can be measured through ratios like ROA, ROE, NIM
5. Liquidity:- In order to meet obligations as they come, the bank needs an effective asset-liability management system that balances gaps in the maturity profile of assets and liabilities. However, if the bank provides too much liquidity, then it will suffer in terms of
   profitability. This can be measured by the Loans to Deposit ratio, separately for short term, medium term and long term.
   
5. What does financial inclusion imply for bank business models? It means that if the banks want to open more branches in metros/cities, they better focus on the unbanked. This is over and above their 30% lending requirement to priority sector
6. Basel III/Volcker rules:-A classic example of bolting the stable after the horse has escaped. It makes banks hold more capital, measure risk more conservatively, cap their pay and a whole host of measures to ensure banks bear some of the costs they impose on others. This debate is clouded with acronyms and technicalities, but that is the essence of it. To avoid regulatory arbitrage, major financial centres should implement these measures consistently, and that is what holds up the implementation of these rules.
7. What differentiates NBFCs from banks? They do not have access to cheap bank deposits from the public (in the form of savings account, current account etc.although they can accept fixed deposits. Their cost of funds being higher than banks, their lending is costlier.
8. Why do people borrow from NBFCs at costlier interest rates? Because they are unable to mobilise funds from banks, or to fund their requirements beyond what banks would give. NBFCs are particularly active in consumer finance and personal finance, as they are flexible, have laxer credit standards, and often give higher loan to value ratio on secured asset financing(cars etc).
9. What are scheduled banks? Banks which meet specific criteria are included in the second schedule of the RBI Act, 1934. These are called  scheduled banks. They may be commercial banks or co-operative banks. Scheduled banks are considered to be safer, and are entitled to special facilities like re-finance from RBI. Inclusion in the schedule also comes with its responsibilities of reporting to RBI and maintaining a percentage of its demand and time liabilities as Cash Reserve Ratio (CRR) with RBI.
10. Why this whole debate on government stake in PSU banks falling below 51%? Other sector PSUs do see this. Even in other sectors, the privatization debate is kicking and alive as the respective sector ministry sees the PSUs as their turfs to implement populist policies, promote loyalists and generally display their power. In banking, while the finance ministry(the owner) itself favours divestment, others do not because that would reduce the power of government and politicans to direct PSUs on lending, CSR etc. For example, no private sector bank would have given Kingfisher Airlines such a long rope as SBI had given, some attribute this to the political influence of the owners. Even industrialists prefer PSU banks for their riskier loans! Of course, the arguments against this are couched in terms of valuation, affecting financial inclusion etc.
11. Why SBI has not merged with its subsidiary banks? There are labour issues because the main SBI staff have better terms of service than those of the subsidiary banks, and hence integrating the workforces is an issue. This issue had cropped up in AI-IA merger also.
12. How big are Indian banks versus global banks? Not very big in terms of assets. But then, they are more profitable and 'safe'.
13. Where do I get reliable data on the Indian banking sector? The RBI releases reports and statistics on the sector, which can be downloaded from its website. For example, the FY11 reports are available at this link. Generally, Mint and other financial newspapers analyze those reports on the day of/soon after their release.
14. Why are voting rights per shareholder capped at 10%, what would this imply for the valuation? Well, the RBI and other financial sector regulators do not want economically important entities like stock exchanges, banks, insurers etc to see concentration of ownership. Hence, the 10% rule leads to broadbased ownership. While there is no study on what is the valuation impact, one could argue that the voting stake beyond 10%, should be modeled as a Differentiation Voting rights share with economic benefits w/o voting rights! That model would invariably lead to a discount. 
15. What is this whole financial inclusion furore? Thanks to challenges of geography, income inequality, logistics, technology etc, it is not practicable to profitably operate one branch in each of India's 600000 villages. Instead, it is proposed to use para banking(MFIs, banking correspondents, NBFCs) and  existing retail outlets( post offices, village knowledge kiosks) as outlets, use multi-language technology platforms via mobile phones etc. An unsaid fear is that while moneylenders can counter populist politician calls to voters of not to repay loans, banks constrained by the code of conduct and slow legal process, are helpless in the event of such political interference, which brought the MFI industry in Andhra Pradesh on its knees. 
16. What are priority sector lending norms? Why does that encourage specialized institutions like MFIs and gold loan companies? The RBI currently mandates domestic commercial banks operating in India to maintain an aggregate 40.0% (32.0% for foreign banks) of their adjusted net bank credit or credit equivalent amount of off-agriculture, small enterprises, exports and similar sectors where the Government seeks to encourage flow of credit for developmental reasons. Banks in India that have traditionally been constrained or unable to meet these requirements organically, have relied on specialised institutions, better positioned to or focus on originating such assets through on-lending or purchase of assets or securitised pools to comply with these targets.
17. What are the larger implications of the sector? Money talks bigtime. One of the obstacles cited for slow growth of organized retail/farm credit etc, is that farmers are indebted to the traders/landlords/rich farmers for their personal loans/crop loans, and are thus compelled to sell their produce to them for lower rates, and buy inferior inputs at higher rates. It is hoped that micro loans and rural credit will break the financial dependence of small farmers. Once this is done, one can explore reforms like rural warehouses for grains, retail reforms etc.
18. How do many big banks manage to release their audited accounts before even a month elapses from year end? Thanks to the multiplicity of audits(concurrent, internal, inspection, RBI inspection, systems), the bank internal control systems are generally current. And the existence of core banking and sophisticated internal control systems ensures that the records are reasonably uptodate. That is why balance sheet audit of just test checking major accounts balances/revenue streams is in vogue.
19. Non fee income:-More is better as it insulates a bank from the competition induced squeeze on NIM. But if these profits come from derivatives trading, then the quality of earnings may actually be lower and thus the bank riskier! Unfortunately, few banks disclose the true extent of their non fee income dependence on such activities. 

Phew! that ended a longish post. Depending on the response and my time constraints, I'll follow this up. 

How Government policies play havoc with share prices-sugar, coal, steel..

Recently, UP announced a hike(yet again!) in the prices sugar mills need to pay farmers for their cane. This, without any improvement in yield. Unsurprisingly, the states moved court, and demanded a stay on the order. But irrespective of the legal gymnastics, the market already responded and hammered down sugar stocks, sending premier players like Shree Renuka Sugars to their 52 week lows.

But this story is not only for sugar. When the draft Land Acquisition Bill was promulgated mandating compensating existing project affected people to the tune of 25% of profits, the coal sector took a major hit especially PSUs like Coal India, because unlike the private sector, they do not have the option of challenging the act in court. Another factor which played havoc under the previous Environmental Minister Jairam Ramesh, was the delaying/banning mining in certain areas. While that hit even other companies, Coal India again took a major hit. And while one may argue that the policy stayed same-only the law of the land was enforced-one cannot deny that this was a political shock.

And when the export tax on domestic iron ore was increased, the steel lobby salivated at the prospects of cheaper steel. But when the Karnataka mining scam forced the Supreme Court to react, it switched to the other extreme and stopped mining in all but 2 mines, and ordered open auction disregarding the existing supply contracts. Hence, companies like JSW Steel without their own captive mines, suffered the most and saw lower capacity utilization. Of course, the Govt policy of not challenging the SC order, played a role in this, but again it was in no position to do so.

Takeaway: When the inputs/outputs are strongly regulated by the state, there is a case to embedd this discount into the stock, because one does not know what will happen next in this political environment.

Selectively picking court orders to inflate profits-some examples

Indian litigation is final only when it reaches the apex court, and is either turned down or dismissed. But till that stage, people can interpret judgements to their convenience, or the assessment whether it will be upheld or dismissed at further courts. Unless the judgement is perverse(evidently wrong on facts/law), it would be apt to pass accounting entries at status quo. But companies often pass entries as per their favoured outcome, thus boosting profits/non cash assets. Below are some examples.

1. Music royalties from FM radio stations to composers/lyricists:- Indian Performing Right Society (IPRS)  collected royalties on behalf of music composers and lyricists.  But between June-July 2011, the Delhi & Mumbai High courts held that the collection had no legal basis. Both HCs stayed the judgement till September 30, to permit IPRS to appeal for a stay in the Supreme Court. That means the judgement has no legal effect till that date, and may not continue if the Supreme Court agrees with IPRS and grants a stay. Naturally, FM radio channels who had paid the royalties till date were pleased. One of them, Reliance Broadcast Network promptly obtained a legal opinion and decided not only to avoid paying future dues, but also claim refund of the Rs 8.79 crores paid till date. They credited that amount to the accounts, assuming that they would get back those proceeds.  That is indeed jumping the gun, and premature, because even if IPRS loses in the SC, it would be difficult to recover payments made under a mistake of law. 
2. State Advisory Prices(SAP) for sugar procurement in UP:- An annual charade is played out where the UP Govt fixes SAP much above the Centrally advised MSP(minimum support price). Sugar mills do not want to pay that SAP, and thus approach the HC for stays, which is granted if the mills pay farmers at the SAP pending resolution of the case. Cash outflows happen at higher level, but sugar mills account it at the lower MSP, assuming they would win the case, which is doubtful.
3. Stayed cess/state taxes:- States periodically impose water cess, electricity duty etc which the user industries naturally dislike. They then waste 3-4yrs at the HC/SC level and end up paying the cess with interest, but till then avoid booking those expenses in their books. Of late, to sanctify this practice, an industry association is roped in to file the suit, so that companies can claim to be following an industry practice. 

Takeaway:- As an investor, be aware of such legal risk, especially if the amounts at stake are high. An example of RNRL should warn even the casual investor, how legal risk can destroy the economics of a company. Even if orders do not destroy the company, adverse outcomes may still erode the share price, with no advance warning(orders usually are not leaked in India!). 

So why do corporates hate jury trials/court processes?

Right from an employment contract to an ISDA agreement, two standard clauses leaps out at you 'waiver of jury trial', and 'arbitration clause'. That dashes any hopes of staging 'The Runaway Jury' type Grishamseque trials, and wheedling out millions of filthy lucre for any supposed offenses. From the corporate's point, you cannot fault it. Typically, their counterparties would be less sophisticated(individuals or SMEs or even other interbank parties at times), and would evoke more sympathy from a jury of their peers. Though one signs away the right to challenge the fairness of contracts etc, when the interpretation of law enters grey areas; when the issue comes about discretionary/punitive damages and emotions come into play, then juries can even ignore the 'true intent' of law and instead apply common commonsensical principles.

The famous Nanavati murder trial in India(1950s) is a classic case where despite a confession, the jury found the decorated naval officer not guilty by way of insanity of murdering his wife's lover. That case(where the jury verdict was declared a mistrial) led to abolition of jury trials, and now common law systems like India rarely have them. Modern corporates have learned at considerable expense(ask any tobacco company!) about how much juries may feel for the underdog. And now judicial activism(judges bend the legal interpretation to achieve their own version of social good over legal correctitude)  is plaguing countries like India. So now, arbitration is the in thing, specially to decide over technical matters/highly specialized issues like construction, finance etc. The advantage of this for frequent users is that the arbitrator(like an auditor) is beholden to the corporates for his appointment, so he may take their side in case of ambiguity. Also, the verdict(called 'award') of the arbitrator cannot be easily struck down for technical grounds(like alternate view possible etc).

High legal costs in the court system are not the only demerits of going to court. The (un)welcome publicity, disclosure of information, interrogation of key executives etc accompanying it; all these are good reasons to avoid court. That is why 'out of court' settlements are quite common, specially where the lawsuit may carry a reputation risk  as in most financial sector related lawsuits.

How Regulation impacts the Indian sugar industry

This series aims to explore how regulation significantly impacts industry prospects and what investors should know before taking positions on stocks in the industry. After all, in many of these industries, changes occur at sea change and before getting seduced by analyst reports, the investors should not lose track of reality. 

The first industry covered is sugar. An annual drama is enacted involving global scenario(Brazil rainfall, global demand), cane recovery rates(% of sugar obtained from crushing 1 quintal of cane-around 8%-12%), procurement price(Union Govt 'Fair and Remunerative Price' or State Govt 'State Advisory Price') and export/import policy. When there is an uptrend, investors are asked to buy stating stocking position etc but on downtrend still people point to low valuations(P/BV, dividend yield etc) to recommend 'buy'!!  Before analyzing the merits of these positions, we should realize that there is no free market at all in this industry.

1. On the buy side, state Government decides at what price sugarcane will be produced and what will be the area from which sugarcane will be procured. However, these areas are often violated by both farmers and mills. 
2. On the sell side, Central Government decides the quantity of sugar that each sugar mill will sell every month. 
3. The situation is complicated by the requirement that industry must subsidize the sale of sugar in public Distribution system(PDS). 10% of production of every sugar mill is required to be offered for PDS at significantly below cost of production. 
4. There is neither scope for smart buying nor scope for smart selling. Also, the commodity futures market has experienced suspensions in this commodity and is uncertain. 
5. This being an 'essential commodity', exports are often capped. The high prices paid by the customer often end up as 'super normal profits' of retailers-not the mills or farmers. 

Given all this, sugar perhaps remains the only regulated industry in the Country whose fortunes can significantly fluctuate as per the regulatory policies. To be fair, mills are doing all they can to reduce dependence on these vagaries like

1. Recycling their waste into energy(co-production), byproducts(industrial alcohol etc) or building materials production. Like how Jindal Steel had diversified into power and spun off the SPV, the next big trigger for sugar mills could be launch into power. While the cap on power trading margins(few paise) deters super profits like Rs 13-14/unit rate, profits can still be made here. Also, these projects could accrue carbon credits(doubtful now but still may be extended beyond 2011) 
2. Improving their own production efficiencies and helping farmers improve yield