GUIDELINE ANSWERS
FINAL EXAMINATION
DECEMBER 2005
GROUP II
The Institute of
Company Secretaries of
India
IN PURSUIT OF PROFESSIONAL EXCELLENCE
Statutory body under an Act of Parliament
ICSI House, 22, Institutional Area, Lodi Road, New Delhi 110 003
Ph. : 41504444, 24617321; Fax : 91-11-24626727
E-mail : info@icsi.edu; Website : www.icsi.edu
These answers have been written by competent persons
and the Institute hopes that the GUIDELINE ANSWERS
will assist the students in preparing for the Institute’s
examinations. It is, however, to be noted that the
answers are to be treated only as model and not
exhaustive answers and the Institute is not in any way
responsible for the correctness or otherwise of the
answers compiled and published herein.
CONTENTS
Group II
Page
1. Financial, Treasury and Forex Management
2. Corporate Restructuring—Law and Practice
3. Banking and Insurance—Law and Practice
…
…
…
1
20
36
© THE INSTITUTE OF COMPANY SECRETARIES OF INDIA
PRICE :
Rs. 40.00
Rs. 70.00
(Excluding Postage & Packing)
(By Registered Post)
Laser Typeset by Delhi Computer Services, 135-136, 1st Floor, Pocket 17, Sector 24, Rohini,
Delhi-110 085. Ph: 55786531 and Printed at Samrat Offset Works/2,000/February 2006
FINAL EXAMINATION
DECEMBER 2005
FINANCIAL, TREASURY AND FOREX MANAGEMENT
NOTE: 1. Answer FIVE questions including Question No. 1 which is
COMPULSORY. All working notes should be shown distinctly.
2. Tables showing the present value of Re. 1 and the present value of an
annuity of Re. 1 for 15 years are annexed.
Question 1
(a) "Internal treasury control is a process of self-improvement." Explain.
(b) List out the benefits of public deposits to the company as well as to the
depositors.
(c) "For the lessor, lease decision is akin to a capital budgeting exercise."
Examine the statement and explain its implications.
(d) "Economic value added (EVA) concept is in conformity with the objective of
wealth maximisation." Explain.
(5 marks each)
Answer 1(a)
Internal Treasury Control
Internal treasury control is a process of self improvement. It is concerned with all
flows of funds, cash and credit and all financial aspects of operations. From time to
time and on regular basis, the internal treasury control is exercised on financial
targets. The financial aspects of operations include procuring of inputs, paying
creditors, making arrangement for finance against inventory and receivables. The
gaps between inflows and outflows are met by planned recourse to low cost mix of
financing. The control aims at operational efficiency and removal of wastages and
inefficiencies and promotion of cost effectiveness in the firm. The control is exercised
under phases of planning and budgeting. These phases include setting up of targets,
laying down financial standards, evaluation of performance as per these norms and
reporting in a standard format.
Answer 1(b)
Benefits to the company
(i)
(ii)
(iii)
(iv)
Funds are available at low cost.
There is no need to provide security.
Process is very simple and no restrictive covenants are involved.
Restrictions put by the RBI on financial institutions to advance, to prevent
hoarding and black marketing leads the companies to accept deposits from
the public.
(v) Tax deductibility of interest paid on deposits.
Benefits to the depositors
(i) High rate of interest.
(ii) Maturity period is relatively short.
1
FFTFM-Dec. 2005
2
Answer 1(c)
In assessing the financial viability of a lease proposal, the lessor has to look at
both the return and risk associated with it. For lessor, lease decision is akin to capital
budgeting exercise.
As far as lessor’s return is concerned, usual capital budgeting techniques are
used to evaluate the various decisions such as whether to accept a lease plan or not,
or which plan among various alternatives to accept, or how to quote lease rates.
For assessing the return from a lease there is a need to define the lease-related
cash flows. Cash flow stream from lessor’s point of view can not be different from the
cash flow stream of the lessee except that the cash outflows of the lessee will
constitute the inflows of the lessor. However, the lessor may use a different discount
rate and may be in a different tax-bracket. Having identified the cash flows from
lessor’s point of view, NPV (or other techniques) may be used as a decision criterion.
Another aspect of lease evaluation from lessor’s point of view is the assessment
of risk – the variability of NPV (or IRR etc.) around their expected values. Two major
concerns of the lessor here are (a) the credit worthiness of the lessee and (b) the
residual value of the equipment. And the return accruing from a lease transaction
have to be carefully evaluated in terms of these two factors.
Answer 1(d)
Economic value added is a concept used by various firms to determine whether
an existing/proposed investment positively contributes to the owners’/shareholders’
wealth. It is the difference of after-tax operating profits of a firm and cost of funds
used to finance investments. Therefore, from the point of view of maximizing
shareholders’ wealth only those investments would be desirable which have positive
EVA. For instance, if there are after tax profits of Rs. 10 crore associated with an
investment project and its cost of financing is Rs. 8 crore, the difference of Rs. 2
crores reflects EVA. A positive EVA would add value and increase the wealth of the
owners and hence would be acceptable.
The concept of EVA is simple and easy to use in decision-making process
related to investments. However, computation of after tax profits and cost of funds
used to finance the project involve various accounting and financial issues.
Question 2
(a) Mention any four tools available to cover exchange rate risk.
(4 marks)
(b) A firm has total credit sales of Rs. 80 lakh and its average collection period is
80 days. The past experience indicates that bad debt losses are around 1%
of the credit sales. The firm spends Rs. 1,20,000 per year on administering
its credit sales. This cost includes salary of one officer and two clerks who
handle the credit checking, collection, etc., telephone and telefax charges.
These are avoidable costs. A factor is prepared to buy the firm's receivables.
He will charge 2% commission. He will advance against receivables to the
firm at 18% after withholding 10% as reserve. What is the cost of factoring?
Should the firm avail factoring service?
(6 marks)
3
FFTFM-Dec. 2005
(c) Following information is available in respect of EPS and DPS of Intelligent
Ltd. for the last five years:
Year
2004
2003
2002
2001
2000
EPS (Rs.)
14.10
13.60
13.10
12.70
12.20
DPS (Rs.)
8.20
8.10
7.90
7.80
7.70
Dividends for a particular year are paid in the same calendar year. If the
same dividend policy is maintained, it is expected that the annual growth rate
of earnings will be no better than the average of last four years. The risk-free
rate is 6% and the market risk premium is 4%. With reference to the market
rate of return, the equity shares of the company have a β of 1.5 and is not
expected to change in near future.
The company has received a proposal from Smart Ltd. to acquire its
operations by paying the value of shares. You are required to value the
equity shares of the company using (i) dividend growth model; (ii) earnings
growth model; and (iii) capital asset pricing model (CAPM).
(10 marks)
Answer 2(a)
The four tools available to cover exchange rate risk are as follows:
(a) Invoicing Policies: Invoices to third parties abroad should be denominated in
the relatively stronger currency. On the other hand, while importing goods,
etc. from third parties, a firm should try to negotiate payments in the weaker
currency. Respective bargaining strengths and the need for good customer
relations have a bearing on the invoicing decision.
(b) Transfer Pricing: It is a mechanism by which profits are transferred through
an adjustment of prices on intra-firm transactions. It can be applied to
transactions currency subsidiaries.
(c) Leading and Lagging and extension of Trade Credit: Leading implies
speeding up collections on receivables if the foreign currency in which they
are invoiced is expected to appreciate. Lagging implies delaying payments of
payables invoices in a foreign currency that is expected to depreciate.
(d) Netting: All transactions-gross receipts and payments among the parent firm
and subsidiaries should be adjusted and only net amounts should be
transferred. This technique is called netting.
Answer 2(b)
Average receivables = Credit Sales x Average Collection Period ÷ 360
Rs. 80,00,000 × 80 days
= Rs. 17,77,778
360
Evaluation of Factor Proposal
Average receivables:
Factoring Commission @ 2% (2% x Rs. 17,77,778)
Reserve @ 10% of receivables
Advance payable by the factor
(17,77,778 – 1,77,778 – 35,556)
Interest @ 18% (18% of Rs. 15,64,444 ×
80
days)
360
=
=
(Rs.)
35,556
1,77,778
=
15,64,444
=
62,578
FFTFM-Dec. 2005
4
Net Amount of Advance (Rs. 15,64,444 – 62,578)
=
15,01,866
Commission
=
35,556
Interest
=
62,578
Cost of Factoring:
98,134
Annualised Cost =
98134× 360
80
=
4,41,603
Less: Savings in Bad Debts
(1% of Rs. 80,00,000)
(–)
80,000
Administrative Cost
(–) 1,20,000
Net Incremental Cost
2,00,000
2,41,603
The total cost of factoring is Rs. 4,41,603 which is more than the existing cost by
Rs. 2,41,603. So the firm need not avail the services of the factor.
Answer 2(c)
Valuation as per Dividend Growth Model:
EPS for the year 2000
Rs. 12.20
EPS for the year 2004
Rs. 14.10
Growth rate table for 4 years (14.10 + 12.20)
1.155
In the CVF table for 4 years, the value of 1.155 lies in between 3% and 4%. So,
the growth rate, g. may be taken as 3.5%.
Rs =
IRF + (IRM – IRF ) β
=
0.06 + (0.10 – 0.06) 1.5
=
0.12 or 12%
Now, valuation as per dividend growth model is:
P0 =
=
D 0 (1 + g)
Ke − g
Rs. 8.20 (1 + .035 )
= Rs. 99.85
0.12 − 0.035
Earnings Growth Model:
P0 =
E (1− b)
k e − br
For the last 5 years, the company has been following a dividend payout ratio of
60% (approx). If the same dividend policy is maintained, then retention ratio, b, is
40% and r is 12%. So,
br = 0.12 x 0.4 = 4.8%
Now, Po =
14.10 (1 − 0.4) 8.46
= Rs. 117.50
=
0.12 − 0.048 0.072
5
FFTFM-Dec. 2005
Valuation as per CAPM:
Po =
14.10
= Rs. 117.50
0.12
Question 3
(a) Rex of Mumbai intends to set-up a plant involving a cost outlay of Rs. 20
lakh. After vigorous persuasion, the bankers agree to finance the project and
allow a moratorium period of 3 years, i.e., repayment will start from the end of
third year with the condition that the loan as such will be squared up by Rex
in three equal yearly installments along with interest @ 6% per annum. You
are required to find out the amount of the yearly installment and also the
amount to be paid on account of interest.
(4 marks)
(b) The market portfolio has a historically based expected return of 0.10 and a
standard deviation of 0.04 during a period when risk-free assets yielded 0.03.
The 0.07 risk premium is thought to be constant through time. Riskless
investments may now be purchased to yield 0.09. A security has a standard
deviation of 0.08 and a co-efficient of correlation with the market portfolio is
0.85. The market portfolio is now expected to have a standard deviation of
0.04. You are required to find —
(i) market's return-risk trade-off;
(ii) security beta; and
(iii) equilibrium required expected return of the security.
(6 marks)
(c) DIGI Computers Ltd. is a manufacturer of computer systems. The company
is marketing its products in domestic as well as global markets. It has a total
sales of Rs. 1 crore. Its variable and fixed costs amount to Rs. 60 lakh and
Rs. 10 lakh respectively. It has borrowed Rs. 60 lakh @ 10% per annum and
has an equity capital of Rs. 75 lakh.
(i) What is company's return on investment?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 1, does it have a
high or low asset leverage?
(iv) What are the operating, financial arid combined leverages of the firm?
(v) If sales drop to Rs. 50 lakh, what will be the new EBIT?
(10 marks)
Answer 3(a)
Loan Taken
Rate of Interest
Moratorium Period
Amount due at the end of year two
Size of instalment
:
:
:
:
:
Rs. 20,00,000
6% p.a.
3 years
Rs. 20,00,000 x 1.06 x 1.06 = 22,47,200
Rs. 22,47,200 ÷ (sum of the PV of Re.1 for
three years = 0.9434 + 0.8900 + 0.8396
= 2.673) = Rs. 8,40,703
FFTFM-Dec. 2005
Year
Opening Balance
(Rs.)
20,00,000
21,20,000
22,47,200
15,41,329
7,93,106
1
2
3
4
5
6
Interest at 6%
(Rs.)
1,20,000
1,27,200
1,34,832
92,480
47,597
5,22,109
Amount paid
(Rs.)
0
0
8,40,703
8,40,703
8,40,703
25,22,109
Amount due at year
end (Rs.)
Answer 3(b)
(i) Market’s Return-Risk Tradeoff
=
Where,
R m − RF
σ
Rm = Market rate of return, i.e. 0.10
RF = Risk free return, i.e. 0.03
σ = Standard deviation 0.04
0.10 − 0.03
= 1.75
0.04
(ii) Security Beta:
=
β1 =
σs
× rm
σm
Where,
β1 = Beta factor of investment
σs= Standard deviation of investment in security, i.e. 0.08
rm = Co-efficient of Correlation with market portfolio, i.e., 0.85
σm = Market portfolio standard deviation, i.e., 0.04
β1 =
0.08
× 0.85 = 1.7
0.04
(iii) Equilibrium required for expected rate of return on the security:
E(R1) = RF + β1 (Rm – RF)
Where:
E(R1)
RF
Rm
β1
E(R1)
= Expected rate of return on investment
= Riskless investments yield = 0.09
= Expected Return on Market Portfolio
= Market sensitive index (Beta factor) of investment i.e, 1.7
= 0.09 + 1.7 (0.10 – 0.03)
= 0.09 + 1.7(0.07)
= 0.09 + 0.119
= 0.209
= 20.9%
21,20,000
22,47,200
15,41,329
7,93,106
0
FFTFM-Dec. 2005
7
Answer 3(c)(i)
Return on Investment =
EBIT
× 100
Investment
EBIT:
(Amount in Rs.)
Sales
Less: Variable Cost
Contribution
Less: Fixed Cost
EBIT
-
1,00,00,000
60,00,000
40,00,000
10,00,000
30,00,000
-
75,00,000
60,00,000
1,35,00,000
Investment:
Equity Capital
Borrowed funds
Total investment
EBIT
× 100
ROI =
Total − Investments
ROI =
30,00,000
× 100 = 22.22%
1,35,00,000
Answer 3(c)(ii)
ROI = 22.22%, Rate of Interest on borrowed funds = 10%
Yes, the firm, DIGI Computers Ltd. has favourable financial leverage as the ROI
is higher than the interest on borrowed funds.
Answer 3(c)(iii)
Asset Turnover =
Rs.1,00,00,000
Sales
= 0.74
=
Total Assets or Total Investments Rs.1,35,00,000
Industry Asset Turnover = 1
Digi Computers Ltd. has lower asset leverage.
Answer 3(c)(iv)
Operating leverage =
Rs. 40,00,000
S- V
C
=
= 1.33
=
EBIT EBIT Rs. 30,00,000
Financial Leverage =
Rs. 30,00,000
EBIT
=
= 1.25
EBIT − Interest Rs. 30,00,000 − 6,00,000
Combined leverage =
Rs. 40,00,000
C
=
= 1.667
EBT Rs. 24,00,000
Answer 3(c)(v)
EBIT at sales level of Rs. 50,00,000
Sales
Less: Variable cost (Rs. 50,00,000 x 0.60)
Rs. 50,00,000
Rs. 30,00,000
FFTFM-Dec. 2005
8
Contribution
Less: Fixed Costs
EBIT
Rs. 20,00,000
Rs. 10,00,000
Rs. 10,00,000
Alternative Solution
Decrease in Sales
Operating Leverage
Decrease in EBIT (50 x 1.33)
Present EBIT
Less: Decrease @ 66.5%
EBIT
50%
1.33
66.5% (approx.)
Rs. 30,00,000
Rs. 20,00,000 (approx.)
Rs. 10,00,000
Question 4
Differentiate between the following:
(i) 'Factoring' and 'bill discounting'.
(ii) 'NPV' and 'IRR' methods of capital budgeting.
(iii) 'Bonus issue of shares' and 'stock split'.
(iv) 'Stock future' and 'index future'.
(v) 'Futures contracts' and 'forward contracts'.
(4 marks each)
Answer 4(i)
Factoring and Bill Discounting
Under a bill discounting arrangement, the drawer undertakes the responsibility of
collecting the bills and remitting the proceeds to the financing agency, whereas under
factoring agreement, the factor collects client’s bills. Moreover, bill discounting is
always with recourse whereas factoring can be either with recourse or without
recourse. The finance house discounting bills does not offer any non-financial
services unlike a factor which finances and manages the receivables of a client.
Answer 4(ii)
NPV and IRR Methods of Capital Budgeting
Point of Differences:
1. Interest Rate: Under the net present value method rate of discount is
assumed as the known factor whereas it is unknown in case of internal rate
of return method.
2. Reinvestment Axiom: Under both the methods, it is assumed that cash
inflows can be re-invested at the discount rate in the new projects. However,
reinvestment of funds, at discount rate is more possible than internal rate of
return. So net present value method is more reliable than internal rate of
return method for ranking two or more projects.
3. Objective: The net present value method attempts to ascertain the amount
which can be invested in a project so that its expected yield will exactly
match to repay this amount with interest at the market rate. On the other
hand, internal rate of return method attempts to find out the rate of interest
which is maximum to repay the invested fund out of the cash inflows.
FFTFM-Dec. 2005
9
Points of Similarities:
IRR will give the same results as NPV in terms of acceptance or rejection of
investment proposals in the following circumstances:
1. Projects having conventional cash flows i.e, a situation where initial
investment (outlay or cash outflow) is followed by series of cash inflows.
2. Independent Investment proposals: Such proposals, the acceptance of which
does not exclude the acceptance of others.
Answer 4(iii)
‘Bonus issue of shares’ and ‘stock split’
A comparison between a bonus issue and a stock split is given below:
Bonus Issue
Stock Split
The par value of the share is unchanged
The par value of the share is reduced.
A part of reserves is capitalized.
There is no capitalization of reserves.
The
shareholders’
proportional
ownership remains unchanged.
The
shareholders’
proportional
ownership remains unchanged.
Total paid up capital increases.
Total paid up capital remains same.
The book value per share, the earnings
per share, and the market price per
share decline.
The book value per share, the earnings
per share, and the market price per
share decline.
The market price per share is brought
within a more popular trading range.
The market price per share is brought
within a more popular trading range.
Answer 4(iv)
‘Stock future’ and ‘index future’
Stock futures are financial contracts where the underlying asset is an individual
stock. Stock future contract is an agreement to buy or sell a specified quantity of
underlying equity share for a future date at a price agreed upon between the buyer
and seller. The contracts have standardized specifications like market lot, expiry day,
unit of price quotation, tick size and method of settlement.
Index futures are the future contracts for which the underlying is the cash market
index. In a normal contract for purchase of equity shares, physical quantity of shares
is delivered but in a futures contract, there is nothing to be delivered.
In India, futures on both BSE Sensex and NSE Nifty are traded.
Any eligible investors who can trade in the cash market, can trade in the futures
market. For every buyer there is a seller of the futures. What makes them agree on
the contract value is the divergence of their views on the likely value of the index
future at the expiry of the contract.
Answer 4(v)
‘Futures Contracts’ and ‘forward contracts’
A Future represents the right to buy or sell a standard quantity and quality of an
asset or security at a specified date and price.
FFTFM-Dec. 2005
10
In a forward contract, the purchaser and its counter party are obligated to trade in
security or other asset at a specified date in future. The price paid for the security of
assets is agreed upon at the time the contract is entered into.
Futures are similar to Forward Contracts, but are standardized and traded on an
exchange, and are valued or “Marked to Market” daily. The “Marking to Market”
provides both parties with a daily accounting of their financial obligation under the
terms of the future. Unlike Forward contracts, the counter party to a Futures contract
is the clearing corporation of the appropriate exchange. Futures often are settled in
cash or cash equivalents, rather than requiring physical delivery of the underlying
assets. The difference in forwards and futures relate to contractual features the way
markets are organized, profiles of gains and losses, kinds of participants in the
markets and the way in which they use the two instruments.
Question 5
(a) Write a short note on 'credit rating'.
(4 marks)
(b) Following are the extracts from financial statements of Zipway Ltd.:
(Rs. in Lakhs)
Earnings before interest and tax
250
50
Less: Interest on debentures
Earnings before tax
200
Less: Income-tax (40%)
80
Net profit
120
Equity share capital (shares of Rs. 10 each)
Reserve and surplus
10% Non-convertible debentures
500
250
500
1,250
The market price per equity share is Rs. 15 and per debenture is Rs. 95.
Calculate the following:
(i) earnings per share; and
(ii) percentage of cost of capital to the company for the debenture fund and
the equity.
(8 marks)
(c) Madhuri Ltd. is evaluating a project for which the initial investment required is
Rs. 50 lakh to be met by internally generated funds of Rs. 10 lakh, from a
rights issue of Rs. 15 lakh and the rest from a term loan @ 12% per annum.
Rights issue will involve flotation cost of 5% and the term loan processing will
cost 1%. Corporate tax rate is 40%. The risk-free rate of interest is 6.5%,
market return is 15% and the relevant asset beta for the investment is
estimated to be 1.5. Net operating cash inflows after tax from the project are:
Year-1: Rs. 15 lakh; Year-2: Rs. 35 lakh; and Year-3: Rs. 15 lakh.
Besides these cash inflows, residual value of Rs. 5 lakh (net of taxes) is also
expected at the end of third year. Should the project be taken up? (8 marks)
Answer 5(a)
Credit rating is a symbolic indication of the current opinion regarding the relative
capability of a corporate entity to service its debt obligations in time with reference to
the instrument being rated. It enables the investor to differentiate between
11
FFTFM-Dec. 2005
instruments on the basis of their underlying credit quality. To facilitate simple and
easy understanding, credit rating is expressed in alphabetical or alphanumerical
symbols.
Credit rating aims to (i) provide superior information to the investors at a low cost;
(ii) provide a sound basis for proper risk-return structure; (iii) subject borrowers to a
healthy discipline, and (iv) assist in the framing of public policy guidelines on
institutional investment. Thus, credit rating financial services represent an exercise in
faith building for the development of a healthy financial system.
Answer 5(b)
(i) Earning per share:
EPS =
1,20,00,000
Net Profit
=
= Rs. 2.40
No. of Equity Shares 50,00,000
(ii) Cost of Capital:
Cost of Debenture Fund –
KD =
Int. (1 − T)
D
Where,
KD
Int.
T
D
= Cost of debenture fund
= Interest paid on debenture funds, i.e. Rs. 50,00,000
= Corporate tax rate (40%)
= Total Debenture Fund
At Book Value:
KD =
50,00,000(1 − 0.40) 30,00,000
=
= 0.06 = 6%
500,00,000
500,00,000
At Market Value:
KD =
50,00,000 (1 − 0.40)
30,00,000
=
= 0.0.631 = 6.31%
475,00,000
475,00,000
KE =
E
PE
Where,
KE = Cost of Equity Capital
E = Current earnings per share Rs. 2.40
PE = Market Price of Equity Share Rs. 15
KE =
Rs. 2.4
= 0.16 = 16%
Rs. 15
Answer 5(c)
Initial investment required
= Rs. 50,00,000
FFTFM-Dec. 2005
12
Internal funds available
Rights issue
Right issue floatation cost
Term loan @ 12%
Term loan processing cost
Rf
Rm
β
Corporate tax rate
= Rs. 10,00,000
= Rs. 15,00,000
= 5%
= Rs. 25,00,000
= 1%
= 6.5%
= 15%
= 1.5
= 40%
K= Rf + β (Rm – Rf) = 6.5 + 1.5 ( 15 – 6.5)
= 6.5 + 1.5 x 8.5
= 19.25
NPV at 19.25% =
15,00,000
1
(1.1925)
+
35,00,000
(1.1925)
2
+
(15,00,000 + 5,00,000)
(1.1925) 3
− 50,00,000
15,00,000
35,00,000
20,00,000
+
+
− 50,00,000
1.1925
1.42205625 1.695802078
= 12,57,682 + 24,61,225 + 11,79,383 – 50,00,000
= Rs. 48,98,290 – Rs. 50,00,000
= (–) Rs. 1,01,710
=
Impact of financing:
Loan amount
Tax shield
=
=
=
Pv. of Tax Shield =
=
Cost of Rights issue =
Debt Cost
=
Rs. 25 lakh
= Rs. 25,25,253
(1 - 0.01)
25,25,253 x 12% x 40%
Rs. 1,21,212 per year
1,21,212 x PVAF (12%, 3 years)
1,21,212 x 2.4018 = Rs. 2,91,127
Rs. 15 lakh x 5/95 = Rs. 78,947/Rs. 25 lakh x 1/99 = 25,253
Adjusted NPV
Base NPV
Issue cost of Rights
Debt
Tax Shield
NPV
=
=
=
=
=
Rs.
(–) 1,01,710
(–) 78,947
(–) 25,253
2,91,127
85,217
Since, adjusted NPV is positive, the project may be taken up.
Question 6
(a) Syntex Ltd. has to make a US $5 million payment in three months' time. The
required amount in dollars is available with Syntex Ltd. The management of
the company decides to invest them for three months and following
information is available in this context:
— The US $ deposit rate is 9% per annum.
13
FFTFM-Dec. 2005
— The sterling pound deposit rate is 11% per annum.
— The spot exchange rate is $1.82/pound.
— The three month forward rate is $1.80/pound.
Answer the following questions —
(i) Where should the company invest for better returns?
(ii) Assuming that the interest rates and the spot exchange rate remain as
above, what forward rate would yield an equilibrium situation?
(iii) Assuming that the US interest rate and the spot and forward rates remain
as above, where should the company invest if the sterling pound deposit
rate were 15% per annum?
(iv) With the originally stated spot and forward rates and the same dollar deposit
rate, what is the equilibrium sterling pound deposit rate?
(15 marks)
(b) The following quotes are available for 3-months options in respect of a share
currently traded at Rs. 31:
Strike price
Rs. 30
Call option
Rs. 3
Put option
Rs. 2
An investor devises a strategy of buying a call and selling the share and a put
option. Draw his profit/loss profile if it is given that the rate of interest is 10%
per annum. What would be the position if the strategy adopted is selling a call
and buying the put and the share?
(5 marks)
Answer 6(a)(i)
US$ Deposit Rate
= 9% per annum
Sterling Pound Deposit Rate
= 11% per annum
Spot Exchange Rate
= $ 1.82 / pound
Three Month Forward Rate
= $ 1.80 / pound
Option I:
Invest in $ deposit @ 9% per annum for 3 months
Income = 50,00,000 ×
9
3
= $ 1,12,500
×
100 12
Option II:
Available dollars may be converted to pounds at spot rate. Cover forward position
and invest @ 11% p.a. for three months.
Spot exchange rate = $ 1.82/ £
So, $ 5 million
= 5,000,000 = £2747252.747
1.82
Interest earning on £2747252.747 @ 11% p.a.
11 3 months
= £ 75549.450
×
100
12
∴ Amount after 3 months = £ 2747252.747
Plus Interest
£ 75549.450
£ 2822802.197
= 2747252.747 ×
FFTFM-Dec. 2005
14
Pound converted to dollar at 1.80 / pound
Forward rate
= 2822802.197 x 1.80 = $ 5081043.954
Gain
= 5081043.954 – 5,000,000 = $ 81043.954
Hence, Gain – Option I = $ 1,12,500
Gain – Option II = $ 81043.95
Therefore, Syntex Ltd. must invest under Option I in $ at 9%
Answer 6(a)(ii)
For an equilibrium situation, amount at the end of three months should be equal.
Therefore, amount invested in sterling covered by forward rate
= $ 50,00,000 + $1,12,500 = $ 51,12,500
Let forward rate be $ x /£
∴ at equilibrium £ 2822802.197 equals 2822802.197 x = $ 51,12,500
∴x=
51,12,500
= 1.811
28,22,802.197
∴ Forward Rate = $ 1.811/£
Answer 6(a)(iii)
Interest earned in pounds given same spot and forward rates:
15
3
= £103021.978
×
100 12
∴ Total £ = 2747252.747 + 1,03,021.978 = 2850274.725
Total $
= 2850274.725 x 1.80
= $ 5130494.505
Gain
= $ 51,30,494.505 – $ 50,00,000 = $ 130494.505
Earlier Gain = $ 1,12,500
= £2747252.747 ×
Therefore, at 15% Syntex Ltd. should invest in $ Sterling.
Answer 6(a)(iv)
For equilibrium sterling deposit rate, amount invested in sterling equals
$ 51,12,500 after three months.
Now, $ 51,12,500 converted to £ at forward rate =
$ 5,112,500
= £ 2840277.777
1.80
Let sterling rate be X% p.a.
∴ 2747252.747 ×
X
3
+ 2747252.747 = 2840277.777
×
100 12
6868.131867X + 2747252.742 = 2840277.777
6868.131867X = 93025.035
X = 13.54% per annum
FFTFM-Dec. 2005
15
Answer 6(b)
Strategy I: (Buying a Call and Selling a Put and a Share)
Initial Cash Inflow (Rs. 31 – Rs. 3 + Rs. 2)
Interest Rate
Amount grows in 3 months to (30 x e1.25)
Rs. 30
10%
Rs. 30.76*
If the share price is greater than Rs. 30, he would exercise the call option and
buy one share for Rs. 30 and his net profit is Rs. 0.76 (i.e., Rs. 30.76 – 30)
However, if the share price is less than Rs. 30, the counter-party would exercise
the put option and the investor would buy one share at Rs. 30. The net profit to the
investor is again Rs. 0.76.
Strategy II: (Selling a Call and buying a put and a share)
In this case, the investor has to arrange a loan @ 10% of Rs. 30 (i.e., Rs. 31 + 2 – 3).
This amount would be repaid after 3 months. Amount payable is:
30 x e1.25
Rs. 30.76
After 3 months, if the market price is more than Rs. 30, the counter-party would
exercise the call option and the investor would be required to sell the share at Rs. 30.
The loss to the investor would be Rs. 0.76 (i.e., Rs. 30.76 – 30)
However, if the rate is less than Rs. 30, the investor would exercise the put
option and would get Rs. 30 from the rate of share. The loss to the buyer would again
be Rs. 0.76.
*Interest can also be calculated on simple interest basis instead of continuous
compound interest.
Question 7
Daisy Ltd.. is being floated with a project to manufacture a new product called
'Novo Fresh'. Currently it is being imported at a landed cost of Rs. 8,500 per ton.
Following data has been collected relating to the project:
Rs.
(a) Investment in land
1,00,000
Investment in building
8,00,000
Investment in plant
12,00,000
(b) Cost of production — per annum:
Imported raw material
6,50,000
Local raw material
6,26,000
Salary
1,35,000
Administrative expenses
50,000
Power
60,000
Repairs and maintenance
5% of plant cost; and
2% of building cost.
Depreciation
7% of plant cost; and
2.5% of building cost.
Steam
7,000 ton @ Rs. 16/ton
FFTFM-Dec. 2005
16
Packing drums
Rs. 30/500 kgs.
(c) Working capital requirements:
Imported raw material
Local raw material
Packing drums stock
Finished goods stock
Credit to customers
Credit from suppliers
Cash expenses
(d) Expected production: 250 ton per annum.
6 months
3 months
3 months
1 month
1 month
1 month
1 month
You are required to —
(i) calculate the total capital needed for the project;
(14 marks)
(ii) assume that entire production can be sold at import rate, calculate
percentage yield on investment and profit on sales; and
(3 marks)
(iii) calculate rate of cash generation per year.
(3 marks)
Answer 7
(i) Total Capital needed for the project
Investment in Fixed Assets:
Land
Building
P&M
Investment in working capital
Imported Raw material
Local Raw Material
Packing drums stock
Debtors (Rs. 8,500 x 250)
Finished goods stock
Cash exp.
(Amt. in Rs.)
1,00,000
8,00,000
12,00,000
(Amt. in Rs.)
6,50,000 x 6/12
6,26,000 x 3/12
15,000 x 3/12
21,25,000 x 1/12
18,28,000 x 1/12
4,48,000 x 1/12
3,25,000
1,56,500
3,750
1,77,083
1,52,333
37,334
8,52,000
21,00,000
Creditors
Import Rs. 6,50,000
Local Rs. 6,26,000
12,76,000 x 1/12
1,06,333
Working Capital 7,45,667
Total Capital required = Fixed Capital + Working Capital
(Rs. 21,00,000 + Rs. 7,45,667)
= Rs. 28,45,667
(ii) Sales (Rs. 8,500 x 250 ton)
Cost of Production
Profit
Rate of Return in sales
Rs. 21,25,000
Rs. 18,28,000
Rs. 2,97,000
2,97,000 × 100
=
= 13.98%
21,25,000
FFTFM-Dec. 2005
17
Yield on Investment of fixed assets =
2,97,000 × 100
= 14.14%
21,00,000
2,97,000 × 100
= 10.44%
28,45,667
(iii) Rate of Cash Generation, i.e. FUND FROM OPEERATIONS
(Amount in Rs.)
Net Profit
2,97,000
+ Dep. on Building
20,000
+ Dep. on Plant
84,000
4,01,000
Yield on Capital employed
=
Working Notes:
Sales
250 ton x Rs. 8,500 = Rs. 21.25 lakhs
Cost of Production
(Amount in Rs. Lakhs)
Imported Raw Material
Local Raw Material
6.50
6.26
Cash expenses:
Salaries
Repairs – Plant 5% of Rs. 12 lakhs
Repairs – Bldg 0.2% of Rs. 8 lakhs
Steam 7000 tons @ Rs. 16 per ton
Power
Drums for packing (250 tons x Rs. 30/500 Kg)
Admn. Exp.
1.35
0.60
0.16
1.12
0.60
0.15
0.50
4.48
0.84
0.20
1.04
Depreciation:
Plant –7%
Building –2.5%
18.28
Investment in Finished Goods:
Cost of Production (Inc. Dep.): (18,28,000/12)
Cash Expenses/month 4,48,000/12
Debtors 250 ton x Rs. 8500=21,25,000/12
= Rs. 1,52,333
= Rs. 37,334
= Rs. 1,77,083
Alternatively, investment in finished goods may be calculated at cash cost also.
In that case, total cost is (Rs. 18,28,000 – 1,04,000) = Rs. 17,24,000) The working
capital required for finished goods would be Rs. 17,24,000/12 = Rs. 1,43,667.
FFTFM-Dec. 2005
18
TABLE 1 : PRESENT VALUE OF RUPEE ONE
19
FFTFM-Dec. 2005
TABLE 2 : PRESENT VALUE OF AN ANNUITY OF RUPEE ONE
CORPORATE RESTRUCTURING – LAW AND PRACTICE
Time allowed: 3 hours
Maximum marks: 100
NOTE: Answer SIX questions including Question No. 1 which is COMPULSORY.
Question 1
(a) You are the Company Secretary of Strong Base Ltd., which has just now
taken over Weak Links Ltd. pursuant to a scheme confirmed by the court.
The court order has been received. Briefly mention the various steps required
to be taken to give effect to the merger. Also mention the various authorities
with whom you will file the order of merger to ensure that the records are
updated properly in their offices.
(12 marks)
(b) Amar Ltd. proposed a scheme of arrangement with its shareholders for the
purpose of buying-back the small lot of shares held in physical form. The
scheme was approved by majority of shareholders. However, the Registrar of
Companies, representing the Central Government, raised an objection that
the purpose of the scheme is to buy-back the shares and as such the
company ought to have followed the provisions of Section 77A. Discuss in
the light of judicial pronouncements.
(8 marks)
Answer 1(a)
Steps required to give effect to merger of Weak Links Ltd. with Strong Base Ltd.:
Filling of order with Registrar
Sub-section (3) of Section 391 provides that an order made by the Court under
Section 391(2) shall have no effect until a certified copy of the order has been filed
with the Registrar of Companies. Section 394(3) provides that within 30 days after the
making of an order under this section, every company in relation to which the order is
made, shall cause a certified true copy thereof to be field with the Registrar for
registration. The certified copy is to be filed with Form No.21 prescribed under the
Companies (Central Government’s) General Rules and Forms, 1956. The
amalgamation is effective from the date on which From No. 21 and a certified true
copy of the order is filed with Registrar, or if it is to be filed with two separate
Registrars, the date which is latter of the two dates of filing.
Order to be incorporated in memorandum
A copy of the High Court under Section 391 shall be annexed to every copy of
the memorandum of the company issued after certified copy of the order has been
filed with the Registrar as aforesaid [Section 391(4)].
Stamp duty on High Court’s order – Appropriate stamp duty is to paid. In Gemini
Silk Ltd. v. Gemini Overseas Ltd. (2003) 53 CLA 328 (Cal), the High Court directed
the Registrar of Companies not to take on record any order sanctioning a scheme
until the order was duly stamped.
Drawing up a list of eligible shareholders
For the purpose of drawing up list of shareholders of the transferor company who
will be entitled to get the shares of the transferee company as per the share
exchange ratio—
20
21
FCRLP-Dec. 2005
— The Register of Members of the transferor company will be closed if the
transferor company is an unlisted company;
— A record date will be fixed to ascertain the names of shareholders and their
shareholdings in the transferor company, if the transferor company is a listed
company.
If the transferor company is a listed company, a notice of the proposed record
date will be given to the Stock Exchanges on which the company’s shares are listed
stating the record date, and specifying the purpose for which the record date is fixed.
Copies of such notice will be sent to other recognised Stock Exchanges in India
simultaneously. A public notice regarding the record date will be given in the
newspapers.
Where the Register of Members is proposed to be closed, a public notice of the
closure of the Register of Members will be given in newspapers in accordance with
the requirement under Section 154 of the Companies Act.
A statement of allotment will be prepared based on the list of members of the
transferor company as on the conclusion of the period of the closure of the Register
of Members or the record date.
Allotment
A meeting of the Board of Directors or Allotment Committee shall be convened
for allotment of the shares to the shareholders of the transferor-company.
Exchange of share certificates
The shareholders of the transferor-company will be intimated about the
sanctioning of the scheme of amalgamation and the exchange of shares and will be
advised to return the share certificates to the transferee-company or its Registrar &
Share Transfer Agent.
The shares of the transferor-company are cancelled and the certificates of those
shares are extinguished after they have been surrendered to the transferee-company
by the shareholders of the transferor-company. In exchange thereof the shares of the
transferee-company are allotted to them according to the share exchange ratio
stipulated in the scheme of amalgamation as sanctioned by the High Court.
New share certificates will be prepared according to the statement of Allotment
and dispatched to shareholders by registered post.
Listing/Delisting
If the transferee-company is a listed company, the shares allotted to the
shareholders of the transferee-company will be listed by making an application to all
the stock Exchanges on which the transferee-company’s shares are listed, regardless
of whether the transferor-company’s shares are listed or not.
If the transferor company is a listed company, its shares will be delisted for which
an application will be made to the concerned Stock Exchanges enclosing a certified
true copy of High Court’s order sanctioning the scheme of merger.
Authorities with whom court’s order shall be filed /intimation shall be given:
— Concerned ROC within 30 days of High Court’s order.
— Stock Exchanges.
FCRLP-Dec. 2005
22
—
—
—
—
—
Bankers including for closure of old Bank Accounts.
Central Excise/Service Tax Registration authorities.
VAT/Sales Tax Registration authorities
Customs authorities.
With various courts in case of:
— claims against the transferor company;
— claims made by the transferor company.
— Income tax authorities.
— In all other places, where the transferor company is a party.
Answer 1(b)
The objection of Registrar is not tenable as Sections 391 and 77A are
independent of each other. The Legislative intention behind the introduction of
Section 77A is to provide an alternative method by which a company may buyback its
own shares upto a certain percentage.
There is nothing in the provisions of Section 77A to indicate that the jurisdiction of
the Court under Section 391 or 394 has been taken away or substituted. Section 77A
is an enabling provision and the Court’s power under Sections 100 to 104 and 391
are not in any way affected. [TCI Industries Ltd., (2004) 118 Comp. Cas. 373 (AP)
N.V. Ramana J.].
In the case of Union of India v. Sterlite Industries (India) Ltd. (2003)-(113)-Comp
Cas 0273, (Bom), the Court observed that the non obstante clause in Section 77A,
namely “Notwithstanding anything contained in this Act……” means that
notwithstanding the provisions of Section 77 and Sections 100 to 104, the company
can buy-back its shares subject to compliance with the conditions mentioned in
Section 77A without approaching the Court under Sections 100 to 104 or
Section 391.Therefore, Section 77A is an enabling provision and the Court’s powers
under Sections 100 to 104 and Sections 391 are not in any way curtailed or affected.
The provisions of Section 77A are applicable only to buy-back of securities under
Section 77A and the conditions applicable to Sections 100 to 104 and Section 391
cannot be imported into or made applicable to buy-back of securities under
Section 77A. Similarly, the conditions for buy-back of securities under Section 77A
cannot be applied to a scheme under Sections 100 to 104 and Section 391, as the
two operate in independent fields.
In the case of Himachal Telematics Ltd. v. Himachal Futuristic Communications
Ltd. (1996) 86 Comp Cas 325 (Del) a scheme of amalgamation was to be
undertaken. However, the transferee company had a subsidiary which was holding
shares of the transferor company. An objection was raised that the sanction of the
scheme of amalgamation would result in the buying back by the transferee company
of shares of its subsidiary and would thereby violate the provisions of Sections 42
and 77 of the Act. Dealing with the argument regarding violation of Section 77, it was
held that no violation would result as a consequence of sanctioning the scheme of
amalgamation as the transferee company was not buying any of its own shares.
In Gurmit Singh v. Polymer Papers Ltd. (2003) 45 SCL 251 (CLB – N. Delhi),
petitions were filed under Sections 397 and 398. The issue considered in this case
was whether the power of CLB is subject to compliance with the provisions of
23
FCRLP-Dec. 2005
Section 77A in view of its non obstante clause. It was observed that the object of
Section 77A is to put some checks and balances when a company, on its own,
desires to buy-back its own shares and as such Section 77A has no application in a
case where the CLB exercises its powers under Section 402. The contention that no
court can bypass the provisions of Section 77A would only mean that the provisions
of those Sections empowering the Court to pass an order on a company to purchase
its own shares would be nugatory. When the Legislature had intended that the CLB
should have the power to order purchase of its own shares by a company with the
purpose of putting an end to the matters complained of, it would never have intended
that such a power was subject to the provisions of other Sections. Thus, the powers
of the CLB to pass an order directing a company to purchase its own shares in terms
of Section 402 are not curtailed by the provisions of Section 77A. Moreover,
Section 402 empowers the CLB to direct purchase of shares of a member not only by
the company but even by other members.
It was also held that even assuming that Section 77A is a bar to give a direction
to a company to purchase its shares, directions can be given to other members to
purchase the shares of any member as long as the direction is with a view to put an
end to the matters against which complaints were raised. The ultimate aim in such a
direction is to safeguard the interest of the company and its members.
Question 2
(a) Allen Ltd., a listed company, is in the process of acquiring the entire paid-up
share capital of Ben Ltd. The Board meeting of Allen Ltd. is to be convened
for approving the issue of offer document. You are required to list out the
documents to be placed before the Board meeting for its consideration.
(b) Draft a petition to the court for sanctioning the scheme of amalgamation
covering in brief all the relevant points mentioned under Section 394(1).
(8 marks each)
Answer 2(a)
Documents to be tabled at the Board meeting held for issue of offer document
are:
— A final draft of the offer document to be dispatched to shareholders of Ben
Ltd.
— A final draft of form of acceptance referred to in the offer document.
— Individual responsibility letters each signed by one of the directors of the
company confirming that they accept responsibility for the information
contained in the offer document.
— Powers of attorney executed by each of the directors authorizing any other
director to approve and execute all documents and to do all acts and things
necessary or desirable to implement the offer.
— Letters from the financial advisor, accountants, solicitors of both the
companies for inclusion of their names in the offer document.
— Letter from the auditors of the company in relation to the indebtedness of the
company.
— A schedule of estimated expenses to be incurred by the company and Ben
Ltd. in connection with the offer as stated in the offer document.
FCRLP-Dec. 2005
24
— A letter from the auditors relating to the company’s working capital
requirements.
— In respect of each director not present at the meeting, a copy of the latest
proof of the offer document initialed by him.
— Draft press announcement to be issued by the company.
Answer 2(b)
IN THE HIGH COURT OF JUDICATURE AT……….
Company Petition No…… of……..
In the matter of the Companies Act, 1956
AND
In the matter of scheme of amalgamation between ABC Ltd. and XYZ Ltd.
ABC Ltd.
Petitioner (Transferor)
XYZ Ltd.
(Transferee)
Petition to sanction Amalgamation of ABC Ltd. with XYZ Ltd.
The Petition of ABC Ltd., the Petitioner is as follows:
The object of this Petition is to obtain sanction of Court to the proposed
amalgamation to combine the resources of ABC Ltd. and XYZ Ltd. with a view to
optimize their utilization, effect internal economies and improve efficiency.
The company was incorporated under the Companies Act, 1956 with a nominal
capital of Rs. 5.00 Lakhs divided into 5,000 Equity Shares of Rs. 100/- each.
The company is trading company and dealing in the coal business activities
mainly. The objects are more particularly described in the company’s MOA annexed
with the Petition.
Both the companies have same business activities and by way of amalgamation,
the sales, income and delivery schedule will help in improving market share, self
dependency and achieving competitive edge.
The company has reserves and surplus of Rs. 141.28 lacs, fixed assets of net
value of Rs. 26.51 lacs and current assets of Rs. 452 lacs and against these it has a
liability of secured loan of Rs. 106 lacs and current liability of Rs. 210 lacs.
Terms and Conditions:
Appointed date: 1st April, 2005. All the undertakings and liabilities of the
company shall be transferred to the transferee company as from the appointed date,
etc.
By an order made in the above matter on …………. the Petitioner was directed to
convene a meeting of creditors/members for the purpose of considering and, if
thought fit, with or without modifications, the said amalgamation, and said order
directed that CD or failing him EF should act as the chairman of the said meeting and
should report the result thereof to this Court.
Notice of the meeting was sent individually to all the members and creditors as
directed by the order together with the copy of the scheme of amalgamation and of
25
FCRLP-Dec. 2005
the statement required under Section 393 and a form of proxy. The notice of the
meeting was also advertised as directed by the Court in the following newspapers:
Dainik Bhaskar on…………………..
Free Press ……………..
On …………. A meeting of members/creditors duly convened in accordance with
the said order was held at …………… and the said EF acted as the Chairman of the
meting.
The said EF has reported the result of the meeting to this Hon’ble Court.
The said meeting was attended by all the members/creditors and the total value
of their shares/debts is Rs…… The said amalgamation was approved by all the
members/creditors unanimously without any modification and the following resolution
was passed as a special resolution:
“RESOLVED that the arrangement as embodied in the Scheme of Amalgamation
of ABC Ltd., the Transferor Company with XYZ Ltd., the Transferee Company, placed
before the Meeting and initialled by the Secretary of the Transferee Company for the
purpose of identification, be and is hereby approved;
RESOLVED FURTHER that the Board of Directors of the Transferee Company
be and are hereby authorised to do all such acts, deeds, matters and things as are
considered requisite or necessary to effectively implement the said Scheme of
Amalgamation and to accept such modifications and/or conditions, if any, which may
be required and/or imposed by the Hon’ble High Court of Judicature at Bombay
and/or by any other authority while sanctioning said Scheme of Amalgamation".
The Petitioner/transferor company submits that the transferee company has also
filed a similar petition before this Hon’ble Court for the sanction of the scheme.
The petitioner/transferor company has disclosed all material particulars in relation
to itself and the transferee company.
It is further submitted that no investigation proceedings in relation to the
petitioner/transferor company under Sections 235-251 of the Companies Act, 1956
are pending or were ever initiated.
The petitioner/transferor company submits that the scheme does not affect any
material interest of the employees or anybody else.
It is submitted that necessary directions may be given to issue notice to the
Central Government through the Regional Director, ….. Region at …….. and the
Official Liquidator attached to this High Court at….. and for publication of notice of
hearing under Rule 80 of the Companies (Court) Rules, 1959.
PETITIONER
Question 3
(a) In the context of corporate restructuring, briefly mention the provisions of
Section 395 relating to powers and duties to acquire shares of shareholders
dissenting from scheme or contract approved by majority shareholders.
(5 marks)
(b) Explain the concept of 'management buy-out'.
(5 marks)
(c) Explain the concepts of 'financial restructuring' in the cases of undercapitalised and over-capitalised companies.
(6 marks)
FCRLP-Dec. 2005
26
Answer 3(a)
Sub-section (1) of Section 395 lays down that where a scheme or contract
involving the transfer of shares or any class of shares of transferor company to
transferee company has, within four months after the making of the offer by the
transferee company, been approved by the holders of not less than nine-tenth in
value of the shares whose transfer is involved, the transferee company may, at any
time within two months after the expiry of the said four months, give notice in the
prescribed manner to any dissenting shareholder, that it desires to acquire his
shares. The transferee company shall, unless on an application made by the
dissenting shareholder within one month from the date on which the notice was
given, the Court thinks fit to order otherwise, be entitled and bound to acquire those
shares on the terms on which under the scheme or contract, the shares of the
approving shareholders are to be transferred to the transferee company.
The Board of Directors of the transferor company is required to consider the draft
scheme and either accept it or reject it.
If the Board of the transferor company accepts the offer, it must call and hold a
general meeting of the shareholders of the company to pass a resolution by the
shareholders of not less than nine-tenth in value.
If the shares in the transferor company held as aforesaid are in excess of onetenth of the aggregate of the value of all the shares in the company of such class, the
provisions of sub-section (1) shall not apply unless—
(a) the transferee company offers the same terms to all holders of the shares of
that class, whose transfer is involved; and
(b) the holders who approve the scheme or contract, besides holding not less
than nine-tenths in value of the shares (other than those already held as
aforesaid), whose transfer is involved, are not less than three fourths in
number of the holders of those shares.
Any sums received by the transferor company shall be paid into a separate bank
account, and any such sums and any other consideration so received shall be held
by that company in trust for the several persons entitled to the shares.
Answer 3(b)
Management Buy-Out
Management buy-out is a form of corporate divestment and has become very
popular in UK, US and other European nations. When there is a hostile raid for
takeover, shareholders offer their equity and voting rights to the senior management
executives with a view to pass the management to own persons rather than to
unwanted acquirers. Management buy-out is also generally resorted to in those
companies where the division or subsidiary is unprofitable and the owner cannot find
an alternative buyer at a higher price.
A Management Buyout (MBO) is simply a transaction through which the
incumbent management buys out all or most of the other shareholders. The
management may take on partners, it may borrow funds or it can organize the entire
restructuring on its own. An MBO begins with arrangement/raising of finance.
Thereafter, an offer to purchase all or nearly all of the shares of a company not
presently held by the management has to be made which may necessitate a public
offer and even delisting. Consequent upon this, restructuring may be affected and
once targets have been achieved, then the company can go public again.
27
FCRLP-Dec. 2005
Answer 3(c)
Restructuring of under-capitalized Company
A company should always try to seek a balance between its debt and equity
keeping in view its financial requirements at a particular point of time.
An under-capitalized company may consider restructuring its capital by taking
one or more of the following corrective steps:
(i) injecting more capital whenever required either by resorting to rights issue or
additional public issue.
(ii) resorting to additional borrowings from financial institutions, banks, other
companies etc.
(iii) issuing debentures, bonds, etc. or
(iv) inviting and accepting fixed deposits from directors, their relatives, business
associates and public.
Restructuring of over-capitalized company
If a company is over-capitalized, its capital also requires restructuring by taking
following corrective measures:
(i) Buy-back of own shares.
(ii) Paying back surplus share capital to shareholders in the form of special
dividend, etc.
(iii) Repaying loans to financial institutions, banks, etc.
(iv) Repaying fixed deposits to public etc.
(v) Redeeming its debentures, bonds, etc.
Question 4
(a) Prudent Ltd. has agreed to acquire 51% of the holding of Volatile Co. Ltd. for
Rs. 100 crore in cash and by issuing 10% non-convertible debentures of
Rs. 100 each for Rs. 150 crore. As one of the promoters of Volatile Co. Ltd.
demanded payment in cash instead of debentures, Prudent Ltd. decided to
make cash payment in place of non-convertible debentures at a discount of
10%. The company does not have necessary cash to meet the obligation.
How can the company raise necessary cash to make the payment? Suggest
the ways the company can moblise funds for meeting the cash requirement
with their respective implications.
(8 marks)
(b) State whether the following statements are true or false and mention briefly
the relevant provisions of law:
(i) Appeal can be made to a superior court against orders under
Sections 391/394.
(ii) SEBI (Substantial Acquisition of Shares and Takeovers) Regulations,
1997 is applicable even if the acquirer is a person resident outside India.
(iii) A company can buy-back more than 25% of its paid-up capital in a single
year.
(iv) Section 396 contemplates a situation where a merger can take place
without the court's intervention.
(2 marks each)
FCRLP-Dec. 2005
28
Answer 4(a)
Where its own funds are found to be inadequate for funding of mergers,
takeovers, etc., a company may seek financial assistance from financial institutions
and banks depending on the quantum and urgency of their requirements. It may
issue further equity or preference shares, debentures, or even resort to external
commercial borrowings etc. Some companies raise funds through private placement
of their shares, debentures and other loan instruments.
Funding through equity share capital
Equity capital is the best suited source of funding a merger or a takeover. Equity
needs no servicing as a company is not required to pay to its equity shareholders any
fixed amount of return in the form of interest etc. When the profits of a company
permit, the Board at its discretion, may resolve to pay them a suitable amount as
dividend, after approval by the shareholders.
However, the disadvantage to the shareholders of the merged company is the
resultant temporary dilution in earnings per share (EPS) due to the issuance of
additional shares. Further, the time taken to raise equity needs to be considered.
Funding through preference share capital
Another source of funding a merger or a takeover is through the issue of
preference shares, but unlike equity capital, preference share capital involves the
payment of fixed preference dividend or a fixed rate of dividend. Therefore, the Board
of directors of the company has to make sure that the merged company or the target
company would be able to yield sufficient profits for discharging the liability in respect
of payment of preference dividend, i.e. the cost aspect should be duly considered.
Funding through financial institutions and banks
Funding of a merger or takeover with the help of loans from financial institutions,
banks etc. has its own merits and demerits. The advantage in this method of funding is
that the period of such funds is definite which is fixed at the time of taking such loans.
Therefore, the Board of the company is assured about continued availability of such
funds for the pre-determined period. On the negative side, the interest burden on such
loans, which is quite high in India, must be kept in mind by the Board while deciding to
use borrowed funds from financial institution.
Funding through debentures
A company may meet the cost of its proposed scheme of merger or takeover by
issuing debentures. This route involves a burden of interest, which the company
would be required to pay to the depositors in quarterly, six-monthly or annual
instalments according to the terms and conditions of issue. The Board must resort to
this route of funding if it is confident that after the proposed merger, the merged
company would be able to meet its commitment of timely payment of interest and
repayment of the principal amount of the debentures on redemption.
Answer 4(b)(i)
Yes, an appeal can lie to Supreme Court. In terms of Sub-section (7) of Section 391,
an appeal shall lie from any order made by a court exercising original jurisdiction under
this section to the court empowered to hear appeals for the decisions of the Courts.
29
FCRLP-Dec. 2005
Answer 4(b)(ii)
Yes, the statement is true. As per the definition of ‘acquirer’ as given in SEBI
(Substantial Acquisition of Shares and Takeovers) Regulations, 1997, ‘Acquirer
means any person who, directly or indirectly, acquires or agrees to acquire shares or
voting rights in the target company, or acquires or agrees to acquire control over the
target company, either by himself or with any person acting in concert with the
acquirer.’ Thus, the definition of acquirer does not distinguish between a person
resident in India or outside India. It applies to all individuals whether Indian residents
or foreign nationals or body corporates incorporated outside India.
Answer 4(b)(iii)
The statement is partly true. In terms of Section 77A(2)(c), a company cannot
buy-back more than 25% of its total paid-up capital and free reserves. Further, buyback of equity shares in any financial year should not exceed 25% of the total paid-up
equity capital of the company [Proviso to Section 77A(2)(c)].
However, in the case of SEBI v. Sterlite Industries (India) Ltd. (2003) 53 CLA 41
(2002) 113 Comp Cas 273 (Bom), the Bombay High Court has held that, the
submission that the non-obstinate clause in Section 77A gives precedence to that
section over the provisions of Sections 100 to 104, and Section 391 is misconceived.
Section 77A is merely an enabling provision and the court’s powers under
Sections 100 to 104 and Section 391 are not in any way affected.
Therefore, if so directed by the court, the company can buy back more than 25%
of its paid up capital in a single year.
Answer 4(b)(iv)
The statement is true. Section 396 of Companies Act, 1956 confers on the
Central Government special power to order amalgamation of two or more
government companies into a single company, if the Government is satisfied that it is
essential in the public interest that two or more companies should amalgamate.
This power is unaffected by, and can be exercised, notwithstanding anything
contained in Sections 394 and 395 but subject to the provisions of Section 396. But
this exclusion is only in respect of Sections 394 and 395 (including Section 392), and
not any other provision of the Act.
Question 5
(a) Desi Textiles Ltd. was incorporated in 1920. Ramchandra Rao, promoter of
the company, was follower of the ‘Swadesi Movement’ and started this
company with the objectives of — (i) generating employment for Indians; (ii)
giving good price to the cotton growers; and (iii) giving quality cloth to the end
users at affordable prices. Motto of the company was ‘for Indians, by Indians
and of Indians’.
The company was being run like a trust with nominal profits. The company
did well till 1980s and was well managed by the second and third generation
of promoters.
Due to changing business environment and problems like adverse
government policies, advancement in technologies, fierce competition from
foreign companies, opening-up of economy, the company's health
deteriorated. At present, the factory is working at 60% of its capacity. There
FCRLP-Dec. 2005
30
are statutory defaults and it is a capital starved company, hence, cannot
replace old machinery. Fourth generation promoters do not have the capacity
to raise capital themselves. However, looking at the intangibles of Desi
Textiles Ltd., like brand equity, loyal staff, and tangibles like — land and
building, one of the foreign investors contacted by Desi Textile Ltd. through
some intermediary is willing to infuse required funds in preferred capital on
the condition that 50% of the Board members (6 out of 12 directors) would be
nominated by them and the managing director would also be of their own
choice.
The intermediary also brought in for discussion another foreign company,
engaged as International Trading House. This foreign company, after proper
scrutiny, expressed willingness to invest required funds on the condition that
it will have 33% share in the equity of Desi Textiles Ltd. against which it will
supply machinery matching the requirements of modern day fashion world to
replace old and unusable machinery and it should be the sole marketing
agent of the products of Desi Textiles Ltd. in Europe. It also demanded 6
positions of directors including the position of the managing director.
Prakash, the great-grandson of Ramchandra Rao, is in a dilemma because
such infusion of foreign capital and changing composition of the Board with
foreign nominees would hit at the very objective/purpose of its incorporation
as a part of Swadesi Movement.
One more option was explored when Prakash approached an Indian
industrialist who agreed to infuse the required capital on the condition of
getting 74% stake in the equity share capital and 7 nominees on the Board
out of 12 directors and also the position of the managing director. This
proposal was not acceptable to Prakash because he was losing the control
on the affairs of the company without corresponding consideration to him.
If he refuses to accept any of the above proposals, the company has no
chance of survival. Advise Prakash.
(12 marks)
(b) A listed company is controlled by three separate groups, out of which two
groups are having family relations as per the definition of 'relative' and one
group is absolutely outsider. In the light of regulation 11 of the SEBI
(Substantial Acquisition of Shares and Takeovers) Regulations, 1997,
whether all the three groups shall be treated as 'person acting in concert' to
each other?
(4 marks)
Answer 5(a)
Prakash has to analyse all the three proposals available with him in depth
keeping in view the objectives of the company as well as his desire to control the
affairs of the company. He has also to take into consideration the fact that the
company is capital starved and the fourth generation promoters do not have the
capacity to raise capital themselves.
In the first option, the foreign investor is willing to bring in required funds in the
form of preference capital which could be preference share capital. The condition is
that 50% of the Board members would be nominated by the foreign investor including
the appointment of Managing Director. The option seems to be suitable as the funds
are proposed to be invested by the foreign investor through preference share capital
which would be redeemable or irredeemable upto a period of 20 years. Thus, there
31
FCRLP-Dec. 2005
would not be any dilution of control for the equity shareholders and the voting rights
shall remain with the promoter thereby giving him an effective control in respect of
passing of resolution at the general body meetings. The Managing Director proposed
to be appointed shall also share the responsibility for defaults, liabilities and violations
and would be willing to turn the company around. As 50% of the Board members
would be of the promoter the complete control at Board meetings would not vest with
foreign investor. Prakash, can therefore, opt for this proposal.
In the second proposal the International Trading House proposes to bring in 33%
of the equity share capital in lieu of replacing old machinery with the modern
machinery. No working capital is proposed to be infused into the company to meet its
working capital requirements and to enable it to meet its liabilities. The proposal of
International Trading House to be a sole marketing agent of the products of the Desi
Textiles Ltd. in Europe tends to be against the basic principles of the company which
is Desi movement, as the Trading House would tend to focus more on the foreign
market than on the Indian requirements. Though 50% of the Board members shall be
of the promoter, the Managing Director shall be of the International Trading House.
Nevertheless on the positive side, 77% of equity capital shall be with the promoter.
Further, the contention that Swadesi Movement shall be affected is to be judged
against the present day environment of fierce competition and opening up of
economy. The closed door policy may no longer be in the interest of the company or
even of the country. Therefore, Prakash may consider this option.
The third proposal given by an Indian industrialist to infuse the required capital
into the company on the condition of getting 74% of stake in the equity capital and
7 nominees on the Board, is certainly not in the interest of Prakash. Through such a
proposal Prakash would lose the controlling interest in the company as only 26% of
equity capital would be left with him. Simultaneously, he would also lose control over
the Board of Directors of the company. Prakash is therefore, right in not accepting
this proposal.
Answer 5(b)
The ‘persons acting in concert’ (PAC) defined under Section 2(e) of the SEBI
(Substantial Acquisition of Shares and Takeover) Regulations, 1997 means persons
who, for a common objective or purpose of substantial acquisition of shares or voting
rights or gaining control over the target company, directly or indirectly cooperate by
acquiring or agreeing to acquire shares or voting rights in the target company or
control over the target company.
Regulation 2(e)(2) enumerates certain types of persons who would be
considered as PAC without prejudice to the generality of the definition given in
Regulation 2(e) and unless the contrary is established. Hence, even when parties are
distinct but the entire transaction is carried out in a way having common objective
they would be considered as PAC.
Therefore, all the three groups would be treated as persons acting in concert.
Question 6
(a) "Valuation of shares is more an art than science." Do you agree? Also
explain various aspects of valuation of shares.
(5 marks)
(b) Explain the strategic reasons behind reverse mergers.
(5 marks)
FCRLP-Dec. 2005
32
(c) Calculate the 'minimum offer price' under the SEBI (Substantial Acquisition of
Shares and Takeovers) Regulations, 1997 in the following case:
— Negotiated price in three tranches Rs. 100, Rs. 125 and Rs. 75;
— Average weekly high-low of 26 weeks prior to public announcements
Rs. 110-56;
— Average high-low of two weeks prior to public announcement Rs. 110-75;
and
— Latest traded price Rs. 200.
(6 marks)
Answer 6(a)
Valuation of shares is more an art than science is a correct statement.
Determining the value of a business is a complicated and intricate process. Valuation
of shares in an amalgamation or takeover is made on a consideration of a number of
relevant factors, such as stock exchange prices of the shares of the two companies,
the dividends paid on the shares, relevant growth prospects of the companies, values
of the net assets and even factors which are not evident from the face of the balance
sheet like quality and integrity of the management, present and prospective
competition, yield on comparable securities, market sentiments, etc. Valuation has to
be tempered by the exercise of judicious discretion and judgement as it is a very
crucial and complicated issue.
Valuing a business also requires the determination of its future earnings
potential, the risks inherent in those future earnings, etc.
There is no method of valuation which is absolutely correct. Hence a combination
of all or some is usually adopted.
Usually two valuers are appointed to make recommendations independently.
Answer 6(b)
Generally, a loss making or less profit earning company merges with a company
with track record, to obtain the benefits of economies of scale of production,
marketing network, etc. This situation arises when the sick company’s survival
becomes more important for strategic reasons and to conserve the interest of
community. However, in a reverse merger, a healthy company merges with a
financially weak company. The main reason for this type of reverse merger is the tax
savings under the Income-tax Act, 1961. Section 72A of the Income-tax Act ensures
the tax relief, which becomes attractive for such reverse mergers, since the healthy
and profitable company can take advantage of the carry forward losses/of the other
company. The healthy units loses its name and surviving sick company retains its
name.
The other reasons for a reverse merger are -Economies of scales; use of patents
and trademarks; use of exclusive benefits; goodwill and brand name; use of
established distribution and marketing network.
Answer 6(c)
In terms of Regulation 20 of SEBI (Substantial Acquisition of Shares and
Takeovers) Regulations, the offer to acquire shares shall be made at a price which
shall be highest of –
(a) the negotiated price under the agreement.
33
FCRLP-Dec. 2005
(b) the average of the weekly high and low of the closing prices of the shares of
the target company as quoted on the stock exchange where the shares of the
company are most frequently traded during the twenty six weeks or the
average of the daily high and low of the closing prices of the shares as
quoted on the stock exchange where the shares of the company are most
frequently traded during the two weeks preceding the date of public
announcement, whichever is higher.
Therefore, in the given case negotiated price = Rs. 125
Average of High-Low of 26 weeks =
Average of High-Low of 2 weeks = =
110 + 56 166
=
= 83
2
2
110 + 75 185
=
= 92.50
2
2
Therefore, Minimum offer price should be = Rs. 125/- (being the highest of all the
prices)
Latest traded price is irrelevant.
Question 7
Advise on the following with supporting judicial decisions, if any:
(i) In a scheme of reconstruction by a multinational company listed in India, the
company wanted the minority shareholders to get out of the company by
selling their shares back to the promoters at a price determined by the
promoters. The minority shareholders were not given a choice whether they
wanted to tender their shares or not. In the meeting, there were six nonpromoter shareholders who voted against the scheme, but the chairman
declared that the motion was carried with an overwhelming majority of more
than 90% of shareholding. However, the minority shareholders contended
that they had a right to reject the offer. Will they succeed?
(ii) Vivek Ltd. proposed to merge with Bidur Ltd. The motions in the respective
court convened meetings were carried out with 99% of shareholders
agreeing for the same. The scheme of merger provided for retention of all the
employees, with terms of employment not adverse to the present terms.
However, there was no assurance about retrenchment in future. The
employees' union of Vivek Ltd. opposed it on the ground that it was against
the interests of the employees and the merger should not be sanctioned, as it
could lead to retrenchment of workers. Advise the employees' union.
(iii) You are the Company Secretary of Grow Fast Ltd. which has just merged
Agile Co. Ltd. with itself. The State government has sent a notice for payment
of stamp duty on the court order. However, the financial controller of your
company is of the opinion that as this is a court order, there is no liability to
pay stamp duty. Advise the company.
(iv) Is it correct to say that the term 'arrangement' has wider scope than
'compromise' under Section 390(b)? Give your considered views.
(4 marks each)
Answer 7(i)
Yes, minority shareholders can succeed. The facts of the case are similar to
FCRLP-Dec. 2005
34
Sandvik Asia Ltd. in Re. (2004) 121 Comp. Cases 58 CLA 125 (Bom) wherein the
proposal was for reduction of capital by paying it off at a premium to the shareholders
other than the company’s promoters. The shareholders were given no option for not
opting for the repayment of capital. It was held that, even a single minority
shareholder was entitled to oppose the proposal and if the court found the scheme to
be unjust, the court should not confirm the reduction as proposed. Dismissing the
petition, the court held that the proposal was highly inequitable, unjust and unfair, in
the sense that the minority shareholders will have to leave the company, and that the
promoters could purchase their shares at a price dictated by them.
Answer 7(ii)
The employees union would not succeed in this case as the facts are similar to
the case of Hindustan Lever Employees Union v. Hindustan Lever Ltd. (1994) 2 SCL
157 (SC).
In this case the Court held that, the scheme had fully safeguarded the interest of
employees by providing that the terms and conditions of their service will be
continuous and uninterrupted and their service conditions will not be prejudicially
affected by reason of the scheme. They would get what they were getting earlier. No
one can envisage what will happen in the long run and but on this hypothetical
question, the scheme cannot be rejected. The Court further held that once the
shareholders agree to a proposal, there can be no other objection.
Answer 7(iii)
The facts of the case are similar to the Hindustan Lever Ltd. v. State of
Maharashtra (2003) 117 Comp Cas SC 758.
The Supreme Court held in the case that the amalgamation scheme sanctioned
by the Court would be an “instrument”, within the meaning of Section 2(i) of the
Bombay Stamp Act, 1958 which transfers the properties from the transferor company
to the transferee company and the State Legislature has the legislative competence
to impose stamp duty on the order of amalgamation passed by a court.
The Supreme Court declared that Court order is a conveyance as per
Section 2(g)(iv) and the Court order is an instrument of conveyance and hence liable
for stamp duty.
Answer 7(iv)
The word ‘arrangement’ is of wider importance than ‘compromise’. Compromise
implies the existence of dispute which it seeks to settle. Reorganization of share
capital by consolidation of different classes of shares or division of shares into
different classes of shares amounts to an arrangement (Hindustan Commercial Bank
Ltd. v. General Electric Corporation 1960).
Compromise means a settlement of disputes by mutual concessions; whereas
arrangement denotes a final settlement.
Question 8
Write notes on the following:
(i) Cross cultural alliances
(ii) Franchising
(iii) Operational synergy
35
(iv) Bail-out takeovers.
FCRLP-Dec. 2005
(4 marks each)
Answer 8(i)
Cross Cultural Alliances
When an organization enters into an international market, there are certain
strategic management capabilities that must be modified for the venture to be
successful. The most important of these are flexible organizational culture, political
risk awareness, decentralized strategic planning, multifaceted management
structures and share authority. Cross cultural alliances thus require care, planning
and open attitude. One of the characteristics of culture is that it creates a form of
ethnocentrism in which one tends to regard activities which do not conform to one’s
own view of doing business, as abnormal or deviant. Differences in cultures have
clear implications for joint formulation of future business strategies. Therefore,
negotiations need to be carried out keeping the cultural differences in view.
Answer 8(ii)
Franchising
Franchising may be defined as a contract, either expressed or implied, written or
oral, between two persons or parties by which franchisee is granted the right to
engage in the business of offering, selling, distributing goods and service prescribed
in substantial part by franchiser. Operation of franchisee’s business is substantially
associated with franchiser’s trademark, service mark or advertisement or commercial
symbol. Franchising aims at distributing goods and services that have a high
reputation in the market and involves servicing the customers and end-users.
Answer 8(iii)
Operational Synergy
Synergy means working together. The gains obtained by working together by
amalgamated undertakings result into synergistic operating gains. When two
undertakings combine their resources and efforts they may with combined efforts
produce better results than two separate undertakings because of savings in
operating costs viz. combined sales offices, staff facilities, plants management, etc.
which lower the operating costs. Thus, the resultant economies are known as
synergistic operating economies. The worth of the combined undertakings should be
greater than the sum of the worth of the two separate undertakings i.e. 2 + 2 = 5. This
implies that synergy means the sum of the total is more than its part. If there are two
companies with profit of Rs. 10 each, then, if they merge, their profits will be more
than Rs. 20/-. This extra profit is called synergy.
Operational synergy is the synergy due to improvement in operations. Usually
operational synergy occurs due to deduction of costs or better utilisation of fixed
costs over a large base.
Answer 8(iv)
Bail-out Takeover
Takeover of a financially sick company by a profit earning company to bail out the
former is known as bail out takeover. Such takeover normally takes place in
pursuance to the scheme of rehabilitation approved by the financial institution or the
scheduled bank, who have lent money to the sick company. The lead financial
institutions, evaluate the bids received in respect of the purchase price track record of
the acquirer and his financial position. This kind of takeover is done with the approval
FCRLP-Dec. 2005
of the financial institutions and banks.
36
BANKING AND INSURANCE—LAW AND PRACTICE
Time allowed: 3 hours
Maximum marks: 100
PART A
(Answer Question No. 1 which is COMPULSORY and
any two of the rest from this part)
Question 1
Attempt any four of the following:
(i) A bank disbursed a loan to one of its customers after obtaining from him a
demand promissory note. Later on, it is noticed that the promissory note was
not stamped. Bank wants your advice on the following available options:
— to affix necessary stamp duty on the promissory note which has already
been executed; or
— to obtain a fresh promissory note duly stamped and executed from the
customer.
(ii) A letter of credit is valid upto 10th April, 2005 for shipment and 25th April,
2005 for negotiation. Amendment is received extending the date of shipment
upto 10th May, 2005. What will be the validity period of the letter of credit?
(iii) Prakash is the managing director of a limited company. In his capacity as the
managing director, he is authorised to sign alone for operating the company's
bank account which is maintained with Kripa Bank Ltd. in Chennai. Prakash's
personal account is also with the same bank, where he has maintained an
average credit balance of Rs. 15,000.
Prakash draws a cheque on the company's account in favour of himself for
Rs. 1.85 lakh and deposits it with the Kripa Bank Ltd. for credit to his personal
account. The cheque is duly collected by the Kripa Bank Ltd. and the proceeds
credited to his account. Subsequently, the company goes into liquidation and
the liquidator files a suit against the Kripa Bank Ltd. for recovery of the money
on the ground that there had been fraudulent conversion. What is the position
of the Kripa Bank Ltd.? Give reasons for your answer.
(iv) The Blessed Bank Ltd. had advanced a loan for purchasing a truck and deed
of hypothecation was executed by the owners in favour of the bank under
that agreement, the truck was pledged with the bank for due repayment of
the loan advanced by the bank. The truck remained in the possession of the
owners and was plied by the driver engaged by the owners. The truck
collided with a passenger bus due to which some passengers of the bus
were injured. The injured persons preferred separate claim applications. It
was claimed that the bank along with owners of the truck should be held
liable vicariously. Decide whether the hypothecating bank can be held liable
for payment of compensation to the victims of the accident caused by the
owners' employee. What is the status of the hypothecating bank — only as a
debtor or as a creditor?
(v) Raju has a current account with a bank. His clerk forged his signature to a
cheque for Rs. 15,000 and encashed it at the bank. Raju, having come to
know of this irregularity, claims the amount from the bank. Meanwhile, the
banker claims that it has paid the cheque in due course. Can the banker
36
37
escape from its liability? Give reasons.
FBILP-Dec. 2005
(5 marks each)
Answer 1(i)
In order to be valid, a document must be executed according to law after
compiling with all legal requirements. Among various legal requirements, one is that a
document must be stamped properly as per the provisions of law applicable to the
document in question. The liability of an instrument/document to stamp duty has to be
determined on or before the time of execution. The documents not stamped or understamped, are not properly stamped documents, and the same cannot be admitted in
evidence in the Court of Law. However, Section 35 of the Indian Stamp Act, 1899,
provides an exception that on payment of penalties and stamp duties, certain kinds of
documents can be admitted in evidence even after execution. However, some
documents are expressly excluded from the purview of said Section 35, and Demand
Promissory Note (DPN) is one of such excluded document.
Thus, an unstamped pronote will be inadmissible in evidence for any purpose. It
can neither be received nor acted upon.
Thus, in view of the above, the bank is advised not to go for first option, and
should go for the second option i.e., obtain a fresh DPN duly stamped and executed
from the customer, as such document is valid and can be admitted in evidence in the
Court.
Answer 1(ii)
Definition: Letter of Credit - A letter addressed by a bank, at the insurance and
responsibility of a buyer of merchandise, to a seller, authorizing him to draw drafts to
a stipulated amount under specified terms and undertaking conditionally or
unconditionally to provide eventual payment for drafts.
The provision of Liabilities And Responsibilities of Various Parties of Letter of
Credit Under Uniform Customs and Practice for Documentary Credits (UCPDC) 1993
Revision (ICC Brochure No: 500) in its articles provide that:
Article 8: A revocable credit may be amended or cancelled by the Issuing Bank
at any moment and without prior notice to the Beneficiary. However, the Issuing Bank
must reimburse the paying or the negotiating bank for any payment/negotiation made
by such bank prior to receipt by it of notice of amendment or cancellation, against
documents which appear on their face to be in compliance with the terms and
conditions of the credit.
Article 12: If incomplete or unclear instructions are received to advise, confirm or
amend a credit, the bank requested to act on such instructions may give preliminary
notification to the Beneficiary clearly stating that it is for his information only and
without responsibility of the Advising Bank. In any event, the Advising Bank must
inform the Issuing Bank of action taken and request it to provide the necessary
information.
The Issuing Bank must provide the necessary information without delay. The
credit will be advised, confirmed or amended only when complete and clear
instructions have been received.
As the date of shipment is extended and the extended date of validity of the letter
FBILP-Dec. 2005
38
of credit is not furnished, hence the validity date of letter of credit may also be taken
as 10.05.2005.
Answer 1(iii)
‘Kirpa Bank’ is liable for fraudulent conversion. It cannot seek the protection
available to a collecting banker as the circumstances show that the bank has failed to
act without negligence and it has not collected the cheque in good faith and without
negligence, it may be emphasized that—
(a) the banker must know his customers well. It should have been in the
knowledge of the collecting banker that Prakash is the Managing Director of
the United Company and was authorized to sign the cheques drawn by the
company alone in his official capacity. Any cheque drawn by him on behalf of
the company for credit of his personal account should have aroused sufficient
suspicion and he should have made proper enquiries before going in for
collecting it. Here, the collecting banker had failed to take such care.
(b) Prior to paying in of this particular cheque Prakash used to maintain an
average credit balance of Rs. 15,000 in his personal account. Therefore,
when he presented a cheque of Rs. 1,85,000, the bank should have made
due enquiries as to what was the source of such cheque the amount of which
was unproportionate to his range of income. Failure to make such enquiries
makes Bank liable, for negligence and it loses the statutory protection
available under Section 131 of the Negotiable Instruments Act.
Answer 1(iv)
In the said case, the jural relationship which comes into existence by
hypothecation is that of a creditor and a debtor. Hypothecating bank is only a creditor.
The only right which the hypothecating bank has under the arrangement is to have
the chattel sold for realising its dues. The title in the vehicle remains with the owners.
The de jure and de facto possession also remains with the owners and the only right
that the creditor bank has is to recover the amount by the sale of the vehicle in the
event of default. The hypothecating bank has no title over the vehicle. It is not even in
the constructive possession of the vehicle but it has merely a right to recover its dues
by the sale of that vehicle. So long as there is no default in the payment of the loan
amount, it cannot exercise that special right to sell the vehicle for realization of its
dues. Therefore, hypothecating bank is not liable for the compensation to the victims
of the accident caused by the vehicle.
Hypothecating banks status is that of only as a creditor. Facts of the case are
similar to the decided case of Bank of Baroda, Ahmedabad v. Babari Bachubhai
Hirabhai & Others, AIR 1987 Gujarat.
Answer 1(v)
The payment is not payment in due course. If the signature on the cheque is not
genuine, there is no mandate on the bank to pay the cheque and the cheque is a
mere nullity. Therefore the banker cannot escape from his liability. Every banker is
expected to know the signature of its customers.
Question 2
(a) "Financial sector reforms have changed the face of public sector banks in
39
FBILP-Dec. 2005
India." Do you agree? Explain what should be the mission for banking sector
in India.
(8 marks)
(b) State briefly the procedure followed by the National Housing Bank (NHB) for
securitisation of housing loans granted by housing finance companies.
(7 marks)
Answer 2(a)
The ongoing financial sector reforms and more particularly the banking sector
reforms aims at promoting a diversified, efficient and competitive financial sector with
the ultimate objective of improving the allocative efficiency of available resources,
increasing the return on investments and promoting an accelerated growth of the real
sector of the economy. It seeks to achieve the following:
(i) Suitable modifications in the policy framework within which various
components of the financial system operate, reduction in the levels of
resources pre-emptions and improving the effectiveness of direct credit
programmes;
(ii) Improvement in the financial health and competitive capabilities by means of
prescription of prudential orders, recapitalisation of banks, restructuring of
weaker banks, allowing free entry of new banks and generally improving the
incentive system under which banks function;
(iii) Building financial infrastructure relating to supervision, audit, technology and
legal frameworks; and
(iv) Upgradation of the level of managerial competence and the quality of human
resource of banks by reviewing the policies relating to recruitment, training
and placement.
How the face of public sector banks has been changed, specially after
introduction of the Financial Sector Reforms, can be tested on the following
parameters:
(i) Overall health of these Banks has improved.
(ii) Asset quality has improved.
(iii) Almost all PSBs are earning net profits.
(iv) NPA level has come down drastically.
(v) Capital Adequacy Ratio has improved substantially.
(vi) Latest technology has been adopted as such customer service has improved
tremendously. More PSBs banks are switching over to Centralised Banking
Solutions (CBS); ATMs have been set-up, Internet banking facilities are
being provided.
(vii) Supervisory and Monitoring Systems have been adopted, which are of
International Standards.
There is no doubt that banking sector reforms have increased the profitability,
productivity and efficiency of banks. The public sector banks are turning the spotlight
on the customer and offering quicker, better service. That includes everything from
ATM machines and computerized branches to never-before-seen marketing
initiatives. Even once-dowdy branches are being modernized and turned into
FBILP-Dec. 2005
40
symphonies of chrome and glass. With the commencement of the banking sector
reforms in the early 1990’s, further RBI has been consistently upgrading the Indian
banking sector by adopting international best practices.
Business per employee in most banks has gone up. Overall retail lending and
deposit business is expected to go up substantially. The response of the public sector
banks to the ideological changes brought about by the implementation of prudential
accounting norms and capital adequacy as well as the liberalization of structural
barriers to entry has been quite encouraging. After an initial bout of loss by quite a
few banks, there has been a quick recovery and the banks are on the way to
consolidation. The banking system has thus successfully responded to the move
towards increased market friendliness and competition with India joining the group of
economies broadly termed as the ‘emerging markets’.
Mission for Banking Sector in India should be, as recommended, by the
President of India, Dr. A.P.J. Abdul Kalam—
(i) Increase the agriculture and agro processing credit.
(ii) Create and nurture five rural development projects leading to employment
generation through enterprises for at least the million youth.
(iii) Innovatively fund the 3-lakh sick SSI units so that latest technology can be
infused.
(iv) Provide concessional interest rate funding for creation of corporate hospitals,
which can provide networked health care for the rural community.
(v) Participate in infrastructural development including provision of 100 million
quality dwelling units in rural areas.
(vi) Provide venture capital to innovative scientists and technologists in all the
three sectors.
Answer 2(b)
National Housing Bank (NHB)—Securitisation of Housing Loans
The NHB has taken the initiative to raise additional resources for investment in
housing by securitisation of the housing loans granted by housing finance companies.
The transaction of securitisation involves the following steps:
(i) The retail housing loans are assigned by the Housing Finance Company
(HFC) to the NHB. The resources of the HFC are thus augmented.
(ii) The housing loans which are repayable in equated monthly instalments (EMI)
are repackaged and offered to investors by NHB as tradable securities in the
form of pass through certificates (PTCs).
(iii) The PTCs are in the nature of trust certificates and represent proportionate
undivided beneficial interest in the pool of housing loans, i.e., the principal
interest and repayment of the mortgagee are paid to the investors of these
securities on a monthly basis.
(iv) The housing loans which are receivables scrutinized are to be held by a
Special Purpose Vehicle (SPV) in the nature of a trust declared by NHB.
41
FBILP-Dec. 2005
(v) A detailed profile of the mortgage pool is conducted and is divided into Class
A and B. While, Class-‘A’ PTCs are allotted to investors, Class ‘B’ go to
HFCs. ‘Class B’ PTCs are subordinated to ‘Class A’ and PTCs thus act as a
credit enhancement for ‘Class A’ PTC holders.
Question 3
(a) What precautions a bank should take before opening a letter of credit (L/C)
limit for the use of importers?
(5 marks)
(b) Write notes on any two of the following:
(i) 'Treasury management' in banks
(ii) 'Approved' and 'non-approved', securities for banks
(iii) 'Credit Information Bureau of India Ltd.' (CIBIL).
(5 marks each)
Answer 3(a)
Precautions while opening a Letter of Credit (L/C) Limit for the use of Importer
The bank should note the following points before opening the L/C limit for the use
of importer:
(i) The limit should not be disproportionate to the working capital needs/limit
sanctioned to the applicant, if any;
(ii) Proper arrangements for retiring the bills and for payment of other charges
like custom duty etc. should be made;
(iii) The L/C should be opened only to the regular customer of the Bank;
(iv) The applicant should be in possession of valid import licence from the Import
Control Authority where such licence is necessary.
Answer 3(b)(i)
Treasury Management in Banks
Treasury Management in Banks involves an effective internal and external inter
face. It perform a myriad of functions ranging from balance management, liquidity
management, reserves and investment, funds management, management of capital
adequacy to transfer pricing, technology and operations, risk management, trading
activities and offering hedge products. It has to work on arriving at an optimal size of
the balance sheet, interface with various liability and assets groups internally, give
correct pricing signals keeping in mind the liquidity profile of the bank on the external
front, it has to provide active trading support to the market, make two way prices, add
to the liquidity and continuously strive to provide the customers with risk added
solutions to their specific financial needs.
Treasury management combines in-depth, customized consulting with powerful
analytical tools-including more than a dozen proprietary computer models—to
translate data into relevant, understandable information. Treasury management
results in actionable solutions that address an organisation’s style.
FBILP-Dec. 2005
42
Treasury management help in—
— Growing revenues.
— Improving profitability of product portfolios
— Determining competitive strengths and weaknesses.
— Understanding buyer’s behaviors.
— Managing customers’ liquidity.
— Understanding the implications of key industry trends.
— Shaping critical strategic direction.
Answer 3(b)(ii)
‘Approved’ and ‘Non-approved’ Securities for Banks
The Banks use resources mobilized through deposits for giving loans as well as
for investment in various securities. The major part of investment funds is in approved
securities and is done to comply with Statutory Liquidity Ratio (SLR) requirements.
The approved securities generally consist of Central and State Government
securities. Bonds are issued by Public Financial Institutions, State Electricity Boards,
Municipal Corporations etc.
Non-approved securities are PSU Bonds, Unit of UTI, shares and debentures of
Joint Stock Companies etc.
Answer 3(b)(iii)
Credit Information Bureau of India Limited (CIBIL)
CIBIL has been set-up to compile and disseminate credit information on
borrowers in a systematic manner for sound credit decisions, thereby helping to
facilitate avoidance of adverse selection and thus, curbing growth of NPAs.
CIBIL’s aim is to fulfill the need of credit granting institutions for comprehensive
credit information by collecting, collating and disseminating credit information
pertaining to both commercial and consumer borrowers, to a closed user group of
members. Banks, Financial Institutions, Non Banking Financial Companies and
Credit Card Companies use CIBIL’s services. Data sharing is based on the Principle
of Reciprocity, which means that only Members who have submitted all their credit
data, may access Credit Information Reports from CIBIL. The relationship between
CIBIL and its members is that of close interdependence.
The establishment of CIBIL is an effort made by the Government of India and the
Reserve Bank of India to improve the functionality and stability of the Indian Financial
System by containing NPA’s while improving credit grantors’ portfolio quality. CIBIL
provides a vital service, which allows its members to make informed, objective and
faster credit decisions.
At present, CIBIL is entrusted with the task of development of a system of proper
43
FBILP-Dec. 2005
credit record and sharing credit information among financial intermediaries.
This would help in enhancing the quality of credit decisions; improving the assetquality of banks and facilitating faster credit delivery.
Information pertaining to suit filed accounts of willful defaulters as well as non-suit
filed accounts is now required to be filed by Banks with CIBIL.
Question 4
Attempt any five of the following:
(i) "We should have small number of large banks rather than large number of
small banks." Comment.
(ii) "Rating for banks is based on 'CAMELS' approach." Comment.
(iii) What is meant by 'virtual distribution' of bank products?
(iv) What is the amended definition of a 'cheque' under the Negotiable
Instruments Act, 1881?
(v) Distinguish between 'garnishee order nisi' and 'garnishee order absolute'.
(vi) Distinguish between 'quantitative credit control' and 'qualitative credit control'.
(3 marks each)
Answer 4(i)
The statement is True. The new era is going to be one of consolidation around
identified core competencies. Mergers and acquisitions in the banking sector are
going to be the order of the day. Successful merger of HDFC Bank and Times Bank
earlier and Standard Chartered and ANZ Grindlays has demonstrated that trend
towards consolidation is almost an accepted fact. We are also looking for such signs
in respect of a number of old private sector banks, many of which are not able to
cushion their NPAs, expand their business and induct technology due to limited
capital base. Coming times may usher in large banking institutions, if the
development financial institutions opt for conversion into commercial banking in line
with the recommendation of Narasimhan II.
Answer 4(ii)
‘CAMELS’ approach is being adopted for rating of banks. The Reserve Bank of
India has evolved this model for rating the Indian Banks. ‘CAMELS’ factors refer to:
C
A
M
E
L
S
=
=
=
=
=
=
Capital Adequacy
Asset Quality
Management
Earnings
Liquidity
System and Control.
Each of these six components would be weighed on a scale of 1 to 100. Each
component has also been divided into several segments.
Answer 4(iii)
FBILP-Dec. 2005
44
By ‘virtual distribution’ of banks products, we mean distribution of banking
services through electronic means with the use of state-of-the art technology. In the
recent years Indian Banking has witnessed a technological upswing. Some of the
innovations that are made possible on account of infusion of technology include Total
Branch Automation, Automated Teller Machines (ATMs), Electronic Funds Transfer
(EFT), Automated Cash Dispersing, Anywhere Banking, Anytime Banking, Home
Banking, Telebanking, Plastic cards, internet cards etc. The technology has really
changed the face of Banking in India.
Answer 4(iv)
Amended Section 6 of the Negotiable Instrument Act is that a cheque is a Bill of
Exchange drawn on a specified banker and not expressed to be payable otherwise
than on demand and it includes the electronic image of a truncated cheque and a
cheque in the electronic Form.
Answer 4(v)
‘Garnishee order nisi’: This order gives an opportunity to the Banker to prove that
the order could not be enforced.
If the banker does not make a counter-claim, the order becomes absolute
‘Garnishee order absolute’ actually attaches the account of the customer.
The expression “Garnishee” is derived from the French word garnir, which means
to warm. The object of garnishee order is the attachment by a judgment creditor of
moneys of the judgment debtor in the hands of third party (the garnishes) Bankers, as
the depositees of other people’s money, are the most usual receipts of garnishee
orders.
The Court may make Garnishee order nisi on an application with affidavit filed by
or on behalf of judgment creditor.
Garnishee order nisi gives an opportunity to the Banker to prove that the order
could not to be enforced. It restrains garnishee (the person sought to be warned)
from parting with any moneys due or accruing due to the judgment debtor and
contains orders for appearance of garnishee in the Court to show cause, if he can,
why such moneys shall not be taken in satisfaction of the debt due to the judgment
creditor.
However, if on the appointed day, banker does not make counter claim, the order
becomes absolute and whereupon the garnishee (bank) will pay over to the judgment
creditor the amount of the order and costs. Garnishee order absolute actually
attaches the account of the customer. Such payment operates as a full discharge by
the bank against his customer the judgment debtor.
Answer 4(vi)
Control of credit is one of the important function of a Central Bank in order to
make available appropriate money supply in the country and to achieve desirable rate
of economic growth, trade and price stability. Credit Control may be quantitative or
qualitative. Some of the important distinctions between the two types of control
methods are as under:
(i) Quantitative credit control methods aim to control the total quantity and cost
45
FBILP-Dec. 2005
of credit. Qualitative credit control methods control the use and direction of
credit.
(ii) Quantitative credit control methods are traditional and indirect whereas
qualitative credit control methods are direct.
(iii) Quantitative credit control methods are: Bank Rate Policy, Open Market
Operations – Variable Reserve Ratio. Where Qualitative credit control
methods are: Minimum margin for lending, ceiling on the amount of credit,
discriminatory rates of interest, Moral suasion.
PART B
(Answer Question No. 5 which is COMPULSORY and
any two of the rest from this part)
Question 5
Attempt any four of the following:
(i) Manoj applied for a life insurance policy. He stated in the application that he
had never smoked cigarettes. In fact, he had been smoking cigarettes for the
last 13 years and during the months before he applied for insurance, he was
smoking approximately 10 cigarettes daily. About 10 months later, Manoj
died of reasons unrelated to smoking. The beneficiary filed a claim for the
death proceeds. The insurer discovered that Manoj smoked cigarettes and
denied payment because of a material misrepresentation. Can the insurer
deny liability because of Manoj's false statement?
(5 marks)
(ii) Joseph Basker Raj applied for a life insruance policy on his life. Five months
after the policy was issued, he died. The death certificate named the
deceased as Joseph Prakash Raj,.his true name. The insurer denied
payment on the ground that Joseph had concealed a material fact not
revealing his real identity. Is it correct on the part of the insurer to deny
payment? Give reasons.
(5 marks)
(iii) Ganeshan assigned his policy to his minor son Kartik and appointed the
mother as the guardian to receive the money till his son was a minor. After
sometime, the family needed the money and decided to surrender the policy.
Whether surrender of the policy is possible? Suggest any other alternative by
which Ganeshan can take back the ownership over the policy?
(5 marks)
(iv) Suresh takes out an endowment policy for 15 years for Rs. 15,000 and the
premium payable is Rs. 1,200 per annum. He pays premium for 3 years and
then stops. What is the surrender value of the policy assuming that surrender
value of bonuses already accrued is Rs. 300?
(5 marks)
(v) Identify the type of hazard in the following cases giving reasons therefor:
(a) Defective lock on a door.
(b) Leaving car keys in an unlocked car.
(c) Defective wiring.
(d) Inflating the amount of claim.
(e) Leaving the cheque book on the table.
(1 mark each)
FBILP-Dec. 2005
46
Answer 5(i)
In a contract of insurance, there is an implied condition that each party must
disclose every material fact known to him. This type of contract is called Ueberrimal
fide i.e. contract of utmost good faith, which requires duty of full disclosure of material
facts by insurer as well as insured.
Every circumstance is material, which would influence the judgment of prudent
insurer in fixing the premium or determining whether he should take the risk or not.
Therefore, the facts regarding age, height, weight, smoking drinking habits etc. must
be disclosed. It is not for the proposer to decide which fact is material to the risk.
The policy is void when the insured knowingly makes false statements that are
material. Smoking habits are clearly material. So, the insurer can deny the liability
Answer 5(ii)
The intentional concealment of the true identity is material and it breached the
obligation of good faith. So the insurer can deny payment.
Answer 5(iii)
The surrender of the policy is not permitted. They have to wait till the child
becomes a major. The only manner in which Ganeshan can take back the ownership
over the policy is to have the policy reassigned to himself.
Answer 5(iv)
The premium paid is 3 x 1,200 = Rs. 3,600.
The premium payable is 15 x 1,200 = Rs. 18,000.
The ratio between the two is Rs. 3,600 ÷ Rs. 18,000 = 1/5
∴
The surrender value of the policy is 1/5 x 15,000 = Rs. 3,000
300
(+) Accrued Bonus
Rs. 3,300
Answer 5(v)
(a) Physical hazard: It increases the chance of loss.
(b) Morale hazard: It is indifference to loss because of existence of insurance.
(c) Physical hazard: It increases the chances of fire.
(d) Moral hazard: It is character defects in an individual that increase the severity
of loss.
(e) Physical hazard: It increases the chance of theft and chance of loss.
Question 6
(a) Describe the role of the Export Credit Guarantee Corporation (ECGC) in risk
management in international trade.
(8 marks)
(b) Explain the concept of 'subrogation'. How is the doctrine of subrogation
applied on marine insurance policies, personal accident insurance policies
and fire and miscellaneous insurance policies?
(7 marks)
Answer 6(a)
Export Credit Guarantee Corporation (ECGC) was established by the
47
FBILP-Dec. 2005
Government of India in the Year 1957 to strengthen the export promotion drive by
covering the risk of exporting on credit. ECGC plays an important role in risk
management in international, trade, in terms of following:
— Insurance protection to exporters against payment risks.
— Guidance in export related activities.
— Provides information on credit-worthiness of overseas buyers.
— Provides information on about 180 countries with its own credit ratings.
— Makes it easy to obtain export finance from banks/financial institutions.
— Assists exporters in recovering bad debts.
Policies Available from ECGC
ECGC provides various policies to exporters, which can broadly be classified as
standard policies, specific policies, financial guarantees and special schemes.
At pre-shipment stage, standard policies protect the exports against risk involved
in exports on short-term credit basis.
Specific policies protect exporters against risk involved in exports on deferred
payment terms or services to foreign parties.
ECGC also provides financial guarantees to banks to protect them from risks of
loss involved in the financial support to exporters at pre and post shipment stages.
ECGC has certain special schemes such as transfer guarantee, overseas
investment insurance and exchange fluctuation risk insurance to save the specific
needs of exporters.
Answer 6(b)
Subrogation may be defined as the transfer of rights and remedies of the insured
to the insurer who has indemnified the insured in respect of the loss. If the insured
has any rights of action to recover the loss from any third party, who is primarily
responsible for making good the loss, the insurer, having paid the loss, is entitled to
avail of these rights to recover the loss from the third party. The effect is that the
insured does not receive more than the actual amount of his loss and any recovery
effected from the third party goes to the insurer. The principle of subrogation arises
from the principle of indemnity. To allow the insured to collect the claim from the
insurers and then collect again from the person responsible for the loss would be
contrary to the principle of indemnity. He would then, be clearly making a profit out of
the misfortune, and that would defeat the principle of indemnity. Common law has,
therefore, evolved the doctrines of subrogation and contribution as corollaries of
indemnity. The doctrine may be illustrated by the following examples:
(i) Insured property may be destroyed by fire caused by the negligence of a
third party that is at law responsible to make good the loss. The insurer
having indemnified the insured is entitled to the insured’s right of recovery
against the third party.
(ii) If cargo is damaged due to the negligence of a carrier (e.g. railways, truck
operators, shipping companies etc.) who have an obligation to make good
the loss of the insured, the benefit of this obligation passes to the insurer.
FBILP-Dec. 2005
48
(iii) A private car may be damaged in a collision caused by the rash and
negligent driving of a truck. The private car owner’s right of recovery against
the truck owner is transferred to the insurer who has indemnified the loss.
(iv) Under products liability policies, if a retailer is indemnified in respect of a
claim preferred against him for a defective product, the insurer can recover
from the wholesaler or manufacturer who supplied the product, if liability can
be established against him.
(v) Under fidelity guarantee policy, the insurer after payment of the loss is
entitled to claim reimbursement from the defaulting employee.
Subrogation under policy conditions
The right of subrogation is implied in all contracts of indemnity. In other words its
application to contracts of indemnity is automatic without any express condition in the
contract. It arises, however, only after payment of a loss.
(i) Marine insurance policies are subject to the doctrine of subrogation, but the
policies do not contain any condition, and the insurers are subrogated to the
rights of the insured only after payment of claim.
(ii) Personal accident insurance policies are not contracts of strict indemnity, and
hence the doctrine of subrogation does not apply to these policies.
(iii) Fire and miscellaneous policies contain an express condition to the effect
that the insurer even before payment of a claim can exercise the right of
subrogation.
Question 7
(a) State briefly the functions which are mandated for the Insurance Regulatory
and Development Authority (IRDA).
(b) Narrate the salient features of licensing of surveyors and loss assessors.
(c) Explain different types of marine insurance policies generally being issued by
insurance companies in India.
(5 marks each)
Answer 7(a)
Function which are mandated for IRDA
IRDA has been established to protect the interest of holders of insurance
policies, to regulate, promote and ensure orderly growth of insurance industry and for
matters connected therewith or incidental thereto. IRDA has a vital role in the
insurance sector by virtue of its functions mandated:
(i) To issue certificate of registration, renew, withdraw, suspend or cancel such
registration.
(ii) To protect the interests of the policy holders/insured in the matter of
insurance contract with the insurance company.
(iii) To specify requisite qualifications, code of conduct and training for insurance
intermediaries and agents.
(iv) To specify code of conduct for surveyors/loss assessors.
(v) To promote efficiency in the conduct of insurance business.
(vi) To promote and regulate professional organizations connected with the
insurance and reinsurance organizations and connected with such business.
49
FBILP-Dec. 2005
(vii) To undertake inspection, conduct enquiries and investigations including audit
of insurers and insurance intermediaries.
(viii) To control and regulate the rates, terms and conditions to be offered by
insurer.
(ix) To specify the form and manner for maintenance of book of accounts and the
statement of accounts.
(x) To regulate investment of funds by the insurance companies.
(xi) To supervise the functioning of Tariff Advisory Committee.
(xii) To specify the percentage of life and general insurance business to be
undertaken in the rural or social sector.
Answer 7(b)
Licensing of Surveyors and Loss Assessors
The features as stated under section 64UM of the Insurance Act are:
(i) Unless a valid licence is held no person shall act as surveyor.
(ii) The licence is to be issued by IRDA.
(iii) In respect of any loss whose amount is equal to or more than Rs. 20,000/surveyor needs to be appointed and report submitted before the claim is
settled.
(iv) Provision for a surveyors and Loss Assessors Committee.
(v) The IRDA has prescribed that the surveyors undergo practical training as
part of the licensing procedure.
(vi) Surveyors have been categorized and licence fee has been prescribed
according to the category of surveyorship.
(vii) The surveyor’s duties and responsibilities have also been defined by the
surveyor’s regulations.
(viii) Code of conduct to be followed by the surveyors.
Answer 7(c)
Different types of marine insurance policies generally being issued by insurance
companies in India are given as under:
(i) Annual policy;
(ii) Declaration policy;
(iii) Special declaration;
(iv) Open cover;
(v) Duty policy;
(vi) Increased value insurance.
Question 8
Attempt any five of the following:
(i) Write short note on 'solatium fund scheme'.
(ii) "Self-insurance is the same as insurance." Comment.
(iii) Explain rural sector definition for insurance companies as per the Insurance
FBILP-Dec. 2005
50
Regulatory and Development Authority (IRDA) regulations.
(iv) Explain basic categories of risks.
(v) Explain 'insured's declared value' (IDV) under the motor insurance.
(vi) What are the 'captive insurers'?
(3 marks each)
Answer 8(i)
Solatium Fund Scheme
Solatium Fund Scheme is a scheme introduced in accordance with the provisions
of the Motor Vehicle Act to provide compensation to the victims of a Hit and Run
Motor accident.
It is the scheme formed by the Central Government to provide compensation to
the victims of “Hit and Run” motor accident. However, the amount of compensation
will vary in the event of death, grievous hurt respectively.
The applicant is required to submit the application seeking the compensation in
the prescribed form to the Claims Enquiry Officer of the Sub-division/Taluk or Mandal
where the accident takes place. Some of the important factors of the scheme include
amount of compensation, time limit to make an application, mode of payments etc.
Answer 8(ii)
Self-insurance is the same as insurance
Self-insurance is a special form of planned retention whereby part or all of a
given loss exposure is retained by the firm. Self-insurance is widely used in workers
compensation insurance. It is also used by employers to provide good health benefits
to employees. However, Self-insurance is not technically insurance as the pure risk is
not transferred to an insurer.
Answer 8(iii)
Rural sector definition for insurance companies
The insurance companies are allowed to follow the census of India style for
identifying and tapping rural business market. Anything that is not urban will be
treated as rural.
Going by the 1991 census, the word rural was not defined. For urban, there were
three parameters:
(a) The place should have a population of more than 5000.
(b) The density of population should be more than 400 persons per sq. km. and
finally.
(c) 75% of the male population should be engaged in non-agricultural pursuit.
Answer 8(iv)
Basic categories of ‘risks’
Risk can be classified into several distinct categories. The major categories of
risks are as follows:
FBILP-Dec. 2005
51
(a) Pure and speculative risks;
(b) Static and Dynamic risks;
(c) Fundamental and Particular risks.
Answer 8(v)
Insured Declared Value (IDV) under Motor Insurance
The IDV of the vehicle will not be deemed to be the sum insured for the purpose
of this tariff and it will be fixed at the commencement of each policy period for each
insured vehicle.
The IDV of the vehicle is to be fixed on the basis of manufacturer’s listed selling
price of the brand and model as the vehicle proposed for insurance at the
commencement of insurance/renewal and adjusted for depreciation (as per schedule
specified below):
Schedule of Depreciation for Arriving at IDV
Age of the Vehicle
Not Exceeding 6 months
Exceeding 6 months but not exceeding 1 year
Exceeding 1 year but not exceeding 2 years
Exceeding 2 years but not exceeding 3 years
Exceeding 3 years but not exceeding 4 years
Exceeding 4 years but not exceeding 5 years
% of Depreciation for fixing IDV
5%
15%
20%
30%
40%
50%
Answer 8(vi)
Captive Insurer
A firm can establish a captive insurer—an insurance company established and
owned by the parent firm for the purpose of insuring the firm’s loss exposures. Most
captive insurer are located in Bermuda because of the favorable regulatory climate,
low capitalization requirements and low taxes. There are several reasons why
corporations have framed captive insurers-reduction in premium costs, greater
stability of earnings, and easier access to a reinsurer, profit center, international
advantage etc.