India: Listen up

Two recent regulatory cases in India, one relating to tax and the other auditing, highlight the perils of not listening to market feedback before making policy. 

Regulators worldwide consult stakeholders when they envisage new laws and market rules or seek to amend those already on the books. Public consultations enable policy makers to explain and justify changes while stakeholders provide feedback. When a new regulation or overhaul comes into play, the market is prepared, and the process is afforded legitimacy.

Indian regulators by and large follow this playbook. The Securities and Exchange Board of India (SEBI) and the Ministry of Corporate Affairs (MCA) generally consult and are open to private discussions. They even extend timelines for feedback.

Occasionally, however, regulators go their own way—and it can be messy. Just last month, a disastrous income tax rule which came into being in 2012 without seeking market views was finally rolled back. It followed epic legal losses by the government in battles against telco Vodafone and energy company Cairn Energy for close to a decade.

Yet as officials in the tax department lick their wounds, it seems as if history is about to repeat itself over at the Reserve Bank of India (RBI). In late April 2021, the central bank announced new auditor rotation rules without seeking market feedback. While the outcome is likely to be less catastrophic, the move will do little to improve audit quality or, for that matter, investor confidence.

The taxman always rings twice

In late August, the government finally pulled the plug on a controversial tax law which was more rooted in a fit of pique than fiscal prudence against telco Vodafone. India tax officials had been pursuing Vodafone for capital gains tax over its 2007 stake in local JV partner Essar, arguing that the underlying assets were based in India and therefore the transaction was liable to be taxed.

By 2012, however, the Supreme Court had ruled against the government. Unhappy, it took a second bite at the cherry, passing a legal amendment to allow for capital gains tax to be paid in the Vodafone scenario: where an overseas deal involved assets in India. This would not only apply to future mergers and transactions, but ones that took place up to 50 years previously.

This occurred despite the alarm and avid lobbying of multinationals, international business groups and investors who warned of the potential chilling effect on investment in India. The law was used against 17 entities, including Vodafone and UK-based Cairn Energy, with the government levying taxes of US$14.9 billion. Although only US$1.1 billion was ever collected, mostly from Cairn, the episode damaged India’s image both domestically and internationally.

Vodafone and Cairn brought international arbitrations against the government—and won. When India refused to pay up, Cairn filed suits in nine jurisdictions to seize assets. Finally in August 2021 the government admitted defeat and introduced legislation to roll back retrospective taxes, dropping any demands made before 2012 and reimbursing those collected on condition that the companies withdraw all litigation.

Rotate in haste, repent at leisure

Meanwhile RBI, usually adept at issuing comprehensive consultations, introduced new guidelines on statutory central auditors without any warning at the end of April 2021 and barely a month before they took effect.

Much criticism has been levelled on RBI in recent years for supervision shortcomings and we recognise these guidelines are an attempt to address weaknesses in the system. But the new measures are superficial at best and offer little in the way of long-term solutions for audit quality: something they would have realised if they had given investors and other stakeholders a say.

The guidelines require auditor rotation every three years with no eligibility for reappointment to the same bank for six years. The global best practice is in the region of five to seven years and arguably it takes at least 24 months to get up to speed with a company’s processes, systems and technology. A three-year stint at a public sector bank, where some of India’s most egregious audit lapses have occurred, does not inspire investor confidence.

At best, RBI might prevent auditors and management from cosying up, broaden the auditor pool, and provide more choices to companies. Yet there is limited supply of firms with the ability to audit large financial companies—and the prospect of regular rotation does not incentivise them to build up expertise.

Hope springs eternal

While RBI insists it will not scrap the guidelines, the market holds out hope otherwise and there have been suggestions that if it receives enough pushback, it will consider amending them. 

This was not a simple rule change and RBI must have known there would be strong views one way or another: it will be interesting to see how these guidelines impact the confidence and investor sentiment in the financial sector.  

Some assurance can be had in SEBI’s latest consultation that market views do hold value. In July it sought feedback on a follow-up to its 2019 DVR (differential voting rights or dual-class shares) consultation. New technology companies have yet to avail themselves of the new structure, complaining that the rules are too stringent. 

SEBI issued a straightforward document seeking stakeholder views. The only complaint, one that we have for every consultation issued by Indian regulators, is the timeline given for sending feedback: four weeks is too short.