Question

Identify and explain three mechanisms for investor protection which would encourage overseas investors to commit funds to a developing financial market.

Answer 1

Investor protection

Investor protection affects significantly the financial structure of an economy. Strong investor protection is essential for the healthy growth of financial markets. It encourages accurate security prices, efficient investments, and better access to external finance. As India is trying to promote long-term savings by households through financial markets, the protection of investors, especially the smaller retail ones, has become critically important. Most economically significant countries have laws and regulations designed to protect investors from unfair, improper and fraudulent practices. But there is considerable diversity in the contents of those laws and regulations. Significant diversity also exists among countries in the way the applicable investor protection rules and regulations are implemented.

India has developed a comprehensive regulatory system to protect investors.The investor-protection regime that is now prevailing in India is a mixture of self-regulatory and statutory provisions. Self-regulatory provisions are administered by the stock exchanges and the statutory ones by the designated statutory bodies. The pre eminent statutory body responsible for protecting security investors in India is the Securities and Exchange Board of India (SEBI). The Companies Act also plays an important role in protecting investor's interests.

The Need for Investor Protection

Investor protection is fundamental to maintaining investor confidence in the security markets. A country’s level of investor protection has a profound effect on the development of capital markets and on economic growth.Weak investor protection is likely to have several possible adverse effects. It hinders financial development. Investors tend to be shaky in making investment in corporate securities if they have the feeling that their rights would not be adequately protected. When investors’ rights are poorly protected, the ability of companies to raise capital by selling securities is impaired

Mechanisms or Methods of Investor Protection

1. Maintaining the Integrity of Corporate Reporting

High quality corporate financial reporting is of paramount importance for the efficient and effective functioning of the capital market. Corporate financial reporting is a mechanism that enables investors to assess a company’s financial status and performance, its business strategies and risk profiles, and its overall management of resources. Comparable, consistent and transparent reporting serves the basis for efficient allocation of resources. Quality reporting practices reduce risks to investors and the return they demand. Companies often adopt fraudulent means to produce misleading financial statements. There are a variety of techniques that are used for this purpose. The most common manipulating techniques are overstatement of revenue, understatement of expenses, overstatement ofassets and understatement of liabilities.

1. Protecting Investors in the Primary Market

The primary market is the medium for floating pubic issues. It is the primary market which brings together investors and capital seekers. The primary market comprises the public issues and the private placement market. The former consists of companies entering the market to raise funds from all types of investors. Their debut is known as the initial public offers (IPOs). In private placements, there are only a few select subscribers to the issues.Investors investing in the primary market need much more protection and safeguards than those in the secondary market. This is so because the information source about the investment is often confined to offer documents/prospectus of the issuer. There are instances of vanishing companies and fly-by-night promoters, which act as a deterrent to investor confidence. Strong regulation is needed especially in the sphere of IPOs. There should be mechanism to ensure that only credible issuers with adequate disclosures in their offer documents are allowed to access the public issuances. Issuers offering securities for sale to the public should be required to tell the truth about their business, the securities they are selling and the risks involved in those securities. Appropriate procedures should also be in place to regulate the activities of various intermediaries like merchant bankers, brokers, underwriters, registrars, and transfer agents who are involved in primary market operations.

1. Prohibiting Insider Trading

Insider trading is a continuing problem of tremendous magnitude. It continues because the temptation to use inside information make quick profit is very strong. Appropriate procedures should be established to aid in the prevention of insider trading. Insider trading undermines the confidence and integrity in the capital markets. Insider trading, which refers to the illegal selling and/or buying of securities by corporate insiders based on material non-public information, has been at the center of many stock market scandals of late. The information on which insider trading is based is the information that concerns the business or finance of a company or may have a significant effect on the market price of company securities upon making it public. Examples of insider trading include transacting on the advanced knowledge of forthcoming bonus/right issues, on the discovery of new sources of revenue generation, and on an unanticipated increase in expenses. In insider trading, insiders get an unfair advantage, which has the potential to discourage outside investors.

Conclusion

Investors are the backbone of the securities market .They not only determine the level of activity in the securities market but also the level of activity in the economy.The growth in the number of investors in india is encouraging.The corporate systems and processes need to be credible and transparent ,so that the interests of the investors may be safeguarded in a manner that enables them to excercise their choice in an informed manner while making investment decisions and also providing them with a fair exit option.