A long awaited & major change proposed in the Finance Bill 2015, is the merger of law relating to commodity contracts with that of securities contracts. Even the regulatory bodies governing both types of transactions will be merged. Thus, Forward Contracts Regulation Act, 1952 (FCRA) is effectively to be merged with the SEBI Act and Forward Markets Commission to be merged with SEBI. At a first glance, the amendments proposed sound superficial. After all, the definitions of commodity derivatives, commodity contracts, etc. are almost the same under the proposed new scheme, and what is permitted and banned is also similar. So, is it old wine in a new bottle? However, on closer reading, one finds that the changes in law and its implications on commodity trading would be quite significant.
Background
It is interesting to see that SEBI and Securities Laws generally, relatively late-comers to financial markets, saw development in leaps and bounds. Securities Laws developed generally and specifically. Elaborate – perhaps too elaborate in places; law and systems have been put into place. These include regulations, a sophisticated intelligence gathering mechanism, a relatively transparent investigation, adjudicating and enforcement system, etc. In comparison, the law relating to commodity contracts, put into place more than six decades earlier, looked almost ancient. This is despite having huge quantity and volumes in commodity trading.
The turnover on commodity markets is huge, even with the existing relatively rudimentary regulatory structure. The turnover on national commodity exchanges was nearly Rs. 1.80 crore crore during 2013. That is nearly half the turnover on equity markets.
The objective of commodity markets may be different from equity markets. The crop grower, for example, looks up to plan and even hedge his produce, decide what he will produce, what he will sell, when he will sell, what he will store, etc. The buyer too looks at it to decide his output pricing, his product mix, what and how much he will buy and when, how much he will store, etc.
However, perhaps one another reason for the hesitation in making major changes in law was the sensitivity to commodity trading since food crops also happened to be a significant part of commodity trading volumes. Speculation, price manipulation, hoarding, etc, was feared to play havoc to livelihood of farmers and consumers. However, finally, the realisation seems to have sunk in that the answer to that is not keeping hands off, or worse, a relatively poor set of ancient regulations under an ill-equipped regulatory body. The better recourse is to modernise and update the law. Or, as the law makers have chosen, merge it with a body that already has much expertise and infrastructure in a field that is in many ways quite similar to commodity contracts.
The recent massive scam in National Spot Exchange Limited exposed this regulatory gap like never before. What was even more interesting is that many of the players here were also brokers, investors, etc. who operated in the securities markets as well. The practices followed in the spot exchange were also similar. The only difference was that the rules of the game and the regulatory bodies were different. The scam and the subsequent unfolding of facts later showed how inadequate were the law and the systems.
Existing Law
The existing law relating to commodity derivatives was mainly contained in Forward Contracts Regulation Act (FCRA) and rules made thereunder. The governing body is Forward Markets Commission (FMC). FCRA itself has not seen many changes, the last change in 1970 (contrast that with the continuous amendments over the years in SEBI Act). However, significant details are given the Rules, Circulars, Notifications, etc. issued under that Act. Major amendments were sought to be made to give FMC more powers and include several provisions in law that were similar to provisions in Securities Laws. However, the changes could not be finally put in place.
In the existing FCRA, terms like forward contract, ready delivery contract, goods, options, ready delivery contract, etc, are defined. Commodity exchanges regulate the sale and purchase of “goods” and there is a system & criteria for their recognition/registration by the FMC/Central Government. There is a ban/restriction on forward contracts for which the object is to route them through the exchanges. Though drafted in a fairly broad way, there are brief clauses that prohibit making of false statements relating to forward contracts, price manipulation in forward contracts, etc. and provide for their punishment by way of forfeiture, fines and prosecution.
Broadly, the essence and scheme is similar with the Securities Laws such as SEBI Act, Securities Contracts (Regulation) Act (SCRA), and related laws. What is also apparent is the nature of commonality between commodity contracts/derivatives and contracts in securities. The system, the nature of contracts, and even the mathematical sophistication involved in their valuation are quite similar. It makes sense, therefore, that a body having such expertise governs both. The proposal in the 2008/2010 proposed amendments was to create a parallel body and law for commodities that would be quite similar to that under securities laws. Having said that, there are important differences too, warranting special treatment for commodity contracts, which will be discussed later.
Proposals under the Finance Bill, 2015
Part II and III of the Finance Bill, 2015 propose many changes. These are, as will be seen later, merely enabling and do not immediately bring about the change. The changes will come into effect from a date to be notified. The FCRA is sought to be repealed. FMC will be merged with SEBI. The SEBI Act and SCRA will be amended to include certain definitions relating to commodity contracts/ derivatives. Existing commodity markets/associations will become at par with stock exchanges. And so on.
However, it will be a full year before which they will come into effect, and maybe even longer. During this period, SEBI is expected to develop the necessary regulatory base specific to commodity contracts, adapt if needed some of existing law and systems, get the commodity markets/associations change their bye laws and systems to the extent needed similar to existing stock exchanges, etc.
Implications for the law
Clearly, the next one year (and I expect it will be more than a year considering the huge task ahead) would be very busy for SEBI and the commodity regulators/associations. SEBI may appoint one or more Committees to look into the matter and suggest appropriate regulations and/or modification in existing regulations for commodity markets. Model bye laws and similar provisions for commodity markets may be developed and existing commodity associations would be asked to change their bye laws or adapt their existing bye laws, etc. It is possible that considering some specialised aspects of commodity markets, a separate department may be formed.
There are many similarities between commodity contracts and contracts in securities. There are ready delivery contracts for commodities that are treated with less regulations just like spot delivery transactions for securities. The forward contracts and their valuation too have substantial mathematical and structural similarities. Their manipulations too have similarities.
However, there are substantial differences too. Securities are different from commodities in many ways. Commodities are mined, grown, processed, etc. they may have seasonal variation and limited or periodical supplies. they may be renewable or they may be not. they are eventually meant to be usually consumed. Commodities fall into numerous categories and their producers and consumers often fall into very distinct and non-homogenous categories. Many of these differences may eventually need to be reflected into not just the law regulating them but even in the structuring of their contracts. At the same time, considering that most commodities already have a track record of trading and existing well accepted contracts as well as their regulation, the process would not be so much from scratch. In most cases, it may be aligning to a large or small extent the existing contracts and systems into the new scheme. Still the job ahead is large.
The existing regulatory scheme for securities markets are tailor made for capital market operators/intermediaries. there are regulations for companies and listing, intermediaries like brokers/merchant bankers, etc, for mutual funds/alternate investment funds, etc. While there are some lessons to be learnt from these regulations, it is quite clear that commodity market specific regulations would have to be formulated for entities operating there.
Existing regulations for control of malpractices and/or for ensuring fairness are also substantially specific/unique to securities. The takeover regulations for example would have no relevance for commodity markets. the insider trading regulations too may have very little commonality, if at all, with commodity markets (though curiously the earlier Bills did make provisions for insider trading). Similarly, buyback regulations, corporate governance, etc. would not have relevance. however, the regulations relating to unfair, fraudulent, manipulative practices may be quite relevant though it would need substantial adaptation for commodity markets. perhaps relatively sophisticated and directly applicable set of regulations would be the regulations relating to adjudication and punishment of violations. The system for investigation, issuing show cause notices, giving a fair hearing, applying certain well accepted principles for levy of penalty or other adverse actions ought to be substantially and directly applied o commodity markets too. So would the regulations relating to settlement by consent orders and compounding.
Implications for Chartered Accountants and other Professionals
This change offers both a new challenge and opportunity for Chartered accountants. Securities laws have welcomed the services offered by Chartered accountants in several ways. Be it audits, advisory, valuation, inspection and investigation, Chartered accountants have the requisite skills and expertise to provide these services. Commodity contracts and markets are likely to become more developed as well as more complex in laws. CAS will have an active role to play in their audits, in valuation, in tax and advisory, in compliance, reporting, and so on.
Conclusion
One might be tempted to argue that SEBI has not wholly removed malpractices in securities markets, even though it has over the years become very powerful. Insider trading is said to be rampant, price manipulation and scams keep occurring, Satyam happened despite some of the best legal and corporate governance practices in place, etc. So question is while the most recent move will put a very large new market under SEBI it will inevitably make the law very complex. However, clearly, there have been substantial changes in securities laws whose benefits, tangible or intangible, are being seen. The number of cases where violations have been detected and penalties levied is increasing. as perhaps a mark of the sturdiness of the investigation and adjudication process, as all of the law, the decisions of SeBi that are overturned on appeal are also lesser. Thus, in the short term as well as the long term, it would be fair to expect a similar improvement in commodity markets. Eventually, we ought to also see a developed law relating to commodity contracts/markets.
