SECURITIES AND EXCHANGE BOARD OF INDIA

Plan of Actions for Compliance To Eight New IOSCO Objectives and Principles of Securities Regulation

1.0. Objective 1.1. This memorandum seeks to place before the Board certain proposals in respect of implementation of the eight newly inserted IOSCO objectives and principles of securities regulations.

2.0. Background 2.1. Post global financial crisis in October 2008, the Group of 20 Countries (G20) which also includes India, held discussions to enhance their co-operation and work together to restore global growth and achieve needed reforms in the worlds financial system. 2.2 During the Washington Summit of G20, an action plan to implement Common Principles for Reform of Financial Markets was prepared to strengthen transparency and accountability, enhance sound regulation, promote integrity in financial markets, reinforce international co-operation and reform international financial institutions. The action points required, inter alia, that appropriate bodies should review the differentiated nature of regulation in the banking, securities, and insurance sectors and provide a report outlining the issues and making recommendations on needed improvements. A review of the scope of financial regulation, with a special emphasis on institutions, instruments, and markets that are currently unregulated, along with ensuring that all systemically-important instituions are appropriately regulated, should also be undertaken. 2.3. In January 2010, the Joint Forum, comprised of the Basel Committee on Banking Supervision (BCBS), the International Assosciation of Insurance Page 1 of 34

Supervisors (IAIS) and the International Organization of Securities Commissions (IOSCO), published its report on the Differentiated Nature and Scope of Financial Regulation. The report, inter alia, recommended that the core principles for these three sectors be reviewed and revised to ensure that they appropriately take into account systemic risk and the overall stability of the financial system. It recommended that the core principles be made more consistent across sectors and that common cross-sectoral standards be developed as appropriate to reduce regulatory arbitrage. 2.4. IOSCOs Executive Committee charged its Implementation Task Force (ITF) to revise the IOSCO Priciples to take into account the emerging consensus regarding regulatory concerns that the crisis raises. In the 35th Annual Conference of IOSCO on June 10, 2010, the Presidents Committee approved revised IOSCO Principles, which include eight new principles. Objectives and principles of Securities Regulation consisting of 38 principles of Securities Regulation (including the 8 new principles) are based upon three objectives of Securities Regulation; protecting investors, ensuring that markets are fair, efficient and transparent, reducing systemic risk. The detailed assessment methodology in respect of these principles are being finalised by Implnenation Task Force(ITF) of IOSCO. 2.5. The newly included eight IOSCO objectives and principles of securities regulation are as follows: (i) Principle 6: The Regulator should have or contribute to a process to monitor, mitigate and manage systemic risk, appropriate to its mandate. (ii) Principle 7: The Regulator should have or contribute to a process to review the perimeter of regulation regularly.

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(iii) Principle 8: The Regulator should seek to ensure that conflicts of interest and misalignment of incentives are avoided, eliminated, disclosed or otherwise managed. (iv) Principle 19 & 20: Auditors should be subject to adequate levels of oversight by an authority that is independent of the audit profession. Auditors should be independent of the issuing entity that they audit. SEBI should have mechanism for enforcing compliance with auditing standards by the auditors of listed companies. (v) Principle 22: Credit Rating Agencies (CRAs) should be subject to adequate levels of oversight. The regulatory system should ensure that credit rating agencies whose ratings are used for regulatory purposes are subject to registration and ongoing supervision. (vi) Principle 23: Other entities that offer investors analytical or evaluative services should be subject to oversight and regulation appropriate to the impact their activities have on the market or the degree to which the regulatory system relies on them. (vii) Principle 28: Regulation should ensure that hedge funds and/or hedge funds managers/advisers are subject to appropriate oversight.

3.0. FSAP 2011 3.1. Under the G20 summit, Financial Stability Board (FSB) members have committed to pursue the maintenance of financial stability, enhance the openness and transparency of the financial sector, implement international financial standards and agree to undergo periodic peer reviews, using among other evidence IMF / World Bank FSAP (Financial Sector Assessment Program) reports and publishing the results of these assessments. Under the FSB Framework for Strengthening Adherence to International Standards, published in January 2010, FSB member Page 3 of 34

jurisdictions have committed to undergo assessment under the IMF-World Bank FSAP every five years. Based on the schedule of recently completed FSAPs, Italy, Mexico and Spain underwent a country peer review in 2010. 3.2. The FSAP in respect of securities market in India was conducted in 2001. Another review has been done recently in 2006-08 under the self assessment of Indias financial sectora comprehensive health check-up of the countrys financial sectorcarried out by the Committee on Financial Sector Assessment (CFSA) set up by the Government of India and the Reserve Bank in September 2006. The committee published six volume reports in March 2009. This assessment process was based on three, mutually reinforcing pillars: Pillar I (Financial stability assessment and stress testing), Pillar II (issues relating to the institutional and legal infrastructure) and Pillar III (assessment of financial standards and codes). Under the third pillar, SEBI had prepared the assessment of adherence to the earlier Thirty IOSCO Objectives and Principles of Securities Regulation. To make this self-assessment objective and unbiased, assessments were made by four independent Advisory Panels and the advisory panel reports were also peer reviewed by reputed international experts in the field. In case of securities markets, it was peer reviewed by Singapore and Malaysia. 3.3. As a member of the FSB, India is committed for assessment of adherence to global regulatory standards. Government of India, in May 2010 had written to the International Monetary Fund (IMF) and the World Bank (WB) indicating Indias intention to undertake full-fledged Financial Sector assessment Programme (FSAP) evaluation. In response, IMF and WB are making FSAP evaluation for India during June-October 2011.

4.0. Self-Assessment 4.1. In the past, assessment with respect to earlier thirty IOSCO objectives and principle of regulations have been undertaken by SEBI from time to time. Steps have been taken towards compliance to these thirty principles. Page 4 of 34

According to CFSA exercise, of the 30 earlier IOSCO objectives and principles of regulations, India fully comply with 20 principles, broadly comply with 8 principles and partially comply with 2 principles. 4.2. In the absence of assessment methodology, the FSAP team would not be assessing these eight new IOSCO principles with a rating though they would be discussed. It will be desirable to initiate appropriate steps towards implementation of the eight new IOSCO Objectives and Principles of securities regulations. 4.3. In view of this, a self-assessment has been undertaken with respect of the eight new IOSCO objectives and principles of regulations to identify gaps in respect of these eight new principles to identify steps need to be initiated to comply with these principles. The assessment of these principles for Indian securities market and proposed road map in respect of implementing each of these eight new IOSCO principles appears at Annex I.

5.0. Policy Recommendations 5.1. Following policy recommendations emerge out of the self-assessment in respect of these eight new principles in order to make the regulatory framework for Indian securities markets comply to eight new IOSCO objectives and principles of regulations: (i) Set up Systemic Stability Unit (SSU) in SEBI to assess systemic risks, if any, emanating from securities market and offer co-ordinated assistance/ inputs from SEBI to Financial Sector Development Council (FSDC) in monitoring Systemic Risks in respect of Securities Market and monitoring of Systemically Important Financial Institutions under the jurisdiction of SEBI. (ii) Set up an inter-departmental regulations review committee to review gaps, to meet relevant global standards, deal with over regulation, Page 5 of 34

repeal unnecessary regulations, update outdated regulations, simplify procedures, undertake assessment of overall costs to stakeholders, etc., for seeking legislative amendments to securities laws and regulations, etc. (iii) Guidelines may be prescribed for dealing with Conflicts of Interests of Associated Persons in Securities Market. (iv) SEBI may write to the Govt. of India pointing out the gap and possible solutions and requesting the Government that registration/ authorization and oversight of auditors in India should be done by an authority that is independent of audit profession, audit work should be conducted pursuant to well-defined, high and internationally acceptable standards and that there should be mechanisms for enforcing compliance with auditing standards. (v) Entities offering to investors analytical or evaluation services such as Research Analyst and Investment Advisors should be subjected to appropriate oversight and regulation. Therefore, SEBI may regulate research analysts. (vi) SEBI has laid down comprehensive framework for registration and regulation of credit rating agencies (CRAs) and also to address conflicts which may arise in the activities of CRAs. However, as the area of CRA regulations is undergoing changes in the developed countries too, SEBI may keep an intent watch on both international and domestic developments and revisit CRA regulations from time to time to address any emerging issues in connection with role of CRAs and the risks they may pose to the market. (vii) At present there is no exclusive regulatory framework to regulate hedge funds, private equity funds, etc. Investors in private pools of capital such as hedge funds and private equity funds need not be Page 6 of 34

protected from the risks of financial strategies they have agreed to. But they need to be protected from mismanagement, fraud, criminal negligence etc. IOSCO in October 2010 came out with a report to address Private Equity Conflict of Interests. There may be a clear regulatory framework for such private pools of capital which may interalia provide for a mechanism to monitor and assess systemic risks and risks to financial market stability posed by the activities of such funds.

6.0. Proposal 6.1. Board may like to take note of these recommendations and may like to authorize the Chairman to take necessary actions as deemed appropriate for implementation of eight new IOSCO objectives and principles of securities regulations. Separate approval of the Board would be sought for modification/ amendments of existing regulations and for issuing new regulations to implement above recommendations.

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Annex I

Principle 6: The Regulator should have or contribute to a process to monitor, mitigate and manage systemic risk, appropriate to its mandate. Systemic risk refers to the potential that an event, action, or series of events or actions will have a widespread adverse effect on the financial system. Syetemic risk not only has the potential to harm a large number of investors and market participants, but it can also have a widespread negative effect on the overall economy. Reducing systemic risk is one of the objectives of securities regulation. Factors which can give rise to systemic risk may include the design, distribution, or behavior under stressed conditions of certain investment products, the activities or failure of a regulated entity; a market disruption; or an impairment of a markets integrity. Systemic risk is not limited to sudden catastrophic events; it can also take the form of a more gradual erosion of market trust caused by inadequate investor protection standards, lax enforcement, insufficient disclosure requirements, inadequate resolution regimes or other factors. To address these issues, this IOSCO principle states that regulator should have or contribute to a process to monitor, mitigate and manage systemic risk appropriate to its mandate.

Extant Framework The extant framework in Indian securities markets for monitoring and mitigation of various types of risks such as market risks, operational risks, credit risks, systemic risks, etc., includes: o Financial Stability and Development Council (FSDC) which has been established vide notification dated 30-12-2010 monitors macro prudential supervision of the economy, including the functioning of large financial conglomerates, address inter-regulatory co-ordination issues;

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o Monitoring of Systemically Important Financial Institutions (SIFIs) by a Committee having representation of RBI, SEBI and IRDA; o Clearing and settlement of trades on equity and Future & Options segment of exchanges through clearing corporation/ clearing house backed by Settlement Guarantee Fund (SGF) to ensure that failure of market participants do not lead to market disruption; o Regulations, minimum capital norms, exposure/concentration limits for intermediaries setting initial and ongoing norms for credit and market risk containment (exclusive directives on operation risk management are yet to be prescribed in Indian securities market); o Integrated Market Surveillance System (IMSS) to monitor and take appropriate action on abnormal trades, possible price/market manipulation, trade concentration, etc.; o A well tested and regulated repository of investors holdings by depositories with robust disaster recovery provisions in place. SEBI is also setting up a Business Intelligence and Data Warehousing (BI&DW) Project to further strengthen its infrastructure for monitoring and identifying any abnormal trend/ pattern in the market and take timely action to mitigate risks likely from any such abnormal patterns. SEBI is putting in place a unified regulatory filing system for all listed companies and market entities in a standardized format to enable dissemination of information on real time basis. The XBRL technology-based system will help in monitoring the affairs of market intermediaries and listed companies.

Gaps These actions as described above are taken by various departments. However, there is no one single unit where an overall view is taken. Further there is an emphasis on conducting stress test of market infrastructure etc. Conducting stress test is a specialized activity requiring high degree of expertise. There is no such unit in existence in SEBI.

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Steps taken by other regulators In USA, the Securities and Exchange Commission (SEC) has set up a Division of Risk, Strategy, and Financial Innovation in September 2009 for risk and economic analysis; strategic research; and financial innovation. The new division combines the Office of Economic Analysis (OEA), the Office of Risk Assessment (ORA), and other functions to provide the Commission with sophisticated analysis that integrates economic, financial, and legal disciplines. This division of SEC, apart from performing the previous mandates of OEA and ORA, is also mandated to: (i) perform strategic and long-term analysis; (ii) identify new developments and trends in financial markets and systemic risk; (3) make recommendations as to how these new developments and trends affect the Commission's regulatory activities; (4) conduct research and analysis in furtherance and support of the functions of the Commission and its divisions and offices; and (5) provide training on new developments and trends and other matters. This division of SEC, therefore, is helping to bore through the silos that for too long have been compartmentalized. The Reserve bank of India (RBI) constituted a Financial Stability Unit (FSU) in July 2009, drawing upon inter-disciplinary expertise from supervisory, regulatory, statistics, economics and financial markets departments. FSU is mandated by RBI to conduct macro-prudential surveillance of the financial system on an ongoing basis; prepare financial stability reports; develop a database of key variables which could impact financial stability, in co-ordination with the supervisory wings of the Reserve Bank; develop a time series of a core set of financial indicators; conduct systemic stress tests to assess resilience; develop models for assessing financial stability and to provide the Secretariat to the Banks representative in the Financial Stability Board (FSB).

Recommendations A Systemic Stability Unit (SSU) may be set up in SEBI in order to have a holistic approach towards regular monitoring and mitigation of systemic risks likely to emanate from securities markets drawing upon the developments in SEC and RBI towards more focused approach to systemic risk management, and to offer Page 10 of 34

co-ordinated assistance/ inputs from SEBI to FSDC in monitoring Systemic Risks in respect of Securities Market and monitoring of Systemically Important Financial Institutions, if any, under the jurisdiction of SEBI. Accordingly, the SSU may be mandated to: Identify and collect systemic risk information through a template for regular review to identify, assess & mitigate emerging systemic risks; (ii) Develop a time series of core set of securities market indicators having bearing on systemic stability of financial market; (iii) Conduct stress test of systemically important institutions in securities market to assess resilience; (iv) Conduct research relating to Systemic Issues in securities market viz., ownership structure; leverage; inter-connectedness of market segments; risk concentration; behavior under stressed conditions; unregulated products/markets/entities, etc. and recommend regulations to manage systemic risk; (v) Prepare periodic Systemic Stability Report in respect of securities market in India; (vi) Mandate risk assessment methodologies to relevant market participants for their self-assessment and reporting to SEBI; (vii) Co-ordinate with and provide assistance to FSDC/FSB/ Standing Committee (SC7) of IOSCO on issues pertaining to financial stability, macro prudential regulation and supervision. Establishment of an SSU in SEBI would facilitate centralized assessment of systemic risks in securities market by SEBI. Having an exclusive unit like SSU as an interface from SEBI to other regulators and FSDC would further facilitate the inter-regulatory coordination mechanism from SEBI. The intention behind this proposed SSU in SEBI is to complement, and, not in any way to substitute, the efforts being made by other financial market regulators/ authorities within their respective jurisdiction to monitor and mitigate systemic risks. *** Page 11 of 34

(i)

Principle 7: The Regulator should have or contribute to a process to review the perimeter of regulation regularly. In the lead upto the financial crisis in 2008, the limited scope of regulation and market discipline appears to have led to complex securitized and leveraged products without proper mechanism to monitor the nature and extent of risks they posed to the market. Financial crisis over the past sometimes have involved entities or activities that, for a variety of reasons, were not regulated. Further, the interplay between regulated and unregulated entities was one of the major causes of recent financial crisis. Accordingly, the G-20 has called for a review of the scope of financial regulation. The November 15, 2008 communiqu referred to a special emphasis on institutions, instruments and markets that are currently unregulated, along with ensuring that all systemically important institutions are appropriately regulated. Therefore, reviewing the regulations within its extant perimeter alone will not be enough to address the constantly evolving market dynamics. Regulators will have to keep revisiting the perimeter of existing regulation to deal with risks posed to the system by participants or products or markets hithereto not within the perimeter of extant regulatory jurisdictions. Similarly, regulation could be considered for financial products that may be particularly complex and prone to informational asymmetries, especially if they have systemic importance or if the users of these instruments are so dispersed as to fall outside the existing perimeter. Examples of such products in the context of recent financial crisis are systemic risks posed by collateralized debt instruments and credit default swaps.

Extant Framework There are various advisory committees that look into issues pertaining to primary market, secondary market, mutual funds, debt market etc.

Gaps There is a need to have a mechanism by which market participants, investors and regulators systematically undertake to review various products, institutions, Page 12 of 34

market or participants that need to be brought into the perimeter of regulations. In order to provide regular inputs to this committee, it will also be necessary to have an internal committee within SEBI.

Recommendations One of the priorities in the regulatory reform suggested by IMF post crisis was Expanding the perimeter of financial sector surveillance to ensure that the systemic risks posed by unregulated or less regulated financial sector segments are addressed. In this context, following institutional mechanisms may be put in place by SEBI: An inter-departmental regulations review committee chaired by a WTM with Executive Directors as members to make rigorous and regular review of rules and regulations in Indian securities markets to: (i) (ii) (iii) Identify gaps and comply with relevant global standards; Consider the extent to which current regulation adequately addresses investor protection, fair, efficient and transparent markets; Consider the degree to which existing regulations are outmoded or no longer necessary or the degree to which they should be modified to take into account new market developments ; (iv) (v) (vi) Whether regulatory premises underlying any existing regulatory exemptions continue to be valid; Undertake assessment of overall costs to stakeholders;, Seek legislative amendments to securities laws and regulations, etc. *** Principle 8: The Regulator should seek to ensure that conflicts of interest and misalignment of incentives are avoided, eliminated, disclosed or otherwise managed. Potential conflicts of interest are inherent in all economic activities where each of the rational counterparties to an economic transaction tries to maximize its Page 13 of 34

benefit. Such conflicts tend to be more in the case of financial transactions which arises on account of the dual principal-agent role of market intermediaries, information asymmetry, imperfect alignment of incentives in the principal agent relationship of intermediaries, of their employees, etc. As indicated in the Report of the Working Group on Conflicts of Interest in the Financial Sector by RBI, the major source of conflicts of interests in Indian financial sector are: (i) The closely held structures of Indian corporates both in the public and private sectors, inhibits implementing robust corporate governance practices; (ii) Multiple layering of principal-agent chains, weak accountability chain and cross-holding among Public Sector Enterprises (PSEs); (iii) Domination of governance of Indian corporations by promoters; and (iv) Tunneling / diversion between firms in business groups, following the lines of ownership, flowing from firms near the bottom of the pyramid (where the ultimate owners cash flow rights are weak) to firms near the top of the pyramid (where the ultimate owners cash flow rights are strong); represents exploitation of material and pecuniary conflicts of interest, to the detriment of especially the minority shareholders and other stakeholders, in general. As far as securities market is concerned, conflicts of interest arise where market participants entrusted to act in the interests of clients/ investors use their authority or information to instead advance their own interest by means of bad financial advise, inappropriate margin lending, misleading disclosure and reporting, front running, front loading, etc. Conflicts of interest also arise in the case of stock exchanges in their dual role as self regulatory organization (SRO) and commercial business entities. For example the business interest of an exchange may prompt an exchange to turn a blind eye to a broker churning their clients accounts as higher volumes means greater income for the exchange.

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IOSCO has developed guidelines for Regulation of Conflicts of Interest facing Market Intermediaries vide report dated November 2010. As per IOSCO, the most significant type of conflicts of interest faced by jurisdictions include (i) using non public insider information obtained in the course of business; (ii) front-running; (iii) churning; (iv) cherry picking (method that reduces the amount of time required for researching stocks as the pool of securities in which investors pick from is significantly narrowed based on their past performance); (v) unfair treatment among investors and (vi) unfair practices in analysis report preparation and distribution. With growth in the economy, capital market has been increasing in importance both as a source of funds for corporates and as investment destination for investors. As a result the market size is expanding, number and role of intermediaries including retail agents like financial advisors and investment agents are increasing. In this context, SEBI has been exploring for a while the possibilities of alternative models of regulation through Self Regulations to be able to regulate a large and diverse capital market. Self regulation itself is a glaring source of conflict of interest. Therefore, SEBI needs to have a strong mechanism to address both present and future conflicts of interests in securities market.

Extant Framework To deal with conflicts of interests in securities market, SEBI has prescribed codes of conduct for intermediaries. As per these codes of conduct, intermediaries are required to observe high standards of integrity, exercise due diligence and fairness in the conduct of their business; shall make all efforts to protect the interest of investors; shall not to use any unethical means to sell, market or induce any investors to buy any unsuitable investment; advise to clients, if any, should be made only on the basis of supporting facts. Intermediaries are also required to avoid and if not possible, to disclose to the clients, possible sources of conflict of duties and interests. Violation of these codes of conduct amount to violation of the regulations and such violations are subject to penal action by Page 15 of 34

SEBI. SEBI has made insider trading regulations which seek to prohibit insider and deemed insider such as intermediary not to deal in securities based on unpublished information. SEBI (FUTP) regulations seek to prohibit unfair practices such as front running by intermediaries. Intermediaries are required to put in place system and procedures to avoid conflict of interests such as for prevention of insider trading. Stock exchanges in India have been demutualised and corporatised and their manner of increasing and maintaining public shareholding (MIMPS) are required to SEBI prescribed MIMPS regulations to facilitate better governance and deal with conflicts of interest of recognized stock exchanges. As per the report of the RBI constituted working group on Conflicts of Interests in Financial Markets, SEBI has framed several guidelines which are quite detailed in scope and content with regard to corporate governance practices, disclosures, misuse of position or information available in professional capacity and dealing among associate/group concerns. SEBI has also framed code of conduct for almost all categories of intermediaries-merchant bankers, registrar to an issue and share transfer agents, stock brokers and sub-brokers, credit rating agencies, mutual funds etc., aimed at ensuring that conflicts of interest situations are mitigated effectively.

Gaps Internationally several steps have been taken to deal with conflict of interests in securities segments. For instance, as regards controlling conflicts of interest among stock analysts, the Sarbanes-Oxley Act, 2002 gives powers to Securities and Exchange Commission (SEC) to control their activities. The European Union (EU) has issued the market abuse directive, revised investment services directive and has set up a Forum Group on Financial Analysts to frame recommendations on the best regulatory and market practice framework for financial analysts. As regards financial conglomerates, in USA the SEC has further fine-tuned its consolidated supervised entity rules, while EU has enacted the Financial Conglomerates Directive in Jan 2005, to tackle emerging conflicts of interest situations. Page 16 of 34

In this context, though issues relating to conflict of interests in securities industry are being adequately addressed though the SEBI prescribed code of conduct for intermediaries, regulations on insider trading and regulations on fraudulent and unfair trade practices, there is no exclusive guideline to identify and deal with conflict of interests by associated persons in securities market such as research analysts, investment advisors, employees of market intermediaries, etc. which are not registered and regulated by SEBI at present. The absence of a general and comprehensive principle to deal with conflict of interests by such associated persons pose regulatory gaps as far as management and mitigation of possible conflicts of interest that may arise in their activities in securities market.

Recommendations In order to have a framework to deal with conflicts of interests by all participants in Indian securities market, associated persons, investment vehicles, collective pools of capital, institutional investors, stock exchanges etc, SEBI may prescribe a Guidelines For Dealing With Conflicts of Interest in Securities Market. These guidelines for dealing with conflicts of interests in securities market should adequately focus on active involvement of senior management of market participants; adoption of clear and concise policies; adequate disclosures; information barriers; effective procedures; remuneration to commensurate the activities; maintaining record of activities; specific prohibitions, etc. *** Principle 19 & 20: Auditors should be subject to adequate levels of oversight. Auditors should be independent of the issuing entity that they audit. The fundamental duty of an auditor is to verify accounting data and determine the accuracy and reliability of accounting statements and reports. However, over time the role of auditor in ensuring fair play among stakeholders of an economic entity is becoming more and more important. The role of the auditor has evolved from examination of financial transactions to evaluation of management practices. With the advent of technology, demand for more and more information Page 17 of 34

by stakeholders about an economic entity is increasing. As a result, a shift in audit focus from management to governance is being felt strongly in recent years. So the auditors role has evovled from an auditor to an watchdog and is now fast transforming into that of the role of of a first level refree and whitstle blower at appropriate time. In this context, the auditor is required to conduct an independent review of the financial statements and offer an opinion as to whether the annual accounts give a true and fair view of the companys state of affairs and financial position and bring to the notice of its stake holders any wrong doing. To achieve this goal, auditors not only look to be independent, but they should actually be independent. Conflicts of interest may also arise from high audit fee, auditor providing consultancy service to the company, relation of auditors with top management, etc. To deal with these there should be adequate level of oversight. Effective oversight of the accounting profession is critical to the reliability and integrity of the financial reporting process and helps reduce the risks of financial reporting and auditing failures in the public securities market. The ultimate purpose of such oversight is to protect the interest of investors and further the public interest in the preparation of informative, fair and independent audit reports. There are benefits to an auditor oversight system that is not based exclusively or predominantly on self-regulation. Auditors should be subject to oversight by a body that acts and is seen to act in the public interest. Regulation should among other things seek to ensure; 1. 2. 3. 4. Audit work is concluded pursuant to well-defined, high and internationally acceptable standards; Rules are designed to ensure the independence of the auditor; There are mechanisms for enforcing compliance with auditing standards; and Objectivity of audits.

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Extant Framework Institute of Chartered Accountants of India (ICAI) regulates accounting/ auditing professions under the Chartered Accountant (CA) Act, 1949. ICAI is licensing cum regulating body of the audit and accounting profession in India. The audit of a company is carried out in terms of the provisions laid down in sections 224 to 227 of the Companies Act, 1956. Only a member of the ICAI who holds a certificate of practice can act as an auditor of a company. Sec.226 of the said Act lays down requirements aimed at ensuring and protecting the independence of auditors and disqualifies certain persons from appointment as auditors of a company. Sec.227 of the Companies Act, 1956 prescribes the Duty and Liability of the Auditor. Other provisions contained under the Companies Act, 1956 viz., section 324, 325, 326, 314 and provisions contained under the CA Act. 1949, CA Regulations, 1988 and under the Code of Ethics prescribed for CAs address independence of auditors and provide safeguard for independence of auditors. Section 233 of the Companies Act imposes a penalty on the auditors if there is a willful negligence and default on their part. Corporate governance norms for listed companies under clause 49 of listing agreement inter alia provides for independent Audit Committee. The ICAI has in place a system of peer review of audit firms done under the aegis of the Peer Review Board of the ICAI, established in April, 2002. Central Government (CG) in June 2007 constituted an independent Quality Review Board u/s. 28A of CA Act to review quality of services provided by CAs, guide the members in improving quality of service etc. A member of ICAI is subject to its disciplinary jurisdiction. The CA Act, 1949 gives authority to the Central Council of ICAI to enquire into cases of professional or other misconduct on the part of members of ICAI and to take disciplinary action.

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The Act, as amended by the Amendment Act of 2006, provides for the constitution of the Board of Discipline consisting of a presiding officer who has knowledge of disciplinary matters and of the profession and of two members, one of whom shall be a member of the central council and the other a person to be nominated by the CG out of persons of experience having eminence in the field of law, economics, business, finance or accountancy. complaints which fall under the First Schedule to the Act. There is also a disciplinary committee which consists of the President or VicePresident of ICAI as the presiding officer and of two members who are members of the Central Council of ICAI and two members to be nominated by the CG from amongst persons of eminence having experience in the field or accounting. The Disciplinary Committee looks into the complaints against members falling under both the First Schedule as well as Second Schedule to the CA Act, 1949. Gaps Recent developments in high profile cases have shown that in the present structure there is no proper oversight of auditors. In USA, the Sarbanes- Oxley Act,2002, has transferred regulations of accounting to a independent and not for profit body the Public Company Accounting Oversight Board (PCAOB) making the audit standards prescribed by the American Institute of Certified Public Accountants (AICPA), the trade body of accounts in USA, redundant and reducing it to a mere membership organization of auditors. Post the Sarbanes- Oxley Act,2002, SEC also has power to censure accountants (and other professionals), and to suspend or bar them from the privilege of appearing or practicing before the Commission, if it finds that they engaged in improper professional conduct. As per the IOSCO norms auditors should be subjected to the discipline of an auditor oversight body that is independent of the audit profession, or, if the professional body acts as the oversight body, is overseen by an independent body. Page 20 of 34 The Board looks into

Recommendations 1. 2. Auditors should be independent and overseen by an authority independent of profession. SEBI should have mechanism for enforcing compliance with auditing standards by the auditors of listed companies; It may be required to benchmark the operation and oversight of audit profession and accounting standards in India to the Principles 19, 20 (and also existing principle 21) relating to oversight and independence of auditors, and audit standards. SEBI may write to the Govt. of India pointing out the gaps and possible solutions. ***

Principle 22: Credit rating agencies (CRAs) should be subject to adequate levels of oversight. The regulatory system should ensure that credit rating agencies whose ratings are used for regulatory purposes are subject to registration and ongoing supervision. The IOSCO Statement of Principles Regarding the Activities of Credit Rating Agencies (IOSCO CRA Principles and IOSCO CRA Code) addresses four principles viz. quality and integrity in the rating process; independence and avoidance of conflicts of interest; transparency and timeliness of ratings disclosure; and confidential information. The principle of quality and integrity in the rating process requires CRAs to adopt, implement and enforce measures to ensure that credit ratings are based on a thorough analysis of all available and relevant information and that the information they use in developing credit ratings is of sufficient quality and from reliable sources. As per the principle of independence and avoidance of conflict of interests, CRA should implement transparent procedures designed to identify and eliminate conflicts of interest inherent in its business activities. The third principle transparency and timeliness of ratings disclosure require a CRA to publicly disclose to the market Page 21 of 34

information about the methodologies it uses to determine credit ratings. Another common provision across the jurisdictions is the requirement to disclose statistics and other information about the performance of a CRAs credit ratings. The fourth principle on confidential information requires credit rating agencies to provide the non selective information to the larger public while protecting confidential information obtained from entities being rated so that the information cannot be used for inappropriate purposes (e.g., insider trading).

CRAs in developed market were more or less unregulated before the outbreak of the financial crisis. All along there was demand for a more binding form of selfregulation for CRAs. But as the crisis progressed, a heated debate emerged about the rating process, rating agencies, competition, and liability rules, prompting calls by politicians for greater regulation of CRAs.

Extant Framework In India Credit Rating Agencies (CRAs) in India are registered and regulated under the SEBI (Credit Rating Agency) Regulations, 1999. Now there are five credit agencies registered with SEBI under this regulation. The SEBI regulations for CRAs address the principles suggested by IOSCO in its Statement of Principles Regarding the Activities of Credit Rating Agencies (IOSCO CRA Principles 2003). However, in a dynamic market environment, there is always an ongoing process of re-evaluation of regulatory framework as practical considerations emerge. Accordingly, SEBI has further strengthened its regulations for CRAs recently vide circular dated 3.5.10 mandating various disclosures (rating procedure, default studies, income) measures to deal with conflict of interest, obligations in respect of structural products, unsolicited credit ratings etc. The CRAs has also been mandated to disclose every six month the fees they charge companies for assessing their debt profile and the default rate on their previous ratings; to ensure their analysts do not participate in any marketing and business development, including negotiations of fees with the issuer whose securities they are rating and employees involved in the rating Page 22 of 34

process and their dependents do not own shares of the issuer; to maintain records of the important factors underlying the credit rating and a summary of discussions with all the stakeholders involved, as well as decisions of the rating committee, including voting details and notes of dissent.

Recommendations Reasonable steps have been already taken for ensuring independence and quality of ratings. However, as the area of CRA regulations is undergoing changes in the developed countries too, SEBI may keep an intent watch on both international and domestic developments and revisit CRA regulations from time to time to address any emerging issues in connection with role of CRAs and the risks they may pose to the market. No specific steps need to be taken as we are compliant with this IOSCO principle already. *** Principle 23: Other entities that offer investors analytical or evaluative services should be subject to oversight and regulation appropriate to the impact their activities have on the market or the degree to which the regulatory system relies on them. Timely and accurate information about investment products is an important ingredient for making investment decisions. However, the volume and complexity of information is unlikely to be analyzed and grasped by every lay investor. Here comes the role of investment analysts or investment advisor; an entity who is paid for analyzing information to provide recommendations about investments in securities to their clients. Such advice from investment analysts or advisor is prone to conflicts of interest that may prevent them from offering independent and unbiased opinions. Since the prime objective of financial market regulators is to protect investors and enhance confidence in the market, it is a major concern of oversight authorities to identify and deal with conflicts of interest arising from the production and dissemination of research or advice. The resolution of this Page 23 of 34

issue, along with improved corporate governance standards, is crucial to investor confidence in securities markets. The effort to address potential conflicts of interest affecting the production and dissemination of research by securities firms is truly a global one, with regulators in almost all developed market economies having proposed or implemented new rules for research related conflicts of interest. IOSCO statement of principles for addressing sell-side securities analyst conflicts of interest (2003) has prescribed principles as under: 1. Mechanisms should exist so that analysts trading activities or financial interests do not prejudice their research and recommendations. 2. Mechanisms should exist so that analysts research and recommendations are not prejudiced by the trading activities or financial interests or business relationships of the firms that employ them. 3. Reporting lines for analysts and their compensation arrangements should be structured to eliminate or severely limit actual and potential conflicts of interest. 4. Firms that employ analysts should establish written internal procedures or controls to identify and eliminate, manage or disclose actual and potential conflicts of interest on the part of analysts. 5. The undue influence of issuers, institutional investors and other outside parties upon analysts should be eliminated or managed. 6. Disclosures of actual and potential conflicts of interest should be complete, timely, clear, concise, specific and prominent. 7. Analysts should be held to high integrity standards. 8. Investor education should play an important role in managing analyst conflicts of interest. Regulations for research analysts and research related conflicts of interest in USA aims to address following objectives:

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(i)

Ensure that retail investors understand the various conflicts that may affect the objectivity of research analysts views through enhanced disclosure requirements.

(ii)

substantially reduce the opportunities for conflicts through prescriptive measures by (a) strengthening existing Chinese walls between research and business units in integrated financial services firms; (b) regulating analysts ability to own and trade equities of the firms that they cover; and (c) modifying the incentive structure in integrated financial services firms that may encourage the issuance of biased research.

The European Union has issued directives that deal with research related conflicts of interest. The European Commission has also established a Forum Group on Financial Analysts that examines the need for additional regulations and/or best practices for research analysts in the European context.

Extant Framework Credit rating agencies providing analytical services in financial markets are regulated by SEBI under the SEBI (Credit Rating Agency) Regulations, 1999. Portfolio managers, providing advisory services and managing clients assets and funds are regulated under the Securities and Exchange Board of India (Portfolio Managers) Regulations, 1993. Similarly, in case of investment advice in public media by brokers etc., the brokers, under the code of conduct prescribed for brokers/sub-brokers under the SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, have to disclose their holdings while giving such advice. However, there is no exclusive and comprehensive regulatory framework for entities providing analytical services in India except that analyst has to disclose their holding in a client company and shall not trade in securities of the company whose report he is preparing, for 30 days from preparation of such report.

Gap There is no comprehensive regulatory framework for Research Analysts in securities market.

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Recommendations SEBI may regulate research analysts in Indian securities market through an exclusive and comprehensive regulation. ***

Principle 28: Regulation should ensure that hedge funds and/or hedge funds managers/advisers are subject to appropriate oversight. 1. Hedge Funds are privately offered investment vehicles in which the contributions of the high net worth participants are pooled and invested in a portfolio of securities, commodity futures contracts, or other assets. Investment in hedge funds is largely the preserve of sophisticated investors who possess the required knowledge to assess the risks associated with investing in this asset class. 2. IOSCO has considered as hedge funds all those investment schemes displaying a combination of some of the following characteristics: o borrowing and leverage restrictions, which are typically included in collective investment schemes related regulation, are not applied, and many (but not all) hedge funds use high levels of leverage; o significant performance fees (often in the form of a percentage of profits) are paid to the manager in addition to an annual management fee; o investors are typically permitted to redeem their interests periodically, e.g., quarterly, semi-annually or annually; o often significant own funds are invested by the manager; o derivatives are used, often for speculative purposes, and there is an ability to short sell securities; o more diverse risks or complex underlying products are involved. 3. Due to frequent relocation investments by hedge funds across borders to exploit stock price inefficiencies and the complex investment strategies applied by them, hedge funds can pose systemic risks. The inherent risks Page 26 of 34

relating to the activities of hedge funds and their managers are primarily a result of two factors: Lack of transparency regarding the funds to investors and other market participants such as counterparties and regulators, and conflicts of interest between fund managers profit based incentive structure and other market participants. The main risks to the financial markets from the lack of transparency in hedge funds industry are the possible risk of market abuse and fraud, difficulty in assessing counterparty risk, and market instability. 4. While global concerns on the likely role of hedge funds in the financial crisis continues, for many regulators, the current financial crisis has highlighted the need to have robust regimes to ensure that the inherent risks that hedge funds pose do not affect market confidence and investor protection. 5. As per the findings of the IOSCO Task Force on oversight of hedge funds, there are differences across jurisdiction on the nature and extent of hedge funds oversight. While in a few jurisdictions hedge funds are regulated as any other Collective Investment Scheme (CIS), in certain jurisdiction, where it is believed that institutions investors with better due diligence skill are hedge fund investors, hedge funds have to comply to a code of standards prescribed by the industry body. 6. Post crisis new trends towards a more direct regulatory oversight approach (addressed to the managers and the fund) are emerging in the international community. The G-30 Report recommends that Managers of private pools of capital that employ substantial borrowed funds should be required to register with an appropriate national prudential regulator (.). The prudential regulator of such managers should have authority to require periodic regulatory reports and public disclosures of appropriate information regarding the size, investment style, borrowing, and performance of the funds under management. The G-30 recommendations also deal with the moral hazard issue identified by the FSF in 2000 by stating that Since introduction of even a modest system of registration and regulation can create a false impression of lower investment risk, disclosure, and suitability standards will Page 27 of 34

have to be reevaluated. The G-30 also considers that For funds above a size judged to be potentially systemically significant, the prudential regulator should have authority to establish appropriate standards for capital, liquidity, and risk management. 7. The European Parliament and Council has come out with a proposal for a Directive on Alternative Investment Fund Manager (AIFM)1 such as Hedge Funds, Private Equity Managers, etc. The salient features of the directives are: (i) A legally binding authorization and supervisory regime for all AIFM managing AIF in the European Union, irrespective of the legal domicile of the AIF managed except for AIFM managing portfolios of AIF with less than 100 million of assets or of less than 500 million, in case of AIFM managing only AIF which are not leveraged and which do not grant investors redemption rights during a period of five years following the date of constitution of each AIF. (ii) To operate in the European Union, all AIFM will be required to obtain authorization from the competent authority of their home Member State. (iii) AIFM to provide to their investors, initially and on an ongoing basis, a clear description of the investment policy, including descriptions of the type of assets and the use of leverage; redemption policy in normal and exceptional circumstances; valuation, custody, administration and risk management procedures; and fees, charges and expenses associated with the investment. (iv) Disclosures and reporting to the competent authority on a regular basis.

1AIFMincludesallfundmanagersotherthanthosecoveredundertheDirectivesfortheUndertakingsfor CollectiveInvestmentsinTransferableSecurities(UCITS).

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(v)

Power of competent authority to set leverage limits for AIF to ensure the stability and integrity of the financial system.

(vi) AIFM to issue annual disclosure on the investment strategy and objectives of its fund when acquiring control of companies and general disclosures about the performance of the portfolio company following acquisition of control. (vii) An AIFM authorized in its home Member State will be entitled to market its funds to professional investors on the territory of any Member State. Member States may allow for marketing to retail investors within their territory and may apply additional regulatory safeguards for this purpose. Such requirements shall not discriminate according to the domicile of the AIFM. (viii) To facilitate international cooperation in macro-prudential regulations, the competent authorities of the home Member State will be required to transmit relevant macro-prudential data, in a suitably aggregated format, to public authorities in other Member States. Under the new rules, AIFs will be required to hold more capital and make more disclosures and non-European hedge funds will have to gain a "passport" to operate within the EU. 8. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010, Investment Advisers to private funds including hedge funds and private equity funds are required to register with the SEC unless they qualify for one of the exemptions provided such as advisers to Venture Capital Funds, smaller advisers (advising to private funds with AUM less than 150 million), foreign private fund advisers, family offices etc. All hedge fund and private equity fund advisers that are required to register with the SEC must do so before July 21, 2011, and must be fully compliant with requirements under the Investment Advisers Act of 1940. Such advisers will be required to file

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reports containing such information as SEC deem necessary to protect investors or for the assessment of systemic risk. Even if exempt from SEC registration they will be subject to record-keeping and reporting obligations. They also remain subject to anti-fraud rules and thus to the SECs enforcement authority. 9. The IOSCO Consultation Report on Hedge Funds Oversight (June 2009), the IOSCO Task Force suggests that progress towards a consistent and equivalent approach of regulators to hedge fund managers should be a high priority. The Task Force recommends that regulatory oversight for hedge funds should be risk-based, focused particularly on the systemically important and/or higher risk hedge fund managers. Accordingly, in the updated list of 38 IOSCO objectives and principles of regulations, IOSCO in this principle 28 suggests effective oversight of hedge funds. Although some jurisdictions may regulate hedge funds as CIS, hedge funds should fully comply with these principles: (i) Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration. (ii) Hedge fund managers/advisers which are required to register should also be subjected to appropriate ongoing regulatory requirements relating to organizational and operational standards, conflicts of interest and other conduct of business rules, disclosure to investors and prudential regulation. (iii) Prime brokers and banks which provide funding to hedge funds should be subjected to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds.

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(iv)

Hedge fund managers/advisers and prime brokers should provide to the relevant Regulator information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks).

(v)

Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate.

(vi)

Regulators should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active hedge fund managers/advisers and/or hedge funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders.

10. IOSCO on October 2010 published a report on Private Equity Conflicts of Interests. This report outline principles against which both the industry and regulators can assess the quality of mitigation of conflicts of interests by private equity firms. In these funds, one of the key risks identified by IOSCO is the conflicts of interest among the parties involved in private equity sponsored transactions which can pose risks to fund investors or the effeicienct functioning of financial markets. IOSCO has identified key mitigating factors which may serve to minimise the occurance of conflicts of interest bwtween the private equity firm and its fund investesor, viz. (i) (ii) Compensastion arrangement on the basis of performance related remuneration plus a cost of fund management Negotiated contractual agreement with each individual investors stipilating the material terms and conditions of the fund including the funds structure, its investment strategy, the allocation of fees and costs, Page 31 of 34

allocation

of

investment

opportunities,

any

firm

co-investment

arrangements, the allocation and distribution of profits, the content and frequency of investors reporting; key man and devotion of time provisions, mechanisms for conflict and dispute resolution, etc. (iii) Investors should be disclosed of new investment activitiy, a break down both fund expenses/ income and profit/loss, and a review of the performance of individual portfolio assets, etc. Such disclosure should be clear, fair and not misleading. (iv) Contractual requirement for each fund to maintain an investor advisory committee, comprising a small sample of fund investors. The committees main function is to review the firms approach towards resolving all material fund related conflicts of interest before the firm takes any proposed course of action. The committee should act as a forum for conflict management rather than investment decision making. (v) Establishment of robust and effective information barriers between potentially conflicted business units.

Extant Framework SEBI has laid down regulatory framework for Venture Capital Funds (VCFs). There is no separate regulatory framework for regulating private pool of capital except Venture Capital Funds and Foreign Venture Capital Funds. There seems to be no such funds acting under the name of hedge funds in India. In the absence of full capital account convertibility, offshore hedge funds are unable to do business by offering their products to investors in India. Off-shore hedge funds might be investing in India through Participatory Notes (PNs) issued by SEBI registered FIIs or through the FII sub-account route. There are certain Private Equity Funds registered under VCF regulations and operating as registered VCFs. There is no exclusive oversight mechanism for PE firms and their activities.

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Gaps Hedge funds are recognized as a significant source of liquidity to financial market. At the same time their complex trading strategies and frequent switching of investments pose a threat to market stability. In view of the emerging status of India as an economic power, private pool of capital like hedge funds and private equity funds with both Indian and overseas domicile are likely to increase in due course. Reliable and complete data about the impact of hedge funds, as also other sources of funds, such as private equity on Indian securities markets is going to be important for ensuring market stability. At present, there is no mechanism in place to monitor the investments or activities by hedge funds and private equity funds in Indian market. As such there is no mechanism to regulate the activities of hedge fund and private equity funds or their advisors/ managers. There is also no exclusive regulatory framework to have oversight over the activities of hedge funds and private equity funds which can pose risks to the integrity and confidence in the market. To sum up, in India hedge funds and private equity funds are not recognized as such. However, portfolio managers, venture capital funds and some NBFCs perform hedge fund or private equity fund like businesses in the domain of their own regulations. Such an arrangement only obfuscates the issue.

Recommendations SEBI may evolve a clear framework for dealing with pools of capital with following schemes: (i) Pools where large number of small investors/retail investors need to be protected from all kinds of excessive risks taking including market and credit risk. The regulatory framework for protecting small/retail investors in pools of capital has been provided in SEBI regulations for Mutual Funds/ Collective Investment Schemes where there is detailed norms for structure, disclosures, prudential regulations etc.

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(ii)

Private pools where HNIs invest in significant numbers. They need not be protected from market and credit risk and must be protected from fraud and conflicts of ineterest, etc. There should be a limit on maximum number of investors and the minimum amount of investment in respect of such private pool of capital. The regulatory framework to regulate private pool of capital in this case may, interalia spacify: Registration and reporting requirements Investment conditions and restrictions Minimum fund size Minimum investment Maximum no. of shareholders/partners Minimum investment by Sponsor/Promoter/Partner Maturity Minimum lock in period for investments Liquidation norms upon expiry Liability of Sponsor/manager/partner investments General Obligation, Responsibility, Transparency Default and Procedure for Action No solicitation from retail investors through Prospectus/ Offer Document /Advertisements Solicitation from institutional, professional or High Net-worth Investors through private placement and information memorandum, etc. in case for illiquid

(iii)

Entrusting of funds with large amounts for management on individual basis need to be monitored only from systemic risk point of view. Such fund management may be subjected to regulations such as SEBI Portfolio Managers Regulations with suitable amendments. ****

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