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Financial engineers need accountability

business Updated: May 04, 2007 05:25 IST
Financial engineers need accountability

One man’s law is another man’s loophole. In the world of aggressive business, laws are constraints that need to be addressed in the pursuit of profit and power. Nothing wrong with this as such, if you believe that the four corners of the law are to be seen as limits within which entrepreneurs can flourish. However, there is a problem in this.

Somewhere along the way, we have come across a fancy expression called “financial engineering” which has given rise to brash deal-makers who stitch up contracts and clauses to best suit the interests of their clients, who in turn often laugh their ways to the bank or keep in control of their companies while making others share the financial risk or have bureaucrats splitting hairs and wasting taxpayers’ money.

Take the case of Hutchison Essar, which has been going through a controversy over its foreign stakes. To cut the long story short, part of its foreign equity is actually controlled by overseas entities controlled by India’s own Ruia brothers of the Essar group, while a part of so-called Indian shareholders are tied financially and legally to a structure dictated by Hong Kong investors. Similar deals have become common, where legal flexibilities are worked to suit particular interests. The financial world has already become a bewildering minefield. You have private equity funds, hedge funds, vulture funds jostling for space, attention and market power with old fashioned investment bankers and mutual fund managers.

Instruments including derivatives such as futures and options, electronic real-time trading, and international flows of capital using dubious instruments like participatory notes that are little more than a modern-day “hawala” instruments with flimsy accountability have all added to the complexity of the global financial game.

It is pertinent therefore to look at the whole thing through the eyes of the policy-maker as well as the ordinary shareholder who puts her hard-earned savings into risky financial instruments such as stocks.

Of course, the old rule that small investors should leave things to mutual funds applies in general, but is clear as day to me that investors of whatever kind need to be informed in a language they understand of the complexities involved. The collapse of Enron on Wall Street was a case of how a darling company can suddenly disappear one day in the weight of its own cleverness, while the fall of Barings, a bank associated with British royalty, thanks to rogue trading by a reckless young man called Nick Leeson, is another case in point.

As India tries to become a mature place for equity investors, the Securities and Exchange Board of India (SEBI) has hardly ever punished anyone for insider trading, while reports and rumours of price rigging are as as routine as intriguing share movements. Disclosure norms for even simple profit-and-loss numbers are not standardised, while financial engineers thrive on finding the gaps in the system that are perfectly legal but questionable in letter and spirit.

As India Inc goes overseas for acquisitions, and as commercial borrowings and institutional funding gets savvily structured, there could be concerns in the coming days about the use of instruments such as convertible bonds, preference shares and exchangeable bonds. Each of these have implications for policy-makers as well as shareholders, who may have to face time-bombs if they do not get the information they need at the right time in the right place in the right format.

It is ominous that we have hedge funds and financial engineers in our midst in a corporate system where companies are loathe to even disclose quarterly numbers to their investors. There is a clear case to institutionalise transparent methods if we have to build a prudent culture of investment.

Currently, most of the disclosures that raise questions are buried in the fine-print of Red Herring prospectus documents. Perhaps regulators and shareholder groups should push for disclosures in plain language and in formats that make it all intelligible.